##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-Q
 (Mark One)
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the Quarterly Period Ended September 30, 2006
 OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from  to
 Commission File Number 0-18279
 Tri-County Financial Corporation
  Maryland
(State of other jurisdiction of 
incorporation or organization)
    
    52-1652138
(I.R.S. Employer
Identification No.)3035 Leonardtown Road,
Waldorf, Maryland
(Address of principal executive offices)
    
    20601
(Zip Code)
 (301) 843-0854
 Not
applicable
 þ o
  o o þ
 o þ




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##### 



TRI-COUNTY FINANCIAL CORPORATION
 FORM 10-Q
 INDEX
 PagePART I FINANCIAL INFORMATIONItem 1 - Financial Statements (Unaudited)Consolidated Balance Sheets - September 30, 2006
and December 31, 2005
    
    
    3Consolidated Statements of Income and Comprehensive Income -
Three and Nine Months Ended September 30, 2006 and 2005
    
    
    4Consolidated Statements of Cash Flows - Nine Months
Ended September 30, 2006 and 2005
    
    
    6Notes to Consolidated Financial Statements
    
    
    8Item 2 - Managements Discussion and Analysis of Financial Condition
and Results of Operations
    
    
    12Item 3 - Quantitative and Qualitative Disclosures about Market Risk
    
    
    21Item 4 - Controls and Procedures
    
    
    21PART II OTHER INFORMATIONItem 1 - Legal Proceedings
    
    
    21Item 1A. - Risk Factors
    
    
    21Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    21Item 3 - Defaults Upon Senior Securities
    
    
    22Item 4 - Submission of Matters to a Vote of Security Holders
    
    
    22Item 5 - Other Information
    
    
    22Item 6 - Exhibits
    
    
    22SIGNATURES
    
    
    23EX-10.1 SALARY CONTINUATION AGREEMENT/ GREGORY COCKERHAMEX-10.2 SALARY CONTINUATION AGREEMENT/ WILLIAM PASENELLIEX-10.3 EMPLOYMENT AGREEMENT / MICHAEL MIDDLETONEX-31.1 SECTION 302 CERTIFICATION OF CEOEX-31.2 SECTION 302 CERTIFICATION OF CFOEX-32 SECTION 906 CERTIFICATIONS OF CEO AND CFO




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##### Table of Contents



PART I FINANCIAL STATEMENTS
 
 ITEM I. FINANCIAL STATEMENTS
 TRI-COUNTY FINANCIAL CORPORATION
 
 CONSOLIDATED BALANCE SHEETS SEPTEMBER 30, 2006 AND DECEMBER 31, 2005 (UNAUDITED)
 September 30, 2006
    
    
    December 31, 2005ASSETSCash and due from banks
    
    $
    3,474,835
    
    
    $
    7,262,547Federal funds sold
    
    
    567,212
    
    
    
    640,818Interest-bearing deposits with banks
    
    
    11,926,575
    
    
    
    14,671,875Securities available for sale
    
    
    9,702,681
    
    
    
    7,178,894Securities held to maturity - at amortized cost
    
    
    101,382,853
    
    
    
    116,486,685Federal Home Loan Bank and Federal Reserve Bank stock - at cost
    
    
    6,573,400
    
    
    
    7,190,300Loans receivable - net of allowance for loan losses
of $3,667,047 and $3,383,334, respectively
    
    
    411,870,980
    
    
    
    369,592,253Premises and equipment, net
    
    
    6,467,448
    
    
    
    6,460,545Foreclosed real estate
    
    
    460,884
    
    
    
    475,561Accrued interest receivable
    
    
    2,780,633
    
    
    
    2,406,542Investment in bank owned life insurance
    
    
    8,678,020
    
    
    
    6,434,175Other assets
    
    
    2,415,676
    
    
    
    2,487,280TOTAL ASSETS
    
    $
    566,301,197
    
    
    $
    541,287,475LIABILITIES AND STOCKHOLDERS EQUITYLIABILITIES:Noninterest-bearing deposits
    
    $
    43,047,897
    
    
    $
    44,325,083Interest-bearing deposits
    
    
    357,327,992
    
    
    
    319,048,657Total deposits
    
    
    400,375,889
    
    
    
    363,373,740Short-term borrowings
    
    
    14,928,715
    
    
    
    20,074,975Long-term debt
    
    
    98,055,793
    
    
    
    107,823,759Guaranteed preferred beneficial interest in junior
subordinated debentures
    
    
    12,000,000
    
    
    
    12,000,000Accrued expenses and other liabilities
    
    
    4,426,258
    
    
    
    3,436,845Total liabilities
    
    
    529,786,655
    
    
    
    506,709,319STOCKHOLDERS EQUITY:Common stock - par value $.01; authorized - 15,000,000 shares;
issued 1,759,687 and 1,760,991 shares, respectively
    
    
    17,597
    
    
    
    17,610Additional paid in capital
    
    
    9,259,317
    
    
    
    9,057,805Retained earnings
    
    
    27,323,557
    
    
    
    25,580,634Accumulated other comprehensive income
    
    
    11,100
    
    
    
    49,362Unearned ESOP shares
    
    
    (97,029
    )
    
    
    (127,255
    )Total stockholders equity
    
    
    36,514,542
    
    
    
    34,578,156TOTAL LIABILITIES AND STOCKHOLDERS EQUITY
    
    $
    566,301,197
    
    
    $
    541,287,475
  3




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##### Table of Contents



Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005INTEREST INCOME:Interest and fees on loans
    
