**Exhibit13**

 

2002 ANNUAL REPORT

Merrill Merchants Bancshares, Inc.

 

Contents

 
| Financial Highlights                      |
|-------------------------------------------|
| Letter to Shareholders                    |
| Management’s  Analysis of Operations |
| Independent Auditors’  Report        |
| Audited Financial Statements              |
| Corporate Directory                       |
| Employees                                 |
| Corporate Information                     |

** **

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**SelectedFinancial Highlights**

(Dollars inthousands, except per share data)

 
| **For the Year**                       |   | **2002** |    | **2001** |   | **2000** |   | **1999** |    | **1998** |   |
|----------------------------------------|--------|----------|---------|----------|--------|----------|--------|----------|---------|----------|--------|
| Net income                             |   | $        | 3,845   |     | $      | 3,254    |   | $        | 2,619   |     | $      | 2,247 |   | $ | 1,916 |   |
| Net interest  income                   |   | 12,463   |    | 11,542   |   | 10,026   |   | 8,885    |    | 8,032    |   |
| Non-interest  income                   |   | 3,963    |    | 3,299    |   | 3,155    |   | 2,602    |    | 2,211    |   |
| Non-interest  expense                  |   | 10,205   |    | 9,468    |   | 8,823    |   | 7,754    |    | 6,939    |   |
| **Per Common Share**                   |   |     |    |     |   |     |   |     |    |     |   |
| Earnings per  share:                   |   |     |    |     |   |     |   |     |    |     |   |
| Basic                                  |   | $        | 1.31    |     | $      | 1.16     |   | $        | 0.92    |     | $      | 0.78 |   | $ | 0.84 |   |
| Diluted                                |   | 1.18     |    | 1.01     |   | 0.82     |   | 0.68     |    | 0.68     |   |
| Dividends per  share                   |   | 0.40     |    | 0.30     |   | 0.24     |   | 0.19     |    | 0.12     |   |
| Book value per  share                  |   | 9.11     |    | 9.46     |   | 8.49     |   | 7.73     |    | 7.54     |   |
| Dividend payout  ratio                 |   | 31.27    | %       | 25.87    | %      | 25.52    | %      | 24.71    | %       | 15.27    | %      |
| **Key Ratios**                         |   |     |    |     |   |     |   |     |    |     |   |
| Return on  average assets              |   | 1.33     | %       | 1.26     | %      | 1.16     | %      | 1.11     | %       | 1.05     | %      |
| Return on  average equity              |   | 13.93    |    | 13.18    |   | 11.94    |   | 10.58    |    | 12.90    |   |
| Equity to assets  at year end          |   | 9.24     |    | 9.34     |   | 9.45     |   | 9.95     |    | 10.34    |   |
| Non-performing  assets to total assets |   | 0.25     |    | 0.26     |   | 0.25     |   | 0.15     |    | 0.08     |   |
| Net charge-offs  to average loans      |   | 0.07     |    | 0.08     |   | 0.03     |   | 0.07     |    | 0.04     |   |
| **At Year End**                        |   |     |    |     |   |     |   |     |    |     |   |
| Total assets                           |   | $        | 307,316 |     | $      | 278,197  |   | $        | 246,413 |     | $      | 213,747 |   | $ | 199,743 |   |
| Loans  receivable, net (2)             |   | 211,434  |    | 185,094  |   | 163,265  |   | 133,948  |    | 125,632  |   |
| Investment  securities                 |   | 68,867   |    | 71,607   |   | 59,686   |   | 61,475   |    | 55,909   |   |
| Deposits                               |   | 238,857  |    | 219,309  |   | 200,451  |   | 168,578  |    | 164,128  |   |
| Borrowed funds                         |   | 36,932   |    | 29,792   |   | 20,076   |   | 19,069   |    | 13,508   |   |
| Shareholders’  equity             |   | 28,388   |    | 25,985   |   | 23,292   |   | 21,258   |    | 20,655   |   |

 

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(1) Excludeseffect of unrealized gains or losses on securities

(2) Excludes loansheld for sale

 

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2002 Annual Report

 

Dear Shareholders:

2002 was a milestone year for Merrill MerchantsBancshares, Inc., as we celebrated our tenth anniversary in October.  It was an occasion for reflection and thanks,most particularly to our management team and directors, who have served us withdedication and distinction over the past ten years. And, to our employees, whohave maintained a level of caring for our Company, our corporate goals, our customersand our communities, which is truly exceptional.  They remain the heart and soul of our Company, and it is withgreat pride that we dedicate this year’s Annual Report to our valued employees.

2002 will be remembered for a series of corporateaccounting scandals, which exacerbated an already volatile market and fragileeconomy and prompted reforms in corporate governance. The war on terrorism alsoremained a global concern. And, last but not least, interest rates reachedtheir lowest levels in decades. Despite these issues, our Company performedwell, maintaining good asset quality and achieving solid asset and earningsgrowth.

 

FINANCIAL PERFORMANCE

We are very pleased to report earnings of  $3.8 million for the Company, an 18%increase over last year, which translated into diluted earnings per share of$1.18 in 2002, compared to $1.01 in 2001. Our loan portfolio grew 14%

 

Net Income Graph

 
| 1998 |   | $ | 1.9 million |
|------|--------|---|-------------|
| 1999 |   | $ | 2.2 million |
| 2000 |   | $ | 2.6 million |
| 2001 |   | $ | 3.3 million |
| 2002 |   | $ | 3.8 million |

 

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and total assets increased to $307.3 million at December 31, 2002. TheCompany also increased its dividend distribution to shareholders by $.10 pershare, a 33% increase over last year.

 

LENDING ACTIVITIES

Asset quality is the strength of any company andMerrill Merchants Bancshares, Inc. has maintained consistent loan policies andunderwriting standards, which have served us well. Loans grew $26.6 million or14%, compared to growth of $22.2 million in 2001. Non-performing assets, as apercentage of total assets, were at .25% on December 31, 2002, compared to .26%at December 31, 2001. Our ratios remain strong relative to our peer group.

We have a diversified portfolio and an experiencedlending team which looks carefully at every loan opportunity.  Activity in the healthcare sector has beenstrong, and we were very pleased to assist Northeast Cardiology with financingfor construction of their new medical complex. Angela T. Butler was promoted tovice president in the Commercial Loan Department. She joined us as a creditanalyst in 1993 and has assumed increasing responsibilities within our Banksince that time.

We are proud to be a leading lender in the state forthe Small Business Administration and to partner with non-profits in our regionon affordable housing grants and other projects. This year we collaborated withMaine State Housing and the Federal Home Loan Bank of Boston on the financingfor the Wellspring Transitional House in Bangor. This property will providehousing to men and women who have completed substance abuse treatment as theywork to gain the skills they need to live independent lives.

The low interest rate environment spurred considerableactivity in the mortgage lending area and we originated $83 million inresidential mortgages this year, increasing our residential mortgage loan servicingportfolio to $95 million at year-end.

 

Loans Receivable Graph

 
| 1998 |   | $ | 125.6 million |
|------|--------|---|---------------|
| 1999 |   | $ | 133.9 million |
| 2000 |   | $ | 163.3 million |
| 2001 |   | $ | 185.1 million |
| 2002 |   | $ | 211.4 million |

 

TRUST AND INVESTMENT SERVICES

Our Trust and Investment Services Department ended theyear with $237.2 million in assets under administration, an increase of 1% overlast year. Despite strong headwinds from the equity markets, we experienced solidnew customer growth in 2002.

 

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Meris J. Bickford, J.D., who oversees tax and estate settlement, waspromoted to vice president this year, and we were pleased to welcome LawrenceM. Napoleone, vice president, during the fourth quarter. A certified financialplanner, Larry’s investment advisory experience complements the legal, employeebenefit, and other skills of our professional staff.

Our niche is defined by the personal service and fullservice financial capabilities we offer customers. This, along with our investmentperformance, which significantly exceeded equity benchmarks in 2002, positionsus well within our market area.

 

Trust Assets Graph

 
| 1998 |   | $ | 136.5 million |
|------|--------|---|---------------|
| 1999 |   | $ | 189.5 million |
| 2000 |   | $ | 224.8 million |
| 2001 |   | $ | 234.8 million |
| 2002 |   | $ | 237.2 million |

 

RETAIL BANKING

In October we launched a new retail bankinginitiative, High Performance Checking, with the goal of generating significantdeposit growth and associated fee income. The program includes seven new checking accounts, direct mailadvertising, Tell-A-Friend referrals and an attractive selection of premiumgifts. Preliminary statistics indicate that we are tracking well to ourprojections, and we will be focusing much of our sales and marketing efforts onthis program in 2003.

After ten years of retail banking leadership, CharlieHart, executive vice president, elected at year-end to transition to a reducedrole with the Company in our administrative area.  Lynne Spooner, senior vice president of the residential mortgagearea for the past ten years, has assumed management of the retail bankingfunction including branch administration, consumer lending and mortgage banking.

 

Deposits Graph

 
| 1998 |   | $ | 164.1 million |
|------|--------|---|---------------|
| 1999 |   | $ | 168.6 million |
| 2000 |   | $ | 200.5 million |
| 2001 |   | $ | 219.3 million |
| 2002 |   | $ | 238.9 million |

 

COMMUNITY BUILDING

Our employees are dedicated to improving life in ourcommunities through “hands on” volunteer service and positions of leadership onvarious boards. This year Bill Lucy, executive vice president, chaired theUnited Way’s annual campaign, helping to raise $2.65 million in support ofEastern Maine’s most pressing health and human

 

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services needs. Included in the campaign total were generouscontributions by the Bank and its employees. Along with the United Way, otherbeneficiaries of employee volunteer hours were many civic and non-profit groupssuch as: Eastern Maine Target Development; Husson College; St. JosephHealthcare; Penquis Community Action Program; Good Samaritan Agency; EasternMaine Healthcare; Ronald McDonald House; and the Bangor YMCA. The Bank’scharitable contributions supported many capital campaigns, including those of:Eastern Maine Technical College; the University of Maine Art Museum; theCharles A. Dean Memorial Hospital; the Maine Discovery Museum; SebasticookValley Hospital; as well as sponsorships of the National Folk Festival, BangorSymphony Orchestra, and Challenger Learning Center of Maine.

 

LOOKING AHEAD

2003 will be challenging. The Middle East remainsunsettled, a war with Iraq appears imminent, and economic indicators are mixed.Closer to home, the regional economy appears relatively stable, our loan creditquality is strong, and we are poised to take advantage of growth opportunities.Continued low interest rate levels, however, will place additional pressure onour net interest margin.

We have been very pleased, during another year of market volatility, tosee our stock price appreciate and close the year at $15.60 per share, a 42%increase over last year. Building shareholder value continues to be a toppriority for the Company. As always, we appreciate your confidence in MerrillMerchants Bancshares, Inc. and look forward to providing any financial servicesyou may need in the future.

 

Return on Equity Graph

 
| 1998 |   | 12.90 | % |
|------|--------|-------|---|
| 1999 |   | 10.58 | % |
| 2000 |   | 11.94 | % |
| 2001 |   | 13.18 | % |
| 2002 |   | 13.93 | % |

 

Sincerely,

 
| Edwin N. Clift                        | William C. Bullock, Jr. |
|---------------------------------------|-------------------------|
| President and Chief Executive Officer | Chairman                |

 

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**MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**FORWARD LOOKING STATEMENTS**

Management’sdiscussion and analysis may contain forward-looking statements that are providedto assist in the understanding of anticipated future financialperformance.  However, such performanceinvolves risk and uncertainties which may cause actual results to differmaterially from those expressed in forward-looking statements.  For a discussion of these risks anduncertainties, see the Company’s Annual Report on Form 10-KSB for the yearended December 31, 2002.  The Companydisclaims any obligation to publically announce future events or developmentsthat may affect the forward-looking statements contained herein.

 

**GENERAL**

Merrill Merchants Bancshares, Inc. (Company) owns allof the common stock of Merrill Merchants Bank (Bank).  The Bank is a full-service community bank headquartered inBangor, Maine, providing a wide range of consumer, commercial, and trust andinvestment services through its eleven locations in central and easternMaine.  In addition, the Bank providesindirect auto and recreational vehicle lending through its consumer financedivision.

Merrill Merchants Bank is committed to providingoutstanding customer service and building long term banking relationships withcustomers. Delivery on this commitment through local decision-making andpersonal service has helped distinguish Merrill Merchants from its competitors.This will continue to be strategically significant as larger banks consolidateand their service delivery channels become more depersonalized.

The Company’s goal is to sustain profitable,controlled growth by focusing on increased loan and deposit market share;managing yields on earning assets and rates on interest-bearing liabilities;increasing non-interest income; and being prepared for acquisitions andexpansion opportunities within the financial services industry.

 

**REVIEW OF FINANCIAL STATEMENTS**

The Companydeclared a 3% stock dividend both in 2002 and 2001.   All financial data included herein has been restated to reflectthe impact of the stock dividends.

The discussion andanalysis that follows focuses on the factors affecting the Company’s financialcondition at December 31, 2002, and 2001 and financial results of operationsduring 2002 and 2001.  This discussionshould be read in conjunction with the consolidated financial statements andnotes included elsewhere in this report.

 

**CRITICAL ACCOUNTING POLICIES**

Management’s discussion and analysis of the Company’sfinancial condition are based on the consolidated financial statements whichare prepared in accordance with accounting principles generally accepted in theUnited States. The preparation of such financial statements requires managementto make estimates and assumptions that affect the reported amounts of assets,liabilities, revenues and expenses and related disclosure of contingent assetsand liabilities. On an ongoing basis, management evaluates its estimates, includingthose related to the allowance for loan losses. Management bases its estimateson historical experience and on various other assumptions that are believed tobe reasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets that are not readilyapparent from other sources. Actual results could differ from the amountderived from management’s estimates and assumptions under different assumptionsor conditions.

