ITEM 1. BUSINESS
Princeton National Bancorp, Inc. ("PNB" or the "Corporation") is a single-bank holding company which conducts a full service commercial banking and trust business through its subsidiary bank, Citizens First National Bank ("Citizens Bank" or "the Bank"). At December 31, 1996, the Company had consolidated total assets of $420,407,000 and stockholders' equity of $40,197,000.
PNB was incorporated as a Delaware corporation in 1981 in contemplation of the acquisition of all of the outstanding common stock of Citizens Bank and other future acquisitions. Since the formation of the holding company, PNB has made five acquisitions. In 1986, PNB acquired Genoa State Bank (subsequently merged into Citizens Bank), located approximately 90 miles from Princeton and just outside the western suburbs of Chicago. In 1988, PNB acquired First National Bank of Oglesby when it acquired all of the outstanding stock of USA Firstrust, Inc. (subsequently merged into Citizens Bank), which gave PNB a market presence in Oglesby and the Peru/LaSalle area, 27 and 22 miles from Princeton, respectively. In 1992, PNB acquired all of the outstanding capital stock of Illinois Valley Bancshares, Inc. ("Illinois Valley"). Through the acquisition of Illinois Valley, PNB acquired Colonial Bank and Trust Company of Bureau County, located in Princeton, with a branch in DePue (subsequently merged into Citizens Bank) and Colonial Bank and Trust Company of LaSalle County, located in Peru (subsequently converted into a national bank, renamed Citizens First National Bank of Peru, and subsequently merged into Citizens Bank). In 1994, PNB acquired Heart of Illinois Investment Corp. and its subsidiary, Heart of Illinois Bank, F.S.B., with branches in Spring Valley, Henry, Plano and Princeton (subsequently merged into Citizens Bank). In 1996, PNB acquired all of the deposits, equipment and the facility of the Sandwich branch of Superior Bank, FSB (subsequently merged into Citizens Bank), located approximately 50 miles to the northeast of Princeton.
PNB operates the Bank as a community bank -- with offices located for convenience with professional, highly motivated, progressive employees who know the Bank's customers and are able to provide individualized, quality service. As part of its community banking approach, PNB requires officers of the Bank to actively participate in community organizations. In addition, within credit and rate of return parameters, PNB attempts to ensure that the Bank meets the lending needs of the communities in which offices are located, and that the Bank invests in local and municipal securities.
Corporate policy, strategy, and goals are established by the Board of Directors of PNB. Pursuant to PNB's holding company philosophy, operational and administrative policies for the Bank are also established at the holding company level. Within this framework, the Bank focuses on providing personalized services and quality products to its customers to meet the needs of the communities in which offices are located. In 1996, the majority of the directors of PNB also served as the directors of Citizens Bank. This assists PNB in directly implementing its policies at Citizens Bank.
ACQUISITION AND EXPANSION STRATEGY
PNB seeks to diversify both its market area and asset base and increase profitability through acquisitions and expansion. PNB's goal, as reflected by its acquisition policy, is to expand through the acquisition of established financial service organizations, primarily commercial banks to the extent suitable candidates may be identified and by expanding into potential high growth areas. In integrating acquisitions, PNB focuses on, among other actions, implementing the policies established at Citizens Bank, improving asset quality and the net interest margin and encouraging community involvement.
Generally, PNB seeks to acquire banks or other financial institutions with assets of $15 million to $60 million, located on the fringe of metropolitan or potential high growth areas and within 100 miles of Princeton. In addition to price and terms, the other factors considered by PNB in determining the desirability of an acquisition candidate are the general financial condition, earnings potential and quality of the management of the institution. There is no assurance that any further acquisitions will be made.
PNB will also consider establishing branch facilities as a means of expanding its presence into new market areas. PNB opened new branch facilities in the Peru/LaSalle/Oglesby area early in 1994, in Minooka late in 1994, and in Hampshire during 1995.
CITIZENS FIRST NATIONAL BANK
Citizens Bank was organized in 1865 as a national bank under the National Bank Act. Currently in its one hundred and thirty-second year, Citizens Bank has fifteen offices in eleven different communities in north central Illinois: Princeton, DePue, Genoa, Hampshire, Henry, Minooka, Oglesby, Peru, Plano, Sandwich and Spring Valley.
Citizens Bank serves individuals, businesses and governmental bodies in Bureau, LaSalle, Marshall, Grundy, Kane, Kendall, DeKalb and contiguous counties. Citizens Bank operates a full-service community commercial bank and trust business that offers a broad range of financial services to customers. Their services consist primarily of commercial, real estate and agricultural lending, consumer deposit and financial services, and trust and farm management services.
COMMERCIAL, REAL ESTATE AND AGRICULTURAL LENDING
Citizens Bank's commercial loan department provides secured and unsecured loans, including real estate loans, to companies and individuals for business purposes and to governmental units within the Bank's market area. As of December 31, 1996, Citizens Bank had commercial loans of $38.4 million (14.8% of the Bank's total loan portfolio) and commercial real estate loans of $41.2 million (16.0% of the Bank's total loan portfolio). Citizens Bank does not have a concentration of commercial loans in any single industry or business.
Citizens Bank is one of the largest agricultural lenders in the State of Illinois with all of its outstanding agricultural and agricultural real estate loans primarily related to ventures within 30 miles of branch locations. As of December 31, 1996, Citizens Bank had agricultural loans of $36.0 million and agricultural real estate loans of $28.4 million, which represent approximately 14.0% and 11.0%,
respectively, of the Bank's total loan portfolio. Agricultural loans, many of which are secured by crops, machinery and real estate, are provided to finance capital improvements and farm operations as well as acquisitions of livestock and machinery. The agricultural loan department, which has four lending officers, works closely with all agricultural customers, including companies and individual farmers, and assists in the preparation of budgets and cash flow projections for the ensuing crop year. These budgets and cash flow projections are monitored closely during the year. In addition, Citizens Bank works closely with governmental agencies, including the Farmers Home Administration, to assist agricultural customers in obtaining credit enhancement products such as loan guaranties.
In accordance with its loan policy, Citizens Bank maintains a diversified loan portfolio. One of Citizens Bank's goals is to further diversify its loan portfolio. Further diversification will be accomplished through loans made by the Bank and through loans acquired as a result of PNB's acquisition strategy. As part of its loan policy and community banking approach, Citizens Bank does not actively buy loans from or participate its non-consumer loans to other lending institutions, particularly institutions outside its market area. In connection with its credit relationships, Citizens Bank encourages commercial and agricultural borrowers to maintain deposit accounts at the Bank.
PERSONAL FINANCIAL SERVICES
The principal consumer services offered by Citizens Bank are demand, savings and time deposit accounts, home mortgage loans, installment loans, credit cards, and brokerage services.
One of the strengths of Citizens Bank is the stability of its retail deposit base. This is due primarily to the Bank's service oriented competitive strategy and the economically diverse population of the counties encompassing the fifteen banking offices. These locations provide convenience for customers and visibility for Citizens Bank. A variety of marketing strategies are used to attract and retain stable depositors, the most important of which is the officer call program, pursuant to which officers of the Bank call on customers and potential customers of the Bank to maintain and develop deposit relationships. Marketing efforts in 1996 also included the completion of three very successful retail promotions. A credit card program was launched in 1995, and at year end 1996, Citizens Bank had 3,115 credit card holders carrying $1.6 million in balances. Secondly, Citizens Bank introduced its automated telephone service called TeleBanker, providing customers with 24-hour access to account information, along with rate information on loans and deposits. Finally, Citizens Bank introduced a new checking account to compete with other institutions offering "Free Checking". Citizens Bank now offers Advantage/Advantage Gold checking which is better than free because customers receive many value-added benefits.
Citizens Bank is active in consumer lending with approximately $72.5 million in home mortgage loans (28.1% of the Bank's total loan portfolio) and $37.5 million in consumer installment loans (14.5% of the Bank's total loan portfolio) as of December 31, 1996. To better serve its retail customers by providing access to longer term, fixed rate residential real estate mortgages, Citizens Bank is active in the secondary residential mortgage market. As a matter of policy, Citizens Bank does not hold long-term, fixed rate loans.
Another means by which Citizens Bank seeks to attract and serve retail customers in the market area is through the use of its thirteen automated teller machines. The Bank is a member of Magic Line which encompasses all of the major nationwide networks such as CIRUS, PLUS, and STAR.
To further enhance its retail sales, Citizens Bank has undertaken a commitment in developing a stronger sales culture through an all- encompassing program with its major emphasis on customer focused banking. Although the process includes a significant commitment to training, other aspects such as team coaching, reward and recognition, goals and measurements, product knowledge, and selection and placement are a vital part of the success of the overall program.
TRUST DEPARTMENT AND FARM MANAGEMENT SERVICES
Trust Department assets as of December 31, 1996 were approximately $150 million, an increase of 18.1% compared to the December 31, 1995 total of over $127 million. The increase in assets was due in part to an adjustment in market values for certain farm real estate held in various fiduciary accounts. Trust Department Income was $735,000 in 1996 versus $709,000 in 1995. The increase of 3.7% comes from new business development during 1996 as well as increased market value fees due to higher equity values and increased equity investment as a percentage of total trust assets. The assets managed by the Trust Department are currently spread over 764 accounts with nearly 3,000 clients and beneficiaries served.
Farm Management Income was $199,000 in 1996, up from $161,000 in 1995 (an increase of 23.6%). Favorable crop yields and prices as well as new business development caused this increase. Acres under farm management totaled 17,303 at December 31, 1996 with 86 farms and 126 clients served. This compares to the totals at December 31, 1995 of 13,746 acres over 61 farms and 104 clients.
COMPETITION
PNB is committed to community banking and to providing quality products and services at competitive loan rates and deposit pricing in order to remain competitive in its north central Illinois market. Citizens Bank competes with both small, locally owned banks as well as regional financial institutions which have numerous offices. The Bank competes with these organizations, as well as with savings and loan associations, credit unions, mortgage companies, insurance companies and other local financial institutions, for deposits, loans and other business. The principal methods of competition include loan and deposit pricing, the types and quality of services provided and advertising and marketing programs.
