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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

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FORM 10-QSB

 

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x	QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2004

 

¨	TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT

 

For the transition period from              to             

 

COMMISSION FILE NUMBER 0000-50313

 

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SURREY BANCORP

(Exact name of small business issuer as specified in its charter)

 

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North Carolina		59-3772016
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)

 

145 North Renfro Street, Mount Airy NC 27030

(Address of principal executive offices)

 

(336) 783-3900

(Issuer’s telephone number)

 

Not Applicable

(Former name, former address and former fiscal year, if changed since last report

 

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Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15 (d) of the Exchange Act during the past 12 months (or for such shorter period that the reqistrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

 

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practical date:

 

On July 30, 2004, there were 1,196,407 common shares issued and outstanding

 

Transitional Small Business Disclosure Format (Check one):    Yes  ¨    No  x

 

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Table of Contents

PART I – FINANCIAL INFORMATION
Item 1.		Consolidated Financial Statements
		Consolidated Balance Sheets June 30, 2004 (Unaudited) and December 31, 2003		3
		Consolidated Statements of Income, Six Months Ended June 30, 2004 and 2003 (Unaudited)		4
		Consolidated Statements of Income, Three Months Ended June 30, 2004 and 2003 (Unaudited)		5
		Consolidated Statements of Cash Flows, Six Months Ended June 30, 2004 and 2003 (Unaudited)		6
		Consolidated Statements of Changes in Shareholders’ Equity, Six Months Ended June 30, 2004 and 2003 (Unaudited)		7
		Notes to Consolidated Financial Statements		8-11
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations		12-15
Item 3.		Controls and Procedures		16
PART II – OTHER INFORMATION				17
SIGNATURES

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Consolidated Balance Sheets			Unaudited				Audited
June 30, 2004 and December 31, 2003
		June				December
		2004				2003
Assets
Cash and due from banks		$	1,653,520			$	1,956,473
Interest-bearing deposits with banks			19,312,308				4,068,017
Investment securities available for sale			2,970,523				5,425,973
Federal Home Loan Bank stock, at cost			412,500				445,000
Loans, net of allowance of loan losses of $2,149,111 in 2004 and $2,109,820 in 2003			123,597,833				117,362,619
Property and equipment, net			4,177,519				4,281,770
Accrued income			552,047				585,608
Goodwill, net of amortization			120,000				120,000
Other assets			1,299,824				831,545
		$	154,096,074			$	135,077,005
Liabilities and Shareholders’ Equity
Liabilities:
Deposits:
Noninterest-bearing		$	19,808,510			$	16,159,584
Interest-bearing			110,040,064				95,118,292
Total deposits			129,848,574				111,277,876
Federal funds purchased and securities sold under agreements to repurchase			576,824				3,418,635
Short-term debt			—				1,400,000
Long-term debt			8,351,992				5,246,080
Dividends payable on preferred stock			29,653				30,070
Accrued interest payable			145,579				129,193
Other liabilities			943,061				501,685
			139,895,683				122,003,539
Commitments and contingencies
Shareholders’ equity:
Preferred stock, 1,000,000 shares authorized, 189,356 shares of Series A, issued and outstanding with no par value, 4.5% convertible non-cumulative, perpetual; with liquidation value of $14 per share in 2004 and 2003			2,620,325				2,620,325
Common stock, no par value; 5,000,000 shares authorized; 1,196,407 shares issued in 2004, and 1,170,189 in 2003.			7,974,565				7,822,387
Retained earnings			3,621,606				2,627,529
Accumulated other comprehensive Income			(16,105	)			3,225
			14,200,391				13,073,466
		$	154,096,074			$	135,077,005

 

See Notes to Consolidated Financial Statements

 