    $
    7,620,780
    
    
    $
    5,765,253
    
    
    $
    21,459,656
    
    
    $
    16,081,572Taxable interest and dividends
on investment securities
    
    
    1,529,140
    
    
    
    1,644,284
    
    
    
    4,710,343
    
    
    
    5,147,636Interest on deposits with banks
    
    
    36,882
    
    
    
    24,165
    
    
    
    144,672
    
    
    
    53,401Total interest income
    
    
    9,186,802
    
    
    
    7,433,702
    
    
    
    26,314,671
    
    
    
    21,282,609INTEREST EXPENSE:Interest on deposits
    
    
    3,273,112
    
    
    
    1,767,789
    
    
    
    8,501,892
    
    
    
    4,268,209Interest on short-term borrowings
    
    
    276,858
    
    
    
    553,415
    
    
    
    828,026
    
    
    
    2,192,712Interest on long-term debt
    
    
    1,294,107
    
    
    
    1,245,426
    
    
    
    4,033,898
    
    
    
    3,284,245Total interest expenses
    
    
    4,844,077
    
    
    
    3,566,630
    
    
    
    13,363,816
    
    
    
    9,745,166NET INTEREST INCOME
    
    
    4,342,725
    
    
    
    3,867,072
    
    
    
    12,950,855
    
    
    
    11,537,443PROVISION FOR LOAN LOSSES
    
    
    116,563
    
    
    
    11,183
    
    
    
    289,135
    
    
    
    200,307NET INTEREST INCOME AFTER
PROVISION FOR LOAN LOSSES
    
    
    4,226,162
    
    
    
    3,855,889
    
    
    
    12,661,720
    
    
    
    11,337,136
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##### Table of Contents



Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005NONINTEREST INCOME:Loan appraisal, credit, and miscellaneous charges
    
    $
    72,850
    
    
    $
    68,666
    
    
    $
    306,639
    
    
    $
    193,546Net gain on the sale of foreclosed property
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    39,756Income from bank owned life insurance
    
    
    84,037
    
    
    
    63,624
    
    
    
    243,845
    
    
    
    186,954Loss on sale of investment securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (14,581
    )Service charges
    
    
    362,565
    
    
    
    334,360
    
    
    
    952,298
    
    
    
    896,110Total noninterest income
    
    
    519,452
    
    
    
    466,650
    
    
    
    1,502,782
    
    
    
    1,301,785NONINTEREST EXPENSE:Salary and employee benefits
    
    
    1,764,419
    
    
    
    1,547,190
    
    
    
    5,179,316
    
    
    
    4,369,643Occupancy
    
    
    329,805
    
    
    
    309,796
    
    
    
    934,093
    
    
    
    835,254Advertising
    
    
    170,553
    
    
    
    112,982
    
    
    
    416,744
    
    
    
    318,552Data processing
    
    
    202,546
    
    
    
    152,285
    
    
    
    633,119
    
    
    
    475,647Legal and professional fees
    
    
    (50,041
    )
    
    
    201,260
    
    
    
    498,126
    
    
    
    450,428Depreciation of furniture, fixtures, and equipment
    
    
    141,931
    
    
    
    118,161
    
    
    
    383,358
    
    
    
    314,511Telephone communications
    
    
    25,049
    
    
    
    12,381
    
    
    
    66,992
    
    
    
    65,783ATM expenses
    
    
    64,413
    
    
    
    61,346
    
    
    
    180,590
    
    
    
    211,227Office supplies
    
    
    32,671
    
    
    
    33,567
    
    
    
    101,621
    
    
    
    101,518Office equipment
    
    
    10,786
    
    
    
    10,010
    
    
    
    35,037
    
    
    
    39,686Other
    
    
    379,534
    
    
    
    210,586
    
    
    
    970,838
    
    
    
    725,944Total noninterest expenses
    
    
    3,071,666
    
    
    
    2,769,564
    
    
    
    9,399,834
    
    
    
    7,908,193INCOME BEFORE INCOME TAXES
    
    
    1,673,948
    
    
    
    1,552,975
    
    
    
    4,764,668
    
    
    
    4,730,728Income tax expense
    
    
    570,895
    
    
    
    562,908
    
    
    
    1,629,543
    
    
    
    1,637,211NET INCOME
    
    
    1,103,053
    
    
    
    990,067
    
    
    
    3,135,125
    
    
    
    3,093,517OTHER COMPREHENSIVE INCOME NET OF TAXNet unrealized holding gains (losses) arising during
period
    
    
    170,439
    
    
    
    (33,443
    )
    
    
    (38,262
    )
    
    
    (116,512
    )COMPREHENSIVE INCOME
    
    $
    1,273,492
    
    
    $
    956,624
    
    
    $
    3,096,863
    
    
    $
    2,977,005INCOME PER COMMON SHAREBasic
    
    $
    0.42
    
    
    $
    0.38
    
    
    $
    1.19
    
    
    $
    1.19Diluted
    
    
    0.39
    
    
    
    0.35
    
    
    
    1.11
    
    
    
    1.12Dividends Paid Per Share
    
    
    0.36
    
    
    
    0.53
    
    
    
    0.36
    
    
    
    0.53
    5




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TRI-COUNTY FINANCIAL CORPORATION
 
 CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
 NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005
 Nine Months EndedSeptember 30,2006
    
