firstqtr2010.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q


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

For the quarterly period ended March 31, 2010
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 0-13222

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

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes _____ No_____

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or 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.

Large accelerated filer ____                                                                                                   Accelerated filer ____

Non-accelerated filer ____                                                                                                   Smaller reporting company __X__
(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 Exchange Act).  Yes____ No __X__

The number of outstanding shares of the Registrant’s Common Stock, as of May 5, 2010, was 2,875,722.

 
 

 

 
 
Citizens Financial Services, Inc.
Form 10-Q

INDEX
 
 
   
PAGE
Part I
FINANCIAL INFORMATION
 
Item 1.
Financial Statements (unaudited):
 
 
Consolidated Balance Sheet as of March 31, 2010 and December 31, 2009
1
 
Consolidated Statement of Income for the Three Months Ended March 31, 2010 and 2009
2
 
Consolidated Statement of Comprehensive Income for the Three Months Ended March 31, 2010 and 2009
3
 
Consolidated Statement of Cash Flows for the Three Months Ended March 31, 2010 and 2009
4
 
Notes to Consolidated Financial Statements
5-14
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
15-34
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
34
Item 4T.
Controls and Procedures
34
     
Part II
OTHER INFORMATION
 
Item 1.
Legal Proceedings
35
Item 1A.
Risk Factors
35
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
35
Item 3.
Defaults upon Senior Securities
35
Item 4.
[Removed and Reserved]
36
Item 5.
Other Information
36
Item 6.
Exhibits
36
 
Signatures
37

 
 

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED BALANCE SHEET
   
(UNAUDITED)
   
     
 
March 31,
December 31,
(in thousands except share data)
2010
2009
ASSETS:
   
Cash and due from banks:
   
  Noninterest-bearing
 $              9,190
 $            9,505
  Interest-bearing
               15,322
             21,944
Total cash and cash equivalents
               24,512
            31,449
     
Available-for-sale securities
            216,969
          198,582
 
   
Loans (net of allowance for loan losses:
   
  2010, $5,151 and 2009, $4,888)
            459,495
          451,496
 
   
Premises and equipment
               12,450
            12,227
Accrued interest receivable
                 3,538
              3,141
Goodwill
               10,256
            10,256
Bank owned life insurance
               12,791
            12,667
Other assets
                 9,842
              9,659
 
 
 
TOTAL ASSETS
 $         749,853
 $       729,477
 
 
 
LIABILITIES:
   
Deposits:
   
  Noninterest-bearing
 $           60,993
 $         60,061
  Interest-bearing
            563,404
          545,498
Total deposits
            624,397
          605,559
Borrowed funds
               53,429
            54,115
Accrued interest payable
                 1,827
              2,037
Other liabilities
                 6,461
              6,239
TOTAL LIABILITIES
            686,114
          667,950
STOCKHOLDERS' EQUITY:
   
Common stock
   
  $1.00 par value; authorized 10,000,000 shares;
   
  issued 3,076,253 shares at March 31, 2010 and December 31, 2009, respectively
                 3,076
              3,076
Additional paid-in capital
               13,527
            13,457
Retained earnings
               49,381
            47,353
Accumulated other comprehensive income
                 2,205
              2,041
Treasury stock, at cost:  206,421 shares at March 31, 2010
   
  and 204,437 shares at December 31, 2009
               (4,450)
             (4,400)
TOTAL STOCKHOLDERS' EQUITY
               63,739
            61,527
TOTAL LIABILITIES AND
   
   STOCKHOLDERS' EQUITY
 $         749,853
 $       729,477
     
The accompanying notes are an integral part of these unaudited consolidated financial statements.
 


1





CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED STATEMENT OF INCOME
   
(UNAUDITED)
   
 
Three Months Ended
 
March 31,
(in thousands, except per share data)
2010
2009
INTEREST INCOME:
   
Interest and fees on loans
 $     7,734
 $      7,477
Interest-bearing deposits with banks
              14
                 2
Investment securities:
   
    Taxable
        1,335
         1,640
    Nontaxable
            641
             471
    Dividends
                6
                 7
TOTAL INTEREST INCOME
        9,730
         9,597
INTEREST EXPENSE:
   
Deposits
        2,542
         2,915
Borrowed funds
            441
             523
TOTAL INTEREST EXPENSE
        2,983
         3,438
NET INTEREST INCOME
        6,747
         6,159
Provision for loan losses
            305
             150
NET INTEREST INCOME AFTER
   
    PROVISION FOR LOAN LOSSES
        6,442
         6,009
NON-INTEREST INCOME:
   
Service charges
            853
             812
Trust
            146
             163
Brokerage and insurance
              82
             100
Investment securities gains, net
              64
               16
Earnings on bank owned life insurance
            124
             121
Other
            121
             142
TOTAL NON-INTEREST INCOME
        1,390
         1,354
NON-INTEREST EXPENSES:
   
Salaries and employee benefits
        2,441
         2,296
Occupancy
            306
             321
Furniture and equipment
            106
             110
Professional fees
            180
             131
Federal deposit insurance
            237
             375
Other
        1,058
         1,139
TOTAL NON-INTEREST EXPENSES
        4,328
         4,372
Income before provision for income taxes
        3,504
         2,991
Provision for income taxes
            758
             645
NET INCOME
 $     2,746
 $      2,346
 
   
Earnings Per Share
 $       0.96
 $        0.82
Cash Dividends Paid
 $       0.25
 $        0.24
     
Weighted average number of shares outstanding
  2,870,481
  2,872,476
     
The accompanying notes are an integral part of these unaudited consolidated financial statements.



 
2

 

CITIZENS FINANCIAL SERVICES, INC.
           
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
           
(UNAUDITED)
           
 
            Three Months Ended
 
            March 31
(in thousands)
 
2010
 
2009
   
Net income
 
 $   2,746
 
 $    2,346
   
Other comprehensive income:
           
      Unrealized gains on available for sale securities
          409
 
          270
     
      Change in unrealized loss on interest rate swap
          (97)
 
            14
     
       Less:  Reclassification adjustment for gains included in net income
          (64)
 
           (16)
     
Other comprehensive income, before tax
 
          248
 
         268
   
Income tax expense related to other comprehensive income
 
            84
 
            91
   
Other comprehensive income, net of tax
 
          164
 
          177
   
Comprehensive income
 
 $   2,910
 
 $    2,523
   
             
The accompanying notes are an integral part of these unaudited consolidated financial statements.
       




 
3

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED STATEMENT OF CASH FLOWS
   
(UNAUDITED)
Three Months Ended
 
March 31,
(in thousands)
2010
2009
CASH FLOWS FROM OPERATING ACTIVITIES:
   
  Net income
 $        2,746
 $         2,346
  Adjustments to reconcile net income to net
   
   cash provided by operating activities:
   
    Provision for loan losses
               305
                150
    Depreciation and amortization
               103
                163
    Amortization and accretion of investment securities
               171
                  21
    Deferred income taxes
               (33)
                 (9)
    Investment securities gains, net
               (64)
                (16)
    Earnings on bank owned life insurance
             (124)
              (121)
    Realized gains on loans sold
               (13)
                (48)
    Stock award compensation expense
                 65
                  16
    Originations of loans held for sale
             (744)
           (3,829)
    Proceeds from sales of loans held for sale
               757
            3,877
    (Gain) loss on sale of foreclosed assets held for sale
                 (2)
                  15
    Increase in accrued interest receivable
             (397)
              (433)
    Decrease in accrued interest payable
             (210)
              (206)
    Other, net
               (24)
                670
      Net cash provided by operating activities
            2,536
            2,596
     
CASH FLOWS FROM INVESTING ACTIVITIES:
   
  Available-for-sale securities:
   
    Proceeds from sales of available-for-sale securities
            5,855
            2,178
    Proceeds from maturity and principal repayments of securities
         10,052
          10,796
    Purchase of securities
       (34,056)
         (12,398)
  Purchase of regulatory stock
                    -
                (61)
  Net increase in loans
         (8,582)
           (4,902)
  Purchase of premises and equipment
             (384)
              (433)
  Proceeds from sale of premises and equipment
                    -
            1,405
  Proceeds from sale of foreclosed assets held for sale
               253
                  75
      Net cash used in investing activities
       (26,862)
           (3,340)
     
CASH FLOWS FROM FINANCING ACTIVITIES:
   
  Net increase in deposits
         18,838
            7,896
  Proceeds from long-term borrowings
            1,155
            1,185
  Repayments of long-term borrowings
         (2,110)
           (7,028)
  Net increase in short-term borrowed funds
               269
            1,403
  Purchase of treasury stock
               (45)
              (187)
  Dividends paid
             (718)
              (683)
      Net cash provided by financing activities
         17,389
            2,586
     
          Net (decrease) increase in cash and cash equivalents
         (6,937)
            1,842
     
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
         31,449
          19,856
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 $      24,512
 $       21,698
     
Supplemental Disclosures of Cash Flow Information:
   
    Interest paid
 $        3,193
 $         3,534
     
    Income taxes paid
 $            100
 $               50
     
    Loans transferred to foreclosed property
 $            350
 $             147
   
 
The accompanying notes are an integral part of these unaudited consolidated financial statements.
 

4

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


Note 1 - Basis of Presentation
 
Citizens Financial Services, Inc., (individually and collectively with its direct and indirect subsidiaries, the “Company”) is a Pennsylvania corporation organized as the holding company of its wholly owned subsidiary, First Citizens National Bank (the “Bank”), and the Bank’s subsidiary, First Citizens Insurance Agency, Inc. (“First Citizens Insurance”).
 
The accompanying consolidated financial statements have been prepared pursuant to rules and regulations of the Securities and Exchange Commission (“SEC”) and in conformity with U.S. generally accepted accounting principles.  Because this report is based on an interim period, certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted.  Certain of the prior year amounts have been reclassified to conform with the current year presentation.  Such reclassifications had no effect on net income or stockholders’ equity.  All material inter-company balances and transactions have been eliminated in consolidation.
 
