form10-k2007.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K
(Mark One)

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

For the fiscal year ended
 
     December 31, 2007

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.)
15 South Main Street, Mansfield, Pennsylvania
 
16933
(Address of principal executive offices)
 
(Zip Code)
Registrant’s telephone number, including area code
(570) 662-2121
         
Securities registered pursuant to Section 12(b) of the Act:
None
 
         
Securities registered pursuant to Section 12(g) of the Act:
         
Common Stock, par value $1.00 per share
(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
  Yes       No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
  Yes       No

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       No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
                                               
 

 
 


 
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
 
Large accelerated filer o                                                                                      Accelerated filer £
 
 
Non-accelerated filer o                                                                            Smaller reporting company
 
(Do not check if a smaller reporting company)


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


State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $55,143,967 as of June 30, 2007.

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date. 2,825,558as of February 20, 2008

DOCUMENTS INCORPORATED BY REFERENCE

Certain information required by Part III is incorporated by reference to the Registrant’s Definitive Proxy Statement for the 2008 Annual Meeting of Shareholders.



II


 

 
Citizens Financial Services, Inc.
Form 10-K
INDEX
 
Page
PART I
 
ITEM 1 – BUSINESS
1 – 4
ITEM 1A – RISK FACTORS
57
ITEM 1B – UNRESOLVED STAFF COMMENTS
7
ITEM 2 – PROPERTIES
7
ITEM 3 – LEGAL PROCEEDINGS
7
ITEM 4 – SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
7
PART II
 
ITEM 5 – MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
8 - 9
ITEM 6 – SELECTED FINANCIAL DATA
10
ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS  OF OPERATION
11 – 33
ITEM 7A – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
34
ITEM 8 – FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
34 – 68
ITEM 9 – CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND  FINANCIAL DISCLOSURE
69
ITEM 9A(T) – CONTROLS AND PROCEDURES
69
ITEM 9B– OTHER INFORMATION
69
PART III
 
ITEM 10 – DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
70
ITEM 11 – EXECUTIVE COMPENSATION
70
ITEM 12 – SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
7071
ITEM 13 – CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
71
ITEM 14 – PRINCIPAL ACCOUNTANT FEES AND SERVICES
71
PART IV
 
ITEM 15 – EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
7273
SIGNATURES
74

III



 
PART I
 
 
ITEM 1 – BUSINESS.
 
CITIZENS FINANCIAL SERVICES, INC.
 
 
Citizens Financial Services, Inc. (the “Company”), a Pennsylvania business corporation, was incorporated April 30, 1984. The Company is registered with the Board of Governors of the Federal Reserve System as a bank holding company under the Bank Holding Company Act of 1956, as amended.  Simultaneous with establishment of the Company in 1984, First Citizens National Bank (the “Bank”) became a wholly-owned subsidiary of the Company through a merger transaction in which the shareholders of the Bank became shareholders of the Company.   The Company is subject to regulation, supervision and examination by the Board of Governors of the Federal Reserve System.  In general, the Company is limited to owning or controlling banks and engaging in such other activities as are properly incident thereto.
 
 
Our Company does not currently engage in any operating business activities, other than the ownership and management of the Bank and its wholly-owned insurance agency subsidiary.
 
 
FIRST CITIZENS NATIONAL BANK
 
 
The Bank was created as a result of the merger of Citizens National Bank of Blossburg, Pennsylvania with and into The First National Bank of Mansfield in 1970.  Upon consummation of the merger, the Bank had 2 offices and served Tioga County, Pennsylvania.  In 1971, the Bank expanded its operations into Potter County through the acquisition of the Grange National Bank, which had offices in Ulysses and Genesee, Pennsylvania.  As previously discussed, the Bank became the wholly-owned subsidiary of Citizens Financial Services, Inc. in 1984.  On November 16, 1990, the Company acquired Star Savings and Loan Association, originally organized as a Pennsylvania state-chartered mutual savings and loan association in 1899, and converted it into a Pennsylvania state-chartered permanent reserve fund stock savings and loan association on March 27, 1986. On December 31, 1991, the Star Savings and Loan Association merged with and into the Bank.  On April 20, 1996, the Bank purchased two branch offices of Meridian Bank in Canton and Gillett, Pennsylvania.  In October 1996, the Bank opened an office in the Weis Supermarket in Wellsboro, Pennsylvania.  In August of 2000, the Bank opened an office in the Wal-Mart Super-center in Mansfield, Pennsylvania.  On October 27, 2000, the Bank purchased six branch offices of Sovereign Bank in Bradford County, Pennsylvania.  In February 2001, the Bank consolidated two of the six Sovereign branches.  On June 4, 2004, two branches of The Legacy Bank in Bradford County, Pennsylvania were purchased and the Bank consolidated two of its existing branches to maximize efficiencies.  On December 17, 2005, the Hannibal branch of the Fulton Savings Bank in Hannibal, New York was acquired.  Simultaneous with the purchase, the branch was relocated to Wellsville, New York (Allegany County).  A temporary banking facility was opened on December 19, 2005.  A permanent banking facility was constructed during 2006 and was opened for business on October 30, 2006.
 
 
The Bank’s main office is located at 15 South Main Street, Mansfield, (Tioga County) Pennsylvania.  The Bank’s primary market area consists of the Pennsylvania Counties of Bradford, Potter and Tioga in North Central Pennsylvania.  It also includes Allegany, Steuben, Chemung and Tioga Counties in Southern New York.  The economy is diversified and includes manufacturing industries, wholesale and retail trade, service industries, family farms and the production of natural resources of gas and timber.  In addition to the main office, the Bank has 15 other full service branch offices in its market area.
 
 
The Bank is a full-service bank engaging in a broad range of banking activities and services for individual, business, governmental and institutional customers.  These activities and services principally include checking, savings, time and deposit accounts; real estate, commercial, industrial, residential and consumer loans; and a variety of other specialized financial services.  The Trust and Investment division offers a full range of client investment, estate and retirement services.
 
 
As of December 31, 2007, the Bank employed 154full time employees and 30part-time employees, resulting in 167full time equivalent employees at our corporate offices and other banking locations.
 
 
Our Company's profitability does not depend upon a few customers. Losing the business of any one customer or group of customers would not cause a material impact on our business.  The Bank’s business is not seasonal nor does it have any risks attendant to foreign sources.  We are dependent geographically upon the economic conditions in north central Pennsylvania and the southern tier of New York.
 
 
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COMPETITION
 
The banking industry in the Bank’s service area continues to be extremely competitive, both among commercial banks and with financial service providers such as consumer finance companies, thrifts, investment firms, mutual funds, insurance companies, credit unions and internet banks.  The increased competition has resulted from changes in the legal and regulatory guidelines as well as from economic conditions.  Mortgage banking firms, financial companies, financial affiliates of industrial companies, brokerage firms, retirement fund management firms and even government agencies provide additional competition for loans and other financial services.  The Bank is generally competitive with all competing financial institutions in its service area with respect to interest rates paid on time and savings deposits, service charges on deposit accounts and interest rates charged on loans.
 
Additional information related to our business and competition is included in Part II, Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations”.
 
SUPERVISION AND REGULATION

GENERAL

The Company is registered as a bank holding company and is subject to supervision and regulation by the Board of Governors of the Federal Reserve System under the Bank Holding Company Act of 1956, as amended.  The Company is considered a bank holding company.  Bank holding companies are required to file periodic reports with and are subject to examination by the Federal Reserve Board.  The Federal Reserve Board has issued regulations under the Bank Holding Company Act that require a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks.  As a result, the Federal Reserve Board, pursuant to such regulations, may require the Company to stand ready to use its resources to provide adequate capital funds to its bank subsidiary during periods of financial stress or adversity.

The Bank Holding Company Act prohibits the Company from acquiring direct or indirect control of more than 5% of the outstanding shares of any class of voting stock, or substantially all of the assets of, any bank, or from merging or consolidating with another bank holding company, without prior approval of the Federal Reserve Board.  Additionally, the Bank Holding Company Act prohibits the Company from engaging in or from acquiring ownership or control of more than 5% of the outstanding shares of any class of voting stock of any company engaged in a non-banking business, unless such business has been determined by the Federal Reserve Board to be so closely related to banking as to be a proper incident thereto or, for financial holding companies, to be financial in nature or incidental thereto.

The Bank is a national bank and a member of the Federal Reserve System, and its deposits are insured (up to applicable limits) by the Federal Deposit Insurance Corporation (the “FDIC”).  The Bank is subject to regulation and examination by the Office of the Comptroller of the Currency (OCC), and to a much lesser extent, the Federal Reserve Board and the FDIC.  The Bank is also subject to requirements and restrictions under federal and state law, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and the interest that may be charged thereon, and limitations on the types of investments that may be made and the types of services that may be offered.  The Bank is subject to extensive regulation and reporting requirements in a variety of areas, including to help prevent money laundering, to preserve financial privacy and to properly report late payments, defaults and denials of loan applications.  The Community Reinvestment Act requires the Bank to help meet the credit needs of the entire community where the Bank operates, including low and moderate income neighborhoods.  The Bank's rating under the Community Reinvestment Act, assigned by the Comptroller of the Currency pursuant to an examination of the Bank, is important in determining whether the bank may receive approval for, or utilize certain streamlined procedures in, applications to engage in new activities.  The Bank’s present CRA rating is “Outstanding.”  Various consumer laws and regulations also affect the operations of the Bank.  In addition to the impact of regulation, commercial banks are affected significantly by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability in order to influence the economy.
 
