Edgar Filing: PROSPERITY BANCSHARES INC

Form 10-Q Amendment No. 1

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q/A

Amendment No. 1

(Mark One)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004

¨	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: 000-25051

PROSPERITY BANCSHARES, INC.^®

(Exact name of registrant as specified in its charter)

TEXAS

74-2331986

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

Prosperity Bank Plaza

4295 San Felipe

Houston, Texas 77027

(Address of principal executive offices, including zip code)

(713) 693-9300

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨

As of November 5, 2004, there were 22,379,953 shares of the registrant’s Common Stock, par value $1.00 per share, outstanding.

Explanatory Note

The purpose of this Amendment No. 1 on Form 10-Q/A to the Quarterly Report on Form 10-Q of Prosperity Bancshares, Inc. (the “Company”) for the quarter ended September 30, 2004 (the “Original Form 10-Q”) is to restate the Company’s interim consolidated financial statements as of and for the nine months ended September 30, 2004 and 2003 to correct amounts on the Company’s consolidated statements of cash flows related to acquisitions as more fully discussed in Note 8 to the accompanying interim consolidated financial statements. Specifically, the amounts presented in the Company’s consolidated statements of cash flows for the nine months ended September 30, 2004 in this Amendment No. 1 reflect a correction in the presentation of the Company’s common stock issued in connection with acquisitions. This correction resulted in an increase in noncash activities. The Company also corrected certain other immaterial miscellaneous items in the consolidated statements of cash flows for the nine months ended September 30, 2004 and 2003. There was no change in the total increase in cash and cash equivalents. Further, these changes had no effect on the Company’s consolidated statements of income, consolidated balance sheets or consolidated statements of shareholders’ equity.

In addition, the Company has amended Item 4, Controls and Procedures, to update the disclosure regarding disclosure controls and procedures and internal control over financial reporting.

As a result of the restatement, the Company has determined it to be necessary to amend the Original Form 10-Q. This Amendment No. 1 amends and restates in its entirety Part I, Items 1 and 4 and Part II, Item 6 of the Original Form 10-Q. This Amendment No. 1 continues to reflect circumstances as of the date of the filing of the Original Form 10-Q and does not reflect events occurring after the filing of the Original Form 10-Q, or modify or update those disclosures in any way, except as required to reflect the effects of the restatement as described in Note 8 to the accompanying interim consolidated financial statements and to correct certain other immaterial miscellaneous items.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

INDEX TO FORM 10-Q/A


		Page
PART I - FINANCIAL INFORMATION

Item 1. Interim Consolidated Financial Statements		3
	Consolidated Balance Sheets as of September 30, 2004 (unaudited) and December 31, 2003 (unaudited)	3
	Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2004 and 2003 (unaudited)	4
	Consolidated Statements of Shareholders’ Equity for the Year Ended December 31, 2003 (unaudited) and for the Nine Months Ended September 30, 2004 (unaudited)	5
	Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2004 and 2003 (unaudited) (Restated)	6
	Notes to Interim Consolidated Financial Statements (unaudited)	8

Item 4. Controls and Procedures		14

PART II - OTHER INFORMATION

Item 6. Exhibits		14
Signatures		15

PART I – FINANCIAL INFORMATION

ITEM 1. INTERIM CONSOLIDATED FINANCIAL STATEMENTS

PROSPERITY BANCSHARES, INC.^® AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(UNAUDITED)


	September 30, 2004			December 31, 2003
	(Dollars in thousands, except par value and share data)
ASSETS
Cash and due from banks	$	60,874		$	71,983
Federal funds sold		71,995			11,730

Total cash and cash equivalents		132,869			83,713
Interest-bearing deposits in financial institutions		600			262
Available for sale securities, at fair value (amortized cost of $196,259 and $260,533, respectively)		193,396			263,648
Held to maturity securities, at cost (fair value of $1,165,039 and $1,122,451, respectively)		1,160,182			1,113,232
Loans		1,007,420			770,053
Less allowance for credit losses		(12,861	)		(10,345	)

