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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, 2004 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. [ ]
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 June 30, 2004 was $204,103,368.
The number of shares of common stock outstanding at March 9, 2005 was 8,190,990.
DOCUMENTS INCORPORATED BY REFERENCE
-----------------------------------
Portions of the registrant's proxy statement for the annual meeting of its
shareholders to be held April 19, 2005 are incorporated by reference into Parts
III and IV of this report.
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 completed 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;
- - constructed and opened a branch in Muncy, PA in 2000;
- - purchased and remodeled a former bank operations center in Williamsport,
PA, and began offering trust and financial management, commercial lending,
branch banking and other services, in 2004;
- - opened a branch office at a leased facility in South Williamsport, PA in
2004; and
- - replaced the core banking computer system in 2004.
- 2 -
In November 2004, the Corporation, along with Canisteo Valley Corporation
("Canisteo"), announced the signing of a definitive agreement and plan of
merger. Canisteo is the parent company of First State Bank; a New York State
chartered commercial bank with two offices in Steuben County, NY, and assets of
$42.5 million as of September 30, 2004.
Under the agreement, the Corporation will acquire Canisteo in an all-cash merger
transaction. The transaction, which has been approved by the Boards of Directors
of both companies, is expected to be completed during the third quarter 2005,
pending Canisteo stockholder approval, regulatory approval, and other customary
conditions of closing.
At December 31, 2004, the Bank had total assets of $1,093,273,000, total
deposits of $677,537,000 and net loans outstanding of $572,826,000. At December
31, 2004, the Bank had a total of 324 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 facilities located at 68
Main Street, Wellsboro, and 2 East Mountain Avenue, South Williamsport, which
are leased. All of the properties are in good condition. 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 1085 S. Main Street 428 Main Street
Athens, PA 18810 Mansfield, PA 16933 Towanda, PA 18848
111 Main Street Route 220 Courthouse Square
Dushore, PA 18614 Monroeton, PA 18832 Troy, PA 16947
Main Street 3461 Route 405 Highway 90-92 Main Street
East Smithfield, PA 18817 Muncy, PA 17756 Wellsboro, PA 16901
104 Main Street Thompson Street 130 Court Street
Elkland, PA 16920 Ralston, PA 17763 Williamsport, PA 17701
- 3 -
102 E. Main Street 503 N. Elmira Street Route 6
Knoxville, PA 16928 Sayre, PA 18840 Wysox, PA 18854
Main Street 2 East Mountain Avenue
Laporte, PA 18626 South Williamsport, PA 17702
Main Street 41 Main Street
Liberty, PA 16930 Tioga, PA 16946
Other offices:
Bankcard Services C&N Financial Services Corp. Internal Audit
RR 7 Box 503 68 Main Street Water Street
Wellsboro, PA 16901 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 2004, 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. Effective January 13, 2005, the
Corporation's stock began to be listed on the NASDAQ SmallCap Market with the
trading symbol CZNC. Previously, the Corporation's stock was available through
the Over-The-Counter Bulletin Board. As of March 1, 2005, there were 2,444
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 2004 and 2003.
2004 2003
Dividend Dividend
Declared Declared
per Per
High Low Quarter High Low Quarter
------- ------- --------- ------- ------- ---------
First quarter $ 27.00 $ 25.00 $ 0.22 $ 21.63 $ 20.37 $ 0.21
Second quarter 25.50 24.45 0.22 26.95 21.00 0.21
Third quarter 25.90 24.20 0.22 26.95 25.80 0.21
Fourth quarter 27.00 24.80 0.23 27.00 25.80 0.22
plus 1% plus 1%
stock dividend stock dividend
While the Corporation expects to continue its policy of regular quarterly
dividend payments, future dividend payments will depend upon maintenance of a
strong financial condition, future earnings and capital and regulatory
requirements. Also, the Corporation and the Bank are subject to restrictions on
the amount of dividends that may be paid without approval of banking regulatory
authorities. These restrictions are described in Note 18 to the consolidated
financial statements.
Known "market makers" who handle Citizens & Northern Corporation stock
transactions are:
- 4 -
Boenning & Scattergood, Inc. Monroe Securities, Inc. RBC Capital Markets Corp.