 
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CAPITAL ADEQUACY GUIDELINES

Bank holding companies are required to comply with the Federal Reserve Board's risk-based capital guidelines.  The required minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) is 8%.  At least half of the total capital is required to be “Tier 1 capital,” consisting principally of common shareholders' equity, less certain intangible assets.  The remainder (“Tier 2 capital”) may consist of certain preferred stock, a limited amount of subordinated debt, certain hybrid capital instruments and other debt securities, and a limited amount of the general loan loss allowance.  The risk-based capital guidelines are required to take adequate account of interest rate risk, concentration of credit risk, and risks of nontraditional activities.

In addition to the risk-based capital guidelines, the Federal Reserve Board requires a bank holding company to maintain a leverage ratio of a minimum level of Tier 1 capital (as determined under the risk-based capital guidelines) equal to 3% of average total consolidated assets for those bank holding companies which have the highest regulatory examination ratings and are not contemplating or experiencing significant growth or expansion.  All other bank holding companies are required to maintain a ratio of at least 1% above the stated minimum.  The Bank is subject to almost identical capital requirements adopted by the OCC.

PROMPT CORRECTIVE ACTION RULES

The federal banking agencies have regulations defining the levels at which an insured institution would be considered “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.”  Institutions that are classified as undercapitalized, significantly undercapitalized or critically undercapitalized are subject to various supervision measures based on the degree of undercapitalization.  The applicable federal bank regulator for a depository institution could, under certain circumstances, reclassify a “well-capitalized” institution as “adequately capitalized” or require an “adequately capitalized” or “undercapitalized” institution to comply with supervisory actions as if it were in the next lower category.  Such a reclassification could be made if the regulatory agency determines that the institution is in an unsafe or unsound condition (which could include unsatisfactory examination ratings).  The Bank satisfies the criteria to be classified as “well capitalized” within the meaning of applicable regulations.

REGULATORY RESTRICTIONS ON DIVIDENDS

The Bank may not, under the National Bank Act, declare a dividend without approval of the OCC, unless the dividend to be declared by the Bank's Board of Directors does not exceed the total of:  (i) the Bank's net profits for the current year to date, plus (ii) its retained net profits for the preceding two current years, less any required transfers to surplus.  In addition, the Bank can only pay dividends to the extent that its retained net profits (including the portion transferred to surplus) exceed its bad debts.  The Federal Reserve Board, the OCC and the FDIC have formal and informal policies which provide that insured banks and bank holding companies should generally pay dividends only out of current operating earnings, with some exceptions.  The Prompt Corrective Action Rules, described above, further limit the ability of banks to pay dividends, because banks which are not classified as well capitalized or adequately capitalized may not pay dividends.

Under these policies and subject to the restrictions applicable to the Bank, the Bank could have declared, during 2007, without prior regulatory approval, aggregate dividends of approximately $6.2 million, plus net profits earned to the date of such dividend declaration.
 
BANK SECRECY ACT
 
Under the Bank Secrecy Act (BSA), banks and other financial institutions are required to retain records to assure that the details of financial transactions can be traced if investigators need to do so.  Banks are also required to report most cash transactions in amounts exceeding $10,000 made by or on behalf of their customers.  Failure to meet BSA requirements may expose the Bank to statutory penalties, and a negative compliance record may affect the willingness of regulating authorities to approve certain actions by the Bank requiring regulatory approval, including new branches.

INSURANCE OF DEPOSIT ACCOUNTS
 
The Bank’s deposits are insured up to applicable limits by the Deposit Insurance Fund of the FDIC.  The Deposit Insurance Fund is the successor to the Bank Insurance Fund and the Savings Association Insurance Fund, which were merged in 2006.  The FDIC amended its risk-based assessment system for 2007 to implement authority granted by the Federal Deposit Insurance Reform Act of 2005 (“Reform Act”).  Under the revised system, insured institutions are assigned to one of four risk categories based on supervisory evaluations, regulatory capital levels and certain other factors.  An institution’s assessment rate depends upon the category to which it is assigned.  Risk category I, which contains the least risky depository institutions, is
 
3

 
expected to include more than 90% of all institutions.  Unlike the other categories, Risk Category I contains further risk differentiation based on the FDIC’s analysis of financial ratios, examination component ratings and other information.  Assessment rates are determined by the FDIC and currently range from five to seven basis points for the healthiest institutions (Risk Category I) to 43 basis points of assessable deposits for the riskiest (Risk Category IV).  The Federal Deposit Insurance Corporation may adjust rates uniformly from one quarter to the next, except that no single adjustment can exceed three basis points.  No institution may pay a dividend if in default of the FDIC assessment.

The Reform Act also provided a one-time credit for eligible institutions based on their assessment base as of December 31, 1996.  Subject to certain limitations, credits could be used beginning in 2007 to offset assessments until exhausted.  The Bank’s one-time credit approximated $335,000, of which $126,000 was utilized in 2007.  The Reform Act also provided for the possibility that the FDICmay pay dividends to insured institutions once the Deposit Insurance fund reserve ratio equals or exceeds 1.35% of estimated insured deposits.

In addition to the assessment for deposit insurance, institutions are required to make payments on bonds issued in the late 1980s by the Financing Corporation to recapitalize a predecessor deposit insurance fund.  That payment is established quarterly and during the calendar year ending December 31, 2007 averaged 1.18 basis points of assessable deposits.

The Reform Act provided the FDIC with authority to adjust the Deposit Insurance Fund ratio to insured deposits within a range of 1.15% and 1.50%, in contrast to the prior statutorily fixed ratio of 1.25%.  The ratio, which is viewed by the Federal Deposit Insurance Corporation as the level that the fund should achieve, has been established by the agency at 1.25% for 2008, which was unchanged from 2007.

The FDIC has authority to increase insurance assessments.  A significant increase in insurance premiums would likely have an adverse effect on the operating expenses and results of operations of the Bank.  Management cannot predict what insurance assessment rates will be in the future.

Insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the OCC.  The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance.
 
  EFFECT OF GOVERNMENT MONETARY POLICIES
 
The earnings and growth of the banking industry are affected by the credit policies of monetary authorities, including the Federal Reserve System.  An important function of the Federal Reserve System is to regulate the national supply of bank credit in order to control recessionary and inflationary pressures.  Among the instruments of monetary policy used by the Federal Reserve to implement these objectives are open market activities in U.S. Government Securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against member bank deposits.  These operations are used in varying combinations to influence overall economic growth and indirectly, bank loans, securities, and deposits.  These variables may also affect interest rates charged on loans or paid on deposits.  The monetary policies of the Federal Reserve authorities have had a significant effect on the operating results of commercial banks in the past and are expected to continue to have such an effect in the future.
 
In view of the changing conditions in the national economy and in the money markets, as well as the effect of actions by monetary and fiscal authorities including the Federal Reserve System, no prediction can be made as to possible changes in interest rates, deposit levels, loan demand or their effect on the business and earnings of the Company and the Bank.   Additional information is included under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing in this Annual Report on Form 10-K.
 
 
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ITEM 1A – RISK FACTORS.
 
Changes in interest rates could reduce our income, cash flows and asset values.
 
Our income and cash flows and the value of our assets depend to a great extent on the difference between the interest rates we earn on interest-earning assets, such as loans and investment securities, and the interest rates we pay on interest-bearing liabilities such as deposits and borrowings.  These rates are highly sensitive to many factors which are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Board of Governors of the Federal Reserve System. Changes in monetary policy, including changes in interest rates, will influence not only the interest we receive on our loans and investment securities and the amount of interest we pay on deposits and borrowings but will also affect our ability to originate loans and obtain deposits and the value of our investment portfolio.  If the rate of interest we pay on our deposits and other borrowings increases more than the rate of interest we earn on our loans and other investments, our net interest income, and therefore our earnings, could be adversely affected.  Our earnings also could be adversely affected if the rates on our loans and other investments fall more quickly than those on our deposits and other borrowings.
 
Economic conditions either nationally or locally in areas in which our operations are concentrated may adversely affect our business.
 
Deterioration in local, regional, national or global economic conditions could cause us to experience a reduction in deposits and new loans, an increase in the number of borrowers who default on their loans and a reduction in the value of the collateral securing their loans, all of which could adversely affect our performance and financial condition. Unlike larger banks that are more geographically diversified, we provide banking and financial services locally.  Therefore, we are particularly vulnerable to adverse local economic conditions in north central Pennsylvania and southern New York.  The economy in this region is rural in nature with unemployment rates slightly higher than the national average.
 
Our financial condition and results of operations would be adversely affected if our allowance for loan losses is not sufficient to absorb actual losses or if we are required to increase our allowance.
 
Despite our underwriting criteria, we may experience loan delinquencies and losses.  In order to absorb losses associated with nonperforming loans, we maintain an allowance for loan losses based on, among other things, historical experience, an evaluation of economic conditions, and regular reviews of delinquencies and loan portfolio quality.  Determination of the allowance inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes.  At any time there are likely to be loans in our portfolio that will result in losses but that have not been identified as nonperforming or potential problem credits. We cannot be sure that we will be able to identify deteriorating credits before they become nonperforming assets or that we will be able to limit losses on those loans that are identified. We may increase our allowance for loan losses based on our regular review of delinquencies and loan portfolio quality, or for any of several other reasons.  Bank regulators, in reviewing our loan portfolio as part of a regulatory examination, may request that we increase our allowance for loan losses.  Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in our allowance.  In addition, if charge-offs in future periods exceed our allowance for loan losses, we will need additional increases in our allowance for loan losses.  Any increases in our allowance for loan losses will result in a decrease in our net income and, possibly, our capital, and may materially affect our results of operations in the period in which the allowance is increased.
 