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Consolidated Statements of Income							Unaudited
Six months ended June 30, 2004 and 2003
		Six months ended June 30,
		2004				2003
Interest income:
Loans and fees on loans		$	3,971,650			$	3,437,305
Investment securities, taxable			41,533				42,637
Investment securities, non taxable			456				1,362
Deposits with banks			29,263				19,683
			4,042,902				3,500,987
Interest expense:
Deposits			975,248				899,504
Federal funds purchased			1,697				2,198
Securities sold under agreements to repurchase			1,295				2,216
Short-term borrowings			5,291				9,488
Long-term borrowings			112,931				94,058
			1,096,462				1,007,464
Net interest income			2,946,440				2,493,523
Provision for loan losses			126,643				209,229
Net interest income after provision for loan losses			2,819,797				2,284,294
Noninterest income:
Service charges on deposit accounts			458,060				400,242
Gain and fees from the sale of mortgage servicing rights			501,610				—
Other service charges and fees			221,139				107,886
Other operating income			217,856				625,824
			1,398,665				1,133,952
Noninterest expense:
Salaries and employee benefits			1,288,198				1,058,125
Occupancy expense			170,080				120,583
Equipment expense			232,437				189,125
Data processing			179,634				124,899
Other expense			630,531				635,203
			2,500,880				2,127,935
Net income before income taxes			1,717,582				1,290,311
Income tax expense			664,200				498,650
Net income			1,053,382				791,661
Preferred stock dividend declared			(59,305	)			—
Net income available for common shareholders		$	994,077			$	791,661
Basic earnings per share		$	0.84			$	0.69
Diluted earnings per share		$	0.73			$	0.63
Basic weighted average shares outstanding			1,188,709				1,149,261
Diluted weighted average shares outstanding			1,450,297				1,264,575

 

See Notes to Consolidated Financial Statements

 

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Consolidated Statements of Income							Unaudited
Three months ended June 30, 2004 and 2003
		Three months ended June 30,
		2004				2003
Interest income:
Loans and fees on loans		$	2,010,717			$	1,757,672
Investment securities, taxable			18,929				20,656
Investment securities, non taxable			—				679
Deposits with banks			25,286				6,330
			2,054,932				1,785,337
Interest expense:
Deposits			515,525				441,670
Federal funds purchased			—				2,053
Securities sold under agreements to repurchase			533				1,068
Short-term borrowings			1,256				4,657
Long-term borrowings			62,530				42,959
			579,844				492,407
Net interest income			1,475,088				1,292,930
Provision for loan losses			41,484				62,145
Net interest income after provision for loan losses			1,433,604				1,230,785
Noninterest income:
Service charges on deposit accounts			241,715				211,347
Gain and fees from the sale of mortgage servicing rights			501,610
Other service charges and fees			91,996				58,327
Other operating income			70,582				398,970
			905,903				668,644
Noninterest expense:
Salaries and employee benefits			651,319				560,211
Occupancy expense			89,916				65,312
Equipment expense			118,920				106,923
Data processing			88,199				62,235
Other expense			344,156				352,559
			1,292,510				1,147,240
Net income before income taxes			1,046,997				752,189
Income tax expense			405,900				290,850
Net income			641,097				461,339
Preferred stock dividend declared			(29,653	)			—
Net income available for common shareholders		$	611,444			$	461,339
Basic earnings per share		$	0.51			$	0.40
Diluted earnings per share		$	0.44			$	0.36
Basic weighted average shares outstanding			1,196,407				1,149,261
Diluted weighted average shares outstanding			1,460,659				1,290,380

 

See Notes to Consolidated Financial Statements

 

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Consolidated Statements of Cash Flows							Unaudited
Six months ended June 30, 2004 and 2003
		Six months ended June 30,
		2004				2003
Cash flows from operating activities:
Net income		$	1,053,382			$	791,661
Adjustments to reconcile net income to net cash provided (used) by operations:
Depreciation and amortization			195,094				159,775
Provision for loan losses			126,643				209,229
Accretion of discount on securities, net of amortization of premiums			(6,156	)			11,796
Changes in assets and liabilities:
Accrued income			33,561				(20,053	)
Loans held for sale			—				(6,139,253	)
Other assets			(456,151	)			(498,500	)
Accrued interest payable			16,386				2,948
Other liabilities			441,376				(89,461	)
Net cash provided (used) by operating activities			1,404,135				(5,571,858	)
Cash flows from investing activities:
Net decrease (increase) in interest-bearing deposits with banks (15,244,291)							5,814,027
Purchase of investment securities			(2,495,797	)			(2,497,374	)
Sales and maturities of investment securities			4,925,945				3,095,380
(Purchase) redemption of Federal Home Loan Bank stock			32,500				(30,000	)
Net increase in loans			(6,361,857	)			(9,447,869	)
Purchases of property and equipment			(90,843	)			(561,326	)
Net cash used in investing activities			(19,234,343	)			(3,627,162	)
Cash flows from financing activities:
Net increase in deposits			18,570,698				8,025,569
Net decrease (increase) in fed funds puchased and securities sold under agreements to repurchase			(2,841,811	)			92,072
Net decrease in short-term debt			(1,400,000	)			(100,000	)
Net (decrease) increase in long-term debt			3,105,912				(1,328,775	)
Proceeds from the sale of preferred stock			—				2,628,257
Dividends paid on preferred stock			(59,722	)			—
Common stock options exercised			152,178				—
Fractional shares purchased			—				(12,051	)
Net cash provided by financing activities			17,527,255				9,305,072
Net increase (decrease) in cash and cash equivalents (302,953)							106,052
Cash and cash equivalents, beginning			1,956,473				1,409,407
Cash and cash equivalents, ending		$	1,653,520			$	1,515,459
Supplemental disclosure of cash flow information:
Interest paid		$	1,080,076			$	1,004,516
Taxes paid		$	490,292			$	906,595
Supplemental disclosure of Non-cash transactions:
Non-cash transactions related to acquisition of minority interest in subsidiary:
Cancellation of loan and interest receivable		$	—			$	422,984
Cancellation of loans receivable from recourse obligations			—				243,850
Addition to allowance for loan losses			—				57,852
Total transaction		$	—			$	724,686