In the opinion of management of the Company, the accompanying interim financial statements for the quarters ended March 31, 2010 and 2009 include all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the financial condition and the results of operations for the period.  In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. The financial performance reported for the Company for the three-month period ended March 31, 2010 is not necessarily indicative of the results to be expected for the full year.  This information should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.
 

Note 2 - Earnings per Share
 
The following table sets forth the computation of earnings per share. Earnings per share calculations give retroactive effect to stock dividends declared by the Company. The Company has no dilutive securities.
 
 
 
Three months ended
 
March 31,
 
2010
2009
 
   
Net income applicable to common stock
$2,746,000
$2,346,000
Weighted average common shares outstanding
2,870,481
2,872,476
     
Earnings per share
$0.96
$0.82
 
 
Note 3 - Income Tax Expense
 
Income tax expense is less than the amount calculated using the statutory tax rate, primarily as a result of tax-exempt income earned from state and municipal securities and loans and investments in tax credits.

 
Note 4 – Investments
 
The amortized cost and fair value of investment securities at March 31, 2010 and December 31, 2009 were as follows (in thousands):


5


   
Gross
Gross
 
 
Amortized
Unrealized
Unrealized
Fair
March 31, 2010
Cost
Gains
Losses
Value
Available-for-sale securities:
       
  U.S. Agency securities
 $      81,151
 $         1,196
 $             (96)
 $       82,251
  U.S. Treasury notes
           2,994
                   4
                    -
            2,998
  Obligations of state and
       
    political subdivisions
         63,775
            1,029
              (275)
          64,529
  Corporate obligations
           2,998
               204
                    -
            3,202
  Mortgage-backed securities
         60,364
            3,145
                    -
          63,509
  Equity securities
              390
                 90
                    -
               480
Total available-for-sale securities
 $    211,672
 $         5,668
 $           (371)
 $     216,969
         
         
         
   
Gross
Gross
 
 
Amortized
Unrealized
Unrealized
Fair
December 31, 2009
Cost
Gains
Losses
Value
Available-for-sale securities:
       
  U.S. Agency securities
 $      64,583
 $            888
 $           (248)
 $       65,223
  Obligations of state and
       
    political subdivisions
         58,651
            1,085
              (162)
          59,574
  Corporate obligations
           2,998
               168
                    -
            3,166
  Mortgage-backed securities
         67,026
            3,168
                    -
          70,194
  Equity securities
              371
                 54
                    -
               425
Total available-for-sale securities
 $    193,629
 $         5,363
 $           (410)
 $     198,582

 
The following table shows the Company’s gross unrealized losses and fair value of the Company’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time, that the individual securities have been in a continuous unrealized loss position, at March 31, 2010 and December 31, 2009 (in thousands). As of March 31, 2010 and December 31, 2009, the Company owned 36 and 33 securities whose estimated fair value was less than their cost basis, respectively.
 

March 31, 2010
Less than Twelve Months
Twelve Months or Greater
Total
     
Gross
 
Gross
 
Gross
   
Fair
Unrealized
Fair
Unrealized
Fair
Unrealized
   
Value
Losses
Value
Losses
Value
Losses
U.S. Agency securities
 $        21,135
 $               96
 $                  -
 $                  -
 $        21,135
 $               96
Obligations of states and
           
     political subdivisions
           17,771
                255
                475
                  20
           18,246
                275
               
    Total securities
 $        38,906
 $             351
 $             475
 $               20
 $        39,381
 $             371
 
6

 
 
 
             
               
December 31, 2009
Less than Twelve Months
Twelve Months or Greater
Total
     
Gross
 
Gross
 
Gross
   
Fair
Unrealized
Fair
Unrealized
Fair
Unrealized
   
Value
Losses
Value
Losses
Value
Losses
U.S. Agency securities
 $        28,665
 $             248
 $                  -
 $                  -
 $        28,665
 $             248
Obligations of states and
           
     political subdivisions
           11,326
                120
                454
                  42
           11,780
                162
               
    Total securities
 $        39,991
 $             368
 $             454
 $               42
 $        40,445
 $             410

 
The Company’s investment securities portfolio contains unrealized losses on mortgage-related instruments or other agency securities backed by the full faith and credit of the U. S. government.  For fixed maturity investments management considers whether the present value of cash flows expected to be collected are less than the security’s amortized cost basis (the difference defined as the credit loss), the magnitude and duration of the decline, the reasons underlying the decline and the Company’s intent to sell the security or whether it is more likely than not that the Company would be required to sell the security before its anticipated recovery in market value, to determine whether the loss in value is other than temporary. Once a decline in value is determined to be other than temporary, if the Company does not intend to sell the security, and it is more-likely-than-not that it will not be required to sell the security, before recovery of the security’s amortized cost basis, the charge to earnings is limited to the amount of credit loss. Any remaining difference between fair value and amortized cost (the difference defined as the non-credit portion) is recognized in other comprehensive income, net of applicable taxes. Otherwise, the entire difference between fair value and amortized cost is charged to earnings. For equity securities where the fair value has been significantly below cost for one year, the Company’s policy is to recognize an impairment loss unless sufficient evidence is available that the decline is not other than temporary and a recovery period can be predicted.  The Company has concluded that any impairment of its investment securities portfolio outlined in the above table is not other than temporary and is the result of interest rate changes, sector credit rating changes, or company-specific rating changes that are not expected to result in the non-collection of principal and interest during the period.
 
Proceeds from sales of securities available-for-sale for the three months ended March 31, 2010 and 2009 were $5,855,000 and $2,178,000, respectively.  The gross gains and losses were as follows (in thousands):

 
Three Months Ended
 
 March 31,
 
2010
2009
Gross gains
 $             64
 $              53
Gross losses
                   -
                 37
Net gains
 $             64
 $              16

 
Investment securities with an approximate carrying value of $141,270,000 and $144,880,000 at March 31, 2010 and December 31, 2009, respectively, were pledged to secure public funds and certain other deposits.
 
Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.   The amortized cost and estimated fair value of debt securities at March 31, 2010, by contractual maturity, are shown below (in thousands):


7





 
Amortized
   
 
Cost
 
Fair Value
Available-for-sale debt securities:
     
  Due in one year or less
 $        3,816
 
 $         3,879
  Due after one year through five years
         51,046
 
          51,447
  Due after five years through ten years
         37,010
 
          38,175
  Due after ten years
       119,410
 
        122,988
Total
 $    211,282
 
 $     216,489


Note 5 – Federal Home Loan Bank (FHLB) Stock
 
Included in Other Assets in the Consolidated Balance Sheet is the Bank’s investment in the Federal Home Loan Bank (FHLB) system, of which the Bank is a member. Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. FHLB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment. Because this stock is viewed as a long term investment, impairment is based on ultimate recovery of par value.
 
As of March 31, 2010 and December 31, 2009, the Bank holds $3,682,000 of stock in the FHLB. In December 2008, the FHLB announced that due largely to a decline in the fair value of a segment of its mortgage-backed securities portfolio, it had suspended payment of dividends on the stock and made a decision to no longer purchase “excess stock” from its members. The Bank’s stock is not transferrable and can only be redeemed by the FHLB. Further deterioration in the financial condition of the FHLB may lead management to a conclusion that the cost of the Bank’s stock in the FHLB is not recoverable, which would result in a charge to earnings for impairment of the Bank’s holdings of the stock. As of March 31, 2010 and December 31, 2009, the investment in the FHLB is not deemed other-than-temporarily impaired based upon management’s determination of the recoverability of par value.
 
 
Note 6 - Employee Benefit Plans
 
For a detailed disclosure on the Company's pension and employee benefits plans, please refer to Note 10 of the Company's Consolidated Financial Statements included in the 2009 Annual Report on Form 10-K.
 
Noncontributory Defined Benefit Pension Plan
 
The Bank sponsors a noncontributory defined benefit pension plan (“Pension Plan”) covering substantially all employees and officers.  The Bank’s funding policy is to make annual contributions, if needed, based upon the funding formula developed by the plan’s actuary.
 
The Pension Plan was amended, effective January 1, 2008, to cease eligibility for employees with a hire date of January 1, 2008 or later.  In lieu of the Pension Plan, employees with a hire date of January 1, 2008 or later are eligible to receive, after meeting certain length of service requirements, an annual discretionary 401(k) plan contribution from the Bank equal to a percentage of an employee’s base compensation.  The contribution amount, if any, is placed in a separate account within the 401(k) plan and is subject to a vesting requirement.
 
The Pension Plan was also amended, effective January 1, 2008, for employees who are still eligible to participate.  The amended Pension Plan requires benefits to be paid to eligible employees based primarily upon age and compensation rates during employment.  Upon retirement or other termination of employment, employees can elect either an annuity benefit or a lump sum distribution of vested benefits in the Pension Plan.
 
The following sets forth the components of net periodic benefit costs of the Pension Plan for the three months ended March 31, 2010 and 2009, respectively (in thousands):

8


 
Pension Benefits
       
 
2010
 
2009
Service cost
 $    170
 
 $    115
Interest cost
      223
 
      144
Expected return on plan assets
     (292)
 
     (178)
Net amortization and deferral
       24
 
        6
       
Net periodic benefit cost
 $    125
 
 $     87

 
No contributions have been made to the Pension Plan as of March 31, 2010; however, the Company expects to contribute $500,000 to the Pension Plan in 2010.
 
Defined Contribution Plan
 
The Company sponsors a voluntary 401(k) savings plan which eligible employees can elect to contribute up to the maximum amount allowable not to exceed the limits of IRS Code Sections 401(k).  Under the plan, the Company also makes required contributions on behalf of the eligible employees.  The Company’s contributions vest immediately.  Contributions by the Company totaled $56,000 and $49,500 for the three months ended March 31, 2010 and 2009, respectively.
 
Directors’ Deferred Compensation Plan
 
The Company’s directors may elect to defer all or portions of their fees until their retirement or termination from service.  Amounts deferred under the plan earn interest based upon the highest current rate offered to certificate of deposit customers.  Amounts deferred under the plan are not guaranteed and represent a general liability of the Company.  Amounts included in interest expense on the deferred amounts totaled $8,000 and $9,000 for the three months ended March 31, 2010 and 2009, respectively.
 
