secondqtr2013.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q


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

For the quarterly period ended June 30, 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 July 30, 2013, was 3,038,511.

 
 

 

 
 
Citizens Financial Services, Inc.
Form 10-Q

INDEX
 
 
   
PAGE
Part I
FINANCIAL INFORMATION
 
Item 1.
Financial Statements (unaudited):
 
 
Consolidated Balance Sheet as of June 30, 2013 and December 31, 2012
1
 
Consolidated Statement of Income for the Three and Six Months Ended June 30, 2013 and 2012
2
 
Consolidated Statement of Comprehensive Income for the Three and Six Months ended June 30, 2013 and 2012
3
 
Consolidated Statement of Cash Flows for the Six Months ended June 30, 2013 and 2012
4
 
Notes to Consolidated Financial Statements
5-27
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
28-49
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
49-50
Item 4.
Controls and Procedures
50
     
Part II
OTHER INFORMATION
 
Item 1.
Legal Proceedings
50
Item 1A.
Risk Factors
50
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
51
Item 3.
Defaults Upon Senior Securities
51
Item 4.
Mine Safety Disclosures
51
Item 5.
Other Information
51
Item 6.
Exhibits
51-52
 
Signatures
53

 
 

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED BALANCE SHEET
   
(UNAUDITED)
   
     
 
June 30
December 31
(in thousands except share data)
2013
2012
ASSETS:
   
Cash and due from banks:
   
  Noninterest-bearing
 $               7,928
 $          12,307
  Interest-bearing
                  3,642
             14,026
Total cash and cash equivalents
                11,570
             26,333
Available-for-sale securities
              307,935
           310,252
Loans held for sale
                     796
               1,458
 
   
Loans (net of allowance for loan losses:
   
  2013, $6,989 and 2012, $6,784)
              508,747
           495,679
 
   
Premises and equipment
                11,396
             11,521
Accrued interest receivable
                  3,821
               3,816
Goodwill
                10,256
             10,256
Bank owned life insurance
                14,427
             14,177
Other assets
                10,128
               8,935
 
 
 
TOTAL ASSETS
 $           879,076
 $        882,427
 
 
 
LIABILITIES:
   
Deposits:
   
  Noninterest-bearing
 $             86,852
 $          89,494
  Interest-bearing
              661,162
           647,602
Total deposits
              748,014
           737,096
Borrowed funds
                33,993
             46,126
Accrued interest payable
                     964
               1,143
Other liabilities
                  7,223
               8,587
TOTAL LIABILITIES
              790,194
           792,952
STOCKHOLDERS' EQUITY:
   
Preferred Stock
   
  $1.00 par value; authorized 3,000,000 shares June 30, 2013 and December 31, 2012;
   
   none issued in 2013 or 2012
                          -
                      -
Common stock
   
  $1.00 par value; authorized 15,000,000 shares;  issued 3,305,517 at June 30, 2013 and
   
  3,161,324 at December 31, 2012
                  3,306
               3,161
Additional paid-in capital
                23,545
             16,468
Retained earnings
                69,538
             71,813
Accumulated other comprehensive (loss) income
                    (713)
               4,631
Treasury stock, at cost:  267,006 shares at June 30, 2013
   
  and 262,921 shares at December 31, 2012
                 (6,794)
             (6,598)
TOTAL STOCKHOLDERS' EQUITY
                88,882
             89,475
TOTAL LIABILITIES AND
   
   STOCKHOLDERS' EQUITY
 $           879,076
 $        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
Six Months Ended
 
June 30
June 30,
(in thousands, except share and per share data)
2013
2012
2013
2012
INTEREST INCOME:
       
Interest and fees on loans
 $        7,141
 $      7,439
 $     14,278
 $    14,904
Interest-bearing deposits with banks
                   9
                 1
                19
                 6
Investment securities:
   
 
 
    Taxable
               936
         1,237
           1,899
         2,434
    Nontaxable
               844
             920
           1,713
         1,874
    Dividends
                 18
               16
                38
               32
TOTAL INTEREST INCOME
           8,948
         9,613
        17,947
       19,250
INTEREST EXPENSE:
       
Deposits
           1,287
         1,555
           2,615
         3,221
Borrowed funds
               310
             393
              668
             806
TOTAL INTEREST EXPENSE
           1,597
         1,948
           3,283
         4,027
NET INTEREST INCOME
           7,351
         7,665
        14,664
       15,223
Provision for loan losses
                 75
             105
              225
             210
NET INTEREST INCOME AFTER
       
    PROVISION FOR LOAN LOSSES
           7,276
         7,560
        14,439
       15,013
NON-INTEREST INCOME:
       
