First Community Bancshares, Inc.
Annual Report 2002

Plain-text annual report

First Community Bancshares, Inc. 2002 Annual Report Diluted Earnings Per Share ($) } Financial Highlights (Amounts in Thousands, Except Percent and Per Share Data) Contents } Message to Stockholders Introduction 2002 Annual Report }}} } Earnings and Dividends Net income Basic earnings per share Diluted earnings per share Cash dividends per share Return on average equity Return on average assets 2002 $ 24,719 2.49 2.48 1.00 17.16 % 1.68% 2001 $ 19,134 1.92 1.92 .089 14.80% 1.49 % 2000 $ 17,063 1.78 1.78 .086 15.70 % 1.51 % Balance Sheet Data at Year-End Total Assets Deposits Securities sold under agreements to repurchase FHLB borrowings and other indebtedness Stockholders’ equity 2002 2000 $ 1,524,363 $ 1,478,235 $ 1,218,017 899,903 1,078,260 1,139,727 2001 91,877 79,262 46,179 124,357 152,462 145,320 133,041 138,015 120,682 Management’s Discussion and Analysis Application of Critical Accounting Policies Recent and Pending Acquisitions Summary Financial Results Five-Year Selected Financial Data Common Stock and Dividends Results of Operations Balance Sheet Discussion Liquidity Interest Rate Sensitivity, Interest Rate Risk and Asset/Liability Management Trust and Investment Management Services Recent Legislation Consolidated Financial Statements Report of Independent Auditors Report of Management Responsibilities Board of Directors Locations & Other Information 1 5 6 7 10 12 15 16 18 26 33 34 37 37 40 74 75 76 78 A message to our friends and stockholders Stockholders 1 Dear Stockholders and Friends, }} We, at First Community Bancshares, Inc., are very pleased to provide this annual report on the operations of the Company for 2002. It has been an eventful year, full of many new projects geared toward growth of the Company and the establishment of First Community as a regional provider of financial services. We consider ourselves very fortunate that we have been able to post another year of record earnings while continuing to build and invest in resources for development and growth. In the following summary, we will discuss our financial performance for the year along with recent announcements and many of the projects that are part of our strategic plan for growth and expansion of services. At the forefront of our recently completed year, were the strong operating results. Earnings for 2002 not only set new records, but increased by more than 29% over the preceding year. Net income for 2002 was $24.7 million, an increase of $5.6 million over the $19.1 million record posted in 2001. The $5.6 million increase includes a $1.9 million (net of tax) reduction in goodwill amortization as a result of the required adoption of Financial Accounting Standards 142 and 147. In addition, record results for 2002 were principally achieved through an increase in net interest income of $10.8 million. The increase in net interest income is the result of meticulous management of asset yields and cost of funds throughout a year of historic lows in prevailing short-term interest rates and prime loan rates. Interest rate forecasts early in 2002 indicated a possible 50 to 75 basis point increase in short-term interest rates by year- end 2002. However, in response to continued weakness in the U.S. economy, the Federal Reserve Open Market Committee continued an accommodative stance and further lowered the federal funds rate by another 50 basis points in November 2002. The continuation of lower John M. Mendez President and CEO First Community Bancshares, Inc. Continuing to build and invest Growth in resources for growth and development interest rates constrained margins, to a degree, as deposit rates reached historic lows and yields on loans continued to drop as a result of repricing of adjustable rate loans and the attainment of lower yields on new loan production. Despite this unforeseen interest rate environment, we were able to increase net interest margin from 4.55% in 2001 to 4.76% for the full year 2002. Management of rates offered through our product group and growth in average loans held for investment and held for sale were important factors in the improvement in net interest margin for the year. Stockholders Message 2 (continued) In 2002, we opened five new full-service branches. In August, we opened our new West Atlantic branch in Emporia, Virginia. This replaced our Halifax Street location, which did not offer drive-up banking and had limited parking and other facilities. In November, we opened our new Ridgeview branch in Bluefield, Virginia. We believe that this new facility will significantly enhance our service to both our Tazewell County, Virginia, and Mercer County, West Virginia, customers. And on November 30, 2002, we completed the acquisition of Bank of Greenville, which added three branches in Monroe and Summers Counties in West Virginia. }} Non-interest income growth was concentrated in the $1.1 million increase in deposit service charge revenue which stems from continued growth in deposits and refinement in the Company’s product set and service charge structure. Partially offsetting this increase was a $500,000 drop in other operating revenues and a $572,000 decrease in securities gains and losses. During 2002, the Company recorded a $576,000 write- down on the impairment of a municipal bond issue which led to this decrease in securities gains. Low interest rates on fifteen and thirty-year mortgages, which were available throughout the year, resulted in residential mortgage loan originations through the Company’s mortgage subsidiary of over $790.0 million in 2002, up from $621.0 million in 2001. Despite the higher volume of loan originations, net income from mortgage banking fell short of the preceding year as a result of higher hedge costs, primarily in the third quarter. Overall, non-interest revenues were unchanged from the preceding year at $20.3 million. Basic and diluted earnings per share (“EPS”) for 2002 reached $2.49 and $2.48, respectively, and compared with $1.92 per share basic and diluted in 2001, an increase of 29% year over year on a diluted basis. The adoption of the new goodwill accounting standards in 2002 added $0.19 per share to diluted EPS. Without the effect of the new standards, diluted EPS increased 18.0% in 2002 versus 2001. Return on equity in 2002 climbed to 17.16%, up from 14.80% in 2001. The improvement in return on equity came as a result of improved leverage from acquisitions in late 2001 as well as growth in net interest income and operational improvements which impacted net income. Return on average assets also improved significantly, increasing from 1.49% in 2001 to 1.68% for the current year. Based on our year-end closing stock price of $30.76, 2002 earnings per share produce a price/earnings multiple of 12.4X. Our common stock price also experienced significant price appreciation during 2002, increasing from $26.79 (year-end 2001 adjusted for the March 2002 10% stock dividend) to $30.76 at December 31, 2002. Total cash dividends paid in 2002 of $9.93 million also resulted in a 3.7% cash return on the opening market value of First Community common stock and combined with current year price appreciation, resulted in an 18.5% total return on investment for 2002. 3 }} The branch additions are only part of your Company’s plan to expand the scope of its operations and provide a full array of financial services, in a community bank setting, to a larger market which encompasses a large portion of the Mid-Atlantic region. We plan to continue this expansion through the addition of de novo branches, small bank affiliations and acquisition of financial service providers. A major milestone in this strategy was achieved in January 2003 when we announced the signing of a definitive agreement for the The CommonWealth Bank in Richmond, acquisition of Virginia. CommonWealth is a $134 million bank operating four branches within the Richmond metro market. This acquisition will supplement our Southside, Virginia operations and establish a strong base of operations in eastern Virginia. We are very excited about the addition of CommonWealth and its fine staff of financial professionals. Subject to regulatory approvals and the affirmative vote of CommonWealth stockholders, we expect to close on this transaction in the second quarter of 2003. On the North Carolina front, we are pleased to announce that we have completed the acquisition of our first of two branch properties in Winston-Salem, North Carolina with plans to open these new full service banking facilities in the second quarter of 2003. This continues our expansion in North locations within the Carolina and provides our first Piedmont/Triad area. In the area of expanded financial services, we are pleased to announce our recent acquisition of Stone Capital Management, Inc., a registered investment advisory firm providing financial advisory and wealth management services to individual investors. Stone Capital is based in Beckley, West Virginia with current assets under management of over $94 million. Future plans include the expansion of these services to other First Community markets under the Stone Capital brand as well as the extension of asset management services, through Stone Capital, to customers of the First Community Bank Trust and Financial Services Division. The addition of Stone Capital is coupled with the recent recruitment of our new Senior Vice President of Trust and Financial Services who comes to us with superior qualifications and background. Mike Earle, who received his MBA from George Washington University, is also an attorney and Certified Financial Planner with over twenty years of experience in trust management, equity investing and business valuation services. These new resources significantly improve our financial advisory capabilities. Great strides have been made in the past year in the area of asset quality with significant reductions in ninety-day past due loans and non-accrual loans. These two areas of non- performing assets have been reduced to very modest levels and are well below our peer group averages, indicating a higher level of asset quality when benchmarked against commercial banks of similar size. Total non-performing assets to total assets were reduced to 0.41% at year-end 2002, down from 0.58% at December 31, 2001. Asset quality is evident not only in non-performing asset measures but also in loan delinquencies, which are at their lowest level in the history of the Company. Loans past due thirty days or more to total loans were 1.18% at year-end 2002, including ninety-day and non- accrual loans. This compares favorably with 1.53% at year-end 2001. Each of these measures ranks your Company very high among commercial banks in terms of asset quality. In 2002 we recruited some very talented and experienced staff members who have enhanced administrative controls over the credit portfolio and sharpened policy and standards for the production and administration of both commercial and consumer loans. In July of last year Congress passed sweeping legislation known as the Sarbanes-Oxley Act of 2002. This legislation is intended to improve the quality of financial reporting, increase corporate accountability for financial reporting, improve corporate governance and reform the accounting profession in areas of attestation services, all with the objective of restoring investor confidence in public company accounting and reporting. First Community Bancshares has a strong record of producing quality financial reports and integrity in corporate governance. Despite our Company’s existing commitment to excellence in these areas, financial Stockholders Message 4 (continued) }} we have redoubled our efforts to ensure the continued confidence of you, our stockholders, and the investing public at large. Since the passage of the act, we have further formalized our financial reporting processes with the formation of our Financial Reporting and Disclosure Committee, which is an integral part of our financial report review process. This committee further enhances the integrity of the financial reporting process through formalized assessment of accounting policies and evaluation of financial disclosures. We have also formed our Business Trends Committee, which meets monthly to consider and evaluate trends and business conditions, and ensure important disclosures are communicated through the organization and considered for disclosure where appropriate. These new controls are in addition to the many existing controls and processes already employed by our Company to ensure the accuracy and fair presentation of financial information that we publish on a quarterly and annual basis. Portions of this annual report are dedicated to these new processes, the audit committee and the people who work very hard to ensure quality financial reporting. Once again, we thank you for your commitment to the success of our Company, whether as a customer of First Community Bank, as one of our dedicated employees or as an investor and shareholder. We are indeed grateful for the opportunity to provide quality financial services and to serve as custodians of the many resources of this growing company. Sincerely, John M. Mendez President and Chief Executive Officer Introduction 5 }} The 2002 annual report reflects another record year in the history of First Community Bancshares, Inc. As we grow and prosper, the basic tenets of our philosophy remain the same. Our commitment to serve the financial needs of our customers guides our path as we continue our efforts to be Your First Financial Resource. Our shareholders, customers and employees depend on us to be trustworthy. We guard our corporate reputation and strive to earn and keep the trust of our stakeholders. We believe that mutual trust results in strong and stable relationships and creates satisfied shareholders, loyal customers and proud employees. Our commitment to the communities we serve remains strong. Good corporate citizenship and corporate integrity go hand in hand with our efforts to continue to build a financially strong company that provides service to our communities and employment opportunities for our friends and neighbors. We strive to meet the responsibility inherent in the name First Community Bank. This report features the Board of Directors and the committees who provide the oversight that ensures we are true to our values and honor our commitment to our shareholders, customers and employees. These directors and officers provide the guidance for ethical business practices so necessary to maintain our corporate integrity. We trust that you will find it reassuring to learn about the people who attest to the accuracy of the information you receive in this annual report. Robert L. Buzzo Vice President and Secretary First Community Bancshares, Inc. President First Community Bank, N. A. E. Stephen Lilly Chief Operating Officer First Community Bancshares, Inc. Senior Vice President and COO First Community Bank, N. A. Robert L. Schumacher Chief Financial Officer First Community Bancshares, Inc. Senior Vice President-Finance First Community Bank, N. A. Management’s 6 Discussion and Analy }} This discussion should be read in conjunction with the consolidated financial statements, notes and tables included throughout this report and the First Community Bancshares, Inc., (the "Company" or “First Community") Annual Report on Form 10-K. All statements other than statements of historical fact included in this Annual Report, including statements in the Message to Stockholders and in Management’s Discussion and Analysis of Financial Condition and Results of Operations are, or may be deemed to be, forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Exchange Act of 1934. Generally, the words “believe,” “expect,” “intend,” “estimate,” “anticipate,” “project,” “will” and similar expressions identify forward-looking statements, which generally are not in nature. All statements that address operating performance, events or historical developments that we expect or anticipate will occur in the future — including statements relating to growth, share of revenues and earnings per share growth and statements expressing general optimism about future operating results — are forward-looking statements. Forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from our Company’s historical experience and our present expectations or projections. As and when made, management believes that these forward-looking statements are reasonable. However, caution should be taken not to place undue reliance on any such forward-looking statements since such statements speak only as of the date when made. Many factors could cause the Company’s actual results to differ materially from the results contemplated by the forward-looking statements. Some factors, which could negatively affect the results, include: (1) general economic conditions, either nationally or within the Company’s markets, could be less favorable than expected, (2) changes in market interest rates could affect interest margins and profitability, (3) competitive pressures could be greater than anticipated, results, (5) acquisition cost savings may not be realized or the anticipated income may not be achieved, and (6) adverse changes could occur in the securities and investments markets. The foregoing list of important factors is not exclusive. the Company’s or accounting could affect changes legal (4) Forward-looking statements made herein reflect management’s expectations as of the date such statements are made. Such information is provided to assist stockholders and potential investors in understanding current and anticipated financial operations of the Company and are included pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. First Community is a multi-state holding company headquartered in Bluefield, Virginia. With total assets of $1.52 billion at December 31, 2002, First Community through its banking subsidiary, First Community Bank, N. A. (“FCBNA” or “Bank”), provides financial, mortgage brokerage and origination and trust services to individuals and commercial customers through 41 full-service banking locations in West Virginia, Virginia and North Carolina as well as eleven mortgage brokerage facilities operated by United First Mortgage, Inc. (“UFM”.) UFM is a wholly owned subsidiary of FCBNA. FCBNA also operates Stone Capital Management, Inc. (“Stone Capital”), an investment advisory firm, with offices in Beckley, West Virginia. ysis of financial condition and results of operations. 7 Application of Critical Accounting Policies }} First Community's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. First Community’s financial position and results of operations are affected by management’s application of accounting policies, including judgments made to arrive at the carrying value of assets and liabilities and amounts reported for revenues, expenses and related disclosures. Different assumptions in the application of these policies could result in material changes in First Community’s consolidated financial position and/or consolidated results of operations. Estimates, assumptions and judgments are necessary principally when assets and liabilities are required to be recorded at estimated fair value, when a decline in the value of an asset carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded based upon the probability of occurrence of a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by third party sources, when available. When third party information is not available, valuation adjustments are estimated in good faith by management primarily through the use of internal modeling techniques and/or appraisal estimates. First Community’s accounting policies are fundamental to understanding Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following is a summary of First Community’s more subjective and complex “critical accounting policies.” In addition, the disclosures presented in the Notes to the Consolidated Financial Statements and in management’s discussion and analysis, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions and estimates underlying those amounts, management has identified the determination of the allowance for loan losses, the valuation of loans held for sale and the valuation of derivative instruments utilized in hedging activity to be the accounting areas that require the most subjective or complex judgments. Management’s Stability Discussion and Analysis through management 8 Allowance for Loan Losses }} Loans Held for Sale Derivative Instruments and Hedging Activities}} The allowance for loan losses is established and maintained at all levels that management deems adequate to cover losses inherent in the portfolio as of the balance sheet date and is based on management’s evaluation of the risks in the loan portfolio and changes in the nature and volume of loan activity. Estimates for loan losses are determined by analyzing historical loan losses, current trends in delinquencies and charge-offs, plans for problem loan resolution, the opinions of our regulators, changes in the size and composition of the loan portfolio and industry information. Also included in management’s estimates for loan losses are considerations with respect to the impact of economic events, the outcome of which are uncertain. These events may include, but are not limited to, a general slowdown in the economy, fluctuations in overall lending rates, political conditions, legislation that may directly or indirectly affect the banking industry and economic conditions affecting specific geographical areas in which First Community conducts business. The loan portfolio also represents the largest asset type on the consolidated balance sheet. As more fully described in Notes 1 and 6 to the Consolidated Financial Statements and in the discussion included in the Allowance for Loan Losses section of management’s discussion and analysis, the Company determines the allowance for loan losses by making specific allocations to impaired loans and loan pools that exhibit inherent weaknesses and various credit risk factors. Allocations to loan pools are developed giving weight to risk ratings, historical loss trends and management's judgment concerning those trends and other relevant factors. These factors may include, among others, actual versus estimated losses, regional and national economic conditions, business segment and portfolio concentrations, industry competition and consolidation, and the impact of government regulations. The level of consumer and residential mortgage loan allowance is maintained at a total portfolio level based on a review of historical loss percentages and other qualitative factors including concentrations, industry specific factors and economic conditions. The Company’s mortgage subsidiary, UFM, originates, acquires, and sells residential mortgage products on a servicing released basis into the secondary market. Currently, UFM originates all loans with the positive intent to sell. Loans held for sale are stated at the lower of cost or market (“LOCOM”). The LOCOM analysis on pools of homogeneous loans is applied on a net aggregate basis. Interest income with respect to loans held for sale is accrued on the principal amount outstanding. LOCOM valuation techniques applicable to loans held for sale are based on estimated market price indications for similar loans. Pricing estimates are established by participating mortgage purchasers and prevailing economic conditions. The majority of the loans held for sale have predetermined pricing indications. However, loans which have yet to be committed to an individual investor ($6.7 million at December 31, 2002) are evaluated for necessary write-downs. The applicable market for these loans at year-end was $6.9 million and as such, no write-down was necessary. UFM provides a distribution outlet for the sale of loans produced by UFM’s wholesale