secondqtr2011.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, 2011
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 __X__ 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, 2011, was 2,917,924.

 
 

 

 
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, 2011 and December 31, 2010
1
 
Consolidated Statement of Income for the Three Months and Six Months Ended June 30, 2011 and 2010
2
 
Consolidated Statement of Comprehensive Income for the Three Months and Six months Ended June 30, 2011 and 2010
3
 
Consolidated Statement of Cash Flows for the Six months Ended June 30, 2011 and 2010
4
 
Notes to Consolidated Financial Statements
5-23
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
24-47
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
47
Item 4.
Controls and Procedures
47
     
Part II
OTHER INFORMATION
 
Item 1.
Legal Proceedings
48
Item 1A.
Risk Factors
48
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
48
Item 3.
Defaults Upon Senior Securities
48
Item 4.
[Removed and Reserved]
48
Item 5.
Other Information
48
Item 6.
Exhibits
49
 
Signatures
50

 
 

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED BALANCE SHEET
   
(UNAUDITED)
   
     
 
June 30
December 31
(in thousands except share data)
2011
2010
ASSETS:
   
Cash and due from banks:
   
  Noninterest-bearing
 $             11,318
 $            9,541
  Interest-bearing
                33,114
             34,454
Total cash and cash equivalents
                44,432
             43,995
     
Available-for-sale securities
              288,610
           251,303
 
   
Loans (net of allowance for loan losses:
   
  2011, $6,163 and 2010, $5,915)
              470,749
           467,602
 
   
Premises and equipment
                11,956
             12,503
Accrued interest receivable
                  3,717
               3,455
Goodwill
                10,256
             10,256
Bank owned life insurance
                13,416
             13,171
Other assets
                  9,846
             10,241
 
 
 
TOTAL ASSETS
 $           852,982
 $        812,526
 
 
 
LIABILITIES:
   
Deposits:
   
  Noninterest-bearing
 $             80,545
 $          75,589
  Interest-bearing
              632,582
           605,122
Total deposits
              713,127
           680,711
Borrowed funds
                55,408
             55,996
Accrued interest payable
                  1,556
               1,779
Other liabilities
                  7,592
               5,350
TOTAL LIABILITIES
              777,683
           743,836
STOCKHOLDERS' EQUITY:
   
Preferred Stock
   
  $1.00 par value; authorized 3,000,000 shares June 30, 2011 and December 31, 2010;
   
   none issued in 2011 or 2010
                          -
                      -
Common stock
   
  $1.00 par value; authorized 15,000,000 shares;  issued 3,104,434 shares at
   
  June 30, 2011 and December 31, 2010, respectively
                  3,104
               3,104
Additional paid-in capital
                14,295
             14,235
Retained earnings
                59,393
             54,932
Accumulated other comprehensive income
                  3,244
               1,054
Treasury stock, at cost:  214,942 shares at June 30, 2011
   
  and 212,067 shares at December 31, 2010
                 (4,737)
             (4,635)
TOTAL STOCKHOLDERS' EQUITY
                75,299
             68,690
TOTAL LIABILITIES AND
   
   STOCKHOLDERS' EQUITY
 $           852,982
 $        812,526
     
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)
2011
2010
2011
2010
INTEREST INCOME:
       
Interest and fees on loans
 $        7,463
 $      7,752
 $      14,858
 $    15,486
Interest-bearing deposits with banks
                 20
               17
                 42
           31
Investment securities:
 
 
 
 
    Taxable
           1,176
         1,264
           2,348
         2,599
    Nontaxable
               892
             727
           1,757
         1,368
    Dividends
                 14
                 7
                 29
13
TOTAL INTEREST INCOME
           9,565
         9,767
         19,034
       19,497
INTEREST EXPENSE:
       
Deposits
           2,046
         2,519
           4,134
         5,061
Borrowed funds
               443
             439
               888
            880
TOTAL INTEREST EXPENSE
           2,489
         2,958
           5,022
         5,941
NET INTEREST INCOME
           7,076
         6,809
         14,012
       13,556
Provision for loan losses
               150
             235
               375
            540
NET INTEREST INCOME AFTER
       
    PROVISION FOR LOAN LOSSES
           6,926
         6,574
         13,637
       13,016
NON-INTEREST INCOME:
       
Service charges
           1,002
             937
           1,843
         1,790
Trust
               146
             135
               303
            281
Brokerage and insurance
               123
             141
               218
            223
Investment securities gains, net
               114
               35
               234
99
Earnings on bank owned life insurance
               124
             125
               245
            249
Other
               163
             151
               344
            272
TOTAL NON-INTEREST INCOME
           1,672
         1,524
           3,187
         2,914
NON-INTEREST EXPENSES:
       
Salaries and employee benefits
           2,518
         2,416
           5,033
         4,857
Occupancy
               329
             297
               719
            603
Furniture and equipment
               106
             111
               223
            217
Professional fees
               172
             153
               329
            333
FDIC insurance
               250
             217
               500
            454
Other
           1,209
         1,162
           2,456
         2,220
TOTAL NON-INTEREST EXPENSES
           4,584
         4,356
           9,260
         8,684
Income before provision for income taxes
           4,014
         3,742
           7,564
         7,246
Provision for income taxes
               867
             815
           1,587
         1,573
NET INCOME
 $        3,147
 $      2,927
 $        5,977
 $      5,673
 
       
Earnings Per Share
 $          1.09
 $        1.01
 $          2.07
 $        1.96
Cash Dividends Per Share
 $        0.265
 $      0.255
 $        0.525
 $      0.505
         
Weighted average number of shares outstanding
   2,887,276
  2,898,480
   2,888,094
  2,898,571
         
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)
 
2011
 
2010
 
2011
 
2010
Net income
 
 $     3,147
 
 $    2,927
 
 $      5,977
 
 $      5,673
Other comprehensive income:
               
      Change in unrealized net gains on available for sale securities
        2,660
 
       1,560
 
         3,551
 
         1,969
 
      Change in unrealized loss on interest rate swap
            (59)
 
         (150)
 
                1
 
           (247)
 
       Less:  Reclassification adjustment for gain included in net income
          (114)
 
           (35)
 
           (234)
 
             (99)
 
Other comprehensive income, before tax
 
        2,487
 
       1,375
 
         3,318
 
         1,623
Income tax expense related to other comprehensive income
 
           846
 
         468
 
         1,128
 
            552
Other comprehensive income, net of tax
 
        1,641
 
          907
 
         2,190
 
         1,071
Comprehensive income
 
 $     4,788
 
 $    3,834
 
 $      8,167
 
 $      6,744
                 
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)
2011
2010
CASH FLOWS FROM OPERATING ACTIVITIES:
   
  Net income
 $          5,977
 $          5,673
  Adjustments to reconcile net income to net
   
   cash provided by operating activities:
   
    Provision for loan losses
                375
                540
    Depreciation and amortization
                272
                241
    Amortization and accretion of investment securities
                940
                355
    Deferred income taxes
                192
                (33)
    Investment securities gains, net
              (234)
                (99)
    Earnings on bank owned life insurance
              (245)
              (249)
    Stock award compensation
                207
                157
    Originations of loans held for sale
           (5,316)
           (3,204)
    Proceeds from sales of loans held for sale
             5,391
             3,252
    Increase in accrued interest receivable
              (262)
                (87)
    Decrease in accrued interest payable
              (223)
              (250)
    Other, net
              (237)
              (975)
      Net cash provided by operating activities
             6,837
             5,321
CASH FLOWS FROM INVESTING ACTIVITIES:
   