SUPERVISION AND REGULATION
Bank holding companies and banks are extensively regulated under federal and state law. The following information describes the material banking provisions affecting PNB and the Bank, and such discussion is qualified in its entirety by reference to such statutes and regulations. Any change in applicable law or regulations may have a material effect on the business of PNB and the Bank.
PNB is registered as a "bank holding company" with the Federal Reserve, and is subject to supervision by the Federal Reserve Board (the "FRB") under the Bank Holding Company Act of 1956, as amended (the "BHC Act"). PNB is required to file with the FRB periodic reports and such additional information as the FRB may require pursuant to the BHC Act. The FRB examines PNB, and may examine the Bank.
The BHC Act requires prior FRB approval for, among other things, the acquisition by a bank holding company of direct or indirect ownership or control of more than 5% of the voting shares or substantially all the assets of any bank, or for a merger or consolidation of a bank holding company with another bank holding company. With certain exceptions, the BHC Act prohibits a bank holding company from acquiring direct or indirect ownership or control of voting shares of any company which is not a bank or bank holding company and from engaging directly or indirectly in any activity other than banking or managing or controlling banks or performing services for its authorized subsidiaries. A bank holding company may, however, engage in or acquire an interest in a company that engages in activities which the FRB has determined by regulation or order to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.
PNB is a legal entity separate and distinct from the Bank. The major source of PNB's revenue is dividends PNB receives from the Bank. The right of PNB to participate as a stockholder in any distribution of assets of the Bank upon its liquidation or reorganization or otherwise is subject to the prior claims of creditors of the Bank. The Bank is subject to claims by creditors for long-term and short-term debt obligations, including substantial obligations for federal funds purchased and securities sold under repurchase agreements, as well as deposit liabilities.
For the Bank, prior approval of the Office of the Comptroller of the Currency (the "OCC") is required if dividends declared by the Bank in any calendar year will exceed its net profits for that year combined with its retained profits for the preceding two years. In addition, a national bank may not pay a dividend greater than its undivided profits then on hand less the amount of any losses and the amount of statutory bad debts in excess of the balance of the bank's allowance for possible credit losses. "Bad debts" are generally defined to include the principal amounts of loans which are in arrears with respect to interest by six months or more unless such loans are well secured and in the process of collection. As of December 31, 1996, due to the amount of dividends paid to PNB during 1995, the Bank will not be able to pay dividends without prior approval of the OCC. Additionally, future payment of dividends by the Bank will be dependent on individual regulatory capital requirements and levels of profitability. The ability of the Bank to pay dividends may be further restricted as a result of regulatory policies and guidelines relating to dividend payments and capital adequacy.
Federal laws limit the transfer of funds by the Bank to PNB in the form of loans or extensions of credit, investments or purchases of assets. Transfers of this kind to PNB by the Bank are limited to 10% in the aggregate of the Bank's capital and surplus, and are also subject to certain collateral requirements. These transactions, as well as other transactions between the Bank and PNB, must also be on terms substantially the same as, or at least as favorable as, those prevailing at the time for comparable transactions with nonaffiliated companies or,
in the absence of comparable transactions, on terms, or under circumstances, including credit standards, that would be offered to, or would apply to, nonaffiliated companies.
It is the policy of the FRB that PNB is expected to act as a source of financial strength to the Bank and to commit resources to support the Bank. The FRB takes the position that in implementing this policy, it may require PNB to provide such support when PNB otherwise would not consider itself able to do so.
The various federal bank regulators, including the FRB and the OCC, have adopted risk-based capital requirements for assessing bank holding company and bank capital adequacy. These standards establish minimum capital standards in relation to assets and off-balance sheet exposures, as adjusted for credit risks. Capital is classified into two tiers. For bank holding companies, Tier 1 or "core" capital consists of common shareholders' equity, perpetual preferred stock (subject to certain limitations) and minority interests in the common equity accounts of consolidated subsidiaries, and is reduced by goodwill and certain investments in other corporations ("Tier 1 Capital"). Tier 2 capital consists of (subject to certain conditions and limitations) the allowance for possible credit losses, perpetual preferred stock, "hybrid capital instruments," perpetual debt and mandatory convertible debt securities, and term subordinated debt and intermediate-term preferred stock ("Tier 2 Capital"). Total capital is the sum of Tier 1 Capital and Tier 2 Capital (limited to 100% of Tier 1 Capital).
Under the risk-adjusted capital standards, a minimum total capital to risk-weighted assets ratio of 8% is required and Tier l Capital must be at least 50% of total capital. The FRB and OCC also have adopted a minimum leverage ratio of Tier 1 Capital to total assets of 3%. The 3% Tier 1 Capital to total assets ratio constitutes the leverage standard for bank holding companies and national banks, and is used in conjunction with the risk-based ratio in determining the overall capital adequacy of banking organizations.
The FRB and the OCC have emphasized that the foregoing standards are supervisory minimums and that an institution would be permitted to maintain such minimum levels of capital only if it were rated in the highest category under the regulatory rating systems for bank holding companies and banks. All other bank holding companies and banks are required to maintain a leverage ratio of 3% plus at least 1% to 2% of additional capital. These rules further provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain capital positions substantially above the minimum supervisory levels and comparable to peer group averages, without significant reliance on intangible assets. At December 31, 1996, PNB had a risk-based total capital ratio of 13.88% and a Tier 1 capital to risk- based assets ratio of 13.25%, which compare to the regulatory requirements for a well-capitalized bank of 10% and 6%, respectively. Additionally, PNB had a leverage ratio of 8.59%, which also compares favorably to the regulatory requirement for a well-capitalized bank of 5%. Accordingly, PNB maintains a very strong capital position.
The FDIC has a risk-based assessment system for the deposit insurance provided to depositors at depository institutions whereby assessments to each institution are calculated upon the probability that the insurance fund will incur a loss with respect to the institution, the likely amount of such loss, and the revenue needs of the insurance fund. The system utilizes nine separate assessment classifications based on an entity's capital level and supervisory evaluation. Risk classifications of all insured institutions is made by the FDIC for each quarterly assessment period. During 1996, the Bank was classified as well- capitalized, affording it the lowest premium assessment. The Bank's deposits are predominantly insured through the Bank Insurance Fund (the "BIF") and certain deposits held by the Bank are insured through the Savings Association Insurance Fund (the "SAIF"). The BIF and SAIF are both administered by the FDIC.
As of September 30, 1996, PNB paid a one-time SAIF assessment of $336,000, which was mandated by the Federal government to recapitalize that fund. Accordingly, the SAIF fund reached its required reserve ratio of 1.25% of total insured deposits, and a partial refund was issued for the first quarter of 1997 in the amount of $37,000.
The BIF assessment rate currently ranges from zero to 27 cents per $100 of domestic deposits, with PNB assessed at a rate of zero. The FDIC may increase or decrease the assessment rate schedule on a seminannual basis. An increase in the rate assessed on PNB's banking subsidiary could have an adverse effect on PNB's earnings, depending on the amount of the increase.
Deposits insured by SAIF are currently assessed at the BIF rate of zero to 27 cents per $100 of domestic deposits. The SAIF assessment rate may increase or decrease as is necessary to maintain the designated SAIF reserve ratio of 1.25% of SAIF insured deposits.
Effective January 1, 1997, all FDIC-insured depository institutions must pay an annual assessment to provide funds for the payment of interest on bonds issued by the Financing Corporation, a federal corporation chartered under the authority of the Federal Housing Finance Board. The bonds (commonly referred to as FICO bonds) were issued to capitalize the Federal Savings and Loan Insurance Corporation. Until December 31, 1999 or when the last savings and loan association ceases to exist, whichever occurs first, depository institutions will pay approximately 6.4 cents per $100 of SAIF-assessable deposits and approximately 1.3 cents per $100 of BIF-assessable deposits.
Subject to certain conditions, BIF and SAIF will be merged into one insurance fund effective January 1, 1999.
Since September 29, 1995, federal law has permitted adequately capitalized and adequately managed bank holding companies to acquire banks across state lines, without regard to whether the transaction is prohibited by state law; however, they are required to maintain the acquired institutions as separately chartered institutions. Any state law relating to the minimum age of target banks (not to exceed five years) applies. The FRB is not permitted to approve any acquisition if, after the acquisition, the bank holding company would control more than 10% of the deposits of insured depository institutions nationwide or 30%
or more of the deposits in the state where the target bank is located. The FRB could approve an acquisition, notwithstanding the 30% limit, if the state waives the limit either by state regulation or order of the appropriate state official.
In addition, beginning June 1, 1997, banks will be permitted to merge with one another across state lines and thereby create a main bank with branches in separate states. After establishing branches in a state through an interstate merger transaction, the bank could establish and acquire additional branches at any location in the state where any bank involved in the merger could have established or acquired branches under applicable federal or state law.
States may adopt legislation permitting interstate mergers before June 1, 1997. In contrast, states may adopt legislation before June 1, 1997, subject to certain conditions, opting-out of interstate branching. If a state opts-out of interstate branching, no out-of-state bank may establish a branch in that state through an acquisition or de novo, and a bank whose home state opts-out may not participate in an interstate merger transaction. Illinois has adopted legislation permitting interstate mergers beginning June 1, 1997.
PNB is currently permitted to acquire banks located in any state outside Illinois and any organization located outside Illinois is permitted to acquire PNB. These provisions should not materially affect PNB because PNB does not have any current plans to acquire institutions located outside Illinois and because Illinois law, for several years, has permitted institutions located in any state of the United States to acquire banks and bank holding companies within Illinois subject to the ability of Illinois institutions to acquire banks and bank holding companies in such other state on similar conditions as Illinois law. The fact that Illinois has decided to permit interstate branching beginning June 1, 1997, means that if PNB did acquire an institution outside Illinois, PNB could, if it deemed it appropriate, convert such institution's offices into branches of the Bank or any other banking subsidiary then in existence. PNB, however, does not have any current plans to acquire any banking organization located outside the state of Illinois.
EMPLOYEES
PNB presently has no employees. Certain of the employees and executive officers of Citizens Bank provide their services to PNB without charge. As of December 31, 1996, Citizens Bank employed 178 full-time and 37 part-time employees. The Bank offers a variety of employee benefits. The management of PNB considers its employee relations to be excellent.
