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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10 - Q

(Mark One)

x

Quarterly report under Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the quarterly period ended March 31, 2003

o

Transition report under Section 13 or 15(d) of the Exchange Act

For the transition period ___________________ to ___________________

Commission file number 0-26486

Auburn National Bancorporation, Inc.

(Exact Name of Registrant as Specified in Its Charter)

100 N. Gay Street, Auburn, Alabama 36830
(Address of Principal Executive Offices)

(334)821-9200
(Issuer’s Telephone Number, Including Area Code)

___________________________________________________________________________________________
(Former Name, Former Address and Former Fiscal Year, if Changed
Since Last Report)

Check whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No o

Check whether the registrant is an accelerated filer.

Yes oNo x

APPLICABLE ONLY TO CORPORATE ISSUERS

State the number of shares outstanding of each of the issuer’s classes of common equity, as of April 30, 2003: 3,894,818 shares of common stock, $.01 par value per share

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AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY

INDEX

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AUBURN NATIONAL BANCORPORATION, INC.
AND SUBSIDIARY
Consolidated Balance Sheets
March 31, 2003 and December 31, 2002
(Unaudited)

See accompanying notes to consolidated financial statements.

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AUBURN NATIONAL BANCORPORATION, INC.
AND SUBSIDIARY
Consolidated Statements of Earnings
For the Three Months Ended March 31, 2003 and 2002
(Unaudited)

See accompanying notes to consolidated financial statements.

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AUBURN NATIONAL BANCORPORATION, INC.
AND SUBSIDIARY
Consolidated Statement of Stockholders’ Equity and Comprehensive Income
For the Three Months Ended March 31, 2003
(Unaudited)

See accompanying notes to consolidated financial statements.

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AUBURN NATIONAL BANCORPORATION, INC.
AND SUBSIDIARY
Consolidated Statements of Cash Flows
For the Three Months Ended March 31, 2003 and 2002
(Unaudited)

See accompanying notes to consolidated financial statements.

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AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARY
Notes to the Consolidated Financial Statements
March 31, 2003

Note 1 - General

The consolidated financial statements in this report have been prepared in accordance with accounting principles generally accepted in the United States and have not been audited. In the opinion of management, all adjustments necessary to present fairly the financial position and the results of operations for the interim periods have been made. All such adjustments are of a normal recurring nature. The results of operations are not necessarily indicative of the results of operations which Auburn National Bancorporation, Inc. (the “Company”) may achieve for future interim periods or the entire year. For further information, refer to the consolidated financial statements and footnotes included in the Company’s annual report on Form 10-K for the year ended December 31, 2002.

Note 2 - Comprehensive Income

The primary component of the differences between net income and comprehensive income for the Company is unrealized gains/losses on available for sale securities. Total comprehensive income for the three months ended March 31, 2003 was $944,000 compared to a total comprehensive loss of $77,000 for the three months ended March 31, 2002.

Note 3 - Derivatives

As part of its overall interest rate risk management activities, the Company utilizes derivatives instruments to modify the repricing characteristics of on-balance sheet assets and liabilities. The primary instruments utilized by the Company are interest rate swaps and interest rate floor and cap arrangements. The fair value of these off-balance sheet derivative financial instruments are based on dealer quotes and third party financial models.

As of March 31, 2003, the Company had the following derivative instrument:

At March 31, 2003, the $5 million interest rate swap was used as a fair value hedge to convert the interest rate on a like amount of certificates of deposit with similar terms from fixed to variable.

Note 4 – Recent Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 141, “Business Combinations” and SFAS No. 142, “Goodwill and Other Intangible Assets”. SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. SFAS No. 141 also specifies criteria that intangible assets acquired in a business combination must meet to be recognized and reported apart from goodwill. SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS No. 144. SFAS No. 142 also requires that intangible assets with finite lives be amortized over their respective estimated useful lives.

The Company adopted the provisions of SFAS No. 141 effective July 1, 2001, and adopted the provisions of SFAS No. 142 effective January 1, 2002. As the Company has no goodwill or significant identifiable intangibles as of January 1,

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2002, the adoption of SFAS No. 142 did not have an impact on the Company’s consolidated financial position or results of operations.

