Citizens Financial Services ARS - Created Using EDGARIZER HTML
     
 

 
     
 

we’re charting our own COURSE

 

 

            There is now another year’s distance between us and the nightmare of September 11, 2001, but the times are as dangerous as ever. Now we live in a world where on any given day our government informs us that the threat level has escalated from Serious to High, and on every day we have rumor of war and risk of danger.

 

            Because uncertainty is the very worst thing for markets, September 11 changed the world of money and finance as much as it did everything else—maybe more, as the escalating national debt and the continuing decline in stock values indicate. These extra uncertainties add to an ongoing litany of massive change in the banking industry over the past two decades. We have moved from being one of America’s most staid and routine industries to a highly fluid and fiercely competitive arena, where customers have options they never had before.

 

            Over the past year, this reality has moved First Citizens to take a hard look at ourselves and re-evaluate our direction. What we saw compelled us to implement new sales and marketing initiatives that will enable us to more effectively set the course of our immediate future. This is the foundation of this year’s Citizens Financial Services Annual Report. I use the phrase “set the course” purposely: the entire idea here is that, after examining the ship for any and every way to make it more seaworthy, we are, in effect, overhauling the entire craft --so we can be ready to sail just about anywhere.

 

            Before taking up the story, however, I should make one important note, since Annual Reports are about both the past and the future. For First Citizens, 2002 was a very good year. In terms of financial performance, it was the best year in the history of the bank.

 

            In all the major areas—asset growth, net income, return on shareholder equity—we continued our already-solid advances from the previous year, by achieving the best earnings in the history of the corporation. In 2002, net income grew almost 50% to $5.6 million, an increase of $1.8 million. Total assets grew $11.5 million, or 2.7%, while total deposits grew $2.6 million and total loans—the bulwark of our strength—grew $26.7 million. The common stock price improved over 50% this past year, and more than 75% over the past two years. Cash dividends per share were $.68 during 2002, a 6.25% increase over 2001. In fact, return on shareholder equity was 16.5%—the highest ever—and expected to be above average for Pennsylvania community banks. As usual, the details on these and other numbers are in the financial pages; suffice it to say that, given the general state of affairs, we are very pleased.

 

            I should call particular attention to the interrelationship of our 2000 acquisition of the Bradford County Sovereign Bank’s customers and the growth in our loan portfolios, mainly mortgage loans. On one hand, the nationally significant decline in interest rates meant that our cost of funds declined, and our margins increased significantly as thousands of homeowners, who otherwise may not have made such a move, refinanced their homes, thus providing First Citizens with significant new loan volume. At the same time, the deposit funds accrued from Sovereign, which had been temporarily placed in investment securities, were transitioned into higher yielding loans. In fact the redeployment of investments into the loan portfolio has been our objective since the acquisition of the Bradford County Sovereign Bank branches. When you make such a significant acquisition, you hope to do it right. We greatly appreciate the support given to us by the shareholders on this decision, and we believe we have made it well worth their while.

 

            I spoke earlier of our efforts to re-evaluate our direction based on the uncertain economic picture. That fact, together with the already mentioned reality that bank customers now have so many new banking products and investment options, prompted First Citizens to undertake the most comprehensive marketing survey ever, reaching 10,000 of our most active customers.

 
     
 

 

            This outreach was a broad extension of actions taken in 2001, when we held round-table meetings with a number of our small-to-mid-sized businesses, which resulted in significant changes in our approach to satisfying the small business customer.

 

            We’ve never had any doubts about knowing the customers we serve, and customer response to the 2002 survey showed friendly, competent staff service as our strongest quality. But we needed to know more, to know what our customers’ needs and priorities are, and how well we satisfy them. We wanted to know to whom our community turned to for financial services, and why people made those choices. We wanted their candid evaluation of our performance, to assess their knowledge of us and to measure their loyalty to First Citizens. We wanted to know what we needed to do to retain profitable customers and attract new ones. In short, we needed to know what to do in order to gain the competitive advantage.

 

            We confirmed some basic things and discovered some very interesting facts. A significant portion of our customers shared three common goals: saving for retirement, funding their child’s education and paying off their home. Eighty-three percent (83%) of respondents identified First Citizens as their primary financial institution with First Citizens having 75% ore more of their total financial relationship. Fifty-four percent (54%) have used the bank for over 10 years. Nearly 97% said they would recommend First Citizens to others. Only about one third of respondents named First Citizens as their primary investment institution. The survey revealed our major competitors for investment business are non-bank mutual funds and brokerage providers.

 

            We were proud to learn that over 90% of our customers said they were “satisfied” or “highly satisfied” with First Citizens, and there was no doubt that the sincere friendliness and competence of our staff was the largest factor contributing to their satisfaction. This is truly a “Wow” compliment.

 

            Most importantly, we discovered an essential paradox: On one hand, First Citizens has the same dilemma as almost every other bank in the country: the higher the income, the more likely the customer is to use multiple financial service providers. Nonetheless, the survey confirmed that “customers appear to be willing to give the majority of their financial relationship to us.”

 

            The opportunities inherent in this realization are immense. All businesses know that it is always more difficult and more expensive to attract a new customer than to broaden the relationship of existing customers. And, as our research has indicated, our existing customers are ready and willing to give us more business. So the obvious next step was to plan how to fulfill that opportunity to move far beyond “satisfactory” or even “highly satisfactory,” as nice as those compliments are, but to reach the level where we exceed expectations every time.

 

            We’ve found the way to do that in an approach called Customer Relationship Management, or CRM. Yes, it may sound like just another marketing acronym, but this is a systematic approach with true substance, to which First Citizens has made a major commitment. It was, in retrospect, not such a difficult decision, because we know the rewards of perfecting the ability to “Offer What The Customers Need, When They Need It,” will be well worth the effort.

 

            At the heart of CRM is the use of modern tools of “Customer Information” database collection and projection to identify potential matches of our customers and services, to place this information effectively in the hands of our sales associates at the point of sale. To realize the potential power of CRM, our staff will be trained in using this knowledge to connect more precisely and effectively with customers. This customer may be an inexperienced first-time home buyer or a baby boomer concerned about retirement planning. The key is to elevate our already top-level staff to a status far beyond what is commonly known as a “teller” or a “loan officer” into the fully-armed, front-line customer service representative of First Citizens.

 

            The purpose of this Annual Report is to chart in detail CRM’s four seaworthy components: Tools, Process, People and Commitment.

 

Sincerely,

Richard E. Wilber, President

     
 

We’ve organized the TEAM

 

to acquire the TOOLS

 

            The principal tool of CRM is yet another acronym, MCIF, which denotes a patented Customer Information software program. MCIF correlates dozens of different factors (including demographic information) about both individual customers, or groups of customers who share common circumstances, needs and goals. This will enable us to establish profiles of our most profitable prospects and increase our activity with customers with the highest potential.

 

            The goal is to match customer needs and desires with products we offer, to create new products or delivery channels based on the customer needs that we identify. Ideally, the CRM tools and processes will identify customers who are not only most in need of a particular service or product, but who are most likely to contract for them. This enables the sales teams to streamline both the essential “customer of one” service as well as target the appropriate customers for new promotions. The CRM tools are the first step towards achieving our primary goal: To Offer What Customers Need, When They Need It.

 

            For example, Katherine “Kitty” Thompson, of First Citizens Weis Markets branch in Wellsboro, effectively applied the use of customer information tools to identify opportunities when managing the relationship of Mildred Sherman, whom she had worked with previously on a mortgage for her new home. Knowing that Mildred would be selling her previous home, Kitty continued to monitor Mildred’s relationship in order to contact her immediately and offer options for investing the proceeds from the sale of her previous home.

 

 
     
 

and create the PROCESS

 

 

            Since the Tools don’t mean much without a plan of execution (a strategy, if you will), the Business Process is the means by which all the pieces work together to make CRM successful—where we develop and deliver a consistent approach of selling and servicing customers throughout the company. This change in marketing mindset will be accomplished through the development of clear standards of operation, the perfection of sales management and coaching, and the creation of goals and performance measures with corresponding compensation and incentive programs.

 

            It is through the effective execution of these activities and continuous training that an employee comes to understand the dynamics of the transformation to becoming a fully qualified customer-relationship manager. So that, for example, an associate who notices on her screen a customer with a large checking balance may not only proactively suggest options, but also know how best to meet that customer’s needs. It is the use of the CRM tools and process by employees who will now have a thorough knowledge of the customer at their fingertips and product-knowledge skills across a broad enough spectrum, to have a specific, informed discussion regarding the products and services we offer.

 

     
 

to educate our PEOPLE

 

            Which leads back to our People—the lifeblood of the Process. We already know from our survey, we have the right people who know how to please our customers. Now the task is to bring our people to the next level—of exceeding customer expectations.

 

            This gets down to the most basic factors of human nature and communication; things as simple as sharpening skills to be a better listener and knowing when and how to ask the right questions. Not just questions directly related to why the customer came through the door, but more importantly, questions that uncover other needs and opportunities to further satisfy the customer.

 

            Exceeding customer expectations means following up on every contact: “Have you received your new checks? Is your debit card working for you at the grocery store? Did the delivery time on that loan help with your inventory?” Or, best of all: “I understand what you said yesterday and I have some ideas on how to make it happen.”

 

            Business Development Officer Chris Landis applied this approach when Jack and Carol Wheeler turned to him for help to purchase the 125-year-old building that Jack said was “crying to be a bakery.” Chris knew the creation of new jobs meant the Wheelers would qualify for assistance with a loan through the Northern Tier Regional Planning and Development Corporation. Chris’ expertise helped make Troy the place to go for donuts, in that old building now warm with the wonderful aromas of the Endless Mountain Donut Company & Bakery.

 

 
     
 

and engage their COMMITMENT

 

 

            By now, commitment is one of the most famous words in the English language. We all know what it means, because no personal or business plan, either a diet or CRM, no combination of Tools, Process and People, can work without it. That’s why, with the advent of CRM at First Citizens, our focus is on commitment to the VERY IDEA of commitment, since that’s the only way plans work and goals are accomplished.

 

            Commitment is the wind in our sails, the strength that makes our new programs and ideas successful. This commitment exists throughout the company—Board of Directors, President, Management Team, support areas and front-line associates. Just ask Nelle Rounsaville. Nelle wanted to expand her business holdings in the Wellsboro area, where she already owned the Wellsboro Diner and a bed and breakfast called “La Petite Auberge” to include a second bed and breakfast, now called “La Belle Auberge.” Where others may have seen red tape, Jeff Wilson, community office manager and business development officer of the Wellsboro branch, saw the potential for converting Nelle’s ambitious vision into attractive, lucrative businesses. Jeff’s commitment means that Nelle is now the proud owner and operator of three successful businesses in Wellsboro. For ten years, Jeff has been committed to Nelle’s dream, and in turn, Nelle has been turning to First Citizens for all her financial needs. That kind of commitment is the foundation of Customer Relationship Management.

 

 

 
     
 

to BENEFIT our customers

 

            The components of CRM—the detailed customer information tools, the structured business processes that ensure quality service across the board, and our employees, highly skilled in using customer knowledge to identify opportunities, surrounded by a sincere commitment by everyone in this organization—will be especially powerful. Why? Because today, our employees do what they believe is best for the customer and it is that commitment, combined with CRM, that moves us closer to that place where this consistency of exceeding expectations becomes the standard by which all other financial service providers are judged.

 

            Just ask Donna McCaslin. When Donna's husband Leroy died last year, Donna had to try to make some sense of the many files full of stock certificates and other investment instruments that Leroy had accrued in their 56 years together. Mary Brooks, of the First Citizens branch in Ulysses, listened to Donna’s predicament and based on her knowledge of our investment-area capabilities, advised Donna to meet with Investment Representative Jeff Richardson to help her better understand the documents in question. Now First Citizens is partnering with Donna to ensure her retirement needs are taken care of as well.

 

            Donna commented, “Leroy was always a big believer in this bank, and now that he is gone, somebody is helping me shoulder this responsibility. I’m pretty new at this financial business, but this bank and its people have been a Godsend.”

 

     
 

            With Customer Relationship Management, we will think and act faster than our competitors, build stronger and more profitable relationships, utilize our resources more efficiently and effectively, and therefore impact the bottom line more swiftly and with greater consistency. This means that not only will we know what you want when you walk through our doors, but we will also know that when your daughter comes with you, it’s the cherry-flavored lollipop that she wants. It’s just that simple.

 

 
     
 

 

2002 FINANCIAL SECTION


Consolidated Financial Statements

Financial Highlights

 

         
           
           
(dollars in thousands, except per share data)   2002   2001  

       
 
BALANCE SHEET              

       
 
  Assets   $ 432,658   $ 421,110  
  Deposits     373,051     370,474  
  Net Loans     294,836     268,464  
  Investments     100,725     113,604  
  Stockholders' Equity     38,406     33,389  
                 
STATEMENT OF INCOME              

       
 
  Interest Income     27,377     29,025  
  Interest Expense     10,404     14,306  
  Net Interest Income     16,973     14,719  
  Net Income     5,595     3,757  
                 
PER SHARE DATA              

       
 
  Net Income     1.98     1.33  
  Cash Dividends     0.68     0.64  
                 
TRUST DEPARTMENT              

       
 
  Trust Assets Managed     65,171     72,416  

 

 
    17 
 

2002 FINANCIAL SECTION


Consolidated Financial Statements

Financial Highlights

 

 

    December 31,  

 
(in thousands)   2002   2001  

 
ASSETS:              
Cash and due from banks:              
  Noninterest-bearing   $ 11,173   $ 11,413  
  Interest-bearing     421     67  

 
Total cash and cash equivalents     11,594     11,480  
Available-for-sale securities     100,725     113,604  
Loans (net of allowance for loan losses              
     2002, 3,621; 2001, 3,250)   $ 294,836   268,464   
Premises and equipment     11,245     11,768  
Accrued interest receivable     1,976     1,986  
Goodwill     6,905     6,905  
Core deposit intangible     1,413     1,870  
Other assets     3,964     5,033  

 
TOTAL ASSETS   $ 432,658   $ 421,110  

 
                   
LIABILITIES:              
Deposits:              
  Noninterest-bearing   $ 40,143   $ 37,361  
  Interest-bearing     332,908     333,113  

 
Total deposits     373,051     370,474  
Borrowed funds     17,027     13,311  
Accrued interest payable     2,077     2,285  
Other liabilities     2,097     1,651  

 
TOTAL LIABILITIES     394,252     387,721  

 
                   
STOCKHOLDERS' EQUITY:              
Common Stock              
  $1.00 par value; authorized 10,000,000 shares;              
  issued 2,882,070 and 2,854,582              
  shares in 2002 and 2001, respectively     2,882     2,855  
Additional paid-in capital     9,473     9,017  
Retained earnings     24,447     21,253  

 
TOTAL     36,802     33,125  
Accumulated other comprehensive income     2,553     1,213  
Less: Treasury stock, at cost              
    55,162 shares for 2002 and 2001     (949 )   (949 )

 
TOTAL STOCKHOLDERS' EQUITY     38,406     33,389  

 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY   $ 432,658   $ 421,110  

 
                   
See accompanying notes to consolidated financial statements.              