PNB believes one of its strengths is its ability to attract and retain experienced and well-trained personnel who have a knowledge of the market areas in which it operates. Management believes that PNB generally has an easier time attracting and retaining quality employees than other banks in north central Illinois primarily because its size and management style affords greater opportunities to employees and allows direct participation and development of management and banking skills.
In order to implement PNB's community banking philosophy and to promote themselves as community oriented organizations, the Bank has a formal officer call program. Each officer of the Bank calls on existing or potential customers and is expected to become actively involved in leadership positions in community organizations. As of December 31, 1996, employees of the Bank participated in 116 community organizations, serving over 14,000 hours of community service in 1996.
ITEM 2.

ITEM 2. PROPERTIES
PNB's headquarters and Citizens Bank's principal offices are located at 606 South Main Street, Princeton, Illinois. Also located at this address is an annex completed in 1991 that contains the trust and farm management departments. The two buildings at this location are owned by Citizens Bank and contain approximately 36,000 square feet of space, all of which is occupied by PNB and Citizens Bank. Citizens Bank also has two drive-up facilities in Princeton and branch offices in DePue, Genoa, Hampshire, Henry, Minooka, Oglesby, Peru, Plano, Sandwich and Spring Valley. Citizens Bank is the owner of each of these facilities, with the exception of Plano where the entire space is rented. None of the facilities owned by the Bank are subject to a mortgage.
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS
The Bank is subject to legal proceedings and claims that arise in the ordinary course of business. Although management of the Company cannot predict the ultimate outcome of such matters, it believes that the ultimate resolution of these matters will not have a material adverse effect on the Company or the Bank, or the Company's consolidated financial statements.
ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
SUPPLEMENTAL ITEM - EXECUTIVE OFFICERS
D. E. Van Ordstrand President Tony J. Sorcic Executive Vice-President
Mr. Van Ordstrand has been President and Chief Executive Officer of PNB since January, 1983, and first became a director of PNB in 1981. He joined Citizens Bank as loan manager in 1967 and became President in January, 1983. In 1995, Mr. Van Ordstrand retired as President of Citizens Bank, and on December 31, 1996 retired as President and Chief Executive Officer of PNB.
Mr. Sorcic joined Citizens Bank in 1981 as Assistant Vice-President- Operations and has been the Executive Vice-President and a director of PNB since April 1986. In October, 1995, Mr. Sorcic was named President and CEO of Citizens Bank. Effective January 1, 1997, he also became President and Chief Executive Officer of PNB.
PART II
ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND DIVIDENDS
Since May 15, 1992, PNB's Common Stock has been listed on The NASDAQ Stock Market under the symbol PNBC.
The table below indicates the high and low bid prices, and the dividends declared per share for the Common Stock during the periods indicated, in each case adjusted as if the three for two stock dividend (split) paid on April 23, 1994 had occurred prior to such quarters. The prices shown reflect interdealer prices and include retail markups, markdowns or commissions and may not necessarily represent actual transactions.
On December 31, 1996, PNB had 574 holders of record of its Common Stock.
The holders of the Common Stock are entitled to receive such dividends as are declared by the Board of Directors of PNB, which considers payment of dividends quarterly. The ability of PNB to pay dividends is dependent upon its receipt of dividends from the Bank. In determining cash dividends, the Board of Directors considers the earnings, capital requirements, debt servicing requirements, financial ratio guidelines established by the Board, the financial condition of PNB, and other relevant factors. The Bank's ability to pay dividends to PNB is subject to regulatory restrictions. See "Supervision and Regulation."
PNB has paid regular cash dividends on the Common Stock since it commenced operations in 1982. PNB currently anticipates that cash dividends comparable to those that have been paid in the past will continue to be paid in the future. There can be no assurance, however, that any such dividends will be paid by PNB or that such dividends will not be reduced or eliminated in the future. The timing and amount of dividends will depend upon the earnings, capital requirements and financial condition of PNB and the Bank as well as the general economic conditions and other relevant factors affecting PNB and the Bank. See "Management's Discussion and Analysis of Financial Condition and Results of Operations."
ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA
(a) Per share data prior to 1994 has been restated to reflect the stock dividend (3 for 2) split declared in 1994.
ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following discussion and analysis provides information about the Corporation's financial condition and results of operations for the years ended December 31, 1996, 1995, and 1994. This discussion and analysis should be read in conjunction with "Selected Statistical Data," and Princeton National Bancorp, Inc.'s Consolidated Financial Statements and the Notes thereto included in this report (dollar amounts in thousands unless otherwise indicated).
OVERVIEW
Net income for 1996 was $3,427, a significant increase from $358 in 1995. This represents $1.26 per share in 1996 and $.13 per share in 1995. This increase resulted primarily from the reimbursement in 1995 of the subsidiary bank's Trust customers for losses in market value of various inverse floater securities held in their trust accounts, which did not reoccur in 1996, as well as increases in net interest income and other income.
Net interest income increased to $14,518 in 1996, a 10.7% increase from $13,127 in 1995. This significant improvement resulted from $28,000 in loan growth and the increase in the Corporation's net interest margin to 4.15% from 3.86% in 1995.
Other income reached a record level of $2,860, a 12% increase from $2,553 in 1995. Service charges on loans and deposits and Trust and Farm Management fees experienced growth in 1996. The Corporation's strategy to build a strong fee income base through selling additional services to various customer segments proved successful.
Total assets at year-end 1996 surpassed $420,400, an increase from $402,400 at the prior year-end. The increase in deposits resulted from the Sandwich acquisition.
The table below summarizes the changes in the Corporation's assets, equity and net income during the period 1994 to 1996.
ANALYSIS OF RESULTS OF OPERATIONS
NET INTEREST INCOME. Net interest income increased 10.7% in 1996, as compared to increases of 1.5% in 1995 and 12.0% in 1994. The net yield on interest-earning assets increased from 7.90% in 1995 to 8.09% in 1996, while the average rate on interest-bearing liabilities decreased from 4.53% in 1995 to 4.44% in 1996. The resulting net yield on interest-earning assets on a fully taxable equivalent basis increased from 3.86% in 1995 to 4.15% in 1996. This twenty-nine basis-point increase resulted from the increase in loans outstanding and improvements in product pricing, and had a positive impact on net income. The increase is notable considering the Sandwich acquisition did not include loans.
The following table sets forth details of average balances, interest income and expense, and resulting rates for the Corporation for the past three years, reported on a fully taxable equivalent basis using a tax rate of 34%.
(a) Interest income on non-taxable investment securities and non-taxable loans includes the effects of taxable equivalent adjustments using a tax rate of 34% in adjusting interest on tax-exempt securities and tax-exempt loans to a fully taxable basis.
(b) Includes $38 attributable to interest from non-accrual loans.
Net interest income held steady in 1995 as compared to 1994. The net yield on interest-earning assets increased from 7.21% in 1994 to 7.90% in 1995, while the average rate on interest-bearing liabilities increased from 3.90% in 1994 to 4.53% in 1995. The resulting net yield on interest-earning assets on a fully taxable
equivalent basis increased from 3.72% in 1994 to 3.86% in 1995. The fourteen basis-point increase resulted from a greater percentage of loans in the Corporation's asset mix which had a positive impact on 1995 net income.
The following table describes changes in net interest income attributable to changes in the volume of interest-earning assets and interest-bearing liabilities compared to changes in interest rates.
(a) The change in interest due both to rate and volume has been allocated equally.
(b) Interest income on non-taxable investment securities includes the effects of taxable equivalent adjustments using a tax rate of 34% in adjusting interest on tax-exempt securities to a fully taxable basis.
(c) Includes loan fees of $823 in 1996, $707 in 1995, and $671 in 1994. Interest income on loans includes the effect of tax equivalent adjustments for non-taxable loans using a tax rate of 34% in adjusting interest on tax-exempt loans to a fully taxable basis. Includes non-accrual loans, with year-end balances of $1,157 in 1996, $808 in 1995, and $573 in 1994.
NON-INTEREST INCOME. Non-interest income increased in 1996 by $307 to $2,860, up 12.0% from $2,553 in 1995. Non-interest income as a percentage of average assets increased from .65% in 1995 to .70% in 1996. With the exception of a net loss from securities transactions, all categories of non-interest income increased during 1996 when compared to 1995. The largest increase was in the other service charges category which increased by $169 (or 65.5%), a result of an increase in fee income generated during the first full year of the subsidiary bank's credit card product. Service charges on deposits also had a significant increase in 1996 ($83 or 7.6%) as a result of an increase in overdraft charges and an increase in the number and fee income from checking accounts. The following table provides non-interest income by category, total non-interest income, and non-interest income to average total assets for the periods indicated.
Non-interest income decreased just $21 in 1995 to $2,553, from $2,574 in 1994. As a percentage of average total assets, however, non-interest income increased from .64% in 1994 to .65% in 1995. Decreases in farm management fees, net securities transactions, and miscellaneous operating income accounts, were offset by increases in service charges on deposit accounts and secondary loan servicing fees.
NON-INTEREST EXPENSE. Non-interest expense decreased by $3,383 (or 20.8%) in 1996 to $12,864 from $16,247 in 1995. Trust department expenses decreased by $4,661 due to the vast majority of the subsidiary bank's trust department matter being settled in 1995 (see Note 13 in the Notes to Consolidated Financial Statements). However, all other categories showed increases with the largest increases in salaries and employee benefits (up $490 or 8.3%), other operating expenses (up $444 or 19.5%), and goodwill amortization (up $143 or 67.1%). The Sandwich acquisition accounts for part of the increase in salaries and benefits, and all of the increase in goodwill amortization. The increase in other operating expenses is attributable to a full year of expenses associated with the subsidiary bank's credit card product, increased loan administrative costs, and other increases resulting from the Sandwich acquisition. In 1996, the Corporation paid a one-time SAIF assessment of $336, which was mandated by the Federal government to recapitalize that fund. This offset lower premiums paid during 1996 resulting in no increase in FDIC/OCC assessments for 1996 compared to 1995. The following table provides non-interest expense by category, total non-interest expense, and non-interest expense to average total assets for the periods indicated.
