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Section 1: ANNLRPT (ANNUAL REPORT WITH SUPPLEMENT)

Annual Report with Supplement
Table of Contents

ISB FINANCIAL CORP.

2007 ANNUAL REPORT

CONTENTS

 

Letter to Shareholders

   2

Representations of Management

   4

Report of Independent Registered Public Accounting Firm

   5

Financial Statements

  

Consolidated balance sheets

   6

Consolidated statements of income

   7

Consolidated statements of shareholders’ equity

   8 - 9

Consolidated statements of cash flows

   10 - 11

Notes to consolidated financial statements

   12 - 45

Consolidated Five-Year Statistical Summary

   46


Table of Contents

To Our Shareholders:

Our annual report is being sent to you later than normal this year due to the recently completed merger of ISB Financial Corp. and MidWestOne Financial Group, Inc. We normally reserve this space in our annual report to review in detail the prior year’s financial results. Because we just recently mailed our first quarter report to you, we will use this space to talk about recent efforts to bring two fine companies together and to peer into the future of this newly formed banking company.

Iowa State Bank & Trust Company was formed in 1934 in Iowa City in the depths of the Great Depression by a group of investors that included Ben Summerwill. The Mahaska County State Bank was formed in Oskaloosa in 1883 by a group of investors that included Harry Howard. From these modest beginnings emerged a banking company that in 2008 is among the largest five banks based in Iowa.

ISB Financial Corp. and MidWestOne Financial Group, Inc. announced their intent to join companies in a merger of equals on September 12, 2007. Regulatory approval was received and the companies officially merged on March 14, 2008. Although ISB Financial Corp. is the surviving corporation, the company’s name has been changed to MidWestOne Financial Group, Inc. The company owns three banks, Iowa State Bank & Trust Company in Iowa City, MidWestOne Bank in Oskaloosa, and First State Bank in Conrad. Pending regulatory approval, we plan to merge the three banks into one bank in August of 2008. The resulting bank will have $1.5 billion in assets and span 21 communities and 29 locations in Southern and Eastern Iowa, with its headquarters in Iowa City.

We’ve spent a lot of time talking to our primary four constituencies—our customers, employees, shareholders, and the people in our communities—since the merger announcement. As we’ve often said, for any business to succeed, each of these four groups must be well served and we believe they will if we can execute our plans for the new company:

 

   

Our customers will continue to see outstanding “EDGE” (Extraordinary Deeds through Genuine Efforts) service at each MidWestOne location. To assure excellence, we will continue to measure our service quality and we will not waver in our commitment to deepen relationships with our customers. In addition, the new company should be able to better leverage technology and new products that will benefit our customers and differentiate us, over time, from our competitors in most of our markets.

 

   

Our communities will continue to see the strong corporate citizen that they’ve seen for many years. We are leaders in our communities. Our employees are leaders and our communities are better places because we are in them. This will not change.

 

   

Our employees have more opportunities to shine and to perform on a bigger stage than ever before. We have a solid leadership team consisting of the top officers from the two companies. Our culture will be to “pay for performance” and to reward and recognize good work at every level of the company. We realize that we must provide an excellent workplace environment to attract and retain top-notch employees.

 

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Our shareholders are expected to have more liquidity than ever before with a NASDAQ traded stock. We believe that the efficiencies provided by the merger will provide our shareholders with a better earnings stream than could have been provided by either of the merged companies individually.

As we look out on the current banking landscape, we see opportunity as well as risk. Newspapers and magazines are full of stories that chronicle a weaker U.S. economy. We see signs of weakness in Iowa, but as we stated in our first quarter shareholder letter, Iowa seems to be faring somewhat better than the nation as a whole at this time. We saw some deterioration in our loan portfolios in the first quarter of 2008 as measured by past-due loans and charge-offs. At the end of the first quarter, the combined loan loss reserve of our three banks stood at 1.10% of total period-end loans and non-performing assets stood at 1.03% of loans. There are always surprises – both pleasant and unpleasant – when managing a loan portfolio. That said, we are confident in our ability to navigate the choppy seas in which we find ourselves at this time.

Capital and liquidity are two words that are on everyone’s mind these days as the commercial banking system manages its way through the slowing economy. As of March 31, 2008, MidWestOne Financial Group, Inc. had tangible equity to total assets of 8.50%. With an eye toward the unsettled markets experienced early in 2008, we have been building liquidity with the belief that a more liquid balance sheet would serve us well as 2008 unfolds. At March 31, our combined loan to deposit ratio stood at 93.07%. Our goal is to move this ratio into the mid to high 80’s over time.

We see great opportunity in delivering trust and investment services, as well as real estate mortgage services, in the MidWestOne footprint. During 2008 and 2009, we will be seeking to add professionals in selected markets to provide these services to MidWestOne customers. ISB Financial Corp. had been able to cross the 30% threshold in terms of fee income as a percentage of total revenues. While this number has fallen to the 25% range with the merger, we believe adding trust and investment representatives, as well as delivering a better product line of single family real estate mortgage loans, can propel our fee income toward the 30% level over the next few years.

To summarize, the goal for the next 12-18 months is to move our loan-to-deposit ratio into the 80’s, raise our non-interest income to total revenues toward 30%, and also to implement a disciplined approach to expense management. We believe that this path will produce a good and growing income stream for the company.

That brief financial blueprint, however, is only a part of the formula that will make MidWestOne successful. Will we continue to give our customers competitive products and exceptional service? Will we continue to be leaders in the communities in which we have banks? Will we be able to be successful in our efforts to deepen customer relationships and our salespeople be able to attract customers to MidWestOne? Will we be able to put together an energized staff, dedicated to assuring an affirmative answer to these questions?

This we know: your Board of Directors is committed to the notion that MidWestOne Financial Group has the potential to be one of Iowa’s banking leaders. We know that we see a growing core of key employees in our company who are dedicated to making the goals listed above a reality. We thank our directors and employees for all of their hard work over the past year. We look forward to sharing progress reports with you in our quarterly reports and in next year’s annual report. As always, thank you for your investment in MidWestOne and for your continued support.

Sincerely,

 

LOGO     LOGO  
W. Richard Summerwill     Charles N. Funk  
Chairman & CEO     President  
ISB Financial Corp.     ISB Financial Corp.  

 

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REPRESENTATIONS OF MANAGEMENT

Management is responsible for the content of the consolidated financial statements and supplemental information contained in other sections of this annual report. The consolidated financial statements have been prepared in conformity with generally accepted accounting principles appropriate to reflect, in all material respects, the substance of events and transactions that should be included. The consolidated financial statements reflect management’s judgements and estimates as to the effects of events and transactions that are accounted for and disclosed.

The Company maintains accounting and reporting systems, supported by an internal accounting control system, which is adequate to provide reasonable assurance that transactions are authorized, assets are safeguarded and reliable financial statements are prepared, recognizing the cost and expected benefits of internal accounting controls. The internal auditor conducts ongoing reviews of accounting practices and internal accounting controls.

The consolidated financial statements of the Company and its subsidiaries are audited by independent certified public accountants. Their role is to render independent professional opinions on the fairness of the consolidated financial statements based upon performance of procedures they deem appropriate under auditing standards generally accepted in the United States of America.

The Audit Committee of the Board of Directors, composed solely of outside directors, meets periodically with the internal auditor and independent certified public accountants to review matters relating to internal accounting controls and the nature, extent and results of audit efforts. The internal auditor and independent certified public accountants have access to the Audit Committee.

 

LOGO
W. Richard Summerwill
Chairman & CEO
LOGO
Charles N. Funk
President
LOGO
Gary J. Ortale
Treasurer

 

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LOGO

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors

ISB Financial Corp. and Subsidiaries

Iowa City, Iowa

We have audited the consolidated balance sheets of ISB Financial Corp. and Subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2007. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ISB Financial Corp. and Subsidiaries as of December 31, 2007 and 2006 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles.

 

/s/ McGladrey & Pullen, LLP
Cedar Rapids, Iowa
March 13, 2008

McGladrey & Pullen, LLP is an independent member firm of RSM International,

an affiliation of separate and independent legal entities.

 

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ISB Financial Corp. and Subsidiaries

Consolidated Balance Sheets

December 31, 2007, and 2006

(In Thousands, Except Shares)

 

      2007     2006  

Assets

    

Cash and due from banks (Note 11)

   $ 16,378     $ 14,274  

Investment securities (Note 2):

    

Available for sale (amortized cost 2007 $232,446; 2006 $241,926)

     232,125       239,486  

Held to maturity (fair value 2007 $101; 2006 $122)

     95       113  

Federal funds sold

     17,842       3,175  

Loans held for sale

     2,709       2,422  

Loans, net (Notes 3, 7, 12 and 13)

     396,088       373,314  

Property and equipment (Note 4)

     11,802       12,090  

Accrued interest receivable

     4,639       4,568  

Goodwill (Note 1)

     4,356       4,356  

Deferred income taxes (Note 8)

     1,836       2,372  

Bank-owned life insurance

     8,613       8,157  

Other assets

     5,500       4,344  
                

Total assets

   $ 701,983     $ 668,671  
                

Liabilities and Shareholders’ Equity

    

Liabilities:

    

Deposits:

    

Noninterest-bearing demand

   $ 66,340     $ 64,018  

Savings and interest-bearing demand

     215,291       199,148  

Time (Notes 2 and 5)

     244,984       229,735  
                

Total deposits

     526,615       492,901  

Federal funds purchased

     —         3,023  

Securities sold under agreements to repurchase (Notes 2 and 7)

     45,997       48,906  

Federal Home Loan Bank borrowings (Note 7)

     47,000       46,020  

Accounts payable, accrued expenses and other liabilities

     4,979       4,612  
                

Total liabilities

     624,591       595,462  
                

Commitments and Contingencies (Note 12)

    

Shareholders’ Equity (Notes 10 and 15)

    

Capital stock, common, $1 par value; authorized 10,000,000 shares; issued 2007 5,165,308 shares; 2006 5,176,488 shares

     5,165       5,176  

Additional paid-in capital

     100       14  

Retained earnings

     72,333       69,539  

Accumulated other comprehensive (loss)

     (206 )     (1,520 )
                

Total shareholders’ equity

     77,392       73,209  
                

Total liabilities and shareholders’ equity

   $ 701,983     $ 668,671  
                

See Notes to Consolidated Financial Statements.

 

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ISB Financial Corp. and Subsidiaries

Consolidated Statements of Income

Years Ended December 31, 2007, 2006 and 2005

(In Thousands, Except Per Share Amounts)

 

     2007     2006     2005

Interest income:

      

Loans, including fees

   $ 27,564     $ 25,850     $ 22,206

Investment securities:

      

U.S. Treasury

     —         15       74

U.S. Government agencies and corporations

     6,524       6,570       5,897

State and political subdivisions

     2,912       2,308       2,101

Other securities

     757       282       128

Federal funds sold

     548       283       221
                      

Total interest income

     38,305       35,308       30,627
                      

Interest expense:

      

Deposits:

      

Savings and interest-bearing demand

     3,109       3,042       1,791

Time

     11,689       9,306       6,415
                      

Total interest on deposits

     14,798       12,348       8,206

Federal funds purchased and securities sold under agreements to repurchase

     2,114       1,878       727

Other borrowings

     2,126       2,533       2,809
                      

Total interest expense

     19,038       16,759       11,742
                      

Net interest income

     19,267       18,549       18,885

Provision for loan losses (Note 3)

     500       550       300
                      

Net interest income after provision for loan losses

     18,767       17,999       18,585
                      

Other income:

      

Trust and investment fees

     3,688       2,889       2,692

Service charges on deposit accounts

     2,082       1,935       1,936

Income on sale of mortgage loans and servicing fees

     1,208       963       1,207

Other service fees and commissions

     2,084       1,893       2,565

Investment securities gains (losses), net (Note 2)

     (256 )     (108 )     322
                      

Total other income

     8,806       7,572       8,722
                      

Other expenses:

      

Salaries and employee benefits (Notes 9 and 10)

     10,926       10,081       10,053

Occupancy

     1,353       1,291       1,245

Equipment

     1,625       1,520       2,026

Office supplies, postage and telephone

     1,013       960       1,099

Other

     3,703       3,828       3,091
                      

Total other expenses

     18,620       17,680       17,514
                      

Income before income taxes

     8,953       7,891       9,793

Federal and state income taxes (Note 8)

     2,305       2,093       2,876
                      

Net income

   $ 6,648     $ 5,798     $ 6,917
                      

Earnings per share:

      

Basic

   $ 1.29     $ 1.11     $ 1.32
                      

Diluted

   $ 1.29     $ 1.11     $ 1.32
                      

See Notes to Consolidated Financial Statements.

