firstqtr2013.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q


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

For the quarterly period ended March 31, 2013
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 _X__

Non-accelerated filer ____                                                                                                   Smaller reporting company ____
(Do not check if a smaller reporting company)

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

The number of outstanding shares of the Registrant’s Common Stock, as of April 30, 2013, was 2,893,595.

 
 

 
 
Citizens Financial Services, Inc.
Form 10-Q

INDEX
 
 
   
PAGE
Part I
FINANCIAL INFORMATION
 
Item 1.
Financial Statements (unaudited):
 
 
Consolidated Balance Sheet as of March 31, 2013 and December 31, 2012
1
 
Consolidated Statement of Income for the Three Months Ended March 31, 2013 and 2012
2
 
Consolidated Statement of Comprehensive Income for the Three Months ended March 31, 2013 and 2012
3
 
Consolidated Statement of Cash Flows for the Three Months ended March 31, 2013 and 2012
4
 
Notes to Consolidated Financial Statements
5-24
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
25-44
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
44
Item 4.
Controls and Procedures
44
     
Part II
OTHER INFORMATION
 
Item 1.
Legal Proceedings
45
Item 1A.
Risk Factors
45
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
45
Item 3.
Defaults Upon Senior Securities
45
Item 4.
Mine Safety Disclosures
45
Item 5.
Other Information
45
Item 6.
Exhibits
46
 
Signatures
47

 
 

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED BALANCE SHEET
   
(UNAUDITED)
   
     
 
March 31
December 31
(in thousands except share data)
2013
2012
ASSETS:
   
Cash and due from banks:
   
  Noninterest-bearing
 $               6,162
 $          12,307
  Interest-bearing
                30,952
             14,026
Total cash and cash equivalents
                37,114
             26,333
Available-for-sale securities
              300,176
           310,252
Loans held for sale
                          -
               1,458
 
   
Loans (net of allowance for loan losses:
   
  2013, $6,928 and 2012, $6,784)
              496,795
           495,679
 
   
Premises and equipment
                11,446
             11,521
Accrued interest receivable
                  3,840
               3,816
Goodwill
                10,256
             10,256
Bank owned life insurance
                14,301
             14,177
Other assets
                  9,022
               8,935
 
 
 
TOTAL ASSETS
 $           882,950
 $        882,427
 
 
 
LIABILITIES:
   
Deposits:
   
  Noninterest-bearing
 $             85,330
 $          89,494
  Interest-bearing
              651,591
           647,602
Total deposits
              736,921
           737,096
Borrowed funds
                45,556
             46,126
Accrued interest payable
                  1,039
               1,143
Other liabilities
                  8,664
               8,587
TOTAL LIABILITIES
              792,180
           792,952
STOCKHOLDERS' EQUITY:
   
Preferred Stock
   
  $1.00 par value; authorized 3,000,000 shares March 31, 2013 and December 31, 2012;
   
   none issued in 2013 or 2012
                          -
                      -
Common stock
   
  $1.00 par value; authorized 15,000,000 shares;  issued 3,161,324 at March 31, 2013 and
   
  December 31, 2012
                  3,161
               3,161
Additional paid-in capital
                16,534
             16,468
Retained earnings
                74,276
             71,813
Accumulated other comprehensive income
                  3,627
               4,631
Treasury stock, at cost:  267,729 shares at March 31, 2013
   
  and 262,921 shares at December 31, 2012
                 (6,828)
             (6,598)
TOTAL STOCKHOLDERS' EQUITY
                90,770
             89,475
TOTAL LIABILITIES AND
   
   STOCKHOLDERS' EQUITY
 $           882,950
 $        882,427
     
The accompanying notes are an integral part of these unaudited consolidated financial statements.
 


 
1

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED STATEMENT OF INCOME
   
(UNAUDITED)
   
 
Three Months Ended
 
March 31
(in thousands, except share and per share data)
2013
2012
INTEREST INCOME:
   
Interest and fees on loans
 $        7,137
 $      7,465
Interest-bearing deposits with banks
                 10
                 5
Investment securities:
   
    Taxable
               963
         1,197
    Nontaxable
               869
             954
    Dividends
                 20
               16
TOTAL INTEREST INCOME
           8,999
         9,637
INTEREST EXPENSE:
   
Deposits
           1,328
         1,666
Borrowed funds
               358
             413
TOTAL INTEREST EXPENSE
           1,686
         2,079
NET INTEREST INCOME
           7,313
         7,558
Provision for loan losses
               150
             105
NET INTEREST INCOME AFTER
   
    PROVISION FOR LOAN LOSSES
           7,163
         7,453
NON-INTEREST INCOME:
   
Service charges
           1,024
         1,078
Trust
               201
             173
Brokerage and insurance
                 92
             150
Investment securities gains
               196
             108
Gains on loans sold
               111
               54
Earnings on bank owned life insurance
               124
             124
Other
               104
             129
TOTAL NON-INTEREST INCOME
           1,852
         1,816
NON-INTEREST EXPENSES:
   
Salaries and employee benefits
           2,805
         2,753
Occupancy
               342
             310
Furniture and equipment
               102
             106
Professional fees
               229
             268
FDIC insurance
               112
             123
Pennsylvania shares tax
               183
             166
Other
           1,049
         1,102
TOTAL NON-INTEREST EXPENSES
           4,822
         4,828
Income before provision for income taxes
           4,193
         4,441
Provision for income taxes
               906
             992
NET INCOME
 $        3,287
 $      3,449
 
   
PER COMMON SHARE DATA:
   
Net Income - Basic
 $          1.14
 $        1.18
Net Income - Diluted
 $          1.14
 $        1.18
Cash Dividends Paid
 $        0.285
 $      0.295
     
The accompanying notes are an integral part of these unaudited consolidated financial statements.

 
2

 

CITIZENS FINANCIAL SERVICES, INC.
       
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
       
(UNAUDITED)
       
 
            Three Months Ended
 
March 31,
(in thousands)
 
2013
 
2012
Net income
 
 $     3,287
 
 $    3,449
Other comprehensive loss:
       
      Change in unrealized gains on available for sale securities
       (1,376)
 
         (424)
 
      Income tax effect
           468
 
          144
 
      Change in unrealized loss on interest rate swap
             50
 
            21
 
      Income tax effect
            (17)
 
             (7)
 
      Reclassification adjustment for gains included in net income
          (196)
 
         (108)
 
      Income tax effect
             67
 
            37
 
Other comprehensive loss, net of tax
 
      (1,004)
 
         (337)
Comprehensive income
 
 $     2,283
 
 $    3,112
         
The accompanying notes are an integral part of these unaudited consolidated financial statements.
   
