First Commonwealth Financial Annual Report 2004

Plain-text annual report

Building the foundation upon which successful communities grow 2004 Annual Report Table of Contents Message to Shareholders ...........................................................2 Building Successful Communities ...............................................4 Afﬁliate Presidents .....................................................................10 Board of Directors ...................................................................... 11 Corporate Information/Market Area ...........................................12 Management’s Report on Internal Control Over Financial Reporting ...........................................................13 Reports of Ernst & Young, LLP, Independent Registered Public Accounting Firm ...........................................14 Report on Effectiveness of Internal Control over Financial Reporting ...........................................14 Report on Consolidated Financial Statements .....................15 Consolidated Financial Statements ...........................................16 Notes to Consolidated Financial Statements ............................20 Quarterly Summary of Financial Data .......................................44 Selected Financial Data .............................................................45 Management’s Discussion and Analysis of Financial Condition and Results of Operations .........................46 Common Stock Information .......................................................63 Shareholder Information ............................................................64 Golden Tower Awards and Spirit of Community Awards ................................ inside back cover A Message to Shareholders T he year of 2004 was another year of progress for First Commonwealth highlighted by growth of over $1 billion in assets and substantial expansion of our community ofﬁce network. This growth has been balanced with a continued emphasis on improving our corporate governance and risk management processes. First Commonwealth Financial Corporation reported net income of $16.6 million for the fourth quarter of 2004 that translates into $0.24 basic and diluted earnings per share for the quarter. This is compared to net income of $12.7 million and basic and diluted earnings per share of $0.21 for the fourth First Commonwealth enters 2005 with conﬁdence in our strategic plan to grow and improve the corporation. The continued support and conﬁdence of the First Commonwealth shareholders is greatly appreciated. quarter of 2003. Fourth quarter 2004 earnings per share reﬂect an increase of 14.29% over the same quarter of 2003. Return on equity was 12.31% and return on assets was 1.06% for the fourth quarter of 2004 compared to 12.07% and 1.03% respectively for the related 2003 period. Net income for the year ended December 31, 2004, was $38.7 million or $0.59 basic and $0.58 diluted earnings per share compared to $53.3 million net income and $0.90 basic and diluted earnings per share for the year ended December 31, 2003. Return on equity was 7.82% and return on assets was 0.66% for the full year of 2004 compared to 12.95% and 1.12% respectively for the year 2003. The full year 2004 results included a previously disclosed charge of $29.5 million ($19.2 million after tax) representing a penalty for the prepayment of $440 million of Federal Home Loan Bank (FHLB) long-term borrowings. The reﬁnancing expanded the maturity distribution of the company’s FHLB advances in order to minimize the impact of maturities on any one year. This action also improved net interest margin through lower interest cost on the FHLB advances. The prepayment penalty, on an after-tax basis, reduced the company’s earnings per share for year 2004 by $0.29. Results for the year 2003 included a $3.0 million (pre-tax) gain on the sale of two branches. The gain on an after-tax basis added $2.0 million or $0.03 per share to the 2003 results. 2 First Commonwealth strength “First Commonwealth literally catapulted me to the next level by allowing me to bid on larger contracts with conﬁ dence. They gave me the ability to grow my business.” —Michael Dahma, President, MDA Irwin, Pennsylvania 4 First Commonwealth Successful communities—large and small—all have one thing in common. They are built on a solid foundation. A strong economy. A network of well-run civic and service organizations. Good schools. People who care about each other. Successful communities allow businesses to proﬁt and grow. They employ people. They encourage ideas and innovation. What provides the solid foundation for communities that prosper? It is the people who invest in their success. And that’s what First Commonwealth does every day. In 2004, First Commonwealth was named the #1 Small Business Administration lender in Western Pennsylvania. The bank is also #1 in the state and #6 in the country in SBA CommunityExpress loans. When September 11, 2001 hit, businesses like Michael Dahma Associates (MDA) took a hit too. MDA, based in Irwin, Pennsylvania, is a promotional products distributor—everything from coffee cups to gold watches—for virtually any sized organization. But promotional products suddenly became low priorities for businesses, and Michael Dahma, MDA’s founder, was receiving few orders. What Michael needed was cash ﬂow to get him through until new contracts came along. And that’s what First Commonwealth vice president for the Southwest Region Alex Lima helped provide. A Small Business Administration loan and a subsequent line of credit kept MDA on its feet and allowed it to fulﬁll the biggest contract in its history: 32,000 beach towels for the Pittsburgh Pirates. “I can’t thank First Commonwealth enough for what they have helped our company accomplish,” Michael said. 2004 Annual Report 5 community “I had a dream and a shell of a restaurant that had a good reputation. First Commonwealth became my guardian angel and allowed me to renovate and reopen by St. Patrick’s Day!” —Ann Bock, Owner, Coyne’s Pub Indiana, Pennsylvania 6 First Commonwealth P eople don’t necessarily think of banks as being at the core of community success, but First Commonwealth thinks about it all the time. First Commonwealth is behind the scenes when an entrepreneur has a great idea for a new business but needs the capital to get started. First Commonwealth is there to ﬁnd creative ways to keep a struggling business operating. First Commonwealth is committed to offering strategies to help existing or well-established businesses grow. A longstanding community establishment would have been sorely missed had it closed its doors forever. Instead, First Commonwealth found a creative ﬁnancial solution for its owner, allowing her to fulﬁll her dream. A staple in the Indiana community for over 30 years, Coyne’s Pub was a small Irish restaurant with a faithful clientele and a reputation for good food and good company. When the Coynes decided it was time to close, however, their daughter, Ann “wasn’t ready for it to be over.” Coyne’s Pub had not been remodeled since the 1970s; Ann was determined to bring it up to par and use local materials and contractors to do it. With the help of First Commonwealth vice president and market manager Bill Staffen, and a creative commercial loan, Ann found a way to give Indiana its restaurant back. Since Coyne’s Pub reopened on St. Patrick’s Day 2004, its business has increased both in numbers of customers and employees. 2004 Annual Report 7 innovation “First Commonwealth presented the best collection of options for us and used creative ﬁ nancing to help us establish our business. We had hands-on guidance throughout the entire process.” —Jay Marshall, Co-Founder, Treelady Enterprises, LLC Turtle Creek, Pennsylvania 8 First Commonwealth F irst Commonwealth is also there when individuals and families need mortgages, home equity loans, insurance, and ﬁnancial advice. First Commonwealth’s ﬁrst priority has always been to serve and strengthen the communities in which it has a presence. Through its employees and its products, as well as its philosophy, First Commonwealth builds relationships with people all over Pennsylvania, with the intent of providing the impetus, the capital, and the service to promote success. First Commonwealth is building the foundation upon which successful communities grow. First Commonwealth believes that new businesses are essential to strengthening communities. Its ofﬁcers listen to people with good ideas and sound business plans, enabling them to start, and sustain, new companies. Garrett Haines and Jay Marshall were two friends who decided to abandon their conventional careers and pursue what they really loved in life. Out of their passion for music, sound, and technology, Treelady Enterprises was born. Treelady Enterprises is a three- pronged company that includes a recording studio for remastery work, recording, and audio forensics; a technical design division that develops interactive media; and a music academy that will provide instrumental and vocal music lessons for members of the community. With a business plan in place, Garrett and Jay needed to move their ideas—and equipment—out of the basement and into better spaces. With help from First Commonwealth vice president and market manager David McNichol, Treelady Enterprises received a loan from which they could draw to renovate a building, purchase more equipment, and expand the business. 2004 Annual Report 9 First Commonwealth Afﬁliate Presidents Front row (L to R): William A. Mrozowski, Richard R. Applegate, Sue A. McMurdy Back row (L to R): Anthony S. Hewitt, Gerard M. Thomchick, Johnston A. Glass Richard R. Applegate President & Chief Executive Ofﬁcer First Commonwealth Financial Advisors 1001 Village Run Road Wexford, PA 15090 (724) 933-4515 Johnston A. Glass President & Chief Executive Ofﬁcer First Commonwealth Bank Central Ofﬁces Philadelphia and Sixth Streets Indiana, PA 15701 (724) 349-3400 10 First Commonwealth Anthony S. Hewitt President & Chief Executive Ofﬁcer First Commonwealth Insurance Agency First Commonwealth Place 654 Philadelphia Street Indiana, PA 15701 (724) 349-6056 Sue A. McMurdy President & Chief Executive Ofﬁcer First Commonwealth Systems Corporation 22 North Sixth Street Indiana, PA 15701 (724) 349-4310 William A. Mrozowski President & Chief Executive Ofﬁcer First Commonwealth Trust Company 614 Philadelphia Street Indiana, PA 15701 (724) 465-3282 Gerard M. Thomchick President & Chief Executive Ofﬁcer First Commonwealth Professional Resources Inc. 22 North Sixth Street Indiana, PA 15701 (724) 349-7220 President Commonwealth Trust Credit Life Insurance Company 2700 North Third Street, Suite 3050 Phoenix, AZ 85004 Chairman & President FraMal Holdings Corporation 1105 North Market Street Wilmington, DE 19899 Board of Directors Front row (L to R): Johnston A. Glass, Laurie Stern Singer, James W. Newill Middle row (L to R): Joseph E. O’Dell, Alan R. Fairman, David S. Dahlmann, E. James Trimarchi Back row (L to R): Robert J. Ventura, Edward T. Côté, Ray T. Charley, David R. Tomb Jr., Esq. Dale P. Latimer and John A. Robertshaw Jr. were unavailable for the photo. Ray T. Charley Greensburg Chief Executive Ofﬁcer, Thomi Company Edward T. Côté Ligonier Associate, Wakeﬁeld Associates, L.P. David S. Dahlmann Greensburg Adjunct Professor, Saint Vincent College Alan R. Fairman Dubois Partner, Fairman Drilling Company Johnston A. Glass Indiana Vice Chairman, First Commonwealth Financial Corporation, and President and Chief Executive Ofﬁcer, First Commonwealth Bank Dale P. Latimer New Alexandria Chairman of the Board and Chief Executive Ofﬁcer, R & L Development Company James W. Newill Highland Beach, FL Certiﬁed Public Accountant, Former President, J.W. Newill Company Joseph E. O’Dell Indiana President and Chief Executive Ofﬁcer, First Commonwealth Financial Corporation John A. Robertshaw Jr. Greensburg President, Robertshaw Management, LTD Laurie Stern Singer Allison Park President, Allegheny Valley Development Corporation David R. Tomb Jr., Esq. Indiana Attorney at Law E. James Trimarchi Indiana Chairman of the Board, First Commonwealth Financial Corporation Robert J. Ventura Pittsburgh Principal, Ventura Group, LLC 2004 Annual Report 11 Corporate Executive Ofﬁces President Corporate Information Corporate Description First Commonwealth Financial Corporation is a Pennsylvania business corporation established in 1983, registered as a bank holding company by the Board of Governors of the Federal Reserve System. William R. Jarrett Executive Vice President and Chief Risk Ofﬁcer Sue A. McMurdy Senior Vice President and Chief Information Ofﬁcer David R. Tomb Jr., Esq. Senior Vice President, Secretary and Treasurer Thaddeus J. Clements Senior Vice President, Human Resources R. John Previte Senior Vice President, Investments For other information call our Convenience Banking Center at 1-800-711-BANK (2265) or visit our Web site: www.fcbanking.com Executive Ofﬁces Old Courthouse Square, 22 North Sixth Street Indiana, Pennsylvania Mailing Address Post Ofﬁce Box 400 Indiana, Pennsylvania 15701-0400 Telephone (724) 349-7220 Executive Ofﬁcers E. James Trimarchi Chairman of the Board Joseph E. O’Dell President and Chief Executive Ofﬁcer Johnston A. Glass Vice Chairman, Growth Gerard M. Thomchick Senior Executive Vice President and Chief Operating Ofﬁcer John J. Dolan Executive Vice President and Chief Financial Ofﬁcer Market Area by County Elk Jefferson Lawrence Beaver Butler Armstrong Indiana ✶ Clearfield Centre Allegheny Cambria Blair Westmoreland Huntingdon Washington Somerset Bedford 12 First Commonwealth FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING First Commonwealth’s management is responsible for establishing and maintaining adequate internal control over ﬁnancial reporting, as such term is deﬁned in Exchange Act Rule 13a-15(f). Under the supervision and with the participation of management, including First Commonwealth’s principal executive ofﬁcer and principal ﬁnancial ofﬁcer, First Commonwealth conducted an evaluation of the effectiveness of internal control over ﬁnancial reporting based on the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems, determined to be effective can provide only reasonable assurance with respect to ﬁnancial statement preparation and presentation. Based on First Commonwealth’s evaluation under the framework in Internal Control-Integrated Framework, management concluded that internal control over ﬁnancial reporting was effective as of December 31, 2004. Management’s assessment of the effectiveness of internal control over ﬁnancial reporting as of December 31, 2004 has been audited by Ernst & Young LLP, an independent registered public accounting ﬁrm, as stated in their report which is included herein. First Commonwealth Financial Corporation Indiana, Pennsylvania March 10, 2005 Joseph E. O’Dell John J. Dolan President and Chief Executive Ofﬁcer Executive Vice President and Chief Financial Ofﬁcer 13 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders of First Commonwealth Financial Corporation We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that First Commonwealth Financial Corporation (the Company) maintained effective internal control over ﬁnancial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Company’s management is responsible for maintaining effective internal control over ﬁnancial reporting and for its assessment of the effectiveness of internal control over ﬁnancial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over ﬁnancial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over ﬁnancial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over ﬁnancial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over ﬁnancial reporting is a process designed to provide reasonable assurance regarding the reliability of ﬁnancial reporting and the preparation of ﬁnancial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over ﬁnancial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reﬂect the transactions and dispositions of ﬁnancial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the ﬁnancial statements. Because of its inherent limitations, internal control over ﬁnancial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assessment that the Company maintained effective internal control over ﬁnancial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, the Company maintained, in all material respects, effective internal control over ﬁnancial reporting as of December 31, 2004, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of the Company as of December 31, 2004 and 2003, and the related consolidated statements of income, shareholders’ equity, and cash ﬂows for each of the three years in the period ended December 31, 2004 and our report dated March 10, 2005 expressed an unqualiﬁed opinion thereon. Pittsburgh, Pennsylvania March 10, 2005 14 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders of First Commonwealth Financial Corporation We have audited the accompanying consolidated balance sheets of First Commonwealth Financial Corporation and subsidiaries (the “Company”) as of December 31, 2004 and 2003, and the related consolidated statements of income, shareholders’ equity, and cash ﬂows for the years then ended. These ﬁnancial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these ﬁnancial statements based on our audits. The ﬁnancial statements of the company for the year ended December 31, 2002 were audited by other auditors whose report dated January 22, 2003, expressed an unqualiﬁed opinion on those statements. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the ﬁnancial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the ﬁnancial statements. An audit also includes assessing the accounting principles used and signiﬁcant estimates made by management, as well as evaluating the overall ﬁnancial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, based on our audits and, for 2002, the report of other auditors, the ﬁnancial statements referred to above present fairly, in all material respects, the consolidated ﬁnancial position of the Company at December 31, 2004 and 2003, and the consolidated results of their operations and their cash ﬂows for the years then ended in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over ﬁnancial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 10, 2005 expressed an unqualiﬁed opinion thereon. Pittsburgh, Pennsylvania March 10, 2005 15 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollar Amounts in Thousands) ASSETS Cash and due from banks Interest-bearing bank deposits Securities available for sale, at market Securities held to maturity, at amortized cost, (Market value $81,886 in 2004 and $109,609 in 2003) Loans Unearned income Allowance for credit losses Net loans Premises and equipment Other real estate owned Goodwill Amortizing intangibles, net Other assets Total assets LIABILITIES Deposits (all domestic): Noninterest-bearing Interest-bearing Total deposits Short-term borrowings Other liabilities Subordinated debentures Other long-term debt Total long-term debt Total liabilities SHAREHOLDERS’ EQUITY December 31, 2004 2003 $ 79,591 2,403 2,162,313 $ 82,510 5,362 1,969,176 78,164 104,254 $ $ 3,515,085 (252) (41,063) 3,473,770 56,965 1,814 123,607 17,513 202,338 6,198,478 480,843 3,363,632 3,844,475 946,474 35,977 108,250 731,324 839,574 5,666,500 2,825,337 (455) (37,385) 2,787,497 46,538 1,866 29,854 3,256 158,882 $ 5,189,195 $ 408,647 2,879,628 3,288,275 634,127 41,875 75,304 718,668 793,972 4,758,249 Preferred stock, $1 par value per share, 3,000,000 shares authorized, none issued Common stock $1 par value per share, 100,000,000 shares authorized; 71,978,568 shares issued and 69,868,908 shares outstanding in 2004; 63,704,445 shares issued and 60,712,020 shares outstanding in 2003 Additional paid-in capital Retained earnings Accumulated other comprehensive income Treasury stock (2,109,660 and 2,992,425 shares at December 31, 2004 and 2003, respectively at cost) Unearned ESOP shares Total shareholders’ equity Total liabilities and shareholders’ equity -0- -0- 71,978 175,453 307,363 10,002 (26,643) (6,175) 531,978 6,198,478 $ 63,704 79,581 312,261 15,173 (37,779) (1,994) 430,946 $ 5,189,195 The accompanying notes are an integral part of these consolidated financial statements. 16 Interest Income Interest and fees on loans Interest and dividends on investments: Taxable interest Interest exempt from Federal income taxes Dividends Interest on Federal funds sold Interest on bank deposits Total interest income Interest Expense Interest on deposits Interest on short-term borrowings Interest on mandatorily redeemable capital securities of subsidiary trust Interest on subordinated debentures Interest on other long-term debt Total interest on long-term debt Total interest expense Net interest income Provision for credit losses Net interest income after provision for credit losses Other Income Net securities gains Trust income Service charges on deposits Gain on sale of branches Insurance commissions Income from bank owned life insurance Merchant discount income Card related interchange income Other income Total other income Other Expenses Salaries and employee beneﬁts Net occupancy expense Furniture and equipment expense Data processing expense Pennsylvania shares tax expense Intangible amortization Litigation settlement Restructuring charges Merger and integration charges Debt prepayment fees Other operating expenses Total other expenses Income before income taxes Applicable income taxes FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Dollar Amounts in Thousands, except per share data) 2004 Years Ended December 31, 2003 2002 $ 189,629 $ 164,441 $ 179,901 75,309 11,447 1,600 6 34 278,025 58,890 11,989 -0- 6,778 33,033 39,811 110,690 167,335 8,070 159,265 4,077 5,254 14,975 -0- 3,387 5,157 3,638 3,579 7,582 47,649 68,916 9,656 11,688 3,808 4,532 1,443 -0- -0- 2,125 29,495 32,892 164,555 42,359 3,707 66,716 10,561 2,038 4 13 243,773 60,100 6,755 -0- 3,560 29,826 33,386 100,241 143,532 12,770 130,762 5,851 5,142 13,013 3,041 3,305 4,342 3,557 2,537 7,656 48,444 61,144 7,456 10,096 2,520 4,301 43 (610) -0- -0- -0- 27,705 112,655 66,551 13,251 84,137 9,520 1,973 6 31 275,568 78,572 6,029 3,325 -0- 34,747 38,072 122,673 152,895 12,223 140,672 642 5,008 11,538 -0- 3,631 4,711 3,573 2,199 6,793 38,095 58,149 6,750 9,970 2,124 3,937 203 8,000 6,140 -0- -0- 31,057 126,330 52,437 8,911 Net Income $ 38,652 $ 53,300 $ 43,526 Average Shares Outstanding Average Shares Outstanding Assuming Dilution 65,887,611 66,487,516 59,002,277 59,387,055 58,409,614 58,742,018 Per Share Data: Basic Earnings Per Share Diluted Earnings Per Share $ $ 0.59 0.58 $ $ 0.90 0.90 $ $ 0.75 0.74 The accompanying notes are an integral part of these consolidated ﬁnancial statements. 17 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (Dollar Amounts in Thousands) Common Stock Additional Paid-in Capital Accumulated Retained Other Comprehensive Treasury Income (Loss) Earnings Stock Unearned ESOP Shares Total Shareholders’ Equity $ 62,525 $ 66,176 $ 288,219 $ 8,703 $ (51,431) $ (4,126) $ 370,066 Balance at December 31, 2001 Comprehensive income Net income Other comprehensive income, net of tax: Unrealized holding gains on securities arising during the period Less: reclassification adjustment for gains on securities included in net income Total other comprehensive income Total comprehensive income Cash dividends declared Decrease in unearned ESOP shares Discount on dividend reinvestment plan purchases Treasury stock reissued Tax benefit of stock options Balance at December 31, 2002 Comprehensive income Net income Other comprehensive income, net of tax: Unrealized holding losses on securities arising during the period Less: reclassification adjustment for gains on securities included in net income Unrealized holding gains on derivatives used in cash flow hedging relationship arising during the period Total other comprehensive income (loss) Total comprehensive income Cash dividends declared Decrease in unearned ESOP shares Discount on dividend reinvestment plan purchases Treasury stock reissued Tax benefit of stock options Stock issued for acquisition Balance at December 31, 2003 Comprehensive income Net income Other comprehensive income, net of tax: Unrealized holding losses on securities arising during the period Less: reclassification adjustment for gains on securities included in net income Unrealized holding losses on derivatives used in cash flow hedging relationship arising during the period Total other comprehensive income (loss) Total comprehensive income Cash dividends declared Net increase in unearned ESOP shares Discount on dividend reinvestment plan purchases Treasury stock acquired Treasury stock reissued Tax benefit of stock options Stock issued for acquisition Balance at December 31, 2004 -0- -0- -0- -0- -0- -0- -0- -0- -0- -0- -0- -0- -0- -0- -0- -0- -0- -0- -0- -0- -0- -0- -0- -0- 43,526 -0- -0- 17,542 -0- -0- -0- -0- -0- 86 -0- -0- 43,526 (35,580) -0- -0- -0- -0- 62,525 (637) (964) 224 64,885 -0- -0- -0- 296,165 -0- 53,300 -0- -0- -0- -0- 1,179 63,704 (706) (1,076) 535 15,823 79,581 -0- -0- -0- -0- 312,261 -0- 38,652 -0- -0- -0- -0- -0- -0- -0- 120 -0- -0- -0- -0- 53,300 (37,204) -0- -0- -0- -0- -0- -0- -0- 262 -0- -0- -0- -0- 38,652 (43,550) -0- -0- -0- -0- -0- -0- -0- -0- -0- 6,450 -0- (44,981) -0- -0- -0- -0- -0- -0- -0- -0- -0- 7,202 -0- -0- (37,779) -0- -0- -0- -0- -0- -0- -0- -0- -0- (514) 11,650 -0- -0- (26,643) $ $ -0- 43,526 -0- 17,542 -0- -0- -0- -0- 1,071 -0- -0- -0- (3,055) (394) 17,148 60,674 (35,580) 1,157 (637) 5,486 224 401,390 -0- 53,300 -0- -0- -0- -0- -0- -0- 1,061 -0- -0- -0- -0- (1,994) (6,951) (3,734) 7 (10,678) 42,622 (37,204) 1,181 (706) 6,126 535 17,002 430,946 -0- 38,652 -0- -0- -0- -0- -0- -0- (4,181) -0- -0- -0- -0- -0- (6,175) (2,420) (2,633) (118) (5,171) 33,481 (43,550) (3,919) (816) (514) 9,882 1,238 105,230 $ 531,978 (394) 17,148 17,148 -0- -0- -0- -0- -0- 25,851 (6,951) (3,734) 7 (10,678) (10,678) -0- -0- -0- -0- -0- -0- 15,173 (2,420) (2,633) (118) (5,171) (5,171) -0- -0- -0- -0- -0- -0- -0- 10,002 -0- -0- -0- -0- 8,274 $ 71,978 (816) -0- (1,768) 1,238 96,956 $ 175,453 -0- -0- -0- -0- -0- $ 307,363 $ The accompanying notes are an integral part of these consolidated financial statements. 18 Operating Activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Provision for credit losses Depreciation and amortization Net gains on sales of assets Net gains on sales of branches Income from increase in cash surrender value of bank owned life insurance Stock option tax beneﬁt Changes net of acquisition: Decrease in interest receivable Decrease in interest payable Decrease in income taxes payable Net decrease (increase) in loans held for sale Change in deferred taxes Other-net Net cash provided by operating activities Investing Activities Changes net of acquisition: Transactions with securities held to maturity: Sales Maturities and redemptions Purchases of investment securities Transactions with securities available for sale: Sales Maturities and redemptions Purchases of investment securities Proceeds from sales of other assets Acquisition of afﬁliate, net of cash received Investment in bank owned life insurance Net decrease in interest-bearing bank deposits Net (increase) decrease in loans Purchases of premises and equipment Net cash (used) provided by investing activities Financing Activities Changes net of acquisition: Proceeds from issuance of other long-term debt Repayments of other long-term debt Proceeds from issuance of subordinated debentures Repayments of subordinated debentures Discount on dividend reinvestment plan purchases Dividends paid Net increase (decrease) in Federal funds purchased Net increase in other short-term borrowings Sale of branch and deposits, net of cash received Reissuance of treasury stock Net increase (decrease) in deposits Net cash provided (used) by ﬁnancing activities Net (decrease) increase in cash and cash equivalents FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollar Amounts in Thousands) 2004 2003 2002 Years Ended December 31, $ 38,652 $ 53,300 $ 43,526 8,070 9,488 (4,197) -0- (5,157) 1,239 1,212 (39) (1,976) 644 (1,858) (6,855) 39,223 -0- 31,649 (5,542) 115,726 730,494 (755,364) 11,703 (70,872) -0- 4,874 (179,939) (12,041) (129,312) 283,486 (482,150) 41,238 (8,292) (816) (41,736) 21,650 237,102 -0- 9,679 27,009 87,170 (2,919) 12,770 7,498 (6,483) (3,034) (4,342) 535 3,754 (1,120) (843) 2,484 (2,235) (2,525) 59,759 -0- 93,700 -0- 62,941 954,406 (1,414,519) 11,876 7,859 -0- 4,135 2,775 (5,227) (282,054) 10,000 (12,500) 30,929 -0- (706) (36,630) (37,500) 202,562 (21,288) 5,923 82,901 223,691 1,396 12,223 7,360 (498) -0- (4,711) 224 2,860 (2,280) (2,754) (5,439) (594) 2,408 52,325 -0- 110,769 (15,266) 15,328 545,791 (547,799) 11,207 -0- (5,000) 2,278 (58,157) (6,382) 52,769 18,200 (101,425) -0- -0- (637) (35,208) (56,650) 97,980 -0- 4,656 (49,026) (122,110) (17,016) Cash and cash equivalents at January 1 Cash and cash equivalents at December 31 82,510 79,591 $ 81,114 82,510 $ 98,130 81,114 $ The accompanying notes are an integral part of these consolidated financial statements. 