 

 
    18 
 

2002 FINANCIAL SECTION


Consolidated Financial Statements

Consolidated Statement of Income

 

               
    Year Ended December 31,   

 
(in thousands, except per share data)   2002   2001   2000  

 
INTEREST INCOME:                    
Interest and fees on loans   $ 21,600   $ 22,163   $ 20,523  
Interest-bearing deposits with banks     65     547     129  
Investment securities:                    
  Taxable     4,711     4,969     4,093  
  Nontaxable     634     853     932  
  Dividends     367     493     549  

 
TOTAL INTEREST INCOME     27,377     29,025     26,226  

 
INTEREST EXPENSE:                    
Deposits     10,012     13,839     12,766  
Borrowed funds     392     467     1,472  

 
TOTAL INTEREST EXPENSE     10,404     14,306     14,238  

 
NET INTEREST INCOME     16,973     14,719     11,988  
Provision for loan losses     435     445     610  

 
NET INTEREST INCOME AFTER PROVISION FOR                    
  LOAN LOSSES     16,538     14,274     11,378  

 
NON-INTEREST INCOME:                    
Service charges     3,130     2,527     1,853  
Other     1,100     527     385  
Trust     562     578     432  
Realized securities gains (losses), net     254     657     (9 )

 
TOTAL NON-INTEREST INCOME     5,046     4,289     2,661  

 
NON-INTEREST EXPENSES:                    
Salaries and employee benefits     7,120     6,597     4,768  
Occupancy     998     992     610  
Furniture and equipment     881     966     761  
Professional fees     667     494     474  
Amortization     457     1,015     260  
Other     4,103     3,977     3,314  

 
TOTAL NON-INTEREST EXPENSES     14,226     14,041     10,187  

 
Income before provision for income taxes     7,358     4,522     3,852  
Provision for income taxes     1,763     765     644  

 
NET INCOME   $ 5,595   $ 3,757   $ 3,208  

 
NET INCOME - EARNINGS PER SHARE   $ 1.98   $ 1.33   $ 1.13  

 
CASH DIVIDENDS PER SHARE   $ 0.68   $ 0.64   $ 0.60  

 
                       
See accompanying notes to consolidated financial statements.                    

 

 
    19 
 

2002 FINANCIAL SECTION


Consolidated Financial Statements

Consolidated Statement of Changes in Stockholders' Equity

 

                 
          Accumulated     
    Additional    Other     
    Common Stock Paid-in Retained Comprehensive Treasury   
(in thousands, except share data)   Shares Amount Capital Earnings Income(Loss) Stock Total

Balance, December 31, 1999   2,800,563 $ 2,800 $ 8,374 $ 18,432 $ (2,064) $ (460) $ 27,082
                     
Comprehensive income:                
  Net income      3,208   3,208
  Change in net unrealized gain on securities                
    available-for-sale, net of taxes of $1,241       2,408   2,408
               
Total comprehensive income             5,616
Stock dividend   26,846 27 296 (323)      
Purchase of treasury stock (28,577 shares)         (489) (489)
Cash dividends, $.60 per share     (1,660)     (1,660)

Balance, December 31, 2000   2,827,409 2,827 8,670 19,657 344 (949) 30,549
                     
Comprehensive income:                
  Net income     3,757     3,757
  Change in net unrealized gain on securities                
    available-for-sale, net of taxes of $448       869   869
               
Total comprehensive income             4,626
Stock dividend   27,173 28 347 (375)      
Cash dividends, $.64 per share     (1,786)     (1,786)

Balance, December 31, 2001   2,854,582 2,855 9,017 21,253 1,213 (949) 33,389
                     
Comprehensive income:                
  Net income     5,595     5,595
  Change in net unrealized gain on securities                
    available-for-sale, net of taxes of $690       1,340   1,340
               
Total comprehensive income             6,935
Stock dividend   27,488 27 456 (483)      
Cash dividends, $.68 per share     (1,918)     (1,918)

Balance, December 31, 2002   2,882,070 $ 2,882 $ 9,473 $ 24,447 $ 2,553 $ (949) $ 38,406

                     
                     
                     
        2002 2001 2000        

       
Components of comprehensive income:                
  Change in net unrealized gain on investment                
    securities available-for-sale   $ 1,508 $ 1,303 $ 2,402        
  Realized losses (gains) included in net income, net                
    of taxes (benefit) of $86, $223 and $(3)   (168) (434) 6        

       
Total   $ 1,340 $ 869 $ 2,408        

       
                     
See accompanying notes to consolidated financial statements.                
 
    20 
 

2002 FINANCIAL SECTION


Consolidated Financial Statements

Consolidated Statement of Cash Flows

 

    Year Ended December 31,      

 
(in thousands)   2002   2001   2000  

 
Cash Flows from Operating Activities:                    
  Net income   $ 5,595   $ 3,757   $ 3,208  
  Adjustments to reconcile net income to net                    
    cash provided by operating activities:                    
      Provision for loan losses     435     445     610  
      Depreciation     990     953     737  
      Amortization on intangible assets     457     1,015     260  
      Amortization and accretion on investment securities     690     199     206  
      Deferred income taxes     116     (279 )   (254 )
      Realized losses (gains) on securities     (254 )   (657 )   9  
      Realized gains on loans sold     (185 )   (31 )   (6 )
      Originations of loans held for sale     (11,857 )   (3,839 )   (517 )
      Proceeds from sales of loans held for sale     13,119     2,103     523  
      Loss (gain) on sales or disposals of premises and equipment     (30 )   36     3  
      Decrease (increase) in accrued interest receivable     10     332     (198 )
      Increase in other assets and intangibles     (429 )   (615 )   (1,182 )
      Increase (decrease) in accrued interest payable     (208 )   (335 )   62  
      Increase (decrease) in other liabilities     (8 )   478     205  

 
      Net cash provided by operating activities     8,441     3,562     3,666  

 
Cash Flows from Investing Activities:                    
  Available-for-sale securities:                    
    Proceeds from sale of securities     13,927     35,529     10,717  
    Proceeds from maturity of securities     34,090     13,841     4,291  
    Purchase of securities     (32,899 )   (63,216 )   (19,527 )
  Net increase in loans     (28,045 )   (7,218 )   (3,810 )
  Purchase of loans     -     -     (28,027 )
  Acquisition of premises and equipment     (473 )   (2,086 )   (5,722 )
  Proceeds from sale of premises and equipment     275     16     -  
  Proceeds from sale of foreclosed assets held for sale     422     425     271  
  Deposit acquisition premium     -     -     (9,431 )

 
      Net cash used in investing activities     (12,703 )   (22,709 )   (51,238 )

 
Cash Flows from Financing Activities:                    
  Net increase in deposits     2,577     2,688     2,345  
  Proceeds from long-term borrowings     1,268     1,993     3,579  
  Repayments of long-term borrowings     (949 )   (1,720 )   (4,699 )
  Net increase (decrease) in short-term borrowed funds     3,398     1,834     (13,530 )
  Dividends paid     (1,918 )   (1,786 )   (1,660 )
  Acquisition of Treasury Stock     -     -     (489 )
  Deposits of acquired branches     -     -     81,122  

 
      Net cash provided by financing activities     4,376     3,009     66,668  

 
                               
          Net increase (decrease) in cash and cash equivalents     114     (16,138 )   19,096  
                               
Cash and Cash Equivalents at Beginning of Year     11,480     27,618     8,522  

 
Cash and Cash Equivalents at End of Year   $ 11,594   $ 11,480   $ 27,618  

 
Supplemental Disclosures of Cash Flow Information:                    
      Interest paid   $ 10,612   $ 14,641   $ 14,176  

 
      Income taxes paid   $ 1,755   $ 915   $ 955  

 
      Noncash activities:                    
        Real estate acquired in settlement of loans   $ 162   $ 284   $ 177  

 
                               
See accompanying notes to consolidated financial statements.                    

 

 
    21 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

 

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

         Citizens Financial Services, Inc. (individually and collectively, the “Company”) is a Pennsylvania corporation organized as the holding company of its wholly-owned subsidiary, First Citizens National Bank (the “Bank”).  The Bank is a national banking association headquartered in Mansfield, Pennsylvania and operating fifteen full-service banking offices in Potter, Tioga and Bradford counties.  The Company provides a comprehensive range of services including consumer loans, residential real estate loans, commercial loans, and loans to various state and municipal entities.  Deposit programs encompass the full range of consumer as well as commercial checking and savings accounts.  Deposit products include certificates of deposit and individual retirement accounts.  A comprehensive menu of trust and investment services is also available.  The Company’s principal sources of revenue are derived from its loan and investment portfolios.  The Company is supervised by the Board of Governors of the Federal Reserve System, while the Bank is subject to regulation and supervision by the Office of the Comptroller of the Currency.

 

         A summary of significant accounting and reporting policies applied in the presentation of the accompanying financial statements follows:

 

BASIS OF PRESENTATION

 

         The consolidated financial statements include the accounts of the Company and its subsidiary, First Citizens National Bank, and its subsidiary, First Citizens Insurance Agency, Inc.  These statements have been prepared in accordance with accounting principles generally accepted in the United States of America.  All significant intercompany accounts and transactions have been eliminated in the consolidated financial statements.

 

         In preparing the financial statements, management makes estimates and assumptions that affect the reported amounts of assets and liabilities as of the balance sheet date and revenues and expenses for the period.  Actual results could differ significantly from those estimates.

 

INVESTMENT SECURITIES

 

         Investment securities at the time of purchase are classified as one of the three following types:

 

         Held-to-Maturity Securities - includes securities that the Company has the positive intent and ability to hold to maturity. These securities are reported at amortized cost. The Company had no held-to-maturity securities as of December 31, 2002 and 2001.

 

         Trading Securities - includes debt and equity securities bought and held principally for the purpose of selling them in the near term. Such securities are reported at fair value with unrealized holding gains and losses included in earnings. The Company had no trading securities as of December 31, 2002 and 2001.

 

         Available-for-Sale Securities - includes debt and equity securities not classified as held-to-maturity or trading securities. Such securities are reported at fair value, with unrealized holding gains and losses excluded from earnings and reported as a separate component of stockholders’ equity, net of estimated income tax effect.

 

         The amortized cost of investment in debt securities is adjusted for amortization of premiums and accretion of discounts, computed by a method that results in a level yield. Gains and losses on the sale of investment securities are computed on the basis of specific identification of the adjusted cost of each security.

 

 
    22 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

 

         Common stock of the Federal Reserve Bank and Federal Home Loan Bank represents ownership in institutions which are wholly owned by other financial institutions. These equity securities are accounted for at cost and are classified as other assets.

 

         The fair value of investments, except certain state and municipal securities, is estimated based on bid prices published in financial newspapers or bid quotations received from securities dealers. The fair value of certain state and municipal securities is not readily available through market sources other than dealer quotations, so fair value estimates are based on quoted market prices of similar instruments, adjusted for differences between the quoted instruments and the instruments being valued.

 

LOANS

 

         Interest on all loans is recognized on the accrual basis based upon the principal amount outstanding. The accrual of interest income on loans is discontinued when, in the opinion of management, there exists doubt as to the ability to collect such interest. Payments received on nonaccrual loans are applied to the outstanding principal balance or recorded as interest income, depending upon our assessment of our ultimate ability to collect principal and interest.  Loans are returned to the accrual status when factors indicating doubtful collectibility cease to exist.

 

         The Company recognizes nonrefundable loan origination fees and certain direct loan origination costs over the life of the related loan as an adjustment of loan yield using the interest method.

 

ALLOWANCE FOR LOAN LOSSES

 

         The allowance for loan losses represents the amount which management estimates is adequate to provide for potential losses inherent in its loan portfolio. The allowance method is used in providing for loan losses. Accordingly, all loan losses are charged to the allowance and all recoveries are credited to it. The allowance for loan losses is established through a provision for loan losses which is charged to operations. The provision is based upon management’s periodic evaluation of individual loans, the overall risk characteristics of the various portfolio segments, past experience with losses, the impact of economic conditions on borrowers, and other relevant factors. The estimates used in determining the adequacy of the allowance for loan losses are particularly susceptible to significant change in the near term.

 

         Impaired loans are commercial and commercial real estate loans for which it is probable that the Company will not be able to collect all amounts due according to the contractual terms of the loan agreement. The Company individually evaluates such loans for impairment and does not aggregate loans by major risk classifications. The definition of “impaired loans” is not the same as the definition of “nonaccrual loans,” although the two categories overlap. The Company may choose to place a loan on nonaccrual status due to payment delinquency or uncertain collectibility, while not classifying the loan as impaired if the loan is not a commercial or commercial real estate loan. Factors considered by management in determining impairment include payment status and collateral value. The amount of impairment for these types of impaired loans is determined by the difference between the present value of the expected cash flows related to the loan, using the original interest rate, and its recorded value; or, as a practical expedient in the case of collateralized loans, the difference between the fair value of the collateral and the recorded amount of the loans. When foreclosure is probable, impairment is measured based on the fair value of the collateral.

 

         Mortgage loans on one- to four-family properties and all consumer loans are large groups of smaller balance homogeneous loans and are measured for impairment collectively. Loans that experience insignificant payment delays, which is defined as 90 days or less, generally are not classified as impaired. Management determines the significance of payment delays on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the borrower’s prior payment record, and the amount of shortfall in relation to the principal and interest owed.

 

 
    23 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

 

FORECLOSED ASSETS HELD FOR SALE

 

         Foreclosed assets acquired in settlement of foreclosed loans are carried at the lower of fair value minus estimated costs to sell or cost. Prior to foreclosure, the value of the underlying loan is written down to fair market value of the real estate or other assets to be acquired by a charge to the allowance for loan losses, if necessary. Any subsequent write-downs are charged against operating expenses. Operating expenses of such properties, net of related income and losses on disposition, are included in other expenses and gains are included in other income.

 

PREMISES AND EQUIPMENT

 

         Premises and equipment are stated at cost, less accumulated depreciation. Depreciation expense is computed on straight line and accelerated methods over the estimated useful lives of the assets, which range from 3 to 15 years for furniture, fixtures and equipment and 5 to 39 1/2 years for building premises. Repair and maintenance expenditures which extend the useful life of an asset are capitalized and other repair expenditures are expensed as incurred.

 

         When premises or equipment are retired or sold, the remaining cost and accumulated depreciation are removed from the accounts and any gain or loss is credited or charged to income.

 

INTANGIBLE ASSETS

 

         Intangible assets include core deposit intangibles, which are a measure of the value of consumer demand and savings deposits acquired in business combinations accounted for as purchases. The core deposit intangibles are being amortized to expense over a 5 1/2 to 6-year life on a straight-line basis. The recoverability of the carrying value of intangible assets is evaluated on an ongoing basis, and permanent declines in value, if any, are charged to expense.

 

GOODWILL

 

         Goodwill is the excess of the purchase price over the fair value of assets acquired of companies in connection with business acquisitions accounted for as purchases and was being amortized on the straight-line method over 15 years, prior to January 1, 2002. On January 1, 2002, the Company adopted Statement of Financial Accounting Standards (FAS) No. 142, Goodwill and Other Intangible Assets, which changed the accounting for goodwill from an amortization method to an impairment-only approach. This statement eliminates the regularly scheduled amortization of goodwill and replaces this method with a two-step process for testing the impairment of goodwill on at least an annual basis. This approach could cause more volatility in the Company’s reported net income because impairment losses, if any, could occur irregularly and in varying amounts. The Company, upon adoption of this Statement, stopped amortizing existing goodwill of $6.9 million. In addition, the Company performed its initial impairment analysis of goodwill and determined that the estimated fair value exceeded the carrying amount.

 

INCOME TAXES

 

         The Company and the Bank file a consolidated federal income tax return.  Deferred tax assets and liabilities are computed based on the difference between the financial statement, and income tax basis of assets and liabilities using the enacted marginal tax rates.  Deferred income tax expenses or benefits are based on the changes in the net deferred tax asset or liability from period to period.

 

 
    24
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

 

EMPLOYEE BENEFIT PLANS

 

         The Company has a noncontributory defined benefit pension plan covering substantially all employees. It is the Company’s policy to fund pension costs on a current basis to the extent deductible under existing tax regulations. Such contributions are intended to provide not only for benefits attributed to service to date, but also for those expected to be earned in the future.

