secondqtr2010.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 June 30, 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 August 2, 2010, was 2,891,948.

 
 

 

 
 
Citizens Financial Services, Inc.
Form 10-Q

INDEX
 
 
   
PAGE
Part I
FINANCIAL INFORMATION
 
Item 1.
Financial Statements (unaudited):
 
 
Consolidated Balance Sheet as of June 30, 2010 and December 31, 2009
1
 
Consolidated Statement of Income for the Three Months and Six Months Ended June 30, 2010 and 2009
2
 
Consolidated Statement of Comprehensive Income for the Three Months and Six Months Ended June 30, 2010 and 2009
3
 
Consolidated Statement of Cash Flows for the Six Months Ended June 30, 2010 and 2009
4
 
Notes to Consolidated Financial Statements
5-15
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
16-38
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
38
Item 4.
Controls and Procedures
38
     
Part II
OTHER INFORMATION
 
Item 1.
Legal Proceedings
39
Item 1A.
Risk Factors
39
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
39
Item 3.
Defaults upon Senior Securities
40
Item 4.
[Removed and Reserved]
40
Item 5.
Other Information
40
Item 6.
Exhibits
40
 
Signatures
41

 
 

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED BALANCE SHEET
   
(UNAUDITED)
   
     
 
June 30,
December 31,
(in thousands except share data)
2010
2009
ASSETS:
   
Cash and due from banks:
   
  Noninterest-bearing
 $              9,656
 $           9,505
  Interest-bearing
               30,728
            21,944
Total cash and cash equivalents
               40,384
            31,449
     
Available-for-sale securities
            217,261
          198,582
 
   
Loans (net of allowance for loan losses:
   
  2010, $5,302 and 2009, $4,888)
            467,037
          451,496
 
   
Premises and equipment
               12,694
            12,227
Accrued interest receivable
                 3,228
              3,141
Goodwill
               10,256
            10,256
Bank owned life insurance
               12,917
            12,667
Other assets
                 9,900
              9,659
 
 
 
TOTAL ASSETS
 $         773,677
 $       729,477
 
 
 
LIABILITIES:
   
Deposits:
   
  Noninterest-bearing
 $           63,954
 $         60,061
  Interest-bearing
            582,709
          545,498
Total deposits
            646,663
          605,559
Borrowed funds
               52,763
            54,115
Accrued interest payable
                 1,787
              2,037
Other liabilities
                 5,861
              6,239
TOTAL LIABILITIES
            707,074
          667,950
STOCKHOLDERS' EQUITY:
   
 Preferred stock    
  $1.00 par value; authorized 3,000,000 shares at June 30, 2010 and none at    
    December 31, 2009; none issued at June 30, 2010 and December 31, 2009  -  -
Common stock
   
  $1.00 par value; authorized 15,000,000 shares at June 30, 2010 and 10,000,000 at
   
     December 31, 2009; issued 3,076,253 shares at June 30, 2010 and
   
     December 31, 2009
                 3,076
              3,076
Additional paid-in capital
               13,486
            13,457
Retained earnings
               51,575
            47,353
Accumulated other comprehensive income
                 3,112
              2,041
Treasury stock, at cost:  212,486 shares at June 30, 2010
   
  and 204,437 shares at December 31, 2009
               (4,646)
             (4,400)
TOTAL STOCKHOLDERS' EQUITY
               66,603
            61,527
TOTAL LIABILITIES AND
   
   STOCKHOLDERS' EQUITY
 $         773,677
 $       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
Six Months Ended
 
June 30,
June 30,
(in thousands, except share and per share data)
2010
2009
2010
2009
INTEREST INCOME:
       
Interest and fees on loans
 $        7,752
 $      7,558
 $      15,486
 $    15,035
Interest-bearing deposits with banks
                 17
               10
                 31
             12
Investment securities:
 
 
 
 
    Taxable
           1,264
         1,541
           2,599
         3,181
    Nontaxable
               727
             514
           1,368
            985
    Dividends
                   7
                 6
                 13
             13
TOTAL INTEREST INCOME
           9,767
         9,629
         19,497
       19,226
INTEREST EXPENSE:
       
Deposits
           2,519
         2,863
           5,061
         5,778
Borrowed funds
               439
             496
               880
         1,019
TOTAL INTEREST EXPENSE
           2,958
         3,359
           5,941
         6,797
NET INTEREST INCOME
           6,809
         6,270
         13,556
       12,429
Provision for loan losses
               235
             150
               540
            300
NET INTEREST INCOME AFTER
       
    PROVISION FOR LOAN LOSSES
           6,574
         6,120
         13,016
       12,129
NON-INTEREST INCOME:
       
Service charges
               937
             894
           1,790
         1,706
Trust
               135
             113
               281
            276
Brokerage and insurance
               141
               53
               223
            153
Gains on loans sold
                 35
             162
                 48
            209
Investment securities gains, net
                 35
             102
                 99
            118
Earnings on bank owned life insurance
               125
             115
               249
            236
Other
               116
               96
               224
            191
TOTAL NON-INTEREST INCOME
           1,524
         1,535
           2,914
         2,889
NON-INTEREST EXPENSES:
       
Salaries and employee benefits
           2,416
         2,329
           4,857
         4,625
Occupancy
               297
             296
               603
            617
Furniture and equipment
               111
             124
               217
            234
Professional fees
               153
             164
               333
            295
FDIC insurance
               217
             378
               454
            753
Other
           1,162
         1,200
           2,220
         2,339
TOTAL NON-INTEREST EXPENSES
           4,356
         4,491
           8,684
         8,863
Income before provision for income taxes
           3,742
         3,164
           7,246
         6,155
Provision for income taxes
               815
             692
           1,573
         1,337
NET INCOME
 $        2,927
 $      2,472
 $        5,673
 $      4,818
 
       
Earnings Per Share
 $          1.02
 $        0.86
 $          1.98
 $        1.68
Cash Dividends Paid Per Share
 $        0.255
 $      0.245
 $        0.505
 $      0.485
         
Weighted average number of shares outstanding
   2,870,299
  2,874,101
   2,870,390
  2,873,292
         
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
Six Months Ended
 
June 30,
June 30,
(in thousands)
 
2010
 
2009
 
2010
 
2009
Net income
 
 $   2,927
 
 $    2,472
 
 $     5,673
 
 $      4,818
Other comprehensive income:
               
      Unrealized gains on available for sale securities
       1,560
 
          401
 
        1,969
 
            671
 
      Change in unrealized (loss) gain on interest rate swap
        (150)
 
          224
 
         (247)
 
            238
 
       Less:  Reclassification adjustment for gain included in net income
          (35)
 
         (102)
 
           (99)
 
           (118)
 
Other comprehensive income before tax
 
       1,375
 
          523
 
        1,623
 
            791
Income tax expense related to other comprehensive income
 
          468
 
          178
 
           552
 
            269
Other comprehensive income, net of tax
 
          907
 
          345
 
        1,071
 
            522
Comprehensive income
 
 $   3,834
 
 $    2,817
 
 $     6,744
 
 $      5,340
                 
The accompanying notes are an integral part of these unaudited consolidated financial statements.
           




