NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(1) Basis of Presentation
Financial Institutions, Inc. (“FII”), a bank holding company organized under
the laws of New York State, and subsidiaries (the “Company”) provides deposit,
lending and other financial services to individuals and businesses in Central
and Western New York State. FII and subsidiaries are each subject to
regulation by certain federal and state agencies.
The consolidated financial statements include the accounts of FII and its four
banking subsidiaries, Wyoming County Bank (99.65% owned) (“WCB”), National Bank
of Geneva (100% owned) (“NBG”), First Tier Bank & Trust (100% owned) (“FTB”)
and Bath National Bank (100% owned) (“BNB”), collectively referred to as the
“Banks”. During 2003, the Company disclosed that the Boards of Directors of
its two national bank subsidiaries, NBG and BNB, entered into agreements with
their primary regulator, the Office of the Comptroller of the Currency (“OCC”).
Under the terms of the agreements, NBG and BNB, without admitting any
violations, have taken actions designed to assure that their operations are in
accordance with applicable laws and regulations. On July 23, 2004, the OCC
sent “15-day letters” to certain current and former directors and officers of
NBG, notifying them that the OCC is considering an administrative action
against them, such as reprimand or civil money penalty, arising out of
violations of law identified in the September 30, 2002 Report of Examination,
and providing them an opportunity to submit information prior to the
commencement of any administrative action. Four NBG directors and one officer
who received such letters submitted a response on September 9, 2004. NBG’s
By-Laws provide that, to the fullest extent permitted by law, it shall
indemnify directors and officers made a party to an administrative proceeding,
provided that the acts of the indemnified party that are the subject of the
proceeding were not committed in bad faith, were not the result of dishonesty,
and did not result in personal gain. Federal law prohibits indemnifying
directors for fines and civil money penalties, but indemnification is permitted
under certain circumstances for legal and professional expenses. The five
individuals who participated in the joint response to the “15-day letters” that
was submitted on September 9, 2004 have transmitted their legal bills to NBG
for payment.
The Company also has two financial services subsidiaries: The FI Group, Inc.
(“FIGI”) and the Burke Group, Inc. (“BGI”), collectively referred to as the
“Financial Services Group” (“FSG”). FIGI is a brokerage subsidiary that
commenced operations as a start-up company in March 2000. BGI is an employee
benefits and compensation consulting firm acquired by the Company in October
2001. During 2003, the Company terminated its financial holding company status
to operate instead as a bank holding company. The change in status did not
affect the non-financial subsidiaries or activities being conducted by the
Company, although future acquisitions or expansions of non-financial activities
may require prior Federal Reserve Board approval and will be limited to those
that are permissible for bank holding companies.
In February 2001, the Company formed FISI Statutory Trust I (“FISI” or “Trust”)
(100% owned) and capitalized the trust with a $502,000 investment in FISI’s
common securities. The Trust was formed to accommodate the private placement
of $16.2 million in capital securities (“trust preferred securities”), the
proceeds of which were utilized to partially fund the acquisition of BNB.
Effective December 31, 2003, the provisions of FASB Interpretation No. 46
(Revised), “Consolidation of Variable Interest Entities,” resulted in the
deconsolidation of the Company’s wholly-owned Trust. The deconsolidation
resulted in the derecognition of the $16.2 million in trust preferred
securities and the recognition of $16.7 million in junior subordinated
debentures and a $502,000 investment in the subsidiary trust recorded in other
assets in the Company’s consolidated statements of financial condition.
In management’s opinion, the interim consolidated financial statements reflect
all adjustments necessary for a fair presentation. The results of operations
for the interim periods are not necessarily indicative of the results of
operation to be expected for the full year ended December 31, 2004. The
interim consolidated financial statement should be read in conjunction with the
Company’s 2003 Annual report on Form 10K. The consolidated financial
information included herein consolidates the results of operations,
the assets, liabilities and shareholders’ equity of the Company and its
subsidiaries. All significant inter-company transactions and balances have
been eliminated in consolidation. Amounts in the prior year’s consolidated
financial statements are reclassified when necessary to conform to the current
year’s presentation.
The consolidated financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of America and
prevailing practices in the banking industry. In preparing the financial
statements, management is required to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities, and the reported revenues and expenses for
the period. Actual results could differ from those estimates.
(2) Stock Compensation Plans
The Company uses a fixed award stock option plan to compensate certain key
members of management of the Company and its subsidiaries. The Company
accounts for issuance of stock options under the intrinsic value-based method
of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25,
“Accounting for Stock Issued to Employees.” Under APB No. 25, compensation
expense is recorded on the date the options are granted only if the current
market price of the underlying stock exceeded the exercise price. SFAS No.
123, “Accounting for Stock-Based Compensation,” established accounting and
disclosure requirements using a fair value-based method of accounting for
stock-based employee compensation plans. As allowed under SFAS No. 123, the
Company has elected to continue to apply the intrinsic value-based method of
accounting described above and has adopted only the disclosure requirements of
SFAS No. 123, as amended by SFAS No. 148, “Accounting for Stock — Based
Compensation – Transition and Disclosure.”