 

         The Company also has a profit-sharing plan which provides tax-deferred salary savings to plan participants.

 

MORTGAGE SERVICING RIGHTS (MSR’s)

 

         The Company originates certain loans for the express purpose of selling such loans in the secondary market.  The Company maintains all servicing rights for these loans.  The loans are carried at lower of cost or market.  Originated MSR’s are recorded by allocating total costs incurred between the loan and servicing rights based on their relative fair values.  MSR’s are amortized in proportion to the estimated servicing income over the estimated life of the servicing portfolio.

 

COMPREHENSIVE INCOME

 

         The Company is required to present comprehensive income in a full set of general purpose financial statements for all periods presented. Other comprehensive income is comprised exclusively of unrealized holding gains (losses) on the available-for-sale securities portfolio. The Company has elected to report the effects of other comprehensive income as part of the Consolidated Statement of Changes in Stockholders’ Equity.

 

RECENT ACCOUNTING PRONOUNCEMENTS

 

         In August 2001, the Financial Accounting Standards Board (FASB) issued FAS No. 143, Accounting for Asset Retirement Obligations, which requires that the fair value of a liability be recognized when incurred for the retirement of a long-lived asset and the value of the asset be increased by that amount.  The statement also requires that the liability be maintained at its present value in subsequent periods and outlines certain disclosures for such obligations.  The adoption of this statement, which is effective January 1, 2003, is not expected to have a material effect on the Company ‘s financial statements.

 

         In October 2001, the FASB issued FAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets.  FAS No. 144 supercedes FAS No. 121 and applies to all long-lived assets (including discontinued operations) and consequently amends APB Opinion No. 30, Reporting Results of Operations-Reporting the Effects of Disposal of a Segment of a Business.   FAS No. 144 requires that long-lived assets that are to be disposed of by sale be measured at the lower of book value or fair value less costs to sell.  FAS No. 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001 and, generally, its provisions are to be applied prospectively.  The adoption of this statement did not have a material effect on the Company’s financial statements.

 

         In April 2002, the FASB issued FAS No. 145, “Rescission of FASB Statement No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections”. FAS No. 145 rescinds FAS No. 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. As a result, the criteria in APB Opinion No. 30 will now be used to classify those gains and losses. This statement also amends FAS No. 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. FAS No. 145, is effective for transactions occurring after May 15, 2002. The adoption of FAS No. 145 did not have a material effect on the Company’s financial position or results of operations.

 

 
    25
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

         In July 2002, the FASB issued FAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which 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.  The new statement will be effective for exit or disposal activities initiated after December 31, 2002, the adoption of which did not have a material effect on the Company’s financial statements. 

 

         On October 1, 2002, the FASB issued FAS No. 147, Acquisitions of Certain Financial Institutions, effective for all business combinations initiated after October 1, 2002.  This statement addresses the financial accounting and reporting for the acquisition of all or part of a financial institution, except for a transaction between two or more mutual enterprises.  This statement removes acquisitions of financial institutions, other than transactions between two or more mutual enterprises, from the scope of FAS No. 72, Accounting for Certain Acquisitions of Banking or Thrift Institutions, and FASB Interpretation No. 9, Applying APB Opinions No. 16 and 17 When a Savings and Loan Association or a Similar Institution Is Acquired in a Business Combination Accounted for by the Purchase Method. The acquisition of all or part of a financial institution that meets the definition of a business combination shall be accounted for by the purchase method in accordance with FAS No. 141, Business Combinations, and FAS No. 142, Goodwill and Other Intangible Assets. This statement also provides guidance on the accounting for the impairment or disposal of acquired long-term customer-relationship intangible assets (such as depositor- and borrower-relationship intangible assets and credit cardholder intangible assets), including those acquired in transactions between two or more mutual enterprises.  Upon adoption of this statement, the Company ceased the amortization of $6,905,000 in goodwill associated with branch acquisitions. The Company will continue to review the remaining goodwill on an annual basis for impairment. However, $1,413,000 in core deposit intangible will continue to be amortized and reviewed for impairment in accordance with FAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets

 

         On December 31, 2002, the FASB issued FAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, which amends FAS No. 123, Accounting for Stock-Based Compensation.  FAS No. 148 amends the disclosure requirements of  FAS No. 123 to require more prominent and more frequent disclosures in financial statements about the effects of stock-based compensation.  Under the provisions of FAS No. 123, companies that adopted the preferable, fair value based method were required to apply that method prospectively for new stock option awards. This contributed to a “ramp-up” effect on stock-based compensation expense in the first few years following adoption, which caused concern for companies and investors because of the lack of consistency in reported results. To address that concern, FAS No. 148 provides two additional methods of transition that reflect an entity’s full complement of stock-based compensation expense immediately upon adoption, thereby eliminating the ramp-up effect. FAS No.148 also improves the clarity and prominence of disclosures about the pro forma effects of using the fair value based method of accounting for stock-based compensation for all companies—regardless of the accounting method used—by requiring that the data be presented more prominently and in a more user-friendly format in the footnotes to the financial statements. In addition, the statement improves the timeliness of those disclosures by requiring that this information be included in interim as well as annual financial statements.  The transition guidance and annual disclosure provisions of FAS No. 148 are effective for fiscal years ending after December 15, 2002, with earlier application permitted in certain circumstances. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002.

 

 
    26 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

 

         In November, 2002, the FASB issued Interpretation No.45, Guarantor’s Accounting and Disclosure requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.  This interpretation 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.  This interpretation clarifies that a guarantor is required to disclose (a) the nature of the guarantee, including the approximate term of the guarantee, how the guarantee arose, and the events or circumstances that would require the guarantor to perform under the guarantee; (b) the maximum potential amount of future payments under the guarantee; (c) the carrying amount of the liability, if any, for the guarantor’s obligations under the guarantee; and (d) the nature and extent of any recourse provisions or available collateral that would enable the guarantor to recover the amounts paid under the guarantee.  This interpretation also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the obligations it has undertaken in issuing the guarantee, including its ongoing obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur. The objective of the initial measurement of that liability is the fair value of the guarantee at its inception.  The initial recognition and initial measurement provisions of this interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The disclosure requirements in this interpretation are effective for financial statements of interim or annual periods ending after December 15, 2002.

 

TREASURY STOCK

 

         The purchase of the Company’s common stock is recorded at cost.  At the date of subsequent reissue, the treasury stock account is reduced by the cost of such stock on a last-in-first-out basis.

 

CASH FLOWS

 

         The Company utilizes the net reporting of cash receipts and cash payments for deposit and lending activities.  The Company considers amounts due from banks and interest-bearing deposits in banks as cash equivalents. 

 

TRUST ASSETS AND INCOME

 

         Assets held by the Bank in a fiduciary or agency capacity for its customers are not included in the consolidated financial statements since such items are not assets of the Bank.

 

EARNINGS PER SHARE

 

         Earnings per share calculations give retroactive effect to stock dividends declared by the Company.  The number of shares used in the earnings per share computations presented was 2,826,908, 2,826,908 and 2,829,710 for 2002, 2001 and 2000, respectively.  The Company has no dilutive securities.

 

RECLASSIFICATION

 

         Certain of the prior year amounts have been reclassified to conform with the current year presentation. Such reclassifications had no effect on net income or stockholders’ equity.

 

2. RESTRICTIONS ON CASH AND DUE FROM BANKs

 

         The Bank is required to maintain reserves, in the form of cash and balances with the Federal Reserve Bank, against its deposit liabilities.  The amount of such reserves was $546,000 and $428,000 at December 31, 2002 and 2001, respectively.

 

 
    27 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

 

         Deposits with one financial institution are insured up to $100,000.  The Company maintains cash and cash equivalents with other financial institutions in excess of the insured amount.

 

3. INVESTMENT SECURITIES

 

         The amortized cost and estimated fair value of investment securities at December 31, 2002 and 2001, were as follows (in thousands):

 

      Gross   Gross       
      Unrealized   Unrealized   Estimated   
    Amortized   Holding   Holding   Fair  
December 31, 2001    Cost    Gains    Losses    Value  

 
Available-for-sale securities:                          
  U.S. Agency securities   $ 1,008   $ 44   $ -   $ 1,052  
  Obligations of state and                          
    political subdivisions     12,424     307     -     12,731  
  Corporate obligations     19,845     1,311     -     21,156  
  Mortgage-backed securities     58,913     1,888     -     60,801  
  Equity securities     4,667     318     -     4,985  

 
Total available-for-sale   $ 96,857   $ 3,868   $ -   $ 100,725  

 

 

      Gross   Gross       
      Unrealized   Unrealized   Estimated   
    Amortized   Holding   Holding   Fair  
December 31, 2001   Cost   Gains   Losses   Value  

 
Available-for-sale securities:                          
  Obligations of state and                          
    political subdivisions   $ 18,626   $ 64   $ (147 ) $ 18,543  
  Corporate obligations     11,616     584     -     12,200  
  Mortgage-backed securities     76,414     945     (148 )   77,211  
  Equity securities     5,110     540     -     5,650  

 
Total available-for-sale   $ 111,766   $ 2,133   $ (295 ) $ 113,604  

 

         Proceeds from sales of securities available-for-sale during 2002, 2001, and 2000 were $13,927,000, $35,529,000  and $10,717,00 respectively.  Gross gains and gross losses were realized on those sales as follows (in thousands):

 

    2002   2001   2000  

 
Gross gains   $ 287   $ 817   $ 232  
Gross losses     33     160     241  

 
Net gains (losses)   $ 254   $ 657   $ (9 )

 

 

 
    28 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

         Investment securities with an approximate carrying value of $50,733,000 and $57,180,000 at December 31, 2002 and 2001, respectively, were pledged to secure public funds and certain other deposits as provided by law.

 

         Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.   The amortized cost and estimated carrying value of debt securities at December 31, 2002, by contractual maturity, are shown below (in thousands):

 

    Amortized   Estimated  
    Cost   Fair Value  

 
Available-for-sale securities              
  Due in one year or less   $ 372   $ 375  
  Due after one yearthrough five years     25,568     26,787  
  Due after five years through ten years     30,353     31,198  
  Due after ten years     35,897     37,380  

 
Total   $ 92,190   $ 95,740  

 

 

4. LOANS

 

         The Company grants commercial, industrial, residential, and consumer loans primarily to customers throughout Northcentral Pennsylvania and Southern New York.  Although the Company has a diversified loan portfolio at December 31, 2002 and 2001, a substantial portion of its debtors’ ability to honor their contracts is dependent on the economic conditions within this region.

 

         Major classifications of loans are as follows (in thousands):

 

    December 31,    
    2002   2001  

 
Real estate loans:              
  Residential   $ 175,323   $ 160,439  
  Commercial     47,210     43,174  
  Agricultural     9,844     12,169  
  Construction     5,009     3,219  
Loans to individuals for household,              
  family and other purchases     13,915     14,694  
Commercial and other loans     18,564     15,099  
State and political subdivision loans     28,592     22,920  

 
          298,457     271,714  
Less allowance for loan losses     3,621     3,250  

 
Loans, net   $ 294,836   $ 268,464  

 

 

         Real estate loans serviced for Freddie Mac, which are not included in the consolidated balance sheet, totaled $20,087,000 and $9,892,000, at December 31, 2002 and 2001, respectively.

 

 
    29 
 

 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

 

         At December 31, 2002 and 2001, net unamortized loan fees and costs of $767,000 and $794,000, respectively, have been deducted from the carrying value of loans.

 

         The Company had nonaccrual loans, inclusive of impaired loans, of $2,980,000 and $2,062,000 at December 31, 2002 and 2001, respectively.  Interest income on loans would have increased by approximately $84,000, $105,000 and $39,000 during 2002, 2001 and 2000, respectively, if these loans had performed in accordance with their original terms.

 

         Information with respect to impaired loans as of and for the years ended December 31, is as follows (in thousands):

 

    2002   2001   2000  

 
Impaired Loans   $ 1,916     1,077   $ 199  
Related allowance for loan losses     327     325     25  
Average recorded balance of impaired loans     1,967     1,078     202  
Interest income recognized on impaired loans     -     26     1  

 

        Transactions in the allowance for loan losses were as follows (in thousands):

 

    Years Ended December 31,      
    2002   2001   2000  

 
Balance, beginning of year   $ 3,250   $ 2,777   $ 2,270  
  Provision charged to income     435     445     610  
  Recoveries on loans previously                    
    charged against the allowance     115     175     55  

 
          3,800     3,397     2,935  
    Loans charged against the allowance     (179 )   (147 )   (158 )

 
Balance, end of year   $ 3,621   $ 3,250   $ 2,777  

 

 

         The following is a summary of the past due and nonaccrual loans as of December 31, 2002 and 2001 (in thousands):

 

    December 31, 2002      
    Past Due   Past Due      
    30 - 89 days   90 days or more   Nonaccrual  

 
Real estate loans   $ 1,744   $ -   $ 2,980  
Installment loans     307     29     -  
Credit cards and related loans     36     3     -  
Commercial and all other loans     145     7     -  

 
Total   $ 2,232   $ 39   $ 2,980  

 

 

 
    30 
 

 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

    December 31, 2001      
    Past Due   Past Due      
    30 - 89 days   90 days or more   Nonaccrual  

 
Real estate loans   $ 2,329   $ 89   $ 2,062  
Installment loans     298     16     -  
Credit cards and related loans     33     6     -  
Commercial and all other loans     92     -     -  

 
Total   $ 2,752   $ 111   $ 2,062  

 

 

5. PREMISES & EQUIPMENT

 

        Premises and equipment are summarized as follows (in thousands):

 

    December 31,    
    2002   2001  

 
Land   $ 1,867   $ 1,867  
Buildings     9,681     9,524  
Furniture, fixtures and equipment     6,476     5,903  
Construction in process     21     294  

 
      18,045     17,588  
Less accumulated depreciation     6,800     5,820  

 
Premises and equipment, net   $ 11,245   $ 11,768  

 

 

        Depreciation expense amounted to $990,000, $953,000, and $737,000 for 2002, 2001, and 2000, respectively.

 

6. DEPOSITS

 

        Certificates of deposit of $100,000 or more amounted to $35,671,000 and $33,991,000 at December 31, 2002 and 2001, respectively. Interest expense on certificates of deposit of $100,000 or more amounted to $1,654,000, $1,976,000, and $1,612,000 for the years ended December 31, 2002, 2001, and 2000, respectively.

 

        Following are maturities of certificates of deposit as of December 31, 2002 (in thousands):

 

2003

 

 $

88,314

 

2004

 

 

27,959

 

2005

 

 

32,885

 

2006

 

 

18,851

 

2007

 

 

29,479

 

Thereafter

 

 

 4,299

 


Total certificates of deposit

 

 $

201,787

 


 

 
    31 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

 

7. BORROWED FUNDS

 

    Securities                      
    Sold Under           Capital    Total   
    Agreements to   TT&L   FHLB   Term   Lease   Borrowed  
(dollars in thousands)   Repurchase(a)   Borrowings(b)   Advances(c)   Loans(d)   Obligations   Funds  

 
2002                                    
Balance at December 31   $ 7,647   $ -   $ 7,380   $ 2,000   $ -   $ 17,027  
Highest balance at any month-end     14,897     -     7,380     2,000     20     24,297  
Average balance     11,096     -     1,208     2,000     6     14,310  
Weighted average interest rate:                                      
    Paid during the year     2.69 %   -     1.59 %   3.64 %   4.93 %   2.73 %
    As of year-end     2.94 %   -     1.31 %   3.13 %   0.00 %   2.25 %

 
2001                                    
Balance at December 31   $ 8,322   $ -   $ 2,965   $ 2,000   $ 24   $ 13,311  
Highest balance at any month-end     10,758     -     2,965     2,000     67     15,790  
Average balance     8,752     -     47     2,000     49     10,848  
Weighted average interest rate:                                      
    Paid during the year     4.31 %   -     2.00 %   5.94 %   4.93 %   4.60 %
    As of year-end     3.20 %   -     1.88 %   3.61 %   4.90 %   2.97 %

 
2000                                    
Balance at December 31   $ 9,133   $ -   $ -   $ 2,000   $ 71   $ 11,204  
Highest balance at any month-end     10,515     4,606     25,030     8,000     113     48,264  
Average balance     4,705     1,512     13,398     4,093     96     23,804  
Weighted average interest rate:                                      
    Paid during the year     6.29 %   6.08 %   6.47 %   6.48 %   4.92 %   6.40 %
    As of year-end     5.83 %   -     -     8.30 %   4.90 %   6.26 %

 

 

(a)

Securities sold under agreements to repurchase mature within one to five years. The carrying value of the underlying securities at December 31, 2002 and 2001 was $16,297,000 and $13,122,000, respectively.