    
    2005CASH FLOWS FROM OPERATING ACTIVITIES:Net income
    
    $
    3,135,125
    
    
    $
    3,093,517Adjustments to reconcile net income to net
cash provided (used) by operating activities:Provision for loan losses
    
    
    289,135
    
    
    
    200,307Loss on sales of investment securities
    
    
    
    
    
    
    14,581Depreciation and amortization
    
    
    741,179
    
    
    
    594,906Net amortization of premium/discount on investment securities
    
    
    16,587
    
    
    
    288,210Increase in cash surrender of bank owned life insurance
    
    
    (243,845
    )
    
    
    (186,954
    )Deferred income tax benefit
    
    
    (270,486
    )
    
    
    (111,680
    )Increase in accrued interest receivable
    
    
    (374,091
    )
    
    
    (321,837
    )Decrease in deferred loan fees
    
    
    (146,349
    )
    
    
    (210,792
    )Increase in accounts payable, accrued expenses, other liabilities
    
    
    989,413
    
    
    
    381,764Decrease in other assets
    
    
    361,802
    
    
    
    152,255Gain on sale of foreclosed property
    
    
    
    
    
    
    (39,756
    )Net cash provided by operating activities
    
    
    4,498,470
    
    
    
    3,854,521CASH FLOWS FROM INVESTING ACTIVITIES:Purchase of investment securities available for sale
    
    
    (3,092,176
    )
    
    
    (8,439
    )Proceeds from sale, redemption or principal payments
of investment securities available for sale
    
    
    498,736
    
    
    
    4,754,373Purchase of investment securities held to maturity
    
    
    (4,300,000
    )
    
    
    (25,749,248
    )Proceeds from maturities or principal payments
of investment securities held to maturity
    
    
    19,398,924
    
    
    
    60,124,155Net sale (purchase) of FHLB and federal Reserve stock
    
    
    616,900
    
    
    
    (393,900
    )Loans originated or acquired
    
    
    (129,829,352
    )
    
    
    (157,502,581
    )Principal collected on loans
    
    
    87,407,839
    
    
    
    98,185,118Purchase of bank owned life insurance
    
    
    (2,000,000
    )
    
    
    Purchase of premises and equipment
    
    
    (748,082
    )
    
    
    (1,258,360
    )Proceeds from foreclosed real estate
    
    
    14,677
    
    
    
    39,756Net cash used in investing activities
    
    
    (32,032,534
    )
    
    
    (21,809,126
    )
 6




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##### Table of Contents



TRI-COUNTY FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005
 Nine Months EndedSeptember 30,2006
    
    
    2005CASH FLOWS FROM FINANCING ACTIVITIES:Net increase in deposits
    
    $
    37,002,149
    
    
    $
    65,439,233Proceeds from long-term borrowings
    
    
    10,260,000
    
    
    
    20,000,000Payments of long-term borrowings
    
    
    (20,027,966
    )
    
    
    (5,098,892
    )Trust Preferred Debentures
    
    
    
    
    
    
    5,000,000Net decrease in short term borrowings
    
    
    (5,146,260
    )
    
    
    (64,808,090
    )Proceeds of private placement
    
    
    74,550Exercise of stock options
    
    
    83,741
    
    
    
    166,815Net change in unearned ESOP shares
    
    
    73,554
    
    
    
    60,395Dividends Paid
    
    
    (972,966
    )
    
    
    (930,669
    )Redemption of common stock
    
    
    (419,356
    )
    
    
    (232,185
    )Net cash provided by financing activities
    
    
    20,927,446
    
    
    
    19,596,607(DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS
    
    
    (6,606,618
    )
    
    
    1,642,002CASH AND
CASH EQUIVALENTS - JANUARY 1
    
    
    22,575,240
    
    
    
    17,715,779CASH AND
CASH EQUIVALENTS - SEPT 30
    
    $
    15,968,622
    
    
    $
    19,357,781SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:Cash paid during the nine months for:Interest
    
    $
    13,101,351
    
    
    $
    9,693,637Income taxes
    
    $
    1,272,400
    
    
    $
    1,447,500
  7




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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 1.
    
    BASIS OF PRESENTATIONGeneral.The consolidated financial statements of Tri-County Financial
Corporation (the Company) and its wholly owned subsidiary, Community Bank of
Tri-County (the Bank) included herein are unaudited; however, they reflect all
adjustments consisting only of normal recurring accruals that, in the opinion of management,
are necessary to present fairly the Companys financial condition, results of operations,
and cash flows for the periods presented. Certain information and note disclosures normally
included in financial statements prepared in accordance with accounting principles generally
accepted in the United States of America have been condensed or omitted pursuant to the
rules and regulations of the Securities and Exchange Commission. The Company believes that
the disclosures are adequate to make the information presented not misleading. The balances
as of December 31, 2005 have been derived from audited financial statements. There have been
no significant changes to the Companys accounting policies as disclosed in the 2005 Annual
Report. The results of operations for the nine months ended September 30, 2006 are not
necessarily indicative of the results of operations to be expected for the remainder of the
year or any other period. Certain previously reported amounts have been restated to conform
to the 2006 presentation.These consolidated financial statements be read in conjunction with the consolidated
financial statements and notes included in the Companys Annual Report for the year ended
December 31, 2005.2.
    
    NATURE OF BUSINESSThe Company, through its bank subsidiary, provides domestic financial services primarily in
southern Maryland. The primary financial services include real estate, commercial and
consumer lending, as well as traditional demand deposits and savings products.3.
    
