10-Q for third quarter 2006
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q


                                        (Mark One)

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

For the quarterly period ended September 30, 2006

Or

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the transition period from_____________________ to ___________________

Commission File Number 000-13222

CITIZENS FINANCIAL SERVICES, INC.
(Exact name of registrant as specified in its charter)

                                     PENNSYLVANIA                                 23-2265045
                                     (State or other jurisdiction of incorporation or organization)  (I.R.S. Employer Identification No.)


First Citizens National Bank
15 South Main Street
Mansfield, Pennsylvania 16933
(Address of principal executive offices)(Zip Code)

Registrant's telephone number, including area code: (570) 662-2121

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes __X__ No_____

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. (See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act) Check one:

Large accelerated filer ____ Accelerated filer ____ Non-accelerated filer __X__


Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes____ No __X__

The number of shares outstanding of the Registrant's Common Stock, as of November 6, 2006; 2,826,970 shares of Common Stock, par value $1.00.
 

 

 
Citizens Financial Services, Inc.
Form 10-Q

INDEX
 
   
PAGE
Part I 
FINANCIAL INFORMATION
 
Item 1.
Financial Statements (unaudited):
 
 
Consolidated Balance Sheet as of September 30, 2006 and
   December 31, 2005
1
 
Consolidated Statement of Income for the
   Three Months and Nine Months Ended September 30, 2006 and 2005
2
 
Consolidated Statement of Comprehensive Income for the
   Three Months and Nine Months Ended September 30, 2006 and 2005
3
 
Consolidated Statement of Cash Flows for the
   Nine Months Ended September 30, 2006 and 2005
4
 
Notes to Consolidated Financial Statements
5-7
Item 2.
Management’s Discussion and Analysis of Financial
   Condition and Results of Operations
8-22
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
23
Item 4.
Controls and Procedures
23
     
Part II 
OTHER INFORMATION
 
Item 1.
Legal Proceedings
24
Item 1A.
Risk Factors
24
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
24
Item 3.
Defaults upon Senior Securities
24
Item 4.
Submission of Matters to a Vote of Security Holders
24
Item 5.
Other Information
24
Item 6.
Exhibits
25-26
 
Signatures
27
 


CITIZENS FINANCIAL SERVICES, INC.
 
 
 
 
 
CONSOLIDATED BALANCE SHEET
 
 
 
 
 
(UNAUDITED)
 
 
 
 
 
 
 
 
 
 
 
 
 
September 30
 
December 31
 
(in thousands except share data)
 
2006
 
2005
 
ASSETS:
 
 
 
 
 
Cash and due from banks:
         
   Noninterest-bearing
 
$
9,616
 
$
8,498
 
   Interest-bearing
   
26
   
111
 
Total cash and cash equivalents
   
9,642
   
8,609
 
 
         
Available-for-sale securities
   
103,301
   
102,602
 
 
         
Loans (net of allowance for loan losses:
   
407,769
   
379,139
 
2006, $3,841; 2005, $3,664)
         
Premises and equipment
   
12,574
   
12,305
 
Accrued interest receivable
   
2,407
   
2,164
 
Goodwill
   
8,605
   
8,605
 
Bank owned life insurance
   
7,967
   
7,743
 
Other assets
   
8,389
   
8,074
 
 
         
TOTAL ASSETS
 
$
560,654
 
$
529,241
 
 
         
LIABILITIES:
         
Deposits:
         
   Noninterest-bearing
 
$
49,741
 
$
50,600
 
   Interest-bearing
   
398,418
   
379,199
 
Total deposits
   
448,159
   
429,799
 
Borrowed funds
   
64,295
   
52,674
 
Accrued interest payable
   
1,994
   
1,862
 
Commitment to purchase investments
   
-
   
752
 
Other liabilities
   
2,628
   
2,593
 
TOTAL LIABILITIES
   
517,076
   
487,680
 
STOCKHOLDERS' EQUITY:
         
Common Stock
         
   $1.00 par value; authorized 10,000,000 shares; issued
         
   2,992,896 shares in 2006 and 2,965,257 in 2005, respectively
   
2,993
   
2,965
 
Additional paid-in capital
   
11,933
   
11,359
 
Retained earnings
   
33,140
   
31,251
 
TOTAL
   
48,066
   
45,575
 
Accumulated other comprehensive loss
   
(1,018
)
 
(1,540
)
Less: Treasury Stock, at cost 162,674 shares for
         
   2006 and 118,715 for 2005, respectively
   
(3,470
)
 
(2,474
)
TOTAL STOCKHOLDERS' EQUITY
   
43,578
   
41,561
 
TOTAL LIABILITIES AND
         
   STOCKHOLDERS' EQUITY
 
$
560,654
 
$
529,241
 
 
         
The accompanying notes are an integral part of these unaudited consolidated financial statements.
   


1


 

CITIZENS FINANCIAL SERVICES, INC.
 
