<PAGE>
================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON D.C. 20549
FORM 10-K/A
(Amendment #1)
Annual Report Pursuant To Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the fiscal year ended December 31, 1997 Commission File Number 0-15059
HERITAGE FINANCIAL SERVICES, INC.
(Exact name of registrant as specified in its charter)
Illinois 36-3139645
(State or other jurisdiction of (I.R.S. employer
incorporation or organization) identification No.)
17500 South Oak Park Avenue
Tinley Park, Illinois 60477
(Address of principal executive offices) (Zip code)
(708) 532-8000
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Shares, no par value per share
(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
--- ---
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. X
---
As of February 18, 1998, 12,140,528 common shares, no par value, were
outstanding, and the aggregate market value of common shares (based on the last
sale price of the registrant's common shares on February 18, 1998) held by non-
affiliates was approximately $273,400,000. See "Item 5. Market for Registrant's
Common Shares and Related Shareholder Matters".
DOCUMENTS INCORPORATED BY REFERENCE
None
================================================================================
1
<PAGE>
Heritage Financial Services, Inc.
Amendment #1 to 1997 Form 10-K
The Registrant hereby amends Part II, Item 8, Financial Statements and
Supplementary Data, of its 1997 Form 10-K to reflect a change in the Report of
Independent Public Accountants to include an opinion on the consolidated
statements of income, cash flows and changes in shareholders' equity for the
year ended December 31, 1995. Accordingly, the Registrant also amends Exhibit
23, Consent of Arthur Andersen LLP, to refer to such revised Report of
Independent Public Accountants.
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollars in thousands)
<TABLE>
<CAPTION>
December 31 ,
--------------------------
1997 1996
---- ----
<S> <C> <C>
ASSETS
Cash and due from banks $ 48,214 $ 43,830
Federal funds sold and interest-bearing deposits 2,864 -
---------- ----------
Total cash and cash equivalents 51,078 43,830
Securities:
Held-to-maturity (market value: $116,544 in 1997 and $117,046 in 1996) 113,101 115,913
Available-for-sale, at market 407,087 392,754
Trading, at market 450 262
---------- ----------
Total securities 520,638 508,929
Loans, net of unearned income 711,541 639,004
Less: allowance for loan losses (9,621) (9,407)
---------- ----------
Net loans 701,920 629,597
Premises and equipment 19,585 18,786
Goodwill and core deposit intangibles 16,190 18,196
Other assets 9,910 9,682
---------- ----------
Total assets $1,319,321 $1,229,020
========== ==========
LIABILITIES
Demand deposits $ 186,358 $ 185,705
NOW and money market accounts 262,679 190,955
Savings deposits 189,128 203,483
Time deposits 501,466 473,160
---------- ----------
Total deposits 1,139,631 1,053,303
Federal funds purchased - 13,000
Securities sold under agreements to repurchase 45,569 40,706
Notes payable - 7,000
Other liabilities 11,915 9,324
---------- ----------
Total liabilities 1,197,115 1,123,333
---------- ----------
SHAREHOLDERS' EQUITY
Preferred shares - no par value; shares authorized: 12,000,000;
shares issued: none - -
Common shares - no par value in 1997, $.625 par value in 1996;
shares authorized: 16,000,000; shares issued: 12,128,313 in 1997
and 11,950,548 in 1996 - 4,979
Surplus 24,181 17,634
Retained earnings 93,346 83,374
Net unrealized gains on securities, net of tax 5,367 1,525
Treasury stock, at cost (37,911 shares in 1997 and 129,038 shares in 1996) (688) (1,825)
---------- ----------
Total shareholders' equity 122,206 105,687
---------- ----------
Total liabilities and shareholders' equity $1,319,321 $1,229,020
========== ==========
See accompanying notes to consolidated financial statements.
</TABLE>
30
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(dollars in thousands except per share data)
<TABLE>
<CAPTION>
Year Ended December 31,
-------------------------------
1997 1996 1995
------- ------- -------
<S> <C> <C> <C>
Interest Income
Loans, including fees $57,772 $52,907 $48,156
Securities:
Taxable 25,088 24,001 18,881
Exempt from federal income taxes 7,872 6,222 4,445
Federal funds sold and interest-bearing deposits 424 694 2,378
------- ------- -------
Total interest income 91,156 83,824 73,860
------- ------- -------
Interest Expense
Deposits 40,692 36,327 31,516
Short-term borrowings 1,904 1,675 1,661
Notes payable 140 604 187
------- ------- -------
Total interest expense 42,736 38,606 33,364
------- ------- -------
Net interest income 48,420 45,218 40,496
Provision for loan losses 600 400 200
------- ------- -------
Net interest income after provision for loan losses 47,820 44,818 40,296
------- ------- -------
Other Income
Service charges on deposit accounts 5,210 4,477 4,097
Income for trust services 874 784 737
Investment product fees 1,257 1,134 909
Other operating income 1,975 1,209 1,005
Securities gains 291 120 223
------- ------- -------
Total other income 9,607 7,724 6,971
------- ------- -------
Other Expense
Salaries and employee benefits 17,307 16,645 15,146
Net occupancy expense 3,190 3,107 2,618
Equipment expense 1,731 1,697 1,569
Federal deposit insurance premiums 123 53 958
Data processing expense 1,247 1,105 817
Amortization of intangible assets 2,006 2,251 1,613
Other operating expenses 6,161 5,943 4,949
------- ------- -------
Total other expense 31,765 30,801 27,670
------- ------- -------
Income before income taxes 25,662 21,741 19,597
Income tax expense 7,869 6,903 6,303
------- ------- -------
Net income $17,793 $14,838 $13,294
======= ======= =======
Net income per common share:
Basic $1.48 $1.25 $1.12
Diluted $1.43 $1.19 $1.07
Weighted average common and common equivalent
shares outstanding:
Basic 12,052,443 11,898,714 11,905,635
Diluted 12,463,805 12,486,834 12,463,506
</TABLE>
See accompanying notes to consolidated financial statements.
31
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(in thousands except per share data)
<TABLE>
<CAPTION>
Net
Unrealized
Preferred Common Retained Gains (Losses) Treasury
Shares Shares Surplus Earnings on Securities Stock Total
------ ------ ------- -------- ------------- ----- -----
<S> <C> <C> <C> <C> <C> <C> <C>
Balance, January 1, 1995 - $ 4,947 $ 17,385 $ 62,879 $ (2,100) $ 83,111
Net income - - - 13,294 - 13,294
Cash dividends ($.29 per share) - - - (3,492) - (3,492)
Common shares issued upon
exercise of stock options - 15 114 - - 129
Change in net unrealized gains
(losses) on securities, net of
related taxes of $2,468 - - - - 3,741 3,741
--------- ------- -------- -------- --------- ------- --------
Balance, December 31, 1995 - 4,962 17,499 72,681 1,641 96,783
Net income - - - 14,838 - 14,838
Cash dividends ($.35 per share) - - - (4,125) - (4,125)
Common shares issued upon
exercise of stock options - 17 135 - - 152
Purchases of common shares - - - - - (1,852) (1,852)
Treasury stock reissued upon
exercise of stock options - - - (20) - 27 7
Change in net unrealized gains
(losses) on securities, net of
related taxes of $(76) - - - - (116) - (116)
--------- ------- -------- -------- --------- ------- --------
Balance, December 31, 1996 - 4,979 17,634 83,374 1,525 (1,825) 105,687
Net income - - - 17,793 - - 17,793
Cash dividends ($.40 per share) - - - (4,831) - - (4,831)
Change in common share par value - (5,053) 5,053 - - - -
Common shares issued upon
exercise of stock options - 74 877 - - - 951
Purchases of common shares - - - - - (3,446) (3,446)
Treasury stock reissued upon
exercise of stock options - - 617 (2,990) - 4,583 2,210
Change in net unrealized gains
(losses) on securities, net of
related taxes of $2,536 - - - - 3,842 - 3,842
--------- ------- -------- -------- --------- ------- --------
Balance, December 31, 1997 - $ - $ 24,181 $ 93,346 $ 5,367 $ (688) $122,206
========= ======= ======== ======== ========= ======= ========
</TABLE>
See accompanying notes to consolidated financial statements.