Restricted Stock Plan
 
Effective April 18, 2006, shareholders of the Company approved the 2006 Restricted Stock Plan (the “Plan”).  Employees and non-employee corporate directors are eligible to receive awards of restricted stock based upon performance related requirements.  Awards granted under the Plan are in the form of the Company’s common stock and are subject to certain vesting requirements including continuous employment or service with the Company.  100,000 shares of the Company’s common stock have been authorized under the Plan, which terminates April 18, 2016.  The Plan assists the Company in attracting, retaining and motivating employees to make substantial contributions to the success of the Company and to increase the emphasis on the use of equity as a key component of compensation.
 
For the three months ended March 31, 2010 and 2009, 0 and 7,526 shares of restricted stock were awarded and 2,446 and 0 shares were vested, respectively.  Compensation cost related to restricted stock is recognized based on the market price of the stock at the grant date over the vesting period. Compensation expense related to restricted stock was $27,000 and $19,000 for the three months ended March 31, 2010 and 2009, respectively.
 
Supplemental Executive Retirement Plan
 
During 2008, the Company adopted a non-qualified supplemental executive retirement plan (“SERP”) for certain executives to compensate those executive participants in the Company’s noncontributory defined benefit pension plan whose benefits are limited by compensation limitations under current tax law.  At March 31, 2010 and December 31, 2009, an obligation of $459,000 and $399,000, respectively, was included in other liabilities for this plan in the consolidated balance sheet.  Expenses related to this plan totaled $59,000 and $53,000 for the three months ended March 31, 2010 and 2009.

9




Note 7 – Fair Value Measurements
 
FASB ASC Topic 820 establishes a hierarchal disclosure framework associated with the level of pricing observability utilized in measuring assets and liabilities at fair value. The three broad levels defined by FASB ASC Topic 820 hierarchy are as follows:
 
Level I:
Quoted prices are available in active markets for identical assets or liabilities as of the reported date.
 
Level II:
Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these assets and liabilities include items for which quoted prices are available but traded less frequently, and items that are fair valued using other financial instruments, the parameters of which can be directly observed.
   
Level III:
Assets and liabilities that have little to no pricing observability as of the reported date. These items do not have two-way markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.
 
 
The following tables present the assets reported on the consolidated statements of financial condition at their fair value as of March 31, 2010 and December 31, 2009 by level within the fair value hierarchy. As required by FASB ASC Topic 820, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.
 
(In thousands)
 
March 31, 2010
   
Level 1
 
Level II
 
Level III
   
Total
 Fair value measurements on a recurring basis:
                 
Securities available for sale:
                 
 U.S. Agency securities
     
 $             82,251
       
 $             82,251
 U.S. Treasury notes
     
2,998
       
2,998
 Obligations of state and
                 
        political subdivisions
     
64,529
       
64,529
 Corporate obligations
     
3,202
       
3,202
 Mortgage-backed securities
     
63,509
       
63,509
 Equity securities
 
 $             480
           
480
Trust Preferred Interest Rate Swap
     
(263)
       
(263)
                   
Fair value measurements on non-recurring basis:
                 
Impaired Loans
     
6,224
       
6,224
Other real estate owned
     
100
       
100
                   
                   
(In thousands)
 
December 31, 2009
   
Level 1
 
Level II
 
Level III
   
Total
Fair value measurements on a recurring basis:
                 
Securities available for sale:
                 
U.S. Agency securities
     
 $             65,223
       
 $             65,223
Obligations of state and
                 
       political subdivisions
     
59,574
       
59,574
Corporate obligations
     
3,166
       
3,166
Mortgage-backed securities
     
70,194
       
70,194
Equity securities
 
 $             425
           
425
Trust Preferred Interest Rate Swap
     
(166)
       
(166)
                   
Fair value measurements on non-recurring basis:
                 
Impaired Loans
     
5,029
       
5,029
Other real estate owned
     
101
       
101

 
10

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

 
March 31
 
December 31
 
2010
 
2009
 
Carrying
Estimated
 
Carrying
Estimated
 
Amount
Fair Value
 
Amount
Fair Value
Financial assets:
         
Cash and due from banks
 $    24,512
 $    24,512
 
 $    31,449
 $    31,449
Available-for-sale securities
     216,969
     216,969
 
     198,582
     198,582
Net loans
     459,495
     467,177
 
     451,496
     466,967
Bank owned life insurance
       12,791
       12,791
 
       12,667
       12,667
Regulatory stock
         3,957
         3,957
 
         3,957
         3,957
Accrued interest receivable
         3,538
         3,538
 
         3,141
         3,141
           
           
Financial liabilities:
         
Deposits
 $  624,397
 $  629,848
 
 $  605,559
 $  611,705
Borrowed funds
       53,429
       50,296
 
       54,115
       50,582
Trust preferred interest rate swap
            262
            262
 
            166
            166
Accrued interest payable
         1,827
         1,827
 
         2,037
         2,037

 
Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument.  These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument.  Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions can significantly affect the estimates.
 
Estimated fair values have been determined by the Company using historical data, as generally provided in the Company’s regulatory reports, and an estimation methodology suitable for each category of financial instruments. The Company’s fair value estimates, methods and assumptions are set forth below for the Company’s other financial instruments.

Cash and Cash Equivalents:
 
The carrying amounts for cash and due from banks approximate fair value because they have original maturities of 90 days or less and do not present unanticipated credit concerns.

Accrued Interest Receivable and Payable:
 
The carrying amounts for accrued interest receivable and payable approximate fair value because they are generally received or paid in 90 days or less and do not present unanticipated credit concerns.

 
11

 
Available-For-Sale Securities:
 
The fair values of available-for-sale securities are based on quoted market prices as of the balance sheet date.  For certain instruments, fair value is estimated by obtaining quotes from independent dealers.

Loans:
 
Fair values are estimated for portfolios of loans with similar financial characteristics.  The fair value of performing loans has been estimated by discounting expected future cash flows. The discount rate used in these calculations is derived from the Treasury yield curve adjusted for credit quality, operating expense and prepayment option price, and is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The estimate of maturity is based on the Company’s historical experience with repayments for each loan classification, modified as required by an estimate of the effect of current economic and lending conditions.
 
Fair value for significant nonperforming loans is based on recent external appraisals. If appraisals are not available, estimated cash flows are discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows, and discount rates are judgmentally determined using available market information and specific borrower information.

Bank Owned Life Insurance:
 
The carrying value of bank owned life insurance approximates fair value based on applicable redemption provisions.

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

Deposits:
 
The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, savings and NOW accounts, and money market accounts, is equal to the amount payable on demand. The fair value of certificates of deposit is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.
 
The deposits’ fair value estimates do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market, commonly referred to as the core deposit intangible.

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

Trust Preferred Interest Rate Swap:
 
The fair value of the trust preferred interest rate swap is based on a pricing model that utilizes a yield curve and information contained in the swap agreement.


Note 8 – Recent Accounting Pronouncements
 
In December 2009, the FASB issued ASU 2009-16, Accounting for Transfer of Financial Assets.  ASU 2009-16 provides guidance to improve the relevance, representational faithfulness, and comparability of the information that an entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets.  ASU 2009-16 is effective for annual periods beginning after November 15, 2009 and for interim periods within those fiscal years.  The adoption of this guidance did not have a material impact on the Company’s financial position or results of operation.
 
 
12

In December 2009, the FASB issued ASU 2009-17, Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities. The objective of ASU 2009-17 is to improve financial reporting by enterprises involved with variable interest entities and to provide more relevant and reliable information to users of financial statements. ASU 2009-17 is effective for annual periods beginning after November 15, 2009 and for interim periods within those fiscal years.  The adoption of this guidance did not have a material impact on the Company’s financial position or results of operation.
 
In September 2009, the FASB issued new guidance impacting Topic 820. This creates a practical expedient to measure the fair value of an alternative investment that does not have a readily determinable fair value. This guidance also requires certain additional disclosures. This guidance is effective for interim and annual periods ending after December 15, 2009. The adoption of this guidance did not have a material impact on the Company’s financial position or results of operation.
 
In October 2009, the FASB issued ASU 2009-15, Accounting for Own-Share Lending Arrangements in Contemplation of Convertible Debt Issuance or Other Financing. ASU 2009-15 amends Subtopic 470-20 to expand accounting and reporting guidance for own-share lending arrangements issued in contemplation of convertible debt issuance. ASU 2009-15 is effective for fiscal years beginning on or after December 15, 2009 and interim periods within those fiscal years for arrangements outstanding as of the beginning of those fiscal years. The adoption of this guidance did not have a material impact on the Company’s financial position or results of operation.
 
In January 2010, the FASB issued ASU 2010-01, Equity (Topic 505): Accounting for Distributions to Shareholders with Components of Stock and Cash – a consensus of the FASB Emerging Issues Task Force. ASU 2010-01 clarifies that the stock portion of a distribution to shareholders that allows them to elect to receive cash or stock with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance that is reflected in EPS prospectively and is not a stock dividend.  ASU 2010-01 is effective for interim and annual periods ending on or after December 15, 2009 and should be applied on a retrospective basis.  The adoption of this guidance did not have a material impact on the Company’s financial position or results of operation.
 
In January 2010, the FASB issued ASU 2010-02, Consolidation (Topic 810): Accounting and reporting for Decreases in Ownership of a Subsidiary – a Scope Clarification. ASU 2010-02 amends Subtopic 810-10 to address implementation issues related to changes in ownership provisions including clarifying the scope of the decrease in ownership and additional disclosures.  ASU 2010-02 is effective beginning in the period that an entity adopts Statement 160.  If an entity has previously adopted Statement 160, ASU 2010-02 is effective beginning in the first interim or annual reporting period ending on or after December 15, 2009 and should be applied retrospectively to the first period Statement 160 was adopted.   The adoption of this guidance did not have a material impact on the Company’s financial position or results of operation. 
 