and retail operations. UFM originates residential mortgage loans through its production offices located in eastern Virginia and sells the majority of its loans through pooled commitments to national investors. In addition, UFM acquires loans from a network of wholesale brokers for subsequent resale to these national investors as well. The loans held for sale portfolio at December 31, 2002, was $66.4 million compared to $65.5 million at December 31, 2001. Risks associated with this lending function include interest rate risk, which is mitigated through the utilization of financial instruments (commonly referred to as derivatives) to assist in offsetting the effect of changing interest rates. The Company accounts for these instruments in accordance with Financial Accounting Standards Board (“FASB”) Statement No. 133 “Accounting for Derivative Instruments and Hedging Activity” as amended by Statements No. 137 and No. 138. These Statements established accounting and reporting }} standards for derivative instruments and for hedging activities. UFM uses forward mortgage contracts (short position sales) to manage interest rate risk in the pipeline of loans and interest rate lock commitments (“RLCs”) from the point of the loan commitment to the subsequent sale to outside investors. As a result of the timing from origination to sale, and the likelihood of changing interest rates, forward commitments are placed with counter-parties to substantially lock the expected margin on the sale of the loan. The forward commitment to sell the security is considered to be a derivative and, as such, is recorded on the Consolidated Balance Sheets at fair value, and the changes in fair value are reflected in the Consolidated Statements of Income. The RLCs (representing forward commitments to fund loans which will be held for sale) are also considered derivatives and are valued at estimated fair market value based on prevailing interest rates, expected servicing release premiums and the assumed probability of closing (pull-through). The assumption of a given pull-through percentage also enters into the determination of the volume of forward contracts. Pull-through assumptions are continually monitored for changes in the interest rate environment and characteristics of the pool of RLCs. Differences between pull-through assumptions and actual pull-through could result in a mismatch in the volume of forward contracts corresponding to RLCs and lead to volatility in margins on the loan products ultimately delivered. At December 31, 2002, the Company’s mortgage subsidiary held an investment in forward mortgage contracts with a notional value of $75 million. These contracts hedge interest rate risk associated with RLCs and closed loans not allocated to a forward commitment. Adjustment of the forward mortgage contracts to fair value resulted in a $700,000 write-down at December 31, 2002, while the adjustment to market value on RLCs yielded a $1.8 million increase over the prior year. The market valuation of RLCs at December 31, 2002 assumes 68.4% RLC pull-through. If actual pull-through in 9 succeeding months proves to be more or less than 68%, the full market value of RLCs may or may not be realized and/or the valuation of RLCs may change. The valuation of RLCs is considered critical because of the impact of borrower behavior and the impact that this behavior pattern will have on the pull-through ratio during times of significant rate volatility. Customer behavior is modeled by a mathematical tool based upon historical pull-through experience; however, substantial volatility can be and was experienced in 2002, as a result of the continued decline in mortgage rates experienced in the latter half of 2002 and, as a result, daily pull-through varied significantly over this time period. For the year ending December 31, 2002, the Company incurred $8.1 million in forward mortgage derivative contracts to the cost of originate and sell $791.8 million in loans in comparison to the prior year where $621.6 million in loans were sold with underlying forward mortgage contracts that cost $1.6 million. The significant increase in hedging cost demonstrates the potential volatility to earnings and the sensitivity to pull-through assumptions. Partnerships like this are built on trust, Kay Bayless of Princeton, West Virginia, and John Bowling of FCB. Expansion 10 Recent and Pending Acquisitions }} On November 30, 2002, the Company acquired Monroe Financial, Inc. and its banking subsidiary, Bank of Greenville, at a cost of $1.96 million. Bank of Greenville’s three branch facilities, Greenville and Lindside in Monroe County, West Virginia, and Hinton in Summers County, West Virginia, were simultaneously merged with and into the Bank. The completion of this transaction resulted in the addition of $29.8 million in assets, including $17.4 million in loans and added an additional $28.0 million in deposits to the Bank. The excess of the fair market value of the net assets acquired over purchase price of $1.27 million was reallocated to the non-financial assets acquired. On January 27, 2003, the Company announced the signing of a definitive merger agreement pursuant to which the Bank will acquire The CommonWealth Bank, a Virginia-chartered commercial bank ("CommonWealth Bank"), for total consideration of approximately $25.0 million. Under the terms of the merger agreement, each share of CommonWealth Bank common stock issued and outstanding immediately prior to the merger shall become and be converted into the right to receive either $30.50 in cash or a number of whole shares of the Company’s common stock as determined by dividing $30.50 by the average closing price of the Company’s common stock during a specified period preceding the merger agreement, plus cash in lieu of any fractional share interest. The cash/stock allocation is subject to procedures set forth in the merger, as amended, which permits CommonWealth shareholders to elect to have up to 50% of their outstanding shares converted into the right to receive cash. The merger is expected to close during the second quarter of 2003, pending the receipt of all requisite regulatory approvals and the approval of CommonWealth Bank’s shareholders. At December 31, 2002, CommonWealth Bank had total assets of $134.1 million, net loans of $106.2 million and total deposits of $107.3 million. “We’re broadening our base and geographic reach as we take a stronger foothold in Virginia and North Carolina,” said President and CEO, John M. Mendez pictured with Robert L. Buzzo, Robert L. Schumacher and E. Stephen Lilly. In January 2003, the Bank completed the acquisition of Stone Capital Management, Inc. This acquisition will expand the Bank’s operations to include a broader range of financial services, including wealth management, asset allocation, financial planning and investment advice. Stone Capital at December 31, 2002, had total assets of $94 million under management. Stone Capital will continue to operate under its name in conjunction with First Community’s Trust and Financial Services Division. Monroe Financial, Inc. Bank of Greenville The CommonWealth Bank 11 Stone Capital Management Commitment to Excellence 12 Summary Financial Results}} Net income for 2002 was $24.7 million, up $5.6 million from $19.1 million in 2001 and up $7.6 million from 2000 net income of $17.1 million. Basic and diluted earnings per share for 2002 were $2.49 and $2.48, respectively, up from basic and diluted earnings per share of $1.92 each and $1.78 each in 2001 and 2000, respectively. The change in basic earnings per share to $2.49 represents an increase of 29.7% compared to $1.92 per share in 2001. Due to the adoption of a new accounting standard on January 1, 2002, and the application of another new accounting standard retroactively applied to January 1, 2002, the Company discontinued the amortization of goodwill, subject to annual impairment testing. On a comparative basis, without goodwill amortization, the prior year basic and diluted earnings per share would have been $2.11. On a fully comparative basis without goodwill amortization, the current year income increased 18% per dilutive share. The most significant factors contributing to the increase in net income were a $10.8 million increase in net interest income, a $926,000 decrease in the provision for loan losses due to improvement in overall loan quality, and a $2.15 million reduction in goodwill amortization due to the adoption of Financial Accounting Standards Board (“FASB”) Statements No. 142 and 147 in 2002. These factors were partially offset by an increase of approximately $3.4 million in salaries and benefits and a $2.3 million increase in other operating expenses. The improvement in net interest income was largely the result of an increase in average earning assets of $180.3 million. The yield on these assets decreased 81 basis points between 2001 and 2002, but was offset by a 118 basis point decrease in the cost of interest-bearing liabilities. The impact of these rate and volume changes was an increase in the net interest rate spread from 3.91% to 4.29% for the year 2002, a 38 basis point increase between 2001 and 2002. The Company’s tax equivalent net interest margin of 4.76% for 2002 reflects an increase of 21 basis points compared to 2001 when the tax equivalent yield was 4.55%. Interest expense was managed through the use of a combination of retail deposits, Federal Home Loan Bank borrowings, and active product pricing and marketing strategies in the low rate environment. The Company's key profitability ratios of Return on Average Assets (ROA) and Return on Average Equity (ROE) compare favorably with the average of the Company’s national peer ratios of 1.19% and 13.74%, respectively, based on the September 2002 Bank Holding Company Performance Report. ROA, which measures the Company's stewardship of assets, was at 1.68%, compared to 1.49% in 2001 and 1.51% in 2000. ROE for the Company increased to 17.16% in 2002, compared to 14.80% in 2001 and 15.70% in 2000. ROE was impacted positively by increases in the current year earnings and an increase in the Company’s leverage position. Neighborhood Service is our highest priority at all locations 13 Raymond Hall of FCB serves local companies like Artistic Woodworkers of Bluewell, West Virginia. With the adoption of FASB Statement No. 142, the Company ceased amortization of certain goodwill beginning January 1, 2002, as required by the Statement, and with the adoption of Statement 147 in October 2002, amortization of remaining goodwill associated with branch acquisitions was discontinued. Cessation of such amortization decreased goodwill expense in 2002 by $2.15 million compared to 2001. This resulted in an additional $1.9 million in after tax net income, or $0.19 per share, in comparison to the prior year. Non-interest income for 2002 which primarily consists of fiduciary earnings, service charges on deposit accounts and mortgage banking income, remained fairly consistent with the prior year as a result of continued strength in mortgage banking and consistent earnings derived from deposit account charges. Service charges on deposit accounts increased through growth in accounts and improved usage of deposit programs. The level of total non-interest income in 2002 in comparison to the prior year was maintained despite a securities write-down of $576,000 as more fully described under “Results of Operations -- Non-interest Income.” Operating expense for 2002, which included salaries and benefits, increased by $4.3 million from $38.0 million reported for 2001 to $42.3 million in 2002. The cost increases reflect the increased commission payments at UFM related to the substantial increase in the volume of loans originated and sold, the full year impact of four branches acquired in the fourth quarter of 2001, and additional banking facilities opened in Athens, West Virginia, and Emporia and Bluefield, Virginia. 14 Results Earning the respect from customers. Glenn Hawkins, owner of Hawkins Supply and Fertilizer, of Emporia,Virginia, and Cheryl Allen of FCB discuss business. Summary Financial Results continued}} The increase in net income between 2000 and 2001 of $2.0 million or 12.1% was driven by a $7.8 million increase in non-interest income and a $3.8 million increase in net interest income. The improvement in net interest income was the result of continued strong loan demand as indicated by the 7.4% increase in loans outstanding, excluding loans acquired through branch acquisitions in December 2001. In addition, increased mortgage banking activity stemming from the lower interest rate environment during 2001 caused loans held for sale at December 31, 2001 to, increase by 466.4%. As a result of the change in the volume of loans, interest and fees on loans outpaced the preceding year, increasing $7.1 million from $68.4 million in 2000 to $75.5 million in 2001. In 2001, the Company’s cost of funds experienced a $3.0 million dollar increase over 2000, as the level of deposits and borrowings also increased. The rate paid on interest-bearing liabilities declined by 22 basis points to 4.21% while the yield on earning assets declined 58 basis points to 8.13%, resulting in a tax equivalent net interest margin of 4.55% for the year compared to 4.86% in 2000. Operating costs in 2001 included depreciation and certain expenses which reflected a substantial investment in the future of the Company as over $3.0 million was invested in technology upgrades, image campaigns and marketing programs. Operating expense for 2001 increased by $7.0 million from $31.0 million for 2000 to $38.0 million in 2001. This increase included the increased operating costs at UFM related to the substantial increase in the volume of loans originated and sold, the full year impact of Citizens Southern Bank which was acquired in the fourth quarter of 2000, additional banking facilities including the new Athens, West Virginia, branch and the four branches acquired in December 2001. Perform Return on average equity of 17.16 % 15 }} Five-Year Selected Financial Data (Amounts in Thousands, Except Percent and Per Share Data) Balance Sheet Summary (at end of period): Loans, net of unearned income Loans held for sale Allowance for loan losses Securities Total assets Deposits Other indebtedness Stockholders’ equity Summary of Earnings: Total interest income Total interest expense Provision for loan losses Non-interest income Non-interest expense Income tax expense Net income Per Share Data: Basic earnings per common share Diluted earnings per common share Cash dividends Book value at year-end Selected Ratios: Return on average assets Return on average equity Dividend payout Average equity to average assets Risk-based capital to risk-adjusted assets Leverage ratio $ $ $ % 2002 2001 2000 1999 1998 927,621 66,364 14,410 341,899 1,524,363 1,139,727 124,357 152,462 904,496 65,532 13,952 395,891 1,478,235 1,078,260 145,320 133,041 811,256 11,570 12,303 283,298 1,218,017 899,903 138,015 120,682 704,096 N/A 11,900 290,873 1,088,162 833,258 10,218 103,488 611,493 N/A 11,404 277,210 1,053,988 875,996 18,176 101,719 96,204 35,008 4,208 20,049 42,269 10,049 24,719 2.49 2.48 1.00 15.42 1.68 17.16 40.16 9.79 13.33 8.10 92,829 42,409 5,134 20,275 38,025 8,402 19,134 1.92 1.92 0.89 13.39 1.49 14.80 46.35 10.05 12.10 7.93 85,958 39,379 3,986 12,492 30,968 7,054 17,063 1.78 1.78 0.86 12.14 1.51 15.70 48.31 9.64 12.93 8.37 76,492 32,250 2,893 10,732 27,457 7,722 16,852 1.75 1.75 0.80 10.78 1.62 16.23 45.71 9.96 13.22 8.25 81,213 38,128 6,250 11,182 28,752 6,164 13,101 1.35 1.35 0.76 10.55 1.24 13.02 56.30 9.50 13.25 7.37 ance Shareholder Value 16 Common Stock and Dividends }} The Company's common stock trades on the NASDAQ Small-Cap Market under the symbol FCBC. On December 31, 2002, First Community's year-end common stock price was $30.76, a 14.8% increase over the $26.79 closing price on December 31, 2001. Book value per common share was $15.42 at December 31, 2002, compared with $13.39 at December 31, 2001, and $12.14 at the close of 2000. The year-end market price for First Community common stock of $30.76 represents 199.5% of the Company's book value as of the close of the year and reflects total market capitalization of $304.2 million. Utilizing the year-end market price and 2002 diluted earnings per share, First Community common stock closed the year trading at a price/earnings multiple of 12.4 times diluted earnings per share. Cash dividends for 2002 totaled $1.00 per share, up $0.11 or 12.36% from the $0.89 paid in 2001. The 2002 dividends resulted in a cash yield on the year-end market value of 3.25%. Total dividends paid for the current and prior year totaled $9.9 million and $8.9 million, respectively. First Community Bank, N. A. Board of Directors Front Row: Sam Clark, I. Norris Kantor, W.W. Tinder, Jr., B.W. Harvey, Dale F. Woody and Juanita G. Bryan Second Row: Richard G. Rundle, Robert L. Buzzo, K.A. Ammar, Jr., John M. Mendez, William P. Stafford and Allen T. Hamner Back: James P. Bailey, A.A. Modena, Clyde B. Ratliff, Robert E. Perkinson, Jr., D.L. Bowling, Jr. and William P. Stafford, II 17 }} 2002 First Quarter Second Quarter Third Quarter Fourth Quarter 2001 First Quarter Second Quarter Third Quarter Fourth Quarter $ High 30.75 33.00 33.10 33.33 $ 18.88 30.00 33.80 31.60 Bid $ $ Low 25.36 28.00 28.00 29.17 17.13 17.85 29.75 23.75 Book Value Per Share $ 13.67 14.50 15.10 15.42 $ Cash Dividend Per Share 0.25 0.25 0.25 0.25 1.00 $ $ 12.64 12.85 13.33 13.39 $ $ 0.21 0.21 0.21 0.26 0.89 Results of Operations 18 Net Interest Margin }} Net interest margin measures net interest income as a percentage of average earning assets. In 2002, the net interest margin was 4.76% for the year, above the 4.55% and slightly below the 4.86% levels attained in 2001 and 2000, respectively. The current year’s increase was due in large part to the combined effect of a $180.3 million increase in average earning assets, and a general decline in the cost of funds, which was partially offset by a decline in the yield on earning assets. The associated reductions in loan and investment yields were the result of the declining interest rate environment experienced beginning in 2001 and continuing into 2002. Average loans, which include loans held for sale, increased $89.0 million in volume, which resulted in an increase of $400,000 in interest and fees on loans, on a tax equivalent basis, despite the decline in the yield on total loans from 8.56% to 7.82%. Average investment securities available for sale increased $91.0 million over 2001, producing an additional $3.8 million in interest revenue while the yield declined from 6.57% in 2001 to 5.92% by year-end 2002. The slight increase in yield on investment securities held to maturity was offset by a decrease in the average balance to $41.0 million in 2002 as compared to the average balance of $42.2 million in 2001, resulting in a $70,000 decrease in interest income on such investment securities. The increase in average loan and security volume was partially offset by a reduction in yield on the underlying assets. Total tax equivalent interest income increased $3.6 million. Despite volume increases in average interest-bearing deposits of $131.3 million, the Company experienced an overall decrease in interest on total deposits of $6.5 million due to the decline in the cost of funds. Short-term borrowings, including retail repurchase agreements with existing bank customers and Federal Home Loan Bank (“FHLB”) advances increased $17.5 million and experienced an 85 basis point decline in the cost of these funding sources. In 2002, significant increases in the loan portfolio were funded with a combination of increased deposits and short-term borrowings. 19 The increase in net interest income in 2001 was primarily due to a $161.1 million or 15.7% increase in average earning assets over 2000. The 2001 increase in average earning assets was the result of a $137.4 million increase in average total loans, an $8.5 million increase in average investment securities and a $15.8 million increase in average interest-bearing deposits. The net yield on earning assets was 8.13% in 2001, compared to 8.71% in 2000, while the cost of funds was 4.21% in 2001, compared to 4.43% in 2000. Average interest-bearing liabilities increased $118.8 million in 2001, which is largely attributable to increases in deposits of $76.4 million and a $42.3 million increase in short-term borrowings and other indebtedness. Additionally, there was a $17.6 million increase in average non-interest bearing demand deposits compared to the prior year. Net Interest Income }} The primary source of the Company's earnings is net interest income, the difference between income on earning assets and the cost of funds supporting those assets. Significant categories of earning assets are loans and securities while deposits and short-term borrowings represent the major portion of interest-bearing liabilities. On a tax equivalent basis, net interest income increased $11.1 million, or 20.5% in 2002 compared to an increase of $4.1 million, or 8.3% in 2001, in each case, over the prior year. The increase in 2002 was the net result of an $8.7 million increase due to the higher volume of interest-earning assets and interest-bearing liabilities and a $2.4 million increase due to changes in rates on these assets and liabilities. The increase in net interest income in 2002 was primarily due to a $180.3 million or 15.2% increase in average earning assets over 2001. The increase in 2002 average earning assets was the result of an $89.0 million increase in average total loans, an $89.8 million increase in average investment securities and a $3.2 million increase in other interest yielding deposits. The cost of all interest bearing liabilities decreased to 3.03% in 2002, compared to 4.21% in 2001. Average interest-bearing liabilities increased $148.7 million in 2002, which included a $131.3 million increase in interest- bearing deposits, a $26.1 increase in fed funds purchased and repurchase agreements and an $8.7 million decrease in short-term borrowings and other indebtedness. Additionally, there was a $22.6 million increase in average non-interest bearing demand deposits compared to the prior year. The acquisition of Bank of Greenville in the fourth quarter of 2002 accounted for only $2.0 million of the average interest- bearing deposit balance increase in 2002 while the branch acquisitions in the fourth quarter of 2001 accounted for approximately $94.0 million. Objective Measurements 20 Provision for Loan Losses }} Non-interest Income }} The provision for loan losses was $4.2 million in 2002, $5.1 million in 2001 and $4.0 million in 2000. The provision and underlying allowance for loan losses is quantified through a series of objective measurements, evaluation of economic indications and estimation of levels of probable losses within the population of loans that portray inherent weaknesses. The current year provision of $4.2 million decreased by more than $900,000 from 2001 in response to continuing improvements in asset quality in the current year and only modest growth in the loan portfolio year over year. The decline in the provision is consistent with the noted improvements in all categories of non- performing loans and other real estate owned. The 2001 provision of $5.1 million was elevated in comparison to 2000 in response to usual consumer charge-offs in 2001 coupled with larger charge-offs of commercial credits as the Company pursued workout and resolution of two commercial loans in non-accrual status. See the further discussion under “Balance Sheet Discussion -- Allowance for Loan Losses.” Samuel L. Elmore Senior Vice President and Chief Credit Officer First Community Bank, N. A. Non-interest income primarily consists of fiduciary income on trust services, service charges on deposit accounts and income derived from the origination and sale of