 

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ISB Financial Corp. and Subsidiaries

Consolidated Statements of Shareholders’ Equity

Years Ended December 31, 2007, 2006 and 2005

(In Thousands, Except Share Amounts)

 

     Common
Stock
    Additional
Paid-In
Capital
    Retained
Earnings
    Accumulated
Other
Comprehensive
Income (Loss)
    Total  

Balance, December 31, 2004

   $ 1,741     $ 3,458     $ 61,223     $ (650 )   $ 65,772  
                

Comprehensive income:

          

Net income

     —         —         6,917       —         6,917  

Change in net unrealized losses on securities available-for-sale, net of reclassification adjustment and tax effect (Note 1)

     —         —         —         (2,363 )     (2,363 )
                

Total comprehensive income

             4,554  
                

Cash dividends paid ($0.85 per share)

     —         —         (1,480 )     —         (1,480 )

Stock options exercised for 3,160 shares (Note 10)

     3       114       —         —         117  

Repurchase of 60 shares of common stock

     —         (4 )     —         —         (4 )
                                        

Balance, December 31, 2005

     1,744       3,568       66,660       (3,013 )     68,959  
                

Comprehensive income:

          

Net income

     —         —         5,798       —         5,798  

Change in net unrealized losses on securities available-for-sale, net of reclassification adjustment and tax effect (Note 1)

     —         —         —         1,493       1,493  
                

Total comprehensive income

             7,291  
                

Cash dividends paid ($0.95 per share)

     —         —         (1,657 )     —         (1,657 )

Stock options exercised for 4,630 shares (Note 10)

     5       78       —         —         83  

Stock compensation

     —         1       —         —         1  

Repurchase of 26,683 shares of common stock

     (27 )     (1,260 )     (181 )     —         (1,468 )

Stock split, 3,454,066 shares issued (Note 15)

     3,454       (2,373 )     (1,081 )     —         —    
                                        

Balance, December 31, 2006

     5,176       14       69,539       (1,520 )     73,209  

(Continued)

 

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ISB Financial Corp. and Subsidiaries

Consolidated Statements of Shareholders’ Equity (Continued)

Years Ended December 31, 2007, 2006 and 2005

(In Thousands, Except Share Amounts)

 

     Common
Stock
    Additional
Paid-In
Capital
    Retained
Earnings
    Accumulated
Other
Comprehensive
Income (Loss)
    Total  

Balance, December 31, 2006

   $ 5,176     $ 14     $ 69,539     $ (1,520 )   $ 73,209  
                

Comprehensive income:

          

Net income

     —         —         6,648       —         6,648  

Change in net unrealized losses on securities available-for-sale, net of reclassification adjustment and tax effect (Note 1)

     —         —         —         1,314       1,314  
                

Total comprehensive income

             7,962  
                

Cash dividends paid ($0.65 per share)

     —         —         (3,359 )     —         (3,359 )

Stock options exercised for 8,425 shares (Note 10)

     8       99       —         —         107  

Stock compensation

     —         2       —         —         2  

Repurchase of 19,605 shares of common stock

     (19 )     (15 )     (495 )     —         (529 )
                                        

Balance, December 31, 2007

   $ 5,165     $ 100     $ 72,333     $ (206 )   $ 77,392  
                                        

See Notes to Consolidated Financial Statements.

 

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ISB Financial Corp. and Subsidiaries

Consolidated Statements of Cash Flows

Years Ended December 31, 2007, 2006 and 2005

(In Thousands)

 

     2007     2006     2005  

Cash Flows from Operating Activities

      

Net income

   $ 6,648     $ 5,798     $ 6,917  

Adjustments to reconcile net income to net cash provided by operating activities:

      

Depreciation

     1,325       1,251       1,489  

Amortization

     —         15       19  

Provision for loan losses

     500       550       300  

Deferred income taxes

     (269 )     24       (157 )

Stock option expense

     2       1       —    

Investment securities (gains) losses

     256       108       (322 )

Originations of loans held for sale

     (74,032 )     (61,108 )     (71,570 )

Proceeds from loans held for sale

     73,745       59,975       73,573  

Net change in:

      

(Increase) in accrued interest receivable

     (71 )     (533 )     (464 )

Decrease (increase) in other assets

     (1,156 )     1,672       (740 )

Increase in accounts payable, accrued expenses and other liabilities

     367       1,131       181  
                        

Net cash provided by operating activities

     7,315       8,884       9,226  
                        

Cash Flows from Investing Activities

      

Available for sale securities:

      

Sales

     28,774       8,519       20,557  

Maturities

     64,409       48,257       60,217  

Purchases

     (83,959 )     (56,838 )     (66,043 )

Maturities of held to maturity securities

     18       62       67  

Federal funds sold, net

     (14,667 )     11,325       (7,463 )

Loans made to customers, net of collections

     (23,274 )     (8,301 )     (35,284 )

Purchase of property and equipment, net

     (1,037 )     (1,283 )     (2,385 )

Activity in bank-owned life insurance:

      

Purchases

     (118 )     (61 )     (5,000 )

(Increase) in cash value

     (338 )     (316 )     (283 )
                        

Net cash provided by (used in) investing activities

     (30,192 )     1,364       (35,617 )
                        

Cash Flows from Financing Activities

      

Net increase in deposits

     33,714       320       18,022  

Net (decrease) increase in federal funds purchased and securities sold under agreements to repurchase

     (5,932 )     6,881       13,966  

Proceeds from Federal Home Loan Bank borrowings

     28,995       12,770       13,500  

Repayment of Federal Home Loan Bank borrowings

     (28,015 )     (26,450 )     (14,800 )

Stock options exercised

     107       83       117  

Repurchase of common stock

     (529 )     (1,468 )     (4 )

Dividends paid

     (3,359 )     (1,657 )     (1,480 )
                        

Net cash provided by (used in) financing activities

     24,981       (9,521 )     29,321  
                        

(Continued)

 

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ISB Financial Corp. and Subsidiaries

Consolidated Statements of Cash Flows (Continued)

Years Ended December 31, 2007, 2006 and 2005

(In Thousands)

 

     2007    2006    2005

Increase in cash and due from banks

   $ 2,104    $ 727    $ 2,930

Cash and Due From Banks:

        

Beginning balance

     14,274      13,547      10,617
                    

Ending balance

   $ 16,378    $ 14,274    $ 13,547
                    

Supplemental Disclosures

        

Cash payments for:

        

Interest paid to depositors

   $ 14,969    $ 11,721    $ 7,776

Interest paid on other obligations

     4,254      4,429      3,541

Income taxes

     2,572      1,645      2,953

See Notes to Consolidated Financial Statements.

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 1. Nature of Business and Significant Accounting Policies

Nature of business: ISB Financial Corp. and Subsidiaries (the “Company”) is a bank holding company that owns 100% of the outstanding common stock of Iowa State Bank & Trust Company, Iowa City and 100% of the common stock of First State Bank, Conrad, Iowa. Iowa State Bank & Trust Company and First State Bank (collectively the “Banks”) provide services to individuals, businesses, governmental units and institutional customers in Johnson County, Iowa, West Liberty, Iowa, and within a territory approximately 20 miles from Conrad, Melbourne and Parkersburg, Iowa. The Banks are actively engaged in many areas of commercial banking, including: acceptance of demand, savings and time deposits; making commercial, real estate, agricultural and consumer loans, and other banking services tailored for its individual customers. The Investment and Trust Department of Iowa State Bank & Trust Company administers estates, personal trusts, conservatorships, pension and profit-sharing accounts along with providing other management services to customers.

Accounting estimates: The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Certain significant estimates: The allowance for loan losses, unrealized gains and losses on debt securities available for sale, annual impairment testing of goodwill, estimated discount rate and expected long-term rate of return used in actuarial determination of pension plan asset or liability, and the fair values of investment securities and other financial instruments involve certain significant estimates made by management. These estimates are reviewed by management routinely and it is reasonably possible that circumstances that exist may change in the near-term future and that the effect could be material to the financial statements.

Principles of consolidation: The consolidated financial statements include the accounts of the Company and its subsidiary banks. All significant inter-company accounts and transactions have been eliminated in consolidation.

Presentation of cash flows: For purposes of reporting cash flows, cash and due from banks includes cash on hand and amounts due from banks (including cash items in process of clearing). Cash flows from loans originated by the Banks, deposits and federal funds purchased and sold and securities sold under agreements to repurchase are reported net.

Reclassification: Certain amounts in the 2006 consolidated financial statements have been reclassified to conform to the 2007 presentation.

Investment securities: Certain debt securities that the Company has the positive intent and ability to hold to maturity are classified as held to maturity and recorded at amortized cost. Securities not classified as held to maturity, including equity securities with readily determinable fair values, are classified as available for sale and recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income.

Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of held to maturity and available for sale securities below their cost, that are deemed to be other than temporary, are reflected in earnings as realized losses. In determining whether other than temporary impairment exists, management considers: (1) the length of time and the extent of which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.

Loans: Loans that the Banks have the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding unpaid principal balances adjusted for charge-offs and the allowance for loan losses. Interest income is accrued on the unpaid principal balance.

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 1. Nature of Business and Significant Accounting Policies (Continued)

 

The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90-days past due, unless the credit is well secured and in process of collection. Credit card loans and other personal loans are typically charged off no later than 180-days past due. Past due status is based on contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged off at an earlier date, if collection of principal or interest is considered doubtful.

All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Loans held for sale: Loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or estimated fair value, as determined by aggregate outstanding commitments from investors or current investor yield requirements. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income.

Mortgage loans held for sale are generally sold with the mortgage servicing rights released. Gains or losses on sales of mortgage loans with servicing released are recognized based on the difference between the selling price and the carrying value of the related mortgage loans sold.

Allowance for loan losses: The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a quarterly basis by management and is based upon management’s periodic review of the collectiblity of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as doubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers nonclassified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects that margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

A loan is considered impaired when, based on current information and events, it is probable that the Banks will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include: payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial, construction and commercial real estate loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price or the fair value of the collateral, if the loan is collateral dependent.

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 1. Nature of Business and Significant Accounting Policies (Continued)

 

Large groups of smaller-balance, homogeneous loans are collectively evaluated for impairment. Accordingly, the Banks do not separately identify individual consumer and residential loans for impairment disclosures.

Transfers of financial assets: Revenue from the origination and sale of loans in the secondary market is recognized upon the transfer of financial assets and accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when: (1) the assets have been isolated from the Banks, (2) the transferee has the right to pledge or exchange the assets it received and no condition both constrains the transferee from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor and (3) the Banks do not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets.

Revenue recognition: Trust fees, deposit account service charges and other fees are recognized when the services are provided or when customers use the services.

Credit-related financial instruments: In the ordinary course of business, the Banks have entered into commitments to extend credit, including commitments under credit card arrangements, commercial letters of credit and standby letters of credit. Such financial instruments are recorded when they are funded.

Property and equipment: Property and equipment are stated at cost less accumulated depreciation. The estimated useful lives and primary method of depreciation for the principal items are as follows:

 

Type of Assets

   Years    Depreciation Method

Buildings and leasehold improvements

   10 – 30    Straight-line

Furniture and equipment

   3 – 10    Straight-line

Other real estate owned: Real estate parcels acquired in satisfaction of loans are included in other assets at the lower of cost or fair value less estimated costs of disposal. When a property is acquired, the excess of the recorded investment in the property over its estimated fair value, less estimated costs of disposal, if any, is charged to the allowance for loan losses. Subsequent declines in the estimated fair value are recorded in a valuation allowance account. Additions to or reductions from valuation allowances, along with net operating results of the property, are included in other operating expenses. There was no balance as of December 31, 2007 and 2006.