 

 
3

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED STATEMENT OF CASH FLOWS
   
(UNAUDITED)
Three Months Ended
 
March 31,
(in thousands)
2013
2012
CASH FLOWS FROM OPERATING ACTIVITIES:
   
  Net income
 $          3,287
 $          3,449
  Adjustments to reconcile net income to net
   
   cash provided by operating activities:
   
    Provision for loan losses
                150
                105
    Depreciation and amortization
                100
                105
    Amortization and accretion of investment securities
                615
                595
    Deferred income taxes
              (103)
                  42
    Investment securities gains, net
              (196)
              (108)
    Earnings on bank owned life insurance
              (124)
              (124)
    Originations of loans held for sale
           (7,415)
           (4,404)
    Proceeds from sales of loans held for sale
             8,984
             4,458
    Realized gains on loans sold
              (111)
                (54)
    Increase in accrued interest receivable
                (24)
              (684)
    Decrease in accrued interest payable
              (104)
              (192)
    Other, net
                488
                925
      Net cash provided by operating activities
             5,547
             4,113
CASH FLOWS FROM INVESTING ACTIVITIES:
   
  Available-for-sale securities:
   
    Proceeds from sales
             3,856
           11,236
    Proceeds from maturity and principal repayments
           33,882
           26,048
    Purchase of securities
         (29,653)
         (81,628)
  Proceeds from redemption of regulatory stock
                306
                  25
  Purchase of regulatory stock
                     -
           (1,405)
  Net increase in loans
           (1,261)
           (3,841)
  Purchase of premises and equipment
                (99)
                (33)
  Proceeds from sale of foreclosed assets held for sale
                     -
                108
      Net cash provided (used) in investing activities
             7,031
         (49,490)
CASH FLOWS FROM FINANCING ACTIVITIES:
   
  Net (decrease) increase in deposits
              (175)
             8,833
  Repayments of long-term borrowings
                     -
              (109)
  Net (decrease) increase in short-term borrowed funds
              (570)
           18,995
  Purchase of treasury and restricted stock
              (228)
                (81)
  Dividends paid
              (824)
              (856)
      Net cash (used) provided by financing activities
           (1,797)
           26,782
          Net increase (decrease) in cash and cash equivalents
           10,781
         (18,595)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
           26,333
           30,432
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 $        37,114
 $        11,837
     
Supplemental Disclosures of Cash Flow Information:
   
    Interest paid
 $          1,790
 $          2,271
    Income taxes paid
 $             300
 $             210
    Loans transferred to foreclosed property
 $               54
 $               72
   
 
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 Community 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 March 31, 2013 and 2012 include all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the financial condition and the results of operations for the period.  In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. The financial performance reported for the Company for the three month period ended March 31, 2013 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, 2012.

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.
 
 
Three months ended
 
March 31,
 
2013
2012
Net income applicable to common stock
$3,287,000
$3,449,000
     
Basic earnings per share computation
   
Weighted average common shares outstanding
                  2,889,523
                  2,924,268
Earnings per share - basic
$1.14
$1.18
     
Diluted earnings per share computation
   
Weighted average common shares outstanding for basic earnings per share
                  2,889,523
                  2,924,268
Add: Dilutive effects of restricted stock
                            449
                            165
Weighted average common shares outstanding for dilutive earnings per share
                  2,889,972
                  2,924,433
Earnings per share - dilutive
$1.14
$1.18
 
For the three months ended March 31, 2013 and 2012, 147 and 3,073 shares, respectively, related to the restricted stock program were excluded from the diluted earnings per share calculations since they were anti-dilutive.

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.

 
5

 
 
Note 4 – Investments
 
The amortized cost and fair value of investment securities at March 31, 2013 and December 31, 2012 were as follows (in thousands):

   
Gross
Gross
 
 
Amortized
Unrealized
Unrealized
Fair
March 31, 2013
Cost
Gains
Losses
Value
Available-for-sale securities:
       
  U.S. Agency securities
 $    120,575
 $               1,896
 $              (37)
 $     122,434
  U.S. Treasury securities
         11,839
                       85
                      -
          11,924
  Obligations of state and
       
    political subdivisions
         90,503
                  4,711
               (190)
          95,024
  Corporate obligations
         21,287
                     459
               (260)
          21,486
  Mortgage-backed securities in
       
    government sponsored entities
         46,398
                  1,435
               (122)
          47,711
  Equity securities in financial
       
     institutions
              912
                     685
                      -
            1,597
Total available-for-sale securities
 $    291,514
 $               9,271
 $            (609)
 $     300,176
         
   
Gross
Gross
 
 
Amortized
Unrealized
Unrealized
Fair
December 31, 2012
Cost
Gains
Losses
Value
Available-for-sale securities:
       
  U.S. Agency securities
 $    125,125
 $               2,150
 $              (41)
 $     127,234
  U.S. Treasuries
           4,922
                       25
                      -
            4,947
  Obligations of state and
       
    political subdivisions
         95,288
                  5,721
               (134)
        100,875
  Corporate obligations
         21,699
                     452
                 (42)
          22,109
  Mortgage-backed securities in
       
    government sponsored entities
         52,072
                  1,728
               (127)
          53,673
  Equity securities in financial institutions
              912
                     502
                      -
            1,414
Total available-for-sale securities
 $    300,018
 $             10,578
 $            (344)
 $     310,252

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, which individual securities have been in a continuous unrealized loss position, at March 31, 2013 and December 31, 2012 (in thousands). As of March 31, 2013, the Company owned 27 securities whose fair value was less than their cost basis.
 