Competition may decrease our growth or profits.
 
We face substantial competition in all phases of our operations from a variety of different competitors, including commercial banks, savings and loan associations, mutual savings banks, credit unions, consumer finance companies, factoring companies, leasing companies, insurance companies and money market mutual funds.  There is very strong competition among financial services providers in our principal service area.  Our competitors may have greater resources, higher lending limits or larger branch systems than we do.  Accordingly, they may be able to offer a broader range of products and services as well as better pricing for those products and services than we can.
 
In addition, some of the financial services organizations with which we compete are not subject to the same degree of regulation as is imposed on federally insured financial institutions.  As a result, those nonbank competitors may be able to access funding and provide various services more easily or at less cost than we can, adversely affecting our ability to compete effectively.
 
We may be adversely affected by government regulation.
 
The banking industry is heavily regulated. Banking regulations are primarily intended to protect the federal deposit insurance funds and depositors, not shareholders. Changes in the laws, regulations, and regulatory practices affecting the
 
 
5

 
banking industry may increase our costs of doing business or otherwise adversely affect us and create competitive advantages for others. Regulations affecting banks and financial services companies undergo continuous change, and we cannot predict the ultimate effect of these changes, which could have a material adverse effect on our profitability or financial condition.
 
In addition to these banking laws and regulations, we are also subject to the Securities Exchange Act of 1934 and the rules and regulations under that act.  Moreover, we are subject to the provisions of the Sarbanes-Oxley Act of 2002 (SOX) and the rules and regulations issued thereunder by the Securities and Exchange Commission (“SEC”).  These laws and regulations impose, among other things, significant responsibilities on officers, auditors, boards of directors and audit committees. Our expenses related to services rendered by our accountants, legal counsel and consultants have increased and may continue to increase in order to ensure compliance with these laws and regulations.
 
Under Section 404 of SOX, we were required to conduct a comprehensive review and assessment of the adequacy of our existing systems and controls as of the end of 2007and our auditors will have to attest to our assessment beginning with the twelve months ended December 31, 2008, although the SEC has proposed to delay implementation of the auditor attestation requirement until fiscal years ending on or after December 15, 2009.  This resulted in additional expenses in 2007 and will result in further expenses in succeeding years that may adversely affect our results of operations.  In a SOX 404 review, we could uncover deficiencies or material weaknesses in existing systems and controls. If that is the case, we would have to take the necessary steps to correct any deficiencies or material weaknesses, which may be costly and may strain our management resources.   We also would be required to disclose any such material weaknesses, which could adversely affect the market price of our common stock.   
 
We rely on our management and other key personnel, and the loss of any of them may adversely affect our operations.
 
We are and will continue to be dependent upon the services of our executive management team. In addition, we will continue to depend on our ability to retain and recruit key commercial loan officers. The unexpected loss of services of any key management personnel or commercial loan officers could have an adverse effect on our business and financial condition because of their skills, knowledge of our market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.
 
Environmental liability associated with lending activities could result in losses.
 
In the course of our business, we may foreclose on and take title to properties securing our loans.  If hazardous substances were discovered on any of these properties, we could be liable to governmental entities or third parties for the costs of remediation of the hazard, as well as for personal injury and property damage.  Many environmental laws can impose liability regardless of whether we knew of, or were responsible for, the contamination.  In addition, if we arrange for the disposal of hazardous or toxic substances at another site, we may be liable for the costs of cleaning up and removing those substances from the site even if we neither own nor operate the disposal site.  Environmental laws may require us to incur substantial expenses and may materially limit use of properties we acquire through foreclosure, reduce their value or limit our ability to sell them in the event of a default on the loans they secure.  In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability.
 
Failure to implement new technologies in our operations may adversely affect our growth or profits.
 
The market for financial services, including banking services and consumer finance services, is increasingly affected by advances in technology, including developments in telecommunications, data processing, computers, automation, Internet-based banking and telebanking. Our ability to compete successfully in our markets may depend on the extent to which we are able to exploit such technological changes. However, we can provide no assurance that we will be able properly or timely to anticipate or implement such technologies or properly train our staff to use such technologies.  Any failure to adapt to new technologies could adversely affect our business, financial condition or operating results. 
 
An investment in our common stock is not an insured deposit.
 
Our common stock is not a bank deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity.  Investment in our common stock is subject to the same market forces that affect the price of common stock in any company.
 
Our ability to pay dividends is limited by law.
 
Our ability to pay dividends to our shareholders largely depends on our receipt of dividends from the Bank. The amount of dividends that the Bank may pay to us is limited by federal laws and regulations. We also may decide to limit the payment of dividends even when we have the legal ability to pay them in order to retain earnings for use in our business.
 
 
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Federal and state banking laws, our articles of incorporation and our by-laws may have an anti-takeover effect.
 
Federal law imposes restrictions, including regulatory approval requirements, on persons seeking to acquire control over us.  Pennsylvania law also has provisions that may have an anti-takeover effect.  These provisions may serve to entrench management or discourage a takeover attempt that shareholders consider to be in their best interest or in which they would receive a substantial premium over the current market price.
 
ITEM 1B – UNRESOLVED STAFF COMMENTS.
 
Not applicable.
 
ITEM 2 – PROPERTIES.
 
The headquarters of the Company and Bank are located at 15 South Main Street, Mansfield, Pennsylvania. The building contains the central offices of the Company and Bank. Our bank also owns fifteen other banking facilities and leases two other facilities. All buildings owned by the Bank are free of any liens or encumbrances.
 
The net book value of owned properties and leasehold improvements totaled $11,618,228 as of December 31, 2007.  The properties are adequate to meet the needs of the employees and customers. We have equipped all of our facilities with current technological improvements for data and word processing.
 
ITEM 3 - LEGAL PROCEEDINGS.
 
       The Company is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business.  Such routine legal proceedings in the aggregate are believed by management to be immaterial to the Company's financial condition or results of operations.
 
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
 
       During the quarter ended December 31, 2007, no matters were submitted to vote of security holders through a solicitation of proxies or otherwise.
 

 

7


 
PART II
 
ITEM 5 - MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
 
The Company's stock is not listed on any stock exchange, but it is quoted on the OTC Bulletin Board under the trading symbol CZFS.  Prices presented in the table below are bid prices between broker-dealers published by the OTC Bulletin Board and the Pink Sheets Electronic Quotation Service.  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 are summarized in the table below (also see dividend restrictions to Note 13 of the consolidated financial statements).
 
 
Dividends
   
Dividends
 
2007
paid
2006
paid
  
High
Low
per share
High
Low
per share
First quarter
 $      22.57
 $      21.04
 $      0.220
 $    22.77
 $     20.54
 $        0.210
Second quarter
         23.52
         20.94
         0.225
       23.76
        21.38
           0.215
Third quarter
         22.75
         20.25
         0.225
       23.01
        21.38
           0.215
Fourth quarter
         21.75
         19.35
         0.230
       22.80
        21.05
           0.220
 
 
The Company has paid dividends since April 30, 1984, the effective date of our formation as a bank holding company. The Company's Board of Directors intends to continue the dividend payment policy; however, future dividends necessarily depend upon earnings, financial condition, appropriate legal restrictions and other factors as in existence at the time the Board of Directors considers a dividend policy. Cash available for dividend distributions to stockholders of the Company comes from dividends paid to the Company by the Bank. Therefore, restrictions on the ability of the Bank to make dividend payments are directly applicable to the Company.  See “Footnote 13 – Regulatory Matters” to the consolidated financial statements.
 
Under the Pennsylvania Business Corporation Law of 1988, the Company may pay dividends only if, after payment, the Company would be able to pay debts as they become due in the usual course of our business and total assets will be greater than the sum of total liabilities.  The Federal Reserve Board has issued a policy statement regarding the payment of dividends by bank holding companies.  In general, the Federal Reserve Board’s policies provide that dividends should be paid only out of current earnings and only if the prospective rate of earnings retention by the bank holding company appears consistent with the organization’s capital needs, asset quality, and overall financial condition.  The Federal Reserve Board’s policies also require that a bank holding company serve as a source of financial strength to its subsidiary banks by standing ready to use available resources to provide adequate capital funds to those banks during periods of financial stress or adversity and by maintaining the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks where necessary.  Furthermore, the Federal Reserve Board has authority to prohibit a bank holding company from paying a capital distribution where a subsidiary bank is undercapitalized. These regulatory policies could affect the ability of the Company to pay dividends or otherwise engage in capital distributions.
 
The Company distributed a 1% stock dividend on July 27, 2007 to all shareholders of record as of July 13, 2007.
 
As of February 13, 2008, the Company had approximately 1,572 stockholders of record.  The computation of stockholders of record excludes individual participants in securities positions listings.  The Company has not sold any unregistered shares of common stock in the past three years.  The following table presents information regarding the Company’s stock repurchases during the three months ended December 31, 2007:
 
 
8


 

Period
Total Number of Shares (or units Purchased)
Average Price Paid per Share (or Unit)
Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans of Programs
Maximum Number (or Approximate Dollar Value) of Shares (or Units) that May Yet Be Purchased Under the Plans or Programs (1)
10/1/07 to 10/31/07
-
-
-
85,918
11/1/07 to 11/30/07
4,690
$21.29
4,690
81,228
12/1/07 to 12/31/07
5,000
$21.25
5,000
76,228
Total
9,690
$21.27
9,690
76,228
 

On January 7, 2006, the Company announced that the Board of Directors authorized the Company to repurchase up to 140,000 shares.  The repurchases will be conducted through open-market purchases or privately negotiated transactions and will be made from time to time depending on market conditions and other factors.  No time limit was placed on the duration of the share repurchase program.  Any repurchased shares will be held as treasury stock and will be available for general corporate purposes.
 