Bank-owned life insurance: Bank-owned life insurance is carried at cash surrender value with increases/decreases reflected as income/expense in the statement of income.

Employee benefit plans: Annual expense of a defined benefit pension plan includes service cost (measured by projected unit credit method), interest on the projected benefit obligation, actual return on plan assets and other amortization and deferred amounts specified by Financial Accounting Standards Board Statements No. 87 and No. 158.

Deferred benefits under a salary continuation plan are charged to expense during the period the participating employees attain full eligibility.

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 1. Nature of Business and Significant Accounting Policies (Continued)

 

Stock-based compensation: The Company adopted SFAS No. 123(R) on January 1, 2006 using the prospective method in which compensation cost is recognized over the service period for all awards granted subsequent to the Company’s adoption of SFAS No. 123(R). Prior to the adoption of SFAS No. 123(R), the Company accounted for stock-based compensation under the intrinsic value method, as outlined under the provisions of Accounting Principles Board Opinion No. 25 and its related interpretations. Accordingly, no compensation cost was recognized for grants issued prior to the adoption of SFAS No. 123(R) since the options were granted with an exercise price equal to market value at the date of grant.

Income taxes: The Company files a consolidated federal income tax return. Income tax expense is generally allocated as if the Holding Company and its subsidiaries file separate income tax returns. Deferred taxes are provided on an asset and liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax basis. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.

When tax returns are filed, it is highly certain that some positions taken will be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. The evaluation of a tax position taken is considered by itself and not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority.

Interest and penalties related to income taxes are recorded as miscellaneous expense in the statements of income.

Earnings per share: Basic per-share amounts are computed by dividing net income (the numerator) by the weighted-average number of common shares outstanding (the denominator). Diluted per share amounts assume the conversion, exercise or issuance of all potential common stock, unless the effect is to reduce the loss or increase the income per common share from continuing operations.

Following is a reconciliation of the denominator:

 

     Year Ended December 31,
     2007    2006    2005

Weighted-average number of shares

   5,170,898    5,204,957    5,228,775

Potential number of dilutive shares

   1,660    8,921    8,378
              

Total shares to compute diluted earnings per share

   5,172,558    5,213,878    5,237,153
              

There are no potentially dilutive securities that have not been included in the determination of diluted shares.

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 1. Nature of Business and Significant Accounting Policies (Continued)

 

Goodwill: Goodwill represents the cost in excess of the fair value of assets acquired in business combinations. Goodwill has an indefinite life, but is tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The Company established September 30 as the date for its annual impairment test. The annual impairment test consists of a comparison of the fair value of the intangible asset to its carrying amount. If the carrying amount were to exceed the fair value, an impairment loss would be recognized. The Company has completed the annual impairment test and concluded there was no impairment as of September 30, 2007, 2006 and 2005.

Trust assets: Trust assets, other than cash deposits held by the Banks in fiduciary or agency capacities for its customers, are not included in the accompanying financial statements because such accounts are not assets of the Banks.

Comprehensive income: Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income.

The components of other comprehensive income and related tax effects are as follows:

 

     Year Ended December 31,  
     2007     2006     2005  
     (In Thousands)  

Unrealized holding gains (losses) on available for sale securities

   $ 1,863     $ 2,266     $ (3,447 )

Reclassification adjustment for (gains) losses realized in income

     256       108       (322 )
                        
     2,119       2,374       (3,769 )

Tax effects

     805       881       (1,406 )
                        

Other comprehensive income (loss)

   $ 1,314     $ 1,493     $ (2,363 )
                        
The components of accumulated other comprehensive income, included in shareholders’ equity, are as follows:  
     Year Ended December 31,  
     2007     2006     2005  
     (In Thousands)  

Net unrealized (losses) on securities available for sale

   $ (321 )   $ (2,440 )   $ (4,814 )

Tax effects

     (115 )     (920 )     (1,801 )
                        

Accumulated other comprehensive income (loss)

   $ (206 )   $ (1,520 )   $ (3,013 )
                        

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 1. Nature of Business and Significant Accounting Policies (Continued)

 

Recent Accounting Pronouncements: In September 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurement. SFAS No. 157 also emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy with the highest priority being quoted in active markets. Under SFAS No. 157, fair value measurements are disclosed by level within that hierarchy. The requirements of FAS 157 are first effective for our fiscal year beginning January 1, 2008. However, in February 2008, the FASB decided that an entity need not apply this standard to nonfinancial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis until the subsequent year. Accordingly, our adoption of this standard on January 1, 2008 is limited to financial assets and liabilities, and any nonfinancial assets and liabilities recognized or disclosed at fair value on a recurring basis. The Company is currently assessing the potential effect of SFAS No. 157 on its financial position, results of operations and cash flows.

In February 2007, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment of FASB Statement No. 115”, which provides all entities, including not-for-profit organizations, with an option to report selected financial assets and liabilities at fair value. The objective of the Statement is to improve financial reporting by providing entities with the opportunity to mitigate volatility in earnings caused by measuring related assets and liabilities differently without having to apply the complex provisions of hedge accounting. Certain specified items are eligible for the irrevocable fair value measurement option as established by Statement No. 159. Statement No. 159 is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. The Company is currently evaluating the impact that the adoption of this Statement will have on its financial position, results of operation and cash flows.

In September 2006, the Emerging Issues Task Force (“EITF”) reached a final consensus on Issue 06-04, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.” The consensus stipulates that an agreement by an employer to share a portion of the proceeds of a life insurance policy with an employee during the postretirement period is a postretirement benefit arrangement required to be accounted for under SFAS No. 106 or Accounting Principles Board Opinion (“APB”) No. 12, “Omnibus Opinion—1967.” The consensus concludes that the purchase of a split-dollar life insurance policy does not constitute a settlement under SFAS No. 106 and, therefore, a liability for the postretirement obligation must be recognized under SFAS No. 106 if the benefit is offered under an arrangement that constitutes a plan or under APB No. 12 if it is not part of a plan. Issue 06-04 is effective for annual or interim reporting periods beginning after December 15, 2007. The Company has endorsement split-dollar life insurance policies and is currently assessing the financial statement impact of implementing EITF 06-04.

In March 2007, the Emerging Issues Task Force (“EITF”) reached a final conclusion on Issue 06-10, “Accounting for Collateral Assignment Split-Dollar Life Insurance Arrangements”. The consensus concludes that a liability must be recognized for the postretirement obligation related to a collateral assignment split-dollar life insurance arrangement in accordance with SFAS No. 106 or APB No. 12. Any asset should be recognized and measured based on the nature and substance of the collateral assignment split-dollar life insurance arrangement. The effective date of EITF 06-10 is for fiscal years beginning after December 15, 2007. The Company is currently assessing the financial statement impact of implementing EITF 06-10.

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 1. Nature of Business and Significant Accounting Policies (Continued)

 

In December 2007, FASB issued SFAS No. 141(revised), “Business Combinations”. The Statement establishes principles and requirements for how an acquirer recognizes and measures tangible assets acquired, liabilities assumed, goodwill and any noncontrolling interests and identifies related disclosure requirements for business combinations. Measurement requirements will result in all assets, liabilities, contingencies and contingent consideration being recorded at fair value on the acquisition date, with limited exceptions. Acquisition costs and restructuring costs will generally be expensed as incurred. This Statement is effective for the Company for business combinations in which the acquisition date is on or after January 1, 2009.

 

Note 2. Investment Securities

The amortized cost and fair value of investment securities available for sale, with gross unrealized gains and losses, are as follows:

 

     (In Thousands)
     Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Fair Value

December 31, 2007:

          

U.S. Government agencies and corporations

   $ 65,937    $ 1,013    $ (59 )   $ 66,891

State and political subdivisions

     82,876      299      (763 )     82,412

Mortgage-backed and collateralized mortgage obligations

     69,079      374      (325 )     69,128

Other securities

     14,554      368      (1,228 )     13,694
                            

Total

   $ 232,446    $ 2,054    $ (2,375 )   $ 232,125
                            

December 31, 2006:

          

U.S. Government agencies and corporations

   $ 86,329    $ 113    $ (980 )   $ 85,462

State and political subdivisions

     70,357      199      (812 )     69,744

Mortgage-backed and collateralized mortgage obligations

     78,249      25      (1,301 )     76,973

Other securities

     6,991      337      (21 )     7,307
                            

Total

   $ 241,926    $ 674    $ (3,114 )   $ 239,486
                            

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 2. Investment Securities (Continued)

 

The amortized cost and fair value of investment securities held-to-maturity, with gross unrealized gains and losses, are as follows:

 

     (In Thousands)
     Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Fair Value

December 31, 2007:

           

State and political subdivisions

   $ 95    $ 6    $ —      $ 101
                           

December 31, 2006:

           

State and political subdivisions

   $ 113    $ 9    $ —      $ 122
                           

Investment securities with a carrying value of $76,885,000 and $71,828,000 at December 31, 2007 and 2006, respectively, were pledged on public deposits, securities sold under agreements to repurchase and for other purposes, as required or permitted by law.

Gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position are summarized as follows:

December 31, 2007:

 

     Less than 12 Months    12 Months or More    Total
     Fair
Value
   Gross
Unrealized
Losses
   Fair
Value
   Gross
Unrealized
Losses
   Fair
Value
   Gross
Unrealized
Losses
     (In Thousands)

Securities available for sale:

                 

U.S. Government agencies

   $ —      $ —      $ 11,939    $ 59    $ 11,939    $ 59

State and political subdivisions

     12,016      178      33,220      585      45,236      763

Mortgage-backed and collateralized mortgage obligations

     —        —        30,956      325      30,956      325

Other securities

     8,617      1,066      239      162      8,856      1,228
                                         
   $ 20,633    $ 1,244    $ 76,354    $ 1,131    $ 96,987    $ 2,375
                                         

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 2. Investment Securities (Continued)

 

December 31, 2006:

 

     Less than 12-Months    12-Months or More    Total
     Fair
Value
   Gross
Unrealized
Losses
   Fair
Value
   Gross
Unrealized
Losses
   Fair
Value
   Gross
Unrealized
Losses
     (In Thousands)

Securities available for sale:

                 

U.S. Government agencies

   $ 24,803    $ 84    $ 50,679    $ 896    $ 75,482    $ 980

State and political subdivisions

     11,950      109      37,039      703      48,989      812

Mortgage-backed and collateralized mortgage obligations

     18,741      107      55,021      1,194      73,762      1,301

Other securities

     380      21      —        —        380      21
                                         
   $ 55,874    $ 321    $ 142,739    $ 2,793    $ 198,613    $ 3,114
                                         

In reaching the conclusion that the impairments disclosed above are temporary and not other-than-temporary, the Company evaluates the nature of the U.S. Treasury Securities, U.S. Government agency securities, mortgage-backed and collateralized mortgage obligations, and other securities, and the credit ratings of the state and municipal bonds. None of the impairment was due to the deterioration in credit quality of the issuers that might result in the non-collection of principal and interest. The cause of the impairments is due to changes in interest rates and the Company has not recognized any unrealized loss in income because the Company has the intent and ability to hold these investment securities for a period of time sufficient to allow for an anticipated recovery.

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 2. Investment Securities (Continued)

 

The contractual maturity distribution of investment securities at December 31, 2007 is summarized as follows:

 

     (In Thousands)
     Available-For-Sale    Held-To-Maturity
     Amortized
Cost
   Fair Value    Amortized
Cost
   Fair Value

Due in one year or less

   $ 33,880    $ 33,857    $ —      $ —  

Due after one year through five years

     68,392      68,956      95      101

Due after five years through ten years

     39,063      39,161      —        —  

Due after ten years

     19,252      18,395      —        —  

Mortgage-backed and collateralized mortgage obligations

     69,079      69,128      —        —  
                           
   $ 229,666    $ 229,497    $ 95    $ 101
                           

Mortgage-backed and collateralized mortgage obligations are collateralized by mortgage loans guaranteed by U.S. Government agencies. Experience has indicated that principal payments will be collected sooner than scheduled because of prepayments. Therefore, these securities are not scheduled in the maturity categories indicated above. Other equity securities available for sale with an amortized cost of $2,780,000 and a fair value of $2,628,000 are excluded from this table.