 
3

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED STATEMENT OF CASH FLOWS
   
(UNAUDITED)
Six Months Ended
 
June 30,
(in thousands)
2010
2009
CASH FLOWS FROM OPERATING ACTIVITIES:
   
  Net income
 $        5,673
 $         4,818
  Adjustments to reconcile net income to net
   
   cash provided by operating activities:
   
    Provision for loan losses
               540
                300
    Depreciation and amortization
               241
                305
    Amortization and accretion of investment securities
               355
                100
    Deferred income taxes
               (33)
                  15
    Investment securities gains, net
               (99)
              (118)
    Realized gains on loans sold
               (48)
              (209)
    Stock Award Compensation
               157
                  71
    Earnings on bank owned life insurance
             (249)
              (236)
    Originations of loans held for sale
         (3,204)
         (10,597)
    Proceeds from sales of loans held for sale
            3,252
          10,806
    (Gain) loss on sale of foreclosed assets held for sale
               (45)
                  49
    Decrease (increase) in accrued interest receivable
               (87)
                126
    Decrease in accrued interest payable
             (250)
              (185)
    Other, net
             (882)
                404
      Net cash provided by operating activities
            5,321
            5,649
     
CASH FLOWS FROM INVESTING ACTIVITIES:
   
  Available-for-sale securities:
   
    Proceeds from sales of available-for-sale-securities
            8,871
            6,778
    Proceeds from maturity and principal repayments of securities
         22,995
          27,988
    Purchase of securities
       (48,931)
         (41,557)
  Purchase of regulatory stock
                    -
              (586)
  Net increase in loans
       (17,066)
           (9,582)
  Purchase of premises and equipment
             (788)
              (855)
  Proceeds from sale of premises and equipment
                    -
            1,405
  Proceeds from sale of foreclosed assets held for sale
               606
                231
      Net cash used in investing activities
       (34,313)
         (16,178)
     
CASH FLOWS FROM FINANCING ACTIVITIES:
   
  Net increase in deposits
         41,104
          35,790
  Proceeds from long-term borrowings
            1,159
          10,040
  Repayments of long-term borrowings
         (3,310)
         (12,050)
  Net increase in short-term borrowed funds
               799
                189
  Purchase of treasury stock
             (374)
              (192)
  Dividends paid
         (1,451)
           (1,381)
      Net cash  provided by financing activities
         37,927
          32,396
     
          Net increase in cash and cash equivalents
            8,935
          21,867
     
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
         31,449
          19,856
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 $      40,384
 $       41,723
     
Supplemental Disclosures of Cash Flow Information:
   
    Interest paid
 $        6,192
 $         6,982
     
    Income taxes paid
 $        1,675
 $         1,350
     
    Loans transferred to foreclosed property
 $        1,091
 $             374
   
 
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 periods ended June 30, 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 six-month period ended June 30, 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
Six months ended
 
June 30,
June 30,
 
2010
2009
2010
2009
 
       
Net income applicable to common stock
$2,927,000
$2,472,000
$5,673,000
$4,818,000
Weighted average common shares outstanding
2,870,299
2,874,101
2,870,390
2,873,292
         
Earnings per share
$1.02
$0.86
$1.98
$1.68

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 June 30, 2010 and December 31, 2009 were as follows (in thousands):
 
 
5

 

   
Gross
Gross
 
 
Amortized
Unrealized
Unrealized
Fair
June 30, 2010
Cost
Gains
Losses
Value
Available-for-sale securities:
       
  U.S. Agency securities
 $      80,176
 $         1,878
 $                 -
 $       82,054
  Obligations of state and
       
    political subdivisions
         73,274
            1,475
              (136)
          74,613
  Corporate obligations
           2,998
               193
                    -
            3,191
  Mortgage-backed securities
         53,165
            3,405
                    -
          56,570
  Equity securities
              826
                 36
                (29)
               833
Total available-for-sale securities
 $    210,439
 $         6,987
 $           (165)
 $     217,261
         
         
   
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 June 30, 2010 and December 31, 2009 (in thousands). As of June 30, 2010 and December 31, 2009, the Company owned 23 and 33 securities whose estimated fair value was less than their cost basis, respectively.
 

June 30, 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
Obligations of states and
           
     political subdivisions
 $        13,825
 $             126
 $             486
 $               10
 $        14,311
 $             136
Equity securities
                  63
                  29
   
                  63
                  29
               
    Total securities
 $        13,888
 $             155
 $             486
 $               10
 $        14,374
 $             165
               
               
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
 
 
 
 
6

 
As of June 30, 2010, the Company’s investment securities portfolio contains unrealized losses on obligations of states and political subdivisions and certain equity positions. 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 six months ended June 30, 2010 and 2009 were $8,871,000 and $6,778,000, respectively.  For the three months ended June 30, 2010 and 2009, proceeds from sales of securities available-for-sale were $3,016,000 and $4,600,000, respectively.  The gross gains and losses were as follows (in thousands):

 
Three Months Ended
Six Months Ended
 
 June 30,
 June 30,
 
2010
2009
2010
2009
Gross gains
 $             35
 $            157
 $              99
 $            209
Gross losses
                   -
                 55
                    -
                 91
Net gains
 $             35
 $            102
 $              99
 $            118

Investment securities with an approximate carrying value of $153,410,000 and $144,880,000 at June 30, 2010 and December 31, 2009, respectively, were pledged to secure public funds and certain other deposits as provided by law.
 
Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.   The amortized cost and fair value of debt securities at June 30, 2010, by contractual maturity, are shown below (in thousands):

 
Amortized
   
 
Cost
 
Fair Value
Available-for-sale securities:
     
  Due in one year or less
 $        3,366
 
 $         3,402
  Due after one year through five years
         51,382
 
          52,312
  Due after five years through ten years
         34,187
 
          35,494
  Due after ten years
       120,678
 
        125,220
Total
 $    209,613
 
 $     216,428



 
7

 
Note 5 – Loans
 
The Company grants commercial, industrial, agricultural, residential, and consumer loans primarily to customers throughout North central Pennsylvania and Southern New York.  Although the Company believes it had a diversified loan portfolio at June 30, 2010 and December 31, 2009, a substantial portion of its debtors’ ability to honor their contracts is dependent on the economic conditions within these regions. The major classifications of loans are as follows (in thousands):
 
 
June 30,
 
December 31,
 
2010
 
2009
(in thousands)
Amount
 
Amount
Real estate:
     
  Residential
 $   192,548
 
 $   194,989
  Commercial
  138,129
 
     133,953
  Agricultural
   19,768
 
      19,485
  Construction
   12,781
 
       5,619
Loans to individuals
     
  for household, family and other purchases
   11,933
 
      11,895
Commercial and other loans
   50,057
 
      44,101
State & political subdivision loans
   47,123
 
      46,342
Total loans
  472,339
 
     456,384
Less allowance for loan losses
    5,302
 
       4,888
Net loans
 $   467,037
 
 $   451,496
 
The Company had non-accrual loans, inclusive of impaired loans, of $5,535,000 and $5,871,000 at June 30, 2010 and December 31, 2009, respectively. Information with respect to impaired loans as of and for the periods ended June 30, 2010 and December 31, 2009 are as follows (in thousands):

 
June 30, 2010
 
December 31, 2009
Impaired loans without related allowance for loan losses
 $           5,008
 
 $              4,345
Impaired loans with related allowance for loan losses
              6,651
 
                    799
Related allowance for loan losses
                 304
 
                    115
Average recorded balance of impaired loans
              6,993
 
                 2,980

Interest income recognized on impaired loans for the periods ended June 30, 2010 and 2009 was $114,000 and $11,000, respectively.
 
Changes in the allowance for loan losses were as follows (in thousands):
 
 
June 30,
 
June 30,
(in thousands)
2010
 
2009
Balance, at beginning of period
 $  4,888
 
 $     4,378
  Provision charged to income
      540
 
         300
  Recoveries on loans previously
     
    charged against the allowance
      124
 
         43
 
    5,552
 
       4,721
  Loans charged against the allowance
     (250)
 
        (99)
Balance, at end of period
 $  5,302
 
 $     4,622
 
The following is a summary of the past due and non-accrual loans as of June 30, 2010 and December 31, 2009 (in thousands):

 
8

 




 
June 30, 2010
 
30 - 90 Days
 
90 Days Past
 
Non-
(in thousands)
Past Due
 
Due Accruing
 
accrual
Real estate:
         
  Residential
 $            1,133
 
 $                      196
 
 $           823
  Commercial
               1,180
 
                         121
 
790
  Agricultural
                  367
 
                           29
 
2,358
Loans to individuals for household,
         
  family and other purchases
                   36
 
                           43
 
1
Commercial and other loans
                   68
 
                           77
 
1,563
Total
 $            2,784
 
 $                      466
 
 $        5,535
           
 
December 31, 2009
 
 
30 - 90 Days
 
90 Days Past
 
Non-
(in thousands)
Past Due
 
Due Accruing
 
accrual
Real estate:
         
  Residential
 $            1,629
 
$                        75
 
 $           775
  Commercial
               1,558
 
                        635
 
1,863
  Agricultural
                   75
 
                            -
 
2,094
  Construction
                      -
 
                            -
 
749
Loans to individuals for household,
         
  family and other purchases
                   88
 
                          10
 
36
Commercial and other loans
                  610
 
                        164
 
354
Total
 $            3,960
 
 $                     884
 
 $        5,871


Note 6 – 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 June 30, 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 June 30, 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 7 - 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.

 
9

 

 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 and six months ended June 30, 2010 and 2009, respectively (in thousands):

 
Three Months Ended
 
Six Months Ended
 
 June 30,
 
 June 30,
 
2010
2009
 
2010
2009
           
Service cost
 $                 45
$                35
 
 $             214
 $             150
Interest cost
                    59
                  49
 
                282
                193
Expected return on plan assets
                  (77)
                (11)
 
              (369)
               (189)
Net amortization and deferral
                      6
                  56
 
                   31
                  62
           
Net periodic benefit cost
 $                 33
    $              130
 
 $             158
 $             217

No contributions have been made to the Pension Plan as of June 30, 2010; however, the Company expects to contribute $450,000 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 $116,000 and $105,000 for the six months ended June 30, 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 $15,000 and $18,000 for the six months ended June 30, 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.

 
10

 
For the six months ended June 30, 2010 and 2009, 5,090 and 7,526 shares of restricted stock were awarded and 4,948 and 2,517 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 $61,000 and $45,000 for the six months ended June 30, 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 June 30, 2010 and December 31, 2009, an obligation of $546,000 and $399,000, respectively, was included in other liabilities for this plan in the consolidated balance sheet.  Expenses related to this plan totaled $147,000 and $106,000 for the six months ended June 30, 2010 and 2009.

Note 8 – Fair Value Measurements
 
Fair value disclosures establish 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 this 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 June 30, 2010 and December 31, 2009 by level within the fair value hierarchy. Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.


 
11

 
 

(In thousands)
 
June 30, 2010
   
Level 1
 
Level II
 
Level III
   
Total
 Fair value measurements on a recurring basis:
                 
Securities available for sale:
                 
 U.S. Agency securities
     
 $             82,054
       
 $             82,054
 Obligations of state and
                 
        political subdivisions
     
74,613
       
74,613
 Corporate obligations
     
3,191
       
3,191
 Mortgage-backed securities
     
56,570
       
56,570
  Equity securities
 
 $             833
           
833
                   
Trust Preferred Interest Rate Swap
     
(413)
       
(413)
                   
Fair value measurements on non-recurring basis:
                 
Impaired Loans
     
1,751
 
 $             9,603
   
11,354
Other real estate owned
     
795
       
795
                   
                   
(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



 
12

 


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

 
June 30
 
December 31
 
2010
 
2009
 
Carrying
   
Carrying
 
 
Amount
Fair Value
 
Amount
Fair Value
Financial assets:
         
Cash and due from banks
 $    40,384
 $    40,384
 
 $    31,449
 $    31,449
Available-for-sale securities
     217,261
     217,261
 
     198,582
     198,582
Net loans
     467,037
     481,020
 
     451,496
     466,967
Bank owned life insurance
       12,917
       12,917
 
       12,667
       12,667
Regulatory stock
         3,957
         3,957
 
         3,957
         3,957
Accrued interest receivable
         3,228
         3,228
 
         3,141
         3,141
           
Financial liabilities:
         
Deposits
 $  646,663
 $ 653,967
 
 $  605,559
 $  611,705
Borrowed funds
       52,763
      50,184
 
       54,115
       50,582
Trust preferred interest rate swap
            413
            413
 
            166
            166
Accrued interest payable
         1,787
        1,787
 
         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.
 