 

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*AVERAGE BALANCE SHEETS AND ANALYSISOF NET INTEREST INCOME*

 

The following table sets forth, for the years indicated, informationregarding (i) the total dollar amount of interest income of the Company frominterest-earning assets and the resultant average yields; (ii) the total dollaramount of interest expense on interest-bearing liabilities and the resultantaverage costs; (iii) net interest income; (iv) net interest rate spread; and(v) net interest margin.  Income from investment securities and netinterest income is presented on a tax-equivalent basis by adjusting income andyields earned on tax-exempt securities assuming a federal tax rate of 34%.  Accordingly, interest income calculated in accordancewith generally accepted accounting principles has been increased by $52,000,$40,000 and $31,000 in 2002, 2001 and 2000, respectively, to reflect the taxequivalent amount.

 
|                                              |   | **2002**             |    | **2001**     |   | **2000**         |   |
|---------------------------------------------------|--------|----------------------|---------|--------------|--------|------------------|--------|
| **(In Thousands)**                                |   | **Average  Balance** |    | **Interest** |   | **Yield/  Rate** |   | **Average  Balance** |   | **Interest** |   | **Yield/  Rate** |   | **Average  Balance** |   | **Interest** |   | **Yield/  Rate** |   |
| Assets:                                           |   |                 |    |         |   |             |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-earning  assets:                         |   |                 |    |         |   |             |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans (1)                                         |   | $                    | 202,377 |         | $      | 14,959           |   | 7.39 | % | $ | 175,634 |   | $ | 15,731 |   | 8.96 | % | $ | 153,411 |   | $ | 14,708 |   | 9.59 | % |
| Investment  securities                            |   | 67,790               |    | 3,399        |   | 5.01             | %      | 64,583 |   | 3,788 |   | 5.87 | % | 56,159 |   | 3,415 |   | 6.08 | % |
| Other earning  assets                             |   | 90                   |    | 1            |   | 1.11             | %      | 725 |   | 23 |   | 3.17 | % | 1,771 |   | 111 |   | 6.27 | % |
| Total  interest-earning assets                    |   | 270,257              |    | 18,359       |   | 6.79             | %      | 240,942 |   | 19,542 |   | 8.11 | % | 211,341 |   | 18,234 |   | 8.63 | % |
| Non-earning  assets                               |   | 17,812               |    |         |   |             |   | 16,484 |   |   |   |   |   | 15,064 |   |   |   |   |   |
| Total assets                                      |   | $                    | 288,069 |         |   |             |   |   | $ | 257,426 |   |   |   |   |   | $ | 226,405 |   |   |   |   |   |
|                                              |   |                 |    |         |   |             |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Liabilities and  Shareholders’ Equity:       |   |                 |    |         |   |             |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:                    |   |                 |    |         |   |             |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings deposits  and interest - bearing checking |   | $                    | 103,259 |         | 1,354  |             | 1.31   | % | $ | 86,596 |   | 2,222 |   | 2.57 | % | $ | 80,178 |   | 2,867 |   | 3.58 | % |
| Certificates of  deposit                          |   | 87,393               |    | 3,653        |   | 4.18             | %      | 82,160 |   | 4,534 |   | 5.52 | % | 74,223 |   | 4,318 |   | 5.82 | % |
| Securities sold  under agreement to repurchase    |   | 17,096               |    | 240          |   | 1.40             | %      | 16,453 |   | 529 |   | 3.22 | % | 13,055 |   | 612 |   | 4.69 | % |
| Short-term  borrowings                            |   | 3,822                |    | 65           |   | 1.70             | %      | 4,220 |   | 186 |   | 4.41 | % | 2,989 |   | 188 |   | 6.29 | % |
| Long-term  borrowings                             |   | 9,933                |    | 532          |   | 5.36             | %      | 8,302 |   | 489 |   | 5.89 | % | 2,938 |   | 192 |   | 6.54 | % |
| Total  interest-bearing liabilities               |   | 221,503              |    | 5,844        |   | 2.64             | %      | 197,731 |   | 7,960 |   | 4.03 | % | 173,383 |   | 8,177 |   | 4.72 | % |
| Other  liabilities                                |   | 38,965               |    |         |   |             |   | 35,000 |   |   |   |   |   | 31,080 |   |   |   |   |   |
| Shareholders’  equity                        |   | 27,601               |    |         |   |             |   | 24,695 |   |   |   |   |   | 21,942 |   |   |   |   |   |
| Total  liabilities and shareholders’ equity  |   | $                    | 288,069 |         |   |             |   |   | $ | 257,426 |   |   |   |   |   | $ | 226,405 |   |   |   |   |   |
| Net interest  income                              |   |                 |    | $            | 12,515 |             |   |   |   |   | $ | 11,582 |   |   |   |   |   | $ | 10,057 |   |   |   |
| Net interest  rate spread                         |   |                 |    |         |   | 4.15             | %      |   |   |   |   | 4.08 | % |   |   |   |   | 3.91 | % |
| Net interest  margin                              |   |                 |    |         |   | 4.63             | %      |   |   |   |   | 4.81 | % |   |   |   |   | 4.76 | % |

 

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(1) Loans include portfolio loans, loans held for sale andnonperforming loans, but unpaid interest on nonperforming loans has not beenincluded for purposes of determining interest income.

 

*ANALYSISOF CHANGES IN NET INTEREST INCOME*

 

The following table presents the changes in interest income and expenseattributable to changes in interest rates, changes in volume and changes inrate/volume for interest-earning assets and interest-bearing liabilities.  Tax-exempt income is calculated on atax-equivalent basis assuming a federal tax rate of 34%.  Accordingly, interest income calculated in accordance with generallyaccepted accounting principles has been increased by $52,000 in 2002 and$40,000 in 2001 to reflect the tax equivalent amount.

 
| **Year Ended December 31,**                     |   | **2002**                                   |   | **2001**                                   |   |
|-------------------------------------------------|--------|--------------------------------------------|--------|--------------------------------------------|--------|
| **(In Thousands)**                              |   | **Increase  (Decrease) Due to Change in:** |   | **Increase  (Decrease) Due to Change in:** |   |
|                                            |   | **Volume**                                 |   | **Rate**                                   |   | **Rate/  Volume** |   | **Total** |   | **Volume** |   | **Rate** |   | **Rate/  Volume** |   | **Total** |   |
| Interest-earning  assets:                       |   |                                       |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans                                           |   | $                                          | 2,395  |                                       | $      | (2,749 | ) | $ | (418 | ) | $ | (772 | ) | $ | 2,131 |   | $ | (967 | ) | $ | (141 | ) | $ | 1,023 |   |
| Investment  securities                          |   | 188                                        |   | (550                                       | )      | (27 | ) | (389 | ) | 512 |   | (121 | ) | (18 | ) | 373 |   |
| Other earning  assets                           |   | (20                                        | )      | (15                                        | )      | 13 |   | (22 | ) | (66 | ) | (55 | ) | 33 |   | (88 | ) |
| Total interest  income                          |   | 2,563                                      |   | (3,314                                     | )      | (432 | ) | (1,183 | ) | 2,577 |   | (1,143 | ) | (126 | ) | 1,308 |   |
|                                            |   |                                       |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:                  |   |                                       |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings deposits  and interest-bearing checking |   | 428                                        |   | (1,086                                     | )      | (210 | ) | (868 | ) | 229 |   | (810 | ) | (64 | ) | (645 | ) |
| Certificates of  deposit                        |   | 289                                        |   | (1,100                                     | )      | (70 | ) | (881 | ) | 462 |   | (222 | ) | (24 | ) | 216 |   |
| Securities sold  under agreement to repurchase  |   | 21                                         |   | (298                                       | )      | (12 | ) | (289 | ) | 159 |   | (192 | ) | (50 | ) | (83 | ) |
| Short-term borrowings                           |   | (18                                        | )      | (114                                       | )      | 11 |   | (121 | ) | 77 |   | (56 | ) | (23 | ) | (2 | ) |
| Long-term  borrowings                           |   | 96                                         |   | (44                                        | )      | (9 | ) | 43 |   | 351 |   | (19 | ) | (35 | ) | 297 |   |
| Total interest  expense                         |   | 816                                        |   | (2,642                                     | )      | (290 | ) | (2,116 | ) | 1,278 |   | (1,299 | ) | (196 | ) | (217 | ) |
|                                            |   |                                       |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Change in net  interest income                  |   | $                                          | 1,747  |                                       | $      | (672 | ) | $ | (142 | ) | $ | 933 |   | $ | 1,299 |   | $ | 156 |   | $ | 70 |   | $ | 1,525 |   |

 

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Management believes the allowance for loan losses is acritical accounting policy that requires the most significant estimates andassumptions used in the preparation of the consolidated financial statements.The allowance for loan losses is based on management’s evaluation of the levelof the allowance required in relation to the estimated loss exposure in theloan portfolio. Management believes the allowance for loan losses is asignificant estimate and therefore regularly evaluates it for adequacy bytaking into consideration factors such as prior loan loss experience, thecharacter and size of the loan portfolio, business and economic conditions andmanagement’s estimation of probable losses. The use of different estimates orassumptions could produce different provisions for loan losses.

 

**RESULTS OF OPERATIONS**

*Overview*

The Company ended2002 with consolidated assets of $307.3 million representing growth of $29.1million or 10%.  Asset growth wasattributable to strong loan demand in both the commercial and residential mortgageareas.  The Company reported net incomeof $3.8 million or $1.31 per basic share and $1.18 per diluted share in 2002,as compared to $3.3 million or $1.16 per basic share and $1.01 per dilutedshare in 2001.  This representedearnings growth of $591,000 or 18%. Return on average assets increased to 1.33% in 2002 compared to 1.26% in2001, and return on average equity increased to 13.93% in 2002 from 13.18% in2001.

 

*Net Interest Income*

The Company’sprimary source of operating income is net interest income.  Net interest income on a taxable equivalentbasis was $12.5 million for 2002 and $11.6 million for 2001.  Net interest income is the differencebetween the income earned on earning assets and the interest paid oninterest-bearing liabilities.  Both netinterest income and the net interest margin, which is net interest income expressedas a percentage of average earning assets, are affected by the volume and mixof earning assets and interest-bearing liabilities and the interest ratesearned or paid on them.

Net interestincome increased by $933,000 or 8%, on a taxable equivalent basis, in 2002 comparedto 2001.  This increase was due togrowth in the loan portfolio which was reduced by a decline in the Company’snet interest margin to 4.63% for 2002 compared to 4.81% for 2001.  The Federal Reserve reduced the FederalFunds rate twelve times in the past two years for a total reduction of5.25%.   The Federal Funds rate, as setby the Federal Reserve, averaged 1.67% in 2002 and 3.90% in 2001.

Interest income ona taxable equivalent basis was $18.4 million in 2002, a 6% decrease from2001.  The decrease was driven by a declinein the yield on average earning assets to 6.79% in 2002 from 8.11% in 2001which was offset by growth in the average earning assets of $29.3 million or12%.

Interest expensedecreased to $5.8 million in 2002 from $8.0 million in 2001, representing a 27%decrease.  This decrease was a result ofa decline in the cost of funds to 2.64% in 2002 from 4.03% in 2001 which wasoffset by growth in average interest-bearing liabilities of $23.8 million or12%.

Managementcurrently anticipates that net interest income will continue to increase in2003 due to expected growth in earning assets (primarily loans), although acontinued decline in the net interest margin is expected due to industry-widepricing pressure on loans and deposits and the Federal Funds rate remaining athistorically low levels (currently 1.25%).

 

*Non-Interest Income*

Non-interestincome was $4.0 million for 2002 compared to $3.3 million for 2001.  The $664,000 or 20% increase was primarilydriven by the increase in gain on mortgage loan sales of $475,000 in 2002.  The Company experienced growth in most feeincome categories with increases in ATM fees of 35%, service charges onbusiness accounts of 31%, and overdraft fees of 38%.  A decline in merchant processing fees of $133,000 or 25% is theresult of the Company exiting this line of business.

Gain on the saleof mortgage loans increased to $796,000 for 2002 compared to $321,000 for 2001due to the record level mortgage refinances resulting from the favorableinterest rate environment nationally. The Company’s portfolio of residential mortgages serviced for secondarymarket investors at December 31, 2002 of $95.1 million increased by $16.0 million,or 20%, from December 31, 2001.

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Trust feesincreased 6% to $1.1 million in 2002. The market value of client assets under administration increased $2.4million to $237.2 million at December 31, 2002 compared with trust assets of$234.8 million at December 31, 2001. The increase in trust assets was achievedthrough new business development as market conditions remained volatile duringthe year.

The generation ofmortgage sale gains and trust fees is dependent on the market and economic conditionsand, as a result, there can be no assurance that income levels reported inprior periods can be achieved in the future.

** **

*Non-Interest Expense*

Non-interestexpense was $10.2 million for 2002 compared to $9.5 million in 2001.  The $737,000 or 8% increase was primarilyrelated to the increase in salaries and employee benefits of $452,000 and theincrease in other expenses of $146,000. The Company’s efficiency ratio (non-interest expense divided by the sumof net interest income and other income) improved to 62.1% for 2002 compared to63.8% for 2001.

Salaries andemployee benefits expense increased 9% to $5.5 million for 2002.  The 2002 increase was a result of normalannual salary increases and additional staffing required as a result of assetgrowth and market expansion.  Othernon-interest expense increased 6% for 2002 reflecting increases in professional fees and marketing expenses related to a newretail banking initiative which was offset by a decline in merchant processingexpense of $132,000 related to the Company exiting this line of business.

Annual operatingexpenses are also expected to increase in future periods due to future branching,product expansion and the new retail banking marketing program.

** **

**BALANCE SHEET REVIEW**

*Loans*

The Bank offers abroad range of personal and business loan products.  Total loans (which excludes loans held for sale) of $214.7million grew $26.6 million or 14% from December 31, 2001.  Real estate lending was strong in 2002 withresidential mortgages increasing 15% to $40.4 million and construction lendingdoubling to $13.4 million at December 31, 2002.  Commercial loan balances increased 26% in 2002 to $55.0 millionwhile consumer and home equity loans increased 7% to $35.8 million at year-end.

The average yield on loans decreased to 7.39% in 2002 from 8.96% in2001.  This decrease is the result oflower interest rates in 2002 (the prime rate average was 4.67% for 2002 and6.91% for 2001).  Managementanticipates pressure on yields on loans due to sustained lower interest ratesin 2003 and increased competition from banks and non-traditional creditproviders.

 

*Investment Securities*

The investment portfolio provides liquidity,diversification and investment income to the Company.  The investment portfolio represents 22% of the Company’s totalassets.  The portfolio is comprisedprimarily of U.S. Government agencies and collateralized mortgageobligations.  Substantially all of theCompany’s securities are AAA or equivalently rated.  Total investment securities decreased in 2002 by $2.7 million or4% to $68.9 million at December 31, 2002. Mortgage-backed securities and collateralized mortgage obligationsrepresent 49% of the investment portfolio while U.S. Government agencysecurities and money market funds represent 35%.  The average yield on the investment portfolio decreased to 5.01%in 2002 compared to 5.87% in 2001 as a result of maturing investments being reinvestedat lower interest rates.

 

*Deposits*

Deposits are the major source of the Company’s fundsfor lending, investing and other general business purposes.  Deposits are attracted principally fromwithin the Company’s primary market area through the offering of a broadvariety of deposit products, including checking accounts, money marketaccounts, savings accounts, certificates of deposit (including jumbo certificatesin denominations of $100,000 or more) and retirement savings plans.  In addition, the Company uses depositsobtained through investment banking firms which obtain funds from theircustomers for deposit with the Company (“brokered deposits”).

In 2002, total deposits increased by $19.5 million to$238.9 million, a 9% increase over 2001. Comparing year-end

 

9

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balances at 2002 to 2001, checking accounts increased 4%, money marketaccounts grew 23% and savings accounts increased 6%. Core deposits haveincreased from a year ago as customers remain hesitant to invest their fundslong-term in the current interest rate environment.  Certificate of deposit (CD) balances increased $8.2 million dueto $14.5 million growth in brokered CD’s which was offset by a decline inretail CD’s of $6.3 million.

Due to the low interest rate environment, the averageyield on savings deposits and interest-bearing checking accounts decreased to1.31% in 2002 from 2.57% in 2001 and the average yield on certificates ofdeposit decreased to 4.18% in 2002 from 5.52% in 2001.

The Company’s focus on quality customer servicecontributed to the deposit growth in 2002. In addition, in October we launcheda new retail banking initiative, High Performance Checking, with the goal ofgenerating significant deposit growth and associated fee income.  The program includes seven new checkingaccounts, direct mail advertising, Tell-A-Friend referrals and an attractiveselection of premium gifts.  The Companycontinues to develop consumer and commercial deposit relationships throughreferrals and additional contacts within its market area.

 

*Borrowings*

Borrowings supplement deposits as a source ofliquidity.  Borrowed funds consistmainly of securities sold under agreement to repurchase and advances from theFederal Home Loan Bank (FHLB). Total borrowings were $36.9 million at December31, 2002 compared to $29.8 million at December 31, 2001, an increase of $7.1million.  Other short-term borrowingsinclude federal funds purchased, commercial lines of credit, Treasury, tax andloan deposits and interest-bearing demand notes due to the U.S. Treasury.

 

**ASSET QUALITY**

 

Management seeks to maintain a high quality of assetsthrough prudent underwriting and sound lending practices. Approximately 25% ofthe Company’s loan portfolio is collateralized by first liens on primarilyowner-occupied residential homes which have historically carried a relativelylow credit risk.  The Bank alsomaintains a commercial real estate portfolio comprised primarily ofowner-occupied commercial businesses.

The Bank participates in government guaranteed loanprograms including the Small Business Administration (“SBA”), Rural Development(“RD”) and the Finance Authority of Maine (“FAME”). At December 31, 2002, loansunder these programs totaled $13.3 million of which $9.8 million, or 5% of thetotal loan portfolio outstanding, is guaranteed by the various federal andstate government entities.

The Bank continues to focus on asset quality issuesand emphasizes loan review and underwriting procedures.  The Bank utilizes the services of aconsultant, M&M Consulting, LLC (a joint venture owned 50% by the Bank), toperform periodic loan and documentation review. Management has established arisk rating and review process with the objective of quickly identifying,evaluating and initiating necessary corrective action for all commercial andcommercial real estate loans. The goal of the risk rating process is to addressthe watch list, substandard and non-performing loans, as early as possible.These components of risk management are integral elements of the Bank’s loanprogram which have contributed to the loan portfolio performance to date.Nonetheless, management maintains a cautious outlook in attempting toanticipate the potential effects of uncertain economic conditions (both locallyand nationally).