In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations”. SFAS No. 143 requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. SFAS No. 143 applies to legal obligations associated with the retirement of long–lived assets that result from the acquisition, construction, development and/or the normal operation of a long–lived asset, except for certain lease obligations. The adoption of SFAS No. 143 as of January 1, 2003 did not have a material effect on the financial condition or results of operations of the Company.

In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long–Lived Assets”. SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long–lived assets. SFAS No. 144 supersedes SFAS No. 121, “Accounting for the Impairment of Long–Lived Assets and for Long–Lived Assets to Be Disposed Of”, and the accounting and reporting provisions of Accounting Principles Board (APB) Opinion No. 30, “Reporting the Results of Operations – Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions”, for the disposal of a segment of a business (as previously defined in that opinion). This statement also amends Accounting Research Bulletin No. 51, “Consolidated Financial Statements”, to eliminate the exception to consolidation for a subsidiary for which control is likely to be temporary.

SFAS No. 144 improves financial reporting by requiring that one accounting model be used for long–lived assets to be disposed of by sale, whether previously held and used or newly acquired, and by broadening the presentation of discontinued operations to include more disposal transactions. The adoption of SFAS No. 144 as of January 1, 2002 did not have a material effect on the financial condition or results of operations of the Company.

The FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, 64, Amendment of FASB Statement No. 13”, and “Technical Corrections”, in April 2002. SFAS No. 145 rescinds SFAS No. 4, “Reporting Gains and Losses from Extinguishment of Debt”, SFAS No. 44, “Accounting for Intangible Assets of Motor Carriers”, and SFAS No. 64, “Extinguishments of Debt Made to Satisfy Sinking–Fund Requirements”. These rescissions eliminate the requirement to report gains and losses from the extinguishment of debt as an extraordinary item, net of related income tax effect, and are effective for fiscal years beginning after May 15, 2002. This statement also amends SFAS 13, “Accounting for Leases”, and requires that capital leases that are modified so that the resulting lease agreement is classified as an operating lease be accounted for as a sale–leaseback. This amendment is effective for transactions occurring after May 15, 2002. Finally, this statement amends several pronouncements to make technical corrections to existing authoritative pronouncements. The adoption of SFAS No. 145 did not have a material effect on the financial condition or results of operations of the Company.

The FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities”, in July 2002. SFAS No. 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS No. 146 is effective prospectively for exit or disposal activities initiated after December 31, 2002. Management does not expect this statement to have a material impact on the consolidated financial statements.

The FASB issued SFAS No. 147, “Acquisitions of Certain Financial Institutions”, in October 2002. SFAS No. 147 removes certain acquisitions of financial institutions (other than transactions between two or more mutual enterprises) from the scope of SFAS No. 72, Accounting for Certain Acquisitions of Banking or Thrift Institutions and FASB Interpretation 9, “Applying APB Opinions 16 and 17 When a Savings and Loan or a Similar Institution Is Acquired in a Business Combination Accounted for by the Purchase Method”. These types of transactions are now accounted for under SFAS No. 141 and SFAS No. 142. In addition, this statement amends SFAS No. 144, “Accounting for the Impairment or Disposal of Long–Lived Assets”, to include in its scope long–term customer relationship intangible assets of financial institutions. SFAS No. 147 did not have a material effect on the financial condition or results of operations of the Company.

The FASB issued SFAS No. 148, “Accounting for Stock–Based Compensation — Transition and Disclosure” in December 2002. SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock–based compensation. In addition, this statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock–based employee compensation and the effect of the method used on reported results. Finally, this

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statement amends APB Opinion No. 28, “Interim Financial Reporting”, to require disclosure about those effects in interim financial information. This statement is effective for fiscal and interim periods ending after December 15, 2002. The adoption of SFAS No. 148 did not have a material effect on the financial condition or results of operations of the Company.

The FASB issued SFAS No. 149, “Amendment of Statement 144 on Derivative Instruments and Hedging Activities” in April 2003. SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS No. 133. Management does not expect SFAS No. 149 to have a material impact on the financial condition or results of operations of the Company.

The FASB issued FASB Interpretation (FIN) 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” in November 2002. FIN 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of the guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of FIN 45 are applied prospectively to guarantees issued or modified after December 31, 2002. The adoption of these recognition provisions will result in recording liabilities associated with certain guarantees provided by the Company. These currently include standby letters of credit. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. Management does not expect FIN 45 to have a material impact on the financial condition or results of operations of the Company.