Non-interest expense increased by $5,212 (or 47.2%) in 1995 to $16,247 from $11,035 in 1994. As mentioned previously, this increase is due almost entirely to the resolution of the subsidiary bank trust department matter in 1995. However, with the addition of facilities in Minooka and Hampshire, occupancy and equipment charges also increased 15.6% and 4.3%, respectively. Additionally, miscellaneous other operating expenses (such as legal fees, postage, advertising, and loan administrative expenses) increased from $1,849 in 1994 to $2,273 in 1995 ($424 or 22.9%). Offsetting these increases were decreases in data processing expense and FDIC/OCC assessments. Data processing expenses dropped from $751 in 1994 to $487 in 1995 (35.2%) as a result of reduced processing costs as well as reductions resulting from adjustments to prior years' billings. The FDIC/OCC assessments went down sharply from $888 in 1994 to $572 in 1995 (35.6%) as a result of lower premium rates charged by the FDIC.
NET INCOME. Net income for 1996 was $3,427 (or $1.26 per share), an increase of 857.3% from $358 in 1995 (or $0.13 per share). The increase is attributable to the decrease from $5,043 in 1995 to $382 in 1996 of expenses incurred in resolving the trust matter of the subsidiary bank. Accordingly, net income in 1995 was much lower (90.5% decrease) than the $3,758 (or $1.39 per share) reported in 1994.
ANALYSIS OF FINANCIAL CONDITION
Loans. The Corporation's loan portfolio largely reflects the profile of the communities in which it operates. The Corporation essentially makes four types of loans: agricultural, commercial, real estate, and installment. The Corporation has no foreign loans. The following table summarizes the Corporation's loan portfolio.
Total loans increased $25 million or 11% in 1996 as compared to an increase of $28 million or 14% in 1995. As in 1995, loan growth occurred through demand in existing markets rather than through acquisitions.
The agricultural loan portfolio increased $3 million or 9% in 1996 from 1995. The agricultural portfolio grew as customers updated equipment, purchased additional farmland, and borrowed additional operating funds due to increased production costs. From 1994 to 1995, the portfolio increased $2 million in volume. As of year-end 1996, the Corporation had $1 million in agricultural loans guaranteed by the Farm Service Agency (formerly Farmers Home Administration). 1996 was a year of extremes in corn production economics as short supplies, strong demand, and weather concerns for the 1996 crop resulted in corn prices at all time record highs, above $5 per bushel. Soybean prices, to a lesser degree, also experienced favorable prices. Due to the Corporation's market area's quality land, the majority of our customers experienced average or above yields. Profitability in the livestock sector continued to be pressured by high feed costs. Strong pork prices offset the feed costs, but cattle feeders experienced another difficult year.
While agricultural loan volume has continued to increase over the past few years, the percentage of total loans in agricultural production and agricultural real estate loans has decreased from 29% in 1992 to 25% in 1996. This reflects the increased diversification of the portfolio.
Short term commercial loans increased $3.7 million or 11% in 1996. This compares to a reduction of $1.2 million or 3% in 1995. While business activity remains strong in markets served by the Corporation, a large share of the commercial loan demand has been for the acquisition or construction of longer term assets, such as real estate loans. Competition for high quality commercial and agricultural customers remains strong.
Real estate loan volume continued to increase in 1996, posting an $18.7 million or 14.7% increase over 1995. During 1996, residential loans increased $8.6 million to $72.5 million. These loans comprise the largest single component of the portfolio at 28%. Agricultural real estate loans posted an increase of $5.2 million (or 23%) in a very competitive market. Commercial real estate loans grew $3.8 million or 10%. Construction loans increased $1 million, primarily in the commercial sector. Increased loan volumes reflect the high level of business expansion in the Corporation's market areas and successful sales efforts on the part of the staff.
Direct and indirect installment loans (loans to consumers) reflect little change in volume in the portfolio in 1996. This follows an increase of 47% in 1994 to 1995. The Corporation implemented new products and marketing programs during the past three years to increase penetration into its market areas. Long term, these products and programs are expected to provide increased diversification of risk and enhanced profitability. Increased focus on underwriting quality and awareness of general consumer debt levels has tempered growth in this area of the bank's portfolio.
Although the risk of non-payment for any reason exists with respect to all loans, certain other more specific risks are associated with each type of loan. The primary risks associated with commercial loans are quality of the borrower's management and the impact of national economic factors. With respect to agricultural loans, the primary risks are weather and, like commercial loans, quality of borrower's management. Risks associated with real estate loans include concentrations of loans in a loan type, such as commercial or agricultural, and fluctuating land values. Installment loans also have risks associated with concentrations of loans in a single type of loan. Installment loans additionally face the risk of a borrower's unemployment as a result of deteriorating economic conditions.
The Corporation's strategy with respect to addressing and managing these types of risks, whether loan demand is weak or strong, is for the subsidiary bank to follow its conservative loan policies and underwriting practices, which include (i) granting loans on a sound and collectible basis, (ii) investing funds profitably for the benefit of the stockholders and the protection of depositors, (iii) serving the legitimate needs of the community and the bank's general market area while obtaining a balance between maximum yield and minimum risk, (iv) ensuring that primary and secondary sources of repayment are adequate in relation to the amount of the loan, (v) administering loan policies through a Directors ' Loan Committee and Officers' Loan Committees, (vi) developing and maintaining adequate diversification of the loan portfolio as a whole and of the loans within each loan category, and
(vii) ensuring that each loan is properly documented and, if appropriate, secured or guaranteed by government agencies, and that insurance coverage is adequate, especially with respect to certain agricultural loans because of the risk of poor weather.
Non-Performing Loans and Other Real Estate Owned. Non-performing loans amounted to .45% of total loans at year-end 1996 compared to .39% at year-end 1995. The overall low level of non-performing loans is a reflection of the bank's lending staff, credit policies and management's emphasis on asset quality. Potential problem credits are closely monitored by the lending staff, and an independent loan review staff provides further assistance in identifying problem situations. Loans over 90 days past due are normally either charged off, or if well secured and in the process of collection, placed on a non-accrual status. Reflecting the Corporation's sound credit policies, the allowance for possible loan losses was 140.9% of non-performing loans at year-end 1996. The Corporation does not have any significant concentration of commercial real estate loans or commitments in areas which are experiencing deteriorating economic conditions. Total other real estate owned as of December 31, 1996 was $93. The Corporation had no other real estate owned as of December 31, 1995. The following table provides information on the Corporation's non-performing loans since 1992.
The allowance for possible loan losses is based on factors that include the overall composition of the loan portfolio, types of loans, past loss experience, loan delinquencies, potential substandard and doubtful loans, and such other factors that, in management's best judgment, deserve evaluation in estimating possible loan losses. The adequacy of the allowance for possible loan losses is monitored monthly during the ongoing, systematic review of the loan portfolio by the loan review staff of the audit department of the subsidiary bank. The results of these reviews are reported to the Board of Directors of the subsidiary bank on a monthly basis and to the Board of Directors of the Corporation on a quarterly basis. Monitoring and addressing problem loan situations are primarily the responsibility of the subsidiary bank's management and its Board of Directors. More specifically, the Corporation calculates the appropriate level of the allowance for possible loan losses on a monthly basis using historical charge-offs for each loan type, substandard loans, and anticipated losses with respect to specific loans. The amount in the allowance is based on the amount of outstanding loans for each loan type multiplied by the ratio of actual charge-offs to total loans for each loan type for the preceding five years, plus the amount of anticipated losses with respect to specific loans, plus a percentage of identified substandard or delinquent loans for each loan type. In addition to management's assessment of the portfolio, the Corporation and the subsidiary bank are examined periodically by regulatory agencies. Although the regulatory agencies do not determine whether the subsidiary bank's allowance for possible loan losses is adequate, such agencies do review the procedures and policies followed by management of the subsidiary bank in establishing the allowance.
Reflecting the Corporation's emphasis on asset quality, net charge-offs were .18% of average total loans in 1996, and the allowance for possible loan losses at year-end 1996 was $1.63 million, .63% of total loans, net of unearned interest, and 140.9% of non-performing loans. Management considers the allowance for possible loan losses adequate to meet potential losses as of December 31, 1996.
During the period 1982 through 1988, the subsidiary bank charged off a significant dollar amount of loans as a result of aggressive growth during the late 1970's and early 1980's and a severe recession in the agricultural sector of the economy in the mid 1980's. Strict implementation of conservative credit policies that emphasize stringent underwriting criteria for new loans, in conjunction with vigorous collection efforts, resulted in recoveries on loans previously charged off exceeding charge-offs in 1993 and 1995.
In 1996, for the first time in seven years, the Corporation took a provision for possible loan losses, a result of direct and indirect installment loan charge-offs during 1996. While the significant increase in installment loan volume the past three years led to somewhat higher dollar losses, management has strengthened installment loan underwriting practices thereby reversing this trend.
Investment Securities. The objectives of the investment portfolio are to provide the Corporation with a source of liquidity and a source of earnings. The following table provides information on the book value of investment securities as of the dates indicated.
December 31
Total investment securities decreased by $10.1 million to $117.0 million (or 7.9%) at December 31, 1996 compared to December 31, 1995. The major reason for the decrease is due to the need to respond to increased loan demand. Increases totaling $6.1 million occurred in the U.S. Treasury category while decreases totaling $20.5 million occurred in the U.S. Government Agencies category. The lack of adequate spread on non-callable U.S. Government Agencies was the major reason for the shift to U.S. Treasuries from U.S. Government Agencies. Primarily as a result of loan demand, securities decreased by $27.9 million, to $127.1 million (or 18.0%), at December 31, 1995 compared to December 31, 1994.
Deposits. Total average deposits increased $8.2 million (or 2.4%) from 1995 to 1996 as a result of the Sandwich acquisition during 1996. Interest-bearing demand deposits were the only type of deposit to decrease in 1996 ($2.5 million). This reflects a continued trend by customers to invest liquid funds into securities and other non-bank products.
Average time deposits increased approximately $5.6 million (3.1%) in 1996, primarily a result of the Sandwich acquisition, in spite of approximately $1.3 million of out-of-the-area brokered deposits acquired from HOIIC being allowed to "run off" in 1996.
