firstqtr2014.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, 2014
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 29, 2014, was 3,016,695.

 
 

 
 
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, 2014 and December 31, 2013
1
 
Consolidated Statement of Income for the Three Months Ended March 31, 2014 and 2013
2
 
Consolidated Statement of Comprehensive Income for the Three Months ended March 31, 2014 and 2013
3
 
Consolidated Statement of Cash Flows for the Three Months ended March 31, 2014 and 2013
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
44-45
     
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
46
Item 4.
Mine Safety Disclosures
46
Item 5.
Other Information
46
Item 6.
Exhibits
46
 
Signatures
47

 
 

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED BALANCE SHEET
   
(UNAUDITED)
   
     
 
    March 31
    December 31
(in thousands except share data)
    2014
    2013
ASSETS:
   
Cash and due from banks:
   
  Noninterest-bearing
 $             10,642
 $            8,899
  Interest-bearing
                  767
               1,184
Total cash and cash equivalents
                11,409
             10,083
Interest bearing time deposits with other banks
                  2,480
               2,480
Available-for-sale securities
              310,983
           317,301
Loans held for sale
                     242
                  278
 
   
Loans (net of allowance for loan losses:
   
  2014, $7,233 and 2013, $7,098)
              525,990
           533,514
 
   
Premises and equipment
                10,994
             11,105
Accrued interest receivable
                  3,771
               3,728
Goodwill
                10,256
             10,256
Bank owned life insurance
                14,800
             14,679
Other assets
                11,701
             11,510
 
 
 
TOTAL ASSETS
 $           902,626
 $        914,934
 
 
 
LIABILITIES:
   
Deposits:
   
  Noninterest-bearing
 $             95,230
 $          85,585
  Interest-bearing
              658,413
           662,731
Total deposits
              753,643
           748,316
Borrowed funds
                45,728
             66,932
Accrued interest payable
                     774
                  895
Other liabilities
                  6,897
               6,735
TOTAL LIABILITIES
              807,042
           822,878
STOCKHOLDERS' EQUITY:
   
Preferred Stock
   
  $1.00 par value; authorized 3,000,000 shares March 31, 2014 and December 31, 2013;
   
   none issued in 2014 or 2013
                          -
                      -
Common stock
   
  $1.00 par value; authorized 15,000,000 shares;  issued 3,305,517 at March 31, 2014 and
   
  December 31, 2013
                  3,306
               3,306
Additional paid-in capital
                23,623
             23,562
Retained earnings
                76,340
             74,325
Accumulated other comprehensive income (loss)
                     154
             (1,225)
Treasury stock, at cost:  288,822 shares at March 31, 2014
   
  and 290,468 shares at December 31, 2013
                 (7,839)
             (7,912)
TOTAL STOCKHOLDERS' EQUITY
                95,584
             92,056
TOTAL LIABILITIES AND
   
   STOCKHOLDERS' EQUITY
 $           902,626
 $        914,934
     
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)
          2014
       2013
INTEREST INCOME:
   
Interest and fees on loans
 $        6,988
 $      7,137
Interest-bearing deposits with banks
                 13
               10
Investment securities:
   
    Taxable
               888
             963
    Nontaxable
               842
             869
    Dividends
                 50
               20
TOTAL INTEREST INCOME
           8,781
         8,999
INTEREST EXPENSE:
   
Deposits
           1,105
         1,328
Borrowed funds
               164
             358
TOTAL INTEREST EXPENSE
           1,269
         1,686
NET INTEREST INCOME
           7,512
         7,313
Provision for loan losses
               180
             150
NET INTEREST INCOME AFTER
   
    PROVISION FOR LOAN LOSSES
           7,332
         7,163
NON-INTEREST INCOME:
   
Service charges
               995
         1,024
Trust
               191
             201
Brokerage and insurance
               120
               92
Investment securities gains, net
               171
             196
Gains on loans sold
                 40
             111
Earnings on bank owned life insurance
               121
             124
Other
               105
             104
TOTAL NON-INTEREST INCOME
           1,743
         1,852
NON-INTEREST EXPENSES:
   
Salaries and employee benefits
           2,917
         2,805
Occupancy
               350
             342
Furniture and equipment
               100
             102
Professional fees
               234
             229
FDIC insurance
               113
             112
Pennsylvania shares tax
               193
             183
Other
           1,140
         1,049
TOTAL NON-INTEREST EXPENSES
           5,047
         4,822
Income before provision for income taxes
           4,028
         4,193
Provision for income taxes
               852
             906
NET INCOME
 $        3,176
 $      3,287
 
   
PER COMMON SHARE DATA:
   
Net Income - Basic
 $          1.05
 $        1.08
Net Income - Diluted
 $          1.05
 $        1.08
Cash Dividends Paid
 $        0.385
 $      0.272
     
Number of shares used in computation - basic
   3,012,204
  3,033,716
Number of shares used in computation - diluted
   3,012,398
  3,034,165
     
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)
 