 
 
 
 
 
 
 
 
CONSOLIDATED STATEMENT OF INCOME
 
 
 
 
 
 
 
 
 
(UNAUDITED)
 
 
 
 
 
 
 
 
 
 
 
Three Months Ended
 
Nine Months Ended
 
 
 
September 30,
 
September 30,
 
(in thousands, except per share data)
 
2006
 
2005
 
2006
 
2005
 
INTEREST INCOME:
 
 
 
 
 
 
 
 
 
Interest and fees on loans
 
$
7,226
 
$
6,362
 
$
20,639
 
$
18,386
 
Interest-bearing deposits with banks
   
-
   
3
   
-
   
2
 
Investment securities:
                 
   Taxable
   
851
   
698
   
2,549
   
2,240
 
   Nontaxable
   
232
   
153
   
679
   
394
 
   Dividends
   
74
   
50
   
223
   
156
 
TOTAL INTEREST INCOME
   
8,383
   
7,266
   
24,090
   
21,178
 
INTEREST EXPENSE:
                 
   Deposits
   
3,067
   
2,416
   
8,390
   
6,840
 
   Borrowed funds
   
849
   
383
   
2,388
   
1,140
 
TOTAL INTEREST EXPENSE
   
3,916
   
2,799
   
10,778
   
7,980
 
NET INTEREST INCOME
   
4,467
   
4,467
   
13,312
   
13,198
 
Provision for loan losses
   
105
   
30
   
225
   
30
 
NET INTEREST INCOME AFTER
                 
   PROVISION FOR LOAN LOSSES
   
4,362
   
4,437
   
13,087
   
13,168
 
NON-INTEREST INCOME:
                 
Service charges
   
827
   
784
   
2,342
   
2,203
 
Trust
   
135
   
161
   
372
   
368
 
Brokerage
   
45
   
45
   
142
   
138
 
Insurance
   
32
   
61
   
88
   
205
 
Investment securities gains, net
   
5
   
-
   
4
   
-
 
Earnings on bank owned life insurance
   
78
   
71
   
224
   
220
 
Other
   
91
   
109
   
364
   
334
 
TOTAL NON-INTEREST INCOME
   
1,213
   
1,231
   
3,536
   
3,468
 
NON-INTEREST EXPENSES:
                 
Salaries and employee benefits
   
2,055
   
1,993
   
6,078
   
5,888
 
Occupancy
   
261
   
262
   
845
   
846
 
Furniture and equipment
   
146
   
156
   
442
   
491
 
Professional fees
   
125
   
132
   
371
   
408
 
Amortization
   
36
   
145
   
216
   
434
 
Other
   
1,075
   
1,133
   
3,374
   
3,439
 
TOTAL NON-INTEREST EXPENSES
   
3,698
   
3,821
   
11,326
   
11,506
 
Income before provision for income taxes
   
1,877
   
1,847
   
5,297
   
5,130
 
Provision for income taxes
   
329
   
529
   
987
   
1,232
 
NET INCOME
 
$
1,548
 
$
1,318
 
$
4,310
 
$
3,898
 
 
                 
Earnings Per Share
 
$
0.55
 
$
0.46
 
$
1.51
 
$
1.35
 
Cash Dividends Paid Per Share
 
$
0.215
 
$
0.205
 
$
0.640
 
$
0.610
 
 
                 
Weighted average number of shares outstanding
   
2,835,763
   
2,874,181
   
2,850,211
   
2,887,619
 
 
                 
The accompanying notes are an integral part of these unaudited consolidated financial statements.
       

 
2



CITIZENS FINANCIAL SERVICES, INC.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(UNAUDITED)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Three Months Ended
 
Nine Months Ended
 
 
 
September 30,
 
September 30,
 
(in thousands)
 
 
 
2006
 
 
 
2005
 
 
 
2006
 
 
 
2005
 
Net income
     
$
1,548
     
$
1,318
     
$
4,310
     
$
3,898
 
Other comprehensive income:
                                 
   Unrealized gains (losses) on available for sale securities
   
2,035
       
(739
)
     
796
       
(1,580
)
   
   Less: Reclassification adjustment for gains included in net income
   
(5
)
        
-
          
(4
)
        
-
        
Other comprehensive income (loss) before tax
       
2,030
       
(739
)
     
792
       
(1,580
)
Income tax expense (benefit) related to other comprehensive income
       
690
       
(251
)
     
269
       
(537
)
Other comprehensive income (loss), net of tax
          
1,340
          
(488
)
        
523
          
(1,043
)
Comprehensive income
        
$
2,888
        
$
830
        
$
4,833
        
$
2,855
 
 
                                 
The accompanying notes are an integral part of these unaudited consolidated financial statements.
                           


3



CITIZENS FINANCIAL SERVICES, INC.
         
CONSOLIDATED STATEMENT OF CASH FLOWS
         
(UNAUDITED)
 
Nine Months Ended
 
   
September 30,
 
(in thousands)
 
2006
 
2005
 
CASH FLOWS FROM OPERATING ACTIVITIES:
         
   Net income
 
$
4,310
 
$
3,898
 
   Adjustments to reconcile net income to net
             
     cash provided by operating activities:
             
       Provision for loan losses
   
225
   
30
 
       Depreciation and amortization
   
902
   
1,091
 
       Amortization and accretion of investment securities
   
312
   
552
 
       Deferred income taxes
   
(73
)
 
224
 
       Investment securities gains, net
   
(4
)
 
-
 
       Earnings on bank owned life insurance
   
(224
)
 
(220
)
       Originations of loans held for sale
   
(1,847
)
 
(3,566
)
       Proceeds from sales of loans held for sale
   
1,871
   
3,611
 
       Increase in accrued interest receivable
   
(243
)
 
(301
)
       Increase (decrease) in accrued interest payable
   
132
   
(243
)
       Other, net
   
(129
)
 
81
 
         Net cash provided by operating activities
   
5,232
   
5,157
 
               
CASH FLOWS FROM INVESTING ACTIVITIES:
             
  Available-for-sale securities:
             
     Proceeds from sales of available-for-sale securities
   
10,402
   
-
 
     Proceeds from maturity and principal repayments of securities
   
13,952
   
13,149
 
     Purchase of securities
   
(25,322
)
 
(10,046
)
   Proceeds from redemption of Regulatory Stock
   
2,204
   
1,888
 
   Purchase of Regulatory Stock
   
(2,679
)
 
