CITIZENS FINANCIAL SERVICES INC - 10-Q Quarterly Report

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 September 30, 2004

[ ] 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.)

First Citizens National Bank

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 checkmark 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 checkmark whether the registrant is an accelerated filer (as described in Rule 12b-2 of the Exchange Act). Yes____ No __X__

The number of shares outstanding of the Registrant's Common Stock, as of November 1, 2004, 2,840,257 shares of Common Stock, par value $1.00.

Citizens Financial Services, Inc.

Form 10-Q

INDEX

Part I	FINANCIAL INFORMATION	PAGE
Item I -	Financial Statements (unaudited)
	Consolidated Balance Sheet as of September 30, 2004 and December 31, 2003	1
	Consolidated Statement of Income for the Three Months and Nine Months Ended September 30, 2004 and 2003	2
	Consolidated Statement of Comprehensive Income for the Three Months and Nine Months Ended September 30, 2004 and 2003	3
	Consolidated Statement of Cash Flows for the Nine Months Ended September 30, 2004 and 2003	4
	Notes to Consolidated Financial Statements	5-6
Item 2 -	Management’s Discussion and Analysis of Financial Condition and Results of Operations	7-20
Item 3 -	Quantitative and Qualitative Disclosure About Market Risk	21
Item 4 -	Controls and Procedures	21

Part II	OTHER INFORMATION
Item 1 -	Legal Proceedings	22
Item 2 -	Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities	22
Item 3 -	Defaults upon Senior Securities	22
Item 4 -	Submission of Matters to a Vote of Security Holders	22
Item 5 -	Other Information	23
Item 6 -	Exhibits and Reports on Form 8-K	24
	Signatures	24

CITIZENS FINANCIAL SERVICES, INC.
CONSOLIDATED BALANCE SHEET
(UNAUDITED)

	September 30			December 31
(in thousands, except per share data)	2004			2003
ASSETS:
Cash and due from banks:
Noninterest-bearing	$	8,145		$	9,624
Interest-bearing		123			327
Total cash and cash equivalents		8,268			9,951

Available-for-sale securities		100,996			106,587

Loans (net of allowance for loan losses of $4,109 and $3,620)		349,381			314,037

Premises and equipment		11,863			10,645
Accrued interest receivable		1,875			1,703
Goodwill		8,605			6,905
Core deposit intangible		1,406			978
Bank owned life insurance		7,374			7,142
Other assets		7,721			5,930

TOTAL ASSETS	$	497,489		$	463,878

LIABILITIES:
Deposits:
Noninterest-bearing	$	42,420		$	46,820
Interest-bearing		366,592			338,871
Total deposits		409,012			385,691
Borrowed funds		36,253			27,796
Notes payable		7,500			7,500
Accrued interest payable		1,685			1,888
Other liabilities		2,607			2,474
TOTAL LIABILITIES		457,057			425,349
STOCKHOLDERS' EQUITY:
Common Stock
$1.00 par value; authorized 10,000,000 shares;
issued 2,937,519 shares in 2004 and 2,909,849 in 2003, respectively		2,938			2,910
Additional paid-in capital		10,804			10,213
Retained earnings		28,578			26,455
TOTAL		42,320			39,578
Accumulated other comprehensive income		123			956
Less: Treasury Stock, at cost
97,262 shares for 2004 and 96,962 shares for 2003, respectively		(2,011	)		(2,005	)
TOTAL STOCKHOLDERS' EQUITY		40,432			38,529
TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY	$	497,489		$	463,878

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				Nine Months Ended
	September 30,				September 30,
(in thousands, except per share data)	2004		2003		2004		2003
INTEREST INCOME:
Interest and fees on loans	$	5,851	$	5,439	$	16,647	$	16,158
Interest-bearing deposits with banks		1		6		9		27
Investment securities:
Taxable		846		703		2,590		2,468
Nontaxable		76		105		223		363
Dividends		81		76		210		235
TOTAL INTEREST INCOME		6,855		6,329		19,679		19,251
INTEREST EXPENSE:
Deposits		2,126		2,075		6,081		6,504
Borrowed funds		253		74		684		223
TOTAL INTEREST EXPENSE		2,379		2,149		6,765		6,727
NET INTEREST INCOME		4,476		4,180		12,914		12,524
Provision for loan losses		-		120		-		375
NET INTEREST INCOME AFTER
PROVISION FOR LOAN LOSSES		4,476		4,060		12,914		12,149
NON-INTEREST INCOME:
Service charges		783		779		2,265		2,261
Trust		126		142		484		437
Gains on loans sold		17		100		37		326
Realized securities gains, net		-		114		491		514
Earnings on bank owned life insurance		75		61		233		64
Other		152		130		412		488
TOTAL NON-INTEREST INCOME		1,153		1,326		3,922		4,090
NON-INTEREST EXPENSES:
Salaries and employee benefits		1,905		2,680		5,677		6,516
Occupancy		259		252		812		770
Furniture and equipment		181		179		517		533
Professional fees		131		183		443		487
Amortization of intangible assets		145		109		362		326
Other		1,159		1,088		3,314		3,120
TOTAL NON-INTEREST EXPENSES		3,780		4,491		11,125		11,752
Income before provision for income taxes		1,849		895		5,711		4,487
Provision for income taxes		426		89		1,328		935
NET INCOME	$	1,423	$	806	$	4,383	$	3,552

Earnings Per Share	$	0.50	$	0.28	$	1.54	$	1.23
Cash Dividend Declared	$	0.195	$	0.185	$	0.580	$	0.550

Weighted average number of shares outstanding		2,840,257		2,872,362		2,840,439		2,878,990

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									Nine Months Ended
	September 30									September 30
(in thousands)			2004				2003						2004					2003
Net income			$	1,423			$	806					$	4,383				$	3,552
Other comprehensive income (loss):
Unrealized gains (losses) on available for sale securities		1,605			(818	)					(771	)				(1,441	)
Less: Reclassification adjustment for gains included in net income		-			(114	)					(491	)				(514	)
Other comprehensive income (loss) before tax				1,605				(932	)					(1,262	)				(1,955	)
Income tax expense (benefit) related to other comprehensive income (loss)				546				(317	)					(429	)				(665	)
Other comprehensive income (loss), net of tax				1,059				(615	)					(833	)				(1,290	)
Comprehensive income			$	2,482			$	191					$	3,550				$	2,262

The accompanying notes are an integral part of these unaudited consolidated financial statements.