4 Tower Bridge, Suite 300 343 West Erie 60 South 6th St.
200 Barr Harbor Drive Suite 410 P.O. Box 1160
West Conshohocken, PA 19428 Chicago, IL 60610 Minneapolis, MN 55402
Ferris, Baker, Watts, Inc. Knight Equity Markets, LP Ryan Beck & Co.
100 Light Street - Eighth Floor Newport Tower 18 Columbia Turnpike
Baltimore, MD 21201 525 Washington Blvd Florham Park, NJ 07932
Jersey City, NJ 07310
Hill Thompson Magid, L.P. Pershing Trading Company, LP Sandler, O'Neill & Partners, LP
15 Exchange Place 1 Pershing Plaza 919 Third Avenue
Suite 800 Jersey City, NJ 07399 Sixth Floor
Jersey City, NJ 07302 New York, NY 10022
Janney Montgomery Scott, LLC Schwab Capital Markets, LP
1801 Market Street 111 Pavonia Avenue
Philadelphia, PA 19103 East Jersey City, NJ 07310
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, 2004.
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 212,463 $ 20.03 195,823
EQUITY COMPENSATION PLANS
NOT APPROVED BY SHAREHOLDERS 0 N/A 0
Effective January 3, 2005, the Corporation granted options to purchase a total
of 37,176 shares of common stock through the Stock Incentive and Independent
Directors Stock Incentive Plans. The exercise price for these options is $27.00
per share, which was the market price at the date of grant. Also, effective
January 3, 2005, the Corporation awarded a total of 4,128 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 2005
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) 2004 2003 2002 2001 2000
Interest income $ 57,922 $ 55,223 $ 57,285 $ 54,661 $ 51,643
Interest expense 22,606 23,537 26,315 28,356 30,145
------------ ------------ ----------- ----------- -----------
Interest margin 35,316 31,686 30,970 26,305 21,498
Provision for loan losses 1,400 1,100 940 600 676
------------ ------------ ----------- ----------- -----------
Interest margin after provision for loan losses 33,916 30,586 30,030 25,705 20,822
Other income 6,922 6,595 6,624 6,120 5,002
Securities gains 2,877 4,799 2,888 1,920 1,377
Other expenses 26,001 22,114 20,849 18,671 16,906
------------ ------------ ----------- ----------- -----------
Income before income tax provision 17,714 19,866 18,693 15,074 10,295
Income tax provision 2,851 3,609 3,734 3,022 1,819
------------ ------------ ----------- ----------- -----------
Net income $ 14,863 $ 16,257 $ 14,959 $ 12,052 $ 8,476
============ ============ =========== =========== ===========
BALANCE SHEET AT YEAR END (IN THOUSANDS)
Total securities (1) $ 479,626 $ 484,825 $ 513,597 $ 437,398 $ 343,596
Gross loans, excluding unearned discount 579,613 524,897 451,145 379,228 328,305
Total assets 1,123,002 1,066,901 1,018,768 866,999 719,335
Total deposits 676,545 658,065 640,304 576,274 528,967
Stockholders' equity, excluding accumulated
other comprehensive income (4) 121,050 113,306 103,691 94,903 88,887
Total stockholders' equity 131,585 125,343 115,837 100,187 88,969
AVERAGE BALANCE SHEET (IN THOUSANDS)
Total securities, at amortized cost (1) 485,182 474,406 470,764 412,654 371,360
Gross loans, excluding unearned discount 551,352 485,150 410,670 346,353 318,382
Earning assets 1,036,534 959,556 881,434 759,007 689,743
Total assets 1,114,040 1,034,720 943,001 805,229 704,221
Total assets, excluding unrealized gains/
losses (4) 1,097,858 1,014,424 930,539 798,590 717,052
Total deposits 669,307 651,026 613,392 544,579 503,848
Stockholders' equity, excluding accumulated
other comprehensive income (4) 117,695 108,876 99,361 91,703 87,258
Stockholders' equity 128,374 122,271 107,595 96,021 78,792
COMMON STOCK AND PER SHARE DATA
Net income per share - basic $ 1.82 $ 1.99 $ 1.83 $ 1.47 $ 1.03
Net income per share - diluted 1.81 1.98 1.83 1.47 1.03
Cash dividends declared per share 0.89 0.85 0.77 0.71 0.65
Stock dividend 1% 1% 1% 1% 1%
Stockholders' equity per share (2) 16.08 15.33 14.18 12.26 10.84
Stockholders' equity per share, excluding
accumulated other comprehensive
income (loss) (2), (4) 14.79 13.86 12.69 11.61 10.83
Weighted average shares outstanding - basic 8,185,466 8,170,651 8,170,159 8,184,716 8,206,549
Weighted average shares outstanding - diluted 8,233,992 8,219,366 8,192,047 8,206,604 8,208,297
Number of shares outstanding at year-end 8,102,646 8,014,625 5,285,606 5,234,800 5,207,244