mortgages. Non- interest income totaled $20.1 million in 2002, which is substantially unchanged from the $20.3 million recognized in 2001 and a $7.60 million or 60.5% increase over the 2000 total of $12.5 million. The current year reflects a net increase in the level of service charges on deposit accounts of $1.1 million or an 18.3% increase. The prior year also reflected increases over 2000 in this category of non-interest revenues of $2.0 million, or 48.9%. The increases in both 2002 and 2001 can be largely attributed to a program developed for well managed demand deposit accounts, OverdraftHonor®, that allows the customer greater flexibility in managing overdrafts to their accounts. As a result of this program, approximately $5.4 million in deposit account charges were recorded in 2002 in contrast to the $4.6 million recorded in 2001. The aforementioned deposit account program was introduced in the latter part of 2000 and is the primary reason for the increase to $7.1 million in service charges on deposit accounts recorded in 2002. The Company’s mortgage banking segment recognized $9.4 million in mortgage banking income in 2002, which is primarily comprised of origination fees, gains on loan sales, and hedging costs on mortgage derivative commitments. All loans are sold servicing released. The level of mortgage banking income declined slightly from the prior year level of $9.6 million. The decrease, despite increased loan applications, is attributable to lower margins recognized on loan sales in the third and fourth quarters of 2002. The reduction in margin is attributable to lower than anticipated pull-through rates (closings versus commitments) as mortgage rates fell to record lows and the earnings on a portion of the loan commitments outstanding were not realized. Higher than anticipated hedging cost reduced the margin on loan sales by approximately $1.1 million in 2002 due to the increased cost of mortgage derivative }} Fiduciary Income }} 21 Fiduciary income continued at the $1.8 million level again in 2002 as it did in 2001 and 2000. The level of trust and estate revenues remained relatively consistent in 2002 even though the total market value of the assets managed declined during 2002. The volume of revenue generated from sources such as trust, estate and asset management services is highly dependent upon the corresponding assets under management and can be cyclical in nature. Trust revenues, as described above, are comprised of fees for asset management and estate settlement. Expenses associated with the operation of the Trust and Financial Services Division are included in non-interest expense. (continued on next page) to accurately predict commitments used to hedge the price volatility of loan commitments. The inability of the mortgage company’s hedge model loan fallout percentages experienced in the third and early in the fourth quarter 2002 resulted in higher than predicted fallout. This fallout was due to loan applicants who “opted out” of the mortgage company’s process prior to closing and, instead, reapplied elsewhere or simply waited on the sidelines for more declines in mortgage rates, as they continued to decline to historically unprecedented lows. The hedge model, which predicted the need to invest at a specified level based upon historic information, failed to predict the sudden increase in fallout, and in turn, hedge volume was elevated when measured against the loan commitments which ultimately closed. UFM originated and sold $791.8 million in loans during 2002 in comparison to the prior year’s volume of $621.6 million. The corresponding sale of loans resulted in gross gains on sales during 2002 and 2001 of $12.9 million and $7.5 million, respectively. Elevated hedge costs in 2002 and increased expense associated with the higher volume of origination resulted in a drop in mortgage banking pre-tax earnings from $2.0 million in 2001 to $798,000 in 2002. Pretax earnings for 2002 were further reduced by a $400,000 payment to a former mortgage company executive to acquire a non-compete agreement on his termination of employment. In the third quarter of 2002, management implemented various procedures to better manage the mortgage division, loan pipeline and hedging process, including the establishment of a committee to oversee risk management activities of UFM. Committee members meet weekly to measure the ongoing effectiveness of the mortgage delivery and hedging process. In addition, daily monitoring is performed to determine that the adequate level of hedge is carried commensurate with the volume of loans hedged and the implied volatility of the market for mortgage securities. Trust 22 Fiduciary continued }} Non-interest Expense }} Other service charges, commissions and fees of approximately $1.4 million also remained relatively consistent in 2002, 2001 and 2000. These fees are dependent upon customer behaviors and usage of the various products and services of the Company and are transaction oriented revenues. Other service charges, commissions and fees declined by $55,000 in 2002 compared to 2001 and increased by $74,000 in 2001 versus 2000. Revenues in this category include, among others, commissions on sales of credit life insurance, sales of checking supplies, ATM surcharge revenues and safe deposit box rents. During 2002, the Company experienced a net loss from available for sale securities of approximately $390,000. The loss resulted from an other-than-temporary write-down of a municipal issue within the portfolio of $576,000 and losses from the sale of securities of $313,000. These losses were partially offset by gains resulting from securities sold and called of $496,000. During 2001, a net gain of $181,000 was realized as a result of the sale of available for sale securities with gains of $209,000 and losses of $28,000. The increase in total non-interest income in 2001 of $7.8 million in comparison to 2000 was driven by the impact of loan origination income generated by UFM, adding an additional $4.9 million in revenues in 2001 versus 2000, while the OverdraftHonor® deposit account program generated an additional $2.0 million in non-interest income in 2001. Non-interest expense consists of salaries and benefits, occupancy, equipment and all other operating expense incurred by the Company. Non-interest expense totaled $42.3 million in 2002, compared with $38.0 million and $31.0 million in 2001 and 2000, respectively. The increase in non- interest expense in 2002 of $4.3 million is primarily attributable to a $3.4 million increase in salaries and benefits, $1.0 million of which was due to the acquisition of the four branches in the fourth quarter of 2001, along with a $700,000 increase in salaries and commissions in the mortgage operations of UFM (primarily attributable to increased loan production) and a general increase in salaries as staffing needs at several locations were satisfied in order to support added corporate services and continued branch growth. In addition, the combined impact of increases in other non-interest expense categories of $800,000 is attributable to increased operating expenses from the increased operations branch acquisitions ($380,000), of UFM ($820,000) and additional increases of $1.6 million in other non-interest expense categories including costs associated with occupancy and facilities maintainance, data communications and marketing campaigns. These expenses were offset by the decline and goodwill amortization of $2.0 million. The $7.1 million increase in non-interest expense in 2001 relates largely to the impact of the operation of UFM of $3.1 million over the prior year because of substantial increases in loan production and the addition of new branches during 2001. Additional operating cost increases were experienced in 2001 due to the full year’s operations of Citizens Southern Bank, which was acquired in the fourth quarter of 2000 and the new branch acquisitions in December 2001. Other increases in 2001 included the cost of consolidating the Company’s customer databases and the undertaking of substantial marketing campaigns. 23 Financial collaboration with attorneys Meade Snyder and Jim Snyder of Clifton Forge, Virginia and R. Mason Cauthorn of FCB. $150,000 in 2001. The increase in other operating expense in 2001 compared to 2000 of $2.9 million was largely impacted by the substantial increase in loan volume and the corresponding cost associated with the implementation of the wholesale loan origination program at UFM ($1.1 million) and other increases in advertising, ATM fees, correspondent bank fees and data processing costs relative to the increased infrastructure, size and needs of the Company. }} Occupancy expense increased $259,000 or 9.9% between 2001 and 2002, and $133,000 or 5.4% between 2000 and 2001. The current year’s increase primarily consists of $160,000 related to the full year’s occupancy costs of the branch facilities purchased in fourth quarter 2001, and additional costs of $70,000 associated with UFM. The $133,000 increase between 2000 and 2001 was also largely due to a full year’s operations of branch facilities added through the Citizens Southern acquisition as well as a general level of increased maintenance costs throughout the Company. With the adoption of FASB Statement No. 142, the Company certain goodwill beginning ceased amortization of January 1, 2002, as required by the Statement and with the adoption of Statement 147 in October 2002, amortization of remaining goodwill associated with branch acquisitions was discontinued. Cessation of such amortization decreased goodwill expense in 2002 by $2.15 million compared to 2001. This resulted in an additional $1.9 million in after tax net income in comparison to the prior year. Other operating expense also increased by $2.3 million in 2002 compared to 2001. These accounts include increases in other operating costs associated with UFM of $700,000 (tied to increased loan production and the payment of a $400,000 non-compete fee to the retiring president of UFM in connection with his departure). Other increased expenses, largely due to the acquisition of the new branches, included an increase in telephone and data communications expense of $237,000, an increase in ATM service fees of $162,000 and an increase in courier and travel expense of $214,000. Advertising expense was also up $114,000 in comparison to last year due to ad campaigns for new products and branch promotions. A to reimbursement of legal costs which reduced legal fees by litigation settlement led Stewardship 24 Overhead and Efficiency Ratios }} The Company's net overhead ratio (non-interest expense less non-interest income excluding security gains and non-recurring gains divided by average earning assets) is a measure of its ability to manage and control costs. As this ratio decreases, more of the net interest income earned is realized as net income. The net overhead ratios for 2002, 2001 and 2000 were 1.48%, 1.39% and 1.64%, respectively. Improvement in the 2001 ratio reflected substantial increases in non-interest revenues associated with UFM and the Company’s restructured product set. The slight increase in the overhead ratio for 2002 reflects the relative stability of non-interest income coupled with the increased salaries and benefits associated with the first full year of operations of various branches, the increased costs associated with commissions paid at UFM and a one-time charge of $400,000 representing the cost of a non-compete agreement with UFM’s retiring president. The Company's efficiency ratio also measures management's ability to control costs and maximize net revenues. The efficiency ratio is computed by dividing non-interest expense by the sum of net interest income plus non-interest income (all non-recurring items and amortization of intangibles are excluded). The efficiency ratios for 2002, 2001 and 2000 were 51.0%, 47.8% and 45.8%, respectively. Increases in the current and prior year are reflective of the higher operating costs incurred by UFM in the development of its wholesale division which began production in the latter part of 2000 as well as the Bank’s addition of new branch facilities from the branch acquisitions completed in December 2001, the fourth quarter 2001 branch facility constructed in Athens, West Virginia, plus the addition of new Emporia and Bluefield, Virginia, branches in 2002. IntegrityThrough solid business practices Income Tax Expense }} Income tax expense totaled $10.0 million in 2002, compared with $8.4 million in 2001 and $7.1 million in 2000. The $1.6 million increase in 2002 is reflective of the higher level of pre-tax earnings in 2002 as is the $1.3 million increase between 2000 and 2001. Pre-tax earnings increased $7.2 million between 2001 and 2002, including $6.8 million in tax-exempt earnings generated from state and municipal bonds within the Company’s investment portfolio and lower levels of state income tax. The major difference between the statutory tax rate and the effective tax rate (income tax expense divided by pre-tax income) results from income not taxable for federal income tax purposes. The primary category of non-taxable income is that of state and municipal securities and industrial revenue bonds and tax-free loans. The effective tax rate for 2002 was 28.9% compared with 30.5% for 2001 and 29.3% in 2000. The reduction in the Company’s effective tax rate in 2002 was partially attributable to the cessation of amortization of non- deductible goodwill. 25 First Community Bancshares, Inc. Board of Directors Front Row: B.W. Harvey, Sam Clark, William P. Stafford, W.W. Tinder, Jr. and I. Norris Kantor Second Row: John M. Mendez, Robert E. Perkinson, Jr. and Allen T. Hamner Third Row: William P. Stafford, II and A.A. Modena Balance Sheet Discussion 26 Securities Held to Maturity }} Investment securities held to maturity are comprised largely of U.S. Agency obligations and state and municipal bonds. Obligations of States and Political Subdivisions represent the largest portion of the held to maturity portfolio and totaled $40.3 million at December 31, 2002. These are comprised of high-grade municipal securities generally carrying AAA bond ratings, most of which also carry credit enhancement insurance by major insurers of investment obligations. The average final maturity of the investment portfolio decreased from 9.79 years in 2001 to 9.06 years in 2002 with the tax equivalent yield increasing from 8.59% at year-end 2001 to 8.62% at the close of 2002. The average maturity of the investment portfolio, based on market assumptions for prepayment, is reduced to 3.3 years and 4.2 years at December 2002 and 2001, respectively. The average maturity data differs from final maturity data because of the use of assumptions as to anticipated prepayments. Securities Available for Sale }} At December 31, 2002, the Company had $300.9 million in securities available for sale, compared with $354.0 million at year-end 2001, a decrease of $53.1 million or 15.0%. During the year, $41.5 million in securities were purchased. However, these increases were offset by maturities, calls, and mortgage-backed security principal payments and prepayments of $94.8 million and sales of $15.9 million. The fair value of securities available for sale exceeded book value at year-end 2002 by $11.3 million. The increase in the fair value of the securities available for sale is a result of the decline in market rates for comparable securities. When market rates decrease, as they did in 2002, the prices of the securities in the Company’s portfolio rise. The tax equivalent purchase yield on securities available for sale was 6.32% in 2002 and 6.52% in 2001. The average final maturity of the available for sale portfolio was 13.5 years and 14.8 years at December 31, 2002, and 2001, respectively. The decrease in average final maturity was the result of the $94.8 million in calls, principal payments and prepayments that occurred as a result of the declining interest rate environment. The average maturity of the portfolio, based on market assumptions for prepayment, was 2.9 years and 5.4 years, respectively, at December 31, 2002, and 2001, substantially shorter than the average final maturity. Securities available for sale are used as part of management's asset/liability strategy. These securities may be sold in response to changes in interest rates, changes in prepayment risk, for liquidity needs and other factors. These securities are carried at market value. 27 Loan Portfolio }} Loans Held for Sale: Loans held for sale were $66.4 million at December 31, 2002, compared with $65.5 million at December 31, 2001, an increase of just under $1.0 million, or 1.4%. Secondary market loan demand remains strong as a result of the favorable interest rate environment for borrowers. At December 31, 2002, refinance applications represented approximately 85% of the total volume of loan commitments outstanding at year-end. Loans originated for sale and funded during the current year were $791.8 million versus $621.6 million in 2001. 2002 2001 }} Loans Held for Investment: Loans held for investment net of unearned income, were $927.6 million at December 31, 2002. The increase of $23.1 million represents 2.6% growth from the $904.5 million level at December 31, 2001. The fourth quarter acquisition of The Bank of Greenville accounted for $17.4 million of this growth. The addition of these loans did not materially affect the distribution of loan product types within the portfolio. The held for investment loan portfolio is geographically diversified among loan types and industry segments. Commercial and commercial real estate loans represent 38.8% of the total portfolio. During 2002, commercial real estate loans increased by $26.1 million to $285.8 million and comprised 30.8% of total loans. Commercial loans decreased by $22.5 million to $74.2 million and represented 8.00% of total loans. The decline in commercial loans was partially the result of the payoff of several large commercial loans. The combined commercial and commercial real estate sectors increased by only $3.7 million, or 1.03% in 2002. Real estate construction loans, which amounted to $72.3 million, and comprised 7.8% of the portfolio, decreased by $5.1 million in 2002. This category includes both residential and commercial construction with the decrease attributable to completion of a number of development projects during 2002. Additionally, consumer loans decreased by $6.6 million, or 4.8%, to $130.5 million at the close of 2002. Consumer loans represented 14.1% of the portfolio at the close of 2002. Residential real estate loans amounted to $364.1 million, an increase of $31.4 million, or 9.4% in 2002 and represented 39.3% of the total portfolio at the end of 2002. This increase is the result of lower residential mortgage rates during 2002 and the acquisition of Bank of Greenville. Standards 28 }} The total loans held for investment to deposit ratio, a measure of the volume of loans supported by the customer deposit base, declined to 81.4% at December 31, 2002, from the prior year level of 83.9%. The decrease in the loan to deposit ratio is reflective of the $23.1 million increase in the loan portfolio (excluding loans held for sale) coupled with a larger and offsetting increase in deposits of $61.5 million. As a result of the Greenville acquisition completed in the fourth quarter of 2002, the Company also acquired $28.0 million in deposits. The additional deposits and loans acquired in the acquisition accounted for approximately 45.6% and 75.3%, respectively, of the total annual increase in deposits and loans held for investment, respectively. Slower growth in the loan portfolio in 2002 reflects the highly competitive environment for both commercial and residential lending as customers continually seek refinance opportunities. Slower economic conditions in some of the Company’s lending markets have also resulted in fewer requests for new credit and greater competition from competing banks and non-bank lenders. Allowance for Loan Losses }} The allowance for loan losses is maintained at a level sufficient to absorb probable loan losses inherent in the loan portfolio. The allowance is increased by charges to earnings in the form of provisions for loan losses and recoveries of prior loan charge-offs, and decreased by loans charged off. The provision for loan losses is calculated to bring the reserve to a level, which, according to a systematic process of measurement, is the required amount needed to absorb reflective of probable losses. Management performs monthly assessments to determine the appropriate level of allowance. Differences between actual loan loss experience and estimates are reflected through adjustments that are made by either increasing or decreasing the loss provision based upon current measurement criteria. Commercial, consumer and mortgage loan portfolios are evaluated separately for purposes of determining the allowance. The specific components of the allowance include allocations to individual commercial credits and allocations to the remaining non-homogeneous and homogeneous pools of loans. Management’s allocations are based on judgment of qualitative and quantitative factors about both the macro and micro economic conditions reflected within the portfolio of loans and the economy as a whole. Factors considered in this evaluation include, but are not necessarily limited to, probable losses from loan and other credit arrangements, general economic conditions, changes in credit concentrations or pledged collateral, historical loan loss experience, and trends in portfolio volume, maturity, composition, delinquencies, and non-accruals. While management has attributed the allowance for loan losses to various portfolio segments, the allowance is available for the entire portfolio. The allowance for loan losses represents 455% of non-performing loans at year-end 2002 versus 280% and 186% at December 31, 2001, and 2000, respectively. When other real estate is combined with non- performing loans, the allowance equals 239% of non- performing assets at the end of 2002 versus 174% and 137% at December 31, 2001, and 2000, respectively. Net loan charge-offs were $4.1 million in 2002, compared with $4.0 million in 2001 and $4.6 million in 2000, respectively. The level of charge-offs has remained relatively constant over the three-year period, although two commercial loan relationships resulted in spikes in charge-offs within the commercial loan category. In 2000, the Company charged off $373,000 on a convenience store and gasoline retailer along with a $586,000 charge-off on a golf course residential development. These two relationships represented 20% of net charge-offs in 2000. In 2001, the Company charged off an additional $1.2 million (30% of total charge-offs) on the convenience store loans as it intensified its attempts to market the underlying collateral. Excluding these larger commercial charge-offs, a noticeable decrease in consumer charge-offs was realized in 2001 with a reversal in 2002 as consumer charge-offs rose through the third quarter and then moderated late in the year. 29 Non-performing Assets }} Non-performing assets include loans on which interest accruals have ceased, loans contractually past due 90 days or more and still accruing interest, and other real estate owned (OREO) pursuant to foreclosure proceedings. The levels of non- performing assets for the last five years are presented in the table on page 30. Total non-performing assets were $6.0 million at December 31, 2002, compared to $8.0 million at December 31, 2001. Non- performing assets decreased $2.0 million between 2001 and 2002. Every component of non-performing assets improved, led by a $1.3 million or 93.3% decline in loans 90 days or more past due, which are still accruing. In addition, other real estate owned decreased $174,000, or 5.7% and non-accrual loans decreased $558,000, or 