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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
[x] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the fiscal year ended December 31, 2003 Commission file number: 0-16084
CITIZENS & NORTHERN CORPORATION
(Exact name of Registrant as specified in its charter)
PENNSYLVANIA 23-2451943
- ------------ ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
90-92 MAIN STREET, WELLSBORO, PA 16901
- ---------------------------------------------------
(Address of principal executive offices) (Zip code)
570-724-3411
------------
(Registrant's telephone number including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to section 12(g) of the Act:
COMMON STOCK Par Value $1.00
----------------------------
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 [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes [X] No [ ]
The aggregate market value of the registrant's common stock held by
non-affiliates at March 1, 2004 was $212,705,460.
The number of shares of common stock outstanding at March 1, 2004 was 8,118,529.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's proxy statement for the annual meeting of its
shareholders to be held April 20, 2004 are incorporated by reference into Parts
III and IV of this report.
1
PART I
ITEM 1. BUSINESS
Citizens & Northern Corporation ("Corporation") is a one-bank holding company
whose principal subsidiary is Citizens & Northern Bank ("Bank"). The
Corporation's principal office is located in Wellsboro, Pennsylvania. The
Corporation's other wholly-owned subsidiaries are Citizens & Northern Investment
Corporation and Bucktail Life Insurance Company ("Bucktail"). Citizens &
Northern Investment Corporation was formed in 1999 to engage in investment
activities. Bucktail reinsures credit and mortgage life and accident and health
insurance on behalf of the Bank.
The Bank is a Pennsylvania banking institution that was formed by the
consolidation of Northern National Bank of Wellsboro and Citizens National Bank
of Towanda on October 1, 1971. Subsequent mergers included: First National Bank
of Ralston in May 1972; Sullivan County National Bank in October 1977; Farmers
National Bank of Athens in January 1984; and First National Bank of East
Smithfield in May 1990. The Bank has held its current name since May 6, 1975, at
which time the Bank changed its charter from a National bank to a Pennsylvania
bank.
The Bank provides an extensive range of banking services, including deposit and
loan products for personal and commercial customers. The Bank also maintains a
trust division that provides a wide range of financial services, such as 401(k)
Plans, retirement planning, estate planning, estate settlements and asset
management. In January 2000, the Bank formed a subsidiary, C&N Financial
Services Corporation ("C&NFSC"). C&NFSC is a licensed insurance agency that
provides insurance products to individuals and businesses. In 2001, C&NFSC added
a broker-dealer division, which offers mutual funds, annuities, educational
savings accounts and other investment products through registered agents.
C&NFSC's operations are not significant in relation to the total operations of
the Bank.
All phases of the Bank's business are competitive. The Bank primarily competes
in Tioga, Bradford, Sullivan and Lycoming counties. The Bank competes with local
commercial banks headquartered in our market area as well as other commercial
banks with branches in our market area. Some of the banks that have branches in
the Bank's market area are larger in overall size than the Bank. With respect to
lending activities and attracting deposits, the Bank also competes with savings
banks, savings and loan associations, insurance companies, regulated small loan
companies and credit unions. Also, the Bank competes with mutual funds for
deposits. The Bank competes with insurance companies, investment counseling
firms, mutual funds and other business firms and individuals for trust,
investment management, broker dealer and insurance services. The Bank is
generally competitive with all 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. The Bank serves a diverse
customer base, and is not economically dependent on any small group of customers
or on any individual industry.
Although there have been no mergers or acquisitions within the last 5 years, the
Bank has engaged in several ventures designed to improve customer service and
generate financial growth. These ventures included the following major
initiatives:
- - expanded trust and financial services capabilities, including investment
management, employee benefits and insurance services;
- - established internet banking services in 1999;
- - constructed and opened a branch in Muncy, PA in 2000; and
- - purchased a former bank operations center in Williamsport, PA, in 2003, and
began renovations with the intention of offering trust and financial
management, commercial lending, branch banking and other services, starting
in 2004.
Another significant initiative that began in 2003 is evaluation of software
systems to replace the core banking software system. For many years, the Bank
has utilized a system that was written and updated on an ongoing basis by "in
house" programmers. The company that provided the hardware platform that
supports the in house software program announced that it would no longer support
that platform, effective at the end of 2006. After considering various
alternatives, management determined the most appropriate solution was to
evaluate programs available from third party companies. Management's goal in
this process is for the Bank's employees and customers to reap the benefits of
new features and enhancements that will be available on a newer system, while
retaining sufficient flexibility and control over programming changes that may
be required or desired. Management expects to make a decision on a new core
system, and for the conversion to occur, in 2004; however, no contractual
commitment to purchase software has been made.
2
At December 31, 2003, the Bank had total assets of $1,038,575,000, total
deposits of $658,589,000 and net loans outstanding of $518,800,000. At December
31, 2003, the Bank had a total of 293 full-time equivalent employees.
Most of the activities of the Corporation and its subsidiaries are regulated by
federal or state agencies. The primary regulatory relationships are described as
follows:
- - The Corporation is a one-bank holding company formed under the provisions
of Section 3 of the Federal Reserve Act. The Corporation is under the
direct supervision of the Federal Reserve and must comply with the
reporting requirements of the Federal Bank Holding Company Act.
- - The Bank is a state-chartered, nonmember bank, supervised by the Federal
Deposit Insurance Corporation and the Pennsylvania Department of Banking.
- - C&NFSC is a Pennsylvania corporation. The Pennsylvania Department of
Insurance regulates C&NFSC's insurance activities. Brokerage products are
offered through a third party networking agreement between the Bank and
UVEST Financial Services, Inc.
- - Bucktail is incorporated in the state of Arizona and supervised by the
Arizona Department of Insurance.
A copy of the Corporation's annual report on Form 10-K, quarterly reports on
Form 10-Q, current events reports on Form 8-K, and amendments to these reports,
will be furnished without charge upon written request to the Corporation's
Treasurer at P.O. Box 58, Wellsboro, PA 16901. Copies of these reports will be
furnished as soon as reasonably possible, after they are filed electronically
with the Securities and Exchange Commission. The information is also available
through the Corporation's web site at www.cnbankpa.com.
ITEM 2. PROPERTIES
The Bank owns each of its properties, except for the facility located at 68 Main
Street, Wellsboro, which is leased. All of the properties are in good condition.
In 2001, the Bank entered into a lease of the property at 68 Main Street,
Wellsboro. This facility is used for C&NFSC's operations and for training. As
described in Item 1, the Williamsport location is expected to open in 2004. None
of the owned properties are subject to encumbrance.
A listing of properties is as follows:
Main administrative office:
90-92 Main Street
Wellsboro, PA 16901
Branch offices:
428 S. Main Street Main Street 41 Main Street
Athens, PA 18810 Liberty, PA 16930 Tioga, PA 16946
111 Main Street 1085 S. Main Street 428 Main Street
Dushore, PA 18614 Mansfield, PA 16933 Towanda, PA 18848
Main Street Route 220 Courthouse Square
East Smithfield, PA 18817 Monroeton, PA 18832 Troy, PA 16947
104 Main Street 3461 Route 405 Highway 90-92 Main Street
Elkland, PA 16920 Muncy, PA 17756 Wellsboro, PA 16901
102 E. Main Street Thompson Street 130 Court Street
Knoxville, PA 16928 Ralston, PA 17763 Williamsport, PA 17701
Main Street 503 N. Elmira Street Route 6
Laporte, PA 18626 Sayre, PA 18840 Wysox, PA 18854
3
Other offices:
Bankcard Services Facilities Management
RR7 Box 503 One Brewery Lane
Wellsboro, PA 16901 Wellsboro, PA 16901
C&N Financial Services Corp. Audit and Compliance
68 Main Street Water Street
Wellsboro, PA 16901 Wellsboro, PA 16901
ITEM 3. LEGAL PROCEEDINGS
The Corporation and the Bank are involved in various legal proceedings
incidental to their business. Management believes the aggregate liability, if
any, resulting from such pending and threatened legal proceedings will not have
a material, adverse effect on the Corporation's financial condition or results
of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of 2003, no matters were submitted to a vote of
security holders, through the solicitation of proxies or otherwise.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
QUARTERLY SHARE DATA
Trades of the Corporation's stock are executed through various brokers who
maintain a market in the Corporation's stock. Information regarding sales prices
of the Corporation's stock is available through the OTC Bulletin Board
(www.otcbb.com). The Corporation's stock is not listed or traded on Nasdaq or a
national securities exchange. As of March 1, 2004, there were 2,432 shareholders
of record of the Corporation's common stock.
The following table sets forth the approximate high and low sales prices of the
common stock during 2003 and 2002. Amounts for 2002 and the first quarter 2003
have been retroactively adjusted for the effects of a 3-for-2 stock split issued
in April 2003.
2003 2002
Dividend Dividend
Declared Declared
per per
High Low Quarter High Low Quarter
- ------------------------------------------------------------------------------------
First quarter $ 21.63 $ 20.37 $ 0.21 $ 19.00 $ 16.33 $ 0.1867
Second quarter 26.95 21.00 0.21 20.00 18.43 0.1867
Third quarter 26.95 25.80 0.21 21.67 19.53 0.2000
Fourth quarter 27.00 25.80 0.22 22.00 20.10 0.2000
plus 1% plus 1%
stock dividend stock dividend
Known "market makers" who handle Citizens & Northern Corporation stock
transactions are:
Boenning & Scattergood, Inc. Monroe Securities, Inc. RBC Dain Rauscher
4 Tower Bridge, Suite 300 343 West Erie 1211 Avenue of the Americas
200 Barr Harbor Drive Suite 410 New York, NY 10036
West Conshohocken, PA 19428 Chicago, IL 60610
Ferris, Baker, Watts, Inc. Knight Equity Markets, LP Ryan Beck & Co.
250 West Pratt Street 525 Washington Blvd Livingston, NJ 07039
Baltimore, MD 21201 29th Floor 220 South Orange Avenue
Jersey City, NJ 07310
4
Hill Thompson Magid & Co., Inc. Pershing Trading Company, LP Sandler, O'Neill & Partners, LP
15 Exchange Place 1 Pershing Plaza 919 Third Avenue
Eighth Floor Jersey City, NJ 07399 Sixth Floor
Jersey City, NJ 07302 New York, NY 10022
Janney Montgomery Scott, LLC EE Powell & Company, Inc. Schwab Capital Markets, LP
1801 Market Street 1100 Gulf Tower 111 Pavonia Avenue
Philadelphia, PA 19103 Pittsburgh, PA 15219 Jersey City, NJ 07310
INVESTOR INFORMATION
ANNUAL MEETING OF SHAREHOLDERS STOCK TRANSFER AGENT INDEPENDENT AUDITORS
The Annual Meeting of Shareholders AMERICAN STOCK TRANSFER &
will be held at the Arcadia Theatre in TRUST CO. PARENTE RANDOLPH, PC
Wellsboro, PA, at 2:00 p.m. on Tuesday, 59 Maiden Lane, Plaza Level 400 Market Street
April 20, 2004. New York, NY 10038 Williamsport, PA 17701
(800) 278-4353
GENERAL SHAREHOLDER INQUIRIES
SHOULD BE SENT TO:
CITIZENS & NORTHERN
CORPORATION
90-92 Main Street, P.O. Box 58
Wellsboro, PA 16901
EQUITY COMPENSATION PLAN INFORMATION
The following table sets forth information concerning the Stock Incentive Plan
and Independent Directors Stock Incentive Plan, both of which have been approved
by the Corporation's shareholders. The figures shown in the table below are as
of December 31, 2003.
NUMBER OF
NUMBER OF WEIGHTED- SECURITIES
SECURITIES TO BE AVERAGE REMAINING
ISSUED UPON EXERCISE FOR FUTURE
EXERCISE OF PRICE OF ISSUANCE UNDER
OUTSTANDING OUTSTANDING EQUITY COMPEN-
OPTIONS OPTIONS SATION PLANS
---------------- ----------- --------------
EQUITY COMPENSATION PLANS
APPROVED BY SHAREHOLDERS 213,058 $ 18.81 229,026
EQUITY COMPENSATION PLANS
NOT APPROVED BY SHAREHOLDERS 0 N/A 0
Effective January 2, 2004, the Corporation granted options to purchase a total
of 33,249 shares of common stock through the Stock Incentive and Independent
Directors Stock Incentive Plans. The exercise price for these options is $26.59
per share, which was the market price at the date of grant. Also, effective
January 2, 2004, the Corporation awarded a total of 3,714 shares of restricted
stock under the Stock Incentive and Independent Directors Stock Incentive Plans.
The stock options and restricted stock awards that were awarded in January 2004
are not included in the tables above. More details related to the Corporation's
equity compensation plans are provided in Notes 1 and 12 to the consolidated
financial statements.
5
ITEM 6. SELECTED FINANCIAL DATA
INCOME STATEMENT (IN THOUSANDS) 2003 2002 2001 2000 1999
Interest income $ 55,223 $ 57,285 $ 54,661 $ 51,643 $ 48,036
Interest expense 23,537 26,315 28,356 30,145 24,571
----------- ----------- ----------- ----------- -----------
Interest margin 31,686 30,970 26,305 21,498 23,465
Provision for loan losses 1,100 940 600 676 760
----------- ----------- ----------- ----------- -----------
Interest margin after provision for loan losses 30,586 30,030 25,705 20,822 22,705
Other income 6,595 6,624 6,120 5,002 6,823
Securities gains 4,799 2,888 1,920 1,377 3,043
Other expenses 22,114 20,849 18,671 16,906 17,732
----------- ----------- ----------- ----------- -----------
Income before income tax provision 19,866 18,693 15,074 10,295 14,839
Income tax provision 3,609 3,734 3,022 1,819 3,354
----------- ----------- ----------- ----------- -----------
Net income $ 16,257 $ 14,959 $ 12,052 $ 8,476 $ 11,485
=========== =========== =========== =========== ===========
BALANCE SHEET AT YEAR END (IN THOUSANDS)
Total securities (1) $ 484,825 $ 513,597 $ 437,398 $ 343,596 $ 356,287
Gross loans, excluding unearned discount 524,897 451,145 379,228 328,305 310,892
Total assets 1,066,901 1,018,768 866,999 719,335 705,898
Total deposits 658,065 640,304 576,274 528,967 500,474
Stockholders' equity, excluding accumulated
other comprehensive income 113,306 103,691 94,903 88,887 85,507
Total stockholders' equity 125,343 115,837 100,187 88,969 76,623
AVERAGE BALANCE SHEET (IN THOUSANDS)
Total securities, at amortized cost (1) 474,406 470,764 412,654 371,360 349,133
Gross loans, excluding unearned discount 485,150 410,670 346,353 318,382 301,584
Earning assets 959,556 881,434 759,007 689,743 650,717
Total assets 1,034,720 943,001 805,229 704,221 680,864
Total assets, excluding unrealized gains/
losses (4) 1,014,424 930,539 798,590 717,052 672,999
Total deposits 651,026 613,392 544,579 503,848 483,858
Stockholders' equity, excluding accumulated
other comprehensive income (4) 108,876 99,361 91,703 87,258 81,767
Stockholders' equity 122,271 107,595 96,021 78,792 87,143
COMMON STOCK AND PER SHARE DATA
Net income per share - basic $ 2.01 $ 1.85 $ 1.49 $ 1.04 $ 1.41
Net income per share - diluted 2.00 1.84 1.49 1.04 1.41
Cash dividends declared per share (2) 0.85 0.77 0.71 0.65 0.60
Stock dividend 1% 1% 1% 1% 1%
Stockholders' equity per share (2) 15.48 14.32 12.38 10.95 9.43
Stockholders' equity per share, excluding
accumulated other comprehensive income (loss) (2) 14.00 12.82 11.73 10.94 10.52
Weighted average shares outstanding - basic 8,089,753 8,089,266 8,103,679 8,125,296 8,124,734
Weighted average shares outstanding - diluted 8,138,468 8,111,154 8,105,935 8,127,044 8,133,012
Number of shares outstanding at year-end 8,014,625 5,285,606 5,234,800 5,207,244 5,153,729
Number of shares authorized 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000
6
FINANCIAL RATIOS 2003 2002 2001 2000 1999
Return on stockholders' equity, excluding
accumulated other comprehensive income (3), (4) 14.93% 15.06% 13.14% 9.71% 14.05%
Return on stockholders' equity (3) 13.30% 13.90% 12.55% 10.76% 13.18%
Return on assets (3) 1.57% 1.59% 1.50% 1.20% 1.69%
Stockholders' equity to assets, excluding
accumulated other comprehensive income (3), (4) 10.73% 10.68% 11.48% 12.17% 12.15%
Stockholders' equity to assets (3) 11.82% 11.41% 11.92% 11.19% 12.80%
Stockholders' equity to loans (3) 25.20% 26.20% 27.72% 24.75% 28.90%
Net income to:
Total interest income 29.44% 26.11% 22.05% 16.41% 23.91%
Interest margin 51.31% 48.30% 45.82% 39.43% 48.95%
Dividends as a % of net income 41.96% 41.17% 46.08% 60.19% 40.39%
(1) Includes available-for-sale and held-to-maturity securities, and
interest-bearing cash and due from banks.
(2) For purposes of this computation, the number of outstanding shares has
been increased for the effects of a 3-for-2 stock split issued in
April 2003 and for 1% stock dividends issued in January following each
year-end.
(3) Ratios calculated using average balance sheet data.
(4) Generally accepted accounting principles ("GAAP") require that
available-for-sale securities be reported at fair value, with
unrealized gains and losses excluded from earnings and reported
separately through stockholders' equity, net of tax. Management
believes there is an inherent mismatch between the income statement
and balance sheet related to unrealized gains/losses that may create a
material inconsistency in earnings-based ratios. Further, the amount
of unrealized gains/losses may vary widely from period-to-period,
depending on the financial markets as a whole and interest rate
movements. Therefore, management has provided these "non-GAAP" amounts
and ratios because we believe they provide meaningful information for
evaluating the Corporation's financial position and results of
operations.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Certain statements in this section and elsewhere in this Annual Report on Form
10-K are forward-looking statements. Citizens & Northern Corporation and its
wholly-owned subsidiaries (collectively, the Corporation) intend such
forward-looking statements to be covered by the safe harbor provisions for
forward-looking statements contained in the Private Securities Reform Act of
1995. Forward-looking statements, which are not historical facts, are based on
certain assumptions and describe future plans, business objectives and
expectations, and are generally identifiable by the use of words such as,
"believe", "expect", "intend", "anticipate", "estimate", "project", and similar
expressions. These forward-looking statements are subject to risks and
uncertainties that are difficult to predict, may be beyond management's control
and could cause results to differ materially from those currently anticipated.
Factors which could have a material, adverse impact on the operations and future
prospects of the Corporation include, but are not limited to, the following:
- - changes in monetary and fiscal policies of the Federal Reserve Board and
the U.S. Government, particularly related to changes in interest rates
- - changes in general economic conditions
- - legislative or regulatory changes
- - downturn in demand for loan, deposit and other financial services in the
Corporation's market area
- - increased competition from other banks and non-bank providers of financial
services
- - technological changes and increased technology-related costs
- - changes in accounting principles, or the application of generally accepted
accounting principles.
These risks and uncertainties should be considered in evaluating forward-looking
statements and undue reliance should not be placed on such statements.
EARNINGS OVERVIEW
The Corporation posted its third consecutive year of record-high net income in
2003, at $16,257,000, or $2.01 per share - basic and $2.00 per share - diluted.
Net income for 2003 was $1,298,000, or 8.7%, higher than the $14,959,000 ($1.85
per share - basic and $1.84 per share - diluted) recorded in 2002. In comparing
earnings for 2003 with 2002's results, it is important to note the higher level
of realized securities gains generated in 2003, as described below. Assuming an
income tax rate of 34%, the higher securities gains in 2003 increased net income
for 2003 by $1,261,000 over 2002. Excluding the effects of higher securities
gains, net income for 2003 was approximately even with the amount recorded in
2002. In 2001, net income totaled $12,052,000 ($1.49 per share - basic and
diluted).
7
The most significant income statement changes are as follows:
2003 VS. 2002
- The interest margin increased $716,000, or 2.3%, to $31,686,000 in
2003 from $30,970,000 in 2002. In 2003, interest rates were at very
low levels by historical standards. In that rate environment, on
average, interest earning assets repriced faster than interest-bearing
liabilities, which had the effect of driving down the Corporation's
net interest margin. However, substantial growth in loans generated
higher interest income, which more than offset the effects of lower
rates on the net interest margin. As you can calculate from the table
of "Selected Financial Data " (Item 6), gross loans increased 16.3% as
of December 31, 2003, as compared to the balance one year earlier. In
fact, 2003 was the Corporation's third consecutive year with an
increase in gross loans of more than 15%, when comparing the amount
outstanding at year-end to the corresponding balance as of the prior
year-end. The "Net Interest Margin" section of Management's Discussion
and Analysis provides a more detailed discussion of factors that
affected interest income and interest expense.
- Realized securities gains, net of realized losses, increased
$1,911,000, to $4,799,000 in 2003 from $2,888,000 in 2002. In both
2003 and 2002, the Corporation sold selected bank stocks that
management believed to be fully valued, generating substantial
realized gains. Net gains from sales of equity securities, which
consisted primarily of bank stocks, amounted to $3,384,000 in 2003 and
$2,090,000 in 2002. Net gains from sales and calls of debt securities
amounted to $1,415,000 in 2003 and $798,000 in 2002.
- Other (noninterest) operating expenses increased $1,265,000, or 6.1%,
in 2003 over 2002. This increase includes higher employee benefits and
payroll costs. As described in more detail in the "Noninterest
expense" section of Management's Discussion and Analysis, these cost
increases reflect a higher number of employees, as well as increases
in expense related to the defined benefit pension and employee health
insurance plans.
- Although pre-tax income was higher in 2003 than in 2002, the income
tax provision decreased to $3,609,000 in 2003 from $3,734,000 in 2002.
The income tax provision, as a percentage of pre-tax income, was
18.17% in 2003, down from 19.98% in 2002. This lower effective tax
rate reflects management's decision to increase the weighting of
tax-exempt investment securities as a percentage of total assets. Note
13 to the Consolidated Financial Statements presents more detail
concerning the Corporation's accounting for income taxes.