2014
 
2013
Net income
 
 $     3,176
 
 $    3,287
Other comprehensive income (loss):
       
      Change in unrealized gain (loss) on available for sale securities
        2,249
 
      (1,376)
 
      Income tax effect
          (764)
 
          468
 
      Change in unrealized loss on interest rate swap
                -
 
            50
 
      Income tax effect
                -
 
           (17)
 
      Change in unrecognized pension cost
             12
 
               -
 
      Income tax effect
              (5)
 
               -
 
      Less:  Reclassification adjustment for gains included in net income
          (171)
 
         (196)
 
      Income tax effect
             58
 
            67
 
Other comprehensive income (loss), net of tax
 
        1,379
 
      (1,004)
Comprehensive income
 
 $     4,555
 
 $    2,283
         
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)
2014
2013
CASH FLOWS FROM OPERATING ACTIVITIES:
   
  Net income
 $          3,176
 $          3,287
  Adjustments to reconcile net income to net
   
   cash provided by operating activities:
   
    Provision for loan losses
                180
                150
    Depreciation and amortization
                127
                100
    Amortization and accretion of investment securities
                575
                615
    Deferred income taxes
                (49)
              (103)
    Investment securities gains, net
              (171)
              (196)
    Earnings on bank owned life insurance
              (121)
              (124)
    Originations of loans held for sale
           (2,785)
           (7,415)
    Proceeds from sales of loans held for sale
             2,861
             8,984
    Realized gains on loans sold
                (40)
              (111)
    Increase in accrued interest receivable
                (43)
                (24)
    Decrease in accrued interest payable
              (121)
              (104)
    Other, net
                (32)
                488
      Net cash provided by operating activities
             3,557
             5,547
CASH FLOWS FROM INVESTING ACTIVITIES:
   
  Available-for-sale securities:
   
    Proceeds from sales
             5,556
             3,856
    Proceeds from maturity and principal repayments
           19,528
           33,882
    Purchase of securities
         (18,562)
         (29,653)
  Proceeds from redemption of regulatory stock
             1,269
                306
  Purchase of regulatory stock
              (375)
                    -
  Net decrease (increase) in loans
             7,345
           (1,261)
  Purchase of premises, equipment and software
                (28)
                (99)
  Proceeds from sale of foreclosed assets held for sale
                    9
                    -
      Net cash provided by investing activities
           14,742
             7,031
CASH FLOWS FROM FINANCING ACTIVITIES:
   
  Net increase (decrease) in deposits
             5,327
              (175)
  Proceeds from long-term borrowings
             4,005
-
  Repayments of long-term borrowings
           (1,000)
                    -
  Net decrease in short-term borrowed funds
         (24,209)
              (570)
  Purchase of treasury and restricted stock
              (120)
              (228)
  Dividends paid
              (976)
              (824)
      Net cash used by financing activities
         (16,973)
           (1,797)
          Net increase in cash and cash equivalents
             1,326
           10,781
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
           10,083
           26,333
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 $        11,409
 $        37,114
     
Supplemental Disclosures of Cash Flow Information:
   
    Interest paid
 $          1,390
 $          1,790
    Income taxes paid
 $             650
 $             300
    Loans transferred to foreclosed property
 $               22
 $               54
    Investments sold and not settled included in other assets
 $          1,469
 $                 -
   
 
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, 2014 and 2013 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, 2014 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, 2013.

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,
 
2014
2013
Net income applicable to common stock
$3,176,000
$3,287,000
     
Basic earnings per share computation
   
Weighted average common shares outstanding
                  3,012,204
                  3,033,716
Earnings per share - basic
$1.05
$1.08
     
Diluted earnings per share computation
   
Weighted average common shares outstanding for basic earnings per share
                  3,012,204
                  3,033,716
Add: Dilutive effects of restricted stock
                            194
                            449
Weighted average common shares outstanding for dilutive earnings per share
                  3,012,398
                  3,034,165
Earnings per share - dilutive
$1.05
$1.08
 
For the three months ended March 31, 2014 and 2013, there were 2,581 and 147 shares, respectively, related to the restricted stock program that were excluded from the diluted earnings per share calculations since they were anti-dilutive. These anti-dilutive shares had prices ranging from $37.35-$50.15 for the period ended March 31, 2014 and a price of $26.80 for the period ended March 31, 2013.