3

CITIZENS FINANCIAL SERVICES, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
(UNAUDITED)	Nine Months Ended
	September 30,
(in thousands)	2004			2003
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$ 4,383			$ 3,552
Adjustments to reconcile net income to net
cash provided by operating activities:
Provision for loan losses		-			375
Depreciation and amortization		698			689
Amortization of intangible assets		362			326
Amortization and accretion of investment securities		705			914
Deferred income taxes		1			196
Realized gains on securities		(491	)		(514	)
Realized gains on loans sold		(37	)		(326	)
Earnings on bank owned life insurance		(233	)		(64	)
Originations of loans held for sale		(2,080	)		(21,166	)
Proceeds from sales of loans held for sale		2,118			22,418
Gain on sale of foreclosed assets held for sale		(27	)		(14	)
Decrease (increase) in accrued interest receivable		(172	)		235
Increase in other assets and intangibles		(460	)		(642	)
Decrease in accrued interest payable		(203	)		(395	)
Increase in other liabilities		134			735
Net cash provided by operating activities		4,698			6,319
CASH FLOWS FROM INVESTING ACTIVITIES:
Available-for-sale securities:
Proceeds from sales of available-for-sale securities		15,007			10,751
Proceeds from maturity and principal repayments of securities		20,193			41,839
Purchase of securities		(31,319	)		(46,413	)
Net increase in loans		(8,985	)		(17,176	)
Purchase of loans		(27,340	)		-
Purchase of bank owned life insurance		-			(7,000	)
Acquisition of premises and equipment		(2,126	)		(403	)
Proceeds from sale of premises and equipment		30			-
Proceeds from sale of foreclosed assets held for sale		229			73
Deposit acquisition premium		(2,200	)		-
Net cash used in investing activities		(36,511	)		(18,329	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits		2,658			13,275
Proceeds from long-term borrowings		1,334			665
Repayments from long-term borrowings		(1,261	)		(557	)
Net increase in short-term borrowed funds		8,385			216
Acquisition of treasury stock		(7	)		(1,056	)
Dividends paid		(1,642	)		(1,568	)
Deposits of acquired branches		20,663			-
Net cash provided by financing activities		30,130			10,975
Net decrease in cash and cash equivalents		(1,683	)		(1,035	)

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD		9,951			11,594
CASH AND CASH EQUIVALENTS AT END OF PERIOD	$	8,268		$	10,559
Supplemental Disclosures of Cash Flow Information:
Interest paid	$	6,734		$	7,121
Income taxes paid	$	1,450		$	945
The accompanying notes are an integral part of these unaudited consolidated financial statements.


4

CITIZENS FINANCIAL SERVICES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

BASIS OF PRESENTATION

Citizens Financial Service, Inc., (individually and collectively, the “Company”) is a Pennsylvania corporation organized as the holding company of its wholly owned subsidiary, First Citizens National Bank (the “Bank”), and its subsidiary, First Citizens Insurance Agency, Inc. All material inter-company balances and transactions have been eliminated in consolidation.

The accompanying consolidated financial statements have been prepared pursuant to rules and regulations of the Securities and Exchange Commission (SEC) and in compliance with accounting principles generally accepted in the United States of America. 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.

In the opinion of Management of the registrant, the accompanying interim financial statements for the quarters ended September 30, 2004 and 2003 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 nine-month period ended September 30, 2004 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 An nual Report to shareholders and Form 10-K for the period ended December 31, 2003.

EARNINGS PER SHARE

Earnings per share calculations give retroactive effect to a 1 percent stock dividend declared by the Company on July 6, 2004 amounting to 27,670 additional shares outstanding.

INCOME TAX EXPENSE

Income tax expense is less than the amount calculated using the statutory tax rate, primarily the result of tax-exempt income earned from state and municipal securities and loans and investment in tax credits.

EMPLOYEE BENEFIT PLANS

Components of Net Periodic Benefit Cost - Defined Benefit Plans

For a detailed disclosure on the Company's pension and employee benefits plans, please refer to Note 8 of the Company's
Consolidated Financial Statements included in the 2003 Annual Report on Form 10-K.

The following sets forth the components of net periodic benefit cost of the defined benefit plans for the nine months
ended September 30, 2004 and 2003, respectively (dollars presented in thousands).

	Pension Benefits
	For the Nine Months Ended September 30,
	2004	2003
Service cost	$ 252	$ 255
Interest cost	221	200
Expected return on plan assets	(249)	(398)
Net amortization and deferral	18	244

Net periodic benefit cost	$ 242	$ 301


Employer Contributions

The Company expects to contribute $412,000 to its pension plan in 2004. As of September 30, 2004, $229,000
of contributions have been made.


5

ACQUISITIONS

On June 4, 2004, the Bank acquired two leased banking facilities of The Legacy Bank located in the Towanda and Sayre area, known hereafter as the “Acquisition”. This Acquisition included loans of $27,340,000, retail core deposits of $20,663,000 and certain fixed assets. This transaction was accounted for under the purchase method and the Bank recorded $2,490,000 as intangible assets. As part of the Acquisition we elected to consolidate the newly acquired Towanda Legacy office into our existing Towanda branch, thus not assuming the existing lease. We also elected to close our existing Sayre branch located on Keystone Avenue and consolidate our current customers with the new Sayre location on Elmira Street. The consolidated results include the operations of the acquired banking offices from the date of acqu isition.

On July 15, 2004, subsequent to the Acquisition, we purchased the Elmira Street property, which was previously leased by The Legacy Bank.

RECENT ACCOUNTING PRONOUNCEMENTS

In March 2004, the Financial Accounting Standards Board (“FASB”) reached consensus on the guidance provided by Emerging Issues Task Force Issue 03-1 (“EITF 03-1”), The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. The guidance is applicable to debt and equity securities that are within the scope of FASB Statement of Financial Accounting Standard (“SFAS”) No. 115, Accounting for Certain Investments In Debt and Equity Securities and certain other investments. EITF 03-1 specifies that an impairment would be considered other-than-temporary unless (a) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for the recovery of the fair value up to (or beyond) the cost of the investment an d (b) evidence indicating the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. EITF 03-1 cost method investment and disclosure provisions were effective for reporting periods ending after June 15, 2004. The measurement and recognition provisions relating to debt and equity securities have been delayed until the FASB issues additional guidance. The Company adopted cost method investment and disclosure provisions of EITF 03-1 on June 30, 2004. The adoption did not have a material impact on the consolidated financial statements, results of operations or liquidity of the Company.


6

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

CAUTIONARY STATEMENT

We have made forward-looking statements in this document, and in documents that we incorporate by reference, that are subject to risks and uncertainties and as such may prove inaccurate. Forward-looking statements include information concerning possible or assumed future results of operations of Citizens Financial Services, Inc., First Citizens National Bank, First Citizens Insurance Agency, Inc. or the combined company. When we use such words 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:

·	Interest rates could change more rapidly or more significantly than we expect.

·	The economy could change significantly in an unexpected way, which would cause the demand for new loans and the ability of borrowers to repay outstanding loans to change in ways that our models do not anticipate.

·	The stock and bond markets could suffer a significant disruption, which may have a negative effect on our financial condition and that of our borrowers, and on our ability to raise money by issuing new securities.

·	It could take us longer than we anticipate implementing strategic initiatives designed to increase revenues or manage expenses, or we may be unable to implement those initiatives at all.

·	Acquisitions and dispositions of assets could affect us in ways that management has not anticipated.