 
9

 
ITEM 6 - SELECTED FINANCIAL DATA.
 
The following table sets forth certain financial data as of and for each of the years in the five year period ended December 31, 2007:
 
 

 
(in thousands, except share data)
 
2007
   
2006
   
2005
   
2004
   
2003
 
Interest income
  $ 36,024     $ 32,851     $ 28,699     $ 26,606     $ 25,615  
Interest expense
    16,922       14,953       11,000       9,235       8,826  
Net interest income
    19,102       17,898       17,699       17,371       16,789  
Provision for loan losses
    365       330       60       -       435  
Net interest income after provision
                                       
  for loan losses
    18,737       17,568       17,639       17,371       16,354  
Non-interest income
    5,114       4,712       4,688       4,527       4,759  
Investment securities gains (losses), net
    (29 )     4       -       (235 )     553  
Non-interest expenses
    15,314       15,027       15,387       14,922       15,501  
Income before provision for income taxes
    8,508       7,257       6,940       6,741       6,165  
Provision for income taxes
    1,772       1,457       1,666       1,474       1,286  
Net income
  $ 6,736     $ 5,800     $ 5,274     $ 5,267     $ 4,879  
                                         
Return on Assets (net income to average total assets)
    1.16 %     1.05 %     1.04 %     1.09 %     1.11 %
Return on Equity (net income to average total equity)
    14.38 %     13.21 %     12.63 %     13.40 %     13.22 %
Dividend Payout Ratio (dividends declared divided by net income)
    37.86 %     42.10 %     44.28 %     41.90 %     43.10 %
Equity to Asset Ratio (average equity to average total assets,
    8.10 %     7.98 %     8.20 %     8.15 %     8.43 %
  excluding other comprehensive income)
                                       
                                         
Per share data:
                                       
Net income (1)
  $ 2.37     $ 2.02     $ 1.81     $ 1.80     $ 1.65  
Cash dividends (1)
    0.90       0.86       0.80       0.76       0.71  
Book value (1) (2)
    17.30       15.89       14.85       13.90       12.85  
                                         
Total investments
  $ 120,802     $ 109,743     $ 102,602     $ 95,747     $ 106,587  
Loans, net (3)
    419,182       410,897       379,139       355,774       314,037  
Total assets (3)
    591,029       572,168       529,241       499,347       463,878  
Total deposits (3)
    456,028       446,515       429,799       419,074       385,691  
Stockholders' equity
    48,528       43,500       41,561       40,789       38,529  
                                         
(1) Amounts were adjusted to reflect stock dividends.
                                       
(2) Calculation excludes accumulated other comprehensive income and unrecognized pension cost.
                 
(3) Amounts in 2004 reflect the acquisition of branches in the second quarter of 2004.
                         
Amounts in 2005 reflect the branch acquisition in the fourth quarter of 2005.
                                 
 

10

 
 
ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION.
 
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 words such 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 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 or requirements.
 
·
We could experience greater loan delinquencies than anticipated, adversely affecting our earnings and financial condition. We could also experience greater losses than expected due to the ever increasing volume of information theft and fraudulent scams impacting our customers and the banking industry.
 
·
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.
Except as required by applicable law and regulation, we assume no obligation to update or revise any forward-looking statements after the date on which they are made.

 
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 condition 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 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 December of 2005, regulatory approval was received to purchase the Hannibal branch of the Fulton Savings Bank in Hannibal, New York (see footnote 18 to the consolidated financial statements).  The office was relocated to Wellsville, New York, where a temporary banking facility was utilized.  In October, 2006, we officially opened our newly constructed de novo branch facility in Wellsville, accomplishing one of our primary objectives of expanding into New York State.
 
 
11

 
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 policies 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.  We can not anticipate additional requirements or additional compliance efforts regarding the Bank Secrecy Act or USA Patriot Act, or regulatory burdens regarding the ever increasing information theft and fraudulent activities impacting our customers and the banking industry in general.
 
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 reports on Form 10-K, 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 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.  The financial services industry continues to experience tremendous change to competitive barriers between bank and non-bank institutions. We must compete not only with traditional financial institutions, but in addition, with 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 Division is committed to helping our customers meet their financial goals.  The Trust Division offers professional trust administration, investment management services, estate planning and administration, custody of securities and individual retirement accounts.  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.  As of December 31, 2007, non-deposit investment products under management totaled $40.4 million.  Additionally, as summarized in the table below, the Trust Department had assets under management as of December 31, 2007 and 2006 of $94.4 million and $82.6 million, respectively:


12


 

(market values - in thousands)
 
2007
   
2006
 
INVESTMENTS:
           
Bonds
  $ 21,081     $ 17,543  
Stock
    23,014       21,013  
Savings and Money Market Funds
    9,907       9,163  
Mutual Funds
    38,177       32,678  
Mortgages
    1,098       951  
Real Estate
    978       1,263  
Miscellaneous
    12       16  
Cash
    106       10  
TOTAL
  $ 94,373     $ 82,637  
ACCOUNTS:
               
Trusts
    30,306       26,333  
Guardianships
    682       144  
Employee Benefits
    34,944       30,253  
Investment Management
    27,791       24,742  
Custodial
    650       1,165  
TOTAL
  $ 94,373     $ 82,637  

Our Financial Consultants offer full service brokerage services throughout the Bank’s market area.  Appointments can be made at any First Citizens National Bank branch.  The Financial Consultants 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.

RESULTS OF OPERATIONS
 
Net income for the twelve months ended December 31, 2007 was $6,736,000, which represents an increase of $936,000, or 16.1%, when compared to the 2006 related period.  Net income for the twelve months ended December 31, 2006 totaled $5,800,000, an increase of $526,000 from the 2005 related period.  Earnings per share were $2.37, $2.02 and $1.81 for the years ended 2007, 2006 and 2005, 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:


 
2007
2006
2005
Return on Assets (net income to average total assets)
1.16%
1.05%
1.04%
Return on Equity (net income to average total equity)
14.38%
13.21%
12.63%
Dividend Payout Ratio (dividends declared divided by net income)
37.86%
42.10%
44.28%
Equity to Asset Ratio (average equity to average total assets, excluding other comprehensive income)
8.10%
7.98%
8.20%

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


13


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.
The following table sets 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 (dollars in thousands):

14


 

     
Analysis of Average Balances and Interest Rates (1)
   
   
2007
   
2006
   
2005
 
 
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
            102
             5
5.10
           4
            0
5.14
        114
           3
2.63
Total short-term investments
            102
             5
5.10
           4
            0
5.14
        114
           3
2.63
Investment securities:
                 
  Taxable
        95,417
       4,702
4.93
    86,198
      3,892
4.52
    83,787
     3,236
3.86
  Tax-exempt (3)
        24,173
       1,451
6.00
    22,952
      1,368
5.96
    14,705
       903
6.14
  Total investment securities
      119,590
       6,153
5.14
  109,150
      5,260
4.82
    98,492
     4,139
4.20
Loans:
                 
  Residential mortgage loans
      211,171
     15,640
7.41
  209,305
    14,842
7.09
  201,265
   13,814
6.86
  Commercial & agricultural loans
      147,921
     11,740
7.94
  134,813
    10,353
7.68
  118,524
     8,434
7.12
  Loans to state & political subdivisions
        45,259
       2,751
6.08
    43,642
      2,604
5.97
    38,766
     2,308
5.95
  Other loans
        12,426
       1,150
9.25
    12,747
      1,141
8.95
    12,592
     1,106
8.78
  Loans, net of discount (2)(3)(4)
      416,777
     31,281
7.51
  400,507
    28,940
7.23
  371,147
   25,662
6.91
Total interest-earning assets
      536,469
     37,439
6.98
  509,661
    34,200
6.71
  469,753
   29,804
6.34
Cash and due from banks
          9,299
   
     9,093
   
     8,764
   
Bank premises and equipment
        12,773
   
    12,415
   
    12,142
   
Other assets
        18,832
   
    18,610
   
    18,714
   
Total non-interest earning assets
        40,904
   
    40,118
   
    39,620
   
Total assets
      577,373
   
  549,779
   
  509,373
   
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Interest-bearing liabilities:
                 
  NOW accounts
        95,098
       2,026
     2.13
    85,481
      1,638
     1.92
    71,257
       665
     0.93
  Savings accounts
        38,443
         137
     0.36
    39,170
        130
     0.33
    39,939
       113
     0.28
  Money market accounts
        50,189
       1,787
     3.56
    45,717
      1,464
     3.20
    49,482
       999
     2.02
  Certificates of deposit
      225,590
       9,413
     4.17
  218,019
      8,453
     3.88
  213,109
     7,596
     3.56
Total interest-bearing deposits
      409,320
     13,363
     3.26
  388,387
    11,685
     3.01
  373,787
     9,373
     2.51
Other borrowed funds
        66,525
       3,559
     5.35
    63,635
      3,268
     5.14
    41,893
     1,627
     3.88
Total interest-bearing liabilities
      475,845
     16,922
     3.56
  452,022
    14,953
     3.31
  415,680
   11,000
     2.65
Demand deposits
        48,981
   
    49,324
   
    46,890
   
Other liabilities
          6,783
   
     4,757
   
     5,033
   
Total non-interest-bearing liabilities
        55,764
    54,081
    51,923
Stockholders' equity
        45,764
   
    43,676
   
    41,770
   
Total liabilities & stockholders' equity
      577,373
   
  549,779
   
  509,373
    
Net interest income
 
     20,517
   
    19,247
   
   18,804
 
Net interest spread (5)
   
3.42%
   
3.40%
   
3.69%
Net interest income as a percentage
                 
  of average interest-earning assets
   
3.82%
   
3.78%
   
4.00%
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.
               