Number of shares authorized 20,000,000 10,000,000 10,000,000 10,000,000 10,000,000
- 6 -
FINANCIAL RATIOS 2004 2003 2002 2001 2000
Return on stockholders' equity, excluding
accumulated other comprehensive income (3), (4) 12.63% 14.93% 15.06% 13.14% 9.71%
Return on stockholders' equity (3) 11.58% 13.30% 13.90% 12.55% 10.76%
Return on assets (3) 1.33% 1.57% 1.59% 1.50% 1.20%
Stockholders' equity to assets, excluding
accumulated other comprehensive income (3), (4) 10.72% 10.73% 10.68% 11.48% 12.17%
Stockholders' equity to assets (3) 11.52% 11.82% 11.41% 11.92% 11.19%
Stockholders' equity to loans (3) 23.28% 25.20% 26.20% 27.72% 24.75%
Net income to:
Total interest income 25.66% 29.44% 26.11% 22.05% 16.41%
Interest margin 42.09% 51.31% 48.30% 45.82% 39.43%
Dividends as a % of net income 48.54% 41.96% 41.17% 46.08% 60.19%
(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,
"should", "likely", "expect", "plan", "anticipate", "target", "forecast", and
"goal". 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 expressed or implied by such
forward-looking statements. 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.
- 7 -
EARNINGS OVERVIEW
Net income in 2004 was $14,863,000, or $1.82 per share - - basic and $1.81 per
share - - diluted. Net income for 2004 was $1,394,000, or 8.6%, lower than the
$16,257,000 ($1.99 per share - - basic and $1.98 per share - - diluted) recorded
in 2003. In comparing earnings for 2004 with 2003's results, it is important to
note the lower level of realized securities gains generated in 2004, as
described below. Assuming an income tax rate of 34%, the lower securities gains
in 2004 reduced net income for 2004 by $1,269,000 from 2003. Excluding the
effects of lower securities gains, net income for 2004 was approximately 1%
lower than the amount recorded in 2003. In 2002, net income totaled $14,959,000
($1.83 per share - basic and diluted).
The most significant income statement changes are as follows:
2004 VS. 2003
- The interest margin increased $3,630,000, or 11.5% in 2004 from
$31,686,000 in 2003. Higher interest income, primarily from growth
in loans, combined with lower interest expense, combined to drive
the increase in the interest margin. 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, decreased
$1,922,000 to $2,877,000 in 2004 from $4,799,000 in 2003. In both
2004 and 2003. 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 $2,011,000 in 2004
and $3,384,000 in 2003. Net gains from sales and calls of debt
securities amounted to $866,000 in 2004, and $1,415,000 in 2003.
- Other (noninterest) operating expenses increased $1,363,000, or
25.9%, in 2004 over 2003. Overall, this increase is the result of
higher volumes of loans and other transactions, start-up of the
Williamsport and South Williamsport facilities, the implementation
of the core computer system conversion and other activities have
resulted in more expense incidental to additional personnel and
technology. A further explanation of these costs is provided in the
"Noninterest Expense" section of Management's Discussion and
Analysis.
- Pre-tax income was lower in 2004 than in 2003 and the income tax
provision decreased to $2,851,000 in 2004 from $3,609,000 in 2003.
The income tax provision, as a percentage of pre-tax income, was
16.09% in 2004, down from 18.17% in 2003. Note 13 to the
Consolidated Financial Statements presents more detail concerning
the Corporation's accounting for income taxes.
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.
- 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.
- 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.
- 8 -
OUTLOOK FOR 2005
The Corporation is in a growth mode. In addition to the pending acquisition of
Canisteo Valley Corporation (see Note 21 to the consolidated financial
statements), management has several projects planned for 2005. The growth in
administrative, trust and commercial lending staff has resulted in the need for
more room. In order to meet that need, a new administrative building will be
erected within 2 blocks of the Wellsboro main office. The facility will provide
about 17,000 square feet of room. In Lycoming County, the Corporation has signed
agreements for the acquisition of 2 sites for future full-service offices.