Loans, net		994,559			759,708
Accrued interest receivable		10,140			10,119
Goodwill		150,585			118,012
Core deposit intangibles, net of accumulated amortization of $2,231 and $1,010, respectively		13,300			6,743
Bank premises and equipment, net		36,331			34,299
Other real estate owned		535			246
Other assets		20,817			10,505

TOTAL	$	2,713,314		$	2,400,487

LIABILITIES AND SHAREHOLDERS’ EQUITY
LIABILITIES:
Deposits:
Noninterest-bearing	$	527,845		$	467,389
Interest-bearing		1,799,434			1,616,359

Total deposits		2,327,279			2,083,748
Other borrowings		13,315			11,929
Securities sold under repurchase agreements		28,153			19,007
Accrued interest payable		2,717			2,522
Other liabilities		12,781			3,889
Junior subordinated debentures		59,804			59,804

Total liabilities		2,444,049			2,180,899
SHAREHOLDERS’ EQUITY:
Preferred stock, $1 par value; 20,000,000 shares authorized; none issued or outstanding		—			—
Common stock, $1 par value; 50,000,000 shares authorized;
22,415,541 and 20,966,706 shares issued at September 30, 2004 and December 31, 2003, respectively; 22,378,453 and 20,929,618 shares outstanding at September 30, 2004 and December 31, 2003, respectively		22,416			20,967
Capital surplus		134,160			102,594
Retained earnings		115,157			94,610
Accumulated other comprehensive income (loss) — netunrealized (loss) gain on available for sale securities, net of tax benefit of $1,002 and tax of $1,090, respectively		(1,861	)		2,024
Less treasury stock, at cost, 37,088 shares at September 30, 2004 and December 31, 2003, respectively		(607	)		(607	)

Total shareholders’ equity		269,265			219,588

TOTAL	$	2,713,314		$	2,400,487

See notes to interim consolidated financial statements.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)


	Three Months Ended September 30,				Nine Months Ended September 30,
	2004		2003		2004		2003
	(Dollars in thousands, except per share data)
INTEREST INCOME:
Loans, including fees	$	14,760	$	11,675	$	39,222	$	34,630
Securities:
Taxable		13,320		8,758		40,041		28,431
Nontaxable		359		395		1,115		1,228
70% nontaxable preferred dividends		183		452		825		1,327
Federal funds sold.		136		82		238		162
Deposits in financial institutions		5		3		7		14

Total interest income.		28,763		21,365		81,448		65,792

INTEREST EXPENSE:
Deposits		6,316		5,459		17,783		17,074
Junior subordinated debentures		1,044		675		3,011		1,840
Federal funds sold and other borrowings		336		241		889		782

Total interest expense		7,696		6,375		21,683		19,696

NET INTEREST INCOME		21,067		14,990		59,765		46,096
PROVISION FOR CREDIT LOSSES		420		120		660		360

NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES		20,647		14,870		59,105		45,736

NONINTEREST INCOME:
Customer service fees		5,237		3,523		14,827		10,148
Other		874		803		1,933		2,022
Gain on sale of securities		—		—		78		—

Total noninterest income		6,111		4,326		16,838		12,170

NONINTEREST EXPENSE:
Salaries and employee benefits		7,147		5,259		20,459		15,943
Net occupancy expense		1,499		1,045		4,055		2,988
Data processing		540		453		1,473		1,728
Core deposit intangible amortization		455		207		1,220		590
Depreciation expense		728		634		2,118		1,855
Other		2,825		2,109		8,395		6,461

Total noninterest expense		13,194		9,707		37,720		29,565

INCOME BEFORE INCOME TAXES		13,564		9,489		38,223		28,341
PROVISION FOR INCOME TAXES		4,618		3,019		12,852		8,986

NET INCOME	$	8,946	$	6,470	$	25,371	$	19,355

EARNINGS PER SHARE
Basic	$	0.41	$	0.34	$	1.19	$	1.02

Diluted	$	0.40	$	0.34	$	1.18	$	1.01

See notes to interim consolidated financial statements.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(UNAUDITED)


