UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the transition period from                     to                    

Commission file number 0-16276

STERLING FINANCIAL CORPORATION

Registrant’s Telephone number, including area code: (717) 581-6030

     Indicate by check mark whether the Registrant (1) has filed all reports required 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 o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 126-2). Yes x No o

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical data.

     Common Stock, $5.00 Par Value – 21,803,558 shares outstanding as of July 30, 2004.

Sterling Financial Corporation and Subsidiaries

Index

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Part I – Financial Information

STERLING FINANCIAL CORPORATION AND SUBSIDIARIES

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

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STERLING FINANCIAL CORPORATION AND SUBSIDIARIES

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

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STERLING FINANCIAL CORPORATION AND SUBSIDIARIES

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

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STERLING FINANCIAL CORPORATION AND SUBSIDIARIES

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

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Notes to Consolidated Financial Statements

Note 1 — Summary of Significant Accounting Policies

     Basis of Presentation – The accompanying unaudited consolidated financial statements of Sterling Financial Corporation and subsidiaries have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included.

     Operating results for the three months and six months ended June 30, 2004, are not necessarily indicative of the results that may be expected for the year ended December 31, 2004.

     For further information, refer to the audited consolidated financial statements and footnotes thereto, included in the Annual Report on Form 10-K, for the year ended December 31, 2003.

     The consolidated financial statements and footnotes thereto of Sterling Financial Corporation include the accounts of its wholly-owned subsidiaries, Bank of Lancaster County, N.A. (Bank of Lancaster County), First National Bank of North East (First National), Bank of Hanover and Trust Company (Bank of Hanover), HOVB Investment Co., T&C Leasing, Inc. (T&C), Pennbanks Insurance Company, SPC, Church Capital Management, LLC, Bainbridge Securities Inc., Corporate Healthcare Strategies, LLC (d/b/a StoudtAdvisors) and Sterling Mortgage Services, Inc. (inactive). The unaudited consolidated financial statements also include Town & Country Leasing, LLC (Town & Country), Sterling Financial Trust Company, and Equipment Finance, LLC, all wholly-owned subsidiaries of Bank of Lancaster County. All significant intercompany balances and transactions have been eliminated in consolidation.

     Earnings Per Share - Basic earnings per share represents income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if potential dilutive common shares had been issued. Potential common shares that may be issued by Sterling consist solely of outstanding stock options and are determined using the treasury stock method.

     Earnings per common share for the three months and six months ended June 30, 2004 and 2003 have been computed based on the following (dollars in thousands):

     All share and per share amounts have been properly restated to reflect the 5-for-4 stock split effected in the form of a 25% stock dividend declared in January 2004 and paid in February 2004.

     Comprehensive Income - Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on

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available-for-sale securities and interest rate derivatives are reported as separate components of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income.

     The components of other comprehensive income and related tax effects are as follows:

     The ending accumulated balances for each item included in accumulated other comprehensive income, net of related income taxes, were as follows:

     Reclassifications - Certain items in the 2003 consolidated financial statements have been reclassified to conform to the 2004 presentation format. Such reclassifications had no impact on net income.

     Recent Accounting Pronouncements – Sterling accounts for interest rate lock commitments (“IRLCs”) for those mortgage loans that it intends to sell as derivatives in accordance with SFAS No. 133. On March 9, 2004, the SEC staff released Staff Accounting Bulletin (“SAB”) No. 105 that requires registrants to exclude the future expected cash flows related to expected servicing fees from the fair value of IRLCs. This statement delays the recognition of such servicing revenues until such time as the loan is sold, however, the pronouncement would have no effect on the ultimate amount of revenue or cash flows recognized over time. This pronouncement was effective April 1, 2004 and must be adopted prospectively for commitments entered into after March 31, 2004. The adoption of SAB 105 did not have a material impact on Sterling’s financial condition or results of operations.

     In January 2003, the FASB issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities. FIN 46 provides guidance on how to identify a variable interest entity (VIE) and determine when the assets, liabilities, noncontrolling interests, and results of operations of a VIE are to be included in an entity’s consolidated financial statements. A VIE exists when either the total equity investment at risk is not sufficient to permit the entity to finance its activities by itself, or the equity investors lack one of three characteristics associated with owning a controlling financial interest. Those characteristics include the direct or indirect ability to make decisions about an entity’s activities through voting rights or similar rights, the obligation to absorb the expected losses of an entity if they occur, or the right to receive the expected residual returns of the entity if they occur.

     During the third quarter of 2003, Sterling applied the provisions of FIN 46 to two wholly-owned special purpose subsidiary trusts, Sterling Financial Statutory Trust I and II, that have issued preferred capital securities to third-party investors. The application of FIN 46 resulted in the deconsolidation of the two wholly-owned subsidiary trusts. The assets, which consisted entirely of a subordinated debenture in Sterling, and liabilities, which consisted solely of preferred securities held by third parties and common securities held by Sterling, of the subsidiary trusts that were deconsolidated totaled $20.633 million and $36.111 million, respectively. As allowed by the transition provisions of FIN 46, Sterling restated all previous periods presented as if FIN 46 had been adopted as of the date of the establishment of

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the subsidiary trusts. There was no material impact to results of operations or liquidity as of and for the year ended December 31, 2003 and 2002 as a result of applying these provisions of FIN 46.

     In December 2003 the FASB made certain modifications to clarify FIN 46. Application of this guidance was effective for interests in certain VIEs commonly referred to as special-purpose entities (SPEs) as of December 31, 2003. Application for all other types of entities is required for periods ending after March 15, 2004, unless previously applied. The impact upon the adoption of this guidance did not have a material impact on Sterling’s financial condition or results of operations.