 

*Nonperforming Assets*

Nonperforming assets consist of non-accrual loans,other loans past due over 90 days and other real estate owned.  Total nonperforming assets as a percentageof total assets remained consistent at .25% or $766,000 at December 31, 2002,compared to .26% or $728,000 at December 31, 2001.

Loans are placed on non-accrual status when, in thejudgment of management, principal repayment is doubtful, whether current orpast due. When a loan is placed on non-accrual status, previously accrued butunpaid interest is deducted from interest income. As a matter of policy,interest is generally not accrued on loans past due 90 days or more. The Bankdoes not return a loan to accrual status until it is brought current withrespect to both principal and interest, future payments are no longer in doubt,and the loan has been performing for at least six consecutive months.

 

10

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*Provision and Allowance for LoanLosses*

The provision for loan losses is a result ofmanagement’s periodic analysis of the adequacy of the allowance for loanlosses.  The provision for loan losseswas $453,000 for 2002 and $474,000 for 2001, a decrease of $21,000 or 4%.  The allowance for loan losses represented1.53% of loans outstanding at December 31, 2002, compared to 1.59% at December31, 2001.  Net charge-offs were $144,000during 2002 or .07% of average loans outstanding, compared to $146,000 in 2001or .08%.  The portion of the allowancefor loan losses allocated to commercial and commercial real estate loansincreased in 2002 due to growth in the loan balances combined with anenhancement to the risk rating system. The risk rating system was expanded from seven to eight ratings based onthe changing characteristics of the loan portfolio and improved classificationof loans classified as “watch”.  The lowlevel of net loan charge-offs is indicative of the Company’s loan quality andcredit administration standards and the generally stable economic environmentexisting in the Company’s primary market area.

The allowance for loan losses is maintained at a leveldetermined to be adequate by management to absorb future charge-offs of loansdeemed uncollectible.  This allowance isincreased by provisions charged to operating expense and by recoveries on loanspreviously charged off.  A high degreeof judgment is necessary to determine the appropriate level of allowance forloan losses and requires management’s ongoing evaluation of adequacy.  The adequacy of the loan loss allowance isdetermined by use of a risk rating system. The evaluation process includes, among other things, industry standards,management’s experience, the Bank’s historical loan loss experience, evaluationof economic conditions and regular reviews of delinquencies and loan portfolioquality.  Although management believesit uses the best information available to make determinations with respect tothe allowance for loan losses, future adjustments may be necessary if economicconditions differ from the economic conditions in the assumptions used inmaking the final determinations.

Future provisions for loan losses depend on suchfactors as asset quality, net loan charge-offs, loan growth and other criteriadiscussed above.  The appropriate levelof the allowance for loan losses and the corresponding provision will continueto be determined quarterly.  Managementanticipates that there will be a provision for loan losses in 2003; however,the specific amount cannot be determined at this time.  Changes in circumstances affecting thevarious factors of the Company’s methodology will determine the provisionamount in 2003.

 

**ASSET/LIABILITY MANAGEMENT**

*Market Risk*

Market risk is the risk of loss in a financialinstrument arising from adverse changes in market rates/prices, such asinterest rates, foreign currency exchange rates, commodity prices and equityprices. The Company’s primary market risk exposure is interest rate risk. Theongoing monitoring and management of this risk is an important component of theCompany’s asset/liability management process which is governed by policiesestablished by the Board of Directors that are reviewed and approved annually.

The Board of Directors delegates responsibility forcarrying out the asset/liability management policies to its Asset/LiabilityCommittee (ALCO).  In this capacity,ALCO develops guidelines and strategies impacting the Company’s asset/liabilitymanagement activities based upon estimated market risk sensitivity, policylimits and overall market interest rate levels/trends.

 

*Interest Rate Risk*

Interest rate riskrepresents the sensitivity of earnings to changes in market interest rates. Asinterest rates change, the interest income and expense streams associated withthe Company’s financial instruments also change, thereby impacting net interestincome (“NII”), the primary component of the Company’s earnings. ALCO utilizesthe results of a detailed and dynamic simulation model to quantify theestimated exposure of NII to sustained interest rate changes. While ALCOroutinely monitors simulated NII sensitivity over a rolling two-year horizon,it also utilizes additional tools to monitor potential longer-term interestrate risk.

 

The simulation model captures the impact of changinginterest rates on the interest income earned and interest

 

11

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expense incurred on all interest-earning assets and interest-bearing liabilitiesreflected in the Company’s statement of financial condition. This sensitivityanalysis is compared to ALCO policy limits which specify a maximum tolerancelevel for NII exposure over a one-year horizon, assuming no asset growth, givena 200 basis point (bp) upward and a 100 bp downward shift in interest rates. Aparallel and pro rata shift in rates over a 12-month period is assumed. Thefollowing reflects the Company’s NII sensitivity analysis as measured duringthe fourth quarter of 2002.

 

| **Rate Change** |   | **Estimated  Change in NII** |   |
|-----------------|--------|------------------------------|--------|
| +200bp          |   | 3.8                          | %      |
| - 100bp         |   | -3.9                         | %      |

 

The preceding sensitivity analysis does not representa Company forecast and should not be relied upon as being indicative ofexpected operating results. These hypothetical estimates are based upon numerousassumptions including, among others, the nature and timing of interest ratelevels, yield curve shape, prepayments on loans and securities, deposit decayrates, pricing decisions on loans and deposits, and reinvestment/replacement ofasset and liability cash flows. While assumptions are developed based uponcurrent economic and local market conditions, the Company cannot make anyassurances as to the predictive nature of these assumptions, including howcustomer preferences or competitor influences might change.

 

*Liquidity*

Liquidity represents the ability to meet both assetgrowth and deposit withdrawals.  Manyfactors affect a company’s ability to meet liquidity needs, including changesin the markets served, its asset-liability mix, its reputation and creditstanding in the market and general economic conditions.  In addition to traditional in-market depositsources, the Company has other sources of liquidity, including proceeds frommaturing investment securities and loans, the sale of investment securities,Federal Funds through correspondent bank relationships, brokered deposits andFHLB borrowings.  Additional liquidityis available in the loan portfolio through sale of residential mortgages andthe guaranteed portion of SBA loans.   Managementbelieves that the current level of liquidity is sufficient to meet current andfuture funding requirements.

 

**CAPITAL**

At December 31, 2002, shareholders’ equity totaled$28.4 million or 9.2% of total assets, as compared to $26.0 million or 9.3% atDecember 31, 2001.  The net increase inshareholders’ equity was attributable to: net income of $3.8 million; stockoption exercises and the related tax benefit of $957,000; conversion ofmandatory convertible debentures of $300,000, less share repurchases of $1.4million; and $1.2 million in cash dividends.

Capital guidelines issued by the Federal Reserve Boardrequire the Company to maintain certain ratios.  The Company’s risk based capital ratios for Tier 1 and Tier 2Capital (as defined by federal banking agency regulations) at December 31, 2002of 13.10% and 14.35%, respectively, exceed regulatory guidelines for capitaladequacy.  The Company’s Tier 1 and Tier2 risk based capital ratios at December 31, 2001 were 13.69% and 15.11%,respectively.  The Bank is also subjectto federal regulatory capital requirements. At December 31, 2002, the Bank was deemed to be “well capitalized” underthe applicable regulations.

In October 2002, both the mandatory convertibledebentures and convertible cumulative preferred stock were converted to commonstock.  These conversions resulted inadditional capital of $300,000 and the issuance of 305,907 shares of commonstock.

During 2002, theCompany repurchased 91,949 shares of common stock at an average price of$15.32.  In October 2002, the Board ofDirectors approved a third stock repurchase program authorizing the Company torepurchase up to 159,493 shares of the Company’s common stock.  As of December 31, 2002, 11,507 shares hadbeen repurchased under the third repurchase program.  Shares are being repurchased into treasury for the purpose offunding the expected exercise of stock options pursuant to the Company’s stockoption plan and for other corporate purposes.

 

12

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**IMPACT OF NEW ACCOUNTING STANDARDS**

Statement of Financial Accounting Standards (SFAS) No.142, “Goodwill and Other Intangible Assets,” and SFAS No. 144, “Accounting forthe Impairment or Disposal of Long-Lived Assets,” became effective on January1, 2002.  SFAS No. 142 requires thatgoodwill no longer be amortized to earnings, but instead be reviewed forimpairment. The amortization of goodwill ceases upon adoption of the Statementon January 1, 2002.  See Note 1 of theCompany’s Notes to Financial Statements for the effect of the new statement in2002 and pro forma effect for 2001 on page 22. SFAS No. 144 provides guidance concerning the recognition andmeasurement of an impairment loss for certain types of long-lived assets.  These statements are expected to have nomaterial impact on the Company’s consolidated financial condition and resultsof operations.

Statement of Position (SOP) 01-6, “Accounting byCertain Entities (Including Entities with Trade Receivables) That Lend to orFinance the Activities of Others,” was issued in December 2001.  The SOP is effective for financialstatements issued for the fiscal years beginning after December 15, 2001.  The SOP reconciles and conforms theaccounting and financial reporting provisions established by various Audit andAccounting Industry Guides.  Adoption ofthis statement did not affect the Company’s consolidated financial conditionand results of operations.

SFAS No. 148, “Accounting for Stock-BasedCompensation-Transition and Disclosure”, contains enhanced disclosurerequirements for stock-based compensation. Adoption of the Statement in 2002 had no impact on the Company’sconsolidated financial condition and results of operations.

 

**MARKET FOR COMMON STOCK**

Market prices (as quoted by Nasdaq) and cash dividendspaid, per share of the Company’s common stock, by calendar quarter for the pasttwo years are listed below.  Per sharedata information has been adjusted to reflect the 3% stock dividends in both2002 and 2001, respectively.

** **
| **2002 Quarters** |   | **Dividends Declared  Per Share** |       | **Market Prices** |       |
|-------------------|--------|-----------------------------------|------------|-------------------|------------|
| **High**          |   | **Low**                           |
| **Fourth**        |   | **$**                             | **0.11**   | ** **        | **$**      | **16.07** | ** ** | **$** | **15.45** | ** ** |
| **Third**         |   | **0.10**                          | ** ** | **16.25**         | ** ** | **15.01** | ** ** |
| **Second**        |   | **0.10**                          | ** ** | **16.14**         | ** ** | **14.25** | ** ** |
| **First**         |   | **0.09**                          | ** ** | **14.70**         | ** ** | **10.97** | ** ** |
|                   |        |                                   |            |                   |            |  |  |  |  |  |

 
| **2001 Quarters** |   | **Dividends Declared  Per Share** |   | **Market Prices** |   |
|-------------------|--------|-----------------------------------|--------|-------------------|--------|
| **High**          |   | **Low**                           |
| Fourth            |   | $                                 | 0.09   |              | $      | 11.17 |   | $ | 10.12 |   |
| Third             |   | 0.08                              |   | 10.83             |   | 9.71 |   |
| Second            |   | 0.07                              |   | 10.68             |   | 10.08 |   |
| First             |   | 0.06                              |   | 10.84             |   | 8.96 |   |
|                   |        |                                   |        |                   |        |  |  |  |  |  |

 

As of December 31, 2002, the Company had approximately1,000 shareholders of record and 3,116,263 shares outstanding.

There are regulatory limitations on the Company’sability to pay dividends depending on the dividends it receives from itssubsidiary, Merrill Merchants Bank, which are subject to regulations and theBank’s continued compliance with all regulatory capital requirements and theoverall health of the institution.  Seenotes 14 and 17 of the notes to the consolidated financial statements for adiscussion of the Company’s capital and the Bank’s regulatory matters,respectively.

 

13

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**INDEPENDENT AUDITORS’ REPORT**

 

To the Board of Directorsand Shareholders

Merrill MerchantsBancshares, Inc.

 

We have auditedthe accompanying consolidated statements of financial condition of Merrill MerchantsBancshares, Inc. and Subsidiaries as of December 31, 2002 and 2001, and therelated consolidated statements of income, changes in shareholders’ equity andcash flows for the years then ended. These consolidated financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated financial statements based on our audits.

 

We conducted ouraudits in accordance with U.S. generally accepted auditing standards.  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the consolidated financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonablebasis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in all materialrespects, the consolidated financial position of Merrill Merchants Bancshares,Inc. and Subsidiaries at December  31, 2002 and 2001 and the consolidatedresults of their operations and their consolidated cash flows for the yearsthen ended in conformity with U.S. generally accepted accounting principles.

 

 
| /s/Berry, Dunn, McNeil  & Parker |   |
|--------------------------------------|--------|
| BERRY DUNN MCNEIL &  PARKER      |
| Bangor, Maine                        |
| January 10, 2003                     |

 

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**MERRILLMERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF FINANCIAL CONDITION**

**(In Thousands, Except Number of Shares and per Share Data)**

 
|                                                                                                                                                                                |   | **DECEMBER  31,** |       |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|------------|
|                                                                                                                                                                                |   | **2002**          |       | **2001** |   |
| ASSETS                                                                                                                                                                              |   |              |       |   |   |
| Cash and due from banks                                                                                                                                                             |   | $                 | 14,210     |   | $ | 9,789 |   |
| Interest-bearing deposits with banks                                                                                                                                                |   | 57                |       | 55 |   |
| Total cash and cash equivalents                                                                                                                                                     |   | 14,267            |       | 9,844 |   |
| Investment securities – available for sale                                                                                                                                     |   | 68,867            |       | 71,607 |   |
| Loans held for sale                                                                                                                                                                 |   | 1,220             |       | 1,060 |   |
| Loans receivable                                                                                                                                                                    |   | 214,729           |       | 188,080 |   |
| Less allowance for loan losses                                                                                                                                                      |   | 3,295             |       | 2,986 |   |
| Net loans receivable                                                                                                                                                                |   | 211,434           |       | 185,094 |   |
| Other real estate owned                                                                                                                                                             |   | 151               |       | 221 |   |
| Properties and equipment, net                                                                                                                                                       |   | 3,537             |       | 3,674 |   |
| Cash surrender value of life insurance                                                                                                                                              |   | 3,591             |       | 2,900 |   |
| Deferred income tax benefit                                                                                                                                                         |   | 646               |       | 505 |   |
| Accrued income and other assets                                                                                                                                                     |   | 3,603             |       | 3,292 |   |
| Total assets                                                                                                                                                                        |   | $                 | 307,316    |   | $ | 278,197 | ** ** |
|                                                                                                                                                                                |   |              |       |   |   |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                       |   |              | ** ** |   | ** ** |
| Demand deposits                                                                                                                                                                     |   | $                 | 40,951     |   | $ | 39,242 |   |
| Savings and NOW deposits                                                                                                                                                            |   | 106,021           |       | 96,416 |   |
| Certificates of deposit                                                                                                                                                             |   | 91,885            |       | 83,651 |   |
| Total deposits                                                                                                                                                                      |   | 238,857           |       | 219,309 |   |
| Securities sold under agreements to repurchase (term and demand)                                                                                                                    |   | 19,236            |       | 19,138 |   |
| Other borrowed funds                                                                                                                                                                |   | 17,696            |       | 10,654 |   |
| Accrued expenses and other liabilities                                                                                                                                              |   | 3,139             |       | 2,811 |   |
| Mandatory convertible debentures                                                                                                                                                    |   | —            |       | 300 |   |
| Total liabilities                                                                                                                                                                   |   | 278,928           |       | 252,212 |   |
| Commitments (Notes 7, 8, 13, 17 and 18)                                                                                                                                             |   |              |       |   |   |
| Shareholders’ equity                                                                                                                                                           |   |              |       |   |   |
| Convertible cumulative preferred stock, par value $1; authorized  50,000 shares, issued and outstanding 19,566 shares in 2001                                                       |   | —            |       | 20 |   |
| Common stock, $1 par value; 4,000,000 shares authorized; shares  issued 3,194,497 and outstanding 3,116,263 in 2002; and shares issued  2,741,232 and outstanding 2,667,217 in 2001 |   | 3,194             |       | 2,741 |   |
| Capital surplus                                                                                                                                                                     |   | 20,381            |       | 18,794 |   |
| Retained earnings                                                                                                                                                                   |   | 5,498             |       | 4,601 |   |
| Accumulated other comprehensive income                                                                                                                                              |   |              |       |   |   |
| Unrealized gain on securities available for sale, net of tax of $276  and $294 in 2002 and 2001, respectively                                                                       |   | 536               |       | 600 |   |
| Treasury stock, at cost – 78,234 shares in 2002 and 74,015 shares in  2001                                                                                                     |   | (1,221            | )          | (771 | ) |
| Total shareholders’ equity                                                                                                                                                     |   | 28,388            |       | 25,985 |   |
| Total liabilities and shareholders’ equity                                                                                                                                     |   | $                 | 307,316    |   | $ | 278,197 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