										Accumulated Other Comprehensive Income (Loss)
	Common Stock			Capital Surplus			Retained Earnings						Treasury Stock			Total Shareholders’ Equity
	Shares	Amount
	Shares	Amount
	(Amounts in thousands, except share data)
BALANCE AT DECEMBER 31, 2002	18,903,028	$	18,903	$	60,312		$	72,917		$	2,644		$	(37	)	$	154,739
Net income														26,548			26,548
Net change in unrealized gain (loss) on available for sale securities.											(620	)					(620	)

Total comprehensive income																	25,928

Exercise of stock options	170,638		171		824												995
Refund of escrow shares in connection with the Paradigm acquisition														(570	)		(570	)
Common stock issued in connection with the MainBancorp acquisition	1,499,966		1,500		33,149												34,649
Common stock issued in connection with the FSBNT acquisition	393,074		393		8,538												8,931
Stock option compensation					25												25
Junior subordinated debentures issuance costs					(254	)											(254	)
Cash dividends declared, $0.25per share								(4,855	)								(4,855	)

BALANCE AT DECEMBER 31, 2003	20,966,706		20,967		102,594			94,610			2,024			(607	)		219,588
Net income														25,371			25,371
Net change in unrealized gain (loss) on available for sale securities											(3,885	)					(3,885	)

Total comprehensive income																	21,486

Exercise of stock options	203,644		204		808												1,012
Stock option compensation					45												45
Common stock issued in connection with the Liberty Bancshares acquisition	1,245,191		1,245		30,713												31,958
Cash dividends declared, $0.225 per share								(4,824	)								(4,824	)

BALANCE AT SEPTEMBER 30, 2004	22,415,541	$	22,416	$	134,160		$	115,157		$	(1,861	)	$	(607	)	$	269,265

See notes to interim consolidated financial statements.

PROSPERITY BANCSHARES, INC.^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)


	Nine Months Ended September 30,
	2004			2003
	(Dollars in thousands)
	(As restated, see note 8)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	25,371		$	19,355
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		3,338			2,445
Provision for credit losses		660			360
Net amortization of discount on investments		3,848			8,210
Loss (gain) on sale of other real estate		14			(22	)
Gain on sale of premises and equipment		(321	)		(244	)
Stock option compensation expense		45
(Increase) decrease in other assets and accrued interest receivable		(3,788	)		(328	)
Increase (decrease) in other liabilities and accrued interest payable		8,008			(4,707	)

Total adjustments		11,804			5,714

Net cash provided by operating activities		37,175			25,069

CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from maturities and principal paydowns of held to maturity securities		203,661			418,359
Purchase of held to maturity securities		(251,278	)		(698,911	)
Proceeds from maturities and principal paydowns of available for sale securities		73,304			108,782
Purchase of available for sale securities		—			(11,949	)
Net (increase) decrease in loans		(39,611	)		33,058
Purchase of bank premises and equipment		(901	)		(3,119	)
Net decrease in interest-bearing deposits in financial institutions		362			286
Proceeds from sale of bank premises, equipment, and other real estate		2,318			1,674
Purchase of Liberty Bancshares, Inc.		(9,132	)		—
Cash and cash equivalents acquired in the purchase of Liberty Bancshares, Inc		46,599			—
Purchase of Village Bank & Trust ssb		(19,150	)		—
Cash and cash equivalents acquired in the purchase of Village Bank & Trust ssb		16,120			—
Purchase of Dallas Bancshares, Inc.		—			(7,068	)
Cash and cash equivalents acquired in the purchase of Dallas Bancshares, Inc.		—			10,517
Purchase of Abrams Centre Bancshares, Inc.		—			(16,865	)
Cash and cash equivalents acquired in the purchase of Abrams Centre Bancshares, Inc.		—			38,458

Net cash provided by (used in) investing activities		22,292			(126,778	)

(Table continued on following page)