(1,347
)
   Net increase in loans
   
(29,414
)
 
(16,454
)
   Purchase of premises and equipment
   
(828
)
 
(169
)
   Proceeds from sale of premises and equipment
   
-
   
200
 
   Proceeds from sale of foreclosed assets held for sale
   
321
   
372
 
   Property purchased for future expansion
   
-
   
(927
)
         Net cash used in investing activities
   
(31,364
)
 
(13,334
)
               
CASH FLOWS FROM FINANCING ACTIVITIES:
             
   Net decrease in deposits
   
18,360
   
11,608
 
   Proceeds from long-term borrowings
   
8,458
   
8,063
 
   Repayments of long-term borrowings
   
(4,719
)
 
(3,208
)
   Net increase (decrease) in short-term borrowed funds
   
7,882
   
(7,016
)
   Purchase of Treasury Stock
   
(996
)
 
(463
)
   Dividends paid
   
(1,820
)
 
(1,738
)
         Net cash provided by financing activities
   
27,165
   
7,246
 
               
           Net increase (decrease) in cash and cash equivalents
   
1,033
   
(931
)
               
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
   
8,609
   
9,339
 
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 
$
9,642
 
$
8,408
 
               
Supplemental Disclosures of Cash Flow Information:
             
   Interest paid
 
$
10,613
 
$
8,198
 
               
   Income taxes paid
 
$
1,170
 
$
860
 
               
Loans transferred to foreclosed property
 
$
463
 
$
369
 
             
The accompanying notes are an integral part of these unaudited consolidated financial statements.

 
4



CITIZENS FINANCIAL SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


Note 1 - Basis of Presentation

Citizens Financial Service, Inc., (the “Company”) is a Pennsylvania corporation organized as the holding company of its wholly owned subsidiary, First Citizens National Bank (the “Bank”), and its subsidiary, First Citizens Insurance Agency, Inc. (sometimes collectively referred to herein as the “Company”). All material inter-company balances and transactions have been eliminated in consolidation.

The accompanying consolidated financial statements have been prepared pursuant to rules and regulations of the Securities and Exchange Commission (“SEC”) and in conformity with U.S. generally accepted accounting principles. Because this report is based on an interim period, certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted.

In the opinion of Management of the registrant, the accompanying interim financial statements for the quarters ended September 30, 2006 and 2005 include all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the financial condition and the results of operations for the period. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. The financial performance reported for the Company for the nine-month period ended September 30, 2006 is not necessarily indicative of the results to be expected for the full year. This information should be read in conjunction with the Company’s Annual Report to Shareholders and Form 10-K for the period ended December 31, 2005.

Note 2 - Earnings per Share

The following table sets forth the computation of earnings per share. Earnings per share calculations give retroactive effect to stock dividends declared by the Company. The Company has no dilutive securities.

 
 
Three Months Ended
 
Nine Months Ended
 
 
 
September 30,
 
September 30,
 
 
 
2006
 
2005
 
2006
 
2005
 
 
 
 
 
 
 
 
 
 
 
Net income applicable to common stock
 
$
1,548,000
 
$
1,318,000
 
$
4,310,000
 
$
3,898,000
 
Weighted average common shares outstanding
   
2,835,763
   
2,874,181
   
2,850,211
   
2,887,619
 
                           
Earnings per share
 
$
0.55
 
$
0.46
 
$
1.51
 
$
1.35
 

Note 3 - Income Tax Expense

Income tax expense is less than the amount calculated using the statutory tax rate, primarily the result of tax-exempt income earned from state and municipal securities and loans, and investments in tax credits.

Note 4 - Employee Benefit Plans

For a detailed disclosure on the Company's pension and employee benefits plans, please refer to Note 10 of the Company's Consolidated Financial Statements included in the 2005 Annual Report on Form 10-K.


5

 

Defined Benefit Plan

The following sets forth the components of net periodic benefit costs of the noncontributory defined benefit plan for the nine months ended September 30, 2006 and 2005, respectively (dollars presented in thousands):

   
Three Months Ended
 
Nine Months Ended
 
   
September 30,
 
September 30,
 
 
 
2006
 
2005
 
2006
 
2005
 
                   
Service cost
 
$
105
 
$
101
 
$
283
 
$
260
 
Interest cost
   
98
   
91
   
264
   
235
 
Expected return on plan assets
   
(107
)
 
(105
)
 
(288
)
 
(271
)
Net amortization and deferral
   
23
   
16
   
63
   
42
 
                           
Net periodic benefit cost
 
$
119
 
$
103
 
$
322
 
$
266
 


The Company expects to contribute $442,000 to its defined benefit pension plan in 2006. As of September 30, 2006, no contributions have been made.

Defined Contribution Plan

The Company also sponsors a defined contribution, 401(k) plan covering substantially all of its employees. The Company contributes three percent of applicable salaries into the plan. Contributions totaled $141,000 and $145,000 for the nine months ended September 30, 2006 and 2005, respectively.


Note 5 - Recent Accounting Pronouncements

In February 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“FAS”) No. 155, Accounting for Certain Hybrid Instruments, as an amendment of FASB Statements No. 133 and 140. FAS No. 155 allows financial instruments that have embedded derivatives to be accounted for as a whole (eliminating the need to bifurcate the derivative from its host) if the holder elects to account for the whole instrument on a fair value basis. This statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The adoption of this standard is not expected to have a material effect on the Company’s results of operations or financial position.