32
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------------------
1997 1996 1995
------- ------- -------
<S> <C> <C> <C>
Operating Activities
Net income $17,793 $14,838 $13,294
Adjustments to reconcile net income to net cash
provided by operating activities:
Discount accretion on securities (1,925) (1,473) (978)
Deferred loan fee accretion (394) (452) (311)
Provision for loan losses 600 400 200
Securities gains (291) (120) (223)
Depreciation and amortization 1,877 1,740 1,690
Deferred income taxes (450) (346) (464)
Net amortization of purchase accounting adjustments 2,442 2,818 2,085
Increase in accrued interest income (503) (270) (1,249)
Increase in accrued interest expense 78 115 703
Other, net 1,576 869 (430)
--------- --------- ---------
Net cash provided by operating activities 20,803 18,119 14,317
--------- --------- ---------
Investing Activities
Securities held-to-maturity:
Proceeds from maturities, repayments and calls 12,045 9,894 51,333
Purchases (8,472) (25,635) (114,787)
Securities available-for-sale:
Proceeds from maturities, repayments and calls 66,168 88,142 14,391
Proceeds from sales 57,490 38,093 7,962
Purchases (130,397) (150,994) (58,834)
Purchase of trading security - (250) -
Net increase in loans (73,651) (35,308) (45,985)
Purchases of premises and equipment (2,780) (2,180) (1,288)
Proceeds from sales of other real estate owned 695 945 645
Purchase price of acquired bank net of cash and cash equivalents - (7,798) -
--------- --------- ---------
Net cash used in investing activities (78,902) (85,091) (146,563)
--------- --------- ---------
Financing Activities
Net increase in deposits 86,404 56,946 91,848
Net increase (decrease) in federal funds purchased (13,000) 13,000 -
Net increase (decrease) in securities sold under agreements to repurchase 4,863 (10,205) 13,984
Proceeds from notes payable - 14,000 -
Principal payments on notes payable (7,000) (7,000) (6,500)
Proceeds from stock option exercises 1,134 159 129
Dividends paid (4,831) (4,125) (3,492)
Purchases of common shares (2,223) (1,852) -
--------- --------- ---------
Net cash provided from financing activities 65,347 60,923 95,969
--------- --------- ---------
Net increase (decrease) in cash and cash equivalents 7,248 (6,049) (36,277)
Cash and cash equivalents at beginning of year 43,830 49,879 86,156
--------- --------- ---------
Cash and cash equivalents at end of year $51,078 $43,830 $49,879
========= ========= =========
Supplemental disclosures:
Interest paid $42,734 $38,595 $32,807
Income taxes paid 8,400 6,825 7,005
Supplemental schedule of non-cash investing activities:
Securities transferred from held-to-maturity to available-for-sale $ - $ - $205,290
Loans transferred to other real estate owned 767 901 735
Loans made in connection with the disposition of other real estate owned - 370 -
Supplemental schedule of non-cash financing activities:
Purchases of common shares $ 1,223 $ - $ -
</TABLE>
See accompanying notes to consolidated financial statements.
33
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The consolidated financial statements have been prepared in accordance with
generally accepted accounting principles and conform to prevailing practices
within the banking industry. The significant accounting and reporting policies
of Heritage Financial Services, Inc. and subsidiaries are as follows:
Principles of Consolidation
The consolidated financial statements include the accounts of Heritage
Financial Services, Inc. and its wholly-owned subsidiaries, Heritage Bank, First
National Bank of Lockport (a national banking association limited to trust and
insurance agency operations) and Heritage Trust Company (collectively, the
"Company"). Significant intercompany accounts and transactions are eliminated
in consolidation. Certain amounts in the 1996 and 1995 consolidated financial
statements have been reclassified to conform to the 1997 presentation.
Nature of Operations
The Company is a multi-bank holding company which provides a full range of
banking and trust services to individuals and business customers located in the
southwest metropolitan Chicago market. The Company's primary business is the
extension of credit to commercial, real estate and consumer loan customers in
its market area. Funding of the Company's assets is substantially provided by a
combination of consumer, commercial and public fund deposits. The Company
encounters significant competition for loans and deposits from other financial
institutions and non-bank companies. The Company is regulated by federal and
state banking agencies and undergoes periodic examinations by those agencies.
Use of Estimates in Preparation of Financial Statements
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities as of the date of the financial statements, as
well as the reported amounts of income and expenses during the reported periods.
Actual results could differ significantly from those estimates. Estimates that
are particularly susceptible to significant changes relate to the determination
of the allowance for loan losses.
Statements of Cash Flows
For purposes of reporting cash flows in the Statements of Cash Flows, cash and
cash equivalents include cash and due from banks, federal funds sold and
interest-bearing deposits at other institutions. Generally, federal funds are
sold for one-day periods and interest-bearing deposits generally mature in 90
days or less. Included in the 1996 Statement of Cash Flows is the purchase
price of an acquisition, net of cash and cash equivalents acquired.
Securities
Securities which the Company has the ability and intent to hold to maturity
are classified as held-to-maturity and are carried at amortized cost.
Securities that may be sold as part of the Company's management of interest rate
risk, liquidity, or in response to or in anticipation of changes in interest
rates and prepayment risk, or for other similar factors, are classified as
available-for-sale. Securities available-for-sale are carried at their estimated
market values, and net unrealized gains and losses, net of tax, are reported as
a separate category of shareholders' equity. Premiums and discounts on
securities held-to-maturity and securities available-for-sale are amortized in a
manner that approximates the level yield method. Trading securities are carried
at market value and changes in fair value are recorded as securities gains or
losses. Realized gains and losses on securities sold are computed based on the
adjusted cost of the specific securities sold.
On November 15, 1995, the Financial Accounting Standards Board ("FASB") issued
a Special Report on the implementation of Statement of Financial Accounting
Standards No. ("SFAS") 115, "Accounting for Certain Investments in Debt and
Equity Securities". In accordance with the Special Report, the Company
transferred all of its taxable securities classified as held-to-maturity at
December 31, 1995 to available-for-sale. At the date of transfer, the
securities had an approximate market value of $207,000,000 and an unrealized
gain of $1,928,000.
34
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Loans
Interest income on nondiscounted loans is recognized based upon the principal
amount outstanding during the period. Interest income on discounted loans is
recognized based on methods that approximate a level yield. The accrual of
interest income is discontinued when management believes, after considering the
borrower's financial condition and other relevant factors, that future
collection of principal or interest in accordance with contractual terms may be
doubtful. Loans 90 days or more past due are transferred to nonaccrual status
unless they are well secured and in the process of collection. When a loan is
placed on nonaccrual status, interest previously accrued is reversed and charged
against current year income. Interest income on nonaccrual loans is recognized
on a cash basis. Certain loan origination fees in excess of incremental direct
costs are deferred and recognized over the term of the loan using the level
yield method.
Allowance for Loan Losses
The allowance for loan losses is an amount which is available to absorb
potential credit losses. The allowance is comprised of both specific and
general valuation allowances and is maintained at a level management believes to
be adequate to provide for known and potential risks inherent in the Company's
loan portfolio. Management assesses the adequacy of the allowance for loan
losses on a quarterly basis. Management's evaluation of the adequacy of the
allowance considers such factors as prior loss experience, loan portfolio
growth, loan delinquency levels and trends, and reviews of impaired loans and
the value of underlying collateral securing these loans. A provision for loan
losses is charged to income to increase the allowance to a level deemed to be
adequate, but not excessive, based on management's evaluation. When a loan or a
part thereof is considered by management to be uncollectible, a charge is made
against the allowance. Recoveries of loans previously charged off are credited
back to the allowance.