During 1996, average non-interest bearing demand deposits rose $1.7 million, a 5.0% increase. Non-interest-bearing demand deposits have grown steadily since 1992, increasing by $11.6 million (or 56%) as a result of acquisitions and continued efforts by the subsidiary bank to develop core deposits.
The average interest rate paid on deposits in 1996 decreased to 3.93%, down from 4.00% in 1995, primarily as a result of the decline in the rate paid on interest-bearing demand deposits.
Average deposits decreased $8.8 million from 1994 to 1995 (2.5%).
The following table sets forth the classification of average deposits and rates from the indicated periods.
The following table summarizes time deposits in amounts of $100 or more by time remaining until maturity as of December 31, 1996. These time deposits are made by individuals, corporations, and public entities.
Three months or less $17,394 Over three through six months 6,808 Over six months through one year 5,495 Over one year 5,015 ------- Total $34,712 =======
LIQUIDITY. Liquidity is measured by a financial institution's ability to raise funds through deposits, borrowed funds, capital, or the sale of assets. Additional sources of liquidity, including cash flow from both the repayment of loans and the securitization of assets, are also considered in determining whether liquidity is satisfactory. The funds are used to meet deposit withdrawals, maintain reserve requirements, fund loans, and operate the organization. Liquidity is achieved through growth of core funds (including core deposits (defined below), 50% of non-public entity certificates of deposit over $100,000, and repurchase agreements issued to commercial customers) and liquid assets, and accessibility to the money and capital markets. The ratio of temporary investments (those maturing within one year, plus twelve months' projected payments on mortgage-backed securities and collateralized mortgage obligations) to volatile liabilities (50% of non-public entity certificates of deposit over $100,000, repurchase agreements issued to public entities, and deposits of public entities) was 104.1% at December 31, 1996 compared to 159.3% at December 31, 1995. Core deposits, defined as demand deposits, NOW accounts, total savings, and certificates of deposit less than $100,000, were 85.7% of total deposits at December 31, 1996, and 86.3% of total deposits at December 31, 1995. Money market accounts of approximately $22.4 million at December 31, 1996, are classified by the Corporation as core deposits.
The Corporation experienced a net decrease in cash and cash equivalents of $3.3 million in 1996. Net cash provided by operating activities of $2.8 million provided a degree of liquidity. Financing activities provided net cash of $13.9 million. A net increase of $12.4 million in deposits, the result of the Sandwich acquisition, was a major component of the financing activities. Increases in the operating and financing activities were offset by net cash used for investing activities of $20.0 million. Net loan growth of $25.9 million in 1996 was the major component of this decrease, with payment for the Sandwich acquisition representing another $2.9 million of the net cash used for investing activities. Net cash of $9.7 million provided by securities transactions ($2.3 million in proceeds from sales of securities and $67.7 million from maturities of securities, less $60.3 million in purchases of securities) partially offset the cash used by the aforementioned categories of investing activities. Cash and cash equivalents of $21.1 million at December 31, 1996, are deemed adequate to meet short-term liquidity needs.
The cash flows generated by the operating and investing activities and used by the financing activities of the Corporation in 1995 resulted in a net increase in cash and cash equivalents of $2.7 million. Investing activities contributed $5.4 million toward the increase in cash and cash equivalents. Proceeds from sales and maturities of investment securities of $53.7 million more than offset the purchase of investment securities of $21.1 million, and the substantial growth of $26.6 million experienced in the loan portfolio. Financing activities used $3.0 million of the funds generated, with the growth of short-term borrowings (most notably repurchase agreements) only partially offsetting the decrease in deposits during the course of 1995.
The long-term liquidity needs of the Corporation will be driven by the necessity to grow and change in the marketplace to meet the needs of its customers and to offset strategies of its competitors. The Corporation's equity base, along with its low debt level and common stock available for issuance, provide several options for future financing. Proceeds from the sale of securities were $2.3 million, $17.0 million, and $17.9 million in 1996, 1995 and 1994, respectively. Proceeds from maturing securities were $67.7 million, $36.7 million, and $49.8 million in 1996, 1995, and 1994, respectively.
Asset-Liability Management. The Corporation actively manages its assets and liabilities through coordinating the levels of interest rate sensitive assets and liabilities to minimize changes in net interest income despite changes in market interest rates. The Corporation defines interest rate sensitive assets and liabilities as any instrument that can be repriced within 180 days, either because the instrument will mature during the period or because it carries a variable interest rate. Changes in net interest income occur when interest rates on loans and investments change in a different time period from that of changes in interest rates on liabilities, or when the mix and volume of earning assets and interest-bearing liabilities change. The interest rate sensitivity gap represents the dollar amount of difference between rate sensitive assets and rate sensitive liabilities within a given time period (GAP). A GAP ratio is determined by dividing rate sensitive assets by rate sensitive liabilities. A ratio of 1.0 indicates a perfectly matched position, in which case the effect on net interest income due to interest rate movements would be zero.
The Corporation's strategy with respect to asset-liability management is to maximize net interest income while limiting the Corporation's exposure to risks associated with volatile interest rates. The subsidiary bank's Funds Management Committee is responsible for monitoring the subsidiary bank's GAP position. As a general rule, the subsidiary bank's policy is to maintain GAP as a percent of total assets within a range from +20% to -20% in any given time period. Based on the simulation of various rising or falling interest rate scenarios in comparison to one considered to be the most likely interest rate scenario, management seeks to operate with net interest income within a range of +10% to -10% of budgeted net interest income during any twelve month period.
The Funds Management Committee monitors the effect of changes in yields and rates paid on a monthly basis. The Committee considers the subsidiary bank's current and anticipated positions during the next twelve months and the effect of rising and falling interest rate scenarios on net income. The Committee considers various contingency plans if the results of this analysis with regard to the following key ratios indicate a deviation from the funds management policy: loans to assets, net loans to core funds, net loans to total deposits, equity capital to total assets, rate sensitive assets to rate sensitive liabilities, GAP, temporary investments to total assets, and temporary investments to volatile liabilities. The contingency plans considered by the Committee include generating funds through internal and external sources, adjusting maturities within the investment portfolio, repricing of assets, purchasing or selling loans, secondary mortgage activity and liability rate adjustment. The Committee reports the results of their meetings to the subsidiary bank's Board of Directors on a monthly basis.
In the table above, NOW account balances and savings deposits are included as rate sensitive in the amounts reflected in the 0-3 month timeframe, as such interest-bearing liabilities are subject to immediate withdrawal.
Management of the Corporation considers one-half of the NOW account balances (one of the components of interest-bearing demand deposits) and all savings deposits as core, or non-rate sensitive deposits, primarily since interest-bearing demand and savings deposits historically have not been rate sensitive. As a general rule, the subsidiary bank's policy is to maintain RSA as a percent of RSL within a range of +70% to +120% within a 182-day time period.
At December 31, 1996, one-half of the NOW account balances totaled approximately $28.7 million and savings deposits totaled approximately $55.1 million. If the amounts reflected in the 0-3 month timeframe are adjusted to exclude these amounts, rate sensitive liabilities would be approximately $117.2 million for a negative GAP of approximately $2.5 million. RSA as a percent of RSL would be 97.9%. Adjusting the cumulative GAP and GAP ratio for the 4-12 month timeframe would result in a positive cumulative GAP and GAP ratio of $4.4 million, and 102.3%, respectively.
EFFECTS OF INFLATION. The consolidated financial statements and related consolidated financial data presented herein have been prepared in accordance with generally accepted accounting principles and practices within the banking industry which require the measurement of financial position and operating results in terms of historical dollars without
considering changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution's performance than the effects of general levels of inflation.
Selected Statistical Information. The following tables contain information concerning the financial condition and results of operations of the Corporation for the period or periods, or as of the date or dates, shown in each table. All average information is provided on an average daily basis.
INVESTMENT MATURITIES AND YIELDS. The following table sets forth the contractual maturities of investment securities at December 31, 1996, and the tax equivalent yields of such securities.
LOAN MATURITIES. The following table sets forth scheduled loan repayments on agricultural and commercial loans at December 31, 1996. Real estate construction loans constitute less than 2% of the Corporation's total loans and therefore are not included in the table. See note 4 in the Notes to Consolidated Financial Statements.
Of the loans shown above, the following table sets forth those loans due after one year which have predetermined (fixed) interest rates or adjustable (variable) interest rates at December 31,1996.
ALLOCATION OF ALLOWANCE FOR POSSIBLE LOAN LOSSES. The subsidiary bank has allocated the allowance for possible loan losses to provide for the possibility of losses being incurred within the categories of loans set forth in the table below. The allocation of the allowance and the ratio of loans within each category to total loans at December 31 are as follows:
IMPACT OF NEW ACCOUNTING STANDARDS. In June 1996, the FASB issued SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" (FAS 125). FAS 125, among other things, applies a "financial-components approach" that focuses on control, whereby an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes assets when control has been surrendered, and derecognizes liabilities when extinguished. FAS 125 provides consistent standards for distinguishing transfers of financial assets that are sales from transfers that are secured borrowings. FAS 125 is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after December 31, 1996. The Corporation does not expect this pronouncement to have a significant impact on its consolidated financial condition or results of operations.
No other new accounting policies were adopted and the application of existing policies was not changed during fiscal 1996.
ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA)
CONSOLIDATED STATEMENTS OF INCOME (DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA)
See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA)
See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS)
See accompanying notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (dollar amounts in thousands except per share data)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The consolidated financial statements have been prepared in conformity with generally accepted accounting principles and conform with general practices within the banking industry. A description of the significant accounting policies follows:
BASIS OF CONSOLIDATION - The consolidated financial statements of Princeton National Bancorp, Inc. ("the Corporation") include the accounts of the Corporation and its wholly-owned subsidiary, Citizens First National Bank ("Princeton" or the "subsidiary bank"). On June 7, 1996, the Corporation acquired the deposits, equipment, and facility of the Sandwich, Illinois branch of Superior Bank, FSB ("Sandwich"). On January 7, 1994, the Corporation acquired Heart of Illinois Investment Corp. ("HOIIC"). At the time of acquisition, the subsidiary of that corporation was immediately merged into Princeton. Significant intercompany accounts and transactions have been eliminated in consolidation. The cost in excess of the fair value (goodwill) of net assets acquired in the aforementioned transactions is being amortized over a fifteen-year period.