See Notes to Consolidated Financial Statements

 

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Consolidated Statements of Changes in Shareholders’ Equity																											Unaudited
Six months ended June 30, 2004 and 2003
		Convertible Preferred Stock					Common Stock							Additional Paid in Capital				Retained Earnings				Unrealized Appreciation (Depreciation) on Securities				Total
		Shares		Amount			Shares			Amount
Balance January 1, 2003		—		$	—		958,376			$	3,833,504			$	3,879,760			$	1,432,493			$	18,629			$	9,164,386
Comprehensive income
Net income																			791,661								791,661
Net change in unrealized appreciation on investment securities available for sale, net of income taxes of $1,601																							(2,543	)			(2,543	)
Total comprehensive income																											789,118
6 for 5 Common stock exchange pursuant to Plan of Reorganization and Share Exchange							191,675				3,879,760				(3,879,760	)
Fractional shares purchased							(790	)			(12,051	)															(12,051	)
Issuance of convertible preferred stock		189,356			2,628,257																						2,628,257
Balance, June 30, 2003		189,356		$	2,628,257		1,149,261			$	7,701,213			$	—			$	2,224,154			$	16,086			$	12,569,710
Balance January 1, 2004		189,356			2,620,325		1,170,189			$	7,822,387			$	—			$	2,627,529			$	3,225			$	13,073,466
Comprehensive income
Net income																			1,053,382								1,053,382
Net change in unrealized (depreciation) on investment securities available for sale, net of income tax benefits of $12,127																							(19,330	)			(19,330	)
Total comprehensive income																											1,034,052
Common stock issued
Common stock options exercised							26,218				152,178																152,178
Dividends declared on convertible preferred stock																			(59,305	)							(59,305	)
Balance, June 30, 2004		189,356		$	2,620,325		1,196,407			$	7,974,565			$	—			$	3,621,606			$	(16,105	)		$	14,200,391

 

See Notes to Consolidated Financial Statements

 

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SURREY BANCORP

NOTES TO FINANCIAL STATEMENTS

 

NOTE 1. BASIS OF PRESENTATION

 

The accompanying unaudited financial statements were prepared in accordance with instructions for Form 10-QSB and therefore, do not include all disclosures required by generally accepted accounting principles for a complete presentation of financial statements. In the opinion of management, the financial statements contain all adjustments necessary to present fairly the financial condition of Surrey Bancorp as of June 30, 2004 and December 31, 2003, the results of operations for the six and three months ended June 30, 2004 and 2003, and its cash flows for the six months ended June 30, 2004 and 2003. The results of operations for the six months ended June 30, 2004 are not necessarily indicative of the results expected for the full year. These financial statements should be read in conjunction with the Company’s audited financial statements and related disclosures for the year ended December 31, 2003 included in the Company’s Form 10-KSB.

 

ORGANIZATION

 

Surrey Bancorp (the “Company”) began operation on May 1, 2003 and was created for the purpose of acquiring all the outstanding shares of common stock of Surrey Bank & Trust. Shareholders of the bank received six shares of Surrey Bancorp common stock for every five shares of Surrey Bank & Trust common stock owned.

