Suffolk Bancorp 10-K 2006
Documents found in this filing:
The annual report of Suffolk Bancorp on Form 10-K for the year ended December 31, 2005 filed on March 10, 2006 inadvertently omitted certain items from the certifications attached thereto. This filing corrects those omissions, but is otherwise identical in content to the original filing.
May 4, 2006
Suffolk Bancorp does commercial banking through its wholly owned subsidiary, Suffolk County National Bank. Organized in 1890, SCNB is a full-service, nationally chartered commercial bank. Most of SCNBs revenue comes from net interest income, and the remainder from charges for a variety of services. SCNB has built a good reputation for personal, attentive service, resulting in a loyal and growing clientele. SCNB operates 27 full-service offices throughout Suffolk County, New York.
The staff at SCNB works hard to develop and maintain ties to the communities it serves. SCNBs business includes loans to small and medium-sized commercial enterprises, to professionals, and to individual consumers. In recent years commercial loans of all types have increased as a percentage of the loan portfolio and have made substantial contributions to SCNBs profitability. SCNBs primary market is Long Island, New York. Long Island is home to approximately 2.8 million people outside of the limits of New York City and is primarily suburban in nature. Nassau County and the western end of Suffolk County are a center for commerce and are highly developed, supporting a diversified economy. The economy on eastern Long Island is based on services that support tourism, a large number of second homes, and agriculture. Together, they generate family incomes greater than the national average, providing Suffolk Bancorp with a steady and growing demand for loans and other services, and a reliable, reasonably priced supply of deposits.
Suffolk Bancorp and its wholly owned subsidiary, Suffolk County National Bank, rose to a variety of challenges during 2005. The results were these:
Net income was $22,102,000, up 5.9 percent from $20,875,000 last year. Earnings-per-share were $2.09, up 8.9 percent compared to $1.92 during 2004. Net interest income increased by 6.2 percent, to $64,361,000 from $60,605,000. Income other than from interest declined by 17.3 percent, to $10,166,000. Expense other than for interest increased by 2.3 percent, to $37,474,000 from $36,621,000. Our efficiency ratio was essentially unchanged from year to year at 50.28 percent compared to 50.24 percent, considerably better than in the banking industry as a whole. Return on average assets increased to 1.59 percent from 1.53 percent. Overall we achieved return on average equity of 22.18 percent, up from 20.85 percent last year, substantially in excess of recent averages for our industry.
We did this in a year during which the Federal Reserve Board increased the key fed funds rate eight times, and during which the spread between that rate and the ten-year Treasury narrowed to a scant ten basis points. At the end of the year, the yield curve was actually inverted, with short-term rates exceeding those for intermediate terms. This created incentives for borrowers to extend maturities wherever possible without providing lenders with a premium for the risk inherent in longer terms. This may have been, in part, the result of overcapacity in the banking industry which encouraged many institutions to reach for rates on deposits, and to price loans at levels that were insufficient to account for the risks of both credit and variations in rates of interest.
In this complex environment, our core banking business continued to grow, with earnings-per-share and net income increasing from year to year even without the benefit of securities gains of $1,994,000 in 2004. Along with long-term managerial discipline and prudence, one of the most important characteristics of a successful banking company is flexibility. Key is our ability to discern changes in the economy generally and in our own marketplace, and to develop measured, orderly responses. Our first concern is to protect operating margins, and the second, to take advantage of changed opportunities to bolster profits and thus shareholder value. While the principles underlying Suffolks strategic direction and operations remain constant, a review of both balance sheet and income statement reveals significant evolution in our business.
Most important has been the continued redistribution of the loan portfolio out of indirect retail paper. Just three years ago this comprised fully one third of the portfolio, and now it is just 14.7 percent, a level closer to what we believe will be sustainable in light of the structural changes in automobile finance. The loan portfolio grew 9.6 percent from year to year, particularly in commercial real estate, even while overcoming an 18.0 percent decline in indirect paper during that same period. Another example of our adaptability has been in the composition of our investment portfolio, where we have redeployed cash flow from maturing collateralized mortgage obligations, originally purchased to provide downside protection while rates fell to their recent, historic lows, to purchase municipal securities that provide superior returns in the current environment.
We have adapted to the current and somewhat peculiar interest rate environment by further sharpening our focus on demand deposits, primarily in lending
relationships, and on those time deposits that are less sensitive to price. The result has been a 10.0 percent increase in demand deposits, a 13.3 percent decline in non-maturity deposits, and a decline in total deposits of 3.2 percent from year to year. We have replaced these funds with borrowings in the capital markets, and expect to continue to do so until the yield curve assumes a more normal, upward slope and the cost of new deposits is more favorable. The result of this repositioning has been a net interest margin of 5.09 percent for the year, up from 4.90 percent a year ago. This compares to 4.05 and 3.97 percent, respectively for the industry as a whole.
Absent the effect of securities gains taken last year as we repositioned the investment portfolio, non-interest income declined by 1.3 percent for the year. This was a reflection of sharp competition among banks offering free services during 2005. Non-interest expense increased modestly, by only 2.3 percent year to year. The exception was for occupancy as we outgrew certain locations and moved to larger quarters. Facilities in other locations were upgraded to attract and retain customers, and we opened a new office in Deer Park, New York.
Finally, we continue to manage the capital account to adjust it to the size of the business at hand and thus maximize leverage for our shareholders benefit, having repurchased just over 4 percent of the shares outstanding one year ago. This permits us to provide a return to those shareholders who wish to exit their position in Suffolk Bancorp stock while concentrating earnings-per-share among our continuing shareholders and allowing them to time their gains as best benefits their individual tax positions. We balance this with a cash dividend that runs between 35 and 40 percent of net income for shareholders who prefer current income.
Our first obligation to our shareholders is to remain alert to both the challenges and opportunities of our markets as they develop, and to craft strategies and tactics to make the most of them. There are a number of countervailing pressures in our marketplace and in the economy. One obvious example lies in the demographics of our primary market on Long Island. By almost any measure, they are enviable, whether one measures median family incomes, median net worth, business activity, or education. This provides us with rich opportunity, but also attracts the attention of competitors from outside the region, making our market not only attractive, but fiercely competitive, where superior service is our essential edge.
My colleagues and I are committed to finding the best mix of responses to maximize our returns to our shareholders over the long haul. We believe that the key is controlled, orderly growth that finds balance among a wide variety of factors. We believe that we have accomplished that during 2005, and we plan to continue to do so in 2006. This year, as always, we are grateful for your steady support and confidence in our enterprise.
PRICE RANGE OF COMMON STOCK AND DIVIDENDS
Suffolks common stock is traded in the over-the-counter market, and is quoted on the NASDAQ National Market System under the symbol SUBK. Following are quarterly high and low prices of Suffolks common stock as reported by NASDAQ.