 
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 March 31, 2014 and December 31, 2013 were as follows (in thousands):

   
Gross
Gross
 
 
Amortized
Unrealized
Unrealized
Fair
March 31, 2014
Cost
Gains
Losses
Value
Available-for-sale securities:
       
  U.S. agency securities
 $    147,656
 $                  591
 $         (1,695)
 $       146,552
  U.S. treasury securities
         11,862
                          -
               (469)
            11,393
  Obligations of state and
       
    political subdivisions
         95,727
                  2,747
               (532)
            97,942
  Corporate obligations
         15,566
                     307
               (127)
            15,746
  Mortgage-backed securities in
       
    government sponsored entities
         37,160
                     459
               (184)
            37,435
  Equity securities in financial
       
     institutions
           1,097
                     818
                      -
              1,915
Total available-for-sale securities
 $    309,068
 $               4,922
 $         (3,007)
 $       310,983
         
December 31, 2013
       
Available-for-sale securities:
       
  U.S. agency securities
 $    153,896
 $                  702
 $         (2,409)
 $       152,189
  U.S. treasury securities
         11,856
                          -
               (547)
            11,309
  Obligations of state and
       
    political subdivisions
         94,113
                  2,146
            (1,254)
            95,005
  Corporate obligations
         16,651
                     341
               (190)
            16,802
  Mortgage-backed securities in
       
    government sponsored entities
         40,405
                     566
               (300)
            40,671
  Equity securities in financial institutions
              542
                     783
                      -
              1,325
Total available-for-sale securities
 $    317,463
 $               4,538
 $         (4,700)
 $       317,301

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, 2014 and December 31, 2013 (in thousands). As of March 31, 2014, the Company owned 81 securities whose fair value was less than their cost basis.
 
March 31, 2014
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
 $        82,029
 $        (1,564)
 $          2,883
 $           (131)
 $        84,912
 $        (1,695)
U.S. treasury securities
11,393
(469)
                     -
                     -
11,393
(469)
Obligations of state and
           
    political subdivisions
8,888
(197)
             9,551
              (335)
18,439
(532)
Corporate obligations
6,102
(82)
             2,254
                (45)
8,356
(127)
Mortgage-backed securities in
           
   government sponsored entities
23,729
(147)
             2,666
                (37)
26,395
(184)
    Total securities
 $      132,141
 $        (2,459)
 $        17,354
 $           (548)
 $      149,495
 $        (3,007)
 

 
6

 
 
December 31, 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
 $        98,356
 $        (2,212)
 $          2,825
 $           (197)
 $      101,181
 $        (2,409)
 U.S. treasury securities
           11,309
              (547)
                     -
                     -
           11,309
              (547)
Obligations of states and
           
     political subdivisions
           24,201
              (865)
             6,491
              (389)
           30,692
           (1,254)
Corporate obligations
             6,103
              (124)
             2,251
                (66)
             8,354
              (190)
Mortgage-backed securities in
           
     government sponsored entities
           23,920
              (266)
             1,164
                (34)
           25,084
              (300)
               
    Total securities
 $      163,889
 $        (4,014)
 $        12,731
 $           (686)
 $      176,620
 $        (4,700)
 
As of March 31, 2014, 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 three months ended March 31, 2014 and 2013 were $5,556,000 and $3,856,000, respectively.  The gross gains and losses were as follows (in thousands):

 
Three Months Ended
 
 March 31,
 
          2014
          2013
Gross gains
 $           171
 $                  196
Gross losses
                   -
                          -
Net gains
 $           171
 $                  196
 
Investment securities with an approximate carrying value of $172.0 million and $194.7 million at March 31, 2014 and December 31, 2013, respectively, were pledged to secure public funds and certain other deposits.

 
7

 
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, 2014, by contractual maturity, are shown below (in thousands):

 
       Amortized
 
 
       Cost
       Fair Value
Available-for-sale debt securities:
   
  Due in one year or less
 $      19,518
 $             19,738
  Due after one year through five years
       114,020
              113,967
  Due after five years through ten years
         68,444
                67,658
  Due after ten years
       105,989
              107,705
Total
 $    307,971
 $           309,068

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, 2014 and December 31, 2013, 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, 2014 and December 31, 2013 (in thousands):

March 31, 2014
 
Total Loans
Individually
evaluated for
impairment
Collectively
evaluated for
impairment
Real estate loans:
       
     Residential
 
 $                 185,904
 $                        335
 $                 185,569
     Commercial and agricultural
 
                    214,030
                        8,441
                    205,589
     Construction
 
                        3,510
                                -
                        3,510
Consumer
 
                        9,056
                             15
                        9,041
Other commercial and agricultural loans
 
                      55,468
                        2,023
                      53,445
State and political subdivision loans
 
                      65,255
                                -
                      65,255
Total
 
                    533,223
 $                   10,814
 $                 522,409
Allowance for loan losses
 
                        7,233
   
Net loans
 
 $                 525,990
   
December 31, 2013
 
Total Loans
Individually
evaluated for
impairment
Collectively
evaluated for
impairment
Real estate loans:
       
     Residential
 
 $                 187,101
 $                        342
 $                 186,759
     Commercial and agricultural
 
                    215,088
                        8,310
                    206,778
     Construction
 
                        8,937
                                -
                        8,937
Consumer
 
                        9,563
                             15
                        9,548
Other commercial and agricultural loans
 
                      54,029
                        1,733
                      52,296
State and political subdivision loans
 
                      65,894
                                -
                      65,894
Total
 
                    540,612
 $                   10,400
 $                 530,212
Allowance for loan losses
 
                        7,098
   
Net loans
 
 $                 533,514
   
 
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.
 