Under the Company's credit policy, all loans, except for home equity loans and
other consumer loans, are subject to impairment recognition on a quarterly
basis. A loan is considered impaired when it is probable that all principal and
interest due under the contractual terms of a loan will not be collected. The
Company generally considers most loans 90 days or more past due and all
nonaccrual loans to be impaired. Loan impairment is measured based on the
present value of expected future cash flows or the fair value of collateral if
the loan is collateral dependent. If the fair value of an impaired loan is less
than its recorded investment, a specific valuation allowance is allocated to the
loan. Interest income on impaired loans, other than nonaccrual loans, is
recorded on an accrual basis.
Derivative Financial Instruments
A derivative financial instrument is a futures, forward, swap, or option
contract, or other financial instrument with similar characteristics. At
December 31, 1997 and 1996, the Company's derivative financial instruments were
limited to fixed-rate and variable-rate loan commitments.
Premises and Equipment
Premises and equipment are stated at cost, less accumulated depreciation and
amortization. Depreciation and amortization have been computed principally
using the straight-line method. Rates of depreciation are generally based on
the following useful lives: building--40 to 50 years; building improvements,
furniture and equipment--3 to 15 years.
Other Real Estate Owned
Other real estate owned represents properties acquired through foreclosure or
deed in lieu of foreclosure. These properties are recorded at the lower of the
book value of the loan or fair value, less estimated costs to sell. The excess,
if any, of the loan amount over fair value is charged to the allowance for loan
losses. Subsequent declines in the fair value of other real estate owned, along
with related operating expenses, are charged to other operating expenses.
35
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Intangible Assets
The net assets of subsidiaries acquired in purchase transactions have been
recorded at fair value at the acquisition date. The values of the acquired
deposit base intangibles recognized in purchase transactions are being amortized
on a straight-line basis over periods ranging from 5 to 8 years. Goodwill,
representing the cost in excess of the fair value of net assets acquired, is
being amortized on a straight-line basis over periods ranging from 15 to 25
years. Management reviews intangible assets for possible impairment if there is
a significant event that detrimentally affects operations. Impairment is
measured by comparing the carrying amount of intangibles to the current and
estimated future net income of businesses acquired.
Stock Options
The Company accounts for employee stock option plans under APB Opinion 25 and
related Interpretations. Accordingly, no compensation expense is recognized for
grants of stock options.
Income Taxes
The Company files consolidated federal and state income tax returns.
Accordingly, no income tax is applicable to the dividends received by Heritage
Financial Services, Inc. from its subsidiaries. Deferred tax assets and
liabilities are recorded based on the expected tax effect of future taxable
income or deductions resulting from differences in the financial statement and
tax bases of assets and liabilities and the expected tax effect of carryforwards
for tax purposes.
Earnings Per Share
Effective December 15, 1997, the Company adopted SFAS 128, "Earnings Per
Share". SFAS 128 establishes standards for computing and presenting earnings per
share ("EPS") and applies to entities with publicly held common stock or
potential common stock. SFAS 128 replaces the presentation of primary EPS with
earnings per common share ("basic EPS"). Basic EPS is computed by dividing net
income by the weighted average number of common shares outstanding for the
period. SFAS 128 also requires presentation of EPS assuming dilution ("diluted
EPS"). Diluted EPS reflects the potential dilution that could occur if
securities or other contracts to issue common stock were exercised or converted
into common stock. The Company's potential dilutive instruments represent common
shares issuable under its stock option plans. The dilutive effect of stock
options is computed using the treasury stock method. In accordance with SFAS
128, the Company has restated all prior period earnings per share data. Weighted
average common shares have also been adjusted to reflect the Company's 1997
three-for-two stock split. The computation of basic and diluted EPS is set forth
in Note 12 .
Capital Structure
Effective December 15, 1997, the Company adopted SFAS 129, "Disclosure of
Information About Capital Structure". SFAS 129 essentially consolidates
disclosure requirements found in other previously existing literature regarding
capital structure. Since SFAS 129 contains no changes in disclosure
requirements, the adoption of this standard had no effect on the Company's
capital structure disclosures.
Transfers of Financial Assets, Servicing Rights and Extinguishment of
Liabilities
As of January 1, 1997, the Company adopted the provisions of SFAS 125,
"Accounting for Transfers of Financial Assets, Servicing Rights, and
Extinguishment of Liabilities". SFAS 125 sets forth accounting and reporting
standards for transfers and servicing of financial assets and extinguishments of
liabilities. The standards are based on consistent application of a financial-
components approach that focuses on control. Under the approach, after a
transfer of financial assets, an entity recognizes the financial and servicing
assets it controls and the liabilities it has incurred, derecognizes financial
assets when control has been surrendered, and derecognizes liabilities when
extinguished. In December 1996, FASB issued SFAS 127, "Deferral of the Effective
Date of Certain Provisions of SFAS 125". SFAS 127 defers the effective date of
certain provisions of SFAS 125 for one year. The adoption of SFAS 125 did not
have a material effect on the Company's consolidated financial condition or
results of operations.
36
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
New Accounting Pronouncements Not Yet Effective
In June 1997, FASB issued SFAS 130, "Reporting Comprehensive Income", which
establishes standards for reporting and display of comprehensive income and its
components in a full set of financial statements. Comprehensive income is the
total of reported net income and all other revenues, expenses, gains and losses
that under generally accepted accounting principles bypass reported net income.
SFAS 130 requires that comprehensive income be reported in a financial statement
that is displayed with the same prominence as other financial statements and
requires an entity to (a) classify items of other comprehensive income by their
nature in a financial statement and (b) display the accumulated balance of other
comprehensive income separately from retained earnings and surplus in the equity
section of the balance sheet. SFAS 130 is effective for fiscal years beginning
after December 15, 1997. Companies are also required to report comparative
totals for comprehensive income in interim reports. Management is currently
considering the impact of SFAS 130, but does not believe it will have a material
effect on the Company's consolidated financial statements.
In June 1997, FASB issued SFAS 131, "Disclosures About Segments of an
Enterprise and Related Information", which establishes standards for public
companies to report certain financial information about operating segments in
interim and annual financial statements. Operating segments are components of a
business about which separate financial information is available and that are
evaluated regularly by the chief operating decision maker in assessing
performance and deciding how to allocate resources. The statement also requires
public companies to report certain information about their products and services
and the geographic areas in which they operate. SFAS 131 is effective for
financial statements for fiscal years beginning after December 15, 1997. The
statement does not need to be applied to interim financial statements in the
initial year of its application, but such comparative information will be
required in interim statements in the second year. At this time, management is
assessing this statement and has not determined whether the new reporting
provisions will require supplemental disclosures by the Company.
NOTE 2 - ACQUISITION
On February 2, 1996, the Company acquired all of the common stock of the First
National Bank of Lockport ("Lockport") for $16,820,000 in cash. The acquisition
was funded with cash and borrowings of $14,000,000 under a revolving line of
credit facility. The acquisition was accounted for as a purchase and,
accordingly, the results of operations of Lockport have been included in the
consolidated statement of income from the date of acquisition. In connection
with the acquisition, the Company acquired assets with an aggregate fair value
of $104,375,000 and assumed deposits and other liabilities of $87,555,000.