Realized gains and losses on sales of investment securities are as follows:

 

     Year Ended December 31,  
     2007     2006     2005  
     (In Thousands)  

Gross gains

   $ 45     $ 50     $ 363  

Gross losses

     (301 )     (158 )     (41 )
                        
   $ (256 )   $ (108 )   $ 322  
                        

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 3. Loans

The composition of the net loans is as follows:

 

     December 31,
     2007    2006
     (In Thousands)

Commercial, financial and agricultural

   $ 103,029    $ 89,284

Real estate:

     

Construction

     28,774      31,133

Mortgage

     260,201      248,308

Loans to individuals

     8,895      9,475

All other

     655      412
             

Total loans

     401,554      378,612

Less allowance for loan losses

     5,466      5,298
             

Net loans

   $ 396,088    $ 373,314
             

Changes in the allowance for loan losses are as follows:

 

     Year Ended December 31,  
     2007     2006     2005  
     (In Thousands)  

Balance, beginning

   $ 5,298     $ 5,227     $ 4,894  

Provision charged to operating expenses

     500       550       300  

Recoveries of amounts charged-off

     148       103       208  

Loans charged-off

     (480 )     (582 )     (175 )
                        

Balance, ending

   $ 5,466     $ 5,298     $ 5,227  
                        

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 3. Loans (Continued)

 

Information about impaired and nonaccrual loans, as of and for the years ended December 31, 2007 and 2006, is as follows:

 

     2007    2006
     (In Thousands)

Loans for which there is a related allowance for loan losses

   $ 3,154    $ 1,594

Loans for which there is no related allowance for loan losses

     —        —  
             

Total impaired loans

   $ 3,154    $ 1,594
             

Allowance for loan losses on impaired loans

   $ 693    $ 331

Average balance of impaired loans

     2,374      2,335

Nonaccrual loans

     782      371

Loans past due 90-days or more and still accruing interest

     517      395

Interest income recognized on impaired loans

     245      124

 

Note 4. Property and Equipment

Property and equipment is as follows:

 

     December 31,
     2007    2006
     (In Thousands)

Land

   $ 2,428    $ 2,428

Buildings and leasehold improvements

     11,535      11,545

Furniture and equipment

     9,180      8,421
             
     23,143      22,394

Accumulated depreciation and amortization

     11,341      10,304
             
   $ 11,802    $ 12,090
             

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 5. Certificates of Deposit

Certificates of deposit in denominations of $100,000 or more totaled $77,939,000 and $70,230,000 at December 31, 2007 and 2006, respectively.

At December 31, 2007, the scheduled maturities of certificates of deposits (in thousands) are as follows:

 

2008

   $ 212,802

2009

     25,685

2010

     3,033

2011

     1,087

2012

     2,377
      
   $ 244,984
      

 

Note 6. Loans Serviced for Others

Loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid principal balances of mortgage and other loans serviced for others were $96,866,000 and $107,990,000 at December 31, 2007 and 2006, respectively.

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 7. Federal Home Loan Bank and Other Borrowings

The Banks are members of The Federal Home Loan Bank of Des Moines and, as of December 31, 2007, held Federal Home Loan Bank (FHLB) stock totaling $2,995,000, which is recorded in other assets. Advances from the FHLB are collateralized primarily by 1-4 unit residential mortgages equal to various percentages of the total outstanding notes. As of December 31, 2007 and 2006, the borrowings were as follows:

 

     2007    2006
     (In Thousands)

Due in 2007, 2.60% to 5.50%

   $ —      $ 19,020

Due in 2008, 3.40% to 5.25%

     11,000      10,000

Due in 2008, 5.41%, callable quarterly

     3,000      5,000

Due in 2009, 3.56% to 5.24%

     15,000      7,500

Due in 2009, 5.42% to 5.81%, callable quarterly

     4,000      4,000

Due in 2010, 4.04% to 5.35%

     14,000      500
             
   $ 47,000    $ 46,020
             

Securities sold under repurchase agreements with balances of $45,997,000 and $48,906,000 as of December 31, 2007 and 2006, respectively, are used by the Banks to acquire funds from customers where the customer is required or desires to have their funds supported by collateral consisting of U.S. Treasury securities, U.S. Government agencies or other types of securities. The repurchase agreement is a promise to sell these securities to a customer at a certain price and repurchase them within one to four days after the transaction date at that same price plus interest accrued at an agreed upon rate. The weighted average interest rate on these agreements was 3.60% at December 31, 2007.

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 8. Income Taxes

The company files income tax returns in the U.S. Federal and Iowa state jurisdictions. Income tax returns for the years 2004 through 2007, with few exceptions, remain open to examination by Federal and state taxing authorities.

The Company adopted the provisions of Financial Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48), as of January 1, 2007. The Interpretation provides clarification on accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement of Financial Accounting Standard (SFAS) No. 109, Accounting for Income Taxes. The Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. As a result of the Company’s evaluation of the implementation of FIN 48, no significant income tax uncertainties were identified. Therefore, the Company recognized no adjustment for unrecognized income tax benefits during the year ended December 31, 2007.

The Company recognizes interest and penalties related to unrecognized tax benefits in miscellaneous expense. During the years ended December 31, 2007, 2006 and 2005, the Company recognized no material interest or penalties. No accrued interest or penalties is included in accrued tax expenses in the balance sheet at December 31, 2007 and 2006.

Income taxes for the years ended December 31, 2007, 2006 and 2005 are summarized as follows:

 

     December 31,  
     2007     2006    2005  
     (In Thousands)  

Current:

       

Federal

   $ 2,170     $ 1,711    $ 2,576  

State

     404       358      457  

Deferred

     (269 )     24      (157 )
                       
   $ 2,305     $ 2,093    $ 2,876  
                       

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 8. Income Taxes (Continued)

 

The income tax provisions for the years ended December 31, 2007, 2006 and 2005 are less than the amounts computed by applying the maximum effective federal income tax rate to the income before income taxes because of the following items:

 

     2007     2006     2005  
     Amount     % Of
Pretax
Income
    Amount     % Of
Pretax
Income
    Amount     % Of
Pretax
Income
 
     (In Thousands)  

Expected provision

   $ 3,044     34.0 %   $ 2,683     34.0 %   $ 3,330     34.0 %

Tax-exempt interest, net

     (881 )   (9.8 )     (715 )   (9.1 )     (663 )   (6.8 )

Life insurance

     (115 )   (1.3 )     (107 )   (1.4 )     (96 )   (1.0 )

State income taxes, net of federal income tax benefit

     267     3.0       236     3.0       302     3.1  

Other

     (10 )   (0.1 )     (4 )   —         3     —    
                                          
   $ 2,305     25.8 %   $ 2,093     26.5 %   $ 2,876     29.3 %
                                          

Net deferred tax assets consist of the following components:

 

     December 31,
     2007    2006
     (In Thousands)

Deferred income tax assets:

     

Allowance for loan losses

   $ 2,039    $ 1,977

Deferred compensation

     601      437

Unrealized losses on investment securities

     115      920

Other

     59      —  
             

Gross tax assets

     2,814      3,334
             

Deferred income tax liabilities:

     

Property and equipment

     523      621

Pension asset

     244      201

Mortgage servicing rights

     87      —  

Other

     124      140
             

Gross tax liabilities

     978      962
             

Net deferred income tax asset

   $ 1,836    $ 2,372
             

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 8. Income Taxes (Continued)

 

The net change in the deferred income taxes reflected in the financial statements is as follows:

 

     Year Ended December 31,  
     2007     2006    2005  
     (In Thousands)  

Statements of income

   $ (269 )   $ 24    $ (157 )

Statements of shareholders’ equity

     805       881      (1,406 )
                       
   $ 536     $ 905    $ (1,563 )
                       

 

Note 9. Employee Benefit Plans, Pension Curtailment, and Adoption of SFAS No. 158

Iowa State Bank & Trust Company sponsors a noncontributory defined benefit pension plan for substantially all its employees. Effective December 31, 2007 the Bank elected to curtail the plan by limiting this employee benefit to those employees vested as of December 31, 2007. The Company adopted SFAS No. 158, Employers Accounting for Defined Benefit Plans and Other Postretirement Plans as of December 31, 2007. The following table sets forth the plan’s funded status and amounts recognized in the accompanying financial statements as of December 31, 2007, 2006 and 2005:

 

     2007     2006     2005  
     (In Thousands)  

Change in projected benefit obligation

      

Projected benefit obligation at the beginning of year

   $ 12,211     $ 12,013     $ 10,550  

Service cost

     471       455       437  

Interest cost

     687       651       637  

Actuarial (gain) or loss

     (581 )     (508 )     760  

Benefits paid

     (402 )     (400 )     (371 )

Curtailment

     (2,337 )     —         —    
                        

Projected benefit obligation at the end of year

   $ 10,049     $ 12,211     $ 12,013  
                        

Change in plan assets

      

Fair value of plan assets at the beginning of year

   $ 10,489     $ 9,888     $ 7,869  

Actual return on plan assets

     616       1,001       390  

Benefits paid

     (403 )     (400 )     (371 )

Employer contribution

     —         —         2,000  
                        

Fair value of assets at the end of the period

   $ 10,702     $ 10,489     $ 9,888  
                        

 

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Notes to Consolidated Financial Statements

 

 

Note 9. Employee Benefit Plans and Pension Curtailment (Continued)

 

     2007     2006     2005  
     (In Thousands)  

Change in prepaid (accrued) benefit cost

      

Prepaid (accrued) benefit cost, beginning

   $ 538     $ 887     $ (641 )

Contributions

     —         —         2,000  

Pension (cost) benefit

     115       (349 )     (472 )
                        

Prepaid benefit cost, ending

   $ 653     $ 538     $ 887  
                        

Funded status (plan assets less than benefit obligations) at end of years

   $ 653     $ (1,722 )   $ (2,125 )

Unrecognized transitional net assets

     —         (289 )     (329 )

Unrecognized prior service cost

     —         16       19  

Unrecognized net actuarial (gain) loss

     —         2,533       3,322  
                        

Net amount recognized

   $ 653     $ 538     $ 887  
                        

Recognized on balance sheet

      

Other assets

   $ 653     $ 538     $ 887  
                        

Recognized in accumulated other comprehensive income after adoption of SFAS No.158

      

Transition obligation (asset)

   $ (248 )    

Prior service cost (credit)

     —        

Net loss

     248      
            

Total

   $ —        
            

Benefit obligation assumptions as of December 31st:

      

Discount Rate

     6.00 %     5.75 %     5.75 %

Expected return on plan assets

     8.50 %     8.50 %     8.50 %

Rate of compensation increase

     4.50 %     4.50 %     4.50 %

Net periodic benefit cost assumptions as of December 31st:

      

Discount rate

     5.75 %     5.75 %     6.00 %

Expected return on plan assets

     8.50 %     8.50 %     8.50 %

Rate of compensation increase

     4.50 %     4.50 %     4.50 %

A discount rate of 6.00% was utilized at the beginning of the year ended December 31, 2005 for purposes of computing the net periodic pension cost.

 

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Notes to Consolidated Financial Statements

 

 

Note 9. Employee Benefit Plans and Pension Curtailment (Continued)

 

      2007     2006     2005  

Components of net periodic pension cost

      

Service cost

   $ 471     $ 456     $ 437  

Interest cost

     687       651       637  

Expected return on plan assets

     (875 )     (821 )     (653 )

Amortization of net actuarial (gain) or loss

     74       101       89  

Amortization of prior service cost

     3       3       3  

Amortization of transition obligation/(asset)

     (41 )     (41 )     (41 )

Curtailment

     (434 )     —         —    
                        

Total net periodic pension cost (benefit)

   $ (115 )   $ 349     $ 472  
                        

The following pension benefit payments, which reflect expected future service, as appropriate, are expected to be paid as follows:

 

2008

   $ 398

2009

     396

2010

     418

2011

     410

2012

     426

Five years thereafter

     2,994
      
   $ 5,042
      

The accumulated benefit obligation for the defined benefit pension plan was $10.0 million, $9.9 million, and $9.3 million at December 31, 2007, 2006 and 2005. The Bank does not expect to make a contribution to the plan in 2008. The Bank’s pension plan weighted-average asset allocations by asset category are as follows:

 

     Target
Allocation
2007
    December 31,  
     2007     2006     2005  

Mutual funds—equity

   55 - 75 %   65 %   65 %   40 %

Mutual funds—fixed income

   20 - 55 %   34 %   33 %   29 %

Cash and equivalents

   0 - 10 %   1 %   2 %   31 %
                    
     100 %   100 %   100 %
                    

Pension plan assets are allocated by an automated system that determines a target allocation based on expected returns consistent with the Bank’s risk tolerance. The allocations may vary within a range. The asset allocation at December 31, 2005 was not an accurate picture of the long term desired allocation. Funds were shifted to cash before December 31, 2005 prior to reallocating to equity and bond index funds. Upon reallocation in January 2006, the allocation was 63% equities, 34% debt and 3% cash equivalents.