15.4% compared to 2001. The decrease in non-accrual loans resulted from the resolution of a number of loan relationships through payment, repossession, or foreclosure and write-down of the loan balances to reflect the net realizable value of the assets. The decrease in loans 90 days or more past due is a result of movement of these credits to non-accrual status and a more aggressive approach in collecting loans 90 days or more past due. Dedicated To service Helping others to help the community. (Pictured from left to right) Sam Elmore, Jim Shannon, President of the Beaver Volunteer Fire Department, Hazel Burroughs, J.P. Morgan, Brenda Troitino, Larry Raines and Susie Webb Evaluation 30 }} Non-Performing Assets (Amounts in Thousands) Non-accrual Loans Loans 90 Days or more Past Due Other Real Estate Owned Nonperforming loans as a percentage of total loans Nonperforming assets as a percentage of total loans and other real estate owned Allowance for loan losses as a percentage of nonperforming loans Allowance for loan losses as a percentage of nonperforming assets 2002 2001 2000 1999 1998 December 31, $ 3,075 91 2,855 $ 6,021 % 0.3 % 0.6 % 455.1 % 239.3 3,633 1,351 3,029 8,013 0.6 0.9 279.9 174.1 5,397 1,208 2,406 9,011 0.8 1.1 186.3 136.5 7,889 1,259 1,950 11,098 1.3 1.6 130.1 107.2 7,763 377 3,547 11,687 1.3 1.9 140.1 97.6 Certain loans included in the non-accrual and 90 day past due categories have been written down to the estimated realizable value or have been assigned specific reserves within the allowance for loan losses based upon management’s estimate of loss upon ultimate resolution. During 2002, 2001 and 2000, $2,168,000, $2,116,000 and $2,530,000 of assets were acquired through foreclosure and transferred to other real estate owned. In addition to non-performing loans reflected in the foregoing table, the Company has identified certain performing loans as impaired based upon management’s evaluation of credit strength, projected ability to repay in accordance with the contractual terms of the loans and varying degrees of dependence on the sale of related collateral for liquidation of the loans. These loans were current under loan terms and were classified as performing at year-end 2002. In the fourth quarter of 2002, the Company added two loan relationships to this list of impaired loans. The first is a $5.0 million loan secured by a hotel property which has suffered declines in levels of occupancy. The allowance for loan losses related to this loan was $1.7 million at December 31, 2002. The second relationship is a group of loans totaling $1.16 million related to a dairy farm whose performance declined in conjunction with a drop in milk prices. The allowance for loan losses related to this group of loans at year-end was $1.06 million. This group of loans subsequently became uncollectable and resulted in a $1.06 million charge off during the first quarter of 2003. As of the date of this report, management continues its efforts to determine the level of collateral available and priority of liens which will determine the possibility of any recovery. Due to questions raised regarding the priority of lien status and the rights to certain escrowed proceeds, no value was assigned to certain collateral and escrowed funds in arriving at the related allowance and charge off. The following table presents the Company's investment in loans considered to be impaired and related information on those impaired loans: The Company has considered all impaired loans in the evaluation of the adequacy of the allowance for loan losses at December 31, 2002. }} Impaired Loans Recorded investment in loans considered to be impaired Loans considered to be impaired that were on a non-accrual basis Allowance for loan losses related to loans considered to be impaired Average recorded investment in impaired loans Total interest income recognized on impaired loans 2002 2001 (Amount in Thousands) $ 8,980 $ 1,238 3,907 9,176 512 5,129 1,229 1,310 5,674 255 31 Deposits }} Total deposits at December 31,2002,increased $61.5 million or 5.7% when compared to December 31, 2001. Approximately $28 million of the increase related to deposits acquired through Bank of Greenville acquisition in November 2002. Without considering the acquisition, deposits increased for the year by $33.5 million. The Company utilized short-term advances from the FHLB to supplement the funding needs of the Company throughout 2001 and 2002. In 2002, the average rate paid on interest bearing liabilities was 3.03%, down from the 4.21% in 2001. Average deposits increased to $1.1 billion for 2002 versus $939.8 million in 2001, an increase of 16.4%, reflecting the effectiveness of new product offerings and marketing campaigns introduced during the year as well as a full year’s impact of the deposits obtained in the December 2001 branch acquisitions. Average savings deposits increased by $38.6 million while time deposits increased by $48.6 million. Average interest-bearing demand and non-interest bearing demand deposits increased by $44.1 million and $22.6 million, respectively. Short-Term Borrowings }} The Company's short-term borrowings consist primarily of overnight Federal Funds purchased from the FHLB and securities sold under agreements to repurchase. This category of funding is a source of moderately priced short-term funds. Short-term borrowings increased on average approximately $17.5 million in comparison to the prior year. The increase in average short-term borrowings in 2002, along with the increase in average deposits of $153.9 million, was accompanied by an offsetting increase in total loans as these funds were used to finance the average loans held for investment portfolio growth ($73.4 million) and the average increase in available for sale securities ($91.0 million). The price sensitivity of funding cost is managed by the Company’s “Product Group”, which monitors product and pricing initiatives including, among other things, the management of the overall cost of funds to assist in maintaining an acceptable net interest margin, and to act as a resource in developing new products and establishing pricing guidelines. Capitalization and leverage 32 Other Indebtedness }} FHLB borrowings and other indebtedness, which includes long-term advances from the FHLB and structured term borrowings from the FHLB, decreased by $21.0 million in 2002 due primarily to a $25.0 million maturity in June 2002. Fixed rate FHLB term advances and applicable interest rates were $8.0 million (5.95%) and $2.0 million (6.27%), maturing in September 2003 and September 2008, respectively. Additional borrowings of $100.0 million are comprised of structured term convertible advances from the FHLB with final maturities in 2010. These convertible advances are callable by the FHLB based upon predefined factors in quarterly increments after a lockout period that may substantially shorten the lives of these instruments. The callability of these instruments is controlled by and at the option of the FHLB. Additionally, UFM has entered into a loan purchase agreement with Countrywide Credit (“Countrywide”) whereby Countrywide will pre-fund certain loans anticipated to be purchased by Countrywide Home Loans, Inc. This borrowing arrangement by UFM with Countrywide resulted in additional borrowings at December 31, 2002, of $14.3 million at a floating rate of one month LIBOR plus 200 basis points, or approximately 3.42% at December 31, 2002. Stockholders' Equity }} Risk-based capital ratios are a measure of the Company's capital adequacy. At December 31, 2002, the Company's Tier I capital ratio was 12.06% compared with 10.82% in 2001. Federal regulatory agencies use risk-based capital ratios and the leverage ratio to measure the capital adequacy of banking institutions. Risk-based capital guidelines, risk weight balance sheet assets, and off-balance sheet commitments are used in determining capital adequacy. The Company's total risk-based capital-to-asset ratio was 13.33% at the close of 2002 compared with 12.10% in 2001. Both of these ratios are well above the current minimum level of 8% prescribed for bank holding companies. The leverage ratio is the measurement of total tangible equity to total assets. The Company's leverage ratio at December 31, 2002, was 8.10% versus 7.93% at December 31, 2001, both of which are well above the minimum levels prescribed by the Federal Reserve. (See Note 13 of the Notes to Consolidated Financial Statements.) 33 }} The strength of customer service. Ricky Hamm of Sparta, North Carolina with Tom Gentry of FCB. Liquidity }} Liquidity represents the Company's ability to respond to demands for funds and is primarily derived from maturing investment securities, overnight investments, periodic repayment of loan principal, and the Company's ability to generate new deposits. The Company also has the ability to attract short-term sources of funds and draw on credit lines that have been established at financial institutions to meet cash needs. Total liquidity of $619.2 million at December 31, 2002, is comprised of the following: cash on hand and deposits with other financial institutions of $124.6 million; securities available for sale of $300.9 million; securities held to maturity due within one year of $138,000; and Federal Home Loan Bank credit availability of $193.6 million. Liquidity management is both a daily and long-term function of business management. Excess liquidity is generally used to pay down short-term borrowings. On a longer-term basis, the Company maintains a strategy of investing in various securities, mortgage-backed obligations and loans. funds primarily to meet ongoing The Company uses sources of commitments, to pay maturing savings certificates and savings withdrawals, fund loan commitments and maintain a portfolio of securities. At December 31, 2002, approved loan commitments outstanding amounted to $104.9 million. Certificates of deposit scheduled to mature in one year or less totaled $392.8 million and FHLB borrowings that are scheduled to mature within the same period amounted to $8.0 million. Management believes that the Company has adequate resources to fund outstanding commitments and could either adjust rates on certificates of deposit in order to retain or attract deposits in changing interest rate environments or replace such deposits with advances from the FHLB or other funds providers if it proved to be cost effective to do so. Community Lending a hand throughout the community Risk Assessment 34 Interest Rate Sensitivity, Interest Rate Risk and Asset/Liability Management }} The Bank’s profitability is dependent to a large extent upon its net interest income (NII), which is the difference between its interest income on interest-earning assets, such as loans and securities, and its interest expense on interest-bearing liabilities, such as deposits and borrowings. The Bank, like other financial institutions, is subject to interest rate risk to the degree that its interest-earning assets reprice differently than its interest-bearing liabilities. The Bank manages its mix of assets and liabilities with the goals of limiting its exposure to interest rate risk, ensuring adequate liquidity, and coordinating its sources and uses of funds while maintaining an acceptable level of NII given the current interest rate environment. The Company's primary component of operational revenue, NII, is subject to variation as a result of changes in interest rate environments in conjunction with unbalanced repricing interest-bearing opportunities on earning assets and liabilities. Interest rate risk has four primary components including repricing risk, basis risk, yield curve risk and option risk. Repricing risk occurs when earning assets and paying liabilities reprice at differing times as interest rates change. Basis risk occurs when the underlying rates on the assets and liabilities the institution holds change at different levels or in varying degrees. Yield curve risk is the risk of adverse consequences as a result of unequal changes in the spread between two or more rates for different maturities for the same instrument. Lastly, option risk is due to "embedded options" often called put or call options given or sold to holders of financial instruments. In order to mitigate the effect of changes in the general level of interest rates, the Company manages repricing opportunities and thus, its interest rate sensitivity. The Bank seeks to control its interest rate risk (IRR) exposure to insulate and liabilities interest-paying net interest income and net earnings from fluctuations in the general level of interest rates. To measure its exposure to IRR, quarterly simulations of NII are performed using financial models that project NII through a range of possible interest rate environments including rising, declining, most likely and flat rate scenarios. The results of these simulations indicate the existence and severity of IRR in each of those rate environments based upon the current balance sheet position, assumptions as to changes in the volume and mix of interest- and earning assets management’s estimate of yields to be attained in those future rate environments and rates that will be paid on various deposit instruments and borrowings. Specific strategies for management of IRR have included shortening the amortized maturity of new fixed-rate loans, increasing the volume of adjustable rate loans to reduce the average maturity of the Bank’s interest-earning assets and monitoring the term structure of liabilities to maintain a balanced mix of maturity and repricing structures to mitigate the potential exposure. The simulation model used by the Company captures all earning assets, interest bearing liabilities and all off-balance sheet financial instruments and combines the various factors affecting rate sensitivity into an earnings outlook. Based upon the latest simulation, the Company believes that it is biased toward an asset sensitive position. Absent adequate management, asset sensitive positions can negatively impact net income in a falling rate environment or, alternatively, positively impact net interest income in a rising rate environment. interest The Company has established policy limits for tolerance of interest rate risk that allow for no more than a 10% reduction in projected NII based on quarterly income simulations. The most recent simulation indicates that current exposure to interest rate risk is within the Company’s defined policy limits. 35 }} The following table summarizes the impact on NII and the Market Value of Equity (MVE) as of December 31, 2002, and 2001, respectively, of immediate and sustained rate shocks in the interest rate environment of plus and minus 100 and 200 basis points from the flat rate simulation. The results of the rate shock analysis depicted below differ from the results in quarterly simulations, in that all changes are assumed to take effect immediately; whereas, in the quarterly income simulations, changes in interest rates are assumed to take place over a 24-month horizon simulating a more likely scenario for a changing rate environment. This table, which illustrates the prospective effects of hypothetical interest rate changes, is based upon numerous assumptions including relative and estimated levels of key interest rates over a twelve-month time period. This type of modeling technique, although useful, does not take into account all strategies that management might undertake in response to a sudden and sustained rate shock as depicted. Also, as market conditions vary from those assumed in the sensitivity analysis, actual results will also differ due to: prepayment/refinancing levels likely deviating from those assumed, the varying impact of interest rate change caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, and other internal/external variables. (Amount in Thousands) Increase (Decrease) in Interest Rates (Basis Points) 200 100 (100) (200) (Amount in Thousands) Increase (Decrease) in Interest Rates (Basis Points) 200 100 (100) (200) 2002 Net Interest Income $ 4,466 2,387 (2,018) (6,756) 2001 Net Interest Income $ 1,950 1,059 (907) (3,692) % Change 7.1 3.8 (3.2) (10.8) % Change 3.5 1.9 (1.6) (6.6) Market Value of Equity $ (8,709) (3,882) 4,885 12,468 Market Value of Equity $ (4,674) (1,338) 637 1,396 % Change (5.5) (2.5) 3.1 7.9 % Change (3.3) (1.0) 0.5 1.0 36 }} When comparing the impact of the rate shock analysis between 2002 and 2001, the 2002 changes in NII reflect the impact of the change in the balance sheet composition of assets and liabilities and as the profile moved toward greater asset sensitivity. The change is the result of the heightened asset prepayment levels experienced in light of the declining interest rate environment beginning in 2001 and continuing with a 50 basis point decline in the targeted fed funds rate in November 2002. Much of the change in balance sheet composition is attributed to the declining interest rate environment and the level of asset prepayments. The asset sensitivity is reflected in the increased liquidity of $91.2 million (Federal Funds sold and interest-bearing balances held with other banks). The Company began to experience a shift in the balance sheet toward asset sensitivity in 2000 which was attributed to the reduced lives of certain assets and the control measures taken in prior years, and continuing throughout 2002, to reduce deposit cost and identify opportunities for product and net interest income enhancement. The tables present contractual cash obligations and commercial commitments as of December 31, 2002. following Contractual cash obligations: Certificates of deposit FHLB advances Note Payable Total contractual cash obligations Payment Due Period Total $ 593,088 110,000 14,357 Less than One Year Two to Three Years Four to Five Years After Five Years (Amount in Thousands) $ 392,821 8,000 14,322 $ 145,472 - 35 $ 15,102 - - $ 39,693 102,000 - $ 717,445 $ 415,143 $ 145,507 $ 15,102 $ 141,693 Commitments: Commercial lines of credit Consumer lines of credit Undispersed portion of loans in process Letters of credit Total commitments Total $ 39,645 24,547 8,835 6,023 $ 79,050 Amount of Commitment Expiration Per Period Less than One Year Two to Three Years Four to Five Years After Five Years (Amount in Thousands) $ 34,600 10,435 8,835 4,277 58,147 $ $ $ 3,508 926 - 1,652 6,086 $ $ 767 1,274 - 20 2,061 $ $ 770 11,912 - 74 12,756 Lines of credit with no stated maturity date are included in commitments for less than one year. Trust 37 Trust and Investment Management Services }} As part of its banking services, the Company offers trust management and estate administration services through its Trust and Financial Services Division (Trust Division). The Trust Division reported market value of assets under management of $433 million and $486 million at December 31, 2002, and 2001, respectively. The Trust Division manages intervivos trusts and trusts under will, develops and administers employee benefit plans and individual retirement plans and manages and settles estates. Fiduciary fees for these services are charged on a schedule related to the size, nature and complexity of the account. The Trust Division employs 18 professionals and support staff with a wide variety of estate and financial planning, investing and plan administration skills. The Trust Division is located within the Company’s banking offices in Bluefield, West Virginia. Services and trust development activities to other branch locations and primary markets are offered through the Bluefield-based division. Recent Legislation }} On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002 (“Act”). The stated goals of the Act are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies, and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. The proposed changes are intended to allow stockholders to more easily and efficiently monitor the performance of companies and directors. The Act generally applies to all companies, both U.S. and non- U.S., that file or are required to file periodic reports with the Securities and Exchange Commission (“SEC”) under the Securities Exchange Act of 1934 (“Exchange Act”). Given the extensive SEC role in implementing rules relating to many of the Act’s new requirements, the final scope of these requirements remains to be determined. The Act includes very specific additional disclosure requirements and new corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules and mandates further studies of certain issues by the SEC and the Comptroller General. The Act represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees. This Act addresses, among other matters: audit committees; certification of financial statements by the chief executive officer and the chief financial officer; the forfeiture of bonuses and profits made by directors and senior officers in the twelve- month period covered by restated financial statements; a prohibition on insider trading during pension plan black-out periods; disclosure of off-balance sheet transactions; a loans to directors and officers prohibition on personal (excluding Federally insured financial institutions); expedited filing requirements for stock transaction reports by officers and directors; disclosure of a code of ethics and filing a Form 8-K for a change or waiver of such code; “real time” filing of periodic reports; the formation of a public accounting oversight board; auditor independence; and various increased criminal penalties for violations of securities laws. 38 Governance out items of risk, exposure and possible disclosure which might exist and be known at lower levels within the Company, but not necessarily be known to executive management and those who prepare financial statements or make significant decisions regarding disclosures within the financial statements. The BTCE meets monthly and its membership covers all areas of the Company from both an operational and geographic perspective. Although many of the items for discussion at the FRDC and BTCE were already considered in the preparation of financial statements and appropriately disclosed, these new processes are considered valuable in further discussion of these items and should provide a valuable forum for future evaluation of disclosure items and selection of accounting policies. It is believed that the addition of these new processes has brought with it a broader and more in depth analysis to the Company’s already effective and detailed disclosure process. These more recent additions to the process are expected to enhance the Company’s overall disclosure control environment. Recent Legislation continued }} At the September 2002 Board of Directors' meeting, within one month of the passage of the Act, the Board of Directors of First Community approved a series of actions to strengthen and improve its already strong corporate governance practices. Included in those actions was the establishment of a new Financial Reporting and Disclosure Committee (the “FRDC”), which was appointed to evaluate and monitor the continued effectiveness of the design and operation of disclosure controls in order to meet the objectives of adequate disclosure as it impacts the full and fair presentation of the Company’s financial statements. The FRDC consists of key members of senior management as official and ex officio members. SEC counsel participates in the committee on an advisory basis to provide technical and legal guidance on matters of technical preparation, form of periodic reporting and general advice on compliance with securities laws. Independent accountants also attend FRDC meetings to provide technical assistance and advice on matters of financial reporting and to assist in financial accounting interpretation and application of standards. The committee also includes the Chairman of the Audit Committee of the Board of Directors to ensure independent thought and board perspective. The FRDC meets a minimum