 
 
15


Tax exempt interest 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.  Accordingly, tax equivalent adjustments for investments and loans have been made accordingly to the previous table for the years ended December 31, 2007, 2006 and 2005, respectively:

    
2007
   
2006
   
2005
 
Interest and dividend income
                 
    from investment securities (non-tax adjusted)
  $ 5,626     $ 4,750     $ 3,788  
Tax equivalent adjustment
    532       510       354  
Interest and dividend income
                       
    from investment securities (tax equivalent basis)
  $ 6,158     $ 5,260     $ 4,142  
                         
                         
   
2007
   
2006
   
2005
 
Interest and fees on loans (non-tax adjusted)
  $ 30,398     $ 28,101     $ 24,911  
Tax equivalent adjustment
    883       839       751  
Interest and fees on loans (tax equivalent basis)
  $ 31,281     $ 28,940     $ 25,662  
                         
                         
   
2007
   
2006
   
2005
 
Total interest income
  $ 36,024     $ 32,851     $ 28,699  
Total interest expense
    16,922       14,953       11,000  
Net interest income
    19,102       17,898       17,699  
Total tax equivalent adjustment
    1,415       1,349       1,105  
Net interest income (tax equivalent basis)
  $ 20,517     $ 19,247     $ 18,804  


16


 
The following table shows the tax-equivalent effect of changes in volume and rates on interest income and expense (in thousands):
 
Analysis of Changes in Net Interest Income on a Tax-Equivalent Basis (1)
 

 
 2007 vs. 2006 (1)
 2006 vs. 2005 (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
 $              5
 $              -
 $              5
 $            (5)
 $              2
 $            (3)
Investment securities:
           
  Taxable
              436
             374
             810
              90
             566
            656
  Tax-exempt
               73
               10
               83
            493
              (28)
            465
Total investment securities
              509
             384
             893
            583
             538
         1,121
Loans:
           
  Residential mortgage loans
              133
             665
             798
            658
             370
         1,028
  Commercial & agricultural loans
           1,031
             356
          1,387
          1,376
             543
         1,919
  Loans to state & political subdivisions
               97
               50
             147
            291
                5
            296
  Other loans
              (26)
               35
                9
              14
               21
              35
Total loans, net of discount
           1,235
          1,106
          2,341
          2,339
             939
         3,278
Total Interest Income
           1,749
          1,490
          3,239
          2,917
          1,479
         4,396
Interest Expense:
           
Interest-bearing deposits:
           
  NOW accounts
              195
             193
             388
            100
             873
            973
  Savings accounts
                (3)
               10
                7
               (3)
               20
              17
  Money Market accounts
              150
             173
             323
             (81)
             546
            465
  Certificates of deposit
              301
             659
             960
            170
             687
            857
Total interest-bearing deposits
              643
          1,035
          1,678
            186
          2,126
         2,312
Other borrowed funds
              152
             139
             291
          1,562
               79
         1,641
Total interest expense
              795
          1,174
          1,969
          1,748
          2,205
         3,953
Net interest income
 $           954
 $          316
 $        1,270
 $       1,169
 $         (726)
 $         443

 (1) The portion of total change attributable to both volume and rate changes, which cannot be separated, has been allocated proportionally to the change due to volume and the change due to rate prior to allocation.

2007 vs. 2006
As shown in the preceding tables, tax equivalent net interest income for 2007 was $20,517,000 compared with $19,247,000 for 2006, an increase of $1,270,000 or 6.6%.  The increased volume of interest earning assets of $26.8 million generated an increase in interest income of $1,749,000.  The average rate on interest earning assets increased from 6.71% in 2006 to 6.98% in 2007, which had the effect of increasing interest income by $1,490,000.
 
Total tax equivalent interest income from investment securities increased $893,000 in 2007 from 2006.  Income from taxable investment securities increased $810,000.  The average balance of investment securities increased $10.4 million, which had an effect of increasing interest income by $509,000 due to volume.  The average tax-effected yield on our investment portfolio increased from 4.82% in 2006 to 5.14% in 2007.  This had the effect of increasing interest income by $384,000 due to rate.  The Company’s strategy in 2007 was to increase the size and duration of our investment portfolio, given the opportunity that general market conditions provided, which resulted in an increase in the overall yield on our investments.
 
Loan income increased $2,341,000 in 2007 from 2006.  Our commitment and focus on originating good quality, commercial loans was the primary driver as income from these loans increased $1,387,000 over 2006.  The average balance of commercial loans increased $13.1 million or 9.7%, while at the same time the average rate increased from 7.68% to 7.94%.
 
17

 
Residential mortgage loan income increased $798,000.  The increase due to volume was $133,000, as the average balance increased $1.9 million.  During 2007, overall rates increased on 1 to 4 family residential mortgages due to various economic conditions, including well publicized credit issues facing the banking industry.  Although we were not directly impacted by sub-prime credit concerns facing other institutions, the average rate earned on our residential mortgage loan portfolio increased from 7.09% to 7.41%.  This had the effect of increasing interest income by $665,000.  The Company continues to strive on being the top mortgage lender within our service area by providing competitive products and exemplary service to our customers.
 
Total interest expense increased $1,969,000 in 2007 compared to 2006.  This is attributable to an increase in the average balance of interest bearing liabilities, which increased $23.8 million.  This had the effect of increasing interest expense by $795,000.  The average rate paid on interest bearing liabilities increased from 3.31% to 3.56%.  This is primarily due to increased average balances in state and political deposits which are more sensitive to market changes in interest rates.  The overall increase in the average rate had the effect of increasing interest expense by $1,174,000.
 
During the second half of 2007, the Federal Reserve decreased the federal funds rate 100 basis points.  This had an impact on the rates paid on short term deposits, top tier money market and NOW accounts, and on short term borrowing rates particularly from the Federal Home Loan Bank.  The Company’s liabilities, including borrowings and deposits, are shorter in nature and are more sensitive to short-term changes in interest rates.  Many of the Company’s interest-earning assets are priced, or re-price, along the five year point of the curve, where interest rates have not significantly changed during this same period.  Our ability to decrease rates on short term liabilities faster than the average rate on interest earning assets has resulted in a slight increase in our net interest spread.  Our net interest spread for 2007 was 3.42% compared to 3.40% in 2006.  Should short-term interest rates continue to decrease (the Federal Reserve decreased the federal funds rate 125 basis points in January, 2008) and longer term rates remain steady or increase, the result would be a more normal yield curve.  As such, it is anticipated that the Company’s net interest spread should continue to improve.  Should short-term and/or long-term interest rates move in such a way that results in a flattened or inverted yield curve, we would anticipate pressure on our margin.

2006 vs. 2005
Tax equivalent net interest income increased from $18,804,000 in 2005to $19,247,000 in 2006, which is an increase of $443,000 or 2.4%.  The increased volume of interest-earning assets of $39.9 million generated an increase in interest income of $2,917,000 while increased volume of interest-bearing liabilities of $36.3 million produced an additional $1,748,000 of interest expense. The change in volume resulted in a net increase of $1,169,000in net interest income. The net change in rate was a negative $726,000 resulting in a total positive net change of $443,000 when combined with the change in volume.
 
Total tax equivalent interest income from investment securities increased $1,121,000 in 2006 from 2005.  Income from taxable investment securities increased $656,000.  The average rate earned went from 3.86% to 4.52%, which had the effect of increasing income by $566,000.  Interest income from tax-exempt investment securities increased $465,000 in 2006 primarily due to volume as the average balance increased from $14.7 million in 2005 to $23.0 million in 2006.
 
The amount of increase related to loan volume was $2,339,000 while the increase related to rate was $939,000.  The average balance of loans increased $29.4 million from 2005 to 2006.
 
Interest expense on interest bearing deposits increased $2,312,000.  The amount attributable to the change in average rate was $2,126,000, while the increase due to volume was $186,000.  Interest expense on borrowed funds increased $1,641,000 compared with 2005.  The increase due to volume totaled $1,562,000, while the increase due to rate was $79,000.  The average rate paid on interest-bearing liabilities increased from 2.65% in 2005 to 3.31% in 2006.
 
2006’s net interest income compared to 2005 shows the effects of the Federal Reserve’s increasing short-term interest rates during 2005 and a flattened to inverted yield curvethat persisted for most of the year.  As such, the net interest spread decreased from 3.69% in 2005 to 3.40%. 