Service charges
           1,079
         1,129
           2,103
         2,207
Trust
               169
             151
              370
             324
Brokerage and insurance
               121
               75
              213
             225
Investment securities gains, net
                 98
             213
              294
             321
Gains on loans sold
                 50
             131
              161
             185
Earnings on bank owned life insurance
               126
             126
              250
             250
Other
               100
             104
              204
             233
TOTAL NON-INTEREST INCOME
           1,743
         1,929
           3,595
         3,745
NON-INTEREST EXPENSES:
       
Salaries and employee benefits
           2,795
         2,668
           5,600
         5,421
Occupancy
               312
             314
              654
             624
Furniture and equipment
               113
               96
              215
             202
Professional fees
               188
             224
              417
             492
FDIC insurance
               113
             115
              225
             238
Pennsylvania shares tax
               182
             160
              365
             326
Other
           1,129
             988
           2,178
         2,090
TOTAL NON-INTEREST EXPENSES
           4,832
         4,565
           9,654
         9,393
Income before provision for income taxes
           4,187
         4,924
           8,380
         9,365
Provision for income taxes
               907
         1,171
           1,813
         2,163
NET INCOME
 $        3,280
 $      3,753
 $       6,567
 $      7,202
 
       
PER COMMON SHARE DATA:
       
Net Income - Basic
 $          1.08
 $        1.23
 $          2.17
 $        2.35
Net Income - Diluted
 $          1.08
 $        1.23
 $          2.16
 $        2.35
Cash Dividends Paid
 $        0.271
 $      0.283
 $       0.543
 $      0.562
         
The accompanying notes are an integral part of these unaudited consolidated financial statements.
   


 
2

 
 
 
CITIZENS FINANCIAL SERVICES, INC.
               
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
               
(UNAUDITED)
               
 
            Three Months Ended
Six Months Ended
 
June 30,
June 30,
(in thousands)
 
2013
 
2012
 
2013
 
2012
Net income
 
 $   3,280
 
 $ 3,753
 
$  6,567
 
$   7,202
Other comprehensive income (loss):
               
      Change in unrealized gains on available for sale securities
   (6,656)
    741
 (8,032)
318
      Income tax effect
     2,263
  (252)
    2,731
(108)
      Change in unrecognized pension cost
        128
         -
       128
       -
      Income tax effect
        (44)
         -
      (44)
       -
      Change in unrealized loss on interest rate swap
          51
      45
       101
     66
      Income tax effect
        (17)
   (15)
      (34)
  (23)
      Less:  Reclassification adjustment for investment
               
                 security gains included in net income
      (98)
 (213)
    (294)
(321)
      Income tax effect
         33
     72
      100
   109
Other comprehensive income (loss), net of tax
 
  (4,340)
 
      378
 
(5,344)
 
          41
Comprehensive income (loss)
 
 $  (1,060)
 
 $ 4,131
 
 $ 1,223
 
 $   7,243
                 
The accompanying notes are an integral part of these unaudited consolidated financial statements.
 
         
 

 
3

 
 
 
CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED STATEMENT OF CASH FLOWS
   
(UNAUDITED)
Six Months Ended
 
June 30,
(in thousands)
2013
2012
CASH FLOWS FROM OPERATING ACTIVITIES:
   
  Net income
 $          6,567
 $          7,202
  Adjustments to reconcile net income to net
   
   cash provided by operating activities:
   
    Provision for loan losses
                225
                210
    Depreciation and amortization
                216
                211
    Amortization and accretion of investment securities
             1,234
             1,196
    Deferred income taxes
                    9
                  28
    Investment securities gains, net
              (294)
              (321)
    Earnings on bank owned life insurance
              (250)
              (250)
    Originations of loans held for sale
         (11,801)
         (14,241)
    Proceeds from sales of loans held for sale
           12,624
           14,426
    Realized gains on loans sold
              (161)
              (185)
    Increase in accrued interest receivable
                  (5)
              (179)
    Decrease in accrued interest payable
              (179)
              (290)
    Other, net
                413
              (269)
      Net cash provided by operating activities
             8,598
             7,538
CASH FLOWS FROM INVESTING ACTIVITIES:
   
  Available-for-sale securities:
   
    Proceeds from sales
           15,773
           16,654
    Proceeds from maturity and principal repayments
           49,651
           68,914
    Purchase of securities
         (72,372)
         (90,754)
  Proceeds from redemption of regulatory stock
                513
                245
  Purchase of regulatory stock
              (207)
           (1,405)
  Net increase in loans
         (13,246)
           (9,679)
  Purchase of premises and equipment
              (203)
              (117)
  Proceeds from sale of foreclosed assets held for sale
                     -
                345
      Net cash used in investing activities
         (20,091)
         (15,797)
CASH FLOWS FROM FINANCING ACTIVITIES:
   