  Available-for-sale securities:
   
    Proceeds from sales of available-for-sale securities
             7,821
             8,871
    Proceeds from maturity and principal repayments of securities
           32,063
           22,995
    Purchase of securities
         (72,496)
         (48,931)
  Proceeds from redemption of regulatory stock
                312
                    -
  Net increase in loans
           (3,925)
         (17,066)
  Purchase of premises and equipment
                (65)
              (788)
  Purchase of land for potential future expansion
              (545)
                    -
  Proceeds from sale of foreclosed assets held for sale
                371
                606
      Net cash used in investing activities
         (36,464)
         (34,313)
CASH FLOWS FROM FINANCING ACTIVITIES:
   
  Net increase in deposits
           32,416
           41,104
  Proceeds from long-term borrowings
                    9
             1,159
  Repayments of long-term borrowings
           (1,000)
           (3,310)
  Net increase in short-term borrowed funds
                403
                799
  Purchase of treasury and restricted stock
              (360)
              (374)
  Dividends paid
           (1,404)
           (1,451)
      Net cash provided by financing activities
           30,064
           37,927
          Net increase in cash and cash equivalents
                437
             8,935
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
           43,995
           31,449
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 $        44,432
 $        40,384
Supplemental Disclosures of Cash Flow Information:
   
    Interest paid
 $          5,245
 $          6,192
    Income taxes paid
 $          1,300
 $          1,675
    Loans transferred to foreclosed property
 $             490
 $          1,091
    Premises and equipment transferred to other assets
 $             282
 $                 -
    Investments purchased and not settled included in other liabilities
 $          2,085
 $                 -
   
 
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, 2011 and 2010 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, 2011 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, 2010.

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,
 
2011
2010
2011
2010
 
       
Net income applicable to common stock
$3,147,000
$2,927,000
$5,977,000
$5,673,000
Weighted average common shares outstanding
2,887,276
2,898,480
2,888,094
2,898,571
         
Earnings per share
$1.09
$1.01
$2.07
$1.96

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, 2011 and December 31, 2010 were as follows (in thousands):
 
 
5

 

   
Gross
Gross
 
 
Amortized
Unrealized
Unrealized
Fair
June 30, 2011
Cost
Gains
Losses
Value
Available-for-sale securities:
       
  U.S. Agency securities
 $    143,671
 $         1,841
 $             (86)
 $     145,426
  Obligations of state and
       
    political subdivisions
         90,277
            1,858
              (323)
          91,812
  Corporate obligations
           8,339
               319
                    -
            8,658
  Mortgage-backed securities in
       
    government sponsored entities
         38,813
            2,574
                  (7)
          41,380
  Equity securities in financial
       
     institutions
              956
               397
                (19)
            1,334
Total available-for-sale securities
 $    282,056
 $         6,989
 $           (435)
 $     288,610
         
   
Gross
Gross
 
 
Amortized
Unrealized
Unrealized
Fair
December 31, 2010
Cost
Gains
Losses
Value
Available-for-sale securities:
       
  U.S. Agency securities
 $    117,390
 $         1,535
 $           (441)
 $     118,484
  Obligations of state and
       
    political subdivisions
         78,164
               603
           (1,845)
          76,922
  Corporate obligations
           8,415
               268
                  (2)
            8,681
  Mortgage-backed securities in
       
    government sponsored entities
         43,183
            2,832
                    -
          46,015
  Equity securities in financial
       
     institutions
              914
               303
                (16)
            1,201
Total available-for-sale securities
 $    248,066
 $         5,541
 $        (2,304)
 $     251,303

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, 2011 and December 31, 2010 (in thousands). As of June 30, 2011 and December 31, 2010, the Company owned 36 and 85 securities whose fair value was less than their cost basis, respectively.
 

June 30, 2011
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
 $        17,156
 $             (86)
 $                  -
 $                  -
 $        17,156
 $             (86)
Obligations of state and
           
    political subdivisions
20,224
(311)
608
(12)
20,832
(323)
Mortgage-backed securities in
           
   government sponsored entities
5,171
(7)
                     -
                     -
5,171
(7)
Equity securities in financial
           
   institutions
96
(19)
                     -
                     -
96
(19)
               
    Total securities
 $        42,647
 $           (423)
 $             608
 $             (12)
 $        43,255
 $           (435)


 
6

 

 
December 31, 2010
Less than Twelve Months
Twelve Months or Greater
Total
     
Gross
 
Gross
 
Gross
   
Fair
Unrealized
Fair
Unrealized
Fair
Unrealized
   
Value
Losses
Value
Losses
Value
Losses
U.S. Agency securities
 $        38,502
 $           (441)
 $                  -
 $                  -
 $        38,502
 $           (441)
Obligations of states and
           
     political subdivisions
           45,335
           (1,784)
                526
                (61)
           45,861
           (1,845)
Corporate obligations
             1,157
                  (2)
                     -
                     -
             1,157
                  (2)
Equity securities in financial
           
   institutions
                139
                (16)
                     -
                     -
                139
                (16)
               
    Total securities
 $        85,133
 $        (2,243)
 $             526
 $             (61)
 $        85,659
 $        (2,304)
 
As of June 30, 2011, the Company’s investment securities portfolio contained unrealized losses on obligations of U.S Agency securities, states and political subdivisions, mortgage-backed securities in government sponsored entities and certain financial institutions equity securities. 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, 2011 and 2010 were $7,821,000 and $8,871,000, respectively.  For the three months ended June 30, 2011 and 2010, there were sales of $4,632,000 and $3,016,000 of available-for-sale securities, respectively. There were no sales during the three month period ended June 30, 2010. The gross gains and losses were as follows (in thousands):


 
Three Months Ended
Six Months Ended
 
 June 30,
 June 30,
 
2011
2010
2011
2010
Gross gains
 $           114
 $              35
 $            263
 $              99
Gross losses
                   -
                    -
                (29)
                    -
Net gains
 $           114
 $              35
 $            234
 $              99

Investment securities with an approximate carrying value of $177,236,000 and $162,742,000 at June 30, 2011 and December 31, 2010, respectively, were pledged to secure public funds and certain other deposits.
 
Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.   The amortized cost and fair value of debt securities at June 30, 2011, by contractual maturity, are shown below (in thousands):
 
 
7

 

 
Amortized
   
 
Cost
 
Fair Value
Available-for-sale debt securities:
     
  Due in one year or less
 $        4,125
 
 $         4,153
  Due after one year through five years
         96,001
 
          97,347
  Due after five years through ten years
         33,575
 
          34,576
  Due after ten years
       147,399
 
        151,200
Total
 $    281,100
 
 $     287,276

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 had a diversified loan portfolio at June 30, 2011 and December 31, 2010, a substantial portion of its debtors’ ability to honor their contracts is dependent on the economic conditions within these regions. The following table summarizes the primary segments of the loan portfolio as of June 30, 2011 and December 31, 2010 (in thousands):

June 30, 2011
 
Total Loans
Individually evaluated for impairment
Collectively evaluated for impairment
Real estate loans:
       
     Residential
 
 $                 180,817
 $                        145
 $                 180,672
     Commercial and agricultural
 
                    175,118
                        8,532
                    166,586
     Construction
 
                        7,095
                                -
                        7,095
Consumer
 
                      11,304
                                -
                      11,304
Commercial and other loans
 
                      49,551
652
                      48,899
State and political subdivision loans
 
                      53,027
                                -
                      53,027
Total
 
 $                 476,912
 $                     9,329
 $                 467,583
         
         
December 31, 2010
 
Total Loans
Individually evaluated for impairment
Collectively evaluated for impairment
Real estate loans:
       
     Residential
 
 $                 185,012
 $                        172
 $                 184,840
     Commercial and agricultural
 
                    171,577
                        9,976
                    161,601
     Construction
 
                        9,766
                                -
                        9,766
Consumer
 
                      11,285
                                -
                      11,285
Commercial and other loans
 
                      47,156
                        1,374
                      45,782
State and political subdivision loans
 
                      48,721
                                -
                      48,721
Total
 
 $                 473,517
 $                   11,522
 $                 461,995
 
The segments of the Bank’s loan portfolio are disaggregated into classes to a level that allows management to monitor risk and performance. Residential real estate mortgages consists of 15 to 30 year first mortgages on residential real estate, while residential real estate home equities are consumer purpose installment loans or lines of credit secured by a mortgage which is often a second lien on residential real estate with terms of 15 years or less. Commercial real estate loans are business purpose loans secured by a mortgage on commercial real estate. Agricultural real estate loans are loans secured by a mortgage on real estate used in agriculture production. Construction real estate loans are loans secured by residential or commercial real estate used during the construction phase of residential and commercial projects. Consumer loans are typically unsecured or primarily secured by something other than real estate and overdraft lines of credit connected with customer deposit accounts. Commercial and other loans are loans for commercial purposes primarily secured by non-real estate collateral. Other agricultural loans are loans for agricultural purposes primarily secured by non-real estate collateral. State and political subdivisions are loans for state and local municipalities for capital and operating expenses or tax free loans used to finance commercial development.
 
 
8

 
 
Management considers commercial loans, other agricultural loans, commercial real estate loans and agricultural real estate loans which are 90 days or more past due to be impaired. Management will also consider a loan impaired based on other factors it becomes aware of, including the customer’s results of operations and cash flows. These loans are analyzed to determine if it is probable that all amounts will not be collected according to the contractual terms of the loan agreement. If management determines that the value of the impaired loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized through an allowance estimate or a charge-off to the allowance.
 
The following table includes the recorded investment and unpaid principal balances for impaired financing receivables by class, with the associated allowance amount, if applicable (in thousands):

   
Recorded
Recorded
       
 
Unpaid
Investment
Investment
Total
 
Average
Interest
 
Principal
With No
With
Recorded
Related
Recorded
Income
 
Balance
Allowance
Allowance
Investment
Allowance
Investment
Recognized
June 30, 2011
             
Real estate loans:
             
     Mortgages
 $      132
 $          127
 $               -
 $          127
 $             -
 $          129
 $                -
     Home Equity
           18
                  -
               18
               18
               3
               36
                   -
     Commercial
      9,509
             126
          8,406
8,532
           323
          8,812
                27
     Agricultural
             -
                  -
                  -
                  -
                -
             741
                37
     Construction
             -
                  -
                  -
                  -
                -
                  -
                   -
Consumer
             -
                  -
                  -
                  -
                -
                  -
                   -
Commercial and other loans
         704
               37
615
652
           103
             399
                   -
Other Agricultural Loans
             -
                  -
                  -
                  -
                -
             319
                20
State and political
             -
                  -
                  -
                  -
                -
                  -
                   -
   subdivision loans
             -
                  -
                  -
                  -
                -
                  -
                   -
Total
 $ 10,363
 $          290
 $       9,039
 $       9,329
 $        429
 $     10,436
 $             84
               
December 31, 2010
             
Real estate loans:
             
     Mortgages
 $      132
 $               -
 $          131
 $          131
 $          21
 $            55
 $                -
     Home Equity
           72
               41
                  -
               41
                -
               56
                   -
     Commercial
      8,540
          1,682
          6,053
          7,735
           167
          5,445
                67
     Agricultural
      2,421
          2,241
                  -
          2,241
                -
          2,373
                64
     Construction
             -
                  -
                  -
                  -
                -
                  -
                   -
Consumer
             -
                  -
                  -
                  -
                -
                  -
                   -
Commercial and other loans
         455
             404
                  -
             404
                -
             469
                  1
Other Agricultural Loans
      1,040
             970
                  -
             970
                -
             958
                11
State and political
             
   subdivision loans
             -
                  -
                  -
                  -
                -
                  -
                   -
Total
 $ 12,660
 $       5,338
 $       6,184
 $     11,522
 $        188
 $       9,356
 $           143

Credit Quality Information
 
Management uses a nine point internal risk rating system to monitor the credit quality of the overall loan portfolio. The first five categories are considered not criticized and are aggregated as “Pass” rated. The criticized rating categories utilized by management generally follow bank regulatory definitions. The definitions of each rating are defined below:
 
 
9

 
 
 
·  
Pass (Grades 1-5) – These loans are to customers with credit quality ranging from an acceptable to very high quality and are protected by the current net worth and paying capacity of the obligor or by the value of the underlying collateral.
 
·  
Special Mention (Grade 6) – This loan grade is in accordance with regulatory guidance and includes loans where a potential weakness or risk exists, which could cause a more serious problem if not corrected.
 
·  
Substandard (Grade 7) – This loan grade is in accordance with regulatory guidance and includes loans that have a well-defined weakness based on objective evidence and be characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.
 
·  
Doubtful (Grade 8) – This loan grade is in accordance with regulatory guidance and includes loans that have all the weaknesses inherent in a substandard asset.  In addition, these weaknesses make collection or liquidation in full highly questionable and improbable, based on existing circumstances.
 
·  
Loss  (Grade 9) – This loan grade is in accordance with regulatory guidance and includes loans that are considered uncollectible, or of such value that continuance as an asset is not warranted.
 
To help ensure that risk ratings are accurate and reflect the present and future capacity of borrowers to repay loan as agreed, the Bank’s loan rating process includes several layers of internal and external oversight. Generally, residential real estate mortgages and home equities and loans to individuals for household, family and other purchases are included in the pass category, unless a specific action, such as bankruptcy, repossession, death or significant delay in payment occurs to raise awareness of a possible credit event. The Company’s loan officers are responsible for the timely and accurate risk rating of the loans in each of their portfolios at origination and on an ongoing basis under the supervision of management.  All commercial and agricultural loans are reviewed annually to ensure the appropriateness of the loan grade. In addition, the Bank engages an external consultant on at least an annual basis. The external consultant is engaged to 1) review a minimum of 60% of the dollar volume of the commercial loan portfolio on an annual basis, 2) review new loans originated in the last year, 3) review all relationships in aggregate over $500,000, 4) review all aggregate loan relationships over $100,000 which are over 90 days past due, classified Special Mention, Substandard, Doubtful, or Loss, and 5) such other loans which management or the consultant deems appropriate.
 