Non-interest Income

The following table reflects non-interest income by major category for the periods ended December 31 (dollars in thousands):


18



 
2007
2006
2005
 
Service charges
 $          3,210
 $          3,140
 $          2,965
 
Trust
                520
                487
                474
 
Brokerage and Insurance
                132
                260
                443
 
Gains on loans sold
                134
                  68
                  70
 
Investment securities (losses) gains, net
                 (29)
                    4
                     -
 
Earnings on bank owned life insurance
                331
                304
                294
 
Gains on sales of foreclosed properties
                396
                  80
                  23
 
Other
                391
                373
                419
 
Total
 $          5,085
 $          4,716
 $          4,688
 
         
 
 2007/2006
 2006/2005
 
Change
Change
 
Amount
%
Amount
%
Service charges
 $               70
                 2.2
 $             175
                 5.9
Trust
                  33
                 6.8
                  13
                 2.7
Brokerage and Insurance
               (128)
              (49.2)
               (183)
              (41.3)
Gains on loans sold
                  66
               97.1
                   (2)
                (2.9)
Investment securities (losses) gains, net
                 (33)
                     -
                    4
 -
Earnings on bank owned life insurance
                  27
                 8.9
                  10
                 3.4
Gains on sales of foreclosed properties
                316
             395.0
                  57
             247.8
Other
                  18
                 4.8
                 (46)
              (11.0)
Total
 $             369
                 7.8
 $               28
                 0.6

2007 vs. 2006
Non-interest income increased $369,000 in 2007 from 2006, or 7.8%.  Service charge income increased by $70,000 in 2007 compared to 2006.  ATM and related check card fee income increased $90,000 from last year.  The Company continues to promote efforts to increase usage of debit cards by retail customers.  Additionally, service charge fees charged to customers for non-sufficient funds increased by $15,000.  Offsetting these increases was a $40,000 decrease in statement fees, primarily due to the competitive environment for attracting and retaining commercial deposit customers and increased earnings credits with our account analysis product on commercial deposits.
 
Trust revenues increased by 6.8% to 520,000 during 2007, which reflects our efforts to continue growing trust assets under management. This increase was offset by a decrease in brokerage and insurance revenue of $128,000.  During 2006, the Company changed our broker dealer relationship.  This transition continued to impact revenues into 2007; however, improvement was experienced during the latter half of 2007.  The Company continues to expect the new relationship to increase customer service and increase revenues by enhancing our ability to meet the needs of our customers.
 
Gains on sales of foreclosed properties increased by $316,000 in 2007 compared to 2006 primarily due to a pre-tax gain of $381,000 recognized on a large commercial property that was sold in the second quarter of 2007.
 
Gains on loans sold increased by $66,000 due to the increased volume of Freddie Mac and Fannie Mae loans sold on the secondary market.  Investment securities losses of $29,000 were realized this year due to restructuring the investment portfolio in order to improve future yields.

2006 vs. 2005
Non-interest income increased $28,000 in 2006 compared with 2005, or .6%.  Service charge income increased by $175,000 in 2006 compared to 2005.  Service charge fees charged to customers for non-sufficient funds increased by $134,000.  The opening of over 3,000 new checking accounts contributed to this increase.  ATM and check card related fee income also increased by $67,000 due to increased retail customers’ usage of their debit cards.  Offsetting these was a $34,000 decrease in statement fees.
 
Trust revenues increased $13,000 from 2005 while brokerage and insurance revenues decreased $183,000.  This decrease was primarily due to the Company’s decision to change our broker dealer relationship as well as several large annuity transactions recognized in 2005. 
 
 
19

 
Non-interest Expenses

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

 
2007
2006
2005
 
Salaries and employee benefits
 $         8,386
 $         8,026
 $         7,645
 
Occupancy
            1,151
            1,123
            1,142
 
Furniture and equipment
               539
               593
               658
 
Professional fees
               645
               551
               536
 
Amortization of intangibles
               144
               252
               578
 
Other
            4,449
            4,482
            4,828
 
Total
 $       15,314
 $       15,027
 $       15,387
 
         
 
 2007/2006
 2006/2005
 
Change
Change
 
Amount
%
Amount
%
Salaries and employee benefits
 $            360
                4.5
 $            381
                5.0
Occupancy
                 28
                2.5
               (19)
              (1.7)
Furniture and equipment
               (54)
              (9.1)
               (65)
              (9.9)
Professional fees
                 94
              17.1
                 15
                2.8
Amortization of intangibles
             (108)
            (42.9)
             (326)
            (56.4)
Other
               (33)
              (0.7)
             (346)
              (7.2)
Total
 $            287
                1.9
 $          (360)
              (2.3)


 
2007
2006
2005
 
Other professional fees
 $           367
 $           296
 $           286
 
Legal fees
              111
              115
              116
 
Examinations and audits
              167
              140
              134
 
Total
 $           645
 $           551
 $           536
 
         
 
 2007/2006
 2006/2005
 
Change
Change
 
Amount
%
Amount
%
Other professional fees
 $             71
             24.0
 $             10
               3.5
Legal fees
                 (4)
              (3.5)
                 (1)
              (0.9)
Examinations and audits
                27
             19.3
                  6
               4.5
Total
 $             94
             17.1
 $             15
               2.8

2007 vs. 2006
Non-interest expenses for 2007 totaled $15,314,000 which represents and increase of $287,000, or 1.9%, compared with 2006 costs of $15,027,000.  Much of the increase is attributable to salary and benefit costs increasing $360,000. Base salaries increased $111,000, or 1.8%, primarily due to merit increases.  The year to date full time equivalent staffing was 170 for 2007 compared to 172 for 2006.  Incentive costs for employees increased by $236,000 due primarily to the attainment of certain corporate goals and objectives.
 
Professional fees increased by $94,000 due to various consulting arrangements including an evaluation of our employee pension and incentive plans as well as increased internal control testing requirements related to Sarbanes-Oxley regulations.
 
We experienced decreases in furniture and equipment expenses and amortization of intangibles.  Amortization expense decreased $108,000 due to a core deposit intangible from a previous acquisition that became fully amortized in March 2006.  Furniture and equipment expense decreased by $54,000 mainly due to depreciation expense from assets becoming fully depreciated.  Also, during the second quarter of 2007 we recorded a $100,000 write-down of one of our bank properties.

20

 
2006 vs. 2005
Non-interest expenses decreased $360,000, or 2.3% over 2005.  Amortization expense decreased by $326,000 in 2006 compared to 2005 due to the core deposit intangible related to a past acquisition in 2000 becoming fully amortized in March 2006.
 
Furniture and equipment expense decreased by $65,000 compared to 2005 mainly due to depreciation expense from assets becoming fully depreciated.  Other expenses decreased $346,000 in 2006.  Of this decrease, $240,000 was attributable to a decrease in merger and acquisition costs related to the Fulton acquisition in 2005 (see Footnote 18 to the consolidated financial statements for additional information).
 
Offsetting these decreases, salary and benefit costs increased $381,000.  Base salaries increased $90,000, or 1.5%, primarily due to merit increases.  Full time equivalent staffing was 172, unchanged from 2005.  Employee health insurance costs increased $86,000 while pension expenses increased $72,000.  Incentive costs increased $128,000 compared with 2005.
 
Additionally, operating expenses related to our de novo office in Wellsville, New York added significant costs during 2006.  This includes approximately $259,000 of expenses related to personnel, furniture and equipment, occupancy and other expenses.

Provision For Income Taxes
The provision for income taxes was $1,772,000 during 2007, $1,457,000 during 2006 and $1,666,000 for the 2005 related periods.   The effective tax rates for 2007, 2006 and 2005 were 20.8%, 20.1% and 24.1%, respectively.
 
Income before the provision for income taxes increased by $1,251,000 in 2007 compared to 2006.  Due to the level of income, the provision for income taxes has increased by $315,000 when compared to 2006.  We have successfully maintained our effective tax rate of 20.8% by remaining invested in tax-exempt municipal loans and bonds.  Management will continue to monitor our effective tax rate as net income increases.
 
Despite an increase in income, the provision for income taxes for 2006 decreased by $209,000 due to the aforementioned increase in tax-free income attained by municipal loans and bonds.  By increasing our tax-exempt income, we were able to reduce our effective tax rate for 2006 and 2007, as compared to 2005.
 
We are also involved in three limited partnership agreements that established low-income housing projects in our market area.  For tax purposes, we have recognized $662,000 out of a total $913,000 in tax credits from one project and $231,000 out of a total $385,000 in tax credits on the second project.  In 2005, we entered into a third limited partnership for a low-income housing project for senior citizens in our Sayre market area, which was completed at the end of 2006. Beginning in 2007, we have recognized $57,000 out of a total of $574,000 tax credits. $922,000 tax credits remain and will be taken over the next nine years.    

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

 
 2007
 
 %
 2006
 
 %
 2005
 
 Balance
 Increase
 Change
 Balance
 Increase
 Change
 Balance
 Total assets
 $        591.0
 $           18.8
             3.3
 $      572.2
 $           43.0
             8.1
 $      529.2
 Total loans, net
           419.2
                8.3
             2.0
         410.9
              31.8
             8.4
         379.1
 Total investments
           120.8
              11.1
           10.1
         109.7
                7.1
             6.9
         102.6
 Total deposits
           456.0
                9.5
             2.1
         446.5
              16.7
             3.9
         429.8
 Total stockholders' equity
             48.5
                5.0
           11.5
           43.5
                1.9
             4.6
           41.6


Cash and Cash Equivalents
Cash and cash equivalents totaled $10.4 million at December 31, 2007 compared with $10.0 million at December 31, 2006.  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, brokered certificates of deposit 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.

21

 
Investments

2007
The Company’s investment portfolio has increased by $11,059,000, or 10.1% during the past year.  During 2007, we purchased approximately $21.2 million of mortgage-backed securities, $12.4 million of U.S. agency obligations, and $8.4 million of municipal bonds.  Offsetting the purchases were $18.9 million in sales, $11.2 million of principal repayments and $2.2 million in maturities that occurred during 2007.  We increased the balance in our investment portfolio during 2007 primarily due to market opportunities related to fluctuations in the Treasury curve and the resulting impact on bond yields.  In doing so, the effective yield on our portfolio for 2007 improved to 5.14% compared to 4.82% a year ago on a tax equivalent basis.  The market value of our investment portfolio has increased approximately $1.4 million in 2007.