At January 31, 2006, there were approximately 1,639 equity holders of record and approximately 2,400 beneficial shareholders of the Companys common stock.
FIVE-YEAR SUMMARY: (dollars in thousands except per-share amounts)
AND RESULTS OF OPERATIONS
The discussion that follows analyzes Suffolk Bancorps (Suffolk) operations for each of the past three years and its financial condition as of December 31, 2005 and 2004, respectively. Selected tabular data are presented for each of the past five years.
Summary of Recent Developments and Current Trends
Suffolk Bancorp is a one-bank holding company engaged in the commercial banking business through Suffolk County National Bank, a full-service commercial bank headquartered in Riverhead, New York. SCNB is Suffolk Bancorps wholly owned subsidiary. Organized in 1890, Suffolk County National Bank is headquartered on Long Island, with 27 offices in Suffolk County, New York.
Interest rates rose gradually during the year, in part as a result of increases to the federal funds and discount targets set by the Federal Reserve Board. At times, both short- and long-term rates rose in parallel, but during the course of the year, short-term rates rose more than long-term rates. At the end of the year, the short end of the yield curve had inverted, meaning that rates for certain shorter terms exceeded those for certain other intermediate terms. Suffolks net interest margin increased to 5.09 percent from 4.90 percent, year to year.
Return on average equity increased, to 22.18 percent for the year from 20.85 percent during 2004, and basic earnings-per-share increased to $2.09, from $1.92 during the prior year.
Key to maintaining performance was close management of the balance sheet. Steps included:
Nearly all of Suffolks business is to provide banking services to its commercial and retail customers in Suffolk County, on Long Island, New York. Suffolk is a one-bank holding company. Its banking subsidiary, Suffolk County National Bank (the Bank), operates 27 full-service offices in Suffolk County, New York. It offers a full line of domestic, retail, and commercial banking services, and trust services. The Banks primary lending area includes all of Suffolk County, New York, and a limited number of loans or loan-participations in the adjacent markets of Nassau County and New York City. The Bank makes loans that are secured by commercial real estate and float with the prime rate, which are retained in the Banks portfolio: commercial and industrial loans to small manufacturers, wholesalers, builders, farmers, and retailers, including dealer financing. The Bank serves as an indirect lender to the customers of a number of automobile dealers. The Bank also makes loans secured by residential mortgages, and both fixed and floating rate second mortgage loans with a variety of plans for repayment. Real estate construction loans are also offered.
Other investments are made in short-term United States Treasury debt, high-quality obligations of municipalities in New York State, issues of agencies of the United States government, collateralized mortgage obligations, mortgage-backed securities, and stock in the Federal Reserve Bank and the Federal Home Loan Bank of New York, each required as a condition of membership.
The Bank finances most of its activities with deposits, including demand, saving, N.O.W., and money market accounts, as well as term certificates. It also relies on other short-term sources of funds, including inter-bank overnight loans, and sale-repurchase agreements.
General Economic Conditions
Long Island has a population of approximately 2.8 million people, which accounts for 15 percent of the population of New York State. Long Island has a total population greater than that of 19 states, and in fact, if it were a city, it would rank as the fourth largest in the nation. Health is the largest industry cluster; government and military is the largest segment of the regional economy; and the finance and insurance cluster has the greatest economic impact. Long Island added about 13,546 jobs, growing from 1.24 million in 2004 to 1.26 million in 2005; this is an increase of 1.2 percent. Of these 13,545 new jobs, net, 13,568 were added in private industry and 23 jobs were lost in the government and military sectors. Long Islands total employment increased by about 13.2 percent, or 152,850 jobs, from 1995 to 2005. Private industry employment increased by more than 10 percent and government and military employment increased 7 percent. (Source: Long Island Index 2006)
The economy on Long Island continued to prosper during 2005. Interest rates continued to rise from their low point during 2004. Demand for finance, information, transportation, and tourism continued, and employment remained stable in the region. Long Island has a highly educated and skilled work force and a diverse industrial base. It is adjacent to New York City, one of the worlds largest centers of distribution and a magnet for finance and culture. The islands economic cycles vary from those of the national economy. In general, Long Islands economy seems to have been more stable than the national economy, owing in part to its comparative diversity.
Net income was $22,102,000 compared to $20,875,000 last year and $21,336,000 in 2003. These figures represent an increase of 5.9 percent and a decrease of 2.2 percent, respectively. Basic earnings-per-share were $2.09 during 2005, compared to $1.92 last year and $1.92 in 2003.
Net Interest Income
Net interest income during 2005 was $64,361,000, up 6.2 percent from $60,605,000 in 2004, which was down 1.0 percent from $61,194,000 in 2003. Net interest income is the most important part of the net income of Suffolk. The effective interest rate differential, on a taxable-equivalent basis, was 5.09 percent in 2005, 4.90 percent during 2004, and 5.13 percent in 2003. Average rates on average interest-earning assets increased to 5.97 percent in 2005, up from 5.50 percent in 2004, and 5.95 percent in 2003. Average rates on average interest-bearing liabilities increased to 1.34 percent in 2005, up from 0.89 percent in 2004, which was down from 1.19 percent in 2003. The interest rate differential increased in 2005, up from 2004 and 2003. Demand deposits remained a significant source of funds as a percentage of total liabilities.
(on a taxable-equivalent basis)
The following table illustrates the average composition of Suffolks statements of condition. It presents an analysis of net interest income on a taxable-equivalent basis, listing each major category of interest-earning assets and interest-bearing liabilities, as well as other assets and liabilities: (dollars in thousands)
Interest income on a taxable-equivalent basis includes the additional amount of interest income that would have been earned if Suffolks investment in nontaxable U.S. Treasury securities and state and municipal obligations had been subject to New York State and federal income taxes yielding the same after-tax income. The rate used for this adjustment was approximately 34 percent for federal income taxes and 9 percent for New York State income taxes for all periods. For each of the years 2005, 2004, and 2003, $1.00 of nontaxable income from obligations of states and political subdivisions equates to fully taxable income of $1.52. In addition, in 2005, 2004, and 2003, $1.00 of nontaxable income on U.S. Treasury securities equates to $1.02 of fully taxable income. The amortization of loan fees is included in interest income.
Analysis of Changes in Net Interest Income
The table below presents a summary of changes in interest income, interest expense, and the resulting net interest income on a taxable-equivalent basis for the periods presented, each as compared with the preceding period. Because of numerous, simultaneous changes in volume and rate during the period, it is not possible to allocate precisely the changes between volumes and rates. In this table changes not due solely to volume or to rate have been allocated to these categories based on percentage changes in average volume and average rate as they compare to each other: (in thousands)
Interest income increased to $75,673,000 in 2005, up 11.3 percent from $67,984,000 in 2004, which was down 4.2 percent from $70,995,000 in 2003.