Management hopes to begin construction in Jersey Shore by the second quarter
2005. Construction of the second building will most likely begin by the end of
2005. Total capital purchases for 2005 are estimated to range from $6 million to
$8.5 million.
Management expects the expansion and investments in new markets to provide
future, continuing opportunities for earnings growth. It may be difficult in
2005, however, to achieve a level of earnings comparable to 2004's results.
Management expects the Lycoming County expansion to help achieve significant
loan growth in 2005, which would provide a boost to earnings. Over the last 6
months of 2004 and first 2 months of 2005, however, the Federal Reserve has
raised the Fed Funds Target rate 6 times, from 1% to its current level of 2.5%.
Further increases are expected, as various economic pundits speculate the Fed's
"equilibrium" rate to range anywhere from 3% to 5%. Meanwhile, long-term rates
have not changed much over the last year, and many economists believe they will
not move much during 2005. Rising short-term rates, combined with flat long-term
rates, would be expected to have a negative effect on the Corporation's net
interest margin in 2005. Further, noninterest expense in 2005 will include
payroll and other start-up costs related to the new branches, as well as costs
from the planned administrative facility and a full year of depreciation and
maintenance from the core computer system that was placed in service in October
2004.
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. It is difficult to predict, with much precision, the
amount of net securities gains and losses that will be realized in 2005.
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.
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 Note 1
to 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
2004/2003/2002
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 2004, 2003 and
2002. 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 net interest margin, on a taxable-equivalent basis, was $39,218,000 in 2004,
an increase of $3,736,000 or 10.5%, over 2003. As reflected in Table III,
increased interest income from higher volumes of earning assets exceeded
increases in interest expense attributable to higher volumes of interest-bearing
liabilities by $2,830,000 in 2004 compared to 2003. Table III also shows that
interest rate changes had the effect of increasing net interest income $906,000
in 2004 compared to 2003. As shown in Table II, the Interest Rate Spread was
3.43% in 2004, up from 3.31% in 2003.
In 2003, the net interest margin of $35,482,000 was $1,519,000, or 4.5%, higher
than the net interest margin in 2002. In 2003, 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 $4,129,000 in
2003, while changes in rates reduced net interest income $2,610,000.
INTEREST INCOME AND EARNING ASSETS
The Corporation's major categories of earning assets are loans and
available-for-sale investment securities. As shown in Table I, total interest
income increased to $61,824,000 in 2004 from $59,019,000 in 2003, an increase of
4.8%. Interest and fees on loans increased $2,274,000, or 6.8%. Interest and
dividends from available-for-sale securities rose $532,000, or 2.1%. In 2004,
the positive effect on earnings of higher average balances of loans and
available-for-sale securities outstanding more than offset the dampening effect
of lower average rates of return.
Total interest income decreased $1,259,000, or 2.1%, in 2003 as compared to
2002. Interest and fees on loans increased $1,880,000, or 6.0% while interest
and dividends from available-for-sale securities decreased $3,073,000, or 10.7%.
In 2003, interest rates continued a fall to 40-year low levels. In 2003, the
Corporation's lending growth produced an increase in interest income, despite
significantly declining rates. Over the course of 2003, as falling rates caused
principal repayments on mortgage-backed securities and calls of U.S. Government
agency securities to accelerate, the Corporation was forced to reinvest at lower
yields on available-for-sale securities or use the proceeds to help fund loan
growth.
Table II shows the composition of the available-for-sale securities portfolio,
based on average balances. In 2004, the average balance of municipal bonds was
$151,049,000, or 31% of the total portfolio. Municipals bonds were also 31% of
the total portfolio in 2003 and 24% in 2002. 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. Most of the Corporation's mortgage-backed securities are
"Hybrid ARMs," 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 long-term 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 include corporate obligations,
mainly "Trust Preferred Securities" issued by financial institutions, and whole
loan collateralized mortgage obligations. 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.