The FASB issued FIN 46, “Consolidation of Variable Interest Entities”, in January 2003, which clarifies the application of Accounting Research Bulletin (ARB) 51, “Consolidated Financial Statements”, to certain entities (called variable interest entities) in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The disclosure requirements of FIN 46 are effective for all financial statements issued after January 31, 2003. The consolidation requirements apply to all variable interest entities created after January 31, 2003. In addition, public companies must apply the consolidation requirements to variable interest entities that existed prior to February 1, 2003 and remain in existence as of the beginning of annual or interim periods beginning after June 15, 2003. Management is currently assessing the impact of FIN 46, and does not expect it to have a material impact on the financial condition or results of operations of the Company.

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

The following discussion and analysis is designed to provide a better understanding of various factors related to the results of operations and financial condition of the Company and its wholly-owned subsidiary, AuburnBank (the “Bank”). This discussion is intended to supplement and highlight information contained in the accompanying unaudited consolidated financial statements for the three months ended March 31, 2003 and 2002.

Certain of the statements made herein under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and elsewhere, including information incorporated herein by reference to other documents, are “forward-looking statements” within the meaning of, and subject to the protections of Section 27A of the Securities Act of 1933 (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).

Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions, and future performance, and involve known and unknown risks, uncertainties and other factors, which may be beyond our control, and which may cause the actual results, performance or achievements of the “Company” to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements.

All statements other than statements of historical fact are statements that could be forward-looking statements. You can identify these forward-looking statements through our use of words such as “may”, “will”, “anticipate”, “assume”, “should”, “indicate”, “would”, “believe”, “contemplate”, “expect”, “estimate”, “continue”, “plan”, “point to”, “project”, “could”, “intend”, “target”, and other similar words and expressions of the future. These forward-looking statements may not be realized due to a variety of factors, including, without limitation:

•

future economic and business conditions;

•

government monetary and fiscal policies;

•

the risks of changes in interest rates on the levels, composition and costs of deposits, loan demand, and the values of loan collateral, securities, and interest sensitive assets and liabilities;

•

the effects of competition from a wide variety of local, regional, national and other providers of financial,

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investment, and insurance services;

•

the failure of assumptions underlying the establishment of allowance for possible loan losses and other estimates;

•

the risks of mergers and acquisitions, including, without limitation, the related costs, including integrating operations as part of these transactions and the failure to achieve expected gains, revenue growth and/or expense savings from such transactions;

•

changes in laws and regulations, including tax laws and regulations;

•

changes in accounting policies, rules and practices;

•

changes in technology or products may be more difficult or costly, or less effective than anticipated;

•

the effects of war or other conflicts, acts of terrorism or other catastrophic events that may affect general economic conditions and economic confidence; and

•

other factors and risks described in any of our subsequent reports that we make with the Commission under the Exchange Act.

All written or oral forward-looking statements that are attributable to us are expressly qualified in their entirety by this cautionary notice. We have no obligation and do not undertake to update, revise or correct any of the forward-looking statements after the date of this report, or after the respective dates on which such statements otherwise are made.

Summary

Net income of $1,342,000 for the quarter ended March 31, 2003 represented an increase of $439,000 (48.6%) from the Company’s net income of $903,000 for the same period of 2002. Basic and diluted net earnings per share increased $0.11 (47.8%) to $0.34 during the first quarter of 2003 from $0.23 for the first quarter of 2002. During the three month period ended March 31, 2003, compared to the same period of 2002, the Company experienced an increase in noninterest income and a decrease in the provision for loan losses. This was offset by a decrease in net interest income and an increase in noninterest expense. The net yield on total interest-earning assets decreased to 3.03% for the three months ended March 31, 2003 from 3.30% for the three months ended March 31, 2002. The decrease in the net yield on interest-earning assets is due to the reinvestment of interest-bearing liabilities in lower yielding interest-earning assets. See the “CONSOLIDATED AVERAGE BALANCES, INTEREST INCOME/EXPENSE AND YIELDS/RATES” table.

Total assets of $509,301,000 at March 31, 2003 represent an increase of $4,274,000 (0.8%) over total assets of $505,027,000, at December 31, 2002. This increase resulted primarily from an increase in investment securities available for sale offset by a decrease in cash and cash equivalents and investment securities held to maturity.