15

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** **

**MERRILL MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF INCOME**

 
|                                                            |   | **YEARS  ENDED DECEMBER 31,** |   |
|-----------------------------------------------------------------|--------|-------------------------------|--------|
| **(In Thousands, Except Number of  Shares and per Share Data)** |   | **2002**                      |   | **2001** |   |
| Interest and  dividend income                                   |   |                          |   |   |   |
| Interest and fees on loans                                      |   | $                             | 14,959 |   | $ | 15,731 |   |
| Interest on investment securities                               |   | 3,090                         |   | 3,520 |   |
| Dividends on investment securities                              |   | 257                           |   | 228 |   |
| Interest on federal funds sold                                  |   | 1                             |   | 23 |   |
| Total interest and dividend income                              |   | 18,307                        |   | 19,502 |   |
|                                                            |   |                          |   |   |   |
| Interest expense                                                |   |                          |   |   |   |
| Interest on deposits                                            |   | 5,007                         |   | 6,756 |   |
| Interest on borrowed funds                                      |   | 837                           |   | 1,204 |   |
| Total interest expense                                          |   | 5,844                         |   | 7,960 |   |
| Net interest income                                             |   | 12,463                        |   | 11,542 |   |
|                                                            |   |                          |   |   |   |
| Provision for loan losses                                       |   | 453                           |   | 474 |   |
| Net interest income after provision for loan losses             |   | 12,010                        |   | 11,068 |   |
|                                                            |   |                          |   |   |   |
| Other income                                                    |   |                          |   |   |   |
| Service charges on deposit accounts                             |   | 858                           |   | 691 |   |
| Other service charges and fees                                  |   | 944                           |   | 964 |   |
| Trust fees                                                      |   | 1,075                         |   | 1,010 |   |
| Net gain on sale of mortgage loans                              |   | 796                           |   | 321 |   |
| Net (loss) gain on investment securities                        |   | (30                           | )      | 37 |   |
| Other                                                           |   | 320                           |   | 276 |   |
| Total other income                                              |   | 3,963                         |   | 3,299 |   |
|                                                            |   |                          |   |   |   |
| Other expense                                                   |   |                          |   |   |   |
| Salaries and employee benefits                                  |   | 5,452                         |   | 5,000 |   |
| Occupancy expense                                               |   | 825                           |   | 776 |   |
| Equipment expense                                               |   | 716                           |   | 686 |   |
| Data processing                                                 |   | 558                           |   | 498 |   |
| Other                                                           |   | 2,654                         |   | 2,508 |   |
|                                                            |   |                          |   |   |   |
| Total other expense                                             |   | 10,205                        |   | 9,468 |   |
|                                                            |   |                          |   |   |   |
| Income before income taxes                                      |   | 5,768                         |   | 4,899 |   |
|                                                            |   |                          |   |   |   |
| Income tax expense                                              |   | 1,923                         |   | 1,645 |   |
|                                                            |   |                          |   |   |   |
| Net income                                                      |   | $                             | 3,845  |   | $ | 3,254 |   |
|                                                            |   |                          |   |   |   |
| Per share data                                                  |   |                          |   |   |   |
| Basic earnings per common share                                 |   | $                             | 1.31   |   | $ | 1.16 |   |
| Diluted earnings per common share                               |   | $                             | 1.18   |   | $ | 1.01 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

16

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**MERRILLMERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY**

 

**(InThousands, Except Number of Shares and per Share Data)**

 
|                                                                                                   |   | **Convertible  Cumulative  Preferred  Stock** |   | **Common  Stock** |   | **Capital  Surplus** |    | **Retained  Earnings** |   | **Unrealized  Gain  on Securities  Available  for Sale** |   | **Treasury  Stock** |    | **Total  Shareholders’  Equity** |   |
|--------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------|--------|-------------------|--------|----------------------|---------|------------------------|--------|----------------------------------------------------------|--------|---------------------|---------|---------------------------------------|--------|
| Balance at December 31, 2000                                                                           |   | $                                             | 20     |              | $      | 2,661                |    | $                      | 17,958 |                                                     | $      | 3,436               |    | $                                     | 9      |   | $ | (792 | ) | $ | 23,292 |   |
| Net income                                                                                             |   | —                                        |   | —            |   | —               |    | 3,254                  |   | —                                                   |   | —              |    | 3,254                                 |   |
| Change in unrealized gain on securities available for sale, net of  deferred income taxes of $290      |   | —                                        |   | —            |   | —               |    | —                 |   | 591                                                      |   | —              |    | 591                                   |   |
| Total comprehensive income                                                                             |   | —                                        |   | —            |   | —               |    | 3,254                  |   | 591                                                      |   | —              |    | 3,845                                 |   |
| Common stock options exercised, 45,085 shares                                                          |   | —                                        |   | —            |   | —               |    | (343                   | )      | —                                                   |   | 475                 |    | 132                                   |   |
| 3% common stock dividend declared -                                                                    |   | 80                                            |   | 778               |   | (858                 |  ) | —                 |   | —                                                   |   | —              |    |                                  |   |
| Treasury stock purchased (42,319 shares at an average price of  $10.72)                                |   | —                                        |   | —            |   | —               |    | —                 |   | —                                                   |   | (454                | )       | (454                                  | )      |
| Tax benefit related to exercise of stock options                                                       |   | —                                        |   | —            |   | 58                   |    | —                 |   | —                                                   |   | —              |    | 58                                    |   |
| Common stock cash dividend declared, $.31 per share                                                    |   | —                                        |   | —            |   | —               |    | (826                   | )      | —                                                   |   | —              |    | (826                                  | )      |
| Convertible cumulative preferred stock dividends declared, $3.18 per  share                            |   | —                                        |   | —            |   | —               |    | (62                    | )      | —                                                   |   | —              |    | (62                                   | )      |
| Balance at December 31, 2001                                                                           |   | 20                                            |   | 2,741             |   | 18,794               |    | 4,601                  |   | 600                                                      |   | (771                | )       | 25,985                                |   |
| Net income                                                                                             |   | —                                        |   | —            |   | —               |    | 3,845                  |   | —                                                   |   | —              |    | 3,845                                 |   |
| Change in unrealized gain on securities available for sale, net of  deferred income tax benefit of $18 |   | —                                        |   | —            |   | —               |    | —                 |   | (64                                                      | )      | —              |    | (64                                   | )      |
| Total comprehensive income                                                                             |   | —                                        |   | —            |   | —               |    | 3,845                  |   | (64                                                      | )      | —              |    | 3,781                                 |   |
| Conversion of cumulative preferred stock and mandatory convertible  debentures to common stock         |   | (20                                           | )      | 306               |   | 14                   |    | —                 |   | —                                                   |   | —              |    | 300                                   |   |
| Common stock options exercised, 153,424 shares                                                         |   | —                                        |   | 65                |   | 185                  |    | (519                   | )      | —                                                   |   | 959                 |    | 690                                   |   |
| 3% common stock dividend declared                                                                      |   | 82                                            |   | 1,121             |   | (1,205               | )       | —                 |   | —                                                   |   | (2                  | )  |                                  |   |
| Treasury stock purchased (91,949 shares at an average price of  $15.32)                                |   | —                                        |   | —            |   | —               |    | —                 |   | —                                                   |   | (1,409              | )       | (1,409                                | )      |
| Tax benefit related to exercise of stock options                                                       |   | —                                        |   | —            |   | 267                  |    | —                 |   | —                                                   |   | —              |    | 267                                   |   |
| Common stock cash dividend declared, $.40 per share                                                    |   | —                                        |   | —            |   | —               |    | (1,192                 | )      | —                                                   |   | —              |    | (1,192                                | )      |
| Convertible cumulative preferred stock dividends declared, $1.63 per  share                            |   | —                                        |   | —            |   | —               |    | (32                    | )      | —                                                   |   | —              |    | (32                                   | )      |
| Balance at December 31, 2002                                                                           |   | $                                             | — |              | $      | 3,194                |    | $                      | 20,381 |                                                     | $      | 5,498               |    | $                                     | 536    |   | $ | (1,221 | ) | $ | 28,388 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

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**MERRILLMERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
|                                                                                     |   | **YEARS ENDED DECEMBER 31,** |       |
|------------------------------------------------------------------------------------------|--------|------------------------------|------------|
| **(In Thousands)**                                                                       |   | **2002**                     |       | **2001** |   |
| **Cash flows from operating activities**                                                 |   |                         | ** ** |   | ** ** |
| Net income                                                                               |   | $                            | 3,845      |   | $ | 3,254 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities        |   |                         |       |   |   |
| Depreciation                                                                             |   | 504                          |       | 458 |   |
| Amortization                                                                             |   | 436                          |       | 483 |   |
| Net amortization (accretion) on investment securities                                    |   | 44                           |       | (102 | ) |
| Deferred income taxes                                                                    |   | (113                         | )          | (181 | ) |
| Provision for loan losses                                                                |   | 453                          |       | 474 |   |
| Net gain on sale of mortgage loans, investment securities, and  properties and equipment |   | (332                         | )          | (308 | ) |
| Net change in:                                                                           |   |                         |       |   |   |
| Loans held for sale                                                                      |   | (160                         | )          | (233 | ) |
| Deferred loan fees                                                                       |   | 10                           |       | 66 |   |
| Accrued income and other assets                                                          |   | (342                         | )          | 163 |   |
| Accrued expenses and other liabilities                                                   |   | 328                          |       | 277 |   |
| Net cash provided by operating activities                                                |   | 4,673                        |       | 4,351 |   |
| Cash flows from investing activities                                                     |   |                         |       |   |   |
| Net loans made to customers                                                              |   | (26,944                      | )          | (22,805 | ) |
| Acquisition of properties and equipment and computer software                            |   | (420                         | )          | (571 | ) |
| Purchase of investment securities available for sale                                     |   | (111,316                     | )          | (129,387 | ) |
| Proceeds from sales and maturities of investment securities available  for sale          |   | 113,902                      |       | 118,485 |   |
| Acquisition of life insurance policies                                                   |   | (535                         | )          | — |   |
| Proceeds from sale of other real estate owned                                            |   | 217                          |       | 314 |   |
| Net cash used in investing activities                                                    |   | (25,096                      | )          | (33,964 | **)** |
| **Cash flows from financing activities**                                                 |   |                         | ** ** |   | ** ** |
| Net increase in demand, savings and NOW deposits                                         |   | 11,314                       |       | 14,474 |   |
| Net increase in certificates of deposit                                                  |   | 8,234                        |       | 4,384 |   |
| Net increase in securities sold under agreements to repurchase                           |   | 98                           |       | 4,970 |   |
| Net increase (decrease) in other borrowed funds                                          |   | 8,138                        |       | (2,556 | ) |
| Long-term advances from the Federal Home Loan Bank                                       |   | 3,746                        |       | 8,000 |   |
| Payments of long-term advances                                                           |   | (4,842                       | )          | (698 | ) |
| Dividends paid on convertible cumulative preferred stock and common  stock               |   | (1,123                       | )          | (648 | ) |
| Proceeds from stock issuance                                                             |   | 690                          |       | 132 |   |
| Purchase of treasury stock                                                               |   | (1,409                       | )          | (454 | ) |
| Net cash provided by financing activities                                                |   | 24,846                       |       | 27,604 |   |
| Net increase (decrease) in cash and cash equivalents                                     |   | 4,423                        |       | (2,009 | ) |
| Cash and cash equivalents, beginning of year                                             |   | 9,844                        |       | 11,853 |   |
| Cash and cash equivalents, end of year                                                   |   | $                            | 14,267     |   | $ | 9,844 |   |
|                                                                                     |   |                         | ** ** |   | ** ** |
| **Supplemental disclosures of cash flow information**                                    |   |                         | ** ** |   | ** ** |
| Cash paid for interest                                                                   |   | $                            | 5,823      |   | $ | 8,044 |   |
| Transfers to other real estate owned                                                     |   | 141                          |       | 456 |   |
| Income tax paid                                                                          |   | 1,914                        |       | 1,718 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

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**MERRILLMERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**

**Notes toConsolidated Financial Statements**

**December31, 2002 and 2001**

**(Presentedin Thousands, except Number of Shares and per Share Data)**

 

1.             Summary ofSignificant Accounting Policies

The accounting andreporting policies conform to U.S. generally accepted accounting principles andto general practice within the banking industry.  The following is a summary of the significant accounting andreporting policies.

 

Nature of Business

Merrill MerchantsBancshares, Inc. (Company) is a financial holding company that owns all of thecommon stock of Merrill Merchants Bank (Bank). The Bank operates branches in Bangor (three offices), Brewer, Holden,Milford, Newport, Orono, Orrington, Pittsfield, and Waterville, Maine.

 

The Bank’s lendingactivities are conducted principally in central Maine.  The Bank grants single family andmulti-family residential loans, commercial real estate loans, commercial loans,and a variety of consumer loans.  Inaddition, the Bank grants loans for the construction of residential homes,multi-family properties and commercial real estate properties.  Most loans granted by the Bank are eithercollateralized by real estate or guaranteed by federal and local governmental authorities.  The ability and willingness of the singlefamily residential and consumer borrowers to honor their repayment commitmentsis generally dependent on the level of overall economic activity within theborrowers’ geographic areas and real estate values.  The ability and willingness of commercial real estate, commercialand construction loan borrowers to honor their repayment commitments is generallydependent on the health of the real estate economic sector in the borrowers’geographic areas and the general economy.

 

Maine AcceptanceCorporation (MAC), formerly a separate subsidiary of the Company, was mergedinto the Bank effective March 29, 2002. MAC, located in Bangor, Maine, provides indirect auto and recreationalvehicle lending, as well as other types of loans, including personal unsecured,recreational vehicle, automobile, mobile home, and home equity loans.

 

The Bank is under thesupervision of the Board of Governors of the Federal Reserve System and theMaine Bureau of Banking, and its deposits are insured by the Federal DepositInsurance Corporation (FDIC) to the fullest extent permitted by law.

 

Estimates

The preparation offinancial statements in conformity with U.S. generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

 

Material estimates thatare particularly susceptible to significant change in the near term relate tothe determination of the allowance for loan losses and the valuation of realestate acquired in connection with foreclosures or in satisfaction ofloans.  In connection with thedetermination of the allowance for loan losses and the carrying value of otherreal estate owned, management obtains independent appraisals for significantproperties.

 

Financial StatementPresentation

The accompanyingconsolidated financial statements include the accounts of Merrill MerchantsBancshares, Inc. and its wholly-owned subsidiaries, Merrill Merchants Bank,

 

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a state-chartered bank, and Maine AcceptanceCorporation. All intercompany accounts and transactions have been eliminated inthe consolidated financial statements.

 

Statement of FinancialAccounting Standards (SFAS) No. 131, “Disclosures about Segments of anEnterprise and Related Information,” requires a company to disclose certainincome statement and balance sheet information by operating segment. Since theCompany’s operations include only its banking and financing activities, noadditional disclosure standards are required by the Statement.

 

Investment Securities

Investment debtsecurities are classified as available for sale and are carried at fairvalue.  Unrealized gains and losses onsecurities available for sale, net of income taxes, are recognized as direct increasesor decreases in shareholders’ equity. Market values of securities are obtained from independent marketsources.  Cost of securities sold isrecognized using the specific identification method.

 

Premiums are amortizedand discounts are accreted using methods approximating the interest method.