2002 VS. 2001
- The interest margin increased to $30,970,000 in 2002 from $26,305,000
in 2001, an increase of $4,665,000 or 17.7%. As discussed in more
detail in the "Net Interest Margin" section of Management's Discussion
and Analysis, the Corporation achieved significant growth in loans and
deposits in 2002. Also, management identified opportunities to borrow
funds and invest the proceeds in securities at positive spreads.
Changes in interest rates also had a significant, positive impact on
operating results in 2002, as interest rates continued their fall to
levels at or near historical record lows, resulting in a lower cost of
funds for the Corporation.
- Other (noninterest) income (excluding securities gains) was $6,624,000
in 2002, an increase of $504,000 (8.2%) over 2001. As described in
more detail later in Management's Discussion and Analysis, the major
sources of increased noninterest revenue in 2002 were from Service
Charges on Deposit Accounts and Trust and Financial Management
services.
- Net realized securities gains amounted to $2,888,000 in 2002, up from
$1,920,000 in 2001. As in 2003, most of the gains realized in 2002
were from sales of bank stocks.
- Other (noninterest) operating expenses increased $2,178,000, or 11.7%,
in 2002 over 2001. Higher operating expenses resulted from increases
in payroll costs, professional fees, depreciation and maintenance
expense associated with computer hardware and software. These types of
costs have increased as a result of the need to add personnel and
supplement existing systems to keep up with expansions of services and
growth in lending activity over the last few years.
- The income tax provision increased to $3,734,000 in 2002 from
$3,022,000 in 2001, primarily because pre-tax income was higher. The
income tax provision, as a percentage of pre-tax income, was 19.98% in
2002 and 20.05% in 2001.
8
OUTLOOK FOR 2004
Overall, management expects financial results for 2004 to be relatively
comparable to 2003. Continued growth in loans is expected, although perhaps at a
slightly slower pace than the 15% or greater growth levels of the past three
years. The ongoing national economic recovery may be an indicator that interest
rates will increase in 2004. Historically, interest rates have usually not risen
in presidential election years; however, it remains to be seen whether that will
hold true in 2004. Overall, in planning the budget for 2004, management assumed
a slightly rising rate environment, beginning mid-year. The impact of such a
rising rate scenario would be a slight "squeeze" on the net interest margin, as
(on average) deposits and borrowings would be expected to reprice slightly
faster than loans and debt securities. Another major variable that affects the
Corporation's earnings is securities gains and losses. Management's decisions
regarding sales of securities are based on a variety of factors, with the
overall goal of maximizing portfolio return over a long-term horizon. Management
may sell some bank stocks in 2004, as many of the Corporation's holdings are
priced fairly high in comparison to historical "P/E" standards. However, it is
difficult to predict, with much precision, the amount of net securities gains
and losses that will be realized in 2004.
Total capital purchases for 2004 are estimated to range from $5 million to $8
million. In addition to several other substantial projects, this amount includes
estimated costs related to two very significant initiatives that are currently
underway: (1) renovation of the Corporation's eighteenth branch, on Market
Street in downtown Williamsport, and (2) evaluation of alternatives to replace
the core banking software system. The Williamsport office is expected to open in
2004, with Trust and Financial Management, Commercial Lending, Branch Banking
and other services to be provided from that location. At this time, management
is evaluating alternatives for replacement of the core banking system, with a
decision and conversion expected to occur in 2004; however, no contractual
commitment to purchase software has been made. Although the amount of capital
spending expected for 2004 is high by the Corporation's normal standards, it is
not expected to have a material, adverse impact on the Corporation's financial
position or results of operations in 2004.
CRITICAL ACCOUNTING POLICIES
The presentation of financial statements in conformity with U.S. generally
accepted accounting principles requires management to make estimates and
assumptions that affect many of the reported amounts and disclosures. Actual
results could differ from these estimates.
A material estimate that is particularly susceptible to significant change is
the determination of the allowance for loan losses. Management believes that the
allowance for loan losses is adequate and reasonable. The Corporation's
methodology for determining the allowance for loan losses is described in a
separate section later in Management's Discussion and Analysis. Given the very
subjective nature of identifying and valuing loan losses, it is likely that
well-informed individuals could make materially different assumptions, and
could, therefore calculate a materially different allowance value. While
management uses available information to recognize losses on loans, changes in
economic conditions may necessitate revisions in future years. In addition,
various regulatory agencies, as an integral part of their examination process,
periodically review the Corporation's allowance for loan losses. Such agencies
may require the Corporation to recognize adjustments to the allowance based on
their judgments of information available to them at the time of their
examination.
In 2003, the American Institute of Certified Public Accountants (AICPA) issued
an exposure draft of a statement of position that provided detailed
implementation guidance for calculating the allowance for loan losses.
Implementation of that detailed implementation guidance, if it had been
approved, could have resulted in an adjustment to the Corporation's allowance in
2004. However, in January 2004, the AICPA decided to abandon issuance of the
statement of position in that form, and decided to move forward with development
of a statement of position that would require only additional disclosures about
the allowance. The AICPA has not yet issued public comment about a time frame
for issuing a new statement of position related to allowance for loan losses
disclosures.
Another material estimate is the calculation of fair values of the Corporation's
debt securities. The Corporation receives estimated fair values of debt
securities from an independent valuation service, or from brokers. In developing
these fair values, the valuation service and the brokers use estimates of cash
flows, based on historical performance of similar instruments in similar
interest rate environments. Based on experience, management is aware that
estimated fair values of debt securities tend to vary among brokers and other
valuation services. Accordingly, when selling debt securities, management
typically obtains price quotes from more than one source. As described in Notes
1 and 11 of the consolidated financial statements, the large majority of the
Corporation's securities are classified as available-for-sale. Accordingly,
these securities are carried at fair value on the consolidated balance sheet,
with unrealized gains and losses excluded from earnings and reported separately
through accumulated other comprehensive income (included in stockholders'
equity).
9
NET INTEREST MARGIN
2003/2002/2001
The Corporation's primary source of operating income is represented by the net
interest margin. The net interest margin is equal to the difference between the
amounts of interest income and interest expense. Tables I, II and III include
information regarding the Corporation's net interest margin in 2003, 2002 and
2001. In each of these tables, the amounts of interest income earned on
tax-exempt securities and loans have been adjusted to a fully taxable-equivalent
basis. Accordingly, the net interest margin amounts presented in these tables
exceed the amounts presented in the consolidated financial statements. The
discussion that follows is based on amounts in the Tables.
The 2001-2003 time period was one of declining interest rates (dramatically in
2001, then more slowly in 2002 and 2003). Over the course of this time period,
the Corporation's cost of funds has declined to a historically low level.
Another product of this low rate environment has been the "refinancing boom,"
with consumers and businesses refinancing their mortgages and other loans to
lower rates, and in many instances, borrowing more money than ever before. Lower
interest rates had the effect of driving down the Corporation's rate of return
on earning assets over the course of this time period, particularly from
mid-2002 through the end of the third quarter 2003. In 2001 and 2002, the
overall impact of lower rates was a benefit to the Corporation's "Interest Rate
Spread" (excess of average rate of return on interest-earning assets over
average cost of funds on interest-bearing liabilities). By 2003, interest rates
on deposits had fallen to such a low level that there was little room for
further decline, and the overall result of lower market rates was a slight
decrease in the Corporation's Interest Rate Spread. As shown in Table II, the
Interest Rate Spread was 3.31% in 2003, 3.38% in 2002 and 3.17% in 2001. Though
not shown in the Tables, the Interest Rate Spread was 2.53% in 2000.
The net interest margin, on a taxable-equivalent basis, was $35,482,000 in 2003,
an increase of $1,519,000 or 4.5% over 2002. As reflected in Table III, the
increase in net interest margin was caused by the growth in volume. Increased
interest income from higher volumes of earning assets exceeded increases in
interest expense attributable to higher volumes of interest-bearing liabilities
by $4,129,000 in 2003 compared to 2002. Table III also shows that interest rate
changes had the effect of decreasing net interest income $2,610,000 in 2003
compared to 2002.
In 2002, the net interest margin of $33,963,000 was $5,413,000, or 19.0%, higher
than the net interest margin in 2001. In 2002, the increase in net interest
margin resulted mainly from increases in volume of earning assets, and from
declining interest rates on the Corporation's deposits and borrowed funds. Table
III shows that changes in volume of earning assets and interest-bearing
liabilities resulted in an increase in net interest income of $4,264,000 in
2002, while changes in rates increased net interest income $1,149,000.
Interest rate risk is always present in the banking industry. At this time of
very low interest rates, the risk exists that, should rates rise significantly
and rapidly, the Corporation would experience an increase in cost of funds,
while long-term earning assets, such as fixed rate loans and investment
securities, would continue to generate income at their current (low) rates.
Management has taken actions to try to mitigate some of the risk associated with
rising interest rates, without unduly sacrificing current earnings. Among the
actions taken, management has attempted to "shorten" the average term to
repricing of the mortgage-backed securities portion of the securities portfolio,
and has attempted to "lengthen" the average term to repricing of borrowed funds.
More information concerning the Corporation's interest rate risk position and
monitoring procedures is provided in the "Interest Rate Risk" portion of Item
7A.
INTEREST INCOME AND EARNING ASSETS
The Corporation's major categories of interest-bearing assets are
available-for-sale investment securities and loans. As shown in Table I, total
interest income decreased to $59,019,000 in 2003 from $60,278,000 in 2002, a
decline of 2.1%. Declining interest rates caused a decrease in interest and
dividends from available-for-sale securities of $3,073,000, or 10.7%, despite a
small increase in average balance for the year. Interest and fees on loans, on
the other hand, increased $1,880,000, or 6.0%, in 2003 over 2002, as the
positive earnings effect of higher average balances more than offset the
dampening effect of a lower average rate of return.
Total interest income increased $3,372,000, or 5.9%, in 2002 over 2001. Interest
and dividends from available-for-sale securities increased $1,758,000, or 6.5%,
and interest and fees from loans increased $1,864,000, or 6.3%. Higher average
balances of available-for-sale securities and loans in 2002 than in 2001
resulted in increases in interest income in 2002, despite lower average rates of
return.
10
Throughout virtually all of 2001-2003, there was a "steep yield curve"
(longer-term interest rates much higher than shorter-term rates). Several times
in 2001 and 2002, management took advantage of the steep yield curve by
borrowing funds and investing the proceeds in securities at a positive spread.
This is reflected in Table II, which shows an increase in the average balance of
the available-for-sale investment portfolio (at amortized cost) to $465,650,000
in 2002 from $395,908,000 in 2001. Although the steep yield curve was still
present in 2003, management elected not to pursue opportunities for leveraged
securities purchases to as great an extent as in the previous 2 years. In fact,
the available-for-sale securities portfolio gradually shrunk over the course of
2003, with the proceeds used to help fund the very substantial growth in loans.
Overall, the average balance of available-for-sale securities increased slightly
in 2003, to $471,453,000. As can be expected in a declining rate environment,
the average rate of return on available-for-sale securities portfolio declined,
to 5.43% in 2003 from 6.16% in 2002 and 6.80% in 2001.
Table II also shows the composition of the available-for-sale securities
portfolio, based on average balances. The most striking change over the
2001-2003 time period is the increased weighting in municipal bonds. In 2003,
the average balance of municipal bonds was $146,371,000, or 31% of the total
portfolio, up from 24% in 2002 and 20% in 2001. On a taxable equivalent basis,
municipal bonds are the highest yielding category of available-for-sale
security. The Corporation determines the levels of its municipal bond holdings
based on income tax planning and other considerations.
The Corporation's other major categories of available-for-sale securities are
mortgage-backed securities, U.S. Government agency bonds, equity securities and
other securities. Throughout much of 2001-2003, the Corporation experienced very
rapid repayment of mortgage-backed securities. New mortgage-backed purchases in
2002 and 2003 consisted almost exclusively of "Hybrid ARMs," which are
mortgage-backed securities issued by U.S. Government agencies. Hybrid ARMs have
a fixed rate for some period of time (fixed rates on the Corporation's holdings
range from 3-10 years), then reprice once a year thereafter, based on changes in
a market rate (index), subject to annual and lifetime caps. Looking ahead to the
possibility of a rising interest rate environment, Hybrid ARMs would typically
provide a shorter average life, and faster principal repayments, than
longer-term, fixed rate mortgage-backed securities. Equity securities consist
mainly of bank stocks, and are discussed in more detail in the "Equity
Securities" section of Item 7A. Other securities consist of corporate
obligations, mainly "Trust Preferred Securities" issued by financial
institutions. Trust Preferred Securities are long-term obligations (usually
20-40 year maturities, often callable at the issuer's option after 5-10 years)
that bear interest at fixed or variable rates.
In 2003, the average balance of loans outstanding "passed" the average balance
of available-for-sale securities, and became the largest component of the
earning asset base. Average loans outstanding increased $74,480,000, or 18.1%,
in 2003, and $64,317,000, or 18.6%, in 2002. Much of the growth in the loan
portfolio in 2003 and 2002 has been in real estate secured loans, including
commercial as well as residential real estate loans. Lower market interest
rates, which have spurred significant levels of refinancing, have resulted in
many individuals' and businesses' willingness to take on more debt. Also, the
Corporation's loan growth is attributable to the opening of the Muncy office in
October 2000, along with the hiring of several additional lending personnel.
Traditionally, because the Corporation's market area consists mainly of small
rural communities, one-to-four family mortgage loans and other consumer loans
have made up most of the loan portfolio. The mix between consumer and commercial
loans has changed just slightly in recent years to a larger concentration in
commercial loans. Based on an internal report from the Bank's loan system, total
commercial loans outstanding, plus commitments, made up 43% of total loans and
commitments as of December 31, 2003, up from 41% as of December 31, 2002 and 39%
as of the end of 2001. In addition to its other consumer and commercial loan
portfolios, the Corporation has a credit card operation, which is operated for
the Corporation's customers and for other banks.
The average return on the total loan portfolio for 2003 was 6.88%, down from
7.67% in 2002 and 8.56% in 2001. The lower returns in 2003 and 2002 resulted
mainly from significant levels of mortgage refinancings, and by lower returns on
commercial loans with variable or adjustable rates.
INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES
Interest expense fell to $23,537,000 in 2003 from $26,315,000 in 2002 and
$28,356,000 in 2001. As reflected in Table III, lower average rates had the
effect of lowering interest expense $5,069,000 in 2003 and $7,184,000 in 2002.
The impact of lower rates more than offset the effects on interest expense of
higher average balances of interest-bearing liabilities. As shown in Table II,
the average balance of total interest-bearing liabilities increased 9.1%, to
$829,889,000 in 2003, and 18.1%, to $760,738,000 in 2002.
11
As reflected in Table III, interest expense from certificates of deposit (CDs)
decreased $1,793,000 in 2003 and $1,532,000 in 2002. Most of the lower interest
expense from CDs in 2003 was rate-related. However, the average balance also
fell slightly, to $190,019,000 in 2003 from $195,099,000 in 2002. The lower
average balance of CDs in 2003 was impacted by a few large withdrawals by
not-for-profit and governmental entities for building projects. Although less
quantifiable, management believes the lower average balance of CDs in 2003 may
have resulted, in part, from individuals' willingness to invest funds in the
improving U.S. stock market. The trend of decreasing CD balances may continue in
2004, depending on investors' perceptions of the attractiveness of alternative
investment options. In 2002, the decrease in interest expense on CDs was
rate-related, as the average balance of CDs increased 15.3%. The average rate
incurred on CDs was 3.14% in 2003, 3.97% in 2002 and 5.48% in 2001.
Table III shows that interest expense from money market accounts decreased
$1,258,000 in 2003, and $1,392,000 in 2002. Money market accounts are repriced
weekly, and thus are highly rate sensitive. As shown in Table II, the average
cost of money market funds was 1.43% in 2003, 2.31% in 2002 and 3.49% in 2001.
Table II shows that the average balance of money market deposits increased
10.7%, to $190,161,000 in 2003, and 11.7%, to $171,767,000, in 2002.
In contrast to the other major types of deposits, interest expense from
Individual Retirement Accounts (IRAs) increased $654,000 in 2003 and $455,000 in
2002. As shown in Table II, the average balance of IRAs increased 16.9%, to
$106,216,000 in 2003, and 14.3%, to $90,856,000 in 2002. Throughout 2003 and
2002, the Corporation offered the highest IRA rate in its marketplace, which was
instrumental in this growth. For several years, the Corporation's IRA product
was adjustable rate, repriced quarterly based on an index, with a floor of 5%.
Effective September 1, 2002, the Corporation made changes to its IRA products,
including: (1) for new IRAs, reduced the floor to 3%, and removed the tie to an
external index, on the quarterly repricing IRA product, and (2) began to offer
the Index Powered CD as an additional IRA product. (Index Powered CDs are
described in detail in Note 10 to the consolidated financial statements.) Many
of the 5% IRAs will reprice in April 2004. Management will consider the current
state of markets rates, as well as competitors' pricing, in determining the new
IRA rate at that time. The average rate incurred on IRAs was 4.88% in 2003,
4.98% in 2002 and 5.12% in 2001.
Interest expense on borrowed funds is presented in Table I in 2 categories -
"Overnight borrowings" and "Other borrowed funds." Overnight borrowings include
federal funds purchased from other banks and overnight repurchase agreements
with FHLB - Pittsburgh. Other borrowed funds include overnight repurchase
agreements with customers (the Corporation's "RepoSweep" accounts), borrowings
from FHLB - Pittsburgh and other repurchase agreements.
Interest expense on average other borrowed funds decreased $171,000 in 2003,
after increasing $1,278,000 in 2002. Average other borrowed funds balances
increased to $242,358,000 in 2003 from $211,092,000 in 2002 and $151,615,000 in
2001. In 2003, new borrowings were required to help fund growth in loans and to
sustain management's desired level of available-for-sale securities. As
discussed in the "Interest Income - Earning Assets" section above, the
Corporation borrowed funds in 2002, mainly to fund purchases of
available-for-sale securities. Because of a favorable interest rate environment,
throughout 2003 and 2002 the Corporation extended the terms of many its
borrowings to establish a "ladder" of staggered maturities extending out
(primarily) over 5 years. Note 9 to the consolidated financial statements
presents more details regarding the composition of borrowed funds as of December
31, 2003 and 2002. Average interest rates on other borrowed funds fell to 3.67%
in 2003, from 4.29% in 2002 and 5.13% in 2001.
12
TABLE I - ANALYSIS OF INTEREST INCOME AND EXPENSE
YEARS ENDED DECEMBER 31, INCREASE(DECREASE)
(IN THOUSANDS) 2003 2002 2001 03/02 02/01
INTEREST INCOME
Available-for-sale securities:
U.S. Treasury securities $ - $ 75 $ 151 $ (75) $ (76)
Securities of other U.S. Government agencies and corporations 3,174 4,728 7,718 (1,554) (2,990)
Mortgage-backed securities 7,427 11,097 9,487 (3,670) 1,610
Obligations of states and political subdivisions 10,768 8,641 6,216 2,127 2,425
Equity securities 1,168 1,148 1,090 20 58
Other securities 3,054 2,975 2,244 79 731
------- ------- ------- ------- -------
Total available-for-sale securities 25,591 28,664 26,906 (3,073) 1,758
------- ------- ------- ------- -------
Held-to-maturity securities:
U.S. Treasury securities 17 27 40 (10) (13)
Securities of other U.S. Government agencies and corporations 11 20 43 (9) (23)
Mortgage-backed securities 3 9 16 (6) (7)
------- ------- ------- ------- -------
Total held-to-maturity securities 31 56 99 (25) (43)
------- ------- ------- ------- -------
Interest-bearing due from banks 10 17 82 (7) (65)
Federal funds sold 8 42 184 (34) (142)
Loans:
Real estate loans 27,116 25,454 23,431 1,662 2,023
Consumer 2,834 2,974 3,055 (140) (81)
Agricultural 199 199 190 - 9
Commercial/industrial 2,025 1,934 1,831 91 103
Other 56 69 68 (13) 1
Political subdivisions 1,144 858 1,043 286 (185)
Leases 5 11 17 (6) (6)
------- ------- ------- ------- -------
Total loans 33,379 31,499 29,635 1,880 1,864
------- ------- ------- ------- -------
Total Interest Income 59,019 60,278 56,906 (1,259) 3,372
------- ------- ------- ------- -------
INTEREST-BEARING LIABILITIES
Interest checking 266 425 651 (159) (226)
Money market 2,712 3,970 5,362 (1,258) (1,392)
Savings 425 504 1,012 (79) (508)
Certificates of deposit 5,959 7,752 9,284 (1,793) (1,532)
Individual Retirement Accounts 5,182 4,528 4,073 654 455
Other time deposits 17 36 35 (19) 1
Overnight borrowings 91 44 161 47 (117)
Other borrowed funds 8,885 9,056 7,778 (171) 1,278
------- ------- ------- ------- -------
Total Interest Expense 23,537 26,315 28,356 (2,778) (2,041)
------- ------- ------- ------- -------
Net Interest Income $35,482 $33,963 $28,550 $ 1,519 $ 5,413
======= ======= ======= ======= =======
(1) Interest income from tax-exempt securities and loans has been adjusted to a
fully taxable-equivalent basis, using the Corporation's marginal federal income
tax rate of 34%.
(2) Fees on loans are included with interest on loans and amounted to $1,323,000
in 2003, $1,268,000 in 2002 and $1,054,000 in 2001.