19 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 2004, 2003 and 2002 NOTE 1—Statement of Accounting Policies General The following summary of accounting and reporting policies is presented to aid the reader in obtaining a better understanding of the ﬁnancial statements and related ﬁnancial data of First Commonwealth Financial Corporation and its subsidiaries (the “Corporation”) contained in this report. The ﬁnancial information is presented in accordance with generally accepted accounting principles and general practice for ﬁnancial institutions in the United States of America. In preparing ﬁnancial statements, management is required to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the ﬁnancial statements. In addition, these estimates and assumptions affect revenues and expenses in the ﬁnancial statements and as such, actual results could differ from those estimates. Through its subsidiaries which include one commercial bank, a nondepository trust company, insurance agency and ﬁnancial advisor, the Corporation provides a full range of loan, deposit, trust, insurance and ﬁnancial advisory services primarily to individuals and small to middle-market businesses in seventeen counties in central and western Pennsylvania. Under current conditions, the Corporation is reporting one business segment. The Corporation is subject to regulations of certain state and federal agencies. These regulatory agencies periodically examine the Corporation for adherence to laws and regulations. As a consequence, the cost of doing business may be affected. Basis of Presentation The accompanying consolidated ﬁnancial statements include the accounts of the Corporation and its wholly owned subsidiaries. All material intercompany transactions have been eliminated in consolidation. The Corporation determines whether it should consolidate other entities or account for them on the equity method of accounting depending on whether it has a controlling ﬁnancial interest in an entity of less than 100% of the voting interest of that entity by considering the provisions of Accounting Research Bulletin 51 (“ARB 51”), “Consolidated Financial Statements”, or a controlling ﬁnancial interest in a variable interest entity (“VIE”) by considering the provisions of the Financial Accounting Standards Board (“FASB”) Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” issued in January 2003, and FIN 46 (Revised 2003) (“FIN 46R”) issued in December 2003. Under FIN 46R, an entity that holds a variable interest in a VIE is required to consolidate the VIE if the entity is subject to a majority of the risk of loss from the VIE’s activities, is entitled to receive a majority of the entity’s residual returns or both. Refer to the Recent Accounting Pronouncements 20 section of this Note for additional information related to FIN 46 and FIN 46R. The investment in non-consolidated VIE’s and investment in corporations with voting interest of 20 to 50% are accounted for using the equity method of accounting. Reclassiﬁcations Financial statement amounts in prior periods have been reclassiﬁed to conform to the presentation format used in 2004. The reclassiﬁcations had no effect on the Corporation’s ﬁnancial condition or results of operations. Securities Debt securities that the Corporation has the positive intent and ability to hold to maturity are classiﬁed as securities held-to-maturity and are reported at amortized cost. Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are to be classiﬁed as trading securities and reported at fair value, with unrealized gains and losses included in earnings. Debt and equity securities not classiﬁed as either held-to-maturity securities or trading securities are classiﬁed as securities available- for-sale and are reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders’ equity, net of deferred taxes. The Corporation has securities classiﬁed as either held-to- maturity or available-for-sale. The Corporation does not engage in trading activities. Effective January 1, 2003, the Corporation changed the method it utilizes to determine the net gain or loss on the sale of securities from the speciﬁc identiﬁcation method to the average cost method. This change did not result in a material change to the Corporation’s ﬁnancial condition or results of operations. Loans Loans are carried at the principal amount outstanding. Unearned income on installment loans and leases is taken into income on a declining basis which results in an approximately level rate of return over the life of the loan or lease. Interest is accrued as earned on nondiscounted loans. The Corporation considers a loan to be past due and still accruing interest when payment of interest or principal is contractually past due but the loan is well secured and in the process of collection. For installment, mortgage, term and other loans with amortizing payments that are scheduled monthly, 90 days past due is reached when four monthly payments are due and unpaid. For demand, time and other multi-payment obligations with payments scheduled other than monthly, delinquency status is calculated using number of days instead of number of payments. Revolving credit loans, including personal credit lines and home equity lines, are considered to be 90 days past due when the borrower has not made the minimum payment for four billing cycles. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) A loan is placed in nonaccrual status when based on current information and events, it is probable that the Corporation will be unable to fully collect principal or interest due according to the contractual terms of the loan. A loan is also placed in nonaccrual status when based on regulatory deﬁnitions, the loan is maintained on a “cash basis” due to the weakened ﬁnancial condition of the borrower. When a determination is made to place a loan in nonaccrual status, all accrued and unpaid interest for the current year is reversed against interest income and uncollected interest for previous years is charged against the allowance for credit losses. Generally, consumer and residential mortgage loans, which are well-secured and/or in the process of collection, are not normally placed in nonaccrual status. Nonaccrual loans are restored to accrual status when, based on a sustained period of repayment by the borrower in accordance with the contractual terms of the loan, the Corporation expects repayment of the remaining contractual principal and interest, or when the loan otherwise becomes well-secured and in the process of collection. The Corporation considers a loan to be renegotiated when the loan terms have been renegotiated to a below market condition to provide a reduction or deferral of principal or interest as a result of the deteriorating ﬁnancial position of the borrower and the loan is in compliance with the restructured terms. The Corporation considers a loan to be impaired when, based on current information and events, it is probable that the Corporation will be unable to collect principal or interest that is due in accordance with contractual terms of the loan. Impaired loans include nonaccrual loans and renegotiated loans. Loan impairment is measured based on the present value of expected cash ﬂows discounted at the loan’s effective interest rate or, as a practical expedient, at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. Payments received on impaired loans are applied against the recorded investment in the loan. For loans other than those that the Corporation expects repayment through liquidation of the collateral, when the remaining recorded investment in the impaired loan is less than or equal to the present value of the expected cash ﬂows, income is recorded on a cash basis. Loans deemed uncollectible are charged off through the allowance for credit losses. Factors considered in assessing ultimate collectibility include past due status, ﬁnancial condition of the borrower, collateral values and debt covenants including secondary sources of repayment by guarantors. Payments received on previously charged off loans are recorded as recoveries in the allowance for credit losses. Mortgage Servicing Rights When the Corporation purchases or originates mortgage loans with a deﬁnitive plan to sell or securitize those loans and retain the mortgage servicing rights, the Corporation measures the mortgage servicing rights at cost by allocating the cost of the mortgage loans between the mortgage servicing rights and the mortgage loans (without the mortgage servicing rights) based on their relative fair values at the date of purchase or origination. When the Corporation does not have a deﬁnitive plan at the purchase or origination date and later sells or securitizes the mortgage loans and retains the mortgage servicing rights, the Corporation allocates the amortized cost of the mortgage loans between the mortgage servicing rights and the mortgage loans (without mortgage servicing rights) based on their relative fair values at the date of sale. The amount capitalized as the right to service mortgage loans is recognized as a separate asset and amortized in proportion to, and over the period of, estimated net servicing income (servicing revenue in excess of servicing cost). Generally, the Corporation sells mortgages with servicing released. Mortgage servicing rights are periodically evaluated for impairment based on fair values. Loan Fees Loan origination and commitment fees, net of associated direct costs, are deferred and the net amount is amortized as an adjustment to the related loan yield on the interest method, generally over the contractual life of the related loans or commitments. Other Real Estate Owned Real estate, other than bank premises, is recorded at the lower of cost or fair value less selling costs at the time of acquisition. Expenses related to holding the property, net of rental income, are generally charged against earnings in the current period. Allowance for Credit Losses The Corporation maintains an allowance for credit losses at a level deemed sufﬁcient to absorb losses that are inherent in the loan and lease portfolios at each balance sheet date. Management and the Corporation’s Board of Directors review the adequacy of the allowance on a quarterly basis to ensure that the provision for credit losses has been charged against earnings in an amount necessary to maintain the allowance at a level that is appropriate based on management’s assessment of probable estimated losses. The Corporation’s methodology for assessing the appropriateness of the allowance for credit losses consists of several key elements. These elements include an assessment of individual problem loans, delinquency and loss experience trends, and other relevant factors, all of which may be susceptible to signiﬁcant changes. While allocations are made to speciﬁc loans and pools of loans, the total allowance is available for all loan losses. Substandard loans are those with a well-deﬁned weakness or a weakness that jeopardizes the repayment of the debt. A loan may be classiﬁed as substandard as a result of impairment of the borrower’s ﬁnancial condition and repayment capacity. Loans for which repayment plans have not been met or collateral equity margins do not protect the Corporation may also be classiﬁed as substandard. Doubtful loans have the characteristics of substandard loans with the added 21 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) NOTE 1—Statement of Accounting Policies (continued) Allowance for Credit Losses (continued) characteristic that collection or liquidation in full, on the basis of presently existing facts and conditions, is highly improbable. Although the possibility of loss is extremely high for doubtful loans, the classiﬁcation of loss is deferred until pending factors, which might improve the loan, have been determined. Loans rated as doubtful, in whole or in part, are placed in nonaccrual status. Loans which are classiﬁed as loss are considered uncollectible and are charged to the allowance for credit losses at the next meeting of the Corporation’s Credit Committee after placement in this category. There were no loans classiﬁed as loss on the primary watch list as of December 31, 2004. The Corporation consistently applies the following comprehensive methodology and procedure for determining the allowance at the subsidiary bank level. Classiﬁed loans on the primary watch list are analyzed to determine the level of potential loss in the credits under current circumstances. The potential loss that is established for these classiﬁed loans is based on careful analysis of the loan’s performance, the related collateral value, cash ﬂow considerations and the ﬁnancial capability of any guarantor. Primary watch list loans are managed and monitored by assigned account ofﬁcers within the Corporation in conjunction with senior management. A speciﬁc reserve is established for impaired loans that is equal to the total amount of potential unconﬁrmed losses for the impaired loans that are reviewed. All impaired credits in excess of $100 are individually reviewed. Based on this reserve as a percentage of reviewed loan balances, a reserve is also established for the non-reviewed impaired loan balances. A reserve is established for primary watch list loans that are classiﬁed as substandard (and still accruing interest) and OAEM (Other Assets Especially Mentioned). The reserve on these substandard and OAEM loans is calculated as the historical average amount of potential unconﬁrmed losses for the loans similar to those that are reviewed. The historical percentage is based on an eight quarter weighted average calculation. The allowance based on historical trends uses charge-off experience of the Corporation to estimate potential unconﬁrmed losses in the balances of the loan and lease portfolios. The historical loss experience percentage is based on the charge-off history for the greater of the eight most recent quarters or the twenty most recent quarters. The historical loss percentages are adjusted for loss emergence periods based on the type of loan. Adjusted historical loss experience percentages are applied to non-classiﬁed loans from the primary watch list, as well as all other loans and leases which are not on the watch list, to obtain the portion of the allowance for credit losses which is based on historical trends. Before applying the adjusted historical loss experience percentages, 22 loan balances are reduced by the portion of the loan balances which are subject to guarantee by a government agency. Each loan category’s most recent four-quarter average delinquency percentage is compared to its twenty-quarter average. A special allocation is made if the four-quarter delinquency percentage is higher than its twenty-quarter average. An additional allowance for special circumstances may be made where a speciﬁc reserve is warranted. The additional allowance provides management with the opportunity to estimate additional potential allowance amounts which may be needed to cover speciﬁc factors. The special factors that management currently evaluates consist of portfolio risk or concentrations of credit and economic conditions. Portfolio risks include unusual changes or recent trends in speciﬁc portfolios such as unexpected changes in the trends or levels of delinquency, unusual repossession activities or large levels of unsecured loans in a portfolio. The Corporation also maintains an unallocated allowance. The unallocated allowance is used to cover any factors or conditions that may cause a potential credit loss but are not speciﬁcally identiﬁable or considered in the methodology that was deﬁned above. These factors include, but are not limited to potential judgment or data errors or factors not yet considered in the Corporation’s methodology. No matter how detailed an analysis of potential credit losses is performed these estimates by deﬁnition lack precision. Management must make estimates using assumptions and information that is often subjective and changing rapidly. Bank Owned Life Insurance The Corporation purchased insurance on the lives of certain groups of employees. The policies accumulate asset values to meet future liabilities including the payment of employee beneﬁts such as health care. Increases in the cash surrender value are recorded as “Other Income” in the Consolidated Statements of Income. The cash surrender value of bank owned life insurance is reﬂected in “Other Assets” on the Consolidated Balance Sheets in the amount of $124,932 and $103,625 at December 31, 2004 and 2003, respectively. The increase in cash surrender value of bank owned life insurance during 2004 includes $16,657 acquired as a result of a business combination completed during 2004. For additional information on the business combination, refer to NOTE 6 (Business Combinations). Premises and Equipment Premises and equipment are carried at cost less accumulated depreciation and amortization. Depreciation is computed on the straight-line and accelerated methods over the estimated useful life of the asset. Accelerated depreciation methods are used for furniture and equipment while straight-line depreciation is used for buildings and improvements. Charges for maintenance and repairs are expensed as incurred. Where a lease is involved, FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) amortization is charged over the term of the lease or the estimated useful life of the improvement, whichever is shorter. The Corporation records computer software in accordance with the American Institute of Certiﬁed Public Accountants’ Statement of Position 98-1 (“SOP 98-1”), “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” The statement identiﬁes the following three stages of software development: the preliminary project stage, the application development stage and the post-implementation stage. In compliance with SOP 98-1, the Corporation expenses costs that are incurred during the preliminary project stage and capitalizes certain costs that are incurred during the application development stage. Once software is in operation, maintenance costs are expensed over the maintenance period while upgrades that result in additional functionality or enhancements are capitalized. Training and data conversion costs are expensed as incurred. Capitalized costs are amortized on a straight-line basis over a period of 3-7 years, depending on the life of the software license. Business Combinations The Corporation accounts for business combinations in accordance with the FASB Statement No. 141 (“FAS No. 141”), “Business Combinations,” which requires the purchase method of accounting for business combinations initiated after June 30, 2001. Under the purchase method, net assets of the business acquired are recorded at their estimated fair value as of the date of acquisition with any excess of the cost of the acquisition over the fair value of the net tangible and intangible assets that are acquired recorded as goodwill. Results of the acquired business are included in the Corporation’s income statement from the date of the acquisition. Goodwill and Other Intangible Assets Goodwill and other intangible assets with indeﬁnite useful lives are tested for impairment at least annually and written down and charged to results of operations in periods in which their recorded value is more than their estimated fair value. No impairment of goodwill or other intangibles has been identiﬁed since the adoption of FASB Statement No. 142 (“FAS No. 142”), “Goodwill and Other Intangible Assets,” on January 1, 2002. Prior to the adoption of FAS No. 142, goodwill was amortized on a straight-line basis over a period of 15-25 years. Accounting for the Impairment of Long-Lived Assets The Corporation reviews long-lived assets, such as premises and equipment and intangibles for impairment whenever events or changes in circumstances, such as a signiﬁcant decrease in the market value of an asset or the extent or manner in which an asset is used, indicate that the carrying amount of an asset may not be recoverable. If there is an indication that the carrying amount of an asset may not be recoverable, future undiscounted cash ﬂows expected to result from the use of the asset are estimated. If the sum of the expected cash ﬂows is less than the carrying value of the asset, a loss is recognized for the difference between the carrying value and fair market value of the asset. Long-lived assets classiﬁed as held for sale are measured at the lower of their carrying amount or fair value less cost to sell. Depreciation or amortization is discontinued on long-lived assets classiﬁed as held for sale. Income Taxes The Corporation records taxes in accordance with the asset and liability method utilized by FASB Statement No. 109 (“FAS No. 109”), “Accounting for Income Taxes,” whereby deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the ﬁnancial statement carrying amount of existing assets and liabilities and their respective tax bases given the provisions of the enacted tax laws. Deferred tax assets are reduced, if necessary, by the amount of such beneﬁts that are not expected to be realized based upon available evidence. Comprehensive Income Disclosures “Other Comprehensive Income” (comprehensive income, excluding net income), beginning with the 2003 period included two components, the change in unrealized holding gains and losses on available for sale securities and the change in unrealized gains and losses on derivatives used in cashﬂow hedging relationships. Both components of other comprehensive income are reported net of related tax effects in the Statement of Changes in Shareholders’ Equity. Prior to 2003, other comprehensive income included only one component, which was the change in unrealized holding gains and losses on available for sale securities net of related tax effects. Cash and Cash Equivalents For purposes of reporting cash ﬂows, cash and cash equivalents include cash on hand, amounts due from banks and Federal funds sold. Generally, Federal funds are sold for one-day periods. Employee Stock Ownership Plan Accounting treatment for the Corporation’s Employee Stock Ownership Plan (“ESOP”) described in NOTE 23 (Unearned ESOP Shares) follows Statement of Position 93-6 (“SOP 93-6”), “Employers Accounting for Employee Stock Ownership Plans,” for ESOP shares acquired after December 31, 1992 (“new shares”). The Corporation has elected, as permitted under SOP 93-6, not to adopt this statement for ESOP shares acquired on or before December 31, 1992 (“old shares”). ESOP shares purchased subject to debt guaranteed by the Corporation are recorded as a reduction of common shareholders’ equity by charging unearned ESOP shares. As shares are committed to be released to the ESOP Trust for allocation to plan participants, unearned ESOP shares is credited for the average cost of the shares to the ESOP. Compensation cost recognized for new shares in accordance with the provisions of SOP 93-6 is based upon the fair market value of the shares that are committed to be released. Additional paid-in capital is charged or credited for the 23 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) NOTE 1—Statement of Accounting Policies (continued) Employee Stock Ownership Plan (continued) difference between the fair value of the shares committed to be released and the cost of those shares to the ESOP. Compensation cost recognized for old shares committed to be released is recorded at the cost of those shares to the ESOP. Dividends on both old and new unallocated ESOP shares are used for debt service and are reported as a reduction of debt and accrued interest payable. Dividends on allocated ESOP shares are charged to retained earnings and allocated or paid to the plan participants. The average number of common shares outstanding used in calculating earnings per share excludes all unallocated ESOP shares. Employee Stock Option Plan Prior accounting guidelines permit two alternate methods of accounting for stock-based compensation, the intrinsic value method of APB Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees,” and the fair value method of FASB Statement No. 123 (“FAS No. 123”), “Accounting for Stock-Based Compensation.” In December 2002, the FASB issued Statement No. 148 (“FAS No. 148”), “Accounting for Stock-Based Compensation-Transition and Disclosure.” FAS No. 148 did not amend FAS No. 123 to require companies to account for employee stock options using the fair value method but required all companies with stock-based compensation to provide additional disclosures, regardless of whether they account for that compensation using the fair value method of FAS No. 123 or the intrinsic value method of APB 25. As permitted under FAS No. 123, the Corporation had elected to use the intrinsic value method to measure stock based compensation under APB 25 and to disclose in a footnote to the ﬁnancial statements, net income and earnings per share determined as if the fair value methodology of FAS No. 123 had been implemented. No stock-based employee compensation expense is reﬂected in the Corporation’s net income as reported in the Consolidated Statements of Income because all stock options granted under the Corporation’s plan had an exercise price equal to the market value of the underlying common stock on the date of the grant. In December 2004, the FASB issued FASB Statement No.123 (Revised) (“FAS No. 123(R)”), “Share-Based Payment.” FAS No. 123(R) replaces FAS No. 123 and supersedes APB 25. FAS No. 123(R) will require companies to measure compensation costs for all share-based payments including employee stock options using the fair value method. FAS No. 123(R) applies to new awards and to awards modiﬁed, repurchased or cancelled after the required effective date. Public companies that used the fair value based method for either recognition or disclosure under FAS No. 123, will apply FAS No. 123(R) using a modiﬁed prospective application. Under the modiﬁed prospective application, compensation cost is recognized 24 on or after the required effective date for the portion of the outstanding awards for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under FAS No. 123 for either recognition or pro forma disclosures. For periods before the required effective date, those entities may elect to apply a modiﬁed retrospective application. Under the modiﬁed retrospective application method, ﬁnancial statements for prior periods are adjusted on a basis consistent with the pro forma disclosures required for those periods by FAS No. 123. According to FAS No. 123(R), the grant-date fair value of stock options will be recognized as compensation expense in the company’s income statement over the requisite service period or the vesting period. FAS No. 123(R) will become effective as of the beginning of the ﬁrst interim period that begins after June 15, 2005. The adoption of FAS No. 123(R) is not expected to have a material impact on the Corporation’s ﬁnancial condition or results of operations. See NOTE 24 (Stock Option Plan) for additional information on the Employee Stock Option Plan. The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value recognition provisions of FAS No. 123 to stock-based employee compensation: Net income, as reported Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effect Pro forma net income Earnings per share: Basic—as reported Basic—pro forma Diluted—as reported Diluted—pro forma 2004 December 31, 2003 2002 $ 38,652 $ 53,300 $ 43,526 (38) $ 38,614 $ $ $ $ 0.59 0.59 0.58 0.58 $ $ $ $ $ (1,352) 51,948 0.90 0.88 0.90 0.87 (2,278) 41,248 0.75 0.71 0.74 0.70 $ $ $ $ $ Average shares outstanding Average shares outstanding assuming dilution 65,887,611 59,002,277 58,409,614 66,487,516 59,387,055 58,742,018 Derivative Instruments and Hedging Activities The Corporation accounts for derivative instruments and hedging activities utilizing guidelines established in FASB Statement No. 133 (“FASB No. 133”), “Accounting for Derivative Instruments and Hedging Activities,” as amended. The Corporation recognizes all derivatives as either assets or liabilities on the balance sheet and measures those instruments at fair value. Changes in fair value of derivatives designated and accounted for as cash ﬂow hedges, to the extent they are effective as hedges, are recorded in “Other Comprehensive Income,” net of deferred taxes. Any hedge ineffectiveness would be recognized in the income statement line item pertaining to the hedged item. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) Management periodically reviews contracts from various functional areas of the Corporation to identify potential derivatives embedded within selected contracts. Management has identiﬁed potential embedded derivatives in certain loan commitments for residential mortgages where the Corporation has intent to sell to an outside investor. Due to the short-term nature of these loan commitments and the minimal historical dollar amount of commitments outstanding, the corresponding impact on the Corporation’s ﬁnancial condition and results of operation has not been material. The Corporation had no freestanding derivative or hedging instruments prior to the third quarter of 2003 when it entered into its ﬁrst of three interest rate swaps, which are described in NOTE 8 (Derivative Instruments) to the Consolidated Financial Statements. Earnings Per Common Share Basic earnings per share excludes dilution and is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period less unallocated ESOP shares. Diluted earnings per share reﬂects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. For all periods presented, the dilutive effect on average shares outstanding is the result of compensatory stock options outstanding. Recent Accounting Pronouncements In January 2003, the FASB issued FIN 46 and in December 2003, issued FIN 46R. FIN 46R clariﬁed some of the provisions of FIN 46 and exempted certain entities from the original requirements of FIN 46. As deﬁned by FIN 46 a variable interest entity (“VIE”) is a corporation, partnership, trust or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufﬁcient ﬁnancial resources for the entity to support its activities. Under FIN 46R, an entity that holds a variable interest in a VIE is required to consolidate the VIE if the entity is subject to a majority of the risk of loss from the VIE’s activities, is entitled to receive a majority of the entity’s residual returns or both. FIN 46R was implemented for the quarter ended March 31, 2004. Based on the criteria established in FIN 46 as interpreted by the Securities and Exchange Commission, the Corporation deconsolidated its investment in First Commonwealth Capital Trust I, a Delaware business trust (the “Trust”) during the fourth quarter of 2003. The Trust was established in 1999 to issue capital securities through a private offering to qualiﬁed investors and to issue common securities to the Corporation. The Trust used the proceeds from the sale of the capital securities to buy junior subordinated debentures from the Corporation with the same economic terms as the capital securities. The Trust distributes the cash payments it receives from the Corporation on the debentures to the holders of the capital securities and the common securities. The Trust will redeem all of the outstanding capital securities when the debentures are paid at maturity on September 1, 2029. The deconsolidation of the Trust resulted in an increase in long-term debt during the fourth quarter of 2003 of approximately $1,083 as a result of the subordinated debentures no longer being eliminated in consolidation and the capital securities no longer being included in the Consolidated Balance Sheet at December 31, 2003. The Consolidated Balance Sheet at December 31, 2003, also reﬂects an increase in “Other Assets” in the same amount, which represents the Corporation’s investment in the Trust. Although net income did not change as a result of the deconsolidation of the Trust, “Other Revenue” was increased by the income generated by the Trust, which represents the difference between the Trust’s interest income from the subordinated debentures and the Trust’s interest expense from the capital securities. The Consolidated Statement of Income for the year ended December 31, 2003, also reﬂected an increase in “Interest Expense on Long-term Debt” of approximately $103 as a result of the interest expense on the subordinated debentures no longer being eliminated in consolidation and the interest expense on the capital securities no longer being included in the Consolidated Statement of Income. As part of its community reinvestment initiatives, the Corporation invests in qualiﬁed affordable housing projects as a limited partner. The Corporation receives federal affordable housing tax credits and rehabilitation tax credits for these limited partnership investments. The Corporation’s maximum potential exposure to these partnerships is $4,792, consisting of the limited partnership investments as of December 31, 2004. The Corporation has determined that these investments will not be consolidated but continue to be accounted for under the equity method of accounting whereby the Corporation’s portion of partnership losses are recognized as incurred. The adoption of FIN 46 or FIN 46R has not had a material impact on the Corporation’s ﬁnancial condition or results of operation. In December 2003, the FASB issued Statement No. 132(R) (“FAS No. 132(R)”), “Employers’ Disclosures about Pensions and Other Postretirement Beneﬁts.” The FASB’s revision of Statement No. 132 retained all of the disclosure items that were provided in FAS No. 132 and requires new annual disclosures about the types of plan assets, investment strategy, measurement date, plan obligations and cash ﬂows as well as the expanded disclosures of assumptions used in various calculations. The statement also requires interim reporting of the components of the net periodic beneﬁt cost recognized. FAS No. 132(R) does not change the measurement or recognition for pension or other postretirement beneﬁt plans. This statement was effective for ﬁnancial statements with ﬁscal years ending after December 15, 2003. Disclosure 25 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) NOTE 1—Statement of Accounting Policies (continued) Recent Accounting Pronouncements (continued) requirements for future beneﬁt payments are effective for ﬁscal years ending after June 15, 2004. In March 2004, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 105 (“SAB 105”), “Application of Accounting Principles to Loan Commitments.” SAB 105 was issued to inform the SEC’s registrants of the SEC staff’s view that the fair value of the recorded loan commitments that are required to follow derivative accounting under FASB Statement No. 133 (“FAS No. 133”), “Accounting for Derivative Instruments and Hedging Activities,” should not consider the expected future cash ﬂows related to the associated servicing of the future loan. The SEC staff believes that incorporating expected future cash ﬂows related to the associated servicing of the loan essentially results in the immediate recognition of a servicing asset, which is only appropriate once the servicing asset has been contractually separated from the underlying loan by sale or by securitization of the loan with servicing retained. The provisions of SAB 105 were to be applied to loan commitments accounted for as derivatives that were entered into after March 31, 2004; and therefore, was implemented during the second quarter of 2004. The adoption of SAB 105 has not and is not expected to have a material impact on the Corporation’s ﬁnancial condition or results of operations. In May 2004, the FASB issued FASB Staff Position No. FAS 106-2 (“FSP FAS 106-2”), “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003.” FSP FAS 106- 2 supersedes the FASB Staff Position No. FAS 106-1, which has the same title as FSP FAS 106-2. FSP FAS 106-2 provides guidance on the accounting for the effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“the Act”) for employers that sponsor postretirement health care plans that provide prescription drug beneﬁts. FSP FAS 106-2 also requires employers to provide certain disclosures regarding the effect of the federal subsidy provided by the Act. This FSP is effective for the ﬁrst interim or annual period beginning after June 15, 2004. For additional information, refer to NOTE 22 (Retirement Plans). In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on the remaining issues related to Emerging Issues Task Force Issue 03-1 (“EITF 03-1”), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” This guidance is applicable to debt and equity securities that are within the scope of FASB Statement No. 115 (“FAS No. 115”) and certain other investments. EITF 03-1 provides clariﬁcation guidance to determine when an investment is considered impaired, whether the impairment is other-than-temporary, and the measurement of an impairment loss. The guidance 26 also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The Corporation conducts a comprehensive review of the investment portfolio quarterly to determine whether an other-than-temporary impairment has occurred. Securities whose market values have fallen below their book values are initially selected for more in depth analysis based on the percentage decline in value and duration of the decline. Further analysis could include a review of research reports, analysts’ recommendations, credit rating changes, news stories, annual reports, impact of interest rate changes and any other relevant information pertaining to the affected security. Based on this review, a determination is made on a case by case basis as to a potential impairment. In September 2004, the FASB issued FASB Staff Position No. EITF Issue 03-1-1 (“FSP EITF 03-1-1”), “Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”.” FSP EITF 03-1-1 delays the effective date for the measurement and recognition guidance contained in paragraphs 10-20 of EITF 03-1 from reporting periods beginning after June 15, 2004, until implementation guidance is issued. This delay does not suspend the requirement to recognize other- than-temporary impairments as required by existing authoritative literature. Once additional guidance has been released, the Corporation will evaluate the impact of implementation on the Corporation’s ﬁnancial condition and results of operations. In December 2003, the American Institute of Certiﬁed Public Accountants issued Statement of Position 03-3 (“SOP 03-3”), “Accounting for Certain Loans or Debt Securities Acquired in a Transfer.” SOP 03-3 requires acquired loans, including debt securities, to be recorded at the amount of the purchaser’s initial investment and prohibits carrying over valuation allowances from the seller for those individually-evaluated loans that have evidence of deterioration in credit quality since origination, where it is probable that all contractual cash ﬂows on the loan will be unable to be collected. SOP 03-3 also requires the excess of all undiscounted cash ﬂows expected to be collected at acquisition over the purchaser’s initial investment to be recognized as interest income on a level-yield basis over the life of the loan. Subsequent increases in cash ﬂows expected to be collected are recognized prospectively through an adjustment of the loan’s yield over its remaining life, while subsequent decreases are recognized as impairment. Loans carried at fair value, mortgage loans held for sale, and loans to borrowers in good standing under revolving credit agreements are excluded from the scope of SOP 03-3. This guidance is effective for loans acquired in ﬁscal years beginning after December 15, 2004 and is not expected to have a material impact on the Corporation’s ﬁnancial condition or results of operations. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) NOTE 2—Supplemental Comprehensive Income Disclosures The following table identiﬁes the related tax effects allocated to each component of other comprehensive income in the Statements of Changes in Shareholders’ Equity: December 31, 2004 December 31, 2003 Pretax Amount Tax (Expense) Benefit Amount Net of Tax Pretax Amount Tax (Expense) Net of Tax Benefit Amount December 31, 2002 Tax (Expense) Benefit Amount Net of Tax Pretax Amount Unrealized gains (losses) on securities: Unrealized holding gains (losses) arising during the period Less: reclassification adjustment $ (3,723) $ 1,303 $ (2,420) $ (10,693) $ 3,742 $ (6,951) $ 26,987 $ (9,445) $ 17,542 for gains realized in net income (4,051) 1,418 (2,633) (5,745) 2,011 (3,734) (606) 212 (394) Unrealized gains (losses) on derivatives used in cash flow hedging relationships: Unrealized holding gains (losses) arising during the period Net unrealized gains (losses) Other comprehensive income (loss) (182) (7,956) $ (7,956) 64 2,785 $ 2,785 (118) (5,171) $ (5,171) 7 11 (16,427) (10,678) $ (16,427) $ 5,749 $ (10,678) (4) 5,749 -0- 26,381 $ 26,381 -0- -0- (9,233) 17,148 $ (9,233) $ 17,148 NOTE 3—Supplemental Cash Flow Disclosures 2004 2003 2002 Cash paid during the year for: Interest Income taxes $ 110,729 6,302 $ $ 101,361 16,080 $ $ 124,953 12,010 $ Noncash investing and financing activities: 1,332 5,513 ESOP loan reductions ESOP borrowings $ $ $ $ 1,061 -0- $ $ 1,071 -0- (First Commonwealth Bank and Southwest Bank) and the adoption of a new common brand and identity for all ﬁnancial services subsidiaries. Actual termination beneﬁts paid and charged against the total severance liability were $472, $2,823 and $1,263 during 2004, 2003 and 2002, respectively, leaving a remaining unpaid liability for severance costs of $94 at December 31, 2004. No additional severance accruals or adjustments were recorded during 2004 related to the 2002 restructuring. $ 4,613 $ 4,270 $ 5,029 NOTE 5—Merger and Integration Charges Loans transferred to other real estate owned and repossessed assets Gross increase (decrease) in market value adjustment to securities available for sale $ (7,774) $ (16,438) $ 26,381 Gross increase in market value adjustment of derivative instruments Treasury stock reissued for business combination $ (182) $ 11 $ -0- $ 203 $ 203 $ 830 NOTE 4—Restructuring Charges The Corporation incurred restructuring charges of $6,140 during 2002 in accordance with EITF 94-3. These restructuring charges were comprised of the following: $4,652 of employee separation costs consisting of severance packages for 95 employees from various afﬁliates of the Corporation including all levels of staff from the executive management level to back ofﬁce support staff, $1,068 related to realignment of the various Boards of Directors and Board committees and $420 primarily related to the write-off of obsolete signage and supplies. These amounts are included as restructuring charges, as a component of Other Expenses on the Consolidated Statements of Income. These restructuring charges resulted from the merger of the charters of the Corporation’s two commercial banks During 2004, the Corporation recorded merger and integration charges totaling $2,125 ($1,381, net of taxes). The merger and integration charges related to the acquisition of Pittsburgh Financial Corp. (“PFC”). The charges included $485 related to the write-off of the unamortized capitalized costs for the subordinated debentures that were previously issued by PFC and were called and paid off in January of 2004. Also included in the merger and integration charges were $1,640 in salary and beneﬁt severance expenses that were accrued during the ﬁrst nine months of 2004. The severance costs were for 23 employees whose positions were eliminated as part of the acquisition. NOTE 6—Business Combinations Effective May 24, 2004, the Corporation acquired 100% of the outstanding shares of GA Financial, Inc. (“GAF”), a savings and loan holding company, which was headquartered in Whitehall, Pennsylvania. GAF was the parent company of Great American Federal. As a result of the acquisition, GAF merged into First Commonwealth Financial Corporation and Great American Federal merged into First Commonwealth Bank. Shareholders of GAF elected to receive $35.00 in cash or an equivalent of First Commonwealth common stock for each GAF share owned. The aggregate purchase price of the transaction was $176,669, which included cash in the amount 27 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) NOTE 6—Business Combinations (continued) of $71,427 and common stock valued at $105,242. The value of the 8,274,123 issued shares of First Commonwealth common stock was based on the average market price of First Commonwealth’s common stock over the ten-day period ending three trading days prior to consummation of the acquisition. The customer deposit base of $15,700 was the only amortizing intangible that was recorded with the transaction. As of December 31, 2004, the accumulated amortization related to the GAF customer deposit base intangible was $1,149. The estimated amortization expense that should be recorded in each of the next ﬁve years is $1,969. The weighted-average useful life of the customer deposit base intangible is 8 years. The goodwill that was recorded with the transaction is not deductible for tax purposes. Effective December 5, 2003, the Corporation acquired 100% of the outstanding shares of Pittsburgh Financial Corp., a ﬁnancial holding company, which was headquartered in Wexford, Pennsylvania. PFC was the parent company of Pittsburgh Savings Bank (d/b/a BankPittsburgh). As a result of the merger, PFC merged into First Commonwealth Financial Corporation and BankPittsburgh merged into First Commonwealth Bank. Shareholders of PFC elected to receive $20.00 in cash or an equivalent of First Commonwealth common stock for each PFC share owned. The aggregate purchase price of the transaction was $28,589, which included $11,587 in cash and common stock valued at $17,002. The value of the 1,179,037 issued shares of First Commonwealth common stock was based on the average market price of First Commonwealth’s common stock over the ten-day period ending three trading days prior to consummation of the acquisition. The customer deposit base of $3,270 was the only amortizing intangible that was recorded with the transaction. As of December 31, 2004, the accumulated amortization related to the PFC customer deposit base intangible was $314. The estimated amortization expense that should be recorded in each of the next ﬁve years is $290. The weighted-average useful life of the customer deposit base intangible is 12 years. The goodwill that was recorded with the transaction is not deductible for tax purposes. The acquisitions of GAF and PFC were signiﬁcant steps for the Corporation to implement its strategy for expansion into the Pittsburgh, Pennsylvania market. The acquisitions add an additional customer base, which presents the opportunity for First Commonwealth Bank to offer insurance, trust and ﬁnancial planning services to a larger base of customers. The GAF and PFC mergers were accounted for as purchase accounting transactions whereby the identiﬁable tangible and intangible assets and liabilities of GAF and PFC were recorded at their fair values as of the acquisition date. 28 Purchase accounting valuation adjustments, which represent the difference between the carrying value and the fair value of identiﬁable tangible and intangible assets and liabilities, were recorded in the Consolidated Balance Sheets for December 31, 2004 and 2003. As of December 31, 2004, preliminary goodwill in the amount of $93,921 was recorded as a result of the GAF transaction and goodwill in the amount of $21,555 was recorded as a result of the PFC transaction. As prescribed under the purchase method of accounting, the results of GAF and PFC’s operations have been included in the Consolidated Financial Statements since the acquisition date. Effective March 1, 2002, the Corporation acquired all of the outstanding shares of Strategic Capital Concepts, Inc. (“SCC”) and Strategic Financial Advisors, Inc. (“SFA”), each a Pennsylvania corporation headquartered in Allison Park, Pennsylvania. As a registered investment advisor, SCC provided ﬁnancial planning, asset management and consulting services to individuals, businesses, retirement plans, trusts and estates. SFA offered investment and insurance products as well as employee beneﬁt services. Each of the outstanding shares of SCC and SFA were exchanged for shares of the Corporation’s common stock. In addition, the shareholders of SCC and SFA are entitled to receive additional shares of the Corporation’s common stock for each of the years 2002 through 2005 based on a formula deﬁned in the merger agreement which takes into consideration the ﬁnancial performance of SCC and SFA after the merger date. The merger was accounted for as a purchase transaction whereby the identiﬁable tangible and intangible assets and liabilities of SCC and SFA have been recorded at their fair values at the acquisition date. Goodwill in the amount of $1,656 was recorded as a result of the transaction. As prescribed under the purchase method of accounting, the results of operations of SCC and SFA from the date of acquisition are included in the Corporation’s ﬁnancial statements for 2002. In October 2002, SFA was merged into SCC and the name was changed to First Commonwealth Financial Advisors, Inc. This acquisition should expand the Corporation’s product offerings and positively impact fee based revenue, which is a continuing priority. NOTE 7—Cash and Due From Banks on Demand Regulations of the Board of Governors of the Federal Reserve System impose uniform reserve requirements on all depository institutions with transaction accounts (checking accounts, NOW accounts, etc.). Reserves are maintained in the form of vault cash or a noninterest-bearing balance held with the Federal Reserve Bank. The subsidiary bank maintained with the Federal Reserve Bank average balances of $612 during 2004 and $844 during 2003. NOTE 8—Derivative Instruments The Corporation entered into an interest rate swap transaction during the third quarter of 2003 and two additional interest FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) rate swap transactions during the second quarter of 2004. Each of the swaps had a notional amount of $25,000, for a total of $75,000, and were initiated to hedge exposure to the variability in the future cash ﬂows derived from adjustable rate loans. Each of the interest rate swaps will convert the interest receivables generated by the ﬁrst $25,000 of principal outstandings of three month LIBOR based adjustable commercial loans from an adjustable rate to a ﬁxed rate. The swaps are traditional pay-ﬂoating and receive-ﬁxed interest rate swaps with original maturities ranging from 2.5 to 3 years. The transactions are classiﬁed as cash ﬂow hedges whereby the fair value of each swap is recorded as “Other Assets” or “Other Liabilities” and changes in the fair value are recorded as “Other Comprehensive Income,” a component of shareholders’ equity. During 2004, the hedge transactions had no ineffectiveness. NOTE 9—Securities Available For Sale Below is an analysis of the amortized cost and approximate fair values of securities available for sale at December 31, 2004 and 2003: 2004 2003 Gross Amortized Unrealized Unrealized Gains 4 Cost 23,470 $ Losses -0- $ $ $ Fair Value 23,474 $ Gross Amortized Unrealized Unrealized Gains 18 Cost 24,301 Losses Gross $ $ Approximate Fair Value -0- $ 24,319 Gross Approximate U.S. Treasury Securities Obligations of U.S. Government Corporation and Agencies: Mortgage Backed Securities 1,362,705 11,219 (10,874) 1,363,050 1,210,347 12,702 (8,298) 1,214,751 Other 277,085 211 (3,227) 274,069 252,243 803 (1,008) 252,038 Obligations of States and Political Subdivisions Debt Securities Issued by Foreign Governments 190,895 6,810 (75) 197,630 156,790 4,650 (99) 161,341 -0- -0- -0- -0- 50 -0- -0- 50 Corporate Securities 206,719 8,403 (458) 214,664 204,843 8,607 (216) 213,234 Other Mortgage Backed Securities Total Debt Securities 2,217 2,063,091 76 26,723 -0- (14,634) 2,293 2,075,180 4,178 1,852,752 36 26,816 -0- (9,621) 4,214 1,869,947 Equities Total Securities Available for Sale 83,665 $2,146,756 3,468 $30,191 -0- $ (14,634) 87,133 $ 2,162,313 93,103 $ 1,945,855 6,126 $ 32,942 -0- 99,229 $ (9,621) $ 1,969,176 Mortgage backed securities include mortgage backed obligations of U.S. Government agencies and corporations, mortgage backed securities issued by other organizations and other asset backed securities. These obligations have contractual maturities ranging from less than one year to approximately 29 years and have an anticipated average life to maturity ranging from less than one year to approximately 18 years. All mortgage backed securities contain a certain amount of risk related to the uncertainty of prepayments of the underlying mortgages. Interest rate changes have a direct impact upon prepayment speeds, therefore the Corporation uses computer simulation models to test the average life and yield volatility of all mortgage backed securities under various interest rate scenarios to insure that volatility falls within acceptable limits. At December 31, 2004 and 2003, the Corporation owned no high risk mortgage backed securities as deﬁned by the Federal Financial Institutions Examination Council’s Supervisory Policy Statement on Securities Activities. The amortized cost and estimated market value of debt securities at December 31, 2004, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or repay obligations with or without call or prepayment penalties. Due within 1 year Due after 1 but within 5 years Due after 5 but within 10 years Due after 10 years Mortgage Backed Securities Total Debt Securities Amortized Approximate $ Cost 34,974 312,568 31,725 318,902 698,169 1,364,922 $ 2,063,091 Fair Value 34,985 $ 309,288 33,185 332,379 709,837 1,365,343 $ 2,075,180 Proceeds from the sales of securities available for sale were $115,726, $62,941 and $15,328 during 2004, 2003 and 2002, respectively. Gross gains of $4,214, $5,709 and $609 and gross losses of $302, $-0- and $-0- were realized on those sales during 2004, 2003 and 2002, respectively. Securities available for sale with an approximate fair value of $1,090,019 and $949,602 were pledged at December 31, 2004 and 2003, respectively, to secure public deposits and for other purposes required or permitted by law. 29 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) NOTE 9—Securities Available For Sale (continued) The following table shows the book value or fair market value of securities available for sale as of December 31, 2002: U.S. Treasury Securities Obligations of U.S. Government Corporation and Agencies: Mortgage Backed Securities Other Obligations of States and Political Subdivisions Debt Securities Issued by Foreign Governments Corporate Securities Other Mortgage Backed Securities Total Debt Securities Equities Total Securities Available for Sale Approximate Fair Value $ 3,596 895,361 102,788 118,629 75 243,988 52,346 1,416,783 65,988 $ 1,482,771 NOTE 10—Securities Held to Maturity Below is an analysis of the amortized cost and approximate fair values of debt securities held to maturity at December 31, 2004 and 2003: 2004 2003 Gross Amortized Unrealized Unrealized Gains Losses Cost Fair Value Gross Approximate Gross Amortized Unrealized Unrealized Gains Losses Gross Cost Approximate Fair Value Obligations of U.S. Government Corporation and Agencies: Mortgage Backed Securities $ 4,389 $ 208 $ -0- $ 4,597 $ 8,143 $ 444 $ -0- $ 8,587 Other -0- -0- -0- -0- 10,000 366 -0- 10,366 Obligations of States and Political Subdivisions Debt Securities Issued by Foreign Governments Corporate Securities 73,370 3,514 -0- 76,884 76,716 4,322 -0- 81,038 405 -0- -0- -0- -0- -0- 405 -0- 408 -0- 8,987 223 -0- -0- 408 9,210 Total Securities Held to Maturity $ 78,164 $ 3,722 $ -0- $ 81,886 $ 104,254 $ 5,355 $ -0- $ 109,609 The amortized cost and estimated market value of debt securities at December 31, 2004, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or repay obligations with or without call or prepayment penalties. Due within 1 year Due after 1 but within 5 years Due after 5 but within 10 years Due after 10 years Mortgage Backed Securities Total Debt Securities Amortized Approximate Cost 2,477 15,936 29,286 26,076 73,775 4,389 78,164 $ $ Fair Value 2,508 $ 16,516 31,101 27,164 77,289 4,597 81,886 $ There were no sales of securities held to maturity in 2004, 2003 or 2002. 