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.

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.

 
13

 
 
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 9 – 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.
 
 
14

 
 
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 2010-05, 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. 
 
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 2010-18, Receivables (Topic 310):  Effect of a Loan Modification When the Loan is a Part of a Pool That is Accounted for as a Single Asset – a consensus of the FASB Emerging Issues Task Force.  ASU 2010-18 clarifies the treatment for a modified loan that was acquired as part of a pool of assets.  Refinancing or restructuring the loan does not make it eligible for removal from the pool, the FASB said.  The amendment will be effective for loans that are part of an asset pool and are modified during financial reporting periods that end July 15, 2010 or later and the Company is currently evaluating the impact the adoption of the standard will have on the Company’s financial position or results of operations.
 
In July 2010, FASB issued ASU No. 2010-20, Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.  ASU 2010-20 is intended to provide additional information to assist financial statement users in assessing an entity’s credit risk exposures and evaluating the adequacy of its allowance for credit losses. The disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010.  The amendments in ASU 2010-20 encourage, but do not require, comparative disclosures for earlier reporting periods that ended before initial adoption. However, an entity should provide comparative disclosures for those reporting periods ending after initial adoption.  The Company is currently evaluating the impact the   adoption of this guidance will have on the Company’s financial position or results of operations.

 
15

 

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 under “Part II – Item 1A – Risk Factors” in this report and 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 and six months ended June 30, 2010 are not necessarily indicative of the results you may expect for the full year.
 
 
16

 
 
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, reputational 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 cannot 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.

 
17

 

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 June 30, 2010 and December 31, 2009, the Trust Department had $84.7 and $85.9 million of assets under management, respectively.  The $800,000 decrease is primarily attributable to fluctuations in the stock market.

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.  The assets associated with these products are not included in the consolidated financial statements since such items are not assets of the Company. Assets owned and invested by customers of the Bank through the Bank’s Investment Representatives increased from $48.6 million at December 31, 2009 to $54.4 million at June 30, 2010. 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 $5,673,000 for the first six months of 2010 compared to earnings of $4,818,000 for last year’s comparable period, an increase of $855,000 or 17.7%. Earnings per share for the first six months of 2010 were $1.98, compared to $1.68 last year, representing a 17.9% increase.  Annualized return on assets and return on equity for the six months of 2010 were 1.52% and 18.49%, respectively, compared with 1.42% and 17.79% for last year’s comparable period.
 
Net income for the three months ended June 30, 2010 was $2,927,000 compared to earnings of $2,472,000 in the comparable 2009 period, an increase of $455,000. Earnings per share for the three months ended June 30, 2010 and 2009 were $1.02 and $0.86 per share, respectively.  Annualized return on assets and return on equity for the quarter ended June 30, 2010 was 1.57% and 19.09%, respectively, compared with 1.43% and 17.99% for the same 2009 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 six months of 2010 was $13,556,000, an increase of $1,127,000, or 9.1%, compared to the same period in 2009.  For the first six months of 2010, the provision for loan losses totaled $540,000, an increase of $240,000 over the comparable period in 2009.  Consequently, net interest income after the provision for loan losses was $13,016,000 compared to $12,129,000 during the first six months of 2009.
 
For the three months ended June 30, 2010, net interest income was $6,809,000 compared to $6,270,000, an increase of $539,000, or 8.6% over the comparable period in 2009. The provision for loan losses this quarter was $235,000 compared to $150,000 last year.  Consequently, net interest income after the provision for loan losses was $6,574,000 for the quarter ended compared to $6,120,000 in 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 six months and three months ended June 30, 2010 and 2009:

 
18

 

 
Analysis of Average Balances and Interest Rates (1)
 
Six Months Ended
 
June 30, 2010
June 30, 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
       21,886
               31
0.29
        18,336
               12
0.12
Total short-term investments
       21,886
               31
0.29
        18,336
                12
0.12
Investment securities:
           
  Taxable
     145,877
         2,612
3.58
      129,173
          3,195
4.95
  Tax-exempt (3)
       64,460
         2,073
6.43
        46,574
          1,493
6.41
  Total investment securities
     210,337
         4,685
4.45
      175,747
          4,688
5.33
Loans:
           
  Residential mortgage loans
     201,497
         7,110
7.12
      205,237
          7,464
7.33
  Commercial & farm loans
     204,283
         6,933
6.84
      174,692
          6,092
7.03
  Loans to state & political subdivisions
       46,649
         1,374
5.94
        46,422
          1,438
6.25
  Other loans
       11,537
             501
8.76
        11,277
              501
8.96
  Loans, net of discount (2)(3)(4)
     463,966
       15,918
6.92
      437,628
        15,495
7.14
Total interest-earning assets
     696,189
       20,634
5.98
      631,711
        20,195
6.44
Cash and due from banks
         9,310
   
          9,684
   
Bank premises and equipment
       12,400
   
        11,770
   
Other assets
       28,806
   
        27,476
   
Total non-interest earning assets
       50,516
   
        48,930
   
Total assets
     746,705
   
      680,641
   
LIABILITIES AND STOCKHOLDERS' EQUITY
         
Interest-bearing liabilities:
           
  NOW accounts
     144,714
             582
            0.81
      119,847
              497
            0.84
  Savings accounts
       52,006
               78
            0.30
        45,508
               73
            0.32
  Money market accounts
       43,023
             122
            0.57
        41,268
              185
            0.90
  Certificates of deposit
     323,669
         4,279
            2.67
      297,391
          5,023
            3.41
Total interest-bearing deposits
     563,412
         5,061
            1.81
      504,014
          5,778
            2.31
Other borrowed funds
       53,143
             880
            3.34
        57,777
          1,019
            3.56
Total interest-bearing liabilities
     616,555
         5,941
            1.94
      561,791
          6,797
            2.44
Demand deposits
       61,198
   
        55,793
   
Other liabilities
         7,602
   
          8,895
   
Total non-interest-bearing liabilities
       68,800
   
        64,688
   
Stockholders' equity
       61,350
   
        54,162
   
Total liabilities & stockholders' equity
     746,705
   
      680,641
   
Net interest income
 
       14,693
   
        13,398
 
Net interest spread (5)
   
4.04%
   
4.00%
Net interest income as a percentage
           
  of average interest-earning assets
   
4.26%
   
4.27%
Ratio of interest-earning assets
           
  to interest-bearing liabilities
   
            1.13
   
            1.13
             
(1) Averages are based on daily averages.
         