Average investment in U.S. government agency securities increased to $125,443,000 from $107,601,000 in 2004, which was up from $85,743,000 in 2003. Average balances of CMOs decreased to $230,248,000 in 2005 from $251,934,000 in 2004, and $244,547,000 in 2003. Average investments in municipal securities increased to $57,587,000 in 2005, up from $26,022,000 in 2004 and $14,397,000 in 2003. U.S. Treasury, U.S. government agency, collateralized mortgage obligations, and municipal securities provide collateral for various liabilities to municipal depositors. Securities are Suffolks primary source of liquidity. With regard to securities characterized as available for sale, in general, Suffolk has the intent and ability to hold them until maturity. The following table summarizes Suffolks investment securities available for sale and held to maturity as of the dates indicated: (in thousands)
The amortized cost, maturities, and approximate weighted average yields, at December 31, 2005 are as follows: (in thousands)
As a member of the Federal Reserve System, the Bank owns Federal Reserve Bank stock with a book value of $638,000. Being an equity investment, the stock has no maturity. There is no public market for this investment. The last dividend was 6 percent.
As a member of the Federal Home Loan Bank of New York, the Bank owns Federal Home Loan Bank of New York stock with a book value of $5,158,000. Being an equity investment, the stock has no maturity. There is no public market for this investment. The last declared dividend was 5.11 percent.
Loans, net of unearned discounts but before the allowance for loan losses, totaled $905,037,000. Loans secured by commerical real estate amounted to $308,436,000 and comprise 34.1 percent of the portfolio, the largest single component, up from $262,262,000 in 2004, and $232,119,000 in 2003. Commercial and industrial loans followed at $179,523,000, up 13.5 percent from $158,205,000 at the end of 2004. These loans are made to small local businesses throughout Suffolk County. Commercial loan balances are seasonal, particularly in the Hamptons where retail inventories rise in the spring and decline by autumn. Consumer loans are a declining part of the portfolio. Net of unearned discounts, they totaled $132,930,000 at the end of 2005, down 18.0 percent from $162,206,000 at year-end 2004. Consumer loans include primarily indirect, dealer-generated automobile loans. Competition among commercial banks and with captive finance companies of automobile manufacturers has reduced yields and volume. Additionally, rising fuel costs and uncertainties regarding the economic impact of recent hurricanes have led to a decline in consumer confidence, affecting automobile sales. As commerce on Long Island strengthened, commercial mortgages offered continuing opportunity.
The remaining significant components of the loan portfolio are residential mortgages at $131,006,000, up 13.9 percent from $114,969,000; home equity loans at $80,775,000, up 7.0 percent from $75,486,000; and construction loans at $67,411,000, up 33.6 percent from $50,455,000. Current economic trends indicate a slowing housing market, as inventories of unsold homes increased and interest rates gradually increased.
The following table categorizes total loans (net of unearned discounts) at December 31: (in thousands)
Generally, recognition of interest income is discontinued when reasonable doubt exists as to whether interest can be collected. Ordinarily, loans no longer accrue interest when 90 days past due. When a loan stops accruing interest, all interest accrued in the current year, but not collected, is reversed against interest income in the current year. Any interest accrued in prior years is charged against the allowance for loan losses. Loans start accruing interest again when they become current as to principal and interest, and when, in the opinion of management, they can be collected in full. All non-performing loans, of a material amount, are reflected in the foregoing tables. The following table shows non-accrual, past due, and restructured loans at December 31: (in thousands)
Interest on loans that are restructured or are no longer accruing interest would have amounted to about $335,000 for 2005 under the contractual terms of those loans. Suffolk records the payment of interest on such loans as a reduction of principal. Interest income recognized on restructured and non-accrual loans was immaterial for the years 2005, 2004, and 2003. Suffolk has a formal procedure for internal credit review to more precisely identify risk and exposure in the loan portfolio. A single credit, the circumstances of which are particular to that loan, is included in non-accrual loans as of December 31, 2005 and 2004. Management does not believe that it is reflective of a systemic weakness in the loan portfolio or of the underwriting standards and procedures.
Summary of Loan Losses and Allowance for Loan Losses
The allowance for loan losses is determined by continuous analysis of the loan portfolio. That analysis includes changes in the size and composition of the portfolio, historical loan losses, industry-wide losses, current and anticipated economic trends, and details about individual loans. It also includes estimates of the actual value of collateral and other possible sources of repayment. There can be no assurance that the allowance is, in fact, adequate. When a loan, in full or in part, is deemed uncollectible, it is charged against the allowance. This happens when it is well past due and the borrower has not shown the ability or intent to make the loan current, or the borrower does not have enough assets to pay the debt, or the value of the collateral is less than the balance of the loan and not likely to improve soon. Residential real estate and consumer loans are analyzed as a group and not individually because of the large number of loans, small balances, and historically low losses. In the future, the provision for loan losses may change as a percentage of total loans. The percentage of net recoveries to average net loans during 2005 was 0.01 percent, compared to net charge-offs of 0.28 percent in 2004, and 0.13 percent during 2003. The ratio of the allowance for loan losses to loans, net of discounts, was 1.09 percent at the end of 2005, up from 0.99 percent in 2004, which was down from 1.02 percent in 2003. A summary of transactions follows: (in thousands)
The following table summarizes the allowance for loan losses allocated by loan type: (dollars in thousands)
The following table presents information concerning loan balances and asset quality: (dollars in thousands)
Interest expense in 2005 was $11,312,000, up from $7,379,000 the year before, which was down from $9,801,000 during 2003. Most interest was paid for the deposits of individuals, businesses, and various governments and their agencies. Short-term borrowings may include federal funds purchased (short-term lending by other banks), securities sold under agreements to repurchase, and Federal Home Loan Bank borrowings. The Federal Reserve Bank discount window was available though not used during 2005. Short-term borrowings averaged $63,169,000 during 2005, $3,842,000 during 2004, and $4,501,000 during 2003.
Average interest-bearing deposits decreased to $779,962,000 in 2005, down 5.0 percent from $820,916,000 in 2004. Saving, N.O.W., and money market deposits decreased during 2005, averaging $561,137,000, down 6.6 percent from 2004 when they averaged $600,668,000. Average time certificates of less than $100,000 totaled $198,856,000, down 0.7 percent from $200,283,000 in 2004. Average time certificates of $100,000 or more totaled $19,969,000, up very slightly from $19,965,000 during 2004. Each of the Banks demand deposit accounts has a related non-interest-bearing sweep account. The sole purpose of the sweep accounts is to reduce the non-interest-bearing reserve balances that the Bank is required to maintain with the Federal Reserve Bank, and thereby increase funds available for investment. Although the sweep accounts are classified as saving accounts for regulatory purposes, they are included in demand deposits in the accompanying consolidated statements of condition.