30 Securities held to maturity with an amortized cost of $70,227 and $98,173 were pledged at December 31, 2004 and 2003, respectively, to secure public deposits and for other purposes required or permitted by law. The following table shows the book value or amortized cost of securities held to maturity as of December 31, 2002: Amortized Cost Obligations of U.S. Government Corporation and Agencies: Mortgage Backed Securities Other Obligations of States and Political Subdivisions Debt Securities Issued by Foreign Governments Corporate Securities $ Total Securities Held to Maturity $ 63,535 15,000 96,869 408 22,026 197,838 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) NOTE 11—Other-Than-Temporary Impairment of Investments The following table presents the gross unrealized losses and fair values at December 31, 2004 by investment category and time frame for which the loss has been outstanding: Description of Securities Fair Value Unrealized Losses Fair Value Unrealized Losses Fair Value Unrealized Losses Less Than 12 Months 12 Months or More Total U.S. Treasury Obligations $ -0- $ -0- $ -0- $ -0- $ -0- $ -0- U.S. Government Agency Obligations 199,421 (2,766) 24,513 (461) 223,934 (3,227) U.S. Government Agency CMO and MBS Corporate Securities Municipal Securities Total Securities 533,729 29,860 577 (3,835) (178) -0- 304,180 18,290 3,522 (7,039) 837,909 (10,874) (280) (75) 48,150 4,099 (458) (75) $ 763,587 $ (6,779) $ 350,505 $ (7,855) $ 1,114,092 $ (14,634) At December 31, 2004, 97% of the unrealized losses were comprised of securities issued by U.S. Government agencies, U.S. Government sponsored agencies and investment grade municipalities. Corporate securities, comprising 3% of the unrealized losses, consist of 12 issues by companies in the ﬁnancial services industry. Two of the issues are non-rated and have unrealized losses of $15, or .1% of the total. A total of 109 positions are temporarily impaired and none individually has an unrealized loss of more than 5% of its respective amortized cost basis. Management does not believe any individual loss as of December 31, 2004 represents an other-than-temporary impairment. The unrealized losses are predominantly attributable to changes in interest rates and not from the deterioration of the creditworthiness of the issuer. Management has both the intent and ability to hold the securities represented in the table for a time necessary to recover the amortized cost. The following table presents the gross unrealized losses and fair values at December 31, 2003 by investment category and time frame for which the loss has been outstanding: Less Than 12 Months Description of Securities U.S. Treasury Obligations U.S. Government Agency Obligations U.S. Government Agency CMO and MBS Corporate Securities Municipal Securities $ Fair Value -0- 101,423 687,974 21,448 10,286 Total Securities $ 821,131 $ Unrealized Losses $ NOTE 12—Loans Loans at year end were divided among these general categories: Commercial, financial, agricultural and other Real estate loans: Construction and land development 1-4 family dwellings Other real estate loans Loans to individuals for household, family and other personal expenditures Leases, net of unearned income Subtotal Unearned income Total loans and leases December 31, 2004 2003 $ 715,280 $ 655,740 71,351 1,164,707 988,611 27,063 821,159 771,861 562,321 12,815 3,515,085 (252) $ 3,514,833 521,481 28,033 2,825,337 (455) $ 2,824,882 Most of the Corporation’s business activity was with customers located within Pennsylvania. The portfolio is well diversiﬁed, and as of December 31, 2004 and 2003, there were no signiﬁcant concentrations of credit. The following table identiﬁes the amount of nonperforming loans as of December 31: -0- (1,008) (8,298) (216) (99) (9,621) Loans on nonaccrual basis Past due loans Renegotiated loans Total nonperforming loans 2004 10,732 14,671 183 25,586 $ $ 2003 12,459 10,586 195 23,240 $ $ As of December 31, 2003, there were no unrealized losses in the investment portfolio that were outstanding for twelve months or more. 31 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) NOTE 13—Allowance for Credit Losses Description of changes: Allowance at January 1 Additions: Recoveries of previously charged off loans Provisions charged to operating expense From acquisition Deductions: 2004 37,385 2003 34,496 $ $ 2002 34,157 $ 1,237 1,705 2,048 8,070 4,983 12,770 3,109 12,223 -0- Loans charged off Allowance at December 31 10,612 41,063 14,695 37,385 $ $ 13,932 34,496 $ Relationship to impaired loans: Recorded investment in impaired loans at end of period Average balance of impaired loans for the year Allowance for credit losses related to impaired loans Impaired loans with an allocation of the allowance for credit losses Impaired loans with no allocation of the allowance for credit losses Income recorded on impaired loans on a cash basis 2004 2003 2002 $ $ $ 10,915 $ 12,654 $ 23,657 12,601 $ 19,866 $ 24,740 2,252 $ 2,048 $ 5,204 $ 6,500 $ 6,327 $ 15,065 $ $ 4,415 307 $ $ 6,327 1,185 $ $ 8,592 286 NOTE 14—Financial Guarantees The Corporation is a party to ﬁnancial instruments with off-balance sheet risk in the normal course of business to meet the ﬁnancial needs of its customers. These ﬁnancial instruments include commitments to extend credit, standby letters of credit and commercial letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract or notional amount of those instruments reﬂects the extent of involvement the Corporation has in particular classes of ﬁnancial instruments. As of December 31, 2004 and 2003, the Corporation did not own or trade other ﬁnancial instruments with signiﬁcant off-balance sheet risk including derivatives such as futures, forwards, option contracts and the like, although such instruments may be appropriate to use in the future to manage interest rate risk. See NOTE 8 (Derivative Instruments) for a description of interest rate swaps. The Corporation’s exposure to credit loss in the event of nonperformance by the other party of the ﬁnancial instrument for commitments to extend credit, standby letters of credit and commercial letters of credit written is represented by the contract or notional amount of those instruments. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. 32 The following table identiﬁes the notional amount of those instruments at December 31, 2004 and 2003: Financial instruments whose contract amounts represent credit risk: Commitments to extend credit Standby letters of credit Commercial letters of credit 2004 2003 $ 744,942 23,079 $ 215 $ $ $ $ 620,403 28,836 328 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have ﬁxed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based on management’s credit evaluation of the counter-party. Collateral that is held varies but may include accounts receivable, inventory, property, plant and equipment, residential and income-producing commercial properties. Standby letters of credit and commercial letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Current notional amounts outstanding at December 31, 2004, for ﬁnancial standby letters of credit and performance standby letters of credit include amounts of $8,218 and $3,375, respectively, issued during 2004 and subject to the provisions of FIN 45. There is currently no liability recorded on the Corporation’s balance sheet related to these letters of credit. NOTE 15—Premises and Equipment Premises and equipment are described as follows: Land Buildings and improvements Leasehold improvements Furniture and equipment Software Subtotal Estimated Useful Life Indefinite 10-50 Years 5-40 Years 3-10 Years 3-7 Years Less accumulated depreciation and amortization Total premises and equipment $ 2004 10,257 61,048 11,132 68,819 18,636 169,892 $ 2003 7,177 47,438 10,043 58,028 16,599 139,285 112,927 56,965 $ 92,747 46,538 $ Depreciation and amortization related to premises and equipment was $8,017 in 2004, $7,261 in 2003 and $6,840 in 2002. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) The Corporation leases various premises and assorted equipment under noncancellable agreements. Total future minimal rental commitments at December 31, 2004, were as follows: NOTE 16—Interest-Bearing Deposits Components of interest-bearing deposits at December 31 were as follows: 2005 2006 2007 2008 2009 Thereafter Total Premises 2,239 2,179 2,012 1,717 1,431 7,746 17,324 $ $ $ Equipment 463 448 114 113 -0- -0- $ 1,138 Included in the lease commitments above is $827.5 in lease payments to be paid under a sale-leaseback arrangement, whereby a gain of $297 on the sale of a branch is being recognized over the 15 year lease term. Under the terms of various lease agreements, increases in utilities and taxes may be passed on to the lessee. Such adjustments are not reﬂected in the above table. Additionally, various lease renewal options are available and are not included in the minimum lease commitments until such options are exercised. Total lease expense amounted to $3,180 in 2004, $1,939 in 2003 and $1,699 in 2002. NOTE 17—Short-term Borrowings Short-term borrowings at December 31 were as follows: NOW and Super NOW accounts Savings and MMDA accounts Time deposits Total interest-bearing deposits $ 2004 92,168 1,703,258 1,568,206 $ 3,363,632 2003 $ 110,618 1,302,451 1,466,559 $ 2,879,628 Interest-bearing deposits at December 31, 2004 and 2003, include allocations from NOW and Super NOW accounts of $451,938 and $405,521, respectively, into Savings and MMDA accounts. These reallocations are based on a formula and have been made to reduce the Corporation’s reserve requirement in compliance with regulatory guidelines. Included in time deposits at December 31, 2004 and 2003, were certiﬁcates of deposit in denominations of $100 or more of $417,988 and $398,716, respectively. Interest expense related to $100 or greater certiﬁcates of deposit amounted to $15,652 in 2004, $18,227 in 2003 and $21,685 in 2002. Included in time deposits at December 31, 2004, were certiﬁcates of deposit with the following scheduled maturities: 2005 2006 2007 2008 2009 and thereafter $ 649,683 374,273 330,536 104,733 108,981 $ 1,568,206 Federal funds purchased Borrowings from FHLB Securities sold under agreements to repurchase Treasury, tax and loan note option Total Maximum total at any month-end 2004 Ending Average Average Balance Balance 35,750 $ 81,972 230,204 340,000 Rate 1.46% 1.75% $ Ending Balance 2003 Average Average Balance $ 14,100 $ 68,455 151,860 120,000 Rate 1.32% 1.33% 2002 Ending Average Average Balance Balance $ 63,169 $ 51,600 30,044 146,395 Rate 1.86% 1.76% 477,562 93,162 466,381 18,035 $ 946,474 $ 796,592 $ 1,015,881 1.38% 1.65% 1.51% 326,226 450,140 49,887 7,592 $ 634,127 $ 554,133 $ 699,326 1.16% 0.87% 1.22% 225,793 222,577 48,493 20,902 $ 469,065 $ 339,908 $ 469,065 1.78% 1.47% 1.77% Interest expense on short-term borrowings for the years ended December 31 is detailed below: Federal funds purchased Borrowings from FHLB Securities sold under $ 2004 1,199 4,040 $ 2003 902 2,019 $ agreements to repurchase Treasury, tax and loan note option 6,452 298 3,768 66 Total interest on 2002 1,176 530 4,015 308 short-term borrowings $ 11,989 $ 6,755 $ 6,029 33 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) NOTE 18—Subordinated Debentures Subordinated Debentures outstanding at December 31 are as follows: 2004 2003 Amount Rate Amount Rate Subordinated Debentures: Owed to Pittsburgh Home Capital Trust I and due 2028 $ -0- $ 8,292 8.56% Owed to First Commonwealth Capital Trust I and due 2029 Owed to First Commonwealth Capital Trust II and due 2033 Owed to First Commonwealth Capital Trust III and due 2034 Total junior subordinated debentures owed to unconsolidated subsidiary trusts 36,083 9.50% 36,083 9.50% LIBOR + LIBOR+ 30,929 2.85% 30,929 2.85% 41,238 5.888% -0- $ 108,250 $ 75,304 The Corporation has established three trusts, First Commonwealth Capital Trust I, First Commonwealth Capital Trust II and First Commonwealth Capital Trust III, of which 100% of the common equity is owned by the Corporation. The trusts were formed for the purpose of issuing company obligated mandatorily redeemable capital securities to third- party investors and investing the proceeds from the sale of the capital securities solely in junior subordinated debt securities (“subordinated debentures”) of the Corporation. The subordinated debentures held by each trust are the sole assets of the trust. Proceeds from subordinated debentures issued to First Commonwealth Capital Trust III and First Commonwealth Capital Trust II in March 2004 and December 2003, respectively, were used to ﬁnance the business combination of GAF. See NOTE 6 (Business Combinations) for a description of the business combination. Interest on the debentures issued to First Commonwealth Capital Trust III is paid quarterly at a ﬁxed rate of 5.888% for each interest payment prior to April 2009 and LIBOR plus 2.85% for each payment beginning with April 2009 and after. LIBOR is reset quarterly. Subject to regulatory approval, the Corporation may redeem the debentures, in whole or in part, at its option on any interest payment date on or after April 7, 2009, at a redemption price equal to 100% of the principal amount of the debentures. Subject to regulatory approval, the Corporation may also redeem the debentures prior to April 7, 2009, within 90 days following the occurrence of certain tax or bank regulatory events at a special redemption price that is greater than 100%. Deferred issuance costs of $630 are being amortized on a straight-line basis over the term of the securities. Interest on the debentures issued to First Commonwealth Capital Trust II is paid quarterly at a ﬂoating rate of LIBOR plus 2.85% which is reset quarterly. The Corporation may redeem the debentures, in whole or in part, at its option on or after January 23, 2009, at a redemption price equal to 100% of the principal amount of the debentures, plus accrued and unpaid interest to the date of the redemption. Subject to regulatory approval, the Corporation may also redeem the debentures prior to January 23, 2009, within 90 days following the occurrence of certain tax or bank regulatory events at a special redemption price that is greater than 100%. Deferred issuance costs of $471 are being amortized on a straight-line basis over the term of the securities. Subordinated debentures outstanding at December 31, 2003, included $8,292 previously issued by PFC to Pittsburgh Home Capital Trust I. These debentures were assumed by the Corporation when it acquired PFC in December 2003, and were called, in accordance with terms of the debentures, and paid by the Corporation in January 2004. The subordinated debentures issued to First Commonwealth Capital Trust I have the same economic terms as the capital securities issued by the trust. The trust will redeem all of the outstanding capital securities when the debentures are paid at maturity. Subject to regulatory approvals, the Corporation may redeem the debentures, in whole or in part, at any time on or after September 1, 2009, at a redemption price equal to 104.75% of the principal amount of the debentures on September 1, 2009, declining ratably on each September 1 thereafter to 100% on September 1, 2019, plus accrued and unpaid interest to the date of the redemption. The Corporation may also redeem the debentures prior to September 1, 2009, upon the occurrence of certain tax or bank regulatory events, subject to regulatory approval. 34 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) NOTE 19—Other Long-term Debt Other long-term debt at December 31 follows: 2004 2003 ESOP loan due December 2005 ESOP loan due March 2006 ESOP loan due December 2012 Repos due: 2008 Borrowings from FHLB due: 2004 2005 2006 2007 2008 2009 2010 2011 2014 2016 2017 2019 2020 2022 Amount $ 661 -0- 5,514 Weighted Average Weighted Average Contractual Rate LIBOR +1% Effective Rate LIBOR +1% LIBOR +1.25% LIBOR +1.25% Amount $ 1,994 620 Weighted Average Weighted Average Contractual Rate LIBOR +1% 8.50% Effective Rate LIBOR +1% 8.50% 21,970 5.51% 2.46% 22,522 5.51% -0- 8,288 40,930 75,855 106,435 222,563 148,822 59,674 17,165 1,646 5,983 7,470 790 7,558 $ 731,324 5.44% 3.50% 3.86% 4.97% 4.25% 5.14% 4.96% 5.40% 5.65% 6.17% 5.72% 7.37% 5.90% 2.05% 3.02% 3.49% 3.30% 3.66% 4.01% 4.01% 4.61% 5.65% 6.17% 5.72% 7.37% 5.90% 19,271 8,555 6,104 21,319 438,413 11,557 140,025 5,895 17,964 1,748 6,271 7,789 817 7,804 718,668 $ 5.81% 5.46% 6.01% 5.20% 5.39% 6.49% 5.70% 5.68% 5.40% 5.65% 6.17% 5.72% 7.37% 5.90% 2.46% 1.38% 2.05% 2.67% 4.08% 5.26% 3.52% 4.47% 5.68% 4.64% 5.65% 6.17% 5.72% 7.37% 5.90% The weighted-average contractual rate reﬂects the rate due to creditor. The weighted-average effective rates of long-term debt in the schedule above include the effects of the purchase accounting valuation adjustments that were recorded for the acquisition that was discussed in NOTE 6 (Business Combinations). FHLB advances in the amount of $307,575 are convertible on a quarterly basis at the FHLB’s option into ﬂoating rate debt indexed to 3 month LIBOR. Advances in the amount of $22,500 become convertible at the FHLB’s option into ﬂoating rate debt indexed to 3 month LIBOR beginning December 19, 2005 through April 24, 2006 and quarterly thereafter. Advances in the amount of $160,000 become convertible at the FHLB’s option into ﬂoating rate debt indexed to 3 month LIBOR beginning July 25, 2005 and quarterly thereafter but only if 3 month LIBOR is 6% or higher. Should the FHLB elect to convert an advance to a ﬂoating rate, the bank has the right to pay off the advance without penalty. All Federal Home Loan Bank stock, along with an interest in unspeciﬁed mortgage loans and mortgage-backed securities, with an aggregate statutory value equal to the amount of the above advances, have been pledged as collateral with the Federal Home Loan Bank of Pittsburgh. Capital securities included in total long-term debt on the Consolidated Balance Sheets are excluded from this Note, but are described in NOTE 18 (Subordinated Debentures). Scheduled loan payments for other long-term debt are summarized below: 2005 2006 2007 2008 2009 Thereafter $ 25,423 $ 58,693 $ 64,813 $ 130,354 $ 201,645 $ 226,459 Long-term debt payments Purchase valuation amortization $ 5,493 $ 5,365 $ 5,190 $ 4,056 $ 2,397 $ 1,436 The amounts on the purchase valuation amortization row in the table above include fair market adjustments from the business combination, which is described in NOTE 6 (Business Combinations). The third quarter of 2004 included a previously announced charge of $29,495 ($19,172 after tax) representing a penalty for the prepayment of $440,000 in Federal Home Loan Bank, or FHLB, long-term borrowings. The prepayment penalty is reﬂected as “Debt Prepayment Fees” in the Consolidated Statements of Income. The FHLB borrowings were replaced with other borrowings having maturities ranging from overnight to 2010. This transaction expands the maturity distribution of the company’s FHLB advances to minimize the impact of maturities on any one year. It also reduced the initial interest cost on the $440,000 in FHLB advances by 292 basis points (2.92%). First Commonwealth expects that the transaction will result in an increase in net interest income over the remaining term of the original advances in excess of the prepayment penalty. NOTE 20—Common Share Commitments At December 31, 2004 and 2003, the Corporation had 100,000,000 common shares authorized. 71,978,658 shares 35 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) NOTE 20—Common Share Commitments (continued) were issued at December 31, 2004, and 63,704,445 shares were issued at December 31, 2003. Issued shares were reduced by 2,109,660 shares of treasury stock at December 31, 2004 and 2,992,425 shares of treasury stock at December 31, 2003. The Corporation may be required to issue additional shares to satisfy common share purchases related to the employee stock ownership plan described in NOTE 22 (Retirement Plans). The dilutive effect of stock options outstanding on average shares outstanding in the diluted earnings per share reported on the income statement were 599,905, 384,778 and 332,404 shares at December 31, 2004, 2003 and 2002, respectively. Treasury shares consisting of 906,494 and 552,781 were reissued during 2004 and 2003 upon exercise of stock options. Treasury shares consisting of 16,107 and 17,663 were reissued in 2004 and 2003, respectively, to fund the business combination with SCC and SFA as described in NOTE 6 (Business Combinations). Treasury shares consisting of 39,836 were acquired as part of the GAF acquisition. During 2004, 8,274,123 common shares were issued to fund the business combination with GAF and during 2003, 1,179,037 common shares were issued to fund the business combination with PFC. These transactions are also described in NOTE 6 (Business Combinations). NOTE 21—Income Taxes The income tax provision consists of: 2004 2003 2002 Current tax provision for income exclusive of securities transactions: Federal State $ Securities transactions Total current tax provision Benefit of operating loss carryforwards Deferred tax provision (benefit) $ Total tax provision 4,138 -0- 1,427 5,565 (474) (1,384) 3,707 $ 9,279 1 225 9,505 -0- (594) 8,911 $ $ 13,438 -0- 2,048 15,486 -0- (2,235) $ 13,251 2004 Temporary differences between ﬁnancial statement carrying amounts and tax bases of assets and liabilities that represent signiﬁcant portions of the deferred tax assets (liabilities) at December 31, 2004 and 2003, were as follows: 2004 2003 Deferred tax assets: Allowance for credit losses Postretirement benefits other than pensions Basis difference in assets acquired Severance expense Net operating loss carryforward from acquisition Alternative minimum tax credit carryforward Other tax credit carryforward Deferred compensation Other Total deferred tax assets $ 13,997 1,211 6,409 239 1,174 3,297 1,428 854 825 29,434 $ 13,107 1,040 4,710 250 -0- -0- -0- 788 352 20,247 Deferred tax liabilities: Accumulated accretion of bond discount Unrealized gain on securities available for sale Lease financing deduction Loan origination fees and costs Accumulated depreciation Other Total deferred tax (liabilities) (121) (124) (5,445) (3,243) (1,473) (1,737) (490) (12,509) (8,166) (6,439) (1,562) (1,343) (574) (18,208) Net deferred tax asset $ 16,925 $ 2,039 A net operating loss carryforward from acquisition of $3,353 is remaining at December 31, 2004. This carryforward expires in 2024. A tax credit carryforward of $1,428 is remaining as of December 31, 2004, and expires in 2024. Management believes that future taxable income will be sufﬁcient to fully realize the deferred tax assets associated with these carryforwards. The total tax provision for ﬁnancial reporting differs from the amount computed by applying the statutory income tax rate to income before taxes. The differences are as follows: 2003 2002 Amount % of Pretax Income Amount % of Pretax Income Amount % of Pretax Income $ 14,826 35.0 $ 23,293 35.0 $ 18,353 35.0 (1,805) (7,364) -0- (1,428) (522) 3,707 (4.2) (17.4) 0.0 (3.4) (1.2) 8.8 (1,520) (7,332) -0- (651) (539) $ 13,251 (2.3) (11.0) 0.0 (1.0) (0.8) 19.9 (1,649) (6,216) 1 (531) (1,047) 8,911 $ (3.1) (11.9) 0.0 (1.0) (2.0) 17.0 Tax at statutory rate Increase (decrease) resulting from: Income from bank owned life insurance Other nontaxable interest State income taxes Tax credits Other Total tax provision $ 36 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) NOTE 22—Retirement Plans All employees with at least one year of service are eligible to participate in the employee stock ownership plan (“ESOP”). Contributions to the plan are determined by the Board of Directors, and are based upon a prescribed percentage of the annual compensation of all participants. During the current period, the ESOP acquired shares of the Corporation’s common stock in a transaction, whereby the ESOP Trust borrowed funds which were guaranteed by the Corporation. In addition, the borrowings related to the ESOP as of December 31, 2004, included amounts that were borrowed in a similar transaction that took place in a prior period. The borrowed amounts represent leveraged and unallocated shares, and accordingly have been recorded as long-term debt with the offset as a reduction of common shareholders’ equity. Compensation costs related to the plan were $1,442 in 2004, $938 in 2003 and $940 in 2002. See NOTE 23 (Unearned ESOP Shares) for additional information on the ESOP. The employees of PFC were covered by a leveraged ESOP plan. The PFC ESOP had unallocated ESOP shares of 43,174 at the merger date. The plan was terminated effective December 5, 2003. After liquidation of unallocated ESOP shares with a fair value of $620, which were utilized to pay off the outstanding PFC ESOP loan payable, remaining shares were allocated to the participants of the PFC ESOP during 2004. No compensation cost for the PFC ESOP was required to be recognized in the Consolidated Statements of Income. The employees of GAF were covered by a leveraged ESOP plan. The GAF ESOP had unallocated ESOP shares of 157,730 as of December 31, 2004, with a fair market value of $2,427. Termination of the plan is pending approval from the Internal Revenue Service. Once approval is received, the remaining shares will be allocated to participants of the GAF ESOP. No compensation cost for the GAF ESOP is required to be recognized in the Consolidated Statements of Income. The Corporation also has a savings plan pursuant to the provisions of section 401(k) of the Internal Revenue code. Under the terms of the plan, each participant will receive an automatic employer contribution to the plan in an amount equal to 3% of compensation. Each participating employee may contribute up to 80% of compensation to the plan of which up to 4% is matched 100% by the employer’s contribution. The 401(k) plan expense was $2,977 in 2004, $2,606 in 2003 and $2,616 in 2002. Prior to the plan amendment effective February 1, 2002, the Corporation’s 401(k) plan permitted each participating employee to contribute 10% of compensation to the plan of which up to 4% was matched 100% by the employer’s contribution. The 401(k) plan of PFC was merged into the Corporation’s 401(k) plan effective January 1, 2004, whereby all eligible PFC employees began to participate in the Corporation’s plan with no lapse in credited service. During the period from the merger date of December 5, 2003, until December 31, 2003, the PFC employees continued to participate in the PFC plan and to receive employer contributions under the terms of the plan. The GAF 401(k) plan was merged into the Corporation’s 401(k) plan effective July 1, 2004, whereby all eligible GAF employees began to participate in the Corporation’s plan with no lapse in credited service. During the period from the merger date of May 24, 2004, until June 30, 2004, the GAF employees continued to participate in the GAF plan and to receive employer contributions under terms of the plan. Upon shareholder approval at the regular 1998 meeting, the Corporation established a “Supplemental Executive Retirement Plan” (“SERP”) to provide deferred compensation for a select group of management. The purpose of this plan is to restore some of the beneﬁts lost to the highly compensated employees compared to other employees due to limits and restrictions incorporated into the Corporation’s 401(k) and ESOP plans. The Corporation’s 401(k) and ESOP plans include restrictions on maximum compensation, actual deferral percentage, actual contribution, maximum contribution and maximum salary reduction which are required in order to meet speciﬁc legal requirements. Participants in the SERP may elect to contribute up to 25% of compensation (compensation in excess of limits of the Corporation’s 401(k) and ESOP plans) into the SERP, through salary reduction. The Corporation will make an elective contribution to the SERP equal to the elective deferred compensation of the participant for the plan year. Each participant of the SERP will also receive a matching contribution equal to 100% of the employee’s elective contribution up to 4%, and an additional non- elective contribution from the employer equal to 8% of plan compensation. In addition, the Corporation may make an extra non-elective contribution for plan participants. The SERP will continue to supplement the Corporation’s 401(k) and ESOP plans and will therefore be modiﬁed at the same time and in the same respect as the basic plans are modiﬁed in future periods. The SERP plan expense was $418 in 2004, $235 in 2003 and $133 in 2002. PFC participated in a multi-employer deﬁned beneﬁt pension plan that covered all eligible employees and provided beneﬁts based on each employee’s years of service and compensation. No contributions were made to the plan and no compensation costs were recognized in the Consolidated Statements of Income. The withdrawal penalty of $324 was accrued as a liability at December 31, 2003, and paid in 2004. Postretirement Beneﬁts other than Pensions for Acquired Subsidiaries Employees of the former Southwest Bank and GAF were covered by post retirement beneﬁt plans. The measurement date for these plans was October 1. 