13
TABLE II - ANALYSIS OF AVERAGE DAILY BALANCES AND RATES
2003 2002 2001
RATE OF RATE OF RATE OF
RETURN/ RETURN/ RETURN/
COST OF COST OF COST OF
AVERAGE FUNDS AVERAGE FUNDS AVERAGE FUNDS
(DOLLARS IN THOUSANDS) BALANCE % BALANCE % BALANCE %
EARNING ASSETS
Available-for-sale securities, at amortized cost:
U.S. Treasury securities $ - 0.00 $ 1,241 6.04 $ 2,506 6.03
Securities of other U.S. Government agencies and corporations 67,218 4.72 75,646 6.25 113,186 6.82
Mortgage-backed securities 176,800 4.20 209,539 5.30 150,838 6.29
Obligations of states and political subdivisions 146,371 7.36 113,540 7.61 78,741 7.89
Equity securities 28,084 4.16 21,858 5.25 21,060 5.18
Other securities 52,980 5.76 43,826 6.79 29,577 7.59
---------- ---- -------- ----- -------- -----
Total available-for-sale securities 471,453 5.43 465,650 6.16 395,908 6.80
---------- ---- -------- ----- -------- -----
Held-to-maturity securities:
U.S. Treasury securities 320 5.31 511 5.28 742 5.39
Securities of other U.S. Government agencies and corporations 220 5.00 331 6.04 680 6.32
Mortgage-backed securities 64 4.69 131 6.87 205 7.80
---------- ---- -------- ----- -------- -----
Total held-to-maturity securities 604 5.13 973 5.76 1,627 6.08
---------- ---- -------- ----- -------- -----
Interest-bearing due from banks 1,669 0.60 1,444 1.18 2,659 3.08
Federal funds sold 680 1.18 2,698 1.56 5,064 3.63
Loans:
Real estate loans 399,353 6.79 338,133 7.53 279,828 8.37
Consumer 32,386 8.75 29,720 10.01 28,062 10.89
Agricultural 2,924 6.81 2,556 7.79 2,070 9.18
Commercial/industrial 32,909 6.15 28,182 6.86 22,212 8.24
Other 851 6.58 1,028 6.71 892 7.62
Political subdivisions 16,649 6.87 10,929 7.85 13,108 7.96
Leases 78 6.41 122 9.02 181 9.39
---------- ---- -------- ----- -------- -----
Total loans 485,150 6.88 410,670 7.67 346,353 8.56
---------- ---- -------- ----- -------- -----
Total Earning Assets 959,556 6.15 881,435 6.84 751,611 7.57
Cash 13,583 13,318 11,871
Unrealized gain/loss on securities 20,296 12,462 6,639
Allowance for loan losses (5,908) (5,453) (5,370)
Bank premises and equipment 11,090 10,246 9,602
Other assets 36,103 30,993 30,876
---------- -------- --------
Total Assets $1,034,720 $943,001 $805,229
========== ======== ========
INTEREST-BEARING LIABILITIES
Interest checking $ 37,647 0.71 $ 37,984 1.12 $ 37,192 1.75
Money market 190,161 1.43 171,767 2.31 153,738 3.49
Savings 54,789 0.78 49,779 1.01 46,750 2.16
Certificates of deposit 190,019 3.14 195,099 3.97 169,275 5.48
Individual Retirement Accounts 106,216 4.88 90,856 4.98 79,482 5.12
Other time deposits 1,666 1.02 1,814 1.98 1,916 1.83
Overnight borrowings 7,033 1.29 2,347 1.87 4,012 4.01
Other borrowed funds 242,358 3.67 211,092 4.29 151,615 5.13
---------- ---- -------- ----- -------- -----
Total Interest-bearing Liabilities 829,889 2.84 760,738 3.46 643,980 4.40
Demand deposits 70,528 66,093 56,226
Other liabilities 12,032 8,575 9,002
---------- -------- --------
Total Liabilities 912,449 835,406 709,208
---------- -------- --------
Stockholders' equity, excluding other comprehensive income/loss 108,876 99,361 91,703
Other comprehensive income/loss 13,395 8,234 4,318
---------- -------- --------
Total Stockholders' Equity 122,271 107,595 96,021
---------- -------- --------
Total Liabilities and Stockholders' Equity $1,034,720 $943,001 $805,229
========== ======== ========
Interest Rate Spread 3.31 3.38 3.17
Net Interest Income/Earning Assets 3.70 3.85 3.80
(1) Rates of return on tax-exempt securities and loans are calculated on a
fully-taxable equivalent basis, using the Corporation's marginal federal
income tax rate of 34%.
(2) Nonaccrual loans are included in the loan balances above.
14
TABLE III - THE EFFECT OF VOLUME AND RATE CHANGES ON INTEREST INCOME AND
INTEREST EXPENSE
YEARS ENDED 12/31/03 VS. 02 YEARS ENDED 12/31/02 VS. 01
CHANGE IN CHANGE IN TOTAL CHANGE IN CHANGE IN TOTAL
(IN THOUSANDS) VOLUME RATE CHANGE VOLUME RATE CHANGE
EARNING ASSETS
Available-for-sale securities:
U.S. Treasury securities $ (38) $ (37) $ (75) $ (76) $ - $ (76)
Securities of other U.S. Government agencies
and corporations (487) (1,067) (1,554) (2,389) (601) (2,990)
Mortgage-backed securities (1,579) (2,091) (3,670) 3,277 (1,667) 1,610
Obligations of states and political
subdivisions 2,424 (297) 2,127 2,655 (230) 2,425
Equity securities 288 (268) 20 42 16 58
Other securities 567 (488) 79 987 (256) 731
-------- -------- ------- -------- -------- -------
Total available-for-sale securities 1,175 (4,248) (3,073) 4,496 (2,738) 1,758
-------- -------- ------- -------- -------- -------
Held-to-maturity securities:
U.S. Treasury securities (10) - (10) (12) (1) (13)
Securities of other U.S. Government agencies
and corporations (6) (3) (9) (21) (2) (23)
Mortgage-backed securities (4) (2) (6) (5) (2) (7)
-------- -------- ------- -------- -------- -------
Total held-to-maturity securities (20) (5) (25) (38) (5) (43)
-------- -------- ------- -------- -------- -------
Interest-bearing due from banks 2 (9) (7) (27) (38) (65)
Federal funds sold (26) (8) (34) (64) (78) (142)
Loans:
Real estate loans 4,316 (2,654) 1,662 4,550 (2,527) 2,023
Consumer 253 (393) (140) 174 (255) (81)
Agricultural 27 (27) - 41 (32) 9
Commercial/industrial 304 (213) 91 442 (339) 103
Other (12) (1) (13) 9 (8) 1
Political subdivisions 404 (118) 286 (171) (14) (185)
Leases (3) (3) (6) (5) (1) (6)
-------- -------- ------- -------- -------- -------
Total loans 5,289 (3,409) 1,880 5,040 (3,176) 1,864
-------- -------- ------- -------- -------- -------
Total Interest Income 6,420 (7,679) (1,259) 9,407 (6,035) 3,372
-------- -------- ------- -------- -------- -------
INTEREST-BEARING LIABILITIES
Interest checking (4) (155) (159) 14 (240) (226)
Money market 389 (1,647) (1,258) 574 (1,966) (1,392)
Savings 47 (126) (79) 62 (570) (508)
Certificates of deposit (197) (1,596) (1,793) 1,277 (2,809) (1,532)
Individual Retirement Accounts 751 (97) 654 570 (115) 455
Other time deposits (3) (16) (19) (2) 3 1
Overnight borrowings 65 (18) 47 (51) (66) (117)
Other borrowed funds 1,243 (1,414) (171) 2,699 (1,421) 1,278
-------- -------- ------- -------- -------- -------
Total Interest Expense 2,291 (5,069) (2,778) 5,143 (7,184) (2,041)
-------- -------- ------- -------- -------- -------
Net Interest Income $ 4,129 $ (2,610) $ 1,519 $ 4,264 $ 1,149 $ 5,413
======== ======== ======= ======== ======== =======
(1) Changes in interest income on tax-exempt securities and loans are presented
on a fully taxable-equivalent basis, using the Corporation's marginal federal
income tax rate of 34%.
(2) The change in interest due to both volume and rates has been allocated to
volume and rate changes in proportion to the relationship of the absolute dollar
amounts of the change in each.
15
NONINTEREST INCOME
2003/2002/2001
Total noninterest income increased $1,882,000, or 19.8%, in 2003 over 2002. In
2002, total noninterest income increased $1,472,000, or 18.3%, compared to 2001.
The increases in net realized security gains in 2003 and 2002 are discussed in
the "Earnings Overview" section of Management's Discussion and Analysis. Other
items of significance are as follows:
2003 VS. 2002
- - Insurance commissions and fees dropped $186,000, or 32.2%, for 2003
compared to 2002. The decrease in insurance-related revenues had 2
components: (1) a decrease in revenues of $135,000 from Bucktail Life
Insurance Company ("Bucktail"), a subsidiary of the Corporation that
reinsures credit and mortgage life and accident and health insurance, and
(2) a decrease in revenues of $51,000 from the insurance division of C & N
Financial Services Corporation ("C&NFSC"). The decrease in Bucktail
revenues is mainly attributed to timing items which are not expected to be
indicative of a long-term decline. The chief reason for the decline in
Bucktail revenues is the implementation of credit insurance changes to
comply with the Home Owners Equity Protection Act (HOEPA) that became
effective October 1, 2002. Under HOEPA, it is necessary to provide
insurance protection on an outstanding daily balance method, rather than on
a single premium basis. C&NFSC, a subsidiary of Citizens & Northern Bank,
began its insurance agency operations in 2000, with limited activity to
date. C&NFSC insurance revenues amounted to $110,000 in 2003 and $161,000
in 2002. Management continues to explore opportunities to expand insurance
related revenues.
- - The increase in cash surrender value of life insurance fell $138,000 to
$715,000 in 2003 from $853,000 in 2002. The Corporation's policy return is
determined, in part, by the amount of earnings generated from a pooled
separate investment trust held by the life insurance company. In 2003,
earnings on that pooled separate trust fund have been lower than in 2002,
which is reflective of lower market yields on debt securities.
- - Credit card fee income has increased mainly due to the formation of a
"Reward Card Program" which pays users a rebate for using their credit
card. This program was started in April 2003 and has had the desired effect
of raising card usage. This, along with an increased rate on interchange
fees, has raised overall credit card fees 24.2% in 2003.
- - Other operating income increased 13.8% due mainly to an increase in gains
from the sales of other real estate of $51,000 and from the receipt of a
grant of $33,000 for staff training.
2002 VS. 2001
- - Service charges on deposit accounts increased $349,000, or 25.4%. This
increase resulted from growth in deposits, as well as fee increases
implemented in the second half of 2001 on certain types of services.
- - Trust and financial management revenue increased $179,000, or 11.4%. This
increase resulted from fee increases implemented in the latter part of
2001, and from receipt of certain fees for services provided prior to 2002.
Trust revenue is recorded on a cash basis, which does not vary materially
from the accrual basis.
TABLE IV - COMPARISON OF NONINTEREST INCOME
(IN THOUSANDS) 2003 % CHANGE 2002 % CHANGE 2001
Service charges on deposit accounts $ 1,746 1.2 $ 1,725 25.4 $ 1,376
Service charges and fees 287 11.2 258 4.5 247
Trust and financial management revenue 1,733 (1.3) 1,755 11.4 1,576
Insurance commissions, fees and premiums 391 (32.2) 577 (0.9) 582
Increase in cash surrender value of life
insurance 715 (16.2) 853 (5.7) 905
Fees related to credit card operation 784 24.2 631 14.7 550
Other operating income 939 13.8 825 (6.7) 884
------- ----- ------- ---- -------
Total other income before realized gains on
securities, net 6,595 (0.4) 6,624 8.2 6,120
Realized gains on securities, net 4,799 66.2 2,888 50.4 1,920
------- ----- ------- ---- -------
Total Other Income $11,394 19.8 $ 9,512 18.3 $ 8,040
======= ===== ======= ==== =======
16
OTHER NONINTEREST EXPENSE
2003/2002/2001
Total noninterest expense increased 6.1% in 2003, to $22,114,000. In 2002, total
noninterest expense was $20,849,000, or 11.7% higher than in 2001.
2003 VS. 2002
Salaries and wages increased $278,000, or 3.0%, for 2003 compared to 2002. The
increase is mainly the result of annual merit raises, generally ranging from
2%-5%, and an increase in number of employees. Included in salaries and wages
expense is incentive bonus expense. The incentive bonus plan provides for
compensation to be paid to certain key officers, with the payment amounts based
on a combination of personal and corporate performance. Incentive bonus expense
for 2003 decreased $423,000 from the 2002 amount, as a lower amount of growth in
noninterest revenue (as defined) limited the amount of bonuses attributable to
overall corporate performance. Excluding incentive bonus expense, salaries and
wages increased 8.4% in 2003 over 2002.
Pensions and other employee benefits increased $666,000, or 25.1%, in 2003 over
2002. Pension expense from the Corporation's defined benefit pension plan
increased $232,000 in 2003 over 2002. Although the defined benefit pension plan
remains adequately funded, a decline in the market value of plan assets, along
with an increased number of covered employees, contributed to the increase in
expense in 2003. Note 12 to the consolidated financial statements provides more
information related to the defined benefit pension plan. Group health insurance
expense increased $112,000 in 2003, mainly due to increases in rates. Included
in this category is professional fees related to employee benefit plan matters.
In 2003, these professional fees increased $113,000.
Occupancy expense increased $201,000, or 18.4%, in 2003 over 2002. The greatest
portion of the increase in occupancy expense is attributable to increased costs
of $57,000 for building maintenance and repairs. Depreciation expense also rose
$47,000 from 2002's level, as the Corporation recorded depreciation on building
renovation costs that have taken place in several locations. Total energy costs
increased $44,000, primarily due to higher utility rates in several locations,
as well as the initial expenses associated with the Williamsport facility during
the latter portion of 2003.
Furniture and equipment expense decreased $160,000, or 10.4%, in 2003 compared
to 2002. The largest decrease within this category was in depreciation expense,
which decreased $182,000 or 19.9%. There were several substantial capital
expenditures, which became fully depreciated in 2002, reducing the expense for
2003.
In total, other expense increased $122,000, or 2.4%, in 2003 over 2002. This
category includes many different types of expenses. The most significant changes
within this category are as follows:
- Bank professional fees increased $94,000, to $371,000. Included in
this category was approximately $80,000 in expenses for a consulting
firm that has assisted with the core banking software evaluation and
search.
- Telephone - data line expenses increased $68,000, to $325,000. These
expenses increased due to upgrades of several lines.
- Marketing research expenses increased $54,000, to $68,000. In 2003,
increased expenses were incurred for demographic and other
marketing-related data.
- Expenses of Bucktail Life Insurance Company decreased $230,000, to
$105,000. In 2003, a lower amount of life insurance claims were
incurred than in 2002. In addition to the direct effect of lower
claims, the lower amount of claims also had the effect of lowering
reserves for future claims.
- Expenses related to maintaining other real estate properties decreased
$50,000, to $33,000.
2002 VS. 2001
Salaries and wages increased $925,000, or 10.9%, in 2002 compared to 2001. The
increase is the result of annual merit raises ranging from 2%-5%, an increase in
the number of employees and an increase in incentive bonus expense. Total
incentive bonus expense increased $185,000 in 2002. Excluding incentive bonus
expense, salaries and wages expense increased 9.7% in 2002 over 2001.
17
Pensions and other employee benefits increased $438,000, or 19.8%, in 2002 over
2001. A portion of this increase is directly related to the increase in salaries
and wages. Also, pension expense from the Corporation's defined benefit pension
plan increased $245,000 in 2002 over 2001. A decline in the market value of plan
assets was the main cause of the increase in expense in 2002.
Other expense increased $704,000, or 15.9%, in 2002 over 2001. The most
significant changes within this category are as follows:
- Expenses of Bucktail Life Insurance Company, increased $111,000, to
$335,000. This increase resulted mainly from a larger amount of life
insurance claims incurred.
- Professional fees increased $101,000, to $276,000. This increase
reflected costs associated with organizational and product
profitability consultants, human resources consultants and other
consultants related to various aspects of the Corporation's
operations.
- Office and other supplies increased $77,000, to $502,000, as a result
of increased volumes of employees and customers.
- Restricted stock amortization increased $58,000, to $80,000. This
category of expense included amortization associated with 2 years of
awards to Directors and certain employees in 2002, compared to only 1
year in 2001 (the first year for which there were restricted stock
awards). Stock-based compensation plans are described in more detail
in Note 12 to the financial statements.
- In 2002, the Corporation wrote off asset-liability reporting software
of $41,000, due to management's decision to change to an outsourcing
provider of asset-liability reports.
TABLE V - COMPARISON OF NONINTEREST EXPENSE
(IN THOUSANDS) 2003 % CHANGE 2002 % CHANGE 2001
Salaries and wages $ 9,696 3.0 $ 9,418 10.9 $ 8,493
Pensions and other employee benefits 3,317 25.1 2,651 19.8 2,213
Occupancy expense, net 1,295 18.4 1,094 7.5 1,018
Furniture and equipment expense 1,372 (10.4) 1,532 7.1 1,431
Expenses related to credit card operation 385 35.1 285 (3.4) 295
Pennsylvania shares tax 792 7.9 734 (7.1) 790
Other operating expense 5,257 2.4 5,135 15.9 4,431
-------- ----- ------- ---- -------
Total Other Expense $ 22,114 6.1 $20,849 11.7 $18,671
======== ===== ======= ==== =======
INCOME TAXES
The "Earnings Overview" section of Management's Discussion and Analysis includes
a discussion of the Corporation's income tax provision in 2003, 2002 and 2001.
A more complete analysis of income taxes is presented in Note 13 to the
consolidated financial statements.
FINANCIAL CONDITION
Significant changes in the average balances of the Corporation's earning assets
and interest-bearing liabilities are described in the "NET INTEREST MARGIN"
section of Management's Discussion and Analysis. In particular, the discussion
of changes in available-for-sale securities, loans, deposits and borrowed funds
in 2003 is sufficient to explain the overall change in the year-end balances in
2003 compared to 2002. Other significant balance sheet items - the allowance for
loan losses and stockholders' equity - are discussed in separate sections of
Management's Discussion and Analysis.
Table VI shows the composition of the investment portfolio at December 31, 2003,
2002 and 2001.
18
Premises and equipment, net of accumulated depreciation, increased to
$12,482,000 at December 31, 2003 from $10,333,000 at December 31, 2002. The
total cost of premises and equipment purchases was $3,360,000 in 2003,
$1,712,000 in 2002 and $1,935,000 in 2001. In 2003, the Corporation purchased
the land and building, and began renovations, for the Williamsport facility that
is expected to open in 2004. Through December 31, 2003, the total cost of the
Williamsport project was approximately $1.8 million. Other significant capital
projects in 2003 included remodeling and addition to the Sayre facility,
remodeling of the Elkland facility, and purchases of an additional 80 thin
client computer stations for teller lines throughout the branch network. In
2002, the most significant capital projects included renovations to the Tioga
and Athens offices, and completion of renovations to a leased facility in
Wellsboro. Other major categories of capital purchases in 2002 included
purchases of computer hardware and software, and purchase and demolition of
property adjacent to the Wysox office. In 2001, the most significant capital
purchases were for new proof of deposit software, renovations to branches and a
new telephone system. Depreciation expense amounted to $1,211,000 in 2003,
$1,346,000 in 2002 and $1,300,000 in 2001.
Management expects the total cost of capital expenditures for 2004 to be quite
high in comparison to the Corporation's historical standards, in the range of $5
million to $8 million. More information concerning possible capital projects in
2004 is provided in the "Outlook for 2004" section of Management's Discussion
and Analysis. As stated in the "Outlook for 2004" section, management does not
expect capital expenditures, though high, to have a material, detrimental effect
on the Corporation's financial condition or results of operations in 2004.
TABLE VI - INVESTMENT SECURITIES
AS OF DECEMBER 31,
2003 2002 2001
AMORTIZED FAIR AMORTIZED FAIR AMORTIZED FAIR
COST VALUE COST VALUE COST VALUE
AVAILABLE-FOR-SALE SECURITIES:
Obligations of the U.S. Treasury $ - $ - $ - $ - $ 2,503 $ 2,557
Obligations of other U.S. Government agencies 61,437 61,070 71,657 72,348 75,295 75,172
Obligations of states and political subdivisions 159,128 162,418 127,690 130,879 95,835 95,261
Other securities 45,992 47,648 62,296 63,592 34,315 34,532
Mortgage-backed securities 168,285 169,208 207,244 212,276 198,269 198,975
--------- -------- --------- --------- --------- --------
Total debt securities 434,842 440,344 468,887 479,095 406,217 406,497
Marketable equity securities 29,951 42,688 24,886 33,080 19,745 27,472
--------- -------- --------- --------- --------- --------
Total $ 464,793 $483,032 $ 493,773 $ 512,175 $ 425,962 $433,969
========= ======== ========= ========= ========= ========
HELD-TO-MATURITY SECURITIES:
Obligations of the U.S. Treasury $ 319 $ 349 $ 321 $ 359 $ 726 $ 735
Obligations of other U.S. Government agencies 199 216 297 322 547 561
Mortgage-backed securities 42 44 89 93 175 181
--------- -------- --------- --------- --------- --------
Total $ 560 $ 609 $ 707 $ 774 $ 1,448 $ 1,477
========= ======== ========= ========= ========= ========
PROVISION AND ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is maintained at a level which, in management's
judgment, is adequate to absorb credit losses inherent in the loan portfolio.
The amount of the allowance is based on management's evaluation of the
collectibility of the loan portfolio. In evaluating collectibility, management
considers a number of factors, including the status of specific impaired loans,
trends in historical loss experience, delinquency trends, credit concentrations,
comparison of historical loan loss data to that of other financial institutions
and economic conditions within the Corporation's market area. Allowances for
impaired loans are determined based on collateral values or the present value of
estimated cash flows. The allowance is increased by a provision for loan losses,
which is charged to expense, and reduced by charge-offs, net of recoveries.
19
Each quarter, management performs a detailed assessment of the allowance and
provision for loan losses. This assessment is conducted under the direction of
the Bank's Chief Financial Officer and Executive Vice President in charge of
Commercial Lending, with input from the Bank's President and other Branch and
Lending Staff. The assessment process includes review of identified risk
elements in the loan portfolio, including the "Watch List", past due reports and
other information. The "Watch List" is a collection of loans that have a history
of delinquency, collateral deficiency, cash flow problems, or other factors that
have come to management's attention to create the need for special monitoring.
One of the key aspects of the quarterly assessment is a meeting including the
Chief Financial Officer, Executive Vice President in charge of Commercial
Lending and the applicable Loan Officer responsible for each Watch List
relationship with an outstanding balance of $200,000 or more. This meeting
includes an updated assessment of collection activities and planning for each
such relationship, as well as evaluation of the Bank's probable loss (if any).
The Bank also engages a consulting firm each year to perform an independent
credit review. Their review is performed annually on credit relationships of
$250,000 and higher as well as other selected credit relationships. Management
gives substantial consideration to the classifications and recommendations of
the independent credit reviewer in determining the allowance for loan losses.