 

(b)

TT&L borrowings consist of notes issued under the U.S. Treasury Department's program of investing the treasury tax and loan account balances in interest-bearing demand notes insured by depository institutions.  These notes bear interest at a rate of .25 percent less than the average Federal funds rate as computed by the Federal Reserve Bank.

 

(c)

FHLB Advances consist of an "Open RepoPlus" agreement with the Federal Home Loan Bank of Pittsburgh. FHLB "Open RepoPlus" advances are short-term borrowings maturing within one year, bear a fixed rate of interest and are subject to prepayment penalty.  The Company has a borrowing limit of $166,339,000, exclusive of any outstanding advances.  Although no specific collateral is required to be pledged for the "Open RepoPlus" borrowings, FHLB advances are secured by a blanket security agreement that includes the Company's FHLB stock, as well as investment and mortgage-backed securities held in safekeeping at the FHLB and certain residential mortgage loans.  At December 31, 2002 and 2001, the approximate carrying value of the securities collateral was $58,722,000 and $57,183,000, respectively.

 

(d) 

Term Loans consist of separate loans with a third party bank and the Federal Home Loan Bank of Pittsburgh as follows (in thousands):

 

      December 31,   December 31,   
Interest Rate   Maturity   2002   2001  

 
Variable:                    
                (e)    October 15, 2003   $ 2,000   $ 2,000  

 
Total term loans     $ 2,000   $ 2,000  

 

 

(e)       Interest rate floats monthly based on the 1 month LIBOR +1.75, the interest rate was 3.13% and 3.61% at December 31, 2002 and 2001, respectively.

 

 
    32 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

 

Following are maturities of borrowed funds as of December 31, 2002 (in thousands):

 

2003             

$

                13,864

2004             

 

                        956

2005             

 

                        390

2006             

 

                    1,111

2007             

 

                        706


Total borrowed funds             

$

                17,027


 

8. EMPLOYEE BENEFIT PLANS

 

         The Company has a noncontributory, defined-benefit pension plan (the “Plan”) for all employees meeting certain age and length of service requirements. Benefits are based primarily on years of service and the average annual compensation during the highest five consecutive years within the final ten years of employment. The Company’s funding policies are consistent with the funding requirements of federal law and regulations. Plan assets are comprised of common stock, U.S. government and corporate debt securities. Plan assets included 10,510 and 10,406 shares of the Company’s common stock at December 31, 2002 and 2001, respectively.

 

         The following table sets forth the change in plan assets and benefit obligation at December 31 (in thousands):

 

    2002   2001   2000  

 
Plan assets at fair value, beginning of year   $ 3,181   $ 3,158   $ 3,294  
Actual return on plan assets     (371 )   (69 )   (83 )
Amendments     -     -     23  
Employer contribution     391     160     -  
Benefits paid     (84 )   (68 )   (76 )

 
Plan assets at fair value, end of year     3,117     3,181     3,158  

 
                       
Benefit obligation, beginning of year     3,342     2,874     2,515  
Service cost     269     222     155  
Interest cost     229     201     181  
Amendments     74     30     99  
Assumption change     96     83     -  
Benefits paid     (84 )   (68 )   (76 )

 
Benefit obligation, end of year     3,926     3,342     2,874  

 
                       
Funded status     (809 )   (161 )   284  
Transition adjustment     (39 )   (55 )   (70 )
Prior service cost     21     (13 )   (44 )
Unrecognized net gain from past experience                    
  different from that assumed     1,010     244     (161 )

 
Benefit asset, end of year   $ 183   $ 15   $ 9  

 

 

 
    33 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

 

         Assumptions used in determining net periodic pension cost are as follows:

 

    2002   2001   2000  

 
Discount rate     6.50 %   6.75 %   7.00 %
Expected return on plan assets     8.00 %   8.00 %   8.00 %
Rate of compensation increase     3.50 %   3.75 %   4.00 %

 

         Net periodic pension cost includes the following components (in thousands):

 

    2002   2001   2000  

 
Service cost of the current period   $ 269   $ 222   $ 155  
Interest cost on projected benefit obligation     229     201     181  
Actual return on plan assets     371     69     83  
Net amortization and deferral     (646 )   (338 )   (382 )

 
Net periodic pension cost   $ 223   $ 154   $ 37  

 

 

         The Company also has a profit-sharing plan, covering substantially all employees, which provides tax-deferred salary savings to plan participants. The Company’s contributions to the profit-sharing plan are allocated to the participants based upon a percentage of their compensation. The Company’s profit-sharing contribution is determined by the Board of Directors on a discretionary basis. The Company’s contributions for 2002, 2001, and 2000 were $299,000, $131,000, and $49,000, respectively.

 

9. INCOME TAXES

 

         The provision for income taxes consists of the following (in thousands):

 

    Years Ended December 31,   
    2002   2001   2000  

 
Currently payable   $ 1,647   $ 1,044   $ 898  
Deferred liability (benefit)     116     (279 )   (254 )

 
Provision for income taxes   $ 1,763   $ 765   $ 644  

 

 

 
    34 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

 

        The following temporary differences gave rise to the net deferred tax assets (liabilities) at December 31, 2002 and 2001 (in thousands):

 

    2002   2001  

 
Deferred tax assets:              
    Allowance for loan losses   $ 1,038   $ 922  
    Deferred compensation     243     225  
    Goodwill and core deposit intangibles     108     189  
    Merger & acquisition costs     34     44  

 
          Total     1,423     1,380  

 
                           
Deferred tax liabilities:              
    Unrealized gains on available-for-sale securities     (1,315 )   (625 )
    Depreciation and amortization     (259 )   (252 )
    Bond accretion     (126 )   (80 )
    Pension expense     (62 )   (5 )
    Loan fees and costs     (69 )   (56 )
    Mortgage servicing rights     (45 )   (9 )

 
            Total     (1,876 )   (1,027 )

 
Deferred tax asset (liability), net   $ (453 ) $ 353  

 

 

         No valuation allowance was established at December 31, 2001 in view of certain tax strategies coupled with the anticipated future taxable income as evidenced by the Company’s earnings potential.

 

         The total provision for income taxes is different from that computed at the statutory rates due to the following items (in thousands):

 

    Years Ended December 31,  
    2002   2001   2000  

 
Provision at statutory rates on                    
  pre-tax income   $ 2,502   $ 1,537   $ 1,309  
Effect of tax-exempt income     (693 )   (764 )   (780 )
Tax credits     (130 )   (113 )   -  
Nondeductible interest     67     97     110  
State income taxes     9     -     -  
Other items     8     8     5  

 
Provision for income taxes   $ 1,763   $ 765   $ 644  

 
Statutory tax rates     34 %   34 %   34 %
Effective tax rates     24.0 %   16.9 %   16.7 %

 

 
    35 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

 

10. RELATED PARTY TRANSACTIONS

 

         Certain executive officers, corporate directors or companies in which they have 10 percent or more beneficial ownership were indebted to the Bank.

 

         A summary of loan activity with officers, directors, stockholders and associates of such persons is listed below (in thousands):

 

    Years Ended December 31,      
    2002   2001   2000  

 
Balance, beginning of year   $ 3,972   $ 2,814   $ 3,041  
  New loans     847     2,341     627  
  Repayments     (1,141 )   (1,183 )   (854 )

 
Balance, end of year   $ 3,678   $ 3,972   $ 2,814  

 

 

         Such loans were made in the ordinary course of business at the Bank’s normal credit terms and do not present more than a normal risk of collection.

 

 

11. REGULATORY MATTERS

 

Dividend Restrictions:

 

         The approval of the Comptroller of the Currency is required for a national bank to pay dividends up to the Company if the total of all dividends declared in any calendar year exceeds the Bank’s net income (as defined) for that year combined with its retained net income for the preceding two calendar years. Under this formula, the Bank can declare dividends in 2003 without approval of the Comptroller of the Currency of approximately $7,416,000, plus the Bank’s net income for 2003.

 

 

Loans:

 

         The Bank is subject to regulatory restrictions which limit its ability to loan funds to the Company. At December 31, 2002, the regulatory lending limit amounted to approximately $4,360,000.

 

 

Regulatory Capital Requirements:

 

         Federal regulations require the Company and the Bank to maintain minimum amounts of capital. Specifically, each is required to maintain certain minimum dollar amounts and ratios of Total and Tier I capital to risk-weighted assets and of Tier I capital to average total assets.

 

         In addition to the capital requirements, the Federal Deposit Insurance Corporation Improvement Act (FDICIA) established five capital categories ranging from “well capitalized” to “critically undercapitalized.” Should any institution fail to meet the requirements to be considered “adequately capitalized”, it would become subject to a series of increasingly restrictive regulatory actions.

 

         As of December 31, 2002 and 2001, the Federal Reserve Board and the Office of the Comptroller of the Currency categorized the Company and the Bank as well capitalized, under the regulatory framework for prompt corrective action.  To be categorized as a well capitalized financial institution, Total risk-based, Tier I risk-based and Tier I leverage capital ratios must be at least 10%, 6% and 5%, respectively.

 

 
    36 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

 

         The following table reflects the Company’s capital ratios at December 31 (in thousands):

 

    2002    2001     
    Amount   Ratio   Amount   Ratio  
Total capital (to risk weighted assets)                  

 
                   
Company   $ 31,036     11.52 % $ 26,761     10.72 %
For capital adequacy purposes     21,552     8.00 %   19,978     8.00 %
To be well capitalized     26,939     10.00 %   24,972     10.00 %
                           
Tier I capital (to risk weighted assets)                          

 
                           
Company   $ 27,522     10.22 % $ 23,398     9.37 %
For capital adequacy purposes     10,776     4.00 %   9,989     4.00 %
To be well capitalized     16,164     6.00 %   14,983     6.00 %
                           
Tier I capital (to average assets)                          

 
                           
Company   $ 27,522     6.48 % $ 23,398     5.68 %
For capital adequacy purposes     16,978     4.00 %   16,480     4.00 %
To be well capitalized     21,223     5.00 %   20,600     5.00 %

 

         At December 31, 2002, the Bank’s Total capital and Tier I ratios were 12.13% and 10.85%, respectively, and Tier I capital to average assets was 7.00%. At December 31, 2001, the Bank’s Total capital and Tier I ratios were 11.19% and 9.89%, respectively, and Tier I capital to average assets was 6.05%.

 

         This annual report has not been reviewed, or confirmed for accuracy or relevance, by the Federal Deposit Insurance Corporation.

 

12. OFF-BALANCE-SHEET RISK

 

         The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate or liquidity risk in excess of the amount recognized in the consolidated balance sheet.

 

         The Company’s exposure to credit loss from nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

 

 
    37 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

 

         Financial instruments whose contract amounts represent credit risk at December 31, 2002 and 2001, are as follows (in thousands):

 

    2002   2001  

 
Commitments to extend credit   $ 33,946   $ 33,946  
Standby letters of credit     1,143     1,116  

 

         Commitments to extend credit are legally binding agreements to lend to customers. Commitments generally have fixed expiration dates or other termination clauses and may require payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future liquidity requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained if deemed necessary by the Company on extension of credit is based on management’s credit assessment of the counter party.

 

         Standby letters of credit are conditional commitments issued by the Company guaranteeing performance by a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending normal loan commitments to customers. The Company generally holds collateral supporting standby letters of credit.

 

13. ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS

 

         The estimated fair values of the Company’s financial instruments are as follows (in thousands):

 

           
December 31, 2002      

 
           
    Carrying   Estimated  
    Amount   Fair Value  

 
Financial assets:              
Cash and due from banks   $ 11,594   $ 11,594  
Available-for-sale securities     100,725     100,725  
Net loans     294,836     297,913  
Regulatory Stock     1,529     1,529  
Accrued interest receivable     1,976     1,976  

 
Total financial assets   $ 410,660   $ 413,737  

 
               
               
Financial liabilities:              
Deposits   $ 373,051   $ 375,007  
Securities sold under agreements to repurchase     7,648     7,700  
Other borrowed funds     9,380     9,380  
Accrued interest payable     2,077     2,077  

 
Total financial liabilities   $ 392,156   $ 394,164  

 

 

 
    38 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

December 31, 2001      

 
           
    Carrying   Estimated  
    Amount   Fair Value  

 
Financial assets:              
Cash and due from banks   $ 11,480   $ 11,480  
Available-for-sale securities     113,604     113,604  
Net loans     268,464     277,461  
Regulatory Stock     2,175     2,175  
Accrued interest receivable     1,986     1,986  

 
Total financial assets   $ 397,709   $ 406,706  

 
               
               
Financial liabilities:              
Deposits   $ 370,474   $ 373,439  
Securities sold under agreements to repurchase     8,322     8,350  
Other borrowed funds     4,989     4,989  
Accrued interest payable     2,285     2,285  

 
Total financial liabilities   $ 386,070   $ 389,063  

 

 

         Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument.  These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument.  Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions can significantly affect the estimates.

 

         Estimated fair values have been determined by the Company using historical data, as generally provided in the Company’s regulatory reports, and an estimation methodology suitable for each category of financial instruments. The Company’s fair value estimates, methods and assumptions are set forth below for the Company’s other financial instruments.

 

Cash and Due From Banks:

 

         The carrying amounts for cash and due from banks approximate fair value because they mature in 90 days or less and do not present unanticipated credit concerns.

 

Investment Securities:

 

         The fair values of investments are based on quoted market prices as of the balance sheet date.  For certain instruments, fair value is estimated by obtaining quotes from independent dealers.

 

 
    39 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

 

Loans:

 

         Fair values are estimated for portfolios of loans with similar financial characteristics.

 

         The fair value of performing loans has been estimated by discounting expected future cash flows. The discount rate used in these calculations is derived from the Treasury yield curve adjusted for credit quality, operating expense and prepayment option price, and is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The estimate of maturity is based on the Company’s historical experience with repayments for each loan classification, modified as required by an estimate of the effect of current economic and lending conditions.

 

         Fair value for significant nonperforming loans is based on recent external appraisals. If appraisals are not available, estimated cash flows are discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows, and discount rates are judgmentally determined using available market information and specific borrower information.

 

Regulatory Stock:

 

         The carrying value of regulatory stock approximates fair value based on applicable redemption provisions.

 

Deposits:

 

         The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, savings and NOW accounts, and money market accounts, is equal to the amount payable on demand. The fair value of certificates of deposit is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.

 

         The deposits’ fair value estimates do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market, commonly referred to as the core deposit intangible.

 

 

Borrowed Funds:

 

         Rates available to the Company for borrowed funds with similar terms and remaining maturities are used to estimate the fair value of borrowed funds.