2006
During 2006, our investment portfolio increased by $7.1 million, or 6.9%. The increase was primarily attributable to an increase in US Agency securities and mortgage-backed securities of $3.9 million and $4.0 million, respectively.  This was offset by a decrease of $.6 million in corporate bonds.  During 2006, we had maturities of $7.9 million and principal repayments of our mortgage-backed securities of $10.8 million.  In an effort to improve the overall yield of the portfolio, we also sold $10.4 million of our securities and reinvested at higher current market yields.  Included was the sale of 15,800 shares of Freddie Mac Preferred stock in order to utilize capital gains recognized in prior tax years.  Our investment portfolio yielded 4.82% in 2006 compared to 4.20% in 2005, on a tax-equivalent basis.
 
The following table shows the year-end composition of the investment portfolio for the five years ended December 31 (dollars in thousands):

 
2007
% of
2006
% of
2005
% of
2004
% of
2003
% of
 
Amount
Total
Amount
Total
Amount
Total
Amount
Total
Amount
Total
Available-for-sale:
                 
  U. S. Agency securities
 $      17,236
      14.3
 $   16,651
    15.2
 $   12,754
    12.5
 $     5,812
      6.1
 $     1,033
      1.0
  Obligations of state & political
                   
     subdivisions
         30,844
      25.4
      22,562
    20.5
      22,612
    22.0
        7,452
      7.8
        8,303
      7.8
  Corporate obligations
           7,813
        6.5
        7,997
      7.3
        8,627
      8.4
        8,935
      9.3
      14,674
    13.8
  Mortgage-backed securities
         62,642
      51.9
      59,875
    54.6
      55,852
    54.4
      70,449
    73.6
      78,376
    73.5
  Equity securities
           2,267
        1.9
        2,658
      2.4
        2,757
      2.7
        3,099
      3.2
        4,201
      3.9
Total
 $    120,802
    100.0
 $ 109,743
  100.0
 $ 102,602
  100.0
 $   95,747
  100.0
 $ 106,587
  100.0

The expected principal repayments (amortized cost) and average weighted yields for the investment portfolio as of December 31, 2007, are shown below (dollars in thousands). Expected principal repayments, which include prepayment speed assumptions for mortgage-backed 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.

 
22


     
After One Year
After Five Years
       
 
One Year or Less
to Five years
to Ten Years
After Ten Years
Total
 
Amortized
Yield
Amortized
Yield
Amortized
Yield
Amortized
Yield
Amortized
Yield
 
Cost
%
Cost
%
Cost
%
Cost
%
Cost
%
Available-for-sale securities:
                   
  U.S. Agency securities
 $       1,000
     4.8
 $      12,237
     5.5
 $        3,389
     5.4
 $             -
        -
 $      16,626
     5.4
  Obligations of state & political
                   
    subdivisions
          5,355
     5.9
         11,657
     5.9
         13,631
     6.4
                -
        -
         30,643
     6.1
  Corporate obligations
                -
        -
                 -
        -
          7,983
     5.5
                -
        -
          7,983
     5.5
  Mortgage-backed securities
            369
     5.3
         38,534
     4.7
         23,494
     5.6
                -
        -
         62,397
     5.0
Total available-for-sale
 $       6,724
     5.7
 $      62,428
     5.1
 $      48,497
     5.8
 $             -
        -
 $    117,649
     5.4

 Approximately 59% of the amortized cost of debt securities is expected to mature, call or pre-pay 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 and other third party banks will be sufficient to meet future liquidity needs.  There are no securities from a single issuer representing more than 10% of stockholders’ equity.

Loans
Historically, our 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.
 
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 85% 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 85% of the current appraised value. The maximum term for mortgage loans is 30 years for one-to-four family residential property and 20 years for commercial and vacation property.

2007
As evidenced in the table below, total loans grew $8.6 million, or 2.1% in 2007 from a balance of $414.8 million at the end of 2006 to $423.4 million at the end of 2007.  Total loan growth of 2.1% in 2007 compared with an 8.4% loan growth rate in 2006.  Even though the local economy remained relatively stable in 2007, with the local average unemployment rate remaining stable with last year at approximately 5.9%, we experienced a decrease in overall loan demand.  The national crisis related to the sub prime loan market that impacted various banks during 2007 did not have a direct impact on our Company’s loan portfolio.  However, the indirect impact on the national economy and various other economic factors did contribute to slower loan demand during 2007.
 
Commercial real estate loans increased $6.3 million in 2007 or 6.6% while construction real estate loans increased $4.3 million, or 61.2%.  While not compromising credit quality, we are cautiously optimistic that our strong team of seasoned business development officers will enable the Company to grow our high quality, commercial loan portfolio and achieve improved organic loan growth.  However, loan demand and organic growth is subject to significant competitive pressures, the yield curve and the strength of the overall local, regional and national economy.
 
Residential real estate loans decreased $4.2 million primarily due to the lack of loan demand in the residential real estate market.  Mortgage lending continues to be one of our primary focuses, as residential real estate loans totaled $201.9 million and comprised 47.7% of the loan portfolio as of the end of the year.  One of our primary goals is to continue being the premier mortgage lender in our market area, with a variety of mortgage products available for our customers.  In 2007, $6.7 million in conforming mortgage loans were originated and sold in the secondary market through Freddie Mac and Fannie Mae, providing nearly $83,000 of income in origination fees and premiums on loans sold.
 
23

 
2006
Total loans grew $32.0 million, or 8.4% in 2006 from a balance of $382.8 million at the end of 2005 to $414.8 million at the end of 2006.  The primary increases were in residential real estate, commercial real estate, agricultural real estate, and other commercial loans which increased $10.4, $12.0, $4.1, and $3.5 million, respectively.  The loan growth in 2006 of 8.4% compares to the 6.4% loan growth in 2005.
   
Residential real estate loans increased $10.4 million primarily due to the continued, favorable interest rate environment for home mortgages from a historical perspective that existed during 2006.  Due to the prolonged flat yield curve, long-term rates including mortgages and home equity loans, remained relatively flat despite the sharp increase in short-term interest rates.  Residential real estate loans totaled $206.1 million and comprised 49.7% of the loan portfolio as of the end of the year.  In 2006, $3.3 million in conforming mortgage loans were originated and sold in the secondary market through Freddie Mac and Fannie Mae, providing nearly $44,000 of income in origination fees and premiums on loans sold.
 
Commercial loans increased $12.0 million in 2006.  As started in 2005, the Company began to expand its portfolio of agricultural loans, as $4.1 million of agricultural loans were added in 2006.  This represents a 31.3 % increase and is reflective of our goal to better serve agricultural customers within our service area.  Other commercial loans also increased $3.5 million, or 12.0% in 2006.    

 
Five Year Breakdown of Loans by Type as of December 31,
 

 
2007
2006
2005
2004
2003
(dollars in thousands)
Amount
%
Amount
%
Amount
%
Amount
%
Amount
%
Real estate:
               
  Residential
 $   201,861
    47.7
 $  206,059
    49.7
 $  195,628
    51.1
 $  189,803
    52.8
 $  180,333
    56.8
  Commercial
      100,380
    23.7
       94,122
    22.7
       82,128
    21.5
       75,228
    20.9
       57,370
    18.1
  Agricultural
        16,891
      4.0
       17,054
      4.1
       12,991
      3.4
       11,564
      3.2
         7,594
      2.4
  Construction
        11,330
      2.7
         7,027
      1.7
         7,245
      1.9
         7,282
      2.0
         5,784
      1.8
Loans to individuals
                   
  for household,
                   
  family and other purchases
        13,082
      3.1
       12,482
      3.0
       13,017
      3.4
       12,657
      3.5
       13,145
      4.1
Commercial and other loans
        34,664
      8.2
       32,766
      7.9
       29,260
      7.6
       28,069
      7.8
       16,219
      5.1
State & political subdivision loans
        45,171
    10.6
       45,263
    10.9
       42,534
    11.1
       35,090
      9.8
       37,212
    11.7
Total loans
      423,379
  100.0
     414,773
  100.0
     382,803
  100.0
     359,693
  100.0
     317,657
  100.0
Less allowance for loan losses
          4,197
 
         3,876
 
         3,664
 
         3,919
 
         3,620
 
Net loans
 $   419,182
 
 $  410,897
 
 $  379,139
 
 $  355,774
 
 $  314,037
 
                     
 
   2007/2006  2006/2005
   Change  Change
   Amount   %  Amount  %
 Real estate:        
   Residential  $    (4,198) (2.0)  $    10,431  5.3
   Commerical        6,258  6.6       11,994  14.6
   Agricultural           (163)  (1.0)         4,063  31.3
   Construction               4,303  61.2            (218)  (3.0)
 Loans to individuals for household,        
   family and other purchases                 600  4.8           (535)  (4.1)
 Commercial and other loans     1,898  5.8        3,506  12.0
 State & political subdivision loans                  (92)
 (0.2)
       2,729  6.4
 Total loans  $      8,606  2.1  $          31,970  8.4

 
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, 2007, classified according to the sensitivity to changes in interest rates
 
24

 
within various time intervals (in thousands).  The table does not include any estimate of prepayments which significantly shorten the average life of all loans and may cause our actual repayment experience to differ from that shown below.  Demand loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less.  The amounts shown below exclude net deferred loan costs or fees.