Had the Company recognized compensation cost based on the fair value method
under SFAS No. 123, the Company’s net income and earnings per share would have
been as follows:
Three Months Ended
Nine Months Ended
September 30,
September 30,
(Dollars in thousands, except per share amounts)
2004
2003
2004
2003
Reported net income
$
5,117
$
4,055
$
13,324
$
12,001
Less: Total stock-based compensation expense
determined under fair value based method for
all awards, net of related tax effects
96
112
350
223
Pro forma net income
5,021
3,943
12,974
11,778
Less: Preferred stock dividends
374
374
1,122
1,122
Pro forma net income available to common shareholders
Basic earnings per share, after giving effect to preferred stock dividends, has
been computed using weighted average common shares outstanding. Diluted
earnings per share reflect the effects, if any, of incremental common shares
issuable upon exercise of dilutive stock options.
Earnings per common share have been computed based on the following:
Three Months Ended
Nine Months Ended
September 30,
September 30,
(Dollars and shares in thousands)
2004
2003
2004
2003
Net income
$
5,117
$
4,055
$
13,324
$
12,001
Less: Preferred stock dividends
374
374
1,122
1,122
Net income available to common shareholders
$
4,743
$
3,681
$
12,202
$
10,879
Weighted average number of common shares outstanding
used to calculate basic earnings per common share
11,197
11,159
11,184
11,142
Add: Effect of dilutive options
56
107
64
103
Weighted average number of common shares
used to calculate diluted earnings per common share
11,253
11,266
11,248
11,245
Earnings per common share:
Basic
$
0.42
$
0.33
$
1.09
$
0.98
Diluted
$
0.42
$
0.33
$
1.08
$
0.97
There were stock options totaling 222,427 and 52,057 for the three months ended
September 30, 2004 and 2003, respectively that were not considered in the
calculation of diluted earnings per share since the stock options’ exercise
price was greater than the average market price during these periods. There
were stock options totaling 139,785 and 82,974 for the nine months ended
September 30, 2004 and 2003, respectively that were not considered in the
calculation of diluted earnings per share since the stock options’ exercise
price was greater than the average market price during these periods.
The Company participates in The New York State Bankers Retirement System, which
is a defined benefit pension plan covering substantially all employees. The
benefits are based on years of service and the employee’s highest average
compensation during five consecutive years of employment. The Company’s funding
policy is to contribute at least the minimum funding requirement as determined
actuarially to cover current service cost plus amortization of prior service
costs.
Net periodic pension cost consists of the following components:
Three Months Ended
Nine Months Ended
September 30,
September 30,
(Dollars and shares in thousands)
2004
2003
2004
2003
Service cost
$
343
$
338
$
1,030
$
1,014
Interest cost on projected benefit obligation
296
270
889
809
Expected return on plan assets
(359
)
(313
)
(1,077
)
(938
)
Amortization of net transition asset
(9
)
(9
)
(28
)
(28
)
Amortization of unrecognized loss
55
50
164
151
Amortization of unrecognized service cost
4
5
13
16
Net periodic pension cost
$
330
$
341
$
991
$
1,024
The Company contributed $1,406,000 to the pension plan on August 31, 2004.
The Company’s BNB subsidiary has a postretirement benefit plan that provides
health and dental benefits to eligible retirees. The plan was amended in 2001
to curtail eligible benefit payments to only retired employees and active
participants who were fully vested under the plan. Expense for the plan
amounted to $54,000 and $142,000 for the nine months ended September 30, 2004
and 2003, respectively.
(6) Commitments and Contingencies
In the normal course of business, the Company has outstanding commitments to
extend credit not reflected in the Company’s consolidated financial statements.
The commitments generally have fixed expiration dates or other termination
clauses and may require payment of a fee. The Company uses the same credit
policy to make such commitments as it uses for on-balance-sheet items. Unused
lines of credit and loan commitments totaling $253.4 million and $271.9 million
were contractually available at September 30, 2004 and December 31, 2003,
respectively. Since commitments to extend credit and unused lines of credit
may expire without being fully drawn upon, the amount does not necessarily
represent future cash commitments.
The Company guarantees the obligations or performance of customers by issuing
stand-by letters of credit to third parties. The risk involved in issuing
stand-by letters of credit is essentially the same as the credit risk involved
in extending loan facilities to customers, and they are subject to the same
credit origination, portfolio maintenance and management procedures in effect
to monitor other credit and off-balance sheet products. Typically, these
instruments have terms of five years or less and expire unused; therefore, the
amount does not necessarily represent future cash requirements. Standby
letters of credit totaled $11.1 million and $11.8 million at September 30, 2004
and December 31, 2003, respectively. As of September 30, 2004, the fair value
of the standby letters of credit was not material to the Company’s consolidated
financial statements.
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