    INCOME TAXESThe Company uses the liability method of accounting for income taxes as required by SFAS No.
109, Accounting for Income Taxes. Under the liability method, deferred-tax assets
and liabilities are determined based on differences between the financial statement carrying
amounts and the tax bases of existing assets and liabilities (i.e., temporary differences)
and are measured at the enacted rates that will be in effect when these differences reverse.4.
    
    EARNINGS PER SHAREEarnings per common share are computed by dividing net income by the weighted average number
of common shares outstanding during the period. Diluted earnings per common share is
computed by dividing net income by the weighted average number of common shares outstanding
during the period, including any potential dilutive common shares outstanding, such as
options and warrants. As of September 30, 2006, there were no shares excluded from the
diluted earnings per share computation. Basic and diluted earnings per share, have been
computed based on weighted-average common and common equivalent shares outstanding
as follows:
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2006
    
    2005
    
    2006
    
    2005Basic
    
    
    2,639,868
    
    
    
    2,600,834
    
    
    
    2,640,477
    
    
    
    2,598,314Diluted
    
    
    2,824,308
    
    
    
    2,701,296
    
    
    
    2,819,123
    
    
    
    2,769,467
 Share and per share data have been adjusted to reflect the three for two common stock splits
effected on December 12, 2005 and announced on October 25, 2006 as if they had occurred on
January 1, 2005.
 8




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##### Table of Contents



5.
    
    STOCK-BASED COMPENSATIONThe Company has stock option and incentive plans to attract and retain key personnel in
order to promote the success of the business. These plans are described in note 12 to the
financial statements included in our Annual Report to Stockholders for the year ended
December 31, 2005. Prior to 2006, the Company applied the intrinsic value method as outlined
in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees
(APB No. 25) and related interpretations in accounting for stock options granted. Under
the intrinsic value method, no compensation expense was recognized if the exercise price of
the Companys employee stock options equaled the market price of the underlying stock on the
date of the grant. Accordingly, no compensation cost was recognized in the accompanying
consolidated statements of earnings prior to 2006 on stock options granted to employees or
directors, since all options granted under the Companys incentive programs had an exercise
price equal to the market value of the underlying common stock on the date of grant.Effective January 1, 2006, the Company adopted SFAS No. 123(R), Share-Based
Payment (SFAS No. 123(R)). This statement replaced SFAS No. 123, Accounting for
Stock-based Compensation and superseded APB No. 25. SFAS No. 123(R) requires that
all stock-based compensation be recognized as an expense in the financial statements and
that such cost be measured at the fair value of the award. This statement was adopted using
the modified prospective method of application, which requires the Company to recognize
compensation expense on a prospective basis. Therefore, prior period financial statements
have not been restated. Under this method, in addition to reflecting compensation expense
for new share-based awards, expense is also recognized to reflect the remaining service
period of outstanding awards that had been included in pro forma disclosures in prior
periods. As of December 31, 2005, all outstanding options were fully vested, so no expense
will be recognized for options outstanding as of that date. SFAS No. 123(R) also requires
that excess tax benefits related to stock option exercises be reflected as financing cash
flows instead of operating cash flows.The Company and the Bank currently maintain incentive plans which provide for payments to be
made in either cash or stock options. The Company has accrued the full amounts due under
these plans, but currently it is not possible to identify the portion that will be paid out
in the form of stock options.The following table illustrates the effect on the net earnings per common share if the fair
value method had been applied to all outstanding awards for the three and nine months ended
September 30, 2005:
 Three Months Ended
    
    Nine Months EndedSeptember 30, 2005
    
    September 30, 2005Net Income as reported
    
    $
    990,067
    
    
    $
    3,093,517Less pro forma stock based compensation:Expense determined under fair value method, net
of tax effects.
    
    
    (45,979
    )
    
    
    (239,592
    )Pro forma net income
    
    $
    944,088
    
    
    $
    2,853,925Net income per shareBasic - as reported
    
    $
    0.38
    
    
    $
    1.19Basic - pro forma
    
    $
    0.36
    
    
    $
    1.10Diluted - as reported
    
    $
    0.35
    
    
    $
    1.12Diluted - pro forma
    
    $
    0.34
    
    
    $
    1.03
 9




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##### Table of Contents



A summary of the Companys stock option plans as of September 30, 2006 and changes
during the nine-month period then ended is presented below:
 Weighted
    
    
    
    
    
    
    Weighted-AverageAverage
    
    
    Aggregate
    
    
    Contractual LifeExercise
    
    
    Intrinsic
    
    
    Remaining InShares
    
    
    Price
    
    
    Value
    
    
    YearsOutstanding at December 31, 2005
    
    
    444,753
    
    
    $
    13.59Granted at fair value
    
    
    
    
    
    
    Exercised
    
    
    (9,770
    )
    
    
    8.57Expired
    
    
    
    
    
    
    Forfeited
    
    
    (7,734
    )
    
    
    12.85Outstanding at September 30, 2006
    
    
    427,250
    
    
    $
    13.72
    
    
    $
    4,250,754
    
    
    
    5.5Exercisable at September 30, 2006
    
    
    427,250
    
    
    $
    13.72
    
    
    $
    4,250,754
    
    
    
    5.5
  6.
    