37 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) NOTE 22—Retirement Plans (continued) Postretirement Beneﬁts other than Pensions for Acquired Subsidiaries (continued) Net periodic beneﬁt cost of these plans was as follows: $ Service cost Interest cost on projected benefit obligation Amortization of transition obligation Loss amortization Net periodic beneﬁt cost 2004 -0- 308 2 84 $ 394 2003 -0- 338 2 121 461 $ $ 2002 $ -0- 273 2 60 $ 335 The following table sets forth the funded status of the plans and the amounts recognized on the Corporation’s Consolidated Balance Sheet as of December 31: Accumulated post retirement benefit obligation: Retirees Actives Total accumulated postretirement benefit obligation Plan assets at fair value Accumulated postretirement benefit obligation in excess of plan assets Unrecognized transition obligation Unrecognized net loss Accrued benefit liability recognized on the balance sheet 2004 2003 $ 3,784 -0- 3,784 -0- $ 5,901 -0- 5,901 -0- 3,784 (13) (310) 5,901 (14) (2,844) $ 3,461 $ 3,043 The following table sets forth the change in benefit obligation: Benefit obligation at beginning of year Assumed benefit obligation from acquisition Service cost Interest cost Benefit payments Actuarial (gain) loss Beneﬁt obligation at end of year 2004 $ 5,901 449 -0- 308 (451) (2,423) $ 3,784 2003 $ 5,142 -0- -0- 338 (379) 800 $ 5,901 The discount rate used in determining the actuarial present value of the accumulated postretirement beneﬁt obligation was 6.00% for 2004 and 6.25% for 2003. The health care cost trend rates used for 2004 were projected at an initial rate of 8.50% for 2005 decreasing over time to an annual rate of 4.75% in 2014 for both indemnity plan participants and non-indemnity plan participants. For 2003, rates used were projected at an initial rate of 8.00% for 2004 decreasing over time to an annual rate of 4.25% in 2008 for both indemnity plan participants and non-indemnity plan participants. The Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”) introduced a prescription drug beneﬁt under Medicare Part D. The Act also introduced a federal subsidy to sponsors of retiree health care beneﬁt plans that provide a prescription drug beneﬁt that is at least actuarially equivalent to Medicare Part D. The postretirement plans of the Corporation are provided through 38 insurance coverage; therefore, the Corporation will not receive a direct federal subsidy. The preceding measures of the accumulated postretirement beneﬁt obligation and the net periodic postretirement beneﬁt cost assume that the insurer will receive the subsidy and pass those savings onto the Corporation through reduced insurance premiums. The health care cost trend rate assumption can have a signiﬁcant impact on the amounts reported for this plan. A one-percentage-point change in assumed health care cost trend rates would have the following effects: Effect on total of service and interest cost components Effect on postretirement benefit obligation 1-Percentage- Point Increase 1-Percentage- Point Decrease $ (12) $ (215) $ (34) $ (569) As of December 31, 2004, the projected beneﬁt payments for the next ten years are as follows: 2005 2006 2007 2008 2009 2010-2014 $ Projected Benefit Payment 388 390 387 370 363 1,563 The projected payments were calculated using the same assumptions as those used to calculate the beneﬁt obligations included in this note. NOTE 23—Unearned ESOP Shares First Commonwealth Financial Corporation Employee Stock Ownership Plan Trust (“ESOP”) borrowed funds which were guaranteed by the Corporation. The combined balances of the ESOP related loans were $6,175 at December 31, 2004, and $1,994 at December 31, 2003. The outstanding balance at December 31, 2004, included $5,514 in additional borrowings that were used to purchase shares during 2004. The loans have been recorded as long-term debt on the Corporation’s Consolidated Balance Sheets. A like amount of unearned ESOP shares was recorded as a reduction of common shareholders’ equity. Unearned ESOP shares, included as a component of shareholders’ equity, represent the Corporation’s prepayment of future compensation expense. The shares acquired by ESOP are held in a suspense account and will be released to the ESOP for allocation to the plan participants as the debt is reduced. Repayment of the loans is scheduled to occur over a remaining one-year period for the initial loan and an eight- year period for the new loan from contributions to the ESOP by the Corporation and dividends on unallocated ESOP shares. The following is an analysis of ESOP shares held in suspense: See NOTE 1 (Statement of Accounting Policies) for the deﬁnition of “old shares” and “new shares.” FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) Shares in suspense December 31, 2002 Shares allocated during 2003 Shares in suspense December 31, 2003 Shares allocated during 2004 Shares acquired during 2004 Shares in suspense December 31, 2004 Total Old Shares New Shares 271,666 (96,118) 175,548 (124,232) 421,800 66,512 (23,533) 42,979 (28,832) -0- 205,154 (72,585) 132,569 (95,400) 421,800 473,116 14,147 458,969 The fair market value of the new shares remaining in suspense was approximately $7,064 and $1,890 at December 31, 2004 and 2003, respectively. Interest on ESOP loans was $142 in 2004, $60 in 2003 and $109 in 2002. During 2004, 2003 and 2002, dividends on unallocated shares in the amount of $195, $184 and $242, respectively, were used for debt service while all dividends on allocated shares were allocated or paid to the participants. Unearned ESOP shares from PFC at December 31, 2003 were excluded from the preceding analysis. The PFC ESOP plan was terminated effective December 5, 2003. Unallocated shares remaining after liquidation of shares to fund the PFC ESOP loan payable were allocated to PFC ESOP participants. Unearned ESOP shares from GAF at December 31, 2004 are excluded from the preceding analysis. Termination of the GAF ESOP plan is pending approval from the Internal Revenue Service. Once approval is received, the remaining unallocated shares will be allocated to GAF ESOP participants. NOTE 24—Stock Option Plan At December 31, 2003, the Corporation had a stock-based compensation plan, which is described below. All of the exercise prices and related number of shares have been restated to reﬂect historical stock splits. The plan permits the Executive Compensation Committee to grant options for up to 4.5 million shares of the Corporation’s common stock through October 15, 2005. Although the vesting requirements and terms of future options granted are at the discretion of the Executive Compensation Committee, all options granted in 2002 were exercisable by December 31, 2002. Options granted from 2003 through 2004 vested immediately on the respective grant dates. All options expire ten years from the grant date. All equity compensation plans are approved by security holders. At May 24, 2004, the Corporation consummated its merger with GAF, at which time all outstanding GAF options were converted to First Commonwealth options at a conversion rate of 2.752. These options were not granted from the Corporation’s existing stock option plan. First Commonwealth assumed the option plan of GAF. Under this plan, a total of 611,962 First Commonwealth shares were reserved for issuance due to the exercise of previously granted GAF options assumed in the merger. No further grants will be made under the GAF plan. At December 5, 2003, the Corporation consummated its merger with PFC, at which time all outstanding PFC options were converted to First Commonwealth options at a conversion rate of 1.387. These options were not granted from the Corporation’s existing stock option plan. First Commonwealth assumed the option plans of PFC. Under these plans, a total of 62,322 First Commonwealth shares were reserved for issuance due to the exercise of previously granted PFC options assumed in the merger. No further grants will be made under these PFC plans. Equity Compensation Plan Information as of December 31, 2004: Number of Weighted Average Exercise Price of Shares Available for Options Outstanding Future Grant Options Outstanding Equity compensation plans approved by security holders (a) 2,682,938 $10.61 50,274 (a) Includes plans assumed through the acquisitions of GAF and PFC. As of December 31, 2004, outstanding options related to these acquired plans totaled 603,459 with a weighted-average exercise price per share of $6.23. The Corporation has elected, as permitted by FAS No. 123, to apply APB Opinion 25 and related interpretations in accounting for its plan. Accordingly, no compensation cost has been recognized for its stock options outstanding. Had compensation cost for the Corporation’s stock option plan been determined based upon the fair value at the grant dates for awards under the plan consistent with the method of FAS No. 123, the Corporation’s net income and earnings per share would have been reduced to the pro forma amounts shown below: 2004 2003 2002 As Pro Pro Reported Forma Reported Forma Reported Forma $ 38,652 $ 38,614 $ 53,300 $ 51,948 $ 43,526 $ 41,248 Pro As As Net income Basic earnings per share Diluted earnings per share $ 0.59 $ $ 0.58 $ 0.59 $ 0.90 $ 0.88 $ 0.75 $ 0.71 0.58 $ 0.90 $ 0.87 $ 0.74 $ 0.70 The weighted-average grant-date fair value of stock options granted during 2004, 2003 and 2002 was $2.45, $3.24 and $4.27, respectively. The fair value of each option granted is estimated on the date of the grant using the Black-Scholes options pricing model with the following weighted average assumptions used: 2004 2003 4.44% per annum 5.14% per annum 5.13% per annum 2002 Dividend yield Expected volatility Risk-free 23.2% interest rate 4.1% 40.3% 4.1% 54.0% 5.0% Expected option life 7.0 years 7.0 years 7.0 years 39 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) NOTE 24—Stock Option Plan (continued) A summary of the status of the Corporation’s outstanding stock options as of December 31, 2004, 2003 and 2002 and changes for the years ending on those dates is presented below: do they present other unfavorable features. It is anticipated that further such transactions will be made in the future. The following is an analysis of loans to those parties whose aggregate loan balances exceeded $60 during 2004: 2004 2003 2002 Weighted Average Exercise Price Shares Weighted Average Exercise Price Weighted Average Exercise Price Shares Shares Balances December 31, 2003 Advances Repayments Other Balances December 31, 2004 $ $ 4,777 3,411 (4,206) 894 4,876 1 $ 7.60 62,322 $ 7.60 2,965,726 $ 11.51 2,841,772 $ 11.33 2,687,887 $ 11.13 Outstanding at beginning of year PFC converted options at merger GAF converted options at merger Granted Exercised Forfeited Outstanding at end of year 2,682,938 $ 10.61 2,965,726 $ 11.51 2,841,772 $ 11.33 Exercisable at end of year 2,682,938 $ 10.61 2,965,726 $ 11.51 2,841,772 $ 11.33 -0- $ 0.00 -0- $ 0.00 820,775 $ 11.70 641,912 $ 12.06 (549,215) $ 10.71 (447,001) $ 10.51 (31,065) $ 12.91 (219,889) $ 11.90 611,962 $ 6.24 24,000 $ 14.41 (906,494) $ 10.68 (12,257) $ 12.54 -0- $ 0.00 The following table summarizes information about the stock options outstanding at December 31, 2004: Options Exercisable Options Outstanding Weighted- Average Weighted- Number Remaining Average Number Weighted- Average Outstanding Contract Exercise Exercisable Exercise At 12/31/04 Life 5.3 4.7 6.1 5.7 6.4 5.2 539,650 $ 5.85 131,983 $ 9.27 288,683 $ 10.75 949,077 $ 11.48 $ 13.03 773,545 $ 10.61 2,682,938 539,650 131,983 288,683 949,077 773,545 2,682,938 Price $ 5.85 $ 9.27 $ 10.75 $ 11.48 $ 13.03 $ 10.61 Price At 12/31/04 Range of Exercise Prices $ 4.24-$8.99 $ 9.00-$9.99 $ 10.00-$10.99 $ 11.00-$11.99 $ 12.00-$15.00 Total NOTE 25—Contingent Liabilities There are no material proceedings to which the Corporation or its subsidiaries are a party, or of which their property is the subject, except proceedings which arise in the normal course of business and, in the opinion of management, will not have a material adverse effect on the consolidated operations or ﬁnancial position of the Corporation and its subsidiaries. NOTE 26—Related Party Transactions Some of the Corporation’s or its subsidiaries’ directors, executive ofﬁcers, principal shareholders and their related interests, had transactions with the subsidiary banks in the ordinary course of business. All deposit and loan transactions were made on substantially the same terms, such as collateral and interest rates, as those prevailing at the time for comparable transactions. In the opinion of management, these transactions do not involve more than the normal risk of collectibility nor 40 “Other” primarily reﬂects the change in those classiﬁed as a “related party” usually as a result of mergers, resignations or retirements. NOTE 27—Regulatory Restrictions and Capital Adequacy The amount of funds available to the parent from its subsidiary banks is limited by restrictions imposed on all ﬁnancial institutions by banking regulators. At December 31, 2004, dividends from subsidiary banks were restricted not to exceed $269,122. These restrictions have not had, and are not expected to have, a signiﬁcant impact on the Corporation’s ability to meet its cash obligations. The Corporation is subject to various regulatory capital requirements administered by the Federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Corporation’s ﬁnancial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation and its banking subsidiaries must meet speciﬁc capital guidelines that involve quantitative measures of the Corporation’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Corporation’s capital amounts and classiﬁcation are also subject to qualitative judgments by the regulators about components, risk weighting and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Corporation to maintain minimum amounts and ratios of total and Tier I capital (common and certain other “core” equity capital) to risk weighted assets, and of Tier I capital to average assets. As of December 31, 2004, the Corporation and its banking subsidiaries meet all capital adequacy requirements to which they are subject. As of December 31, 2004, the most recent notiﬁcations from the Federal Reserve Board and Federal Deposit Insurance Corporation categorized First Commonwealth Bank as well capitalized under the regulatory framework for prompt corrective action. To be considered as well capitalized, the bank must maintain minimum total risk-based capital, Tier I risk-based capital and Tier I leverage ratios as set forth in the table below. There are no conditions or events since that notiﬁcation that management believes have changed the institution’s category. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) Actual Amount Ratio Regulatory Minimum Ratio Amount To Be Well Capitalized Under Prompt Corrective Action Provisions Amount Ratio As of December 31, 2004 Total Capital to Risk Weighted Assets First Commonwealth Financial Corporation $ $ First Commonwealth Bank 526,916 465,350 12.8% 11.5% Tier I Capital to Risk Weighted Assets First Commonwealth Financial Corporation $ $ First Commonwealth Bank 485,853 424,287 11.8% 10.5% Tier I Capital to Average Assets First Commonwealth Financial Corporation $ $ First Commonwealth Bank 485,853 424,287 8.0% 7.0% As of December 31, 2003 Total Capital to Risk Weighted Assets First Commonwealth Financial Corporation $ $ First Commonwealth Bank 494,541 403,313 14.5% 12.0% Tier I Capital to Risk Weighted Assets First Commonwealth Financial Corporation $ $ First Commonwealth Bank 457,156 365,929 13.4% 10.9% Tier I Capital to Average Assets First Commonwealth Financial Corporation $ $ First Commonwealth Bank 457,156 365,929 9.4% 7.6% $ $ $ $ $ $ $ $ $ $ $ $ 328,500 324,296 164,250 162,148 182,772 181,076 273,207 269,734 136,603 134,867 146,571 145,263 8.0% 8.0% 4.0% 4.0% 3.0% 3.0% 8.0% 8.0% 4.0% 4.0% 3.0% 3.0% N/A 405,370 N/A 243,222 N/A 301,793 N/A 337,167 N/A 202,300 N/A 242,105 $ $ $ $ $ $ N/A 10.0% N/A 6.0% N/A 5.0% N/A 10.0% N/A 6.0% N/A 5.0% NOTE 28—Condensed Financial Information of First Commonwealth Financial Corporation (parent company only) Balance Sheets Statements of Income December 31, 2004 2003 Years Ended December 31, 2002 2003 2004 Assets Cash Securities available for sale Loans to affiliated parties Investment in subsidiaries Investment in unconsolidated subsidiary trusts Investment in jointly-owned company Premises and equipment Dividends receivable from subsidiaries Receivable from subsidiaries Other assets Total assets $ 1,181 20,545 387 601,843 3,302 5,941 5,732 5,325 6,034 10,520 $ 660,810 Liabilities and Shareholders’ Equity Accrued expenses and other liabilities Dividends payable Loans payable Subordinated debentures payable Shareholders’ equity Total liabilities and shareholders’ equity $ 2,879 11,528 6,175 108,250 531,978 $ 660,810 Interest and dividends Dividends from subsidiaries Interest expense Net securities gains (losses) Other revenue Operating expenses Income before taxes and equity in undistributed earnings of subsidiaries Applicable income tax benefits Income before equity in undistributed earnings of subsidiaries Equity in undistributed earnings of subsidiaries Net income $ $ $ $ 1,376 33,052 439 462,894 2,280 5,622 5,887 11,517 6,085 5,126 534,278 14,199 9,714 2,613 76,806 430,946 534,278 $ 50 83,715 (7,405) 84 59 (12,778) 48 $ $ 64,907 (3,629) 742 253 (9,237) 48 43,609 (3,570) -0- -0- (9,161) 63,725 7,439 53,084 4,570 30,926 5,304 71,164 57,654 36,230 (32,512) $ 38,652 (4,354) 7,296 $ 53,300 $ 43,526 41 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) NOTE 28—Condensed Financial Information of First Commonwealth Financial Corporation (parent company only) (continued) Statements of Cash Flows Operating Activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Net gains on sale of assets Decrease (increase) in prepaid income taxes Undistributed equity in subsidiaries Other—net Stock option tax benefit Net cash provided Years Ended December 31, 2002 2003 2004 $ 38,652 $ 53,300 $ 43,526 437 (84) 835 (739) 537 -0- (4,600) 256 (397) 32,512 3,006 1,239 (4,482) (2,193) 535 (7,296) 1,270 225 by operating activities 71,162 47,512 37,865 Investing Activities Transactions with securities available for sale: Purchases of investment securities Sales of investment securities Net change in loans to affiliated parties Purchases of premises and equipment (91,592) 104,058 52 (162) (32,785) 1,766 59 (125) (943) -0- 42 (33) Changes in receivable from and net investment in subsidiary Net cash used by (82,284) (28,918) 436 investing activities (69,928) (60,003) (498) Financing Activities Issuance of subordinated debentures Issuance of other long-term debt Repayment of subordinated debentures Repayment of other long-term debt Discount on dividend reinvestment 41,238 3,486 (9,794) (3,486) 30,929 -0- -0- -0- -0- -0- -0- -0- plan purchases Treasury stock reissued Cash dividends paid Net cash used by ﬁnancing activities Net increase (decrease) in cash Cash at beginning of year Cash acquired with acquisition Cash at end of year (816) 9,679 (41,736) (706) 5,923 (36,630) (637) 4,655 (35,208) (1,429) (195) 1,376 -0- $ 1,181 (484) (12,975) 13,844 507 (31,190) 6,177 7,667 -0- $ 1,376 $ 13,844 Cash dividends declared per common share were $0.645, $0.625 and $0.605 for 2004, 2003 and 2002, respectively. Dividends from subsidiaries for 2004 and 2003 included special dividends in the amounts of $7,598 and $11,436, respectively, that were received from First Commonwealth Bank, a wholly owned subsidiary. After distribution of the special dividends, which were within guidelines established by the banking regulators, First Commonwealth Bank remains classiﬁed as a well-capitalized institution. During 2004, dividends from subsidiaries also included a special dividend from FraMal Holdings Corporation in the amount 42 of $29,529. During 2003, the parent company also received a dividend-in-kind from First Commonwealth Bank in the amount of $8,797, which was received in the form of an investment holding company subsidiary. The subsidiary, known as FraMal Holdings Corporation, was acquired by First Commonwealth Bank in the PFC acquisition that is described in NOTE 6 (Business Combinations). During 2004, the Corporation’s Employee Stock Ownership Trust obtained a $14,000 line of credit from an unrelated ﬁnancial institution. The line of credit was used to purchase stock for the Corporation’s ESOP and is guaranteed by the parent company of the Corporation. During 2004, $5,514 was borrowed on the line. The loan was recorded as long-term debt and the offset was recorded as a reduction of common shareholders’ equity. As of December 31, 2004, the parent company had available a one-year line of credit to be used for general operating cashﬂows. The line of credit was with an unrelated ﬁnancial institution for $15,000, and as of December 31, 2004, had no amounts outstanding. NOTE 29—Fair Values of Financial Instruments Below are various estimated fair values at December 31, 2004 and 2003, as required by Statement of Financial Accounting Standards No. 107 (“FAS No. 107”). Such information, which pertains to the Corporation’s ﬁnancial instruments, is based on the requirements set forth in FAS No. 107 and does not purport to represent the aggregate net fair value of the Corporation. It is the Corporation’s general practice and intent to hold its ﬁnancial instruments to maturity, except for certain securities designated as securities available for sale, and not to engage in trading activities. Many of the ﬁnancial instruments lack an available trading market, as characterized by a willing buyer and seller engaging in an exchange transaction. Therefore, the Corporation had to use signiﬁcant estimations and present value calculations to prepare this disclosure. Changes in the assumptions or methodologies used to estimate fair values may materially affect the estimated amounts. Also, management is concerned that there may not be reasonable comparability between institutions due to the wide range of permitted assumptions and the methodologies in absence of active markets. This lack of uniformity gives rise to a high degree of subjectivity in estimating ﬁnancial instrument fair values. The following methods and assumptions were used by the Corporation in estimating ﬁnancial instrument fair values: Cash and short-term instruments: The balance sheet carrying amounts for cash and short-term instruments approximate the estimated fair values of such assets. Securities: Fair values for securities held to maturity and securities available for sale are based on quoted market prices, if available. If quoted market prices are not available, fair values are based on quoted market prices of comparable FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar Amounts in Thousands, except per share data) instruments. The carrying value of nonmarketable equity securities, such as Federal Home Loan Bank stock, is considered a reasonable estimate of fair value. Loans receivable: The estimated fair values of all loans are estimated by discounting the future cash ﬂows using interest rates currently offered for loans with similar terms to borrowers of similar credit quality. Off-balance sheet instruments: Many of the Corporation’s off-balance sheet instruments, primarily loan commitments and standby letters of credit, are expected to expire without being drawn upon, therefore, the commitment amounts do not necessarily represent future cash requirements. Management has determined that due to the uncertainties of cash ﬂows and difﬁculty in predicting the timing of such cash ﬂows, fair values were not estimated for these instruments for both periods. Deposit liabilities: Management estimates that the fair value of deposits is based on a market valuation of similar deposits. The carrying value of variable rate time deposit accounts and certiﬁcates of deposit approximate their fair values at the report date. Also, fair values of ﬁxed rate time deposits for both periods are estimated by discounting the future cash ﬂows using interest rates currently being offered and a schedule of aggregated expected maturities. Short-term borrowings: The estimated fair values of borrowings from the Federal Home Loan Bank were estimated based on the estimated incremental borrowing rate for similar types of borrowings. The carrying amounts of other short-term borrowings such as Federal funds purchased, securities sold under agreement to repurchase and treasury, tax and loan notes were used to approximate fair value. Long-term debt: The fair value of long-term debt is estimated by discounting the future cash ﬂows using the Corporation’s estimated incremental borrowing rate for similar types of borrowing arrangements. The following table presents carrying amounts and estimated fair values of the Corporation’s ﬁnancial instruments at December 31, 2004 and 2003: Carrying Amount Estimated Fair Value Carrying Amount Estimated Fair Value 2004 2003 Financial assets Cash and due from banks Interest-bearing deposits with banks Securities available for sale Investments held to maturity Loans, net Financial liabilities Deposits Short-term borrowings Long-term debt $ $ $ $ $ $ $ $ 79,591 2,403 2,162,313 78,164 3,473,770 3,844,475 946,474 839,574 $ $ $ $ $ $ $ $ 79,591 2,403 2,162,313 81,886 3,492,547 3,670,438 946,631 847,284 $ $ $ $ $ $ $ $ 82,510 5,362 1,969,176 104,254 2,787,497 3,288,275 634,127 793,972 $ $ $ $ $ $ $ $ 82,510 5,362 1,969,176 109,609 2,844,411 3,193,216 634,361 863,444 43 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES QUARTERLY SUMMARY OF FINANCIAL DATA—UNAUDITED (Dollar Amounts in Thousands, except per share data) The unaudited quarterly results of operations for the years ended December 31, 2004 and 2003 are as follows: Interest income Interest expense Net interest income Provision for credit losses Net interest income after provision for credit losses Net securities gains Other operating income Merger and integration charges Debt prepayment fees Other operating expenses Income (loss) before income taxes Applicable income taxes (benefit) Net income (loss) Basic earnings per share Diluted earnings per share Average shares outstanding Average shares outstanding assuming dilution Interest income Interest expense Net interest income Provision for credit losses Net interest income after provision for credit losses Net securities gains Other operating income Litigation settlement Other operating expenses Income before income taxes Applicable income taxes Net income Basic earnings per share Diluted earnings per share Average shares outstanding Average shares outstanding assuming dilution First Quarter $ 61,972 25,165 36,807 2,100 34,707 3,850 9,733 1,291 -0- 30,426 16,573 3,250 $ 13,323 $ $ 0.22 0.22 60,772,824 61,289,672 2004 Second Quarter $ $ $ $ 65,498 27,063 38,435 2,520 35,915 145 10,952 873 -0- 32,671 13,468 1,908 11,560 0.18 0.18 Third Quarter $ 74,940 28,881 46,059 2,675 $ Fourth Quarter 75,615 29,581 46,034 775 43,384 51 11,752 (39) 29,495 34,597 (8,866) (6,071) (2,795) (0.04) (0.04) $ $ $ 45,259 31 11,135 -0- -0- 35,241 21,184 4,620 16,564 0.24 0.24 $ $ $ 64,455,920 64,947,209 69,077,293 69,702,327 69,173,249 69,938,616 2003 First Quarter $ 62,317 25,471 36,846 3,460 Second Quarter $ 61,186 25,745 35,441 3,465 Third Quarter $ 59,605 24,616 34,989 3,495 Fourth Quarter 60,665 $ 24,409 36,256 2,350 33,386 2,234 8,837 (610) 28,382 16,685 3,381 $ 13,304 $ $ 0.23 0.23 58,703,260 58,934,248 31,976 3,221 9,977 -0- 28,382 16,792 3,365 13,427 0.23 0.23 $ $ $ 58,769,160 59,101,475 31,494 166 13,691 -0- 28,005 17,346 3,511 $ 13,835 $ $ 0.23 0.23 58,950,258 59,376,716 33,906 230 10,088 -0- 28,496 15,728 2,994 12,734 0.21 0.21 $ $ $ 59,577,396 60,122,832 44 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES SELECTED FINANCIAL DATA (Dollar Amounts in Thousands, except per share data) The following selected ﬁnancial data is not covered by the auditor’s report and should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations, which follows, and with the consolidated ﬁnancial statements and related notes. The reclassiﬁcations had no effect on the Corporation’s ﬁnancial condition or results of operations. Interest income Interest expense Net interest income Provision for credit losses Net interest income after provision for credit losses Net securities gains Other operating income Litigation settlement Restructuring charges Merger and related charges Debt prepayment fees Other operating expenses Income before taxes Applicable income taxes Net income Per Share Data Net income Dividends declared Average shares outstanding Per Share Data Assuming Dilution Net income Dividends declared Average shares outstanding 2004 2003 2002 2001 Years Ended December 31, 278,025 110,690 167,335 8,070 159,265 4,077 43,572 -0- -0- 2,125 29,495 132,935 42,359 3,707 38,652 $ $ 243,773 100,241 143,532 12,770 130,762 5,851 42,593 (610) -0- -0- -0- 113,265 66,551 13,251 53,300 $ $ 275,568 122,673 152,895 12,223 140,672 642 37,453 8,000 6,140 -0- -0- 112,190 52,437 8,911 43,526 $ $ 308,891 167,170 141,721 11,495 130,226 3,329 37,776 -0- -0- -0- -0- 105,888 65,443 15,254 50,189 2000 311,882 174,539 137,343 10,030 127,313 1,745 31,938 -0- -0- -0- -0- 99,461 61,535 14,289 47,246 $ $ 0.59 0.645 65,887,611 0.90 $ 0.625 $ 59,002,277 0.75 $ $ 0.605 58,409,614 0.87 $ $ 0.585 57,885,478 0.82 $ $ 0.565 57,558,929 $ $ $ $ $ $ 0.58 0.645 66,487,516 0.90 $ $ 0.625 59,387,055 0.74 $ $ 0.605 58,742,018 0.86 $ $ 0.585 58,118,057 0.82 $ $ 0.565 57,618,671 At End of Period Total assets Investment securities Loans and leases, net of unearned income Allowance for credit losses Deposits Company obligated mandatorily redeemable capital securities of subsidiary trust Subordinated debentures Other long-term debt Shareholders’ equity Key Ratios Return on average assets Return on average equity Net loans to deposits ratio Dividends per share as a percent of net income per share Average equity to average assets ratio $ 6,198,478 2,240,477 3,514,833 41,063 3,844,475 $ 5,189,195 2,073,430 2,824,882 37,385 3,288,275 $ 4,524,743 1,680,609 2,608,634 34,496 3,044,124 $ 4,583,530 1,762,408 2,567,934 34,157 3,093,150 $ 4,372,312 1,636,337 2,490,827 33,601 3,064,146 -0- 108,250 731,324 531,978 0.66% 7.82% 90.36% 109.32% 8.47% -0- 75,304 718,668 430,946 1.12% 12.95% 84.77% 69.44% 8.68% 35,000 -0- 544,934 401,390 0.96% 11.09% 84.56% 80.67% 8.64% 35,000 -0- 629,220 370,066 1.11% 13.85% 81.92% 67.24% 8.01% 35,000 -0- 621,855 334,156 1.10% 15.65% 80.19% 68.90% 7.00% 45 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Introduction This discussion and the related ﬁnancial data are presented to assist in the understanding and evaluation of the consolidated ﬁnancial condition and the results of operations of First Commonwealth Financial Corporation including its subsidiaries (the “Corporation”) for the years ended December 31, 2004, 2003 and 2002 and are intended to supplement, and should be read in conjunction with, the Consolidated Financial Statements and related footnotes. Sections of this ﬁnancial review, as well as the notes to the consolidated ﬁnancial statements, contain forward-looking statements (as deﬁned in the Private Securities Litigation Reform Act of 1995), which reﬂect management’s beliefs and expectations based on information currently available and may contain the words “expect,” “estimate,” “project,” “anticipate,” “should,” “intend,” “probability,” “risk,” “target,” “objective” and similar expressions or variations on such expressions. These forward-looking statements are inherently subject to signiﬁcant risks and uncertainties, including but not limited to: changes in general economic and ﬁnancial market conditions, the Corporation’s ability to effectively carry out its business plans, changes in regulatory or legislative requirements, changes in competitive conditions and continuing consolidation of the ﬁnancial services industry. Although management believes the expectations reﬂected in such forward-looking statements are reasonable, actual results could differ materially. Readers are cautioned not to place undue reliance on these forward-looking statements, which reﬂect management’s analysis only as of the date hereof. The Corporation undertakes no obligation to publicly revise or update these forward-looking statements to reﬂect events or circumstances that arise after the date hereof. Effective May 24, 2004, the Corporation acquired all of the outstanding shares of GA Financial, Inc. (“GAF”), and effective December 5, 2003, the Corporation acquired all of the outstanding shares of Pittsburgh Financial Corporation (“PFC”). In addition, the Corporation acquired all of the outstanding shares of Strategic Capital Concepts, Inc. (“SCC”) and Strategic Financial Advisors, Inc. (“SFA”), effective March 1, 2002. As required under the purchase method of accounting, the results of GAF, PFC, SCC and SFA have been included in the Corporation’s ﬁnancial statements since their respective acquisition dates. In October 2002, SFA was merged into SCC and the name was changed to First Commonwealth Financial Advisors, Inc. Financial statement amounts in prior periods have been reclassiﬁed to conform to the presentation format used in 2004. The reclassiﬁcations had no effect on the Corporation’s ﬁnancial condition or results of operations. Critical Accounting Policies and Signiﬁcant Estimates The Corporation considers accounting policies and estimates to be critical to reported ﬁnancial results if (1) the estimate 46 requires management to make assumptions about matters that are highly uncertain and (2) the different estimates that management reasonably could have used for the accounting estimate in the current period or the changes in the accounting estimates from period to period could have a material impact on the Corporation’s ﬁnancial condition or results of operations. Accounting policies related to the allowance for credit losses are considered to be critical because they are highly dependent on subjective or complex judgments, assumptions and estimates by management. The allowance for credit losses is a reserve established through a provision for credit losses charged to expense, which represents management’s best estimate of probable losses that are inherent in the existing loan portfolio as of the balance sheet date. The allowance includes amounts calculated in accordance with FASB Statement No. 114 “Accounting by Creditors for Impairment of a Loan” as amended by FASB Statement No. 118, and amounts determined in accordance with FASB Statement No. 5 “Accounting for Contingencies.” Management and the Corporation’s Board of Directors review the adequacy of the allowance on a quarterly basis to ensure that the provision for credit losses has been charged against earnings in an amount necessary to maintain the allowance at a level that is appropriate based on management’s assessment of probable estimated losses. The Corporation’s methodology for assessing the appropriateness of the allowance for credit losses consists of several key elements. These elements include an assessment of individual problem loans, delinquency and loss experience trends, and other relevant factors. While allocations are made to speciﬁc loans and pools of loans, the total allowance is available for all loan losses. There are many factors affecting the allowance for credit losses; some are quantitative while others require qualitative judgment and the use of estimates related to the amount and timing of expected future cash ﬂows on impaired loans, estimated losses based on historical loss experience and consideration of current economic trend and conditions, all of which may be susceptible to signiﬁcant change. To the extent that actual outcomes differ from management estimates, additional provision for credit losses could be required that could adversely affect earnings or ﬁnancial position in future periods. The loan portfolio represents the largest asset category on the Consolidated Balance Sheet. Classiﬁed loans on the primary watch list are analyzed to determine the level of potential loss in the credits under current circumstances. The potential loss that is established for these classiﬁed loans is based on careful analysis of the loan’s performance, the related collateral value, cash ﬂow considerations and the ﬁnancial capability of any guarantor. Primary watch list loans are managed and monitored by assigned account ofﬁcers within the Corporation in conjunction with senior management. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The process of determining the allowance also considers special circumstances which may warrant an additional allowance. An additional allowance provides management with the opportunity to estimate additional potential allowance amounts which may be needed to cover speciﬁc factors. The special factors that management currently evaluates consist of portfolio risk or concentrations of credit and economic conditions. Portfolio risks include unusual changes or recent trends in speciﬁc portfolios such as unexpected changes in the trends or levels of delinquency, unusual repossession activities or large levels of unsecured loans in a portfolio. The Corporation also maintains an unallocated allowance. Although the unallocated allowance was signiﬁcantly reduced during 2004 as a result of methodology enhancements, the unallocated allowance is still used to cover any factors or conditions that may cause a potential credit loss but are not speciﬁcally identiﬁable or considered in the methodology that was deﬁned above. These factors include, but are not limited to potential judgment or data errors or factors not yet considered in the Corporation’s methodology. Accounting policies related to goodwill and other intangible assets are also considered to be critical because the assumptions or judgment that was used in determining the fair value of assets and liabilities that were acquired as part of past acquisitions were subjective and complex. As a result, changes in these assumptions or judgment could have a signiﬁcant impact on the ﬁnancial condition or results of operations of the Corporation. The Corporation adopted FASB Statement No. 142 (“FAS No. 142”), “Goodwill and Other Intangible Assets”, effective January 1, 2001. FAS No. 142 requires that goodwill and other intangible assets with indeﬁnite useful lives, including goodwill recorded in past business combinations, no longer be amortized, but instead be tested for impairment at least annually and written down and charged to results of operations only in periods in which the recorded value is more than the estimated fair value. Intangible assets that have ﬁnite useful lives will continue to be amortized over their useful lives. The fair value of acquired assets and liabilities that was used to record goodwill was based either on quoted market prices or provided by other third-party sources, when available. When third-party information was not available, estimates were made in good faith by management primarily through the use of internal cash ﬂow modeling techniques. The assumptions that were used in the cash ﬂow modeling were subjective and are susceptible to signiﬁcant changes. Goodwill and other intangible assets with indeﬁnite useful lives are tested for impairment at least annually and written down and charged to results of operations in periods in which their recorded value is more than their estimated fair value. Although goodwill has not been written down since the adoption of FAS No. 142, changes in future assumptions based on changing economic conditions could result in impairment which could adversely affect earnings or ﬁnancial position in future periods. Results of Operations Net income was $38.7 million in 2004, a decrease of $14.6 million from the 2003 results of $53.3 million. This compared to net income of $43.5 million in 2002. The most signiﬁcant component of the decrease in the 2004 period was the previously announced penalty related to the prepayment of FHLB long-term advances. This penalty was $29.5 million or $19.2 million after taxes. Also impacting the decrease in 2004 was merger and integration costs that were not present in the 2003 period and a gain on the sale of two branches during 2003. The change in net income for the 2003 period reﬂected an increase in security gains compared to the corresponding period of 2002. In addition, the effects of restructuring costs and a litigation settlement negatively impacted net income for 2002. A partial recovery from insurance for the claim related to the litigation settlement was received in 2003. Diluted earnings per share was $0.58 for 2004 compared to $0.90 and $0.74 for 2003 and 2002, respectively. Return on average assets was 0.66% and return on equity was 7.82% during 2004 compared to 1.12% and 12.95%, respectively for 2003 and 0.96% and 11.09%, respectively for 2002. The following is an analysis of the impact of changes in net income on diluted earnings per share: Net income per share, prior year Increase (decrease) from changes in: Net interest income Provision for credit losses Security transactions Insurance commissions Income from bank owned life insurance Service charges on deposits Sale of branches Other income Salaries and employee beneﬁts Occupancy and equipment costs Outside data processing expense Intangible amortization Litigation settlement Restructuring charges Rebranding costs Merger and integration charges Debt prepayment fees Other operating expenses Applicable income taxes 2004 vs. 2003 0.90 $ 0.10 0.09 (0.04) 0.00 0.00 0.01 (0.05) (0.02) (0.01) (0.03) (0.01) (0.02) (0.01) 0.00 0.00 (0.03) (0.44) (0.03) 0.17 0.58 2003 vs. 2002 $ 0.74 (0.18) (0.01) 0.09 (0.01) (0.01) 0.02 0.05 0.02 (0.04) (0.01) 0.00 0.00 0.15 0.10 0.03 0.00 0.00 0.03 (0.07) $ 0.90 Net income per share $ Net Interest Income Net interest income, the engine that powers revenue growth for the Corporation, is deﬁned as the difference between income 47 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS on earning assets and the cost of funds supporting those assets. Net interest income increased $23.8 million in the 2004 period compared to 2003 after declining $9.4 million in 2003 compared to 2002. Interest income and interest expense both increased during the 2004 period due to increases in the volumes of interest-earning assets and interest-bearing liabilities as average yields continued to decline over 2003 levels. During 2003, both interest income and interest expense declined compared to 2002 levels primarily as a result of the dramatic decrease in interest rates that began in 2001 and continued into 2003. Net interest margin (net interest income, on a tax-equivalent basis as a percentage of average earning assets) declined to 3.30% for 2004, a decrease of 17 basis points (0.17%) compared to 2003, and a decrease compared to 3.80% in 2002. The year-to-year decrease in the margin was due to asset yields declining more quickly than the cost of funds. In the lower interest rate environment, deposit costs begin to reach a ﬂoor while asset yields have a bigger cushion and can continue to decline. The Corporation uses computer simulation to help manage interest rate risk. The Corporation’s use of computer simulation is described in the “Interest Sensitivity” section of this discussion. The following is an analysis of the average balance sheets and net interest income for each of the three years in the period ended December 31, 2004: Average Balance 2004 Income/ Yield or Expense Rate(a) Average Balance Sheets and Net Interest Analysis (Dollar Amounts in Thousands) 2003 Average Balance Income/ Expense Yield or Rate(a) Average Balance 2002 Income/ Yield or Expense Rate(a) Assets Interest-earning assets: Time deposits with banks Tax free investment securities Taxable investment securities Federal funds sold Loans, net of unearned income (b)(c) Total interest-earning assets $ 4,964 250,832 1,932,896 512 3,251,645 5,440,849 $ 34 11,447 76,909 6 189,629 278,025 0.69% $ 7.02 3.98 1.22 6.02 5.34 1,289 226,780 1,605,191 358 2,640,935 4,474,553 $ 13 10,561 68,754 4 164,441 243,773 1.03% $ 7.16 4.28 1.05 6.46 5.71 1,785 198,687 1,495,824 359 2,597,862 4,294,517 $ 31 9,520 86,110 6 179,901 275,568 1.74% 7.37 5.76 1.72 7.13 6.66 Noninterest-earning assets: Cash Allowance for credit losses Other assets Total noninterest-earning assets Total Assets 74,559 (41,199) 364,092 397,452 $ 5,838,301 66,614 (36,172) 233,040 263,482 $ 4,738,035 69,735 (34,813) 211,302 246,224 $ 4,540,741 Liabilities and Shareholders’ Equity Interest-bearing liabilities: Interest-bearing demand deposits (d) Savings deposits (d) Time deposits Short-term borrowings Long-term debt Total interest-bearing liabilities Noninterest-bearing liabilities and capital: Noninterest-bearing demand deposits (d) Other liabilities Shareholders’ equity Total noninterest-bearing funding sources Total Liabilities and Shareholders’Equity Net Interest Income and Net Yield on Interest-Earning Assets $ 538,672 1,141,059 1,513,663 796,591 868,784 4,858,769 $ 2,229 11,491 45,170 11,989 39,811 110,690 0.41% $ 457,327 1.01 792,755 2.98 1,524,974 1.51 554,133 4.58 594,383 2.28 3,923,572 $ 1,699 7,028 51,373 6,755 33,386 100,241 0.37% $ 416,184 0.89 727,996 1,592,585 3.37 339,908 1.22 5.62 670,258 3,746,931 2.55 $ 3,410 9,375 65,787 6,029 38,072 122,673 0.82% 1.29 4.13 1.77 5.68 3.27 452,701 32,614 494,217 979,532 380,772 22,241 411,450 814,463 380,878 20,493 392,439 793,810 $ 5,838,301 $ 4,738,035 $ 4,540,741 $ 167,335 3.30% $ 143,532 3.47% $ 152,895 3.80% (a) Yields on interest-earning assets have been computed on a tax equivalent basis using the 35% Federal income tax statutory rate. (b) Income on nonaccrual loans is accounted for on the cash basis, and the loan balances are included in interest-earning assets. (c) Loan income includes net loan fees of $3,470 in 2004, $2,196 in 2003 and $1,437 in 2002. (d) Average balances do not include reallocations from noninterest-bearing demand deposits and interest-bearing demand deposits into savings deposits which were made for regulatory purposes. 48 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Interest and fees on loans increased $25.2 million for 2004 compared to 2003 after declining $15.5 million for 2003 compared to 2002. The increase in interest and fees on loans during 2004 was due to an increase of $610.7 million in average loan balances. The volume increase was due in large part to the loans that were acquired in the acquisitions of PFC and GAF. Commercial loan growth was primarily due to internal growth. Volume increases in 2004 were noted in all loan categories with the exception of leases, which is a product that the Corporation no longer offers. Volume increases were also recorded in the 2003 period compared to 2002. During 2003, the Corporation took advantage of the lower interest rate cycle and changed the mix of the loan portfolio. Average mortgage loans declined during 2003 as consumers reﬁnanced their loans at near record levels. The Corporation continued to offer competitive mortgage loans but generally sold them immediately after origination along with the related servicing rights. The Corporation has since started to retain ﬁxed rate mortgages with maturities of 15 years or less as well as adjustable rate mortgages. Average commercial and municipal loans offset the decline in mortgage loans during 2003, primarily in shorter term and variable rate lending. In addition, 2003 included increases in average installment loans over 2002 levels. The Corporation has continued to capitalize on lending opportunities with small to mid-sized commercial borrowers, including loans generated through its preferred Small Business Administration (“SBA”) lender status. The Corporation has consistently been one of the top small business lenders in Pennsylvania. The declining rate environment has continued to negatively impact interest and fees on loans. During 2003 compared to 2002, the increase in average loan volumes was not enough to offset the reduced interest income caused by declining yields. Tax-equivalent loan yields fell 44 basis points (0.44%) during 2004 compared to 2003 after declining 67 basis points (0.67%) during 2003 from the 2002 levels. Interest income on investments increased $9.0 million in 2004 compared to 2003 after declining $16.3 million in 2003 compared to 2002. Both years reported increases in average investment balances with decreases in yields on investment securities. The most signiﬁcant volume increases during 2004 were related to U.S. government agency securities. Average investment securities included increases due to PFC for the full year of 2004 and GAF since May 24, 2004. Yields on investments for 2004 continued to decline, falling 32 basis points (0.32%) to 4.32%. Yields for 2003 fell to 4.64% compared to 5.95% for 2002. As with the loan category, the increase due to average investment security volumes surpassed the loss due to the declining yields, but during 2003 the increase due to volume was not enough to offset the reduced interest income caused by declining rates. Yields in the 2004 period compared to 2003 decreased for all investment securities with the exception of asset backed securities. During 2003 compared to 2002, all categories of interest income on investments were negatively impacted by interest rate changes with the largest decline being registered in the U.S. government agency category. Prepayment speeds of mortgage backed securities (“MBS”) declined in 2004 after accelerating in 2003 when interest rates continued to decline. Interest rate changes have a direct impact on prepayment speeds. As interest rates increase, prepayments tend to decline and average lives of MBS increase. As interest rates decrease, prepayment speeds tend to increase and average lives of MBS decline, which accelerates the amount of premium amortization that is realized, further reducing the yields in current periods. Using computer simulation modeling, the Corporation tests the average life and yield volatility of all MBS under various interest rate scenarios on a continuing basis to insure that volatility falls within acceptable limits. The Corporation holds no “high risk” securities nor does the Corporation own any securities of a single issuer exceeding 10% of shareholders’ equity other than U.S. government and agency securities. Interest on deposits dropped $1.2 million in 2004 compared to 2003 after a decline of $18.5 million in 2003 compared to 2002. The decrease in both periods was largely due to the lower interest rate environment. The cost of deposits declined 28 basis points (0.28%) in 2004 compared to 2003. Decreases in time deposit yields were partially offset by increases in yields on more non-maturity deposits, such as savings and interest- bearing demand deposits. Average deposits increased by $490 million in 2004 compared to 2003 and included increases in all categories due to PFC for the full year of 2004 and GAF since May 24, 2004. The deposit mix continued to change in 2004 as clients registered a preference for savings products, while time deposits dropped due to the prospect of rising interest rates. During its management of deposit levels and mix, the Corporation continues to evaluate the cost of time deposits compared to alternative funding sources as it balances its goals of providing clients with the competitive rates they are looking for while also minimizing the Corporation’s cost of funds. Interest expense on short-term borrowings rose $5.2 million during 2004 after rising $726 thousand during 2003. Both years reﬂected increases in interest expense due to increases in the average volumes of short-term borrowings. The 2004 period also reﬂected increases in interest expense due to increases in yields, while 2003 reﬂected decreases in interest expense due to decreasing yields. Average short-term borrowings increased $242.5 million in 2004 compared to 2003 and increased $214.2 million for 2003 compared to 2002. The 2004 period included an increase due to the inclusion of short-term borrowings that were acquired with the GAF acquisition on May 24, 2004. The 2004 period also included an increase in short-term borrowings which were used to replace a portion of the $440 million of long-term FHLB advances that were paid before their maturity. Refer to NOTE 19 (Other Long-term Debt) to the Consolidated Financial Statements for additional information on the debt prepayment. The increase in the average short-term borrowings during 2003 was due in part to $100 million of long-term debt 49 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS that matured during the fourth quarter of 2002 and was replaced with short-term borrowings. In addition, the increase in short-term borrowings during 2003 can be attributed to an ALCO strategy implemented to mitigate the risk of further declines in net interest income resulting from a low or declining interest rate environment. This increase in short-term borrowings funded the purchase of U.S. government agency securities maturing in approximately 3.5 years. Interest expense on long-term debt increased by $6.4 million during 2004 compared to 2003 after a decrease of $4.7 million for 2003 compared to the 2002 period. The 2003 period recorded decreases in interest expense due to declining average balances of long-term debt and declining yields, while the 2004 period included decreases in interest expense due to declining yields that were offset by increases in interest expense due to increases in average balances of long-term debt. The increases in volume during 2004 were due in large part to the acquisitions of PFC and GAF. In addition, subordinated debentures in the amount of $41.2 million were issued during March 2004. These subordinated debentures along with the subordinated debentures of $30.9 million that were issued during December 2003 were used to fund the acquisition of GAF in May 2004. Refer to NOTE 18 (Subordinated Debentures) to the Consolidated Financial Statements for further discussion of subordinated debentures that are included in long-term debt. Average long-term debt for 2003 decreased by $75.9 million compared to 2002. This was due in part to the $100 million of long-term debt that matured during the fourth quarter of 2002 that was replaced by short-term borrowings. The interest rate on long-term debt decreased 104 basis points (1.04%) during 2004 compared to 2003. The rate reduction was anticipated in connection with the prepayment of $440 million in FHLB long-term advances during the third quarter of 2004. The Corporation was able to replace these advances with $230 million in other lower rate FHLB advances with maturities ranging from two to six years. The remaining $210 million was replaced with short-term borrowings. Refer to NOTE 19 (Other Long-term Debt) to the Consolidated Financial Statements for additional information on the debt prepayment. The following table shows the effect of changes in volumes and rates on interest income and interest expense: Analysis of Year-to-Year Changes in Net Interest Income (Dollar Amounts in Thousands) 2004 Change from 2003 Change Due Change Due to Rate (a) Total Change 2003 Change from 2002 Change Due Change Due to Volume to Rate (a) Interest-earning assets: Time deposits with banks Securities Federal funds sold Loans Total interest income Interest-bearing liabilities: Deposits Short-term borrowings Long-term debt Total interest expense Net interest income Total Change $ 21 9,041 2 25,188 34,252 (1,210) 5,234 6,425 10,449 $ 23,803 to Volume $ 38 15,759 2 39,451 55,250 3,009 2,956 15,413 21,378 $ 33,872 $ (17) (6,718) -0- (14,263) (20,998) (4,219) 2,278 (8,988) (10,929) $ (10,069) $ (18) (16,315) (2) (15,460) (31,795) (18,472) 726 (4,686) (22,432) $ (9,363) $ (9) 8,367 -0- 3,070 11,428 (1,622) 3,799 (4,310) (2,133) $ 13,561 $ (9) (24,682) (2) (18,530) (43,223) (16,850) (3,073) (376) (20,299) $ (22,924) (a) Changes in interest income or expense not arising solely as a result of volume or rate variances are allocated to rate variances due to interest sensitivity of consolidated assets and liabilities. Provision for Credit Losses The provision for credit losses is an amount added to the allowance against which credit losses are charged. The amount of the provision is determined by management based upon its assessment of the size and quality of the loan portfolio and the adequacy of the allowance in relation to the risks inherent within the loan portfolio. The provision for credit losses decreased $4.7 million for 2004 when compared to 2003. The decrease in the provision reﬂects the trend in improvement of nonperforming loans, net charge-offs and lower levels of the allowance for loan losses allocated to larger impaired credits. Nonperforming loans as a percent of average loans outstanding 50 improved to 0.73% at December 31, 2004, compared to 0.82% and 1.47% at December 31, 2003 and 2002, respectively. The allowance for credit losses was $41.1 million at December 31, 2004, which represents a ratio of 1.26% of average loans outstanding compared to 1.42% and 1.33% reported at December 31, 2003 and 2002, respectively. Net charge-offs for 2004 declined $3.6 million over 2003 levels. The most signiﬁcant components of this year-to-year change were decreases in the following categories: residential loans secured by real estate (down $1.8 million); and commercial, ﬁnancial and agricultural loans (down $1.7 million). Net charge-offs as a percent of average loans FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS outstanding improved to 0.29% at December 31, 2004, compared to 0.49% and 0.46% at December 31, 2003 and 2002, respectively. For an analysis of credit quality, see the “Credit Review” section of this discussion. The following table presents an analysis of the consolidated allowance for credit losses for the ﬁve years ended December 31, 2004 (Dollar Amounts in Thousands): Loans outstanding at end of year $ 3,514,833 $ 2,824,882 $ 2,608,634 $ 2,567,934 $ 2,490,827 Average loans outstanding $ 3,251,645 $ 2,640,935 $ 2,597,862 $ 2,548,596 $ 2,503,036 Summary of Loan Loss Experience 2004 2003 2002 2001 2000 Allowance for credit losses: Balance, beginning of year Addition as a result of acquisition Loans charged off: Commercial, ﬁnancial and agricultural Loans to individuals Real estate-construction Real estate-commercial Real estate-residential Lease ﬁnancing receivables Total loans charged off Recoveries of loans previously charged off: Commercial, ﬁnancial and agricultural Loans to individuals Real estate-construction Real estate-commercial Real estate-residential Lease ﬁnancing receivables Total recoveries Net loans charged off Provision charged to expense $ 37,385 4,983 4,434 3,414 1 1,060 1,456 247 10,612 772 351 -0- -0- 114 -0- 1,237 9,375 8,070 $ 34,496 3,109 $ 34,157 -0- $ 33,601 -0- $ 33,539 -0- 6,424 3,288 384 1,111 3,172 316 14,695 1,047 641 -0- -0- 17 -0- 1,705 12,990 12,770 6,085 4,040 3 1,315 2,065 424 13,932 1,287 710 -0- -0- 46 5 2,048 11,884 12,223 3,297 4,199 -0- 2,300 1,818 606 12,220 456 757 -0- -0- 49 19 1,281 10,939 11,495 4,335 5,521 -0- 130 874 407 11,267 406 826 -0- -0- 42 25 1,299 9,968 10,030 Balance, end of year $ 41,063 $ 37,385 $ 34,496 $ 34,157 $ 33,601 Ratios: Net charge-offs as a percentage of average loans outstanding Allowance for credit losses as a percentage of average loans outstanding 0.29% 1.26% 0.49% 1.42% 0.46% 1.33% 0.43% 1.34% 0.40% 1.34% Noninterest Income Net securities gains decreased $1.8 million during 2004 to $4.1 million from the $5.9 million reported in 2003. This compared to $642 thousand reported in 2002. Securities gains during the 2004 period resulted primarily from the sale of Pennsylvania bank stocks with book values of $19.3 million. The securities gains during the 2003 period resulted primarily from the sales of Pennsylvania bank stocks with book values of $7.6 million and ﬁxed rate corporate bonds classiﬁed as securities “available for sale” with book values of $35 million. The corporate bonds sold during 2003 had an average remaining life of one year, and the proceeds were reinvested in adjustable rate trust preferred securities with maturities of 30 years and mortgage backed securities with an average life of 3.6 years. This reinvestment strategy was initiated to partially mitigate the Corporation’s exposure to low and declining interest rates. The securities gains during 2002 resulted primarily from the sales of Pennsylvania bank stocks, U.S. Treasury securities and ﬁxed rate corporate bonds classiﬁed as securities “available for sale” with book values of $1.1 million, $1.5 million and $3.0 million, respectively. Trust income has increased slightly over each of the past three years. The rebound in market values over prior year levels should help trust income to continue to trend in a positive direction. The referral programs and integrated growth plans for ﬁnancial afﬁliates have continued to help grow trust revenues. The Corporation’s continued success in building relationships with commercial clients provides fee based afﬁliates with additional sales opportunities through the “Total Solutions Financial Management” (“TSFM”) process. This strategy combines products, services and professional staff from the Corporation’s trust, insurance, ﬁnancial advisory and banking afﬁliates and partners them in providing comprehensive ﬁnancial services offerings. 