 
6

 
 
 
March 31, 2012
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
 $      13,131
 $             (37)
 $                  -
 $                  -
 $        13,131
 $             (37)
Obligations of state and
           
    political subdivisions
9,303
(190)
                     -
                     -
9,303
(190)
Corporate obligations
8,330
(260)
                     -
                     -
8,330
(260)
Mortgage-backed securities in
           
   government sponsored entities
4,666
(63)
             2,053
                (59)
6,719
(122)
    Total securities
 $      35,430
 $           (550)
 $          2,053
 $             (59)
 $        37,483
 $           (609)
               
 December 31, 2012
           
U.S. Agency securities
 $        6,016
 $             (41)
 $                  -
 $                  -
 $          6,016
 $             (41)
Obligations of states and
           
     political subdivisions
           7,981
              (134)
                     -
                     -
             7,981
              (134)
Corporate obligations
         10,972
                (42)
                     -
                     -
           10,972
                (42)
Mortgage-backed securities in
           
     government sponsored entities
           8,651
              (127)
                     -
                     -
             8,651
              (127)
    Total securities
 $      33,620
 $           (344)
 $                  -
 $                  -
 $        33,620
 $           (344)
 
As of March 31, 2013, the Company’s investment securities portfolio contained unrealized losses on agency securities issued or backed by the full faith and credit of the United States government or are generally viewed as having the implied guarantee of the U.S. government, obligations of states and political subdivisions, corporate obligations and mortgage backed securities in government sponsored entities. For fixed maturity investments management considers whether the present value of cash flows expected to be collected are less than the security’s amortized cost basis (the difference defined as the credit loss), the magnitude and duration of the decline, the reasons underlying the decline and the Company’s intent to sell the security or whether it is more likely than not that the Company would be required to sell the security before its anticipated recovery in market value, to determine whether the loss in value is other than temporary. Once a decline in value is determined to be other than temporary, if the Company does not intend to sell the security, and it is more likely than not that it will not be required to sell the security before recovery of the security’s amortized cost basis, the charge to earnings is limited to the amount of credit loss. Any remaining difference between fair value and amortized cost (the difference defined as the non-credit portion) is recognized in other comprehensive income, net of applicable taxes. Otherwise, the entire difference between fair value and amortized cost is charged to earnings. For equity securities where the fair value has been significantly below cost for one year, the Company’s policy is to recognize an impairment loss unless sufficient evidence is available that the decline is not other than temporary and a recovery period can be predicted.  The Company has concluded that any impairment of its investment securities portfolio outlined in the above table is not other than temporary and is the result of interest rate changes, sector credit rating changes, or company-specific rating changes that are not expected to result in the non-collection of principal and interest during the period.
 
Proceeds from sales of securities available-for-sale for the three months ended March 31, 2013 and 2012 were $3,856,000 and $11,236,000, respectively.  The gross gains and losses were as follows (in thousands):

 
Three Months Ended
 
 March 31,
 
2013
2012
Gross gains
 $           196
 $                  108
Gross losses
                   -
                          -
Net gains
 $           196
 $                  108
 

 
 
7

 
 
Investment securities with an approximate carrying value of $191.0 million and $193.3 million at March 31, 2013 and December 31, 2012, 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 March 31, 2013, by contractual maturity, are shown below (in thousands):

 
Amortized
 
 
Cost
Fair Value
Available-for-sale debt securities:
   
  Due in one year or less
 $      12,115
 $             12,227
  Due after one year through five years
         75,759
                77,464
  Due after five years through ten years
         76,556
                77,846
  Due after ten years
       126,172
              131,042
Total
 $    290,602
 $           298,579

Note 5 – Loans
 
The Company grants loans primarily to customers throughout North Central Pennsylvania and Southern New York.  Although the Company had a diversified loan portfolio at March 31, 2013 and December 31, 2012, 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 and how those segments are analyzed within the allowance for loan losses as of March 31, 2013 and December 31, 2012 (in thousands):

March 31, 2013
 
Total Loans
Individually evaluated for impairment
Collectively evaluated for impairment
Real estate loans:
       
     Residential
 
 $                 178,461
 $                        491
 $                 177,970
     Commercial and agricultural
 
                    195,083
                        8,550
                    186,533
     Construction
 
                      11,697
                                -
                      11,697
Consumer
 
                      10,094
                                -
                      10,094
Other commercial and agricultural loans
 
                      49,192
                        1,985
                      47,207
State and political subdivision loans
 
                      59,196
                                -
                      59,196
Total
 
                    503,723
 $                   11,026
 $                 492,697
Allowance for loan losses
 
                        6,928
   
Net loans
 
 $                 496,795
   
December 31, 2012
 
Total Loans
Individually evaluated for impairment
Collectively evaluated for impairment
Real estate loans:
       
     Residential
 
 $                 178,080
 $                        424
 $                 177,656
     Commercial and agricultural
 
                    194,725
                        9,093
                    185,632
     Construction
 
                      12,011
                                -
                      12,011
Consumer
 
                      10,559
                                -
                      10,559
Other commercial and agricultural loans
 
                      47,880
                           901
                      46,979
State and political subdivision loans
 
                      59,208
                                -
                      59,208
Total
 
                    502,463
 $                   10,418
 $                 492,045
Allowance for loan losses
 
                        6,784
   
Net loans
 
 $                 495,679
   
 
 
 
8

 
 
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 primarily of 15 to 30 year first mortgages on residential real estate, while residential real estate home equity 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. Other commercial 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.
 
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 or if the loan is modified in a troubled debt restructuring. Certain residential mortgages, home equity and consumer loans that are cross collateralized with commercial relationships determined to be impaired maybe classified as impaired as well. 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 allocation of the allowance for loan losses or a charge-off to the allowance for loan losses.
 
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
 
 
Principal
With No
With
Recorded
Related
March 31, 2013
Balance
Allowance
Allowance
Investment
Allowance
Real estate loans:
         
     Mortgages
 $      378
 $          146
 $          208
 $          354
 $          24
     Home Equity
         137
                  -
             137
             137
             14
     Commercial
    10,157
          5,911
          2,639
          8,550
           528
     Agricultural
              -
                  -
                  -
                  -
                -
     Construction
              -
                  -
                  -
                  -
                -
Consumer
              -
                  -
                  -
                  -
                -
Other commercial loans
      2,036
          1,676
             309
          1,985
                -
Other agricultural loans
              -
                  -
                  -
                  -
                -
State and political subdivision loans
              -
                  -
                  -
                  -
                -
Total
 $ 12,708
 $       7,733
 $       3,293
 $     11,026
 $        566
           
December 31, 2012
         
Real estate loans:
         
     Mortgages
 $      309
 $          150
 $          136
 $          286
 $            8
     Home Equity
         138
                  -
             138
             138
             14
     Commercial
    10,669
          6,476
          2,617
          9,093
           559
     Agricultural
              -
                  -
                  -
                  -
                -
     Construction
              -
                  -
                  -
                  -
                -
Consumer
              -
                  -
                  -
                  -
                -
Other commercial loans
         950
             592
             309
             901
               1
Other agricultural loans
              -
                  -
                  -
                  -
                -
State and political subdivision loans
              -
                  -
                  -
                  -
                -
Total
 $ 12,066
 $       7,218
 $       3,200
 $     10,418
 $        582
 
 
 
9

 
 
The following table includes the average balance of impaired financing receivables by class and the income recognized on impaired loans for the three months ended March 31, 2013 and 2012(in thousands):