 

Loans Held for Sale

Residential mortgageloans originated and intended for sale in the secondary market are carried atthe lower of aggregate cost or estimated market value.  Gains or losses on sales of loans are recognizedat the time of sale and are based upon the difference between the selling priceand the carrying amount of loans sold.

 

Other Real Estate Owned

Other real estate owned(OREO) includes real estate and repossessed personal property held for salewhich have been acquired principally through foreclosure or a similarconveyance of title.  Real estate may beconsidered to be in-substance foreclosed and included in OREO prior to theconveyance of title when specific criteria are met.  Both foreclosed and in-substance foreclosed real estate, as wellas repossessed personal property, are carried at the lower of their recordedamounts or fair value less estimated costs of disposal.  Any write-downs at, or prior to, the datesof acquisition are charged to the allowance for loan losses.  Subsequent write-downs are recorded in otherexpense.  Expenses incurred inconnection with holding such assets and gains and losses upon sale are includedin other expense or other income.

 

LoansReceivable

Loans receivable thatmanagement has the intent and ability to hold for the foreseeable future oruntil maturity or pay-off are reported at their outstanding principal adjustedfor any charge-offs, the allowance for loan losses, and any deferred fees orcosts.

 

Interest on loans isaccrued and credited to income based on the principal amount outstand­ing.  The accrual of interest on loans isdiscontinued when, in the opinion of management, there is an indication thatthe borrower may be unable to meet payments as they become due or the loan becomespast due 90 days or more unless the credit is well-secured and in process ofcollection. Upon such discontinuance, all unpaid accrued interest isreversed.  Interest income issubsequently recognized only to the extent cash payments are received.  Loans 30 days or more past due areconsidered delinquent.

 

The Company’s provisionfor loan losses charged to operations is based upon management’s evaluation ofthe loan portfolio. Loans deemed uncollectible are charged to theallowance.  The allowance for loanlosses is maintained at a level that management believes, to the best of itsknowledge, is at a level at each reporting date to cover known and inherentlosses in the loan portfolio that are both probable and reasonablyestimable.  The ongoing evaluationprocess includes a formal analysis of the allowance each quarter, whichconsiders, among other factors, the character and size of the loan portfolio,business and economic conditions, loan growth, delinquency trends, charge-offexperience and other asset quality factors. While management uses available information to recognize losses onloans, future additions to the allowance may be necessary based on changes ineconomic conditions.  In addition,various regulatory agencies, as an integral part of their examination process,periodically review the Company’s

 

20

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allowance for loan losses.  Such agencies may require the Company to recognize adjustments tothe allowance based on their judgments about information available to them atthe time of their examinations.

 

Loans considered to beimpaired are reduced to the present value of expected future cash flows or tothe fair value of collateral. Management takes into consideration impaired loans in determining theappropriate level of allowance for loan losses.

 

Loan Servicing

The cost of mortgageservicing rights is amortized in proportion to, and over the period of, estimatednet servicing revenues.  Impairment ofmortgage servicing rights is assessed based on the fair value of thoserights.  Fair values are estimated usingdiscounted cash flows based on a current market interest rate.  For purposes of measuring impairment, therights are stratified based on loan type, investor type, and interest rate. Theamount of impairment recognized is the amount by which the capitalized mortgageservicing rights for a stratum exceed their fair value.

 

Properties and Equipment

Properties and equipmentare stated at cost, less accumulated depreciation.  The provision for depreciation is computed on the straight-linemethod and by accelerated methods over the estimated useful lives of theassets.

 

Goodwill

Effective January 1,2002, the Company discontinued amortization of goodwill in accordance with SFASNos. 142 and 147. Prior to 2002, goodwill was being amortized using thestraight-line method over seven and fifteen years. In accordance with SFAS No.142, goodwill will be reviewed for impairment on an annual basis and if certainconditions occur.

 

Loan Origination Fees andCosts

Loan origination fees andcertain direct origination costs are capitalized and recognized as an adjustmentof the yield on the related loan.

 

Income Taxes

The Company recordsdeferred tax assets and liabilities for future tax consequences attributable todifferences between the financial statement carrying amounts of assets andliabilities and their respective tax bases. Deferred tax assets and liabilitiesare measured using enacted tax rates expected to apply to taxable income in theyears in which those temporary differences are expected to be recovered orsettled.

 

Off-Balance-SheetFinancial Instruments

In the ordinary course ofbusiness, the Bank has entered into off-balance-sheet financial instrumentsconsisting of commitments to extend credit, letters of credit and unadvancedcommitments under commercial and home equity lines of credit, credit cards, andoverdraft protection accounts.  Such financialinstruments are recorded in the consolidated financial statements when funded.

 

Cash and Cash Equivalents

For the purpose ofpresentation in the consolidated statements of cash flows, cash and cash equivalentsare defined as cash and due from banks and interest-bearing deposits withbanks.

 

EarningsPer Share

The basic earnings pershare computation is based upon the weighted-average number of shares of stockoutstanding during the period. Potential common stock is considered in the calculation ofweighted-average shares outstanding for diluted earnings per share.

 

The Company declared a 3%stock dividend in 2002 and 2001. Earnings and cash dividends per share and weighted-average sharesoutstanding have been retroactively restated to reflect the stock dividends.

 

Stock Options

Under the Employee andDirector Stock Option Plan, the incentive stock option plan (ISO) for officersand employees and the nonstatutory stock option plan (Non-ISO) for directorsprovide for the issuance of up to 741,082 shares of common stock.  The purchase price of the stock covered byeach option shall be its fair market value, which must be equal to at least100% of the book value of common stock, on the date such option isgranted.  Options granted through 1997were subject to an initial vesting period which ended on December 31, 1997, afterwhich options become exercisable until May 26, 2003.  Options granted after 1997 were

 

21

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granted subject to an initial vesting period of one,two or three years, after which options become exercisable until ten years fromthe grant date.

 

The Company accounts forthese options in accordance with Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees.” As the exercise price of each option equals the market price of the Company’sstock on the date of grant, no compensation cost has been recognized for theplan.  Had compensation cost for theplan been determined based on the fair value of the options at the grant datesconsistent with the method described in SFAS No. 123, “Accounting forStock-Based Compensation,” the Company’s 2002 and 2001 net income and earningsper share would have been reduced to the pro forma amounts indicated below.

 
|                                                                                                                                            |   |           |   |      |   | **Earnings  per Share** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------|--------|-----------|--------|-------------------------|--------|
|                                                                                                                                            |   | **Net Income** |   | **Basic** |   | **Diluted**             |   |
|                                                                                                                                            |   | **2002**       |   | **2001**  |   | **2002**                |   | **2001** |   | **2002** |   | **2001** |   |
| **(in  thousands, except for per-share data)**                                                                                                  |   |           |   |      |   |                    |   |   |   |   |   |   |   |
| Net income, as  reported                                                                                                                        |   | $              | 3,845  |      | $      | 3,254                   |   | $ | 1.31 |   | $ | 1.16 |   | $ | 1.18 |   | $ | 1.01 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of deferred income taxes |   | (16            | )      | (25       | )      | —                  |   | (0.01 | ) | (0.01 | ) | (0.01 | ) |
| Pro forma net  income                                                                                                                           |   | $              | 3,829  |      | $      | 3,229                   |   | $ | 1.31 |   | $ | 1.15 |   | $ | 1.17 |   | $ | 1.00 |   |

 

The fair value of eachoption is estimated on the date of grant using the Black-Scholes option-pricingmodel with the following weighted-average assumptions used for all grants in2002 and 2001: dividend yield of 2.56% in 2002 and 2.74% in 2001, risk-freeinterest rate of 4.4% in 2002 and 3.0% in 2001, expected lives of three yearsin 2002 and two years in 2001, and expected volatility of 20% in 2002 and 23%in 2001.

 

Impact of Recently IssuedAccounting Standards

 

Statement of FinancialAccounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets,”and SFAS No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets,” are effective on January 1, 2002. SFAS No. 142 requires that goodwill no longer be amortized to earnings,but instead be reviewed for impairment. The amortization of goodwill ceasedupon adoption of the Statement on January 1, 2002.  SFAS No. 147, “Acquisitions of Certain Financial Institutions,”amends SFAS No. 72, “Accounting for Certain Acquisitions of Banking or ThriftInstitutions,” to exclude from its scope most acquisitions of financialinstitutions.  Such transactions shouldbe accounted for in accordance with SFAS No. 141, “Business Combinations.”  The Company adopted SFAS No. 147 during2002, and ceased amortization of goodwill with a carrying value of $422 as ofJanuary 1, 2002.  The effect of the newstatement on 2002 and pro forma effect for 2001 was as follows:

 
|                                                          |   |           |   |      |   | **Earnings  per Share** |   |
|---------------------------------------------------------------|--------|----------------|--------|-----------|--------|-------------------------|--------|
|                                                          |   | **Net Income** |   | **Basic** |   | **Diluted**             |   |
|                                                          |   | **2002**       |   | **2001**  |   | **2002**                |   | **2001** |   | **2002** |   | **2001** |   |
| **(in  thousands, except for per-share data)**                |   |           |   |      |   |                    |   |   |   |   |   |   |   |
| Net income  before adoption of SFAS No. 147                   |   | $              | 3,793  |      | $      | 3,254                   |   | $ | 1.30 |   | $ | 1.16 |   | $ | 1.16 |   | $ | 1.01 |   |
| Add back  goodwill amortization, net of deferred income taxes |   | 52             |   | —    |   | 0.01                    |   | — |   | 0.02 |   | — |   |
| Net income, as  reported                                      |   | 3,845          |   | 3,254     |   | 1.31                    |   | 1.16 |   | 1.18 |   | 1.01 |   |
| Add back  goodwill amortization, net of deferred income taxes |   | —         |   | 52        |   | —                  |   | 0.02 |   | — |   | 0.02 |   |
| Adjusted net  income                                          |   | $              | 3,845  |      | $      | 3,306                   |   | $ | 1.31 |   | $ | 1.18 |   | $ | 1.18 |   | $ | 1.03 |   |

 

SFAS No. 144 providesguidance concerning the recognition and measurement of an impairment loss forcertain types of long-lived assets. Adoption of this statement had no material impact on the Company’sconsolidated financial condition and results of operations.

 

Statementof Position (SOP) 01-6, “Accounting by Certain Entities (Including Entitieswith Trade Receivables) That Lend to or Finance the Activities of Others,” wasissued in December 2001.  The SOP iseffective for financial statements issued for the fiscal years beginning afterDecember 15, 2001.  The SOP reconcilesand conforms the accounting and financial reporting provisions established byvarious Audit and Accounting Industry Guides. Adoption of this statement did not affect the Company’s consolidatedfinancial condition and results of operations.

 

SFASNo. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure”,contains enhanced disclosure requirements for stock-based compensation.  Adoption of the Statement in 2002 had noimpact on the Company’s consolidated financial condition and results of operations.

 

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2.             Cash and CashEquivalents

The Federal Reserve Boardrequires the Bank to maintain a rolling average compensating balance of $400 inamounts on deposit. The Company maintains its cash in bank deposit accountswhich, at times, may exceed federally insured limits. The Company has notexperienced any losses in such accounts. The Company believes it is not exposedto any significant risk with respect to these accounts.

 

3.             InvestmentSecurities Available for Sale

The amortized cost of investmentsecurities as shown in the consolidated statements of financial condition andtheir approximate fair values at December 31, 2002, and 2001 were as follows:

 
|                                                                |   | **Amortized  Cost** |   | **Unrealized  Gains** |   | **Unrealized  Losses** |   | **Fair  Value** |   |
|---------------------------------------------------------------------|--------|---------------------|--------|-----------------------|--------|------------------------|--------|-----------------|--------|
| December 31,  2002                                                  |   |                |   |                  |   |                   |   |            |   |
| Mortgage-backed  securities and collateralized mortgage obligations |   | $                   | 33,134 |                  | $      | 533                    |   | $               | (7     | ) | $ | 33,660 |   |
| U.S. Government  agencies and corporations                          |   | 11,520              |   | 230                   |   | —                 |   | 11,750          |   |
| U.S. Government  and agency money market funds                      |   | 11,935              |   | —                |   | —                 |   | 11,935          |   |
| Certificates of  deposit                                            |   | 4,158               |   | —                |   | —                 |   | 4,158           |   |
| State and local  government debt securities                         |   | 2,925               |   | —                |   | —                 |   | 2,925           |   |
| Other securities                                                    |   | 4,382               |   | 93                    |   | (36                    | )      | 4,439           |   |
|                                                                |   | $                   | 68,054 |                  | $      | 856                    |   | $               | (43    | ) | $ | 68,867 |   |

 
|                                                                |   | **Amortized  Cost** |   | **Unrealized  Gains** |   | **Unrealized  Losses** |   | **Fair  Value** |   |
|---------------------------------------------------------------------|--------|---------------------|--------|-----------------------|--------|------------------------|--------|-----------------|--------|
| December 31,  2001                                                  |   |                |   |                  |   |                   |   |            |   |
| Mortgage-backed  securities and collateralized mortgage obligations |   | $                   | 38,123 |                  | $      | 733                    |   | $               | (172   | ) | $ | 38,684 |   |
| U.S. Government  agencies and corporations                          |   | 17,050              |   | 366                   |   | (40                    | )      | 17,376          |   |
| U.S. Government  and agency money market funds                      |   | 3,130               |   | —                |   | —                 |   | 3,130           |   |
| Certificates of  deposit                                            |   | 4,457               |   | —                |   | —                 |   | 4,457           |   |
| State and local  government debt securities                         |   | 5,254               |   | —                |   | —                 |   | 5,254           |   |
| U.S. Treasury  securities                                           |   | 1,000               |   | 30                    |   | —                 |   | 1,030           |   |
| Other securities                                                    |   | 1,699               |   | —                |   | (23                    | )      | 1,676           |   |
|                                                                |   | $                   | 70,713 |                  | $      | 1,129                  |   | $               | (235   | ) | $ | 71,607 |   |

 

At December 31, 2002 and2001, investment securities with amortized cost of $34,081 and $33,848 and fairvalue of $34,652 and $34,727, respectively, were pledged to secure public deposits,Treasury, tax and loan deposits, securities sold under agreements to repurchaseand borrowings and for other purposes required or permitted by law.

 

The amortized cost andfair value of debt securities at December 31, 2002 by contractual maturity areshown below.  Expected maturities maydiffer from contractual maturities because borrowers may have the right to callor prepay obligations with or without call or prepayment penalties.

 
|                        |   | **Amortized  Cost** |   | **Fair  Value** |   |
|-----------------------------|--------|---------------------|--------|-----------------|--------|
|                        |   |                |   |            |   |
| Due in one year  or less    |   | $                   | 6,634  |            | $      | 6,662 |   |
| Due from one to  five years |   | 11,140              |   | 11,362          |   |
| Due from five to  ten years |   | 13,713              |   | 13,920          |   |
| Due after ten  years        |   | 20,250              |   | 20,549          |   |
|                        |   | $                   | 51,737 |            | $      | 52,493 |   |

 

Mortgage-backedsecurities and collateralized mortgage obligations are allocated among the abovematurity groupings based on their final maturity dates.

 

During 2002 and 2001, theCompany sold investment securities available for sale for total proceeds of$82,055 and $92,402, respectively. The sales resulted in gross realized lossesof $30 for 2002 and gross realized gains of $37 for 2001.

 

4.             Loans Receivable

The components of loansreceivable were as follows:

 
|                     |   | **2002** |    | **2001** |   |
|--------------------------|--------|----------|---------|----------|--------|
| Commercial               |   | $        | 55,024  |     | $      | 43,533 |   |
| Commercial real  estate  |   | 70,247   |    | 69,303   |   |
| Construction             |   | 13,379   |    | 6,678    |   |
| Residential real  estate |   | 40,362   |    | 35,040   |   |
| Home equity              |   | 19,889   |    | 17,675   |   |
| Consumer                 |   | 15,932   |    | 15,945   |   |
| Less deferred  loan fees |   | (104     | )       | (94      | )      |
| Total                    |   | $        | 214,729 |     | $      | 188,080 |   |

 

23

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As of December 31, 2002and 2001, nonaccrual loans were $432 for each year.  Interest foregone was $36 for 2002 and $30 for 2001.  Accruing loans which are 90 days past due ormore totaled $169 and $75 at December 31, 2002 and 2001, respectively.