NOTE 3 - SECURITIES
The amortized cost and estimated market values of securities held-to-maturity
are as follows (in thousands):
<TABLE>
<CAPTION>
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
---- ----- ------ -----
<S> <C> <C> <C> <C>
December 31, 1997
State and municipal obligations $113,101 $ 3,514 $ (71) $116,544
======== ======== ======== ========
December 31, 1996
State and municipal obligations $115,913 $ 1,986 $ (853) $117,046
======== ======== ======== ========
</TABLE>
37
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The amortized cost and estimated market values of securities available-for-
sale are as follows (in thousands):
<TABLE>
<CAPTION>
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
---- ----- ------ -----
<S> <C> <C> <C> <C>
December 31, 1997
Mortgage-backed securities:
REMICs and CMOs $150,471 $ 2,582 $ (47) $153,006
Adjustable rate mortgage pools 27,752 998 - 28,750
Pass-through obligations and pools 127,084 3,300 (54) 130,330
Asset-backed securities 29,434 395 (19) 29,810
U.S. Treasury and governmental agencies 6,007 6 (7) 6,006
State and municipal obligations 52,378 1,758 (8) 54,128
Other securities 5,057 - - 5,057
-------- ------- -------- --------
Total $398,183 $ 9,039 $ (135) $407,087
======== ======= ======== ========
December 31, 1996
Mortgage-backed securities:
REMICs and CMOs $166,171 $ 1,410 $ (872) $166,709
Adjustable rate mortgage pools 66,623 1,484 (42) 68,065
Pass-through obligations and pools 91,700 973 (320) 92,353
Asset-backed securities 33,554 212 (233) 33,533
U.S. Treasury and governmental agencies 14,791 27 (91) 14,727
State and municipal obligations 12,471 2 (19) 12,454
Other securities 4,912 2 (1) 4,913
-------- ------- -------- --------
Total $390,222 $ 4,110 $(1,578) $392,754
======== ======= ======== ========
</TABLE>
Securities with carrying values of $155,514,000 and $162,920,000 at December
31, 1997 and 1996, respectively, were pledged principally to secure public fund
deposits and securities sold under agreements to repurchase.
Proceeds from sales of securities available-for-sale were $57,740,000 in 1997,
$38,093,000 in 1996 and $7,962,000 in 1995. In 1997 gross gains from sales were
$482,000 and gross losses were $381,000. In 1997 calls of securities resulted in
gross gains of $1,000. The balance of securities gains recognized in 1997
reflected a market value adjustment of an investment security classified as
trading. In 1996 gross gains from sales were $63,000 and gross losses were
$121,000. In 1996 a gain of $135,000 was recognized on the payoff of a tax-
exempt obligation that was in default and carried on nonaccrual status. In 1996
calls of securities resulted in gross gains of $30,000. In 1995 gross gains from
sales were $177,000. In 1995 calls of securities resulted in gross gains of
$47,000 and gross losses of $1,000. Income tax expense recognized on net
securities gains was $116,000 in 1997, $43,000 in 1996 and $93,000 in 1995.
38
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The following table summarizes the contractual maturities of securities held-
to-maturity and available-for-sale at December 31, 1997. Expected maturities may
differ from contractual maturities because certain issuers have the right to
call or prepay these obligations without penalties. The stated maturities of
mortgage-backed and asset-backed securities are presented in total since the
principal cash flows of these securities are not received at a single maturity
date (in thousands):
<TABLE>
<CAPTION>
Amortized Market
Cost Value
---- -----
<S> <C> <C>
Held-to-Maturity:
Due in one year or less $ 11,150 $ 11,282
Due after one year through five years 31,569 32,200
Due after five years through ten years 59,922 61,957
Due after ten years 10,460 11,105
--------- ---------
Total held-to-maturity $ 113,101 $ 116,544
========= =========
Available-for-Sale:
Due in one year or less $ 10,276 $ 10,275
Due after one year through five years 1,577 1,602
Due after five years through ten years 10,313 10,458
Due after ten years 41,276 42,856
--------- ---------
Subtotal 63,442 65,191
Mortgage-backed securities 305,307 312,086
Asset-backed securities 29,434 29,810
--------- ---------
Total available-for-sale $ 398,183 $ 407,087
========= =========
</TABLE>
NOTE 4 - LOANS
The following table summarizes loan balances by category as of December 31,
1997 and 1996 (in thousands):
<TABLE>
<CAPTION>
1997 1996
---- ----
<S> <C> <C>
Commercial and industrial $ 163,967 $ 143,811
Commercial real estate 157,809 148,798
Construction 12,188 13,515
Residential real estate 275,482 239,380
Home equity 95,924 85,113
Other consumer 7,406 10,192
--------- ---------
Gross loans 712,776 640,809
less: unearned income (1,235) (1,805)
--------- ---------
Loans, net of unearned income $ 711,541 $ 639,004
========= =========
</TABLE>
Loans on which the accrual of interest has been discontinued amounted to
$903,000 and $3,421,000 at December 31, 1997 and 1996, respectively. If interest
on those loans had been accrued at their original terms, such income would
approximate $58,000 in 1997 and $170,000 in 1996. The amount of interest accrued
on these loans and included in interest income was $18,000 in 1997 and $76,000
in 1996. At December 31, 1997, restructured loans totaled $139,000. There were
no restructured loans at December 31, 1996.
Real estate loans with carrying values of $10,843,000 and $10,686,000 at
December 31, 1997 and 1996, respectively, were pledged to secure public fund
deposits.
39
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Certain directors and executive officers of the Company and companies with
which they are affiliated have obtained loans from the Bank on various
occasions. All loans and loan commitments have been made in the ordinary course
of business and on substantially the same terms, including interest rates and
collateral, as those prevailing at the time for comparable transactions with
unrelated persons. The aggregate balance of these loans was $8,670,000 at
December 31, 1997 and $9,056,000 at December 31, 1996. During 1997 $5,802,000 of
new loans were made and repayments were $6,188,000.
NOTE 5 - ALLOWANCE FOR LOAN LOSSES AND IMPAIRED LOANS
The changes in the allowance for loan losses for the years ended December 31,
1997, 1996 and 1995 are as follows (in thousands):
<TABLE>
<CAPTION>
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Balance, beginning of year $9,407 $8,477 $8,720
Allowance of acquired bank - 1,179 -
Provision for loan losses 600 400 200
Loan charge-offs (706) (925) (865)
Loan recoveries 320 276 422
------ ------ ------
Balance, end of year $9,621 $9,407 $8,477
====== ====== ======
</TABLE>
The following table sets forth the recorded investment in impaired loans and
the related valuation allowance for each loan category as of December 31, 1997
and 1996 (in thousands):
<TABLE>
<CAPTION>
Amount of Impaired Loans
---------------------------------------
No Valuation Valuation Amount of
Allowance Allowance Valuation
Required Required Total Allowance
-------- -------- ----- ---------
<S> <C> <C> <C> <C>
December 31, 1997
Commercial and industrial $94 $171 $265 $4
Commercial real estate 951 518 1,469 76
Residential real estate 385 650 1,035 130
------ ------ ------ ----
Total impaired loans $1,430 $1,339 $2,769 $210
====== ====== ====== ====
December 31, 1996
Commercial and industrial $137 $646 $783 $275
Commercial real estate 816 955 1,771 200
Residential real estate 812 240 1,052 66
------ ------ ------ ----
Total impaired loans $1,765 $1,841 $3,606 $541
====== ====== ====== ====
</TABLE>
The average recorded investment in impaired loans for the years ended December
31, 1997 and 1996, were $2,942,000 and $5,855,000, respectively. Interest
income recognized on impaired loans totaled $144,000 in 1997 and $236,000 in
1996. Included in the total balance of impaired loans at December 31, 1997 and
1996, were nonaccrual loans of $742,000 and $2,951,000, respectively. Of the
total amount of impaired loans at December 31, 1997, $717,000 were measured
using the present value of expected future cash flows and $2,052,000 were
measured based on the fair value of collateral.
40
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 6 - PREMISES AND EQUIPMENT
The following is a summary of the Company's premises and equipment as of
December 31, 1997 and 1996 (in thousands):
<TABLE>
<CAPTION>
1997 1996
---- ----
<S> <C> <C>
Land $ 5,333 $ 5,245
Buildings and improvements 19,559 18,324
Furniture and equipment 16,474 15,583
------- -------
Total cost 41,366 39,152
Less: accumulated depreciation and amortization (21,781) (20,366)
-------- -------
Premises and equipment, net $19,585 $18,786
======== =======
</TABLE>
The Company leases certain banking facilities under noncancelable operating
leases which expire on various dates from 1998 through 2017. The leases contain
renewal options for varying terms expiring between 2001 through 2007 and require
the payment of property taxes, insurance and related expenses. The Company also
leases certain equipment under cancelable and noncancelable leases with terms of
up to three years. Total rent expense under operating leases amounted to
$268,000 in 1997, $270,000 in 1996 and $234,000 in 1995. Aggregate amounts of
minimum rental commitments under noncancelable operating leases are $2,957,000
and for each of the years subsequent to December 31, 1997, are $246,000 (1998),
$253,000 (1999), $211,000 (2000), $172,000 (2001) and $117,000 (2002).