 

Surrey Bank & Trust (the “Bank”) was organized and incorporated under the laws of the State of North Carolina on July 15 and commenced operations on July 22, 1996. The Bank currently serves Surry County, North Carolina and Patrick County, Virginia and surrounding areas through five banking offices. As a state chartered bank which is not a member of the Federal Reserve, the Bank is subject to regulation by the State of North Carolina Banking Commission and the Federal Deposit Insurance Corporation.

 

Surrey Investment Services, Inc. (“Subsidiary”) was organized and incorporated under the laws of the State of North Carolina on February 10, 1998. The Subsidiary provides insurance services through SB&T Insurance and investment advice and brokerage services through U-VEST.

 

On July 31, 2000, Surrey Bank & Trust formed Friendly Finance, LLC., a subsidiary operation specializing in the purchase of sales finance contracts from local automobile dealers. The Bank originally had a 60% majority interest in the company. On March 1, 2003 the Bank acquired the minority interest in Friendly Finance, LLC in exchange for the satisfaction of other commitments of the holder of the minority interest.

 

The accounting and reporting policies of the Company and subsidiaries follow generally accepted accounting principles and general practices within the financial services industry. Following is a summary of the more significant policies.

 

PRINCIPLES OF CONSOLIDATION

 

The consolidated financial statements include the accounts of the Company, the Bank and the Subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation.

 

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PRESENTATION OF CASH FLOWS

 

For purposes of reporting cash flows, cash and due from banks includes cash and amounts due from depository institutions (including cash items in process of collection). Overnight interest bearing deposits, and federal funds sold are shown separately. Cash flows from demand deposits, NOW accounts and savings accounts are reported net since their original maturities are less than three months. Loans and time deposits are reported net per FASB Statement No. 104. Federal Funds purchased are shown separately.

 

Investment Securities

 

Investments classified as available for sale are intended to be held for indefinite periods of time and include those securities that management may employ as part of asset/liability strategy or that may be sold in response to changes in interest rates, prepayments, regulatory capital requirements or similar factors. These securities are carried at fair value and are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.

 

Investment securities classified as held to maturity are those debt securities that the Bank has the ability and intent to hold to maturity. Accordingly, these securities are carried at cost adjusted for amortization of premiums and accretion of discount, computed by the interest-method over their contractual lives. At June 30, 2004 and December 31, 2003, the Bank had no investments classified as held to maturity.

 

Loans Held for Sale

 

Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate. Net unrealized losses are recognized through a valuation allowance by charges to income. At June 30, 2004 and December 31, 2003, the Bank had no loans classified as available for sale.

 

Loans Receivable

 

Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at their outstanding principal amount adjusted for any charge-offs, the allowance for loan losses, and any deferred fees or cost on originated loans and unamortized premiums or discounts on purchased loans.

 

The allowance for loan losses is maintained at a level considered adequate to provide for losses that can be reasonably anticipated. The allowance is increased by provisions charged to operating expense and reduced by net charge-offs. The Bank makes continuous credit reviews of the loan portfolio and considers economic conditions, historical loan loss experience, review of specific problem loans and other factors in determining the adequacy of the allowance balance.

 

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Activity in the allowance for loan losses for the six months ended June 30, 2004 and 2003 follows:

 

		June 30,
		2004				2003
Balance at beginning of year		$	2,109,820			$	1,831,167
Add provision charged to expense			126,643				209,229
Less net charge-offs			(87,352	)			(26,173	)
Allowance applicable to the acquisition of the minority interest			—				57,852
		$	2,149,111			$	2,072,075

 

Interest on all loans is accrued daily on the outstanding balance. Accrual of interest is discontinued on a loan when management believes, after considering collection efforts and other factors, that the borrower’s financial condition is such that collection of interest is doubtful.

 

Stock-based Compensation

 

The Company accounts for its stock-based compensation plans using the accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. The Company is not required to adopt the fair value based recognition provisions prescribed under SFAS No. 123, Accounting for Stock Based Compensation, but complies with the disclosure requirements set forth in the Statement (as amended by SFAS No. 148), which include disclosing pro forma net income as if the fair value based method of accounting had been applied.

 

NOTE 2. EARNINGS PER SHARE

 

Basic earnings per share for the six and three months ended June 30, 2004 and 2003 were calculated by dividing net income available to common shareholders by the weighted average number of shares outstanding during the period.

 

The computation of diluted earnings per share is similar to the computation of basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if dilutive potential common shares had been issued. The numerator is adjusted for any changes in income or loss that would result from the assumed conversion of those potential common shares. The potential dilutive shares are represented by the Series A convertible preferred stock which is convertible into .8695 shares of common stock.