 

 

14. Goodwill - Adoption of Statement 142

 

         A summary of goodwill is as follows (in thousands):

 

    December 31,  
    2002   2001   2000  

 
Gross carrying amount   $ 7,685   $ 7,685   $ 7,685  
Less accumulated amoritzation     780     780     268  

 
Net carrying amount   $ 6,905   $ 6,905   $ 7,417  

 

 

         Amortization expense amounted to $512,000 and $268,000 for 2001 and 2000, respectively.

 

 
    40 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

 

         The gross carrying amount of goodwill is tested for impairment in the fourth quarter, after the annual forecasting process.  Due to an increase in overall earning asset growth, operating profits and cashflows were greater than expected. Based on the fair value of the reporting unit, estimated using the expected present value of future cashflows, no goodwill impairment loss was recognized in the current year.

 

         The following table sets forth a comparison of net income and basic earnings per share adjusted for the adoption of SFAS No. 142, "Goodwill and Other Intangible Assets":

 

(in thousands, except per share data)

 

    For the Year Ended  
    December 31,   
    2002   2001   2000  

 
                     
Goodwill amortization   $ -   $ 512   $ 119  
                     
Net Income     5,595     3,757     3,208  
Addback: Goodwill amortization (net of tax)     -     338     79  

 
Adjusted net income   $ 5,595   $ 4,095   $ 3,287  

 
                     
Basic earnings per share:                    
Net income   $ 1.98   $ 1.33   $ 1.13  
Goodwill amortization     -     0.12     0.03  

 
Adjusted basic earnings per share   $ 1.98   $ 1.45   $ 1.16  

 

 

15. Core deposit intangible assets

 

         A summary of core deposit intangible assets is as follows (in thousands):

 

    December 31,      
    2002   2001   2000  

 
Gross carrying amount   $ 2,763   $ 2,763   $ 2,763  
Less accumulated amortization     1,350     893     390  

 
Net carrying amount   $ 1,413   $ 1,870   $ 2,373  

 

 

         Amortization expense amounted to $457,000, $503,000 and $390,000 for 2002, 2001 and 2000, respectively.

 

 
    41 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

 

         Amortization expense of intangible assets for the years ended December 31, 2002, 2001 and 2000 is as follows:

 

Aggregate Amortization Expense (in thousands):

 

    December 31,      
    2002   2001   2000  

 
Core deposit intangibles   $ 457   $ 503   $ 141  

 

         The estimated amortization expense of intangible assets for each of the five succeeding fiscal years is as follows:

 

Estimated annual amortization expense (in thousands)

    Core deposit  
    intangibles  

 
For the year ended December 31, 2003   $ 435  
For the year ended December 31, 2004     435  
For the year ended December 31, 2005     435  
For the year ended December 31, 2006     109  
For the year ended December 31, 2007     -  

 

16. Condensed Financial Information - Parent Company Only

 

CITIZENS FINANCIAL SERVICES, INC.      
CONDENSED BALANCE SHEET     
           
    December 31,    
(in thousands)   2002   2001  

 
Assets:              
  Cash   $ 68   $ 67  
  Investment in subsidiary,              
    First Citizens National Bank     39,978     34,423  
  Available-for-sale securities     416     987  
  Other assets     13     24  

 
Total assets   $ 40,475   $ 35,501  

 
                   
Liabilities:              
  Other liabilities   $ 23   $ 22  
  Deferred tax liability     46     90  
  Borrowed funds     2,000     2,000  

 
Total liabilities   $ 2,069   $ 2,112  
Stockholders' equity     38,406     33,389  

 
Total liabilities and stockholders' equity   $ 40,475   $ 35,501  

 

 

 
    42 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

 

CITIZENS FINANCIAL SERVICES, INC.        
CONDENSED STATEMENT OF INCOME        
               
    Year Ended December 31,   
(in thousands)   2002   2001   2000  

 
Dividends from:                    
  Bank subsidiary   $ 1,478   $ 481   $ 2,219  
  Available-for-sale securities     19     44     63  
Interest-bearing deposits with banks     2     22     9  

 
Total income     1,499     547     2,291  
Realized securities gains, net     178     189     4  
Expenses     213     264     150  

 
Income before equity                    
  in undistributed earnings                    
  of subsidiary     1,464     472     2,145  
Equity in undistributed                    
  earnings - First Citizens National Bank     4,131     3,285     1,063  

 
Net income   $ 5,595   $ 3,757   $ 3,208  

 

 

CITIZENS FINANCIAL SERVICES, INC.        
STATEMENT OF CASH FLOWS        
               
    Year Ended December 31,   
(in thousands)   2002   2001   2000  

 
Cash flows from operating activities:                    
  Net income   $ 5,595   $ 3,757   $ 3,208  
  Adjustments to reconcile net income to net                    
      cash provided by operating activities:                    
        Equity in earnings of subsidiaries     (4,131 )   (3,285 )   (1,063 )
        Deferred income taxes     -     3     (4 )
        Realized gains on securities     (178 )   (189 )   (4 )
        Decrease (increase) in other assets     11     35     (29 )
        Increase (decrease) in other liabilities     1     (4 )   8  

 
          Net cash provided by operating activities     1,298     317     2,116  

 
Cash flows from investing activities:                    
  Purchase of available-for-sale securities     -     (418 )   (1,076 )
  Proceeds from the sale of available-for-sale securities     621     2,283     1,177  
  Additional contribution in subsidiaries     -     (500 )   -  

 
          Net cash provided by investing activities     621     1,365     101  

 
Cash flows from financing activities:                    
  Cash dividends paid     (1,918 )   (1,786 )   (1,660 )
  Acquisition of treasury stock     -     -     (489 )

 
          Net cash used in financing activities     (1,918 )   (1,786 )   (2,149 )

 
                               
          Net increase (decrease) in cash     1     (104 )   68  
                               
Cash at beginning of year     67     171     103  

 
Cash at end of year   $ 68   $ 67   $ 171  

 

 

 
    43 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 

 

17. Condensed Quarterly Data

 

CONSOLIDATED QUARTERLY DATA                  
(dollar amounts in thousands)   Three Months Ended        
2002   Mar 31   Jun 30   Sep 30   Dec 31  

 
Interest income   $ 6,867   $ 6,825   $ 6,894   $ 6,791  
Interest expense     2,723     2,632     2,558     2,491  

 
Net interest income     4,144     4,193     4,336     4,300  
Provision for loan losses     120     90     90     135  
Non-interest income     1,201     1,154     1,177     1,260  
Realized securities gains, net     30     186     38     -  
Non-interest expenses     3,467     3,590     3,571     3,598  

 
Income before provision for income taxes     1,788     1,853     1,890     1,827  
Provision for income taxes     428     438     459     438  

 
Net income   $ 1,360   $ 1,415   $ 1,431   $ 1,389  

 
Earnings Per Share   $ 0.48   $ 0.50   $ 0.51   $ 0.49  

 
                           

 

                   
    Three Months Ended        
2001   Mar 31   Jun 30   Sep 30   Dec 31  

 
Interest income   $ 7,164   $ 7,316   $ 7,339   $ 7,206  
Interest expense     3,815     3,745     3,630     3,116  

 
Net interest income     3,349     3,571     3,709     4,090  
Provision for loan losses     75     120     175     75  
Non-interest income     820     869     873     1,070  
Realized securities gains, net     30     353     138     136  
Non-interest expenses     3,196     3,416     3,513     3,916  

 
Income before provision for income taxes     928     1,257     1,032     1,305  
Provision for income taxes     137     220     147     261  

 
Net income   $ 791   $ 1,037   $ 885   $ 1,044  

 
Earnings Per Share   $ 0.28   $ 0.37   $ 0.31   $ 0.37  

 

 

 
    44 
 

2002 FINANCIAL SECTION


Notes to Consolidated Financial Statements

 
 

 

 

To the Stockholders and Board of Directors of

Citizens Financial Services, Inc.

 

 

We have audited the consolidated balance sheet of Citizens Financial Services, Inc. and subsidiary as of December 31, 2002 and 2001, and the related consolidated statements of income, changes in stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2002.  These financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these financial statements based on our audits. 

 

We conducted our audits in accordance with auditing standards generally accepted in the United States of America.  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Citizens Financial Services, Inc. and subsidiary as of December 31, 2002 and 2001, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America.

 

 

 

Wexford, PA

January 17, 2003

 

 

 

 

 

S.R. Snodgrass, A.C.

1000 Stonewood Drive, Suite 200 Wexford, PA 15090-8399 Phone: 724-934-0344 Facsimile: 724-934-0345

 

 
    45 
 

2002 FINANCIAL SECTION


Selected Financial Data

 

 

FIVE YEAR SUMMARY OF OPERATIONS                      
                       
                       
(dollar amounts in thousands)   2002   2001   2000   1999   1998  

 
Interest income   $ 27,377   $ 29,025   $ 26,226   $ 23,546   $ 23,088  
Interest expense     10,404     14,306     14,238     12,066     11,920  

 
Net interest income     16,973     14,719     11,988     11,480     11,168  
Provision for loan losses     435     445     610     475     218  

 
Net interest income after provision                                
  for loan losses     16,538     14,274     11,378     11,005     10,950  
Non-interest income     4,792     3,632     2,670     2,345     1,838  
Realized securities gains (losses), net     254     657     (9 )   279     457  
Non-interest expenses     14,226     14,041     10,187     9,033     8,214  

 
Income before provision for income taxes and                                
  extraordinary item     7,358     4,522     3,852     4,596     5,031  
Provision for income taxes     1,763     765     644     1,043     1,401  

 
Income before extraordinary item     5,595     3,757     3,208     3,553     3,630  
Extraordinary item     -     -     -     -     141  

 
Net income   $ 5,595   $ 3,757   $ 3,208   $ 3,553   $ 3,489  

 
                                   
Per share data:                                
Income before extraordinary item (1)   $ 1.98   $ 1.33   $ 1.13   $ 1.24   $ 1.26  
Net income (1)     1.98     1.33     1.13     1.24     1.21  
Cash dividends (1)     0.680     0.640     0.600     0.560     0.520  
Book value (1)     13.59     11.81     10.80     9.42     9.95  
                                   
Total investments   $ 100,725   $ 113,604   $ 97,984   $ 90,031   $ 91,734  
Loans, net (2)     294,836     268,464     260,209     229,159     203,583  
Total assets (2)     432,658     421,110     413,332     340,779     313,564  
Total deposits (2)     373,051     370,474     367,785     284,318     274,193  
Stockholders' equity     38,406     33,389     30,549     27,082     28,598  

 

(1) Amounts were adjusted to reflect stock dividends and previous years two-for-one stock split

 

 

(2) Amounts in 2000 reflect the acquisition of branches in the fourth quarter of 2000

 

 

 

 

 
    46 
 

2002 FINANCIAL SECTION


Selected Financial Data

 

 

COMMON STOCK

 

         Common stock issued by Citizens Financial Services, Inc. is traded in the local over-the-counter market, primarily in Pennsylvania and New York. Prices presented in the table below are bid/ask prices between broker-dealers published by the National Association of Securities Dealers through the NASD OTC “Bulletin Board”, its automated quotation system for non-NASDAQ quoted stocks and the National Quotation Bureau’s “Pink Sheets.” The prices do not include retail markups or markdowns or any commission to the broker-dealer. The bid prices do not necessarily reflect prices in actual transactions. Cash dividends are declared on a quarterly basis and the effects of stock dividends have been stated retroactively in the table below (also see dividend restrictions in Note 11).

 

        Dividends            Dividends   
     2002   declared    2001    declared   
    High   Low   per share   High   Low   per share  

 
First quarter   $ 16.75   $ 13.50   $ 0.165   $ 12.00   $ 11.51   $ 0.155  
Second quarter     17.50     16.80     0.170     13.37     12.00     0.160  
Third quarter     19.35     17.00     0.170     13.45     13.02     0.160  
Forth quarter     21.80     19.35     0.175     13.65     12.50     0.165  

 

TRUST AND INVESTMENT SERVICES FUNDS UNDER MANAGEMENT (MARKET VALUE)          
           
    2002   2001  

 
INVESTMENTS:              
Bonds   $ 13,153   $ 15,860  
Stock     20,783     27,964  
Savings and Money Market Funds     11,168     10,378  
Mutual Funds     18,257     16,756  
Mortgages     936     876  
Real Estate     816     496  
Miscellaneous     29     69  
Cash     29     17  

 
TOTAL   $ 65,171   $ 72,416  

 
               
ACCOUNTS:              
Estates   $ 1,016   $ 2,076  
Trusts     25,134     30,720  
Guardianships     184     240  
Employee Benefits     19,490     20,653  
Investment Management     13,377     11,793  
Custodial     5,970     6,934  

 
TOTAL   $ 65,171   $ 72,416  

 

 

 
    47 
 

2002 FINANCIAL SECTION


Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

CAUTIONARY STATEMENT

 

         Forward-looking statements may prove inaccurate. We have made forward-looking statements in this document, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of operations of Citizens Financial Services, Inc., First Citizens National Bank, First Citizens Insurance Agency, Inc. or the combined Company. When we use such words as “believes,” “expects,” “anticipates,” or similar expressions, we are making forward-looking statements.  For a variety of reasons, actual results could differ materially from those contained in or implied by forward-looking statements:

 

  • Interest rates could change more rapidly or more significantly than we expect.
  • The economy could change significantly in an unexpected way, which would cause the demand for new loans and the ability of borrowers to repay outstanding loans to change in ways that our models do not anticipate.
  • The stock and bond markets could suffer a significant disruption, which may have a negative effect on our financial condition and that of our borrowers, and on our ability to raise money by issuing new securities.
  • It could take us longer than we anticipate to implement strategic initiatives designed to increase revenues or manage expenses, or we may be unable to implement those initiatives at all.
  • Acquisitions and dispositions of assets could affect us in ways that management has not anticipated.
  • We may become subject to new legal obligations or the resolution of litigation may have a negative effect on our financial condition.
  • We may become subject to new and unanticipated accounting, tax, or regulatory practices or requirements.

 

INTRODUCTION

 

         The following is management’s discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in its accompanying consolidated financial statements for Citizens Financial Services, Inc., a bank holding company and its subsidiary (the Company). Our Company’s consolidated financial condition and results of operations consist almost entirely of our wholly owned subsidiary’s (First Citizens National Bank) financial conditions and results of operations. Management’s discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes. Except as noted, tabular information is presented in thousands of dollars.

 

         Our Company currently engages in the general business of banking throughout our service area of Potter, Tioga and Bradford counties in North Central Pennsylvania and Allegany, Steuben, Chemung and Tioga counties in Southern New York. We maintain our central office in Mansfield, Pennsylvania. Presently we operate banking facilities in Mansfield, Blossburg, Ulysses, Genesee, Wellsboro, Troy, Sayre, Canton, Gillett, Millerton, LeRaysville, Towanda, the Wellsboro Weis Market store and the Mansfield Wal-Mart Super center. Additionally, we have automatic teller machines (ATMs) located in Soldiers and Sailors Memorial Hospital in Wellsboro and at Mansfield University. Our lending and deposit products and investment services are offered primarily within our service area.

 

         Risk identification and management are essential elements for the successful management of the Company.  In the normal course of business, the Company is subject to various types of risk, including interest rate, credit and liquidity risk.

 

 
    48 
 

2002 FINANCIAL SECTION


Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

         Interest rate risk is the sensitivity of net interest income and the market value of financial instruments to the direction and frequency of changes in interest rates.  Interest rate risk results from various repricing frequencies and the maturity structure of the financial instruments owned by the Company.  The Company uses its asset/liability and funds management policy to control and manage interest rate risk.

 

         Credit risk represents the possibility that a customer may not perform in accordance with contractual terms.  Credit risk results from loans with customers and the purchasing of securities.  The Company’s primary credit risk is in the loan portfolio.  The Company manages credit risk by adhering to an established credit policy and through a disciplined evaluation of the adequacy of the allowance for loan losses.  Also, the investment policy limits the amount of credit risk that may be taken in the investment portfolio.