The allowance for loan losses includes two components, allocated and
unallocated. The allocated component of the allowance for loan losses reflects
expected losses resulting from the analysis of individual (Watch List) loans and
historical loss experience, as modified for identified trends and concerns, for
each loan category. The historical loan loss experience element is determined
based on the ratio of net charge-offs to average loan balances over a five-year
period, for each significant type of loan, modified for risk adjustment factors
identified by management for each type of loan. The charge-off ratio, as
modified, is then applied to the current outstanding loan balance for each type
of loan (net of Watch List loans that are individually evaluated).
The unallocated portion of the allowance is determined based on management's
assessment of general economic conditions as well as specific economic factors
in the market area. This determination inherently involves a higher degree of
uncertainty and considers current risk factors that may not have yet manifested
themselves in the Bank's historical loss factors used to determine the allocated
component of the allowance, and it recognizes that management's knowledge of
specific losses within the portfolio may be incomplete.
Table IX reflects an allowance for losses related to impaired loans of
$1,542,000 at December 31, 2003. This amount reflects management's evaluations
of impairment associated with specific loan relationships. Management believes
it has been conservative, but reasonable, in its loan impairment calculations.
However, the actual losses realized from these relationships could vary
materially from the allowances calculated as of December 31, 2003.
As noted in Table IX, the unallocated portion of the allowance for loan losses
was $2,117,000 at December 31, 2003 and $1,759,000 at December 31, 2002. The
unallocated balances ranged from $1,759,000 to $2,219,000 in 2003 and $1,759,000
to $2,222,000 in 2002. In evaluating the unallocated portion of the allowance,
management considers several trends, including comparisons of loan loss data to
other financial institutions and tracking of delinquency and charge-off trends.
Total 90 day or more past due loans, plus nonaccrual loans, amounted to
$3,691,000 (0.70% of total loans) at December 31, 2003, which is fairly
consistent with the corresponding amount at December 31, 2002 of $3,570,000
(0.79% of total loans). Total 30-89 day past due loans amounted to $12,208,000
(2.33% of total loans) at December 31, 2003, up from $8,853,000 (1.96% of total
loans) at December 31, 2002. Management is monitoring the increase in 30-89 day
past due loans to determine whether it is a sustainable trend, and will increase
the allowance in 2004 if appropriate. As reflected in Table VIII, gross and net
charge-offs were higher in 2003 than in any of the previous 4 years. Gross
charge-offs of $968,000 included approximately $300,000 from charge-offs related
to 2 commercial loan relationships during the 1st quarter 2003. These 2
relationships had been identified as impaired, with allowances fully provided,
at December 31, 2002.
The allocation of the allowance for loan losses at December 31, 2001 and 2000,
as presented in Table IX, reflects reclassifications of amounts among categories
compared to amounts presented in prior years. These reclassifications reflect an
increase in the amount of allowance presented for impaired loans, and decreases
in the allowance amounts for other categories.
20
The provision for loan losses amounted to $1,100,000 in 2003, $940,000 in 2002
and $600,000 in 2001. The amount of the provision in each year is determined
based on the amount required to maintain an appropriate allowance in light of
the factors described above.
Tables VII, VIII, IX and X present an analysis of the loan portfolio, the
allowance for loan losses, the allocation of the allowance and a five-year
summary of loans by type.
TABLE VII - FIVE-YEAR HISTORY OF LOAN LOSSES (IN THOUSANDS)
2003 2002 2001 2000 1999 AVERAGE
Year-end gross loans, excluding
unearned discount $524,897 $451,145 $379,228 $328,305 $310,892 $398,893
Year-end allowance for loan
Losses 6,097 5,789 5,265 5,291 5,131 5,515
Year-end nonaccrual loans 1,145 1,252 1,050 1,608 1,956 1,402
Year-end loans 90 days or more
past due and still accruing 2,546 2,318 2,067 1,221 1,797 1,990
Net charge-offs 792 416 626 516 449 560
Provision for loan losses 1,100 940 600 676 760 815
Earnings coverage of charge-
Offs 20.5 36.0 19.3 16.4 25.6 22.6
Allowance coverage of charge-
Offs 7.7 13.9 8.4 10.3 11.4 9.8
Net charge-offs as a % of
provision for loan losses 72.0% 44.3% 104.3% 76.3% 59.1% 68.7%
TABLE VIII - ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES
(IN THOUSANDS)
YEARS ENDED DECEMBER 31,
2003 2002 2001 2000 1999
Balance, beginning of year $ 5,789 $ 5,265 $ 5,291 $ 5,131 $ 4,820
-------- -------- -------- -------- --------
Charge-offs:
Real estate loans 168 123 144 272 81
Installment loans 326 116 138 77 138
Credit cards and related plans 171 190 200 214 192
Commercial and other loans 303 123 231 53 219
-------- -------- -------- -------- --------
Total charge-offs 968 552 713 616 630
-------- -------- -------- -------- --------
Recoveries:
Real estate loans 75 30 6 26 81
Installment loans 52 30 27 23 60
Credit cards and related plans 17 18 20 28 30
Commercial and other loans 32 58 34 23 10
-------- -------- -------- -------- --------
Total recoveries 176 136 87 100 181
-------- -------- -------- -------- --------
Net charge-offs 792 416 626 516 449
Provision for loan losses 1,100 940 600 676 760
-------- -------- -------- -------- --------
Balance, end of year $ 6,097 $ 5,789 $ 5,265 $ 5,291 $ 5,131
======== ======== ======== ======== ========
21
TABLE IX - ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES BY TYPE
(IN THOUSANDS)
2003 2002 2001 2000 1999
Commercial $ 1,578 $ 1,315 $ 852 $ 441 $ 2,081
Consumer mortgage 456 460 188 187 834
Impaired loans 1,542 1,877 1,736 2,393 609
Consumer 404 378 302 287 437
All other commitments - - - - 150
Unallocated 2,117 1,759 2,187 1,983 1,020
------- ------- ------- ------- -------
Total Allowance $ 6,097 $ 5,789 $ 5,265 $ 5,291 $ 5,131
======= ======= ======= ======= =======
The above allocation is based on estimates and subjective judgments and is not
necessarily indicative of the specific amounts or loan categories in which
losses may occur.
TABLE X - FIVE-YEAR SUMMARY OF LOANS BY TYPE
(IN THOUSANDS)
2003 % 2002 % 2001 % 2000 % 1999 %
Real estate - construction $ 2,856 0.54 $ 103 0.02 $ 1,814 0.48 $ 452 0.14 $ 649 0.21
Real estate - mortgage 431,047 82.13 370,453 82.12 306,264 80.76 263,325 80.21 247,604 79.64
Consumer 33,977 6.47 31,532 6.99 29,284 7.72 28,141 8.57 29,140 9.37
Agricultural 2,948 0.56 3,024 0.67 2,344 0.62 1,983 0.60 1,899 0.61
Commercial 34,967 6.66 30,874 6.84 24,696 6.51 20,776 6.33 18,050 5.81
Other 1,183 0.23 2,001 0.44 1,195 0.32 948 0.29 1,025 0.33
Political subdivisions 17,854 3.40 13,062 2.90 13,479 3.55 12,462 3.80 12,332 3.97
Lease receivables 65 0.01 96 0.02 152 0.04 218 0.07 222 0.07
--------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total 524,897 100.00 451,145 100.00 379,228 100.00 328,305 100.00 310,921 100.00
Less: unearned discount - - - - (29)
--------- -------- -------- -------- --------
524,897 451,145 379,228 328,305 310,892
Less: allowance for loan losses (6,097) (5,789) (5,265) (5,291) (5,131)
--------- -------- -------- -------- --------
Loans, net $ 518,800 $445,356 $373,963 $323,014 $305,761
========= ======== ======== ======== ========
CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS
Table XI presents the Corporation's significant fixed and determinable
contractual obligations as of December 31, 2003, by payment date. The payment
amounts represent those amounts due to the recipients, including interest, and
are not discounted to present value.
TABLE XI - CONTRACTUAL OBLIGATIONS
(IN THOUSANDS)
1 YEAR 1-3 3-5 OVER 5
CONTRACTUAL OBLIGATIONS OR LESS YEARS YEARS YEARS TOTAL
----------------------- -------- --------- -------- -------- --------
Time deposits $185,736 $ 88,083 $ 36,312 $ 168 $310,299
Short-term borrowings - Federal
Home Loan Bank of Pittsburgh 7,558 - - - 7,558
Long-term borrowings:
Federal Home Loan Bank of
Pittsburgh 34,883 94,536 57,933 19,821 207,173
Repurchase agreements 21,199 27,107 4,725 - 53,031
-------- --------- -------- -------- --------
Total $249,376 $ 209,726 $ 98,970 $ 19,989 $578,061
======== ========= ======== ======== ========
22
In addition to the amounts described in Table XI, the Corporation has
obligations related to deposits without a stated maturity with outstanding
principal balances totaling $362,242,000 at December 31, 2003. The Corporation
also has obligations related to overnight borrowings with the Federal Home Loan
Bank of Pittsburgh and overnight customer repurchase agreements with principal
balances totaling $30,263,000 at December 31, 2003.
The Corporation has no capital leases as of December 31, 2003, and commitments
related to operating leases and other purchase commitments are not significant.
The Corporation's significant off-balance sheet arrangements consist of
commitments to extend credit and standby letters of credit. Off-balance sheet
arrangements are described in Note 15 to the consolidated financial statements.
LIQUIDITY
Liquidity is the ability to quickly raise cash at a reasonable cost. An adequate
liquidity position permits the Corporation to pay creditors, compensate for
unforeseen deposit fluctuations and fund unexpected loan demand. The Corporation
maintains overnight borrowing facilities with several correspondent banks that
provide a source of day-to-day liquidity. Also, the Corporation maintains
borrowing facilities with FHLB - Pittsburgh, secured by various securities and
mortgage loans. At December 31, 2003, the Corporation had unused borrowing
availability with correspondent banks and FHLB - Pittsburgh totaling
approximately $218,000,000. Additionally, the Corporation uses repurchase
agreements placed with brokers to borrow short-term funds secured by investment
assets, and uses "RepoSweep" arrangements to borrow funds from commercial
banking customers on an overnight basis.
Historically, one of the tools used to monitor a bank's longer-term liquidity
situation has been the loan-to-deposit ratio. As of December 31, 2003, this
ratio was 79%, which is a moderate-to-low ratio by banking industry standards,
but much higher than the Corporation's position has been in many years. The
higher than historical level of loans-to-deposits reflects the Corporation's
very strong loan growth over the past few years. The loan-to-deposit ratio was
70% at December 31, 2002, 65% at December 31, 2001 and 61% at December 31, 2000.
Management believes the current, higher loan-to-deposit ratio is an indicator
that some of the Corporation's historical liquidity "cushion" has been reduced;
however, the current position continues to provide sufficient funds for
maintenance of a substantial investment securities portfolio. If required to
raise cash in an emergency situation, the Corporation could sell non-pledged
investment securities to meet its obligations.
Management believes the combination of its strong capital position (discussed in
the next section), ample available borrowing facilities and moderate - to-low
loan to deposit ratio have placed the Corporation in a position of minimal
short-term and long-term liquidity risk.
STOCKHOLDERS' EQUITY AND CAPITAL ADEQUACY
The Corporation and the Bank are subject to various regulatory capital
requirements administered by the federal banking agencies. For many years, the
Corporation and the Bank have maintained extremely strong capital positions.
Details concerning the Corporation's and the Bank's regulatory capital amounts
and ratios are presented in Note 17 to the consolidated financial statements. As
reflected in Note 17, at December 31, 2003 and 2002, the ratios of total capital
to risk-weighted assets, tier 1 capital to risk-weighted assets and tier 1
capital to average total assets are well in excess of regulatory capital
requirements.
The Corporation's total stockholders' equity is affected by fluctuations in the
fair values of available-for-sale securities. The difference between amortized
cost and fair value of available-for-sale securities, net of deferred income
tax, is classified as "Accumulated Other Comprehensive Income" within
stockholders' equity. Changes in accumulated other comprehensive income are
excluded from earnings and directly increase or decrease stockholders' equity.
COMPREHENSIVE INCOME
Comprehensive income is a measure of all changes in the equity of a corporation,
excluding transactions with owners in their capacity as owners (such as proceeds
from issuances of stock and dividends). The difference between net income and
comprehensive income is termed "Other Comprehensive Income". For the
Corporation, other comprehensive income consists of unrealized gains and losses
on available-for-sale securities, net of deferred income tax. Comprehensive
income should not be construed to be a measure of net income. The amount of
unrealized gains or losses reflected in comprehensive income may vary widely
from period-to-period, depending on the financial markets as a whole and how the
portfolio of available-for-sale securities is affected by interest rate
movements. Total comprehensive income was $16,148,000 in 2003, $21,821,000 in
2002 and $17,254,000 in 2001. Other comprehensive income (loss) amounted to
($109,000) in 2003, $6,862,000 in 2002 and $5,202,000 in 2001.
23
INFLATION
Over the last several years, direct inflationary pressures on the Corporation's
payroll-related and other noninterest costs have been modest. The Corporation is
significantly affected by the Federal Reserve Board's efforts to control
inflation through changes in interest rates. Management monitors the impact of
economic trends, including any indicators of inflationary pressures, in managing
interest rate and other financial risks.
RECENT ACCOUNTING PRONOUNCEMENTS
In December 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard ("SFAS") No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure - An Amendment of FASB
Statement No. 123." This statement amends SFAS No. 123, "Accounting for
Stock-Based Compensation," to provide alternative methods of transition for a
voluntary change to the fair value based method of accounting for stock-based
employee compensation. The statement also amends the disclosure requirements of
SFAS No. 123 to require additional, prominent disclosures in both annual and
interim financial statements about the method of accounting for stock-based
employee compensation and the effect of the method used on reported results.
This statement announces, "in the near future, the Board plans to consider
whether it should propose changes to the U.S. standards on accounting for
stock-based compensation." The Corporation first adopted the disclosure
requirements of SFAS No. 148 in the 2002 annual financial statements, and in
interim financial statements issued in 2003. However, as permitted by SFAS No.
148, the Corporation continues to use the intrinsic value method of accounting
for stock options (rather than the fair value method). Notes 1 and 12 to the
consolidated financial statements present more details concerning the
Corporation's stock-based compensation plans.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." This statement amends and
clarifies accounting for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities under SFAS
No. 133. The amendments set forth in SFAS No. 149 require that contracts with
comparable characteristics be accounted for similarly. In particular, this
statement clarifies under what circumstances a contract with an initial net
investment meets the characteristic of a derivative as discussed in SFAS No.
133. In addition, it clarifies when a derivative contains a financing component
that warrants special reporting in the statement of cash flows. SFAS No. 149
amends certain other existing pronouncements. Those changes will result in more
consistent reporting of contracts that are derivatives in their entirety or that
contain embedded derivatives that warrant separate accounting. This statement
was effective for contracts entered into or modified after June 30, 2003, with
certain exceptions. The adoption of this statement did not have an effect on the
Corporation's earnings, financial condition or equity.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity." This statement
establishes how an issuer classifies financial instruments with characteristics
of both liabilities and equity. It requires that an issuer classify these
financial instruments as a liability (or, in certain circumstances, an asset).
Previously, these financial instruments would have been classified entirely as
equity, or between the liabilities and equity section of the balance sheet. This
statement also addresses questions about the classification of certain financial
instruments that embody obligations to issue equity shares. The provisions of
this statement were effective for interim periods beginning after June 15, 2003.
The adoption of this statement did not have an effect on the Corporation's
earnings, financial condition or equity.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities." The FASB then revised Interpretation No. 46 in
December 2003. Interpretation No. 46, as revised, is intended to expand upon and
strengthen existing accounting guidance that addresses when a company should
include in its financial statements the assets, liabilities and activities of
another entity. Prior to this interpretation, as revised, one company generally
has included another entity in its consolidated financial statements only if it
controlled the entity through voting interests. This interpretation, as revised,
changes that by requiring a variable interest entity to be consolidated by a
company if that company is subject to a majority of the risk of loss from the
variable interest entity's activities or entitled to receive a majority of the
entity's residual returns or both. Certain of the requirements of this
interpretation, as revised, were effective in 2003, while other requirements
will become effective in 2004. The adoption of the interpretation, as revised,
did not have an effect on the Corporation's earnings, financial condition or
equity in 2003, and management does not expect any impact in 2004.
24
In December 2003, the FASB issued a revision to SFAS No. 132, "Employers'
Disclosures about Pensions and Other Postretirement Benefits." The revision
retains the requirements of the original version of SFAS No. 132, and adds
additional disclosure requirements, such as descriptions of types of plan
assets, investment strategy, measurement dates, plan obligations, cash flows and
components of net periodic benefit costs recognized during interim periods.
Adoption of the revision to SFAS No. 132 did not have an effect on the
Corporation's earnings, financial condition or equity. Most of the additional
disclosure requirements became effective for the Corporation's December 31,
2003, financial statements, and are included in the description of defined
benefit plans in Note 12 to the consolidated financial statements.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
The Corporation's two major categories of market risk, interest rate and equity
securities risk, are discussed in the following sections.
INTEREST RATE RISK
Business risk arising from changes in interest rates is an inherent factor in
operating a bank. The Corporation's assets are predominantly long-term, fixed
rate loans and debt securities. Funding for these assets comes principally from
shorter-term deposits and borrowed funds. Accordingly, there is an inherent risk
of lower future earnings or decline in fair value of the Corporation's financial
instruments when interest rates change.
The Bank uses a simulation model to calculate the potential effects of interest
rate fluctuations on net interest income and the market value of portfolio
equity. Only assets and liabilities of the Bank are included in management's
monthly simulation model calculations. Since the Bank makes up more than 90% of
the Corporation's total assets and liabilities, and because the Bank is the
source of the most volatile interest rate risk, management does not consider it
necessary to run the model for the remaining entities within the consolidated
group. For purposes of these calculations, the market value of portfolio equity
includes the fair values of financial instruments, such as securities, loans,
deposits and borrowed funds, and the book values of other assets and
liabilities, such as premises and equipment and accrued interest. The model
measures and projects potential changes in net interest income, and calculates
the discounted present value of anticipated cash flows of financial instruments,
assuming an immediate increase or decrease in interest rates. Management
ordinarily runs a variety of scenarios within a range of plus or minus 50-300
basis points of current rates.
The Bank's Board of Directors has established policy guidelines for acceptable
levels of interest rate risk, based on an immediate increase or decrease in
interest rates of 200 basis points. The policy limit for fluctuation in net
interest income is minus 20% from the baseline one-year scenario. The policy
limit for market value variance is minus 30% from the baseline one-year
scenario. As reflected in the table that follows, as of December 31, 2003, the
Bank's net interest income calculations show a decrease of 3.5% in the +200
basis point scenario and a decrease of 4.2% in the - 200 basis point scenario.
Both of these levels are well within the policy threshold. However, if interest
rates were to immediately increase 200 basis points, the Bank's calculations
based on the model show that the market value of portfolio equity would decrease
35.5%, which exceeds the policy threshold and is indicative of a long-term
sensitivity to rising rates. At this time, in light of the small amount of
exposure to decline in net interest income over the next 12 months, as well as
the strong capital and liquidity positions of the Bank and the Corporation,
management does not intend to restructure the financial assets and liabilities
to reduce the market value of portfolio equity exposure to fall within the Board
policy mark. However, management will continue to monitor the market value of
portfolio equity position on a monthly basis, and will continue to consider
options for reducing exposure to rising rates.
The table that follows was prepared using the simulation model described above.
The model makes estimates, at each level of interest rate change, regarding cash
flows from principal repayments on loans and mortgage-backed securities and call
activity on other investment securities. Actual results could vary significantly
from these estimates, which could result in significant differences in the
calculations of projected changes in net interest margin and market value of
portfolio equity. Also, the model does not make estimates related to changes in
the composition of the deposit portfolio that could occur due to rate
competition and the table does not necessarily reflect changes that management
would make to realign the portfolio as a result of changes in interest rates.
25
THE EFFECT OF HYPOTHETICAL CHANGES IN INTEREST RATES
PERIOD ENDING DECEMBER 31, 2004
CURRENT PLUS 200 MINUS 200
(IN THOUSANDS) INTEREST BASIS BASIS
DECEMBER 31, 2003 DATA RATES POINTS POINTS
SCENARIO AMOUNT % CHANGE AMOUNT % CHANGE
Interest income $ 54,126 $ 58,319 $ 48,386
Interest expense 20,676 26,047 16,343
-------- -------- ---------
Net Interest Income $ 33,450 $ 32,272 -3.5% $ 32,043 -4.2%
======== ======== ==== ========= ====
Market Value of Portfolio Equity at Dec. 31, 2003 $123,499 $ 79,649 -35.5% $ 152,462 23.5%
======== ======== ==== ========= ====
PERIOD ENDING DECEMBER 31, 2004
CURRENT PLUS 200 MINUS 200
(IN THOUSANDS) INTEREST BASIS BASIS
DECEMBER 31, 2002 DATA RATES POINTS POINTS
SCENARIO AMOUNT % CHANGE AMOUNT % CHANGE
Interest income $ 54,989 $ 59,608 $ 49,607
Interest expense 24,132 29,320 19,083
-------- -------- ----- ---------
Net Interest Income $ 30,857 $ 30,288 -1.8% $ 30,524 -1.1%
======== ======== ===== ========= ====
Market Value of Portfolio Equity at Dec. 31, 2002 $108,144 $ 71,117 -34.2% $ 130,764 20.9%
======== ======== ===== ========= ====
EQUITY SECURITIES RISK
The Corporation's equity securities portfolio consists primarily of investments
in stocks of banks and bank holding companies, mainly based in Pennsylvania. The
Corporation also owns some other stocks and mutual funds. Included in "Other
equity securities" in the table that follows are preferred stocks issued by U.S.
Government agencies with a fair value of $11,347,000 at December 31, 2003 and
$6,997,000 at December 31, 2002.
Investments in bank stocks are subject to the risk factors affecting the banking
industry generally, including competition from non-bank entities, credit risk,
interest rate risk and other factors that could result in a decline in market
prices. Also, losses could occur in individual stocks held by the Corporation
because of specific circumstances related to each bank. Further, because of the
concentration of its holdings in Pennsylvania banks, these investments could
decline in value if there were a downturn in the state's economy.