(2) Includes loan origination and commitment fees.
         
(3) Tax exempt interest revenue is shown on a tax equivalent basis for proper comparison using
   
       a statutory federal income tax rate of 34%.
     
(4) Income on non-accrual loans is accounted for on a cash basis, and the loan balances are included in interest-earning assets.
(5) Interest rate spread represents the difference between the average rate earned on interest-earning assets
      and the average rate paid on interest-bearing liabilities.
       
 

 
19

 
 
 
Analysis of Average Balances and Interest Rates (1)
 
 Three Months Ended
 
June 30, 2010
June 30, 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
        24,598
                17
0.27
          28,062
                10
0.14
Total short-term investments
        24,698
                17
0.27
          28,062
                10
0.14
Investment securities:
           
  Taxable
      148,636
           1,271
3.42
        128,082
            1,547
4.83
  Tax-exempt (3)
        68,734
           1,101
6.41
          48,346
              779
6.45
  Total investment securities
      217,370
           2,372
4.36
        176,428
            2,326
5.27
Loans:
           
  Residential mortgage loans
      202,335
           3,561
7.06
        203,680
            3,717
7.32
  Commercial & farm loans
      208,180
           3,468
6.68
        178,297
            3,111
7.00
  Loans to state & political subdivisions
        46,551
              682
5.88
          45,613
              704
6.19
  Other loans
        11,544
              250
8.69
          11,276
              250
8.89
  Loans, net of discount (2)(3)(4)
      468,610
           7,961
6.81
        438,866
            7,782
7.11
Total interest-earning assets
      710,678
        10,350
5.84
        643,356
          10,118
6.30
Cash and due from banks
           9,555
   
          10,516
   
Bank premises and equipment
        12,535
   
          11,770
   
Other assets
        28,998
   
          27,652
   
Total non-interest earning assets
        51,088
   
          49,938
   
Total assets
      761,666
   
        693,294
   
LIABILITIES AND STOCKHOLDERS' EQUITY
         
Interest-bearing liabilities:
           
  NOW accounts
      152,234
              315
             0.83
        124,630
              249
             0.80
  Savings accounts
        53,599
                40
             0.30
          46,111
                37
             0.32
  Money market accounts
        44,933
                61
             0.54
          41,901
                85
             0.81
  Certificates of deposit
      324,777
           2,103
             2.60
        301,066
            2,492
             3.32
Total interest-bearing deposits
      575,543
           2,519
             1.76
        513,708
            2,863
             2.23
Other borrowed funds
        52,858
              439
             3.33
          57,861
              496
             3.44
Total interest-bearing liabilities
      628,401
           2,958
             1.89
        571,569
            3,359
             2.36
Demand deposits
        63,319
   
          57,553
   
Other liabilities
           7,526
   
            9,224
   
Total non-interest-bearing liabilities
        70,845
   
          66,777
   
Stockholders' equity
        62,420
   
          54,948
   
Total liabilities & stockholders' equity
      761,666
   
        693,294
   
Net interest income
 
           7,392
   
            6,759
 
Net interest spread (5)
   
3.95%
   
3.94%
Net interest income as a percentage
           
  of average interest-earning assets
   
4.17%
   
4.21%
Ratio of interest-earning assets
           
  to interest-bearing liabilities
   
             1.13
   
              1.13
             
(1) Averages are based on daily averages.
         
(2) Includes loan origination and commitment fees.
         
(3) Tax exempt interest revenue is shown on a tax equivalent basis for proper comparison using a statutory federal income tax rate of 34%.
(4) Income on non-accrual loans is accounted for on a cash basis, and the loan balances are included in interest-earning assets.
(5) Interest rate spread represents the difference between the average rate earned on interest-earning assets
 
 

 
20

 
 
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 June 30, 2010 and 2009:
 

 
For the Three Months
 
For the Six Months
(dollars in thousands)
Ended June 30
 
Ended June 30
 
2010
2009
 
2010
2009
Interest and dividend income from investment securities
         
   and interest bearing deposits at banks (non-tax adjusted)
 $             2,015
 $              2,071
 
 $        4,011
 $          4,191
Tax equivalent adjustment
                   374
                   265
 
               705
               509
Interest and dividend income from investment securities
         
   and interest bearing deposits at banks (tax equivalent basis)
 $             2,389
 $              2,336
 
 $        4,716
 $          4,700
           
           
           
Interest and fees on loans (non-tax adjusted)
 $             7,752
 $              7,558
 
 $      15,486
 $        15,035
Tax equivalent adjustment
                   209
                   224
 
               432
               460
Interest and fees on loans (tax equivalent basis)
 $             7,961
 $              7,782
 
 $      15,918
 $        15,495
           
           
           
Total interest income
 $             9,767
 $              9,629
 
 $      19,497
 $        19,226
Total interest expense
                2,958
                3,359
 
            5,941
             6,797
Net interest income
                6,809
                6,270
 
         13,556
           12,429
Total tax equivalent adjustment
                   583
                   489
 
            1,137
               969
Net interest income (tax equivalent basis)
 $             7,392
 $              6,759
 
 $      14,693
 $        13,398

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


 
21

 
 

Analysis of Changes in Net Interest Income on a Tax-Equivalent Basis (1)
             
 
 Three months ended June 30, 2010 vs. 2009 (1)
 Six months ended June 30, 2010 vs. 2009 (1)
 
 Change in
 Change
 Total
 Change in
 Change
 Total
 (in thousands)
 Volume
 in Rate
 Change
 Volume
 in Rate
 Change
Interest Income:
           
Short-term investments:
           
  Interest-bearing deposits at banks
$                (1)
 $                  8
 $                  7
 $                 1
 $               18
 $               19
Investment securities:
           
  Taxable
                223
                (499)
                (276)
                513
           (1,096)
              (583)
  Tax-exempt
                327
                   (5)
                 322
                575
                    5
                580
Total investments
                550
                (504)
                   46
            1,088
           (1,091)
                 (3)
Loans:
           
  Residential mortgage loans
                (25)
                (131)
                (156)
              (134)
              (220)
              (354)
  Commercial & farm loans
                503
                (146)
                 357
                999
              (158)
                841
  Loans to state & political subdivisions
                  14
                 (36)
                 (22)
                    7
                (71)
                (64)
  Other loans
                    6
                   (6)
                      -
                  24
                (24)
                    -
Total loans, net of discount
                498
                (319)
                 179
                896
              (473)
                423
Total Interest Income
              1,047
                (815)
                 232
            1,985
           (1,546)
                439
Interest Expense:
           