 
8

 
Management considers commercial loans, other agricultural loans, state and political subdivision 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):
   
Recorded
Recorded
   
 
Unpaid
Investment
Investment
Total
 
 
Principal
With No
With
Recorded
Related
March 31, 2014
Balance
Allowance
Allowance
Investment
Allowance
Real estate loans:
         
     Mortgages
 $       228
 $          133
 $            69
 $          202
 $          14
     Home Equity
          133
               65
               68
             133
             13
     Commercial
     10,141
          6,485
          1,956
          8,441
           504
     Agricultural
               -
                  -
                  -
                  -
                -
     Construction
               -
                  -
                  -
                  -
                -
Consumer
            15
               15
                  -
               15
                -
Other commercial loans
       2,086
          1,770
             253
          2,023
           145
Other agricultural loans
               -
                  -
                  -
                  -
                -
State and political
         
   subdivision loans
               -
                  -
                  -
                  -
                -
Total
 $  12,603
 $       8,468
 $       2,346
 $     10,814
 $        676
           
December 31, 2013
         
Real estate loans:
         
     Mortgages
 $       232
 $          138
 $            70
 $          208
 $          14
     Home Equity
          134
               65
               69
             134
             13
     Commercial
       9,901
          6,335
          1,975
          8,310
           305
     Agricultural
               -
                  -
                  -
                  -
                -
     Construction
               -
                  -
                  -
                  -
                -
Consumer
            15
               15
                  -
               15
                -
Other commercial loans
       1,794
          1,679
               54
          1,733
               1
Other agricultural loans
               -
                  -
                  -
                  -
                -
State and political
         
   subdivision loans
               -
                  -
                  -
                  -
                -
Total
 $  12,076
 $       8,232
 $       2,168
 $     10,400
 $        333

 
9

 
The following table includes the average balance of impaired financing receivables by class and the income recognized on impaired loans for the three month period ended March 31, 2014 and 2013(in thousands):


 
March 31, 2014
 
March 31, 2013
     
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
 $       205
 $              2
 $               -
 
 $          284
 $            2
 $               -
     Home Equity
          133
                 1
                  -
 
             137
               1
                  -
     Commercial
       8,533
               26
                  -
 
          8,785
             45
14
     Agricultural
               -
                  -
                  -
 
                  -
                -
                  -
     Construction
               -
                  -
                  -
 
                  -
                -
                  -
Consumer
            15
                  -
                  -
 
                  -
                -
                  -
Other commercial loans
       1,893
               33
                  -
 
          1,656
             19
                  -
Other agricultural loans
               -
                  -
                  -
 
                  -
                -
                  -
State and political
             
   subdivision loans
               -
                  -
                  -
 
                  -
                -
                  -
Total
 $  10,779
 $            62
 $               -
 
 $     10,862
 $          67
 $            14

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, agricultural and municipal 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% 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, 2014 and December 31, 2013 (in thousands):

March 31, 2014
Pass
Special Mention
Substandard
Doubtful
Loss
Ending Balance
Real estate loans:
           
     Commercial
 $          167,432
 $           5,399
 $                  19,493
 $              461
 $              -
 $          192,785
     Agricultural
               15,574
              1,556
                       4,115
                      -
                 -
               21,245
     Construction
                 3,510
                      -
                              -
                      -
                 -
                 3,510
Other commercial loans
               37,586
              6,198
                       2,024
                 205
                 -
               46,013
Other agricultural loans
                 7,453
                 131
                       1,871
                      -
                 -
                 9,455
State and political
           
   subdivision loans
               65,255
                      -
                              -
                      -
                 -
               65,255
Total
 $          296,810
 $         13,284
 $                  27,503
 $              666
 $              -
 $          338,263
             
December 31, 2013
           
Real estate loans:
           
     Commercial
 $          166,956
 $           4,645
 $                  21,284
 $              202
 $              -
 $          193,087
     Agricultural
               15,923
              1,910
                       4,168
                      -
                 -
               22,001
     Construction
                 8,937
                      -
                              -
                      -
                 -
                 8,937
Other commercial loans
               40,798
              1,747
                       1,938
                     5
                 -
               44,488
Other agricultural loans
                 7,431
                 153
                       1,957
                      -
                 -
                 9,541
State and political
           
   subdivision loans
               65,894
                      -
                              -
                      -
                 -
               65,894
Total
 $          305,939
 $           8,455
 $                  29,347
 $              207
 $              -
 $          343,948
 
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, 2014 and December 31, 2013 (in thousands):

March 31, 2014
Performing
Non-performing
Total
Real estate loans:
     
     Mortgages
 $          120,033
 $              964
 $                120,997
     Home Equity
               64,766
                 141
                     64,907
Consumer
                 9,041
                   15
                       9,056
Total
 $          193,840
 $           1,120
 $                194,960
       
December 31, 2013
     
Real estate loans:
     
     Mortgages
 $          119,075
 $              809
 $                119,884
     Home Equity
               66,989
                 228
                     67,217
Consumer
                 9,547
                   16
                       9,563
Total
 $          195,611
 $           1,053
 $                196,664