Note 2 — Business Combinations

     Corporate Healthcare Strategies, Inc. – On May 28, 2004, Sterling acquired 100 percent of the outstanding common shares of Corporate Healthcare Strategies, Inc. d/b/a StoudtAdvisors. StoudtAdvisors is one of the largest employee benefits administrators in Pennsylvania and is headquartered in Lancaster, Pennsylvania. As a result of the acquisition, Sterling plans to enhance earnings and provide financial product diversification.

     In connection with the completion of the acquisition of StoudtAdvisors, Sterling issued 282,657 shares of its common stock and paid $7.398 million. In addition, 121,139 shares of Sterling’s common stock and $2.640 million are to be paid out over the next four years as contingent consideration based upon StoudtAdvisors reaching specified performance criteria. Based on the closing price of Sterling’s common stock on May 25, 2004, the 282,657 shares of common stock were valued at $7.162 million.

     The transaction was accounted for under the provisions of FASB Statement No. 141, Business Combinations. As of June 30, 2004, the purchase price allocation is preliminary, subject to obtaining the final valuation of identifiable intangible assets. Preliminarily, the purchase price allocation included $6.379 million to finite-lived intangible assets, including $6.006 million to customer lists, $139 thousand to vendor contracts and $234 thousand to covenants not to compete. The intangible assets have lives ranging from 2 to 12 years, and a weighted average life of 10.5 years. The remaining portion of the purchase price, or $9.317 million, was assigned to goodwill, within the Insurance Services segment. The goodwill is expected to be amortized for tax purposes.

     Church Capital Management, LLC and Bainbridge Securities Inc. — On October 15, 2003, Sterling acquired 100 percent of the outstanding common shares of Church Capital Management, LLC and its affiliate, Bainbridge Securities Inc. Church Capital Management is a SEC registered investment advisor with assets under management of approximately $700 million. Bainbridge Securities is a National Association of Securities Dealers (NASD) securities broker/dealer offering a wide array of investment services. As a result of the acquisition, Sterling plans to enhance earnings and provide financial product diversification.

     In connection with the completion of the acquisition of Church and Bainbridge, Sterling issued 359,998 shares of its common stock and paid $7.920 million. In addition, 240,002 shares of Sterling’s common stock and $5.280 million were placed in escrow, which will be released over the next five years based upon Church and Bainbridge reaching specified performance criteria and the settlement, if any, of outstanding litigation at the date of acquisition. To date, $1.016 million of cash and stock have been released from escrow, resulting in additional goodwill. Based on the closing price of Sterling’s common stock at the time the agreement was entered into, the 600,000 shares of common shares were valued at $12.192 million.

     The transaction was accounted for under the provisions of FASB Statement No. 141, Business Combinations. The purchase price allocation included $38 thousand to premises and equipment and $5.110 million to finite-lived intangible assets, including $3.700 million to customer lists, $480 thousand to trademark, and $930 thousand to covenants not to compete. The intangible assets have a weighted average life of approximately 7 years. The remaining portion of the purchase price, or $12.218 million, was assigned to goodwill, within the Trust and Investment Services segment. This transaction will generate additional goodwill as the cash and shares held in escrow are released upon the attainment of the specified performance criteria. The goodwill is not expected to be amortized for tax purposes.

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Note 3 – Goodwill and Intangible Assets

The changes in the carrying amount of goodwill for the six months ended June 30, 2003 and 2004, are as follows:

     A summary of finite-lived intangible assets is as follows:

Note 4 – Stock Compensation

     Sterling has an omnibus stock incentive plan under which incentive and nonqualified stock options, stock appreciation rights, or restricted stock may be issued. To date, only incentive and nonqualified stock options have been issued under the plan. The options are granted periodically to key employees at a price not less than the fair value of the shares at the date of grant, and may have a term of ten years. As of June 30, 2004, Sterling had approximately 706,261 shares of common stock reserved for issuance under the stock incentive plans. All options issued were in connection with the omnibus stock incentive plan, which was approved by shareholders.

     Sterling accounts for its stock incentive plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost for option grants are reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant.

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     The following table illustrates the effect on net income and earnings per share if Sterling had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.

Note 5 – Retirement Benefit Plan

     The components of Sterling’s post-retirement benefits cost for the three and six months ended June 30, 2004 and 2003 are as follows:

     In December 2003, President Bush signed into law a bill that expands Medicare benefits, primarily adding a prescription drug benefit for Medicare-eligible retirees beginning in 2006. The law also provides a federal subsidy to companies that sponsor post-retirement benefit plans that provide prescription drug coverage. FASB Staff Position 106-1, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003 permits deferring the recognition of the new Medicare provisions’ impact due to lack of specific authoritative guidance on accounting for the federal subsidy. Sterling has elected to defer accounting for the effects of this new legislation until the specific authoritative guidance is issued. Accordingly, the post-retirement benefit obligations and net periodic costs reported in the accompanying financial statements and notes do not reflect the impact of this legislation. The accounting guidance, when issued, could require changes to previously reported financial information. Sterling anticipates its benefit costs after 2006 will be somewhat lower as a result of the new Medicare provisions, however, the adoption of this standard is not expected to have a material impact on results of operations, financial position, or liquidity.

Note 6 – Segment Information

     Sterling operates five major lines of business: Community Banking and Related Services; Leasing; Commercial Finance; Trust and Investment Services; and Insurance Related Services.

     Information about reportable segments, and reconciliation of such information to the consolidated financial statements follows (in thousands):

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