The following tables represent credit exposures by internally assigned grades as of June 30, 2011 and December 31, 2010 (in thousands):

 
Pass
Special Mention
Substandard
Doubtful
Loss
Ending Balance
June 30, 2011
           
Real estate loans:
           
     Mortgages
 $            95,722
 $              414
 $                      549
 $            -
 $              -
 $            96,685
     Home Equity
               83,880
                 111
                          141
              -
                 -
               84,132
     Commercial
             130,707
            10,623
                     15,835
  -
                 -
             157,165
     Agricultural
               12,909
              1,041
                       4,003
  -
                 -
               17,953
     Construction
                 7,095
                      -
                              -
   -
                 -
                 7,095
Consumer
               11,291
                     4
                              9
   -
                 -
               11,304
Commercial and other loans
               38,142
              3,663
                       1,047
18
                 2
               42,872
Other Agricultural Loans
                 4,622
                 497
                       1,560
    -
                 -
                 6,679
State and political
           
   subdivision loans
               51,824
                      -
                       1,203
               -
                 -
               53,027
Total
 $          436,192
 $         16,353
 $                  24,347
 $          18
 $              2
 $          476,912

 
 
10

 


 
Pass
Special Mention
Substandard
Doubtful
Loss
Ending Balance
December 31, 2010
           
Real estate loans:
           
     Mortgages
 $            96,218
 $              628
 $                       397
 $                   -
 $              -
 $            97,243
     Home Equity
               87,359
                 175
                          202
                   33
                 -
               87,769
     Commercial
             120,344
            15,570
                     16,585
                      -
                 -
             152,499
     Agricultural
               12,007
              1,063
                       6,008
                      -
                 -
               19,078
     Construction
                 9,766
                      -
                              -
                      -
                 -
                 9,766
Consumer
               11,265
                     4
                            16
                      -
                 -
               11,285
Commercial and other loans
               36,784
              2,545
                          848
                   24
                 -
               40,201
Other Agricultural Loans
                 4,024
                 469
                       2,462
                      -
                 -
                 6,955
State and political
           
   subdivision loans
               47,482
                      -
                       1,239
                      -
                 -
               48,721
Total
 $          425,249
 $         20,454
 $                  27,757
 $                57
 $              -
 $          473,517

Age Analysis of Past Due Financing Receivables by Class
 
Management further monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a recorded payment is past due. The following table includes an aging analysis of the recorded investment of past due financing receivables as of June 30, 2011 and December 31, 2010 (in thousands):

   
30-59 Days
60-89 Days
90 Days
Total Past
 
Total Financing
90 Days and
   
Past Due
Past Due
Or Greater
Due
Current
Receivables
Accruing
June 30, 2011
             
                 
Real estate loans:
             
     Mortgages
 $        278
 $          62
 $        486
 $        826
 $     95,859
 $             96,685
 $            110
     Home Equity
           295
             20
           174
           489
        83,643
                84,132
                 23
     Commercial
             79
           129
        2,719
        2,927
      154,238
              157,165
                 31
     Agricultural
           534
                -
-
           534
        17,419
                17,953
                   -
     Construction
                -
                -
-
-
          7,095
                  7,095
                   -
Consumer
             25
             11
               3
             39
        11,265
                11,304
                   3
Commercial and other loans
             30
             49
           358
           437
        42,435
                42,872
                   -
Other Agricultural Loans
                -
                -
-
-
          6,679
                  6,679
                   -
State and political
             
   subdivision loans
                -
                -
-
-
        53,027
                53,027
                   -
                 
 
Total
 $     1,241
 $        271
 $     3,740
 $     5,252
 $   471,660
 $           476,912
 $            167



 
11

 

 
   
30-59 Days
60-89 Days
90 Days
Total Past
 
Total Financing
90 Days and
   
Past Due
Past Due
Or Greater
Due
Current
Receivables
Accruing
December 31, 2010
             
                 
Real estate loans:
             
     Mortgages
 $        518
 $          50
 $        412
 $        980
 $     96,263
 $             97,243
 $            104
     Home Equity
           762
           139
           262
        1,163
        86,606
                87,769
               116
     Commercial
           188
        1,647
        1,827
        3,662
      148,837
              152,499
               426
     Agricultural
                -
                -
                -
                -
        19,078
                19,078
                   -
     Construction
                -
                -
                -
                -
          9,766
                  9,766
                   -
Consumer
             83
               3
               7
             93
        11,192
                11,285
                   6
Commercial and other loans
           111
               6
           398
           515
        39,686
                40,201
                 40
Other Agricultural Loans
               5
                -
                -
               5
          6,950
                  6,955
 
State and political
             
   subdivision loans
                -
                -
                -
                -
        48,721
                48,721
                   -
                 
 
Total
 $     1,667
 $     1,845
 $     2,906
 $     6,418
 $   467,099
 $           473,517
 $            692
 
Troubled Debt Restructurings
 
In situations where, for economic or legal reasons related to a borrower's financial difficulties, management may grant a concession for other than an insignificant period of time to the borrower that would not otherwise be considered, the related loan is classified as a Troubled Debt Restructuring (TDR). Management strives to identify borrowers in financial difficulty early and work with them to modify more affordable terms before their loan reaches nonaccrual status. These modified terms may include rate reductions, principal forgiveness, payment forbearance and other actions intended to minimize the economic loss and to avoid foreclosure or repossession of the collateral. In cases where borrowers are granted new terms that provide for a reduction of either interest or principal, management measures any impairment on the restructuring as noted above for impaired loans. In addition to the allowance for the pooled portfolios, management has developed a separate allowance for loans that are identified as impaired through a TDR. These loans are excluded from pooled portfolios and a separate allocation within the allowance for loan and lease losses is provided. Management continually evaluates loans that are considered troubled debt restructurings, including payment history under the modified loan terms, the borrower's ability to continue to repay the loan based on continued evaluation of their operating results and cash flows from opertions.  Based on this evaluation management would no longer consider a loan to be a troubled debt when the relevant facts support such a conclusion. 
 
During the first six months of 2011, a loan modification for one customer, encompassing five loans, was completed that was considered a TDR. In exchange for additional collateral, the Bank agreed to lower the contractual interest rate on four of the loans through February 2020 at which time the loans will be paid in full or will pay an increased rate for an 11 additional years. All the loans associated with this customer are current through July 2011; however, the loans are considered non-accrual as of June 30, 2011.
 
The following table includes an analysis of loans modified that are considered TDR’s and the primary modification made as of June 30, 2011 (in thousands):

 
12

 


     
Recorded
   
     
Investment, net of
   
     
Allowance
Interest
Term
 
   
Accruing
Non-accruing
Total
Modification
Modification
Real estate loans:
             
     Mortgages
   
 $                -
 $                 -
 $              -
 $            -
 $            -
     Home Equity
   
                   -
                    -
                 -
               -
               -
     Commercial
   
                   -
              5,845
            5,845
         5,730
115
     Agricultural
   
                   -
                    -
                 -
               -
               -
     Construction
   
                   -
                    -
                 -
               -
               -
Consumer
   
                   -
                    -
                 -
               -
               -
Commercial and other loans
   
                   -
                     3
                   3
               -
                3
Other Agricultural Loans
   
                   -
                    -
                 -
               -
               -
State and political
   
                   -
                    -
                 -
               -
               -
   subdivision loans
   
                   -
                    -
                 -
               -
               -
      Subtotal
   
                   -
              5,848
            5,848
         5,730
            118
Allowance
   
                   -
                 128
               128
            128
               -
Total
   
 $                -
 $           5,720
 $         5,720
 $      5,602
 $         118

Nonaccrual Loans
 
Loans are considered for non-accrual status upon reaching 90 days delinquency, unless the loan is well secured and in the process of collection, although the Company may be receiving partial payments of interest and partial repayments of principal on such loans or if full payment of principal and interest is not expected.
 