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 9. Employee Benefit Plans and Pension Curtailment (Continued)

 

Effects of curtailment on components of the pension:

 

     Year Ending December 31, 2007  
     Pre-
Curtailment
    Curtailment
Effect
    Post-
Curtailment
 

Projected benefit obligation

   $ 12,386     $ (2,337 )   $ 10,049  

Fair value of assets

     10,702       —         10,702  
                        

Funded status:

   $ (1,684 )   $ 2,337     $ 653  
                        

Unrecognized transition obligation/(asset)

   $ (248 )   $ —       $ (248 )

Unrecognized prior service cost

     14       (14 )     —    

Unrecognized net gain/(loss)

     2,137       (1,889 )     248  

Prepaid/(accrued) pension cost at December 31, 2007

     219       434       653  

The adoption of SFAS No. 158 at December 31, 2007 had no affect on the Company’s financial position or results of operations for the year ended December 31, 2007.

The Banks have a salary reduction profit-sharing 401(k) plan covering all employees fulfilling minimum age and service requirements. Employee contributions to the plan are optional. Employer contributions are discretionary and may be made to the plan in an amount equal to a percentage of the employee’s salary. The 401(k) contribution expense for this plan totaled $265,000, $230,000, and $232,000 for the years ended December 31, 2007, 2006 and 2005, respectively.

Iowa State Bank & Trust Company has a salary continuation plan for several officers and directors. This plan provides annual payments of various amounts upon retirement or death. The Bank accrues the expense for these benefits by charges to operating expense during the period the respective officer or director attains full eligibility. The amount charged to operating expense during the years ended December 31, 2007, 2006 and 2005 totaled $326,000, $123,000 and $114,000, respectively. To provide the retirement benefits, the Bank carries life insurance policies with cash values totaling $3,077,000, $2,817,000 and $2,637,000 at December 31, 2007, 2006 and 2005, respectively.

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 10. Stock Compensation Plans

The Company has a Stock Option Plan for designated officers and directors of the Company and subsidiaries whereby the Company may grant options to purchase common stock, with a maximum term of five years, at the fair value of the stock on the date of the grant. As of December 31, 2007, options for up to 121,385 shares may be granted. Effective January 1, 2006, the Company adopted SFAS No. 123(R), Share-Based Payment, which requires that compensation cost relating to share-based payment transactions be recognized in the financial statements with measurement based upon the fair value of the equity or liability instruments issued. For the years ended December 31, 2007 and 2006, the Company recognized $2,000 and $1,000, respectively, in compensation expense for stock options.

The following table illustrates the effect on the Company’s reported net income and earnings per share if the Company had applied the fair value recognition provision of SFAS No. 123(R) to stock-based employee compensation prior to the adoption date. This table only relates to options granted prior to the adoption of 123(R) which are not subject to the recording of expense under 123(R):

 

          Years Ended December 31,  
          2007     2006     2005  
          (In thousands, except per share data)  

Net income, as reported

      $ 6,648     $ 5,798     $ 6,917  

Additional expense

        (8 )     (8 )     (10 )

Related tax benefit

        3       3       4  
                           

Pro forma net income

   $ 6,643     $ 5,793     $ 6,911  
                           

Basic earnings per share

   - As reported    $ 1.29     $ 1.11     $ 1.32  
  

- Pro forma

     1.28       1.11       1.32  

Diluted earnings per share

   - As reported    $ 1.29     $ 1.11     $ 1.32  
  

- Pro forma

     1.28       1.11       1.32  

The fair value of each grant is established at the grant date using the Black-Scholes valuation model with the following assumptions:

 

     2007     2006  

Expected dividends

   1.32 %   1.65 %

Risk-free interest rate

   4.96     4.75  

Expected option life

   1.5 Years     2 Years  

Expected volatility

   13 %   12 %

The expected volatility is based on historical volatility of the Company. The risk-free interest rates for periods within the expected life of the awards are based on the U.S. Treasury yield curve in effect at the time of the grant. The expected life is based on historical exercise experience. The dividend yield assumption is based on the Company’s history and expectation of dividend payouts.

 

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Notes to Consolidated Financial Statements

 

 

Note 10. Stock Compensation Plans (Continued)

 

A summary of the stock options outstanding is as follows:

 

     Number
Of
Shares
    Weighted
Average Exercise
Price

Balance, December 31, 2004

   32,640     $ 12.68

Granted

   3,120       19.54

Exercised

   (9,480 )     12.37

Forfeited

   (2,520 )     12.67
            

Balance, December 31, 2005

   23,760       13.70

Granted

   870       25.63

Exercised

   (5,690 )     14.51

Forfeited

   (900 )     16.17
            

Balance, December 31, 2006

   18,040       13.90

Granted

   450       27.00

Exercised

   (8,425 )     12.70

Forfeited

   —         —  
            

Balance, December 31, 2007

   10,065     $ 15.49
            

Options exercisable

   10,065     $ 15.49
            

 

     2007    2006    2005

Number of options exercisable, end of year

     10,065      7,915      4,440

Weighted-average fair value of options granted during the year determined utilizing the Black-Scholes valuation model

   $ 2.37    $ 2.41    $ 0.94

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 10. Stock Compensation Plans (Continued)

 

Other pertinent information related to the options outstanding at December 31, 2007 is as follows:

 

Exercise
Price

  Number
Outstanding
  Remaining
Contractual
Life
  Number
Exercisable
$12.67   6,670   6-months   6,670
17.50   1,350   6-months   1,350
19.33   450   6-months   450
19.67   450   6-months   450
24.17   245   6-months   245
27.00   900   6-months   900
         
  10,065     10,065
         

 

     Number of
Shares
    Weighted Average
Grant Date Fair
Value

Non-vested options, December 31, 2006

   10,125     $ 1.26

Granted

   450     $ 2.37

Vested

   (10,575 )   $ 1.31
        

Non-vested options, December 31, 2007

   —       $ —  
        

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 11. Regulatory Capital Requirements and Restrictions on Subsidiary Cash

The Company (on a consolidated basis) and the Banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and Banks’ financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Banks must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Banks to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 2007, 2006 and 2005, that the Company and the Banks meet all capital adequacy requirements to which they are subject.

As of December 31, 2007, the most recent notification from the Federal Deposit Insurance Corporation categorized the Banks as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following tables. There are no conditions or events since the notification that management believes have changed the Banks’ category. The Company’s and the Banks’ actual capital amounts and ratios as of December 31, 2007 and 2006 are also presented in the table.

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 11. Regulatory Capital Requirements and Restrictions on Subsidiary Cash (Continued)

 

A comparison of the Company’s and the Banks’ capital with the regulatory requirements is presented below:

 

     Actual     For
Capital
Adequacy
Purposes
    To Be Well
Capitalized
Under Prompt
Corrective
Action
Provisions
 
     Amount    Ratio     Ratio     Ratio  
     (In Thousands)  

At December 31, 2007:

         

Consolidated:

         

Total risk based capital

   $ 78,533    16.49 %   8 %   —    

Tier 1 risk based capital

     73,066    15.35     4     —    

Leverage ratio

     73,066    10.67     4     —    

Iowa State Bank & Trust Company:

         

Total risk based capital

   $ 52,190    13.01 %   8 %   10 %

Tier 1 risk based capital

     48,186    12.01     4     6  

Leverage ratio

     48,186    8.34     4     5  

First State Bank:

         

Total risk based capital

   $ 9,688    13.68 %   8 %   10 %

Tier 1 risk based capital

     8,796    12.42     4     6  

Leverage ratio

     8,796    8.48     4     5  

At December 31, 2006:

         

Consolidated:

         

Total risk based capital

   $ 75,628    15.79 %   8 %   —    

Tier 1 risk based capital

     70,329    14.69     4     —    

Leverage ratio

     70,329    10.54     4     —    

Iowa State Bank & Trust Company:

         

Total risk based capital

   $ 51,028    12.61 %   8 %   10 %

Tier 1 risk based capital

     47,244    11.68     4     6  

Leverage ratio

     47,244    8.41     4     5  

First State Bank:

         

Total risk based capital

   $ 9,589    13.33 %   8 %   10 %

Tier 1 risk based capital

     8,682    12.07     4     6  

Leverage ratio

     8,682    8.38     4     5  

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 11. Regulatory Capital Requirements and Restrictions on Subsidiary Cash (Continued)

 

The ability of the Company to pay dividends to its shareholders is dependent upon dividends paid by the Banks. The Banks are subject to certain statutory and regulatory restrictions on the amount they may pay in dividends. To maintain acceptable capital ratios in the Banks, a portion of their retained earnings are not available for the payment of dividends. To maintain a ratio of capital-to-assets of 8%, retained earnings, totaling approximately $2,669,000 as of December 31, 2007 are available for the payment of dividends.

The Banks are required to maintain reserve balances in cash on hand or on deposit with Federal Reserve Banks. Reserve balances totaled $3,532,000 and $4,892,000 as of December 31, 2007 and 2006, respectively.

 

Note 12. Commitments and Contingencies

Financial instruments with off-balance sheet risk: The Banks are party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheets.

The Banks use the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. A summary of the Banks’ commitments at December 31, 2007 and 2006 is as follows:

 

     2007    2006
     (In Thousands)

Commitments to extend credit

   $ 111,233    $ 101,121

Standby letters of credit

     1,920      2,048
             
   $ 113,153    $ 103,169
             

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 12. Commitments and Contingencies (Continued)

 

The Banks’ exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Banks evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Banks upon extension of credit, is based on management’s credit evaluation of the party. Collateral held varies, but may include accounts receivable, crops, livestock, inventory, property and equipment, residential real estate and income-producing commercial properties.

Standby letters of credit are conditional commitments issued by the Banks to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements and, generally, have terms of one year or less. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Banks hold collateral, which may include accounts receivable, inventory, property, equipment and income-producing properties, supporting those commitments, if deemed necessary. In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Banks would be required to fund the commitment. The maximum potential amount of future payments the Banks could be required to make is represented by the contractual amount shown in the summary above. If the commitment is funded, the Banks would be entitled to seek recovery from the customer. At December 31, 2007, 2006 and 2005, no amounts have been recorded as liabilities for the Banks’ potential obligations under these guarantees.

Contingencies: In the normal course of business, the Banks are involved in various legal proceedings. In the opinion of management, any liability resulting from such proceedings would not have a material adverse effect on the accompanying financial statements.

Concentrations of credit risk: Substantially all of the Banks’ loans, commitments to extend credit and standby letters of credit have been granted to customers in the Banks’ market areas. Although the loan portfolio of the Banks’ are diversified, approximately 72% of the loans are real estate loans and approximately 8% are agriculturally related. The concentrations of credit by type of loan are set forth in Note 3. Commitments to extend credit are primarily related to commercial loans and home equity loans. Standby letters of credit were granted primarily to commercial borrowers. Investments in securities issued by state and political subdivisions involve certain governmental entities within Iowa. Investment securities of Iowa political subdivisions totaled $68,545,000 as of December 31, 2007. No individual municipality exceeded $2,701,000.

 

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Table of Contents

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Notes to Consolidated Financial Statements

 

 

Note 13. Related Party Transactions

Certain directors of the Company and the Banks and companies with which they are affiliated and certain principal officers are customers of, and have banking transactions with, the Banks in the ordinary course of business. Such indebtedness has been incurred on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons.