Critical Accounting Policies

The accounting and financial policies of the Company conform to generally accepted accounting principles and to general practices within the banking industry. The allowance for loan losses is an accounting policy applied by the Company which is deemed critical. Critical accounting policies are defined as policies which are important to the portrayal of the Company’s financial condition and results of operations, and that require management’s most difficult, subjective or complex judgements. The Company’s financial results could differ significantly if different judgements or estimates are applied in the application of this policy. See “ALLOWANCE FOR LOAN LOSSES AND RISK ELEMENTS.”

Financial Condition

Investment Securities and Federal Funds Sold

Investment securities held to maturity were $2,175,000 and $7,928,000 at March 31, 2003 and December 31, 2002, respectively. This decrease of $5,753,000 (72.6%) was primarily the result of a $5 million maturity of U.S. agency securities.

Investment securities available for sale increased $18,449,000 (10.1%) to $201,439,000 at March 31, 2003 from $182,990,000 at December 31, 2002. This increase is a result of purchases of $33,321,000 in U.S. agency securities, $22,471,000 in mortgage backed securities, $18,172,000 in CMOs and $460,000 in state and political subdivisions. These increases are offset by $27,366,000 of scheduled paydowns, maturities and calls of principal amounts. In addition, $5,090,000 of U.S. agency securities, $15,981,000 of CMOs, and $6,554,000 of mortgage backed securities were sold in the three months of 2003.

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Federal funds sold decreased to $8,834,000 at March 31, 2003 from $17,832,000 at December 31, 2002. This reflects normal activity in the Bank’s funds management efforts.

Loans

Total loans of $259,310,000 at March 31, 2003 reflected a decrease of $1,050,000 (0.4%) compared to the total loans of $260,360,000, at December 31, 2002. Overall, most of the loan categories decreased slightly; however, the Bank did experience growth in commercial real estate loans during the three months ended March 31, 2003. Commercial real estate, commercial, financial and agricultural, and residential real estate represented the majority of the loan portfolio with approximately 48.78%, 21.11% and 17.47% of the Bank’s total loans at March 31, 2003, respectively. The net yield on loans was 6.60% for the three months ended March 31, 2003 compared to 6.98% for the three months ended March 31, 2002. See the “CONSOLIDATED AVERAGE BALANCES, INTEREST INCOME/EXPENSE AND YIELDS/RATES” table.

Allowance for Loan Losses and Risk Elements

The allowance for loan losses reflects management’s assessment and estimates of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. Management reviews the components of the loan portfolio in order to estimate the appropriate provision required to maintain the allowance at a level believed adequate in relation to anticipated future loan losses. In assessing the allowance, management reviews the size, quality and risk of loans in the portfolio. Management also considers such factors as the Bank’s loan loss experience, the amount of past due and nonperforming loans, specific known risks, the status, amounts, and values of nonperforming assets (including loans), underlying collateral values securing loans, current and anticipated economic conditions, and other factors, including developments anticipated by management with respect to various credits which management believes affects the allowance for loan losses.

The table below summarizes the changes in the allowance for loan losses for the three months ended March 31, 2003 and the year ended December 31, 2002.

The allowance for loan losses was $4,835,000 at March 31, 2003 compared to $5,104,000 at December 31, 2002. Management believes that the current level of allowance (1.86% of total outstanding loans, at March 31, 2003) is adequate to absorb anticipated risks identified in the portfolio at that time.

Consistent with its methodology for calculating the adequacy of the allowance for loan losses, management believes the provisions made during the first quarter will place the allowance at a level sufficient to absorb probable loan losses in the portfolio as of March 31, 2003. No assurance can be given, however, that adverse economic circumstances or other events, including additional loan review or examination findings or changes in borrowers’ financial conditions, will not result in increased losses in the Bank’s loan portfolio or in additional provision to the allowance for loan losses.

During the first three months of 2003, the Bank made $225,000 in provisions to the allowance for loan losses based on managem``ent’s assessment of the credit quality of the loan portfolio. For the three months ended March 31, 2003, the Bank had charge-offs of $527,000 and recoveries of $33,000.