  Net increase in deposits
           10,918
             4,774
  Repayments of long-term borrowings
         (10,800)
           (4,110)
  Net decrease in short-term borrowed funds
           (1,333)
           (2,706)
  Purchase of treasury and restricted stock
              (380)
              (637)
  Dividends paid
           (1,675)
           (1,726)
      Net cash used in financing activities
           (3,270)
           (4,405)
          Net decrease in cash and cash equivalents
         (14,763)
         (12,664)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
           26,333
           30,432
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 $        11,570
 $        17,768
     
Supplemental Disclosures of Cash Flow Information:
   
    Interest paid
 $          3,462
 $          4,317
    Income taxes paid
 $          2,295
 $          2,095
    Loans transferred to foreclosed property
 $               54
 $             123
   
 
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 June 30, 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 six month period ended June 30, 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
Six months ended
 
June 30,
June 30,
 
2013
2012
2013
2012
Net income applicable to common stock
$3,280,000
$3,753,000
$6,567,000
$7,202,000
         
Basic earnings per share computation
       
Weighted average common shares outstanding
   3,031,279
   3,058,663
     3,032,491
   3,063,500
Earnings per share - basic
$1.08
$1.23
$2.17
$2.35
         
Diluted earnings per share computation
       
Weighted average common shares outstanding for basic earnings per share
   3,031,279
   3,058,663
     3,032,491
   3,063,500
Add: Dilutive effects of restricted stock
          1,578
          1,409
               781
             624
Weighted average common shares outstanding for dilutive earnings per share
   3,032,857
   3,060,072
     3,033,272
   3,064,124
Earnings per share - diluted
$1.08
$1.23
$2.16
$2.35
 
For the three months ended June 30, 2013 there were no anti-dilutive securities, compared to 2,447 shares for the three months ended June 30, 2012 related to the restricted stock program that were excluded from the diluted earnings per share calculations since they were anti-dilutive. For the six months ended June 30, 2013 and 2012, 1,415 and 4,115 shares, respectively, related to the restricted stock program were excluded from the diluted earnings per share calculations since they were anti-dilutive.
 
 
 
5

 
 
Note 3 - Income Tax Expense
 
Income tax expense is less than the amount calculated using the statutory tax rate, primarily as a result of tax-exempt income earned from state and municipal securities and loans and investments in tax credits.

Note 4 – Investments
 
The amortized cost and fair value of investment securities at June 30, 2013 and December 31, 2012 were as follows (in thousands):

   
Gross
Gross
 
 
Amortized
Unrealized
Unrealized
Fair
June 30, 2013
Cost
Gains
Losses
Value
Available-for-sale securities:
       
  U.S. agency securities
 $    138,674
 $                  875
 $          (1,669)
 $       137,880
  U.S. treasury securities
         11,845
                          -
                (374)
            11,471
  Obligations of state and
       
    political subdivisions
         93,203
                  2,939
                (965)
            95,177
  Corporate obligations
         21,161
                     356
                (551)
            20,966
  Mortgage-backed securities in
       
    government sponsored entities
         40,313
                     844
                (277)
            40,880
  Equity securities in financial institutions
              832
                     729
                      -
              1,561
Total available-for-sale securities
 $    306,028
 $               5,743
 $          (3,836)
 $       307,935
         
   
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. treasury securities
           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 June 30, 2013 and December 31, 2012 (in thousands). As of June 30, 2013, the Company owned 74 securities whose fair value was less than their cost basis.
 
 
6

 
 
 
June 30, 2013
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
 $      79,007
 $        (1,669)
 $                  -
 $                  -
 $        79,007
 $        (1,669)
U.S. treasury securities
11,471
(374)
                     -
                     -
11,471
(374)
Obligations of state and
           
    political subdivisions
19,910
(965)
                     -
                     -
19,910
(965)
Corporate obligations
12,018
(551)
                     -
                     -
12,018
(551)
Mortgage-backed securities in
           
   government sponsored entities
23,272
(266)
                  47
                (11)
23,319
(277)
    Total securities
 $    145,678
 $        (3,825)
 $               47
 $             (11)
 $      145,725
 $        (3,836)
               
 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 June 30, 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, U.S treasuries, 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 six months ended June 30, 2013 and 2012 were $15,773,000 and $16,654,000, respectively.  For the three months ended June 30, 2013 and 2012, there were sales of $11,917,000 and $5,418,000, respectively, of available-for-sale securities. The gross gains and losses were as follows (in thousands):


 
7

 

 
 