NOTE 7 - NOTES PAYABLE
Notes payable, which were repaid in 1997, represented borrowings under a $20
million unsecured revolving line of credit. At December 31, 1996, the weighted
average interest rate of notes payable was 6.59%.
NOTE 8 - COMMON AND PREFERRED SHARES
In 1987 shareholders authorized 12,000,000 no par value preferred shares. The
preferred shares may be issued in one or more series by the board of directors,
which has been given the authority to establish or change the number of shares
of each series, fix the designation and relative powers, preferences and rights
and restrictions. At December 31, 1997 and 1996 there were no preferred shares
issued.
Pursuant to a Registration Statement on Form S-8 filed in March, 1993, as
amended by a Post-Effective Amendment filed in May, 1997, the Company registered
1,241,700 common shares for issuance pursuant to the Company's stock option
plans. Common shares issued pursuant to the exercise of stock options totaled
177,808 in 1997, 41,510 in 1996 and 35,081 in 1995.
In June, 1996, the Company's board of directors approved a stock repurchase
program which authorized the repurchase of up to 325,000 common shares to be
used for the issuance of shares under the Company's stock option plans. In May,
1997, the board of directors authorized the repurchase of an additional 68,850
shares as a result of the Company's 1997 three-for-two stock split. The shares
were authorized to be repurchased from time to time in the open market or in
private transactions. In 1997, on a split adjusted basis, the Company
repurchased 205,001 common shares at a cost of $3,446,000 and reissued 296,128
treasury shares upon the exercise of stock options. In 1996, on a split adjusted
basis, the Company repurchased 130,950 common shares at a cost of $1,852,000 and
reissued 1,912 treasury shares upon the exercise of stock options. At December
31, 1997, the Company had 129,049 common shares remaining to be repurchased
under the stock repurchase program.
On May 14, 1997, the Company's board of directors declared a three-for-two
stock split, payable June 13, 1997, to shareholders of record at the close of
business on May 27, 1997. The board of directors also voted to eliminate the par
value of common shares. As a result of the stock split, shareholders of record
as of May 27, 1997 received one additional common share for every two shares
owned. Shareholders entitled to fractional shares received cash in lieu of
fractional shares. Per share information included in the consolidated financial
statements has been adjusted to reflect the split.
41
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 9 - STOCK OPTION PLANS
In April, 1991, shareholders approved the 1990 Executive Equity Incentive
Plan (the "Plan") which provides for the grant to certain officers and key
employees of the Company of incentive and non-qualified stock options, tandem
stock appreciation rights, stand-alone stock appreciation rights and limited
stock appreciation rights, with respect to not more than 675,000 common shares
(split adjusted). The Plan replaced the 1987 Stock Option Plan (the "Prior
Plan") for grants of stock options after September, 1990. The Prior Plan
provided for options of up to 1,125,000 common shares (split adjusted). Options
outstanding under the Prior Plan retain the terms as set forth at the time such
options were granted. The Plan and the Prior Plan (the "Option Plans") are
administered by a Committee of the board of directors.
The exercise prices of stock options granted under Option Plans were equal
to the market prices on the dates of grant, and each such option has a maximum
duration of ten years. Each option generally becomes exercisable in up to four
annual installments, commencing one year from the date of grant.
A summary of the Company's stock options for the years ended December 31,
1997 and 1996 is presented below (shares in thousands):
<TABLE>
<CAPTION>
Year Ended Year Ended
December 31, 1997 December 31, 1996
----------------- -----------------
Weighted Weighted
Option Average Option Average
Shares Price Shares Price
------ ----- ------ -----
<S> <C> <C> <C> <C>
Balance, beginning of period 1,022 $5.82 1,065 $5.73
Granted - - - -
Exercised (474) $4.98 (43) $3.70
Forfeited - - - -
----- -----
Balance, end of period 548 $6.55 1,022 $5.82
===== =====
</TABLE>
A summary of the Company's outstanding and exercisable options at December
31, 1997 is presented below (shares in thousands):
<TABLE>
<CAPTION>
Outstanding Options Exercisable Options
--------------------------- -------------------
Weighted Average Weighted
Option Average Remaining Option Average
Exercise Price Ranges: Shares Price Life Shares Price
------ ----- ---- ------ -----
<S> <C> <C> <C> <C> <C>
$4.73 - $7.08 418 $5.60 2.6 yrs 418 $5.60
$9.00 - $11.00 130 $9.60 5.5 yrs 100 $9.20
--- ---
Total 548 518
=== ===
</TABLE>
NOTE 10 - PROFIT SHARING PLAN
The Company has a noncontributory profit sharing plan which covers
substantially all employees who meet certain age and employment requirements.
The contribution to the plan each year is made in accordance with a resolution
passed by the board of directors. Charges to expense with respect to the plan
for the years ended December 31, 1997, 1996 and 1995 amounted to $1,120,000,
$1,184,000 and $940,000, respectively.
42
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 11 - INCOME TAXES
The components of income tax expense (benefit) for the years ended December
31, 1997, 1996 and 1995 are as follows (in thousands):
<TABLE>
<CAPTION>
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Current:
Federal $6,816 $5,644 $5,370
State 1,504 1,605 1,397
------ ------ ------
Total current 8,320 7,249 6,767
------ ------ ------
Deferred:
Federal (682) (338) (439)
State 231 (8) (25)
------ ------ ------
Total deferred (451) (346) (464)
------ ------ ------
Total income tax expense $7,869 $6,903 $6,303
====== ====== ======
</TABLE>
A reconciliation of the federal statutory tax rate to the Company's effective
tax rate for the years ended December 31, 1997, 1996 and 1995 is as follows:
<TABLE>
<CAPTION>
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Federal income tax at statutory rate 35.0% 35.0% 35.0%
State income tax, net of federal income tax benefit 4.4 4.7 4.6
Amortization of goodwill 1.5 1.8 1.5
Tax-exempt interest income, less disallowed interest
expense (10.1) (9.7) (8.3)
Other, net (.1) (.1) (.6)
----- ---- ----
Actual effective income tax rate 30.7% 31.7% 32.2%
===== ==== ====
</TABLE>
The tax effects of temporary differences which comprise the significant
portions of the Company's deferred tax assets and deferred tax liabilities as of
December 31, 1997 and 1996 are as follows (in thousands):
<TABLE>
<CAPTION>
1997 1996
---- ----
<S> <C> <C>
Deferred tax assets:
Allowance for loan losses $ 3,824 $ 3,690
Loan fees 229 288
State net operating loss carryforward - 232
Compensation expense 746 594
Other 131 123
------- -------
4,930 4,927
------- -------
Deferred tax liabilities:
Purchase accounting adjustments (3,086) (3,607)
Net unrealized gains on securities (3,544) (1,008)
Depreciation (84) (85)
Other (80) (6)
------- -------
(6,794) (4,706)
------- -------
Net deferred tax asset (liability) $(1,864) $ 221
======= =======
</TABLE>
Management believes that it is more likely than not that deferred tax assets
will be fully realized. As a result, no valuation allowances were recorded at
December 31, 1997 and 1996.