- 10 -
Average loans outstanding increased $66,202,000, or 13.6%, in 2004, and
$74,480,000, or 18.1%, in 2003. Much of the growth in the loan portfolio in 2004
and 2003 has been in real estate secured loans, including commercial as well as
residential real estate loans. Historically low market interest rates, which
spurred significant levels of refinancing throughout 2001-2003, 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
2000 and the Williamsport and South Williamsport offices in 2004, along with the
hiring of several additional lending personnel. Excluding credit card loans, the
mix between residential mortgage and other consumer loans outstanding, and
commercial loans outstanding, was 58% mortgage and consumer, 42% commercial, as
of December 31, 2004.
The average return on the total loan portfolio for 2004 was 6.47%, down from
6.88% in 2003 and 7.67% in 2002. The lower returns in 2004 and 2003 resulted
mainly from significant levels of mortgage refinancings, and by lower average
returns on commercial loans with variable or adjustable rates.
INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES
Interest expense fell to $22,606,000 in 2004 from $23,537,000 in 2003 and
$26,315,000 in 2002. As reflected in Table III, lower average rates had the
effect of lowering interest expense $3,161,000 in 2004 and $5,069,000 in 2003.
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 7.8%, to
$894,975,000 in 2004, and 9.1%, to $829,889,000 in 2003.
As reflected in Table III, interest expense from certificates of deposit (CDs)
decreased $824,000 in 2004 and $1,793,000 in 2003. Much of the lower interest
expense from CDs in 2004 and 2003 was rate-related. However, the average balance
also fell in both years, to $180,332,000 in 2004 from $190,019,000 in 2003 and
$195,099,000 in 2002. The lower average balance of CDs in 2004 and 2003 was
impacted by a reduction in average balances maintained by a few governmental and
not-for-profit customers. The average rate incurred on CDs was 2.85% in 2004,
3.14% in 2003 and 3.97% in 2002.
Table III shows that interest expense from money market accounts decreased
$198,000 in 2004, and $1,258,000 in 2003. 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 1.31% in 2004, 1.43% in 2003 and 2.31% in 2002.
Table II shows that the average balance of money market deposits increased 1.2%,
to $192,450,000 in 2004, and 10.7%, to $190,161,000, in 2003.
Interest expense from Individual Retirement Accounts (IRAs) decreased $806,000
in 2004 and increased $654,000 in 2003. As shown in Table II, the average
balance of IRAs increased 9.8%, to $116,622,000 in 2004, and 16.9%, to
$106,216,000 in 2003. Throughout 2004 and 2003, the Corporation offered one of
the highest IRA rates 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 repriced in April
2004, resulting in the reduction in average rate incurred on IRAs to 3.75% in
2004, from 4.88% in 2003 and 4.98% in 2002.
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 increased $1,076,000 in 2004,
after decreasing $171,000 in 2003. Average other borrowed funds balances
increased to $300,585,000 in 2004 from $242,358,000 in 2003 and $211,092,000 in
2002. In 2004, new borrowings were required to help fund growth in loans and to
sustain management's desired level of available-for-sale securities. Average
interest rates on other borrowed funds fell to 3.31% in 2004, from 3.67% in 2003
and 4.29% in 2002.
- 11 -
TABLE I - ANALYSIS OF INTEREST INCOME AND EXPENSE
YEARS ENDED DECEMBER 31, INCREASE(DECREASE)
(IN THOUSANDS) 2004 2003 2002 04/03 03/02
INTEREST INCOME
Available-for-sale securities:
U.S. Treasury securities $ - $ - $ 75 $ - $ (75)
Securities of other U.S. Government agencies and corporations 2,521 3,174 4,728 (653) (1,554)
Mortgage-backed securities 7,654 7,427 11,097 227 (3,670)
Obligations of states and political subdivisions 10,708 10,768 8,641 (60) 2,127