Three Months Ended
Six Months Ended
 
 June 30,
 June 30,
 
2013
2012
2013
2012
Gross gains
 $           238
 $                  213
 $              434
 $              321
Gross losses
             (140)
                          -
                (140)
                      -
Net gains
 $             98
 $                  213
 $              294
 $              321
 
Investment securities with an approximate carrying value of $189.9 million and $193.3 million at June 30, 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 June 30, 2013, by contractual maturity, are shown below (in thousands):

 
Amortized
 
 
Cost
Fair Value
Available-for-sale debt securities:
   
  Due in one year or less
 $      10,605
 $             10,697
  Due after one year through five years
         93,632
                93,674
  Due after five years through ten years
         84,743
                83,978
  Due after ten years
       116,216
              118,025
Total
 $    305,196
 $           306,374

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 June 30, 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 June 30, 2013 and December 31, 2012 (in thousands):

June 30, 2013
 
Total Loans
Individually
evaluated for
impairment
Collectively
evaluated for
 impairment
Real estate loans:
       
     Residential
 
 $                 180,782
 $                        487
 $                 180,295
     Commercial and agricultural
 
                    198,127
                        8,332
                    189,795
     Construction
 
                      13,455
                                -
                      13,455
Consumer
 
                      10,062
                                -
                      10,062
Other commercial and agricultural loans
 
                      54,073
                        1,774
                      52,299
State and political subdivision loans
 
                      59,237
                                -
                      59,237
Total
 
                    515,736
 $                   10,593
 $                 505,143
Allowance for loan losses
 
                        6,989
   
Net loans
 
 $                 508,747
   

 
8

 

 
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
   
 
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 loans 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. In addition, certain residential mortgages, home equity and consumer loans that are cross collateralized with commercial relationships that are determined to be impaired may also be classified as impaired. Impaired 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):
 
 
9

 

 
   
Recorded
Recorded
   
 
Unpaid
Investment
Investment
Total
 
 
Principal
With No
With
Recorded
Related
June 30, 2013
Balance
Allowance
Allowance
Investment
Allowance
Real estate loans:
         
     Mortgages
 $       376
 $          144
 $          207
 $          351
 $          24
     Home Equity
          136
                  -
             136
             136
             13
     Commercial
     10,023
          5,704
          2,628
          8,332
           499
     Agricultural
               -
                  -
                  -
                  -
                -
     Construction
               -
                  -
                  -
                  -
                -
Consumer
               -
                  -
                  -
                  -
                -
Other commercial loans
       1,828
          1,466
             308
          1,774
             1
Other agricultural loans
               -
                  -
                  -
                  -
                -
State and political
         
   subdivision loans
               -
                  -
                  -
                  -
                -
Total
 $  12,363
 $       7,314
 $       3,279
 $     10,593
 $        537
           
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
 
The following table includes the average balance of impaired financing receivables by class and the income recognized on impaired loans for the three and six month periods ended June 30, 2013 and 2012(in thousands):

 
 For the Six Months ended
 
June 30, 2013
June 30, 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
 $       330
 $              4
 $               -
 $            83
 $            1
 $               -
     Home Equity
          137
                 2
                  -
               93
               2
                 1
     Commercial
       8,595
               84
35
          8,138
             39
               23
     Agricultural
               -
                  -
                  -
                  -
                -
                  -
     Construction
               -
                  -
                  -
                  -
                -
                  -
Consumer
               -
                  -
                  -
                  -
                -
                  -
Other commercial loans
       1,786
               41
                  -
             468
                -
                  -
Other agricultural loans
               -
                  -
                  -
                  -
                -
                  -
State and political
           
   subdivision loans
               -
                  -
                  -
                  -
                -
                  -
Total
 $  10,848
 $          131
 $            35
 $       8,782
 $          42
 $            24
 
 
 
10

 
 
 
 
 For the Three Months Ended
 
June 30, 2013
June 30, 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
 $       352
 $              2
 $               -
 $          165
 $            1
 $               -
     Home Equity
          136
                 1
                  -
               93
               1
                  -
     Commercial
       8,406
               39
               21
          8,049
             21
                 5
     Agricultural
               -
                  -
                  -
                  -
                -
                  -
     Construction
               -
                  -
                  -
                  -
                -
                  -
Consumer
               -
                  -
                  -
                  -
                -
                  -
Other commercial loans
       1,916
               22
                  -
             457
                -
                  -
Other agricultural loans
               -
                  -
                  -
                  -
                -
                  -
State and political
           
   subdivision loans
               -
                  -
                  -
                  -
                -
                  -
Total
 $  10,810
 $            64
 $            21
 $       8,764
 $          23
 $              5
 

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.