The Corporation's management monitors its risk associated with its equity
securities holdings by reviewing its holdings on a detailed, individual security
basis, at least monthly, considering all of the factors described above.
26
Equity securities held as of December 31, 2003 and 2002 are as follows:
(IN THOUSANDS)
HYPOTHETICAL HYPOTHETICAL
10% 20%
DECLINE IN DECLINE IN
FAIR MARKET MARKET
AT DECEMBER 31, 2003 COST VALUE VALUE VALUE
Banks and bank holding companies $ 16,375 $ 29,288 $ (2,929) $ (5,858)
Other equity securities 13,576 13,400 (1,340) (2,680)
-------- -------- -------- ---------
Total $ 29,951 $ 42,688 $ (4,269) $ (8,538)
======== ======== ======== =========
HYPOTHETICAL HYPOTHETICAL
10% 20%
DECLINE IN DECLINE IN
FAIR MARKET MARKET
AT DECEMBER 31, 2002 COST VALUE VALUE VALUE
Banks and bank holding companies $ 16,336 $ 24,511 $ (2,451) $ (4,902)
Other equity securities 8,550 8,569 (857) (1,714)
-------- -------- -------- ---------
Total $ 24,886 $ 33,080 $ (3,308) $ (6,616)
======== ======== ========= =========
27
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
CONSOLIDATED BALANCE SHEET
DECEMBER 31, DECEMBER 31,
(In Thousands Except Share Data) 2003 2002
ASSETS
Cash and due from banks:
Noninterest-bearing $ 13,938 $ 14,185
Interest-bearing 1,233 715
---------- ----------
Total cash and cash equivalents 15,171 14,900
Available-for-sale securities 483,032 512,175
Held-to-maturity securities 560 707
Loans, net 518,800 445,356
Bank-owned life insurance 17,473 16,758
Accrued interest receivable 5,632 5,960
Bank premises and equipment, net 12,482 10,333
Foreclosed assets held for sale 101 56
Other assets 13,650 12,523
---------- ----------
TOTAL ASSETS $1,066,901 $1,018,768
========== ==========
LIABILITIES
Deposits:
Noninterest-bearing $ 75,616 $ 70,824
Interest-bearing 582,449 569,480
---------- ----------
Total deposits 658,065 640,304
Dividends payable 1,763 1,586
Short-term borrowings 37,763 43,635
Long-term borrowings 235,190 208,214
Accrued interest and other liabilities 8,777 9,192
---------- ----------
TOTAL LIABILITIES 941,558 902,931
---------- ----------
STOCKHOLDERS' EQUITY
Common stock, par value $1.00 per share; authorized 10,000,000
shares; issued 8,226,033 in 2003 and 5,431,021 in 2002 8,226 5,431
Stock dividend distributable 2,164 1,639
Paid-in capital 20,104 21,153
Retained earnings 84,940 77,584
---------- ----------
Total 115,434 105,807
Accumulated other comprehensive income 12,037 12,146
Unamortized stock compensation (54) (49)
Treasury stock, at cost:
211,408 shares at December 31, 2003 (2,074)
145,415 shares at December 31, 2002 (2,067)
---------- ----------
TOTAL STOCKHOLDERS' EQUITY 125,343 115,837
---------- ----------
TOTAL LIABILITIES & STOCKHOLDERS' EQUITY $1,066,901 $1,018,768
========== ==========
The accompanying notes are an integral part of the consolidated financial
statements.
28
CONSOLIDATED STATEMENT OF INCOME
(IN THOUSANDS EXCEPT PER SHARE DATA)
YEARS ENDED DECEMBER 31,
2003 2002 2001
INTEREST INCOME
Interest and fees on loans $ 32,235 $ 30,641 $ 28,592
Interest on balances with depository institutions 10 17 82
Interest on loans to political subdivisions 781 587 719
Interest on federal funds sold 8 42 184
Income from available-for-sale and held-to-maturity securities:
Taxable 13,686 19,051 19,752
Tax-exempt 7,335 5,799 4,242
Dividends 1,168 1,148 1,090
-------- -------- --------
Total interest and dividend income 55,223 57,285 54,661
-------- -------- --------
INTEREST EXPENSE
Interest on deposits 14,561 17,215 20,417
Interest on short-term borrowings 487 916 3,944
Interest on long-term borrowings 8,489 8,184 3,995
-------- -------- --------
Total interest expense 23,537 26,315 28,356
-------- -------- --------
Interest margin 31,686 30,970 26,305
Provision for loan losses 1,100 940 600
-------- -------- --------
Interest margin after provision for loan losses 30,586 30,030 25,705
-------- -------- --------
OTHER INCOME
Service charges on deposit accounts 1,746 1,725 1,376
Service charges and fees 287 258 247
Trust and financial management revenue 1,733 1,755 1,576
Insurance commissions, fees and premiums 391 577 582
Increase in cash surrender value of life insurance 715 853 905
Fees related to credit card operation 784 631 550
Other operating income 939 825 884
-------- -------- --------
Total other income before realized gains on securities, net 6,595 6,624 6,120
Realized gains on securities, net 4,799 2,888 1,920
-------- -------- --------
Total other income 11,394 9,512 8,040
-------- -------- --------
OTHER EXPENSES
Salaries and wages 9,696 9,418 8,493
Pensions and other employee benefits 3,317 2,651 2,213
Occupancy expense, net 1,295 1,094 1,018
Furniture and equipment expense 1,372 1,532 1,431
Expenses related to credit card operation 385 285 295
Pennsylvania shares tax 792 734 790
Other operating expense 5,257 5,135 4,431
-------- -------- --------
Total other expenses 22,114 20,849 18,671
-------- -------- --------
Income before income tax provision 19,866 18,693 15,074
Income tax provision 3,609 3,734 3,022
-------- -------- --------
NET INCOME $ 16,257 $ 14,959 $ 12,052
======== ======== ========
NET INCOME PER SHARE - BASIC $ 2.01 $ 1.85 $ 1.49
======== ======== ========
NET INCOME PER SHARE - DILUTED $ 2.00 $ 1.84 $ 1.49
======== ======== ========
The accompanying notes are an integral part of the consolidated financial
statements
29
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(IN THOUSANDS EXCEPT PER SHARE DATA)
ACCUMULATED
STOCK OTHER UNAMORTIZED
COMMON DIVIDEND PAID-IN RETAINED COMPREHENSIVE STOCK TREASURY
STOCK DISTRIBUTABLE CAPITAL EARNINGS INCOME COMPENSATION STOCK TOTAL
------ ------------- ------- -------- ------------- ------------ -------- --------
BALANCE, DECEMBER 31, 2000 $5,325 $ 1,054 $18,756 $65,206 $ 82 $ (35) $ (1,419) $ 88,969
Comprehensive income:
Net income 12,052 12,052
Unrealized gain on securities,
net of reclassification
adjustment and tax effects 5,202 5,202
-------- --------
Total comprehensive income 17,254
--------
Cash dividends declared, $0.7067 per share (5,554) (5,554)
Treasury stock purchased (521) (521)
Amortization of restricted stock 22 22
Tax benefit from employee benefit plan 17 17
Stock dividend issued 53 (1,054) 1,001 -
Stock dividend declared, 1% 1,369 (1,369) -
Restricted stock granted 1 (4) 3 -
------- ------- -------- --------
BALANCE, DECEMBER 31, 2001 5,378 1,369 19,758 70,352 5,284 (17) (1,937) 100,187
Comprehensive income:
Net income 14,959 14,959
Unrealized gain on securities,
net of reclassification adjustment
and tax effects 6,862 6,862
-------- --------
Total comprehensive income 21,821
--------
Cash dividends declared, $0.7733 per share (6,158) (6,158)
Treasury stock purchased (239) (239)
Amortization of restricted stock 80 80
Shares issued from treasury related to
exercise of stock options 26 50 76
Tax benefit from employee benefit plan 70 70
Stock dividend issued 53 (1,369) 1,316 -
Stock dividend declared, 1% 1,639 (1,639) -
Restricted stock granted 55 (116) 61 -
Forfeiture of restricted stock (2) 4 (2) -
------- ------- -------- --------
BALANCE, DECEMBER 31, 2002 5,431 1,639 21,153 77,584 12,146 (49) (2,067) 115,837
Comprehensive income:
Net income 16,257 16,257
Unrealized loss on securities,
net of reclassification adjustment
and tax effects (109) (109)
-------- --------
Total comprehensive income 16,148
--------
Cash dividends declared, $.85 per share (6,821) (6,821)
Treasury stock purchased (174) (174)
Shares issued from treasury related to
exercise of stock options 78 119 197
Amortization of restricted stock 102 102
Tax benefit from employee benefit plan 84 84
Stock dividend issued 53 (1,639) 1,556 (30)
3-for-2 stock split, April 2003 2,742 (2,742) -
Stock dividend declared, 1% 2,164 (2,164) -
Restricted stock granted 59 (107) 48 -
------- ------- -------- --------
BALANCE, DECEMBER 31, 2003 $8,226 $ 2,164 $20,104 $84,940 $ 12,037 $ (54) $ (2,074) $125,343
====== ========= ======= ======= ======== ======= ======== ========
The accompanying notes are an integral part of the consolidated financial
statements.
30
CONSOLIDATED STATEMENT OF CASH FLOWS
(IN THOUSANDS)
YEARS ENDED DECEMBER 31,
2003 2002 2001
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 16,257 $ 14,959 $ 12,052
Adjustments to reconcile net income to net cash provided by
operating activities:
Provision for loan losses 1,100 940 600
Realized gains on securities, net (4,799) (2,888) (1,920)
Gain on sale of foreclosed assets, net (105) (39) (88)
Depreciation expense 1,211 1,346 1,300
Accretion and amortization, net 1,241 (376) (1,869)
Increase in cash surrender value of life insurance (715) (853) (905)
Amortization of restricted stock 102 80 22
Deferred income taxes (25) (284) (349)
Decrease (Increase) in accrued interest receivable and other assets 487 (958) (126)
(Decrease) Increase in accrued interest payable and other liabilities (164) 669 579
--------- --------- ---------
Net Cash Provided by Operating Activities 14,590 12,596 9,296
--------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from maturity of held-to-maturity securities 145 731 1,083
Purchase of held-to-maturity securities - - (626)
Proceeds from sales of available-for-sale securities 53,562 29,345 25,788
Proceeds from calls and maturities of available-for-sale securities 178,682 155,811 152,568
Purchase of available-for-sale securities (199,705) (249,693) (261,148)
Purchase of Federal Home Loan Bank of Pittsburgh stock (1,855) (3,943) (1,750)
Redemption of Federal Home Loan Bank of Pittsburgh stock 482 1,870 869
Net increase in loans (74,824) (72,819) (51,984)
Purchase of low-income housing partnerships - - (306)
Purchase of premises and equipment (3,360) (1,712) (1,935)
Proceeds from sale of foreclosed assets 340 648 660
--------- --------- ---------
Net Cash Used in Investing Activities (46,533) (139,762) (136,781)
--------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits 17,761 64,030 47,307
Net decrease in short-term borrowings (5,872) (14,429) (36,627)
Proceeds from long-term borrowings 64,500 117,653 125,000
Repayments of long-term borrowings (37,524) (35,023) (21)
Purchase of treasury stock (174) (239) (521)
Sale of treasury stock 197 76 -
Dividends paid (6,674) (6,038) (5,441)
--------- --------- ---------
Net Cash Provided by Financing Activities 32,214 126,030 129,697
--------- --------- ---------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 271 (1,136) 2,212
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 14,900 16,036 13,824
--------- --------- ---------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 15,171 $ 14,900 $ 16,036
========= ========= =========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Assets acquired through foreclosure of real estate loans $ 280 $ 486 $ 435
Interest paid $ 23,736 $ 26,424 $ 28,665
Income taxes paid $ 3,195 $ 4,509 $ 2,961
The accompanying notes are an integral part of the consolidated financial
statements.
31
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF CONSOLIDATION - The consolidated financial statements include the
accounts of Citizens & Northern Corporation ("Corporation"), and its
subsidiaries, Citizens & Northern Bank ("Bank"), Bucktail Life Insurance Company
and Citizens & Northern Investment Corporation. The consolidated financial
statements also include the accounts of the Bank's wholly-owned subsidiary, C&N
Financial Services Corporation. All material intercompany balances and
transactions have been eliminated in consolidation.
NATURE OF OPERATIONS - The Corporation is primarily engaged in providing a full
range of banking and mortgage services to individual and corporate customers in
Northcentral Pennsylvania. Lending products include mortgage loans, commercial
loans, consumer loans and credit cards, as well as specialized instruments such
as commercial letters-of-credit. Deposit products include various types of
checking accounts, passbook and statement savings, money market accounts,
interest checking accounts, individual retirement accounts and certificates of
deposit. The Corporation also offers non-insured "Repo Sweep" accounts.
The Corporation provides Trust and Financial Management services, including
administration of trusts and estates, retirement plans, and other employee
benefit plans, and investment management services. The Corporation offers a
variety of personal and commercial insurance products through C&N Financial
Services Corporation. C&N Financial Services Corporation also has a
broker-dealer division, which offers mutual funds, annuities, educational
savings accounts and other investment products through registered agents.
The Corporation is subject to competition from other financial institutions. It
is also subject to regulation by certain federal and state agencies and
undergoes periodic examination by those regulatory authorities.
USE OF ESTIMATES - The presentation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect reported amounts and disclosures. Actual results
could differ from these estimates.
A material estimate that is particularly susceptible to significant change is
the determination of the allowance for loan losses. Management believes that the
allowance for loan losses is adequate and reasonable. While management uses
available information to recognize losses on loans, changes in economic
conditions may necessitate revisions in future years. In addition, various
regulatory agencies, as an integral part of their examination process,
periodically review the Corporation's allowance for loan losses. Such agencies
may require the Corporation to recognize adjustments to the allowance based on
their judgments of information available to them at the time of their
examination.
INVESTMENT SECURITIES - Investment securities are accounted for as FOLLOWS:
HELD-TO-MATURITY SECURITIES - includes debt securities that the Corporation has
the positive intent and ability to hold to maturity. These securities are
reported at cost adjusted for amortization of premiums and accretion of
discounts, computed using the level-yield method.
AVAILABLE-FOR-SALE SECURITIES - includes debt securities not classified as
held-to-maturity and unrestricted equity securities. Such securities are
reported at fair value, with unrealized gains and losses excluded from earnings
and reported separately through accumulated other comprehensive income, net of
tax. Amortization of premiums and accretion of discounts on available-for-sale
securities are recorded using the level yield method over the remaining
contractual life of the securities, adjusted for actual prepayments. Realized
gains and losses on sales of available-for-sale securities are computed on the
basis of specific identification of the adjusted cost of each security.
RESTRICTED EQUITY SECURITIES - Restricted equity securities consist primarily of
Federal Home Loan Bank of Pittsburgh stock, and are carried at cost and
evaluated for impairment. Holdings of restricted equity securities are included
in Other Assets in the Consolidated Balance Sheet, and dividends received on
restricted securities are included in Other Income in the Consolidated Statement
of Income.
LOANS - Loans are stated at unpaid principal balances, less the allowance for
loan losses and net deferred loan fees. Loan origination and commitment fees, as
well as certain direct origination costs, are deferred and amortized as a yield
adjustment over the lives of the related loans using the interest method.
Amortization of deferred loan fees is discontinued when a loan is placed on
nonaccrual status.
32
Loans are placed on nonaccrual status when, in the opinion of management,
collection of interest is doubtful. Any unpaid interest previously accrued on
those loans is reversed from income. Interest income is not recognized on
specific impaired loans unless the likelihood of further loss is remote.
Interest payments received on such loans are applied as a reduction of the loan
principal balance. Interest income on other nonaccrual loans is recognized only
to the extent of interest payments received.
The allowance for loan losses is maintained at a level which, in management's
judgment, is adequate to absorb credit losses inherent in the loan portfolio.
The amount of the allowance is based on management's evaluation of the
collectibility of the loan portfolio, based on factors such as credit
concentrations, past due or delinquency status, trends in historical loss
experience, specific impaired loans, and economic conditions. Past due or
delinquency status of loans is computed based on the contractual terms of the
loans. Allowances for impaired loans are determined based on collateral values
or the present value of estimated cash flows. The allowance is increased by a
provision for loan losses, which is charged to expense, and reduced by
charge-offs, net of recoveries. Loan balances are charged off when it becomes
evident that such balances are not fully collectible.
BANK PREMISES AND EQUIPMENT - Bank premises and equipment are stated at cost
less accumulated depreciation. Repair and maintenance expenditures which extend
the useful lives of assets are capitalized, and other repair and maintenance
expenditures are expensed as incurred. Depreciation expense is computed using
the straight-line method.
FORECLOSED ASSETS HELD FOR SALE - Foreclosed assets held for sale consist of
real estate acquired by foreclosure and are carried at estimated fair value,
less selling cost.
INCOME TAXES - Provisions for deferred income taxes are made as a result of
temporary differences in financial and income tax methods of accounting. These
differences relate principally to loan losses, securities gains or losses,
depreciation, pension and other postretirement benefits and amortization of loan
origination fees and costs.
STOCK COMPENSATION PLANS - As permitted by Accounting Principles Board Opinion
No. 25, the Corporation uses the intrinsic value method of accounting for stock
compensation plans. Utilizing the intrinsic value method, compensation cost is
measured by the excess of the quoted market price of the stock as of the grant
date (or other measurement date) over the amount an employee or director must
pay to acquire the stock. Stock options issued under the Corporation's stock
option plans have no intrinsic value, and accordingly, no compensation cost is
recorded for them.
The Corporation has also made awards of restricted stock. Compensation cost
related to restricted stock is recognized based on the market price of the stock
at the grant date over the vesting period.
The following table illustrates the effect on net income and earnings per share
if the Corporation had applied the fair value provisions of Statement of
Financial Accounting Standards No. 123, "Accounting for Stock-based
Compensation," to stock options. The number of shares used in each computation
of earnings per share has been restated for the effects of 1% stock dividends
issued in January of each year, and for the effects of a 3-for-2 stock split
issued in April 2003.
(NET INCOME IN THOUSANDS)
2003 2002 2001
Net income, as reported $16,257 $14,959 $12,052
Deduct: Total stock option compensation
expense determined under fair value
method for all awards, net of tax effects (124) (191) (63)
------- ------- -------
Pro forma net income $16,133 $14,768 $11,989
======= ======= =======
Earnings per share-basic
As reported $ 2.01 $ 1.85 $ 1.49
Pro forma $ 1.99 $ 1.83 $ 1.48
Earnings per share-diluted
As reported $ 2.00 $ 1.84 $ 1.49
Pro forma $ 1.98 $ 1.82 $ 1.48
33
PENSIONS AND OTHER POSTRETIREMENT BENEFIT PLANS - Effective December 31, 2003,
the Corporation adopted Statement of Financial Accounting Standards No. 132
(revised 2003), "Employers' Disclosures about Pensions and Other Postretirement
Benefits" ("Revised SFAS No. 132"). Revised SFAS No. 132 requires additional
disclosures about defined benefit plans and other postretirement plans. It does
not change the measurement or recognition of those plans. Applicable prior year
disclosures have been restated to conform to Revised SFAS No. 132 requirements.
OFF-BALANCE SHEET FINANCIAL INSTRUMENTS - In the ordinary course of business,
the Corporation has entered into off-balance sheet financial instruments
consisting of commitments to extend credit and standby letters of credit. Such
financial instruments are recorded in the financial statements when they become
payable.
CASH FLOWS - The Corporation utilizes the net reporting of cash receipts and
cash payments for certain deposit and lending activities. The Corporation
considers all cash and amounts due from depository institutions,
interest-bearing deposits in other banks, and federal funds sold to be cash
equivalents.
TRUST ASSETS AND INCOME - Assets held by the Corporation in a fiduciary or
agency capacity for its customers are not included in the financial statements
since such items are not assets of the Corporation. Trust income is recorded on
a cash basis, which is not materially different from the accrual basis.
2. 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 available-for-sale
securities, are reported as a separate component 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 the
related tax effects are as follows:
YEARS ENDED DECEMBER 31,
(IN THOUSANDS) 2003 2002 2001
Unrealized holding gains on available-for-sale securities $ 4,636 $ 13,283 $ 9,802
Less: Reclassification adjustment for gains realized in income (4,799) (2,888) (1,920)
------- -------- -------
Net unrealized (losses) gains (163) 10,395 7,882
Tax effect 54 (3,533) (2,680)
------- -------- -------
Net-of-tax amount $ (109) $ 6,862 $ 5,202
======= ======== =======
3. PER SHARE DATA
Net income per share is based on the weighted-average number of shares of common
stock outstanding. The number of shares used in calculating net income and cash
dividends per share reflect the retroactive effect of a 3-for-2 stock split
issued in April 2003, as well as 1% stock dividends declared in the fourth
quarter of each year presented, payable in the first quarter of the following
year. The following data show the amounts used in computing basic and diluted
net income per share. The dilutive effect of stock options is computed as the
weighted-average common shares available from the exercise of all dilutive stock
options, less the number of shares that could be repurchased with the proceeds
of stock option exercises based on the average share price of the Corporation's
common stock during the period.
34
WEIGHTED-
AVERAGE EARNINGS
NET COMMON PER
INCOME SHARES SHARE
2003
Earnings per share - basic $ 16,257,000 8,089,753 $2.01
Dilutive effect of potential common stock
arising from stock options:
Exercise of outstanding stock options 195,624
Hypothetical share repurchase at $24.27 (146,909)
- ---------------------------------------------------------------------------------------------------
Earnings per share - diluted $ 16,257,000 8,138,468 $2.00
===================================================================================================
2002
Earnings per share - basic $ 14,959,000 8,089,266 $1.85
Dilutive effect of potential common stock
arising from stock options:
Exercise of outstanding stock options 139,374
Hypothetical share repurchase at $19.45 (117,486)
- ---------------------------------------------------------------------------------------------------
Earnings per share - diluted $ 14,959,000 8,111,154 $1.84
===================================================================================================
2001
Earnings per share - basic $ 12,052,000 8,103,679 $1.49
Dilutive effect of potential common stock
arising from stock options:
Exercise of outstanding stock options 35,733
Hypothetical share repurchase at $14.43 (33,477)
- ---------------------------------------------------------------------------------------------------
Earnings per share - diluted $ 12,052,000 8,105,935 $1.49
===================================================================================================
4. CASH AND DUE FROM BANKS
Banks are required to maintain reserves consisting of vault cash and deposit
balances with the Federal Reserve Bank in their district. The reserves are based
on deposit levels during the year and account activity and other services
provided by the Federal Reserve Bank. Average daily currency, coin, and cash
balances with the Federal Reserve Bank needed to cover reserves against deposits
for 2003 ranged from $2,402,000 to $4,434,000. For 2002, theses balances ranged
from $2,161,000 to $6,458,000. Average daily cash balances with the Federal
Reserve Bank required for services provided to the Bank were $2,500,000 in 2003
and 2002. Total balances restricted amounted to $6,324,000 at December 31, 2003
and $6,332,000 at December 31, 2002.