51 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Service charges on deposits are the most signiﬁcant component of noninterest income and have continued to increase over the past three years with an increase of $2.0 million for 2004 compared to 2003 and an increase of $1.5 million for 2003 compared to 2002. Increases in nonsufﬁcient funds (“NSF”) fees of $1.9 million in 2004 compared to 2003 and $2.1 million in 2003 compared to 2002 helped to pace the continued year-to-year rise. The increase in NSF fees is due to the growth of the High Performance Checking products for consumer and business clients as well as the inclusion of PFC and GAF. In addition, the increase in NSF fees is due in part to better management of the collection process to ensure that fee waivers are kept to a minimum. Management strives to implement reasonable fees for services and closely monitors collection of those fees. The 2003 period included a $3.0 million gain which occurred when First Commonwealth Bank, a wholly-owned subsidiary of the registrant, sold two of its branch ofﬁces. The sale included $29.2 million in deposit liabilities and $4.4 million in loans associated with the two ofﬁces. Insurance commissions remained relatively stable from 2004 compared to 2003 after a decrease of $326 thousand from 2003 compared to 2002. Decreases in 2003 were primarily due to decreases in annuity commissions. As part of the previously discussed TSFM process, the Corporation’s insurance subsidiary will continue to have expanded opportunities to meet the insurance needs of commercial clients. Income from bank owned life insurance was $5.2 million for 2004 compared to $4.3 million for 2003 and compared to $4.7 million for 2002. The 2004 period included an addition of $16.7 million related to the GAF acquisition, while the 2003 period included an addition of $6.6 million due to the PFC acquisition. The 2002 period included an additional investment in bank owned life insurance of $5.0 million. Other changes in noninterest income during 2004 compared to 2003 included increases in card related interchange income in the amount of $1.0 million. Card related interchange income includes income on debit, credit and ATM cards that are issued to consumers and/or businesses. The increase was due in part to the inclusion of PFC and GAF. The card related interchange income growth was favorably affected by additional volume related to card usage and the migration of business accounts from the consumer debit card product. The business debit card product pays a higher rate than the consumer debit card. Changes in other noninterest income for 2003 over 2002 levels included increases in card related interchange income in the amount of $338 thousand and income from the increase in cash surrender value of split dollar life insurance in the amount of $248 thousand. Noninterest Expense Total noninterest expenses for 2004 increased $51.9 million to $164.6 million from $112.7 million reported in 2003. The 2003 amount represented a decrease of $13.6 million compared to $126.3 million reported in 2002. Noninterest expenses during the 2004 period included a one-time penalty of $29.5 million for the prepayment of $440 million in long-term FHLB advances. The FHLB advances were replaced with other long-term debt with lower interest rates as well as with short-term borrowings. The transaction is expected to result in an increase in net interest income over the remaining term of the original advances in excess of the prepayment penalty. Noninterest expenses during the 2004 period also included merger and integration charges in the amount of $2.1 million. The merger and integration charges included $485 thousand related to the write-off of the unamortized capitalized costs for the subordinated debentures that were previously issued by PFC and were called and paid off in January of 2004. Merger and integration charges also included $1.6 million of severance related salary and beneﬁt expenses that were accrued during 2004 and were due to the integration of PFC into the Corporation. Future periods could be impacted by similar costs as the GAF integration continues. The inclusion of PFC and GAF results since the acquisition dates were the primary causes of the remaining increase in noninterest expenses during the 2004 period. The 2003 year included the beneﬁt of a $610 thousand partial recovery of the litigation settlement from the 2002 period. The decrease in noninterest expenses for 2003 was primarily the result of charges that were incurred during 2002 for the previously described litigation settlement of $8.0 million and corporate restructuring of $6.1 million. The litigation settlement related to a lender liability action ﬁled in 1994 against one of the Corporation’s subsidiary banks and followed an adverse pre-trial judgment by the trial judge on procedural grounds. The restructuring charges consisted principally of severance amounts paid to employees as part of the plan to consolidate the multiple bank charters and develop the First Commonwealth brand and identity for all of the ﬁnancial services subsidiaries. Payments to retiring directors as part of the realignment for the Corporation’s new vision on corporate governance were also included in restructuring charges. Employee costs were $68.9 million in 2004, representing 1.18% of average assets compared to $61.1 million and 1.29%, respectively, in 2003. Employee costs for 2002 were $58.1 million and 1.28% of average assets. Salary costs for the 2004 period increased $5.1 million compared to 2003, while salary 52 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS costs for the 2003 period increased $1.6 million compared to 2002 levels. Employee beneﬁt costs rose $2.7 million for 2004 compared to 2003 and rose $1.4 million for 2003 compared to 2002. Hospitalization costs continue to reﬂect the largest increases in employee beneﬁt costs with increases of $743 thousand or 12.7% in 2004 and $1.1 million or 23.1% in 2003. The increases in employee costs during 2004 were due in large part to an increase in the number of employees from the addition of PFC and GAF. Full-time equivalent employees were 1,634 at the end of 2004 compared to 1,474 at the same time in 2003. The Corporation continues to evaluate its current menu of employee beneﬁts to provide a competitive beneﬁts package while also managing costs. Current beneﬁt options include coverages fully paid for by the employer, as well as voluntary beneﬁts whereby employees have the option of purchasing additional beneﬁts at reduced group rates. Net occupancy expense increased $2.2 million during 2004 to $9.7 million compared to expenses of $7.5 million during 2003 and $6.8 million during 2002. The most signiﬁcant increases during the 2004 period were related to building rental expense and building repairs and maintenance, largely due to the branches that were acquired with the PFC and GAF mergers. The 2003 period included increases in building repairs and maintenance, net rental expense and utilities compared to 2002 costs. Much of these increases were due to increased utility costs and snow removal expenses resulting from the harsh winter. The 2003 period also included an increase in the amortization of the purchase accounting adjustments related to premises of $328 thousand over the 2002 period. An adjustment of $291 thousand was taken during the 2003 period for the write-off of the remaining purchase accounting adjustment for three branch ofﬁces that were closed during 2003. These branch ofﬁces were closed and their clients are served at nearby existing branch ofﬁces. The Corporation continues to actively evaluate its branch delivery network to optimize client service in existing branch ofﬁces and to continue expansion into growth markets. The Corporation expects to open three new branch ofﬁces in growth areas of Washington and Allegheny counties as well as renovate or relocate ofﬁces in existing markets. The execution of these initiatives may continue to impact occupancy and other expenses in future periods. Furniture and equipment expenses increased $1.6 million to $11.7 million in 2004 after an increase of $126 thousand to $10.1 million in 2003. Increases during both periods were largely due to continued increases in depreciation expense some of which was related to the inclusion of PFC and GAF since the acquisition dates. Outside data processing expense increased $1.3 million for the 2004 period to $3.8 million compared to $2.5 million for the 2003 period and $2.1 million for 2002. Data processing expense increases during 2004 were due in part to the acquisitions of PFC and GAF. Additional expenses were incurred until the PFC and GAF systems, which were processed through an outsourced processing vendor, were converted to the systems that are provided by a subsidiary of the Corporation. In addition, the data processing expense in 2004 was unfavorably impacted by a rate increase related to clients using debit and credit cards over the STAR network. Outside data processing costs are managed by the Corporation’s data processing subsidiary. Its needs are evaluated based on technology, efﬁciency and cost considerations. Intangible amortization expense increased by $1.4 million during 2004 compared to the same period of 2003. The increase was due to the amortization of the core deposit intangibles that were recorded for the recent acquisitions. Other operating expenses increased $5.2 million to $32.9 million for 2004, while the expenses decreased $3.4 million to $27.7 million for 2003. Increases in noninterest expense during the 2004 period included increase in telephone and data line expenses, other professional fees and advertising costs in the amounts of $897 thousand, $801 thousand and $599 thousand, respectively. Telephone and data line expense increases were due in large part to the recent acquisitions. The increase in other professional services is due in part to the use of a consultant in 2004 to provide targeted marketing services. Advertising expense increases are due in large part to grand re-opening events that have taken place in branches that have been newly re-built, remodeled or acquired. The 2003 period included decreases in other professional fees and services, advertising, expenses related to training and seminars, telephone and loss on the sale of other assets (primarily vehicles previously leased) in the amounts of $1.4 million, $637 thousand, $428 thousand, $420 thousand and $402 thousand, respectively, compared to 2002 costs. Directors’ fees for the 2003 period reﬂected decreases of $349 thousand resulting from the restructuring of the Corporation’s Boards of Directors and committees during 2002. Other professional fees in 2002 included consulting fees related to implementation of the Corporation’s “Balanced Scorecard” performance measurement system, enhancements to product and customer proﬁtability systems, corporate restructuring and common branding and identity. Consultants were also utilized to assist in the ongoing efforts to develop a world class sales culture and to generate new deposit dollars and relationships. Corporate 53 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS restructuring and movement towards a sales culture also impacted the decision to have employee beneﬁt plans reviewed by outside specialists during 2002. Advertising and promotion expenses in the 2002 period included expenditures related to the $1.8 million launch of the new corporate brand and identity and expenses incurred in the successful marketing campaign for free checking products introduced during 2002. These products have had a favorable impact on deposit growth, interest expense and service charge revenue since their introduction. Income tax expense was $3.7 million during 2004, representing a decrease of $9.6 million from the 2003 amount of $13.3 million and compared to $8.9 million in 2002. Pretax income in the 2004 period was reduced by the $29.5 million in debt prepayment fees related to the previously mentioned prepayment of FHLB advances, which allowed the effect of nontaxable income and tax credits to have a greater impact on the effective tax rate in 2004. The Corporation’s effective tax rate was 8.75% for 2004 compared to 19.9% for 2003 and 17.0% for 2002. The Corporation’s 2003 effective tax rate was favorably impacted by tax-free municipal income. Pretax income in the 2002 period was reduced by the $8.0 million litigation settlement as well as the $6.1 million restructuring charges, which allowed the effect of nontaxable income to have a greater impact on the effective tax rate in 2002. Aggregate Contractual Obligations and Off-Balance Sheet Arrangements The following table summarizes the Corporation’s contractual obligations to make future payments as of December 31, 2004. Payments for borrowings do not include interest. Payments related to operating leases are based on actual payments speciﬁed in the underlying contracts. (Dollar Amounts In Thousands) Federal Home Loan Bank advances Repurchase agreements Subordinated debentures ESOP loan Operating leases Total contractual obligations Footnote Reference 19 19 18 19 15 1 Year or Less $ 24,768 -0- -0- 661 2,702 $ 28,131 The preceding table excludes unamortized premiums and discounts on Federal Home Loan Bank advances because these premiums and discounts do not represent future cash obligations. The preceding table also excludes the Corporation’s cash obligations upon maturity of certiﬁcates of deposit whose maturities are described in NOTE 16 (Interest- Bearing Deposits) to the Consolidated Financial Statements. The following table summarizes the Corporation’s off-balance sheet commitments as of December 31, 2004. Commitments to extend credit and standby letters of credit are presented at contractual amounts; however, since many of these commitments are expected to expire unused or only partially used, the total amounts of these commitments do not necessarily reﬂect future cash requirements. After 1 But Within 3 Years After 3 But Within 5 Years After 5 Years Total $ 121,944 -0- -0- 1,575 4,753 $ 128,272 $ 310,437 20,000 -0- 1,576 3,261 $ 335,274 (Dollar Amounts In Thousands) Commitments to extend credit Standby letters of credit Total lending-related commitments $ 224,096 -0- 108,250 2,363 7,746 $ 342,455 Footnote Reference 14 14 $ 681,245 20,000 108,250 6,175 18,462 $ 834,132 Amount $ 744,942 23,079 $ 768,021 Commitments to extend credit include unfunded loan commitments as well as the undrawn portions of revolving and closed-end lines of credit as of December 31, 2004. The contractual provisions of these commitments normally include ﬁxed expiration dates or termination clauses, speciﬁc interest rates and clauses indicating that funding is contingent upon borrowers maintaining stated credit standards at the time of loan funding. 54 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Standby letters of credit are written conditional commitments issued by the Corporation to guarantee the performance of a client to a third party. In the event that the client does not perform in accordance with the terms of the agreement with the third party, the Corporation would be required to fund the commitment. The maximum potential amount of future payments the Corporation could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, the Corporation would be entitled to seek repayment from the client. The Corporation’s policies generally require that standby letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements. Liquidity Liquidity is a measure of the Corporation’s ability to efﬁciently meet normal cash ﬂow requirements of both borrowers and depositors. In the ordinary course of business, funds are generated from deposits (primary source) and the maturity or repayment of earning assets, such as securities and loans. As an additional secondary source, short-term liquidity needs may be provided through the use of overnight Federal funds purchased, borrowings through the use of lines available for repurchase agreements and borrowings from the Federal Reserve Bank. Additionally, the Corporation’s banking subsidiary is a member of the Federal Home Loan Bank and may borrow under overnight and term borrowing arrangements. The sale of earning assets may also provide an additional source of liquidity. In addition to the previously described funding sources, the Corporation also has the ability to access the capital markets. Liquidity risk stems from the possibility that the Corporation may not be able to meet current or future ﬁnancial obligations, or the Corporation may become overly reliant on alternative funding sources. The Corporation maintains a liquidity risk management policy to manage this risk. This policy identiﬁes the primary sources of liquidity, establishes procedures for monitoring and measuring liquidity and quantiﬁes minimum liquidity requirements based on board approved limits. The policy also includes a liquidity contingency plan to address funding needs to maintain liquidity under a variety of business conditions. The Corporation’s liquidity position is monitored by the Asset/Liability Management Committee (“ALCO”). The Corporation’s long-term liquidity source is a large core deposit base and a strong capital position. Core deposits are the most stable source of liquidity a bank can have due to the long- term relationship with a deposit customer. Deposits increased $556.2 million in 2004. This included an increase of $524.2 million for the deposits that were assumed in the acquisition of GAF and an increase due to purchase accounting adjustments in the amount of $5.4 million that were recorded as part of the GAF acquisition transaction. Excluding the GAF acquisition activity, noninterest-bearing demand deposits and savings deposits increased by $32.4 million and $105.1 million, respectively, while time deposits decreased by $110.9 million. Noncore deposits, which are time deposits in denominations of $100 thousand or more, represented 10.9% of total deposits at December 31, 2004. Noncore deposits increased by $19.3 million in 2004. The total increase in short-term borrowings of $312.3 million included $53.6 million that was acquired from GAF. During the third quarter of 2004, the Corporation prepaid $440 million of long-term FHLB advances to minimize the impact of maturities in any one year. The advances were replaced with short-term borrowings and other long-term FHLB advances with lower interest rates. Refer to NOTE 19 (Other Long-term Debt) to the Consolidated Financial Statements for additional information on the debt repayment. Although the Corporation’s primary source of funds remains traditional deposits from within the communities served by its banking subsidiary, future sources of deposits utilized could include the use of brokered time deposits offered outside the Corporation’s traditional market area. Time deposits of $100 thousand or more at December 31, 2004, 2003 and 2002 had remaining maturities as follows: Maturity Distribution of Large Certiﬁcates of Deposit (Dollar Amounts in Thousands) 2004 2003 2002 Amount Percent Amount Percent Amount Percent Remaining Maturity: 3 months or less Over 3 months through 6 months Over 6 months through 12 months Over 12 months Total $ 74,463 49,691 51,485 242,349 $ 417,988 18% 12 12 58 100% $ 77,603 50,132 69,239 201,742 $ 398,716 19% 13 17 51 100% $ 97,862 54,758 114,596 222,486 $ 489,702 20% 11 24 45 100% 55 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net loans increased $686.3 million during 2004 as increases were noted in all categories with the exception of leases. Most notable were increases in residential loans secured by real estate of $343.5 million and increases in commercial loans secured by real estate of $216.8 million compared to year-end 2003. Net loans in the amount of $532.7 million, which includes a purchase accounting adjustment of ($3.3) million, were acquired with the GAF acquisition. Below is a schedule of loans by classiﬁcation for the ﬁve years ended December 31, 2004: Loans by Classiﬁcation (Dollar Amounts in Thousands) 2004 2003 2002 2001 2000 Amount % Amount % Amount % Amount % Amount % Commercial, ﬁnancial, agricultural and other $ 715,280 71,351 Real estate-construction 988,611 Real estate-commercial 1,164,707 Real estate-residential 562,321 Loans to individuals 12,815 Net leases 20% 2 28 33 16 1 $ 655,740 27,063 771,861 821,159 521,481 28,033 23% 1 27 29 19 1 $ 633,955 20,998 663,220 739,018 505,139 47,110 24% 1 26 28 19 2 $ 529,300 14,727 638,576 849,787 473,515 63,326 21% 1 25 33 18 2 $ 443,618 37,146 560,066 932,915 450,154 68,975 18% 2 22 37 18 3 Gross loans and leases Unearned income Total loans and leases net of 3,515,085 (252) 100% 2,825,337 (455) 100% 2,609,440 (806) 100% 2,569,231 (1,297) 100% 2,492,874 (2,047) 100% unearned income $ 3,514,833 $ 2,824,882 $ 2,608,634 $ 2,567,934 $ 2,490,827 An additional source of liquidity is marketable securities that the Corporation holds in its investment portfolio. These securities are classiﬁed as “securities available for sale.” While the Corporation does not have speciﬁc intentions to sell these securities, they have been designated as “available for sale” because they may be sold for the purpose of obtaining future liquidity, for management of interest rate risk or as part of the implementation of tax management strategies. As of December 31, 2004, securities available for sale had an amortized cost of $2,147 million and an approximate fair value of $2,162 million. Gross unrealized gains were $30,191 thousand and gross unrealized losses were $14,634 thousand. Based upon the Corporation’s historical ability to fund liquidity needs from other sources, the current available for sale portfolio is deemed more than adequate, as the Corporation does not anticipate a need to liquidate the investments until maturity. Below is a schedule of the contractual maturity distribution of securities held to maturity and securities available for sale at December 31, 2004: 56 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Maturity Distribution of Securities Held to Maturity At Amortized Cost (Dollar Amounts in Thousands) U.S. Government Agencies and Corporations $ 146 3,254 860 129 $ 4,389 States and Political Subdivisions $ 2,377 15,631 29,286 26,076 $ 73,370 Other Securities $ 100 305 -0- -0- $ 405 Total Amortized Cost $ 2,623 19,190 30,146 26,205 $ 78,164 Weighted Average Yield* 7.02% 7.30% 7.39% 6.99% 7.22% Maturity Distribution of Securities Available for Sale At Amortized Cost (Dollar Amounts in Thousands) U.S. Treasury, and other U.S. Government Agencies and Corporations $ 22,036 317,850 497,265 826,109 $ 1,663,260 States and Political Subdivisions $ 2,837 3,295 31,725 153,038 $ 190,895 Other Securities $ 10,101 30,754 -0- 251,746 $ 292,601 Total Amortized Cost Weighted Average Yield* $ 34,974 351,899 528,990 1,230,893 $ 2,146,756 2.17% 3.08% 3.96% 4.78% 4.25% Within 1 year After 1 but within 5 years After 5 but within 10 years After 10 years Total Within 1 year After 1 but within 5 years After 5 but within 10 years After 10 years Total * Yields are calculated on a tax-equivalent basis. Interest Sensitivity Market risk is the risk of loss arising from adverse changes in the fair value of ﬁnancial instruments due to changes in interest rates, currency exchange rates or equity prices. The Corporation’s market risk is composed primarily of interest rate risk. Interest rate risk results principally from timing differences in the repricing of assets and liabilities, changes in the relationship of rate indices and the potential exercise of freestanding or embedded options. The objective of interest rate sensitivity management is to maintain an appropriate balance between the stable growth of income and the risks associated with maximizing income through interest sensitivity imbalances. While no single number can accurately describe the impact of changes in interest rates on net interest income, interest rate sensitivity positions, or “gaps,” when measured over a variety of time periods, can be informative. An asset or liability is considered to be interest-sensitive if the rate it yields or bears is subject to change within a predetermined time period. If interest-sensitive assets (“ISA”) exceed interest-sensitive liabilities (“ISL”) during a prescribed time period, a positive gap results. Conversely, when ISL exceeds ISA during a time period, a negative gap results. The cumulative gap at the 365-day repricing period was negative in the amount of $1,258 million or 20.30% of total assets at December 31, 2004. A positive gap tends to indicate that earnings will be impacted favorably if interest rates rise during the period and negatively when interest rates fall during the time period. A negative gap tends to indicate that earnings will be affected inversely to interest rate changes. In other words, as interest rates fall, a negative gap should tend to produce a positive effect on earnings and when interest rates rise, a negative gap should tend to affect earnings negatively. The primary components of ISA include adjustable rate loans and investments, loan repayments, investment maturities and money market investments. The primary components of ISL include maturing certiﬁcates of deposit, money market deposits, savings deposits, NOW accounts and short-term borrowings. 57 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table lists the amounts and ratios of assets and liabilities with rates or yields subject to change within the periods indicated as of December 31, 2004 and 2003 (Dollar Amounts in Thousands): Loans Investments Other interest-earning assets Total interest-sensitive assets Certiﬁcates of deposit Other deposits Borrowings Total interest-sensitive liabilities Gap ISA/ISL Gap/Total assets Loans Investments Other interest-earning assets Total interest-sensitive assets Certiﬁcates of deposit Other deposits Borrowings Total interest-sensitive liabilities Gap ISA/ISL Gap/Total assets 0-90 Days $ 1,300,777 190,336 2,403 1,493,516 346,191 1,795,426 985,049 3,126,666 $ (1,633,150) 2004 91-180 Days 181-365 Days $ 185,633 133,127 -0- 318,760 205,507 -0- 5,497 211,004 $ 107,756 $ 333,978 185,979 -0- 519,957 237,318 -0- 15,513 252,831 $ 267,126 Cumulative 0-365 Days $ 1,820,388 509,442 2,403 2,332,233 789,016 1,795,426 1,006,059 3,590,501 $ (1,258,268) 0.48 26.35% 1.51 1.74% 2.06 4.31% 0.65 20.30% 0-90 Days $ 1,057,021 241,163 5,362 1,303,546 325,957 1,413,069 634,878 2,373,904 $ (1,070,358) 0.55 20.63% 2003 91-180 Days 181-365 Days $ 178,006 116,979 -0- 294,985 242,706 -0- 1,407 244,113 $ 50,872 1.21 0.98% $ 291,352 189,610 -0- 480,962 249,361 -0- 21,290 270,651 $ 210,311 1.78 4.05% Cumulative 0-365 Days $ 1,526,379 547,752 5,362 2,079,493 818,024 1,413,069 657,575 2,888,668 (809,175) $ 0.72 15.59% Although the periodic gap analysis provides management with a method of measuring current interest rate risk, it only measures rate sensitivity at a speciﬁc point in time, and as a result may not accurately predict the impact of changes in general levels of interest rates or net interest income. Therefore, to more precisely measure the impact of interest rate changes on the Corporation’s net interest income, management simulates the potential effects of changing interest rates through computer modeling. The income simulation model used by the Corporation captures all assets, liabilities, and off-balance sheet ﬁnancial instruments, accounting for signiﬁcant variables that are believed to be affected by interest rates. These variables include prepayment speeds on mortgage loans and mortgage backed securities, cash ﬂows from loans, deposits and investments and balance sheet growth assumptions. The model also captures embedded options, such as interest rate caps/ﬂoors or call options, and accounts for changes in rate relationships as various rate indices lead or lag changes in market rates. The Corporation is then better able to implement strategies which would include an acceleration of a deposit rate reduction or lag in a deposit rate increase. The repricing strategies for loans would be inversely related. The Corporation’s asset/liability management policy guidelines limit interest rate risk exposure for the succeeding twelve-month period. Simulations are prepared under the base case where interest rates remain ﬂat, and most likely case where interest rates are deﬁned using projections of economic factors. Additional simulations are produced estimating the impact on net interest income of a 200 basis point (2.00%) movement upward or downward which cannot result in more than a 5.0% decline in net interest income when compared to the base case. The analysis at December 31, 2004, indicated that a 200 basis point (2.00%) increase in interest rates would decrease net interest income by 48 basis points (0.48%) below the base case scenario and a 200 basis point (2.00%) decrease in interest rates would decrease net interest income by 285 basis points (2.85%) below the base case scenario over the next twelve months, both within policy limits. 