In March 2006, the FASB issued FAS No. 156, Accounting for Servicing of Financial Assets. This Statement, which is an amendment to FAS No. 140, will simplify the accounting for servicing assets and liabilities, such as those common with mortgage securitization activities. Specifically, FAS No. 156 addresses the recognition and measurement of separately recognized servicing assets and liabilities and provides an approach to simplify efforts to obtain hedge-like (offset) accounting. FAS No. 156 also clarifies when an obligation to service financial assets should be separately recognized as a servicing asset or a servicing liability, requires that a separately recognized servicing asset or servicing liability be initially measured at fair value, if practicable, and permits an entity with a separately recognized servicing asset or servicing liability to choose either of the amortization or fair value methods for subsequent measurement. The provisions of FAS No. 156 are effective as of the beginning of the first fiscal year that begins after September 15, 2006. The Company is currently evaluating the impact the adoption of the standard will have on the Company’s results of operations. 

In September 2006, the FASB issued FAS No. 157, Fair Value Measurements, which provides enhanced guidance for using fair value to measure assets and liabilities. The standard applies whenever other standards require or permit assets or liabilities to be measured at fair value. The Standard does not expand the use of fair value in any new circumstances. FAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. Early adoption is permitted. The adoption of this standard is not expected to have a material effect on the Company’s results of operations or financial position.  

6


In September 2006, the FASB issued FAS No. 158, Employers' Accounting for Defined Benefit Pension and Other Post Retirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R). FAS No. 158 requires that a company recognize the overfunded or underfunded status of its defined benefit post retirement plans (other than multiemployer plans) as an asset or liability in its statement of financial position and that it recognize changes in the funded status in the year in which the changes occur through other comprehensive income. FAS No. 158 also requires the measurement of defined benefit plan assets and obligations as of the fiscal year end, in addition to footnote disclosures. FAS No. 158 is effective for fiscal years ending after December 15, 2006. The Company is currently evaluating the impact the adoption of the standard will have on the Company’s financial position.

In June 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes. FIN 48 is an interpretation of FAS No. 109, Accounting for Income Taxes, and it seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. In addition, FIN No. 48 requires expanded disclosure with respect to the uncertainty in income taxes and is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact the adoption of the standard will have on the Company’s results of operations. 

In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”), Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements, providing guidance on quantifying financial statement misstatement and implementation when first applying this guidance. Under SAB No. 108, companies should evaluate a misstatement based on its impact on the current year income statement, as well as the cumulative effect of correcting such misstatements that existed in prior years existing in the current year's ending balance sheet. SAB 108 is effective for fiscal years ending after November 15, 2006. The Company is currently evaluating the impact the adoption of the standard will have on the Company’s results of operations.

In September 2006, the FASB reached consensus on the guidance provided by Emerging Issues Task Force Issue 06-4 (“EITF 06-4”), Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements. The guidance is applicable to endorsement split-dollar life insurance arrangements, whereby the employer owns and controls the insurance policy, that are associated with a postretirement benefit. EITF 06-4 requires that for a split-dollar life insurance arrangement within the scope of the Issue, an employer should recognize a liability for future benefits in accordance with FAS No. 106 (if, in substance, a postretirement benefit plan exists) or Accounting Principles Board Opinion No. 12 (if the arrangement is, in substance, an individual deferred compensation contract) based on the substantive agreement with the employee. EITF 06-4 is effective for fiscal years beginning after December 15, 2007. The Company is currently evaluating the impact the adoption of the standard will have on the Company’s results of operations or financial condition. 

In September 2006, the FASB reached consensus on the guidance provided by Emerging Issues Task Force Issue 06-5(“EITF 06-5”), Accounting for Purchases of Life Insurance—Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4, Accounting for Purchases of Life Insurance. EITF 06-5 states that a policyholder should consider any additional amounts included in the contractual terms of the insurance policy other than the cash surrender value in determining the amount that could be realized under the insurance contract. EITF 06-5 also states that a policyholder should determine the amount that could be realized under the life insurance contract assuming the surrender of an individual-life by individual-life policy (or certificate by certificate in a group policy). EITF 06-5 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact the adoption of the standard will have on the Company’s results of operations or financial condition.


7


 
ITEM 2. 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. The Company would like to caution readers that the following important factors, among others, may have affected and could in the future affect the Company’s actual results and could cause the Company’s actual results for subsequent periods to differ materially from those expressed in any forward looking statement:
 
·  
Interest rates could change more rapidly or more significantly than we expect. Additionally, the relative changes in the direction and frequency between short-term versus long-term interest rates, i.e., the yield curve, could move in ways unexpected by management.
·  
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 in implementing 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, regulations or requirements, including the costs of compliance with such changes.
·  
We could experience greater loan delinquencies than anticipated, adversely affecting our earnings and financial condition.
·  
We could lose the services of some or all of our key personnel, which would negatively impact our business because of their business development skills, financial expertise, lending experience, technical expertise and market area knowledge.

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 Service, 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 condition and results of operations. Management’s discussion and analysis should be read in conjunction with the preceding September 30, 2006 financial information. The results of operations for the nine months ended September 30, 2006 are not necessarily indicative of the results you may expect for the full year.

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 16 banking facilities. In Pennsylvania, these offices are located 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. In New York, we have completed construction of our first de novo branch office in the town of Wellsville. We began doing business in the new facility on October 30, 2006. This marks the Company’s first office location in New York.

8

 
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, liquidity and regulatory risk.

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 re-pricing 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, among other things, contingent funding alternatives.

Regulatory risk represents the possibility that a change in law, regulations or regulatory policy may have a material effect on the business of the Company and its subsidiary. We can not predict what legislation might be enacted or what regulations might be adopted, or if adopted, the effect thereof on our operations.