The following table reflects the financing receivables on nonaccrual status as of June 30, 2011 and December 31, 2010, respectively. The balances are presented by class of financing receivable (in thousands):

   
June 30, 2011
 
December 31, 2010
Real estate loans:
     
     Mortgages
 $                455
 
 $                      309
     Home Equity
                   151
 
                         193
     Commercial
                8,532
 
                      7,735
     Agricultural
                      -
 
                      2,241
     Construction
                      -
 
                            -
Consumer
                      -
 
                             1
Commercial and other
                   651
 
                         404
Other Agricultural
                      -
 
                         970
State and political subdivision
                      -
 
                           -
   
 $             9,789
 
 $                 11,853

Allowance for Loan Losses

The following table rolls forward the balance of the allowance for loan and lease losses for the periods ended June 30, 2011 and 2010(in thousands):
 

 
13

 
 

 
Six Months Ended
 
June 30,
 
2011
2010
Balance, at beginning of period
 $        5,915
 $        4,888
  Provision charged to income
             375
             540
  Recoveries on loans previously
   
    charged against the allowance
               36
124
 
           6,326
           5,552
  Loans charged against the allowance
              (163)
            (250)
Balance, at end of year
 $        6,163
 $        5,302
 
The Company allocates the allowance for loan and lease losses based on the factors described below, which conform to the Company’s loan classification policy. In reviewing risk within the Bank’s loan portfolio, management has determined there to be several different risk categories within the loan portfolio. The allowance for loan and lease losses consists of amounts applicable to: (i) residential real estate loans; (ii) residential real estate home equity loans; (iii) commercial real estate loans; (iv) agricultural real estate loans; (v) real estate construction loans; (vi) commercial and other loans; (vii) consumer loans; (viii) other agricultural loans and (ix) state and political subdivision loans. Factors considered in this process include general loan terms, collateral, and availability of historical data to support the analysis. Historical loss percentages are calculated and used as the basis for calculating allowance allocations. Certain qualitative factors are evaluated to determine additional inherent risks in the loan portfolio, which are not necessarily reflected in the historical loss percentages. These factors are then added to the historical allocation percentage to get the adjusted factor to be applied to non classified loans. The following qualitative factors are analyzed:

·  
Level of and trends in delinquencies, impaired/classified loans
§  
Change in volume and severity of past due loans
§  
Volume of non-accrual loans
§  
Volume and severity of classified, adversely or graded loans;
·  
Level of and trends in charge-offs and recoveries;
·  
Trends in volume, terms and nature of the loan portfolio;
·  
Effects of any changes in risk selection and underwriting standards and any other changes in lending and recovery policies, procedures and practices;
·  
Changes in the quality of the Bank’s loan review system;
·  
Experience, ability and depth of lending management and other relevant staff
·  
National, state, regional and local economic trends and business conditions
§  
General economic conditions
§  
Unemployment rates
§  
Inflation / CPI
§  
Changes in values of underlying collateral for collateral-dependent loans
·  
Industry conditions including the effects of external factors such as competition, legal, and regulatory requirements on the level of estimated credit losses; and
·  
Existence and effect of any credit concentrations, and changes in the level of such concentrations.
 
The Company also maintains an unallocated allowance to account for any factors or conditions that may cause a potential loss but are not specifically addressed in the process described above. The Company analyzes its loan portfolio each quarter to determine the appropriateness of its allowance for loan losses.
 
We continually review the model utilized in calculating the required allowance. During the second quarter, management made a determination that special mention and substandard loans should have additional qualitative adjustments applied to them in comparison to pass graded loans. As a result of this and other factors discussed below, the following factors experienced changes during the first six months of 2011:
 
 
14

 
 

·  
The qualitative factors for changes in levels of and trends in delinquencies, impaired/classified loans were decreased for all loans portfolio types due to the decreases in nonaccrual loans from December 31, 2010 to June 30, 2011.
·  
The qualitative factor for changes in the trends of charge-offs and recoveries were decreased for consumer loans, commercial and agricultural loans due to reduced losses over the most recent three year period.
·  
The qualitative factor for changes in portfolio volumes during 2011 were reduced for agricultural loans due to the decreased size of the portfolio in relation to the total portfolio.
·  
Separate factors for special mention and substandard loans were developed for each qualitative factor reviewed.
 
The changes in these qualitative factors resulted in a negative provision for residential real estate, construction and other commercial loans, while increasing the provision associated with commercial and agricultural real estate loans.
 
The following table rolls forward the balance of the allowance for loan and lease losses by portfolio segment from December 31, 2010 to June 30, 2011 and segregates the ending balance into the amount required for loans individually evaluated for impairment and the amount required for loans collectively evaluated for impairment as of June 30, 2011 (in thousands):

 
Balance at December
31, 2010
Charge-
offs
Recoveries
Provision
Balance at
June 30, 2011
Individually
evaluated for impairment
Collectively
evaluated for impairment
Real estate loans:
             
     Residential
 $         969
 $        (101)
 $              -
 $     (190)
 $         678
 $               3
 $             675
     Commercial and agricultural
         3,380
             (29)
                 -
          561
         3,912
              323
             3,589
     Construction
              22
                 -
                 -
            (9)
              13
                   -
                  13
Consumer
            108
             (33)
              29
              5
            109
                   -
                109
Commercial and other loans
            983
                 -
                7
        (278)
            712
              103
                609
State and political
     
               -
     
  subdivision loans
            137
                 -
                 -
          (18)
            119
                   -
                119
Unallocated
            316
                 -
                 -
          304
            620
                   -
                620
Total
 $      5,915
 $        (163)
 $           36
 $       375
 $      6,163
 $           429
 $          5,734

Note 6 – Federal Home Loan Bank Stock
 
The Bank is a member of the Federal Home Loan Bank of Pittsburgh (FHLB) and as such, is required to maintain a minimum investment in stock of the FHLB that varies with the level of advances outstanding with the FHLB. As of June 30, 2011 and December 31, 2010, the Bank holds $3,186,300 and $3,498,000, respectively of FHLB stock. The stock is bought from and sold to the FHLB based upon its $100 par value.  The stock does not have a readily determinable fair value and as such is classified as restricted stock, carried at cost and evaluated for impairment by management.  The stock’s value is determined by the ultimate recoverability of the par value rather than by recognizing temporary declines. The determination of whether the par value will ultimately be recovered is influenced by criteria such as the following: (a) the significance of the decline in net assets of the Federal Home Loan Bank as compared to the capital stock amount and the length of time this situation has persisted (b) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance (c) the impact of legislative and regulatory changes on the customer base of the FHLB and (d) the liquidity position of the FHLB.
 
The FHLB has incurred a significant cumulative loss in regards to comprehensive income and net income in the three years ended December 31, 2010 and has suspended the payment of dividends; however, the results for 2010 were significantly improved from those of 2008 and 2009.  The cumulative losses are primarily attributable to impairment of investment securities associated with the distressed economic conditions during 2008 and 2009.  Management evaluated the stock and concluded that the stock was not impaired for the periods presented herein.  Management considered that the FHLB’s regulatory capital ratios have improved in the most recent quarters, liquidity appears adequate, and new shares of FHLB Stock continue to exchange hands at the $100 par value and the FHLB has repurchased shares of excess capital stock from its members in the past three quarters.