USE OF ESTIMATES - In order to prepare the Corporation's financial statements in conformity with generally accepted accounting principles, management is required to make certain estimates that affect the amounts reported in the financial statements and accompanying notes. These estimates may differ from actual results.
BASIS OF ACCOUNTING - The Corporation and its subsidiary bank follow the accrual basis of accounting for all major sources of income and expense.
INVESTMENT SECURITIES - Investment securities which the Corporation has the positive intent and ability to hold to maturity are classified as held-to-maturity and recorded at amortized cost. All other investment securities that are not classified as held-to-maturity are classified as available-for-sale. Investments available-for-sale are recorded at fair value with any changes in fair value reflected as a separate component of stockholders' equity, net of related tax effects. Gains and losses on the sale of securities are determined using the specific identification method.
LOANS - Loans are stated at the principal amount outstanding, net of unearned interest and allowance for possible loan losses. Interest on commercial, real estate, and selected installment loans is credited to operations as earned, based upon the principal amount outstanding. Interest on the remaining installment loans is credited to operations using a method which approximates the interest method.
It is the subsidiary bank's policy to discontinue the accrual of interest on any loan when, in the opinion of management, there is reasonable doubt as to the collectibility of interest or principal. Interest on these loans is credited to income only when the collection of principal has been assured and only to the extent interest payments are received.
In addition, the terms and conditions of certain loans are restructured with the borrower when it is deemed in the best interest of the subsidiary bank. Restructured loans are loans on which interest is being accrued at less than the original contractual rate of interest because of the inability of the borrower to service the obligation under the original terms of the agreement. Income is accrued at the lower rate so long as the borrower is current under the revised terms and conditions of the agreement.
Effective January 1, 1995, the Corporation adopted Statement of Financial Accounting Standard No. 114 "Accounting by Creditors for Impairment of a Loan" (FAS 114) and Statement of Financial Accounting Standard No. 118 "Accounting by Creditors for Impairment of a Loan -- Income Recognition and Disclosures" (FAS 118). A loan is considered impaired, based on current information and events, if it is probable that the Corporation will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. FAS 114 and FAS 118 do not apply to certain groups of small-balance homogenous loans which are collectively evaluated for impairment and are generally represented by consumer and residential mortgage loans or loans which are measured at fair value or at the lower of cost or fair value. The Corporation generally identifies impaired loans within the nonaccrual and restructured commercial and commercial real estate portfolios on an individual loan-by-loan basis. The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral.
Certain non-refundable loan fees and direct costs of loan origination are deferred at the time a loan is originated. Net deferred loan fees are recognized as yield adjustments over the contractual life of the loan using the interest method.
ALLOWANCE FOR POSSIBLE LOAN LOSSES - The allowance for possible loan losses is increased by provisions charged to operating expense and decreased by charge-offs, net of recoveries, and is available for losses incurred on loans.
The allowance is based on factors that include overall composition of loan portfolio, types of loans, past loss experience, loan delinquencies, potential substandard and doubtful credits, and such other factors that, in management's best judgement, deserve evaluation in estimating potential loan losses.
SALES OF FIRST MORTGAGE LOANS AND LOAN SERVICING - The subsidiary bank sells first mortgage loans on a non-recourse basis with yield rates to the buyer based upon the current market rates which may differ from the contractual rate on the loans sold. At the time that loans are sold (servicing retained), a gain or loss is recorded which reflects the difference between the assumed cash flow (prepayments are estimated) to be generated by the contractual interest rates of the loans sold and the assumed cash flow resulting from the yield to be paid to the buyer, adjusted for servicing and discounted to reflect present value. Loan servicing fees are recognized over the lives of the related loans. Loan servicing costs are charged to expense as incurred. Loans held-for-sale are stated at the lower of aggregate cost or market. Real estate loans serviced for others are not included in the accompanying consolidated balance sheets.
In May 1995, the FASB issued Statement of Financial Accounting Standard No. 122, "Accounting for Mortgage Servicing Rights, an amendment of FASB Statement No. 65" (FAS 122). FAS 122 requires that a mortgage banking enterprise recognize as separate assets the rights to service mortgage loans for others, however those servicing rights are acquired, eliminating the previously existing accounting distinction between servicing rights acquired through purchase transactions and those acquired through loan originations. FAS 122 also requires the assessment of capitalized mortgage servicing rights for impairment to be based on the current fair value of those rights. The Corporation adopted FAS 122 effective January 1, 1995. At December 31, 1996
the fair value of the originated mortgage servicing rights was $151 and will be amortized in future periods in proportion to, and over the period of, estimated net servicing income similar to the interest method using an accelerated amortization method. The amortization of capitalized mortgage servicing rights is reflected in the statements of income as a reduction to loan servicing fees and other charges.
NEW ACCOUNTING STANDARD - The FASB issued Statement No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities," which requires an entity to recognize the financial and servicing assets it controls and the liabilities it has incurred and to derecognize financial assets when control has been surrendered in accordance with the criteria provided in the Statement. The Corporation will apply the new rates prospectively to transactions beginning in the first quarter of 1997. Based on current circumstances, the Corporation believes the application of the new rules will not have a material impact on the financial statements.
PREMISES AND EQUIPMENT - Premises and equipment are carried at cost, less accumulated depreciation. Depreciation is computed on the straight-line basis over the estimated useful lives of the assets, as follows: buildings, fifteen to forty years; equipment, three to fifteen years. The carrying amounts of assets sold or retired and the related allowance for depreciation are eliminated from the accounts, and the resulting gains or losses are reflected in income.
OTHER REAL ESTATE - Other real estate, which is included in other assets in the consolidated balance sheets, represents assets to which the Corporation's subsidiary bank has acquired legal title in satisfaction of indebtedness. Such real estate is recorded at cost or its fair market value at the date of acquisition, less estimated selling costs, whichever is lower. Subsequent declines in estimated fair market value, based on changes in market conditions, are recorded as expenses as incurred. Gains or losses on the disposition of other real estate are recorded in the period in which they are realized to other expenses.
EMPLOYEE BENEFIT PLANS - The subsidiary bank has a defined contribution investment (401-K) plan. Under this plan, employees may elect to contribute, on a tax-deferred basis, up to ten percent of their salary. In addition, the subsidiary bank will match employees's contributions up to three percent of each employee's salary.
The subsidiary bank also has a stock-purchase program in which the employee contributes through payroll deductions. These amounts are pooled and used to purchase shares of the Corporation's common stock on a quarterly basis. Additionally, the subsidiary bank has a profit-sharing plan. Annual contributions to the bank plan are based on a formula. The total contribution is at the discretion of the Board of Directors.
INCOME TAXES - Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
NET INCOME PER SHARE - Net Income per share is computed by dividing net income by the weighted average number of shares outstanding during the year.
CASH FLOWS - For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks and federal funds sold. Generally, federal funds are sold for one-day periods.
2. CASH AND DUE FROM BANKS
The average compensating balances held at correspondent banks during 1996, 1995, and 1994 were $3,738, $3,703, and $5,307, respectively. The subsidiary bank maintains such compensating balances with correspondent banks to offset charges for services rendered by those banks. In addition, the Federal Reserve Bank required the subsidiary bank to maintain average balances of approximately $2,013, $1,334, and $738, for 1996, 1995, and 1994, respectively, as a reserve requirement.
3. INVESTMENT SECURITIES
The amortized cost, gross unrealized gains, gross unrealized losses and estimated fair value of available-for-sale and held-to-maturity securities by major security type at December 31 were as follows:
Maturities of investment securities classified as available-for-sale and held-to-maturity were as follows at December 31, 1996:
Proceeds from sales of investment securities available-for-sale during 1996, 1995, and 1994 were $2,318, $16,991, and $17,867, respectively. Gross gains of $15 in 1996, $238 in 1995, and $112 in 1994, and gross losses of $13 in 1996, $209 in 1995, and $24 in 1994, were realized on those sales. There were no sales of investment securities held-to-maturity during 1996, 1995, and 1994.
As of December 31, 1996, 1995, and 1994, the Corporation had $9.6, $11.8, and $9.2 million, respectively, in structured notes, as defined by regulatory agencies. These securities are obligations of U.S. Government agencies and are comprised primarily of step-up bonds and deleveraged bonds. Step-up bonds initially pay an above-market yield for a short noncall period; if not called, the security steps-up to a higher coupon rate. The higher initial yield is received because the investor has implicitly sold a call option. Deleveraged bonds pay interest according to a formula based upon a fraction on an increase of a specified index, such as the Constant Maturity Treasury Rate (CMT). The deleveraging multiplier, for example 50% of 10 year CMT, causes the coupon to lag overall movements in market yields. These securities are carried in the Corporation's available-for-sale portfolio and had unrealized losses of $119, $295, and $740 at December 31, 1996, 1995, and 1994, respectively, and will mature by December 31, 1997.
Certain investment securities are pledged to secure public and trust deposits, and for other purposes required or permitted by law. The book value of these pledged assets at December 31, 1996, 1995, and 1994 was $68,072, $63,694, and $64,084, respectively.
On November 15, 1995, the Financial Accounting Standards Board issued its Special Report on the implementation of FAS 115. Guidance in this special report allowed entities to reclassify securities, including held-to-maturity debt securities, without calling into question the intent of the entity to hold debt securities to maturity in the future. The Special Report indicated that the one-time reclassification permitted should occur as of a single date between November 15, 1995 and December 31, 1995. In conjunction with the provisions contained in the Special Report, the Corporation reclassified approximately $13,867 of held-to-maturity securities, at amortized cost, into the available-for-sale classification. Unrealized gains of approximately $78 were recognized as a result of this reclassification.
The Bank did not hold any securities of any one issuer, other than United States Treasury and Agency obligations, for which the aggregate book value exceeded 10% of stockholders' equity during any of the periods presented.