The following table classifies average deposits for each of the periods indicated: (in thousands)
At December 31, 2005, the remaining maturities of time certificates of $100,000 or more were as follows: (in thousands)
Suffolk uses short-term funding when it is advantageous to do so in comparison with the alternatives. As the yield curve remained flat, short-term funding activity increased during 2005. This includes borrowings from the Federal Home Loan Bank, lines of credit for federal funds with correspondent banks, retail sale-repurchase agreements, and the Federal Reserve Bank discount window. Average balances of federal funds purchased were $781,000 and $27,000 for 2005 and 2004, respectively. Average balances of Federal Home Loan Bank borrowings were $27,961,000 during 2005 and $3,815,000 in 2004. Average balance of repurchase agreements were $34,427,000 during 2005. There were no repurchase agreements made during 2004.
Other income decreased to $10,166,000 during 2005, down 17.3 percent from $12,294,000 during 2004, which was up 8.7 percent from $11,310,000 during 2003. Service charges on deposit accounts remained flat from 2004 to 2005, and from 2003 to 2004. Other service charges were up 1.0 percent and down 0.7 percent for the same periods, respectively. Fiduciary fees in 2005 totaled $1,183,000, down 2.0 percent from 2004 when they amounted to $1,207,000, which was up 0.7 percent from 2003, at $1,199,000. There were no net gains on sales of securities in 2005. Net gains on sales of securities amounted to $1,994,000 and $464,000 in 2004 and 2003, respectively.
Other expense during 2005 was $37,474,000, up 2.3 percent from 2004 when it was $36,621,000, and 1.2 percent from $36,190,000 in 2003. Increases were primarily due to increase in net occupancy expense, up 20.3 percent from 2004 to 2005 and in outside services, up 2.4 percent from 2004 to 2005. Net losses on sales of securities amounted to $22,000 in 2005. During 2005, non-interest expense grew at 2.3 percent.
Interest Rate Sensitivity
Interest rate sensitivity is determined by the date when each asset and liability in Suffolks portfolio can be repriced. Sensitivity increases when interest-earning assets and interest-bearing liabilities cannot be repriced at the same time. While this analysis presents the volume of assets and liabilities repricing in each period of time, it does not consider how quickly various assets and liabilities might actually be repriced in response to changes in interest rates. Management reviews its interest rate sensitivity regularly and adjusts its asset/liability management strategy accordingly. Because the interest rates of assets and liabilities vary according to their maturity, management may selectively mismatch the repricing of assets and liabilities to take advantage of temporary or projected differences between short- and long-term interest rates.
The following table reflects the sensitivity of Suffolks assets and liabilities at December 31, 2005: (dollars in thousands)
Footnotes to Interest Rate Sensitivity
At December 31, 2005, interest-earning assets with maturities of less than one year exceed interest-bearing liabilities of similar maturity. This cumulative gap might result in increased net interest income if interest rates increase. If interest rates decline, net interest income might decrease.
Market risk is the risk that a financial instrument will lose value as the result of adverse changes in market prices, interest rates, foreign currency exchange rates, commodity prices, or the prices of equity securities. Suffolks primary exposure to market risk is to changing interest rates.
Monitoring and managing this risk is an important part of Suffolks asset/liability management process. It is governed by policies established by its Board of Directors. These policies are reviewed and approved annually. The Board delegates responsibility for asset/liability management to the Asset/Liability Committee (ALCO). ALCO then develops guidelines and strategies to implement the policy.
Interest Rate Risk
Interest rate risk is the sensitivity of earnings to changes in interest rates. As interest rates change, interest income and expense also change, thereby changing net interest income (NII). NII is the primary component of Suffolks earnings. ALCO uses a detailed and dynamic model to quantify the effect of sustained changes in interest rates on NII. While ALCO routinely monitors simulated NII sensitivity two years into the future, it uses other tools to monitor longer term interest rate risk.
The model measures the effect in the future of changing interest rates on both interest income and expense for all assets and liabilities, as well as for derivative financial instruments that do not appear on the balance sheet. The results are compared to ALCO policy limits that specify a maximum effect on NII one year in the future, assuming no growth in assets or liabilities, or 200 basis point (bp) change in interest rates upward and downward. Following is Suffolks NII sensitivity as of December 31, 2005. Suffolks Board has approved a policy limit of 12.5 percent.
These estimates should not be interpreted as Suffolks forecast, and should not be considered as indicative of managements expectations for operating results. They are hypothetical estimates that are based on many assumptions including: the nature and time of changes in interest rates, the shape of the yield curve (variations in interest rates for financial instruments of varying maturity at a given moment in time), prepayments on loans and securities, deposit outflows, pricing on loans and deposits, and the reinvestment of cash flows from assets and liabilities, among other things. While these assumptions are based on managements best estimate of current economic conditions, Suffolk cannot give any assurance that they will actually predict results, nor can they anticipate how the behavior of customers and competitors may change in the future.
Factors that may affect actual results include: prepayment and refinancing of loans other than as assumed, interest rate change caps and floors, re-pricing intervals on adjustable rate instruments, changes in debt service on adjustable rate loans, and early withdrawal of deposits. Actual results may also be affected by actions ALCO takes in response to changes in interest rates, actual or anticipated.
When appropriate, ALCO may use off-balance-sheet instruments such as interest rate floors, caps, and swaps to hedge its position with regard to interest rate risk. The Board of Directors has approved a hedging policy statement that governs the use of such instruments. As of December 31, 2005, there were no derivative financial instruments outstanding.
The following table illustrates the contractual sensitivity to changes in interest rates of the Companys total loans, net of discounts, not including overdrafts and loans not accruing interest, together totaling $9,185,000 at December 31, 2005: (in thousands)
The following table illustrates the contractual sensitivity to changes in interest rates on the Companys commercial, financial, agricultural, and real estate construction loans not including non-accrual loans totaling approximating $3,575,000 at December 31, 2005: (in thousands)
Asset/Liability Management & Liquidity
The asset/liability management committee reviews Suffolks financial performance and compares it to the asset/liability management policy. The committee includes four outside directors, executive management, the senior lender, the comptroller, and the head of risk management. It uses computer simulations to quantify interest rate risk and to project liquidity. The simulations also help the committee to develop contingent strategies to increase net interest income. The committee always assesses the impact of any change in strategy on Suffolks ability to make loans and repay deposits. Only strategies and policies that meet regulatory guidelines and that are appropriate under the economic and competitive circumstances are considered by the committee. Suffolk has not used forward contracts or interest rate swaps to manage interest rate risk.