In January 2010, the FASB issued ASU 2010-04, Accounting for Various Topics – Technical Corrections to SEC Paragraphs. ASU 2010-04 makes technical corrections to existing SEC guidance including the following topics: accounting for subsequent investments, termination of an interest rate swap, issuance of financial statements - subsequent events, use of residential method to value acquired assets other than goodwill, adjustments in assets and liabilities for holding gains and losses, and selections of discount rate used for measuring defined benefit obligation.  ASU 2010-04 is effective January 15, 2010.  The adoption of this guidance did not have a material impact on the Company’s financial position or results of operation. 
 
In January 2010, the FASB issued ASU 2010-05, Compensation – Stock Compensation (Topic 718): Escrowed Share Arrangements and the Presumption of Compensation. ASU 2010-05 updates existing guidance to address the SEC staff’s views on overcoming the presumption that for certain shareholders escrowed share arrangements represent compensation.  ASU 2010-05 is effective January 15, 2010.  The adoption of this guidance did not have a material impact on the Company’s financial position or results of operation. 
 
 
13

In January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. ASU 2010-06 amends Subtopic 820-10 to clarify existing disclosures, require new disclosures, and includes conforming amendments to guidance on employers’ disclosures about postretirement benefit plan assets. ASU 2010-06 is effective for interim and annual periods beginning after December 15, 2009, except for disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years.  The adoption of this guidance is not expected to have a significant impact on the Company’s financial statements.
 
In February 2010, the FASB issued ASU 2010-08, Technical Corrections to Various Topics. ASU 2010-08 clarifies guidance on embedded derivatives and hedging. ASU 2010-08 is effective for interim and annual periods beginning after December 15, 2009. The adoption of this guidance did not have a material impact on the Company’s financial position or results of operation.
 
In March 2010, the FASB issued ASU 2010-11, Derivatives and Hedging.  ASU 2010-11 provides clarification and related additional examples to improve financial reporting by resolving potential ambiguity about the breadth of the embedded credit derivative scope exception in ASC 815-15-15-8.  ASU 2010-11 is effective at the beginning of the first fiscal quarter beginning after June 15, 2010. The Company is currently evaluating the impact the adoption of this standard will have on the Company’s financial position or results of operation.
 
In April 2010, the FASB issued ASU 2010-13, Compensation – Stock Compensation (Topic 718):  Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Trades.  ASU 2010-13 provides guidance on the classification of a share-based payment award as either equity or a liability.  A share-based payment that contains a condition that is not a market, performance, or service condition is required to be classified as a liability.  ASU 2010-13 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010 and the Company is currently evaluating the impact the adoption of the standard will have on the Company’s financial position or results of operation.

 
Note 9 - Subsequent Events
 
On April 20, 2010, the shareholders of the Company approved increasing the number of authorized common stock shares from 10,000,000 to 15,000,000. They also approved the authorization of 3,000,000 shares of blank check preferred stock.
 

 
14

 

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements
 
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.  The Company would like to caution readers that the following important factors, among others, may have affected and could in the future affect the Company’s actual results and could cause the Company’s actual results for subsequent periods to differ materially from those expressed in any forward-looking statement:
 
·  
Interest rates could change more rapidly or more significantly than we expect.
·  
The economy could change significantly in an unexpected way, which would cause the demand for new loans and the ability of borrowers to repay outstanding loans to change in ways that our models do not anticipate.
·  
The stock and bond markets could suffer a significant disruption, which may have a negative effect on our financial condition and that of our borrowers, and on our ability to raise money by issuing new securities.
·  
It could take us longer than we anticipate to implement strategic initiatives designed to increase revenues or manage expenses, or we may not be able to implement those initiatives at all.
·  
Acquisitions and dispositions of assets could affect us in ways that management has not anticipated.
·  
We may become subject to new legal obligations or the resolution of litigation may have a negative effect on our financial condition.
·  
We may become subject to new and unanticipated accounting, tax, or regulatory practices, regulations or requirements, including the costs of compliance with such changes.
·  
We could experience greater loan delinquencies than anticipated, adversely affecting our earnings and financial condition.  We could 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.
·  
Exploration and drilling of the natural gas reserves in the Marcellus Shale in our market area may be affected by federal, state and local laws and regulations such as restrictions on production, permitting, changes in taxes and environmental protection, which could negatively impact our customers and, as a result, negatively impact our loan and deposit volume.
 

Additional factors that may affect our results are discussed in the Company’s Annual Report on Form 10-K under “Item 1.A/ Risk Factors.”  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 the Company.  Our Company's consolidated financial condition and results of operations consist almost entirely of the Bank’s financial condition and results of operations. Management’s discussion and analysis should be read in conjunction with the preceding financial statements presented under Part I.  The results of operations for the three months March 31, 2010 are not necessarily indicative of the results you may expect for the full year.
 

 
15

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 main office in Mansfield, Pennsylvania. Presently we operate 17 banking facilities.  In Pennsylvania, these offices are located in Mansfield, Blossburg, Ulysses, Genesee, Wellsboro, Troy, Sayre, Canton, Gillett, Millerton, LeRaysville, Towanda, the Wellsboro Weis Market store, and the Mansfield Wal-Mart Super Center.  In New York, we have a branch office in Wellsville, Allegany County.

Risk Management
 
Risk identification and management are essential elements for the successful management of the Company.  In the normal course of business, the Company is subject to various types of risk, including interest rate, credit, liquidity and regulatory risk.
 
Interest rate risk is the sensitivity of net interest income and the market value of financial instruments to the direction and frequency of changes in interest rates.  Interest rate risk results from various re-pricing frequencies and the maturity structure of the financial instruments owned by the Company.  The Company uses its asset/liability and funds management policy to control and manage interest rate risk.
 
Credit risk represents the possibility that a customer may not perform in accordance with contractual terms.  Credit risk results from loans with customers and the purchasing of securities.  The Company’s primary credit risk is in the loan portfolio.  The Company manages credit risk by adhering to an established credit policy and through a disciplined evaluation of the adequacy of the allowance for loan losses.  Also, the investment policy limits the amount of credit risk that may be taken in the investment portfolio.
 
Liquidity risk represents the inability to generate or otherwise obtain funds at reasonable rates to satisfy commitments to borrowers and obligations to depositors.  The Company has established guidelines within its asset/liability and funds management policy to manage liquidity risk.  These guidelines include, among other things, contingent funding alternatives.
 
Reputational risk, or the risk to our business, earnings, liquidity, and capital from negative public opinion, could result from our actual or alleged conduct in a variety of areas, including legal and regulatory compliance, lending practices, corporate governance, litigation, ethical issues, or inadequate protection of customer information. We expend significant resources to comply with regulatory requirements. Failure to comply could result in reputational harm or significant legal or remedial costs. Damage to our reputation could adversely affect our ability to retain and attract new customers, and adversely impact our earnings and liquidity.
 
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.
 
Competition
 
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 the Bank. 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 also 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 primarily based on price, nature of product, quality of service, and convenience of location.

16


Trust and Investment Services
 
Our Investment and Trust Services Department offers professional trust administration, investment management services, estate planning and administration, and custody of securities.  Assets held by the Company in a fiduciary or agency capacity for its customers are not included in the consolidated financial statements since such items are not assets of the Company.  Revenues and fees of the Trust Department are reflected in the Company’s financial statements.  As of March 31, 2010 and December 31, 2009, the Trust Department had $87.9 and $85.9 million of assets under management, respectively.  The $2.0 million increase is primarily attributable to the continued recovery in market values of trust assets since the end of 2008.
 
Our Investment Representatives offer full service brokerage services and financial planning throughout the Bank’s market area.  Products such as mutual funds, annuities, health and life insurance are made available through our insurance subsidiary, First Citizens Insurance.  Fee income from the sale of these products is reflected in the Company’s financial statements as a component of non-interest income in the Consolidated Statement of Income.

Results of Operations

Overview of the Income Statement
 
The Company had net income of $2,746,000 for the first three months of 2010 compared to earnings of $2,346,000 for last year’s comparable period, an increase of $400,000 or 17.1%. Earnings per share for the first three months of 2010 were $0.96, compared to $0.82 last year, representing a 17.1% increase.  Annualized return on assets and return on equity for the three months of 2010 were 1.50% and 18.22%, respectively, compared with 1.41% and 17.59% for last year’s comparable period.
 
Net Interest Income
 
Net interest income, the most significant component of the Company’s earnings, is the amount by which interest income generated from interest-earning assets exceeds interest expense on interest-bearing liabilities.
 
Net interest income for the first three months of 2010 was $6,747,000, an increase of $588,000, or 9.5%, compared to the same period in 2009.  For the first three months of 2010, the provision for loan losses totaled $305,000, an increase of $155,000 over the comparable period in 2009.  Consequently, net interest income after the provision for loan losses was $6,442,000 compared to $6,009,000 during the first three months of 2009.
 