58 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Corporation’s “Asset/Liability Management Committee” (“ALCO”) is responsible for the identiﬁcation, assessment and management of interest rate risk exposure, liquidity, capital adequacy and investment portfolio position. The primary objective of the ALCO process is to ensure that the Corporation’s balance sheet structure maintains prudent levels of risk within the context of currently known and forecasted economic conditions and to establish strategies which provide the Corporation with appropriate compensation for the assumption of those risks. The ALCO attempts to mitigate interest rate risk through the use of strategies such as asset sales, asset and liability pricing and matched maturity funding. The ALCO strategies are established by the Corporation’s senior management. The Corporation entered into an interest rate swap transaction during the third quarter of 2003 and two additional interest rate swap transactions during the second quarter of 2004. Each of the swap transactions involved hedging adjustable LIBOR based commercial loans with a receive-ﬁxed and pay-ﬂoating interest rate swap of $25 million notional amount, for a total of $75 million. The original maturities of the swap transactions ranged from 2.5 to 3 years. The purpose of the swaps was to reduce the Corporation’s exposure to further declines in interest rates. The ALCO continues to evaluate the use of additional derivative instruments to protect against the risk of adverse price or interest rate movements on the value of certain assets and liabilities. Another strategy aimed at reducing the Corporation’s exposure to falling interest rates was implemented during 2003. U.S. government agency securities maturing in approximately 3.5 years were purchased with short-term borrowings. Final loan maturities and rate sensitivities of the loan portfolio excluding consumer installment and mortgage loans and before unearned income at December 31, 2004 were as follows (Dollar Amounts in Thousands): Commercial and industrial Financial institutions Real estate-construction Real estate-commercial Other Totals Loans at ﬁxed interest rates Loans at variable interest rates Totals Credit Review Maintaining a high quality loan portfolio is of great importance to the Corporation. The Corporation manages the risk characteristics of the loan portfolio through the use of prudent lending policies and procedures and monitors risk through a periodic review process provided by internal auditors, regulatory authorities and our loan review staff. These reviews include the analysis of credit quality, diversiﬁcation of industry, compliance to policies and procedures and an analysis of current economic conditions. In the management of its credit portfolio, the Corporation emphasizes the importance of the collectibility of loans and leases as well as asset and earnings diversiﬁcation. The Corporation immediately recognizes as a loss all credits judged to be uncollectible and has established an allowance for credit losses that may exist in the portfolio at a point in time, but have not been speciﬁcally identiﬁed. Within One Year One to 5 Years After 5 Years $ 244,771 55 18,047 122,723 20,929 $ 406,525 $ 127,535 300 15,229 239,807 17,116 $ 399,987 125,592 274,395 $ 399,987 $ 108,049 -0- 38,075 626,081 196,525 $ 968,730 256,406 712,324 $ 968,730 Total $ 480,355 355 71,351 988,611 234,570 $ 1,775,242 The Corporation’s written lending policy requires certain underwriting standards to be met prior to funding any loan, including requirements for credit analysis, collateral value coverage and documentation. The principal factor used to determine potential borrowers’ credit worthiness is business cash ﬂows or consumer income available to service debt payments. Secondary sources of repayment, including collateral and guarantees, are frequently obtained. The lending policy provides limits for individual and bank committee lending authorities. In addition to the bank loan approval process, requests for borrowing relationships which will exceed one million dollars must also be approved by the Corporation’s Credit Committee. This Committee consists of a minimum of three members of the Corporation’s Board of Directors. The Corporation has an additional level of approval for credit relationships between $500 thousand and $1.0 million. This procedure requires approval of those credits by a committee consisting of senior lenders of the Corporation. 59 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Commercial and industrial loans are generally granted to small and middle market customers for working capital, operations, expansion or asset acquisition purposes. Operating cash ﬂows of the business enterprise are identiﬁed as the principal source of repayment, with business assets held as collateral. Collateral margins and loan terms are based upon the purpose and structure of the transaction as set forth in loan policy. Commercial real estate loans are granted for the acquisition or improvement of real property. Generally, commercial real estate loans do not exceed 75% of the appraised value of property pledged to secure the transaction. Repayment of such loans is expected from the operations of the subject real estate and is carefully analyzed prior to approval. Real estate construction loans are granted for the purposes of constructing improvements to real property, both commercial and residential. On-site inspections are conducted by qualiﬁed individuals prior to periodic permanent project ﬁnancing, which is generally committed prior to the commencement of construction ﬁnancing. Real estate loans secured by 1-4 family residential housing properties are granted subject to statutory limits in effect for the bank regarding the maximum percentage of appraised value of the mortgaged property. Residential loan terms are normally established in compliance with secondary market requirements. Residential mortgage portfolio interest rate risk is controlled by secondary market sales, variable interest rate loans and balloon maturities. Loans to individuals represent ﬁnancing extended to consumers for personal or household purposes, including automobile ﬁnancing, education, home improvement and personal expenditures. These loans are granted in the form of installment, credit card or revolving credit transactions. Consumer credit worthiness is evaluated on the basis of ability to repay, stability of income sources and past credit history. The Corporation maintains an allowance for credit losses at a level deemed sufﬁcient to absorb losses which are inherent in the loan and lease portfolios at each balance sheet date. Management reviews the adequacy of the allowance on a quarterly basis to ensure that the provision for credit losses has been charged against earnings in an amount necessary to maintain the allowance at a level that is appropriate based on management’s assessment of probable estimated losses. The Corporation’s methodology for assessing the appropriateness of the allowance for credit losses consists of several key elements. These elements include an assessment of individual problem loans, delinquency, loss experience, trends and other relevant factors, all of which may be susceptible to signiﬁcant changes. Enhancements to the Corporation’s methodology during 2004 resulted in reallocation of the allowance for credit losses from unallocated to speciﬁc loan categories. While the Corporation consistently applies a comprehensive methodology and procedure, which is described in NOTE 1 (Statement of Accounting Policies) to the Consolidated Financial Statements, the allowance for credit loss methodologies incorporate management’s current judgments about the credit quality of the loan portfolio as well as collection probabilities for problem credits. Although management considers the allowance for credit losses to be adequate based on information currently available, additional allowance for credit loss provisions may be necessary due to changes in management estimates and assumptions about asset impairment, information about borrowers that indicate changes in the expected future cash ﬂows or changes in economic conditions. The allowance for credit losses and the provision for credit losses are signiﬁcant elements of the Corporation’s ﬁnancial statements, therefore management periodically reviews the processes and procedures utilized in determining the allowance for credit losses to identify potential enhancements to these processes including development of additional management information systems to ensure that all relevant factors are appropriately considered in the allowance analysis. In addition, the Corporation maintains a system of internal controls which are independently monitored and tested by internal audit and loan review staff to ensure that the loss estimation model is maintained in accordance with internal policies and procedures as well as generally accepted accounting principals. Since all identiﬁed losses are immediately charged off, no portion of the allowance for credit losses is restricted to any individual credit or groups of credits, and the entire allowance is available to absorb any and all credit losses. For analytical purposes, the following table sets forth an allocation of the allowance for credit losses at December 31 according to the categories indicated. Management feels the unallocated portion of the reserve is necessary due to the uncertain economic and geo-political environment and its impact on a variety of sectors such as health care and lodging. The unallocated allowance was reduced during 2004 as a result of methodology enhancements. 60 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Allocation of the Allowance for Credit Losses (Dollar Amounts in Thousands) 2004 2003 2002 2001 2000 Commercial, industrial, ﬁnancial, agricultural and other Real estate-construction Real estate-commercial Real estate-residential Loans to individuals Lease ﬁnancing receivables Unallocated Total Allowance as percentage of average total loans $ $ 13,422 1,088 13,099 8,759 3,806 136 753 41,063 1.26% $ 10,739 330 11,361 4,910 4,614 202 5,229 $ 37,385 $ 7,856 600 7,201 5,294 3,035 259 10,251 $ 34,496 $ 6,315 432 9,808 7,379 3,845 401 5,977 $ 34,157 $ 6,263 643 9,064 10,211 4,938 638 1,844 $ 33,601 1.42% 1.33% 1.34% 1.34% The decrease in the allowance as a percent of average loans in 2004 reﬂects the trend of improvement in nonperforming loans, net charge-offs and lower levels of the allowance being allocated to larger classiﬁed credits. The spike in the allowance for credit losses as a percentage of average total loans outstanding during the 2003 period was due to the impact of having the BankPittsburgh loans included in the average for only a short period during the year, or from the acquisition date of December 5, 2003. While the allowance for credit losses as a percentage of average total loans outstanding spiked during 2003, the allowance for credit losses as a percentage of actual loans outstanding remained at 1.32% for 2002 and 2003 before declining to 1.17% in 2004. Other than those described below, there are no material credits that management has serious doubts as to the borrower’s ability to comply with the present loan repayment terms. The following table identiﬁes nonperforming loans at December 31. A loan is placed in a nonaccrual status at the time when ultimate collectibility of principal or interest, wholly or partially, is in doubt. Past due loans are those loans which are contractually past due 90 days or more as to interest or principal payments but are well secured and in the process of collection. Renegotiated loans are those loans which terms have been renegotiated to provide a reduction or deferral of principal or interest as a result of the deteriorating ﬁnancial position of the borrower. Nonperforming and Impaired Assets and Effect on Interest Income Due to Nonaccrual (Dollar Amounts in Thousands) Loans on nonaccrual basis Past due loans Renegotiated loans Total nonperforming loans Nonperforming loans as a percentage of total loans 2004 $ 10,732 14,671 183 $ 25,586 0.73% Allowance as percentage of nonperforming loans 160.49% 2003 $ 12,459 10,586 195 $ 23,240 0.82% 160.86% Other real estate owned $ 1,814 $ 1,866 Gross income that would have been recorded at original rates Interest that was reﬂected in income Net reduction to interest income due to nonaccrual $ $ 1,757 307 1,450 $ $ 1,962 1,185 777 2002 $ 23,450 14,774 207 $ 38,431 1.47% 89.76% 1,651 1,542 286 1,256 $ $ $ 2001 $ 22,899 17,781 832 $ 41,512 1.62% 82.28% 2000 $ 10,698 22,086 2,263 $ 35,047 1.41% 95.87% $ 1,619 $ 1,661 $ $ 1,422 750 672 $ $ 750 333 417 The reduction of income due to renegotiated loans was less than $50 thousand in any year presented. Nonperforming loan levels at December 31, 2004, increased $2.3 million compared to 2003 levels due to increases in past due loans. The increases in past due loans in 2004 were largely due to increases in residential loans secured by real estate. Increases in past due loans during 2004 were partially offset by decreases in nonaccrual loans which were largely due to decreases in residential loans secured by real estate. Nonperforming loan levels at December 31, 2003 decreased $15.2 million compared to 2002 levels as decreases were noted in nonaccrual and past due loans. The decrease in nonaccrual loans during 2003 was due to eight commercial loans that paid in full or were charged down and/or charged off. The decrease in past due loans for the 2003 period included decreases in all major categories with the most signiﬁcant decreases in loans secured by residential real estate, loans secured by commercial real estate and other commercial loans. This decrease in past due loans during 2003 was due to successful collection strategies. Interest income on nonaccrual loans decreased in the 2004 period compared to 2003 as the 2003 period included the ﬁnal resolution of several large credits that included collection of some interest income. 61 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Corporation’s loan portfolio continues to be monitored by senior management to identify potential portfolio risks and detect potential credit deterioration in the early stages. The Corporation has a “Watch List Committee” which includes credit workout ofﬁcers of the bank and reviews watch list credits for workout progress or deterioration. Loan loss adequacy and the status of signiﬁcant nonperforming credits are monitored on a quarterly basis by a committee made up of senior ofﬁcers of the bank and parent company. These committees were established to provide additional internal monitoring and analysis in addition to that provided by the Credit Committees of the bank and parent company. Credit risk is mitigated during the loan origination process through the use of sound underwriting policies and collateral requirements and its previously described committee structure. Management also attempts to minimize loan losses by analyzing and modifying collection techniques on a periodic basis. Management believes that the allowance for credit losses and nonperforming loans remained safely within acceptable levels. Capital Resources Equity capital stood at $532.0 million at December 31, 2004, a $101.0 million increase compared to December 31, 2003. The most signiﬁcant change in equity resulted from the issuance of stock related to the GAF acquisition which increased equity by $105.2 million, while the conversion of GAF’s investment in FCFC stock into treasury shares resulted in a decrease of $514 thousand to equity capital. Dividends declared reduced equity by $43.6 million during 2004 as dividends were increased over 2003 levels, while net income increased equity by $22.1 million for the same period. Additional advances by the Corporation’s Employee Stock Ownership Plan (“ESOP”) to fund the acquisition of the Corporation’s common stock for future distribution as employee compensation, net of long-term debt payments and fair value adjustments to unearned ESOP shares, decreased equity by $3.9 million. The market value adjustment to securities available for sale decreased equity by $5.1 million for the period. Amounts paid to fund the discount on reinvested dividends reduced equity by $816 thousand. Proceeds from the issuance of treasury shares to provide for stock options exercised increased equity by $9.7 million during 2004, while the tax beneﬁt related to the stock options increased equity by $1.2 million. Equity capital was also impacted during 2004 by an increase of $203 thousand from the reissuance of treasury shares to fund contingent payments related to the acquisition of First Commonwealth Financial Advisors, which consummated in 2002. This contingent payment of the Corporation’s common stock was the second of four scheduled annual installments. A capital base can be considered adequate when it enables the Corporation to intermediate funds responsibly and provide related services while protecting against future uncertainties. 62 The evaluation of capital adequacy depends on a variety of factors, including asset quality, liquidity, earnings history and prospects, internal controls and management caliber. In consideration of these factors, management’s primary emphasis with respect to the Corporation’s capital position is to maintain an adequate and stable ratio of equity to assets. See NOTE 27 (Regulatory Restrictions and Capital Adequacy) to the Consolidated Financial Statements for an analysis of regulatory capital guidelines and the Corporation’s capital ratios relative to these measurement standards. Risk Management In the normal course of business the Corporation assumes various types of risk. The Corporation has identiﬁed twenty- six standard risks which have been summarized into seven major risk categories. The seven major risk categories include credit risk, market risk, liquidity risk, compliance/ legal risk, operational risk, reputation risk and strategic risk. Credit risk, market risk and liquidity risk are discussed in this Management’s Discussion and Analysis of Financial Condition and Results of Operations section. The remaining major risk categories are deﬁned as follows: compliance/ legal risk—the risk arising from violations of, or noncompliance with laws, rules, regulations, prescribed practices, or ethical standards; operational risk—threat created by inadequate information systems, operational problems, weak internal control systems, fraud, or any other unforeseen catastrophes; reputation risk—the risk to earnings or capital arising from negative public opinion; and strategic risk—the risk arising from adverse business decisions or improper implementation of those decisions. These factors and others could impact the Corporation’s business, ﬁnancial condition and results of operation. Corporate management has taken strong and wide-ranging actions to enhance the awareness of and proactively manage risk within the Corporation. In addition to establishing a comprehensive policy and procedure manual that is updated and regularly communicated throughout the Corporation, the Executive Vice President, Chief Risk Ofﬁcer, oversees all aspects of the risk process. Our committee structure embraces a risk management culture, which begins with the Risk Committee that provides oversight and monitoring of key risk areas. The Risk Committee, which is chaired by the Senior Vice President, Risk Management, and has representation from all of the disciplines across the organization, meets to discuss and assess current and emerging risks as well as to identify solutions and mitigants. Credit quality and loan loss adequacy issues are addressed by the Credit Quality, Watch List and Loan Loss Reserve committees. Additional committees include Security, which is responsible for coordinating the security program; Privacy, which focuses on safeguarding client information; ALCO, which monitors interest rate and liquidity risks; and Disclosure, which evaluates internal controls regarding FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS information utilized in certain regulatory reports, as well as reviewing those reports and the disclosure process to ensure that disclosures are timely, complete and accurate. The Risk Department has speciﬁc procedures to analyze and quantify risks in the seven major risk categories. Gaps between inherent risks and mitigants are quantiﬁed and presented to the Risk Committee for their review. Management continually reviews the mitigants and controls to ensure their continuity. The Internal Audit Department validates the existence and effectiveness of the controls. Risk gaps are compiled to develop a risk rating, which is incorporated into the balanced scorecard measure and is reported to the Board of Directors. An analytical review of key indicators, both monetary and nonmonetary, as well as other current information that may become available through discussions with management serves as an early warning system to detect potential deteriorating internal controls. All signiﬁcant new initiatives and products are subject to a risk assessment prior to being presented for implementation. An annual assessment of risk is also performed to identify potential threat areas to our computer systems. Our internal audit staff performs routine and consistent information technology reviews of identiﬁed risk areas, security measures and control processes. With these processes in place the Corporation believes that its objective of establishing a risk culture that identiﬁes, measures, controls and monitors events or actions that may adversely affect our organization has been achieved. Our goal is not to eliminate risk but to understand fully the risk the Corporation is assuming and appropriately manage those risks. Inﬂation and Changing Prices Management is aware of the impact inﬂation has on interest rates and therefore, the impact it can have on a bank’s performance. The ability of a ﬁnancial institution to cope with inﬂation can only be determined by analyzing and monitoring its asset and liability structure. The Corporation monitors its asset and liability position with particular emphasis on the mix of interest-sensitive assets and liabilities in order to reduce the effect of inﬂation upon its performance. However, it must be remembered that the asset and liability structure of a ﬁnancial institution is substantially different from an industrial corporation in that virtually all assets and liabilities are monetary in nature, meaning that they have been or will be converted into a ﬁxed number of dollars regardless of changes in general price levels. Examples of monetary items include cash, loans and deposits. Nonmonetary items are those assets and liabilities which do not gain or lose purchasing power solely as a result of general price level changes. Examples of nonmonetary items are premises and equipment. Inﬂation can have a more direct impact on categories of noninterest expenses such as salaries and wages, supplies and employee beneﬁt costs. These expenses are very closely monitored by management for both the effects of inﬂation and increases relating to such items as stafﬁng levels, usage of supplies and occupancy costs. COMMON STOCK INFORMATION First Commonwealth Financial Corporation (the “Corporation”) is listed on the New York Stock Exchange under the symbol “FCF.” The approximate number of holders of record of the Corporation’s common stock is 20,100. The table below sets forth the high and low sales prices per share and cash dividends declared per share for common stock of the Corporation. Period 2004 First Quarter Second Quarter Third Quarter Fourth Quarter Period 2003 First Quarter Second Quarter Third Quarter Fourth Quarter High Sale Low Sale $ 15.00 $ 14.96 $ 14.30 $ 15.90 $ $ $ $ 13.99 12.01 12.50 13.61 High Sale Low Sale $ 12.55 $ 13.30 $ 14.00 $ 14.98 $ $ $ $ 11.50 11.57 12.60 13.15 Cash Dividends Per Share $ $ $ $ 0.160 0.160 0.160 0.165 Cash Dividends Per Share $ $ $ $ 0.155 0.155 0.155 0.160 63 Our Mission The mission of First Commonwealth Financial Corporation is to maximize the long-term total return to shareholders. Shareholder Value First Commonwealth is committed to building shareholder value. It is our mission, our highest priority. Value is delivered through a combination of total return (dividend yields plus market price appreciation), market liquidity (the ease of buying or selling First Commonwealth shares), and shareholder services. This section of our annual report summarizes the many services that are made available to our shareholders. Dividend Reinvestment First Commonwealth Financial Corporation's Dividend Reinvestment Plan offers shareholders an opportunity to reinvest their dividends in additional shares of the Corporation's common stock. Once enrolled in the plan, participants may also purchase shares through voluntary cash investments. For more information on the plan, please call The Bank of New York, Plan Administrator, at 1-800-524-4458. Annual Meeting The Annual Meeting of Shareholders will be held at: First Commonwealth Place 654 Philadelphia St., Indiana, PA On Monday, April 18, 2005 at 3:00 PM. Common Stock First Commonwealth Financial Corporation common stock is listed on The New York Stock Exchange and is traded under the symbol FCF. Current market prices for First Commonwealth Financial Corporation common stock can be obtained from your local stock broker or by calling the Corporation at (724) 349-7220 (in Indiana, PA) or 1-800-331-4107 (outside Indiana, PA). Transfer Agent The Bank of New York Telephone Inquiries: 1-800-524-4458 1-610-382-7833 (outside the U.S.) 1-888-269-5221 (Hearing Impaired—TDD Phone) Address Shareholder Inquiries To: Shareholder Relations Department P.O. Box 11258 Church Street Station New York, NY 10286 E-Mail Address: Shareowners@bankofny.com The Bank of New York's Stock Transfer Website: http://www.stockbny.com Send Certiﬁcates For Transfers and Address Changes To: Receive and Deliver Department P.O. Box 11002 Church Street Station New York, NY 10286 Dividend Payments Subject to the approval of the Board of Directors, quarterly cash dividends are paid on or about the 15th day of January, April, July and October. 64 For shareholders who do not participate in the Dividend Reinvestment Plan, Automated Direct Dividend Deposit Service is available for direct deposit of quarterly dividend payments to a checking or savings account. To enroll, please call The Bank of New York at 1-800-524-4458 for an Authorization Form (completed forms must be received by the Bank 30 days prior to dividend payment date). Form 10K A copy of the Form 10K as ﬁled with the Securities and Exchange Commission will be provided to any shareholder on request to the Corporation, to the attention of the Corporate Secretary. Investor/Shareholder Inquiries Requests for information or assistance regarding the corporation should be directed to the Corporation, to the attention of Shareholder Relations, 1-800-331-4107. Additional Investor/Shareholder Information Form 10K and other corporate ﬁlings to the Securities and Exchange Commission are available on the Corporation’s website at www.fcbanking.com under “Investor Relations”. The “Investor Relations” section of the website also includes additional information of interest to shareholders such as: press releases, historical stock prices, dividend declarations and corporate governance information, including the Corporation’s “Code of Ethics”. First Commonwealth’s Chief Executive Ofﬁcer has certiﬁed to the NYSE that, as of the date of the certiﬁcation, he was not aware of any violation by First Commonwealth of NYSE’s corporate governance listing standards. In addition, First Commonwealth’s Chief Executive Ofﬁcer and Chief Financial Ofﬁcer have made certain certiﬁcations concerning the information contained in the annual report on Form 10-K pursuant to Section 302 of the Sarbanes-Oxley Act. The Section 302 certiﬁcations appear as exhibits 31.1 and 31.2 to the annual report on Form 10-K as of December 31, 2004. Golden Tower Awards January ............................................................................Pat Nagle February ................................................................... William Locher March .........................................................................Lori Schreiber April ............................................................................. Lisa Resslar May ........................................................................... Melanie Ansell June ........................................................................... Randy Koontz July ........................................................................... Janine Fennell August ............................................................................. Tim Nagle September ......................................................................Gary Bentz October ............................................................... Robert Ellenberger November ..................................................................... Dave Hanna December .....................................................................Peter Zerega Spirit of Community Service Awards January ....................................................... Lori Styers, Irene Caskey February .......................................Daniel Gehring, Barbie Wojichowski March ................................................. Jacqueline Snyder, John Parsch April .................................................. Deborah Robertson, Connie Biss May ....................................................... Leo Klebacha, Deborah Aller June ......................................................... Cheryl Knisely, Joni Kosior July .......................................................... Joslin Bennett, Aja Whiting August .................................................... Michael James, Valerie Korb September ...................................................Tanya Snyder, Joyce Lock October .................................................. Karen Walters, Diane Eppley November ......................................... Candi Beltowski, Claudia Jacobson December ......................................................Judy Anthony, Lloyd Rager First Commonwealth Financial Corporation Old Courthouse Square 22 North Sixth Street Indiana, Pennsylvania 15701-0400 (724) 349-7220 (800) 711-BANK (2265) www.fcbanking.com

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