	Nine Months Ended September 30,
	2004			2003
	(Dollars in thousands)
	(As restated—see Note 8)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net (decrease) increase in noninterest-bearing deposits		(405	)		86,975
Net (decrease) increase in interest-bearing deposits		(14,011	)		52,800
Proceeds from the issuance of junior subordinated debentures		—			12,500
Junior subordinated debentures issuance costs		—			(129	)
Net repayments of other borrowings		(1,230	)		(24,202	)
Net increase in securities sold under repurchase agreements		9,146			—
Proceeds from exercise of stock options		1,012			372
Payments of cash dividends		(4,823	)		(3,551	)

Net cash (used in) provided by financing activities		(10,311	)		124,765

NET INCREASE IN CASH AND CASH EQUIVALENTS	$	49,156		$	23,056
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD		83,713			80,799

CASH AND CASH EQUIVALENTS, END OF PERIOD	$	132,869		$	103,855

NONCASH ACTIVITIES:
Stock issued in connection with the Liberty Bancshares acquisition	$	31,958			—

See notes to interim consolidated financial statements.

PROSPERITY BANCSHARES, INC.^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004

(UNAUDITED)

1. BASIS OF PRESENTATION

The interim consolidated financial statements include the accounts of Prosperity Bancshares, Inc. ^{^®}(the “Company”) and its wholly-owned subsidiaries, Prosperity Bank^{^®}(the “Bank”) and Prosperity Holdings of Delaware, L.L.C. All significant inter-company transactions and balances have been eliminated. Prior period data has been restated to reflect the adoption of FIN 46R on January 1, 2004.

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the rules and regulations of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the statements reflect all adjustments necessary for a fair presentation of the financial position, results of operations and cash flows of the Company on a consolidated basis, and all such adjustments are of a normal recurring nature. These financial statements and the notes thereto should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. Operating results for the nine month period ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.

2. INCOME PER COMMON SHARE

The following table illustrates the computation of basic and diluted earnings per share:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2004		2003		2004		2003
	(In Thousands Except Per Share Amounts)
Net income available to common shareholders	$	8,946	$	6,470	$	25,371	$	19,355
Weighted average common shares outstanding		21,843		18,974		21,250		18,948
Potential dilutive common shares		263		280		278		290

Weighted average common shares and equivalents outstanding		22,106		19,254		21,528		19,238

Basic earnings per common share	$	0.41	$	0.34	$	1.19	$	1.02

Diluted earnings per common share	$	0.40	$	0.34	$	1.18	$	1.01

The incremental shares for the assumed exercise of the outstanding options were determined by application of the treasury stock method. No options issued by the Company had an anti-dilutive effect for the three months September 30, 2004 and 2003 or for the nine months ended September 30, 2004 and 2003.

3. NEW ACCOUNTING STANDARDS

FIN No. 46 “Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulleting No. 51.” FIN 46 establishes accounting guidance for consolidation of variable interest entities (VIE) that function to support the activities of the primary beneficiary. The primary beneficiary of a VIE is the entity that absorbs a majority of the VIE’s expected losses, receives a majority of the VIE’s expected residual returns, or both, as a result of ownership, controlling interest, contractual relationship or other business relationship with a VIE. Prior to the implementation of FIN 46, VIE’s were generally consolidated by an enterprise when the enterprise had a controlling financial interest through ownership of a majority of voting

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004

(UNAUDITED)

interest in the entity. The provisions of FIN 46 were effective immediately for all arrangements entered into after January 31, 2003, and are otherwise effective at the beginning of the first interim period beginning after December 15, 2003. The Company adopted FIN 46 on July 1, 2003.