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Nonperforming assets, comprised of nonaccrual loans, renegotiated loans, other nonperforming assets, and accruing loans 90 days or more past due were $3,089,000 at March 31, 2003, an increase of 2.7% from the $3,114,000 of non-performing assets at December 31, 2002. This increase is due to a slight increase in accruing loans 90 days or more past due and other real estate owned. If nonaccrual loans had performed in accordance with their original contractual terms, interest income would have increased approximately $50,000 for the three months ended March 31, 2003.

The table below provides information concerning nonperforming assets and certain asset quality ratios.

Potential problem loans consist of those loans where management has serious doubt as to the borrower’s ability to comply with the present loan repayment terms. At March 31, 2003, 90 loans totaling $10,447,000, or 4.0% of total loans outstanding, net of unearned income, were considered potential problem loans compared to 98 loans totaling $11,574,000, or 4.4% of total loans outstanding, net of unearned income, at December 31, 2002. At March 31, 2003, the amount of impaired loans were $583,000, which included 3 loans to 1 borrower with a total valuation allowance of approximately $87,000. In comparison, at December 31, 2002, the Company had approximately $5,281,000 of impaired loans, which included 5 loans to 3 borrowers with a total valuation allowance of approximately $861,000.

Deposits

Total deposits increased $12,935,000 (3.3%) to $408,126,000 at March 31, 2003, as compared to $395,191,000 at December 31, 2002. Noninterest-bearing deposits increased $4,346,000 (8.2%) during the first three months of 2003, while total interest-bearing deposits increased $8,589,000 (2.5%) to $350,561,000 at March 31, 2003 from $341,972,000 at December 31, 2002. The increase in noninterest-bearing deposits is due primarily to an increase in regular demand deposit accounts. During the first three months of 2003, the Bank primarily experienced increases in NOW accounts of $8,094,000 (11.7%). The Company considers the shifts in the deposit mix to be within the normal course of business and in line with the management of the Bank’s overall cost of funds. The average rate paid on interest-bearing deposits was 2.61% for the three months ended March 31, 2003 compared to 3.27% for the same period of 2002. See the “CONSOLIDATED AVERAGE BALANCES, INTEREST INCOME/EXPENSE AND YIELDS/RATES” table.

Capital Resources and Liquidity

The Company’s consolidated stockholders’ equity was $40,059,000 at March 31, 2003, compared to $39,582,000 at December 31, 2002. This represents an increase of $477,000 (1.2%) during the first three months of 2003. Net earnings for the first three months of 2003 were $1,342,000 compared to $903,000 for the same period of 2002. In addition, the Company’s accumulated other comprehensive income was $1,444,000 at March 31, 2003 compared to $1,842,000 at December 31, 2002. This decrease was due to a decrease in the fair value of investment securities available for sale. During the first three months of 2003, cash dividends of $467,000 or $0.12 per share, were declared on Common Stock.

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Certain financial ratios for the Company are presented in the following table:

The Company’s Tier I leverage ratio was 7.69%, Tier I risk-based capital ratio was 12.69% and Total risk-based capital ratio was 13.94% at March 31, 2003. These ratios exceed the minimum regulatory capital percentages of 4.0% for Tier I leverage ratio, 4.0% for Tier I risk-based capital ratio and 8.0% for Total risk-based capital ratio. Based on current regulatory standards, the Company believes it is “well capitalized.”

The primary source of liquidity during the first three months of 2003 was deposit growth. The Company used these funds primarily to purchase investment securities available for sale. Under the advance program with Federal Home Loan Bank of Atlanta (“FHLB-Atlanta”), the Bank had outstanding advances totaling approximately $53,255,000 at March 31, 2003.

Net cash provided by operating activities of $2,535,000 for the three months ended March 31, 2003, consisted primarily of net earnings. Net cash used in investing activities of $13,336,000 principally resulted from investment securities purchases of $74,425,000, offset by proceeds from maturities, calls and paydowns of investment securities available for sale and held to maturity of $33,128,000 and proceeds from sale of investment securities available for sale of $27,624,000. The $3,207,000 in net cash provided by financing activities resulted primarily from an increase of $4,346,000 in non-interest bearing deposits and an increase in interest bearing deposits of $8,589,000. In addition, securities sold under agreements to repurchase decreased by $9,225,000 and the Company paid dividends of $467,000.