Interest-bearing deposits:
           
  NOW accounts
                  57
                     9
                   66
                  99
                (14)
                  85
  Savings accounts
                    6
                   (3)
                     3
                  10
                 (5)
                    5
  Money Market accounts
                    6
                 (30)
                 (24)
                    8
                (71)
                (63)
  Certificates of deposit
                185
                (574)
                (389)
                510
           (1,254)
              (744)
Total interest-bearing deposits
                254
                (598)
                (344)
                627
           (1,344)
              (717)
Other borrowed funds
                (41)
                 (16)
                 (57)
                (79)
                (60)
              (139)
Total interest expense
                213
                (614)
                (401)
                548
           (1,404)
              (856)
Net interest income
 $             834
 $             (201)
 $              633
 $         1,437
 $           (142)
 $         1,295
             
(1) The portion of the total change attributable to both volume and rate changes, which cannot be separated, has been
      allocated proportionally to the change due to volume and the change due to rate prior to allocation.
   
 
Tax equivalent net interest income increased from $13,398,000 for the 2009 six month period to $14,693,000 in the 2010 six month period, an increase of $1,295,000 for the six months ended June 30, 2010.  The tax equivalent net interest margin decreased from 4.27% for the first six months of 2009 to 4.26% in 2010.
 
Total tax equivalent interest income for the six month period increased $439,000.  This increase is primarily a result of a $1,985,000 increase due to volume as the average balance of interest earning assets increased by $64.5 million.  There was a decrease of $1,546,000 due to change in rate, as the yield on interest earning assets decreased 46 basis points from 6.44% to 5.98%.
 
Investment income for the six months ended June 30, 2010 decreased $3,000 over the same period last year.  The average balance of total investment securities at June 30, 2010 increased by $34.6 million from June 30, 2009 primarily due to investing excess cash, primarily the result of increased deposits.
 
·  
The average balance of taxable securities increased by $16.7 million while tax-exempt securities increased by $17.9 million, which had the effect of increasing interest income by $513,000 and $575,000, respectively, due to volume.
 
·  
This increase was offset by a decrease in the yield on investment securities of 88 basis points from 5.33% to 4.45%, which corresponds to a decrease in interest income of $1,091,000. The majority of this decrease is attributable to the change in yield on taxable securities, which experienced a decrease of 137 basis points from 4.95% to 3.58%.
 
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.
 
 
22

 
 
Total loan interest income increased $423,000 for the six months ended June 30, 2010 compared to the same period last year.
 
·  
Interest income on residential mortgage loans decreased $354,000 of which $134,000 was due to volume and $220,000 was due to a decrease in rate.  The average balance decreased $3.7 million due to the continuing recessionary pressures within the economy, high unemployment rates and other negative economic factors that resulted in lower loan demand for non-conforming residential mortgages and home equity lines. Management also believes that a portion of the decreased loan demand for home equity loans is the result of customers receiving monies related to exploration and drilling of the natural gas reserves in the Marcellus Shale in our market area. As a result, customers are less reliant on home equity loans.
 
·  
The average balance of commercial and farm loans increased $29.6 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 $999,000 on total interest income due to volume, which was offset by a reduction due a decrease in rate of $158,000.
 
Total interest expense decreased $856,000 for the six months ended June 30, 2010 compared with last year.  This decrease is primarily due to a change in rate, accounting for a $1,404,000 decrease in our interest expense.  The average interest rate on interest-bearing liabilities decreased 50 basis points, from 2.44% to 1.94%. The historically low interest rates supported by the Federal Reserve and continuing recessionary pressures within the economy 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 $54.8 million resulting in an increase in interest expense of $548,000 (see also “Financial Condition – Deposits”).
 
·  
Interest expense on certificates of deposits decreased $744,000 over the same period last year. The average balance of certificates of deposit increased $26.3 million causing an increase in interest expense of $510,000.  Offsetting this was a decrease in the average rate on certificates of deposit from 3.41% to 2.67% resulting in a decrease in interest expense of $1,254,000.
 
 
·  
The average balance of NOW accounts also increased $24.9 million accounting for an increase of $99,000 in interest expense. The change in the average rate from 84 basis points to 81 basis points, contributed to a decrease in interest expense of $14,000 resulting in an overall increase of $85,000.
 
 
·  
The average balance of borrowed funds decreased by $4.6 million resulting in a decrease in interest expense of $79,000.  The average interest rate paid on borrowed funds also decreased by 22 basis points accounting for a decrease in interest expense of $60,000 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.
 
Tax equivalent net interest income for the three months ended June 30, 2010 was $7,392,000 which compares to $6,759,000 for the same period last year.  This represents an increase of $633,000 or 9.4%. Total tax equivalent interest income was $10,350,000 compared with $10,118,000 for the comparable period last year, an increase of $232,000:
 
·  
Of this amount, $1,047,000 was due to an increase in volume and $815,000 was due to a decrease in rate.
 
·  
Total investment income increased by $46,000 compared to last year.  This was predominantly due to a change in volume of $40.9 million in average investment securities offset by a 91 point decrease in rate.
 
·  
Total loan interest income increased $179,000 compared to last year. This was predominantly due to a change in volume as a result of $29.7 million increase in average loans outstanding offset by a decrease of 30 points in rate.
 
Total interest expense decreased $401,000 for the three months ended June 30, 2010 compared with last year. $213,000 is attributable to an increase in volume mostly due to a $23.7 million increase in certificates of deposit.  Conversely, $614,000 is due to a decrease in rate as the average rate on interest-bearing liabilities decreased 47 basis points from 2.36% to 1.89%.
 
 
23

 

Provision For Loan Losses
 
For the six month period ending June 30, 2010, we recorded a provision for loan losses of $540,000, which represents an increase of $240,000 over the $300,000 provision recorded in the corresponding six months of last year. This is the result of current economic conditions, the growth in commercial real estate, construction and commercial business loans, which tend to be riskier than residential real estate loans, and an increase in non-performing loans as of June 30, 2010, which have impacted management's quarterly review of the allowance for losses (see also “Financial Condition – Allowance for Loan Losses and Credit Quality Risk”).
 
For the three months ending June 30, 2010, we recorded a provision of $235,000 compared to $150,000 in 2009.