·	We may become subject to new legal obligations or the resolution of litigation may have a negative effect on our financial condition.

·	We may become subject to new and unanticipated accounting, tax, or regulatory practices or requirements.

INTRODUCTION

The following is management's discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in its accompanying consolidated financial statements for Citizens Financial Service, Inc., a bank holding company and its subsidiary (the “Company”). Our Company's consolidated financial condition and results of operations consist almost entirely of our wholly owned subsidiary’s (First Citizens National Bank) financial conditions and results of operations. Management’s discussion and analysis should be read in conjunction with the preceding September 30, 2004 financial information. The results of operations for the nine months ended September 30, 2004 and 2003 are not necessarily indicative of the results that can be expected for the full year. First Citizens National Bank is a member of the Federal Reserve System and subject to regulation, supervision and examination by the Office of the Comptroller of the Currency (“OCC”).

Our Company currently engages in the general business of banking throughout our service area of Potter, Tioga and Bradford counties in North Central Pennsylvania and Allegany, Steuben, Chemung and Tioga counties in Southern New York. Our lending and deposit products and investment services are offered primarily within the vicinity of our service area.

The market area that First Citizens National Bank operates is rural in nature. The customer makeup consists of small businesses and individuals. The state of the economy in the region is mixed with unemployment rates running above the state average over time.

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 and liquidity 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 management policy to control and manage interest rate risk.


7

Credit risk represents the possibility that a customer may not perform in accordance with contractual terms. Credit risk results from loans with customers and 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 policy to manage liquidity risk. These guidelines include contingent funding alternatives.

Readers should carefully review the risk factors described in other documents our Company files, from time to time, with the Securities and Exchange Commission, including the Annual Report on Form 10-K for the year ended December 31, 2003, filed by our Company and any Current Reports on Form 8-K filed by our Company.

We face strong competition in the communities we serve from other commercial banks, savings banks, savings and loan associations and credit unions, some of which are substantially larger institutions than our subsidiary. In addition, insurance companies, investment-counseling firms, and other business firms and individuals offer personal and corporate trust services. We also compete with credit unions, issuers of money market funds, securities brokerage firms, consumer finance companies and mortgage brokers. These entities are strong competitors for virtually all types of financial services.

The financial services industry continues to experience tremendous change to the competitive barriers between bank and non-bank institutions. We not only must compete with traditional financial institutions, but also with other business corporations that have begun to deliver competing financial services. Competition for banking services is based on price, nature of product, quality of service, and in the case of certain activities, convenience of location.

TRUST AND INVESTMENT SERVICES

Our Trust & Investment Department services range from professional estate settlement services through management of complex trust accounts to investment management and custody of securities. Our expanded Retirement and Trust Department manages retirement accounts for many area companies and individuals. We also manage many individual IRAs, both rollover and contributory.

The Investment Department offers full service brokerage services in selected locations throughout the Bank’s market area and appointments can be made in any First Citizens National Bank branch.

The Bank offers annuities and life insurance through our insurance subsidiary, First Citizens Insurance Agency, Inc.

FINANCIAL CONDITION

Total assets (shown in the Consolidated Balance Sheet) have increased 7.2% since year-end 2003 to $497.5 million. Total loans increased 11.3% to $353.5 million and investment securities decreased 5.2% to $101.0 million since year-end 2003. Total deposits increased 6.0% to $409.0 million since year-end 2003. Explanations of variances will be described within the following appropriate sections.

CASH AND CASH EQUIVALENTS

Cash and cash equivalents totaled $8,268,000 at September 30, 2004 compared to $9,951,000 on December 31, 2003. Noninterest-bearing cash decreased $1,479,000 since year-end 2003, while interest-bearing cash also decreased $204,000 during that same period. We continue to experience monthly principal repayments from our mortgage backed securities portfolio along with the recognition of the sale of approximately $4,000,000 of Corporate bonds in June 2004.

We believe the liquidity needs of the Company are satisfied by the current balance of cash and cash equivalents, readily available access to traditional funding sources, and the portion of the investment and loan portfolios that mature within one year. These sources of funds will enable the Company to meet cash obligations and off-balance sheet commitments as they come due.


8

INVESTMENTS

Our investment portfolio decreased by $5,591,000 or 5.2% from December 31, 2003 to September 30, 2004. Our investment portfolio has decreased primarily as a result of mortgage-backed securities monthly principal payments and selected security sales. We have utilized the cash from those principal payments for loan growth and re-investment purposes. During the first nine months, we sold approximately $8,211,000 of U.S. Government Agency Mortgage-backed securities, $5,263,000 of Corporate Bonds, along with $571,000 of equity securities. Proceeds from the fore mentioned sales along with monthly principal repayments were re-invested in Agencies, Mortgage-backed securities, Municipals, as well as used for partial funding of the Acquisition.

Management monitors the earnings performance and the effectiveness of the liquidity of the investment portfolio on a regular basis. Through active balance sheet management and analysis of the securities portfolio, the Company maintains sufficient liquidity to satisfy depositor requirements and various credit needs of its customers.

LOANS

The Company’s loan demand picked up slightly during the first nine months of 2004. We anticipate loan demand will continue to increase moderately during the remainder of 2004 as we introduce some new loan products to help stimulate growth. Signs of an improving economy should also help to stimulate demand for commercial loans. The Company’s lending is focused in the north central Pennsylvania market and the southern tier of New York. The composition of our loan portfolio consists principally of retail lending, which includes single-family residential mortgages, other consumer lending and commercial lending primarily to locally owned small businesses. New loans are generated primarily from direct loans to our existing customer base, with new customers generated by referrals from real estate brokers, buildi ng contractors, attorneys, accountants and existing customers.

As shown in the following tables (dollars in thousands), total loans increased by $35,833,000 or 11.3% for the period compared to December 31, 2003, primarily as the result of the Acquisition. Residential mortgage lending is a principal business activity and one our Company expects to continue by providing a full complement of competitively priced conforming, nonconforming and home equity mortgages. Management continues to explore new products to enhance further growth in this area.

September 30,

December 31,

2004

2003

Amount%

Real estate:

Residential

196,322

55.5

186,117

58.6

Commercial

73,992

20.9

57,370

18.1

Agricultural

7,970

2.3

7,594

2.4

Loans to individuals

for household, family and other purchases

12,353

3.5

13,145

4.1

Commercial and other loans

27,458

7.8

16,219

5.1

State & political subdivision loans

35,395

10.0

37,212

11.7

Total loans

353,490

100.0

317,657

100.0

Less allowance for loan losses

4,109

3,620

Net loans

349,381

314,037

	September 30, 2004/
	December 31, 2003
	Change
	Amount%
Real estate:
Residential	$	10,205		5.5
Commercial		16,622		29.0
Agricultural		376		5.0
Loans to individuals
for household, family and other purchases		(792	)	(6.0	)
Commercial and other loans		11,239		69.3
State & political subdivision loans		(1,817	)	(4.9	)
Total loans	$	35,833		11.3


9

Although loan demand has slowed compared to the refinancing boom we have experienced the last several years, we expect to continue to generate additional loan volume through the expanding of existing relationships, especially from the new recently acquired relationships and the hiring of a new commercial lender in our east region.