The following table sets forth the average balances of, and the interest earned or incurred on, each principal category of assets, liabilities and stockholders’ equity, the related rates, net interest income and rate “spread” created for the three months March 31, 2010 and 2009:

 
17

 


 
Analysis of Average Balances and Interest Rates (1)
             
 
March 31, 2010
March 31, 2009
 
Average
 
Average
Average
 
Average
 
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
(dollars in thousands)
$
$
%
$
$
%
ASSETS
           
Short-term investments:
           
   Interest-bearing deposits at banks
     19,143
          14
0.30
      8,417
             2
0.08
Total short-term investments
     19,143
          14
0.30
      8,417
             2
0.08
Investment securities:
           
  Taxable
   143,087
    1,340
3.75
  130,276
      1,648
5.06
  Tax-exempt (3)
     60,139
        972
6.47
    44,783
         714
6.38
  Total investment securities
   203,226
    2,312
4.55
  175,059
      2,362
5.40
Loans:
           
  Residential mortgage loans
   200,650
    3,549
7.17
  206,812
      3,747
7.35
  Commercial & farm loans
   200,342
    3,465
7.01
  171,048
      2,981
7.07
  Loans to state & political subdivisions
     46,748
        693
6.01
    47,240
         734
6.30
  Other loans
     11,530
        250
8.79
    11,276
         251
9.03
  Loans, net of discount (2)(3)(4)
   459,270
    7,957
7.03
  436,376
      7,713
7.17
Total interest-earning assets
   681,639
  10,283
6.12
  619,852
    10,077
6.59
Cash and due from banks
        9,062
   
      8,929
   
Bank premises and equipment
     12,265
   
    11,770
   
Other assets
     28,611
   
    27,297
   
Total non-interest earning assets
     49,938
   
    47,996
   
Total assets
   731,577
   
  667,848
   
LIABILITIES AND STOCKHOLDERS' EQUITY
         
Interest-bearing liabilities:
           
  NOW accounts
   137,109
        267
      0.79
  115,010
         248
    0.87
  Savings accounts
     50,396
          38
      0.31
    44,899
           37
    0.33
  Money market accounts
     41,092
          61
      0.60
    40,627
           99
    0.99
  Certificates of deposit
   322,548
    2,176
      2.74
  293,675
      2,531
    3.50
Total interest-bearing deposits
   551,145
    2,542
      1.87
  494,211
      2,915
    2.39
Other borrowed funds
     53,430
        441
      3.34
    57,691
         523
    3.68
Total interest-bearing liabilities
   604,575
    2,983
      2.00
  551,902
      3,438
    2.53
Demand deposits
     59,053
   
    54,013
   
Other liabilities
        7,681
   
      8,567
   
Total non-interest-bearing liabilities
     66,734
   
    62,580
   
Stockholders' equity
     60,268
   
    53,366
   
Total liabilities & stockholders' equity
   731,577
   
  667,848
   
Net interest income
 
    7,300
   
      6,639
 
Net interest spread (5)
   
4.12%
   
4.06%
Net interest income as a percentage
           
  of average interest-earning assets
   
4.34%
   
4.34%
Ratio of interest-earning assets
           
  to interest-bearing liabilities
   
      1.13
   
    1.12
             
(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.
       
 

18

 
Tax exempt revenue is shown on a tax-equivalent basis for proper comparison using a statutory, federal income tax rate of 34%.  For purposes of the comparison, as well as the discussion that follows, this presentation facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the Company’s 34% Federal statutory rate.  The following table represents the adjustment to convert net interest income to net interest income on a fully taxable equivalent basis for the periods ending March 31, 2010 and 2009:
 

 
For the Three Months
 
Ended March 31
 
2010
2009
Interest and dividend income
   
    from investment securities (non-tax adjusted)
 $        1,996
 $          2,120
Tax equivalent adjustment
               330
               244
Interest and dividend income
   
    from investment securities (tax equivalent basis)
 $        2,326
 $          2,364
     
     
     
Interest and fees on loans (non-tax adjusted)
 $        7,734
 $          7,477
Tax equivalent adjustment
               223
               236
Interest and fees on loans (tax equivalent basis)
 $        7,957
 $          7,713
     
     
     
Total interest income
 $        9,730
 $          9,597
Total interest expense
            2,983
             3,438
Net interest income
            6,747
             6,159
Total tax equivalent adjustment
               553
               480
Net interest income (tax equivalent basis)
 $        7,300
 $          6,639


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

Analysis of Changes in Net Interest Income on a Tax-Equivalent Basis (1)
       
 
 2010 vs. 2009 (1)
 
 Change in
 Change
 Net
 
 Volume
 in Rate
 Change
Interest Income:
     
Short-term investments:
     
  Interest-bearing deposits at banks
 $             4
 $             8
 $          12
Investment securities:
     
  Taxable
           188
         (496)
         (308)
  Tax-exempt
           248
              10
           258
Total investments
           436
         (486)
           (50)
Loans:
     
  Residential mortgage loans
         (111)
           (87)
         (198)
  Commercial & farm loans
           507
           (23)
           484
  Loans to state & political subdivisions
              (7)
           (34)
           (41)
  Other loans
                8
              (9)
              (1)
Total loans, net of discount
           397
         (153)
           244
Total Interest Income
           837
         (631)
           206
Interest Expense:
     
Interest-bearing deposits:
     
 
19

 
 
  NOW accounts
              38
           (19)
              19
  Savings accounts
                3
              (2)
                1
  Money Market accounts
                1
           (39)
           (38)
  Certificates of deposit
           293
         (648)
         (355)
Total interest-bearing deposits
           335
         (708)
         (373)
Other borrowed funds
           (36)
           (46)
           (82)
Total interest expense
           299
         (754)
         (455)
Net interest income
 $        538
 $        123
 $        661
       
(1) The portion of the net 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.
 
Tax equivalent net interest income increased from $6,639,000 for the 2009 three month period to $7,300,000 in the 2010 three month period, an increase of $661,000.  The tax equivalent net interest margin was 4.34% for the first three months of 2010 and 2009.
 
Total interest income for the three months ended March 31, 2010, increased $206,000 over the same period in 2009. This increase is primarily a result of an $837,000 increase due to volume as the average balance of interest earning assets increased by $61.8 million.  There was a decrease of $631,000 due to change in rate, as the yield on interest earning assets decreased 59 basis points from 6.59% to 6.12%.
 
Investment income for the three months ended March 31, 2010 decreased $50,000 over the same period last year.  The average balance of total investment securities at March 31, 2010 increased by $28.2 million from last year, due to investment opportunities and investing excess cash, primarily the result of increased deposits.
 
·  
The average balance of taxable securities increased by $12.8 million while tax-exempt securities increased by $15.4 million, which had the effect of increasing interest income by $188,000 and $248,000, respectively, due to volume.
·  
This increase was offset by a decrease in the yield on the investment securities of 85 basis points from 5.40% to 4.55%, which corresponds to a decrease in interest income of $486,000. The majority of this decrease is attributable to the change in yield on taxable securities, which experienced a decrease of 131 basis points from 5.06% to 3.75%.
 
The purchase of tax-exempt securities, along with municipal loans, allows us to manage our effective tax rate as well as the overall yield on our interest earning assets.
 
Total loan interest income increased $244,000 for the three months ended March 31, 2010 compared to the same period last year:
 
·  
Interest income on residential mortgage loans decreased $198,000 of which $111,000 was due to volume and $87,000 was due to a decrease in rate.  The average balance decreased $6.2 million due to the continuing economic recession, high unemployment rates and other negative economic factors that resulted in lower loan demand for non-conforming residential mortgages and home equity lines.
·  
The average balance of commercial and farm loans increased $29.3 million from a year ago primarily due to our emphasis to grow this segment of the loan portfolio utilizing disciplined underwriting standards.  This had a positive impact of $507,000 on total interest income due to volume.
 
Total interest expense decreased $455,000 for the three months ended March 31, 2010 compared with last year. This decrease is primarily due to a change in rate, accounting for a $754,000 decrease in our interest expense.  The average interest rate on interest-bearing liabilities decreased 53 basis points, from 2.53% to 2.00%.  The historically low interest rates supported by the Federal Reserve and continuing economic recession had the effect of decreasing our short-term borrowing costs as well as rates on deposit products, including shorter-term certificates of deposit and rate sensitive NOW and money market accounts.   Offsetting this, the average balance of interest-bearing liabilities increased $52.7 million resulting in an increase in interest expense of $335,000 (see also “Financial Condition – Deposits”).
 

20

 
·  
Interest expense on certificates of deposits decreased $355,000 over the same period last year. The average balance of certificates of deposit increased $28.9 million causing an increase in interest expense of $293,000.  Offsetting this was a decrease in the average rate on certificates of deposit from 3.50% to 2.74% resulting in a decrease in interest expense of $648,000.
·  
The average balance of NOW accounts also increased $22.1 million accounting for an increase of $38,000 in interest expense. The change in the average rate from 87 basis points to 79 basis points, contributed to a decrease in interest expense of $19,000 resulting in an overall increase of $19,000.
·  
The average balance of borrowed funds decreased by $4.3 million resulting in a decrease in interest expense of $36,000.  The average interest rate paid on borrowed funds also decreased by 34 basis points accounting for a decrease in interest expense of $46,000 due to rate. Borrowed funds decreased due to the significant increase in deposits, which continued to limit our need for borrowings from the Federal Home Loan Bank.
 
Provision For Loan Losses
 
For the three month period ending March 31, 2010, we recorded a provision for loan losses of $305,000, which represents an increase of $155,000 over the same time period in 2009.  This is the result of current economic conditions and an increase in non-performing loans as of March 31, 2010, which have impacted management's quarterly review of the allowance for loan losses (see also “Financial Condition – Allowance for Loan Losses and Credit Quality Risk”).

Non-interest Income
 
Non-interest income for the three months ended March 31, 2010 totaled $1,390,000, an increase of $36,000 when compared to the same period in 2009.  During the first three months of 2010, investment security gains amounted to $64,000 compared to investment security gains of $16,000 last year.  We sold two agency bonds at a gain of $9,000 that were likely to be called later in the year and a mortgage backed security due to favorable market conditions for a gain of $55,000 in 2010. In 2009, we sold an agency bond at a gain of $32,000, which was offset with a loss on the sale of bank equity shares of $16,000.
 
Service charge income increased by $41,000 and continues to be the Company’s primary source of non-interest income.  For the first three months of 2010, account service charges totaled $853,000 compared to $812,000 last year.  There was a $42,000 increase attributable to customers’ usage of their debit cards due to continuing efforts on the Bank’s part to encourage customers to utilize their debit cards.
 
The following table shows the breakdown of non-interest income for the three months ended March 31, 2010 and 2009:


 
Three months ended
   
 
March 31,
Change
(dollars in thousands)
2010
2009
Amount
%
Service charges
 $     853
 $    812
 $     41
    5.0
Trust
       146
      163
      (17)
  (10.4)
Brokerage and insurance
        82
      100
      (18)
  (18.0)
Investment securities gains, net
        64
       16
       48
  300.0
Earnings on bank owned life insurance
       124
      121
        3
    2.5
Other
       121
      142
      (21)
  (14.8)
Total
 $   1,390
 $  1,354
 $     36
    2.7


21


Non-interest Expense
 
Non-interest expenses decreased $44,000 or 1.0%, through March 31, 2010 compared to the same period in 2009.  Salaries and employee benefits increased $145,000 due mainly to annual merit increases effective the beginning of 2010 and increased employee insurance premiums.
 