of quarterly, but typically more frequently and its process culminates in the pre-Audit Committee review of the interim (10-Q) and annual financial statements (10-K). The FRDC complements the Company’s longstanding committee structure and process, which has consistently proven an invaluable tool for communication of disclosure information. Every key element of operation is subject to oversight by a committee to ensure proper administration, risk management and an upstreaming of critical management information and disclosures to finance and control, executive management and the board of directors. The FRDC agenda is designed to capture information from all segments of the business though reports from senior managers and committee chairmen. In addition to the FRDC, the Company also implemented the Business Trends and Current Events Committee (BTCE), which is designed to draw Assurance 39 Audit Committee: Allen T. Hamner, William P. Stafford, Robert E. Perkinson, Jr. and B.W. Harvey. Financial Reporting and Disclosure Committee: Kenneth P. Mulkey, E. Stephen Lilly, Robert L. Schumacher, Robert L. Buzzo, John M. Mendez, Timothy D. Velie, and Allen T. Hamner. Consolidated Financial Statements 40 Consolidated Balance Sheets Consolidated Statements of Income Consolidated Statements of Cash Flow Consolidated Statements of Changes in Stockholders’ Equity Notes to Consolidated Financial Statements Report of Independent Auditors Report of Management’s Responsibilities 41 42 43 44 46 74 75 Consolidated Financial Statements Consolidated Financial Statements }} }} Consolidated Balance Sheets }} }} (Amounts in Thousands, Except Share Data) Assets Cash and due from banks Interest-bearing deposits with banks Federal funds sold Total cash and cash equivalents Securities available for sale (amortized cost of $289,616, 2002; $352,759, 2001) Securities held to maturity (fair value, $43,342, 2002; $43,393, 2001) Loans held for sale Loans held for investment, net of unearned income Less allowance for loan losses Net loans held for investment Premises and equipment Other real estate owned Interest receivable Other assets Goodwill Other intangible assets Total Assets Liabilities Deposits: Non-interest-bearing Interest-bearing Total Deposits Interest, taxes and other liabilities Federal funds purchased Securities sold under agreements to repurchase FHLB borrowings and other indebtedness Total Liabilities Stockholders’ Equity Common stock, $1 par value; 15,000,000 shares authorized in 2002 and 2001; 9,956,714 shares issued in 2002 and 9,955,425 in 2001; 9,888,482 and 9,936,442 shares outstanding in 2002 and 2001 Additional paid-in capital Retained earnings Treasury stock, at cost Accumulated other comprehensive income Total Stockholders’ Equity Total Liabilities and Stockholders’ Equity See Notes to Consolidated Financial Statements December 31, 2002 2001 41 $ 33,364 88,064 3,157 124,585 300,885 41,014 66,364 927,621 14,410 913,211 25,078 2,855 7,897 15,391 25,758 1,325 $ 1,524,363 $ $ 165,557 974,170 1,139,727 15,940 – 91,877 124,357 1,371,901 $ 47,566 249 – 47,815 354,007 41,884 65,532 904,496 13,952 890,544 21,713 3,029 8,765 18,468 25,347 1,131 $ 1,478,235 $ $ 161,346 916,914 1,078,260 15,852 26,500 79,262 145,320 1,345,194 9,957 58,642 79,084 (1,982) 6,761 152,462 $ 1,524,363 9,955 60,189 62,566 (424) 755 133,041 $ 1,478,235 Consolidated Financial Statements }} }} Consolidated Statements of Income (Amounts in Thousands, Except Share and Per Share Data) 42 Interest Income Interest and fees on loans held for investment Interest on loans held for sale Interest on securities-taxable Interest on securities-nontaxable Interest on federal funds sold and deposits in banks Total interest income $ Interest Expense Interest on deposits Interest on short-term borrowings Interest on other indebtedness Total interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses Non-interest Income Fiduciary income Service charges on deposit accounts Other service charges, commissions and fees Mortgage banking income Net securities (losses) gains Other operating income Total non-interest income Non-interest Expense Salaries and employee benefits Occupancy expense of bank premises Furniture and equipment expense Goodwill and core deposit amortization Other operating expense Total non-interest expense Income before income taxes Income tax expense Net Income Weighted average basic shares outstanding Weighted average diluted shares outstanding Basic earnings per common share Diluted earnings per common share See Notes to Consolidated Financial Statements Years Ended December 31, 2001 2002 72,415 3,584 13,001 6,819 385 96,204 25,366 9,035 607 35,008 61,196 4,208 56,988 1,773 7,056 1,380 9,435 (391) 796 20,049 $ 72,582 2,956 10,259 6,190 842 92,829 31,884 9,913 612 42,409 50,420 5,134 45,286 1,815 5,966 1,435 9,582 181 1,296 20,275 23,267 2,874 2,082 245 13,801 42,269 34,768 10,049 24,719 9,924,636 9,973,129 2.49 2.48 $ $ $ 19,830 2,615 1,814 2,285 11,481 38,025 27,536 8,402 19,134 9,944,310 9,980,919 1.92 1.92 $ $ $ 2000 68,132 281 11,543 5,575 427 85,958 30,718 8,045 616 39,379 46,579 3,986 42,593 1,804 4,007 1,361 4,651 1 668 12,492 16,046 2,482 1,698 2,154 8,588 30,968 24,117 7,054 17,063 9,607,217 9,607,217 1.78 1.78 $ $ $ $ Consolidated Financial Statements }} }} Consolidated Statements of Cash Flow (Amounts in Thousands) Operating Activities Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by (used in) operating activities: Provision for loan losses Depreciation of premises and equipment Amortization of intangibles Net investment amortization and accretion Net gain on the sale of assets Mortgage loans originated for sale Proceeds from sale of mortgage loans Decrease (increase) in interest receivable (Increase) decrease in other assets Increase in other liabilities Other, net Net cash provided by (used in) operating activities Investing Activities Cash flows from investing activities: Proceeds from sales of securities available for sale Proceeds from maturities and calls of securities available for sale Proceeds from maturities and calls of held to maturity securities Purchase of securities available for sale Net increase in loans made to customers Purchase of bank-owned life insurance Cash provided by acquisitions, net Purchase of premises and equipment Proceeds from sale of equipment Net cash provided by (used in) investing activities Financing Activities Cash flows from financing activities: Net increase (decrease) in demand and savings deposits Net (decrease) increase in time deposits Net (decrease) increase in short-term debt Repayment of long-term debt Acquisition of treasury stock Dividends paid Net cash (used in) provided by financing activities Cash and Cash Equivalents Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year See Notes to Consolidated Financial Statements 2002 Years Ended December 31, 2001 2000 43 $ 24,719 $ 19,134 $ 17,063 4,208 1,630 32 1,467 (11,669) (737,101) 749,039 1,082 (1,810) 410 163 32,170 15,871 94,815 1,754 (41,527) (9,300) – 1,982 (5,545) – 58,050 52,874 (19,059) (34,734) (114) (2,491) (9,926) (13,450) 5,134 1,490 2,119 485 (7,659) (563,018) 516,812 874 (175) 2,728 (17) (22,093) 18,907 102,458 1,602 (232,056) (67,115) – 77,021 (3,462) 127 (102,518) 36,144 28,625 66,902 (14) (599) (8,875) 122,183 3,986 1,396 2,156 233 (2,517) (106,169) 100,148 (861) 8,454 66 (296) 23,659 2,163 17,849 3,016 (4,591) (66,918) (4,100) 3,065 (1,019) 466 (50,069) (7,755) 22,731 35,126 (39) (2,869) (8,338) 38,856 76,770 47,815 124,585 $ (2,428) 50,243 47,815 $ $ 12,446 37,797 50,243 Consolidated Financial Statements }} }} Consolidated Statements of Changes in Stockholders’ Equity (Amounts in Thousands, Except Share and Per Share Information) 44 Common Stock Additional Paid-in Capital Retained Earnings Unallocated ESOP Shares Treasury Stock Total $ 8,992 $ 34,264 $ 69,372 $ (2,945) $ (722) $ (5,473) $ 103,488 Accumulated Other Compre- hensive Income (Loss) Balance December 31, 1999 Comprehensive income: Net income Other comprehensive income Unrealized gains on securities available for sale, net of tax Comprehensive income Common dividends declared ($.86 per share) Retirement of treasury shares Issuance of common stock Purchase 145,682 treasury shares at $19.70 per share Allocation of ESOP shares Balance December 31, 2000 Comprehensive income: Net income Other comprehensive income Unrealized gains on securities available for sale, net of tax Less reclassification adjustment for gains realized in net income, net of tax Comprehensive income Common dividends declared ($.89 per share) Purchase 27,036 treasury shares at $22.17 per share Issuance of ESOP shares Effect of 10% stock dividend Balance December 31, 2001 Comprehensive income: – – – – (374) 434 – – 9,052 – – – – – – – – – (5,238) 6,343 – (96) 35,273 – – – – – – – 903 9,955 – 29 24,887 60,189 Net income Other comprehensive income Unrealized gains on securities available for sale, net of tax Less reclassification adjustment for gains realized in net income, net of tax Comprehensive income – – – – – – – – (continued) 17,063 – 17,063 (8,338) – – – – 78,097 19,134 – – 19,134 (8,875) – – (25,790) 62,566 24,719 – – 24,719 – – – – 5,612 – (2,869) – (202) – – – – – (599) 377 – (424) – – – – – – – – – – – 17,063 3,935 3,935 3,935 20,998 – – – (8,338) – 6,777 – 722 – – – (1,538) (2,869) 626 120,682 – – – – – – – – – – – – – – 19,134 2,402 2,402 (109) 2,293 (109) 21,427 – (8,875) – – – 755 (599) 406 – 133,041 – 24,719 5,770 5,770 236 6,006 236 30,725 Consolidated Financial Statements }} }} Consolidated Statements of Changes in Stockholders’ Equity (continued) (Amounts in Thousands, Except Share and Per Share Information) Common Stock Additional Paid-in Capital Retained Earnings Accumulated Other Compre- hensive Income (Loss) Unallocated ESOP Shares Treasury Stock Common dividends declared ($1.00 per share) Purchase 85,844 treasury shares at $29.00 per share Issuance of 5,500 shares under stock option plan Issuance of ESOP shares Fractional share adjustment for 10% dividend – – – – – – 42 140 (9,926) – – – (2,491) 155 792 (14) – – – – – – Balance December 31, 2002 $ 9,957 $ 58,642 $ 79,084 $ (1,982) $ See Notes to Consolidated Financial Statements 2 (1,729) 1,725 – – (16) – $ 6,761 $ 152,462 45 Total (9,926) (2,491) 197 932 Notes to Consolidated Financial Statements }} 46 Note 1. Summary of Significant Accounting Policies Trading Securities Basis of Presentation At December 31, 2002 and 2001, no securities were held for trading The accounting and reporting policies of First Community purposes and no trading account was maintained. Bancshares, Inc. (“First Community” or the “Company”) and Securities Available for Sale subsidiary conform to accounting principles generally accepted in the United States and to predominant practices within the banking industry. In preparing financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ from those estimates. Assets held in an agency or fiduciary capacity are not assets of the Company and are not included in the accompanying consolidated balance sheets. Certain amounts in the 2001 and 2000 financial statements have been reclassified to conform to the 2002 presentation. Principles of Consolidation Securities to be held for indefinite periods of time including securities that management intends to use as part of its asset/liability management strategy, and that may be sold in response to changes in interest rates, changes in prepayment risk, or other similar factors are classified as available for sale and are recorded at estimated fair value. Unrealized appreciation or depreciation in fair value above or below amortized cost is included in stockholders’ equity net of income taxes and is entitled “Other Comprehensive Income.” Premiums and discounts are amortized to expense or accreted to income over the life of the security. Gain or loss on sale is based on the specific identification method. Other than temporary losses on available for sale securities are in net The consolidated financial statements of First Community include the accounts of all wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in securities losses and gains. Securities Held to Maturity consolidation. Cash and Cash Equivalents Cash and cash equivalents include cash and due from banks, time deposits with other banks, federal funds sold, and interest-bearing balances on deposit with the Federal Home Loan Bank that are available for immediate withdrawal. Interest and income taxes paid were as follows: 2002 2001 2000 (Amounts in Thousands) Interest Income taxes $ 36,273 9,523 $ 42,968 6,945 $ 37,526 7,206 Investments in debt securities that management has the ability and intent to hold to maturity are carried at cost. Premiums and discountsare amortized to expense and accreted to income over the lives of the securities. Gain or loss on the call or maturity of investment securities, if any, is recorded based on the specific identification method. Loans Held for Sale and Derivative Financial Investments Loans held for sale primarily consist of one to four family residential loans originated for sale in the secondary market and carried at the lower of cost or fair value determined on an aggregate basis. Gains and losses on sales of loans held for sale are included in mortgage Pursuant to agreements with the Federal Reserve Bank, the banking income in the Consolidated Statements of Income. Company maintains a cash balance of approximately $661,000 in For loans to be sold, the Company enters into forward commitments lieu of charges for check clearing and other services. or derivatives to manage the risk inherent in interest rate lock commitments made to potential borrowers. The inventory of loans serves as the primary means by which the Company evaluates the 47 and loan commitments (both retail and wholesale) is hedged to adequacy of the allowance for loan losses. The allowance is protect the Company from interest rate risk and any corresponding maintained by making specific allocations to impaired loans and fluctuation in cash flows derived upon settlement of the loans with loan pools that exhibit inherent weaknesses and various credit risk secondary market purchasers, and consequently, to achieve a factors. Allocations to loan pools are developed giving weight to risk desired margin upon delivery. The hedge transactions are used for ratings, historical loss trends and management’s judgment risk mitigation and are not for trading purposes. The derivative concerning those trends and other relevant factors. financial instruments derived from these hedging transactions are The allowance is allocated to specific loans to cover loan recorded at fair value in Other Assets and Liabilities on the relationships identified with significant cash flow weaknesses and Consolidated Balance Sheets and the changes in fair value are for which a collateral deficiency may be present. The allowance reflected in Mortgage Banking Income on the Consolidated established under the specific reserve method is based upon the Statements of Income. For the year ended December 31, 2002 the borrower’s estimated cash flow and projected liquidation value of net derivative expense reflected in the Consolidated Statements of related collateral. The allowance is allocated to pools of loans based Income, was $6.9 million which is comprised of a $700,000 decline on historical loss experience to cover the homogeneous and in the fair value of the forward mortgage contracts, an $8.1 million nonhomogeneous loans not individually evaluated. Pools of loans loss on the contract settlements, and a gain of $1.9 million on rate are grouped by specific category and risk characteristics. To lock commitments. Forward mortgage contracts are settled at fair determine the amount of allowance needed for each loan category, value upon expiration of the contract and result in either the an estimated loss percentage is developed based upon historical payment or receipt or funds. UFM’s accumulated net derivative loss experience. The historical loss experience is weighted for position was $1.7 million and $480,000 as of December 31, 2002 variousriskfactorsincluding macro and micro economicconditions, and 2001, respectively. qualitative assessments relative to the composition of the loan Loans transferred to the held for sale classification are transferred at portfolio, the level of delinquencies and non-accrual loans, trends in fair value. Any write-down recorded at the point of transfer is the volume and term of loans, anticipated impact from changes in charged to the allowance for loan losses. Subsequent write-downs lending policies and procedures, and any concentration of credits in in fair value are recorded in non-interest expense while further certain industries or geographic areas. The calculated percentage is appreciation in fair value is not recorded. During the fourth quarter used to determine the estimated allowance excluding any of 2002, the Company transferred $6.0 million in loans held for relationshipsspecificallyidentified and evaluated. While allocations investment to loans held for sale and recognized a write-down are made to specific loans and classifications within the various through the allowance for loan losses of $246,000. categories of loans, the reserve is available for all loan losses. Allowance for Loan Losses The allowance for loan losses related to impaired loans is based The allowance for loan losses is maintained at a level deemed upon the discounted estimated cash flows or fair value of collateral adequate to absorb probable losses inherent in the loan portfolio. when it is probable that all amounts due pursuant to contractual The Company consistently applies a monthly review process to terms of the loan will not be collected and the recorded investment continually evaluate loans for changes in credit risk. This process in the loan exceeds the fair value. Certain smaller balance, 48 homogeneous loans, such as consumer installment loans and fees are deferred and amortized over the related commitment residential mortgage loans, are evaluated for impairment on an period. aggregate basis in accordance with the Company’s policy. Other Real Estate Owned Premises and Equipment Other real estate owned and acquired through foreclosure is stated Premises and equipment are stated at cost less accumulated at the lower of cost or fair value less estimated costs to sell. Loan depreciation. Depreciation is computed on the straight-line method losses arising from the acquisition of such properties are charged over estimated useful lives. Maintenance and repairs are charged to against the allowance for possible loan losses. Expenses incurred in current operations while improvements that extend the economic connection with operating the properties, subsequent write-downs useful life of the underlying asset are capitalized. Disposition gains and gains or losses upon sale are included in other non-interest and losses are reflected in current operations. In addition, in income and expense. accordance with Statement of Financial Accounting Standards Stock Options (“FAS”) No. 144, “Accounting for Long-Lived Assetsand for Long-Lived The Company has a stock option plan for certain executives and Assets to be Disposed of” requires that any material excess of the directors accounted for under the intrinsic value method in carrying value over the fair value be recorded as an impairment loss. accordance with Accounting Principles Board Opinion (“APB”) 25. Loan Interest Income Recognition Because the exercise price of the Company’s employee/director Accrual of interest on loans is based generally on the daily amount stock options equals the market price of the underlying stock on the of principal outstanding. It is the Company’s policy to discontinue date of grant, no compensation expense is recognized. the accrual of interest on loans based on the payment status and In December 2002, the FASB issued FAS 148, “Accounting for Stock- evaluation of the related collateral and the financial strength of the Based Compensation.” This new standard provides alternative borrower. The accrual of interest income is normally discontinued methods of transition for a voluntary change to the fair value when a loan becomes 90 days past due as to principal or interest. method of accounting for stock-based compensation. In addition, Management may elect to continue the accrual of interest when the the Statement amends the disclosure requirements of FAS 123 to loan is well secured and in process of collection. When interest require prominent disclosure in both annual and interim financial accruals are discontinued, interest accrued and not collected in the statements about the method of accounting for stock-based current year is reversed and interest accrued and not collected from compensation and the underlying effect of the method used on prior years is charged to the reserve for possible loan losses. reported results until exercised. Loan Fee Income The effect of option shares on earnings per share relates to the Loan origination and underwriting fees are recorded as a reduction dilutive effect of the underlying options outstanding. To the extent of direct costs associated with loan processing, including salaries, the granted exercise share price is less than the current market review of legal documents, obtainment of appraisals, and other price, (“in the money”), there is an economic incentive for the direct costs. Fees in excess of those related direct costs are deferred shares to be exercised and an increase in the dilution effect on and amortized over the life of the related loan. Loan commitment earnings per share. Assuming use of the fair value method of accounting for stock options, pro forma net income and earnings per share for the years ended 49 December 31 would have been estimated as follows: Net income as reported Less: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects Earnings per share: Basic as reported Basic pro forma Diluted as reported Diluted pro forma 2002 2001 2000 (Amounts in Thousands, Except Per Share Data) $ 24,719 $ 19,134 $ 17,063 (163) 24,556 (310) $ 18,824 2.49 2.47 2.48 2.46 $ $ $ $ 1.92 1.89 1.92 1.89 $ $ $ $ $ (37) 17,026 1.78 1.77 1.78 1.77 $ $ $ $ $ The fair value of options was estimated at the date of grant using the net carrying amount of goodwill related to the community banking Black-Scholes option pricing model using the following segment at December 31, 2002 and 2001 was $24.0 million and assumptions: i) risk-free interest rate of 5.15%, 5.12% and 6.00% for $24.3 million, respectively. A portion of the purchase price in certain 2002, 2001 and 2000, respectively; ii) a dividend yield of 3.20%, transactions has been allocated to values associated with the future 3.40% and 5.21% for 2002, 2001 and 2000, respectively; iii) earnings potential of acquired deposits and is being amortized over volatility factors for the expected market price of the Company’s the estimated lives of the deposits, ranging from seven to ten years common stock of 24.5%, 31.2% and 26.1% for 2002, 2001 and while the weighted average remaining life of these core deposits is 2000, respectively; and iv) a weighted-average expected life of the approximately 3.8 years. As of December 31, 2002 and 2001, the option of 10.4, 12.2 and 13.7 years, for 2002, 2001 and 2000, balance ofacquired core depositswas$2.9 million and $2.6 million, respectively. Intangible Assets respectively, while the corresponding accumulated amortization was $1.2 million and $1.5 million, respectively. The current year The excess of the cost of an acquisition over the fair value of the net acquisition of Monroe added an additional $441,000 in deposit assets acquired is recorded as goodwill. The net carrying amount of intangible. The net unamortized balance of identified intangibles goodwill was $25.8 million and $25.3 million at December 31, 2002 associated with acquired deposits was $1.3 million and $1.1 million and 2001, respectively. The net carrying amount of goodwill at atDecember 31, 2002 and 2001, respectively. Amortization expense December 31, 2002 and 2001 related to the mortgage banking of intangibles for each of the next five years is approximately segment was $1.8 million and $1.0 million, respectively, while the $200,000 annually. 