Following is a table describing certain liabilities not included in Suffolks consolidated statement of condition in the period in which they are due: (in thousands of dollars)
Amounts listed as purchase obligations represent agreements to purchase services for Suffolks core banking system.
Primary capital, including stockholders equity, not including the net unrealized gain (loss) on securities available for sale, net of tax, and the allowance for loan losses, amounted to $114,107,000 at year-end 2005, compared to $112,951,000 at year-end 2004 and $104,187,000 at year-end 2003. During 2005, Suffolk repurchased 435,816 shares for an aggregate price of $14,200,488. Management determined that this would increase leverage while preserving capital ratios well above regulatory requirements.
The following table presents Suffolks capital ratio and other related ratios for each of the past five years: (dollars in thousands)
In 2000, the Board adopted a policy whereby management will maximize both return on average equity and earnings-per-share, and therefore shareholder value, while maintaining the regulatory standard of well capitalized. That standard is 10 percent Total Risk-Based Capital, 6 percent Tier 1 Capital, and 5 percent Leverage Capital. When capital exceeds that standard by more than a small cushion over what is expected to be required to maintain the well-capitalized standard during the current quarter, shares may be repurchased as they become available at prices that remain accretive to earnings-per-share in transactions under SEC rule 10-b 18 and in private purchases. When capital expected to be required during the current quarter does not exceed the standard, repurchases will not be made. Further, the dividend reinvestment program will automatically follow the same standard, purchasing shares in the market when Suffolk is in the market to repurchase shares, and issuing from the reserve when it is not. Each of these replaces the prior practice of authorizing the repurchase of a specific number of shares by Suffolk, or the purchase or issuance of shares by the dividend reinvestment program without specific reference to capital ratios.
The following table details repurchases during 2005:
Suffolk measures how effectively it uses capital by two widely accepted performance ratios: return on average assets and return on average common stockholders equity. The return in 2005 on average assets of 1.59 percent and average common equity of 22.18 percent increased from 2004 when returns were 1.53 percent and 20.85 percent, respectively.
All dividends must conform to applicable statutory requirements. Suffolk Bancorps ability to pay dividends depends on Suffolk County National Banks ability to pay dividends. Under 12 USC 56-9, a national bank may not pay a dividend on its common stock if the dividend would exceed net undivided profits then on hand. Further, under 12 USC 60, a national bank must obtain prior approval from the Office of the Comptroller of the Currency to pay dividends on either common or preferred stock that would exceed the banks net profits for the current year combined with retained net profits (net profits minus dividends paid during that period) of the prior two years. The amount the Bank currently has available to pay dividends is approximately $26,263,000.
Risk-Based Capital and Leverage Guidelines
The Federal Reserve Banks risk-based capital guidelines call for bank holding companies to require minimum ratios of capital to risk-weighted assets, which include certain off-balance-sheet activities, such as standby letters of credit. The guidelines define capital as being core, or Tier 1 capital, which includes common stockholders equity; a limited amount of perpetual preferred stock; minority interest in unconsolidated subsidiaries, less goodwill; or supplementary or Tier 2 capital, which includes subordinated debt, redeemable preferred stock, and a limited amount of the allowance for loan losses. All bank holding companies must meet a minimum ratio of total qualifying capital to risk-weighted assets of 8.00 percent, of which at least 4.00 percent should be in the form of Tier 1 capital. At December 31, 2005 Suffolks ratios of core capital and total qualifying capital (core capital plus Tier 2 capital) to risk-weighted assets were 9.96 percent and 10.91 percent, respectively.
Discussion of New Accounting Pronouncements
On March 9, 2004, the SEC Staff issued Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments (SAB 105). SAB 105 clarifies existing accounting practices relating to the valuation of issued loan commitments, including interest rate lock commitments (IRLC), subject to SFAS No. 149 and Derivative Implementation Group Issue C13, Scope Exceptions: When a Loan Commitment is included in the Scope of Statement 133. Furthermore, SAB 105 disallows the inclusion of the values of a servicing component and other internally developed intangible assets in the initial and subsequent IRLC valuation. The provisions of SAB 105 were effective for loan commitments entered into after March 31, 2004. The Company has adopted the provisions of SAB 105 which did not have a material effect on either the Companys consolidated financial position or consolidated results of operations.
In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment (SFAS 123R). This statement is a revision of SFAS No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. The provisions of this statement are effective for periods beginning after December 31, 2005. The Company is currently evaluating the provisions of this revision to determine the impact on its consolidated financial statements. A pro forma effect is listed in Footnote 1 (K), Stock-Based Compensation. The recording of this expense is, however, expected to decrease consolidated net income. Suffolk will adopt this prospectively in 2006.
On March 29, 2005, the SEC released Staff Accounting Bulletin 107, Share-Based Payments, (SAB 107). The interpretations in SAB 107 express the views of the SEC staff regarding the application of SFAS No. 123(R). Among other things, SAB 107 provides interpretive guidance about the interaction of Statement 123(R) and certain SEC rules and regulations. It also provides the staffs views regarding the valuation of share-based payments by public companies. Suffolk is evaluating the impact that the implementation of SAB 107 and SFAS 123(R) will have on options granted in the future.
In May 2005, FASB issued Statement No. 154, Accounting Changes and Error Corrections a replacement of APB Opinion No. 20 and FASB Statement No. 3. This statement changes the requirements for the accounting for and reporting of a change in accounting principle. Opinion 20 previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new principle. Statement No. 154 requires retrospective application to prior periods, financial statements of changes in accounting principle, where practicable, and limits retrospective application of a change to direct effects of the change in accounting principle. Indirect effects of a change in accounting principle should be recognized in the period of accounting change. This statement is effective for accounting changes made in fiscal years after December 15, 2005. Suffolk is currently evaluating the impact of FAS No. 154 on its financial condition and results of operations.
Emerging Issues Task Force (EITF) Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, (EITF 03-1) provides guidance for determining when an investment is considered impaired, whether impairment is other-than-temporary, and measurement of an impairment loss. An investment is considered impaired if the fair value of the investment is less than its cost. Generally, an impairment is considered other-than-temporary unless: (i) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for an anticipated recovery of fair value up to (or beyond) the cost of the investment; and (ii) evidence indicating that the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. If impairment is determined to be other-than-temporary, then an impairment loss should be recognized equal to the difference between the investments cost and its fair value. Certain disclosure requirements of EITF 03-1 were adopted in 2003 and Suffolk began presenting the new disclosure requirements in its consolidated financial statements for the year ended December 31, 2003. The recognition and measurement provisions were initially effective for other-than-temporary impairment evaluations in reporting periods beginning after June 15, 2004. However, in September 2004, the effective date of these provisions was delayed until the finalization of a FASB Staff Position (FSP) to provide additional implementation guidance.