43
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 12 - EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings
per share for the years ended December 31, 1997, 1996 and 1995 (in thousands,
except per share data):
<TABLE>
<CAPTION>
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Net income available to common shareholders $17,793 $14,838 $13,294
======= ======= =======
Weighted average common shares outstanding use
in basic earnings per share calculation 12,053 11,899 11,906
Dilutive effect of employee stock options after
application of the treasury stock method 411 588 558
------- ------- -------
Weighted average number of shares outstanding adjusted
for the effect of dilutive securities 12,464 12,487 12,464
======= ======= =======
Basic earnings per share $1.48 $1.25 $1.12
===== ===== =====
Diluted earnings per share $1.43 $1.19 $1.07
===== ===== =====
</TABLE>
NOTE 13 - COMMITMENTS AND CONTINGENT LIABILITIES
Credit
The Company is a 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 lines of credit, letters of credit and other
commitments to extend credit. Each of these instruments involves, to varying
degrees, elements of credit and interest rate risk in excess of the amount
recognized in the consolidated balance sheets. The Company uses the same credit
policies and requires similar collateral in approving lines of credit and
commitments and issuing letters of credit as it does in making loans. The
exposure to credit losses on financial instruments is represented by the
contractual amount of these instruments; however, the Company does not
anticipate any losses from these instruments.
The off-balance sheet financial instruments whose contract amounts
represent credit risk at December 31, 1997 and 1996 are as follows (in
thousands):
<TABLE>
<CAPTION>
1997 1996
---- ----
<S> <C> <C>
Commitments to extend credit:
Unused lines of credit: $ 65,564 $ 66,994
Commercial and other 32,293 19,808
Home equity 27,768 29,019
Commitments to originate credit -------- --------
Total $125,625 $115,821
======== ========
Letters of credit $11,361 $9,199
======== ========
</TABLE>
44
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Lines of credit are agreements by which the Bank agrees to provide a borrowing
accommodation up to a stated amount as long as there is no violation of any
condition established in the loan agreement. The borrower may periodically
reduce or retire amounts drawn under a line and subsequently redraw these
amounts. Lines of credit generally have fixed expiration dates or other
termination clauses and may require payment of a fee.
Commitments to originate credit represent approved commercial and real estate
loans which generally are expected to be funded within ninety days.
Letters of credit are conditional commitments issued by the Company to
guarantee the financial performance of customers to third parties. Letters of
credit are primarily issued to facilitate trade or support borrowing
arrangements and generally expire in one year or less. The credit risk involved
in issuing letters of credit is essentially the same as that involved in
extending credit facilities to customers.
Concentrations of Credit Risks
In addition to financial instruments with off-balance sheet risk, the Company,
to a certain extent, is exposed to varying risks associated with concentrations
of credit. Concentrations of credit risk generally exist if an individual or
number of counterparties are engaged in similar activities and have similar
economic characteristics that would cause their ability to meet contractual
obligations to be similarly affected by economic or other conditions.
At December 31, 1997, approximately 60% of the securities portfolio was
comprised of mortgage-backed securities which consisted of pass-through
securities directly or implicitly backed by the full faith and credit of the
United States government. Concentrations of securities of a single issuer
consisted of investments in tax-exempt obligations issued by the Village of
Alsip. At December 31, 1997, the amortized cost and market value of Village of
Alsip securities were $14,106,000 and $14,691,000, respectively. In addition to
securities, the Company has granted tax-exempt loans to the Village of Alsip
which totaled $4,462,000 at December 31, 1997. All securities and loans are
secured by the general taxing authority of the respective issuer except for
$257,000 in securities which are secured solely by revenue from certain real
estate taxes. Some loans are further secured by real estate or other marketable
collateral.
The Company conducts substantially all of its lending activities in the
southwest suburbs of Chicago and, to a lesser extent, the Chicago metropolitan
area. Loans granted to businesses are primarily secured by business assets,
owner-occupied real estate or personal assets of commercial borrowers. Loans to
individuals are primarily secured by automobiles, residential real estate or
other personal assets. Since the Company's borrowers and its loan collateral
have geographic concentration in the Chicago metropolitan area, the Company
could have exposure to a decline in the local economy and real estate market.
However, management believes that the diversity of its customer base and local
economy, its knowledge of the local market and its proximity to customers limit
the risk from exposure to adverse economic conditions.
Litigation
The Company is a defendant in certain claims and legal actions arising in the
ordinary course of business. In the opinion of management, after consultation
with legal counsel, the ultimate disposition of these matters is not expected to
have a material adverse effect on the consolidated financial condition or
results of operations of the Company.
NOTE 14 - FAIR VALUE OF FINANCIAL INSTRUMENTS
As a financial institution, most of the Company's assets and liabilities are
considered financial instruments. However, many of the Company's financial
instruments lack an available trading market as characterized by a willing buyer
and willing seller engaging in an exchange transaction.
45
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Presented below are the carrying amounts and estimated fair values of the
Company's financial instruments as of December 31, 1997 and 1996 (in thousands):
<TABLE>
<CAPTION>
1997 1996
------------------------- -------------------------
Carrying Estimated Carrying Estimated
Value Fair Value Value Fair Value
-------- ---------- -------- ----------
<S> <C> <C> <C> <C>
Financial Assets:
Cash and cash equivalents $ 51,078 $ 51,078 $ 43,830 $ 43,830
Securities:
Held-to-maturity 113,101 116,544 115,913 117,046
Available-for-sale 407,087 407,087 392,754 392,754
Trading 450 450 262 262
Loans, net 701,920 717,239 629,597 636,671
Interest receivable 7,922 7,922 7,419 7,419
Financial Liabilities:
Demand deposits 186,358 186,358 185,705 185,705
NOW, money market and savings deposits 451,807 451,807 394,438 394,438
Time deposits 501,466 500,678 473,160 473,184
Federal funds purchased - - 13,000 13,000
Securities sold under agreements to
repurchase 45,569 45,569 40,706 40,706
Notes payable - - 7,000 7,000
Interest payable 3,488 3,488 3,410 3,410
</TABLE>
The estimated fair values of financial instruments have been determined by the
Company using available market information and appropriate valuation
methodologies. However, considerable judgment was used by the Company in
interpreting market data to develop the estimates of fair value. In addition,
significant estimations and present value calculations were used by the Company
for purposes of this disclosure. Accordingly, the estimates presented herein
are not necessarily indicative of the amounts the Company could realize in a
current market exchange. The use of different market assumptions and estimation
methodologies may have a material effect on the estimated fair value amounts.
The Company has used an entry-value market perspective as a basis of
estimating the fair value of most financial instruments. For purposes of fair
value disclosures the carrying values of cash and cash equivalents, accrued
interest receivable, demand deposits, NOW accounts, money market accounts,
savings deposits, federal funds purchased, securities sold under agreements to
repurchase, notes payable and interest payable are assumed to approximate fair
value since these assets and liabilities have no stated maturity or are
relatively short-term financial instruments.
Securities have been valued using quoted market prices, dealer quotes or
prices from independent pricing services that specialize in matrix pricing and
modeling techniques.
Net loans with stated maturities have been valued using present value
discounted cash flow techniques. The discount rates used to calculate the fair
values of loans were the applicable risk-adjusted spreads to the U.S.Treasury
curve to approximate current entry-value interest rates applicable to each
category. No adjustment was made to the entry-value interest rates for changes
in credit of performing loans for which there are no known credit concerns. The
Company believes that the risk factor embedded in the entry-value interest rates
results in a fair valuation of such loans on an entry-value basis. It is
assumed that the fair value of floating rate loans approximates the recorded
book value. For real estate loans, contractual cash flows were adjusted for
anticipated prepayments. For loans delinquent ninety days or more and
nonaccrual loans, fair value is assumed to equal the recorded book value less
specific reserves which have been allocated to these financial instruments.
46
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Time deposits with stated maturities have been valued using present value
discounted cash flow techniques. The discount rates used to calculate the fair
value of time deposits were the market rates currently offered for deposits of
similar remaining maturities.
There is no material difference between the contract amount and the
estimated fair value of off-balance sheet items which are primarily comprised of
unfunded loan commitments which are either floating-rate or generally funded
within ninety days.