 

         Liquidity risk represents the inability to generate or otherwise obtain funds at reasonable rates to satisfy commitments to borrowers and obligations to depositors.  The Company has established guidelines within its asset/liability and funds management policy to manage liquidity risk.  These guidelines include contingent funding alternatives.

 

         Readers should carefully review the risk factors described in other documents our Company files from time to time with the Securities and Exchange Commission, including the quarterly reports on Form 10-Q and any current reports on Form 8-K filed by us.

 

         We face strong competition in the communities we serve from other commercial banks, savings banks, and savings and loan associations, some of which are substantially larger institutions than our subsidiary. In addition, insurance companies, investment-counseling firms, and other business firms and individuals offer personal and corporate trust services. We also compete with credit unions, issuers of money market funds, securities brokerage firms, consumer finance companies, mortgage brokers and insurance companies. These entities are strong competitors for virtually all types of financial services.

 

         In recent years, the financial services industry has experienced tremendous change to competitive barriers between bank and non-bank institutions. We not only must compete with traditional financial institutions, but also with other business corporations that have begun to deliver competing financial services. Competition for banking services is based on price, nature of product, quality of service, and in the case of certain activities, convenience of location.

 

TRUST AND INVESTMENT SERVICES

 

         Our Trust & Investment Department services range from professional estate settlement services through management of complex trust accounts to investment management and custody of securities.  Our expanded Retirement and Trust Department manages retirement accounts for many area companies and individuals.  We also manage many individual IRAs, both rollover and contributory.

 

         The Investment Department offers full service brokerage services in selected locations throughout the Bank’s market area and appointments can be made in any First Citizens National Bank branch.

 

         Effective October 2001, the Bank began offering annuities and life insurance through our new insurance subsidiary, First Citizens Insurance Agency, Inc.  We will add long term care insurance and other consumer insurance products in the near future.

 

 
    49 
 

2002 FINANCIAL SECTION


Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

FINANCIAL CONDITION

 

The following table presents ending balances (dollars in millions), growth (reduction) and the percentage change during the past two years:

 

    2002 Increase % 2001 Increase % 2000
    Balance (Decrease) Change Balance (Decrease) Change Balance

Total assets   $      432.7 $      11.6 2.8 $      421.1 $      7.8 1.9 $       413.3
Total loans, net   294.8 26.3 9.8 268.5 8.3 3.2 260.2
Total investments   100.7 (12.9) (11.4) 113.6 15.6 15.9 98.0
Total deposits   373.1 2.6 0.7 370.5 2.7 0.7 367.8
Total stockholders' equity   38.4 5.0 15.0 33.4 2.9 9.5 30.5

 

CASH AND CASH EQUIVALENTS

 

         Cash and cash equivalents totaled $11,594,000 at December 31, 2002 compared to $11,480,000 at December 31, 2001.  Non-interest bearing cash decreased $240,000 since December 31, 2001, while interest-bearing cash increased $354,000 during that same time period.

 

         We believe the Company’s liquidity needs are satisfied by the current balance of cash and cash equivalents, readily available access to traditional funding sources, Federal Home Loan Bank financing, and the portion of the investment and loan portfolios that mature within one year.  These sources of funds should permit us to meet cash obligations and off-balance sheet commitments as they come due.

 

INVESTMENTS

 

         Our investment portfolio decreased by $12.9 million or 11.4% in 2002 as compared to an increase of $15.6 million in 2001. Our investment portfolio has decreased primarily as a result of mortgage-backed securities monthly principal repayments and the sale of some callable municipal bonds, allowing excess funds to be used for our continued loan growth. 

 

         During 2002 new investments were made primarily in short-term mortgage-backed securities and corporate bonds.  Our current investment strategy is to reinvest in short-term mortgage-backed securities as funds become available.

 

         The following table shows the year-end composition of the investment portfolio for the five years ended December 31, 2002:

 

Estimated Fair Market Value at December 31,                      
                       
    2002 % of 2001 % of 2000 % of 1999 % of 1998 % of
    Amount Total Amount Total Amount Total Amount Total Amount Total

Available-for-sale:                      
  U. S. Treasury securities   $            - - $            - - $    8,655 15.2 $ 13,628 15.1 $ 32,763 35.7
  U. S. Agency securities   1,052 1.1 - - 1,531 15.2 - - - -
  Obligations of state & political                      
    subdivisions   12,731 12.6 18,543 16.3 20,592 21.0 19,469 21.6 18,452 20.1
  Corporate obligations   21,156 21.0 12,200 10.7 19,710 20.1 18,629 20.7 14,889 16.2
  Mortgage-backed securities   60,801 60.4 77,211 68.0 38,473 39.3 34,045 37.8 23,113 25.2
  Other equity securities   4,985 4.9 5,650 5.0 9,023 9.2 4,260 2.8 2,517 2.7

Total   $ 100,725 100.0 $ 113,604 100.0 $ 97,984 100.0 $ 90,031 100.0 $ 91,734 100.0

 

 
    50 
 

2002 FINANCIAL SECTION


Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

The expected principal repayments (amortized cost) and average weighted yields for the investment portfolio as of December 31, 2002, are shown below. Expected maturities, which include prepayment speed assumptions for mortgage-back securities, are significantly different than the contractual maturities detailed in Footnote 3 of the Consolidated Financial Statements. Yields on tax-exempt securities are presented on a fully taxable equivalent basis, assuming a 34% tax rate.

 

 

 

Within

 

One-

 

Five-

 

After

 

Amortized

 

 

One

Yield

Five

Yield

Ten

Yield

Ten

Yield

Cost

Yield

 

Year

(%)

Years

(%)

Years

(%)

Years

(%)

Total

(%)


Available-for-sale securities:

 

 

 

 

 

 

 

  U.S. Agency securities

 $             -

 $     1,008

4.0

 $             -

 

 $             -

 

 $         1,008

4.0

  Obligations of state & political

  

  

  

  

  

  

  

  

  

  

    subdivisions

        5,418

6.9

        4,703

6.7

        2,303

6.8

                -

          12,424

6.8

  Corporate obligations

                -

      17,901

5.8

        1,944

7.2

                -

          19,845

5.9

  Mortgage-backed securities

        7,531

5.4

      51,382

5.7

                -

                -

          58,913

5.6

  Equity securities

           279

2.9

        4,388

5.9

                -

                -

            4,667

5.8


Total available-for-sale

 $   13,228

5.9

 $   79,382

5.7

 $     4,247

7.0

 $             -

 $       96,857

5.8


 

         Approximately 95% of the amortized cost of debt securities is expected to mature within five years or less.

 

         Our Company expects that earnings from operations, the high liquidity level of the available-for-sale securities, growth of deposits and the availability of borrowings from the Federal Home Loan Bank will be sufficient to meet future liquidity needs.

 

         Our Company has no securities from a single issuer representing more than 10% of stockholders’ equity.

 

LOANS

 

         Historically, our Company’s loan customers have been located in North Central Pennsylvania and the Southern Tier of New York. We originate loans primarily through direct loans to our existing customer base, with new customers generated by referrals from real estate brokers, building contractors, attorneys, accountants and existing customers. We also do a limited amount of indirect loans through new and used car dealers in the primary lending area.

 

         All lending is governed by a lending policy that is developed and maintained by us and approved by the Board of Directors. Our Company’s real estate loan lending policy generally permits the Bank to lend up to 80% of the appraised value or purchase price (whichever is lower) on owner-occupied residential property, when secured by the first mortgage on the property. Home equity lines of credit or second mortgage loans are generally originated subject to maximum mortgage liens against the property of 80% of the current appraised value. The maximum term for mortgage loans is 25 years for one- to four-family residential property and 20 years for commercial and vacation property.

 

         As shown in the following table, total loans grew by $26.7 million in 2002, or 9.8%. In addition, $11.9 million in conforming mortgage loans were originated and $13.1 million sold on the secondary market through the Federal Home Loan Mortgage Corporation, providing over $185,000 of income in origination fees and premiums on loans sold, compared to $3.8 million in loans originated and $31,000 of income in 2001. The increased activity in loans sold was primarily a result of the conducive interest rate environment that continued during 2002. Residential mortgage lending is a principal business activity and one we expect to continue.

 

 
    51 
 

2002 FINANCIAL SECTION


Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

         Our Company focuses its commercial lending activity on small businesses and our Company’s commercial lending officers have attracted new business loans, especially loans to state and political subdivisions. 

 

         The majority of lending activity has been mortgage loans secured by one- to four-family residential property. As of December 31, 2002, residential real estate and real estate construction loans made up 60.4% of our Company’s total loan portfolio.

 

         Continuing in 2003, our Company’s primary goal is to be the premier mortgage lender in our market area, with our menu of conforming mortgages (including “jumbo” and low- to moderate-income homebuyer mortgages) through Farmers Home Administration (FmHA). The local economy has slowed and the average unemployment rate has recently been approximately 5.9% (slightly higher than the state unemployment rate of 5.4%) up from 4.5% in 2001.  Loan demand has continued during the last quarter of 2002 for residential mortgages and commercial loans. We believe that our continued training of branch office personnel (particularly in our newly acquired offices) and the focus on flexibility and fast “turn around time” will aid in growing our loan portfolio. (Also see the discussion in Footnote 4 of the Consolidated Financial Statements.)

 

Five Year Breakdown of Loans by Type           
December 31,           
                       
    2002 2001 2000  1999   1998  
    Amount % Amount % Amount % Amount % Amount %

Real estate:                      
  Residential   $ 175,323

58.7

$ 160,439 59.0 $ 151,782 57.7 $ 139,518 60.3 $ 127,053 61.7
  Commercial   47,210

15.8

43,174 15.9 40,044 15.2 32,159 13.9 27,164 13.2
  Agricultural   9,844

3.3

12,169 4.5 12,075 4.6 9,392 4.1 9,266 4.5
  Construction   5,009

1.7

3,219 1.2 3,112 1.2 4,359 1.9 5,234 2.5
Loans to individuals  

 

                 
  for household,    

 

               
  family and other purchases   13,915

4.7

14,694 5.4 15,020 5.7 15,540 6.7 14,429 7.0
Commercial and other loans  

18,564

6.2 15,099 5.6 17,509 6.7 12,313 5.3 12,457 6.1
State & political subdivision loans  

28,592

9.6 22,920 8.4 23,444 8.9 18,148 7.8 10,272 5.0
       

 

               

Total loans  

298,457

100.0 271,714 100.0 262,986 100.0 231,429 100.0 205,875 100.0
Less allowance for loan losses  

3,621

3,250 2,777 2,270 2,292          

Net loans  

$ 294,836

$ 268,464 $ 260,209   $ 229,159   $ 203,583  

 

    2002/2001    2001/2000     
    Change    Change     
    Amount   %   Amount   %  

 
Real estate:                          
  Residential   $ 14,884     9.3   $ 8,657     5.7  
  Commercial     4,036     9.3     3,130     7.8  
  Agricultural     (2,325 )   (19.1 )   94     0.8  
  Construction     1,790     55.6     107     3.4  
Loans to individuals                          
  for household,                          
  family and other purchases     (779 )   (5.3 )   (326 )   (2.2 )
Commercial and other loans     3,465     22.9     (2,410 )   (13.8 )
State & political subdivision loans     5,672     24.7     (524 )   (2.2 )

 
Total loans   $ 26,743     9.8   $ 8,728     3.3  

 

 

 
    52 
 

2002 FINANCIAL SECTION


Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

         Our loan portfolio is our predominant source of earning assets.

 

         The following table shows the maturity of state and political subdivision loans, commercial and agricultural loans and commercial loans secured by real estate as of December 31, 2002, classified according to the sensitivity to changes in interest rates within various time intervals:

 

    Commercial,          
    municipal,   Real estate      
    agricultural   construction   Total  

 
Maturity of loans:                    
  One year or less   $ 9,038   $ 235   $ 9,273  
  Over one year but less than five years     14,168     -     14,168  
  Over five years     81,004     4,774     85,778  

 
Total   $ 104,210   $ 5,009   $ 109,219  

 
Sensitivity of loans to changes in interest                    
    rates - loans due after one year:                    
  Predetermined interest rate   $ 17,463   $ 1,412   $ 18,875  
  Floating or adjustable interest rate     77,709     3,362     81,071  

 
Total   $ 95,172   $ 4,774   $ 99,946  

 

 

LOAN QUALITY AND PROVISION FOR LOAN LOSSES

 

         As discussed previously, the loan portfolio contains a large portion of real estate secured loans (generally residential home mortgages, mortgages on small business properties, etc.), consumer installment loans and other commercial loans. Footnote 4 of the Consolidated Financial Statements provides further details on the composition of the loan portfolio.

 

         The following table indicates the level of non-performing assets over the past five years ending December 31:

 

    2002   2001   2000   1999   1998  

 
Non-performing loans:                                
  Non-accruing loans   $ 1,064   $ 985   $ 488   $ 421   $ 1,495  
  Impaired loans     1,916     1,077     199     1,334     382  
  Accrual loans - 90 days or                                
    more past due     39     111     39     78     15  

 
Total non-performing loans     3,019     2,173     726     1,833     1,892  

 
Foreclosed assets held for sale     221     408     508     573     529  

 
Total non-performing assets   $ 3,240   $ 2,581   $ 1,234   $ 2,406   $ 2,421  

 
Non-performing loans as a percent of loans                                
    net of unearned income     1.01 %   0.80 %   0.28 %   0.79 %   0.92 %

 
Non-performing assets as a percent of loans                                
  net of unearned income     1.09 %   0.95 %   0.47 %   1.04 %   1.18 %

 

 

         Other than those disclosed above, we do not believe there are any loans classified for regulatory purposes as loss, doubtful, substandard, special mention or otherwise which will result in losses or have a material impact on future operations, liquidity or capital reserves. We are not aware of any other information that causes us to have serious doubts as to the ability of borrowers in general to comply with repayment terms.

 

 
    53 
 

2002 FINANCIAL SECTION


Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

         The following table presents an analysis of the allowance for loan losses for the five years ending December 31:

 

                       
    2002   2001   2000   1999   1998  

 
Balance                      
  at beginning of period   $ 3,250   $ 2,777   $ 2,270   $ 2,292   $ 2,138  

 
Charge-offs:                                
  Real estate-mortgage     59     19     86     73     -  
  Loans to individuals for household,                                
    family and other purchases     90     109     50     93     105  
  Commercial and other loans     30     19     22     385     7  

 
Total loans charged-off     179     147     158     551     112  
Recoveries:                                
  Real estate-mortgage     14     1     24     1     2  
  Loans to individuals for household,                                
    family and other purchases     34     20     26     38     37  
  Commercial and other loans     67     154     5     15     9  

 
Total loans recovered     115     175     55     54     48  
                                     
Net loans charged-off (recovered)     64     (28 )   103     497     64  
Provision charged to expense     435     445     610     475     218  

 
Balance at end of year   $ 3,621   $ 3,250   $ 2,777   $ 2,270   $ 2,292  

 
                                     
Loans outstanding at end of year   $ 298,457   $ 271,714   $ 262,986   $ 231,429   $ 205,875  
Average loans outstanding, net   $ 285,241   $ 266,116   $ 241,359   $ 217,265   $ 196,281  
Net charge-offs to average loans     0.02 %   -0.01 %   0.04 %   0.23 %   0.03 %
Year-end allowance to total loans     1.21 %   1.20 %   1.06 %   0.98 %   1.11 %
Year-end allowance to total                                
    non-performing loans     119.94 %   149.56 %   382.51 %   123.84 %   121.14 %

 

         As detailed in Footnote 4 of the Consolidated Financial Statements and the above tables, total past due (90 days or more) and non-performing loans increased 39% from December 31, 2001 to December 31, 2002. Charged off commercial and other loans remained at historically low levels after the increase in 1999, which was the result of a single borrower going into bankruptcy during the fourth quarter. Overall, Northern Tier area development corporations were reporting an increase in unemployment, and property values have been stable to slightly increasing. The majority of our loan volume is well collateralized by real estate.