 
15

 
 
Note 7 - Employee Benefit Plans
 
For a detailed disclosure on the Company's pension and employee benefits plans, please refer to Note 11 of the Company's Consolidated Financial Statements included in the 2010 Annual Report on Form 10-K.
 
Noncontributory Defined Benefit Pension Plan
 
The Bank sponsors a noncontributory defined benefit pension plan (“Pension Plan”) covering substantially all employees and officers.  The Bank’s funding policy is to make annual contributions, if needed, based upon the funding formula developed by the plan’s actuary.
 
Any employee with a hire date of January 1, 2008 or later is not eligible to participate in the Pension Plan. 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.
 
For employees who are eligible to participate in the Pension Plan, the 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, 2011 and 2010, respectively (in thousands):

 
Three Months Ended
 
Six Months Ended
 
 June 30,
 
 June 30,
 
2011
2010
 
2011
2010
Service cost
 $               71
 $   45
 
 $          185
 $ 214
Interest cost
                   87
      59
 
             226
    282
Expected return on plan assets
              (130)
    (77)
 
           (336)
  (369)
Net amortization and deferral
                   10
        6
 
                26
      31
           
Net periodic benefit cost
 $               38
 $   33
 
 $          101
 $ 158

The Company expects to contribute $505,000 to the Pension Plan in 2011.
 
 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 $124,000 and $116,000 for the six months ended June 30, 2011 and 2010, 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 $12,000 and $15,000 for the six months ended June 30, 2011 and 2010, respectively.


 
16

 
 
Restricted Stock Plan

The Company maintains a Restricted Stock Plan (the “Plan”) whereby employees and non-employee corporate directors are eligible to receive awards of restricted stock based upon performance related requirements.  Awards granted under the Plan are in the form of the Company’s common stock and are subject to certain vesting requirements including continuous employment or service with the Company.  100,000 shares of the Company’s common stock have been authorized under the Plan, which terminates April 18, 2016.  The Plan assists the Company in attracting, retaining and motivating employees to make substantial contributions to the success of the Company and to increase the emphasis on the use of equity as a key component of compensation.
 
For the six months ended June 30, 2011 and 2010, 3,968 and 5,090 shares of restricted stock were awarded and 5,502 and 4,948 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 $73,000 and $61,000 for the six months ended June 30, 2011 and 2010, respectively.
 
Supplemental Executive Retirement Plan
 
The Company maintains 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, 2011 and December 31, 2010, an obligation of $778,000 and $747,000, respectively, was included in other liabilities for this plan in the consolidated balance sheet.  Expenses related to this plan totaled $31,000 and $147,000 for the six months ended June 30, 2011 and 2010, respectively.

Note 8 – Fair Value Measurements
 
The Company established 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.
 
A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.
 
In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality, the Company's creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. Our valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally coincides with the Company’s monthly and/or quarterly valuation process

 
17

 
 
Financial Instruments Recorded at Fair Value on a Recurring Basis
 
The fair values of securities available for sale are determined by quoted prices in active markets, when available, and classified as Level 1. If quoted market prices are not available, the fair value is determined by a matrix pricing, which is a mathematical technique, widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities and classified as Level 2. The fair values consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. In cases where significant credit valuation adjustments are incorporated into the estimation of fair value, reported amounts are classified as Level 3 inputs.
 
Currently, we use an interest rate swap, which is a derivative, to manage our interest rate risk related to the trust preferred security. The valuation of this instrument is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative and classified as Level 2. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including LIBOR rate curves. We also obtain dealer quotations for these derivatives for comparative purposes to assess the reasonableness of the model valuations.
 
The following tables present the assets and liabilities reported on the consolidated balance sheet at their fair value on a recurring basis as of June 30, 2011 and December 31, 2010 by level within the fair value hierarchy (in thousands). Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

   
June 30, 2011
   
Level 1
 
Level II
 
Level III
   
Total
Fair value measurements on a recurring basis:
                 
Assets
                 
  Securities available for sale:
                 
     U.S. Agency securities
 
 $       -
 
 $ 145,426
 
 $         -
   
 $ 145,426
     Obligations of state and
                 
        political subdivisions
 
          -
 
91,812
 
            -
   
91,812
     Corporate obligations
 
          -
 
8,658
 
            -
   
8,658
     Mortgage-backed securities in
                 
       government sponsored entities
 
          -
 
41,380
 
            -
   
41,380
     Equity securities in financial
                 
       Institutions
 
1,334
 
                -
 
            -
   
1,334
Liabilities
                 
   Trust Preferred Interest Rate Swap
 
          -
 
(408)
 
            -
   
(408)
                   


 
18

 

 
 
 
December 31, 2010
   
Level 1
 
Level II
 
Level III
   
Total
Fair value measurements on a recurring basis:
                 
Assets
                 
  Securities available for sale:
                 
     U.S. Agency securities
 
 $       -
 
 $ 118,484
 
 $         -
   
 $ 118,484
     Obligations of state and
                 
          political subdivisions
 
          -
 
76,922
 
            -
   
76,922
     Corporate obligations
 
          -
 
8,681
 
            -
   
8,681
     Mortgage-backed securities in
                 
          government sponsored entities
 
          -
 
46,015
 
            -
   
46,015
     Equity securities in financial
                 
          institutions
 
1,201
 
                -
 
            -
   
1,201
 Liabilities
                 
   Trust Preferred Interest Rate Swap
 
          -
 
(409)
 
            -
   
(409)

Financial Instruments Recorded at Fair Value on a Nonrecurring Basis
 
The Company may be required, from time to time, to measure certain financial assets and financial liabilities at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principles. These include assets that are measured at the lower of cost or market value that were recognized at fair value below cost at the end of the period.
 
Impaired Loans. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with ASC Topic 310. The fair value of impaired loans is estimated using one of several methods, including collateral value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. Collateral values are estimated using Level 2 inputs based on observable market data or Level 3 inputs based on customized discounting criteria. For a majority of impaired real estate related loans, the Company obtains a current external appraisal. Other valuation techniques are used as well, including internal valuations, comparable property analysis and contractual sales information.
 
Non-Financial Assets and Non-Financial Liabilities Recorded at Fair Value
 
The Corporation has no non-financial assets or non-financial liabilities measured at fair value on a recurring basis. Certain non-financial assets measured at fair value on a non-recurring basis include foreclosed assets (upon initial recognition or subsequent impairment), non-financial assets and non-financial liabilities measured at fair value in the second step of a goodwill impairment test, and intangible assets and other non-financial long-lived assets measured at fair value for impairment assessment. Non-financial assets measured at fair value on a non-recurring basis during 2011 and 2010 include certain foreclosed assets which, upon initial recognition, were remeasured and reported at fair value through a charge-off to the allowance for possible loan losses and certain foreclosed assets which, subsequent to their initial recognition, were remeasured at fair value through a write-down included in other non-interest expense. The fair value of a foreclosed asset is estimated using Level 2 inputs based on observable market data or Level 3 inputs based on customized discounting criteria.
 