In June, the FASB decided not to provide additional guidance on the meaning of other-than-temporary impairment, but directed its staff to issue proposed FSP EITF 03-1-a, Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1, as final. The final FSP will supersede EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, and EITF Topic No. D-44, Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value. The final FSP (re-titled FSP FAS 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments) will replace the guidance set forth in paragraphs 10-18 of Issue 03-1 with references to existing other-than-temporary impairment guidance, such as FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities; SEC Staff Accounting Bulletin No. 59, Accounting for Non-current Marketable Equity Securities; and APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. FASB Staff Position No. FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (the FSP), were issued on November 3, 2005 and addresses the determination of when an investment is considered impaired; whether the impairment is other than temporary; and how to measure an impairment loss. The FSP replaces the impairment guidance in EITF Issue No. 03-1 with references to existing authoritative literature concerning other-than-temporary determinations (principally Statement of Financial Accounting Standards No. 115 and SEC Staff Accounting Bulletin 59). Under the FSP, impairment losses must be recognized in earnings equal to the entire difference between the securitys cost and its fair value at the financial statement date, without considering partial recoveries subsequent to that date. The FSP also requires that an investor recognize an other-than-temporary impairment loss when a decision to sell a security has been made and the investor does not expect the fair value of the security to fully recover prior to the expected time of sale. The FSP is effective for reporting periods beginning after December 15, 2005. Suffolk does not expect that the application of the FSP will have a material impact on its financial condition, results of operations, or financial statement disclosures.
Critical Accounting Policies, Judgments, and Estimates
The accounting and reporting policies of Suffolk conform to accounting principles generally accepted in the United States of America and general practices in the financial services industry. The preparation of financial statements in conformity with these accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results in the future could differ from those estimates.
Suffolk considers that the determination of the allowance for loan losses involves a higher degree of judgment and complexity than its other significant accounting policies. The allowance for loan losses is calculated to maintain a reserve believed by management to be sufficient to absorb estimated credit losses. Managements determination of the adequacy of the allowance is based on periodic evaluations of the loan portfolio and other relevant factors. This evaluation is inherently subjective as it requires material estimates, including, among others, the expected probability of default; the amount of loss in the event of default; the expected usage of loan commitments; the amounts and timing of cash flows expected in the future from impaired loans and mortgages; and an additional factor for potential loan losses based on historical experience. Management also considers economic conditions, uncertainties in estimating losses, and inherent risks in the loan portfolio. All of these factors may change significantly in the future. To the extent that actual results differ from managements estimates, additional provisions for loan losses may be required that could reduce earnings in future periods.
Suffolk recognizes deferred-tax assets and liabilities. Deferred income taxes occur when income taxes are allocated through time. Some items are temporary resulting from differences in the timing of a transaction under generally accepted accounting principles (GAAP), and for the computation of income tax. Examples would include the future tax effects of temporary differences for such items as deferred compensation and the provision for loan losses. Estimates of deferred tax assets are based upon evidence available to management that future realization is more likely than not. If management determines that Suffolk may be unable to realize all or part of net deferred tax assets in the future, a direct charge to income tax expense may be required to reduce the recorded value of the net deferred tax asset to the amount that management expects to realize.
Business Risks and Uncertainties
This annual report contains some statements that look to the future. These may include remarks about Suffolk Bancorp, the banking industry, and the economy in general. Factors affecting Suffolk Bancorp include particularly, but are not limited to: changes in interest rates; increases or decreases in retail and commercial economic activity in Suffolks market area; variations in the ability and propensity of consumers and businesses to borrow, repay, or deposit money, or to use other banking and financial services. Further, it could take Suffolk longer than anticipated to implement its strategic plans to increase revenue and manage non-interest expense, or it may not be possible to implement those plans at all. Finally, new and unanticipated legislation, regulation, or accounting standards may require Suffolk to change its practices in ways that materially change the results of operations. Each of the factors may change in ways that management does not now foresee. These remarks are based on current plans and expectations. They are subject, however, to a variety of uncertainties that could cause future results to vary materially from Suffolks historical performance, or from current expectations.
Managements Report on Internal Control over Financial Reporting
The management of Suffolk Bancorp is responsible for establishing and maintaining adequate internal control over financial reporting. Suffolk Bancorps internal control system was designed to provide reasonable assurance to the companys management and board of directors regarding the preparation and fair presentation of published financial statements.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
Suffolk Bancorp management assessed the effectiveness of the companys internal control over financial reporting as of December 31, 2005. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control Integrated Framework. Based on our assessment and those criteria we have determined that, as of December 31, 2005, the companys internal control over financial reporting is effective.
Suffolk Bancorps independent registered public accounting firm has issued its report on our assessment of the companys internal control over financial reporting. This report appears on page 35.
CONSOLIDATED STATEMENTS OF CONDITION
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF INCOME
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
Note 1 Summary of Significant Accounting Policies
The accounting and reporting policies of Suffolk Bancorp and its subsidiary conform to generally accepted accounting principles and general practices within the banking industry. The following footnotes describe the most significant of these policies.
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported assets and liabilities as of the date of the consolidated statements of condition. The same is true of revenues and expenses reported for the period. Actual results could differ significantly from those estimates.
(A) Consolidation The consolidated financial statements include the accounts of Suffolk and its wholly owned subsidiary, Suffolk County National Bank (the Bank). In 1998, the Bank formed a Real Estate Investment Trust named Suffolk Green-way, Inc. In 2004, the Bank formed an insurance agency named SCNB Financial Services, Inc. All intercompany transactions have been eliminated in consolidation.
(B) Investment Securities Suffolk reports debt securities and mortgage-backed securities in one of the following categories: (i) held to maturity (management has the intent and ability to hold to maturity), which are to be reported at amortized cost; (ii) trading (held for current resale), which are to be reported at fair value, with unrealized gains and losses included in earnings; and (iii) available for sale (all other debt securities and mortgage-backed securities), which are to be reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders equity. Accordingly, Suffolk classified all of its holdings of debt securities and mortgage-backed securities as either held to maturity or available for sale. At the time a security is purchased, a determination is made as to the appropriate classification.
Premiums and discounts on debt and mortgage-backed securities are amortized as expense and accreted as income over the estimated life of the respective security using a method that approximates the level-yield method. Gains and losses on the sales of investment securities are recognized upon realization, using the specific identification method and shown separately in the consolidated statements of income.