    GUARANTEED PREFERRED BENEFICIAL INTEREST IN JUNIOR SUBORDINATED DEBENTURES
 On June 15, 2005, Tri County Capital Trust II (Capital Trust II), a Delaware business
trust formed, funded and wholly owned by the Company, issued $5,000,000 of
variable-rate capital securities with an interest rate of 5.07% in a private pooled
transaction. The variable rate is based on the 90 day LIBOR rate plus 1.70% and adjusts
quarterly. The Trust used the proceeds from this issuance to purchase $5.2 million of the
Companys junior subordinated debentures. The interest rate on the debentures is identical
to the interest rate on the trust preferred securities. The Company has, through various
contractual arrangements, fully and unconditionally
guaranteed all of Capital Trust IIs obligations with respect to the capital securities.
These capital securities qualify as Tier I capital and are presented in the Consolidated
Balance Sheets as Guaranteed Preferred Beneficial Interests in Junior Subordinated
Debentures. Both the capital securities of Capital Trust II and the junior subordinated
debentures are scheduled to mature on June 15, 2035, unless called by the Company not
earlier than June 15, 2010.
 10




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##### Table of Contents



On July 22, 2004, Tri County Capital Trust I (Capital Trust I), a Delaware business trust
formed, funded and wholly owned by the Company, issued $7,000,000 of variable-rate
capital securities with an interest rate of 4.22% in a private pooled transaction. The
variable rate is based on the 90 day LIBOR rate plus 2.60% and adjusts quarterly. The Trust
used the proceeds from this issuance to purchase $7.2 million of the Companys junior
subordinated debentures. The interest rate on the debentures is identical to the interest
rate on the trust preferred securities. The Company has, through various contractual
arrangements, fully and unconditionally guaranteed all of Capital Trust Is obligations with
respect to the capital securities. These capital securities qualify as Tier I capital and
are presented in the Consolidated Balance Sheets as Guaranteed Preferred Beneficial
Interests in Junior Subordinated Debentures. Both the capital securities of Capital Trust I
and the junior subordinated debentures are scheduled to mature on July 22, 2034, unless
called by the Company not earlier than July 22, 2009.Costs associated with the issuance of the trust-preferred securities were less than
$10,000 and were expensed as period costs.7.
    
    NEW ACCOUNTING STANDARDSIn February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial
Instruments which amends SFAS No. 133 Accounting for Derivative Instruments and Hedging
Activities and SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities. SFAS 155 simplifies the accounting for certain
derivative embedded in other financial instruments by allowing them to be accounted for as a
whole if the holder elects to account for the whole instrument on a fair value basis. SFAS
155 also clarifies and amends certain other provisions of SFAS 133 and SFAS 140. SFAS 155
is effective for all financial instruments acquired, issued or subject to a re-measurement
event occurring in fiscal years beginning after September 15, 2006. Earlier adoption is
permitted, provided the Company has not yet issued financial statements, including for
interim periods, for that fiscal year. Management does not expect the adoption of SFAS 155
to have a material impact on the consolidated financial statements.In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial
Assets which amends SFAS No. 14 and SFAS 156 requires that all separately recognized
servicing assets and servicing liabilities be initially measured at fair value, if
practicable. The statement permits, but does not require, the subsequent measurement of
servicing assets and servicing liabilities at fair value. SFAS 156 is effective for fiscal
years beginning after September 15, 2006. Management does not expect the adoption of SFAS 155
to have a material impact on the consolidated financial statements.In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation
(FIN) No. 48, Accounting for Uncertainty in
Income Taxes-an interpretation of FASB
Statement No. 109. This Interpretation prescribes a recognition threshold and measurement
attribute for the financial statement recognition and measurement of a tax position taken, or
expects to be taken in a tax return, and provides guidance on derecognition, classification,
interest and penalties, accounting in interim periods, disclosure and transition. This
Interpretation is effective for fiscal years beginning after December 15, 2006. Management does
not expect the adoption of (FIN) No. 48 to have a material impact on the consolidated
financial statements.In June 2006, the FASB ratified Emerging Issues Task Force (EITF) No. 06-2, Accounting
for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43, Accounting
for Compensated Absences (SAFS 43) (EITF 06-2). EITF 06-2 provides guidelines under which
sabbatical leave or other similar benefits provided to an employee are considered to
accumulate, as defined in SFAS 43. If such benefits are deemed to accumulate, then the
compensation cost associated with a sabbatical or other similar benefit arrangement should be
accrued over the requisite service period. The provisions of the EITF are effective for fiscal
years beginning after December 15, 2006 and allow for either retrospective application or a
cumulative effect adjustment approach upon adoption. Management does not expect the adoption of
(EITF 06-2) to have a material impact on the
consolidated financial statements.
 11




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##### Table of Contents



ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
        12




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##### Table of Contents



Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2006
    
    2005
    
    2006
    
    2005Condensed Income Statement:Interest Income
    
    $
    9,186,802
    
    
    $
    7,433,702
    
    
    $
    26,314,671
    
    
    $
    21,282,609Interest Expense
    
    
    4,844,077
    
    
    
    3,566,630
    
    
    
    13,363,816
    
    
    
    9,745,166Net Interest Income
    
    
    4,342,725
    
    
    
    3,867,072
    
    
    
    12,950,855
    
    
    
    11,537,443Provision for Loan Loss
    
    
    116,563
    
    
    
    11,183
    
    
    
    289,135
    
    
    
    200,307Noninterest Income
    
    
    519,452
    
    
    