Deposits with one financial institution are insured up to $100,000. The
Corporation maintains cash and cash equivalents with certain financial
institutions in excess of the insured amount.
35
5. SECURITIES
Amortized cost and fair value of securities at December 31, 2003 and 2002 are
summarized as follows:
DECEMBER 31, 2003
GROSS GROSS
UNREALIZED UNREALIZED
AMORTIZED HOLDING HOLDING FAIR
(IN THOUSANDS) COST GAINS LOSSES VALUE
AVAILABLE-FOR-SALE SECURITIES:
Obligations of the U.S. Treasury $ - $ - $ - $ -
Obligations of other U.S. Government agencies 61,437 562 (929) 61,070
Obligations of states and political subdivisions 159,128 4,791 (1,501) 162,418
Other securities 45,992 1,764 (108) 47,648
Mortgage-backed securities 168,285 1,933 (1,010) 169,208
- ----------------------------------------------------------------------------------------------------------------------------
Total debt securities 434,842 9,050 (3,548) 440,344
Marketable equity securities 29,951 13,609 (872) 42,688
- ----------------------------------------------------------------------------------------------------------------------------
Total $ 464,793 $ 22,659 $(4,420) $ 483,032
============================================================================================================================
HELD-TO-MATURITY SECURITIES:
Obligations of the U.S. Treasury $ 319 $ 30 $ - $ 349
Obligations of other U.S. Government agencies 199 17 - 216
Mortgage-backed securities 42 2 - 44
- ----------------------------------------------------------------------------------------------------------------------------
Total $ 560 $ 49 $ - $ 609
============================================================================================================================
DECEMBER 31, 2002
GROSS GROSS
UNREALIZED UNREALIZED
AMORTIZED HOLDING HOLDING FAIR
(IN THOUSANDS) COST GAINS LOSSES VALUE
AVAILABLE-FOR-SALE SECURITIES:
Obligations of the U.S. Treasury $ - $ - $ - $ -
Obligations of other U.S. Government agencies 71,657 1,624 (933) 72,348
Obligations of states and political subdivisions 127,690 3,482 (293) 130,879
Other securities 62,296 1,398 (102) 63,592
Mortgage-backed securities 207,244 5,188 (156) 212,276
- ------------------------------------------------------------------------------------------------------------------------
Total debt securities 468,887 11,692 (1,484) 479,095
Marketable equity securities 24,886 8,959 (765) 33,080
- ------------------------------------------------------------------------------------------------------------------------
Total $ 493,773 $ 20,651 $(2,249) $ 512,175
========================================================================================================================
HELD-TO-MATURITY SECURITIES:
Obligations of the U.S. Treasury $ 321 $ 38 $ - $ 359
Obligations of other U.S. Government agencies 297 25 - 322
Mortgage-backed securities 89 4 - 93
- ------------------------------------------------------------------------------------------------------------------------
Total $ 707 $ 67 $ - $ 774
========================================================================================================================
36
The following table presents gross unrealized losses and fair value of
investments aggregated by investment category and length of time that individual
securities have been in a continuous unrealized loss position at December 31,
2003:
LESS THAN 12 MONTHS 12 MONTHS OR MORE TOTAL
FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED
(IN THOUSANDS) VALUE LOSSES VALUE LOSSES VALUE LOSSES
AVAILABLE-FOR-SALE SECURITIES:
Obligations of the U.S. Treasury $ - $ - $ - $ - $ - $ -
Obligations of other U.S. Government agencies 17,059 (929) - - 17,059 (929)
Obligations of states and political subdivisions 41,764 (1,478) 2,451 (23) 44,215 (1,501)
Other securities 3,190 (33) 5,025 (75) 8,215 (108)
Mortgage-backed securities 89,256 (1,010) - - 89,256 (1,010)
- --------------------------------------------------------------------------------------------------------------------------------
Total debt securities 151,269 (3,450) 7,476 (98) 158,745 (3,548)
Marketable equity securities 4,979 (751) 1,208 (121) 6,187 (872)
- --------------------------------------------------------------------------------------------------------------------------------
Total temporarily impaired available-for-sale
securities $156,248 $ (4,201) $ 8,684 $ (219) $ 164,932 $ (4,420)
================================================================================================================================
HELD-TO-MATURITY SECURITIES:
Obligations of the U.S. Treasury $ - $ - $ - $ - $ - $ -
Obligations of other U.S. Government agencies - - - - - -
Mortgage-backed securities - - - - - -
- --------------------------------------------------------------------------------------------------------------------------------
Total temporarily impaired held-to-maturity
securities $ - $ - $ - $ - $ - $ -
================================================================================================================================
The unrealized losses on debt securities are primarily the result of volatility
in interest rates. Based on the credit worthiness of the issuers, which are
almost exclusively U.S. Government agencies or state and political subdivisions,
management believes the Corporation's debt securities at December 31, 2003 were
not other-than-temporarily impaired.
Of the total $872,000 unrealized losses on equity securities at December 31,
2003, $655,000 was from a preferred stock issued by an U.S. Government agency.
Management believes this security's fair value is affected primarily by
volatility in interest rates, and that there is very little credit risk
associated with this security. For the remaining equity securities for which
fair value was less than cost at December 31, 2003, management believes the
financial condition and near-term prospects of those issuers indicate those
securities were not other-than-temporarily impaired.
The amortized cost and fair value of investment debt securities at December 31,
2003 follow. Maturities of debt securities (including mortgage-backed
securities) are presented based on contractual maturities. Expected maturities
differ from contractual maturities because monthly principal payments are
received from mortgage-backed securities, and because borrowers may have the
right to prepay obligations with or without prepayment penalties.
37
DECEMBER 31, 2003
AMORTIZED FAIR
(IN THOUSANDS) COST VALUE
AVAILABLE-FOR-SALE SECURITIES:
Due in one year or less $ 1,166 $ 1,169
Due after one year through five years 4,389 4,635
Due after five years through ten years 69,051 69,088
Due after ten years 360,236 365,452
--------- ---------
Total $ 434,842 $ 440,344
========= =========
HELD-TO-MATURITY SECURITIES:
Due in one year or less $ - $ -
Due after one year through five years - -
Due after five years through ten years 547 596
Due after ten years 13 13
--------- ---------
Total $ 560 $ 609
========= =========
The following table shows the amortized cost and maturity distribution of the
debt securities portfolio at December 31, 2003:
WITHIN ONE - FIVE - AFTER
ONE FIVE TEN TEN
(IN THOUSANDS, EXCEPT FOR PERCENTAGES) YEAR YIELD YEARS YIELD YEARS YIELD YEARS YIELD TOTAL YIELD
AVAILABLE-FOR-SALE SECURITIES:
Obligations of the U.S. Treasury $ - - $ - - $ - - $ - - $ - -
Obligations of other U.S. Government
agencies - - 2,500 4.25% 35,139 4.52% 23,798 5.00% 61,437 4.69%
Obligations of states and political
subdivisions 166 7.09% 1,866 6.57% 3,153 5.82% 153,943 4.80% 159,128 4.84%
Other securities 1,000 9.25% - - 11,000 5.15% 33,992 6.42% 45,992 6.18%
Mortgage-backed securities 23 8.11% 19,759 4.24% 148,503 4.59% 168,285 4.55%
------- ----- ------- ----- -------- ----- --------- ----- --------- -----
Total $ 1,166 8.94% $ 4,389 5.26% $ 69,051 4.60% $ 360,236 4.88% $ 434,842 4.85%
======= ===== ======= ===== ======== ===== ========= ===== ========= =====
HELD-TO-MATURITY SECURITIES:
Obligations of the U.S. Treasury $ - - $ - - $ 319 5.30% $ - - $ 319 5.30%
Obligations of other U.S. Government
agencies - - - 199 6.76% - - 199 6.76%
Mortgage-backed securities - - - 29 6.18% 13 3.33% 42 5.30%
------- ----- ------- ----- -------- ----- --------- ----- --------- -----
Total $ - - $ - - $ 547 5.88% $ 13 3.33% $ 560 5.82%
======= ===== ======= ===== ======== ===== ========= ===== ========= =====
Investment securities carried at $80,308,000 at December 31, 2003 and
$90,655,000 at December 31, 2002, were pledged as collateral for public
deposits, trusts and certain other deposits as provided by law. Also, see Note 9
for information concerning securities pledged to secure borrowing arrangements.
Gross realized gains and losses from the sales of available-for-sale securities,
and the income tax provision related to net realized gains, for 2003, 2002 and
2001 were as follows:
(IN THOUSANDS) 2003 2002 2001
Gross realized gains $ 4,860 $ 2,926 $ 2,408
Gross realized losses (61) (38) (488)
--------- --------- ---------
Net realized gains $ 4,799 $ 2,888 $ 1,920
========= ========= =========
Income tax provision related to net realized gains $ 1,632 $ 982 $ 653
========= ========= =========
38
6. LOANS
Major categories of loans and leases included in the loan portfolio are as
follows:
(IN THOUSANDS) DECEMBER 31, % OF DECEMBER 31, % OF
2003 TOTAL 2002 TOTAL
Real estate - construction $ 2,856 0.54% $ 103 0.02%
Real estate - mortgage 431,047 82.13% 370,453 82.11%
Consumer 33,977 6.47% 31,532 6.99%
Agricultural 2,948 0.56% 3,024 0.67%
Commercial 34,967 6.66% 30,874 6.84%
Other 1,183 0.23% 2,001 0.44%
Political subdivisions 17,854 3.40% 13,062 2.90%
Lease receivables 65 0.01% 96 0.02%
------------ ------ ------------ ------
Total 524,897 100.00% 451,145 100.00%
Less: allowance for loan losses (6,097) (5,789)
------------ ------------
Loans, net $ 518,800 $ 445,356
============ ============
Net unamortized loan fees and costs of $1,629,000 at December 31, 2003 and
$1,564,000 at December 31, 2002 have been offset against the carrying value of
loans.
There is no concentration of loans to borrowers engaged in similar businesses or
activities that exceed 10% of total loans at December 31, 2003.
The Corporation grants commercial, residential and personal loans to customers
primarily in Tioga, Bradford, Sullivan and Lycoming Counties. Although the
Corporation has a diversified loan portfolio, a significant portion of its
debtors' ability to honor their contracts is dependent on the local economic
conditions within the region.
LOAN MATURITY DISTRIBUTION
(IN THOUSANDS)
FIXED RATE LOANS: VARIABLE OR ADJUSTABLE
RATE LOANS:
1 YEAR OR 1 YEAR OR
LESS 1-5 YEARS > 5 YEARS TOTAL LESS 1-5 YEARS > 5 YEARS TOTAL
Real estate - construction $ 2,856 $ - $ - $ 2,856 $ - $ - $ - $ -
Real estate - mortgage 56,314 127,437 109,572 293,323 25,507 20,049 92,168 137,724
Consumer 8,430 13,173 2,346 23,949 9,443 274 311 10,028
Agricultural 615 1,087 62 1,764 404 572 208 1,184
Commercial 3,846 6,668 2,129 12,643 14,008 4,033 4,283 22,324
Other 328 341 416 1,085 98 - - 98
Political subdivisions 1,619 5,088 11,147 17,854 - - - -
Lease receivables 16 49 - 65 - - - -
--------- --------- --------- -------- --------- --------- --------- --------
Total $ 74,024 $ 153,843 $ 125,672 $353,539 $ 49,460 $ 24,928 $ 96,970 $171,358
========= ========= ========= ======== ========= ========= ========= ========
Loans in the preceding table that are due on demand are shown as one year or
less.
39
Transactions in the allowance for loan losses were as follows:
(IN THOUSANDS)
2003 2002 2001
Balance at beginning of year $ 5,789 $ 5,265 $ 5,291
Provision charged to operations 1,100 940 600
Loans charged off (968) (552) (713)
Recoveries 176 136 87
------- ------- -------
Balance at end of year $ 6,097 $ 5,789 $ 5,265
======= ======= =======
Information related to impaired and nonaccrual loans, and loans past due 90 days
or more, as of December 31, 2003 and 2002 is as follows:
(IN THOUSANDS)
2003 2002
Impaired loans without a valuation allowance $ 114 $ 675
Impaired loans with a valuation allowance 4,507 3,039
------- -------
Total impaired loans $ 4,621 $ 3,714
======= =======
Valuation allowance related to impaired loans $ 1,542 $ 1,877
Total nonaccrual loans $ 1,145 $ 1,252
Total loans past due 90 days or more and
still accruing $ 2,546 $ 2,318
The following is a summary of information related to impaired loans for 2003,
2002 and 2001:
(IN THOUSANDS)
2003 2002 2001
Average investment in impaired loans $3,425 $3,838 $781
====== ====== ====
Interest income recognized on impaired loans $ 313 $ 247 $ 14
====== ====== ====
Interest income recognized on a cash basis
on impaired loans $ 313 $ 247 $ 14
====== ====== ====
No additional funds are committed to be advanced in connection with impaired
loans.
7. BANK PREMISES AND EQUIPMENT
Bank premises and equipment are summarized as follows:
(IN THOUSANDS)
DECEMBER 31,
2003 2002
Land $ 1,275 $ 1,275
Buildings and improvements 13,125 12,295
Furniture and equipment 9,663 9,022
Construction in progress 1,807 -
-------- --------
Total 25,870 22,592
Less: accumulated depreciation (13,388) (12,259)
-------- --------
Net $ 12,482 $ 10,333
======== ========
Depreciation expense included in occupancy expense and furniture and equipment
expense was as follows:
40
(IN THOUSANDS)
2003 2002 2001
Occupancy expense $ 479 $ 432 $ 401
Furniture and equipment expense 732 914 899
------- ------- -------
Total $ 1,211 $ 1,346 $ 1,300
======= ======= =======
8. DEPOSITS
Balances and maturities of time deposits are as follows:
(IN THOUSANDS)
DECEMBER 31, 2003
2004 2005 2006 2007 2008 THEREAFTER TOTAL
Certificates of Deposit $103,044 $ 26,914 $ 17,094 $ 21,678 $ 13,137 $ 162 $ 182,029
Yield 2.07% 3.27% 4.05% 4.65% 3.64% 3.73% 2.86%
Individual Retirement Accounts 74,881 38,657 - 199 57 - 113,794
Yield 4.82% 4.82% - 4.59% 4.18% - 4.82%
-------- --------- -------- --------- -------- ---------- -----------
Total Time Deposits $177,925 $ 65,571 $ 17,094 $ 21,877 $ 13,194 $ 162 $ 295,823
-------- --------- -------- --------- -------- ---------- -----------
Yield 3.23% 4.18% 4.05% 4.65% 3.64% 3.73% 3.61%
======== ========= ======== ========= ======== ========== ===========
DECEMBER 31, 2002
2003 2004 2005 2006 2007 THEREAFTER TOTAL
Certificates of Deposit $127,796 $ 20,369 $ 14,648 $ 10,878 $ 19,743 $ 251 $ 193,685
Yield 3.18% 3.75% 4.38% 4.84% 4.83% 4.47% 3.59%
Individual Retirement Accounts 76,875 22,690 - - 169 - 99,734
Yield 5.00% 5.00% - - 4.62% - 5.00%
-------- --------- -------- --------- -------- ---------- -----------
Total Time Deposits $204,671 $ 43,059 $ 14,648 $ 10,878 $ 19,912 $ 251 $ 293,419
-------- --------- -------- --------- -------- ---------- -----------
Yield 3.86% 4.41% 4.38% 4.84% 4.83% 4.47% 4.07%
======== ========= ======== ========= ======== ========== ===========
Included in interest-bearing deposits are time deposits in the amount of
$100,000 or more. As of December 31, 2003, the remaining maturities or repricing
frequency of time deposits of $100,000 or more are as follows:
(IN THOUSANDS)
Three months or less $37,136
Over 3 months through 12 months 16,276
Over 1 year through 3 years 5,468
Over 3 years 10,356
------
Total $69,236
=======
Interest expense from deposits of $100,000 or more amounted to $2,693,000 in
2003, $3,238,000 in 2002 and $3,220,000 in 2001.
41
9. BORROWED FUNDS
SHORT-TERM BORROWINGS
Short-term borrowings include the following:
(IN THOUSANDS)
AT DECEMBER 31,
2003 2002
Overnight borrowings (a) $ 6,900 $ 14,350
Federal Home Loan Bank of Pittsburgh borrowings (b) 7,500 2,500
Customer repurchase agreements (c) 23,363 20,218
Other repurchase agreements (d) - 6,567
-------- --------
Total short-term borrowings $ 37,763 $ 43,635
======== ========
The weighted average interest rate on total short-term borrowings outstanding
was 1.21% at December 31, 2003 and 1.77% at December 31, 2002. The maximum
amount of total short-term borrowings outstanding at any month-end was
$45,166,000 in 2003 and $43,635,000 in 2002.
(a) Overnight borrowings include federal funds purchased overnight from
correspondent banks and overnight borrowings from the Federal Home Loan Bank of
Pittsburgh (FHLB-Pittsburgh) on the "Open Repo Plus" facility. The maximum
month-end amount of such borrowings was $16,950,000 in 2003, $14,350,000 in 2002
and $20,000,000 in 2001. The average amount of such borrowings was $6,044,000 in
2003, $2,347,000 in 2002 and $4,012,000 in 2001. Weighted average interest rates
were 1.50% in 2003, 1.86% in 2002 and 4.58% in 2001.
(b) Short-term FHLB - Pittsburgh loans are as follows:
(IN THOUSANDS)
AT DECEMBER 31,
2003 2002
Fixed Rate 1.51% matured February 19, 2003 $ - $ 1,000
Fixed Rate 1.68% matured November 19, 2003 - 1,500
Fixed Rate 1.33% maturing April 28, 2004 2,000 -
Fixed Rate 1.28% maturing May 13, 2004 2,500 -
Fixed Rate 1.25% maturing June 29, 2004 1,500 -
Fixed Rate 1.26% maturing July 28, 2004 1,500 -
-------- --------
Total short-term FHLB - Pittsburgh borrowings $ 7,500 $ 2,500
======== ========
Collateral for FHLB - Pittsburgh loans is described under the "Long-term
Borrowings" section of this note.
(c) Customer repurchase agreements mature overnight, and are collateralized by
securities with a carrying value of $35,680,000 at December 31, 2003 and
$23,305,000 at December 31, 2002.
(d) Other repurchase agreements included in short-term borrowings are as
follows:
(IN THOUSANDS)
AT DECEMBER 31,
2003 2002
Fixed Rate 2.91% matured March 25, 2003 $ - $ 6,567
------ --------
Total other repurchase agreements $ - $ 6,567
====== ========
The terms and collateral related to repurchase agreements are described under
the "Long-term Borrowings" section of this note.
42
LONG-TERM BORROWINGS
Long-term borrowings are as follows:
(IN THOUSANDS)
AT DECEMBER 31,
2003 2002
FHLB - Pittsburgh borrowings (e) $ 185,037 $ 170,061
Repurchase agreements (f) 50,153 38,153
--------- ---------
Total long-term borrowings $ 235,190 $ 208,214
========= =========
(e) Long-term borrowings from FHLB - Pittsburgh are as follows:
(IN THOUSANDS)
AT DECEMBER 31,
2003 2002
Loans matured in 2003 with rates ranging from 4.63% to 4.82% $ - $ 30,000
Loans maturing in 2004 with rates ranging from 2.16% to 4.65% 28,000 28,000
Loans maturing in 2005 with rates ranging from 1.64% to 5.05% 40,000 29,500
Loans maturing in 2006 with rates ranging from 2.07% to 4.83% 45,000 32,000
Loans maturing in 2007 with rates ranging from 2.93% to 4.58% 45,000 35,000
Loans maturing in 2008 with rates ranging from 2.97% to 3.67% 9,500 -
Loan maturing in 2009 with a rate of 3.62% 2,000 -
Loan maturing in 2011 with a rate of 4.98% 5,000 5,000
Loan maturing in 2012 with a rate of 4.54% 10,000 10,000
Loan maturing in 2016 with a rate of 6.86% 476 498
Loan maturing in 2017 with a rate of 6.83% 61 63
--------- ---------
Total long-term FHLB - Pittsburgh borrowings $ 185,037 $ 170,061
========= =========
The FHLB - Pittsburgh loan facilities are collateralized by qualifying
securities and mortgage loans with a book value totaling $398,584,000 at
December 31, 2003. Also, the FHLB - Pittsburgh loan facilities require the
Corporation to invest in established amounts of FHLB - Pittsburgh stock. The
carrying values of the Corporation's holdings of FHLB - Pittsburgh stock were
$11,575,000 at December 31, 2003 and $10,202,000 at December 31, 2002.
(f) Repurchase agreements included in long-term borrowings are as follows:
(IN THOUSANDS)
AT DECEMBER 31,
2003 2002
Agreement matured in 2003 with a rate of 2.53% $ - $ 7,500
Agreements maturing in 2004 with rates ranging from 1.62% to 3.96% 19,767 14,067
Agreements maturing in 2005 with rates ranging from 2.01% to 4.63% 15,666 11,766
Agreements maturing in 2006 with rates ranging from 2.79% to 4.63% 10,220 4,820
Agreement maturing in 2007 with a rate of 3.23% 2,500 -
Agreement maturing in 2008 with a rate of 3.60% 2,000 -
-------- --------
Total long-term repurchase agreements $ 50,153 $ 38,153
======== ========
Securities sold under repurchase agreements were delivered to the broker-dealers
who arranged the transactions. The broker-dealers may have sold, loaned or
otherwise disposed of such securities to other parties in the normal course of
their operations, and have agreed to resell to the Corporation substantially
identical securities at the maturities of the agreements. The carrying value of
the underlying securities was $58,086,000 at December 31, 2003 and $54,763,000
at December 31, 2002. Average daily repurchase agreement borrowings amounted to
$40,333,000 in 2003, $36,482,000 in 2002 and $14,217,000 in 2001. During 2003,
2002 and 2001, the maximum amounts of outstanding borrowings under repurchase
agreements with broker-dealers were $50,153,000, $44,720,000 and $19,450,000.