 

ALLOWANCE FOR LOAN LOSSES

 

         The allowance is maintained at a level, which in management’s judgment is adequate to absorb potential future loan losses inherent in the loan portfolio.  The amount of the allowance is determined by a formal analysis of delinquencies, large problem credits, non-accrual loans, local economic conditions, trends in the loan portfolio and historic and projected losses.  As part of this evaluation, the loan portfolio is divided into several categories in order to improve the analysis.  These categories are loans classified on the Watch List, residential mortgages, commercial and consumer loans.

 

 
    54 
 

2002 FINANCIAL SECTION


Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

         Historical loss factors are calculated for consumer, residential mortgage, and commercial loans for the past seven years.  The worst historical loss factor for each category is applied to the performing portion of the loan category.  For Watch List loans, the losses are calculated for the last eight quarters of experience.  This is used along with regulatory guidelines to establish the loss factor applied to Watch List loans.  These historical factors, for both the Watch List and homogeneous loan pools, are adjusted based on the five following qualitative factors:

 

  • Level of Delinquencies and Non-Accruals
  • Trends in Volume and Terms of Loans
  • Experience, Ability and Depth of Management
  • National and Local Economic Trends and Conditions
  • Concentration of Credit

 

         While we evaluate all of this information quarterly, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the evaluation. In addition, various regulatory agencies, as an integral part of their examination process, review our Company’s allowance for loan losses. These agencies may require us to recognize additions to the allowance based on their evaluation of information available to them. We believe that the current allowance is adequate to offset any exposure that may exist for loans that are under secured or loans that might not be collectible. In 2000, we added $210,000 to our loan loss provision when our loans increased by approximately $28 million in connection with the branch acquisition. 

 

         The accrual of interest income on loans is discontinued when, in the opinion of management, there exists doubt as to the ability to collect interest.  Payments received on nonaccrual loans are applied to the outstanding principal balance or recorded as interest income, depending upon our assessment of our ability to collect principal and interest.  Loans are returned to the accrual status when factors indicating doubtful collectibility cease to exist.  

 

         Allocation of the Allowance for Loan Losses

 

         The allocation of the allowance for loan losses is our determination of the amounts necessary for concentrations and changes in mix and volume of the loan portfolio.

 

         The unallocated portion of the allowance is based upon our assessment of general and specific economic conditions within our market. This allocation is more uncertain and considers risk factors that may not be reflected in our historical loss factors. Total charge-offs for 2003 are expected to be close to their moderate historic levels.

 

         The following table shows the distribution of the allowance for loan losses and the percentage of loans compared to total loans by loan category:

 

    2002 2001 2000   1999  1998  
   Amount % Amount % Amount % Amount % Amount %

Real estate loans:                      
  Residential   $ 347 58.7 $ 252 59.0 $ 294 57.7 $ 232 60.3 $ 140 61.7
  Commercial, agricultural   1,947 19.1 1,689 20.4 1,269 19.8 1,190 18.0 1,030 17.7
  Construction   6 1.7 - 1.2 - 1.2 - 1.9 - 2.5
Loans to individuals                      
  for household,                      
  family and other purchases   471 4.7 402 5.4 367 5.7 313 6.7 365 7.0
Commercial and other loans   537 6.2 542 5.6 488 6.7 350 5.3 299 6.1
State & political subdivision loans   26 9.6 21 8.4 21 8.9 15 7.8 4 5.0
Unallocated   287 N/A 344 N/A 338 N/A 170 N/A 454 N/A

Total allowance for loan losses   $ 3,621 100.0 $ 3,250 100.0 $ 2,777 100.0 $ 2,270 100.0 $ 2,292 100.0

 

 
    55 
 

2002 FINANCIAL SECTION


Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

DEPOSITS

 

         Traditional deposits continue to be the most significant source of funds for the Company.  We are one of the only banks within our market to pay interest on a senior checking product and the only bank that does not require a minimum balance to do so.  Larger deposit relationships are rewarded with higher interest rates on our Money Market Investor accounts and Certificates of Deposits. 

 

         In addition to a competitive interest rate, the introduction of two new Certificates of Deposit, the Easy Access CD and the Hassle Free CD in 2001, has helped us retain existing CD deposit relationships and attracting new ones. Continuous emphasis on personal quality service also plays a large role in our ability to retain existing customers.  One of our strategies for growth is to obtain a greater share of wallet from our existing deposit and loan customers.  We plan to continue our focus on existing customer growth in 2003.

 

         The Company experienced moderate deposit growth in 2002 of $2.6 million or .7%.  The table below shows that non-interest bearing deposits increased $2.8 million at December 31, 2002, while savings and certificates of deposit increased $1.6 million and $2.5 million, respectively, in 2002.  Money market funds decreased by $4.3 million in 2002, as state & political customers moved money out of the bank into other financial alternatives.  

 

    2002    2001     2000     
    Amount   %   Amount   %   Amount   %  

 
Non-interest-bearing deposits   $ 40,143     10.8   $ 37,361     10.1   $ 42,353     11.5  
NOW accounts     51,304     13.7     51,259     13.8     48,384     13.2  
Savings deposits     33,683     9.0     32,112     8.7     31,456     8.6  
Money market deposit accounts     46,134     12.4     50,458     13.6     50,555     13.7  
Certificates of deposit     201,787     54.1     199,284     53.8     195,037     53.0  

 
Total   $ 373,051     100.0   $ 370,474     100.0   $ 367,785     100.0  

 

 

    2002/2001    2001/2000     
    Change    Change     
    Amount   %   Amount   %  

 
Non-interest-bearing deposits   $ 2,782     7.4   $ (4,992 )   (11.8 )
NOW accounts     45     0.1     2,875     5.9  
Savings deposits     1,571     4.9     656     2.1  
Money market deposit accounts     (4,324 )   (8.6 )   (97 )   (0.2 )
Certificates of deposit     2,503     1.3     4,247     2.2  

 
Total   $ 2,577     0.7   $ 2,689     0.7  

 

 

         Remaining maturities of certificates of deposit of $100,000 or more:

 

    2002   2001   2000  

 
3 months or less   $ 4,674   $ 9,557   $ 2,517  
3 through 6 months     2,559     8,523     3,295  
6 through 12 months     4,819     3,866     6,569  
Over 12 months     23,619     12,045     17,568  

 
Total   $ 35,671   $ 33,991   $ 29,949  

 
As a percent of total                    
  certificates of deposit     17.68 %   17.06 %   15.36 %

 

 

 
    56 
 

2002 FINANCIAL SECTION


Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

         Deposits by Type of Depositor:

 

    2002    2001     2000     
    Amount   %   Amount   %   Amount   %  

 
Individual, partnerships                                      
  & corporations   $ 338,079     90.6   $ 332,547     89.8   $ 332,362     90.4  
United States government     160     0.0     155     0.0     162     0.0  
State & political subdivisions     32,366     8.7     35,381     9.6     32,008     8.7  
Other     2,446     0.7     2,391     0.6     3,253     0.9  

 
Total   $ 373,051     100.0   $ 370,474     100.0   $ 367,785     100.0  

 

 

        We have retained and acquired deposits through new product introductions and competitive pricing, increased marketing efforts, continuous, proactive one-to-one contact from consumer and business customer contact associates, as well as expanded trust and investment management services.

 

        Our wide range of delivery channels provides our customers with convenient options to satisfy their banking needs.  This includes Saturday office hours, increased focus on the supermarket branches as full service offices, a network of 17 ATMs which are part of the STAR network, MasterMoney Debit Card for purchases, Bank-by-Phone and Internet Banking.

 

BORROWED FUNDS

 

        Borrowed funds increased $3.7 million during the twelve months ending December 31, 2002 primarily due to funding needs required at the end of the year. The Company’s daily cash requirements for short-term investments are met by using the financial instruments available through the Federal Home Loan Bank.

 

        In November 2000, the holding Company borrowed $2 million to invest in the bank subsidiary.  This action increased the bank’s capital and improved the negative impact on the regulatory capital ratios as a result of the branches acquired in 2000 (approximately $9.7 million in goodwill).  It is our intent to pay down the $2 million loan sometime during 2003, as a result of this projected pay down our analysis indicates that we would still be well capitalized for regulatory purposes.

 

STOCKHOLDERS’ EQUITY

 

        We evaluate stockholders’ equity in relation to total assets and the risk associated with those assets. The greater the capital resources, the more likely a corporation is to meet its cash obligations and absorb unforeseen losses. For these reasons, capital adequacy has been, and will continue to be, of paramount importance.

 

        Stockholders’ equity increased by 15.0% in 2002 to $38.4 million, after increasing 9.5% in 2001 and increasing 12.5% in 2000. In 2002, we realized an increase of $1,340,000, compared to 2001 when equity was positively impacted by $869,000 to reflect unrealized holding gains and losses on available-for-sale securities. In comparison, in 2000, equity increased $2,408,000 as a direct result of the change in interest rates. Total equity was approximately 8.9% of total assets at December 31, 2002, as compared to 7.9% at December 31, 2001.

 

        Our Board of Directors determines our dividend rate after considering our Company’s capital requirements, current and projected net income, and other factors. In 2002 and 2001, our Company paid out 34.3% and 47.5% of net income in dividends, respectively.

 

 
    57 
 

2002 FINANCIAL SECTION


Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

        For the year ended December 31, 2002, the total number of common shares outstanding was 2,826,908. For comparative purposes, outstanding shares for prior periods were adjusted for the 2002 stock dividend in computing earnings and cash dividends per share.

 

        There are currently three federal regulatory measures of capital adequacy. Our Company’s ratios meet the regulatory standards for well capitalized for 2002 and 2001, as detailed in Footnote 11 of the Consolidated Financial Statements.

 

RESULTS OF OPERATIONS

 

        Net income for the twelve months ending December 31, 2002 was $5.6 million, an increase of $1,838,000 or 48.9% from the $3.8 million for the 2001 related period.  Net income for the twelve months ending December 31, 2001 increased $549,000 or 17.1% from the $3.2 million for the 2000 related period.  Operating cash earnings were $5.9 million, $4.4 million and $3.5 million for the twelve months ending December 31, 2002, 2001 and 2000, respectively. Earnings per share were $1.98, $1.33 and $1.13 for the years ended 2002, 2001 and 2000, respectively.  The reasons for these changes are discussed on the following pages.

 

The following table sets forth certain performance ratios of our Company for the periods indicated:

 

    2002   2001   2000  

 
Return on Assets (net income to average total assets)     1.30 %   0.90 %   0.89 %
Return on Equity (net income to average total equity)     16.53 %   12.10 %   10.84 %
Dividend Payout Ratio (dividends declared divided by net income)     34.27 %   47.54 %   51.79 %
Equity to Asset Ratio (average equity to average total assets)     7.94 %   7.43 %   8.20 %

 

OVERVIEW OF THE INCOME STATEMENT   

 

        In 2002, net income was $5,595,000, an increase of 48.9% compared to 2001 net income of $3,757,000.  The increase in earnings is the result of enhanced net interest income from the utilization of increased earning assets, improved margin and improved non-interest income.

 

        Net income prior to amortization of intangible assets for 2002 was $5,897,000 compared to $4,427,000 for 2001 and $3,515,000 for 2000.  The 2001 and 2000 period reflects net income prior to acquisitions cost and amortization of intangible assets and goodwill.  This reflects the operating cash earnings of the Company for the three years.

 

        Net income is influenced by five key components: net interest income, non-interest income, non-interest expenses, provision for income taxes and the provision for loan losses. A discussion of these five components follows.

 

NET INTEREST INCOME

 

        The most significant source of revenue is net interest income; the amount of interest earned on interest-earning assets exceeding interest incurred on interest-bearing liabilities.

 

        Factors that influence net interest income are changes in volume of interest-earning assets and interest-bearing liabilities as well as changes in the associated interest rates.

 

        Net interest income for 2002, after provision for loan losses, was $16,538,000, an increase of $2,264,000 or 15.9% compared with an increase of $2,896,000 during the same period in 2001. 

 

 
    58 
 

2002 FINANCIAL SECTION


Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

        The following tables set forth our Company’s average balances of, and the interest earned or incurred on, each principal category of assets, liabilities and stockholders’ equity, the related rates, net interest income and rate “spread” created:

 

    2002    2001     2000   
    Average Average Average Average Average    Average 
    Balance (1) Interest Rate Balance (1) Interest Rate Balance (1) Interest Rate
    $ $ % $ $ % $ $ %

ASSETS                    
Short-term investments:                    
  Interest-bearing deposits at banks   4,174 65 1.56 13,944 547 3.92 2,048 129 6.30

Total short-term investments   4,174 65 1.56 13,944 547 3.92 2,048 129 6.30
Investment securities:                    
  Taxable   91,915 5,169 5.62 85,570 5,553 6.49 73,393 4,761 6.49
  Tax-exempt (3)   14,016 960 6.85 18,858 1,292 6.85 20,635 1,412 6.84

  Total investment securities   105,931 6,129 5.79 104,428 6,845 6.55 94,028 6,173 6.57
Loans:                    
  Residential mortgage loans   172,638 13,373 7.75 160,022 13,432 8.39 146,801 12,434 8.47
  Commercial & farm loans   72,230 5,683 7.87 68,708 6,088 8.86 59,844 5,583 9.33
  Loans to state & political subdivisions   26,698 1,847 6.92 22,906 1,760 7.68 20,210 1,639 8.11
  Other loans   13,675 1,305 9.54 14,480 1,472 10.17 14,504 1,400 9.65

  Loans, net of discount (2)(3)(4)   285,241 22,208 7.79 266,116 22,752 8.55 241,359 21,056 8.72

Total interest-earning assets   395,346 28,402 7.18 384,488 30,144 7.84 337,435 27,358 8.11
Cash and due from banks   9,310 9,912     7,991    
Bank premises and equipment   11,613 11,281     7,078    
Other assets   10,187 12,260     8,594    

Total non-interest earning assets   31,110 33,453     23,663    

Total assets   426,456 417,941     361,098    

LIABILITIES AND STOCKHOLDERS' EQUITY                    
Interest-bearing liabilities:                    
  NOW accounts   51,851 284 0.55 48,407 561 1.16 40,059 767 1.91
  Savings accounts   34,345 164 0.48 32,560 310 0.95 27,584 447 1.62
  Money market accounts   49,494 789 1.59 52,879 1,743 3.30 39,659 2,099 5.28
  Certificates of deposit   200,485 8,775 4.38 201,656 11,225 5.57 166,777 9,453 5.65

Total interest-bearing deposits   336,175 10,012 2.98 335,502 13,839 4.12 274,079 12,766 4.66
Other borrowed funds   14,449 392 2.71 10,185 467 4.59 24,248 1,443 5.95

Total interest-bearing liabilities   350,624 10,404 2.97 345,687 14,306 4.14 298,327 14,209 4.75
Demand deposits   38,272 36,241     25,244    
Other liabilities   3,703 4,953     7,931    

Total non-interest-bearing liabilities   41,975 41,194     33,175    
Stockholders' equity   33,857 31,060     29,596    

Total liabilities & stockholders' equity   426,456 417,941     361,098    

Net interest income   17,998 15,838   13,149  

Net interest spread (5)   4.22%     3.70%   3.36%
Net interest income as a percentage                    
  of average interest-earning assets   4.55%     4.12%   3.90%
Ratio of interest-earning assets                    
  to interest-bearing liabilities   1.13     1.11   1.13

 

(1)

 Averages are based on daily averages.