 
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, 2014 and December 31, 2013 (in thousands):

   
30-59 Days
60-89 Days
90 Days
Total Past
 
Total Financing
90 Days and
March 31,2014
Past Due
Past Due
Or Greater
Due
Current
Receivables
Accruing
Real estate loans:
             
     Mortgages
 $          46
 $          93
 $        805
 $        944
 $   120,053
 $           120,997
 $            262
     Home Equity
           406
             84
           104
           594
        64,313
                64,907
                 31
     Commercial
           825
             83
        2,999
        3,907
      188,878
              192,785
               305
     Agricultural
                -
                -
                -
                -
        21,245
                21,245
                   -
     Construction
                -
                -
                -
                -
          3,510
                  3,510
                   -
Consumer
             71
             21
             15
           107
          8,949
                  9,056
                   -
Other commercial loans
           102
           111
           588
           801
        45,212
                46,013
               334
Other agricultural loans
                -
                -
                -
                -
          9,455
                  9,455
                   -
State and political
             
   subdivision loans
                -
                -
                -
                -
        65,255
                65,255
                   -
 
Total
 $     1,450
 $        392
 $     4,511
 $     6,353
 $   526,870
 $           533,223
 $            932
                 
Loans considered non-accrual
 $        257
 $        174
 $     3,579
 $     4,010
 $       4,223
 $               8,233
 
Loans still accruing
        1,193
           218
           932
        2,343
      522,647
              524,990
 
 
Total
 $     1,450
 $        392
 $     4,511
 $     6,353
 $   526,870
 $           533,223
 
                 
December 31, 2013
             
Real estate loans:
             
     Mortgages
 $        362
 $          40
 $        739
 $     1,141
 $   118,743
 $           119,884
 $            301
     Home Equity
           632
               2
           229
           863
        66,354
                67,217
                 51
     Commercial
             88
           319
        3,091
        3,498
      189,589
              193,087
               344
     Agricultural
                -
                -
                -
                -
        22,001
                22,001
                   -
     Construction
                -
                -
                -
                -
          8,937
                  8,937
                   -
Consumer
             96
             36
             16
           148
          9,415
                  9,563
                   1
Other commercial loans
             29
             28
             49
           106
        44,382
                44,488
                   -
Other agricultural loans
                -
                -
                -
                -
          9,541
                  9,541
                   -
State and political
             
   subdivision loans
                -
                -
                -
                -
        65,894
                65,894
                   -
 
Total
 $     1,207
 $        425
 $     4,124
 $     5,756
 $   534,856
 $           540,612
 $            697
                 
Loans considered non-accrual
 $          98
 $        164
 $     3,427
 $     3,689
 $       4,408
 $               8,097
 
Loans still accruing
        1,109
           261
           697
        2,067
      530,448
              532,515
 
 
Total
 $     1,207
 $        425
 $     4,124
 $     5,756
 $   534,856
 $           540,612
 

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.

 
12

 
The following table reflects the financing receivables on non-accrual status as of March 31, 2014 and December 31, 2013, respectively. The balances are presented by class of financing receivable (in thousands):
 
   
March 31, 2014
 
December 31, 2013
Real estate loans:
     
     Mortgages
 $                702
 
 $                   508
     Home Equity
                   110
 
                      177
     Commercial
                7,066
 
                   7,247
     Agricultural
                      -
 
                        -
     Construction
                      -
 
                        -
Consumer
                     15
 
                        15
Other commercial loans
                   340
 
                      150
Other agricultural loans
                      -
 
                        -
State and political subdivision
                      -
 
                        -
   
 $             8,233
 
 $                8,097

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. As of March 31, 2014 and December 31, 2013, included within the allowance for loan losses are reserves of $27,100 and $28,000 respectively, that are associated with loans modified as TDRs.
 
Loan modifications that are considered TDR’s completed during the three months ended March 31, 2014 and 2013 were as follows (dollars in thousands):

 
For the Three Months Ended March 31, 2014
 
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:
           
     Commercial
                     -
                          1
$                   -
$                125
                    $                  -
$             125
Total
                     -
                          1
 $                   -
 $                125
 $                  -
 $             125

 
For the Three Months Ended March 31, 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:
           
     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
 
 
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. 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, 2014 and 2013 (three month periods), respectively, and that subsequently defaulted during these reporting periods (dollars in thousands):

 
For the Three Months Ended
 
March 31, 2014
March 31, 2013
 
Number of
contracts
Recorded
investment
Number of
contracts
Recorded
investment
Real estate loans:
       
     Commercial
                    1
 $                   483
                   -
 $              -
Total recidivism
                    1
 $                   483
                   -
 $              -

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, 2014 and December 31, 2013, respectively (in thousands):
 
March 31, 2014
 
 December 31, 2013
 
Individually
evaluated for
impairment
Collectively
evaluated for
impairment
Total
 
Individually
evaluated for
impairment
Collectively
evaluated for
impairment
Total
Real estate loans:
             