 
March 31, 2013
March 31, 2012
     
Interest
   
Interest
 
Average
Interest
Income
Average
Interest
Income
 
Recorded
Income
Recognized
Recorded
Income
Recognized
 
Investment
Recognized
Cash Basis
Investment
Recognized
Cash Basis
Real estate loans:
           
     Mortgages
 $       284
 $              2
 $               -
 $               -
 $             -
 $               -
     Home Equity
          137
                 1
                  -
               93
               1
                 1
     Commercial
       8,785
               45
14
          8,228
             18
               18
     Agricultural
               -
                  -
                  -
                  -
                -
                  -
     Construction
               -
                  -
                  -
                  -
                -
                  -
Consumer
               -
                  -
                  -
                  -
                -
                  -
Other commercial loans
       1,656
               19
                  -
             479
                -
                  -
Other agricultural loans
               -
                  -
                  -
                  -
                -
                  -
State and political
           
   subdivision loans
               -
                  -
                  -
                  -
                -
                  -
Total
 $  10,862
 $            67
 $            14
 $       8,800
 $          19
 $            19

Credit Quality Information
 
For commercial real estate, agricultural real estate, construction, other commercial, other agricultural and state and political subdivision loans, management uses a nine point internal risk rating system to monitor the credit quality. 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:
 
·  
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. 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 55% (60% during 2012) 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 or classified Special Mention, Substandard, Doubtful, or Loss, and 5) such other loans which management or the consultant deems appropriate.

 
10

 
 
The following tables represent credit exposures by internally assigned grades as of March 31, 2013 and December 31, 2012 (in thousands):

March 31, 2013
Pass
Special Mention
Substandard
Doubtful
Loss
Ending Balance
Real estate loans:
           
     Commercial
 $          150,863
 $          6,964
 $          18,646
 $              214
 $              -
 $          176,687
     Agricultural
               14,107
           2,374
               1,915
                      -
                 -
               18,396
     Construction
               11,697
                   -
                       -
                      -
                 -
               11,697
Other commercial loans
               39,223
              707
               2,561
                      -
                 -
               42,491
Other agricultural loans
                 5,141
               740
                  820
                      -
                 -
                 6,701
State and political
           
   subdivision loans
               58,128
                    -
              1,068
                      -
                 -
               59,196
Total
 $          279,159
 $        10,785
 $          25,010
 $              214
 $              -
 $          315,168
December 31, 2012
Pass
Special Mention
Substandard
Doubtful
Loss
Ending Balance
Real estate loans:
           
     Commercial
 $          149,892
 $          7,616
 $          19,127
 $                75
 $              -
 $          176,710
     Agricultural
               13,690
             2,386
               1,939
                      -
                 -
               18,015
     Construction
               12,011
                    -
                       -
                      -
                 -
               12,011
Other commercial loans
               39,239
               826
               1,555
                      -
                 -
               41,620
Other agricultural loans
                 4,833
               589
                  838
                      -
                 -
                 6,260
State and political
           
   subdivision loans
               58,120
                    -
              1,088
                      -
                 -
               59,208
Total
 $          277,785
 $        11,417
 $          24,547
 $                75
 $              -
 $          313,824
 
For residential real estate mortgages, home equity and consumer loans, credit quality is monitored based on whether the loan is performing or non-performing, which is typically based on the aging status of the loan and payment activity, unless a specific action, such as bankruptcy, repossession, death or significant delay in payment occurs to raise awareness of a possible credit event. Non-performing loans include those loans that are considered nonaccrual, described in more detail below and all loans past due 90 or more days. The following table presents the recorded investment in those loan classes based on payment activity as of March 31, 2013 and December 31, 2012 (in thousands):

March 31, 2013
Performing
Non-performing
Total
Real estate loans:
     
     Mortgages
 $          108,005
 $              592
 $                108,597
     Home Equity
               69,670
                 194
                     69,864
Consumer
               10,057
                   37
                     10,094
Total
 $          187,732
 $              823
 $                188,555
       
December 31, 2012
Performing
Non-performing
Total
Real estate loans:
     
     Mortgages
 $          105,822
 $              726
 $                106,548
     Home Equity
               71,263
                 269
                     71,532
Consumer
               10,555
                     4
                     10,559
Total
 $          187,640
 $              999
 $                188,639


 
11

 

Age Analysis of Past Due Financing Receivables
 
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 March 31, 2013 and December 31, 2012 (in thousands):

   
30-59 Days
60-89 Days
90 Days
Total Past
 
Total Financing
90 Days and
March 31,2013
Past Due
Past Due
Or Greater
Due
Current
Receivables
Accruing
Real estate loans:
             
     Mortgages
 $        229
 $        106
 $        400
 $        735
 $   107,862
 $           108,597
 $              93
     Home Equity
           481
               7
           168
           656
        69,208
                69,864
                 65
     Commercial
        1,267
             24
        1,974
        3,265
      173,422
              176,687
               171
     Agricultural
             50
                -
                -
             50
        18,346
                18,396
                   -
     Construction
                -
                -
                -
                -
        11,697
                11,697
                   -
Consumer
               5
             25
             37
             67
        10,027
                10,094
                 37
Other commercial loans
           260
             16
           309
           585
        41,906
                42,491
                   -
Other agricultural loans
                -
                -
                -
                -
          6,701
                  6,701
                   -
State and political
             
   subdivision loans
                -
                -
                -
                -
        59,196
                59,196
                   -
 
Total
 $     2,292
 $        178
 $     2,888
 $     5,358
 $   498,365
 $           503,723
 $            366
                 
Loans considered non-accrual
 $          20
 $          93
 $     2,522
 $     2,635
 $       5,240
 $               7,875
 
Loans still accruing
        2,272
             85
           366
        2,723
      493,125
              495,848
 
 
Total
 $     2,292
 $        178
 $     2,888
 $     5,358
 $   498,365
 $           503,723
 
                 
   
30-59 Days
60-89 Days
90 Days
Total Past
 
Total Financing
90 Days and
December 31, 2012
Past Due
Past Due
Or Greater
Due
Current
Receivables
Accruing
Real estate loans:
             
     Mortgages
 $        636
 $        294
 $        493
 $     1,423
 $   105,125
 $           106,548
 $            244
     Home Equity
           267
             17
           222
           506
        71,026
                71,532
                 88
     Commercial
           602
                -
        2,149
        2,751
      173,959
              176,710
               152
     Agricultural
             54
                -
                -
             54
        17,961
                18,015
                   -
     Construction
                -
                -
                -
                -
        12,011
                12,011
                   -
Consumer
             45
             43
               4
             92
        10,467
                10,559
                   4
Other commercial loans
           962
                -
           317
        1,279
        40,341
                41,620
                 18
Other agricultural loans
                -
                -
                -
                -
          6,260
                  6,260
                   -
State and political
             
   subdivision loans
                -
                -
                -
                -
        59,208
                59,208
                   -
 