4. LOANS
The composition of the loan portfolio as of December 31 was as follows:
1996 1995 Gross loans: Commercial $ 38,410 $ 34,687 Agricultural 36,030 33,106 Real estate-construction 4,160 3,116 Real estate-mortgage 142,004 124,350 Installment 37,514 37,434 ------- ------- Total $258,118 $232,693 ======= =======
Changes in the allowance for possible loan losses for the years ended December 31 were as follows:
Loans on non-accrual status at December 31, 1996, 1995, and 1994 were $1,157, $808, and $573, respectively. Interest income that would have been recorded on these loans had they remained current was approximately $93, $49, and $35, respectively.
Restructured loans at December 31, 1996, 1995, and 1994 were $0, $0, and $384, respectively. For 1994, additional interest income that would have been earned on these loans (had their terms not been restructured) was not materially different than actual interest recognized. Interest rates on restructured loans reflect changes in the original contractual rate and are not considered to be significantly different than the rates on other loans.
At December 31, 1996 and 1995, the recorded investment in loans for which impairment has been recognized in accordance with FAS 114 totaled $624 and $189, respectively, all of which related to impaired loans which do not require a related allowance for possible loan losses because the carrying value of the loans exceeds the discounted present value of expected future cash flows. For the year ended December 31, 1996 and 1995, the average recorded investment in impaired loans was approximately $380 and $195, respectively. Interest recognized on impaired loans during the portion of the year that they were impaired is not considered material.
The Corporation's subsidiary bank had loans outstanding to directors, executive officers, and to their related interests (related parties) of the Corporation and its subsidiary of approximately $1,735, $1,180, and $892 at December 31, 1996, 1995, and 1994, respectively. These loans were made in the ordinary course of business on the same terms and conditions, including interest rates and collateral, as those prevailing at the time for comparable transactions with other customers and did not involve more than the normal risk of collectibility. An analysis of the 1996 activity in loans made to directors, executive officers, or principal holders of common stock or to any associate of such persons for which the aggregate to any such person exceeds $60,000 is as follows:
Balance Balance January 1, 1996 Additions Payments December 31, 1996 --------------- --------- -------- ----------------- $1,180 $1,211 $ 656 $1,735
The Corporation services loans with unpaid principal balances at December 31, 1996, 1995, and 1994 of approximately $36,649, $33,072, and $27,967, respectively. Additionally, the fair value of the originated mortgage servicing rights was $151 at December 31, 1996 and $72 at December 31, 1995.
5. PREMISES AND EQUIPMENT
As of December 31, the components of premises and equipment (at cost), less accumulated depreciation, were as follows:
1996 1995
Land $ 2,040 $ 1,836 Buildings 10,051 9,716 Furniture and Equipment 5,665 5,334 ------- ------ 17,756 16,886
Less accumulated depreciation 8,609 7,790 ------- ------ Total $ 9,147 $ 9,096 ======= ======
Depreciation expense charged to operating expense for 1996, 1995, and 1994 was $908, $803, and $793, respectively.
6. DEPOSITS
As of December 31, the aggregate amounts of time deposits in denominations of $100 or more and the total interest expense for this category of time deposits were as follows:
7. LONG-TERM BORROWINGS
The Corporation's long-term borrowings consisted of a note payable totaling $4,350 and $4,700 at December 31, 1996 and 1995, respectively. Proceeds of the note payable, which had an original balance of $6,000, were used to fund the HOIIC acquisition and repay certain HOIIC indebtedness. An additional $1,000 was borrowed in 1996 to partially fund the Sandwich acquisition. The demand note carries a floating interest rate equal to the lender's prime rate and is secured by 100% of the stock of Princeton. Scheduled payments will be $600 annually through 2003, and $150 is scheduled to be paid in 2004.
8. INCOME TAXES
Income tax expense (benefit) attributable to income from operations consists of:
There were no state income taxes for 1996, 1995 or 1994.
Income tax expense attributable to income from operations differed from the amounts computed by applying the U.S. Federal income tax rate of 34 percent to pretax income from operations as a result of the following:
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1996 and 1995 are presented below:
1996 1995 ---- ---- Deferred tax assets: Deferred directors fees $ 120 $ 133 State NOL carryforwards 349 429 Other, net 15 42 ----- ------ Total gross deferred tax assets 484 604 Less: Valuation allowance (148) (283) ------ ------ Net deferred tax assets 336 321 ------ ------ Deferred tax liabilities: Plant and equipment, principally due to differences in depreciation (157) (102) Provision for possible loan losses (436) (456) Accretion ( 76) ( 43) Core deposits ( 52) ( 49) Unrealized gain on investment securities available-for-sale (155) (125) Purchase accounting adjustments (114) (152) Other -0- -0- ----- ------ Total gross deferred tax liabilities (990) (927) ----- ------ Net deferred tax liabilities $ (654) $ (606) ===== ======
At December 31, 1996, the Corporation has net operating loss carryforwards for state income tax purposes of approximately $7,400 which expire in the years 2002-2010 and are available to offset future state taxable income. Approximately $2,600 of such carryforwards relate to purchased institutions.
The valuation allowance for deferred tax assets at December 31, 1995 was $283. The net change in the total valuation allowance for the year ended December 31, 1996 was a decrease of $135. Subsequently recognized tax benefits of $125 relating to the valuation allowance for state net operating loss carryforwards from purchased institutions will be utilized to reduce goodwill from these purchases. The remaining $23 of valuation allowance relates primarily to state net operating loss carryforwards which are available to offset future state taxable income. Management believes that it is more likely than not that the deferred tax assets, net of the valuation allowances, will be realized.
9. REGULATORY MATTERS
The Corporation and its subsidiary bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Corporation's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation and its subsidiary bank must meet specific capital guidelines that involve quantitative measures of each entity's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Corporation's and its subsidiary bank's capital amounts and classification are also subject to qualitative judgements by the regulators about components, risk-weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Corporation and its subsidiary bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). As of December 31, 1996, the Corporation and its subsidiary bank were both categorized as well capitalized under the regulatory framework. There are no conditions or events since year-end that management believes have changed the Corporation's or its subsidiary bank's category.
10. EMPLOYEE BENEFIT PLANS
The subsidiary bank's contribution to the defined contribution investment (401-K) plan for 1996, 1995, and 1994 was $129, $124, and $112, respectively.
The cost of the profit-sharing plan charged to operating expense was $162 in 1996, $9 in 1995, and $157 in 1994.
11. FAIR VALUE OF FINANCIAL INSTRUMENTS
Statement of Financial Accounting Standards No. 107 ("FAS 107"), "Disclosures about Fair Value of Financial instruments, requires all entities to disclose the estimated fair value of its financial instrument assets and liabilities. For the Corporation, as for most financial institutions, the majority of its assets and liabilities are considered financial instruments as defined in FAS 107. Many of the Corporation's financial instruments, however, lack an available trading market as characterized by a willing buyer and willing seller engaging in an exchange transaction. It is also the Corporation's general practice and intent to hold its financial instruments to maturity and not to engage in trading or sales activities except for loans held-for-resale and available-for-sale securities. Therefore, significant estimations and assumptions, as well as present value calculations, were used by the Corporation for the purposes of this disclosure.
Estimated fair values have been determined by the Corporation using the best available data and an estimation methodology suitable for each category of financial instruments. For those loans and deposits with floating interest rates it is presumed that estimated fair values generally approximate the recorded book balances. The estimation methodologies used, the estimated fair values, and the recorded book balances at December 31, 1996 and 1995, were as follows:
Financial instruments actively traded in a secondary market have been valued using quoted available market prices. Cash and due from banks, federal funds sold, loans held-for-sale, and interest receivable are valued at book value which approximates fair value.
Financial liability instruments with stated maturities have been valued using a present value discounted cash flow with a discount rate approximating current market for similar liabilities. Interest payable is valued at book value which approximates fair value.
Financial instrument liabilities with no stated maturities have an estimated fair value equal to both the amount payable on demand and the recorded book balance.
The net loan portfolio has been valued using a present value discounted cash flow. The discount rate used in these calculations is the current rate at which similar loans would be made to borrowers with similar credit ratings, same remaining maturities, and assumed prepayment risk.
Changes in assumptions or estimation methodologies may have a material effect on these estimated fair values.
The Corporation's remaining assets and liabilities which are not considered financial instruments have not been valued differently than has been customary with historical cost accounting. No disclosure of the relationship value of the Corporation's core deposit base is required by FAS 107. Because the Corporation's 1996 cost of funds compares favorably with alternative funding sources available to the Corporation, the relationship value of these liabilities is believed by management to be significant. There is no material difference between the notional amount and the estimated fair value of off-balance-sheet items which total $44,649 and $43,847 at December 31, 1996 and December 31, 1995 respectively, and are primarily comprised of unfunded loan commitments which are generally priced at market at the time of funding.
Fair value estimates are based on existing on and off-balance-sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. For example, the subsidiary bank has a substantial trust department that contributes net fee income annually. The trust department is not considered a financial instrument, and its value has not been incorporated into the fair value estimates. Other significant assets and liabilities that are not considered financial assets or liabilities include the mortgage banking operation, brokerage network, deferred tax liabilities, property, plant, equipment, and goodwill. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in many of the estimates.
Management is concerned that reasonable comparability between financial institutions may not be likely due to the wide range of permitted valuation techniques and numerous estimates which must be made given the absence of active secondary markets for many of the financial instruments. This lack of uniform valuation methodologies also introduces a greater degree of subjectivity to these estimated fair values.
12. UNDISTRIBUTED EARNINGS OF SUBSIDIARY BANK
National banking regulations and capital guidelines limit the amount of dividends that may be paid by banks. Due to the amount of dividends paid by the subsidiary bank to the Corporation in 1996 and 1995, these regulations and guidelines will not permit the subsidiary bank to distribute dividends in 1997 without prior approval from the national banking regulators. Future payment of dividends by the subsidiary bank would be dependent on individual regulatory capital requirements and levels of profitability. Since the Corporation is a legal entity, separate and distinct from the bank, the dividends of the Corporation are not subject to such bank regulatory guidelines.
13. COMMITMENTS AND CONTINGENCIES
The subsidiary bank is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract amounts of those instruments reflect the extent of involvement the subsidiary bank has in particular classes of financial instruments.