Interest Rate Sensitivity Management

At March 31, 2003, interest sensitive assets that repriced or matured within the next 12 months were $226,892,700 compared to interest sensitive liabilities that reprice or mature within the same time frame totaling $324,415,330. The cumulative GAP position (the difference between interest sensitive assets and interest sensitive liabilities) of a negative $97,522,630 resulted in a GAP ratio (calculated as interest sensitive assets divided by interest sensitive liabilities) of 0.70%. This compares to a twelve month cumulative GAP position at December 31, 2002, of a negative $86,674,300 and a GAP ratio of 0.74%. A negative GAP position indicates that the Company has more interest-bearing liabilities than interest-earning assets that reprice within the GAP period, and that net interest income may be adversely affected in a rising rate environment as rates earned on interest-earning assets rise more slowly than rates paid on interest-bearing liabilities. A positive GAP position indicates that the Company has more interest-earning assets than interest-bearing liabilities that reprice within the GAP period. The Bank’s Asset/Liability Management Committee (“ALCO”) is charged with the responsibility of managing, to the degree prudently possible, its exposure to “interest rate risk,” while attempting to provide earnings enhancement opportunities. The Bank’s ALCO Committee realizes that GAP is limited in scope since it does not capture all the options or repricing opportunities in the balance sheet. Therefore, the ALCO Committee places its emphasis on Income at Risk and Economic Value of Equity measurements. Based on ALCO’s alternative interest rate scenarios used by the Company in modeling for asset/liability planning purposes and the GAP position at March 31, 2003 and various assumptions and estimates, the Company’s asset/liability model predicts that the changes in the Company’s net interest income would be less than 5.0% over 12 months. Economic Value of Equity would change less than 20%. Such estimates and predictions are forecasts which may or may not be realized. See “ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK”.

Results of Operations

Net Income

Net income increased $439,000 (48.6%) to $1,342,000 for the three month period ended March 31, 2003 compared to $903,000 for the same period of 2002. Basic and diluted net earnings per share were $0.34 and $0.23 for the first quarters of 2003 and 2002, respectively. During the three month period ended March 31, 2003 compared to the same period of 2002, the Company experienced an increase in noninterest income and a decrease in the provision for loan losses. This was offset by a decrease in net interest income and an increase in noninterest expense.

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Net Interest Income

Net interest income was $3,447,000 for the first quarter of 2003, a decrease of $96,000 (2.7%) from $3,543,000 for the same period of 2002. The decrease in net interest income resulted primarily from the decrease in interest on loans. This was offset by a decrease in interest on deposits. Through the first quarter of 2003, the Company’s GAP position remained more liability sensitive to changes in interest rates. The Company continues to regularly review and manage its asset/liability position in an effort to manage the negative effects of changing rates. See the “CONSOLIDATED AVERAGE BALANCES, INTEREST INCOME/EXPENSE AND YIELDS/RATES” table.

Interest and Dividend Income

Interest income is a function of the volume of interest earning assets and their related yields. Interest and dividend income was $6,412,000 and $6,911,000 for the three months ended March 31, 2003 and 2002, respectively. This represents a decrease of $499,000 (7.2%) for the first quarter of 2003 compared to 2002. This change for the first three months of 2003 resulted as the average volume of interest-earning assets outstanding increased $27,794,000 (6.4%) over the same period of 2002 but the Company’s yield on interest-earning assets decreased 82 basis points. See the “CONSOLIDATED AVERAGE BALANCES, INTEREST INCOME/EXPENSE AND YIELDS/RATES” table.

Loans are the main component of the Bank’s earning assets. Interest and fees on loans were $4,239,000 and $4,723,000 for the first quarters of 2003 and 2002, respectively. This reflects a decrease of $484,000 (10.2%) during the three months ended March 31, 2003 over the same period of 2002. The average volume of loans decreased $14,109,000 (5.1%) for the three months ended March 31, 2003 compared to the same period for 2002, while the Company’s yield on loans also decreased by 38 basis points comparing these same periods.

For the three month period ended March 31, 2003, interest income on investment securities increased $17,000 (0.8%) to $2,134,000 from $2,117,000 for the same period of 2002. The Company’s average volume of investment securities increased by $45,535,000 (31.2%) for the first three months of 2003, compared to the same period of 2002, while the net yield on these average balances decreased by 136 basis points. See the “CONSOLIDATED AVERAGE BALANCES, INTEREST INCOME/EXPENSE AND YIELDS/RATES” table.