 

NOTE 3. BALANCE SHEETS

 

The balance sheet at December 31, 2003, has been taken from the audited financial statements at that date.

 

NOTE 4. COMMITMENTS AND LETTERS OF CREDIT

 

At June 30, 2004, the Company had commitments to extend credit, including unused lines of credit of approximately $24,231,000. Letters of credit totaling $622,509 were outstanding.

 

NOTE 5. CHANGES IN SHAREHOLDERS EQUITY

 

On May 1, 2003, Surrey Bancorp exchanged six shares of its no par value common stock for every five shares of $4.00 par value common stock of Surrey Bank & Trust. Fractional shares resulting from the transaction were paid in cash.

 

On June 12, 2003 the Company issued 189,356 shares of Series A, 4.5% Convertible Non-Cumulative Perpetual Preferred Stock at a liquidation value of $14.00 per share. The issue was a private placement of which the net proceeds amounted to $2,620,325. The shares are convertible into .8695 shares of common stock.

 

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NOTE 6. STOCK OPTION PLANS

 

The Company has adopted a qualified incentive stock option plan which reserves, as amended, 77,204 shares for purchase by eligible employees. Options granted under this plan vest at the rate of 20% per year, expire not more than ten years from the date of grant, and are exercisable at not less than the fair market value of the stock at the date of the grant.

 

The Company also adopted a non-qualified stock option plan which reserves, as amended, 101,912 shares for purchase by non-employee directors. Options granted under this plan are exercisable after six months from the date of the grant at not less than the fair market value of the stock at the date of the grant. The life of such options shall not extend more than ten years from the date of the grant.

 

Information related to pro forma net income for the periods presented is as follows:

 

		June 30,
		2004			2003
Compensation cost recognized in income for all stock-based compensation awards		$	—		$	—
Pro forma net income available for common shareholders, based on SFAS No. 123		$	984,984		$	784,551
Pro forma earnings per common share, based on SFAS No. 123		$	0.83		$	0.68
Pro forma earnings per fully dilutive common share, based on SFAS No. 123		$	0.72		$	0.63

 

NOTE 7. PURCHASE OF MINORITY INTEREST

 

On March 1, 2003, the Bank acquired the minority interest in Friendly Finance, LLC in a transaction accounted for as a purchase. Purchase consideration (equal to the Bank’s recorded minority interest in subsidiary) consisted of cancellation of notes and interest receivable from the minority interest amounting to $422,984, cancellation of identified recourse obligations of the minority interest to the Bank of $243,850 and release of the minority interest from any future recourse obligation contingencies to the Bank, valued at $57,852. The Bank recorded the release of the future recourse obligation amount as an increase in the allowance for loan losses.

 

NOTE 8. SALE OF MORTGAGE SERVICING RIGHTS

 

On April 16, 2004, the Company sold its rights to service residential mortgage loans for others to another bank. The fees and gain recognized on the sale of these rights amounted to $501,610. The sale marked the exit of the Bank from the residential mortgage servicing business.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Introduction

 

This discussion, analysis and related financial information are presented to explain the significant factors which affected Surrey Bancorp’s financial condition and results of operations for the six months ending June 30, 2004 and 2003. This discussion should be read in conjunction with the financial statements and related notes contained within this report.

 

Surrey Bancorp (“Company”) is a North Carolina corporation, located in Mount Airy, North Carolina. The Company was incorporated on February 6, 2003 and began business on May 1, 2003.

 

Surrey Bank & Trust (“Bank”) is a North Carolina state Chartered Bank, located in Mount Airy, North Carolina. The Bank was chartered on July 15, 1996 and began operations one week later on July 22, 1996.

 

Effective March 5, 1998 the Bank became a member of the Federal Home Loan Bank.

 

Highlights

 

This Quarterly Report on Form 10-QSB may contain certain forward-looking statements consisting of estimates with respect to the financial condition, results of operations and business of the Company that are subject to various factors which could cause actual results to differ materially from these estimates. These factors include, but are not limited to, general economic conditions, changes in interest rates, deposit flows, loan demand, real estate values, and competition; changes in accounting principles, policies, or guidelines; changes in legislation or regulation; and other economic, competitive, governmental, regulatory, and technological factors affecting the Company’s operations, pricing, products, and services.