Assets measured at fair value on a nonrecurring basis as of June 30, 2011 and December 31, 2010 are included in the table below (in thousands):

 
 
June 30, 2011
   
Level 1
 
Level II
 
Level III
   
Total
                   
Impaired Loans
 
 $       -
 
 $             -
 
 $  8,900
   
 $     8,900
Other real estate owned
 
          -
 
          -
 
768
   
768
 
 
19

 

                   
 
 
December 31, 2010
   
Level 1
 
Level II
 
Level III
   
Total
                   
Impaired Loans
 
 $       -
 
 $     2,238
 
 $  9,096
   
 $   11,334
Other real estate owned
 
          -
 
693
 
          -
   
693

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

 
June 30
 
December 31
 
2011
 
2010
 
Carrying
   
Carrying
 
 
Amount
Fair Value
 
Amount
Fair Value
Financial assets:
         
Cash and due from banks
 $    44,432
 $    44,432
 
 $    43,995
 $    43,995
Available-for-sale securities
     288,610
     288,610
 
     251,303
     251,303
Net loans
     470,749
     498,606
 
     467,602
     494,098
Bank owned life insurance
       13,416
       13,416
 
       13,171
       13,171
Regulatory stock
         3,461
         3,461
 
         3,773
         3,773
Accrued interest receivable
         3,717
         3,717
 
         3,455
         3,455
           
           
Financial liabilities:
         
Deposits
 $  713,127
 $  719,713
 
 $  680,711
 $  683,315
Borrowed funds
       55,408
       52,344
 
       55,996
       52,820
Trust preferred interest rate swap
            408
            408
 
            409
            409
Accrued interest payable
         1,556
         1,556
 
         1,779
         1,779

Fair value is determined, 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:

 
20

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

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

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

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

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

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

Trust Preferred Interest Rate Swap:
 
The fair value of the trust preferred interest rate swap is based on a pricing model that utilizes a yield curve and information contained in the swap agreement.
 
 Note 9 – Recent Accounting Pronouncements
In December 2010, the FASB issued ASU 2010-29, Disclosure of Supplementary Pro Forma Information for Business Combinations.  The amendments in this update specify that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only.  The amendments also expand the supplemental pro forma disclosures under Topic 805 to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings.   The amendments in this Update are effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. Early adoption is permitted.  This ASU is not expected to have a significant impact on the Company’s financial statements.
 
 
21

 
 
In January 2011, the FASB issued ASU 2011-01, Receivables (Topic 310):  Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20. The amendments in this Update temporarily delay the effective date of the disclosures about troubled debt restructurings in Update 2010-20, enabling public-entity creditors to provide those disclosures after the FASB clarifies the guidance for determining what constitutes a troubled debt restructuring.  The deferral in this Update will result in more consistent disclosures about troubled debt restructurings.  This amendment does not defer the effective date of the other disclosure requirements in Update 2010-20.  In the proposed Update for determining what constitutes a troubled debt restructuring, the FASB proposed that the clarifications would be effective for interim and annual periods ending after June 15, 2011. For the new disclosures about troubled debt restructurings in Update 2010-20, those clarifications would be applied retrospectively to the beginning of the fiscal year in which the proposal is adopted.  The adoption of this guidance in not expected to have a significant impact on the Company’s financial statements.
 
In April 2011, the FASB issued ASU 2011-02, Receivables (Topic 310):  A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.  The amendments in this Update provide additional guidance or clarification to help creditors in determining whether a creditor has granted a concession and whether a debtor is experiencing financial difficulties for purposes of determining whether a restructuring constitutes a troubled debt restructuring.  The amendments in this Update are effective for the first interim or annual reporting period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning annual period of adoption.  As a result of applying these amendments, an entity may identify receivables that are newly considered impaired.  For purposes of measuring impairment of those receivables, an entity should apply the amendments prospectively for the first interim or annual period beginning on or after June 15, 2011.  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 April 2011, the FASB issued ASU 2011-03, Reconsideration of Effective Control for Repurchase Agreements.  The main objective in developing this Update is to improve the accounting for repurchase agreements (repos) and other agreements that both entitle and obligate a transferor to repurchase or redeem financial assets before their maturity.  The amendments in this Update remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation guidance related to that criterion.  The amendments in this Update apply to all entities, both public and nonpublic.  The amendments affect all entities that enter into agreements to transfer financial assets that both entitle and obligate the transferor to repurchase or redeem the financial assets before their maturity. The guidance in this Update is effective for the first interim or annual period beginning on or after December 15, 2011 and should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date.  Early adoption is not permitted.  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 May 2011, the FASB issued ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.  The amendments in this Update result in common fair value measurement and disclosure requirements in U.S. GAAP and IFRSs.  Consequently, the amendments change the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements.  The amendments in this Update are to be applied prospectively.  For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011.  For nonpublic entities, the amendments are effective for annual periods beginning after December 15, 2011.  Early application by public entities is not permitted. This ASU is not expected to have a significant impact on the Company’s financial statements.
 
 
22

 
 
In June 2011, the FASB issued ASU 2011-05, Presentation of Comprehensive Income.  The amendments in this Update improve the comparability, clarity, consistency, and transparency of financial reporting and increase the prominence of items reported in other comprehensive income.  To increase the prominence of items reported in other comprehensive income and to facilitate convergence of U.S. GAAP and IFRS, the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity was eliminated.  The amendments require that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements.  In the two-statement approach, the first statement should present total net income and its components followed consecutively by a second statement that should present total other comprehensive income, the components of other comprehensive income, and the total of comprehensive income.  All entities that report items of comprehensive income, in any period presented, will be affected by the changes in this Update.  For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011.  For nonpublic entities, the amendments are effective for fiscal years ending after December 15, 2012, and interim and annual periods thereafter.  The amendments in this Update should be applied retrospectively, and early adoption is permitted. The Company is currently evaluating the impact the adoption of the standard will have on the Company’s financial position or results of operations.

 
23

 
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 implementing 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 and loan quality.
 
Additional factors that may affect our results are discussed under “Part II – Item 1A – Risk Factors” in this report and in the Company’s 2010 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, 2011 are not necessarily indicative of the results you may expect for the full year.

 
24

 
 
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 18 banking facilities.  In Pennsylvania, we have branch offices located in Mansfield, Blossburg, Ulysses, Genesee, Wellsboro, Troy, Sayre, Canton, Gillett, Millerton, LeRaysville, Towanda, Rome, the Wellsboro Weis Market store and the Mansfield Wal-Mart Super Center. We also have a loan production office in Lock Haven, Pennsylvania. 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
 
The banking industry in the Bank’s service area continues to be extremely competitive, both among commercial banks and with financial service providers such as consumer finance companies, thrifts, investment firms, mutual funds, insurance companies, credit unions and internet banks.  The increased competition has resulted from changes in the legal and regulatory guidelines as well as from economic conditions, specifically, the additional wealth resulting from the exploration of the Marcellus Shale in our primary market.  Mortgage banking firms, financial companies, financial affiliates of industrial companies, brokerage firms, retirement fund management firms and even government agencies provide additional competition for loans and other financial services.  The Bank is generally competitive with all competing financial institutions in its service area with respect to interest rates paid on time and savings deposits, service charges on deposit accounts and interest rates charged on loans.

 
25

 

Trust and Investment Services; Oil and Gas 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, 2011 and December 31, 2010, the Trust Department had $99.9 and $95.1 million of assets under management, respectively.  The $4.8 million increase is primarily attributable to net additions of $5.1 million with the remaining change the result of 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 $70.1 million at December 31, 2010 to $79.0 million at June 30, 2011. 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.
 