FDIC Insurance decreased by $138,000 for the three months ended March 31, 2010 compared to last year.  During 2009, as a result of additional bank failures related to the economic crisis, the FDIC increased premiums and added a special assessment for insurance premiums, which resulted in a significantly higher level of fees.  In lieu of an additional special assessment in the fourth quarter of 2009, the FDIC required assessments for the following three years, 2010 – 2012, to be prepaid in order to increase the monies available in the insurance fund.  These prepayments will be recognized as a charge to operations over the applicable three year period.
 
Professional fees increased $49,000 due to various legal and consulting costs.  The $36,000 decrease in amortization of intangibles is due to intangible assets becoming fully amortized in 2009.
 
The following tables reflect the breakdown of non-interest expense and professional fees for the three and three months ended March 31, 2010 and 2009:

         
 
Three months ended
   
 
March 31,
Change
(in thousands)
2010
2009
Amount
%
Salaries and employee benefits
     2,441
 $  2,296
 $    145
     6.3
Occupancy
       306
      321
      (15)
    (4.7)
Furniture and equipment
       106
      110
       (4)
    (3.6)
Professional fees
       180
      131
       49
    37.4
Amortization of intangibles
         4
       40
      (36)
   (90.0)
FDIC insurance
       237
      375
     (138)
   (36.8)
ORE expenses
        81
       76
        5
     6.6
Other
       973
    1,023
      (50)
    (4.9)
Total
 $   4,328
 $  4,372
 $    (44)
    (1.0)
         
         
 
Three months ended
   
 
March 31,
Change
(in thousands)
2010
2009
Amount
%
Other professional fees
 $     103
 $     72
 $     31
    43.1
Legal fees
        22
        8
       14
   175.0
Examinations and audits
        55
       51
        4
     7.8
Total
 $     180
 $    131
 $     49
    37.4
         

Provision For Income Taxes
 
The provision for income taxes was $758,000 for the three month period ended March 31, 2010 compared to $645,000 for the same period in 2009.  The increase is primarily attributable to an increase in income before provision for income taxes of $513,000. Through management of our municipal loan and bond portfolios, management is focused on minimizing our effective tax rate.  Our effective tax rate was 21.7% and 21.6% for the first three months of 2010 and 2009, respectively, compared to the statutory rate of 34%.
 
 
22

We invest in three limited partnership agreements that established low-income housing projects in our market areas. As a result of these agreements, for tax purposes we have recognized $867,000 out of a total $913,000 of tax credits from one project in the Towanda area that began in October of 2000. We have recognized $318,000 out of a total $385,000 of tax credits on the second project in the Wellsboro market which was completed in November 2001.  In 2005, we entered into a third limited liability partnership for a low-income housing project for senior citizens in our Sayre market area.  Beginning in 2007, we have recognized $187,000 out of a total $574,000 of tax credits.  We anticipate recognizing $500,000 of tax credits over the next seven years, with $164,000 expected to be recognized in 2010.

Financial Condition
 
Total assets were $749.9 million at March 31, 2010, an increase of $20.4 million, or 2.8% from $729.5 million at December 31, 2009.  Net loans increased 1.8% to $459.5 million and investment securities increased 9.3% to $217.0 million at March 31, 2010.  Total deposits increased $18.8 million or 3.1% to $624.4 million since year-end 2009. Borrowed funds have decreased $700,000 to $53.4 million compared with $54.1 million at year-end.

Cash and Cash Equivalents
 
Cash and cash equivalents totaled $24.5 million at March 31, 2010 compared to $31.4 million at December 31, 2009, a decrease of $6.9 million.  Non-interest-bearing cash decreased $300,000 since year-end 2009, while interest-bearing cash decreased $6.6 million during that same period.  The increase in deposits over the first three months has been offset by the increase in investment securities and loans issued during this time. Management actively measures and evaluates its liquidity through our Asset – Liability committee and believes its 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, federal funds lines with correspondent banks, brokered certificates of deposit and the portion of the investment and loan portfolios that mature within one year.  Management expects that these sources of funds will permit us to meet cash obligations and off-balance sheet commitments as they come due.

Investments
 
Our investment portfolio increased by $18.4 million or 9.3% from December 31, 2009 to March 31, 2010.  During 2010 we purchased approximately $24.5 million of U.S. agency obligations, $3.0 million of U.S. Treasury notes, $1.3 million of mortgage backed securities and $5.3 million of state and local obligations which offset the $6.9 million of principal repayments and $3.1 million of calls that occurred during the quarter. We also selectively sold $5.9 million of U.S agency obligations and mortgage backed securities at a net gain of $64,000.  The overall market value of our investment portfolio increased approximately $300,000 due to market fluctuations since year end.  Excluding our short-term investments consisting of monies held primarily at the Federal Reserve for liquidity purposes, our investment portfolio is currently yielding 4.55% compared to 5.40% a year ago on a tax equivalent basis.
 
As mentioned above and seen in the table below, due to the continued economic downturn and the low interest rates, we have experienced significant prepayments of our mortgage backed securities of $6.9 million and calls on our agency bonds of $3.1 million.  Due to the amount of cash flow from the investment portfolio as well as an increase in deposits and a lack of opportunities in other investment types, our strategy has been to reinvest funds mainly in short-term agency bonds via purchases of $24.5 million and longer-term municipal bond purchases of $5.3 million.  We believe this strategy will enable us to reinvest cash flows in the next one to four years when we expect investment opportunities to improve.


23


 
 
Estimated Fair Market Value of Investment Portfolio
 
  March 31, 2010
December 31, 2009
(dollars in thousands)
Amount
%
 
Amount
%
Available-for-sale:
         
  U. S. Agency securities
 $    82,251
    37.9
 
 $  65,223
  32.8
  U. S. Treasury notes
       2,998
     1.4
 
         -
    -
  Obligations of state & political
         
     subdivisions
      64,529
    29.7
 
    59,574
  30.0
  Corporate obligations
       3,202
     1.5
 
     3,166
   1.6
  Mortgage-backed securities
      63,509
    29.3
 
    70,194
  35.3
  Equity securities
         480
     0.2
 
       425
   0.3
Total
 $   216,969
   100.0
 
 $ 198,582
 100.0
           
 
 
 
March 31,  2010/
 
 December 31, 2009
 
        Change
(dollars in thousands)
Amount
%
Available-for-sale:
   
  U. S. Agency securities
 $    17,028
    26.1
  U. S. Treasury notes
       2,998
 N/A
  Obligations of state & political
   
     subdivisions
       4,955
     8.3
  Corporate obligations
          36
     1.1
  Mortgage-backed securities
      (6,685)
    (9.5)
  Equity securities
          55
    12.9
Total
 $    18,387
     9.3
 
Management continues to monitor the earnings performance and the liquidity of the investment portfolio on a regular basis.  Through active balance sheet management and analysis of the securities portfolio, the Company believes it maintains sufficient liquidity to satisfy depositor requirements and various credit needs of its customers.

Loans
 
The Company’s lending is focused in the north central Pennsylvania market and the southern tier of New York.  The composition of our loan portfolio consists principally of retail lending, which includes single-family residential mortgages and other consumer lending, and commercial lending primarily to locally owned small businesses and farms.  New loans are generated primarily from direct loans to our existing customer base, with new customers generated by referrals from real estate brokers, building contractors, attorneys, accountants and existing customers.
 
Total loans increased approximately $8.3 million or 1.8% during the first three months of 2010.  Commercial real estate, agricultural, construction, commercial and other loans and municipal loans increased $2.9 million, $1.0 million, $2.9 million, $3.8 million and $878,000, respectively.  Residential real estate and consumer loans have decreased $3.0 million and $247,000, respectively.
 
We have continued to experience lower demand for residential real estate and consumer loans due to several economic factors.  Recessionary pressures, higher unemployment, and a depressed housing market have had a negative impact on nonconforming, residential real estate mortgage and home equity loan growth.  Additionally, loan demand for conforming mortgages, which the Company sells on the secondary market, has also declined from last year.  Through March 31, 2010, we have sold $0.7 million of loans in the secondary market compared to $3.8 million through this time last year.  The Company does recognize fee income for servicing these loans, which is included in non-interest income on the consolidated statement of income.  The Company considers residential mortgage lending a principal business activity.  Despite the current lower level of loan demand, management continues to explore new competitively priced products that are attractive to our customers, and to build technologies which make it easier and more efficient for customers to choose the Company for their mortgage needs.
 
24

The growth in commercial real estate, agricultural, construction and commercial and other loans, despite the recessionary economic environment, reflects the Company’s focus on commercial lending as a means to increase loan growth and obtain deposits from farmers and small businesses throughout our market area.  We believe we have a strong team of experienced professionals and disciplined underwriting standards that enable us to meet the needs of these customers within our service area without incurring unreasonable risks.