 

Net income available for common shareholders for the six months ended June 30, 2004, was $994,077 or $.73 per diluted share outstanding compared to a $791,661 or $.63 per diluted share outstanding for the same period in 2003. Earnings for the period ended June 30, 2004 are approximately 25.6% higher than for the same period in 2003. Loan growth, improved margins and growth in noninterest income contributed to this increase. Non interest income was bolstered by a one time gain of $501,610 resulting from the sale of the Company’s residential mortgage servicing rights. This sale marked the Company’s exit from the residential mortgage servicing business. The Company continues to originate mortgages for other institutions collecting origination fees and yield spread premiums.

 

On June 30, 2004, Surrey Bancorp’s assets totaled $154,096,074 compared to $135,077,005 on December 31, 2003. Net loans were $123,597,833 compared to $117,362,619 on December 31, 2003. This growth was primarily in the commercial loan area which increased 7.3% over December 2003 totals.

 

Total deposits on June 30, 2004, were $129,848,574 compared to $111,277,876 at the end of 2003. This increase is attributable to an increase in all deposit account categories. Demand deposits increased 27.5% over 2003 totals. Certificates of deposit increased 9.7% over December 31, 2003 totals, while savings deposits increased 23.7%.

 

Common shareholders’ equity increased by $1,126,925 or 8.6% during the six months ended June 30, 2004 resulting in a common stock book value of $9.68 per share, up from $8.93 on December 31, 2003.

 

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Financial Condition, Liquidity and Capital Resources

 

Investments

 

The Bank maintains a portfolio of securities as part of its asset/liability and liquidity management programs which emphasize effective yields and maturities to match its needs. The composition of the investment portfolio is examined periodically and appropriate realignments are initiated to meet liquidity and interest rate sensitivity needs for the Bank.

 

Bonds, notes, and debentures for which the Bank has the positive intent and ability to hold to maturity are reported at cost, adjusted by premiums and discounts that are recognized in interest income using the interest method over the period to maturity or to call dates. The Bank had no “Held to Maturity” securities at June 30, 2004 or December 31, 2003.

 

Available for sale securities are reported at fair value and consist of bonds, notes, debentures, and certain equity securities not classified as trading securities or as held to maturity securities.

 

Unrealized holding gains and losses, net of tax, on available for sale securities are reported as a net amount in a separate component of shareholders’ equity. Realized gains and losses on the sale of available for sale securities are determined using the specific-identification method. Premiums and discounts are recognized in interest income using the interest method over the period to maturity or to call dates.

 

Declines in the fair value of individual held to maturity and available for sale securities below cost that are other than temporary are reflected as write-downs of the individual securities to fair value. Related write-downs are included in earnings as realized losses.

 

Investments in available for sale securities of $2,970,523 consisted of U.S. Governmental Agency obligations with maturities ranging from one month to two years, and GNMA adjustable rate mortgage securities, which adjust annually.

 

Loans

 

Net loans outstanding on June 30, 2004, were $123,597,833 compared to $117,362,619 on December 31, 2003. The Bank maintains a loan portfolio dominated by real estate and commercial loans diversified among various industries. Approximately 60.8% of the Bank’s loans as of June 30, 2004 are fixed rate loans with 39.2% floating with the Bank’s prime rate or other appropriate internal or external indices.

 

Deposits

 

Deposits on June 30, 2004, were $129,848,574, compared to $111,277,876 on December 31, 2003.

 

The June total comes from a base of approximately 9,696 accounts compared to 8,840 accounts at December 31, 2003; a 9.7% increase. Interest-bearing accounts represented 84.7% of the 2004 period-end deposits versus 85.5% at December 31, 2003.

 

Shareholders’ Equity

 

Surrey Bancorp maintains a strong capital position which exceeds all capital adequacy requirements of Federal regulatory authorities. Under the risk-based capital guidelines, the Bank’s ratios of tier one capital to risk-weighted assets were 9.05% on June 30, 2004 and 8.87% on December 31, 2003. Total capital equals 10.30% of risk-based assets on June 30, 2004, and 10.13% on December 31, 2003. The Bank’s capital ratios thus well exceeded the minimums of 4% for tier one capital and 8% for total capital set by banking regulators.

 

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The Bank also exceeds all capital requirements under the leverage guidelines with the Bank’s ratio of core capital to total average assets totaling 7.83% on June 30, 2004, and 8.13% on December 31, 2003.