50 On January 1, 2002, the Company adopted FAS 142 which required management has concluded that the current value placed on that goodwill resulting from business acquisitions (as defined) no goodwill is not impaired and no impairment losses were recorded longer be amortized to earnings, but instead be reviewed for for 2002 or prior years. impairment. Accordingly, the Company ceased the amortization of In October 2002, the FASB issued FAS No. 147, “Acquisitions of goodwill on January 1, 2002. FASB Statement 142 required a Certain Financial Institutions.” This new Standard which became transitional impairment test to be applied to all goodwill and other effective upon issuance provides interpretive guidance on the indefinite-lived intangible assets within the first six months after application of the purchase method to acquisitions of financial adoption. The impairment test involved identifying separate institutions, and requires companies to cease amortization of reporting units based on the reporting structure of the Corporation, goodwill related to certain branch acquisitions. In addition, this then assigning all assets and liabilities, including goodwill, to these Statement amends FASB Statement No. 144 to include in its scope units. Goodwill is assigned based on the reporting unit benefiting long-term customer-relationship intangible assets of financial from the factors that gave rise to the goodwill. Each reporting institutions such as depositor- and borrower-relationship intangible segment (community and mortgage banking) is then tested for assets and credit cardholder intangible assets. Consequently, those goodwill impairment by comparing the fair value of the unit with its intangible assets are subject to the same undiscounted cash flow book value, including goodwill. If the fair value of the reporting unit recoverability test and impairment loss recognition and is greater than its book value, no goodwill impairment exists. measurement provisions thatStatement 144 requires for other long- However, if the book value of the reporting unit is greater than its lived assets that are held and used. determined fair value, goodwill impairment may exist and further The effect of the application of the non-amortization provisions of testing is required to determine the amount, if any, of the actual FAS Statements 142 and 147 on net income and earnings per share impairment loss. Through the results of impairment tests, is presented below. Reported net income Add back goodwill amortization, net of tax, subject to FAS 142 & 147 Adjusted net income Basic and diluted earnings per share Add back goodwill amortization, net of tax, subject to FAS 142 & 147 Adjusted basic and diluted earnings per share Years Ended December 31, 2001 December 31, 2000 (Amounts in Thousands, Except Per Share Data) $ $ $ $ 19,134 1,875 21,009 1.92 0.19 2.11 $ $ $ $ 17,063 1,778 18,841 1.78 0.19 1.97 Recent Accounting Developments require the guarantor to make payments to the guaranteed party 51 FAS 149, “Accounting for Certain Financial Instruments with based on changes in an underlying value that is related to an asset, Characteristics of Liabilities and Equity,” which is anticipated to be liability, or equity security of the guaranteed party. Certain issued in March 2003, establishes standards for issuers’ guarantee contracts are excluded from both the disclosure and classification as liabilities in the Statement of Financial Position for recognition requirements of this interpretation, including, among certain equity linked contracts tied to the issuers’ shares. others, guarantees relating to employee compensation, residual Implementation of FAS 149 is not anticipated to have a material value guarantees under capital lease arrangements, commercial impact on the Company’s financial position or results of operation. letters of credit, loan commitments, subordinated interests in a In January 2003, the FASB issued Interpretation No. 46 (FIN 46), special purpose entity, and guarantees of a company’s own future “Consolidation of Variable Interest Entities”. The objective of this performance. Other guarantees are subject to the disclosure interpretation is to provide guidance on how to identify a variable requirements of FIN 45 but not to the recognition provisions and interest entity (VIE) and determine when the assets, liabilities, non- include, among others, a guarantee accounted for as a derivative controlling interests, and results of operations of a VIE need to be instrument under FAS 133, a parent’s guarantee of debt owed to a included in a company’s consolidated financial statements. A third party by its subsidiary or vice versa, and a guarantee which is company that holds variable interests in an entity will need to based on performance rather than price. The disclosure consolidate the entityifthe company’sinterestin the VIEissuch that requirementsofFIN 45 are effective for the CompanyasofDecember the company will absorb a majority of the VIE’s expected losses 31, 2002, and require disclosure of the nature of the guarantee, the and/or receive a majority of the entity’s expected residual returns, if maximum potential amount of future payments that the guarantor they occur. FIN 46 also requires additional disclosures by primary could be required to make under the guarantee, and the current beneficiaries and other significant variable interest holders. The amount of the liability, if any, for the guarantor’s obligations under provisions of this interpretation became effective upon issuance. the guarantee. The recognition requirements of FIN 45 are to be The Company does not anticipate the requirements of FIN 46 to applied prospectively to guarantees issued or modified after have a material impact on results of operations, financial position, December 31, 2002. The Company does not expect the or liquidity. requirements of FIN 45 to have a material impact on results of In November 2002, the FASB issued Interpretation No. 45 (FIN 45), operations, financial position, or liquidity. “Guarantor’s Accounting and Disclosure Requirements for In June 2002, the FASB issued FAS No 146, “Accounting for Costs Guarantees, Including Indirect Guarantees of Indebtedness of Associated with Exit or Disposal Activities.” This pronouncement is Others”. This interpretation expands the disclosures to be made by effective for exit or disposal activities initiated after December 31, a guarantor in its financial statements about its obligations under 2002. This Statement addresses financial accounting and reporting certain guarantees and requires the guarantor to recognize a for costs associated with exit or disposal activities and nullifies liability for the fair value of an obligation assumed under a Emerging Issues Task Force (EIFT) Issue No. 94-3, “Liability guarantee. FIN 45 clarifies the requirements of FAS 5, “Accounting Recognition for Certain Employee Termination Benefits and Other for Contingencies”, relating to guarantees. In general, FIN 45 applies Costs to Exit an Activity (including Certain Costs Incurred in a to contracts or indemnification agreements that contingently Restructuring).” Management is currently evaluating the impact of 52 this standard. However, it is not anticipated to have a material effective rate is determined based upon a combination of the impact on the results of operations, financial position or liquidity. enacted statutory federal and state rates and reduced or increased In April2002, the FASB issued FAS145, which updates, clarifies, and by any corresponding nontaxable income or nondeductible simplifiescertain existing accounting pronouncementsbeginning at expenses, respectively. various dates in 2002 and 2003. The statement rescinds FAS 4 and Deferred income taxes, which are included in other assets, are FAS 64, which required net gains or losses from the extinguishment recognized for the tax consequences of “temporary differences” by of debt to be classified as an extraordinary item in the income applying enacted statutory tax rates to the differences between the statement. These gains and losses will now be classified as financial statement carrying amounts and the tax bases of existing extraordinary only if the item is material and both unusual and assets and liabilities. The bookversus taxbasis difference is created infrequent in nature. The changes required by FAS 145 are not by the timing of expense and/or income recognition required for expected to have a material impact on results of operations, financial accounting reporting purposes as opposed to what is financial position, or liquidity of the Company. required statutorily by enacted federal and state tax laws, as well as In August 2001, the FASB issued FAS 143, Accounting for Asset differences assigned to the underlying asset and liability values at Retirement Obligations. FAS 143 requires an entity to record a acquisition. Deferred taxes are also applied to the unrealized liability for an obligation associated with the retirement of an asset appreciation or depreciation on available for sale securities at the time the liability is incurred by capitalizing the cost as part of recorded in Other Comprehensive Income in the Stockholders’ the carrying value of the related asset and depreciating it over the Equity section of the Consolidated Balance Sheet. remaining useful life of that asset. The standard is effective for the Company beginning January 1, 2003, and its adoption is not expected to have a material impact on results of operations, financial position, or liquidity. Income Taxes Earnings Per Share Basic earnings per share is determined by dividing net income by the weighted average number of shares outstanding. Diluted earnings per share is determined by dividing net income by the weighted average shares outstanding increased by the dilutive The Company and its subsidiary file a consolidated federal income effect of stock options. Basic and diluted net income per common tax return. The provision for income tax expense and the underlying share calculations follow: For the Year Ended December 31, 2002 2001 2000 (Amounts in Thousands, Except Per Share Data) Basic: Net income Weighted average shares outstanding Earnings per share — basic Diluted: Net income Weighted average shares outstanding Dilutive shares for stock options Weighted average dilutive shares outstanding Earnings per share — dilutive $ $ 24,719 9,9,9924,24,663636 2.49 $ $ 19,134 9,944,310 1.92 $ $ 17,063 9,607,217 1.78 $ $ 24,719 9,924,636 48,493 9,973,129 2.48 $ $ 19,134 9,944,310 36,609 9,980,919 1.92 $ $ 17,063 9,607,217 – 9,607,217 1.78 Note 2. Merger and Acquisitions 53 On November 30, 2002, the Company acquired Monroe Financial, and Hinton in Summers County, West Virginia, were simultaneously Inc. (“Monroe”), and its banking subsidiary, The Bank of Greenville merged with and into First Community Bank, N. A. (“FCBNA” or the (“Greenville”) for $1.96 million cash. Greenville’s three branch “Bank”). The completion of this transaction resulted in the addition facilities in Greenville and Lindside in Monroe County, West Virginia of $29.8 million in assets including $16.5 million to the loan portfolio, and an additional $28.0 million in deposits to the Bank. Note 3. Securities Available for Sale As of December 31, the amortized cost and estimated fair value of securities classified as available for sale are as follows: U.S. government agency securities States and political subdivisions Other securities Total U.S. government agency securities States and political subdivisions Other securities Total 2002 Amortized Cost Unrealized Gains Unrealized Losses Fair Value (Amounts in Thousands) $ 138,981 93,587 57,048 $ 289,616 $ $ 5,006 2,739 4,144 11,889 $ $ – (620) – (620) $ 143,987 95,706 61,192 $ 300,885 2001 Amortized Cost Unrealized Gains Unrealized Losses Fair Value (Amounts in Thousands) $ 195,689 97,683 59,387 $ 352,759 $ $ 981 1,230 1,022 3,233 $ $ (467) (1,464) (54) (1,985) $ 196,203 97,449 60,355 $ 354,007 Securities available for sale with estimated fair values of because issuersmayhave the rightto callor prepayobligationswith $207,391,813 and $180,086,000 at December 31, 2002 and 2001, or without call or prepayment penalties. Included in the amounts respectively, were pledged to secure publicdeposits, securitiessold below are securities that were acquired in the November 30, 2002 under agreements to repurchase and other short-term borrowings acquisition of The Bank of Greenville. The book and estimated and for other purposes. market value of these securities are $7.6 million and $7.7 million, As a condition to membership in the Federal Home Loan Bank respectively, at December 31, 2002. During 2002, the Company (“FHLB”) system, FCBNA is required to subscribe to a minimum level experienced a net loss from available for sale securities of of stockin the FHLB of Atlanta. At December 31, 2002, FCBNA owned $393,000. Gross losses resulted from an other-than-temporary approximately $6.3 million in stock which is classified as available write-down of a municipal issue within the portfolio of $576,000 for sale. The amortized cost and estimated fair value of securities available for sale by contractual maturity, at December 31, 2002, are shown below. Expected maturities may differ from contractual maturities and losses from the sale of securities of $313,000. These losses were offset by gross gains resulting from securities sold and called of$496,000. During 2001, a netgain of$181,000 wasrecognized as a result of the sale of available for sale securities with gains of $209,000 and losses of $28,000. 54 Amortized Cost Maturity: Within one year After one year through five years After five years through ten years After ten years Total amortized cost Tax equivalent purchase yield Average maturity (in years) Fair Value Maturity: U.S. Government Agencies & Corporations States and Political Subdivisions Other Securities Total (Amounts in Thousands) $ – 1,910 37,669 99,402 $ 138,981 5.49% 16.15 $ 500 18,537 14,247 60,303 $ 93,587 8.02% 12.39 $ – 26,106 20,295 10,647 $ 57,048 5.56% 8.75 $ 500 46,553 72,211 170,352 $ 289,616 6.32% 13.48 Tax Equivalent Purchase Yield 7.72% 6.68% 6.17% 6.28% Within one year After one year through five years After five years through ten years After ten years Total fair value $ – 1,944 39,020 103,023 $ 143,987 $ 504 18,983 14,653 61,566 $ 95,706 $ – 28,046 22,142 11,004 $ 61,192 $ 504 48,973 75,815 175,593 $ 300,885 Note 4. Securities Held to Maturity The following table presents amortized cost and approximate fair values of investment securities held to maturity at December 31: U.S. government agency securities States and political subdivisions Other securities Total U.S. government agency securities States and political subdivisions Other securities Total 2002 Amortized Cost Unrealized Gains Unrealized Losses Fair Value (Amounts in Thousands) $ 336 40,303 375 $ 41,014 $ $ 8 2,320 – 2,328 $ $ – – – – $ 344 42,623 375 $ 43,342 2001 Amortized Cost Unrealized Gains Unrealized Losses Fair Value (Amounts in Thousands) $ 743 39,768 1,373 $ 41,884 $ $ 16 1,487 6 1,509 $ $ – – – – $ 759 41,255 1,379 $ 43,393 U.S. Government Agencies & Corporations States and Political Subdivisions Other Securities Total 55 Tax Equivalent Purchase Yield (Amounts in Thousands) Amortized Cost Maturity: Within one year After one year through five years After five years through ten years After ten years Total amortized cost Tax equivalent purchase yield Average maturity (in years) Fair Value Maturity: Within one year After one year through five years After five years through ten years After ten years Total fair value $ $ $ $ 63 98 175 – 336 5.08% 4.43 $ – 4,594 15,663 20,046 $ 40,303 8.67% 9.14 64 99 181 – 344 $ – 4,935 16,525 21,163 $ 42,623 $ $ $ $ 75 – 300 – 375 6.60% 4.79 $ 138 4,692 16,138 20,046 $ 41,014 8.62% 9.06 5.78% 8.50% 8.58% 8.70% 75 – 300 – 375 $ 139 5,034 17,006 21,163 $ 43,342 Various investment securities classified as held to maturity with an FCBNA is a party to financial instruments with off-balance sheet risk amortized cost of approximately $4,454,299 and $4,439,000 were in the normal course of business to meet the financing needs of its pledged at December 31, 2002 and 2001, respectively, to secure customers. These financial instruments include commitments to public deposits and for other purposes required by law. extend credit, standby letters of credit and financial guarantees. Note 5. Loans Loans consist of the following at December 31: These instruments involve, to varying degrees, elements of credit and interest rate risk beyond the amount recognized on the balance 2002 2001 sheet. The contractual amounts of those instruments reflect the Real estate-commercial Real estate-construction Real estate-residential Commercial, financial and agricultural (Amounts in Thousands) $ 285,847 $ 259,717 77,402 332,671 72,275 364,065 74,186 96,641 Loans to individuals for household All other loans and other consumer expenditures 130,522 726 $ 927,621 137,104 961 $904,496 extent of involvement the Company has in particular classes of financial instruments. The Company’s exposure to credit loss in the event of non- performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual amount of those instruments. The Company uses the same credit 56 policies in making commitments and conditional obligations as it extending loan facilities to customers. To the extent deemed does for on-balance sheet instruments. necessary, collateral of varying types and amounts is held to secure Commitmentsto extend creditare agreementsto lend to a customer customer performance under certain of those letters of credit as long as there is not a violation of any condition established in the outstanding at December 31, 2002. contract. Commitments generally have fixed expiration dates or Financial instruments whose contract amounts represent credit risk other termination clauses and may require payment of a fee. Since at December 31, 2002 are commitments to extend credit (including many of the commitments are expected to expire without being availability of lines of credit) – $64.2 million, and standby letters of drawn upon, the total commitment amounts do not necessarily credit and financial guarantees written – $6.0 million. At December represent future cash requirements. The Company evaluates each 31, 2002, FCBNA’ssubsidiary, United FirstMortgage, Inc. (UFM), had customer’screditworthinesson a case-by-case basis. The amountof commitments to originate loans of $120.2 million. collateral obtained, if deemed necessary by the Company, upon extension of credit is based on management’s credit evaluation of the counterparties. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income- producing commercial properties. Loan commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The Company evaluates each customer’s creditworthiness on a case-by- case basis. The amount of collateral deemed necessary by the Company is based on management’s credit evaluation and Standby letters of credit and financial guarantees written are underwriting guidelines for the particular loan. The total conditional commitments issued by the Company to guarantee the commitments outstanding at December 31, 2002 are summarized performance of a customer to a third party. The credit risk involved in the following table: in issuing letters of credit is essentially the same as that involved in Real estate-commercial (fixed) Real estate-commercial (variable) Real estate-construction (fixed) Real estate-construction (variable) Real estate-residential (fixed) Real estate-residential (variable) Commercial, financial, agricultural (fixed) Commercial, financial, agricultural (variable) Loans to individuals for household and other consumer expenditures (fixed) Loans to individuals for household and other consumer expenditures (variable) Total 2002 Notional Amount Rate (Amounts in Thousands) $ 5,573 10,349 4,904 8,349 4,211 14,099 1,689 14,739 4,537 1,765 $ 70,215 3.38 - 10.50 % 2.25 - 19.50 % 4.40 - 10.50 % 4.25 - 19.00 % 5.75 - 18.00 % 3.75 - 12.00 % 4.00 - 18.00 % 2.25 - 10.50 % 3.70 - 18.50 % 4.25 - 14.50 % Management analyzes the loan portfolio regularly for surrounding mid-Atlantic area. Although sections of the West 57 concentrations of credit risk, including concentrations in specific Virginia and Southwestern Virginia economies are closely related to industries and geographic location. At December 31, 2002, natural resource production, they are supplemented by service commercial real estate loans comprised 30.8% of the total loan industries. The Company’s presence in three states, West Virginia, portfolio. Commercial loans include loans to small to mid-size Virginia, and North Carolina, provides additional diversification industrial, commercial and service companies that include but are against geographic concentrations of credit risk. not limited to coal mining companies, manufacturers, automobile In the normal course of business, FCBNA has made loans to dealers, and retail and wholesale merchants. Commercial real directors and executive officers of the Company and its subsidiary. estate projects represent several different sectors of the commercial All loans and commitments made to such officers and directors and real estate market, including residential land development, to companies in which they are officers, or have significant apartment building operators, commercial real estate lessors, and ownership interest, have been made on substantially the same hotel/motel developers. Underwriting standards require terms, including interest rates and collateral, as those prevailing at comprehensive reviewsand independentevaluationsbe performed the time for comparable transactions with other persons. The on credits exceeding predefined market limits on commercial loans. aggregate dollar amount of such loans was $6.0 million and Updates to these loan reviews are done periodically or on an annual $7.8 million at December 31, 2002 and 2001, respectively. Advances basis depending on the size of the loan relationship. and repayments of these loans during 2002 were $1.9 million and The majority of the loans in the current portfolio, other than $3.7 million, respectively. commercial and commercial real estate, were made and Note 6. Allowance for Loan Losses collateralized in West Virginia, Virginia, North Carolina and the Activity in the allowance for loan losses was as follows: Balance, January 1 Provision for loan losses Acquisition balance Loans charged off Recoveries credited to reserve Net charge-offs Balance, December 31 2002 2001 2000 (Amounts in Thousands) $ 13,952 4,208 395 (4,868) 723 (4,145) $ 14,410 $ 12,303 5,134 484 (4,880) 911 (3,969) $ 13,952 $ 11,900 3,986 1,051 (5,536) 902 (4,634) $ 12,303 58 The following table presents the Company’s investment in loans considered to be impaired and related information on those impaired loans: Recorded investment in loans considered to be impaired Loans considered to be impaired that were on a non-accrual basis Allowance for loan losses related to loans considered to be impaired Average recorded investment in impaired loans Total interest income recognized on impaired loans 2002 2001 (Amounts in Thousands) $ 8,980 1,238 3,907 9,176 512 $ 5,129 1,229 1,310 5,674 255 During 2002, 2001 and 2000, $2,168,000, $2,116,000, and $2,530,000 of assets were acquired through foreclosure and transferred to other real estate owned. Note 7. Premises and Equipment Premises and equipment are comprised of the following as of December 31: Land Bank premises Equipment Less: accumulated depreciation and amortization Total 2002 2001 (Amounts in Thousands) $ $ 7,648 24,317 16,832 48,797 23,719 25,078 $ $ 7,123 22,258 15,831 45,212 23,499 21,713 Note 8. Other Indebtedness mortgage assets. At December 31, 2002, credit availability with the Other indebtedness includes structured term borrowings from the FHLB totaled approximately $193.6 million. Advances from the FHLB FHLB of $100 million and $125 million at December 31, 2002 and are secured by stockin the FHLB of Atlanta, qualifying first mortgage 2001, respectively, in the form of convertible and callable advances. loans of $331.0 million, mortgage-backed securities, and certain The callable advances may be called, based on predefined factors, other investment securities. The FHLB advances are subject to in quarterly increments that may substantially shorten the lives of restrictions or penalties in the event of prepayment. these instruments. If these advances are called, the debt may be Other indebtedness also includes term borrowings with the FHLB of paid in full, converted to another FHLB credit product or converted $10 million as of December 31, 2002 and 2001. This debt has a to an adjustable rate advance. The contractual maturity of these weighted average interest rate of 6.01% and $8 million matures in borrowings is 2010 and the weighted average rate is 5.83% at 2003, while $2 million matures in 2008. Other various debt December 31, 2002. At December 31, 2001, the Company also held obligations of the Company, excluding the borrowings of UFM a non-callable term advance of $10.0 million which matured in mentioned below, approximated $50,000 at December 31, 2002 December 2002. and $320,000 at December 31, 2001. FCBNA is a member of the FHLB which provides credit in the form of In late 2002, the Bank’s mortgage subsidiary, UFM, entered into a short-term and long-term advances collateralized by various loan purchase agreement with Countrywide Warehouse Lending (“Countrywide”) whereby Countrywide will pre-fund certain loans December 31, 2002 was $300,000 deficient of Countrywide’s 59 anticipated to be purchased by Countrywide Home Loans, Inc. minimum net worth requirement. Subsequent to year-end, UFM This financing arrangement by UFM with Countrywide resulted received a letter of forbearance from Countrywide, cured the in additional borrowings at December 31, 2002 of $14.3 million at deficiency, ceased continuance of this credit facility and ultimately a floating rate of one month LIBOR plus 200 basis points or 3.42% requested the return of all related collateral. at December 31, 2002. UFM’s net worth of $4.2 million at Note 9. Deposits At December 31, 2002, the scheduled maturities of certificates of Time deposits, including certificates of deposit issued in deposit are as follows: denominations of $100,000 or more, amounted to $176.8 million (Amounts in Thousands) and $173.0 million at December 31, 2002 and 2001, respectively. 