NOTE 15 - CONDENSED FINANCIAL STATEMENTS - PARENT COMPANY
The following presents the condensed Balance Sheets as of December 31, 1997
and 1996, and Statements of Income and Statements of Cash Flows for each of the
three years ended December 31, 1997, for Heritage Financial Services, Inc. (in
thousands):
<TABLE>
<CAPTION>
Balance Sheets
1997 1996
---- ----
<S> <C> <C>
Cash $ 3,889 $ 2,678
Trading securities 450 262
Investment in bank subsidiaries 115,804 108,629
Investment in non-bank subsidiary 1,927 1,761
Other assets 911 153
-------- --------
Total assets $122,981 $113,483
======== ========
Notes payable $ - $ 7,000
Other liabilities 775 796
Shareholders' equity 122,206 105,687
-------- --------
Total liabilities and shareholders' equity $122,981 $113,483
======== ========
</TABLE>
<TABLE>
<CAPTION>
Statements of Income
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Income:
Dividends from bank subsidiary $15,000 $18,500 $10,500
Other income 291 71 40
------- ------- -------
Total income 15,291 18,571 10,540
------- ------- -------
Expenses:
Interest on notes payable 141 604 187
Salaries and employee benefits 793 564 559
Other expenses 499 429 320
------- ------- -------
Total expenses 1,433 1,597 1,066
------- ------- -------
Income before income taxes and equity in
undistributed earnings of subsidiaries 13,858 16,974 9,474
Income tax benefit (436) (634) (460)
Equity in undistributed earnings of subsidiaries 3,499 (2,770) 3,360
------- ------- -------
Net income $17,793 $14,838 $13,294
======= ======= =======
</TABLE>
47
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
<TABLE>
<CAPTION>
Statements of Cash Flows
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Operating Activities:
Net income $ 17,793 $ 14,838 $ 13,294
Adjustments to reconcile net income to cash
provided by operating activities:
Equity in undistributed earnings of subsidiaries (3,499) 2,770 (3,360)
Securities gains (188) (12) -
Increase (decrease) in accrued expenses (21) 316 (48)
Other, net 56 18 (94)
--------- ---------- ---------
Net cash provided by operating activities 14,141 17,930 9,792
--------- ---------- ---------
Investing Activities:
Acquisition of bank subsidiary - (16,820) -
Purchase of trading security - (250) -
--------- ---------- ---------
Net cash used in investing activities - (17,070) -
--------- ---------- ---------
Financing Activities:
Proceeds from notes payable - 14,000 -
Principal payments on notes payable (7,000) (7,000) (6,500)
Proceeds from stock option exercises 1,134 159 129
Dividends paid (4,831) (4,125) (3,492)
Purchases of common stock (2,223) (1,852) -
--------- ---------- ---------
Net cash provided by (used in) financing activities (12,920) 1,182 (9,863)
--------- ---------- ---------
Net increase (decrease) in cash 1,221 2,042 (71)
Cash at beginning of year 2,678 636 707
--------- ---------- ---------
Cash at end of year $ 3,899 $ 2,678 $ 636
========= ========== ==========
Supplemental disclosures:
Interest paid $162 $582 $284
Income tax benefit received 436 634 460
</TABLE>
NOTE 16 - REGULATORY RESTRICTIONS AND CAPITAL ADEQUACY
Heritage Bank ("the Bank") is required to maintain vault cash and non-
interest-bearing balances with the Federal Reserve Bank to satisfy reserve
requirements. The average reserve requirement balances for the years ended
December 31, 1997 and 1996 were $12,382,000 and $15,126,000, respectively.
The Bank is subject to various capital requirements administered by its
principal regulatory agency. 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 Bank's
and consolidated financial statements. Under capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Bank must meet specific
capital guidelines that involve quantitative measures of the Bank's assets,
liabilities, and certain off-balance-sheet items as calculated under regulatory
accounting practices. The Bank's capital amounts and classification are also
subject to qualitative judgments by regulators about components, risk
weightings, and other factors.
48
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Quantitative measures established by regulation to ensure capital adequacy
require the Company and the Bank to maintain minimum amounts and ratios of total
and Tier I capital (as defined in the regulations) to risk-weighted assets (as
defined), and Tier I capital (as defined) to average assets (as defined). The
following table sets forth the actual and required regulatory capital amounts
and ratios of the Company and Bank as of December 31, 1997 and 1996:
<TABLE>
<CAPTION>
To Be Well
Minimum Capitalized Under
For Capital Prompt Corrective
Actual Adequacy Purposes Action Provisions
---------------- ------------------ -----------------
Amount Ratio Amount Ratio Amount Ratio
------ ----- ------ ----- ------ -----
<S> <C> <C> <C> <C> <C> <C>
December 31, 1997
Tier I Capital to Average Assets
Consolidated $100,651 7.81% greater than $51,572 4.00%
Bank $ 93,042 7.26% greater than $51,256 4.00% greater than $64,070 5.00%
Tier I Capital to Risk Weighted Assets
Consolidated $100,651 13.91% greater than $28,933 4.00%
Bank $ 93,042 12.86% greater than $28,951 4.00% greater than $43,426 6.00%
Total Capital to Risk Weighted Assets
Consolidated $109,700 15.17% greater than $57,866 8.00%
Bank $102,096 14.11% greater than $57,901 8.00% greater than $72,376 10.00%
December 31, 1996
Tier I Capital to Average Assets
Consolidated $ 85,757 7.19% greater than $47,723 4.00%
Bank $ 87,537 7.36% greater than $47,558 4.00% greater than $59,448 5.00%
Tier I Capital to Risk Weighted Assets
Consolidated $ 85,757 12.74% greater than $26,915 4.00%
Bank $ 87,537 13.03% greater than $26,874 4.00% greater than $40,311 6.00%
Total Capital to Risk Weighted Assets
Consolidated $ 94,183 14.00% greater than $53,830 8.00%
Bank $ 95,948 14.28% greater than $53,748 8.00% greater than $67,185 10.00%
</TABLE>
Management believes that the Company and the Bank meet all capital adequacy
requirements as of December 31, 1997. The most recent notification from the
Federal Deposit Insurance Corporation, dated December 31, 1997, categorized the
Bank as "well capitalized" under the regulatory framework for prompt corrective
action. To be categorized as "well capitalized", the Bank must maintain minimum
Tier 1 and total risk-based capital ratios and Tier 1 leverage ratios as set
forth in the table above. Since December 31, 1997, there are no conditions or
events that management believes have changed the Bank's capital category.
Regulatory authorities limit the amount of dividends which can be paid by
the Bank to Heritage Financial Services, Inc. without prior approval from such
authorities. At December 31, 1997, $31,222,000 of undistributed earnings of the
Bank were available for payment of dividends to Heritage Financial Services,
Inc. without prior regulatory approval.
NOTE 17 - SUBSEQUENT EVENTS
On January 14, 1998, the Company, First Midwest Bancorp, Inc. ("First
Midwest") and First Midwest Acquisition Corporation, a wholly owned subsidiary
of First Midwest ("Acquisition Corporation"), entered into an Agreement and Plan
of Merger ("Merger Agreement") whereby the Company will be merged with and into
Acquisition Corporation (the "Merger"). Pursuant to the Merger Agreement, the
transaction will be structured as a tax-free exchange and accounted for as a
pooling-of-interests. Each of the Company's outstanding common shares will be
converted into 0.7695 shares of First Midwest common stock. In conjunction with
the approval of the Merger Agreement, the Company rescinded the balance of its
stock repurchase program authorized in June 1996.
49
<PAGE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The Merger is conditioned upon, among other things, approval by the
shareholders of both the Company and First Midwest and receipt of customary
regulatory approvals. The Merger Agreement has been approved by the boards of
directors of both companies. It is anticipated that the acquisition will be
consummated late in the second quarter of 1998.
Incident to the entry into the Merger Agreement, the Company and First Midwest
executed a Stock Option Agreement (the "Option Agreement") pursuant to which the
Company granted First Midwest an option to acquire up to 2,400,000 common shares
(representing 19.9% of the Company's then outstanding common shares) at a price
of $21.25 per share, subject to certain terms and conditions set forth in the
Option Agreement.