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 Annual Report for the year ended December 31, 2005, filed by our Company and any current reports on Form 8-K filed by us.

We face strong competition in the communities that 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 must compete with traditional financial institutions, other business corporations that have begun to deliver competing financial services, and banking services that are easily accessible through the internet. 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 Investment and Trust Services Department is committed to helping our customers meet their financial goals. The Trust Department offers professional trust administration, investment management services, estate planning and administration, and custody of securities. We also help the members of our communities prepare for retirement by providing retirement plans for local employers and by managing individual IRA accounts. Assets held by the Company 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 Company. As of September 30, 2006 and December 31, 2005, the Trust Department had $78.4 million and $75.2 million of assets under management, respectively.

Our Investment Representatives offer full service brokerage services throughout the Bank’s market area, and appointments can be made at any First Citizens National Bank branch. The Investment Representatives provide financial planning and help our customers achieve their financial goals with their choice of mutual funds, annuities, health and life insurance. These products are made available through our insurance subsidiary, First Citizens Insurance Agency, Inc.

9



Results of Operations

Overview of the Income Statement

For the three months ended September 30, 2006, The Company earned $1,548,000 in net income versus $1,318,000 in 2005, up $230,000, or 17.5%. Earnings per share for the third quarter was $0.55 compared to $0.46 in 2005. Annualized return on assets and return on equity for the third quarter was 1.12% and 14.03% compared to 1.03% and 12.55% in 2005.
 
The Company had net income of $4,310,000 for the first nine months of 2006 compared with earnings of $3,898,000 for last year’s comparable period, an increase of $412,000, or 10.6%. Earnings per share for the first nine months of 2006 were $1.51, compared to $1.35 last year. Annualized return on assets and return on equity for the nine months of 2006 was 1.06% and 13.18%, respectively, compared with 1.03% and 12.53% for last year’s comparable period. Details of the reasons for this change are discussed on the following pages.

Net Interest Income

Net interest income, the most significant component of earnings, is the amount by which interest income generated from interest-earning assets exceeds interest expense on interest-bearing liabilities.

Net interest income, through the third quarter of 2006, after provision for loan losses, was $13,087,000 a decrease of $81,000, compared to the same period in 2005. For the first nine months of 2006, the provision for losses totaled $225,000. For the first nine months of 2005, the provision was $30,000.

The following table sets forth the 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: 
 
 
10


           
Analysis of Average Balances and Interest Rates (1)
     
                                       
   
September 30, 2006
 
September 30, 2005
 
September 30, 2004
 
   
Average
     
Average
 
Average
     
Average
 
Average
     
Average
 
   
Balance (1)
 
Interest
 
Rate
 
Balance (1)
 
Interest
 
Rate
 
Balance (1)
 
Interest
 
Rate
 
(dollars in thousands)
   $  
$
  %     $  
$
  %    $   
$
   %  
ASSETS
                                     
Short-term investments:
                                     
   Interest-bearing deposits at banks
   
11
   
-
   
1.70
   
133
   
2
   
2.01
   
1,227
   
9
   
0.98
 
Total short-term investments
   
11
   
-
   
1.70
   
133
   
2
   
2.01
   
1,227
   
9
   
0.98
 
Investment securities:
                                                       
   Taxable
   
84,688
   
2,805
   
4.42
   
84,808
   
2,432
   
3.82
   
98,668
   
2,864
   
3.87
 
   Tax-exempt (3)
   
23,065
   
1,029
   
5.95
   
12,795
   
597
   
6.22
   
6,772
   
338
   
6.65
 
   Total investment securities
   
107,753
   
3,834
   
4.74
   
97,603
   
3,029
   
4.14
   
105,440
   
3,202
   
4.05
 
Loans:
                                                       
   Residential mortgage loans
   
207,480
   
10,905
   
7.03
   
200,203
   
10,249
   
6.84
   
190,899
   
9,949
   
6.97
 
   Commercial & farm loans
   
132,662
   
7,566
   
7.63
   
117,033
   
6,148
   
7.02
   
93,648
   
4,767
   
6.81
 
   Loans to state & political subdivisions
   
43,400
   
1,936
   
5.96
   
38,730
   
1,734
   
5.99
   
36,092
   
1,653
   
6.12
 
   Other loans
   
12,855
   
856
   
8.90
   
12,507
   
822
   
8.79
   
12,330
   
827
   
8.97
 
   Loans, net of discount (2)(3)(4)
   
396,397
   
21,263
   
7.17
   
368,473
   
18,953
   
6.88
   
332,969
   
17,196
   
6.90
 
Total interest-earning assets
   
504,161
   
25,097
   
6.66
   
466,209
   
21,984
   
6.30
   
439,636
   
20,407
   
6.21
 
Cash and due from banks
   
8,993
               
8,699
               
8,473
             
Bank premises and equipment
   
12,280
               
12,085
               
10,927
             
Other assets
   
18,610
                 
18,693
                 
18,283
               
Total non-interest earning assets
   
39,883
               
39,477
               
37,683
             
Total assets
   
544,044
                 
505,686
                 
477,319
               
LIABILITIES AND STOCKHOLDERS' EQUITY
                                               
Interest-bearing liabilities:
                                                       