2003 2004 2005 2006 2007 and thereafter Note 10. Income Taxes Income taxes are as follows: Income exclusive of securities gains Net securities (losses) gains Income tax provisions consists of: Current tax expense Deferred tax expense (benefit) $ 392,821 97,079 48,393 15,102 39,693 $ 593,088 Interest expense on these certificates was $6.1 million, $6.7 million, and $6.5 million for 2002, 2001, and 2000, respectively. At December 31, 2002, the scheduled maturities of certificates of deposit of $100,000 or more are as follows: Three Months or Less Over Three to Six Months Over Six to Twelve Months Over Twelve Months Total (Amounts in Thousands) $ 39,653 37,998 45,048 54,068 $ 176,767 Years Ended December 31, 2002 2001 2000 (Amounts in Thousands) 10,205 (156) 10,049 $ $ 8,330 72 8,402 $ $ 7,053 1 7,054 Years Ended December 31, 2002 2001 2000 (Amounts in Thousands) 9,056 993 10,049 $ $ 8,734 (332) 8,402 $ $ 7,150 (96) 7,054 $ $ $ $ 60 Deferred income taxes reflect the net effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting versus tax purposes. The tax effects of significant items comprising the Company’s net deferred tax assets as of December 31, 2002 and 2001 are as follows: Deferred tax assets: Allowance for loan losses Unrealized losses on assets Deferred compensation Deferred insurance premiums Other Total deferred tax assets Deferred tax liabilities: Intangible assets Fixed assets Deferred loan fees Unrealized gain on securities available for sale Other Total deferred tax liabilities Net deferred tax (liabilities) assets 2002 2001 (Amounts in Thousands) $ $ $ $ 5,644 214 979 222 739 7,798 1,537 701 346 4,507 1,636 8,727 (929) $ $ $ $ 5,514 203 916 256 148 7,037 601 267 397 494 1,145 2,904 4,133 The reconciliation between the federal statutory tax rate and the effective income tax rate is as follows: Tax at statutory rate (Reduction) increase resulting from: Tax-exempt interest on investment securities and loans State income taxes, net of federal benefit Amortization of goodwill Other, net Effective tax rate Years Ended December 31, 2001 2002 2000 35.00% 35.00% 35.00% (6.42)% 1.82% –% (1.50)% 28.90% (7.31)% 2.55% 1.57% (1.30)% 30.51% (7.77)% 2.36% 1.90% (2.19)% 29.30% Note 11. Employee Benefits The Company has a post-retirement obligation for a group of 61 Employee Stock Ownership and Savings Plan The Companymaintainsan Employee StockOwnership and Savings Plan (“KSOP”). Coverage under the plan isprovided to allemployees meeting minimum eligibility requirements. Employer Stock Fund: Annual contributions to the stock portion of the plan are made atthe discretion ofthe Board ofDirectors, and are allocated to plan participants on the basis of relative compensation. Substantially all plan assets are invested in common stock of the Company. Total expense recognized by the Company related to the retirees that relates to benefits received prior to 1993. The obligation, which approximated $122,000 and $135,000 at December 31, 2002 and 2001, respectively, is being amortized over the average remaining life expectancy of the retirees. Amortization expense approximated $(13,000), $26,000 and $45,000 in 2002, 2001 and 2000, respectively. The current year decline in amortization expense was the result of the reduction in the number of participants involved in the remaining pool of former employees and the corresponding reduction in the present value of the benefit Employer StockFund within the KSOP was$675,000, $948,000 and obligation. $992,000 in 2002, 2001 and 2000, respectively. Deferred Compensation Plan Employee Savings Plan: The Company provides a 401(k) Savings FCBNA has deferred compensation agreements with certain current feature within the KSOP that is available to substantially all and former officers providing for benefit payments over various employees meeting minimum eligibility requirements. The cost of periods commencing at retirement or death. The liability at Company contributions under the Savings Plan component of the December 31, 2002 and 2001 was approximately $700,000 and KSOP was $563,000, $216,000, and $66,000 in 2002, 2001 and $750,000, respectively. The annual expenses associated with this 2000, respectively. The Company’s matching contributions are at plan for 2002 and 2001 were $91,000 and $138,000 for 2000. The the discretion of the Board up to 100% of elective deferrals of no obligation is based upon the present value of the expected more than 6% of compensation. The Company matching rate was payments and estimated life expectancies. 100% for 2002, 50% for 2001, and 25% for 2000. The Company maintains life insurance contracts on the lives of Employee Welfare Plan certain of the officers covered under this plan. Proceeds derived The Company provides various medical, dental, vision, life, from death benefits are intended to provide reimbursement of plan accidental death and dismemberment and long-term disability benefits paid over the post employment lives of the participants. insurance benefits to all full-time employees who elect coverage Premiums on the insurance contracts are currently paid through under this program (basic life, accidental death and policy dividends on the cash surrender values of $598,000 and dismemberment, and long-term disability coverage are automatic). $594,000 at December 31, 2002 and 2001, respectively. The health plan is managed by a third party administrator (“TPA”). Executive Retention Plan Monthly employer and employee contributions are made to a tax- The Company maintains an Executive Retention Plan for key exempt employer benefits trust, against which the TPA processes members of senior management. This Plan provides for a benefit at and paysclaims. Stop lossinsurance coverage limitsthe Company’s normal retirement (age 62) targeted at 35% of final compensation funding requirements and risk of loss to $50,000 and $1.95 million projected at an assumed 3% salary progression rate. Benefits under for individual and aggregate claims, respectively. Total Company the Plan become payable at age 62. Actual benefits payable under expenses under the plan were $1.9 million, $1.4 million, and the Retention Plan are dependent on an indexed retirement benefit $1.4 million in 2002, 2001 and 2000, respectively. formula which accrues benefits equal to the aggregate after-tax 62 income of associated life insurance contracts less the Company’s Benefits under the Executive Plan vest 25% after five years, 50% tax-effected cost of funds for that plan year. Benefits under the Plan after ten years, 75% after 15 years and 5% per year thereafter, with are dependent on the performance of the insurance contracts and vesting accelerated to 100% upon attainmentof age 62, irrespective are not guaranteed by the Company. Additionally, during 2001, the of years of service under the Plan. Company entered into a similar retirement plan arrangement as Directors Supplemental Retirement Plan described below with non-employee board members of the In the fourth quarter of 2001, the Company established a Directors Company. Supplemental Retirement Plan for its non-employee Directors. This The Company funded the contracts through the purchase of bank- Plan provides for a benefit upon retirement from service on the owned life insurance, (“BOLI”), which is anticipated to fully fund the Board at specified ages depending upon length of service or death. projected benefit payout after retirement. The total amount invested Benefits under the Plan become payable at age 70, 75, and 78 in BOLI for the Executive Retention Plan during 2000 and the depending upon the individual director’s age and original date of corresponding cash surrender value at December 31, 2002 was election to the Board. Actual benefits payable under the Plan are $4.1 million and $4.7 million, respectively. The associated dependent on an indexed retirement benefit formula that accrues obligation expense incurred in connection with the Executive Plan benefits equal to the aggregate after-tax income associated life was $177,000, $156,000 and $193,000 for 2002, 2001 and 2000, insurance contracts less the Company’s tax-effected cost of funds respectively. The income derived from policy appreciation was for that plan year. Benefits under the Plan are dependent on the $157,000, $240,000 and $184,000 in 2002, 2001 and 2000, performance of the insurance contracts and are not guaranteed by respectively. A portion of the pre-existing life insurance contracts on the Company. non-vested terminating executives was reallocated and used to In connection with the Directors Supplemental Retirement Plan, the fund the newly created Director Supplemental Retirement Plan Company has also entered into Life Insurance Endorsement Method referenced below. Split Dollar Agreements (the “Agreements”) with certain directors In connection with the Executive Retention Plan, the Company has covered under the Plan. Under the Agreements, the Company also entered into Life Insurance Endorsement Method Split Dollar shares 80% of death benefits (after recovery of cash surrender Agreements (the “Agreements”) with the individuals covered under value) with the designated beneficiaries of the executives under life the Plan. Under the Agreements, the Company shares 80% of death insurance contracts referenced in the Retention Plan. The Company, benefits (after recovery of cash surrender value) with the designated as owner of the policies, retains a 20% interest in life proceeds and beneficiaries of the plan participants under life insurance contracts a 100% interest in the cash surrender value of the policies. Because referenced in the Plan. The Company as owner of the policies retains the Plan was designed to retain the future services of Board a 20% interest in life proceeds and a 100% interest in the cash members, no benefits are payable under the Plan in the event of surrender value of the policies. involuntary or involuntary termination prior to retirement age as The Plan also contains provisions for change of control, as defined, defined in the Plan document. which allow the participants to retain benefits, subject to certain The Plan also contains provisions for change of control, as defined, conditions, under the Plan in the event of a change in control. which allow the Directors to retain benefits under the Plan in the event of a termination of service, other than for cause, during the 12 months prior to a change in control or anytime thereafter, unless options granted pursuant to the Plan are exercisable for a period of 63 the Director voluntarily terminates his service within 90 days five years after the date of the grantee’s retirement (provided following the change in control. retirement occurs at or after age 62), and at disability, or death. If The Plan expenses associated with the Directors Supplemental employment is terminated other than by retirement, disability, or Retirement Plan for 2002 and 2001 were $217,000 and $32,000, death, vested options must be exercised within 90 days after the respectively. The level of expense in the prior year is reflective of the effective date of termination. Any option not exercised within such fourth quarter 2001 implementation of the Plan. period will be deemed cancelled. Stock Options In the fourth quarter of 2001, the Company also granted stock In 1999, the Company instituted a Stock Option Plan to encourage options to non-employee directors. The Director Option Plan was and facilitate investment in the common stock of the Company by implemented to facilitate and encourage investment in the common key executives and to assist in the long-term retention of service by stock of the Company by non-employee directors whose efforts, those executives. The Plan covers key executives as determined by solely as directors, are expected to contribute to the Company’s the Company’s Board of Directors from time to time. Options under future growth and continued success. The options granted pursuant the Plan were granted in the form of non-statutory stock options to the Plan expire at the earlier of 10 years from the date of grant or with the aggregate number of shares of common stock available for two years after the optionee ceases to serve as a director of the grant under the Plan set at 302,500 (adjusted for the 10% stock Company. Options not exercised within the appropriate time shall dividend paid in 2002 ) shares. The options granted under the Plan expire and be deemed cancelled. The Plan covers non-employee represent the rights to acquire the option shares with deemed grant directors as determined by the Company’s Board of Directors. dates of January 1 for each year beginning with the initial year Options under the Plan were granted in the form of non-statutory granted and the following four anniversaries. All stock options stock options with the aggregate number of shares of common granted pursuant to the Plan vest ratably on the first through the stock available for grant under the Plan set at 99,000 (adjusted for seventh anniversary dates of the deemed grant date. The option the 10% stock dividend) shares. price of each stock option is equal to the fair market value (as A summary of the Company’s stock option activity, and related defined by the Plan) of the Company’s common stock on the date of information for the years ended December 31 is as follows: each deemed grant during the five-year grant period. Vested stock Outstanding, beginning of year Granted Exercised Forfeited Outstanding, end of year 2002 2001 2000 Weighted- Option Option Average Shares Exercise Price Shares Weighted- Average Exercise Price 202,302 68,351 5,500 – 265,153 $ 18.65 27.12 23.91 – $ 21.18 84,451 120,601 – 2,750 202,302 $ 19.69 17.90 – 15.33 $ 18.65 Option Shares 59,968 59,968 – 35,485 84,451 Weighted- Average Exercise Price $ 21.78 17.60 – 19.69 $ 19.69 Exercisable at end of year 44,000 $ 23.91 49,500 $ 23.91 – $ – Weighted-average fair value of options granted during the year $ 7.31 $ 5.28 $ 2.97 64 For options with exercise prices ranging from $15.33 to $23.91 the loans totaling $250,000 have been considered for repurchase. number of options outstanding is 196,802, the weighted-average Accordingly, loan repurchases have not had a material adverse exercise price and the weighted-average remaining estimated life of effect on the financial position, results of operations or cash flows of the options outstanding are $19.12 and approximately 10 years, UFM or the Company. respectively, while the number and weighted-average exercise price UFM also originates government guaranteed FHA and VA loans that of options currently exercisable is 44,000 and $23.91. are also sold to third-party investors. The department of Housing For options with the exercise price of $27.12, the number and the and Urban Development (“HUD”) periodically audits loan files of remaining estimated life were 68,351 and approximately 13 years, government guaranteed loans and may require UFM to execute while none of the options are currently exercisable. indemnification agreements on loans which do not meet certain Note 12. Litigation, Commitments and Contingencies predefined underwriting guidelines. To date, UFM has been required to execute only three such indemnification agreements for In the normal course of business, the Company is a defendant in defaults which may occur over the five-year period following the various legal actions and asserted claims most of which involve indemnification and no losses have occurred under such lending and collection activities. While the Company and legal agreements. Accordingly, loan indemnifications have not had a counsel are unable to assess the ultimate outcome of each of these material adverse effect on the financial position, results of matters with certainty, they are of the belief that the resolution of operations or cash flows of UFM or the Company. these actions should not have a material adverse affect on the UFM is subject to net worth requirements issued by HUD. Failure to financial position of the Company. meet these minimum capital requirements can initiate certain The Companyconductsmortgage banking operationsthrough UFM, mandatory and possibly additional discretionary actions that, if a wholly-owned subsidiary of FCBNA. The majority of loans undertaken, could have a directmaterialeffecton UFM’soperations. originated by UFM are sold to larger national investors on a service UFM was in compliance with HUD’s $1.0 million minimum net worth released basis. Loans are sold under Loan Sales Agreements which requirement at December 31, 2002 and 2001. UFM’s tangible net contain various repurchase provisions. These repurchase provisions worth was $4.2 million at December 31, 2002, which exceeded the give rise to a contingent liability for loans which could subsequently HUD requirement. be submitted to UFM for repurchase. The principal events which could result in a repurchase obligation are i.) the discovery of fraud Note 13. Regulatory Capital Requirements and Restrictions or material inaccuracies in a sold loan file, and ii.) a default on the The primary source of funds for dividends paid by the Company is first payment due after a loan is sold to the investor, coupled with a dividends received from FCBNA. Dividends paid by FCBNA are ninety-day delinquency in the first year of the life of the loan. Other subject to restrictions by banking regulations. The most restrictive events and variations of these events could result in a loan provision of the regulations requires approval by the Office of the repurchase under terms of other Loan Sales Agreements. The Comptroller of the Currency if dividends declared in any year exceed volume of contingent loan repurchases is dependent on the quality the year’s net income, as defined, plus retained net profit of the two of loan underwriting and systems employed by UFM for quality preceding years. During 2003, subsidiary accumulated earnings control in the production of mortgage loans. To date, only two such available for distribution as dividends to the Company without prior approval are $22.0 million plus net income for the interim period Quantitative measures established by regulation to ensure capital 65 through the date of dividend declaration. adequacy require the Company and FCBNA to maintain minimum The Company and FCBNA are subject to various regulatory capital amounts and ratios for total and Tier 1 capital (as defined in the requirements administered by the federal banking agencies. Failure regulations) to risk-weighted assets(asdefined), and ofTier 1 capital to meet minimum capital requirements can initiate certain (as defined) to average assets (as defined). As of December 31, mandatory and possibly additional discretionary actions by 2002, the Company and banking subsidiary met all capital regulators that, if undertaken, could have a direct material effect on adequacy requirements to which they are subject. the Company’s financial statements. Under the capital adequacy As of December 31, 2002 and 2001, the most recent notifications guidelines and the regulatory framework for prompt corrective from the Federal Reserve Board categorized the Bank as well action, which applies only to the Bank, the Bank must meet specific capitalized under the regulatory framework for prompt corrective capital guidelines that involve quantitative measures of the entity’s action. To be categorized as well capitalized, the Bank must assets, liabilities, and certain off-balance sheet items as calculated maintain minimum Total risk-based, Tier 1 risk-based, and Tier 1 under regulatory accounting practices. The entity’s capital amounts leverage ratios as set forth in the table below. There are no and classifications are also subject to qualitative judgments by the conditions or events since those notifications that management regulators about components, risk weightings, and other factors. believes have changed the institution’s category. December 31, 2002 Actual For Capital Adequacy Purposes To Be Well Capitalized Under Prompt Corrective Action Provisions Amount Ratio Amount Ratio Amount Ratio (Amounts in Thousands) Total Capital to Risk-Weighted Assets First Community Bancshares, Inc. First Community Bank, N. A. Tier 1 Capital to Risk-Weighted Assets First Community Bancshares, Inc. First Community Bank, N. A. Tier 1 Capital to Average Assets (Leverage) First Community Bancshares, Inc. First Community Bank, N. A. $ 131,097 119,434 13.33% 12.20% $ 78,671 78,344 8.00% 8.00% $ 118,618 107,164 12.06% 10.94% $ 39,336 39,172 $ 118,618 107,164 8.10% 7.35% $ 58,581 58,344 4.00% 4.00% 4.00% 4.00% $ $ $ N/A N/A 97,930 10.00% N/A 58,758 N/A 6.00% N/A 72,930 N/A 5.00% 66 December 31, 2001 Actual For Capital Adequacy Purposes To Be Well Capitalized Under Prompt Corrective Action Provisions Amount Ratio Amount Ratio Amount Ratio (Amounts in Thousands) Total Capital to Risk-Weighted Assets First Community Bancshares, Inc. First Community Bank, N. A. Tier 1 Capital to Risk-Weighted Assets First Community Bancshares, Inc. First Community Bank, N. A. Tier 1 Capital to Average Assets (Leverage) First Community