 

Impaired loans recordedin conformity with SFAS No. 114, as amended by SFAS No. 118, totaled $333 and$420 at December 31, 2002, and 2001, respectively.  The total allowance for loan losses related to these loans was$33 and $189 at December 31, 2002, and 2001, respectively. The average balanceof outstanding impaired loans was $272 and $460 for 2002 and 2001,respectively.  Interest incomerecognized for cash payments on impaired loans during 2002 and 2001 was notmaterial to the consolidated financial statements.

 

5.             Allowance forLoan Losses

An analysis of theallowance for loan losses at December 31, 2002, and 2001 is as follows:

 
|                          |                                | **2002** |   | **2001** |   |
|-------------------------------|-------------------------------------|----------|--------|----------|--------|
| Balance at  beginning of year |                                | $        | 2,986  |     | $      | 2,658 |   |
| Add:                          | Provision for  loan losses          |     | 453    |     | 474    |   |
|                          | Recoveries of  previous charge-offs |     | 45     |     | 38     |   |
| Less:  Loans charged off |                                | (189     | )      | (184     | )      |
| Balance at end  of year       |                                | $        | 3,295  |     | $      | 2,986 |   |

 

6.             MortgageServicing

The Bank servicesresidential mortgage loans sold to investors under nonrecourse agreementsamounting to $95,095 and $79,073 at December 31, 2002, and 2001, respectively.  Mortgage servicing rights of $423 and $340are capitalized and recorded at their estimated fair value at December 31,2002, and 2001, respectively and are included in other assets.  Mortgage servicing rights of $361 and $270were capitalized in 2002 and 2001, respectively and amortization of mortgageservicing rights was $278 in 2002 and $243 in 2001.

 

7.             Properties andEquipment

Properties and equipmentare comprised of the following:

 
|                           |   | **2002** |   | **2001** |   |
|--------------------------------|--------|----------|--------|----------|--------|
| Land and land  improvements    |   | $        | 559    |     | $      | 559 |   |
| Bank premises                  |   | 2,332    |   | 2,327    |   |
| Furniture and  equipment       |   | 2,985    |   | 2,796    |   |
| Leasehold  improvements        |   | 320      |   | 308      |   |
| Total cost                     |   | 6,196    |   | 5,990    |   |
| Less accumulated  depreciation |   | 2,659    |   | 2,316    |   |
| Net properties  and equipment  |   | $        | 3,537  |     | $      | 3,674 |   |

 

Certain Bank facilitiesand equipment are leased under various operating leases.  Rental expense was approximately $309 for2002 and $289 for 2001.   Future minimumrental commitments under noncancelable leases at December 31, 2002 are:

 

| 2003  |   | $   | 285    |   |
|-------|--------|-----|--------|--------|
| 2004  |   | 258 |   |
| 2005  |   | 154 |   |
| 2006  |   | 137 |   |
| 2007  |   | 111 |   |
| Total |   | $   | 945    |   |

 

8.             Employee BenefitPlans

The Company hasestablished a defined contribution pension plan under Section 401(k) of the InternalRevenue Code.  Plan participants, whoconsist of all employees meeting minimum age and service requirements who electto participate, are permitted to contribute a percentage of their wages to theplan on a pre-tax basis.  The Companymatches a portion of each employee’s contribution, resulting in an expense of$101 and $90 for 2002 and 2001, respectively.

 

In 1997, the Companyadopted a nonqualified supplemental executive retirement plan for the benefitof key employees.  The plan wasrestructured and amended in 2000.  Lifeinsurance policies were acquired to generate income to offset the cost of theplan.  During 2002, additional life insurancepolicies acquired totaled $535.  Theamount of each annual benefit is indexed to the financial performance of eachinsurance policy owned by the Bank over the Bank’s cost of funds expense. Thepresent value of these benefits is being expensed over the employment serviceperiod which amounted to $127 for 2002 and $132 for 2001. The cash value ofthese policies was $3,591 and $2,900 at December 31, 2002, and 2001, respectively.

 

24

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9.             Deposits

The aggregate amount ofcertificates of deposit with a minimum denomination of $100 was $37,643 and$29,409 at December 31, 2002, and 2001, respectively.  Certificates of deposit included brokereddeposits in the amount of $20,831 and $6,302 at December 31, 2002 and 2001,respectively.

 

At December 31, 2002, thescheduled maturities of certificates of deposit are as follows:

 

| 2003       |   | $      | 40,513 |   |
|------------|--------|--------|--------|--------|
| 2004       |   | 18,583 |   |
| 2005       |   | 13,448 |   |
| 2006       |   | 10,025 |   |
| 2007       |   | 8,861  |   |
| Thereafter |   | 455    |   |
|       |   | $      | 91,885 |   |

 

10.           Borrowed Funds

Securities sold underagreements to repurchase generally mature within one to four days from thetransaction date.  Other borrowed fundsconsist of Federal Home Loan Bank (FHLB) advances, commercial bank line ofcredit advances and Treasury, tax and loan deposits.  Treasury, tax and loan deposits are repaid upon notification bythe U.S. Treasury.

 

Information concerningsecurities sold under agreements to repurchase is summarized as follows:

 
|                                       |   | **2002** |   | **2001** |   |
|--------------------------------------------|--------|----------|--------|----------|--------|
| Average balance  during the year           |   | $        | 17,096 |     | $      | 16,453 |   |
| Maximum  month-end balance during the year |   | 19,428   |   | 23,539   |   |
| Average interest  rate during the year     |   | 1.40     | %      | 3.21     | %      |
| Average interest  rate at end of the year  |   | 1.07     | %      | 1.59     | %      |
|                                            |        |          |        |          |        |  |  |

 

The Bank is required toown stock of the FHLB in order to borrow from the FHLB.  FHLB advances are collateralized by a pledgeof certain mortgage loans and by a lien on the Bank’s FHLB stock of $1,022 atDecember 31, 2002, which is included in investment securities available for salein the consolidated statements of financial condition.  The Company, through its banking subsidiary,has an available line of credit with the FHLB of $3,509.

 

At December 31, 2002, theCompany had a $5 million commercial bank line of credit that expires in2003.  The floating rate note is basedon the one month London Interbank Offer Rate (1.38% at December 31, 2002) plus1.75%.

 

A summary of theborrowings from the Federal Home Loan Bank follows:

 

December 31, 2002

 

| **Maturity Dates** |   | **Principal  Amounts** | ** ** | **Interest  Rates** | ** **       |
|--------------------|--------|------------------------|------------|---------------------|------------------|
| 2003               |   | $                      | 661        |                | 4.60 – 7.34 | % |
| 2004               |   | 2,002                  |       | 4.60 – 7.34    | %                |
| 2005               |   | 1,943                  |       | 4.60 – 7.34    | %                |
| 2006               |   | 2,235                  |       | 4.60 – 6.47    | %                |
| 2007               |   | 1,815                  |       | 4.60 – 6.47    | %                |
|               |   | $                      | 8,656      |                |             |   |

 

December 31, 2001

 

| **Maturity Dates** |   | **Principal  Amounts** | ** ** | **Interest  Rates** | ** **       |
|--------------------|--------|------------------------|------------|---------------------|------------------|
| 2002               |   | $                      | 2,825      |                | 4.67 – 7.34 | % |
| 2003               |   | 678                    |       | 4.67 – 7.34    | %                |
| 2004               |   | 2,001                  |       | 4.67 – 7.34    | %                |
| 2005               |   | 1,943                  |       | 4.67 – 7.34    | %                |
| 2006               |   | 2,235                  |       | 4.67 – 6.47    | %                |
| Thereafter         |   | 70                     |       | 6.47                | %                |
|               |   | $                      | 9,752      |                |             |   |

 

11.           Income Taxes

The current and deferred components of income taxexpense are as follows:

 
|             |   | **2002** |   | **2001** |   |
|------------------|--------|----------|--------|----------|--------|
| Current          |   |     |   |     |   |
| Federal          |   | $        | 1,974  |     | $      | 1,771 |   |
| State            |   | 62       |   | 55       |   |
|             |   | 2,036    |   | 1,826    |   |
| Deferred federal |   | (113     | )      | (181     | )      |
|             |   | $        | 1,923  |     | $      | 1,645 |   |

 

The actual tax expensediffers from the expected tax expense computed by applying the applicable U.S.federal corporate income tax rate to income before income taxes as follows:

 
|                                                        |   | **2002** |   | **2001** |   |
|-------------------------------------------------------------|--------|----------|--------|----------|--------|
| Computed tax  expense                                       |   | $        | 1,961  |     | $      | 1,666 |   |
| Increase  (reduction) in income tax expense resulting from: |   |     |   |     |   |
| Income from life  insurance                                 |   | (53      | )      | (45      | )      |
| Tax exempt  income                                          |   | (52      | )      | (40      | )      |
| State taxes, net  of federal benefit                        |   | 41       |   | 36       |   |
| Other                                                       |   | 26       |   | 28       |   |
|                                                        |   | $        | 1,923  |     | $      | 1,645 |   |

 

25

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The tax effects of temporary differences that giverise to deferred income tax assets and liabilities are as follows:

 
|                                              |   | **2002**  |   | **2001**      |   |
|---------------------------------------------------|--------|-----------|--------|---------------|--------|
|                                              |   | **Asset** |   | **Liability** |   | **Asset** |   | **Liability** |   |
|                                              |   |      |   |          |   |   |   |   |   |
| Allowance for  loan losses                        |   | $         | 852    |          | $      | — |   | $ | 698 |   | $ | — |   |
| Unrealized gain  on securities available for sale |   | —    |   | 276           |   | — |   | 294 |   |
| Deferred  compensation                            |   | 241       |   | —        |   | 250 |   | — |   |
| Mortgage  servicing rights                        |   | —    |   | 144           |   | — |   | 116 |   |
| Depreciation and  amortization                    |   | —    |   | 144           |   | — |   | 92 |   |
| Other                                             |   | 117       |   | —        |   | 70 |   | 11 |   |
|                                              |   | $         | 1,210  |          | $      | 564 |   | $ | 1,018 |   | $ | 513 |   |

 

Management expects theCompany will realize all deferred income tax benefits to offset the income taxliabilities arising from the reversal of taxable temporary differences andtaxable income generated in future years. Accordingly, the Company has not established a valuation allowance fordeferred income tax benefits.

 

12.           Related Parties

The Bank has entered intoloan transactions with its directors, executive officers, significantshareholders of the Company and their affiliates (related parties).  Such transactions were made in the ordinarycourse of business on substantially the same terms and conditions, including interestrates and collateral, as those prevailing at the same time for comparabletransac­tions with other customers, and did not, in the opinion of management,involve more than normal credit risk or present other unfavorable features.Loans to related parties which in aggregate exceed $60 were as follows:

 
|                  |   | **2002** |   | **2001** |   |
|-----------------------|--------|----------|--------|----------|--------|
| Balance, January  1   |   | $        | 8,964  |     | $      | 8,640 |   |
| Loans  made/advanced  |   | 5,698    |   | 3,631    |   |
| Repayments            |   | (2,006   | )      | (3,307   | )      |
| Balance,  December 31 |   | $        | 12,656 |     | $      | 8,964 |   |

 

Commitments, as describedin Note 13, to related parties which in aggregate exceed $60 totaled $1,929 and$1,814 at December 31, 2002, and 2001, respectively.

 

13.           FinancialInstruments With Off-Balance-Sheet Risk

The Bank is a party tofinancial instruments with off-balance-sheet risk in the normal course ofbusiness to meet the financing needs of its customers which involve, to varyingdegrees, elements of credit risk in excess of the amount recognized in theconsolidated statements of financial condition. The Bank’s exposure to creditloss in the event of nonperformance by the other party to the financialinstrument for commitments to extend credit is represented by the contractualnotional amount of those instruments. The Bank follows the same credit policies in making commitments and conditionalobligations as it does for on-balance-sheet instruments, including requiringcollateral or other security to support financial instruments with credit risk.

 

The Bank’s commitments atDecember 31, 2002, and 2001 are as follows:

 
|                           |   | **2002** |   | **2001** |   |
|--------------------------------|--------|----------|--------|----------|--------|
| Commitments to  extend credit  |   | $        | 21,736 |     | $      | 15,656 |   |
| Letters of  credit             |   | 831      |   | 897      |   |
| Unadvanced  commitments        |   |     |   |     |   |
| Commercial lines  of credit    |   | 20,550   |   | 28,487   |   |
| Construction  lines of credit  |   | 5,512    |   | 2,508    |   |
| Home equity  lines of credit   |   | 13,989   |   | 11,786   |   |
| Overdraft  protection accounts |   | 1,300    |   | 1,697    |   |
| Credit card  lines             |   | 3,191    |   | 3,023    |   |
|                                |        |          |        |          |        |  |  |

 

14.       Shareholders’ Equity

The Companydistributed a 3% stock dividend on April 11, 2002 and a 3% stock dividend onMarch 7, 2001.  Earnings per share for2002 and 2001 have been restated to reflect these stock dividends.

 

On October 1,2002, the preferred stock was converted into 229,433 shares of commonstock.  Prior to conversion, each holderof preferred stock was entitled to dividends equal to the total stated value of$46.00 per share multiplied by the prime rate in effect from time to time asannounced by FleetBoston. The preferred stock was non-voting.

 

On October 21,2002, the mandatory convertible debentures were converted into 76,474 shares ofcommon stock and shareholders’ equity increased by $300.  Prior to conversion, the mandatoryconvertible debentures paid quarterly interest at 1% per annum in excess of theprime rate of interest of FleetBoston.

 

26

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15.       Other Expense

Other expenseamounts are summarized as follows for 2002 and 2001:

 
|                                                   |   | **2002** |   | **2001** |   |
|--------------------------------------------------------|--------|----------|--------|----------|--------|
| Professional fees                                      |   | $        | 459    |     | $      | 348 |   |
| Merchant processing                                    |   | 388      |   | 520      |   |
| Advertising and promotion                              |   | 346      |   | 202      |   |
| Printing, postage, stationery, and supplies            |   | 266      |   | 237      |   |
| Telephone                                              |   | 182      |   | 159      |   |
| ATM expense                                            |   | 159      |   | 144      |   |
| Trust expense                                          |   | 137      |   | 161      |   |
| Travel, meetings, conventions, and employee  education |   | 131      |   | 131      |   |
| Other                                                  |   | 586      |   | 606      |   |
| Total                                                  |   | $        | 2,654  |     | $      | 2,508 |   |

 

 

16.  Earnings Per Share

The followingtable sets forth the computation of basic and diluted earnings per share (inthousands, except for number of shares and per share data):

 
|                                                             |   | **2002**  |   | **2001**  |   |
|------------------------------------------------------------------|--------|-----------|--------|-----------|--------|
| Basic earnings per share                                         |   |      |   |      |   |
| Net income, as reported                                          |   | $         | 3,845  |      | $      | 3,254 |   |
| Preferred stock dividends declared                               |   | (32       | )      | (62       | )      |
| Income available to common shareholders                          |   | $         | 3,813  |      | $      | 3,192 |   |
| Weighted-average shares outstanding                              |   | 2,902,748 |   | 2,744,633 |   |
| Basic earnings per share                                         |   | $         | 1.31   |      | $      | 1.16 |   |
|                                                             |   |      |   |      |   |
| Diluted earnings per share                                       |   |      |   |      |   |
| Net income, as reported                                          |   | $         | 3,845  |      | $      | 3,254 |   |
| Interest on mandatory convertible debentures, net of tax         |   | 9         |   | 16        |   |
| Income available to common shareholders                          |   | $         | 3,854  |      | $      | 3,270 |   |
|                                                             |   |      |   |      |   |
| Weighted-average shares outstanding                              |   | 2,902,748 |   | 2,744,633 |   |
| Effect of stock options, net of assumed treasury stock purchases |   | 141,003   |   | 186,816   |   |
| Effect of convertible preferred stock                            |   | 171,727   |   | 229,599   |   |
| Effect of mandatory convertible debentures                       |   | 61,434    |   | 76,530    |   |
| Adjusted weighted-average shares outstanding                     |   | 3,276,912 |   | 3,237,578 |   |
| Diluted earnings per share                                       |   | $         | 1.18   |      | $      | 1.01 |   |

 

Options to purchase42,100 shares of common stock at $15.80 were outstanding at December 31, 2002but were not included in the computation of diluted earnings per share becausethe options’ exercise price was greater than the average market price of thecommon stock.