 
11

 
 
The following tables represent credit exposures by internally assigned grades as of June 30, 2013 and December 31, 2012 (in thousands):

June 30, 2013
Pass
Special
Mention
Substandard
Doubtful
Loss
Ending Balance
Real estate loans:
           
     Commercial
 $          152,901
 $           6,141
 $                  19,227
 $              211
 $              -
 $          178,480
     Agricultural
               15,042
              2,713
                       1,892
                      -
                 -
               19,647
     Construction
               13,455
                      -
                              -
                      -
                 -
               13,455
Other commercial loans
               41,744
                 601
                       2,304
                     9
                 -
               44,658
Other agricultural loans
                 7,205
                 935
                       1,275
                      -
                 -
                 9,415
State and political
           
   subdivision loans
               59,237
                      -
                              -
                      -
                 -
               59,237
Total
 $          289,584
 $         10,390
 $                  24,698
 $              220
 $              -
 $          324,892
             
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 June 30, 2013 and December 31, 2012 (in thousands):

June 30, 2013
Performing
Non-performing
Total
Real estate loans:
     
     Mortgages
 $          111,395
 $              545
 $                111,940
     Home Equity
               68,677
                 165
                     68,842
Consumer
               10,062
                      -
                     10,062
Total
 $          190,134
 $              710
 $                190,844
       
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

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 June 30, 2013 and December 31, 2012 (in thousands):
 
 
12

 

 
   
30-59 Days
60-89 Days
90 Days
Total Past
 
Total Financing
90 Days and
June 30, 2013
Past Due
Past Due
Or Greater
Due
Current
Receivables
Accruing
Real estate loans:
             
     Mortgages
 $        443
 $        214
 $        450
 $     1,107
 $   110,833
 $           111,940
 $              63
     Home Equity
           389
           117
           140
           646
        68,196
                68,842
                 38
     Commercial
           158
                -
        2,496
        2,654
      175,826
              178,480
               137
     Agricultural
                -
                -
                -
                -
        19,647
                19,647
                   -
     Construction
                -
                -
                -
                -
        13,455
                13,455
                   -
Consumer
             58
               1
                -
             59
        10,003
                10,062
                   -
Other commercial loans
           864
               1
           323
        1,188
        43,470
                44,658
                 15
Other agricultural loans
             49
                -
                -
             49
          9,366
                  9,415
                   -
State and political
             
   subdivision loans
                -
                -
                -
                -
        59,237
                59,237
                   -
 
Total
 $     1,961
 $        333
 $     3,409
 $     5,703
 $   510,033
 $           515,736
 $            253
                 
Loans considered non-accrual
 $        108
 $             -
 $     3,156
 $     3,264
 $       4,942
 $               8,206
 
Loans still accruing
        1,853
           333
           253
        2,439
      505,091
              507,530
 
 
Total
 $     1,961
 $        333
 $     3,409
 $     5,703
 $   510,033
 $           515,736
 
                 
   
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 June 30, 2013 and December 31, 2012, respectively. The balances are presented by class of financing receivable (in thousands):
 
 
13

 

 
   
June 30, 2013
 
December 31, 2012
Real estate loans:
     
     Mortgages
 $                482
 
 $                   482
     Home Equity
                   127
 
                      181
     Commercial
                7,241
 
                   7,042
     Agricultural
                    -
 
                        -
     Construction
                    -
 
                        -
Consumer
                    -
 
                        -
Other commercial loans
                   356
 
                      362
Other agricultural loans
                    -
 
                        -
State and political subdivision
                    -
 
                        -
   
 $             8,206
 
 $                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 TDRs, 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.
 
There were no loan modifications that were considered TDRs during the three months ended June 30, 2013. Loan modifications that are considered TDRs completed during the six months ended June 30, 2013 and 2012 and the three months ended June 30, 2012, were as follows (dollars in thousands):

 
For the Six Months Ended June 30, 2013
 
Number of contracts
Pre-modification Outstanding Recorded Investment
Post-Modification Outstanding Recorded Investment
 
Interest
Modification
Term
Modification
Interest
Modification
Term
Modification
Interest Modification
Term
Modification
Real estate loans:
           
     Mortgages
                    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


 
14

 

 
 
For the Three Months Ended June 30, 2012
 
Number of contracts
Pre-modification Outstanding Recorded Investment
Post-Modification Outstanding Recorded Investment
 
Interest
Modification
Term
 Modification
Interest
Modification
Term
Modification
Interest Modification
Term
Modification
Real estate loans:
           
     Mortgages
                    1
                      1
 $                       48
 $                71
 $              48
 $              71
Total
                    1
                       1
 $                       48
 $                71
 $              48
 $              71

 
For the Six Months Ended June 30, 2012
 
Number of contracts
Pre-modification Outstanding Recorded Investment
Post-Modification Outstanding Recorded Investment
 