    466,650
    
    
    
    1,502,782
    
    
    
    1,301,785Noninterest Expense
    
    
    3,071,666
    
    
    
    2,769,564
    
    
    
    9,399,834
    
    
    
    7,908,193Income Before Income Taxes
    
    
    1,673,948
    
    
    
    1,552,975
    
    
    
    4,764,668
    
    
    
    4,730,728Income Taxes
    
    
    570,895
    
    
    
    562,908
    
    
    
    1,629,543
    
    
    
    1,637,211Net Income
    
    
    1,103,053
    
    
    
    990,067
    
    
    
    3,135,125
    
    
    
    3,093,517Per Common Share: (I)Basic Earnings
    
    $
    0.42
    
    
    $
    0.38
    
    
    $
    1.19
    
    
    $
    1.19Diluted Earnings
    
    $
    0.39
    
    
    $
    0.35
    
    
    $
    1.11
    
    
    $
    1.12Book Value
    
    $
    13.83
    
    
    $
    12.75
    
    
    $
    13.83
    
    
    $
    12.75
 
 (I)
    
    Share and per share data have been adjusted to reflect the three for two common stock splits
effected on December 12, 2005 and announced on October 25, 2006 as if they had occurred on January
1, 2005.    13




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##### Table of Contents



Nine Months Ended September 30,2006
    
    
    2005
    
    
    $ Change
    
    
    % ChangeNONINTEREST INCOMELoan
appraisal, credit, and miscellaneous charges
    
    $
    306,639
    
    
    $
    193,546
    
    
    $
    113,093
    
    
    
    58.43
    %Net gain on the sale of foreclosed property
    
    
    
    
    
    
    39,756
    
    
    
    (39,756
    )
    
    
    (100.00
    %)Income from bank owned life insurance
    
    
    243,845
    
    
    
    186,954
    
    
    
    56,891
    
    
    
    30.43
    %Loss on sale of investment securities
    
    
    
    
    
    
    (14,581
    )
    
    
    14,581
    
    
    
    (100.00
    %)Service charges
    
    
    952,298
    
    
    
    896,110
    
    
    
    56,188
    
    
    
    6.27
    %Total noninterest income
    
    $
    1,502,782
    
    
    $
    1,301,785
    
    
    $
    200,997
    
    
    
    15.44
    %
  Nine Months Ended September 30,2006
    
    
    2005
    
    
    $ Change
    
    
    % ChangeNONINTEREST EXPENSESalary and employee benefits
    
    $
    5,179,316
    
    
    $
    4,369,643
    
    
    $
    809,673
    
    
    
    18.53
    %Occupancy
    
    
    934,093
    
    
    
    835,254
    
    
    
    98,839
    
    
    
    11.83
    %Advertising
    
    
    416,744
    
    
    
    318,552
    
    
    
    98,192
    
    
    
    30.82
    %Data processing
    
    
    633,119
    
    
    
    475,647
    
    
    
    157,472
    
    
    
    33.11
    %Legal and professional fees
    
    
    498,126
    
    
    
    450,428
    
    
    
    47,698
    
    
    
    10.59
    %Depreciation of furniture, fixtures, and equipment
    
    
    383,358
    
    
    
    314,511
    
    
    
    68,847
    
    
    
    21.89
    %Telephone communications
    
    
    66,992
    
    
    
    65,783
    
    
    
    1,209
    
    
    
    1.84
    %ATM expenses
    
    
    180,590
    
    
    
    211,227
    
    
    
    (30,637
    )
    
    
    (14.50
    %)Office supplies
    
    
    101,621
    
    
    
    101,518
    
    
    
    103
    
    
    
    0.10
    %Office equipment
    
    
    35,037
    
    
    
    39,686
    
    
    
    (4,649
    )
    
    
    (11.71
    %)Other
    
    
    970,838
    
    
    
    725,944
    
    
    
    244,894
    
    
    
    33.73
    %Total noninterest expenses
    
    $
    9,399,834
    
    
    $
    7,908,193
    
    
    $
    1,491,641
    
    
    
    18.86
    %
  14




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##### Table of Contents



Three Months Ended September 30,2006
    
    
    2005
    
    
    $ Change
    
    

%
ChangeNONINTEREST INCOMELoan appraisal, credit, and miscellaneous charges
    
    $
    72,850
    
    
    $
    68,666
    
    
    $
    4,184
    
    
    
    6.09
    %Income from bank owned life insurance
    
    
    84,037
    
    
    
    63,624
    
    
    
    20,413
    
    
    
    32.08
    %Service charges
    
    
    362,565
    
    
    
    334,360
    
    
    
    28,205
    
    
    
    8.44
    %Total noninterest income
    
    $
    519,452
    
    
    $
    466,650
    
    
    $
    52,802
    
    
    
    11.32
    %
  Three Months Ended September 30,2006
    
    
    2005
    
    

$ Change
    
    
    % ChangeNONINTEREST EXPENSESalary and employee benefits
    
    $
    1,764,419
    
    
    $
    1,547,190
    
    
    $
    217,229
    
    
    
    14.04
    %Occupancy
    
    
    329,805
    
    
    
    309,796
    
    
    
    20,009
    
    
    
    6.46
    %Advertising
    
    
    170,553
    
    
    
    112,982
    
    
    
    57,571
    
    
    
    50.96
    %Data processing
    
    
    202,546
    
    
    