   NOW accounts
   
84,514
   
1,176
   
1.86
   
70,416
   
445
   
0.84
   
61,880
   
174
   
0.38
 
   Savings accounts
   
39,526
   
96
   
0.32
   
40,279
   
85
   
0.28
   
39,323
   
83
   
0.28
 
   Money market accounts
   
45,056
   
1,036
   
3.07
   
47,745
   
649
   
1.82
   
44,322
   
335
   
1.01
 
   Certificates of deposit
   
214,381
   
6,082
   
3.79
   
213,469
   
5,661
   
3.55
   
208,811
   
5,489
   
3.51
 
Total interest-bearing deposits
   
383,477
   
8,390
   
2.93
   
371,909
   
6,840
   
2.46
   
354,336
   
6,081
   
2.29
 
Other borrowed funds
   
63,935
   
2,388
   
4.99
   
41,192
   
1,140
   
3.70
   
34,966
   
684
   
2.62
 
Total interest-bearing liabilities
   
447,412
   
10,778
   
3.22
   
413,101
   
7,980
   
2.58
   
389,302
   
6,765
   
2.32
 
Demand deposits
   
48,592
               
46,551
               
44,553
             
Other liabilities
   
4,665
               
4,551
               
4,591
             
Total non-interest-bearing liabilities
   
53,257
           
51,102
           
49,144
         
Stockholders' equity
   
43,375
               
41,061
               
38,873
             
Total liabilities & stockholders' equity
   
544,044
                 
505,264
                 
477,319
               
Net interest income
          
14,319
                 
14,004
                 
13,642
        
Net interest spread (5)
               
3.44
%
             
3.72
%
             
3.89
%
Net interest income as a percentage
                                                       
of average interest-earning assets
               
3.80
%
             
4.02
%
             
4.15
%
Ratio of interest-earning assets
                                                       
to interest-bearing liabilities
               
1.13
               
1.13
               
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.
                                         
 
 
11

 
 
Tax exempt revenue is shown on a tax-equivalent basis for proper comparison using a statutory, federal income tax rate of 34%. For purposes of the comparison, as well as the discussion that follows, this presentation facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the Company’s 34% Federal statutory rate. The following table represents the adjustment to convert net interest income to net interest on a fully tax equivalent basis for the periods ending September 30, 2006, 2005 and 2004:
 
 
   
For the nine months ended September 30,
 
 
 
2006
 
2005
 
2004
 
               
Total interest income
 
$
24,090
 
$
21,178
 
$
19,679
 
Total interest expense
   
10,778
   
7,980
   
6,765
 
                     
Net interest income
   
13,312
   
13,198
   
12,914
 
Tax equivalent adjustment
   
1,007
   
806
   
728
 
                     
Net interest income (fully taxable equivalent)
 
$
14,319
 
$
14,004
 
$
13,642
 
 

The following table shows the tax-equivalent effect of changes in volume and rate on interest income and expense.

   
2006 vs. 2005 (1)
 
2005 vs. 2004 (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
 
$
(2
)
$
-
 
$
(2
)
$
(12
)
$
5
 
$
(7
)
Investment securities:
                                     
   Taxable
   
(3
)
 
376
   
373
   
(397
)
 
(35
)
 
(432
)
   Tax-exempt
   
459
   
(27
)
 
432
   
282
   
(23
)
 
259
 
Total investments
   
456
   
349
   
805
   
(115
)
 
(58
)
 
(173
)
Loans:
                                     
   Residential mortgage loans
   
409
   
247
   
656
   
479
   
(179
)
 
300
 
   Commercial & farm loans
   
1,017
   
401
   
1,418
   
1,234
   
147
   
1,381
 
   Loans to state & political subdivisions
   
208
   
(6
)
 
202
   
119
   
(38
)
 
81
 
   Other loans
   
24
   
10
   
34
   
11
   
(16
)
 
(5
)
Total loans, net of discount
   
1,658
   
652
   
2,310
   
1,843
   
(86
)
 
1,757
 
Total Interest Income
   
2,112
   
1,001
   
3,113
   
1,716
   
(139
)
 
1,577
 
Interest Expense:
                                     
Interest-bearing deposits:
                                     
   NOW accounts
   
68
   
663
   
731
   
20
   
251
   
271
 
   Savings accounts
   
(2
)
 
13
   
11
   
2
   
-
   
2
 
   Money Market accounts
   
(38
)
 
425
   
387
   
23
   
291
   
314
 
   Certificates of deposit
   
24
   
397
   
421
   
124
   
48
   
172
 
   Total interest-bearing deposits
   
52
   
1,498
   
1,550
   
169
   
590
   
759
 
   Other borrowed funds
   
1,229
   
19
   
1,248
   
83
   
373
   
456
 
Total interest expense
   
1,281
   
1,517
   
2,798
   
252
   
963
   
1,215
 
Net interest income
 
$
831
 
$
(516
)
$
315
 
$
1,464
 
$
(1,102
)
$
362
 
                                       
(1) The portion of the total change attributable to both volume and rate changes during the year has been allocated
      to volume and rate components based upon the absolute dollar amount of the change in each component prior to allocation.
 
 
12

 
As can be seen from the preceding tables, we continue to experience a compression of our net interest margin. During 2006, the Federal Reserve has continued its policy of monetary tightening by raising short-term interest rates. Although the Federal Reserve has not increased rates in the third quarter, they have increased short-term interest rates 425 basis points since June of 2004. Accordingly, our cost of funds (interest paid on deposits and borrowings) has increased significantly. During this same period, long-term rates have remained relatively stable, resulting in a flattening of the yield curve. The rates earned on interest bearing assets have also increased during this period, but have not increased by the same magnitude. As such, our net interest spread has decreased from 3.72% for the first nine months of 2005 to 3.44% for the first nine months of 2006. We would anticipate our interest margin improving as the yield curve returns to a more normal slope. We continue to review various pricing and investment strategies to enhance our current deposit growth while maintaining or improving the current interest margin.
 