 
Commercial,
   
 
municipal,
Real estate
 
 
agricultural
construction
Total
Maturity of loans:
     
  One year or less
 $           10,696
 $                    -
 $           10,696
  Over one year through five years
              27,139
                       -
              27,139
  Over five years
            159,271
              11,330
            170,601
Total
 $         197,106
 $           11,330
 $         208,436
Sensitivity of loans to changes in interest
     
   rates - loans due after December 31, 2008:
     
  Predetermined interest rate
 $           41,056
 $             1,846
 $           42,902
  Floating or adjustable interest rate
            145,354
                9,484
            154,838
Total
 $         186,410
 $           11,330
 $         197,740

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 ended December 31 (dollars in thousands).  We did not have any troubled debt restructurings at the dates presented.

 
2007
2006
2005
2004
2003
Non-performing loans:
     
  Non-accruing loans, exclusive of impaired loans
 $          827
 $          478
 $          867
 $          722
 $          578
  Impaired loans
          1,088
          1,190
          1,031
          1,061
          1,926
  Accrual loans - 90 days or
         
    more past due
             275
          1,690
             337
             437
             185
Total non-performing loans
          2,190
          3,358
          2,235
          2,220
          2,689
Foreclosed assets held for sale
             203
             758
             619
             712
             305
Total non-performing assets
 $       2,393
 $       4,116
 $       2,854
 $       2,932
 $       2,994
Non-performing loans as a percent of loans
         
   net of unearned income
0.52%
0.81%
0.58%
0.62%
0.85%
Non-performing assets as a percent of loans
         
  net of unearned income
0.57%
0.99%
0.75%
0.82%
0.94%

 The following table presents an analysis of the allowance for loan losses for the five years ending December 31 (dollars in thousands):

25

 
Summary of Loan Loss Experience
 

 
2007
2006
2005
2004
2003
Balance
     
  at beginning of period
 $          3,876
 $          3,664
 $          3,919
 $          3,620
 $          3,621
Charge-offs:
         
  Real estate-mortgage
                  70
                  37
                  43
                110
                  68
  Loans to individuals for household,
         
    family and other purchases
                111
                118
                168
                  70
                140
  Commercial and other loans
                    5
                135
                161
                135
                344
Total loans charged-off
                186
                290
                372
                315
                552
Recoveries:
         
  Real estate-mortgage
                  81
                    6
                    2
                     -
                  33
  Loans to individuals for household,
         
    family and other purchases
                  57
                  44
                  12
                  25
                  63
  Commercial and other loans
                    4
                122
                  43
                299
                  20
Total loans recovered
                142
                172
                  57
                324
                116
           
Net loans charged-off (recovered)
                  44
                118
                315
                   (9)
                436
Provision charged to expense
                365
                330
                  60
                     -
                435
Increase related to acquisition
                     -
                     -
                     -
                290
                     -
Balance at end of year
 $          4,197
 $          3,876
 $          3,664
 $          3,919
 $          3,620
           
Loans outstanding at end of year
 $      423,379
 $      414,773
 $      382,803
 $      359,693
 $      317,657
Average loans outstanding, net
 $      411,927
 $      400,507
 $      371,147
 $      338,836
 $      306,776
Net charge-offs to average loans
0.01%
0.03%
0.08%
0.00%
0.14%
Year-end allowance to total loans
0.99%
0.93%
0.96%
1.09%
1.14%
Year-end allowance to total
         
    non-performing loans
191.64%
115.43%
163.94%
176.53%
134.62%

As detailed in the preceding table, total non-performing loans returned to normal levels in all categories during 2007.   The decrease in accrual loans – 90 days or more past due from 2006 to 2007 is primarily due to a temporary delay in payment from one large commercial loan customer totaling $1.1 million in 2006.  Early in 2007 the loan became current as expected.
 
The percent of non-performing loans to total loans decreased from .81% to .52% as of the end of December, 2007.  Foreclosed assets held for sale decreased by $555,000 mainly due to the sale of a large commercial property.  Total loans charged-off in 2007 totaled $186,000, a decrease of $104,000 compared to last year.  Total loans recovered were $142,000, resulting in a net charge-off for the year of $44,000 compared to $118,000 in 2006.  $365,000 was charged to the provision in 2007 compared to $330,000 in 2006.  During 2006, there were $290,000 of loans charged-off while $172,000 of loans were recovered, resulting in a net charge-off of $118,000.
 
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.
 
Allowance For Loan Losses
The allowance is maintained at a level, which in management’s judgment is adequate to absorb probable 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 appropriately measure the risks within the portfolio.  These categories are loans classified on the Watch List, residential mortgages, commercial loans and consumer loans.
 
 
26

 
Historical loss factors are calculated for consumer, residential mortgage, and commercial loans for the past seven years.  The five year average historical loss factor for each category is applied to the performing portion of the loan category.  For Watch List loans, the losses are calculated using regulatory guidelines and are based on historical losses.  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 changes 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.
 
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.

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

 
2007
2006
2005
2004
2003
 
Amount
%
Amount
%
Amount
%
Amount
%
Amount
%
Real estate loans:
                 
  Residential
 $         599
      47.7
 $       614
      49.7
 $       493
      51.1
 $       392
      52.8
 $       368
      56.8
  Commercial, agricultural
         2,128
      27.7
       1,676
      26.8
       1,551
      24.9
       1,591
      24.1
       1,742
      20.5
  Construction
                -
        2.7
              -
        1.7
              -
        1.9
              -
        2.0
              -
        1.8
Loans to individuals
                   
   for household,
                   
   family and other purchases
            424
        3.1
          734
        3.0
          542
        3.4
          463
        3.5
          492
        4.1
Commercial and other loans
            736
        8.2
          582
        7.9
          484
        7.6
          515
        7.8
          445
        5.1
State & political subdivision loans
              22
      10.6
            22
      10.9
            21
      11.1
            18
        9.8
            15
      11.7
Unallocated
            288
 N/A
          248
 N/A
          573
 N/A
          940
 N/A
          558
 N/A
Total allowance for loan losses
 $      4,197
    100.0
 $    3,876
    100.0
 $    3,664
    100.0
 $    3,919
    100.0
 $    3,620
    100.0


Bank Owned Life Insurance
In 2003 the Company purchased $7.0 million of bank owned life insurance to offset future employee benefit costs.  The Bank is the sole beneficiary on the policies, and will provide the Bank with an asset that will generate earnings to partially offset the current costs of benefits, and eventually (at the death of the insured’s) provide partial recovery of cash outflows associated with the benefits.  As of December 31, 2007 and 2006, the cash surrender value of the life insurance was $8.4 and $8.0 million, respectively.  The change in cash surrender value is recognized in the results of operations.  The amounts recorded as non-interest income totaled $331,000, $304,000 and $294,000 in 2007, 2006 and 2005, respectively.  
 
27

 
The Company evaluates annually the risks associated with the life insurance policies, including limits on the amount of coverage and an evaluation of the various carriers’ credit ratings.
 
Deposits
 
2007
As can be seen in the tables below, total deposits increased $9.5 million in 2007, or 2.1%.  Non-interest bearing deposits increased $2.4 million, or 5.0%.  As a percent to total, non-interest bearing deposits totaled 11.2% as of the end of 2007, which compares to 10.9% at the end of 2006.  In order to manage our overall cost of funds, the Company continues to focus on adding low cost deposits by having a free checking product available for retail customers and being one of the few banks within our market to pay interest on a senior checking product.  Additionally, our business development officers and branch personnel are focused on providing outstanding customer service and developing larger deposit relationships with our commercial customers.
 
NOW accounts increased by $13.8 million, or 16.0% since the end of 2006.  Most of the increase in NOW accounts is due to state and local governmental agencies.  Similarly, money market deposit accounts also increased by $5.3 million in 2007, an increase of 11.6%, due to state and local governmental agencies.
 
Certificates of deposit decreased $12.4 million, or 5.4% from 2006 primarily due to the maturity of $10.3 million of brokered certificates of deposit as of December 31, 2007.  As the Federal Reserve decreased short-term interest rates during the latter half of 2007, alternative funding mostly from the Federal Home Loan Bank resulted in less expensive borrowing costs.

2006
Total deposits increased $16.7 million in 2006, or 3.9%.  Non-interest bearing deposits decreased $2.1 million.  As a percent to total, non-interest bearing deposits totaled 10.9% as of the end of 2006, which compared to 11.8% at the end of 2005.  NOW accounts increased by $12.5 million, or 17.0% since the end of 2005.  Most of the increase in NOW accounts was due to local governmental agencies moving their accounts from money market accounts to NOW accounts.  As a consequence, money market deposit accounts decreased by $6.6 million in 2006, a decrease of 12.5%.
 
Certificates of deposit increased $13.5 million, or 6.3% from 2005 primarily due to $13.9 million of brokered certificates of deposit as of December 31, 2006.  Due to the flattened yield curve that prevailed during 2006, the maturities of brokered deposits were kept between six and eighteen months.
 
The following table shows the breakdown of deposits by deposit type (dollars in thousands):

 
2007
2006
2005
 
Amount
%
Amount
%
Amount
%
Non-interest-bearing deposits
 $       50,944
     11.2
 $       48,509
     10.9
 $       50,600
     11.8
NOW accounts
          99,862
     21.9
          86,067
     19.3
          73,548
     17.1
Savings deposits
          37,996
       8.3
          37,637
       8.4
          38,303
       8.9
Money market deposit accounts
          51,398
     11.3
          46,066
     10.3
          52,632
     12.2
Certificates of deposit
        215,828
     47.3
        228,236
     51.1
        214,716
     50.0
Total
 $     456,028
   100.0
 $     446,515
   100.0
 $     429,799
   100.0
             
 
 2007/2006
 2006/2005
   
 
Change
Change
   
 
Amount
%
Amount
%
   
Non-interest-bearing deposits
 $