 

17.                     RegulatoryMatters

The Company andBank are subject to various regulatory capital requirements administered by thefederal banking agencies.  Failure tomeet minimum capital requirements can initiate certain mandatory - and possiblyadditional discretionary - actions by regulators that, if undertaken, couldhave a direct material effect on the Company and Bank’s consolidated financialstatements. Under capital adequacy guidelines and the regulatory framework forprompt corrective action, the Company and Bank must meet specific capitalguidelines that involve quantitative measures of the Company’s and Bank’sassets, liabilities and certain off-balance-sheet items as calculated underregulatory accounting practices.  TheCompany’s and Bank’s capital amounts and classification are also subject toqualitative judgments by the regulators about components, risk weightings, andother factors.

 

Quantitativemeasures established by regulation to ensure capital adequacy require the Companyand Bank to maintain minimum amounts and ratios (set forth in the table on thenext page) of total and Tier I capital (as defined in the regulations) torisk-weighted assets (as defined), and of Tier I capital (as defined) toaverage assets (as defined).  Managementbelieves as of December 31, 2002, that the Company and Bank meet all capitaladequacy requirements to which they are subject.

 

As ofDecember 31, 2002, the most recent notification from the Federal ReserveBank categorized the Bank as well capitalized under the regulatory frameworkfor prompt corrective action.  To becategorized “well capitalized,” the Bank must maintain minimum totalrisk-based, Tier I risk-based, and Tier I leverage ratios as set forth in thetable.  There are no conditions orevents since that notification that management believes have changed this category.

 

The Company’s andBank’s actual capital amounts and ratios are also presented in the table.  No deduction was made from capital forinterest-rate risk in 2002 and 2001.

 

27

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|                                                   |   | **Actual** |   | **For  capital  adequacy purposes** |       | **To be well****capitalized  under prompt  corrective action provisions** |       |
|--------------------------------------------------------|--------|------------|--------|-------------------------------------|------------|---------------------------------------------------------------------------|------------|
|                                                   |   | **Amount** |   | **Ratio**                           | ** ** | **Amount**                                                                | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| As of December 31, 2002                                |   |       |   |                                |       |                                                                      |       |   |   |   |   |   |   |
| Total capital (to risk- weighted assets) Consolidated  |   | $          | 30,010 |                                | 14.35      | %                                                                         | $          | 16,728 |   | 8.00 | % | N/A |   |   |   |
| Bank                                                   |   | 24,419     |   | 11.80                               |       | 16,552                                                                    |       | 8.00 |   | $ | 20,690 |   | 10.00 | % |
| Tier I capital (to risk- weighted assets) Consolidated |   | 27,388     |   | 13.10                               |       | 8,364                                                                     |       | 4.00 |   | N/A |   |   |   |
| Bank                                                   |   | 21,824     |   | 10.55                               |       | 8,276                                                                     |       | 4.00 |   | 12,414 |   | 6.00 |   |
| Tier I capital (to average assets) Consolidated        |   | 27,388     |   | 9.18                                |       | 11,928                                                                    |       | 4.00 |   | N/A |   |   |   |
| Bank                                                   |   | 21,824     |   | 7.49                                |       | 8,740                                                                     |       | 3.00 |   | 14,566 |   | 5.00 |   |
|                                                   |   |       |   |                                |       |                                                                      |       |   |   |   |   |   |   |
| As of December 31, 2001                                |   |       |   |                                |       |                                                                      |       |   |   |   |   |   |   |
| Total capital (to risk- weighted assets) Consolidated  |   | $          | 27,507 |                                | 15.11      | %                                                                         | $          | 14,560 |   | 8.00 | % | N/A |   |   |   |
| Bank                                                   |   | 21,021     |   | 11.97                               |       | 14,053                                                                    |       | 8.00 |   | $ | 17,566 |   | 10.00 | % |
| Tier I capital (to risk- weighted assets) Consolidated |   | 24,923     |   | 13.69                               |       | 7,280                                                                     |       | 4.00 |   | N/A |   |   |   |
| Bank                                                   |   | 18,819     |   | 10.71                               |       | 7,027                                                                     |       | 4.00 |   | 10,540 |   | 6.00 |   |
| Tier I capital (to average assets) Consolidated        |   | 24,923     |   | 9.04                                |       | 11,029                                                                    |       | 4.00 |   | N/A |   |   |   |
| Bank                                                   |   | 18,819     |   | 7.01                                |       | 8,059                                                                     |       | 3.00 |   | 13,431 |   | 5.00 |   |

 

 

18.       Stock Options

A summary of thestatus of the stock option plan (Note 1) as of December 31, 2002, and 2001, andchanges during the years then ended, is presented below.
|                                                                        |   | **2002**              |   | **2001**                              |   |
|-----------------------------------------------------------------------------|--------|-----------------------|--------|---------------------------------------|--------|
|                                                                        |   | **Number  of Shares** |   | **Weighted  Average  Exercise Price** |   | **Number  of Shares** |   | **Weighted  Average  Exercise Price** |   |
| Outstanding at beginning of year                                            |   | 384,682               |   | $                                     | 5.44   |   | 423,733 |   | $ | 5.40 |   |
| Granted during the year                                                     |   | 50,000                |   | 15.53                                 |   | 9,000 |   | 10.50 |   |
| Exercised during the year                                                   |   | (153,424              | )      | 4.81                                  |   | (45,085 | ) | 4.55 |   |
| Forfeited during the year                                                   |   | (11,886               | )      | 7.35                                  |   | (14,800 | ) | 5.56 |   |
| Additional shares for which options are exercisable due to stock  dividends |   | 9,961                 |   | —                                |   | 11,834 |   | — |   |
| Outstanding at end of year                                                  |   | 279,333               |   | $                                     | 7.32   |   | 384,682 |   | $ | 5.44 |   |
| Exercisable at end of year                                                  |   | 222,298               |   | $                                     | 5.40   |   | 345,067 |   | $ | 5.04 |   |
|                                                                        |   |                  |   |                                  |   |   |   |   |   |
| Weighted-average fair value of options granted during the year              |   |                  |   | $                                     | 2.27   |   |   |   | $ | 1.32 |   |

 

The followinginformation applies to options outstanding at December 31, 2002:

 
|                        |   | **Options  Outstanding** |       | **Options  Exercisable**                    |       |
|-----------------------------|--------|--------------------------|------------|---------------------------------------------|------------|
| **Range of Exercise Price** |   | **Number  of  Shares**   | ** ** | **Wtd. Avg.  Remaining  Contractual  Life** | ** ** | **Wtd. Avg.  Exercise  Price** | ** ** | **Number  of  Shares** | ** ** | **Wtd. Avg.  Exercise  Price** | ** ** |
|                        |   |                     |       |                                        |       |   |   |   |   |   |   |
| $4.00 - $5.99               |   | 179,442                  |       | 0.4                                         |       | $4.57 |   | 179,442 |   | $4.57 |   |
| $8.25 - $10.19              |   | 50,478                   |       | 7.3                                         |       | 9.08 |   | 42,856 |   | 8.89 |   |
| $13.67 - $15.80             |   | 49,413                   |       | 9.9                                         |       | 15.48 |   | — |   | — |   |

 

28

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19.       Fair Value of Financial Instruments

Fair valueestimates, methods and assumptions are set forth below for the Company’sfinancial instruments.

 

Cash and Cash Equivalents

The fair value ofcash and due from banks and interest-bearing deposits with banks approximatestheir relative book values at December 31, 2002, and 2001, as these financial instrumentshave short maturities.

 

Investment Securities

The fair values ofinvestment securities are estimated based on bid prices published in financialnewspapers or bid quotations received from securities dealers.

 

Loans Held for Sale

The fair values ofloans held for sale are based on quoted market prices from the Federal NationalMortgage Association.

 

Loans Receivable

Fair values areestimated for portfolios of loans receivable with similar financial characteristics.  The fair values approximate carrying valuefor all loans with variable interest rates.

 

The fair values offixed rate loans are calculated by discounting scheduled cash flows through theestimated maturity using estimated market discount rates that reflect the riskinherent in the loan. The estimates of maturity are based on the Bank’s historicalexperience with repayments for each loan classification, modified, as required,by an estimate of the effect of current economic and lending conditions, andthe effects of estimated prepayments.

 

Management hasmade estimates of fair value using discount rates that it believes to be reasonable.However, because there is no market for many of these financial instruments,management has no basis to determine whether the fair value presented belowwould be indicative of the value negotiated in the actual sale.

 

Cash Surrender Value of Life Insurance

The fair value isbased on the actual cash surrender value of life insurance policies.

 

Accrued Interest Receivable

The fair valueapproximates the carrying value as this financial instrument has a short maturity.  It is the Bank’s policy to stop accruinginterest on loans for which it is probable that the interest is notcollectible.  Therefore, the fair valueof this financial instrument has been adjusted to reflect credit risk.

 

Capitalized Mortgage Servicing Rights

The fair value ofmortgage servicing rights is based on the expected present value of future mortgageservicing income, net of estimated servicing costs, considering marketconsensus loan prepayment predictions.

 

Deposits

The fair value ofdeposits with no stated maturity, such as noninterest-bearing demand deposits,savings, NOW accounts and money market accounts, is equal to the amount payableon demand.  The fair value ofcertificates of deposit is based on the discounted value of contractual cashflows.  The discount rate is estimatedusing the rates currently offered for deposits of similar remaining maturities.

 

The fair valueestimates do not include the benefit that results from the low-cost funding providedby the deposits compared to the cost of borrowing funds in the market.  If that value were considered, the fairvalue of the Bank’s net assets could increase.

 

Borrowed Funds

The fair value ofborrowed funds is based on the discounted value of contractual cash flows.  The discount rate is estimated using therates currently available for borrowings of similar remaining maturities.

 

Accrued Interest Payable

The fair valueapproximates the book value as this financial instrument has a short maturity.

 

29

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Off-Balance Sheet Instruments

The Company’soff-balance sheet instruments consist of loan commitments.  Fair values for loan commitments have notbeen presented as the future revenue derived from such financial instruments isnot significant.

 

Limitations

Fair valueestimates are made at a specific point in time, based on relevant marketinformation and information about the financial instrument.  These values do not reflect any premium ordiscount that could result from offering for sale at one time the Company’sentire holdings of a particular financial instrument.  Because no market exists for a significant portion of theCompany’s financial instruments, fair value estimates are based on judgmentsregarding future expected loss experience, current economic conditions, riskcharacteristics of various financial instruments, and other factors. Theseestimates are subjective in nature and involve uncertainties and matters ofsignificant judgment and therefore cannot be determined with precision.  Changes in assumptions could significantly affectthe estimates.

 

Fair valueestimates are based on existing on and off-balance sheet financial instrumentswithout attempting to estimate the value of anticipated future business and thevalue of assets and liabilities that are not considered financialinstruments.  Other significant assetsand liabilities that are not considered financial instruments include propertyand equipment and other real estate owned. In addition, the tax ramifications related to the realization of theunrealized gains and losses can have a significant effect on fair valueestimates and have not been considered in any of the estimates.

 

A summary of theestimated fair values for the Company’s significant financial instruments atDecember 31, 2002, and 2001 follows:

 
| **December 31, 2002**             |   | **Carrying  Value** |   | **Estimate  of  Fair Value** |   |
|----------------------------------------|--------|---------------------|--------|------------------------------|--------|
| Financial Assets                       |   |                |   |                         |   |
| Cash and cash equivalents              |   | $                   | 14,267 |                         | $      | 14,267 |   |
| Investment securities                  |   | 68,867              |   | 68,867                       |   |
| Loans held for sale                    |   | 1,220               |   | 1,220                        |   |
| Loans receivable, net                  |   | 211,434             |   | 215,101                      |   |
| Cash surrender value of life insurance |   | 3,591               |   | 3,591                        |   |
| Accrued interest receivable            |   | 1,190               |   | 1,190                        |   |
| Capitalized mortgage servicing rights  |   | 423                 |   | 769                          |   |
| Financial Liabilities                  |   |                |   |                         |   |
| Deposits                               |   | 238,857             |   | 241,170                      |   |
| Accrued interest payable               |   | 404                 |   | 404                          |   |
| Borrowed funds                         |   | 36,932              |   | 37,595                       |   |
|                                        |        |                     |        |                              |        |  |  |

 
| **December 31, 2001**             |   | **Carrying  Value** | ** ** | **Estimate  of  Fair Value** | ** ** |
|----------------------------------------|--------|---------------------|------------|------------------------------|------------|
| Financial Assets                       |   |                |       |                         |       |
| Cash and cash equivalents              |   | $                   | 9,844      |                         | $          | 9,844 |   |
| Investment securities                  |   | 71,607              |       | 71,607                       |       |
| Loans held for sale                    |   | 1,060               |       | 1,060                        |       |
| Loans receivable, net                  |   | 185,094             |       | 188,222                      |       |
| Cash surrender value of life insurance |   | 2,900               |       | 2,900                        |       |
| Accrued interest receivable            |   | 1,189               |       | 1,189                        |       |
| Capitalized mortgage servicing rights  |   | 340                 |       | 587                          |       |
| Financial Liabilities                  |   |                |       |                         |       |
| Deposits                               |   | 219,309             |       | 220,764                      |       |
| Accrued interest payable               |   | 383                 |       | 383                          |       |
| Borrowed funds                         |   | 30,092              |       | 30,446                       |       |
|                                   |   |                |       |                         |       |
|                                        |        |                     |            |                              |            |  |  |

 

20.       Parent Company Financial Information

The following issummarized financial statement information for Merrill Merchants Bancshares,Inc. as of December 31, 2002, and 2001 and for the years then ended:

 

30

----

 

 

SUMMARIZED BALANCE SHEETINFORMATION

 
|                                             |   | **2002** |       | **2001** |       |
|--------------------------------------------------|--------|----------|------------|----------|------------|
| ASSETS                                           |   |     |       |     | ** ** |
| Cash                                             |   | $        | 4          |     | $          | 55 |   |
| Investment securities at fair value              |   | 5,620    |       | 868      |       |
| Investment in subsidiaries                       |   | 22,787   |       | 19,989   |       |
| Loan and interest receivable from subsidiary     |   | —   |       | 5,565    |       |
| Deferred income tax benefits                     |   | 113      |       | 33       |       |
| Other assets                                     |   | 280      |       | —   |       |
| Total assets                                     |   | $        | 28,804     |     | $          | 26,510 |   |
|                                             |   |     | ** ** |     | ** ** |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**    |   |     | ** ** |     | ** ** |
| Liabilities                                      |   |     |       |     |       |
| Dividend payable and accrued expenses            |   | $        | 416        |     | $          | 225 |   |
| Mandatory convertible debentures                 |   | —   |       | 300      |       |
| Total liabilities                                |   | 416      |       | 525      |       |
| Shareholders’ equity                        |   |     |       |     |       |
| Convertible cumulative preferred stock           |   | —   |       | 20       |       |
| Common stock                                     |   | 3,194    |       | 2,741    |       |
| Capital surplus                                  |   | 20,381   |       | 18,794   |       |
| Retained earnings                                |   | 5,498    |       | 4,601    |       |
| Accumulated other comprehensive income           |   |     |       |     |       |
| Unrealized gain on securities available for sale |   | 536      |       | 600      |       |
| Treasury stock                                   |   | (1,221   | )          | (771     | )          |
| Total shareholders’ equity                  |   | 28,388   |       | 25,985   |       |
| Total liabilities and shareholders’ equity  |   | $        | 28,804     |     | $          | 26,510 |   |

 

 