The following is an analysis of the changes in the loans to related parties:

 

     Year Ended December 31,  
     2007     2006  
     (In Thousands)  

Balance, beginning

   $ 5,555     $ 6,320  

Advances

     1,357       36  

Collections

     (60 )     (801 )
                

Balance, ending

   $ 6,852     $ 5,555  
                

None of these loans are past due, nonaccrual or restructured to provide a reduction or deferral of interest or principal because of deterioration in the financial position of the borrower.

Deposits from related parties are accepted subject to the same interest rates and terms as those from nonrelated parties.

 

Note 14. Fair Value of Financial Instruments

SFAS No. 107, Disclosures About Fair Value of Financial Instruments, requires all entities to disclose the estimated fair value of its financial instrument assets and liabilities. For the Company, substantially all its assets and liabilities are considered financial instruments as defined. Many of the Banks’ financial instruments, however, lack an available trading market as characterized by a willing buyer and a willing seller engaging in an exchange transaction. It is also the Banks’ general practice and intent to hold its financial instruments and not to engage in trading or sales activities. Therefore, significant estimations and present value calculations were used for the purpose of this disclosure.

The Company discloses fair value information about financial instruments for which it is practicable to estimate that value. When quoted market values are not available, fair values are based upon estimates using present value or other techniques. These assumptions are significantly affected by the assumptions used, including discount rates and estimates of future cash flows. In this regard, fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in an immediate settlement. Since the term financial instruments does not include all assets and liabilities of the Company or the Banks, the aggregate fair value amounts of the financial instruments presented do not represent the underlying value of the net assets (financial and nonfinancial). Some financial instruments, all nonfinancial instruments and other factors relevant to the underlying value of the Company and the Banks are excluded from the disclosure.

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 14. Fair Value of Financial Instruments (Continued)

 

The Banks determine estimated fair values using the best available data and an estimation methodology suitable for each category of financial instruments. For those loans and deposits with variable interest rates, it is presumed that estimated fair values generally approximate the recorded book balances. The estimation methodologies used at December 31, 2007 and 2006 were as follows:

 

 

Cash and due from banks, noninterest-bearing demand deposits, federal funds sold and purchased, securities sold under repurchase agreements and accrued interest are instruments with carrying values that approximate market value.

 

 

Loans held for sale have an estimated fair value based on quoted market prices of similar loans sold on the secondary market.

 

 

Financial instruments actively traded in a secondary market have been valued using quoted available market prices.

 

 

Fixed rate financial instruments with stated final maturities have been valued using present value discounted cash flows with a discount rate approximating current market for similar assets and liabilities.

 

 

Variable rate financial instruments with no stated maturities have an estimated fair value equal to both the amount payable on demand and the recorded book balance.

Changes in assumptions or estimation methodologies may have a material effect on these estimated fair values.

The carrying or face amount and estimated fair value of financial instruments were as follows:

 

     2007    2006
     Carrying
Amount
   Estimated
Fair Value
   Carrying
Amount
   Estimated
Fair Value
     (In Thousands)

Financial assets:

           

Cash and due from banks

   $ 16,378    $ 16,378    $ 14,274    $ 14,274

Investment securities

     232,220      232,226      239,599      239,608

Federal funds sold

     17,842      17,842      3,175      3,175

Loans held for sale

     2,709      2,709      2,422      2,422

Loans, net

     396,088      395,764      373,314      367,844

Accrued interest receivable

     4,639      4,639      4,568      4,568

Financial liabilities:

           

Deposits

   $ 526,615    $ 527,123    $ 492,901    $ 492,677

Federal funds purchased and securities sold under agreements to repurchase

     45,997      45,997      51,929      51,929

Federal Home Loan Bank borrowings

     47,000      47,442      46,020      45,652

Accrued interest payable

     1,734      1,734      1,915      1,915

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 15. Common Stock Split

On July 11, 2006, the Company’s Board of Directors declared a three-for-one stock split to be effected in the form of a stock dividend. Accordingly, an additional 3,454,066 shares of common stock were issued and distributed on August 18, 2006 to shareholders of record on August 8, 2006. The net income per share of common stock and cash dividends per share of common stock for the years ended December 31, 2006 and 2005, have been retroactively adjusted for this split. In addition, all stock options have been retroactively restated for the stock split in accordance with the terms of the plan.

 

Note 16. Merger

On September 12, 2007, the Company announced that it had entered into a definitive agreement to merge with MidWestOne Financial Group, Inc. of Oskaloosa, Iowa. The transaction will be a merger of equals with the resulting company to be called MidWestOne Financial Group, Inc. Headquarters of the merged entity will be located in Iowa City. Under the terms of the agreement, shareholders of MidWestOne Financial Group, Inc. would exchange one share of their stock for 0.95 share of the Company’s stock. The resulting stock will be listed on the NASDAQ Global Market under the new stock symbol MOFG. The transaction is subject to regulatory and shareholder approval and it is anticipated that it will be consummated in the first quarter of 2008. The two bank subsidiaries of ISB Financial Corp. and the bank subsidiary of MidWestOne Financial Group, Inc. will be merged into one bank charter later in 2008, with the resulting bank to be called MidWestOne Bank. Through December 31, 2007 the Company has incurred and capitalized $788,000 of merger-related costs carried in Other Assets.

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 17. Parent Company Only Financial Information

Following is condensed financial information of ISB Financial Corp. (parent company only):

 

     2007     2006  
     (In Thousands)  

Balance Sheets

    

As of December 31:

    

Assets

    

Cash

   $ 12,626     $ 12,513  

Equipment

     26       10  

Investment in subsidiary banks

     61,255       58,597  

Marketable equity securities, available for sale

     2,628       2,308  

Other assets

     869       27  
                

Total assets

   $ 77,404     $ 73,455  
                

Liabilities and Shareholders’ Equity

    

Liabilities

    

Income tax payable

   $ —       $ 137  

Deferred income taxes

     —         108  

Other liabilities

     12       1  
                

Total liabilities

     12       246  
                

Shareholders’ equity:

    

Capital stock, common

     5,165       5,176  

Additional paid-in capital

     100       14  

Retained earnings

     72,333       69,539  

Accumulated other comprehensive (loss)

     (206 )     (1,520 )
                

Total shareholders’ equity:

     77,392       73,209  
                

Total liabilities and shareholders’ equity

   $ 77,404     $ 73,455  
                

 

      2007     2006     2005  

Statements of Income

      

Year Ended December 31:

      

Dividends received from subsidiaries

   $ 5,250     $ 5,175     $ 6,675  

Interest income and dividends on marketable equity securities

     649       468       239  

Investment securities gains

     —         50       252  

Operating expenses

     (113 )     (93 )     (98 )
                        

Income before income taxes and equity in subsidiaries’ undistributed income

     5,786       5,600       7,068  

Income tax expense

     171       138       130  
                        
     5,615       5,462       6,938  

Equity in subsidiaries’ undistributed income

     1,033       336       (21 )
                        

Net income

   $ 6,648     $ 5,798     $ 6,917  
                        

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 17. Parent Company Only Financial Information (Continued)

 

     2007     2006     2005  
     (In Thousands)  

Statements of Cash Flows

      

Year ended December 31:

      

Cash flows from operating activities:

      

Net income

   $ 6,648     $ 5,798     $ 6,917  

Adjustments to reconcile net income to net cash provided by operating activities:

      

Undistributed earnings of subsidiaries

     (1,033 )     (336 )     21  

Depreciation

     5       5       7  

Investment securities gains

     —         (50 )     (252 )

(Increase) decrease in accrued interest receivable

     4       19       (46 )

(Increase) decrease in other assets

     (6 )     —         20  

Increase (decrease) in other liabilities

     (126 )     7       130  
                        

Net cash provided by operating activities

     5,492       5,443       6,797  
                        

Cash flows from investing activities:

      

Proceeds from sales of investment securities

     —         224       506  

Purchase of investment securities

     (789 )     (1,177 )     (740 )

Capitalized merger costs

     (788 )     —         —    

Purchase of equipment, net

     (21 )     —         —    
                        

Net cash (used in) investing activities

     (1,598 )     (953 )     (234 )
                        

Cash flows from financing activities:

      

Stock options exercised

     107       83       117  

Repurchase of common stock

     (529 )     (1,468 )     (4 )

Dividends paid

     (3,359 )     (1,657 )     (1,480 )
                        

Net cash (used in) financing activities

     (3,781 )     (3,042 )     (1,367 )
                        

Increase in cash

     113       1,448       5,196  

Cash Balance:

      

Beginning

     12,513       11,065       5,869  
                        

Ending

   $ 12,626     $ 12,513     $ 11,065  
                        

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 18. Segment Reporting

The Company manages its core bank operations and prepares management reports with a primary focus on each banking subsidiary. The accounting policies of the segments are consistent with those described in Note 1. The Company derives a majority of its revenues from interest income and the chief operating decision maker relies primarily on net interest income to assess the performance of the segments and make decisions about resources to be allocated to the segment. The Company does not have operating segments other than those reported. Parent company information is included in the other category, and is deemed to represent an overhead function rather than an operating segment.

There are no significant transactions between operating segments other than transfers of loan participations at par value with no gain or loss.

The following is a summary of selected operating segment information as of and for the years ended December 31, 2007, 2006 and 2005:

 

2007:    Iowa State Bank
& Trust Company
    First State Bank     All Other    Intersegment
Eliminations
    Consolidated
Company
 

Assets

   $ 589,821     $ 108,662     $ 16,149    $ (12,649 )   $ 701,983  

Gross Loans

     339,698       61,856       —        —         401,554  

Less: Allowance for loan losses

     (4,004 )     (1,462 )     —        —         (5,466 )

Net Loans

     335,694       60,394       —        —         396,088  

Deposits

     454,789       84,452       —        (12,626 )     526,615  

Shareholders’ Equity

     48,228       13,027       16,137      —         77,392  

Net interest income

   $ 15,845     $ 2,772     $ 650    $ —       $ 19,267  

Provision for loan losses

     500       —         —        —         500  

Net interest income after provision for loan losses

     15,345       2,772       650      —         18,767  

Noninterest income

     7,673       1,133       —        —         8,806  

Noninterest expense

     15,744       2,763       113      —         18,620  

Income before income taxes

     7,274       1,142       537      —         8,953  

Income tax expense

     1,910       223       172      —         2,305  

Net income

   $ 5,364     $ 919     $ 365    $ —       $ 6,648  

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

 

Note 18. Segment Reporting (Continued)

 

 

2006:    Iowa State Bank
& Trust Company
    First State Bank     All Other    Intersegment
Eliminations
    Consolidated
Company
 

Assets

   $ 554,665     $ 111,941     $ 14,606    $ (12,541 )   $ 668,671  

Gross Loans

     315,323       63,289       —        —         378,612  

Less: Allowance for loan losses

     (3,784 )     (1,514 )     —        —         (5,298 )

Net Loans

     311,539       61,775       —        —         373,314  

Deposits

     422,535       82,879       —        (12,513 )     492,901  

Shareholders’ Equity

     45,842       12,755       14,612      —         73,209  

Net interest income

   $ 15,339     $ 2,741     $ 469    $ —       $ 18,549  

Provision for loan losses

     550       —         —        —         550  

Net interest income after provision for loan losses

     14,789       2,741       469      —         17,999  

Noninterest income

     6,590       950       50      (18 )     7,572  

Noninterest expense

     14,955       2,650       93      (18 )     17,680  

Income before income taxes

     6,424       1,041       426      —         7,891  

Income tax expense

     1,720       235       138      —         2,093  

Net income

   $ 4,704     $ 806     $ 288    $ —       $ 5,798  
2005:    Iowa State Bank
& Trust Company
    First State Bank     All Other    Intersegment
Eliminations
    Consolidated
Company
 

Assets

   $ 561,865     $ 106,956     $ 12,059    $ (11,111 )   $ 669,769  

Gross Loans

     310,900       59,949       —        —         370,849  

Less: Allowance for loan losses

     (3,697 )     (1,530 )     —        —         (5,227 )

Net Loans

     307,203       58,419       —        —         365,622  

Deposits

     424,028       79,618       —        (11,065 )     492,581  

Shareholders’ Equity

     44,189       12,701       12,069      —         68,959  

Net interest income

   $ 15,677     $ 2,969     $ 239    $ —       $ 18,885  

Provision for loan losses

     300       —         —        —         300  

Net interest income after provision for loan losses

     15,377       2,969       239      —         18,585  

Noninterest income

     7,654       929       252      (113 )     8,722  

Noninterest expense

     15,088       2,441       98      (113 )     17,514  

Income before income taxes

     7,943       1,457       393      —         9,793  

Income tax expense

     2,339       407       130      —         2,876  

Net income

   $ 5,604     $ 1,050     $ 263    $ —       $ 6,917  

 

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ISB FINANCIAL CORP. AND SUBSIDIARIES

Consolidated Five-Year Statistical Summary

 

All data expressed in thousands, except per share data.