 
Tax equivalent net interest income rose from $13,642,000 in 2004 to $14,004,000 in 2005, and increased to $14,319,000 in 2006. In the period ending September 30, 2006, net interest income increased $315,000 on a tax equivalent basis over the same period in 2005. The increased volume of interest-earning assets of $38.0 million generated an increase in interest income of $2,112,000 while the increased volume of interest-bearing liabilities of $34.3 million produced an additional $1,281,000 of interest expense. Combined, this resulted in an increase due to volume of $831,000 in net interest income.
 
 
Comparing the first nine months of 2006 with 2005, the yield on interest-earning assets increased 36 basis points from 6.30% to 6.66% and the average interest rate on interest-bearing liabilities increased 64 basis points, from 2.58% to 3.22%. As such, the net change in rate resulted in a negative $516,000 of net interest income primarily due to the flattened yield curve referred to above.
 

Provision For Loan Losses

    For the nine-month period ending September 30, 2006, we charged $225,000 to the provision as a result of our quarterly review of the allowance for loan losses, which compares to $30,000 for the same period last year. The increase is primarily attributable to continued loan growth. Management's quarterly review of the allowance for loan losses is based on the following information: migration analysis of delinquent and non-accrual loans, estimated future losses on loans, recent review of large problem credits, local and national economic conditions, historical loss experience, OCC qualitative factors and peer comparisons.

Non-interest Income
 
As detailed below, non-interest income for the three months ended September 30, 2006 totaled $1,213,000 compared with $1,231,000 for the same period last year. This represents a decrease of $18,000, or 1.5%. For the first nine months of 2006, non-interest income increased $68,000 or 2.0% when compared to 2005. For the year, service charge income increased by $139,000 as it continues to be the primary source of non-interest income. For the first nine months, account service charges totaled $2,342,000 compared to $2,203,000 last year. Most of the increase is attributable to the increase in NSF fees of $109,000 and an increase of $50,000 of fee income derived from customers’ usage of their debit cards. Insurance revenue is down due to a couple of large annuity sales recognized in 2005 and also an overall decrease in annuity transactions. Other income is up $51,000 over last year due predominantly to gains recognized from the sale of three foreclosed properties. The following tables show the breakdown of non-interest income for the three months and nine months ended September 30, 2006 and 2005 (dollars in thousands):
   
Three months ended September 30,
 
Change
 
 
 
2006
 
2005
 
Amount
   %  
Service charges
 
$
827
 
$
784
 
$
43
   
5.5
 
Trust
   
135
   
161
   
(26
)
 
(16.1
)
Brokerage
   
45
   
45
   
-
   
-
 
Insurance
   
32
   
61
   
(29
)
 
(47.5
)
Gains on loans sold
   
11
   
24
   
(13
)
 
(54.2
)
Investment securities gains, net
   
5
   
-
   
5
   
N/A
 
Earnings on bank owned life insurance
   
78
   
71
   
7
   
9.9
 
Other
   
80
   
85
   
(5
)
 
(5.9
)
Total
 
$
1,213
 
$
1,231
 
$
(18
)
 
(1.5
)

 
13


 
   
Nine months ended September 30,
 
Change
 
 
 
2006
 
2005
 
Amount
  %   
Service charges
 
$
2,342
 
$
2,203
 
$
139
   
6.3
 
Trust
   
372
   
368
   
4
   
1.1
 
Brokerage
   
142
   
138
   
4
   
2.9
 
Insurance
   
88
   
205
   
(117
)
 
(57.1
)
Gains on loans sold
   
24
   
45
   
(21
)
 
(46.7
)
Investment securities gains, net
   
4
   
-
   
4
   
N/A
 
Earnings on bank owned life insurance
   
224
   
220
   
4
   
1.8
 
Other
   
340
   
289
   
51
   
17.6
 
Total
 
$
3,536
 
$
3,468
 
$
68
   
2.0
 
 
We continue to evaluate means of increasing non-interest income. Recently, management has implemented a debt cancellation program that should help us earn more income than the credit insurance program that it’s replacing. Debt cancellation is an agreement with the Bank and a customer that if a covered event takes place, the bank will cancel or suspend the debt owed by the customer. In addition, we are focused on the continued growth of our Trust and brokerage areas as a means to service all of our customers’ financial needs and increase non-interest income.
 
Non-interest Expense

The tables below reflect the breakdown of non-interest expense and professional fees for the three months ended and the nine months ended September 30, 2006 (dollars in thousands). For the three months ended September 30, 2006 compared to last year, expenses decreased $123,000. Most of this decrease is attributable to a decrease in the amortization of intangibles, as the core deposit intangible related to the Sovereign acquisition in 2000 was fully amortized as of the end of March, 2006. Salaries and benefits increased by $62,000 for the three months ended September 30, 2006 compared to 2005 mainly due to increases in insurance, pension expense, and merit increases. Professional fees modestly decreased by $7,000 compared to 2005.

For the first nine months of 2006, expenses decreased $180,000 or 1.6% compared to the same period in 2005. The increase in salaries and employee benefits of $190,000 is due mainly to merit increases and higher costs for health insurance and pension expense. Furniture and equipment costs are down $49,000 due to decreased depreciation expense from assets becoming fully depreciated. Professional fees are down mainly due to a decrease of legal fees. The amortization of intangibles has decreased $218,000 through the first nine months of 2006, as discussed above.