Total
 $     2,566
 $        354
 $     3,185
 $     6,105
 $   496,358
 $           502,463
 $            506
                 
Loans considered non-accrual
 $          73
 $          69
 $     2,679
 $     2,821
 $       5,246
 $               8,067
 
Loans still accruing
        2,493
           285
           506
        3,284
      491,112
              494,396
 
 
Total
 $     2,566
 $        354
 $     3,185
 $     6,105
 $   496,358
 $           502,463
 

Nonaccrual Loans
 
Loans are considered for non-accrual status upon reaching 90 days delinquency, 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. Additionally, if management is made aware of other information including bankruptcy, repossession, death, or legal proceedings, the loan may be placed on non-accrual status. If a loan is 90 days or more past due and is well secured and in the process of collection, it may still be considered accruing.
 
The following table reflects the financing receivables on non-accrual status as of March 31, 2013 and December 31, 2012, respectively. The balances are presented by class of financing receivable (in thousands):
 
 
12

 

 
   
March 31, 2013
 
December 31, 2012
Real estate loans:
     
     Mortgages
 $                499
 
 $                   482
     Home Equity
                   129
 
                      181
     Commercial
                6,890
 
                   7,042
     Agricultural
                     -
 
                        -
     Construction
                     -
 
                        -
Consumer
                     -
 
                        -
Other commercial loans
                   357
 
                      362
Other agricultural loans
                     -
 
                        -
State and political subdivision
                     -
 
                        -
   
 $             7,875
 
 $                8,067

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 by calculating the present value of the revised loan terms and comparing this balance to the Company’s investment in the loan prior to the restructuring. As these loans are individually evaluated, they are excluded from pooled portfolios when calculating the allowance for loan and lease losses and a separate allocation within the allowance for loan and lease losses is provided. Management continually evaluates loans that are considered TDR’s, 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 operations.  Based on this evaluation management would no longer consider a loan to be a TDR when the relevant facts support such a conclusion.
 
Loan modifications that are considered TDR’s completed during the three months ended March 31, 2013 and 2012 were as follows (dollars in thousands):
 
   
 
Number of contracts
Pre-modification Outstanding Recorded Investment
Post-Modification Outstanding Recorded Investment
March 31, 2013
Interest Modification
Term Modification
Interest Modification
Term Modification
Interest Modification
Term Modification
Real estate loans:
           
     Residential
                    1
                          -
 $                     72
 $                     -
 $               72
 $                  -
     Commercial
                     -
                          2
                           -
                1,365
                     -
             1,365
Other commercial loans
                     -
                          2
                           -
                1,530
                     -
             1,530
Total
                    1
                          4
 $                     72
 $             2,895
 $               72
 $          2,895
   
March 31, 2012
 
Real estate loans:
           
     Commercial
                     -
                   2
 $                        -
 $               98
 $                  -
 $               98
Total
                     -
                    2
 $                        -
 $               98
 $                  -
 $               98
 
 
 
13

 
 
Recidivism, or the borrower defaulting on its obligation pursuant to a modified loan, results in the loan once again becoming a non-accrual loan. Recidivism occurs at a notably higher rate than do defaults on new origination loans, so modified loans present a higher risk of loss than do new origination loans. Loan modifications considered TDR’s made during the twelve months ended March 31, 2013 and 2012, that defaulted during the three month periods ended March 31, 2013 and 2012 were as follows (dollars in thousands):

 
For the Three Months Ended
 
March 31, 2013
March 31, 2012
 
Number of contracts
Recorded investment
Number of contracts
Recorded investment
Real estate loans:
       
     Commercial
              -
 $              -
                1
 $         48
Total recidivism
              -
 $              -
1
 $         48

Allowance for Loan Losses

The following table segregates the allowance for loan losses (ALLL) into the amount required for loans individually evaluated for impairment and the amount required for loans collectively evaluated for impairment as of March 31, 2013 and December 31, 2012, respectively (in thousands):
 
 
March 31, 2013
 
 December 31, 2012
 
Individually evaluated for impairment
Collectively evaluated for impairment
Total
 
Individually evaluated for impairment
Collectively evaluated for impairment
Total
Real estate loans:
             
     Residential
 $           38
 $         875
 $         913
 
 $           22
 $           853
 $             875
     Commercial and agricultural
            528
         3,888
4,416
 
            559
           3,878
             4,437
     Construction
                 -
              78
78
 
                        -
                38
                  38
Consumer
                 -
            118
118
 
                        -
              119
                119
Other commercial and agricultural loans
                 -
            700
700
 
                1
              727
                728
State and political
             
  subdivision loans
                 -
            303
303
 
                        -
              271
                271
Unallocated
                 -
            400
400
 
                        -
              316
                316
Total
 $         566
 $      6,362
 $      6,928
 
 $         582
 $        6,202
 $          6,784
 
The following tables roll forward the balance of the ALLL by portfolio segment for the three month period ended March 31, 2013 and 2012, respectively (in thousands):
 
 
Balance at December 31, 2012
Charge-offs
Recoveries
Provision
Balance at March 31, 2013
Real estate loans:
         
     Residential
 $         875
 $              -
 $             2
 $         36
 $         913
     Commercial and agricultural
         4,437
                 -
                 -
          (21)
         4,416
     Construction
              38
                 -
                 -
            40
              78
Consumer
            119
            (20)
              12
              7
            118
Other commercial and agricultural loans
            728
                 -
                 -
          (28)
            700
State and political
     
               -
 
  subdivision loans
            271
                 -
                 -
            32
            303
Unallocated
            316
                 -
                 -
            84
            400
Total
 $      6,784
 $         (20)
 $           14
 $       150
 $      6,928
 
 
 
14

 

 
Balance at December 31, 2011
Charge-offs
Recoveries
Provision
Balance at March 31, 2012
Real estate loans:
         
     Residential
 $         805
 $         (49)
 $              -
 $         (3)
 $         753
     Commercial and agricultural
         4,132
              (2)
                 -
          206
         4,336
     Construction
              15
                 -
                 -
              1
              16
Consumer
            111
              (8)
                9
          (16)
              96
Other commercial and agricultural loans
            674
                 -
                3
            (6)
            671
State and political
     
               -
 
  subdivision loans
            235
                 -
                 -
            10
            245
Unallocated
            515
                 -
                 -
          (87)
            428
Total
 $      6,487
 $         (59)
 $           12
 $       105
 $      6,545
 
The Company allocates the ALLL based on the factors described below, which conform to the Company’s loan classification policy and credit quality measurements. In reviewing risk within the Bank’s loan portfolio, management has determined there to be several different risk categories within the loan portfolio. The ALLL 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 / Consumer Price Index
 
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.
 