 

As of December 31,

   2007     2006     2005     2004     2003  

Balance Sheet

          

Assets

   $ 701,983     $ 668,671     $ 669,769     $ 635,713     $ 613,420  

Deposits

     526,615       492,901       492,581       474,559       453,252  

Loans, net

     396,088       373,314       365,622       330,657       316,465  

Cash

     16,378       14,274       13,547       10,617       13,321  

Securities available for sale

     232,125       239,486       237,158       255,336       252,955  

Securities held to maturity

     95       113       175       242       393  

Minority interest

     —         —         —         —         —    

Shareholders’ equity

     77,392       73,209       68,959       65,772       61,611  
                                        

Year Ended December 31,

   2007     2006     2005     2004     2003  

Operations

          

Interest income

   $ 38,305     $ 35,308     $ 30,627     $ 28,417     $ 28,794  

Interest expense

     (19,038 )     (16,759 )     (11,742 )     (9,503 )     (10,775 )

Provision for loan losses

     (500 )     (550 )     (300 )     (195 )     (660 )

Noninterest income

     8,806       7,572       8,722       8,189       9,253  

Noninterest expense

     (18,620 )     (17,680 )     (17,514 )     (16,551 )     (16,172 )

Minority interest

     —         —         —         —         (28 )

Applicable income taxes

     (2,305 )     (2,093 )     (2,876 )     (3,149 )     (3,271 )
                                        

Net income

     6,648       5,798       6,917       7,208       7,141  
                                        

Per Share

          

Earnings

   $ 1.29     $ 1.11     $ 1.32     $ 1.38     $ 1.37  
                                        

Cash dividends

     0.65       0.32       0.28       0.27       0.23  
                                        

Book value as of December 31

     14.98       14.14       13.18       12.59       11.79  
                                        

Market value as of December 31

     18.55       27.50       21.17       19.00       15.33  
                                        

Performance Ratios

          

Return on Assets (Average)

     0.97 %     0.87 %     1.06 %     1.15 %     1.20 %

Return on Equity (Average)

     8.83 %     8.16 %     10.27 %     11.32 %     12.01 %

Return on Tangible Equity (Average)

     9.37 %     8.69 %     10.98 %     12.15 %     12.94 %

 

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ISB Financial Corp.

Supplement to Annual Report

December 31, 2007

 

 


Table of Contents

Supplement To The Annual Report

Introductory Note

On Friday, March 14, 2008, MidWestOne Financial Group, Inc. (“Former MidWestOne”) merged with and into ISB Financial Corp. (“ISBF”) in accordance with the Agreement and Plan of Merger, dated as of September 11, 2007 (the “Merger”). As a result of the Merger, ISB Financial Corp. survived the merger and changed its name to “MidWestOne Financial Group, Inc.” and Former MidWestOne ceased to exist as a legal entity.

This Supplement to the Annual Report reports on the historical financial information for ISBF (now known as MidWestOne Financial Group, Inc.) as of the dates indicated, all of which are prior to the consummation of the Merger. This Supplement does not contain any historical financial information for Former MidWestOne. All references to “ISBF” relate to the surviving corporation prior to the Merger. This document clearly references “New MidWestOne” for instances where information is presented for the current company, and the context of such references should make it clear whether the information relates to information prior to, or following, the Merger.

This document is intended to supplement ISBF’s Annual Report for 2007 and should be read in conjunction with the financial statements and notes thereto, presented in the Annual Report.

Business of ISBF

MERGER TRANSACTION

As noted above, on Friday, March 14, 2008, Former MidWestOne merged with and into ISBF in accordance with the Agreement and Plan of Merger, dated as of September 11, 2007. As a result of the Merger, Former MidWestOne ceased to exist as a legal entity and ISBF survived the merger and changed its name to “MidWestOne Financial Group, Inc.”

At the time of the Merger, ISBF was the holding company of Iowa State Bank & Trust Company, an Iowa state bank with its main office in Iowa City, Iowa and First State Bank, an Iowa state bank with its main office in Conrad, Iowa. Former MidWestOne was the holding company of MidWestOne Bank, an Iowa state bank with its main office in Oskaloosa, Iowa. As a result of the Merger, New MidWestOne (formerly known as ISBF) became the holding company of MidWestOne Bank, Iowa State Bank & Trust and First State Bank. New MidWestOne’s management intends on consolidating these three current bank subsidiaries into one bank charter with the name “MidWestOne Bank” with its headquarters in Iowa City, Iowa. It is expected that this consolidation will be completed in the third quarter of 2008.

BUSINESS

ISBF (now known as MidWestOne Financial Group, Inc.) incorporated in the state of Iowa in 1983 and headquartered in Iowa City, Iowa, is a multi-bank holding company registered under the Bank Holding Company Act of 1956, as amended. Prior to the Merger, ISBF had two bank subsidiaries—Iowa State Bank & Trust Company, an Iowa state non-member bank with its main office in Iowa City, Iowa, and First State Bank, an Iowa state non-member bank with its main office in Conrad, Iowa. As of December 31, 2007, Iowa State Bank & Trust had total assets of $589.8 million and total deposits of $454.8 million and First State Bank had total assets of $108.7 million and total deposits of $84.5 million. Iowa State Bank & Trust was chartered as an Iowa state bank in 1934, and became a wholly-owned subsidiary of ISBF upon its formation in 1983. ISBF acquired First State Bank in 1998. Iowa State Bank & Trust operates a total of seven banking locations in east-central Iowa, and First State Bank operates three banking locations in north-central Iowa.

The banks provide full service retail banking in the communities in which they are located. Deposit products offered by the banks include checking and other demand deposit accounts, NOW accounts, savings accounts,

 

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money market accounts, certificates of deposit, individual retirement accounts and other time deposits. Loans include commercial and industrial, agricultural, real estate mortgage and consumer. Other products and services include debit cards, automated teller machines, on-line banking and safe deposit boxes. The principal service of the banks consists of making loans to and accepting deposits from individuals, businesses, governmental units and institutional customers. These loans are made at the offices of the banks. Both of the banks have trust and investment departments through which they offer a variety of trust services, including administering estates, personal trusts, conservatorships, pension and profit-sharing funds and providing property management, farm management and investment advisory and custodial services. First State Bank also operates an insurance agency division, First State Insurance Services, and a real estate brokerage division, First State Realty.

Selected Financial Data

 

Period Ended

   12/31/07     12/31/06     12/31/05     12/31/04     12/31/03  
     (In thousands, except per share data)  

Summary of income data:

          

Total interest income .

   $ 38,305     $ 35,308     $ 30,627     $ 28,417     $ 28,794  

Total interest expense .

     19,038       16,759       11,742       9,503       10,775  
                                        

Net interest income

     19,267       18,549       18,885       18,914       18,019  

Provision for loan losses

     500       550       300       195       660  

Noninterest income .

     8,806       7,572       8,722       8,189       9,253  

Noninterest expenses .

     18,620       17,680       17,514       16,551       16,172  
                                        

Income before income tax .

     8,953       7,891       9,793       10,357       10,440  

Income tax expense .

     2,305       2,093       2,876       3,149       3,271  
                                        

Income before minority interest

     6,648       5,798       6,917       7,208       7,169  

Minority interest in net income of subsidiary

     —         —         —         —         (28 )
                                        

Net income .

   $ 6,648     $ 5,798     $ 6,917     $ 7,208     $ 7,141  
                                        

Per share data:

          

Net income—basic

   $ 1.29     $ 1.11     $ 1.32     $ 1.38     $ 1.37  

Net income—diluted

     1.29       1.11       1.32       1.38       1.37  

Cash dividends declared

     0.65       0.32       0.28       0.27       0.23  

Book value .

     14.98       14.14       13.18       12.59       11.79  

Net tangible book value

     14.14       13.29       12.34       11.76       10.96  

Selected financial ratios:

          

Net income to average assets

     0.98 %     0.87 %     1.06 %     1.15 %     1.20 %

Net income to average equity

     8.83       8.16       10.27       11.32       12.01  

Net income to average tangible equity

     9.37       8.69       10.98       12.15       12.94  

Dividend payout ratio

     57.90       23.96       20.53       19.52       19.69  

Total shareholders' equity to total assets

     11.02       10.95       10.30       10.35       10.04  

Average shareholders' equity to average assets

     10.94       10.39       10.39       10.00       9.96  

Tangible shareholders' equity to tangible assets

     10.47       10.36       9.71       9.73       9.40  

Tier 1 risk-based capital ratio .

     15.35       14.69       15.65       15.60       15.65  

Net interest margin .

     3.25       3.12       3.29       3.35       3.39  

Allowance for loan losses to total loans .

     1.36       1.40       1.41       1.46       1.72  

Non-performing loans to total loans

     0.32       0.20       0.20       0.16       0.33  

Net loans charged off (recovered) to average loans .

     0.09       0.13       (0.01 )     0.26       0.11  

December 31

   12/31/07     12/31/06     12/31/05     12/31/04     12/31/03  
     (In thousands)  

Selected balance sheet data:

          

Total assets

   $ 701,983     $ 668,671     $ 669,769     $ 635,713     $ 613,420  

Total loans net of unearned discount .

     401,554       378,612       370,849       335,551       322,018  

Allowance for loan losses

     5,466       5,298       5,227       4,894       5,553  

Total deposits

     526,615       492,901       492,581       474,559       453,252  

Total shareholders' equity .

     77,392       73,209       68,959       65,772       61,611  

 

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following presents management’s discussion and analysis of the consolidated financial condition and results of operations of ISBF as of the dates and for the periods indicated. This discussion should be read in conjunction with ISBF’s consolidated financial statements and the notes thereto presented in the Annual Report.

SAFE HARBOR STATEMENT

This report contains certain “forward-looking statements” within the meanings of such term in the Private Securities Litigation Reform Act of 1995. The Company and its representatives may, from time to time, make written or oral statements that are “forward-looking” and provide information other than historical information. These statements involve known and unknown risks, uncertainties and other factors that may cause actual results to be materially different from any results, levels of activity, performance or achievements expressed or implied by any forward-looking statement. These factors include, among other things, the factors listed below.

Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company’s management and on information currently available to management, are generally identifiable by the use of words such as “believe”, “expect”, “anticipate”, “should”, “could”, “would”, “plans”, “intend”, “project”, “estimate’, “forecast”, “may” or similar expressions. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those expressed in, or implied by, these statements. The Company wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made. Additionally, the Company undertakes no obligation to update any statement in light of new information or future events.

The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors that could have an impact on the Company’s ability to achieve operating results, growth plan goals and future prospects include, but are not limited to, the following:

 

   

Management’s ability to reduce and effectively manage interest rate risk and the impact of interest rates in general on the volatility of the Company’s net interest income.

 

   

Changes in the economic environment, competition, or other factors that may affect the Company’s ability to acquire loans.

 

   

Fluctuations in the value of the Company’s investment securities.

 

   

The ability to attract and retain key executives and employees experienced in banking and financial services.

 

   

The sufficiency of the allowance for loan losses to absorb the amount of actual losses inherent in the existing loan portfolio.

 

   

The Company’s ability to adapt successfully to technological changes to compete effectively in the marketplace.

 

   

Credit risks and risks from concentrations (by geographic area and by industry) within the Bank’s loan portfolio.