     Residential
 $           27
 $         859
 $         886
 
 $           27
 $           919
 $             946
     Commercial and agricultural
            504
         4,026
4,530
 
            305
           4,253
             4,558
     Construction
                 -
                8
8
 
                 -
                50
                  50
Consumer
                 -
              83
83
 
                 -
              105
                105
Commercial and other loans
            145
         1,028
1,173
 
                1
              941
                942
State and political
             
  subdivision loans
                 -
            396
396
 
                 -
              330
                330
Unallocated
                 -
            157
157
 
                 -
              167
                167
Total
 $         676
 $      6,557
 $      7,233
 
 $         333
 $        6,765
 $          7,098
 
The following tables roll forward the balance of the ALLL by portfolio segment for the three month period ended March 31, 2014 and 2013, respectively (in thousands):
 
 
Balance at
December 31,
2013
Charge-offs
Recoveries
Provision
Balance at
March 31,
2014
Real estate loans:
         
     Residential
 $         946
 $          (38)
 $              -
 $       (22)
 $         886
     Commercial and agricultural
         4,558
             (10)
                2
          (20)
         4,530
     Construction
              50
                 -
                 -
          (42)
                8
Consumer
            105
               (8)
                9
          (23)
              83
Commercial and other loans
            942
                 -
                 -
          231
         1,173
State and political
     
               -
 
  subdivision loans
            330
                 -
                 -
            66
            396
Unallocated
            167
                 -
                 -
          (10)
            157
Total
 $      7,098
 $          (56)
 $           11
 $       180
 $      7,233
 
 
14

 
 
 
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
Commercial and other loans
            728
                 -
                 -
          (28)
            700
State and political
     
               -
 
  subdivision loans
            271
                 -
                 -
            32
            303
Unallocated
            316
                 -
                 -
            84
            400
Total
 $      6,784
 $          (20)
 $           14
 $       150
 $      6,928
 
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.
·  
Any change in the level of board oversight

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.

 
15

 
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 three months of 2014:
 
·  
The qualitative factor for national, state, regional and local economic trends and business conditions was decreased for all loan categories due to a decrease in the unemployment rates in the local economy.
·  
The qualitative factors for changes in levels of and trends in delinquencies, impaired/classified loans were decreased for commercial real estate due to the decrease in the Company’s classified loans to its lowest level in three years.
·  
The qualitative factors for changes in levels of and trends in delinquencies, impaired/classified loans were increased for other commercial loans due to an increase in classified loans during the quarter.
The primary factor that resulted in a negative provisions for the first quarter of 2014 for residential real estate, commercial and agricultural real estate loans, construction and consumer loans was the decrease in loan balances from December 31, 2013 and the decrease in the qualitative factor associated with the improvement in unemployment rates noted above.
 
The following factors experienced changes during the three months ended March 31, 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, 2014 and December 31, 2013, the Bank holds $2,757,800 and $3,652,100, 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, 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 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 2013 Annual Report on Form 10-K.

 
16

 
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, 2014 and 2013, respectively (in thousands):

 
Three Months Ended
 
March 31
 
2014
2013
Service cost
 $               90
 $ 101
Interest cost
                   96
    106
Expected return on plan assets
              (122)
  (174)
Net amortization and deferral
                   12
      42
     
Net periodic benefit cost
 $               76
 $   75
 
The Company expects to contribute $500,000 to the Pension Plan in 2014.
 
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 $57,000 and $56,000 for the three months ended March 31, 2014 and 2013, 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, 2014 and December 31, 2013, an obligation of $949,000 and $981,000, respectively, was included in other liabilities for this plan in the Consolidated Balance Sheet. Amounts included in interest expense on the deferred amounts totaled $5,000 and $4,000 for the three months ended March 31, 2014 and 2013, 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 March 31, 2014, 67,364 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.

 
17

 
The following table details the vesting, awarding and forfeiting of restricted shares during 2014 and 2013:

 
Three Months Ended March 31,
 
2014
2013
   
Weighted
 
Weighted
 
Unvested
Average
Unvested
Average
 
Shares
Market Price
Shares
Market Price
Outstanding, beginning of period
         7,172
 $          42.02
   8,646
 $       35.51
Granted
            392
             50.50
           -
                  -
Forfeited
                 -
                     -
       (55)
          37.10
Vested
        (1,324)
             37.35
  (1,322)
          37.35
Outstanding, end of period
         6,240
 $          43.55
   7,269
 $       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 $36,000 and $38,000 for the three months ended March 31, 2014 and 2013, 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 March 31, 2014 and December 31, 2013, an obligation of $1,084,000 and $1,046,000, respectively, was included in other liabilities for this plan in the Consolidated Balance Sheet. Expenses related to this plan totaled $38,000 and $36,000 for the three months ended March 31, 2014 and 2013, respectively.