Loans determined to be TDR’s are impaired and for purposes of estimating the ALLL must be individually evaluated for impairment. In calculating the impairment, the Company calculates the present value utilizing an analysis of discounted cash flows. If the present value calculated is below the recorded investment of the loan, impairment is recognized by a charge to the provision for loan and lease losses and a credit to the ALLL.
 
 
 
15

 
 
We continually review the model utilized in calculating the required allowance. The following qualitative factors experienced changes during the first three months of 2013:
 
·  
The qualitative factor for national, state, regional and local economic trends and business conditions was increased for all loan categories due to rising unemployment rates in the local economy as a result of the slowdown in the development of the Marcellus shale natural gas exploration activities.
 
The primary factor that resulted in a negative provision for the first quarter of 2013 for commercial and agricultural real estate loans and other commercial loans was the increase in impaired loans that were specifically reviewed as of March 31, 2013 that did not require a specific allowance.

Note 6 – Federal Home Loan Bank Stock
 
The Bank is a member of the FHLB of Pittsburgh 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 March 31, 2013 and December 31, 2012, the Bank holds $2,984,000 and $3,290,000, respectively. 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 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) A significant decline in net assets of the FHLB 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. 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, 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 during 2012 and 2013 and has reinstituted the dividend.

Note 7 - Employee Benefit Plans
 
For additional 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 2012 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, 2007 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, 2007 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 months ended March 31, 2013 and 2012, respectively (in thousands):

 
16

 

 
Three Months Ended
 
March 31,
 
2013
2012
Service cost
 $             101
 $ 113
Interest cost
                106
    139
Expected return on plan assets
              (174)
  (206)
Net amortization and deferral
                   42
      16
Net periodic benefit cost
 $               75
 $   62
 
The Company expects to contribute $500,000 to the Pension Plan in 2013.
 
Defined Contribution Plan
 
The Company sponsors a voluntary 401(k) savings plan which eligible employees can elect to contribute up to the maximum amount allowable not to exceed the limits of IRS Code Sections 401(k).  Under the plan, the Company also makes required contributions on behalf of the eligible employees.  The Company’s contributions vest immediately.  Contributions by the Company totaled $56,000 and $52,000 for the three months ended March 31, 2013 and 2012, 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.  At March 31, 2013 and December 31, 2012, an obligation of $967,000 and $1,001,000, respectively, was included in other liabilities for this plan in the consolidated balance sheet. Amounts included in interest expense on the deferred amounts totaled $4,000 for each of the three months ended March 31, 2013 and 2012.
 
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.  A total of 100,000 shares of the Company’s common stock have been authorized under the Plan. As of March 31, 2013, 70,783 shares remain available to be issued under the Plan.  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.
 
The following table details the vesting, awarding and forfeiting of restricted shares during 2013 and 2012:

 
Three months ended March 31
 
2013
2012
   
Weighted
 
Weighted
   
Average
 
Average
 
Shares
Market Price
Shares
Market Price
Outstanding, beginning of period
          8,646
 $         35.51
          9,921
 $      29.37
Granted
                 -
                   -
                 -
                 -
Forfeited
             (55)
            37.10
                 -
                 -
Vested
        (1,322)
            37.35
        (3,641)
         25.06
Outstanding, end of period
          7,269
 $         35.16
          6,280
 $      28.15
 
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 $38,000 and $33,000 for the three months ended March 31, 2013 and 2012, respectively.

 
17

 
 
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 March 31, 2013 and December 31, 2012, an obligation of $937,000 and $901,000, respectively, was included in other liabilities for this plan in the consolidated balance sheet.  Expenses related to this plan totaled $36,000 and $23,000 for the three months ended March 31, 2013 and 2012, respectively.

Note 8 – Accumulated Comprehensive Income
 
The following table presents the changes in accumulated other comprehensive income by component net of tax for the three months ended March 31, 2013:

 
Unrealized gains on available for sale securities (a)
Unrealized loss on interest rate swap (a)
Defined benefit pension items (a)
Total
Balance as of December 31, 2012
 $              6,754
 $         (132)
 $    (1,991)
 $ 4,631
Other Comprehensive Income (loss) before reclassifications (net of tax)
                 (908)
               33
                -
    (875)
Amounts reclassified from accumulated other comprehensive income (net of tax)
                  (129)
                   -
                 -
    (129)
Net current period other comprehensive income (loss)
           (1,037)
             33
              -
(1,004)
Balance as of March 31, 2013
 $              5,717
 $               (99)
 $    (1,991)
 $ 3,627
(a) Amounts in parentheses indicate debits
       
 
The following table presents the significant amounts reclassified out of each component of accumulated other comprehensive income for the three months ended March 31, 2013:

Details about Accumulated Other Comprehensive income
Amount Reclassified from Accumulated Other Comprehensive Income (a)
 
Affected Line Item in the Consolidated Statement of Income
Unrealized gains on available for sale securities
     
 
 $                                196
 
Investment securities gains
 
                                  (67)
 
Provision for income taxes
 
 $                                129
 
Net of tax
(a) Amounts in parentheses indicate debits to profit/loss
   

Note 9 – 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.
 
 
18

 
 
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.

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 I. 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 II. 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 III 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 II. 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 March 31, 2013 and December 31, 2012 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.