In December 2003, the FASB issued FIN 46R, “Consolidation of Variable Interest Entities.” FIN 46R provides guidance on how to identify a variable interest entity and determine when the assets, liabilities, non-controlling interests and results of operations of a variable interest entity need to be included in a company’s consolidated financial statements. A company that holds variable interest in an entity is required to consolidate the entity if the company’s interest in the variable interest entity is such that the company will absorb a majority of the variable interest entity’s expected losses and/or receive a majority of the entity’s expected residual returns, if they occur. As of September 30, 2004, the Company had no investments in variable interest entities requiring consolidation. FIN 46R requires that Prosperity Capital Trust I, Prosperity Capital Trust II, Prosperity Statutory Trust III, Prosperity Statutory Trust IV and Paradigm Capital Trust II be deconsolidated from the consolidated financial statements. The Company adopted FIN 46R on January 1, 2004. After adoption, the trust preferred securities issued by each of the foregoing trusts are no longer shown in the consolidated financial statements. Instead, the junior subordinated debentures issued by the Company to each of these trusts are shown as liabilities in the consolidated balance sheets and interest expense associated with such junior subordinated debentures is shown in the consolidated statements of income.

In May 2004, the EITF reached a consensus on Issue 03-03 (EITF 03-03) “Applicability of EITF Abstracts, Topic No. D-79, ‘Accounting for Retroactive Insurance Contracts Purchased by Entities Other Than Insurance Enterprises,’ to Claims-Made Insurance Policies”. This EITF clarifies that a claims-made insurance policy that provides coverage for specific known claims prior to the policy period contains a retroactive provision that should be accounted for accordingly; either separately, if practicable, or, if not practicable, the claims-made insurance policy should be accounted for entirely as a retroactive contract. The Company adopted the provisions of EITF No. 03-03 on January 1, 2004. The adoption of EITF 03-03 did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

In March 2004, the EITF reached consensus on Issue 03-01 (EITF 03-01), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”. EITF 03-01 includes new guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. This Issue specifically addresses whether an investor has the ability and intent to hold an investment until recovery. In addition, Issue 03-01 contains disclosure requirements that provide useful information about impairments that have not been recognized as other-than-temporary for investments with in the scope of this Issue. On September 30, 2004, the Financial Accounting Standards Board deferred the effective date of the Issue’s guidance on how to evaluate and recognize an impairment loss that is other-than-temporary. This Issue’s guidance is pending the issuance of a final FASB Staff Position (“FSP”) relating to the draft FSP EITF Issue 03-01-a, Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-01, “The Meaning of Other-Than-Temporary Impairment and Its application to Certain Investments,” which the Board may issue as early as November. This deferral did not change the disclosure guidance which remains effective for fiscal years ending after December 15, 2003. Matters being considered by the FASB which may impact the Company’s financial reporting include the accounting as a component in determining net income for declines in market value of debt securities which are due solely to changes in market interest rates and the effect of sales of available-for-sale securities which have market values below cost at the time of sale and whether such sale indicates an absence of intent and ability of the investor to hold to a forecasted recovery of the investment’s value to its original cost.

SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” SFAS 150 establishes standards for how an issuer classifies, measures and discloses in its financial statements certain financial instruments with characteristics of both liabilities and equity. SFAS 150 requires that an issuer classify financial instruments that are within its scope as liabilities, in most circumstances. Such financial instruments include (i) financial instruments that are issued in the form of shares that are mandatorily redeemable; (ii) financial instruments that embody an obligation to repurchase the issuer’s equity shares, or are indexed to such an obligation, and that require the issuer to settle the obligation by transferring assets; (iii) financial instruments that embody an obligation that the issuer may settle by issuing a variable number of its equity shares if, at inception, the monetary value of the obligation is predominantly based on a fixed amount, variations in something other than the fair value of the issuer’s equity shares or variations inversely related to changes in the fair value of the issuer’s equity shares; and (iv) certain freestanding financial instruments. The Company adopted SFAS 150 on January 1, 2004 and its adoption did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004

(UNAUDITED)

4. RECENT DEVELOPMENTS

On October 26, 2004, the Company announced the signing of a definitive agreement with FirstCapital Bankers, Inc. (“FirstCapital”), Corpus Christi, Texas. Under the terms of the agreement, FirstCapital will merge into the Company and subsequently, FirstCapital’s wholly owned subsidiary, FirstCapital Bank, s.s.b. will merge into the Bank. The Company will issue approximately 5.0 million shares of its common stock for all of the issued and outstanding capital stock of FirstCapital.