 
          March 31,
       December 31,
 
          2010
       2009
(in thousands)
Amount
%
Amount
%
Real estate:
       
  Residential
 $ 191,986
   41.3
 $ 194,989
   42.7
  Commercial
   136,885
   29.5
   133,953
   29.4
  Agricultural
    20,456
    4.4
    19,485
    4.3
  Construction
     8,523
    1.8
     5,619
    1.2
Consumer Loans
    11,648
    2.5
    11,895
    2.6
Commercial and other loans
    47,928
   10.3
    44,101
    9.7
State & political subdivision loans
    47,220
   10.2
    46,342
   10.1
Total loans
   464,646
  100.0
   456,384
  100.0
Less allowance for loan losses
     5,151
 
     4,888
 
Net loans
 $ 459,495
 
 $ 451,496
 
 
     
 
March 31, 2010/
 
 December 31, 2009
 
Change
(in thousands)
Amount
%
Real estate:
   
  Residential
 $  (3,003)
   (1.5)
  Commercial
     2,932
    2.2
  Agricultural
       971
    5.0
  Construction
     2,904
   51.7
Consumer Loans
      (247)
   (2.1)
Commercial and other loans
     3,827
    8.7
State & political subdivision loans
       878
    1.9
Total loans
 $   8,262
    1.8

Allowance For Loan Losses
 
The allowance for loan losses is maintained at a level, which in management’s judgment is adequate to absorb probable future loan losses inherent in the loan portfolio.  The provision for loan losses is charged against current income.  Loans deemed not collectable are charged-off against the allowance while subsequent recoveries increase the allowance.  The following table presents an analysis of the allowance for loan losses for the three months ended March 31, 2010 and for the years ended December 31, 2009, 2008, 2007 and 2006:

 
25

 


 
     March 31,
December 31,
 
2010
2009
2008
2007
2006
Balance
         
  at beginning of period
 $          4,888
 $          4,378
 $          4,197
 $          3,876
 $          3,664
Charge-offs:
         
  Real estate:
         
     Residential
                  30
                  76
                  31
                  64
                  37
     Commercial
                     -
                236
                  36
                    6
                  86
     Agricultural
                     -
                    1
                  20
                     -
                     -
  Consumer loans
                    7
                  80
                  44
                103
                103
  Commercial and other loans
                  48
                153
                115
                  13
                  64
Total loans charged-off
                  85
                546
                246
                186
                290
Recoveries:
         
  Real estate:
         
     Residential
                     -
                    1
                    6
                    2
                    6
     Commercial
                  12
                    1
                     -
                  79
                115
     Agricultural
                     -
                     -
                  20
                     -
                     -
  Consumer loans
                  15
                  52
                  19
                  52
                  39
  Commercial and other loans
                  16
                  77
                  52
                    9
                  12
Total loans recovered
                  43
                131
                  97
                142
                172
           
Net loans charged-off
                  42
                415
                149
                  44
                118
Provision charged to expense
                305
                925
                330
                365
                330
Balance at end of period
 $          5,151
 $          4,888
 $          4,378
 $          4,197
 $          3,876
           
Loans outstanding at end of period
 $      464,646
 $      456,384
 $      432,814
 $      423,379
 $      414,773
Average loans outstanding, net
 $      458,409
 $      442,921
 $      423,382
 $      411,927
 $      400,507
Non-performing assets:
         
    Non-accruing loans
 $          7,006
 $          5,871
 $          2,202
 $          1,915
 $          1,668
    Accrual loans - 90 days or more past due
                429
                884
                383
                275
             1,690
      Total non-performing loans
 $          7,435
 $          6,755
 $          2,585
 $          2,190
 $          3,358
    Foreclosed assets held for sale
                402
                302
                591
                203
                758
      Total non-performing assets
 $          7,837
 $          7,057
 $          3,176
 $          2,393
 $          4,116
Annualized net charge-offs to average loans
0.04%
0.09%
0.04%
0.01%
0.03%
Allowance to total loans
1.11%
1.07%
1.01%
0.99%
0.93%
Allowance to total non-performing loans
69.28%
72.36%
169.36%
191.64%
115.43%
Non-performing loans as a percent of loans
         
   net of unearned income
1.60%
1.48%
0.60%
0.52%
0.81%
Non-performing assets as a percent of loans
       
  net of unearned income
1.69%
1.55%
0.73%
0.57%
0.99%
 
The following table identifies amounts of loans contractually past due 30 to 90 days and non-performing loans by loan category, as well as the change from December 31, 2009 to March 31, 2010 in non-performing loans(dollars in thousands). Non-performing loans include those loans that are contractually past due 90 days or more and non-accrual loans. Interest does not accrue on non-accrual loans.  Subsequent cash payments received are applied to the outstanding principal balance or recorded as interest income, depending upon management's assessment of its ultimate ability to collect principal and interest.

26




 
March 31, 2010
 
December 31, 2009
   
Non-Performing Loans
   
Non-Performing Loans
 
30 - 90 Days
90 Days Past
Non-
Total Non-
 
30 - 90 Days
90 Days Past
Non-
Total Non-
(in thousands)
Past Due
Due Accruing
accrual
Performing
 
Past Due
Due Accruing
accrual
Performing
Real estate:
                 
  Residential
 $       1,329
 $             264
 $   897
 $         1,161
 
 $       1,629
 $              75
 $   775
 $           850
  Commercial
          2,759
               121
2,008
2,129
 
          1,558
               635
1,863
2,498
  Agricultural
              98
                   -
2,398
2,398
 
              75
                   -
2,094
2,094
  Construction
                -
                   -
          -
-
 
                -
                   -
749
749
Loans to individuals for household,
               
  family and other purchases
            116
                 44
33
77
 
              88
                 10
36
46
Commercial and other loans
            893
                   -
1,670
1,670
 
            610
               164
354
518
Total nonperforming loans
 $       5,195
 $             429
 $7,006
 $         7,435
 
 $       3,960
 $             884
 $5,871
 $         6,755
 
     
 
Change in Non-Performing Loans
 
 March 31, 2010 /December 31, 2009
(in thousands)
Amount
%
Real estate:
   
  Residential
 $          311
              36.6
  Commercial
           (369)
             (14.8)
  Agricultural
            304
              14.5
  Construction
           (749)
 -
Loans to individuals for household,
 
  family and other purchases
              31
              67.4
Commercial and other loans
          1,152
             222.4
Total nonperforming loans
 $          680
              10.1
 
The Company utilizes a disciplined and thorough loan review process based upon our internal loan policy approved by the Company’s Board of Directors.  The purpose of the review is to assess loan quality, analyze delinquencies, identify problem loans, evaluate potential charge-offs and recoveries, and assess general overall economic conditions in the markets served.  An external independent loan review is performed on our commercial portfolio semi-annually for the Company.  As part of this review, our underwriting process and loan grading system is evaluated.
 
Management believes it uses the best information available to make such determinations and that the allowance for loan losses is adequate as of March 31, 2010.  However, future adjustments could be required if circumstances differ substantially from assumptions and estimates used in making the initial determination.  A prolonged downturn in the economy, continued high unemployment rates, significant changes in the value of collateral and delays in receiving financial information from borrowers could result in increased levels of non-performing assets, charge-offs, loan loss provisions and reduction in income.  Additionally, bank regulatory agencies periodically examine the Bank’s allowance for loan losses.  The banking agencies could require the recognition of additions to the allowance for loan losses based upon their judgment of information available to them at the time of their examination.
 
On a monthly basis, problem loans are identified and updated primarily using internally prepared past due reports.  Based on data surrounding the collection process of each identified loan, the loan may be added or deleted from the monthly watch list.  The watch list includes loans graded special mention, substandard, doubtful, and loss, as well as additional loans that management may chose to include.  Watch list loans are continually monitored going forward until satisfactory conditions exist that allow management to upgrade and remove the loan.  In certain cases, loans may be placed on non-accrual status or charged-off based upon management’s evaluation of the borrower’s ability to pay.  All commercial loans, which include commercial real estate, agricultural real estate, state and political subdivision loans and other commercial loans, on non-accrual are evaluated quarterly for impairment.
 
27

The adequacy of the allowance for loan losses is subject to a formal, quarterly analysis by management of the Company.  In order to better analyze the risks associated with the loan portfolio, the entire portfolio is divided into several categories.  As stated above, loans on non-accrual status are specifically reviewed for impairment and given a specific reserve, if appropriate.  Loans evaluated and not found to be impaired are included with other performing loans, by category, by their respective homogenous pools.  For the analysis prepared as of March 31, 2010, three year average historical loss factors were calculated for each pool and applied to the performing portion of the loan category.  Previously, five year averages were utilized.  Management believes that using a shorter experience period better reflects more current economic impacts and loan charge-off trends. The historical loss factors for both reviewed and homogeneous pools are adjusted based upon the following qualitative factors:

§  
Level of and trends in charge-offs and recoveries
§  
Trends in volume, terms and nature of the loan portfolio
§  
Effects of any changes in risk selection and underwriting standards and any other changes in lending and recovery policies, procedures and practices
§  
Changes in the quality of the Company’s loan review system
§  
Experience, ability and depth of lending management and other relevant staff
§  
National, state, regional and local economic trends and business conditions
§  
Industry conditions including the effects of external factors such as competition, legal, and regulatory requirements on the level of estimated credit losses.
§  
Existence and effect of any credit concentrations, and changes in the level of such concentrations
 
The balance in the allowance for loan losses was $5,151,000 or 1.11% of total loans as of March 31, 2010 as compared to $4,888,000 or 1.07% of loans as of December 31, 2009.  The $263,000 increase is a result of a $305,000 provision for the first three months less net charge-offs of $42,000.  Gross charge-offs for the first three months of 2010 were $85,000.  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) as of the three months ended March 31, 2010 and for the years ended December 31, 2009, 2008, 2007 and 2006:


 
March 31
December 31
 
2010
2009
2008
2007
2006
 
Amount
%
Amount
%
Amount
%
Amount
%
Amount
%
Real estate loans:
                   
  Residential
 $    787
    41.3
 $    801
    42.7
 $    694
    46.0
 $    599
    47.7
 $    614
    49.7
  Commercial, agricultural
    3,000
    33.9
    2,864
    33.6
    2,303
    28.8
    2,128
    27.7
    1,676
    26.8
  Construction
         20
      1.8
         20
      1.2
           5
      2.6
            -
      2.7
            -
      1.7
Loans to individuals
                   
   for household,
                   
   family and other purchases
       130
      2.5
       131
      2.6
       449
      2.7
       424
      3.1
       734
      3.0
Commercial and other loans
    1,100
    10.3
       918
      9.7
       807
      8.8
       736
      8.2
       582
      7.9
State & political subdivision loans
       105
    10.2
         93
    10.1
         19
    11.1
         22
    10.6
         22
    10.9
Unallocated
           9
 N/A
         60
 N/A
       101
 N/A
       288
 N/A
       248
 N/A
Total allowance for loan losses
 $ 5,151
  100.0
 $ 4,888
  100.0
 $ 4,378
  100.0
 $ 4,197
  100.0
 $ 3,876
  100.0
 