Note 8 – Accumulated Comprehensive Income
 
The following tables present the changes in accumulated other comprehensive (loss) income by component net of tax for the three months ended March 31, 2014 and 2013 (in thousands):

 
Three Months Ended March 31, 2014
 
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, 2013
 $                      (108)
 $                     -
 $             (1,117)
 $     (1,225)
Other comprehensive income (loss) before reclassifications (net of tax)
                        1,485
                        -
                        -
         1,485
Amounts reclassified from accumulated other
       
     comprehensive income (loss) (net of tax)
                         (113)
                        -
                         7
           (106)
Net current period other comprehensive income
                        1,372
                        -
                         7
         1,379
Balance as of March 31, 2014
 $                     1,264
 $                     -
 $             (1,110)
 $         154
         
 
Three months ended March 31, 2013
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
       

 
18

 
The following table presents the significant amounts reclassified out of each component of accumulated other comprehensive income for the three months ended March 31, 2014 and 2013 (in thousands):

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  March 31,
   
 
2014
2013
   
Unrealized gains and losses on available for sale securities
       
 
 $                          171
 $                    196
 
Investment securities gains, net
 
                             (58)
                       (67)
 
Provision for income taxes
 
 $                          113
 $                    129
 
Net of tax
         
Defined benefit pension items
       
 
 $                          (12)
 $                         -
 
Salaries and employee benefits
 
                                 5
                            -
 
Provision for income taxes
 
 $                            (7)
 $                         -
 
Net of tax
         
Total reclassifications, net of tax
 $                          106
 $                    129
   
       
(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.

 
19

 
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.
 
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, 2014 and December 31, 2013 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.

March 31, 2014
Level I
 
Level II
Level III
Total
Fair value measurements on a recurring basis:
         
Assets
         
  Securities available for sale:
         
     U.S. Agency securities
 $                -
 
 $             146,552
 $                    -
 $             146,552
     U.S. Treasury securities
                   -
 
11,393
                       -
11,393
     Obligations of state and
         
        political subdivisions
                   -
 
97,942
                       -
97,942
     Corporate obligations
                   -
 
15,746
                       -
15,746
     Mortgage-backed securities in
         
       government sponsored entities
                   -
 
37,435
                       -
37,435
     Equity securities in financial institutions
           1,915
 
                            -
                       -
1,915
           
December 31, 2013
           
Fair value measurements on a recurring basis:
           
Securities available for sale:
           
     U.S. Agency securities
 
 $              -
 
 $             152,189
 $                    -
 $             152,189
     U.S. Treasuries securities
 
                -
 
11,309
                       -
11,309
     Obligations of state and
           
       political subdivisions
 
                -
 
95,005
                       -
95,005
     Corporate obligations
 
                -
 
16,802
                       -
16,802
     Mortgage-backed securities in
           
       government sponsored entities
 
                -
 
40,671
                       -
40,671
     Equity securities in financial institutions
 
          1,325
 
                           -
                       -
1,325

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 2014 and 2013 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.
 
 
20

 

·  
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 and 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 and Level 3 inputs based on customized discounting criteria. At the time the foreclosure is completed, the Company obtains an updated external appraisal.

Assets measured at fair value on a nonrecurring basis as of March 31, 2014 and December 31, 2013 are included in the table below (in thousands):

March 31, 2014
 
Level I
 
Level II
 
Level III
   
Total
Impaired Loans
 
 $                -
 
 $                         -
 
 $          10,138
   
 $               10,138
Other real estate owned
 
                   -
 
                            -
 
1,374
   
1,374
                   
December 31, 2013
                 
Impaired Loans
 
 $                -
 
 $                         -
 
 $          10,067
   
 $               10,067
Other real estate owned
 
                   -
 
                            -
 
               1,360
   
1,360
 
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 at     
March 31,
2014
Fair Value at
December 31,
2013
 
Valuation Technique(s)
Unobservable input
Range
Impaired Loans
 $         266
 $         263
 
Discounted Cash Flows
Probability of Default
0%
         
Change in interest rates
0-7%
             
 
         9,872
         9,804
 
Appraised Collateral Values
Discount for time since appraisal
0-30%
         
Selling costs
4%-10%
         
Holding period
0 - 18 months
             
Other real estate owned
         1,374
         1,360
 
Appraised Collateral Values
Discount for time since appraisal
0-30%
         
Selling costs
4%-10%
         
Holding period
0 - 18 months

 
21

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

 
Carrying
       
March 31, 2014
Amount
Fair Value
Level I
Level II
Level III
Financial assets:
         
Cash and due from banks
 $   11,409
 $   11,409
 $   11,409
 $                -
 $               -
Interest bearing time deposits with other banks
2,480
2,484
   
2,484
Available-for-sale securities
    310,983
    310,983
        1,915
 309,068
 
Loans held for sale
           242
           242
           242
   
Net loans
    525,990
    540,585
                -
             -
    540,585
Bank owned life insurance
      14,800
      14,800
      14,800
             -
                -
Regulatory stock
        3,032
        3,032
        3,032
             -
                -
Accrued interest receivable
        3,771
        3,771
3,771
             -
                -
           
Financial liabilities:
         