 
19

 

 
   
March 31, 2013
   
Level I
 
Level II
 
Level III
   
Total
Fair value measurements on a recurring basis:
                 
Assets
                 
  Securities available for sale:
                 
     U.S. Agency securities
 
 $                -
 
 $             122,434
 
 $                    -
   
 $             122,434
     U.S. Treasury securities
     
11,924
       
11,924
     Obligations of state and
                 
        political subdivisions
 
                   -
 
95,024
 
                       -
   
95,024
     Corporate obligations
 
                   -
 
21,486
 
                       -
   
21,486
     Mortgage-backed securities in
                 
       government sponsored entities
 
                   -
 
47,711
 
                       -
   
47,711
     Equity securities in financial
                 
       institutions
 
           1,597
 
                            -
 
                       -
   
1,597
Liabilities
                 
   Trust Preferred Interest Rate Swap
 
                   -
 
(150)
 
                       -
   
(150)

   
December 31, 2012
   
Level I
 
Level II
 
Level III
   
Total
Fair value measurements on a recurring basis:
                 
Assets
                 
  Securities available for sale:
                 
     U.S. Agency securities
 
 $                -
 
 $             127,234
 
 $                    -
   
 $             127,234
     U.S. Treasury securities
 
                   -
 
4,947
 
                       -
   
4,947
     Obligations of state and
                 
          political subdivisions
 
                   -
 
100,875
 
                       -
   
100,875
     Corporate obligations
 
                   -
 
22,109
 
                       -
   
22,109
     Mortgage-backed securities in
                 
          government sponsored entities
 
                   -
 
53,673
 
                       -
   
53,673
     Equity securities in financial institutions
 
           1,414
 
                            -
 
                       -
   
1,414
Liabilities
                 
   Trust Preferred Interest Rate Swap
 
                   -
 
(200)
 
                       -
   
(200)

Financial Instruments, Non-Financial Assets and Non-Financial Liabilities Recorded at Fair Value on a Nonrecurring Basis
 
The Company may be required, from time to time, to measure certain financial assets, financial liabilities, non-financial assets and non-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. 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 2013 and 2012 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.

·  
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 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.
·  
Other Real Estate owned – Other real estate owned, which is obtained through the Bank’s foreclosure process is valued utilizing the appraised collateral value. Collateral values are estimated using Level 2 inputs based on observable market data or Level 3 inputs based on customized discounting criteria. At the time, the foreclosure is completed, the Company obtains a current external appraisal.

 
20

 
 
Assets measured at fair value on a nonrecurring basis as of March 31, 2013 and December 31, 2012 are included in the table below (in thousands):

   
March 31, 2013
   
Level 1
 
Level II
 
Level III
   
Total
                   
Impaired Loans
 
 $                -
 
 $                         -
 
 $          10,460
   
 $               10,460
Other real estate owned
 
                   -
 
                            -
 
670
   
670
                   
   
December 31, 2012
   
Level 1
 
Level II
 
Level III
   
Total
                   
Impaired Loans
 
 $                -
 
 $                         -
 
 $            9,836
   
 $                 9,836
Other real estate owned
 
                   -
 
                            -
 
                  616
   
616

The following table provides a listing of the significant unobservable inputs used in the fair value measurement process for items valued utilizing level III techniques.

 
Fair value as of
       
 
March 31, 2013
December 31, 2012
 
Valuation Technique(s)
Unobservable input
Range
Impaired Loans
 $      4,795
 $      4,882
 
Discounted Cash Flows
Change in discount rates
0-7%
             
             
 
         5,665
         4,954
 
Appraised Collateral Values
Discount for time since appraisal
0-20%
         
Selling costs
0%-10%
         
Holding period
0 - 18 months
             
Other real estate owned
            670
            616
 
Appraised Collateral Values
Discount for time since appraisal
0-20%
         
Selling costs
0%-10%
         
Holding period
0 - 18 months
 
The fair values of the Company’s financial instruments are as follows (in thousands):

 
21

 

 
 
Carrying
         
March 31, 2013
Amount
Fair Value
Level I
Level II
Level III
Total
Financial assets:
           
Cash and due from banks
 $    37,114
 $    37,114
 $          37,114
 $              -
 $                     -
 $    37,114
Available-for-sale securities
     300,176
     300,176
               1,597
     298,579
                        -
     300,176
Net loans
     496,795
     519,254
                       -
                 -
     519,254
     519,254
Bank owned life insurance
       14,301
       14,301
             14,301
                 -
                        -
       14,301
Regulatory stock
         3,259
3,259
3,259
                 -
                        -
3,259
Accrued interest receivable
         3,840
         3,840
3,840
                 -
                        -
         3,840
             
Financial liabilities:
           
Deposits
 $  736,921
 $  741,510
 $        461,725
 $              -
 $         279,785
 $  741,510
Borrowed funds
       45,556
       43,261
                       -
       43,261
                        -
       43,261
Trust preferred interest rate swap
            150
            150
                       -
            150
                        -
            150
Accrued interest payable
         1,039
         1,039
1,039
                 -
                        -
         1,039
             

 
Carrying
         
December 31, 2012
Amount
Fair Value
Level I
Level II
Level III
Total
Financial assets:
           
Cash and due from banks
 $    26,333
 $    26,333
 $          26,333
 $              -
 $                     -
 $    26,333
Available-for-sale securities
     310,252
     310,252
               1,414
     308,838
                        -
     310,252
Loans held for sale
         1,458
         1,458
               1,458
   
         1,458
Net loans
     495,679
     522,502
                       -
                 -
            522,502
     522,502
Bank owned life insurance
       14,177
       14,177
             14,177
                 -
                        -
       14,177
Regulatory stock
         3,565
         3,565
               3,565
                 -
                        -
         3,565
Accrued interest receivable
         3,816
         3,816
               3,816
                 -
                        -
         3,816
             
Financial liabilities:
           
Deposits
 $  737,096
 $  742,422
 $        462,557
 $              -
 $         279,865
 $  742,422
Borrowed funds
       46,126
       43,403
                       -
       43,403
                        -
       43,403
Trust preferred interest rate swap
            200
            200
                       -
            200
                        -
            200
Accrued interest payable
         1,143
         1,143
1,143
                 -
                        -
         1,143

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.

 
22

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

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

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

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

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

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

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

Note 10 – Recent Accounting Pronouncements
 
In July, 2012, the FASB issued ASU 2012-02, Intangibles – Goodwill and Other (Topic 350) – Testing Indefinite-Lived Intangible Assets for Impairment. ASU 2012-02 give entities the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that an indefinite-lived intangible asset is impaired. If, after assessing the totality of events or circumstances, an entity determines it is more likely than not that an indefinite-lived intangible asset is impaired, then the entity must perform the quantitative impairment test. If, under the quantitative impairment test, the carrying amount of the intangible asset exceeds its fair value, an entity should recognize an impairment loss in the amount of that excess. Permitting an entity to assess qualitative factors when testing indefinite-lived intangible assets for impairment results in guidance that is similar to the goodwill impairment testing guidance in ASU 2011-08. ASU 2012-02 is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012 (early adoption permitted). This ASU is not expected to have a significant impact on the Company’s financial statements.