FirstCapital is privately held and operates thirty-two (32) banking offices in and around Corpus Christi, Houston and Victoria, Texas. As of September 30, 2004, FirstCapital had, on a consolidated basis, total assets of $773.6 million, loans of $518.2 million, deposits of $638.9 million and shareholders’ equity of $60.0 million. The acquisition is expected to close in the first quarter of 2005 and is subject to the approval of the Company and FirstCapital shareholders and customary regulatory approvals.

On August 1, 2004, the Company completed its acquisition of Village Bank and Trust, s.s.b. (“Village”), Austin, Texas. Under the terms of the agreement, the Company paid approximately $19.1 million in cash for all of the issued and outstanding capital stock of Village. Village was privately held and operated one (1) banking office in the Lakeway area of Austin, Texas. As of June 30, 2004, Village had total assets of $110.9 million, loans of $79.7 million, deposits of $97.3 million and shareholders’ equity of $10.4 million.

In connection with the purchase, the Company recorded a premium of $12.2 million, of which $1.0 million was identified as core deposit intangibles. The remaining $11.2 million of the premium was recorded as goodwill. The core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branch were recorded at their fair values at the acquisition date.

On August 1, 2004, the Company completed its acquisition of Liberty Bancshares, Inc. (“Liberty”), Austin, Texas, pursuant to which Liberty merged into the Company and its wholly owned subsidiary, Liberty Bank, S.S.B., merged into the Bank. Under the terms of the agreement, the Company paid approximately $9.1 million in cash and issued approximately 1.3 million shares of its Common Stock for all of the issued and outstanding capital stock of Liberty and Liberty Bank. and all outstanding stock options of Liberty Bank. Liberty was privately held and operated six (6) banking offices in Austin, Texas. As of June 30, 2004, Liberty had on a consolidated basis, total assets of $178.7 million, loans of $120.3 million, deposits of $158.9 million and shareholders’ equity of $16.5 million.

In connection with the purchase, the Company recorded a premium of $27.6 million of which $4.6 million was identified as core deposit intangibles. The remaining $23.0 million of the premium was recorded as goodwill. The core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branches were recorded at their fair values at the acquisition date.

PROSPERITY BANCSHARES, INC.^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004

(UNAUDITED)

5. GOODWILL AND CORE DEPOSIT INTANGIBLES

Changes in the carrying amount of the Company’s goodwill and core deposit intangibles (CDI) for nine months ended September 30, 2004 were as follows:


	Goodwill			Core Deposit Intangibles
	(Dollars in thousands)
Balance as of December 31, 2003	$	118,012		$	6,743
Amortization		—			(1,220	)
Acquisition of Liberty Bancshares, Inc.		22,914			4,636
Acquisition of Village Bank & Trust, ssb		11,114			1,040
Core deposit intangibles-First State Bank of North Texas		(1,801	)		1,801
Expenses associated with the acquisition of First State Bank of North Texas		(239	)		—
Core deposit intangibles-MainBancorp		(300	)		300
Expenses associated with the acquisition of MainBancorp		96			—
Adjustments associated with the acquisition of Dallas Bancshares (deferred taxes)		(7	)		—
Adjustments associated with the acquisition of Southwest Bank Holding Company (deferred taxes)		796			—

Balance as of September 30, 2004	$	150,585		$	13,300

The Company initially records the total premium paid on acquisitions at management’s best estimate of goodwill and CDI. Subsequent to the acquisition, a third party valuation of CDI is performed. Adjustments to CDI, if necessary, are appropriately reclassified within goodwill. Net income is decreased by the amortization of CDI which is amortized at an accelerated rate over an eight year period from the acquisition date. Adjustments to estimates of deferred taxes that relate to goodwill are made after reconciliations of the final tax returns are prepared. The reclassifications have no effect on total assets, liabilities, shareholder’s equity or cash flows.