   
Three months ended September 30,
 
Change
 
 
 
2006
 
2005
 
Amount
  %   
Salaries and employee benefits
 
$
2,055
 
$
1,993
 
$
62
   
3.1
 
Occupancy
   
261
   
262
   
(1
)
 
(0.4
)
Furniture and equipment
   
146
   
156
   
(10
)
 
(6.4
)
Professional fees
   
125
   
132
   
(7
)
 
(5.3
)
Amortization of intangibles
   
36
   
145
   
(109
)
 
(75.2
)
Other
   
1,075
   
1,133
   
(58
)
 
(5.1
)
Total
 
$
3,698
 
$
3,821
 
$
(123
)
 
(3.2
)
 
                 
 
Three months ended September 30, 
Change
 
   
2006
   
2005
   
Amount
 
 
% 
 
Other professional fees
 
$
68
 
$
73
 
$
(5
)
 
(6.8
)
Legal fees
   
21
   
23
   
(2
)
 
(8.7
)
Examinations and audits
   
36
   
36
   
-
   
-
 
Total
 
$
125
 
$
132
 
$
(7
)
 
(5.3
)
 
 
14


 

   
Nine months ended September 30,
 
Change
 
 
 
2006
 
2005
 
Amount
  %   
Salaries and employee benefits
 
$
6,078
 
$
5,888
 
$
190
   
3.2
 
Occupancy
   
845
   
846
   
(1
)
 
(0.1
)
Furniture and equipment
   
442
   
491
   
(49
)
 
(10.0
)
Professional fees
   
371
   
408
   
(37
)
 
(9.1
)
Amortization of intangibles
   
216
   
434
   
(218
)
 
(50.2
)
Other
   
3,374
   
3,439
   
(65
)
 
(1.9
)
Total
 
$
11,326
 
$
11,506
 
$
(180
)
 
(1.6
)
 
                 
 
Nine months ended September 30, 
Change
 
   
2006
   
2005
   
Amount
 
 
% 
 
Other professional fees
 
$
215
 
$
223
 
$
(8
)
 
(3.6
)
Legal fees
   
50
   
72
   
(22
)
 
(30.6
)
Examinations and audits
   
106
   
113
   
(7
)
 
(6.2
)
Total
 
$
371
 
$
408
 
$
(37
)
 
(9.1
)

Provision For Income Taxes

Income before the provision for income taxes has increased $167,000 in 2006 compared with last year. However, the provision for income taxes has decreased from $1,232,000 to $987,000, a reduction of $245,000. The decrease was primarily a result of our increase in tax-exempt municipal securities and municipal loans. Our current tax-exempt securities and loan portfolio totals approximately $67.6 million compared with approximately $55.7 million this time last year.

We are also involved in 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 $547,863 out of a total $911,000 of tax credits from one project and $182,856 out of a total $385,000 on the second project, which was completed in November 2001. A total of approximately $1,296,000 of tax credits is anticipated over a ten-year period. In 2005, we entered into a third limited liability partnership for a low-income housing project for senior citizens in our Sayre market area. We expect to recognize approximately $574,000 of tax credits over a ten year period beginning late in 2006.

Financial Condition

Total assets (as shown in the Consolidated Balance Sheet) of $560.7 million have increased 5.9% since year-end 2005’s balance of $529.2 million. Net loans increased 7.6% to $407.8 million while investment securities increased .7% to $103.3 million. Total deposits have increased $18.4 million or 4.3% to $448.2 million since year-end 2005. Borrowed funds have increased $11.6 million to $64.3 million compared with $52.7 million at year-end. Explanations of variances will be described within the following appropriate sections.

Cash and Cash Equivalents

Cash and cash equivalents totaled $9,642,000 at September 30, 2006 compared to $8,609,000 at December 31, 2005. Non-interest bearing cash increased $1,118,000 since year-end 2005, while interest-bearing cash decreased $85,000 during that same period. The increase in non-interest bearing cash is primarily attributable to a temporary increase in our balance at the Federal Reserve Bank of Philadelphia. We believe the liquidity needs of the Company, are satisfied by the current balance of cash and cash equivalents, readily available access to traditional funding sources, and the portion of the investment and loan portfolios that mature within one year. These sources of funds will enable the Company to meet cash obligations and off-balance sheet commitments as they come due.


15


Investments

As shown in the table below, our investment portfolio increased by $699,000 or .7% from December 31, 2005 to September 30, 2006. During the first nine months of 2006 we purchased approximately $7.8 million of U.S. agency bonds, $9.4 million of mortgage-backed securities, $3.3 million of tax-exempt municipal securities, and $3.9 million of corporate bonds. Offsetting this, we continued to receive principal repayments in the amount of $8.1 million from our mortgaged backed securities portfolio as well as maturities in the amount of $5.8 million from our corporate and municipal portfolios. We have also sold approximately $10.4 million of the portfolio in an effort to maximize our total return by reinvesting at higher yields. We sold nearly $4.0 million of low yielding agencies at losses offset by the sale of a $2.0 million high yielding corporate. We also sold $1.9 million of higher yielding mortgage-backed securities and $1.9 million of Municipal bonds that were pre-refunded and set to be called in the near future. Additionally, we sold 14,900 shares of our Freddie Mac Preferred stock in order to utilize capital gains in prior tax years. The overall market value of our investment portfolio has also decreased approximately $800,000 due to increases in interest rates which had a direct effect on our investment portfolio. Our investment portfolio is currently yielding 4.75% compared to 4.15% a year ago, on a tax-effected basis.

 
 
September 30, 2006
 
December 31, 2005
 
(dollars in thousands)
 
Amount
  %   
Amount
  %   
Available-for-sale:
                 
   U. S. Agency securities
 
$
16,656
   
16.1
 
$
12,754
   
12.5
 
   Obligations of state & political
                         
     subdivisions
   
23,762
   
23.0
   
22,612
   
22.0
 
   Corporate obligations
   
4,915