Consistent with the past several years, our focus on commercial lending continues to expand with the establishment of a core group of commercial lenders to handle a higher volume of small business loans. As can be seen from the table above, the majority of the loans acquired from the Acquisition are commercial in nature. This reemphasizes our focus on the small business customer base.

ALLOWANCE FOR LOAN LOSSES

As shown in the following table (dollars in thousands), the Allowance for Loan Losses as a percentage of loans was 1.16% and 1.14%, at September 30, 2004 and December 31, 2003, respectively. The dollar amount of the reserve increased $489,000, since year-end 2003. The increase is a result of a valuation allowance of $290,000 being recorded and added to goodwill as a result of the Acquisition during the first nine months, less net recoveries. Gross charge-offs for the first nine months of 2004 were $122,000, while recoveries were $321,000, of which $299,000 was related to one borrower. This loan was previously charged-off in the third quarter of 2003.

	September 30,			December 31,
	2004			2003			2002			2001			2000
Balance, at beginning of period	$	3,620		$	3,621		$	3,250		$	2,777		$	2,270
Provision charged to income		-			435			435			445			610
Provision related to the Acquisition		290			-			-			-			-
Recoveries on loans previously
charged against the allowance		321			116			115			175			55
		4,231			4,172			3,800			3,397			2,935
Loans charged against the allowance		(122	)		(552	)		(179	)		(147	)		(158	)
Balance, at end of year	$	4,109		$	3,620		$	3,621		$	3,250		$	2,777

Allowance for loan losses as a percent
of total loans		1.16	%		1.14	%		1.21	%		1.20	%		1.06	%
Allowance for loan losses as a percent
of non-performing loans		228.91	%		134.62	%		119.94	%		149.56	%		382.51	%

The adequacy of the allowance for loan losses is subject to a formal analysis by management of the Company. Management deems the allowance to be adequate to absorb inherent losses probable in the portfolio, as of September 30, 2004. The Company has disclosed in its annual report on Form 10-K the process and methodology supporting the loan loss provision. A decrease in classified loans has resulted in an increase to the allowance for loan losses as a percent of non-performing loans to 228.91%.

BANK OWNED LIFE INSURANCE

During the second quarter of 2003 the Company elected to purchase $7,000,000 of bank owned life insurance to offset future employee benefit costs. The use of life insurance policies will provide the bank with an asset that will generate earnings to partially offset the current costs of benefits, and eventually (at the death of the insureds) provide partial recovery of cash outflows associated with the benefits.

DEPOSITS

Traditional deposits continue to be the most significant source of funds for the Company. As shown in the following tables (dollars in thousands), deposits increased $23,321,000 or 6.0%, since December 31, 2003, again, primarily the result of the Acquisition. As of September 30, 2004, non-interest-bearing deposits decreased by $4,400,000 due to a temporary decline in state and political accounts and commercial demand deposits, while NOW, savings, and money markets, increased by $6,382,000, $2,903,000, and $3,614,000, respectively. Certificates of Deposit increased by $14,822,000 mainly due to the Acquisition.


10

	September 30,			December 31,
	2004			2003
	Amount%			Amount%
Non-interest-bearing deposits	$	42,420	10.4	$	46,820	12.1
NOW accounts		63,483	15.5		57,101	14.8
Savings deposits		40,532	9.9		37,629	9.8
Money market deposit accounts		46,196	11.3		42,582	11.0
Certificates of deposit		216,381	52.9		201,559	52.3
Total	$	409,012	100.0	$	385,691	100.0

	September 30, 2004/
	December 31, 2003
	Change
	Amount%
Non-interest-bearing deposits	$	(4,400	)	(9.4	)
NOW accounts		6,382		11.2
Savings deposits		2,903		7.7
Money market deposit accounts		3,614		8.5
Certificates of deposit		14,822		7.4
Total	$	23,321		6.0

BORROWED FUNDS

Borrowed funds increased $8,457,000 during the first nine months of 2004. The majority of this increase is due to the Acquisition, loan growth and a decrease in non-interest bearing deposits due to timing. The Company's daily cash requirements or short-term investments are met by using the financial instruments available through the Federal Home Loan Bank.

In September 2003, the Company borrowed $1.1 million from its line of credit with an unrelated financial institution to buy back 41,800 shares of treasury stock from an estate. This line was paid off in August 2004, as monthly principal payments have been made since December 2003.

NOTES PAYABLE

In December 2003, the Company formed a special purpose entity; Citizens Financial Statutory Trust I (“the Entity”), to issue $7,500,000 of floating rate obligated mandatory redeemable securities as part of a pooled offering. The rate is determined quarterly and floats based on the 3 month LIBOR plus 2.80%. At September 30, 2004, the rate was 4.77%. The Entity may redeem them, in whole or in part, at face value after December 17, 2008. The Company borrowed the proceeds of the issuance from the Entity in December 2003 in the form of a $7,500,000 note payable, which is included in the liabilities section of the Company’s balance sheet. Debt issue costs of $75,000 have been capitalized and are being amortized through the first call date.

Under current accounting rules, the Company’s minority interest in the Entity was recorded at the initial investment amount and is included in the other assets section of the balance sheet. The Entity is not consolidated as part of the Company’s consolidated financial statements.

STOCKHOLDERS’ EQUITY

We evaluate stockholders’ equity in relation to total assets and the risk associated with those assets. The greater the capital resources, the more likely a corporation is able to meet its cash obligations and absorb unforeseen losses. For these reasons, capital adequacy has been, and will continue to be, of paramount importance.

Total Stockholders’ Equity was $40,432,000, at September 30, 2004 compared to $38,529,000, at December 31, 2003, an increase of $1,903,000 or 4.9%. In the first nine months, the Company earned $4,383,000 and declared dividends of $1,642,000 a dividend payout ratio of 37.5% of net income.

All of the Company’s investment securities are classified as available-for-sale making this portion of the Company’s balance sheet more sensitive to the changing market value of investments. Accumulated other comprehensive income decreased $833,000 compared to December 31, 2003 primarily as a result of interest rate movements and current year portfolio activity.