The weighted average interest rate on repurchase agreements was 3.68% in 2003,
3.72% in 2002 and 6.20% in 2001.
43
10. DERIVATIVE FINANCIAL INSTRUMENTS
The Corporation utilizes derivative financial instruments related to a
certificate of deposit product called the "Index Powered Certificate of Deposit"
(IPCD). IPCDs have a term of 5 years, with interest paid at maturity based on
90% of the appreciation (as defined) in the S&P 500 index. There is no
guaranteed interest payable to a depositor of an IPCD - however, assuming an
IPCD is held to maturity, a depositor is guaranteed the return of his or her
principal, at a minimum.
Statement of Financial Accounting Standards No. 133 requires the Corporation to
separate the amount received from each IPCD issued into 2 components: (1) an
embedded derivative, and (2) the principal amount of each deposit. Embedded
derivatives are derived from the Corporation's obligation to pay each IPCD
depositor a return based on appreciation in the S&P 500 index. Embedded
derivatives are carried at fair value, and are included in other liabilities in
the consolidated balance sheet. Changes in fair value of the embedded derivative
are included in other expense in the consolidated income statement. The
difference between the contractual amount of each IPCD issued, and the amount of
the embedded derivative, is recorded as the initial deposit (included in
interest-bearing deposits in the consolidated balance sheet). Interest expense
is added to principal ratably over the term of each IPCD at an effective
interest rate that will increase the principal balance to equal the contractual
IPCD amount at maturity.
In connection with IPCD transactions, the Corporation has entered into Equity
Indexed Call Option (Swap) contracts with FHLB-Pittsburgh. Under the terms of
the Swap contracts, the Corporation must pay FHLB-Pittsburgh quarterly amounts
calculated based on the contractual amount of IPCDs issued times a negotiated
rate. In return, FHLB-Pittsburgh is obligated to pay the Corporation, at the
time of maturity of the IPCDs, an amount equal to 90% of the appreciation (as
defined) in the S&P 500 index. If the S&P 500 index does not appreciate over the
term of the related IPCDs, the FHLB-Pittsburgh would make no payment to the
Corporation. The effect of the Swap contracts is to limit the Corporation's cost
of IPCD funds to the market rate of interest paid to FHLB-Pittsburgh. (In
addition, the Corporation pays a fee of 0.75% to a consulting firm at inception
of each deposit. This fee is amortized to interest expense over the term of the
IPCDs.) Swap liabilities are carried at fair value, and included in other
liabilities in the consolidated balance sheet. Changes in fair value of swap
liabilities are included in other expense in the consolidated income statement.
Amounts recorded related to IPCDs are as follows (in thousands):
AT DECEMBER 31,
2003 2002
Contractual amount of IPCDs (equal
to notional amount of Swap contracts) $ 3,593 $ 3,028
Carrying value of IPCDs 3,160 2,572
Carrying value of embedded derivative liabilities 298 156
Carrying value of Swap contract liabilities 130 309
FOR THE YEARS ENDED DECEMBER 31,
2003 2002 2001
Interest expense $ 112 $ 88 $ 17
Other expense 10 8 7
11. FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair value of a financial instrument is the current amount that would be
exchanged between willing parties, other than in a forced liquidation. Fair
value is best determined based upon quoted market prices. However, in many
instances, there are no quoted market prices for the Corporation's financial
instruments. In cases where quoted market prices are not available, fair values
are based on estimates using present value or other valuation techniques. Those
techniques are significantly affected by the assumptions used, including the
discount rate and estimates of future cash flows. Accordingly, the fair value
estimates may not be realized in an immediate settlement of the instrument. SFAS
No. 107 excludes certain financial instruments and all nonfinancial instruments
from its disclosure requirements. Therefore, the aggregate fair value amounts
presented may not represent the underlying fair value of the Corporation.
The Corporation used the following methods and assumptions in estimating fair
value disclosures for financial instruments:
CASH AND CASH EQUIVALENTS - The carrying amounts of cash and short-term
instruments approximate fair values.
44
SECURITIES - Fair values for securities, excluding restricted equity securities,
are based on quoted market prices. The carrying value of restricted equity
securities approximates fair value based on applicable redemption provisions.
LOANS - Fair values are estimated for portfolios of loans with similar financial
characteristics. Loans are segregated by type such as commercial, commercial
real estate, residential mortgage, credit card and other consumer. Each loan
category is further segmented into fixed and adjustable rate interest terms and
by performing and nonperforming categories. The fair value of performing loans,
except residential mortgage and credit card loans, 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
loans. The estimate of maturity is based on the Corporation's historical
experience with repayments for each loan classification, modified, as required,
by an estimate of the effect of current economic and lending conditions. For
performing residential mortgage loans, fair value is estimated by discounting
contractual cash flows adjusted for prepayment estimates based on historical
experience. For credit card loans, cash flows and maturities are estimated based
on contractual interest rates and historical experience. Fair value of
nonperforming loans is based on recent appraisals or estimates prepared by the
Corporation's lending officers.
DEPOSITS - The fair value of deposits with no stated maturity, such as
noninterest-bearing demand deposits, savings, money market and interest checking
accounts, is (by definition) equal to the amount payable on demand at December
31, 2003 and 2002. The fair value of all other deposit categories 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 fair value estimates of deposits do not include the benefit that results
from the low-cost funding provided by the deposit liabilities compared to the
cost of borrowing funds in the market, commonly referred to as the core deposit
intangible.
BORROWED FUNDS - The fair value of borrowings is estimated using discounted cash
flow analyses based on rates currently available to the Corporation for similar
types of borrowing arrangements.
ACCRUED INTEREST - The carrying amounts of accrued interest receivable and
payable approximate fair values.
EMBEDDED DERIVATIVE LIABILITIES - IPCDs - The fair values of embedded
derivatives are calculated by a third party. Factors that affect the fair value
of embedded derivatives include term to maturity, market interest rates and
other market factors that affect the present value of the Corporation's
obligation to pay each IPCD depositor a return based on appreciation in the S&P
500 index.
EMBEDDED DERIVATIVE LIABILITIES - EQUITY OPTION SWAP CONTRACTS - The fair values
of equity option Swap contracts are calculated by a third party. Factors that
affect the fair value of equity option Swap contracts include: (1) the
negotiated rate associated with the Corporation's obligation to make quarterly
payments to the FHLB-Pittsburgh over the term of each IPCD; and (2) term to
maturity, market interest rates and other market factors that affect the present
value of the FHLB-Pittsburgh's obligation to pay the Corporation a return based
on appreciation in the S&P 500 index.
The estimated fair values, and related carrying amounts, of the Corporation's
financial instruments are as follows:
(IN THOUSANDS)
DECEMBER 31, 2003 DECEMBER 31, 2002
CARRYING FAIR CARRYING FAIR
AMOUNT VALUE AMOUNT VALUE
FINANCIAL ASSETS:
Cash and cash equivalents $ 15,171 $ 15,171 $ 14,900 $ 14,900
Available-for-sale securities 483,032 483,032 512,175 512,175
Held-to-maturity securities 560 609 707 774
Restricted equity securities 11,575 11,575 10,202 10,202
Loans, net 518,800 524,407 445,356 447,382
Accrued interest receivable 5,632 5,632 5,960 5,960
FINANCIAL LIABILITIES:
Deposits 658,065 661,141 640,304 643,305
Short-term borrowings 37,763 37,762 43,635 43,662
Long-term borrowings 235,190 240,527 208,214 215,875
Accrued interest payable 1,105 1,105 1,307 1,307
Embedded derivative liabilities -
IPCDs 298 298 156 156
Equity option Swap contracts -
IPCDs 130 130 309 309
45
12. EMPLOYEE AND POSTRETIREMENT BENEFIT PLANS
DEFINED BENEFIT PLANS
The Corporation has a noncontributory defined benefit pension plan for all
employees meeting certain age and length of service requirements. Benefits are
based primarily on years of service and the average annual compensation during
the highest five consecutive years within the final ten years of employment.
Also, the Corporation sponsors a defined benefit health care plan that provides
postretirement medical benefits and life insurance to employees who meet certain
age and length of service requirements. This plan contains a cost-sharing
feature, which causes participants to pay for all future increases in costs
related to benefit coverage. Accordingly, actuarial assumptions related to
health care cost trend rates do not affect the liability balance at December 31,
2003 and 2002, and will not affect the Corporation's future expenses.
The Corporation uses a December 31 measurement date for its plans.
The following tables show the funded status and amounts recognized in the
consolidated balance sheet from these defined benefit plans:
(IN THOUSANDS)
PENSION POSTRETIREMENT
BENEFITS BENEFITS
2003 2002 2003 2002
CHANGE IN BENEFIT
OBLIGATION:
Benefit obligation at beginning of year $ 8,769 $ 7,679 $ 886 $ 888
Service cost 394 349 32 24
Interest cost 590 553 60 57
Plan participants' contributions - - 147 115
Actuarial loss (gain) 755 617 105 (25)
Benefits paid (422) (429) (201) (173)
-------- -------- ------- ------
Benefit obligation at end of year $ 10,086 $ 8,769 $ 1,029 $ 886
======== ======== ======= ======
2003 2002 2003 2002
CHANGE IN PLAN ASSETS:
Fair value of plan assets at
beginning of year $ 7,668 $ 8,423 $ - $ -
Actual return on plan assets 1,013 (326) - -
Employer contribution 395 - 54 58
Plan participants' contributions - - 147 115
Benefits paid (422) (429) (201) (173)
-------- -------- ------- ------
Fair value of plan assets at end of year $ 8,654 $ 7,668 $ - $ -
======== ======== ======= ======
Funded status $ (1,432) $ (1,101) $(1,029) $ (886)
Unrecognized net actuarial loss (gain) 1,997 1,726 61 (43)
Unrecognized transition (asset) obligation (160) (182) 328 365
-------- -------- ------- ------
Prepaid (accrued) benefit cost $ 405 $ 443 $ (640) $ (564)
======== ======== ======= ======
The accumulated benefit obligation for the defined benefit pension plan was
$7,595,000 at December 31, 2003 and $6,695,000 at December 31, 2002.
46
The components of net periodic benefit costs from these defined benefit plans
are as follows:
(IN THOUSANDS)
PENSION BENEFITS POSTRETIREMENT BENEFITS
2003 2002 2001 2003 2002 2001
Service cost $ 394 $ 349 $ 271 $ 32 $ 24 $ 19
Interest cost 590 553 497 60 57 58
Expected return on plan assets (615) (702) (787) - - -
Amortization of transition (asset) obligation (22) (23) (23) 37 36 37
Recognized net actuarial loss (gain) 86 8 (30) 1 1 1
------ ------ ------ ------ ------ ------
Net periodic benefit cost (benefit) $ 433 $ 185 $ (72) $ 130 $ 118 $ 115
====== ====== ====== ====== ====== ======
The weighted-average assumptions used to determine benefit obligations as of
December 31, 2003 and 2002 are as follows:
PENSION POSTRETIREMENT
BENEFITS BENEFITS
2003 2002 2003 2002
Discount rate 6.25% 6.75% 6.25% 6.75%
Expected return on plan assets 8.50% 8.50% N/A N/A
Rate of compensation increase 4.50% 4.75% N/A N/A
The expected return on pension plan assets is a significant assumption used in
the calculation of net periodic benefit cost. This assumption reflects the
average long-term rate of earnings expected on the funds invested or to be
invested to provide for the benefits included in the projected benefit
obligation. The selected rate considers the historical and expected future
investment trends of the present and expected future assets in the plan.
Management believes the assumed 8.50% return on plan assets, which was used for
net periodic benefit cost calculations in 2001, 2002 and 2003, is reasonable.
Management has calculated the average annual return on pension plan assets over
the period 1991-2003 to be 9.50%, with annual returns ranging from a low of
- -7.23% to a high of +19.87% over that period.
The Corporation's pension plan weighted-average asset allocations at December
31, 2003 and 2002 are as follows:
2003 2002
Cash and cash equivalents 3% 1%
Debt securities 40% 42%
Equity securities 57% 57%
---- ----
Total 100% 100%
==== ====
The Bank's Trust and Financial Management Department manages the investment of
pension plan assets. The targeted asset allocation for the pension plan is 60%
equity securities, 35% debt securities and 5% cash. This targeted asset
allocation reflects a balanced approach, considering the need for growth of plan
assets to meet future demand, as well as the need for ongoing liquidity to fund
benefit payments. Specifically, the Trust Department attempts to match the
maturities of zero-coupon bonds with the estimated amounts of benefit payments
over the ensuing 10-year period. Within the equity portion of pension plan
investments, the Trust Department employs a strategy of diversification.
Holdings include large capitalization stocks from many different industries, as
well as mid-cap and foreign mutual funds. The pension plan's assets do not
include any shares of the Corporation's common stock.
At this time, management cannot provide a reasonable estimate of the amount, if
any, of the Corporation's 2004 pension contribution. The estimated amount of
2004 postretirement contribution is $60,000.
47
In December 2003, the Medicare Prescription Drug, Improvement and Modernization
Act (the "Act") was signed into law. The Act introduces a prescription drug
benefit under Medicare (Medicare Part D) as well as a federal subsidy to
sponsors of retiree health care benefit plans that provide a benefit that is at
least "actuarially equivalent" to Medicare Part D.
As permitted by FASB Staff Position No. 106-1, the Corporation has elected to
defer accounting for the effects of the Act. Accordingly, the financial
statement amounts and disclosures related to the postretirement benefits plan do
not reflect the effects of the Act on the plan. At this time, detailed
regulations necessary to implement the Act have not been issued, including those
that would specify the manner in which actuarial equivalency would be
determined. Specific authoritative guidance on the accounting for the federal
subsidy is pending and that guidance, when issued, could require the Corporation
to change previously reported information.
PROFIT SHARING AND DEFERRED COMPENSATION PLANS
The Corporation has a profit sharing plan that incorporates the deferred salary
savings provisions of Section 401(k) of the Internal Revenue Code. The
Corporation's matching contributions to the Plan depend upon the tax deferred
contributions of employees. The Corporation's total basic and matching
contributions were $728,000 in 2003, $667,000 in 2002 and $588,000 in 2001.
Effective December 31, 2001, the Corporation amended the 401(k) Plan to convert
the "Basic Stock Fund" component of the Plan to an Employee Stock Ownership Plan
(ESOP). A portion of the Corporation's basic contributions to the Plan are made
to the ESOP, and the Plan uses these funds to purchase Corporation stock for the
accounts of Plan participants. These purchases are made on the market (not
directly from the Corporation), and employees are not permitted to purchase
Corporation stock under the Plan. The Plan includes a diversification feature
which permits Plan participants, upon reaching age 55 and 10 years of service
(as defined), to sell up to 50% of their Corporation shares back to the Plan
over a period of 6 years. As of December 31, 2003, there were no shares
allocated for repurchase by the Plan.
Dividends paid on shares held by the ESOP are charged to retained earnings. All
Corporation shares owned through the ESOP are included in the calculation of
weighted-average shares outstanding for purposes of calculating earnings per
share - basic and diluted. As of December 31, 2003, the ESOP held 301,243 shares
of Corporation stock, all of which had been allocated to Plan participants. The
Corporation's contributions to the ESOP portion of the Plan (included in total
contributions reported above) totaled $377,000 in 2003 and $343,000 in 2002.
The Corporation also has a nonqualified supplemental deferred compensation
arrangement with its key officers. Charges to expense for officers' supplemental
deferred compensation were $45,000 in 2003, $44,000 in 2002 and $38,000 in 2001.
STOCK-BASED COMPENSATION PLANS
The Corporation has a Stock Incentive Plan for a selected group of senior
officers. A total of 400,000 shares of common stock may be issued under the
Stock Incentive Plan. Awards may be made under the Stock Incentive Plan in the
form of qualified options ("Incentive Stock Options," as defined in the Internal
Revenue Code), nonqualified options, stock appreciation rights or restricted
stock. Through 1999, all awards under the Stock Incentive Plan were Incentive
Stock Options, with exercise prices equal to the market price of the stock at
the date of grant, ratable vesting over 5 years and a contractual expiration of
10 years. In 2000, 2002 and 2003, there were awards of Incentive Stock Options
and restricted stock. The Incentive Stock Options granted in 2000, 2002 and 2003
have an exercise price equal to the market value of the stock at the date of
grant, vest after 6 months and expire after 10 years. The restricted stock
awards vest ratably over 3 years.
Also, the Corporation has an Independent Directors Stock Incentive Plan. This
plan permits awards of nonqualified stock options and/or restricted stock to
non-employee directors. As adjusted for the 3-for-2 stock split in April 2003, a
total of 75,000 shares of common stock may be issued under the Independent
Directors Stock Incentive Plan. The recipients' rights to exercise stock options
under this plan expire 10 years from the date of grant. The exercise prices of
all stock options awarded under the Independent Directors Stock Incentive Plan
are equal to market value as of the dates of grant. The restricted stock awards
vest ratably over 3 years.
Effective January 2, 2004, the Corporation granted options to purchase a total
of 33,249 shares of common stock through the Stock Incentive and Independent
Directors Stock Incentive Plans. The exercise price for these options is $26.59
per share, which was the market price at the date of grant. Also, effective
January 2, 2004, the Corporation awarded a total of 3,714 shares of restricted
stock under the Stock Incentive and Independent Directors Stock Incentive Plans.
The stock options and restricted stock awards that were awarded in January 2004
are not included in the tables that follow.
48
As described in Note 1, the Corporation applies Accounting Principles Board
Opinion 25 and related interpretations in accounting for stock options.
Accordingly, no compensation expense has been recognized for the stock options.
Had compensation cost for the stock options been determined based on the fair
value at the grant dates for awards consistent with the method of SFAS No. 123,
the effect on the Corporation's net income and earnings per share would have
been adjusted to the pro forma amounts indicated in the following table.
(NET INCOME IN THOUSANDS)
2003 2002 2001
Net income
As reported $16,257 $14,959 $12,052
Pro forma $16,133 $14,768 $11,989
Earnings per share-basic
As reported $ 2.01 $ 1.85 $ 1.49
Pro forma $ 1.99 $ 1.83 $ 1.48
Earnings per share-diluted
As reported $ 2.00 $ 1.84 $ 1.49
Pro forma $ 1.98 $ 1.82 $ 1.48
For purposes of the calculations of SFAS No. 123, the fair value of each option
grant is estimated on the date of grant using the Black-Scholes option-pricing
model with the following assumptions:
2003 2002 2001
Volatility 15% 17% 17%
Expected option lives 6 Years 6 Years 6 Years
Risk-free interest rate 3.55% 5.00% 5.08%
Dividend yield 4.30% 4.16% 3.57%
A summary of the status of the Corporation's stock option plans is presented
below:
2003 2002 2001
------------------ ------------------- -------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
Outstanding, beginning of year 180,722 $ 18.11 124,842 $ 18.49 151,203 $ 18.69
Granted 46,411 $ 20.73 61,223 $ 17.00 2,964 $ 14.17
Exercised (12,066) $ 16.28 (5,343) $ 13.98 - $ -
Forfeited (2,009) $ 16.19 - $ - (29,325) $ 19.15
------- -------- -------- -------- -------- --------
Outstanding, end of year 213,058 $ 18.81 180,722 $ 18.11 124,842 $ 18.49
======= ======== ======== ======== ======== ========
Options exercisable at year-end 207,898 $ 18.82 165,824 $ 17.97 97,359 $ 17.96
Fair value of options granted $ 2.11 $ 2.45 $ 2.32
49
The following table summarizes information about stock options outstanding as of
December 31, 2003:
OUTSTANDING EXERCISABLE
AT REMAINING AT
DECEMBER 31, CONTRACTUAL DECEMBER 31,
EXERCISE PRICES 2003 LIFE IN YEARS 2003
$13.33 3,068 2 3,068
$17.00 8,600 3 8,600
$18.03-$22.17 18,668 4 18,668
$24.25-$24.33 24,150 5 24,150
$18.00-$22.08 28,680 6 23,520
$13.50-$16.67 25,247 7 25,247
$17.00 58,234 8 58,234
$20.73 46,411 9 46,411
------------ ------------- ------------
213,058 207,898
============ ============= ============
The following table summarizes restricted stock awards through December 31,
2003:
2003 2002 2001
Number of shares awarded 5,166 6,647 332
Market price of stock at date of grant $20.73 $17.00 $14.17
Compensation expense related to restricted stock was $102,000 in 2003, $80,000
in 2002 and $22,000 in 2001.