SUMMARIZED STATEMENTS OFINCOME INFORMATION

 
|                                                             |   | **2002** |   | **2001** |   |
|------------------------------------------------------------------|--------|----------|--------|----------|--------|
| Dividends from bank subsidiary                                   |   | $        | 900    |     | $      | 1,526 |   |
| Interest income on loan from subsidiary                          |   | 64       |   | 342      |   |
| Interest and dividend income on investments                      |   | 164      |   | 20       |   |
| Total income                                                     |   | 1,128    |   | 1,888    |   |
|                                                             |   |     |   |     |   |
| Net loss on investment securities                                |   | (30      | )      | —   |   |
|                                                             |   |     |   |     |   |
| Interest expense on borrowed funds                               |   | 14       |   | 26       |   |
| Operating expenses                                               |   | 114      |   | 119      |   |
| Total expenses                                                   |   | 128      |   | 145      |   |
|                                                             |   |     |   |     |   |
| Income before income tax expense                                 |   | 970      |   | 1,743    |   |
| Income tax expense                                               |   | 30       |   | 65       |   |
| Income before equity in undistributed net income of subsidiaries |   | 940      |   | 1,678    |   |
| Equity in undistributed net income of subsidiaries               |   | 2,905    |   | 1,576    |   |
| Net income                                                       |   | $        | 3,845  |     | $      | 3,254 |   |

 

SUMMARIZED STATEMENTS OFCASH FLOWS INFORMATION

 
|                                                                                   |   | **2002** |   | **2001** |   |
|----------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|
| Cash flows from operating activities                                                   |   |     |   |     |   |
| Net income                                                                             |   | $        | 3,845  |     | $      | 3,254 |   |
| Adjustments to reconcile net income to net cash provided  by operating activities |   |     |   |     |   |
| Deferred income tax benefit                                                            |   | (52      | )      | 38       |   |
| Equity in undistributed net income of subsidiaries                                     |   | (2,905   | )      | (1,576   | )      |
| Net loss on investment securities                                                      |   | 30       |   | —   |   |
| Increase in accrued income and other assets                                            |   | (12      | )      | -        |   |
| Increase in accrued expenses                                                           |   | 17       |   | 15       |   |
| Net cash provided by operating activities                                              |   | 923      |   | 1,731    |   |
| Cash flows from investing activities                                                   |   |     |   |     |   |
| Proceeds from sales and maturities of investment securities                            |   | 8,953    |   | 665      |   |
| Purchase of investment securities                                                      |   | (13,654  | )      | (1,095   | )      |
| Net repayment from (advances to) subsidiaries                                          |   | 5,569    |   | (175     | )      |
| Net cash provided (used) by investing activities                                       |   | 868      |   | (605     | )      |
|                                                                                   |   |     |   |     |   |
| Cash flows from financing activities                                                   |   |     |   |     |   |
| Dividends paid on convertible cumulative preferred stock                               |   | (32      | )      | (62      | )      |
| Dividends paid on common stock                                                         |   | (1,091   | )      | (586     | )      |
| Payment of note payable                                                                |   | —   |   | (110     | )      |
| Proceeds from issuance of common stock                                                 |   | 690      |   | 132      |   |
| Purchase of treasury stock                                                             |   | (1,409   | )      | (454     | )      |
| Net cash used by financing activities                                                  |   | (1,842   | )      | (1,080   | )      |
| Net (decrease) increase in cash and cash equivalents                                   |   | (51      | )      | 46       |   |
| Cash and cash equivalents, beginning of year                                           |   | 55       |   | 9        |   |
| Cash and cash equivalents, end of year                                                 |   | $        | 4      |     | $      | 55 |   |

 

31

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| **Merrill  Merchants Bancshares, Inc.**                  |   |
|----------------------------------------------------------|--------|
|                                                     |   |
| **Board of Directors**                                   |   |
|                                                     |   |
| William C. Bullock, Jr., Chairman                        |   |
| Merrill  Merchants Bank, Bangor, Maine                   |   |
|                                                     |   |
| Edwin N. Clift, President & Chief Executive  Officer |   |
| Merrill  Merchants Bank, Bangor, Maine                   |   |
|                                                     |   |
| Joseph H. Cyr, President                                 |   |
| John T. Cyr  & Sons, Inc., Old Town, Maine           |   |
|                                                     |   |
| Perry B. Hansen, Chairman & Chief Executive  Officer |   |
| THE National  Bank, Bettendorf, Iowa                     |   |
|                                                     |   |
| Robert E. Knowles, Investor                              |   |
| Unity, Maine                                             |   |
|                                                     |   |
| Frederick A. Oldenburg, Jr., M.D., Director              |   |
| Penobscot  Respiratory, P.A., Bangor, Maine              |   |
|                                                     |   |
| Lloyd D. Robinson, Investor                              |   |
| Hermon, Maine                                            |   |
|                                                     |   |
| Dennis L. Shubert, M.D., Ph.D., Investor                 |   |
| Bangor, Maine                                            |   |
|                                                     |   |
| Susan B. Singer, Investor                                |   |
| Bangor, Maine                                            |   |
|                                                     |   |
| **Officers**                                             |   |
|                                                     |   |
| William C. Bullock, Jr., Chairman                        |   |
| Edwin N. Clift President & Chief Executive  Officer  |   |
| Deborah A. Jordan, Treasurer                             |   |
| James A. MacLeod, Esquire, Secretary & Clerk         |   |

 

32

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| Merrill Merchants Bank                                   |   |
|----------------------------------------------------------|--------|
| **Board  of Directors**                                  |   |
|                                                     |   |
| William C. Bullock, Jr., Chairman                        |   |
| Merrill  Merchants Bank, Bangor, Maine                   |   |
|                                                     |   |
| Edwin N. Clift, President & Chief Executive  Officer |   |
| Merrill  Merchants Bank, Bangor, Maine                   |   |
|                                                     |   |
| Joseph H. Cyr, President                                 |   |
| John T. Cyr  & Sons, Inc., Old Town, Maine           |   |
|                                                     |   |
| John R. Graham III, President                            |   |
| Automatic  Distributors, Bangor, Maine                   |   |
|                                                     |   |
| Perry B. Hansen, Chairman & Chief Executive  Officer |   |
| THE National  Bank, Bettendorf, Iowa                     |   |
|                                                     |   |
| Charles M. Hutchins, Vice President                      |   |
| Alternative  Energy, Inc., Bangor, Maine                 |   |
|                                                     |   |
| Joseph P. Irish, President                               |   |
| Waldo County  Oil, Troy, Maine                           |   |
|                                                     |   |
| Robert E. Knowles, Investor                              |   |
| Unity, Maine                                             |   |
|                                                     |   |
| Frederick A. Oldenburg, Jr., M.D., Director              |   |
| Penobscot  Respiratory, P.A., Bangor, Maine              |   |
|                                                     |   |
| Lloyd D. Robinson, Investor                              |   |
| Hermon, Maine                                            |   |
|                                                     |   |
| Dennis L. Shubert, M.D., Ph.D., Investor                 |   |
| Bangor, Maine                                            |   |
|                                                     |   |
| Susan B. Singer, Investor                                |   |
| Bangor, Maine                                            |   |
|                                                     |   |
| **Merrill Merchants Bank**                               |   |
|                                                     |   |
| **Honorary  Directors**                                  |   |
| J. Donald Mackintosh                                     |   |
| Leonard E. Minsky                                        |   |
| Norman Minsky, Esq.                                      |   |
| Joseph Sewall                                            |   |
| Harold S. Wright                                         |   |

# ** **

33

----

** **
| **Merrill Merchants Bank**                              |
|---------------------------------------------------------|
| **Senior  Management**                                  |
|                                                    |
| William C. Bullock, Jr.                                 |
| Chairman                                                |
|                                                    |
| Edwin N. Clift                                          |
| President & Chief Executive Officer                 |
|                                                    |
| Charles W. Hart                                         |
| Executive Vice President, Administration                |
|                                                    |
| Deborah A. Jordan                                       |
| Executive Vice President, Chief Financial Officer       |
|                                                    |
| William P. Lucy                                         |
| Executive Vice President, Commercial Banking            |
|                                                    |
| James A. MacLeod, Esquire                               |
| Senior Vice President, Trust & Investment  Services |
|                                                    |
| Jane H. Madigan                                         |
| Senior Vice President, Marketing & Human  Resources |
|                                                    |
| Lynne A. Spooner                                        |
| Senior Vice President, Retail Banking                   |
|                                                    |
| Reginald C. Williams, Jr.                               |
| Senior Vice President, Operations                       |
|                                                    |
| Sara E. Carr                                            |
| Vice President, Risk Management                         |
|                                                    |
| Susan L. Rush                                           |
| Vice President, Systems Administration                  |

 

34

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| EMPLOYEES                  |   |                           |
|----------------------------|--------|--------------------------------|
|                       |   |                           |
| ACCOUNTING                 |   | LOAN OPERATIONS                |
| Linda G. England*          |   | Judith D. Kelly                |
| Deborah A. Jordan*         |   | Ginger K. Stalls               |
| Janet L. Kochis            |   | Judy M. Walls                  |
| Pamela J. Mugnai           |   | Jerina K. Warner*              |
| Lorraine M. Therrien*      |   |                           |
|                       |   | MORTGAGE LENDING               |
| ADMINISTRATION             |   | Alison J. Bailey*              |
| William C. Bullock, Jr.*   |   | Abbee L. Bissonnette           |
| Edwin N. Clift*            |   | Michelle T. Czapiga            |
| Barbara J. Cochran         |   | P. David DeFroscia*            |
| Charles W. Hart*           |   | Tami E. Farnsworth             |
| Lynne A. Spooner*          |   | Shawn P. Mallison              |
| Judy L. York               |   | Kim L. Shaw                    |
|                       |   | Thomas A. Tilley*              |
|                       |   | Robert G. Wyman                |
| BANK OPERATIONS            |   |                           |
| Scott D. Bennett           |   |                           |
| Matthew J. Harvey          |   | RISK MANAGEMENT                |
| Michael J. Moody           |   | Sara E. Carr*                  |
| Donna M. Poland            |   | Susan V. Terrillion            |
| Reginald C. Williams, Jr.* |   |                           |
|                       |   |                           |
|                       |   | SYSTEMS ADMINISTRATION         |
| COMMERCIAL LENDING         |   | Thomas W. Austin               |
| Matthew E. Arnold          |   | Susan L. Rush*                 |
| Fred A. Brown*             |   | Jason D. Simsay                |
| Angela T. Butler*          |   |                           |
| Jeremy J. Dubay            |   | TRUST & INVESTMENTS        |
| Jerry C. Jarrell*          |   | Clarence E. Bickford, Jr.*     |
| Jonathan S. Lander*        |   | Meris J. Bickford,  Esquire*   |
| William P. Lucy*           |   | Jacqueline A. Bouchey*         |
| Lewis H. Payne*            |   | Julie K. Cote                  |
| Cindy L. Rickman           |   | Betsy B. Hanscom               |
| Jane F. Smith              |   | James A. MacLeod, Esquire*     |
|                       |   | Lawrence M. Napoleone*         |
| DEPOSIT OPERATIONS         |   | Valrie G. SmithCindy L.  Allen |
| Clarice J. Hannan          |   | Joyce D. Toman                 |
| Linda M. Lizotte           |   | Holly A. Vetelino*             |
| Kathleen G. Prescott*      |   | Ellen N. Ziobron               |
|                       |   |                           |
| HUMAN RESOURCES            |   | MAINE ACCEPTANCE  CORPORATION  |
| Cynthia L. Leighton*       |   | Robert J. Gardner              |
| Carol L. Littlefield       |   | Kim M. Kirchdorfer             |
| Jane H. Madigan*           |   | Floyd W. Libby*                |
|                       |   |                           |
| BRANCH OFFICES             |   |                           |
|                       |   |                           |
| Bangor, 201 Main Street    |   | Milford                        |
| Theresa M. Brooks*         |   | Angela R. Madore               |
| Joanne M. Fish             |   | Kelly A. Shorey                |
| Eunice M. Harris           |   |                           |
| Jody E. Holmes             |   | Newport                        |
| Janet L. Lane              |   | Cynthia J. Brawn               |
| Lori A. Pardun             |   | Marjorie J. Downing*           |
| Donna J. Peavey            |   | Melissa M. Mallory             |
| Sue E. Perkins             |   | Jaime L. Moore                 |
| Alena J. Sibley            |   | Debra L. Murray                |
|                       |   | Veronica E. Sylvia             |
| Bangor, Stillwater Avenue  |   |                           |
| Jamie M. Bernard           |   | Orono                          |
| Jennifer C. Coutts         |   | Brent A. Folster*              |
| George E. Dandaneau*       |   | Gwendolyn A. King              |
| Lynne M. Gray              |   | Darleen M. Lanphere            |
| Deanna L. Ouellette        |   | Kathleen Spruce                |
| Betsy A. Simpson           |   | Christopher R. Winstead        |
| Tricia T. Tibbetts         |   |                           |
| Jason R. Wilkes            |   | Orrington                      |
|                       |   | Bonita L. Hodgins              |
| Bangor, Union Street       |   | Ronald J. Landry               |
| Jayne T. Dickey            |   |                           |
| Patricia L. Eldridge       |   | Pittsfield                     |
| Angela M. Gray             |   | Nancy L. Bellfleur             |
| Stacie A. Severance        |   | Suzanne M. Mercier             |
| Hope J. Smith              |   | Andrew C. Reed*                |
| Natalie E. Stiles          |   | Carole L. Robinson             |
| Marlene D. Thomas*         |   | Micheline K. Ross              |
|                       |   | Dianne L. Roy                  |
|                       |   |                           |
| Brewer                     |   |                           |
| Terri M. Adam              |   |                           |
| Marla J. Billings          |   |                           |
| Farrah L. Carmichael       |   |                           |
| Eva M. Charity             |   |                           |
| Diane M. Hewett            |   |                           |
| Linda J. St. Louis         |   |                           |
| Jessica L. Welch           |   |                           |
| Danelle L. Weston          |   |                           |
|                       |   |                           |
| Holden                     |   |                           |
| Jill E. Bean               |   |                           |
| Ann M. Brewer              |   |                           |
| Sandra J. Leavitt          |   |                           |
| Roland L. Narofsky         |   |                           |
| Diane T. Pearson           |   |                           |

 

----

| *Officers |   |   |
|-----------|--------|--------|

 

35

----

 

CORPORATEINFORMATION

# **Corporate Headquarters**

Merrill MerchantsBancshares, Inc.

201 Main Street

Bangor, Maine 04401

207-942-4800

 

# **Inquiries and Financial Information**

Analysts, shareholders and other investors seeking financialinformation including our 2002 Annual Report on Form 10-KSB should contactDeborah Jordan, Chief Financial Officer and Manager of Investor Relations at207-942-2494.

News media and others seeking general information should contact JaneMadigan, Senior Vice President and Manager of Media Relations at 207-990-4075.

 

# **Internet**

Our internet address is www.merrillmerchants.com or via electronicmail: info@merrillmerchants.com

 

# **Stock Listing**

Merrill Merchants Bancshares, Inc. is traded over the counter on theNasdaq National Market system under the symbol MERB.

 

# **Transfer Agent**

Shareholder inquiries regarding change of address or title should bedirected to:

Registrar and Transfer Company

10 Commerce Drive

Cranford, NJ  07016

1-800-368-5948

 

# **Independent Certified Public Accountants**

Berry Dunn McNeil and Parker

36 Pleasant Street

Bangor, Maine 04401

 

# **Annual Shareholder Meeting**

The annual meeting of shareholders will be at 5:00 p.m. on Wednesday,April 17, 2003, at the Bangor Conference Center, Hogan Road, Bangor, Maine.

 
| BRANCH LOCATIONS      |   |           |   |           |
|-----------------------|--------|----------------|--------|----------------|
| **Bangor**            |   | **Milford**    |   | **Orrington**  |
| 201 Main Street       |   | 2 Main Street  |   | 191 River Road |
| 920 Stillwater Avenue |   |           |   |           |
| 992 Union Street      |   | **Newport**    |   | **Pittsfield** |
|                  |   | Newport Plaza  |   | 27 Main Street |
| **Brewer**            |   |           |   |           |
| 366 Wilson Street     |   | **Orono**      |   | **Waterville** |
|                  |   | 69 Main Street |   | 58 Elm Street  |
| **Holden**            |   |           |   |           |
| Route 1A              |   |           |   |           |

 

36

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