 

Asset Quality

 

The notes to the financial statements contained within this report provide details of the activity in the allowance for possible loan losses.

 

The provision for possible loan losses charge to operations was $126,643 in the six months of 2004 compared to $209,229 for the same period in 2003. The reserve for loan losses on June 30, 2004 was $2,149,111 or 1.71% of period end loans. This percentage is derived from total loans. Approximately $19,639,569 of loans at June 30, 2004 are government guaranteed loans which the Bank’s exposure ranges from 10% to 50% of the outstanding balance. When the guaranteed portion of the loans are removed from the equation the loan loss reserve is approximately 1.93% of outstanding loans.

 

Additionally, loan balances in Friendly Finance have reduced by approximately $574,000 since December 31, 2003 due to a slow down in the used car market and more strict underwriting standards. Accordingly, the reserve attributable to this reduction in loans has been recaptured by Friendly Finance, LLC. Through June 30, 2004 reserves in Friendly Finance, LLC have been reduced by $21,745.

 

The level of reserve is established based upon management’s evaluation of portfolio composition, current and projected national and local economic conditions, and results of independent reviews of the loan portfolio by internal and external examination. Management recognizes the inherent risk associated with commercial and consumer lending, including whether or not a borrower’s actual results of operations will correspond to those projected by the borrower when the loan was funded; economic factors such as the number of housing starts and increases in interest rates, etc.; depression of collateral values; and completion of projects within the original cost and time estimates. As a result, management continues to actively monitor the Bank’s asset quality and lending policies. Management believes that its loan portfolio is diversified so that a downturn in a particular market or industry will not have a significant impact on the loan portfolio or the Bank’s financial condition. Management believes that its provision and reserve offer an adequate allowance for future loan losses and provide a sound reserve for the loan portfolio.

 

At June 30, 2004, the Bank had loans totaling approximately $440,420 in nonaccrual status.

 

Interest Rate Sensitivity and Liquidity

 

One of the principal duties of the Bank’s Asset/Liability Management Committee is management of interest rate risk. The Bank utilitizes quarterly asset/liability reports prepared by a regional correspondent bank to project the impact on net interest income that might occur with hypothetical interest rate changes. The committee monitors and manages asset and liability strategies and pricing.

 

Another function of the Asset/Liability Committee is maintaining adequate liquidity and planning for future liquidity needs. Having adequate liquidity means the ability to meet current needs, including deposit withdrawals and commitments, in an orderly manner without sacrificing

 

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earnings. The Bank funds its investing activities, including making loans and purchasing investments, by attracting deposits and utilizing short-term borrowings when necessary.

 

At June 30, 2004, the liquidity position of the Company was good, with short-term liquid assets of $20,966,828. Deposit growth was approximately $9,450,000 greater than the growth in loans in the first six months of 2004 resulting in a more liquid liquidity position compared to December 31, 2003. To provide supplemental liquidity, the Bank has five lines of credit with correspondent banks totaling $10,700,000. There were no outstanding advances against these lines at June 30, 2004. Additionally, the Bank has a secured borrowing arrangement with the Federal Home Loan Bank. The maximum credit available under this agreement approximates $19,077,000 at June 30, 2004. Advances taken down against the Federal Home Loan Bank line amounted to $8,250,000 at June 30, 2004. In addition, Friendly Finance, LLC has a secured revolving line of credit with another commercial bank in the amount of $1,200,000. At June 30, 2004 no balance was due on this line.

 

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ITEM 3. CONTROLS & PROCEDURES

 

As of the end of the period covered by the report, an evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15e. Based on the evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the design and operation of these disclosure controls and procedures were effective. There have not been any changes in the Company’s internal control over financial reporting that occurred during the Company’s last quarter that has materially affected, or is reasonable likely to materially affect, internal control over financial reporting.

 

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PART II - OTHER INFORMATION

 

Item 1.		Legal Proceedings
		No significant changes in legal proceedings occurred during the quarter.
Item 2.		Changes in Securities
		None
Item 3.		Defaults Upon Senior Securities
		Not Applicable
Item 4.		Submission of Matters to a Vote of Security Holders
		None
Item 5.		Other Information
		None
Item 6.		Exhibits and Reports on Form 8-K

 

(a.)

Exhibits

 

31.1

Certification

 

31.2

Certification

 

32.

Certification

 

(b.)

Reports on 8-K

 

Incorporated by Reference to 8-Ks filed April 22, 2004 and April 28, 2004

 

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