Interest Expense

Total interest expense decreased $402,000 (11.9%) to $2,965,000 for the first quarter of 2003 compared to $3,367,000 for the same period of 2002. This change resulted as the Company’s average interest-bearing liabilities increased 5.0% but the rates paid on these liabilities decreased 57 basis points during the first three months of 2003 compared to the same period of 2002. See the “CONSOLIDATED AVERAGE BALANCES, INTEREST INCOME/EXPENSE AND YIELDS/RATES” table.

Interest on deposits, the primary component of total interest expense, decreased $382,000 (14.6%) to $2,230,000 for the first quarter of 2003 compared to $2,612,000 for the same period of 2002. The decrease for the three month period ended March 31, 2003 is due to a 66 basis point decrease in the rate paid on interest-bearing deposits offset by a 6.9% increase in the average volume.

Interest expense on other borrowings, was $728,000 and $732,000 for the first quarters of 2003 and 2002, respectively. This represents a decrease of $4,000 or 0.5%. This decrease for the three month period ended March 31, 2003 is due to a 1 basis point decrease in the rate paid on other borrowed funds and by a 0.3% decrease in the average volume. The decrease in the average volume is primarily from the slight decrease in FHLB-Atlanta advances.

Provision for Loan Losses

The provision for loan losses is based on management’s assessments and estimates of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. The provision for loan losses was $225,000 for the three months ended March 31, 2003 compared to $1,005,000 for the three months ended March 31, 2002. The decrease in the provision for the three months ended March 31, 2003 compared to 2002 is due to reduced loan growth and improved performance in the loan portfolio than in the three months ended March 31, 2002. See “ —ALLOWANCE FOR LOAN LOSS AND RISK ELEMENTS.”

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Noninterest Income

Noninterest income increased $93,000 (6.1%) to $1,613,000 for the first quarter of 2003 from $1,520,000 for the same period of 2002. This increase for the three months ended March 31, 2003 is due to increases in service charges on deposit accounts, net investment securities gains and other noninterest income.

Service charges on deposit accounts for the first quarter of 2003 increased $29,000 (8.7%) to $363,000 from $334,000 for the first quarter of 2002. This increase for the three months ended March 31, 2003 is primarily due to an increase in service charge fees.

Net investment securities gains were $16,000 and $406,000 for the three months ended March 31, 2003 and 2002, respectively. The decrease is primarily due to a gain in the first quarter of 2002 on the sale of stock.

Other noninterest income increased $453,000 (58.0%) to $1,234,000 for the first quarter of 2003 from $781,000 for the same period of 2002. This increase was due to an increase in MasterCard/VISA discounts and fees due to an increase in transaction volume and an increase in gains on the sale of mortgage loans over amounts reported in the three months ended March 31, 2002.

Noninterest Expense

Total noninterest expense was $2,945,000 and $2,856,000 for the first quarters of 2003 and 2002, respectively, representing an increase of $89,000 or 3.1%. This increase was mainly due to an increase in other noninterest expense.

For the first quarter of 2003, other noninterest expense increased $56,000 (4.0%) to $1,449,000 from $1,393,000 for the first quarter of 2002. This increase is mainly due to increases in the MasterCard/VISA transaction volume mentioned above.

Income Taxes

Income tax expense was $548,000 and $300,000 for the first quarters of 2003 and 2002, respectively. For the three months ended March 31, 2003, income tax expense increased $248,000 (82.7%). These levels represent an effective tax rate on pre-tax earnings of 29.0% and 24.9% for the three months ended March 31, 2003 and 2002, respectively.

Impact of Inflation and Changing Prices

Virtually all of the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a more significant effect on the Company’s performance than the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or with the same magnitude as the price of goods and services because such prices are affected by inflation. In the current interest rate environment, liquidity and the maturity structure of the Company’s assets and liabilities are critical to the maintenance of desired performance levels. However, relatively low levels of inflation in recent years have resulted in a rather insignificant effect on the Company’s operations.

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AUBURN NATIONAL BANCORPORATION, INC. & SUBSIDIARY
Consolidated Average Balances, Interest Income/Expense and Yields/Rates
Taxable Equivalent Basis