13. INCOME TAXES
The following temporary differences gave rise to the net deferred tax liability
at December 31, 2003 and 2002:
(IN THOUSANDS)
2003 2002
Deferred tax liabilities:
Depreciation $ 340 $ 275
Prepaid pension 142 155
Accretion on securities 9 6
Investments in limited partnerships 13 21
Realized gains on securities 62 -
Unrealized holding gains on securities 6,201 6,257
------- -------
Total 6,767 6,714
------- -------
Deferred tax assets:
Allowance for loan losses (2,134) (2,026)
Postretirement and sick benefits (243) (216)
Loan fees and costs (63) (76)
Supplemental executive retirement plan (182) (175)
Restricted stock compensation (32) (27)
------- -------
Total (2,654) (2,520)
------- -------
Deferred tax liability, net $ 4,113 $ 4,194
======= =======
Tax provision:
2003 2002 2001
Currently payable $ 3,634 $ 4,018 $ 3,371
Deferred (25) (284) (349)
------- ------- -------
Total provision $ 3,609 $ 3,734 $ 3,022
======= ======= =======
50
Reconciliation of tax provision:
2003 2002 2001
AMOUNT % AMOUNT % AMOUNT %
Expected provision $ 6,953 35.00% $ 6,543 35.00% $ 5,276 35.00%
Tax-exempt interest income (2,766) (13.92) (2,223) (11.89) (1,730) (11.48)
Nondeductible interest expense 242 1.22 239 1.28 226 1.50
Dividends received deduction (284) (1.43) (280) (1.50) (267) (1.77)
Increase in cash surrender value of
life insurance (250) (1.26) (299) (1.60) (317) (2.10)
Surtax exemption (185) (0.93) (176) (0.94) (151) (1.00)
Other, net (101) (0.51) (70) (0.37) (15) (0.10)
--------- ------ ------- ------ ------- ------
Effective income tax provision $ 3,609 18.17% $ 3,734 19.98% $ 3,022 20.05%
========= ====== ======= ====== ======= ======
14. RELATED PARTY TRANSACTIONS
Loans to executive officers, directors of the Corporation and its subsidiaries
and any associates of the foregoing persons are as follows:
(IN THOUSANDS)
BEGINNING NEW OTHER ENDING
BALANCE LOANS REPAYMENTS CHANGES BALANCE
13 directors, 5 executive officers 2003 $ 6,623 $ 612 (956) $ 914 $ 7,193
14 directors, 6 executive officers 2002 6,535 2,464 (2,722) 346 6,623
14 directors, 6 executive officers 2001 5,730 658 (1,833) 1,980 6,535
The above transactions were made in the ordinary course of business on
substantially the same terms, including interest rates and collateral, as those
prevailing at the time for comparable transactions with other persons and do not
involve more than normal risks of collectibility. Other changes represent net
increases in existing lines of credit and transfers in and out of the related
party category.
Deposits from related parties held by the Corporation amounted to $3,078,000 at
December 31, 2003.
15. OFF-BALANCE SHEET RISK
The Corporation is a party to financial instruments with off-balance sheet risk
in the normal course of business to meet the financial needs of its customers.
These financial instruments include commitments to extend credit and financial
standby letters of credit. These instruments involve, to varying degrees,
elements of credit, interest rate or liquidity risk in excess of the amount
recognized in the consolidated balance sheet. The contract amounts of these
instruments express the extent of involvement the Corporation has in particular
classes of financial instruments.
The Corporation's exposure to credit loss from nonperformance by the other party
to the financial instruments for commitments to extend credit and financial
standby letters of credit is represented by the contractual amount of these
instruments. The Corporation uses the same credit policies in making commitments
and conditional obligations as it does for on-balance sheet instruments.
Financial instruments whose contract amounts represent credit risk at December
31, 2003 and 2002 are as follows:
(IN THOUSANDS)
2003 2002
Commitments to extend credit $111,843 $ 103,138
Standby letters of credit 14,064 10,753
51
Commitments to extend credit are legally binding agreements to lend to
customers. Commitments generally have fixed expiration dates or other
termination clauses and may require payment of fees. Since many of the
commitments are expected to expire without being drawn upon, the total
commitment amounts do not necessarily represent future liquidity requirements.
The Corporation evaluates each customer's creditworthiness on a case-by-case
basis. The amount of collateral obtained, if deemed necessary by the
Corporation, for extensions of credit is based on management's credit assessment
of the counterparty.
Financial standby letters of credit are conditional commitments issued by the
Corporation guaranteeing performance by a customer to a third party. Those
guarantees are issued primarily to support public and private borrowing
arrangements, including commercial paper, bond financing and similar
transactions. The credit risk involved in issuing letters of credit is
essentially the same as that involved in extending loan facilities to customers.
Some of the financial standby letters of credit are collateralized by real
estate or other assets, while others are unsecured. The extent to which proceeds
from liquidation of collateral would be expected to cover the maximum potential
amount of future payments related to financial standby letters of credit is not
estimable. The Corporation has recorded no liability associated with financial
standby letters of credit as of December 31, 2003 and 2002.
Financial standby letters of credit as of December 31, 2003 expire as follows:
(IN THOUSANDS)
Year of Expiration Amount
- ------------------ --------
2004 $ 7,998
2005 1,481
2006 4,532
2007 53
- ------------------ --------
Total $ 14,064
================== ========
16. CONTINGENCIES
In the normal course of business, the Corporation may be subject to pending and
threatened lawsuits in which claims for monetary damages could be asserted. In
management's opinion, the Corporation's financial position and results of
operations would not be materially affected by the outcome of such legal
proceedings.
17. REGULATORY MATTERS
The Corporation (on a consolidated basis) and the Bank are subject to various
regulatory capital requirements administered by the federal banking agencies.
Failure to meet minimum capital requirements can initiate certain mandatory -
and possibly additional discretionary - actions by regulators that, if
undertaken, could have a direct material effect on the Corporation's financial
statements. Under capital adequacy guidelines and the regulatory framework for
prompt corrective action, the Corporation and the Bank must meet specific
capital guidelines that involve quantitative measures of their assets,
liabilities and certain off-balance sheet items as calculated under regulatory
accounting practices. The capital amounts and classification are also subject to
qualitative judgments by the regulators about components, risk weightings and
other factors. Prompt corrective action provisions are not applicable to bank
holding companies.
Quantitative measures established by regulation to ensure capital adequacy
require the Corporation and the Bank to maintain minimum amounts and ratios (set
forth in the following table) of total and Tier I capital (as defined in the
regulations) to risk-weighted assets (as defined) and of Tier I capital (as
defined) to average assets (as defined). Management believes, as of December 31,
2003 and 2002, that the Corporation and the Bank meet all capital adequacy
requirements to which they are subject.
To be categorized as well capitalized, an institution must maintain minimum
total risk based, Tier I risk based and Tier I leverage ratios as set forth in
the following table. The Corporation's and the Bank's actual capital amounts and
ratios are also presented in the following table.
52
(DOLLARS IN THOUSANDS)
MINIMUM
TO BE WELL
MINIMUM CAPITALIZED UNDER
CAPITAL PROMPT CORRECTIVE
ACTUAL REQUIREMENT ACTION PROVISIONS
AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
---------- ------- ---------- -------- ---------- ---------
DECEMBER 31, 2003:
Total capital to risk-
weighted assets:
Consolidated $ 125,136 20.61% $ 48,564 > or = 8% n/a n/a
Bank 102,050 17.31% 47,160 > or = 8% $58,950 > or = 10%
Tier 1 capital to risk-
weighted assets:
Consolidated 113,307 18.67% 24,282 > or = 4% n/a n/a
Bank 103,691 17.59% 23,580 > or = 4% 35,370 > or = 6%
Tier 1 capital to
average assets:
Consolidated 113,307 10.80% 41,968 > or = 4% n/a n/a
Bank 103,691 10.15% 40,854 > or = 4% 51,068 > or = 5%
DECEMBER 31, 2002:
Total capital to risk-
weighted assets:
Consolidated $ 113,168 20.09% $ 45,055 > or = 8% n/a n/a
Bank 94,044 17.17% 43,825 > or = 8% $54,782 > or = 10%
Tier 1 capital to risk-
weighted assets:
Consolidated 103,691 18.41% 22,528 > or = 4% n/a n/a
Bank 86,140 15.72% 21,913 > or = 4% 32,869 > or = 6%
Tier 1 capital to
average assets:
Consolidated 103,691 10.53% 39,372 > or = 4% n/a n/a
Bank 86,140 8.94% 38,520 > or = 4% 48,150 > or = 5%
Restrictions imposed by Federal Reserve Regulation H limit dividend payments in
any year to the current year's net income plus the retained net income of the
prior two years without approval of the Federal Reserve Board. Accordingly, the
Corporation's dividends in 2004 may not exceed $18,237,000, plus consolidated
net income for 2004. Additionally, banking regulators limit the amount of
dividends that may be paid by the Bank to the Corporation. Retained earnings
against which dividends may be paid without prior approval of the banking
regulators amounted to approximately $83,262,000 at December 31, 2003, subject
to the minimum capital ratio requirements noted above.
Restrictions imposed by federal law prohibit the Corporation from borrowing from
the Bank unless the loans are secured in specific amounts. Such secured loans to
the Corporation are generally limited to 10% of the Bank's stockholder's equity
(excluding accumulated other comprehensive income) or $9,329,000 at December 31,
2003.
53
18. PARENT COMPANY ONLY
The following is condensed financial information for Citizens & Northern
Corporation.
CONDENSED BALANCE SHEET
(IN THOUSANDS)
DECEMBER 31,
2003 2002
ASSETS
Cash $ 329 $ 592
Investment in subsidiaries:
Citizens & Northern Bank 100,754 95,879
Citizens & Northern Investment Corporation 23,758 18,929
Bucktail Life Insurance Company 2,223 2,006
Other assets 54 45
-------- --------
TOTAL ASSETS $127,118 $117,451
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Dividends payable $ 1,763 $ 1,586
Other liabilities 12 28
Stockholders' equity 125,343 115,837
-------- --------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $127,118 $117,451
======== ========
CONDENSED INCOME STATEMENT
(IN THOUSANDS)
YEARS ENDED DECEMBER 31,
2003 2002 2001
Dividends from Citizens & Northern Bank $ 6,870 $ 7,063 $ 6,286
Other dividend income - 174 250
Expenses (183) (140) (74)
-------- -------- -------
Income before equity in undistributed income
of subsidiaries 6,687 7,097 6,462
Equity in undistributed income of subsidiaries 9,570 7,862 5,590
-------- -------- -------
NET INCOME $ 16,257 $ 14,959 $12,052
======== ======== =======
54
CONDENSED STATEMENT OF CASH FLOWS
(IN THOUSANDS)
YEARS ENDED DECEMBER 31,
2003 2002 2001
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 16,257 $ 14,959 $12,052
Adjustments to reconcile net income to net
cash provided by operating activities:
Equity in undistributed net income of
subsidiaries (9,570) (7,862) (5,590)
Amortization of restricted stock 102 80 22
(Increase) decrease in other assets (9) (32) 14
Increase in other liabilities 68 98 -
-------- -------- -------
Net Cash Provided by Operating Activities 6,848 7,243 6,498
-------- -------- -------
CASH FLOWS FROM INVESTING ACTIVITIES,
Investment in subsidiary (460) (783) (266)
-------- -------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from sale of treasury stock 197 76 -
Purchase of treasury stock (174) (239) (521)
Dividends paid (6,674) (6,038) (5,441)
-------- -------- -------
Net Cash Used in Financing Activities (6,651) (6,201) (5,962)
-------- -------- -------
(DECREASE) INCREASE IN CASH AND CASH
EQUIVALENTS (263) 259 270
CASH AND CASH EQUIVALENTS, BEGINNING
OF YEAR 592 333 63
-------- -------- -------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 329 $ 592 $ 333
======== ======== =======
19. SUMMARY OF QUARTERLY CONSOLIDATED FINANCIAL DATA (UNAUDITED)
The following table presents summarized quarterly financial data for 2003 and
2002:
2003 QUARTER ENDED
(IN THOUSANDS, EXCEPT PER SHARE DATA) Mar. 31, June 30, Sept. 30, Dec. 31,
Interest income $ 13,930 $ 13,943 $ 13,553 $ 13,797
Interest expense 6,243 6,089 5,655 5,550
-------- -------- --------- --------
Interest margin 7,687 7,854 7,898 8,247
Provision for loan losses 350 250 250 250
-------- -------- --------- --------
Interest margin after provision for loan losses 7,337 7,604 7,648 7,997
Other income 1,540 1,628 1,705 1,722
Securities gains 1,721 908 660 1,510
Other expenses 5,532 5,356 5,336 5,890
-------- -------- --------- --------
Income before income tax provision 5,066 4,784 4,677 5,339
Income tax provision 994 864 759 992
-------- -------- --------- --------
Net income $ 4,072 $ 3,920 $ 3,918 $ 4,347
======== ======== ========= ========
Net income per share - basic $ 0.50 $ 0.48 $ 0.48 $ 0.54
======== ======== ========= ========
Net income per share - diluted $ 0.50 $ 0.48 $ 0.48 $ 0.53
======== ======== ========= ========
55
2002 QUARTER ENDED
(IN THOUSANDS, EXCEPT PER SHARE DATA) Mar. 31, June 30, Sept. 30, Dec. 31,
Interest income $ 13,642 $ 14,523 $ 14,675 $ 14,445
Interest expense 6,316 6,745 6,675 6,579
-------- -------- --------- --------
Interest margin 7,326 7,778 8,000 7,866
Provision for loan losses 180 180 280 300
-------- -------- --------- --------
Interest margin after provision for loan losses 7,146 7,598 7,720 7,566
Other income 1,687 1,681 1,642 1,614
Securities gains 1,226 781 489 392
Other expenses 5,106 5,248 5,310 5,185
-------- -------- --------- --------
Income before income tax provision 4,953 4,812 4,541 4,387
Income tax provision 1,115 992 831 796
-------- -------- --------- --------
Net income $ 3,838 $ 3,820 $ 3,710 $ 3,591
======== ======== ========= ========
Net income per share - basic $ 0.47 $ 0.47 $ 0.46 $ 0.44
======== ======== ========= ========
Net income per share - diluted $ 0.47 $ 0.47 $ 0.46 $ 0.44
======== ======== ========= ========
56
INDEPENDENT AUDITORS' REPORT
To the Stockholders and Board of Directors of Citizens & Northern Corporation:
We have audited the accompanying consolidated balance sheet of Citizens &
Northern Corporation and subsidiaries as of December 31, 2003 and 2002, and the
related consolidated statements of income, changes in stockholders' equity, and
cash flows for each of the three years in the period ended December 31, 2003.
These financial statements are the responsibility of the Corporation's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Citizens & Northern
Corporation and subsidiaries as of December 31, 2003 and 2002, and the results
of their operations and their cash flows for each of the three years in the
period ended December 31, 2003, in conformity with accounting principles
generally accepted in the United States of America.
Parente Randolph, PC /s/
Williamsport, Pennsylvania
February 13, 2004
57
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None
ITEM 9A. CONTROLS AND PROCEDURES
The Corporation's Chief Executive Officer and Chief Financial Officer carried
out an evaluation of the design and effectiveness of the Corporation's
disclosure controls and procedures as defined in Rule 13a-15(e) and Rule
15d-15(e) of the Securities Exchange Act of 1934 as of the end of period covered
by this report. Based upon that evaluation, the Chief Executive Officer and
Chief Financial Officer concluded that the Corporation's disclosure controls and
procedures are effective to ensure that information required to be disclosed in
reports the Corporation files or submits under the Securities Exchange Act of
1934 is recorded, processed, summarized and reported, within the time periods
specified in the Securities and Exchange Commission's rules and forms.
There were no significant changes in the Corporation's internal control over
financial reporting that occurred during the period covered by this report that
has materially affected, or that is reasonably likely to affect, our internal
control over financial reporting.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information concerning Directors and Executive Officers is incorporated herein
by reference to disclosure under the captions "Proposal 1 - Election of
Directors," "Corporation's and Bank's Executive Officers," "Section 16(a)
Beneficial Ownership Reporting Compliance," "Board of Director Committees,
Attendance at Meetings and Compensation of Directors" and "Stockholder
Proposals" of the Corporation's proxy statement dated March 23, 2004 for the
annual meeting of stockholders to be held on April 20, 2004.
The Corporation's Board of Directors has adopted a Code of Ethics, available on
the Corporation's web site at www.cnbankpa.com for the Corporation's employees,
officers and directors. (The provisions of the Code of Ethics will be included
in the Corporation's employee handbook, which is issued to all new employees and
officers at the time of employment and reissued to existing employees and
officers from time to time.)
ITEM 11. EXECUTIVE COMPENSATION
Information concerning executive compensation is incorporated herein by
reference to disclosure under the caption "Executive Compensation" of the
Corporation's proxy statement dated March 23, 2004 for the annual meeting of
stockholders to be held on April 20, 2004.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED MATTERS
Information concerning security ownership of certain beneficial owners and
management is incorporated herein by reference to disclosure under the caption
"Security Ownership of Management" of the Corporation's proxy statement dated
March 23, 2004 for the annual meeting of stockholders to be held on April 20,
2004.
"Equity Compensation Plan Information" as required by Item 201(d) of Regulation
S-K is incorporated by reference herein from Item 5 (Market for Registrant's
Common Equity and Related Stockholder Matters) of this Form 10-K.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information concerning loans and deposits with Directors and Executive Officers
is provided in Note 14 to the Consolidated Financial Statements, which is
included in Part II, Item 8 of this Annual Report on Form 10-K. Additional
information is incorporated herein by reference to disclosure appearing under
the caption "Certain Transactions" of the Corporation's proxy statement dated
March 23, 2004 for the annual meeting of stockholders to be held on April 20,
2004.
58
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information concerning services provided by the Corporation's independent
auditors, Parente Randolph, PC, the audit committee's pre-approval policies and
procedures for such services, and fees paid by the Corporation to that firm, is
incorporated herein by reference to disclosure under the caption "Audit
Committee" of the Corporation's proxy statement dated March 23, 2004 for the
annual meeting of stockholders to be held on April 20, 2004.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) (1). The following consolidated financial statements are set forth in Part
II, Item 8:
Page
------
Independent Auditors' Report 57
Financial Statements:
Consolidated Balance Sheet - December 31, 2003 and 2002 28
Consolidated Statement of Income - Years Ended
December 31, 2003, 2002 and 2001 29
Consolidated Statement of Changes in Stockholders' Equity -
Years Ended December 31, 2003, 2002 and 2001 30
Consolidated Statement of Cash Flows - Years Ended
December 31, 2003, 2002 and 2001 31
Notes to Consolidated Financial Statements 32- 56
(a)(2) Financial statement schedules are not applicable or included in the
financial statements or related notes.
(a)(3) Exhibits (numbered as in Item 601 of Regulation S-K):
2. Plan of acquisition, reorganization, arrangement,
liquidation or succession Not applicable
3. (i) Articles of Incorporation Incorporated by reference to the
exhibits filed with the
Corporation's registration
statement on Form S-4 on March 27,
1987.
3. (ii) By-laws Incorporated by reference to the
exhibits filed with the
Corporation's registration
statement on Form S-4 on March 27,
1987.
4. Instruments defining the rights
of security holders, including
indentures Not applicable
9. Voting trust agreement Not applicable
10. Material contracts:
10.1 Change in Control Agreement
dated December 31, 2003 between the
Corporation and Craig G. Litchfield Filed herewith
10.2 Change in Control Agreement
dated December 31, 2003 between the
Corporation and Mark A. Hughes Filed herewith
59
10.3 Change in Control Agreement
dated December 31, 2003 between the
Corporation and Matthew P. Prosseda Filed herewith
10.4 Change in Control Agreement
dated December 31, 2003 between the
Corporation and Deborah E. Scott Filed herewith
10.5 Second Amendment to Citizens &
Northern Corporation Stock
Incentive Plan Filed herewith
10.6 First Amendment to Citizens &
Northern Corporation Stock
Incentive Plan Filed herewith
10.7 Citizens & Northern
Corporation Stock Incentive Plan Filed herewith
Citizens & Northern Corporation Incorporated by reference to the
Independent Directors Stock exhibits filed with the
Incentive Plan Corporation's proxy statement dated
March 19, 2001 for the annual
meeting of stockholders held on
April 17, 2001.
11. Statement re: computation of Information concerning the
per share earnings computation of earnings per share
is provided in Note 3 to the
Consolidated Financial Statements,
which is included in Part II, Item
8 of Form 10-K.
12. Statements re: computation of
ratios Not applicable
13. Annual report to security
holders, Form 10-Q or quarterly
report to security holders Not applicable
14. Code of ethics The Code of Ethics is available
through the Corporation's website
at www.cnbankpa.com. To access the
Code of Ethics, click on
"Shareholder News & Info.,"
followed by "Corporate Governance"
and "Code of Ethics."
16. Letter re: change in certifying
accountant Not applicable
18. Letter re: change in accounting
principles Not applicable
21. Subsidiaries of the registrant Filed herewith
22. Published report regarding
matters submitted to vote of
security holders Not applicable
23. Consents of experts and counsel Not applicable
24. Power of attorney Not applicable
60
31. Rule 13a-14(a)/15d-14(a) certifications:
31.1 Certification of Chief
Executive Officer Filed herewith
31.2 Certification of Chief
Financial Officer Filed herewith
32. Section 1350 certifications Filed herewith
99. Additional exhibits:
99.1 Additional information mailed
to stockholders with proxy
statement and Form 10-K on March
23, 2004 Filed herewith
(b) On October 9, 2003, a Current Report on Form 8-K, reported under Items 7 and
12, was filed to report the Corporation's consolidated earnings results for the
three-month and nine-month periods ended September 30, 2003.
(c) Exhibits - The required exhibits are listed under Part IV, Item 15(a)(3) of
Form 10-K.
(d) Financial statement schedules are omitted because the required information
is not applicable or is included elsewhere in Form 10-K.
61
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, Citizens & Northern Corporation has duly caused this report to be
signed on its behalf by the undersigned, thereunto duly authorized:
CITIZENS & NORTHERN CORPORATION
By: Craig G. Litchfield /s/
- ---------------------------
Craig G. Litchfield
Chairman, President and Chief Executive Officer
Date: March 10, 2004
By: Mark A. Hughes /s/
- ----------------------
Treasurer and Principal Accounting Officer
Date: March 10, 2004
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.
BOARD OF DIRECTORS
/s/ Dennis F. Beardslee /s/ Edward L. Learn
Dennis F. Beardslee Edward L. Learn
Date: March 10, 2004 Date: March 10, 2004
/s/ R. Robert DeCamp /s/ Craig G. Litchfield
R. Robert DeCamp Craig G. Litchfield
Date: March 10, 2004 Date: March 10, 2004
/s/ Jan E. Fisher /s/ Edward H. Owlett, III
Jan E. Fisher Edward H. Owlett, III
Date: March 10, 2004 Date: March 10, 2004
/s/ R. Bruce Haner /s/ Leonard Simpson
R. Bruce Haner Leonard Simpson
Date: March 10, 2004 Date: March 10, 2004
/s/ Susan E. Hartley /s/ James E. Towner
Susan E. Hartley James E. Towner
Date: March 10, 2004 Date: March 10, 2004
/s/ Karl W. Kroeck /s/ Ann M. Tyler
Karl W. Kroeck Ann M. Tyler
Date: March 10, 2004 Date: March 10, 2004
/s/ Leo F. Lambert
Leo F. Lambert
Date: March 10, 2004
62