Emerging Issues Task Force (EITF) Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF 03-1) provides guidance for determining when an investment is considered impaired, whether impairment is other-than-temporary, and measurement of an impairment loss. An investment is considered impaired if the fair value of the investment is less than its cost. Generally, an impairment is considered other-than-temporary unless: (i) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for an anticipated recovery of fair value up to (or beyond) the cost of the investment; and (ii) evidence indicating that the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. If impairment is determined to be other-than-temporary, then an impairment loss should be recognized equal to the difference between the investments cost and its fair value. Certain disclosure requirements of EITF 03-1 were adopted in 2003 and the Company began presenting the new disclosure requirements in its consolidated financial statements for the year ended December 31, 2003. The recognition and measurement provisions were initially effective for other-than-temporary impairment evaluations in reporting periods beginning after June 15, 2004. However, in September 2004, the effective date of these provisions was delayed until the finalization of a FASB Staff Position (FSP) to provide additional implementation guidance.
In June, the FASB decided not to provide additional guidance on the meaning of other-than-temporary impairment, but directed its staff to issue proposed FSP EITF 03-1-a, Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1, as final. The final FSP will supersede EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, and EITF Topic No. D-44, Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value. The final FSP (re-titled FSP FAS 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments) will replace the guidance set forth in paragraphs 10-18 of Issue 03-1 with references to existing other-than-temporary impairment guidance, such as FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities; SEC Staff Accounting Bulletin No. 59, Accounting for Non-current Marketable Equity Securities; and APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. FASB Staff Position No. FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (the FSP), were issued on November 3, 2005 and addresses the determination of when an investment is considered impaired; whether the impairment is other than temporary; and how to measure an impairment loss. The FSP replaces the impairment guidance in EITF Issue No. 03-1 with references to existing authoritative literature concerning other-than-temporary determinations, principally Statement of Financial Accounting Standards (SFAS) No. 115 and SEC Staff Accounting Bulletin 59. Under the FSP, impairment losses must be recognized in earnings equal to the entire difference between the securitys cost and its fair value at the financial statement date, without considering partial recoveries subsequent to that date. The FSP also requires that an investor recognize an other-than-temporary impairment loss when a decision to sell a security has been made and the investor does not expect the fair value of the security to fully recover prior to the expected time of sale. The FSP is effective for reporting periods beginning after December 15, 2005. The Company does not expect that the application of the FSP will have a material impact on its financial condition, results of operations, or financial statement disclosures.
(C) Loans and Loan Interest Income Recognition Loans are stated at the principal amount outstanding. Interest on loans not made on a discounted basis is credited to income, based upon the principal amount outstanding during the period. Unearned discounts on installment loans are credited to income
using methods that approximate a level yield. Recognition of interest income is discontinued when reasonable doubt exists as to whether interest due can be collected. Loans generally no longer accrue interest when 90 days past due. When a loan is placed on non-accrual status, all interest previously accrued in the current year, but not collected, is reversed against current-year interest income. Any interest accrued in prior years is charged against the allowance for loan losses. Loans and leases start accruing interest again when they become current as to principal and interest, and when, in the opinion of management, the loans can be collected in full.
(D) Allowance for Loan Losses The balance of the allowance for loan losses is determined by managements estimate of the amount of financial risk in the loan portfolio and the likelihood of loss. The analysis also considers the Banks loan loss experience and may be adjusted in the future depending on economic conditions. Additions to the allowance are made by charges to expense, and actual losses, net of recoveries, are charged to the allowance. Regulatory examiners may require the Bank to add to the allowance based upon their judgment of information available to them at the time of their examination.
In accordance with SFAS No. 114, titled Accounting by Creditors for Impairment of a Loan, as amended by Statement No. 118, titled Accounting by Creditors for Impairment of Loan-Income Recognition and Disclosures, an allowance is maintained for impaired loans to reflect the difference, if any, between the principal balance of the loan and the present value of projected cash flows, observable fair value, or collateral value. SFAS No. 114 defines an impaired loan as a loan for which it is probable that the lender will not collect all amounts due under the contractual terms of the loan.
The Bank accounts for its transfers and servicing financial assets in accordance with SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. SFAS No. 140 revises the standards for accounting for the securitizations and other transfers of financial assets and collateral. Transfers of financial assets for which the Bank has surrendered control of the financial assets are accounted for as sales to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. Retained interests in a sale or securitization of financial assets are measured at the date of transfer by allocating the previous carrying amount between the assets transferred and based on their relative estimated fair values. The fair values of retained servicing rights and any other retained interests are determined based on the present value of expected future cash flows associated with those interests and by reference to market prices for similar assets. There were no transfers of financial assets to related or affiliated parties. At December 31, 2005 and 2004, the Banks servicing loan portfolio approximated $97,913,000, and $99,929,000, respectively. The estimated fair value of mortgage servicing rights was $1,189,000 and $1,164,000 as of December 31, 2005 and 2004, respectively.
Suffolk adopted FASB Interpretation 45 (FIN 45), Guarantors Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others, on January 1, 2003. FIN 45 requires a guarantor entity, at the inception of a guarantee covered by the measurement provisions of the interpretation, to record a liability for the fair value of the obligation undertaken in issuing the guarantee. Suffolk has financial and performance letters of credit. Financial letters of credit require Suffolk to make payment if the customers financial condition deteriorates, as defined in the agreements. Performance letters of credit require Suffolk to make payments if the customer fails to perform certain nonfinancial contractual obligations. Suffolk previously did not record a liability when guaranteeing obligations unless it became probable that Suffolk would have to perform under the guarantee. FIN 45 applies prospectively to guarantees Suffolk issues or modifies subsequent to December 31, 2002. The maximum potential undiscounted amount of the future payments of these letters of credit as of December 31, 2005 is $6,647,000 and they expire as follows:
Amounts due under these letters of credit would be reduced by any proceeds that Suffolk would be able to obtain in liquidating the collateral for the loans, which varies depending on the customer. The valuation of the allowance for loan losses includes a provision of $10,000 for loan losses based on the letters of credit outstanding on December 31, 2005.
In October 2003, the AICPA issued SOP 03-3, Accounting for Loans or Certain Debt Securities Acquired in a Transfer. SOP 03-3 applies to loans with evidence of deterioration of credit quality since origination acquired by completion of a transfer for which it is probable at acquisition that the Company will be unable to collect all contractually required payments receivable. SOP 03-3 requires that the Company recognize the excess of all cash flows expected at acquisition over the investors initial investment in the loan as interest income on a level-yield basis over the life of the loan as the accretable yield. The loans contractual required payments receivable in excess of the amount of its cash flows excepted at acquisition (non-accretable difference) should not be recognized as an adjustment to yield, a loss accrual, or a valuation allowance for credit risk. SOP 03-3 is effective for loans acquired in fiscal years beginning after December 31, 2004. Early adoption is permitted. Based on current business operations, management expects that the provisions of SOP 03-3 will not materially impact Suffolks financial condition, results of operations, or disclosures.