Bancshares, Inc. First Community Bank, N. A. $ 118,296 106,957 12.10% 10.98% $ 78,234 77,933 8.00% 8.00% $ 105,809 94,753 10.82% 9.73% $ 39,117 38,967 $ 105,809 94,753 7.93% 7.13% $ 53,398 53,170 4.00% 4.00% 4.00% 4.00% $ $ $ N/A N/A 97,417 10.00% N/A N/A 58,450 6.00% N/A N/A 66,462 5.00% The tangible common equity ratio excludes goodwill and other Both the Tier 1 and the total risk-based capital ratios are computed intangible assets from both the numerator and denominator. by dividing the respective capital amounts by risk-weighted assets, Tier 1 capital consists of total equity plus qualifying capital securities as defined. and minority interests, less unrealized gains and losses The leverage ratio reflects Tier 1 capital divided by average total accumulated in other comprehensive income, certain intangible assetsfor the period. Average assetsused in the calculation exclude assets, and adjustments related to the valuation of mortgage certain intangible and mortgage servicing assets. servicing assets and certain equity investments in non-financial Note 14. Other Operating Expenses companies (principal investments). Included in other operating expenses are certain costs, the total of Total risk-based capital is comprised of Tier 1 capital plus qualifying which exceeds one percent of combined interest income and non- subordinated debt and allowance for loan losses and a portion of interest income. Following are such costs for the years indicated: unrealized gains on certain equity securities. Advertising and public relations Other service fees Telephone and data communications * Cost did not exceed the one percent requirement for the reported period. Years Ended December 31, 2002 2001 2000 (Amounts in Thousands) 1,347 1,547 1,207 $ $ $ 1,223 1,261 * $ $ $ $ $ $ * * * Note 15. Fair Value of Financial Instruments The following summary presents the methodologies and 67 Fair value information about financial instruments, whether or not assumptions used to estimate the fair value of the Company’s recognized in the balance sheet, for which it is practical to estimate financial instruments presented below. The information used to the value is based upon the characteristics of the instruments and determine fair value is highly subjective and judgmental in nature relevant market information. Financial instruments include cash, and, therefore, the results may not be precise. Subjective factors evidence of ownership in an entity, or contracts that convey or include, among other things, estimates of cash flows, risk impose on an entity the contractual right or obligation to either characteristics, credit quality, and interest rates, all of which are receive or deliver cash for another financial instrument. Fair value is subject to change. Since the fair value is estimated as of the balance the amount at which a financial instrument could be exchanged in a sheet date, the amounts that will actually be realized or paid upon current transaction between willing parties, other than in a forced settlement or maturity on these various instruments could be sale or liquidation, and is best evidenced by a quoted market price significantly different. if one exists. Assets: Cash and cash equivalents Securities available for sale Securities held to maturity Derivative financial instruments Loans held for sale Loans held for investment Interest receivable Liabilities: Demand deposits Interest-bearing demand deposits Savings deposits Time deposits Federal funds purchased Securities sold under agreements to repurchase Interest, taxes and other obligations Other indebtedness 2002 2001 Carrying Amount Fair Value Carrying Amount Fair Value (Amounts in Thousands) $ $ 124,585 300,885 41,014 1,677 66,364 913,211 7,897 $ 124,585 300,885 43,342 1,677 67,503 933,691 7,897 165,557 200,296 180,786 593,088 – 91,877 15,940 124,357 165,557 200,296 180,786 604,313 – 92,112 15,940 141,496 47,815 354,007 41,884 480 65,532 890,544 8,765 161,346 183,685 142,839 590,390 26,500 79,262 15,852 145,320 $ 47,815 354,007 43,393 480 66,787 905,361 8,765 161,346 183,685 142,839 593,548 26,500 79,524 15,852 155,104 68 Financial Instruments with Book Value Equal to Fair Value Deposits and Securities Sold Under Agreements to Repurchase The bookvalues of cash and due from banks, federal funds sold and Deposits without a stated maturity, including demand, interest- purchased, interest receivable, and interest, taxes and other bearing demand, and savings accounts, are reported at their liabilities are considered to be equal to fair value as a result of the carrying value in accordance with FAS No. 107. No value has been short-term nature of these items. Securities Available for Sale assigned to the franchise value of these deposits. For other types of deposits with fixed maturities, fair value has been estimated by For securities available for sale, fair value is based on current market discounting future cash flows based on interest rates currently quotations, where available. If quoted market prices are not being offered on deposits with similar characteristics and available, fair value has been based on the quoted price of similar maturities. instruments. Securities Held to Maturity Other Indebtedness Fair value has been estimated based on interest rates currently For investment securities, fair value has been based on current available to the Company for borrowings with similar characteristics market quotations, where available. If quoted market prices are not and maturities. available, fair value has been based on the quoted price of similar instruments. Derivative Financial Instruments Derivative financial instruments are recorded at estimated fair value based upon current market pricing for similar instruments. Loans The estimated value of loans held for investment is measured based upon discounted future cash flows and using the current rates for similar loans. Loans held for sale are recorded at lower of cost or estimated fair value. The fair value of loans held for sale is determined based upon the market sales price of similar loans. Commitments to Extend Credit, Standby Letters of Credit, and Financial Guarantees The amount of off-balance sheet commitments to extend credit, standby letters of credit, and financial guarantees is considered equal to fair value. Because of the uncertainty involved in attempting to assess the likelihood and timing of commitments being drawn upon, coupled with the lack of an established market and the wide diversity of fee structures, the Company does not believe it is meaningful to provide an estimate of fair value that differs from the given value of the commitment. Note 16. Parent Company Financial Information 69 Condensed financial information related to First Community Bancshares, Inc. as of December 31, 2002 and 2001, and for each of the years ended December 31, 2002, 2001 and 2000 is as follows: Condensed Balance Sheets Assets Cash Investment in subsidiary Other assets Total assets Liabilities Other liabilities Stockholders’ Equity Common stock Additional paid-in capital Retained earnings Treasury stock Accumulated other comprehensive income Total stockholders’ equity Total liabilities and stockholders’ equity Condensed Statements of Income Cash dividends received from subsidiary bank Other income Operating expense Income tax benefit Equity in undistributed earnings of subsidiary Net income Basic earnings per share Diluted earnings per share December 31, 2002 2001 (Amounts in Thousands) $ 6,129 140,767 6,220 $ 153,116 $ 5,820 121,679 6,056 $ 133,555 $ 654 $ 514 9,957 58,642 79,084 (1,982) 6,761 152,462 $ 153,116 9,955 60,189 62,566 (424) 755 133,041 $ 133,555 2002 December 31, 2001 2000 (Amounts in Thousands, Except Per Share Data) $ 11,500 650 (759) 11,391 311 13,017 $ 24,719 2.49 $ 2.48 $ $ $ $ $ 8,500 331 (552) 8,279 72 10,783 19,134 1.92 1.92 $ $ $ $ 7,000 339 (278) 7,061 (18) 10,020 17,063 1.78 1.78 70 Condensed Statements of Cash Flows Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed earnings of subsidiary (Decrease) increase in other assets Gain on sale of assets Increase in other liabilities Other, net Net cash provided by operating activities Cash flows from investing activities: Purchase of securities available for sale Proceeds from sale of securities available for sale Net cash provided by (used in) investing activities Cash flows from financing activities: Repayment of long-term debt Acquisition of treasury stock Dividends paid Net cash used in financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Note 17. Segment Information Years Ending December 31, 2001 2002 2000 (Amounts in Thousands) $ 24,719 $ 19,134 $ 17,063 (13,017) (138) (375) 1,169 185 12,543 (1,671) 1,954 283 (100) (2,491) (9,926) (12,517) 309 5,820 6,129 (10,783) 85 (9) 621 – 9,048 (2,855) 586 (2,269) – (599) (8,875) (9,474) (2,695) 8,515 5,820 $ $ (10,020) 132 – 138 – 7,313 (1,038) 26 (1,012) – (2,869) (8,338) (11,207) (4,906) 13,421 8,515 $ The Company operates two business segments: community traditional banking products and services through various delivery banking and mortgage banking. These segments are primarily channels. The mortgage banking segment consists of mortgage identified by the products or services offered and the channels brokerage facilities that originate, acquire, and sell mortgage through which they are offered. The community banking segment products. The accounting policiesfor each ofthe businesssegments consists of the Company’s full-service bank which offers customers are the same as those of the Company described in Note 1. Information for each of the segments is included below: 71 December 31, 2002 Community Banking Mortgage Banking Parent Eliminations Total (Amounts in Thousands) Net interest income Provision for loan losses Net interest income after provision for loan losses Other income Other expenses Income (loss) before income taxes Income tax expense (benefit) Net income Average assets $ 59,998 4,208 55,790 10,075 31,786 34,079 10,051 24,028 $ $ 1,467,969 $ $ $ $ 915 $ – 915 9,435 9,552 798 309 489 $ 61,196 4,208 56,988 20,049 42,269 34,768 10,049 24,719 62,457 $ 143,356 $ (201,538) $ 1,472,244 268 $ – 268 382 759 (109) (311) 202 $ 15 – 15 157 172 – – – $ December 31, 2001 Community Banking Mortgage Banking Parent Eliminations Total Net interest income Provision for loan losses Net interest income after provision for loan losses Other income Other expenses Income (loss) before income taxes Income tax expense (benefit) Net income Average assets $ 49,379 5,134 44,245 10,839 29,285 25,799 7,805 $ 17,994 $ 1,365,164 Community Banking Net interest income Provision for loan losses Net interest income after provision for loan losses Other income Other expenses Income (loss) before income taxes Income tax expense (benefit) Net income Average assets $ 45,969 3,986 41,983 7,911 25,560 24,334 7,122 $ 17,212 $ 1,124,304 (Amounts in Thousands) 462 $ – 462 9,582 8,086 1,958 669 1,289 $ 45,271 $ 315 $ – 315 16 552 (221) (72) (149) $ 264 – 264 (162) 102 – – – 128,732 $ (252,853) $ 50,420 5,134 45,286 20,275 38,025 27,536 8,402 $ 19,134 $ 1,286,314 December 31, 2000 Mortgage Banking Parent Eliminations Total (Amounts in Thousands) 65 $ – 65 4,651 4,994 (278) (86) (192) $ 7,024 $ 339 $ – 339 – 278 61 18 43 $ 108,133 $ 206 – 206 (70) 136 – – – (111,782) $ 46,579 3,986 42,593 12,492 30,968 24,117 7,054 $ 17,063 $ 1,127,679 $ $ $ $ $ $ 72 Note 18. Supplemental Financial Data (Unaudited) Quarterly earnings for the years ended December 31, 2002 and 2001 are as follows: Interest income Interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses Other income Securities gains (losses) Other expenses Income before income taxes Income taxes Net income FAS 147 goodwill amortization Net income as previously reported Per share: Basic earnings Diluted Earnings per share as previously reported Dividends Weighted-average basic shares outstanding Weighted-average diluted shares outstanding First Community Bancshares, Inc. Quarterly Earnings Summary 2002 March 31 June 30 Sept. 30 Dec. 31 (Amounts in Thousands, Except Per Share Data) $ $ $ $ $ $ 24,043 $ 9,570 14,473 937 13,536 5,677 177 10,609 8,781 2,464 6,317 139 6,178 $ 0.64 $ 0.64 $ 0.62 $ 0.25 $ 9,933 9,978 24,179 $ 9,007 15,172 1,022 14,150 4,955 9 10,446 8,668 2,630 6,038 142 5,896 $ 0.61 $ 0.61 $ 0.59 $ 0.25 $ 9,945 9,994 $ $ $ $ $ $ 24,451 8,440 16,011 1,302 14,709 4,975 22 10,251 9,455 2,869 6,586 143 6,443 0.66 0.66 0.65 0.25 9,928 9,978 23,531 7,991 15,540 947 14,593 4,833 (599) 10,963 7,864 2,086 5,778 * * 0.58 0.57 * 0.25 9,893 9,945 73 Interest income Interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses Other income Securities gains (losses) Other expenses Income before income taxes Income taxes Net income as reported FAS 142 & 147 goodwill amortization Adjusted net income Per share: $ $ Basic earnings and diluted $ Basic & diluted earnings per share adjusted for FAS 142 & 147 $ $ Dividends Weighted-average basic shares outstanding Weighted-average diluted shares outstanding First Community Bancshares, Inc. Quarterly Earnings Summary 2001 March 31 June 30 Sept. 30 Dec. 31 (Amounts in Thousands, Except Per Share Data) 22,901 $ 10,986 11,915 747 11,168 4,167 51 8,953 6,433 1,977 4,456 458 4,914 $ 0.45 $ 0.49 $ 0.21 $ 9,945 9,952 23,135 $ 10,882 12,253 985 11,268 5,010 (7) 9,628 6,643 2,034 4,609 464 5,073 $ 0.46 $ 0.51 $ 0.21 $ 9,948 9,967 $ $ $ $ $ 23,390 10,580 12,810 1,282 11,528 5,333 153 9,703 7,311 2,311 5,000 468 5,468 0.50 0.55 0.21 9,944 10,003 23,403 9,961 13,442 2,120 11,322 5,584 (16) 9,741 7,149 2,080 5,069 485 5,554 0.51 0.56 0.26 9,940 9,992 * Goodwill amortization on branch acquisitions ceased October 1, 2002 in accordance with FAS 147. Goodwill amortization on all other purchase business combinations ceased on January 1, 2002. Report of Independent Auditors }} To the Board of Directors of First Community Bancshares, Inc. 74 We have audited the accompanying consolidated balance sheetsofFirstCommunityBancshares, Inc. and subsidiaryasofDecember 31, 2002 and 2001, and the related consolidated statements of income, cash flows and changes in stockholders’ equity for each of the three years in the period ended December 31, 2002. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the auditto obtain reasonable assurance aboutwhether the consolidated financialstatementsare free ofmaterialmisstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of First Community Bancshares, Inc. and subsidiary at December 31, 2002 and 2001, and the consolidated results of their operations and cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States. As discussed in Note 1 to the consolidated financial statements, in 2002 the Company changed its method of accounting for goodwill as required by Financial Accounting Standards Board Statement No. 142, Goodwill and Other Intangible Assets, and Statement No. 147, Acquisitions of Certain Financial Institutions. Charleston, West Virginia January 27, 2003 Report of Management’s Responsibilities The management of First Community Bancshares, Inc. is responsible for the integrity of its financial statements and their preparation in 75 accordance with accounting principlesgenerallyaccepted in the United States. To fulfillthisresponsibilityrequiresthe maintenance ofa sound accounting system supported by strong internal controls. The Company believes it has a high level of internal control which is maintained by the recruitment and training of qualified personnel, appropriate divisions of responsibility, the development and communication of accounting and other procedures, and comprehensive internal audits. Our independent auditors, Ernst & Young LLP, are engaged to audit, and render an opinion on, the fairness of our consolidated financial statements in conformity with accounting principles generally accepted in the United States. Our independent auditors obtain an understanding of our internal accounting control systems, review selected transactions and carry out other auditing procedures before expressing their opinion on our consolidated financial statements. The Board of Directors has appointed an Audit Committee, composed of outside directors, that periodically meets with the independent auditors, bank examiners, management and internal auditors to review the work of each. The independent auditors, bank examiners and the Company’s internal auditors have free access to meet with the Audit Committee without management’s presence. John M. Mendez, President & Chief Executive Officer Kenneth P. Mulkey, Controller Robert L. Schumacher, Chief Financial Officer }} Board of Directors First Community Bancshares, Inc. }} Officers First Community Bancshares, Inc. 76 Sam Clark (Emeritus) Agent, State Farm Insurance Owner, Country Junction Company, Inc. John M. Mendez President and Chief Executive Officer Robert L. Schumacher Chief Financial Officer Robert L. Buzzo Vice President and Secretary E. Stephen Lilly Chief Operating Officer Kenneth P. Mulkey Controller Allen T. Hamner Professor of Chemistry, West Virginia Wesleyan College; Member Executive Committee and Chairman, Audit Committee B. W. Harvey President, Highlands Real Estate Management, Inc.; Member Executive Committee and Audit Committee I. Norris Kantor Partner, Katz, Kantor & Perkins, Attorneys-at-Law John M. Mendez President and Chief Executive Officer, First Community Bancshares, Inc.; Executive Vice President, First Community Bank, N. A.; Member Executive Committee A. A. Modena Past Executive Vice President and Secretary, First Community Bancshares, Inc.; Past President & Chief Executive Officer, The Flat Top National Bank of Bluefield; Member Executive Committee Robert E. Perkinson, Jr. Past Vice President – Operations, MAPCO Coal, Inc. – Virginia Region; Vice Chairman, Audit Committee William P. Stafford President, Princeton Machinery Service, Inc.; Chairman, First Community Bancshares, Inc.; Member Executive Committee and Audit Committee William P. Stafford, II Attorney-at-Law, Brewster, Morhous, Cameron, Mullins, Caruth, Moore, Kersey & Stafford, PLLC; Member Executive Committee W. W. Tinder, Jr. Chairman of the Board and Chief Executive Officer, Tinder Enterprises, Inc.; CEO, Tinco Leasing Corporation (Real Estate Holdings); Member Executive Committee 77 A. A. Modena Past Executive Vice President and Secretary, First Community Bancshares, Inc.; Past President and Chief Executive Officer, The Flat Top National Bank of Bluefield Robert E. Perkinson, Jr. Past Vice President – Operations, MAPCO Coal, Inc. – Virginia Region Clyde B. Ratliff President, Gasco Drilling, Inc. Richard G. Rundle Attorney-at-Law, Rundle and Rundle, LC William P. Stafford President, Princeton Machinery Service, Inc. William P. Stafford, II Attorney at Law, Brewster, Morhous, Cameron, Mullins, Caruth, Moore, Kersey & Stafford, PLLC W. W. Tinder, Jr. Chairman and Chief Executive Officer, Tinder Enterprises, Inc. Dale F. Woody President, Woody Lumber Company }} Board of Directors First Community Bank, N. A. K. A. Ammar, Jr. President and Chief Executive Officer, Ammar's Inc. and Magic Mart Dr. James P. Bailey Veterinarian, Veterinary Associates, Inc. Chairman Emeritus, First Community Bank, N. A. W. C. Blankenship, Jr. Agent, State Farm Insurance D. L. Bowling, Jr. President, True Energy, Inc. Juanita G. Bryan Homemaker Robert L. Buzzo Vice President and Secretary, First Community Bancshares, Inc. President, First Community Bank, N. A. Sam Clark Agent, State Farm Insurance Owner, Country Junction Company, Inc. C. William Davis Attorney-at-Law, Richardson & Davis Allen T. Hamner, Ph.D. Professor of Chemistry, West Virginia Wesleyan College B. W. Harvey President, Highlands Real Estate Management, Inc.; Chairman, First Community Bank, N. A. I. Norris Kantor Partner, Katz, Kantor & Perkins, Attorneys-at-Law John M. Mendez President and Chief Executive Officer, First Community Bancshares, Inc.; Executive Vice President, First Community Bank, N. A. 78 Locations & Other Information First Community Bank, N. A. }} 1001 Mercer Street Princeton, West Virginia 24740-5939 (304) 487-9000 or (304) 327-5175 Pine Plaza Branch (304) 431-2225 211 Federal Street Bluefield, West Virginia 24701-0950 (304) 325-7151 Mercer Mall Branch (304) 327-0431 Blue Prince Road, Green Valley Bluefield, West Virginia 24701-6160 (304) 325-3641 Highway 52 Bluefield, West Virginia 24701-3068 (304) 589-3301 101 Vermillion Street Athens, West Virginia 24712 (304) 384-9010 Corner of Bank & Cedar Streets Pineville, West Virginia 24874-0249 (304) 732-7011 East Pineville Branch (304) 732-7011 Mullens Shopping Plaza Route 54 Mullens, West Virginia 25882 (304) 294-0700 Route 10, Cook Parkway Oceana, West Virginia 24870-1680 (304) 682-8244 2 West Main Street Buckhannon, West Virginia 26201-0280 (304) 472-1112 100 Market Street Man, West Virginia 25635 (304) 583-6525 Corner of Main & Latrobe Streets Grafton, West Virginia 26354-0278 (304) 265-1111 216 Lincoln Street Grafton, West Virginia 26354-1442 (304) 265-5111 Main Street Rowlesburg, West Virginia 26425 (304) 454-2431 16 West Main Street Richwood, West Virginia 26261 (304) 846-2641 Railroad and White Avenue Richwood, West Virginia 26261 (304) 846-2641 874 Broad Street Summersville, West Virginia 26651 (304) 872-4402 Route 20 & Williams River Road Cowen, West Virginia 26206 (304) 226-5924 Route 55, Red Oak Plaza Craigsville, West Virginia 26205 (304) 742-5101 111 Citizens Drive Beckley, West Virginia 25801-2970 (304) 252-9400 50 Brookshire Lane Beckley, West Virginia 25801-6765 (304) 254-9041 119 Main Street Greenville, West Virginia 24945 (304) 832-6265 298 Stokes Drive Hinton, West Virginia 25951 (304) 466-5502 U. S. 219 North Lindside, West Virginia 24951 (304) 753-4311 101 Sanders Lane Bluefield, Virginia 24605 (276) 322-5487 643 E. Riverside Drive Tazewell, Virginia 24651 (276) 988-5577 302 Washington Square Richlands, Virginia 24641 (276) 964-7454 Chase Street & Alley 7 Clintwood, Virginia 24228 (276) 926-4671 747 Fort Chiswell Road Max Meadows, Virginia 24360 (276) 637-3122 8044 Main Street Pound, Virginia 24279 (276) 796-5431 910 East Main Street Wytheville, Virginia 24382 (276) 228-1901 431 South Main Street Emporia, Virginia 23847-2313 (434) 634-8866 4677 Main Street Drakes Branch, Virginia 23937 (434) 568-3301 125 West Atlantic Street Emporia, Virginia 23847 (434) 634-6555 511 Main Street Clifton Forge, Virginia 24422 (540) 862-4251 101 Brookfall Dairy Road Elkin, North Carolina 28621 (336) 835-2265 5519 Mountain View Road Hays, North Carolina 28635 (336) 696-2265 57 N. Main Street Sparta, North Carolina 28675 (336) 372-2265 150 N. Center Street Taylorsville, North Carolina 28681 (828) 632-2265 Subsidiaries of First Community Bank, N. A. }} Financial Information }} United First Mortgage, Inc. (A wholly owned subsidiary of First Community Bank, N. A.) 1503 Santa Rosa Road, Suite 109 P. O. Box K-177 Richmond, Virginia 23288 (804) 282-5631 Corporate Headquarters One Community Place P.O. Box 989 Bluefield, Virginia 24605-0989 (276) 326-9000 (276) 326-9010 Fax Stone Capital Management, Inc. (A wholly owned subsidiary of First Community Bank, N. A.) 207 Brookshire Lane Beckley, West Virginia 25801 (304) 256-3982 Stock Registrar and Transfer Agent Registrar and Transfer Company 10 Commerce Drive Cranford, New Jersey 07016-3572 (800) 368-5948 79 Form 10-K The Annual Report on Form 10-K, filed with the Securities and Exchange Commission, is available to shareholders upon request to the Chief Financial Officer of First Community Bancshares, Inc. or through the Company’s website listed below. Financial Contact Robert L. Schumacher Chief Financial Officer First Community Bancshares, Inc. P. O. Box 989 Bluefield, Virginia 24605-0989 Phone: (276) 326-9000 Internet Access Website: www.fcbinc.com E-mail: ir@fcbinc.com Website: www.fcbresource.com E-mail: marketing@fcbinc.com Notes 80 First Community Bancshares, Inc. One Community Place Bluefield, VA 24605 276-326-9000 www.fcbinc.com 

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