11

The Company has also complied with standards of well capitalized mandated by the banking regulators. The Company’s primary regulators have established “risk-based” capital requirements designed to measure capital adequacy. Risk-based capital ratios reflect the relative risks associated with various assets entities hold in their portfolios. A weight category of 0% (lowest risk assets), 20%, 50%, or 100% (highest risk assets), is assigned to each asset on the balance sheet. The Company’s computed risk-based capital ratios are as follows (dollars in thousands):

	September 30,					December 31,
	2004					2003
Total capital (to risk-weighted assets)	Amount		Ratio			Amount		Ratio
Company	$	41,535		12.92	%	$	40,655		14.07	%
For capital adequacy purposes		25,718		8.00	%		23,115		8.00	%
To be well capitalized		32,147		10.00	%		28,894		10.00	%

Tier I capital (to risk-weighted assets)
Company	$	37,512		11.67	%	$	37,042		12.82	%
For capital adequacy purposes		12,859		4.00	%		11,557		4.00	%
To be well capitalized		19,288		6.00	%		17,336		6.00	%

Tier I capital (to average assets)
Company	$	37,512		7.74	%	$	37,042		8.50	%
For capital adequacy purposes		19,394		4.00	%		17,437		4.00	%
To be well capitalized		24,243		5.00	%		21,796		5.00	%

On April 4, 2001, our Company filed a Registration Statement on Form S-3 establishing a Dividend Re-Investment Plan (DRIP), which was effective for the second quarter dividend in 2001. As of September 30, 2004 we have 420 shareholders participating in the plan, representing 309,307 shares and the total number of shares purchased since the inception of the plan is 22,943.

OFF BALANCE SHEET ACTIVITIES

Some financial instruments, such as loan commitments, credit lines, letters of credit and overdraft protection, are issued to meet customer financing needs. The contractual amount of financial instruments with off-balance sheet risk was as follows at September 30, 2004:

Commitments to extend credit	$	58,478
Standby letters of credit		1,387
	$	59,865

RESULTS OF OPERATIONS

OVERVIEW OF THE INCOME STATEMENT

The Company had net income of $1,423,000 and $4,383,000 for the third quarter and first nine months of 2004, respectively. Earnings per share, for the respective periods were $0.50 and $1.54. Net income was $806,000 and $3,552,000 for the third quarter and first nine months of 2003, which equates to earnings per share of $0.28 and $1.23, respectively. The annualized return on average assets and the return on average equity, for the first nine months of 2004, were 1.22% and 15.04%, respectively. Details of the reasons for this change are discussed on the following pages.


12

NET INTEREST INCOME

Net interest income, the most significant component of earnings, is the amount by which interest generated from earning assets exceeds interest expense on interest-bearing liabilities.

Net interest income, after provision for loan losses, totaled $4,476,000 in the third quarter, an increase of $416,000 or 10.2%, over the third quarter of 2003 and totaled $12,914,000 for the first nine months of 2004, an increase of $765,000 or 6.3% over the prior year. The Bank experienced an increase in earning assets in the past nine months of 9.3%, which came primarily from the fore mentioned Acquisition and our continued efforts to grow our existing offices and current customer relationships.

The following table sets forth the average balances of, and the interest earned or incurred on, each principal category of assets, liabilities and stockholders’ equity, the related rates, net interest income and rate “spread” created. Income tax adjustments of $179,000 and $258,000 for investments and $549,000 and $534,000 for loans at September 30, 2004 and September 30, 2003 have been made accordingly to the table below (dollars in thousands):


13

	September 30, 2004							September 30, 2003							September 30, 2002
	Average				Average			Average				Average			Average				Average
	Balance (1)		Interest		Rate			Balance (1)		Interest		Rate			Balance (1)		Interest		Rate
(dollars in thousands)	$		$		%			$		$		%			$		$		%
ASSETS
Short-term investments:
Interest-bearing deposits at banks		1,227		9		0.98			3,615		27		1.00			4,971		58		1.56
Total short-term investments		1,227		9		0.98			3,615		27		1.00			4,971		58		1.56
Investment securities:
Taxable		98,668		2,864		3.87			82,572		2,774		4.48			92,059		4,034		5.84
Tax-exempt (3)		6,772		338		6.65			10,851		550		6.76			14,556		749		6.86
Total investment securities		105,440		3,202		4.05			93,423		3,324		4.74			106,615		4,783		6.11
Loans:
Residential mortgage loans		190,899		9,949		6.97			179,926		9,855		7.32			170,249		9,952		7.82
Commercial & farm loans		93,648		4,767		6.81			76,503		4,354		7.61			71,372		4,216		7.90
Loans to state & political subdivisions		36,092		1,653		6.12			34,307		1,616		6.30			26,359		1,372		6.96
Other loans		12,330		827		8.97			12,692		867		9.13			13,624		983		9.65
Loans, net of discount (2)(3)(4)		332,969		17,196		6.90			303,428		16,692		7.36			281,604		16,523		7.84
Total interest-earning assets		439,636		20,407		6.21			400,466		20,043		6.69			393,190		21,364		7.26
Cash and due from banks		8,473							9,549							9,315
Bank premises and equipment		10,927							11,048							11,690
Other assets		18,283							14,754							11,202
Total non-interest earning assets		37,683							35,351							32,207
Total assets		477,319							435,817							425,397
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest-bearing liabilities:
NOW accounts		61,880		174		0.38			54,525		165		0.40			51,517		218		0.57
Savings accounts		39,323		83		0.28			35,963		98		0.36			34,534		127		0.49
Money market accounts		44,322		335		1.01			47,679		392		1.10			49,721		619		1.66
Certificates of deposit		208,811		5,489		3.51			203,954		5,850		3.83			199,983		6,659		4.45
Total interest-bearing deposits		354,336		6,081		2.29			342,121		6,505		2.54			335,755		7,623		3.04
Other borrowed funds		34,966		684		2.62			12,942		223		2.30			13,748		290		2.82
Total interest-bearing liabilities		389,302		6,765		2.32			355,063		6,728		2.53			349,503		7,913		3.03
Demand deposits		44,553							40,325							37,865
Other liabilities		4,591							3,591							4,468
Total non-interest-bearing liabilities		49,144							43,916							42,333
Stockholders' equity		38,873							36,838							33,561
Total liabilities & stockholders' equity		477,319							435,817							425,397
Net interest income				13,642							13,315							13,451
Net interest spread (5)						3.89	%						4.16	%						4.24	%
Net interest income as a percentage
of average interest-earning assets						4.15	%						4.45	%						4.57	%
Ratio of interest-earning assets
to interest-bearing liabilities						1.13							1.13							1.12

(1) Averages are based on daily averages.
(2) Includes loan origination and commitment fees.
(3) Tax exempt interest revenue is shown on a tax equivalent basis for proper comparison using
a statutory federal income tax rate of 34%
(4) Income on non-accrual loans is accounted for on a cash basis, and the loan balances are included in interest-earning assets.
(5) Interest rate spread represents the difference between the average rate earned on interest-earning assets
and the average rate paid on interest-bearing liabilities.


14

We continued to experience an attractive interest margin percentage during the first nine months of 2004. However, our margin is continuing to narrow as a result of a flatter yield curve compared to the same period last year. Most of the Company's investments, loans, deposits and borrowings are priced or re-priced along the three month to five-year portion of the yield curve. Our net interest margin should improve as a more normal yield curve develops. We continue to review various investment and pricing strategies to enhance deposit growth while maintaining or expanding the current interest margin.