6. NONPERFORMING ASSETS

The Company had $2.6 million in nonperforming assets at September 30, 2004 and $967,000 in nonperforming assets at December 31, 2003, an increase of $1.6 million or 165.0%. The increase in nonperforming assets is primarily due to two commercial loans, assumed from previous acquisitions, being placed on nonaccrual status and an additional two loans, assumed from acquisitions, being classified as accruing loans 90 or more days past due.

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004

(UNAUDITED)

The following table presents information regarding nonperforming assets as of the dates indicated.


	September 30, 2004			December 31, 2003
	(Dollars in thousands)
Nonaccrual loans	$	709		$	2
Restructured loans		—			—
Accruing loans 90 or more days past due		1,238			679

Total nonperforming loans		1,947			681
Repossessed assets		81			40
Other real estate		535			246

Total nonperforming assets	$	2,563		$	967

Non-performing assets to total loans and other real estate		0.25	%		0.13	%

7. SUBSEQUENT EVENT

The Company has notified Wachovia Trust Company, trustee of Prosperity Capital Trust I (the “Trust”), that the Company intends to redeem on December 31, 2004 (the “Redemption Date”), subject to regulatory approval, the $12.4 million in 9.60% Subordinated Debentures due 2029 issued by the Company to the Trust at a redemption price equal to $12.4 million plus all accrued but unpaid interest up to the Redemption Date. In conjunction with the redemption of the Debentures, the Trust will notify the holders of its 9.60% Cumulative Trust Preferred Securities (“Trust Preferred Securities”) and its 9.60% Common Securities (“Common Securities”) of its intention to redeem on the Redemption Date all 1.2 million of its outstanding Trust Preferred Securities and all 38,000 of its outstanding Common Securities at a redemption price equal to the $10.00 liquidation amount of each security plus all accrued but unpaid distributions up to the Redemption Date.

After redemption of the $12.4 million in Subordinated Debentures issued to Prosperity Capital Trust I, the Company will have outstanding $47.4 million in junior subordinated debentures issued to the Company’s subsidiary trusts.

8. RESTATEMENT OF INTERIM CONSOLIDATED FINANCIAL STATEMENTS

Subsequent to the issuance of the Company’s September 30, 2004 interim consolidated financial statements, the Company determined that amounts presented in the Company’s consolidated statement of cash flows for the nine months ended September 30, 2004 reflected an error in the presentation of the Company’s common stock issued in connection with acquisitions. This correction resulted in a $32.0 million increase in non-cash activities. The Company also corrected certain other immaterial miscellaneous items in the consolidated statements of cash flows for the nine months ended September 30, 2004 and 2003. There was no change in the net increase in cash and cash equivalents. Further, these changes had no effect on the Company’s consolidated statements of income, consolidated balance sheets or consolidated statements of shareholders’ equity.

PROSPERITY BANCSHARES, INC.^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004

(UNAUDITED)

The effect of the restatement on the Company’s consolidated statement of cash flows for the nine months ended September 30, 2004 and 2003 is reflected in the table below:

Consolidated statement of cash flows:


	2004						2003
	As Previously Reported			As Restated			As Previously Reported			As Restated
	(Dollars in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
(Increase) decrease in other assets and accrued interest receivable	$	(5,237	)	$	(3,788	)	$	78		$	(328	)
Increase (decrease) in other liabilities and accrued interest payable		7,088			8,008			(4,569	)		(4,707	)
Stock option compensation expense		—			45			—			—
Net cash provided by operating activities		34,761			37,175			25,613			25,069

CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sale of bank premises, equipment and other real estate		1,543			2,318			1,674			1,674
Premium paid for the purchase of Liberty Bancshares, Inc.		(22,914	)		—			—			—
Net liabilities acquired in the purchase of Liberty Bancshares, Inc. (net of acquired cash of $46,599)		64,115			—			—			—
Purchase of Liberty Bancshares, Inc.		—			(9,132	)		—			—
Cash and cash equivalents acquired in the purchase of Liberty Bancshares, Inc.		—			46,599			—			—
Premium paid for the purchase of Village Bank & Trust ssb		(12,154	)		—			—			—
Net liabilities acquired in the purchase of Village Bank & Trust ssb (net of acquired cash of $16,120)		8,579			—			—			—
Purchase of Village Bank & Trust ssb		—			(19,150	)		—			—
Cash and cash equivalents acquired in the purchase of Village Bank & Trust ssb		—			16,120			—			—
Premium paid for the purchase of Dallas Bancshares, Inc.		—			—			(2,982	)		—
Net liabilities acquired in the purchase of Dallas Bancshares, Inc. (net of acquired cash of $10,517)		—			—			6,269			—
Purchase of Dallas Bancshares, Inc.		—			—			—			(7,068	)
Cash and cash equivalents acquired in the purchase of Dallas Bancshares, Inc.		—			—			—			10,517
Premium paid for the purchase of Abrams Centre Bancshares, Inc.		—			—			(6,992	)		—
Net liabilities acquired in the purchase of Abrams Centre Bancshares, Inc. (net of acquired cash of $38,458)		—			—			28,203			—
Purchase of Abrams Centre Bancshares, Inc.		—			—			—			(16,865	)
Cash and cash equivalents acquired in the purchase of Abrams Centre Bancshares, Inc.		—			—			—			38,458
Total cash provided by (used in) investing activities		24,706			22,292			(127,322	)		(126,778	)
Net increase in cash and cash equivalents	$	49,156		$	49,156		$	23,056		$	23,056

NONCASH ACTIVITIES:
Stock issued in connection with the Liberty Bancshares, Inc. acquisition.	$	—		$	31,958		$	—		$	—

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in its SEC filings is recorded, processed, summarized and reported within the time period specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure based on the definition of “disclosures controls and procedures” in Rule 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply judgment in evaluating its controls and procedures.

Management, under the supervision and with the participation of the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective. Subsequent to the date of that evaluation, management considered the restatement of the Company’s interim consolidated financial statements and concluded that such restatement was the result of a material weakness related to controls over the preparation and review of its consolidated statement of cash flows. Based on such considerations, the Company’s Chief Executive Officer and Chief Financial Officer concluded that as of September 30, 2004, the Company’s disclosure controls and procedures were not effective solely because of the material weakness described below. Specifically, the Company did not maintain effective controls to appropriately classify the presentation of the Company’s common stock issued in connection with acquisitions as a noncash activity rather than presenting it as a cash activity in the Company’s consolidated statement of cash flows for the nine months ended September 30, 2004. This change in presentation resulted in an increase in noncash activities. The Company also corrected certain other immaterial miscellaneous items in the consolidated statements of cash flows for the nine months ended September 30, 2004 and 2003. There was no change in the net increase in cash and cash equivalents. Further, these changes had no effect on the Company’s consolidated statements of income, consolidated balance sheets or consolidated statements of shareholders’ equity.

Changes in Internal Control Over Financial Reporting

In an effort to remediate the material weakness in the Company’s internal control over the preparation and review of its consolidated statements of cash flows described above, during the third quarter of 2005, management has implemented a process to aid in correctly classifying amounts related to acquisitions reflected in the consolidated statement of cash flows, including a more detailed cash flow statement preparation checklist. Accordingly, management believes this process will remediate the material weakness discussed above. There were no changes in the Company’s internal controls over financial reporting during the third quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II – OTHER INFORMATION

ITEM 6. EXHIBITS

Exhibits:


Exhibit Number		Description of Exhibit
21.1**		Subsidiaries of Prosperity Bancshares, Inc.

31.1*		Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.

31.2*		Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.

32.1*		Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2*		Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

*	Filed herewith.

**	Previously filed.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


				PROSPERITY BANCSHARES, INC. ^SM
				(Registrant)

		Date: 10/28/05		/s/ David Zalman
				David Zalman
				Chief Executive Officer/President

		Date: 10/28/05		/s/ David Hollaway
				David Hollaway
				Chief Financial Officer

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