In addition to the Trust and Investment services offered we have created an oil and gas management team, which serves as a network of experts to assist our customers through various oil and gas specific leasing matters from lease negotiations to establishing a successful approach to personal wealth management.  We have partnered with a professional firm to provide mineral management expertise and services to customers in our market who have been impacted by the Marcellus Shale exploration and drilling activities. Through this relationship, we are able to assist customers negotiate lease payments and royalty percentages, protect their property, resolve leasing issues, account for and ensure the accuracy of royalty checks, distribute revenue to satisfy investment objectives and provide customized reports outlining payment and distribution information.
 
 Results of Operations

Overview of the Income Statement
 
The Company had net income of $5,977,000 for the first six months of 2011 compared to earnings of $5,673,000 for last year’s comparable period, an increase of $304,000 or 5.4%. Earnings per share for the first six months of 2011 were $2.07, compared to $1.96 last year, representing a 5.6% increase.  Annualized return on assets and return on equity for the six months of 2011 were 1.44% and 17.22%, respectively, compared with 1.52% and 18.49% for last year’s comparable period.
 
Net income for the three months ended June 30, 2011 was $3,147,000 compared to earnings of $2,927,000 in the comparable 2010 period, an increase of $220,000. Earnings per share for the three months ended June 30, 2011 and 2010 were $1.09 and $1.01 per share, respectively.  Annualized return on assets and return on equity for the quarter ended June 30, 2011 was 1.50% and 17.85%, respectively, compared with 1.57% and 19.09% for the same 2010 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 2011 was $14,012,000, an increase of $456,000, or 3.4%, compared to the same period in 2010.  For the first six months of 2011, the provision for loan losses totaled $375,000, a decrease of $165,000 over the comparable period in 2010.  Consequently, net interest income after the provision for loan losses was $13,637,000 compared to $13,016,000 during the first six months of 2010.
 
For the three months ended June 30, 2011, net interest income was $7,076,000 compared to $6,809,000, an increase of $267,000, or 3.9% over the comparable period in 2010. The provision for loan losses this quarter was $150,000 compared to $235,000 for last year’s second quarter.  Consequently, net interest income after the provision for loan losses was $6,926,000 for the quarter ended compared to $6,574,000 in 2010.
 
 
 
26

 
 
The following table sets forth the average balances of, and the interest earned or incurred on, for each principal category of assets, liabilities and stockholders’ equity, the related rates, net interest income and interest rate spread created for the six months and three months ended June 30, 2011 and 2010 on a tax equivalent basis (dollars in thousands):

 
27

 


 
Analysis of Average Balances and Interest Rates (1)
 
Six Months Ended
 
June 30, 2011
June 30, 2010
 
Average
 
Average
Average
 
Average
 
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
 
$
$
%
$
$
%
ASSETS
           
Short-term investments:
           
   Interest-bearing deposits at banks
       30,142
               42
0.28
        21,886
31
0.29
Total short-term investments
       30,142
               42
0.28
        21,886
               31
0.29
Investment securities:
           
  Taxable
     194,115
         2,377
2.45
      145,877
          2,612
3.58
  Tax-exempt (3)
       86,387
         2,663
6.17
        64,460
          2,073
6.43
  Total investment securities
     280,502
         5,040
3.59
      210,337
          4,685
4.45
Loans:
           
  Residential mortgage loans
     187,859
         6,427
6.90
      201,497
          7,110
7.12
  Commercial & farm loans
     222,084
         7,069
6.42
      204,283
          6,933
6.84
  Loans to state & political subdivisions
       49,990
         1,312
5.29
        46,649
          1,374
5.94
  Other loans
       10,845
             458
8.52
        11,537
501
8.76
  Loans, net of discount (2)(3)(4)
     470,778
       15,266
6.54
      463,966
        15,918
6.92
Total interest-earning assets
     781,422
       20,348
5.25
      696,189
        20,634
5.98
Cash and due from banks
         9,871
   
          9,310
   
Bank premises and equipment
       12,392
   
        12,400
   
Other assets
       28,246
   
        28,806
   
Total non-interest earning assets
       50,509
   
        50,516
   
Total assets
     831,931
   
      746,705
   
LIABILITIES AND STOCKHOLDERS' EQUITY
           
Interest-bearing liabilities:
           
  NOW accounts
     185,502
             488
            0.53
      144,714
             582
            0.81
  Savings accounts
       67,528
             101
            0.30
        52,006
78
            0.30
  Money market accounts
       53,661
             140
            0.53
        43,023
             122
            0.57
  Certificates of deposit
     315,179
         3,405
            2.18
      323,669
          4,279
            2.67
Total interest-bearing deposits
     621,870
         4,134
            1.34
      563,412
          5,061
            1.81
Other borrowed funds
       56,648
             888
            3.16
        53,143
             880
            3.34
Total interest-bearing liabilities
     678,518
         5,022
            1.49
      616,555
          5,941
            1.94
Demand deposits
       76,892
   
        61,198
   
Other liabilities
         7,083
   
          7,602
   
Total non-interest-bearing liabilities
       83,975
   
        68,800
   
Stockholders' equity
       69,438
   
        61,350
   
Total liabilities & stockholders' equity
     831,931
   
      746,705
   
Net interest income
 
       15,326
   
        14,693
 
Net interest spread (5)
   
3.76%
   
4.04%
Net interest income as a percentage
           
  of average interest-earning assets
   
3.96%
   
4.26%
Ratio of interest-earning assets
           
  to interest-bearing liabilities
   
            1.15
   
            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.
       
 

 
 
28

 

 
Analysis of Average Balances and Interest Rates (1)
 
 Three Months Ended
 
June 30, 2011
June 30, 2010
 
Average
 
Average
Average
 
Average
 
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
 
$
$
%
$
$
%
ASSETS
           
Short-term investments:
           
   Interest-bearing deposits at banks
        27,068
                20
0.30
          24,598
                17
0.27
Total short-term investments
        27,068
                20
0.30
          24,598
                17
0.27
Investment securities:
           
  Taxable
      203,176
           1,191
2.34
        148,636
            1,271
3.42
  Tax-exempt (3)
        88,055
           1,352
6.14
          68,734
            1,101
6.41
  Total investment securities
      291,231
           2,543
3.49
        217,370
            2,372
4.36
Loans:
           
  Residential mortgage loans
      186,843
           3,183
6.83
        202,335
            3,561
7.06
  Commercial & farm loans
      222,659
           3,583
6.45
        208,180
            3,468
6.68
  Loans to state & political subdivisions
        51,296
              674
5.27
          46,551
682
5.88
  Other loans
        10,748
              228
8.51
          11,544
250
8.69
  Loans, net of discount (2)(3)(4)
      471,546
           7,668
6.52
        468,610
            7,961
6.81
Total interest-earning assets
      789,845
        10,231
5.20
        710,578
          10,350
5.84
Cash and due from banks
           9,898
   
            9,555
   
Bank premises and equipment
        12,317
   
          12,535
   
Other assets
        28,521
   
          28,998
   
Total non-interest earning assets
        50,736
   
          51,088
   
Total assets
      840,581
   
        761,666
   
LIABILITIES AND STOCKHOLDERS' EQUITY
           
Interest-bearing liabilities:
           
  NOW accounts
      189,369
              250
             0.53
        152,234
315
             0.83
  Savings accounts
        69,970
                53
             0.30
          53,599
                40
             0.30
  Money market accounts
        54,326
                69