The following table shows the effect of changes in volume and rate on interest income and expense. Tax-exempt interest revenue is shown on a tax-equivalent basis for proper comparison using a statutory federal income tax rate of 34%:

	2004 vs. 2003 (1)									2003 vs. 2002 (1)
	Change in			Change			Total			Change in			Change			Total
	Volume			in Rate			Change			Volume			in Rate			Change
Interest Income:
Short-term investments:
Interest-bearing deposits at banks	$	(17	)	$	(1	)	$	(18	)	$	(34	)	$	3		$	(31	)
Investment securities:
Taxable		497			(407	)		90			(492	)		(768	)		(1,260	)
Tax-exempt		(204	)		(8	)		(212	)		(188	)		(11	)		(199	)
Total investments		293			(415	)		(122	)		(680	)		(779	)		(1,459	)
Loans:
Residential mortgage loans		585			(491	)		94			549			(646	)		(97	)
Commercial & farm loans		906			(493	)		413			296			(158	)		138
Loans to state & political subdivisions		83			(46	)		37			384			(140	)		244
Other loans		(23	)		(17	)		(40	)		(51	)		(65	)		(116	)
Total loans, net of discount		1,551			(1,047	)		504			1,178			(1,009	)		169
Total Interest Income		1,827			(1,463	)		364			464			(1,785	)		(1,321	)
Interest Expense:
Interest-bearing deposits:
NOW accounts		21			(12	)		9			12			(65	)		(53	)
Savings accounts		9			(24	)		(15	)		5			(34	)		(29	)
Money Market accounts		(44	)		(13	)		(57	)		(27	)		(200	)		(227	)
Certificates of deposit		137			(498	)		(361	)		130			(939	)		(809	)
Total interest-bearing deposits		123			(547	)		(424	)		120			(1,238	)		(1,118	)
Other borrowed funds		436			25			461			(18	)		(49	)		(67	)
Total interest expense		559			(522	)		37			102			(1,287	)		(1,185	)
Net interest income	$	1,268		$	(941	)	$	327		$	362		$	(498	)	$	(136	)

(1) The portion of the total change attributable to both volume and rate changes during the year has been allocated
to volume and rate components based upon the absolute dollar amount of the change in each component prior to allocation.

As can be seen from the preceding tables, tax equivalent net interest income went from $13,451,000, in 2002, to $13,315,000 in 2003, and increased to $13,642,000 through September 2004. Our overall spread decreased from 4.16% on September 30, 2003 to 3.89% on September 30, 2004. The increased volume of interest-earning assets generated an increase in interest income of $1,827,000 while increased volume of interest-bearing liabilities produced $559,000 of interest expense. The change in volume resulted in an increase of $1,268,000 in net interest income. The net change in rate resulted in a negative $941,000. Combining the increase due to volume and the decrease due to rate, net interest income increased $327,000 in 2004 compared to 2003. The yield on interest-earning assets decreased 48 basis points from 6.69% t o 6.21% and the average interest rate on interest-bearing liabilities decreased 21 basis points, from 2.53% to 2.32%, because of the previously described changes to the yield curve.


15

PROVISION FOR LOAN LOSSES

For the three month and nine month period ended September 30, 2004 we did not provide any provision as a result of our quarterly review of the allowance for loan losses being adequately reserved, compared to $120,000 and $375,000, for the same periods in 2003.

This provision was appropriate given management's quarterly review of the allowance for loan losses that are based on the following information: migration analysis of delinquent and non-accrual loans, estimated future losses on loans, recent review of large problem credits, local and national economic conditions, historical loss experience, OCC qualitative adjustments and peer comparisons.

NON-INTEREST INCOME

Non-interest income, as detailed below, decreased $173,000 or 13.0% and decreased $168,000 or 4.1% in the third quarter and the first nine months of 2004, respectively, when compared to the same periods in 2003. Service charge income continues to be the primary source of non-interest income. For the first nine months, account service charges totaled $2,265,000, compared to $2,261,000 last year. Trust income for the nine months ended increased by $47,000 mainly due to a large estate fee that was recognized during the first half of the year. Bank owned life insurance increased by $169,000 over 2003 due to the timing of the initial investment. Gains on loans sold decreased $289,000 for the first nine months of 2004, when compared to the same period in 2003, as a direct result of a decrease of loans being originated for sale on the secondary market. Other income also decreased for the first nine months of 2004, when compared to the same period in 2003. This is also due to less mortgage servicing income being recognized in the first nine months of 2004 as a direct result of less refinancing activity.

The following tables shows the breakdown of non-interest income for the three months and nine months ended September 30, 2004 and 2003(dollars in thousands):

	Three months ended
	September 30,				Change
	2004		2003		Amount%
Service charges	$	783	$	779	$	4		0.5
Trust		126		142		(16	)	(11.3	)
Gains on loans sold		17		100		(83	)	(83.0	)
Realized securities gains, net		-		114		(114	)	(100.0	)
Earnings on bank owned life insurance		75		61		14		23.0
Other		152		130		22		16.9
Total	$	1,153	$	1,326	$	(173	)	(13.0	)

	Nine months ended
	September 30,				Change
	2004		2003		Amount%
Service charges	$	2,265	$	2,261	$	4		0.2
Trust		484		437		47		10.8
Gains on loans sold		37		326		(289	)	(88.7	)
Realized securities gains, net		491		514		(23	)	(4.5	)
Earnings on bank owned life insurance		233		64		169		264.1
Other		412		488		(76	)	(15.6	)
Total	$	3,922	$	4,090	$	(168	)	(4.1	)

In an effort to take advantage of current market conditions, we elected to sell approximately $15,007,000 of investment securities in the first nine months of 2004, which resulted in $491,000 of security gains.

We continue to evaluate means of increasing non-interest income. Our approach is to apply service charges on business transaction accounts by charging fees on transaction activity (reduced by earnings credit based on customers' balances) to more equitably recover costs. We expect to continue this analysis for our other products, along with reviewing additional revenue sources.


16

NON-INTEREST EXPENSES

Total non-interest expense, as detailed below, decreased $711,000 or 15.8% during the third quarter of 2004 and $627,000 or 5.3% in the first nine months of 2004 when compared to the same periods last year. The decrease in salaries and employee benefits is primarily the result of a retirement package paid to our past Chief Executive Officer (CEO) who retired in 2003. A smaller portion of the decrease can be attributed to no CEO salary for the first four months of 2004. Management expects salary and benefits expense to increase through the remainder of 2004, as a result of the recent Acquisition and the filling of the CEO position and other retail positions. The increase in other is a direct result of merger and acquisition costs associated with the fore mentioned Acquisition.