Equity securities 1,443 1,168 1,148 275 20
Other securities 3,797 3,054 2,975 743 79
---------- -------- -------- ------- --------
Total available-for-sale securities 26,123 25,591 28,664 532 (3,073)
---------- -------- -------- ------- --------
Held-to-maturity securities:
U.S. Treasury securities 17 17 27 - (10)
Securities of other U.S. Government agencies and corporations 8 11 20 (3) (9)
Mortgage-backed securities 2 3 9 (1) (6)
---------- -------- -------- ------- --------
Total held-to-maturity securities 27 31 56 (4) (25)
---------- -------- -------- ------- --------
Interest-bearing due from banks 11 10 17 1 (7)
Federal funds sold 10 8 42 2 (34)
Loans:
Real estate loans 28,603 27,116 25,454 1,487 1,662
Consumer 2,659 2,834 2,974 (175) (140)
Agricultural 146 199 199 (53) -
Commercial/industrial 2,810 2,025 1,934 785 91
Other 30 56 69 (26) (13)
Political subdivisions 1,402 1,144 858 258 286
Leases 3 5 11 (2) (6)
---------- -------- -------- ------- --------
Total loans 35,653 33,379 31,499 2,274 1,880
---------- -------- -------- ------- --------
Total Interest Income 61,824 59,019 60,278 2,805 (1,259)
---------- -------- -------- ------- --------
INTEREST-BEARING LIABILITIES
Interest checking 232 266 425 (34) (159)
Money market 2,514 2,712 3,970 (198) (1,258)
Savings 283 425 504 (142) (79)
Certificates of deposit 5,135 5,959 7,752 (824) (1,793)
Individual Retirement Accounts 4,376 5,182 4,528 (806) 654
Other time deposits 5 17 36 (12) (19)
Overnight borrowings 100 91 44 9 47
Other borrowed funds 9,961 8,885 9,056 1,076 (171)
---------- -------- -------- ------- --------
Total Interest Expense 22,606 23,537 26,315 (931) (2,778)
---------- -------- -------- ------- --------
Net Interest Income $ 39,218 $ 35,482 $ 33,963 $ 3,736 $ 1,519
========== ======== ======== ======= ========
(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 $987,000
in 2004, $1,323,000 in 2003 and $1,268,000 in 2002.
- 12 -
TABLE II - ANALYSIS OF AVERAGE DAILY BALANCES AND RATES
RATE OF RATE OF RATE OF
RETURN/ RETURN/ RETURN/
2004 COST OF 2003 COST OF 2002 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 $ - 0.00 $ 1,241 6.04
Securities of other U.S. Government agencies and corporations 55,443 4.55 67,218 4.72 75,646 6.25
Mortgage-backed securities 181,012 4.23 176,800 4.20 209,539 5.30
Obligations of states and political subdivisions 151,049 7.09 146,371 7.36 113,540 7.61
Equity securities 29,346 4.92 28,084 4.16 21,858 5.25
Other securities 65,646 5.78 52,980 5.76 43,826 6.79
---------- ---- ---------- ---- --------- -----
Total available-for-sale securities 482,496 5.41 471,453 5.43 465,650 6.16
---------- ---- ---------- ---- --------- -----
Held-to-maturity securities:
U.S. Treasury securities 318 5.35 320 5.31 511 5.28
Securities of other U.S. Government agencies and corporations 113 7.08 220 5.00 331 6.04
Mortgage-backed securities 29 6.90 64 4.69 131 6.87
---------- ---- ---------- ---- --------- -----
Total held-to-maturity securities 460 5.87 604 5.13 973 5.76
---------- ---- ---------- ---- --------- -----
Interest-bearing due from banks 1,449 0.76 1,669 0.60 1,444 1.18
Federal funds sold 778 1.29 680 1.18 2,698 1.56
Loans:
Real estate loans 446,004 6.41 399,353 6.79 338,133 7.53
Consumer 34,637 7.68 32,386 8.75 29,720 10.01
Agricultural 2,243 6.51 2,924 6.81 2,556 7.79
Commercial/industrial 46,635 6.03 32,909 6.15 28,182 6.86
Other 478 6.28 851 6.58 1,028 6.71
Political subdivisions 21,307 6.58 16,649 6.87 10,929 7.85
Leases 48 6.25 78 6.41 122 9.02
---------- ---- ---------- ---- --------- -----
Total loans 551,352 6.47 485,150 6.88 410,670 7.67
---------- ---- ---------- ---- --------- -----
Total Earning Assets 1,036,535 5.96 959,556 6.15 881,435 6.84
Cash 14,273 13,583 13,318
Unrealized gain/loss on securities 16,182 20,296 12,462
Allowance for loan losses (6,523) (5,908) (5,453)
Bank premises and equipment 14,953 11,090 10,246