For the three month period ending March 31, 2010, we recorded a provision for loan losses of $305,000, which compares to $150,000 for the same time period in 2009.  The significant increase is attributable to current economic conditions and an increase in non-performing loans in comparison to the same period last year.  Non-performing loans increased $680,000, or 10.1%, from December 31, 2009 to March 31, 2010. Approximately 80% of the Bank’s non-performing loans are associated with the following five customer relationships:

28

  
An agricultural customer with a total loan relationship of $3.5 million is considered non-accrual as of March 31, 2010. Included within this relationship is $1.1 million of loans which are subject to Farm Service Agency guarantees. The current economic struggles of dairy farmers, caused primarily from decreased milk prices, have created cash flow difficulties for this customer.  While we are hopeful that increased milk prices would significantly improve cash flows for this borrower, there is no certainty that this will occur.  Without a sizable and sustained increase in milk prices, we will need to rely upon the collateral for repayment of interest and principal.  A real estate appraisal was completed in October, 2009, which together with a collateral analysis on equipment and livestock, resulted in an updated collateral value of approximately $4.0 million.  Based upon this analysis, management determined not to allocate a specific reserve to this loan.
§  
A real estate rental customer with a total loan relationship of $1.1 million is considered non-accrual as of March 31, 2010. The current recessionary economic conditions have significantly impacted the cash flows from the customer’s rental properties. This relationship was evaluated and found to be impaired and was written down in third quarter of 2009 by $175,000, to the net realizable value. Based on an evaluation performed in the first quarter, a specific reserve of $91,000 has been established for this relationship.
§  
A commercial real estate property with a loan of $500,000 is considered non-accrual due to inadequate cash flow as a result of the economy. The loan was evaluated for impairment and a specific reserve of $11,000 was allocated to this loan.
§  
A commercial customer a total relationship of $469,000 composed of commercial real estate and other commercial loans was placed on non-accrual due to inadequate cash flows as a result of the downturn in the economy, which has had a significant impact on his modular home business. Based upon an analysis of the collateral value, management determined not to allocate a specific reserve to this loan.
§  
A real estate rental customer with a total loan relationship of $549,000 is considered non-accrual as of March 31, 2010. The current recessionary economic conditions have significantly impacted the cash flows from the customer’s rental properties. Based upon an analysis of the collateral values, management determined not to allocate a specific reserve to this loan.

The increase in loans 30-89 days past due is the result of one significant commercial customer. The customer is actively selling the property with an anticipated closing during the second quarter of 2010.
 
We have not experienced the significant decrease in the collateral values of local residential, commercial or agricultural real estate loan portfolios as seen in other parts of the country during this current economic downturn.  Real estate market values in our service area did not realize the significant, and sometimes speculative, increases as seen in other parts of the country prior to the current economic downturn.  As such, the collateral value of our real estate loans has not significantly deteriorated with the downturn.  In addition, our market area is predominately centered in the Marcellus Shale natural gas exploration and drilling area. These natural gas exploration and drilling activities have significantly impacted the overall interest in real estate in our market area due to the related lease and royalty revenues associated with it.  The natural gas activities have had a positive impact on the value of local real estate.  Due to the relatively stable or increasing collateral values in our service area, management determined not to increase the provision for loan losses and allowance for loan losses at the same magnitude as the increase in non-performing loans.

Bank Owned Life Insurance
 
The Company purchased bank owned life insurance to offset future employee benefit costs.  As of March 31, 2010 the cash surrender value of this life insurance is $12,791,000.  The use of life insurance policies provides the bank with an asset that will generate earnings to partially offset the current costs of benefits, and eventually (at the death of the individuals) provide partial recovery of cash outflows associated with the benefits.

29


Premises and Equipment
 
Premises and equipment increased $223,000 from $12.2 million at December 31, 2009 to $12.5 million at March 31, 2010, an increase of 1.8%.  This occurred primarily due to the new branch construction in Wellsboro, Pennsylvania of $379,000 during the first quarter of 2010.  Expected construction costs are approximately $1.1 million, with completion anticipated in the second quarter 2010.

Deposits
 
Core deposits continue to be the most significant source of funds for the Company. Deposits increased $18.8 million or 3.1%, since December 31, 2009.  The increase in deposits is due to several reasons.  Our market area has been positively impacted by oil and gas exploration activities.  We have developed targeted products to meet the needs of customers benefiting from this activity.  The overall turbulence and volatility in the financial markets has also resulted in customers seeking more stability in their deposits.  Finally, our ability to work with local municipalities to meet their business needs has resulted in increased deposits.
 
As of March 31, 2010, non-interest-bearing deposits, NOW accounts, savings accounts and money market accounts, have all increased by $932,000, $2.2 million, $3.3 million and $2.1 million, respectively, from December 31, 2009.  Certificates of deposit also increased by $10.4 million.  The increase in certificates of deposit is primarily due to customers shifting balances from lower paying deposit accounts into CD’s in order to increase their return.  As mentioned, oil and gas exploration has had a significant impact on this segment as well.  The Bank currently does not have any outstanding brokered certificates of deposit.


 
March 31,
December 31,
 
2010
2009
(in thousands)
Amount
%
Amount
%
Non-interest-bearing deposits
 $    60,993
     9.8
 $  60,061
   9.9
NOW accounts
     138,327
    22.1
   136,153
  22.5
Savings deposits
      52,332
     8.4
    49,049
   8.1
Money market deposit accounts
      44,299
     7.1
    42,210
   7.0
Certificates of deposit
     328,446
    52.6
   318,086
  52.5
Total
 $   624,397
   100.0
 $ 605,559
 100.0
         
 
 
March 31,  2010/
 
 December 31, 2009
 
        Change
(in thousands)
Amount
%
Non-interest-bearing deposits
 $       932
     1.6
NOW accounts
       2,174
     1.6
Savings deposits
       3,283
     6.7
Money market deposit accounts
       2,089
     4.9
Certificates of deposit
      10,360
     3.3
Total
 $    18,838
     3.1

Borrowed Funds
 
Borrowed funds decreased $700,000 during the first three months of 2010.  The ability to grow deposits decreased our reliance on borrowed funds.  The Company's daily cash requirements or short-term investments are primarily met by using the financial instruments available primarily through the Federal Home Loan Bank of Pittsburgh.

30

In December 2003, the Company formed a special purpose entity, Citizens Financial Statutory Trust I (“the Entity”), to issue $7,500,000 of floating rate obligated mandatory redeemable securities as part of a pooled offering.  The rate is determined quarterly based on the 3 month LIBOR plus 2.80%.  The Entity may redeem them, in whole or in part, at face value at any time.  The Company borrowed the proceeds of the issuance from the Entity in December 2003 in the form of a $7,500,000 note payable, which is included within “Borrowed Funds” in the liabilities section of the Company’s balance sheet. Under current accounting rules, the Company’s minority interest in the Entity was recorded at the initial investment amount and is included in the other assets section of the balance sheet.  The Entity is not consolidated as part of the Company’s consolidated financial statements.
 
In December, 2008, the Company entered into an interest rate swap agreement to convert the above mentioned floating-rate debt to fixed rate debt on a notional amount of $7.5 million. The interest rate swap instrument involves an agreement to receive a floating rate and pay a fixed rate, at specified intervals, calculated on the agreed-upon notional amount. The differentials paid or received on interest rate swap agreements are recognized as adjustments to interest expense in the period. The interest rate swap agreement was entered into on December 17, 2008 and expires December 17, 2013.  The fair value of the interest rate swap at March 31, 2010 was a liability of $263,000 and is included within other liabilities on the Consolidated Balance Sheet.
 
Stockholder’s Equity
 
We evaluate stockholders’ equity in relation to total assets and the risks associated with those assets.  The greater the capital resource, the more likely a corporation will meet its cash obligations and absorb unforeseen losses.  For these reasons, capital adequacy has been, and will continue to be, of paramount importance.
 
Total stockholders’ equity was $63.7 million at March 31, 2010 compared to $61.5 million at December 31, 2009, an increase of $2.2 million or 3.6%.  Excluding accumulated other comprehensive income, stockholder’s equity increased $2.0 million, or 3.4%.  In the first three months of 2010, the Company had net income of $2.7 million and paid dividends of $0.7 million, representing a dividend payout ratio of 26.1%.  The Company purchased 1,725 shares of treasury stock at a weighted average cost of $26.00 per share.  
 
All of the Company’s investment securities are classified as available-for-sale, making this portion of the Company’s balance sheet more sensitive to the changing market value of investments.  Accumulated other comprehensive income increased $164,000 from December 31, 2009 as a result of market value fluctuations.
 
The Company has also complied with standards of being well capitalized mandated by the banking regulators.  The Company’s primary regulators have established “risk-based” capital requirements designed to measure capital adequacy.  Risk-based capital ratios reflect the relative risks associated with various assets entities hold in their portfolios.  A weight category of 0% (lowest risk assets), 20%, 50%, or 100% (highest risk assets), is assigned to each asset on the balance sheet. The Company’s computed risk-based capital ratios are as follows:
 
March 31,
 
December 31,
(dollars in thousands)
2010
 
2009
Total capital (to risk-weighted assets)
Amount
 
Ratio
 
Amount
 
Ratio
Company
 $65,166
 
13.92%
 
 $62,751
 
13.77%
For capital adequacy purposes
  37,439
 
8.00%
 
  36,464
 
8.00%
To be well capitalized
  46,799
 
10.00%
 
  45,580
 
10.00%
               
Tier I capital (to risk-weighted assets)
           
Company
 $59,975
 
12.82%
 
 $57,839
 
12.69%
For capital adequacy purposes
  18,719
 
4.00%
 
  18,232
 
4.00%
To be well capitalized
  28,079
 
6.00%
 
  27,348
 
6.00%
               
Tier I capital (to average assets)