The subsidiary bank's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The bank uses the same credit policies in making commitments and conditional obligations as they do for on-balance-sheet instruments. At December 31, 1996, commitments to extend credit and standby letters of credit were approximately $44,253 and $396, respectively.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The subsidiary bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary, by the subsidiary bank upon extension of credit is based on management's credit evaluation of the counterparty. Collateral held varies, but may include real estate, accounts receivable, inventory, property, plant and equipment, and income-producing properties.
Standby letters of credit are conditional commitments issued by the subsidiary bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers. The subsidiary bank secures the standby letters of credit with the same collateral used to secure the loan.
There are various claims pending against the Corporation's subsidiary, arising in the normal course of business. Management believes, based upon consultation with counsel, that liabilities arising from these proceedings, if any, will not be material to the Corporation's financial position.
14. SUBSIDIARY BANK TRUST DEPARTMENT
During the first quarter of 1995, the Corporation's subsidiary bank decided to reimburse trust customers for losses in the market value of various inverse floater securities held in their trust accounts. These losses were a result of increases in interest rates which both extended the expected average life and lowered the market value of these securities. As a result of reimbursing customers for the market value loss, the Corporation recorded charges totaling $5,043 ($3,126 after tax) to 1995 earnings.
In addition to the first quarter reimbursement, following a comprehensive review of the subsidiary bank's trust department, a plan was implemented during the third quarter of 1995 to provide for the purchase, on an ongoing basis, of selected securities from the Trust Department by the Corporation. These securities were purchased at the higher of current market value or original cost to the individual trust customer. Purchased securities are held by the Corporation in an available-for-sale account and will be held to maturity or sold if market conditions permit or for liquidity purposes under the plan. The excess, if any, of the cost of these securities to the Corporation over the market value was expensed at the time of the purchase, resulting in a negative effect on current income. For the years ended December 31, 1996 and 1995, the Corporation incurred losses of $26 and $189, respectively, relating to the purchase of these securities. This effect may be offset in the future by gains from sales, or maturities of the securities, and/or possible proceeds from claims that have been filed with the insurance carrier of the Corporation. At December 31, 1996 and 1995, the market value of these available-for-sale securities held by the Corporation was $930 and $1,971, respectively. As of December 31, 1996, there were no additional securities remaining to be purchased under the plan.
15. STOCK DIVIDENDS
In April, 1994, the Corporation declared a common stock split in the form of a dividend at the rate of one additional half share of common stock for each issued share of common stock resulting in 903,515 additional shares being issued to stockholders of record on April 25, 1994. An additional amount of retained earnings was transferred to common stock to properly reflect the capitalization of the par value of the shares issued in accordance with legal requirements. All share and per share data have been restated for all periods presented to reflect the stock dividend.
16. ACQUISITIONS
On June 7, 1996, the Corporation acquired all of the deposits ($24.6 million), equipment, and facility of the Sandwich branch of Superior Bank, FSB ("Sandwich"). The acquisition of Sandwich was accounted for under the purchase method of accounting and accordingly, the assets acquired were adjusted to their fair market values as of the acquisition date. Goodwill and prepaid acquisition costs in connection with this acquisition in the amount of $3,002 are being amortized over fifteen years on a straight-line basis. The Corporation additionally entered into a three-year covenant not-to-compete in the amount of $100, which is being amortized on a straight-line basis.
On January 7, 1994, the Corporation acquired Heart of Illinois Investment Corp. ("Heart of Illinois"), a $70.3 million bank holding company with offices in Spring Valley, Henry, Plano, and Princeton, Illinois, for a purchase price of $4,131. At the time of the acquisition the subsidiary bank of that company
(Heart of Illinois Bank, FSB) was immediately merged into Citizens First National Bank. The acquisition of Heart of Illinois was accounted for under the purchase method of accounting, and accordingly, the assets and liabilities of Heart of Illinois were adjusted to their fair market values as of the acquisition date. The operating results of the acquired offices have been consolidated with those of the Corporation from January 1, 1994. Goodwill in connection with this acquisition in the original amount of $1,271 is being amortized over fifteen years on a straight-line basis.
17. POST-RETIREMENT BENEFITS OTHER THAN PENSIONS
Effective January 1, 1995, the Corporation adopted Statement of Financial Accounting Standard No. 106, "Employers' Accounting for Post-Retirement Benefits Other than Pensions" (FAS 106). FAS 106 changes the practice of accounting for post-retirement benefits on a pay-as-you-go (cash) basis by requiring accrual of the expected cost of providing those benefits to an employee, the employee's beneficiaries, and covered dependents. The expected cost is to be accrued over the employee's period of service to the Corporation.
The Corporation's subsidiary bank offers its retirees the opportunity to continue benefits in the subsidiary bank's Employee Health Benefit Plan provided the retiree agrees to pay a portion of their monthly premiums. The Corporation's level of contribution is based upon an age and service formula and will provide benefits to active participants until age 65. The components of the 1996 and 1995 net periodic post-retirement benefit cost are shown below:
1996 1995 ---- ---- Service cost $ 26 $ 24 Interest cost 23 23 Net amortization of transition obligation 16 16 ----- ----- Net periodic post-retirement benefit cost $ 65 $ 63 ===== ======
As of December 31, 1996 and 1995, the accumulated post-retirement benefit obligation totaled $328 and $327, respectively. For measurement purposes, a 10% annual rate of increase in the cost of covered benefits (health care cost trend rate) was assumed for 1996 and 1995 and the rate was further assumed to decline to 5% after six years. The weighted average discount rate used in determining the accumulated post-retirement benefit obligation was 7% at December 31, 1996 and 1995.
18. CONDENSED FINANCIAL INFORMATION OF PRINCETON NATIONAL BANCORP, INC.
The following condensed financial statements are presented for the Corporation alone (that is, without consolidation of the subsidiary bank's financial information).
CONDENSED BALANCE SHEETS
CONDENSED STATEMENTS OF INCOME
CONDENSED STATEMENTS OF CASH FLOWS
INDEPENDENT AUDITORS' REPORT
KPMG Peat Marwick LLP
To the Board of Directors and Stockholders of Princeton National Bancorp, Inc.
We have audited the accompanying consolidated balance sheets of Princeton National Bancorp, Inc. and subsidiary as of December 31, 1996 and 1995 and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the years in the three-year period ending December 31, 1996. These consolidated financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Princeton National Bancorp, Inc. and subsidiary as of December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the years in the three-year period ending December 31, 1996 in conformity with generally accepted accounting principles.
KPMG PEAT MARWICK LLP
Chicago, Illinois January 24, 1997
ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Certain information regarding executive officers of the Corporation is included as a Supplementary Item at the end of Part I of this Form 10-K.
Information regarding executive officers and directors of the Corporation is included in the Corporation's Definitive Proxy Statement for the Annual Meeting of Stockholders to be held April 8, 1997 (the "Proxy Statement" under the caption "Proposal 1-Election of Directors"), which information is hereby incorporated by reference herein.
Information regarding compliance with Section 16(a) of the Exchange Act is included in the Proxy Statement under the caption "Section 16(a) Beneficial Ownership Compliance Reporting", which information is hereby incorporated by reference herein.
ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION
Information regarding executive compensation is included in the Proxy Statement under the captions "Proposal 1-Election of Directors--Board of Directors and Committees", and "Executive Compensation -- Summary; -- Summary Compensation Table; and Employment Agreements," which information is hereby incorporated by reference herein.
ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information regarding security ownership is included in the Proxy Statement under the captions "Election of Directors" and "Security Ownership of Certain Beneficial Owners," which information is hereby incorporated by reference herein.
ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information regarding relationships and transactions is included in the Proxy Statement under the caption "Certain Transactions," which information is hereby incorporated by reference herein.
PART IV.
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) The following is a list of the Financial Statements included in Part II, Item 8 of this report:
Consolidated Balance Sheets as of December 31, 1996 and 1995.
Consolidated Statements of Income for the years ended December 31, 1996, 1995 and 1994.
Consolidated Statements of Changes in Stockholders' Equity for the years ended December 31, 1996, 1995, and 1994.
Consolidated Statements of Cash Flows for the years ended December 31, 1996, 1995, and 1994.
Notes to Consolidated Financial Statements.
Independent Auditors' Report
(a)(2) Financial Statement Schedules
No consolidated financial statement schedules are required to be included in this Report on Form 10-K.
(a)(3) Exhibits
The exhibits filed herewith are listed on the Exhibit Index filed as part of this report on Form 10-K. Each management contract or compensatory plan or arrangement of the Corporation listed on the Exhibit Index is separately identified by an asterisk.
(b) Reports on Form 8-K
No reports on Form 8-K were filed by the Corporation for the quarter ended December 31, 1996.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registration has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
PRINCETON NATIONAL BANCORP, INC.
By: /s/ Tony J. Sorcic ------------------------- Tony J. Sorcic President and Chief Executive Officer
Date: March 24, 1997
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
INDEX TO EXHIBITS
Exhibit Number Exhibit - ------- --------
3.1 Amended and Restated Certificate of Incorporation of Princeton National Bancorp, Inc. ("PNB") (incorporated by reference to Exhibit 3.1 to the PNB Registration Statement on Form S-1 (Registration No. 33-46362) (the "S-1 Registration Statement")).
3.2 By-Laws of PNB (as amended through January 23, 1995), (incorporated by reference to Exhibit 3.2 to the PNB Annual Report on Form 10-K for the year ended December 31, 1995 (the "1995 Form 10-K")).
10.1* Employment Agreement, dated as of October 16, 1995, between PNB and Tony J. Sorcic (incorporated by reference to Exhibit 10.1 to the 1995 Form 10-K).
10.2* Employment Agreement, dated as of July 10, 1995, between PNB and D. E. Van Ordstrand (incorporated by reference to Exhibit 10.2 to the 1995 Form 10-K).
10.3* Citizens First National Bank Profit Sharing Plan, as amended and restated January 1, 1989 (incorporated by reference to Exhibit 10.4 to the S-1 Registration Statement).
10.4* Citizens First National Bank Defined Contribution Plan and Trust, as amended and restated January 1, 1989 (incorporated by reference to Exhibit 10.5 to the S-1 Registration Statement).
21 Subsidiaries of PNB.
27 Financial Data Schedule.
* Management contract or compensatory plan.