 
23

 
 
In October, 2012, the FASB issued ASU 2012-06, Business Combinations (Topic 805) - Subsequent Accounting for an Indemnification Asset Recognized at the Acquisition Date as a Result of a Government-Assisted Acquisition of a Financial Institution.  ASU 2012-06 requires that when a reporting entity recognizes an indemnification asset (in accordance with Subtopic 805-20) as a result of a government assisted acquisition of a financial institution and subsequently a change in the cash flows expected to be collected on the indemnification asset occurs (as a result of a change in cash flows expected to be collected on the assets subject to indemnification), the reporting entity should subsequently account for the change in the measurement of the indemnification asset on the same basis as the change in the assets subject to indemnification.  Any amortization of changes in value should be limited to the contractual term of the indemnification agreement (that is, the lesser of the term of the indemnification agreement and the remaining life of the indemnified assets).  ASU 2012-06 is effective for fiscal years, and interim periods within those years, beginning on or after December 15, 2012. Early adoption is permitted. The amendments should be applied prospectively to any new indemnification assets acquired after the date of adoption and to indemnification assets existing as of the date of adoption arising from a government-assisted acquisition of a financial institution.  This ASU is not expected to have a significant impact on the Company’s financial statements.
 
In February 2013, the FASB issued ASU 2013-02, Comprehensive Income (Topic 220):  Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.   The amendments in this Update require an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under U.S. generally accepted accounting principles (GAAP) to be reclassified in its entirety to net income.  For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required under U.S. GAAP that provide additional detail about those amounts.  For public entities, the amendments are effective prospectively for reporting periods beginning after December 15, 2012. For nonpublic entities, the amendments are effective prospectively for reporting periods beginning after December 15, 2013. Early adoption is permitted.  This ASU did not have a significant impact on the Company’s disclosures in its financial statements.

 
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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 Community 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, could in the future affect the Company’s actual results and could cause the Company’s actual results for subsequent periods to differ materially from those expressed in any forward-looking statement:
 
·  
Interest rates could change more rapidly or more significantly than we expect.
·  
The economy could change significantly in an unexpected way, which would cause the demand for new loans and the ability of borrowers to repay outstanding loans to change in ways that our models do not anticipate.
·  
The stock and bond markets could suffer a significant disruption, which may have a negative effect on our financial condition and that of our borrowers, and on our ability to raise money by issuing new securities.
·  
It could take us longer than we anticipate to implement strategic initiatives designed to increase revenues or manage expenses, or we may not be able to implement those initiatives at all.
·  
Acquisitions and dispositions of assets could affect us in ways that we have 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.
·  
Similarly, customers dependent on the exploration and drilling of the natural gas reserves may be dependent on the market price of natural gas.  As a result, decreases in the market price of natural gas could also negatively impact our customers.
 
Additional factors that may affect our results are discussed under “Part II – Item 1A – Risk Factors” in this report and in the Company’s 2012 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 financial condition in the results of operations, capital resources and liquidity presented in the 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 ended March 31, 2013 are not necessarily indicative of the results you may expect for the full year.

 
25

 
 
The 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 20 banking facilities, 17 of which operate as bank branches.  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 loan production offices in Lock Haven and Dallas, 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.  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 entities.  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 and the limited loan growth opportunities in our primary market and surrounding areas.  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.

 
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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 March 31, 2013 and December 31, 2012, the Trust Department had $106.8 and $105.6 million of assets under management, respectively.  The $1.2 million increase is a result of market value increases offset by a reduction of $1.2 million of trust assets through closed accounts, net of new accounts and additions in the first three months of 2013.

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 Agency, Inc.  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 $92.0 million at December 31, 2012 to $99.1 million at March 31, 2013. 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 division, 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 with the negotiation of 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.

Dividend Reinvestment Plan
 
On March 22, 2013 the Company amended and restated its dividend reinvestment plan prospectus with the Securities and Exchange Commission.  The amended prospectus can be found on the Company’s website at www.firstcitizensbank.com.

Results of Operations

Overview of the Income Statement
 
The Company had net income of $3,287,000 for the first three months of 2013 compared to net income of $3,449,000 for last year’s comparable period, a decrease of $162,000 or 4.7%. Earnings per share for the first three months of 2013 were $1.14, compared to $1.18 last year, representing a 3.4% decrease.  Annualized return on assets and return on equity for the three months of 2013 were 1.50% and 15.22%, respectively, compared with 1.57% and 17.76% for last year’s comparable period.

Net Interest Income
 
Net interest income, the most significant component of the Company’s earnings, is the amount by which interest income generated from interest-earning assets exceeds interest expense on interest-bearing liabilities.
 
Net interest income for the first three months of 2013 was $7,313,000, a decrease of $245,000, or 3.2%, compared to the same period in 2012.  For the first three months of 2013, the provision for loan losses totaled $150,000, an increase of $45,000 over the comparable period in 2012.  Consequently, net interest income after the provision for loan losses was $7,163,000 compared to $7,453,000 during the first three months of 2012.
 
 
 
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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 three months ended March 31, 2013 and 2012 on a tax equivalent basis (dollars in thousands):
 
 
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Analysis of Average Balances and Interest Rates (1)
 
 Three Months Ended
 
March 31, 2013
March 31, 2012
 
Average
 
Average
Average
 
Average
 
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
(dollars in thousands)
$
$
%
$
$
%
ASSETS
           
Short-term investments:
           
   Interest-bearing deposits at banks
        23,198
                10
0.17
            7,565
                  5
0.27
Total short-term investments
        23,198
                10
0.17
            7,565
                  5
0.27
Investment securities:
           
  Taxable
      211,459
              983
1.86
        231,069
            1,212
2.10
  Tax-exempt (3)
        92,170
           1,317
5.72
          95,845
            1,446
6.03
  Total investment securities
      303,629
           2,300
3.03
        326,914
            2,658
3.25
Loans:
           
  Residential mortgage loans
      179,268
           2,742
6.20
        185,046
            3,025
6.57
  Construction
        11,834
              155
5.31
            8,772
              126
5.78
  Commercial & farm loans
      242,758
           3,578
5.98
        230,834
            3,640
6.34
  Loans to state & political subdivisions
        59,192
              670
4.59
          55,474
              656
4.76
  Other loans
        10,023
              206
8.34
          10,296
              218
8.52
  Loans, net of discount (2)(3)(4)
      503,075
           7,351
5.93
        490,422
            7,665
6.29
Total interest-earning assets
      829,902
           9,661
4.72
        824,901
          10,328
5.04
Cash and due from banks
           3,553
   
            9,826
   
Bank premises and equipment
        11,493
   
          11,667
   
Other assets
        31,236
   
          30,969
   
Total non-interest earning assets
        46,282
   
          52,462
   
Total assets
      876,184
   
        877,363