Other assets 38,621 36,103 30,993
---------- ---------- ---------
Total Assets $1,114,041 $1,034,720 $ 943,001
========== ========== =========
INTEREST-BEARING LIABILITIES
Interest checking $ 39,188 0.59 $ 37,647 0.71 $ 37,984 1.12
Money market 192,450 1.31 190,161 1.43 171,767 2.31
Savings 57,439 0.49 54,789 0.78 49,779 1.01
Certificates of deposit 180,332 2.85 190,019 3.14 195,099 3.97
Individual Retirement Accounts 116,622 3.75 106,216 4.88 90,856 4.98
Other time deposits 1,275 0.39 1,666 1.02 1,814 1.98
Overnight borrowings 7,084 1.41 7,033 1.29 2,347 1.87
Other borrowed funds 300,585 3.31 242,358 3.67 211,092 4.29
---------- ---- ---------- ---- --------- -----
Total Interest-bearing Liabilities 894,975 2.53 829,889 2.84 760,738 3.46
Demand deposits 82,001 70,528 66,093
Other liabilities 8,691 12,032 8,575
---------- ---------- ---------
Total Liabilities 985,667 912,449 835,406
---------- ---------- ---------
Stockholders' equity, excluding other comprehensive income/loss 117,695 108,876 99,361
Other comprehensive income/loss 10,679 13,395 8,234
---------- ---------- ---------
Total Stockholders' Equity 128,374 122,271 107,595
---------- ---------- ---------
Total Liabilities and Stockholders' Equity $1,114,041 $1,034,720 $ 943,001
========== ========== =========
Interest Rate Spread 3.43 3.31 3.38
Net Interest Income/Earning Assets 3.78 3.70 3.85
(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.
- 13 -
TABLE III - THE EFFECT OF VOLUME AND RATE CHANGES ON INTEREST INCOME AND
INTEREST EXPENSE
YEARS ENDED 12/31/04 VS. 03 YEARS ENDED 12/31/03 VS. 02
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)
Securities of other U.S. Government agencies
and corporations (539) (114) (653) (487) (1,067) (1,554)
Mortgage-backed securities 178 49 227 (1,579) (2,091) (3,670)
Obligations of states and political
sub-divisions 338 (398) (60) 2,424 (297) 2,127
Equity securities 54 221 275 288 (268) 20
Other securities 733 10 743 567 (488) 79
------- ------- ------- ------- -------- -------
Total available-for-sale securities 764 (232) 532 1,175 (4,248) (3,073)
------- ------- ------- ------- -------- -------
Held-to-maturity securities:
U.S. Treasury securities - - - (10) - (10)
Securities of other U.S. Government agencies
and corporations (6) 3 (3) (6) (3) (9)
Mortgage-backed securities (2) 1 (1) (4) (2) (6)
------- ------- ------- ------- -------- -------
Total held-to-maturity securities (8) 4 (4) (20) (5) (25)
------- ------- ------- ------- -------- -------
Interest-bearing due from banks (1) 2 1 2 (9) (7)
Federal funds sold 1 1 2 (26) (8) (34)
Loans:
Real estate loans 3,049 (1,562) 1,487 4,316 (2,654) 1,662
Consumer 188 (363) (175) 253 (393) (140)
Agricultural (44) (9) (53) 27 (27) -
Commercial/industrial 828 (43) 785 304 (213) 91
Other (23) (3) (26) (12) (1) (13)
Political subdivisions 308 (50) 258 404 (118) 286
Leases (2) - (2) (3) (3) (6)
------- ------- ------- ------- -------- -------
Total loans 4,304 (2,030) 2,274 5,289 (3,409) 1,880
------- ------- ------- ------- -------- -------
Total Interest Income 5,060 (2,255) 2,805 6,420 (7,679) (1,259)
------- ------- ------- ------- -------- -------
INTEREST-BEARING LIABILITIES
Interest checking 11 (45) (34) (4) (155) (159)
Money market 33 (231) (198) 389 (1,647) (1,258)
Savings 20 (162) (142) 47 (126) (79)
Certificates of deposit (294) (530) (824) (197) (1,596) (1,793)
Individual Retirement Accounts 473 (1,279) (806) 751 (97) 654
Other time deposits (3) (9) (12) (3) (16) (19)
Overnight borrowings 1 8 9 65 (18) 47
Other borrowed funds 1,989 (913) 1,076 1,243 (1,414) (171)
------- ------- ------- ------- -------- -------
Total Interest Expense 2,230 (3,161) (931) 2,291 (5,069) (2,778)
------- ------- ------- ------- -------- -------
Net Interest Income $ 2,830 $ 906 $ 3,736 $ 4,129 $ (2,610) $ 1,519
======= ======= ======= ======= ======== =======
(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.