Non-interest Income
 
Non-interest income for the six months ended June 30, 2010 totaled $2,914,000, an increase of $25,000 when compared to the same period in 2009. During the first six months of 2010, investment security gains amounted to $99,000 compared to investment security gains of $118,000 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 and U.S treasury note due to favorable market conditions for gains of $55,000 and $20,000, respectively in 2010. We also had two municipal bonds and an agency called that resulted in total gains of $15,000. In 2009, we sold an agency bond at a gain of $32,000 and several higher coupon mortgage-backed securities that were prepaying very quickly realizing a total of $157,000 in gains.  This was offset with a $16,000 loss on the sale of bank equity shares as well as an other than temporary impairment charge of $54,000 on our Freddie Mac preferred stock.
 
Service charge income increased by $84,000 or 4.9%, and continues to be the Company’s primary source of non-interest income.  For the first six months of 2010, account service charges totaled $1,790,000 compared to $1,706,000 last year. There was a $87,000 increase attributable to customers’ usage of their debit cards due to continuing efforts on the Bank’s part to encourage customers to pay for items utilizing this payment method.
 
Brokerage and insurance income increased $70,000 as we continue to increase the principal amounts invested through us by our customers by adding additional employees to serve our customers’ needs.  Gains on loans sold decreased $161,000 compared to last year due to the significant amount of refinancing completed last year with the favorable rates in the secondary markets.
 
For reasons previously mentioned above, service charges increased by $43,000 for the three months ended June 30, 2010 compared to the same period in 2009. Brokerage and insurance increased by $88,000 as a result of the Bank’s emphasis in this area.   Gains on loans sold decreased by $127,000 compared to last year’s three months ended due to significantly higher refinancing activity in the secondary market last year.  Investment securities gains amounted to $35,000 for the quarter compared to $102,000 last year.
 
Management is still evaluating the impact to the Company’s non-interest income as a result of recently enacted changes to regulations pertaining to the fees the Company can charge in regards to customer overdrafts (Regulation E).

The following table shows the breakdown of non-interest income for the three and six months ended June 30, 2010 and 2009:

 
24

 
 

 
Six months ended June 30,
Change 
 
2010
2009
Amount
%
Service charges
 $               1,790
 $              1,706
 $                  84
                 4.9
Trust
                      281
                   276
                      5
                 1.8
Brokerage and insurance
                      223
                   153
                     70
               45.8
Gains on loans sold
                        48
                  209
                 (161)
             (77.0)
Investment securities gains, net
                        99
                   118
                  (19)
(16.1)
Earnings on bank owned life insurance
                      249
                   236
                     13
                 5.5
Other
                      224
                   191
                     33
               17.3
Total
 $               2,914
 $              2,889
 $                  25
                 0.9
         
 
Three months ended June 30,
Change
 
2010
2009
Amount
%
Service charges
 $                   937
 $                894
 $                  43
                 4.8
Trust
                      135
                   113
                     22
               19.5
Brokerage and insurance
                      141
                     53
                     88
             166.0
Gains on loans sold
                        35
                   162
                 (127)
             (78.4)
Investment securities gains, net
                        35
                   102
                  (67)
                 (65.7)
Earnings on bank owned life insurance
                      125
                   115
                     10
                 8.7
Other
                      116
                     96
                     20
               20.8
Total
 $               1,524
 $              1,535
$                 (11)
               (0.7)

Non-interest Expense
 
Non-interest expenses decreased $179,000, or 2.0% for the six months ended June 30, 2010 compared to the same period in 2009.  The increase in salaries and employee benefits of $232,000 is due to annual merit increases effective the beginning of 2010 which are approximately $110,000, increased expense related to providing employee’s insurance of $21,000, a $41,000 increase in the Company’s Supplemental Executive Retirement Plan (SERP) plan and a $61,000 increase related to profit sharing, offset by a decrease of $59,000 related to the Company’s defined benefit pension plan.  
 
FDIC Insurance decreased by $299,000 for the six months ended June 30, 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 $38,000 due to various legal and consulting costs.  The $72,000 decrease in amortization of intangibles is due to intangible assets becoming fully amortized in 2009.
 
For the three months ended, June 30, 2010, salaries and employee benefits increased by $87,000 due to the reasons described above, which include merit increases of $59,000, SERP expense of $35,000, Profit sharing of $39,000 offset by a decrease in pension of $97,000. As mentioned above, FDIC insurance also decreased by $161,000 compared to the same period last year.
 
The following tables reflect the breakdown of non-interest expense and professional fees for the three and six months ended June 30, 2010 and 2009:

 
25

 
 

 
Six months ended June 30,
Change
 
2010
2009
Amount
%
Salaries and employee benefits
 $               4,857
 $              4,625
 $                 232
                   5.0
Occupancy
                      603
                   617
                   (14)
                (2.3)
Furniture and equipment
                      217
                   234
                   (17)
                (7.3)
Professional fees
                      333
                   295
                     38
                 12.9
Amortization of intangibles
         8
                     80
                   (72)
               (90.0)
FDIC Insurance
                      454
                   753
                 (299)
               (39.7)
ORE expenses
                      171
                   169
                       2
                   1.2
Other
                   2,041
                2,090
                   (49)
                (2.3)
Total
 $               8,684
 $              8,863
 $               (179)
                (2.0)
         
 
Six months ended June 30,
Change
 
2010
2009
Amount
%
Other professional fees
 $                   170
$                 145
 $                   25
                 17.2
Legal fees
                        53
                     38
                     15
                 39.5
Examinations and audits
                      110
                   112
                     (2)
                (1.8)
Total
 $                   333
 $                295
 $                   38
                 12.9
 
 
Three months ended June 30,
Change
 
2010
2009
Amount
%
Salaries and employee benefits
 $               2,416
 $              2,329
 $                   87
                   3.7
Occupancy
                      297
                   296
                       1
                   0.3
Furniture and equipment
                      111
                   124
                   (13)
               (10.5)
Professional fees
                      153
                   164
                   (11)
                (6.7)
Amortization of intangibles
                           4
                     40
                   (36)
               (90.0)
FDIC Insurance
                      217
                   378
                 (161)
               (42.6)
ORE expenses
                        90
                     93
                     (3)
                (3.2)
Other
                   1,068
                1,067
                       1
                   0.1
Total
 $               4,356
 $              4,491
 $               (135)
                (3.0)
         
 
Three months ended June 30,
Change
 
2010
2009
Amount
%
Other professional fees
 $                     67
$                   73
$                   (6)
                (8.2)
Legal fees
                        31
                     30
                       1
                   3.3
Examinations and audits
                        55
                     61
                     (6)
                (9.8)
Total
 $                   153
 $                164
 $                (11)
                (6.7)

Provision For Income Taxes
 
The provision for income taxes was $1,573,000 for the six month period ended June 30, 2010 compared to $1,337,000 for the same period in 2009.  The increase is primarily attributable to an increase in income before provision for income taxes of $1,091,000. 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% for the first six months of 2010 and 2009 compared to the statutory rate of 34%.
 