NOTE 18 - QUARTERLY FINANCIAL DATA (unaudited)
The following sets forth condensed quarterly results of operations for 1997
and 1996 (in thousands, except per share data):
<TABLE>
<CAPTION>
First Second Third Fourth
Quarter Quarter Quarter Quarter
------- ------- ------- -------
<S> <C> <C> <C> <C>
1997
Interest income $22,041 $22,575 $23,076 $23,464
Interest expense 10,057 10,519 10,917 11,243
------- ------- ------- -------
Net interest income 11,984 12,056 12,159 12,221
Provision for loan losses 150 150 150 150
Other income 2,301 2,234 2,342 2,730
Other expense 7,774 7,931 7,799 8,261
Income tax expense 2,030 1,957 2,054 1,828
------- ------- ------- -------
Net income $ 4,331 $ 4,252 $ 4,498 $ 4,712
======= ======= ======= =======
Net income per common share:
Basic $.36 $.35 $.37 $.39
Diluted $.35 $.34 $.36 $.38
1996
Interest income $20,089 $21,015 $21,179 $21,541
Interest expense 9,347 9,520 9,808 9,931
------- ------- ------- -------
Net interest income 10,742 11,495 11,371 11,610
Provision for loan losses 100 100 100 100
Other income 1,682 1,936 2,089 2,017
Other expense 7,364 7,751 7,699 7,987
Income tax expense 1,483 1,811 1,804 1,805
------- ------- ------- -------
Net income $ 3,477 $ 3,769 $ 3,857 $ 3,735
======= ======= ======= =======
Net income per common share:
Basic $.29 $.32 $.32 $.32
Diluted $.28 $.30 $.31 $.30
</TABLE>
50
<PAGE>
MANAGEMENT'S REPORT
Management of Heritage Financial Services, Inc. and subsidiaries (the
"Company") has prepared and is responsible for the integrity and fairness of the
financial statements and other financial information included in this annual
report. The financial statements are prepared in accordance with generally
accepted accounting principles and, when appropriate, include amounts based on
management's estimates and judgment.
To meet its responsibility both for the integrity and fairness of these
financial statements and information, management maintains accounting systems
and related internal accounting controls. These systems and controls provide for
an appropriate division of responsibility and are designed to provide reasonable
assurance that transactions are properly authorized and recorded, that assets
are safeguarded and financial records are reliably maintained.
The Company monitors the effectiveness and compliance of its internal
control systems through a continuous program of internal audits. Management has
reviewed the recommendations of its internal auditors and Arthur Andersen LLP,
independent auditors, and has responded in an appropriate, cost-effective
manner.
The Audit Committee of the board of directors, composed of three outside
directors, meets periodically with the Company's internal auditors and the
independent auditors to review matters relative to financial reporting, internal
accounting controls and the scope and results of audits. In addition, reports of
examination conducted by federal and state regulatory agencies are reviewed by
management and the board of directors.
RICHARD T. WOJCIK PAUL A. ECKROTH
Chairman and CEO Executive Vice President and Treasurer
51
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Shareholders of
Heritage Financial Services, Inc.:
We have audited the accompanying consolidated balance sheets of Heritage
Financial Services, Inc. and subsidiaries as of December 31, 1997 and 1996 and
the related consolidated statements of income, changes in shareholders' equity
and cash flows for each of the three years in the period ended December 31,
1997. 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 audit.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits 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 Heritage
Financial Services, Inc. and subsidiaries as of December 31, 1997 and 1996, and
the results of its operations and its cash flows for each of the three years in
the period ended December 31, 1997 in conformity with generally accepted
accounting principles.
ARTHUR ANDERSEN LLP
Chicago Illinois,
January 19, 1998
52
<PAGE>
Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995
Certain matters discussed in this Annual Report on Form 10-K are "forward-
looking statements" within the meaning of Section 27A of the Securities Act of
1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as
amended. The Company intends such forward-looking statements to be covered by
the safe harbors provisions for forward-looking statements contained in the
Private Securities Litigation Reform Act of 1995, and is including this
statement for purposes of these safe harbor provisions. Forward-looking
statements, which are based on certain assumptions and describe future plans,
goals, objectives, strategies and expectations of the Company, are generally
identifiable by use of the words "believe," "expect," "intend," "anticipate,"
"estimate," "project," or other similar words or expressions. The Company's
ability to predict results or the actual effect of future plans or strategies is
inherently uncertain. Factors which could have a material adverse affect on the
operations and future prospects of the Company and its subsidiaries include, but
are not limited to: significant fluctuations in market interest rates; changes
in general economic conditions and inflation; changes in the competitive
environment that can affect the Company's funding and asset generation
capabilities; changes in management's assessment of the adequacy of the
allowance for loan losses based upon changes in the composition of the loan
portfolio, loan delinquency rates, the level of loan losses, and business and
market conditions that affect the value of collateral securing loans;
legislative or regulatory changes which adversely affect the business of the
Company or its subsidiaries, including federal deposit insurance premiums;
changes in accounting principles, policies and guidelines. These risks and
uncertainties should be considered in evaluating the forward-looking statements
and undue reliance should not be placed on such forward-looking statements. The
forward-looking statements included herein are only made as of the date of this
Annual Report on Form 10-K and the Company undertakes no obligation to publicly
update such forward-looking statements to reflect subsequent events or
circumstances.
53
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, Heritage Financial Services, Inc. has duly caused this
amendment to be signed on its behalf by the undersigned, thereunto duly
authorized, on this the 17th day of April, 1998.
HERITAGE FINANCIAL SERVICES, INC.
(Registrant)
by /s/ Richard T. Wojcik
---------------------------------
Richard T. Wojcik
Chairman of the Board
Pursuant to the requirements of the Securities Exchange Act of 1934, this
amendment has been signed below on the 17th day of April, 1998 by the following
persons on behalf of the Registrant and in the capacities indicated.
<TABLE>
<CAPTION>
SIGNATURE AND TITLE SIGNATURE AND TITLE
------------------- -------------------
<S> <C>
by /s/ Richard T. Wojcik by /s/ Lael W. Mathis *
--------------------------------------------- ---------------------------------------------
Richard T. Wojcik, Chairman of the Board Lael W. Mathis, Director
(Principal Executive Officer) and Director
by /s/ Jack Payan *
by /s/ Frederick J. Sampias ---------------------------------------------
--------------------------------------------- Jack Payan, Director
Frederick J. Sampias, President and Director
by /s/ Arthur E. Sieloff *
by /s/ Paul A. Eckroth ---------------------------------------------
--------------------------------------------- Arthur E. Sieloff, Director
Paul A. Eckroth, Executive Vice President and
Treasurer
(Principal Financial and Accounting Officer) by /s/ John L. Sterling *
---------------------------------------------
John L. Sterling, Director
by /s/ John J. Gallagher *
---------------------------------------------
John J. Gallagher, Director by
---------------------------------------------
Chester Stranczek, Director
by /s/ Ronald P. Groebe
---------------------------------------------
Ronald P. Groebe, Director by /s/ Arthur G. Tichenor *
---------------------------------------------
Arthur G. Tichenor, Director
by /s/ Dominick J. Velo *
---------------------------------------------
Dominick J. Velo, Director
* Signed by /s/ Frederick J. Sampias
------------------------------------
Frederick J. Sampias
Attorney-in-Fact
</TABLE>
64
<PAGE>
EXHIBIT 23
Consent of Arthur Andersen LLP
We consent to the incorporation by reference in the Registration Statement No.
33-59924 of Heritage Financial Services, Inc. on Form S-8 of our report dated
January 19, 1998, appearing in this Amendment #1 to the Annual Report on Form
10-K of Heritage Financial Services, Inc. for the year ended December 31, 1997.
ARTHUR ANDERSEN LLP
Chicago, Illinois
April 17, 1998