The following tables reflect the breakdown of non-interest expense and professional fees for the three months ended September 30, 2004 and 2003(dollars in thousands):

	Three months ended
	September 30,				Change
	2004		2003		Amount%
Salaries and employee benefits	$	1,905	$	2,680	$	(775	)	(28.9	)
Occupancy		259		252		7		2.8
Furniture and equipment		181		179		2		1.1
Professional fees		131		183		(52	)	(28.4	)
Amortization		145		109		36		33.0
Other		1,159		1,088		71		6.5
Total	$	3,780	$	4,491	$	(711	)	(15.8	)

	Three months ended
	September 30,				Change
	2004		2003		Amount%
Other professional fees	$	85	$	106	$	(21	)	(19.8	)
Legal fees		10		43		(33	)	(76.7	)
Examinations and audits		36		34		2		5.9
Total	$	131	$	183	$	(52	)	(28.4	)

The following tables reflect the breakdown of other operating expense and professional fees for the nine months ended September 30, 2004 and 2003(dollars in thousands):

	Nine months ended
	September 30,				Change
	2004		2003		Amount%
Salaries and employee benefits	$	5,677	$	6,516	$	(839	)	(12.9	)
Occupancy		812		770		42		5.5
Furniture and equipment		517		533		(16	)	(3.0	)
Professional fees		443		487		(44	)	(9.0	)
Amortization		362		326		36		11.0
Other		3,314		3,120		194		6.2
Total	$	11,125	$	11,752	$	(627	)	(5.3	)

	Nine months ended
	September 30,				Change
	2004		2003		Amount%
Other professional fees	$	274	$	320	$	(46	)	(14.4	)
Legal fees		60		83		(23	)	(27.7	)
Examinations and audits		109		84		25		29.8
Total	$	443	$	487	$	(44	)	(9.0	)


17

PROVISION FOR INCOME TAXES

The provision for income taxes was $426,000 for the third quarter of 2004 compared to $89,000 in the third quarter of 2003. For the nine-month period comparisons, the provision for income taxes was $1,328,000 in 2004 and $935,000 in 2003. The increase was primarily a result of increased levels of taxable income.

We have entered into two limited partnership agreements to establish low-income housing projects in our market area. As a result of these agreements for tax purposes, we have recognized $365,000 out of a total $911,000 of tax credits from one project and $106,000 out of a total $385,000 on the second project. A total of approximately $1,290,000 of tax credits is anticipated over a ten-year period.

LIQUIDITY

Liquidity is a measure of our Company's ability to efficiently meet normal cash flow requirements of both borrowers and depositors. To maintain proper liquidity, we use funds management policies along with our investment policies to assure we can meet our financial obligations to depositors, credit customers and stockholders. Liquidity is needed to meet depositors' withdrawal demands, extend credit to meet borrowers' needs, provide funds for normal operating expenses and cash dividends, and fund other capital expenditures.

Our Company's historical activity in this area can be seen in the Consolidated Statement of Cash Flows from investing and financing activities.

Cash generated by operating activities, investing activities and financing activities influences liquidity management. The most important source of funds is the deposits that are primarily core deposits (deposits from customers with other relationships). Short-term debt from the Federal Home Loan Bank supplements our Company's availability of funds. Another source of short-term liquidity is the sale of loans if needed.

Our Company's use of funds is shown in the investing activity section of the Consolidated Statement of Cash Flows, where the net loan activity is presented. Other significant uses of funds include capital expenditures. Surplus funds are then invested in investment securities.

Capital expenditures during the first nine months of 2004 were $2,126,000, $1,723,000 more than the same period in 2003 due mainly to the acquisition of the Elmira St. property in Sayre which was purchased in July 2004 for $1,450,000.

Our Company achieves additional liquidity primarily from temporary or short-term investments in the Federal Home Loan Bank of Pittsburgh, PA, and investments that mature in less than one year. The Company also has a maximum borrowing capacity at the Federal Home Loan Bank of approximately $211 million as an additional source of liquidity.

Apart from those matters described above, management does not currently believe that there are any current trends, events or uncertainties that would have a material impact on capital.

CREDIT QUALITY RISK

The following table identifies amounts of loan losses and non-performing loans. Past due loans are those that were contractually past due 90 days or more as to interest or principal payments (dollars in thousands):

	September 30,			December 31,
	2004			2003			2002			2001			2000
Non-performing loans:
Non-accruing loans	$	565		$	578		$	1,064		$	985		$	488
Impaired loans		876			1,926			1,916			1,077			199
Accrual loans - 90 days or
more past due		354			185			39			111			39
Total non-performing loans		1,795			2,689			3,019			2,173			726
Foreclosed assets held for sale		793			305			221			408			508
Total non-performing assets	$	2,588		$	2,994		$	3,240		$	2,581		$	1,234
Non-performing loans as a percent of loans
net of unearned income		0.51	%		0.85	%		1.01	%		0.80	%		0.28	%
Non-performing assets as a percent of loans
net of unearned income		0.73	%		0.94	%		1.09	%		0.95	%		0.47	%


18

Interest does not accrue on non-accrual loans. Subsequent cash payments received are applied to the outstanding principal balance or recorded as interest income, depending upon management's assessment of its ultimate ability to collect principal and interest.

Foreclosed assets held for sale increased $488,000 from December 31, 2003 to September 30, 2004. This is predominately due the repossession of a commercial property that will be sold after some pending litigation. The decrease in impaired loans is also directly related to this case as well.

INTEREST RATE AND MARKET RISK MANAGEMENT

The objective of interest rate sensitivity management is to maintain an appropriate balance between the stable growth of income and the risks associated with maximizing income through interest sensitivity imbalances and the market value risk of assets and liabilities.

Because of the nature of our operations, we are not subject to foreign currency exchange or commodity price risk and, since our Company has no trading portfolio, it is not subject to trading risk.

Currently, our Company has equity securities that represent only 3.8% of our investment portfolio and, therefore, equity risk is not significant.

The primary components of interest-sensitive assets include adjustable-rate loans and investments, loan repayments, investment maturities and money market investments. The primary components of interest-sensitive liabilities include maturing certificates of deposit, IRA certificates of deposit and short-term borrowings. Savings deposits, NOW accounts and money market investor accounts are considered core deposits and are not short-term interest sensitive (except for the top-tier money market investor accounts which are paid current market interest rates).

Gap analysis, one of the methods used by us to analyze interest rate risk, does not necessarily show the precise impact of specific interest rate movements on our Company's net interest income because the re-pricing of certain assets and liabilities is discretionary and is subject to competitive and other pressures. In addition, assets and liabilities within the same period may, in fact, be repaid at different times and at different rate levels. We have not experienced the kind of earnings volatility that might be indicated from gap analysis.

Our Company currently uses a computer simulation model to better measure the impact of interest rate changes on net interest income. We use the model as part of our risk management process that will effectively identify, measure, and monitor our Company's risk exposure.

We use numerous interest rate simulations employing a variety of assumptions to evaluate our interest rate risk exposure. A shock analysis during the second quarter of 2004 indicated that a 200 basis point movement in interest rates in either direction would have a minor impact on our Company's anticipated net interest income over the next twenty-four months.