Interest
Modification
Term
Modification
Interest
Modification
Term
Modification
Interest Modification
Term
Modification
Real estate loans:
           
     Mortgages
1
1
$                       48
$                 71
 $               48
$                 71
     Commercial
                     -
                       2
                             -
98
                     -
                98
Total
                    1
                       3
 $                       48
 $              169
 $               48
 $             169
 
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. The following table presents the recorded investment in loans that were modified as TDRs during each 12-month period prior to the current reporting periods, which begin January 1, 2013 and 2012 (six month periods) and April 1, 2013 and 2012 (3 month periods), respectively, and that subsequently defaulted during these reporting periods (dollars in thousands):

 
For the Three Months Ended
For the Six Months Ended
 
June 30, 2013
June 30, 2012
June 30, 2013
June 30, 2012
 
Number of contracts
Recorded investment
Number of contracts
Recorded investment
Number of contracts
Recorded investment
Number of contracts
Recorded investment
Real estate loans:
               
     Commercial
             1
 $              535
                   -
 $              -
                   -
 $              -
            1
 $               48
Total recidivism
             1
 $              535
                   -
 $              -
                   -
 $              -
            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 June 30, 2013 and December 31, 2012, respectively (in thousands):
 
 
June 30, 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
 $         896
 $         934
 
 $           22
 $           853
 $             875
     Commercial and agricultural
            499
         3,741
4,240
 
            559
           3,878
             4,437
     Construction
                 -
              91
91
 
                      -
                38
                  38
Consumer
                 -
            114
114
 
                      -
              119
                119
Other commercial and agricultural loans
                 -
            957
957
 
                1
              727
                728
State and political subdivision loans
                 -
            310
310
 
                      -
              271
                271
Unallocated
                 -
            343
343
 
                      -
              316
                316
Total
 $         537
 $      6,452
 $      6,989
 
 $         582
 $        6,202
 $          6,784
 
 
 
15

 
 
The following tables roll forward the balance of the ALLL by portfolio segment for the three and six month periods ended June 30, 2013 and 2012, respectively (in thousands):
 

 
Balance at
March 31, 2013
Charge-offs
Recoveries
Provision
Balance at
June 30, 2013
Real estate loans:
         
     Residential
 $         913
 $          (13)
 $              -
 $         34
 $         934
     Commercial and agricultural
         4,416
                 -
                 -
        (176)
         4,240
     Construction
              78
                 -
                 -
            13
              91
Consumer
            118
             (10)
                9
            (3)
            114
Other commercial and agricultural loans
            700
                 -
                 -
          257
            957
State and political
     
               -
 
  subdivision loans
            303
                 -
                 -
              7
            310
Unallocated
            400
                 -
                 -
          (57)
            343
Total
 $      6,928
 $          (23)
 $             9
 $         75
 $      6,989
           
 
Balance at
December 31, 2012
Charge-offs
Recoveries
Provision
Balance at
June 30, 2013
Real estate loans:
         
     Residential
 $         875
 $          (13)
 $             2
 $         70
 $         934
     Commercial and agricultural
         4,437
                 -
                 -
        (197)
         4,240
     Construction
              38
                 -
                 -
            53
              91
Consumer
            119
             (30)
              21
              4
            114
Other commercial and agricultural loans
            728
                 -
                 -
          229
            957
State and political
     
               -
 
  subdivision loans
            271
                 -
                 -
            39
            310
Unallocated
            316
                 -
                 -
            27
            343
Total
 $      6,784
 $          (43)
 $           23
 $       225
 $      6,989
           
 
Balance at
March 31, 2012
Charge-offs
Recoveries
Provision
Balance at
June 30, 2012
Real estate loans:
         
     Residential
 $         753
 $              -
 $              -
 $         33
 $         786
     Commercial and agricultural
         4,336
                 -
                6
            63
         4,405
     Construction
              16
                 -
                 -
              3
              19
Consumer
              96
             (16)
                7
            21
            108
Other commercial and agricultural loans
            671
                 -
                3
            11
            685
State and political
     
               -
 
  subdivision loans
            245
                 -
                 -
              1
            246
Unallocated
            428
                 -
                 -
          (27)
            401
Total
 $      6,545
 $          (16)
 $           16
 $       105
 $      6,650
           
 
Balance at
December 31, 2011
Charge-offs
Recoveries
Provision
Balance at
June 30, 2012
Real estate loans:
         
     Residential
 $         805
 $          (49)
 $              -
 $         30
 $         786
     Commercial and agricultural
         4,132
               (2)
                6
          269
         4,405
     Construction
              15
                 -
                 -
              4
              19
Consumer
            111
             (24)
              16
              5
            108
Other commercial and agricultural loans
            674
                 -
                6
              5
            685
State and political
     
               -
 
  subdivision loans
            235
                 -
                 -
            11
            246
Unallocated
            515
                 -
                 -
        (114)
            401
Total
 $      6,487
 $          (75)
 $           28
 $       210
 $      6,650
 
 
 
16

 
 
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 TDRs 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.
 