    152,285
    
    
    
    50,261
    
    
    
    33.00
    %Legal and professional fees
    
    
    (50,041
    )
    
    
    201,260
    
    
    
    (251,301
    )
    
    
    (124.86
    %)Depreciation of furniture, fixtures, and equipment
    
    
    141,931
    
    
    
    118,161
    
    
    
    23,770
    
    
    
    20.12
    %Telephone communications
    
    
    25,049
    
    
    
    12,381
    
    
    
    12,668
    
    
    
    102.32
    %ATM expenses
    
    
    64,413
    
    
    
    61,346
    
    
    
    3,067
    
    
    
    5.00
    %Office supplies
    
    
    32,671
    
    
    
    33,567
    
    
    
    (896
    )
    
    
    (2.67
    %)Office equipment
    
    
    10,786
    
    
    
    10,010
    
    
    
    776
    
    
    
    7.75
    %Other
    
    
    379,534
    
    
    
    210,586
    
    
    
    168,948
    
    
    
    80.23
    %Total noninterest expenses
    
    $
    3,071,666
    
    
    $
    2,769,564
    
    
    $
    302,102
    
    
    
    10.91
    %
 15




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##### Table of Contents



September 30, 2006
    
    
    December 31, 2005
    
    
    $ Change
    
    

%
ChangeAssetsCash and due from banks
    
    $
    3,474,835
    
    
    $
    7,262,547
    
    
    $
    (3,787,712
    )
    
    
    (52.15
    %)Federal Funds sold
    
    
    567,212
    
    
    
    640,818
    
    
    
    (73,606
    )
    
    
    (11.49
    %)Interest-bearing deposits with banks
    
    
    11,926,575
    
    
    
    14,671,875
    
    
    
    (2,745,300
    )
    
    
    (18.71
    %)Securities available for sale
    
    
    9,702,681
    
    
    
    7,178,894
    
    
    
    2,523,787
    
    
    
    35.16
    %Securities held to maturity  at amortized cost
    
    
    101,382,853
    
    
    
    116,486,685
    
    
    
    (15,103,832
    )
    
    
    (12.97
    %)Federal Home Loan Bank and Federal Reserve Bank
stock
    
    
    6,573,400
    
    
    
    7,190,300
    
    
    
    (616,900
    )
    
    
    (8.58
    %)Loans receivable  net of allowance for loan losses
of $3,667,047 and $3,383,334, respectively
    
    
    411,870,980
    
    
    
    369,592,253
    
    
    
    42,278,727
    
    
    
    11.44
    %Premises and equipment, net
    
    
    6,467,448
    
    
    
    6,460,545
    
    
    
    6,903
    
    
    
    0.11
    %Foreclosed real estate
    
    
    460,884
    
    
    
    475,561
    
    
    
    (14,677
    )
    
    
    (3.09
    %)Accrued interest receivable
    
    
    2,780,633
    
    
    
    2,406,542
    
    
    
    374,091
    
    
    
    15.54
    %Investment in bank owned life insurance
    
    
    8,678,020
    
    
    
    6,434,175
    
    
    
    2,243,845
    
    
    
    34.87
    %Other assets
    
    
    2,415,676
    
    
    
    2,487,280
    
    
    
    (71,604
    )
    
    
    (2.88
    %)Total Assets
    
    $
    566,301,197
    
    
    $
    541,287,475
    
    
    $
    25,013,722
    
    
    
    4.62
    %
   September 30, 2006
    
    
    December 31, 2005Amount
    
    
    %
    
    
    Amount
    
    
    %Real Estate LoansCommercial
    
    $
    173,024,531
    
    
    
    41.59
    %
    
    $
    166,850,838
    
    
    
    44.66
    %Residential first mortgages
    
    
    78,573,247
    
    
    
    18.89
    %
    
    
    73,627,717
    
    
    
    19.71
    %Residential construction
    
    
    39,044,884
    
    
    
    9.39
    %
    
    
    32,608,002
    
    
    
    8.73
    %Second mortgage loans
    
    
    26,866,914
    
    
    
    6.46
    %
    
    
    25,884,406
    
    
    
    6.93
    %Commercial lines of credit
    
    
    77,255,675
    
    
    
    18.57
    %
    
    
    54,737,693
    
    
    
    14.65
    %Consumer loans
    
    
    3,155,803
    
    
    
    0.76
    %
    
    
    3,128,425
    
    
    
    0.84
    %Commercial equipment
    
    
    18,074,337
    
    
    
    4.34
    %
    
    
    16,742,220
    
    
    
    4.48
    %415,995,391
    
    
    
    100.00
    %
    
    
    373,579,301
    
    
    
    100.00
    %Less:Deferred loan fees
    
    
    457,365
    
    
    
    0.11
    %
    
    
    603,714
    
    
    
    0.16
    %Allowance for loan loss
    
    
    3,667,047
    
    
    
    0.88
    %
    
    
    3,383,334
    
    
    
    0.91
    %$
    411,870,979
    
    
    
    
    
    
    $
    369,592,253
 16




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##### Table of Contents



Nine Months Ended
    
    
    Nine Months EndedSeptember 30, 2006
    
    
    September 30, 2005Beginning balance
    
    $
    3,383,334
    
    
    $
    3,057,558Charge-offs
    
    
    8,181
    
    
    
    4,468Recoveries
    
    
    2,759
    
    
    
    5,185Net charge-offs
    
    
    5,422
    
    
    