 

   

The effects of competition from other commercial banks, thrifts, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and other mutual funds, and other financial institutions operating in the Company’s market or elsewhere or providing similar services.

 

   

The failure of assumptions underlying the establishment of allowances for loan losses and estimation of values of collateral and various financial assets and liabilities.

 

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Volatility of rate sensitive deposits.

 

   

Operation risks, including data processing system failures or fraud.

 

   

Asset/liability matching risks and liquidity risks.

 

   

Changes in the economic environment, competition, or other factors that may influence the anticipated growth rate of loans and deposits and the quality of the loan portfolio and loan and deposit pricing.

 

   

The Company’s ability to successfully pursue acquisition and expansion strategies and integrate any acquired companies.

 

   

The costs, effects and outcomes of existing or future litigation.

 

   

Governmental monetary and fiscal policies, as well as legislative and regulatory changes, that may result in the imposition of costs and constraints on the Company.

 

   

Changes in general economic or industry conditions, nationally or in the communities in which the Company conducts business.

 

   

Acts of war or terrorism.

 

   

Changes in accounting policies and practices, as may be adopted by state and federal regulatory agencies and the Financial Accounting Standards Board.

 

   

The ability of the Company to manage the risks associated with the foregoing as well as anticipated.

These risks and uncertainties should be considered in evaluation of the forward-looking statement and undue reliance should not be placed on such statements. The Company cautions that the foregoing list of important factors may not be all-inclusive and specifically declines to undertake any obligation to publicly revise any forward-looking statements that have been made to reflect any events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

PERFORMANCE SUMMARY

For the year ended December 31, 2007, the Company recorded net income of $6,648,000, or $1.29 per share basic and diluted. This compares with $5,798,000, or $1.11 per share basic and diluted, for the year ended December 31, 2006. Net income was $850,000, or 14.7%, greater in 2007 due to increases in both net interest income and noninterest income, partially offset by an increase in noninterest expense.

Total assets of the Company increased $33,312,000 or 5.0% to $701,983,000 as of December 31, 2007 from $668,671,000 as of December 31, 2006. The Company’s total loans outstanding increased $22,942,000 or 6.1% to $401,554,000 at December 31, 2007 from $378,612,000 at December 31, 2006; while deposits increased $33,714,000 or 6.8% to $526,615,000 as of December 31, 2007 from $492,901,000 at December 31, 2006.

Return on average assets is a measure of profitability that indicates how effectively a financial institution utilizes its assets. It is calculated by dividing net income by average total assets. The Company’s return on average assets was 0.98% for the year ended December 31, 2007 and 0.87% for the same period in 2006. The increased return for the year ended December 31, 2007 compared to the year ended December 31, 2006 results from net income increasing at a much greater rate than the increase in average assets. Return on average equity indicates what the Company earned on its shareholders’ investment and is calculated by dividing net income by average total shareholders’ equity. The return on average equity for the Company was 8.83% at December 31, 2007 compared to 8.16% at December 31, 2006. The increase in the return on average shareholders’ equity results from net income growing at a faster rate than average shareholders’ equity grew.

Various operating and equity ratios for the Company are presented in the table below for the years indicated. The dividend payout ratio represents the percentage of the Company’s prior year’s net income that is paid to

 

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shareholders in the form of cash dividends. Average equity to average assets is a measure of capital adequacy that presents the percentage of average total shareholders’ equity compared to the average assets of the Company. The equity to assets ratio expresses this ratio using the period-end amounts instead of on an average basis.

 

     12/31/07     12/31/06     12/31/05  

Return on average total assets

   0.98 %   0.87 %   1.06 %

Return on average equity

   8.83     8.16     10.27  

Dividend payout ratio

   57.90     23.96     20.53  

Average equity to average assets

   10.94     10.62     10.32  

Equity to assets ratio (at period end)

   11.02     10.95     10.30  

Results of Operations

Year Ended December 31, 2007 Compared to December 31, 2006

Net Interest Income. Net interest income is the total of interest income earned on earning assets less interest expense paid on interest bearing liabilities. Net interest income is affected by changes in the volume and yields on earning assets and the volume and rates paid on interest bearing liabilities. Net interest margin is a ratio measurement of the net return on interest earning assets computed by dividing net interest income on a tax-equivalent basis by the annual average balance of all interest earning assets.

Net interest income for the year ended December 31, 2007 totaled $19,267,000, an increase of $718,000 or 3.9% compared with the $18,549,000 in net interest income for the year ended December 31, 2006. This increase was due primarily to higher market interest rates followed by greater loan volumes. The net interest margin (on a tax-equivalent basis) also increased during 2007 to 3.27% compared with 3.12% for 2006 as the increase in net interest income was proportionately greater than the increase in average earning assets.

Total interest income increased $2,997,000, or 8.5%, for the year ended December 31, 2007 compared with the year ended December 31, 2006. This increase in interest income was experienced in all earning asset categories (loans, investment securities and federal funds sold and interest–bearing balances). Interest income on loans totaled $27,564,000 for 2007, an increase of $1,714,000 or 6.6% compared with 2006. The higher interest income on loans was due primarily to higher market interest rates and secondarily to growth in loan volumes. The increase in the national prime rate has benefited the Company as the overall average rate on the total loan portfolio increased to 7.11% for the year ended December 31, 2007 compared with 6.83% for the year ended December 31, 2006. The average volume of loans outstanding for 2007 was $9,593,000 greater than the average volume of loans for 2006. Most of this increase was in the commercial, financial and agricultural category followed by the residential 1-4 family real estate loan category. Interest income on investment securities increased $1,018,000, or 11.1%, in 2007 to $10,193,000. This compares with $9,175,000 in 2006. The average balance of investment securities declined $10,585,000 as the proceeds from maturing securities were utilized to fund loan growth and to reduce dependency on Federal Home Loan Bank advances. The average tax-equivalent yield on the investment portfolio increased to 4.91% for the year ended December 31, 2007 compared with 4.17% for the year ended December 31, 2006 as lower-yielding securities matured and were replaced with securities having a higher market rate, which helped to offset the decrease in volume. The overall yield on earning assets increased to 6.25% for the year ended December 31, 2007 from 5.76% for the year ended December 31, 2006, while total earning assets averaged $637,521,000 for the year ended December 31, 2007, or $3,022,000 higher than for the year ended December 31, 2006.

Growth in deposits, growth in federal funds purchased and repurchase agreements and higher market interest rates contributed to an increase in total interest expense for the year ended December 31, 2007 when compared to the year ended December 31, 2006. Total interest expense increased $2,279,000, or 13.6%, for 2007 to $19,038,000, up from $16,759,000 for 2006. Total deposits averaged $8,038,000 higher for 2007 compared with 2006, while the average rate paid on these deposits during 2007 increased to 3.35% from 2.85% for 2006. Interest expense on deposits was $14,798,000 for the year ended December 31, 2007, an increase of $2,450,000

 

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or 19.8% from the $12,348,000 in interest expense for the year ended December 31, 2006. The primary factor contributing to this increase in interest expense on deposits is higher market interest rates. For the year ended December 31, 2007, the Company averaged $49,629,000 in federal funds purchased and repurchase agreements compared with $48,378,000 for 2006. Interest expense on federal funds purchased and repurchase agreements increased $236,000 to $2,114,000 for 2007 compared with $1,878,000 for 2006. This was also primarily due to higher market interest rates. The interest rates on federal funds purchased and repurchase agreements correlate directly with the actions taken by the Federal Reserve Bank in raising the discount rate during 2006 and 2007. The average rate paid by the Company on federal funds purchased and repurchase agreements increased to 4.26% for the year ended December 31, 2007 compared with 3.88% for the year ended December 31, 2006, which increased interest expense. The average balance of Other Borrowings (primarily Federal Home Loan Bank advances) was $9,430,000 lower for the year ended December 31, 2007, while the average rate paid increased slightly to 4.65% for 2007 from 4.59% for 2006. The decrease in Other Borrowings was a strategic decision to reduce the Company’s dependence on high cost funding alternatives during a rising interest rate environment and was accomplished through use of the Company’s investment securities portfolio. As liquidity provided, maturing securities were used to pay off maturing advances. As a consequence, interest expense on Other Borrowings was $407,000 lower for 2007 compared with 2006. The average rate paid on all interest-bearing liabilities increased to 3.55% for 2007, compared with 3.12% for 2006.

The following table presents a comparison of the average balance of earning assets, interest-bearing liabilities, interest income and expense, and average yields and costs for the years indicated. Interest income on tax-exempt securities is reported on a fully tax-equivalent basis assuming a 34% tax rate. Dividing income or expense by the average balances of assets or liabilities results in such yields and costs. Nonaccrual loans are included in the loan category.

 

     Year ended December 31,  
     2007     2006  
     Average
Balance
   Interest
Income/
Expense
   Average
Rate/
Yield
    Average
Balance
   Interest
Income/
Expense
   Average
Rate/
Yield
 
     (dollars in thousands)  

Average earning assets:

                

Loans(1)

   $ 390,862    $ 27,771    7.11 %   $ 381,269    $ 26,024    6.83 %

Investment securities:

                

Taxable investments

     163,608      7,552    4.62       183,057      7,076    3.87  

Tax exempt investments

     71,752      4,001    5.58       62,888      3,181    5.06  
                                        

Total investment securities

     235,360      11,553    4.91       245,945      10,257    4.17  
                                        

Federal funds sold and interest-bearing balances

     11,299      548    4.85       7,285      283    3.88  
                                        

Total earning assets

   $ 637,521    $ 39,872    6.25 %   $ 634,499    $ 36,564    5.76 %
                                        

Average interest-bearing liabilities:

                

Savings and interest-bearing demand deposits

   $ 193,044    $ 3,109    1.61 %   $ 205,074    $ 3,042    1.48 %

Time Certificates of deposit

     248,377      11,689    4.71       228,309      9,306    4.08  
                                        

Total deposits

     441,421      14,798    3.35       433,383      12,348    2.85  
                                        

Federal funds purchased and repurchase agreements

     49,629      2,114    4.26       48,378      1,878    3.88  

Federal Home Loan Bank advances

     44,181      2,023    4.58       53,730      2,435    4.53  

Other long-term debt

     1,582      103    6.51       1,463      98    6.70  
                                        

Total interest-bearing liabilities

   $ 536,813    $ 19,038    3.55 %   $ 536,954    $ 16,759    3.12 %
                                        

Net interest income

      $ 20,834    2.71 %      $ 19,805    2.64 %
                                

Net interest margin(2)

         3.27 %         3.12 %
                        

 

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(1) Loan fees included in interest income are not material.
(2) Net interest margin is net interest income (computed on a tax-equivalent basis) divided by average total earning assets.

The following table sets forth an analysis of volume and rate changes in interest income and interest expense of the Company’s average earning assets and average interest-bearing liabilities reported on a fully tax-equivalent basis assuming a 34% tax rate. The table distinguishes between the changes related to average outstanding balances (changes in volume holding the initial interest rate constant) and the changes related to average interest rates (changes in average rate holding the initial outstanding balance constant). The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.

 

     Year ended December 31,
2007 Compared to 2006
Increase/(Decrease) Due to
 
     Volume     Rate     Net  
     (in thousands)  

Interest income from average earning assets:

      

Loans

   $ 665     $ 1,082     $ 1,747  

Investment securities:

      

Taxable investments

     (575 )     1,051       476  

Tax exempt investments

     475       345       820  
                        

Total investment securities

     (100 )     1,396       1,296  
                        

Federal funds sold and interest-bearing balances

     183       82       265  
                        

Total income from earning assets

     747       2,561       3,308  
                        

Interest expense from average interest-bearing liabilities:

      

Savings and interest-bearing demand deposits

     (145 )     212       67  

Time Certificates of deposit

     864       1,519       2,383  
                        

Total deposits

     719       1,731       2,450  
                        

Federal funds purchased and repurchase agreements

     50       186       236  

Federal Home Loan Bank advances

     (438 )     26       (412 )

Other long-term debt

     8       (3 )     5  
                        

Total expense form interest-bearing liabilities

     338       1,941       2,279  
                        

Net interest income

   $ 409     $ 620     $ 1,029 &nbs