(2)

 Includes loan origination and commitment fees.

(3)

 Tax exempt interest revenue is shown on a tax equivalent basis for proper comparison using a statutory federal income tax rate of 34%.

(4)

 Income on non-accrual loans is accounted for on a cash basis, and the loan balances are included in interest-earning assets.

(5)

 Interest rate spread represents the difference between the average rate earned on interest-earning assets and the average rate paid on interest-bearing liabilities.

 

 
    59
 

2002 FINANCIAL SECTION


Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

        As disclosed in the previous table, we continued to experience an increasing interest margin percentage during 2001 and 2002, compared to the narrowing margin we experienced in the previous years. Currently, the yield curve is extremely steep beyond 3 months. Most of the Company’s investments, loans, deposits and borrowings are priced or repriced along the three month to five-year portion of the yield curve and a more normal yield curve should enable us to maintain our current favorable net interest margin. We continue to review various pricing and investment strategies to enhance deposit growth, while maintaining or expanding the current interest margin.

 

        The following table shows the effect of changes in volume and rates on interest income and expense. Tax-exempt interest revenue is shown on a tax-equivalent basis for proper comparison using a statutory federal income tax rate of 34%.

 

     2002 vs. 2001 (1)       2001 vs. 2000 (1)     
    Change in   Change   Total   Change in   Change   Total  
    Volume   in Rate   Change   Volume   in Rate   Change  

 
Interest Income:                                      
Short-term investments:                                      
  Interest-bearing deposits at banks   $ (259 ) $ (223 ) $ (482 ) $ 447   $ (29 ) $ 418  
Investment securities:                                      
  Taxable     481     (865 )   (384 )   790     2     792  
  Tax-exempt     (332 )   -     (332 )   (121 )   1     (120 )

 
Total investments     149     (865 )   (716 )   669     3     672  

 
Loans:                                      
  Residential mortgage loans     1,059     (1,118 )   (59 )   1,108     (110 )   998  
  Commercial & farm loans     342     (747 )   (405 )   764     (259 )   505  
  Loans to state & political subdivisions     218     (131 )   87     200     (79 )   121  
  Other loans     (80 )   (87 )   (167 )   (2 )   74     72  

 
Total loans, net of discount     1,539     (2,083 )   (544 )   2,070     (374 )   1,696  

 
Total Interest Income     1,429     (3,171 )   (1,742 )   3,186     (400 )   2,786  

 
Interest Expense:                                      
Interest-bearing deposits:                                      
  NOW accounts     43     (320 )   (277 )   233     (439 )   (206 )
  Savings accounts     18     (164 )   (146 )   107     (244 )   (137 )
  Money Market accounts     (105 )   (849 )   (954 )   698     (1,054 )   (356 )
  Certificates of deposit     (65 )   (2,385 )   (2,450 )   1,911     (139 )   1,772  

 
Total interest-bearing deposits     (109 )   (3,718 )   (3,827 )   2,949     (1,876 )   1,073  
Other borrowed funds     195     (270 )   (75 )   (701 )   (275 )   (976 )

 
Total interest expense     86     (3,988 )   (3,902 )   2,248     (2,151 )   97  

 
Net interest income   $ 1,343   $ 817   $ 2,160   $ 938   $ 1,751   $ 2,689  

 

 

(1)  

The change in interest due to both rate and volume has been allocated to the volume and rate in proportion to the absolute dollar amounts of each change.

 

        As can be seen from the preceding tables, tax equivalent net interest income rose from $13,149,000 in 2000 to $15,838,000 in 2001, and increased to $17,998,000 in 2002. In 2002, net interest income increased $2,160,000 while overall spread increased from 3.70% to 4.22%. The increased volume of interest-earning assets generated an increase in interest income of $1,429,000 while increased volume of interest-bearing liabilities produced $86,000 of interest expense. The change in volume resulted in a net increase of $1,343,000 in net interest income. The net change in rate was a positive $817,000 resulting in a total positive net change of $2,160,000 when combined with change in volume. The yield on interest-earning assets declined 66 basis points from 7.84% to 7.18% and the average interest rate on interest-bearing liabilities declined 117 basis points from 4.14% to 2.97%. Analysis of our Company’s net interest income in 2001 and 2002 shows the effects of declining short-term interest rates and the effect of the steepening of the yield curve.

 

 
    60 
 

2002 FINANCIAL SECTION


Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

        During 2002 the Federal Reserve reduced short-term interest rates by 50 basis points in the fourth quarter.  We expect the 2002 Federal Reserve rate reduction to continue to help us maintain our current net interest margin during the first half of 2003. We continue to evaluate alternatives to improve or sustain the interest spread.

 

NON-INTEREST INCOME

 

        Non-interest income, as detailed below, increased $757,000 or 17.6% in 2002 compared to a $1,628,000 increase in 2001.  Service charge income, which increased $603,000 or 23.9% in 2002, continues to be the primary source of growth in non-interest income.   The increase in fee income was mainly the result of the checking account acquisition strategy we put into place in the latter half of 2001.  Other income increased $573,000 or 108.7% in 2002.  This increase is due to $80,000 from our insurance agency along with a $70,000 increase in Master Card/Visa and loan insurance commissions and a $280,000 increase associated with the previously mentioned loans sold on the secondary market.

 

        The following table reflects non-interest income by major category for the periods ended December 31:

 

    2002   2001   2000  

 
Service charges   $ 3,130   $ 2,527   $ 1,853  
Other     1,100     527     385  
Trust     562     578     432  
Realized securities gains (losses), net     254     657     (9 )

 
Total   $ 5,046   $ 4,289   $ 2,661  

 

 

    2002/2001    2001/2000     
    Change    Change     
    Amount   %   Amount   %  

 
Service charges   $ 603     23.9   $ 674     36.4  
Other     573     108.7     142     36.9  
Trust     (16 )   (2.8 )   146     33.8  
Realized securities gains (losses), net     (403 )   (61.3 )   666     N/A  

 
Total   $ 757     17.6   $ 1,628     61.2  

 

 

        We continue to evaluate additional means of increasing non-interest income. Our approach is to apply service charges on business accounts by charging fees on transaction activity (reduced by earnings credit based on customers’ balances) to more equitably recover costs.

 

        In an effort to continue to improve our capital ratios and take advantage of current market conditions, we elected to sell and reinvest approximately $13,927,000 of investment securities in 2002, which resulted in $254,000 of security gains.

 

 
    61 
 

2002 FINANCIAL SECTION


Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

NON-INTEREST EXPENSES

 

        The costs associated with operating the Company rose by 1.3% to $14,226,000 during 2002 compared to $14,041,000 in 2001.  These costs include but were not limited to salaries, supplies, insurance, occupancy, and amortization expenses.  The increase in salaries and employee benefits is the result of filling some corporate positions related to the growth strategies that we have implemented, along with annual salary increases and adjustments.  Amortization expense decreased as a result of the adoption of FAS No. 142 that was previously discussed (see footnote 14). 

 

        The following tables reflect the breakdown of non-interest expense and professional fees for the periods ended December 31:

 

    2002   2001   2000  

 
Salaries and employee benefits   $ 7,120   $ 6,597   $ 4,768  
Occupancy     998     992     610  
Furniture and equipment     881     966     761  
Professional fees     667     494     474  
Amortization     457     1,015     260  
Other     4,103     3,977     3,314  

 
Total   $ 14,226   $ 14,041   $ 10,187  

 

 

    2002/2001    2001/2000     
    Change    Change     
    Amount   %   Amount   %  

 
Salaries and employee benefits   $ 523     7.9   $ 1,829     38.4  
Occupancy     6     0.6     382     62.6  
Furniture and equipment     (85 )   (8.8 )   205     26.9  
Professional fees     173     35.0     20     4.2  
Amortization     (558 )   (55.0 )   755     290.4  
Other     126     3.2     663     20.0  

 
Total   $ 185     1.3   $ 3,854     37.8  

 

 

 
    62 
 

2002 FINANCIAL SECTION


Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

PROFESSIONAL FEES

 

    2002   2001   2000  

 
Other professional fees   $      505   $   366   $   362  
Legal fees     70      43      41  
Examinations and audits     92      85      71  

 
Total   $ 667   $   494   $   474  

 
    2002/2001    2001/2000     
    Change    Change     
    Amount   %   Amount   %  

 
Other professional fees   $ 139     38.0   $ 4     1.1  
Legal fees     27     62.8     2     4.9  
Examinations and audits     7     8.2     14     19.7  

 
Total   $ 173     35.0   $ 20     4.2  

 

 

        The professional fees increase in 2002 reflects management’s efforts to implement strategic income initiatives where we share a portion of the revenue over a stated time period as a result of the account acquisition strategy.

 

PROVISION FOR INCOME TAXES

 

        The provision for income taxes was $1,763,000 during 2002 compared with $765,000 during the 2001 related period. Income before taxes increased $2,836,000 in the 2002 period over the same period in 2001 reflecting the change in income, levels of tax-exempt income and tax credits described below.

 

        We have entered into two limited partnership agreements to establish low-income housing projects in our market area. As a result of these agreements for tax purposes, we have recognized $205,000 out of a total $911,000 from one project and $38,000 out of a total $385,000 on the second project, which was completed in November 2001.  A total of approximately $1,290,000 of tax credits is anticipated over a ten-year period.

 

LIQUIDITY

 

        Liquidity is a measure of our Company’s ability to efficiently meet normal cash flow requirements of both borrowers and depositors. To maintain proper liquidity, we use funds management policies along with our investment policies to assure we can meet our financial obligations to depositors, credit customers and stockholders. Liquidity is needed to meet depositors’ withdrawal demands, extend credit to meet borrowers’ needs, provide funds for normal operating expenses and cash dividends, and fund other capital expenditures.

 

        Our Company’s historical activity in this area can be seen in the Consolidated Statement of Cash Flows from investing and financing activities.

 

        Cash generated by operating activities, investing activities and financing activities influences liquidity management. The most important source of funds is the deposits that are primarily core deposits (deposits from customers with other relationships). Short-term debt from the Federal Home Loan Bank supplements our Company’s availability of funds.

 

 
    63 
 

2002 FINANCIAL SECTION


Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

        Our Company’s use of funds is shown in the investing activity section of the Consolidated Statement of Cash Flows, where the net loan activity is detailed. Other significant uses of funds are capital expenditures, purchase of loans and acquisition premiums. Surplus funds are then invested in investment securities.

 

        Capital expenditures were $473,000 in 2002, $1,613,000 less than 2001.  The large decrease is primarily the result of the building projects completed during 2001 (described below):

 

        Major capital expenditures for 2002 were:

 

  • Of the $473,000 capital expenditures recognized this year, $241,000 was attributable to a new roof on the operations facilities and the final implementation of our new document imaging system.

        Some major capital expenditures for 2001 were:

 

  • The majority of the $2,086,000 of capital expenditures recognized this year is attributable to the final completion of the new Mansfield office and operations facilities.

        These expenditures will allow us to support our growth over the next decade, create greater operating efficiency and provide the customer with higher quality banking services.

 

        Our Company achieves additional liquidity primarily from temporary or short-term investments in the Federal Home Loan Bank of Pittsburgh, PA, and investments that mature in less than one year.  The Company also has a maximum borrowing capacity at the Federal Home Loan Bank of approximately $166 million as an additional source of liquidity.

 

        Apart from those matters described above, management does not currently believe that there are any current trends, events or uncertainties that would have a material impact on capital.

 

INTEREST RATE AND MARKET RISK MANAGEMENT

 

        The objective of interest rate sensitivity management is to maintain an appropriate balance between the stable growth of income and the risks associated with maximizing income through interest sensitivity imbalances and the market value risk of assets and liabilities.

 

        Because of the nature of our operations, we are not subject to foreign currency exchange or commodity price risk and, since our Company has no trading portfolio, it is not subject to trading risk.

 

        Currently our Company has equity securities that represent approximately 5% of our investment portfolio and, therefore, equity risk is not significant.

 

        The primary components of interest-sensitive assets include adjustable-rate loans and investments, loan repayments, investment maturities and money market investments. The primary components of interest-sensitive liabilities include maturing certificates of deposit, IRA certificates of deposit and short-term borrowings. Savings deposits, NOW accounts and money market investor accounts are considered core deposits and are not short-term interest sensitive (except for the top-tier money market investor accounts which are paid current market interest rates).

 

 
    64 
 

2002 FINANCIAL SECTION


Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

        The following table shows the cumulative static GAP (at amortized cost) for various time intervals:

 

Maturity or Repricing of Company Assets and Liabilities as of December 31, 2002
                 
    Within Four to One to Two to Three to Over  
    Three Twelve Two Three Five Five  
    Months Months Years Years Years Years Total

Interest-earning assets:                
Interest-bearing deposits at banks   $        421 $             - $             - $             - $             - $             - $       421
Investment securities   8,265 24,853 39,231 15,775 2,901 5,832 96,857
Residential mortgage loans   18,259 39,923 25,399 17,077 18,670 61,004 180,332
Commercial and farm loans   3,277 8,383 9,894 11,426 19,361 23,277 75,618
Loans to state & political subdivisions   2,818 2,062 539 3,495 10,731 8,947 28,592
Other loans   1,939 1,078 842 986 1,187 7,883 13,915

Total interest-earning assets   $   34,979 $ 76,299 $ 75,905 $ 48,759 $ 52,850 $ 106,943 $ 395,735

Interest-bearing liabilities:                
NOW accounts   $   12,269 $             - $             - $             - $             - $ 39,035 $ 51,304
Savings accounts   - - - - - 33,683 33,683
Money Market accounts   46,134 - - - - - 46,134
Certificates of deposit   31,536 56,778 27,959 32,885 48,330 4,299 201,787
Short-term borrowing   7,680 - - - - 3,430 11,110
Long-term borrowing   200 2,554 956 390 1,817 - 5,917

Total interest-bearing liabilities   $    97,819 $    59,332 $ 28,915 $ 33,275 $ 5  0,147 $   80,447 $ 349,935

Excess interest-earning                
  assets (liabilities)   $ (62,840) $    16,967 $ 46,990 $ 15,484 $    2,703 $   26,496  

Cumulative interest-earning assets   34,979 111,278 187,183 235,942 288,792 395,735  
Cumulative interest-bearing liabilities   97,819 157,151 186,066 219,341 269,488 349,935  

Cumulative gap   $ (62,840) $ (45,873) $ 1,117 $ 16,601 $ 19,304 $   45,800  

Cumulative interest rate                
  sensitivity ratio (1)   0.36 0.71 1.01 1.08 1.07 1.13  

 

(1)    Cumulative Interest-earning assets divided by interest-bearing liabilities.

 

        The previous table and the simulation models discussed below are presented assuming money market investment accounts and NOW accounts in the top interest rate tier are repriced within the first three months. The loan amounts reflect the principal balances expected to be repriced as a result of contractual amortization and anticipated early payoffs.

 

        Gap analysis, one of the methods used by us to analyze interest rate risk, does not necessarily show the precise impact of specific interest rate movements on our Company’s net interest income because the repricing of certain assets and liabilities is discretionary and is subject to competition and other pressures. In addition, assets and liabilities within the same period may, in fact, be repaid at different times and at different rate levels.

 

        Our Company currently uses a computer simulation model to better measure the impact of interest rate changes on net interest income. We use the model as part of our risk management process that will effectively identify, measure, and monitor our Company’s risk exposure.

 

        Interest rate simulations using a variety of assumptions are used by us to evaluate our interest rate risk exposure. A shock analysis at December 31, 2002, indicated that a 200 basis point movement in interest rates in either direction would have a minor impact on our Company’s anticipated net interest income and the market value of assets and liabilities over the next twenty-four months, well within our ability to manage effectively.