(E) Premises and Equipment Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation is calculated by the declining-balance or straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized using the straight-line method over the term of the lease or the estimated life of the asset, whichever is shorter.
On January 1, 2002, the Bank adopted SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 retains the existing requirements to recognize and measure the impairment of long-lived assets to be held and used or to be disposed of by sale. SFAS No. 144
changes the requirements relating to reporting the effects of a disposal or discontinuation of a segment of a business. The adoption of this statement did not have an impact on the financial condition or results of operations of the Bank.
(F) Other Real Estate Owned Property acquired through foreclosure (other real estate owned or OREO), is stated at the lower of cost or fair value less selling costs. Credit losses arising at the time of the acquisition of property are charged against the allowance for loan losses. Any additional write-downs to the carrying value of these assets that may be required, as well as the cost of maintaining and operating these foreclosed properties, are charged to expense. Additional write-downs are recorded in a valuation reserve account that is maintained asset by asset.
(G) Excess of Cost Over Fair Value of Net Assets Acquired and Other Intangible Assets Through December 31, 2001, the excess of cost over fair value of net assets acquired (goodwill) was amortized on a straight-line basis over a period of ten years. Effective with the adoption of SFAS No. 142, Goodwill and Other Intangible Assets, on January 1, 2002, the Bank ceased amortizing goodwill and, instead, tests goodwill for impairment on a periodic basis.
(H) Income Taxes Suffolk uses an asset and liability approach to accounting for income taxes. The asset and liability approach requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. Deferred tax assets are recognized if it is more likely than not that a future benefit will be realized. It is managements position that no valuation allowance is necessary against any of Suffolks deferred tax assets.
(I) Summary of Retirement Benefits Accounting Suffolks retirement plan is noncontributory and covers substantially all eligible employees. The plan conforms to the provisions of the Employee Retirement Income Security Act of 1974, as amended. Suffolks policy is to accrue for all pension costs and to fund the maximum amount allowable for tax purposes. Actuarial gains and losses that arise from changes in assumptions concerning future events are amortized over a period that reflects the long-term nature of pension expense used in estimating pension costs.
Suffolk accrues for post-retirement benefits other than pensions by accruing the cost of providing those benefits to an employee during the years that the employee serves.
(J) Cash and Cash Equivalents For purposes of the consolidated statement of cash flows, cash and due from banks, and federal funds sold are considered to be cash equivalents. Generally, federal funds are sold for one-day periods.
(K) Stock-Based Compensation At December 31, 2005, the Bank had one stock-based employee compensation plan, which is more fully described in Note 8. The bank accounts for that plan under the recognition and measurement principles of APB No. 25, Accounting for Stock Issued to Employees, and related interpretations, as an accepted alternative under FASB No. 123, Accounting for Stock-Based Compensation. All options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings-per-share if the Bank had applied the fair value recognition provisions of FASB No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation: (in thousands, except per-share amounts)
(L) Treasury Stock The balance of treasury stock is computed at par value. The excess cost over par is subtracted from undivided profits.
(M) Earnings-per-share Basic earnings-per-share is computed by dividing net income by the number of weighted-average shares outstanding during the period. Diluted earnings-per-share reflect the dilution that would occur if stock options were exercised in return for common stock that would then share in Suffolks earnings. It is computed by dividing net income by the sum of the weighted-average number of common shares outstanding and the weighted-average number of stock options exercisable during the period. Suffolk has no other securities that could be converted into common stock, nor any contracts that would result in the issuance of common stock.
(N) Comprehensive Income Comprehensive income includes net income and all other changes in equity during a period except those resulting from investments by owners and distributions to owners. Other comprehensive income includes revenues, expenses, gains, and losses that under generally accepted accounting principles are included in comprehensive income but excluded from net income. Comprehensive income and accumulated other comprehensive income are reported net of related income taxes. Accumulated other comprehensive income for the Bank consists solely of unrealized holding gains or losses on securities available for sale.
As of December 31, 2005, the fair market value of the Companys investments classified Available for Sale was $400,038,000. The book value of the Companys investments classified Available for Sale was $403,899,000. The net difference or net unrealized loss on Available for Sale investments as of December 31, 2005 was $3,861,000. Available for Sale investments are recorded on the Statement of Condition at fair market value. The corresponding entries as of December 31, 2005 include in liabilities a deferred tax asset of $1,583,000 and in capital accumulated other comprehensive loss, net of tax amount of $2,278,000.
(O) Segment Reporting SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, requires that public companies report certain information about operating segments. It also requires that public companies report certain information about their products and services, the
geographic areas in which they operate, and their major customers. Suffolk is a regional bank, which offers a wide array of products and services to its customers. Pursuant to its banking strategy, emphasis is placed on building relationships with its customers, as opposed to building specific lines of business. As a result, at December 31, 2005 and 2004, Suffolk is not organized around discernible lines of business and prefers to work as an integrated unit to customize solutions for its customers, with business line emphasis and product offerings changing over time as needs and demands change. Thus, all necessary requirements of SFAS No. 131 have been met by Suffolk as of December 31, 2005.
(P) Variable Interest Entities (VIEs) In January 2003, the FASB issued FASB Interpretation 46 (FIN 46), Consolidation of Variable Interest Entities. FIN 46 clarifies the application of Accounting Research Bulletin 51, Consolidated Financial Statements, for certain entities that do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties or in which equity investors do not have the characteristics of a controlling financial interest (variable interest entities). Variable interest entities within the scope of FIN 46 will be required to be consolidated by their primary beneficiary. The primary beneficiary of a variable interest entity is determined to be the party that absorbs a majority of the entitys expected losses, receives a majority of its expected returns, or both. Subsequent to the issuance of FIN 46, the FASB issued a revised interpretation, FIN 46(R), the provisions of which must be applied to certain variable interest entities by March 31, 2004. Suffolk has determined the adoption of the provisions of FIN 46 do not materially impact its financial condition or results of operation.
(Q) Reclassification of Prior Year Consolidated Financial Statements Certain reclassifications have been made to the prior years consolidated financial statements that conform with the current years presentation.
Note 2 Investment Securities
The amortized cost, estimated fair values, and gross unrealized gains and losses of Suffolks investment securities available for sale and held to maturity at December 31, 2005 and 2004 were: (in thousands)