We continually review the model utilized in calculating the required allowance. The following qualitative factors experienced changes during the first six 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 Marcellus shale natural gas exploration activities.
·  
The qualitative factor for trends in volume, terms and nature of the loan portfolio was increased for commercial and agricultural real estate, other commercial and agricultural loans and state and political subdivision loan categories due to the increase of the number of loans that are participations that were purchased from other banks and therefore subject to different underwriting standards.
·  
The qualitative factor for the existence and effect of any credit concentrations and changes in the level of such concentrations was increased for commercial and other loans and was lowered for commercial and agricultural real estate as the loan growth has slowed in 2013.
 

 
 
17

 
 
The following qualitative factors experienced changes during the three months ended June 30, 2013:
·  
The qualitative factor for trends in volume, terms and nature of the loan portfolio was increased for commercial and agricultural real estate, other commercial and agricultural loans and state and political subdivision loan categories due to the increase of the number of loans that are participations that were purchased from other banks and therefore subject to different underwriting standards.
·  
The qualitative factor for the existence and effect of any credit concentrations and changes in the level of such concentrations was increased for commercial and other loans and was lowered for commercial and agricultural real estate as the loan growth has slowed in 2013.
 
The following factors experienced changes during the first six months of 2012:
 
·  
The qualitative factor for changes in values of underlying collateral was decreased for residential and commercial real estate loans due to the serious flooding experienced in our primary market in the third quarter of 2011 not being as severe as originally expected.
·  
The qualitative factors for changes in levels of and trends in delinquencies, impaired/classified loans were increased for commercial real estate due to the increase in the Company’s internal watch list for commercial real estate loans since December 31, 2011.
·  
The qualitative factors for changes in industry conditions were increased for agricultural real estate and other agricultural loans due to decreases in milk prices from December 31, 2011 to June 30, 2012.
 
During the second quarter of 2012, there were no significant changes in any qualitative factor. As a result, the change in the allocation of the allowance from March 31, 2012, is mainly attributable to the changes in the loan portfolio balances since that date.

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 June 30, 2013 and December 31, 2012, the Bank holds $2,984,200 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.

 
18

 
 
For employees who are eligible to participate in the Pension Plan, the Pension Plan requires benefits to be paid to eligible employees based primarily upon age and compensation rates during employment.  Upon retirement or other termination of employment, employees can elect either an annuity benefit or a lump sum distribution of vested benefits in the Pension Plan.
 
The following sets forth the components of net periodic benefit costs of the Pension Plan for the three and six months ended June 30, 2013 and 2012, respectively (in thousands):

 
Three Months Ended
Six Months Ended
 
 June 30,
 June 30,
 
2013
2012
2013
2012
Service cost
 $            76
 $       54
 $        177
 $       167
Interest cost
             79
       35
           185
         174
Expected return on plan assets
        (169)
      (80)
        (343)
       (286)
Net amortization and deferral
              86
         52
           128
           68
Net periodic benefit cost
 $            72
 $       61
 $        147
 $       123
 
The Company expects to contribute $1,000,000 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 $147,000 and $132,000 for the six months ended June 30, 2013 and 2012, respectively. For the three months ended June 30, 2013 and 2012, contributions by the Company totaled $92,000 and $80,000, 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 June 30, 2013 and December 31, 2012, an obligation of $971,000 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 $3,000 and $4,000 for each of the three months ended June 30, 2013 and 2012. For the six months ended June 30, 2013 and 2012, amounts included in interest expense on the deferred amounts totaled $7,000 and $8,000, respectively.
 
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 June 30, 2013, 67,756 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.

 
19

 
 
 
The following table details the vesting, awarding and forfeiting of restricted shares during 2013 and 2012:
 
Three months ended June 30,
Six months ended June 30,
 
2013
2012
2013
2012
   
Weighted
 
Weighted
 
Weighted
 
Weighted
 
Unvested
Average
Unvested
Average
Unvested
Average
Unvested
Average
 
Shares
Market Price
Shares
Market Price
Shares
Market Price
Shares
Market Price
Outstanding, beginning of period
        7,269
 $         35.16
   6,280
 $       28.15
       8,646
 $          35.51
   9,921
 $       29.37
Granted
        3,027
            48.21
   3,808
          37.10
      3,027
             48.21
   3,808
          37.10
Forfeited
                -
                   -
           -
                  -
          (55)
             37.10
           -
                  -
Vested
      (2,830)
            31.35
  (1,581)
          26.80
     (4,152)
             33.26
  (5,222)
          25.59
Outstanding, end of period
        7,466
 $         41.89
   8,507
 $       35.16
       7,466
 $          41.89
   8,507
 $       35.16
 
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 $77,000 and $66,000 for the six months ended June 30, 2013 and 2012, respectively. For the three months ended June 30, 2013 and 2012, compensation expense totaled $39,000 and $33,000, respectively.
 