 
26

 
 
For the three-months ended June 30, 2010 the provision for income taxes was $815,000 compared to $692,000 for the same period in 2009. The increase is primarily attributable to an increase in income before provision for income taxes of $578,000.

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 $890,000 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 $327,000 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 $201,000 out of a total $574,000 of tax credits.  We anticipate recognizing $454,000 of tax credits over the next seven years, with $164,000 expected to be recognized in 2010.

Financial Condition
 
Total assets were $773.7 million at June 30, 2010, an increase of $44.2 million, or 6.1% from $729.5 million at December 31, 2009.  Net loans increased 3.4% to $467.0 million and investment securities increased 9.4% to $217.3 million at June 30, 2010.  Total deposits increased $41.1 million or 6.8% to $646.7 million since year-end 2009. Borrowed funds have decreased $1.3 million to $52.8 million compared with $54.1 million at year-end.

Cash and Cash Equivalents
 
Cash and cash equivalents totaled $40.4 million at June 30, 2010 compared to $31.4 million at December 31, 2009, an increase of $9.0 million. The Company continues to hold significant cash reserves to invest in a future higher rate environment.   Non-interest-bearing cash decreased $151,000 since year-end 2009, while interest-bearing cash increased $8.8 million during that same period.  A portion of the increase in deposits over the first six 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 $18.7 million or 9.4% from December 31, 2009 to June 30, 2010.  During 2010 we purchased approximately $28.6 million of U.S. agency obligations, $3.0 million of U.S. Treasury notes, $1.3 million of mortgage backed securities, $15.5 million of state and local obligations and $450,000 of equity securities, which help offset the $14.1 million of principal repayments and $8.9 million of calls that occurred during the year. We also selectively sold $8.9 million of U.S agency obligations, U.S Treasury notes and mortgage backed securities at a net gain of $99,000. The overall market value of our investment portfolio increased approximately $1.9 million due to market fluctuations since year end.  Significant unrealized gains were seen in our U.S. agency obligations  and state and local obligations 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 4.45% compared to 5.33% 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 $14.1 million and calls on our agency bonds and state and local obligations of $8.9 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 $28.6 million and longer-term municipal bond purchases of $15.5 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.

 
27

 

 
Estimated Fair Market Value of Investment Portfolio
 
June 30, 2010
December 31, 2009
(dollars in thousands)
Amount
%
Amount
%
Available-for-sale:
       
  U. S. Agency securities
 $    82,054
    37.8
 $  65,223
  32.8
  Obligations of state & political
       
     subdivisions
     74,613
    34.3
    59,574
  30.0
  Corporate obligations
      3,191
     1.5
     3,166
   1.6
  Mortgage-backed securities
     56,570
    26.0
    70,194
  35.3
  Equity securities
        833
     0.4
       425
   0.3
Total
 $   217,261
   100.0
 $ 198,582
 100.0
 
     
 
June 30, 2010/
 
 December 31, 2009
 
        Change
(dollars in thousands)
Amount
%
Available-for-sale:
   
  U. S. Agency securities
 $    16,831
    25.8
  Obligations of state & political
   
     subdivisions
      15,039
    25.2
  Corporate obligations
          25
     0.8
  Mortgage-backed securities
     (13,624)
   (19.4)
  Equity securities
         408
    96.0
Total
 $    18,679
     9.4

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.  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 $16.0 million or 3.5% during the first six months of 2010.  Commercial real estate, agricultural real estate, construction, commercial and other loans and loans to state and political subdivisions increased $4.2 million, $283,000, $7.2 million, $6.0 million and $781,000, respectively.  Residential real estate loans have decreased $2.4 million.
 
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 June 30, 2010, we have sold $3.3 million of loans in the secondary market compared to $10.8 million through this time last year.  The Company recognizes fee income for servicing these sold loans, which is included in non-interest income on the consolidated statement of income.  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.

 
28

 
 
The growth in commercial real estate, agricultural, construction, other commercial loans and state and political subdivision 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.

 
June 30,
December 31,
 
2010
2009
(in thousands)
Amount
%
Amount
%
Real estate:
       
  Residential
 $ 192,548
   40.8
 $ 194,989
   42.7
  Commercial
   138,129
   29.2
   133,953
   29.4
  Agricultural
    19,768
    4.2
    19,485
    4.3
  Construction
    12,781
    2.7
     5,619
    1.2
Loans to individuals
       
  for household, family and other purchases
    11,933
    2.5
    11,895
    2.6
Commercial and other loans
    50,057
   10.6
    44,101
    9.7
State & political subdivision loans
    47,123
   10.0
    46,342
   10.1
Total loans
   472,339
  100.0
   456,384
  100.0
Less allowance for loan losses
     5,302
 
     4,888
 
Net loans
 $ 467,037
 
 $ 451,496
 
 
     
 
June 30, 2010/
 
 December 31, 2009
 
Change
(in thousands)
Amount
%
Real estate:
   
  Residential
 $  (2,441)
   (1.3)
  Commercial
     4,176
    3.1
  Agricultural
       283
    1.5
  Construction
     7,162
  127.5
Loans to individuals
   
  for household, family and other purchases
        38
    0.3
Commercial and other loans
     5,956
   13.5
State & political subdivision loans
       781
    1.7
Total loans
 $  15,955
    3.5

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 six months ended June 30, 2010 and for the years ended December 31, 2009, 2008, 2007 and 2006:

 
29

 


 
June 30,
December 31,
 (dollars in thousands)
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
                  47
                  76
                  31
                  64
                  37
     Commercial
                  53
                236
                  36
                    6
                  86
     Agricultural
                     -
                    1
                  20
                     -
                     -
  Loans to individuals for household,
         
    family and other purchases
                    9
                  80
                  44
                103
                103
  Commercial and other loans
                141
                153
                115
                  13
                  64
Total loans charged-off
                250
                546
                246
                186
                290
Recoveries:
         
  Real estate:
         
     Residential
                     -
                    1
                    6
                    2
                    6
     Commercial
                  12
                    1
                     -
                  79
                115
     Agricultural
                     -
                     -
                  20
                     -
                     -
  Loans to individuals for household,
         
    family and other purchases
                  22
                  52
                  19
                  52
                  39
  Commercial and other loans
                  90
                  77
                  52
                    9
                  12
Total loans recovered
                124
                131
                  97
                142
                172
           
Net loans charged-off
                126
                415
                149
                  44