FUTURE OUTLOOK

With short term interest rates increasing relative to long-term rates, the Company is beginning to experience pressure on earnings resulting from a lower net interest margin percentage when compared to 2003. Without the impact of the recent Acquisition, net interest income could have shown little or no growth in the remainder of 2004 if interest rates remained at present levels. Short-term rates have moved higher as a result of the Federal Reserve (Fed) increasing the fed funds rate by 75 basis points, thus creating a flatter yield curve. A flatter yield curve will continue to put additional pressure on our current net interest margin. Management continues to focus on growth by increasing market share utilizing deposit acquisition strategies to gain additional business from existing customers along with mortgage le nding as core banking services augmented by the sale of other income producing products and services. The Bank is focused on providing an array of financial products including fixed annuities and brokerage services to generate additional non-interest income over the remainder of the year. Management also continues to focus on loan growth with the generation of commercial loans throughout its market.


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Management expects loan growth (excluding the Acquisition) for the year to be between 5 and 8 percent. The Company’s loan to deposit ratio has increased through the first nine months to 86.43% compared to 82.36% at year-end 2003 as deposit growth has been positive during the first nine months and is expected to remain favorable throughout 2004. Overall, deposits have grown approximately 6% since year-end 2003 and are expected to increase moderately for the balance of the year.

Enhancing non-interest income and controlling non-interest expense are important factors in the success of the company and is measured in the financial services industry by the efficiency ratio, calculated according to the following: non-interest expense (less amortization of intangibles) as a percentage of fully tax equivalent net interest income and non-interest income (less non-recurring income). For the nine months ended September 30, 2004, the Bank’s efficiency ratio was 61.19% compared to 66.85% for the same period last year. The decrease in this ratio is predominantly due to the retirement package that was paid last year.

Management concentrates on return on average equity and earnings per share evaluations, plus other methods, to measure and direct the performance of the Company. While past results are not an indication of future earnings, management feels the Company is positioned to enhance performance of normal operations through the remainder of 2004.

GENERAL

The majority of assets and liabilities of a financial institution are monetary in nature and, therefore, differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. However, inflation does have an important impact on the growth of total assets and on non-interest expenses, which tend to rise during periods of general inflation. The recent action by the Federal Reserve of increasing short-term interest rates will help ensure that the level of inflation remains at a relatively low level.

Various congressional bills have been passed and other proposals have been made for significant changes to the banking system, including provisions for: limitation on deposit insurance coverage; changing the timing and methods financial institutions use to pay for deposit insurance; and tightening the regulation of bank derivatives' activities.

Aside from those matters described above, we do not believe that there are any trends, events or uncertainties, which would have a materially adverse impact on future operating results, liquidity or capital resources. We are not aware of any current recommendations by the regulatory authorities (except as described herein) which, if they were to be implemented, would have such an effect, although the general cost of compliance with numerous and multiple federal and state laws and regulations does have, and in the future may have, a negative impact on our Company's results of operations.


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Item 3-Quantitative and Qualitative Disclosure About Market Risk

In the normal course of conducting business activities, the Company is exposed to market risk, principally interest rate risk, through the operations of its banking subsidiary. Interest rate risk arises from market driven fluctuations in interest rates that affect cash flows, income, expense and values of financial instruments and was discussed previously in this Form 10-Q. Management and a committee of the board of directors manage interest rate risk.

No material changes in market risk strategy occurred during the current period. A detailed discussion of market risk is provided in the SEC Form 10-K for the period ended December 31, 2003.

Item 4-Control and Procedures

We maintain a system of controls and procedures designed to provide reasonable assurance as to the reliability of the financial statements and other disclosures included in this report, as well as to safeguard assets from unauthorized use or disposition. We evaluated the effectiveness of the design and operation of our disclosure controls and procedures under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, within 90 days prior to the filing date of this report. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in our periodic Securities and Exchange Commission filings.

There were no changes in the Company’s internal control over financial reporting that occurred during the Company’s last fiscal quarter that have materially affected, or are reasonably likely to affect, the Company’s internal control over financial reporting.


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PART II - OTHER INFORMATION AND SIGNATURES

Item 1 - Legal Proceedings

Management is not aware of any litigation that would have a materially adverse effect on the consolidated financial position of the Company. Any pending proceedings are ordinary, routine litigation incidental to the business of the Company and its subsidiary. In addition, no material proceedings are pending or are known to be threatened or contemplated against the Company and its subsidiary by government authorities.

Item 2 - Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

ISSUER PURCHASES OF EQUITY SECURITIES


Period	Total Number of Shares (or units Purchased)	Average Price Paid per Share (or Unit)	Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans of Programs	Maximum Number (or Approximate Dollar Value) of Shares (or Units) that May Yet Be Purchased Under the Plans or Programs

1/1/04 to 1/31/04	-	-
2/1/04 to 2/29/04	-	-
3/1/04 to 3/31/04	-	-
4/1/04 to 4/30/04	-	-
5/1/04 to 5/31/04	-	-
6/1/04 to 6/30/04	300	$22.95
7/1/04 to 7/31/04	-	-
8/1/04 to 8/31/04	-	-
9/1/04 to 9/30/04	-	-


On June 14, 2004, the Company purchased 300 shares of stock in the open market.

Item 3 - Defaults Upon Senior Securities - Not applicable

Item 4 - Submission of Matters to a Vote of Security Holders - None

Item 5 - Other Information - None


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Item 6 -Exhibits and Reports on Form 8-K.

(a) Exhibits.

(3)(i)	-	Articles of Incorporation of the Corporation, as amended. (Incorporated by Reference to Exhibit (3)(ii) to the Quarterly Report of Form 10-Q for the period ended December 31, 1999, as filed with the Commission on May 11,2000.)
(3)(ii)	-	By-laws of the Corporation, as amended. (Incorporated by Reference to Exhibit (3)(ii) to the Annual Report of Form 10-K for the fiscal year ended December 31, 2003, as filed with the Commission on April 29, 2004.)
(4)	-	Instruments Defining the Rights of Stockholders. (Incorporated by reference to the Registrant's Registration Statement No.2-89103 on Form S-14, as filed with the Commission on February 17, 1984.)
(10)	-	Material Contracts. Consulting and Non-Compete Agreement with Richard E. Wilber, Former Executive Officer of our company. (Incorporated by Reference to Exhibit (10) to the Annual Report of Form 10-K for the fiscal year ended December 31, 2003, as filed with the Commission on March 18, 2004.)
(31.1)	-	302 Certification of Principal Executive Officer
(31.2)	-	302 Certification of Principal Accounting Officer
(32.1)	-	Certification of Principal Executive Officer
(32.2)	-	Certification of Principal Accounting Officer
(99.1)	-	Independent accountant's review of financial statements for the period ended September 30, 2004.

(b) Reports on Form 8-K - Earnings release entitled “Citizens Financial Services, Inc. Reports Third Quarter earnings” filed October 22, 2004.


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Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the undersigned Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.

Citizens Financial Services, Inc.

(Registrant)

November 3, 2004			November 3, 2004
/s/ Randall E. Black			/s/ Mickey L. Jones

by: Randall E. Black President (Principal Executive Officer)			by: Mickey L. Jones Chief Financial Officer (Prinicipal Accounting Officer)