Supplemental Executive Retirement Plan
 
The Company maintains a non-qualified supplemental executive retirement plan (“SERP”) for certain executives to compensate those executive participants in the Company’s noncontributory defined benefit pension plan whose benefits are limited by compensation limitations under current tax law. At June 30, 2013 and December 31, 2012, an obligation of $973,000 and $901,000, respectively, was included in other liabilities for this plan in the consolidated balance sheet.  Expenses related to this plan totaled $72,000 and $47,000 for the six months ended June 30, 2013 and 2012, respectively. For the three months ended June 30, 2013 and 2012, expenses totaled $36,000 and $24,000, respectively.

Note 8 – Accumulated Comprehensive Income
 
The following tables present the changes in accumulated other comprehensive income (loss) by component net of tax for the three and six months ended June 30, 2013:

 
Three months ended June 30, 2013
 
Unrealized gain (loss)
on available for sale securities (a)
Unrealized gain
(loss) on interest
rate swap (a)
Defined Benefit Pension Items
(a)
Total
Balance as of March 31, 2013
 $                     5,717
 $                 (99)
 $            (1,991)
 $     3,627
Other comprehensive income (loss) before reclassifications (net of tax)
                      (4,393)
                     34
                        -
     (4,359)
Amounts reclassified from accumulated other
       
     comprehensive income (loss) (net of tax)
                           (65)
                        -
                     84
            19
Net current period other comprehensive income (loss)
               (4,458)
                34
                84
  (4,340)
Balance as of June 30, 2013
 $                     1,259
 $                 (65)
 $            (1,907)
 $     (713)
         
 
Six months ended June 30, 2013
 
Unrealized gain (loss)
on available for sale securities (a)
Unrealized gain
(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)
                      (5,301)
                      67
                        -
     (5,234)
Amounts reclassified from accumulated other
       
     comprehensive income (loss) (net of tax)
                         (194)
                        -
                     84
       (110)
Net current period other comprehensive income (loss)
               (5,495)
                67
                84
  (5,344)
Balance as of June 30, 2013
 $                     1,259
 $                 (65)
 $            (1,907)
 $     (713)
(a) Amounts in parentheses indicate debits
       
 

 
 
20

 
 
The following table presents the significant amounts reclassified out of each component of accumulated other comprehensive income for the three and six months ended June 30, 2013:

Details about accumulated other comprehensive income (loss)
Amount reclassified from accumulated
comprehensive income (loss) (a)
 
Affected line item in the statement
 where net Income is presented
 
Three Months Ended
Six Months Ended
   
 
June 30, 2013
   
Unrealized gains and losses on available for sale securities
       
 
 $                            98
 $                     294
 
Investment securities gains, net
 
                             (33)
                       (100)
 
Provision for income taxes
 
 $                            65
 $                     194
 
Net of tax
         
Defined benefit pension items
       
 
 $                        (128)
 $                    (128)
 
Salaries and employee benefits
 
                               44
                          44
 
Provision for income taxes
 
 $                          (84)
 $                      (84)
 
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.
   
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
 
 
21

 
 
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 June 30, 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.

   
June 30, 2013
 
   
Level I
 
Level II
 
Level III
   
Total
 
Fair value measurements on a recurring basis:
                   
Assets
                   
  Securities available for sale:
                   
     U.S. Agency securities
 
 $                -
 
 $             137,880
 
 $                    -
   
 $             137,880
 
     U.S. Treasury securities
     
11,471
       
11,471
 
     Obligations of state and
                   
        political subdivisions
 
                   -
 
95,177
 
                       -
   
95,177
 
     Corporate obligations
 
                   -
 
20,966
 
                       -
   
20,966
 
     Mortgage-backed securities in
                   
       government sponsored entities
 
                   -
 
40,880
 
                       -
   
40,880
 
     Equity securities in financial institutions
 
           1,561
 
                            -
 
                       -
   
1,561
 
Liabilities
                   
   Trust Preferred Interest Rate Swap
 
                   -
 
(99)
 
                       -
   
(99)
 

   
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
 
                   -