    (717
    )Provision for loan losses
    
    
    289,135
    
    
    
    200,307Balance at the end of the Period
    
    $
    3,667,047
    
    
    $
    3,258,582
  Balances as of
    
    
    Balances as ofSeptember 30, 2006
    
    
    December 31, 2005Restructured Loans
    
    $
    
    
    
    $
    Accruing loans which are contractually
past due 90 days or more:
    
    $
    
    
    
    $
    Loans accounted for on a non-accrual
basis
    
    $
    1,072,943
    
    
    $
    590,498Total non-performing loans
    
    $
    1,072,943
    
    
    $
    590,498Non-performing loans to total loans
    
    
    0.26
    %
    
    
    0.16
    %Allowance for loan losses to non-
performing loans
    
    
    341.77
    %
    
    
    572.96
    %
  17




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##### Table of Contents



September 30, 2006
    
    
    December 31, 2005
    
    
    $ Change
    
    
    % ChangeLiabilities:Noninterest-bearing deposits
    
    $
    43,047,897
    
    
    $
    44,325,083
    
    
    $
    (1,277,186
    )
    
    
    (2.88
    %)Interest-bearing deposits
    
    
    357,327,992
    
    
    
    319,048,657
    
    
    
    38,279,335
    
    
    
    12.00
    %Total deposits
    
    
    400,375,889
    
    
    
    363,373,740
    
    
    
    37,002,149
    
    
    
    10.18
    %Short-term borrowings
    
    
    14,928,715
    
    
    
    20,074,975
    
    
    
    (5,146,260
    )
    
    
    (25.64
    %)Long-term debt
    
    
    98,055,793
    
    
    
    107,823,759
    
    
    
    (9,767,966
    )
    
    
    (9.06
    %)Guaranteed preferred beneficial
interest in junior subordinated
debentures
    
    
    12,000,000
    
    
    
    12,000,000
    
    
    
    
    
    
    
    0.00
    %Accrued expenses and other liabilities
    
    
    4,426,258
    
    
    
    3,436,845
    
    
    
    989,413
    
    
    
    28.79
    %Total liabilities
    
    $
    529,786,655
    
    
    $
    506,709,319
    
    
    $
    23,077,336
    
    
    
    4.55
    %
  September 30, 2006
    
    
    December 31, 2005
    
    
    $ Change
    
    
    % ChangeStockholders Equity:Common stock
    
    $
    17,597
    
    
    $
    17,610
    
    
    $
    (13
    )
    
    
    (0.07
    %)Additional paid in capital
    
    
    9,259,317
    
    
    
    9,057,805
    
    
    
    201,512
    
    
    
    2.22
    %Retained earnings
    
    
    27,323,557
    
    
    
    25,580,634
    
    
    
    1,742,923
    
    
    
    6.81
    %Accumulated other comprehensive income
    
    
    11,100
    
    
    
    49,362
    
    
    
    (38,262
    )
    
    
    (77.51
    %)Unearned ESOP shares
    
    
    (97,029
    )
    
    
    (127,255
    )
    
    
    30,226
    
    
    
    (23.75
    %)$
    36,514,542
    
    
    $
    34,578,156
    
    
    $
    1,936,386
    
    
    
    5.60
    %
     18




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19




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##### Table of Contents



20




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##### Table of Contents



ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
  
 ITEM 4. CONTROLS AND PROCEDURES.
   
 PART II OTHER INFORMATION
 
  
  
   21




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##### Table of Contents



(c)Total Numberof Shares
    
    (d)Purchased
    
    Maximum(a)
    
    
    
    
    
    as Part of
    
    Number of SharesTotal
    
    (b)
    
    Publicly
    
    that May Yet BeNumber of
    
    Average
    
    Announced Plans
    
    Purchased UnderShares
    
    Price Paid
    
    or
    
    the Plans orPeriod
    
    Purchased (I)
    
    per Share
    
    Programs
    
    ProgramsJuly 2006
    
    
    2,630
    
    
    $
    24.26
    
    
    
    2,630
    
    
    
    78,578August 2006
    
    
    2,370
    
    
    
    24.11
    
    
    
    2,370
    
    
    
    76,208September 2006
    
    
    1,220
    
    
    
    23.33
    
    
    
    1,220
    
    
    
    74,9886,219
    
    
    $
    24.10
    
    
    
    6,219
  
 
 
  
  
  
  Exhibit 10.1
    
    Salary Continuation Agreement between
Community Bank of Tri-County and Gregory C. CockerhamExhibit 10.2
    
    Salary Continuation Agreement between
Community Bank of Tri-County and William J. PasenelliExhibit 10.3
    
    Salary Continuation Agreement between
Community Bank of Tri-County and Michael L. MiddletonExhibit 31.1
    
    Rule 13a14(a) Certification of CEOExhibit 31.2
    
    Rule 13a14(a) Certification of CFOExhibit 32
    
    Section 1350 Certifications
 22




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##### Table of Contents



SIGNATURES
  TRI-COUNTY FINANCIAL CORPORATION:Date: November 13, 2006
    
    By :
    
    /s/ Michael L. MiddletonMichael L. Middleton, President, ChiefExecutive Officer and Chairman of the BoardDate: November 13, 2006
    
    By:
    
    /s/ William J. PaseneelliWilliam J. Pasenelli, Executive VicePresident and Chief Financial Officer(Principal Financial and Accounting Officer)
 23