Deposits
 $ 753,643
 $ 755,082
 $ 492,756
 $                -
 $ 262,326
Borrowed funds
      45,728
      42,343
                -
   42,343
                -
Accrued interest payable
           774
           774
774
             -
                -
           
December 31, 2013
         
Financial assets:
         
Cash and due from banks
 $   10,083
 $   10,083
 $   10,083
 $                 -
 $               -
Interest bearing time deposits with other banks
        2,480
        2,474
   
        2,474
Available-for-sale securities
    317,301
    317,301
        1,325
 315,976
                -
Loans held for sale
           278
           278
           278
   
Net loans
    533,514
    547,405
                -
             -
    547,405
Bank owned life insurance
      14,679
      14,679
      14,679
             -
                -
Regulatory stock
        3,926
        3,926
        3,926
             -
                -
Accrued interest receivable
        3,728
        3,728
        3,728
             -
                -
           
Financial liabilities:
         
Deposits
 $ 748,316
 $ 750,172
 $ 481,957
 $                  -
 $    268,215
Borrowed funds
      66,932
      63,500
                -
   63,500
                -
Accrued interest payable
           895
           895
895
             -
                -
 
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.

 
22

 
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.

Interest bearing time deposits with other banks:
 
The fair value of interest bearing time deposits with other banks 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.

Available-For-Sale Securities:
 
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.

Loans held for sale
 
The carrying amount for loans held for sale approximates fair value as the loans are only held for less than a week from origination.

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.

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.

 
23

 
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.

Note 10 – Recent Accounting Pronouncements
 
In January 2014, FASB issued ASU 2014-01, Investments – Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects. The amendments in this Update permit reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense (benefit).  The amendments in this Update should be applied retrospectively to all periods presented. A reporting entity that uses the effective yield method to account for its investments in qualified affordable housing projects before the date of adoption may continue to apply the effective yield method for those preexisting investments. The amendments in this Update are effective for public business entities for annual periods and interim reporting periods within those annual periods, beginning after December 15, 2014.  Early adoption is permitted. The Company is currently evaluating the impact the adoption of the standard will have on the Company’s financial position or results of operations.
 
In January 2014, the FASB issued ASU 2014-04, Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure. The amendments in this Update clarify that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendments require interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. The amendments in this Update are effective for public business entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. An entity can elect to adopt the amendments in this Update using either a modified retrospective transition method or a prospective transition method. The Company is currently evaluating the impact the adoption of the standard will have on the Company’s financial position or results of operations.

 

 
24

 
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 financial 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 2013 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, 2014 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. We have recently received approval to construct a full service branch in the Lock Haven market, which will replace the loan production office currently located there, when completed.

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.

 
26

 
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, 2014 and December 31, 2013, the Trust Department had $99.3 and $99.4 million of assets under management, respectively.

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 $102.5 million at December 31, 2013 to $105.5 million at March 31, 2014. 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. Management believes that there are opportunities to increase non-interest income through these products and services, and as such, has added additional resources to support this growth.
 
In addition to the trust and investment services offered we have 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 additional expertise and services to customers in our market who have been impacted by the Marcellus Shale exploration and drilling activities.  As of March 31, 2014, customers owning 8,213 acres have signed agreements with the Bank that provide for the Bank to manage oil and gas matters related to the customers land, which may include negotiating lease payments and royalty percentages, resolving leasing issues, accounting for and ensuring the accuracy of royalty checks, distributing revenue to satisfy investment objectives and providing customized reports outlining payment and distribution information.

Results of Operations

Overview of the Income Statement
 
The Company had net income of $3,176,000 for the first three months of 2014 compared to net income of $3,287,000 for last year’s comparable period, a decrease of $111,000 or 3.4%. Basic earnings per share for the first three months of 2014 were $1.05, compared to $1.08 last year, representing a 2.8% decrease.  Annualized return on assets and return on equity for the three months of 2014 were 1.41% and 13.38%, respectively, compared with 1.50% and 15.22% 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 2014 was $7,512,000, an increase of $199,000, or 2.7%, compared to the same period in 2013.  For the first three months of 2014, the provision for loan losses totaled $180,000, an increase of $30,000 over the comparable period in 2013.  Consequently, net interest income after the provision for loan losses was $7,332,000 compared to $7,163,000 during the first three months of 2013.
 
 
27

 
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, 2014 and 2013 on a tax equivalent basis (dollars in thousands):


 
28

 

 
 
Analysis of Average Balances and Interest Rates (1)
 
 Three Months Ended
 
March 31, 2014
March 31, 2013
 
Average
 
Average
Average
 
Average
 
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
(dollars in thousands)
$
$
%
$
$
%
ASSETS
           
Short-term investments:
           
   Interest-bearing deposits at banks
           5,276
                   1
0.05
          23,198
                 10
0.17
Total short-term investments
           5,276
                   1
0.05
          23,198
                 10
0.17
Interest bearing time deposits at banks
           2,480
                12
2.02
                    -
                    -
                    -
Investment securities:
           
  Taxable
      220,146
              938
1.70
        211,459<