- 14 -
NONINTEREST INCOME
2004/2003/2002
Total noninterest income decreased $1,595,000, or 14.0%, in 2004 as compared to
2003. In 2003, total noninterest income increased $1,882,000, or 19.8%, compared
to 2002. The decreases and increases in net realized security gains in 2004 and
2003 are discussed in the "Earnings Overview" section of Management's Discussion
and Analysis. Other items of significance are as follows:
2004 VS. 2003
- - Trust and financial management revenue rose $372,000, or 21.5% for 2004
compared to 2003. Trust and financial management revenue is affected
significantly by the market value of assets under management. As of
December 31, 2004, the value of trust assets under management amounted to
$383,062,000, an increase of $53,447,000 or 16.2% from $329,615,000 as of
December 31, 2003.
- - The increase in cash surrender value of life insurance fell $105,000 to
$610,000 in 2004 from $715,000 in 2003. 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 2004,
earnings on that pooled separate trust fund were lower than in 2003, which
is reflective of lower market yields on debt securities.
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.
- - 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 were lower than in 2002, which
is reflective of lower market yields on debt securities.
- - Credit card fee income 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 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.
- 15 -
TABLE IV - COMPARISON OF NONINTEREST INCOME
(IN THOUSANDS) 2004 % CHANGE 2003 % CHANGE 2002
Service charges on deposit accounts $ 1,717 (1.7) $ 1,746 1.2 $ 1,725
Service charges and fees 308 7.3 287 11.2 258
Trust and financial management revenue 2,105 21.5 1,733 (1.3) 1,755
Insurance commissions, fees and premiums 439 12.3 391 (32.2) 577
Increase in cash surrender value of life
insurance 610 (14.7) 715 (16.2) 853
Fees related to credit card operation 773 (1.4) 784 24.2 631
Other operating income 970 3.3 939 13.8 825
------- ---- ------- ---- -------
Total other income before realized gains on
securities, net 6,922 5.0 6,595 (0.4) 6,624
Realized gains on securities, net 2,877 (40.1) 4,799 66.2 2,888
------- ---- ------- ---- -------
Total Other Income $ 9,799 (14.0) $11,394 19.8 $ 9,512
======= ===== ======= ==== =======
OTHER NONINTEREST EXPENSE
2004/2003/2002
Total noninterest expense increased 17.6% in 2004, to $26,001,000. In 2003,
total noninterest expense was $22,114,000,000, or 6.1% higher than in 2002.
2004 VS. 2003
Salaries and wages increased $1,552,000, or 16.0%, for 2004 compared to 2003.
The number of full-time equivalent employees (FTEs) increased 10.6%, to 324 at
December 31, 2004 from 293 at December 31, 2003. The increased number of
employees includes 10 FTEs for the new Willamsport and South Williamsport
branches opened in 2004. Other positions added in 2004 include staff for Trust,
Commercial Lending, Loan Administration, Accounting and Employee Training
functions, as well as 5 Management Trainees who worked primarily on the core
computer system conversion in 2004 and are now being groomed to assume new
roles. In addition, paid overtime increased approximately $90,000 in 2004 over
2003, mainly due to core system conversion efforts.
Pensions and other employee benefits increased $87,000, or 2.6%, in 2004 over
2003. As a percentage of salaries and wages, pensions and other employee
benefits fell to 30.3% in 2004 from 34.2% in 2003. In 2004, employer
contributions to the 401(k) profit sharing plan totaled 6.7% of salaries and
wages, down from 7.8% in 2003. The lower percentage of profit sharing
contributions in 2004 reflects a higher proportion of new employees hired in
2004, as the new hires will begin to qualify for contributions in 2005. Other
expense reductions in 2004 included professional fees related to employee
benefit matters, which decreased $89,000 to $167,000, defined benefit pension
plan expense, which decreased $45,000 to $388,000 and supplemental executive
retirement plan expense, which fell $41,000 to $4,000.
Occupancy expense increased $369,000, or 28.5%, in 2004 over 2003. The greatest
portion of the increase in occupancy expense is attributable to increased costs
of $112,000 for building maintenance and repairs. Depreciation expense also rose
$93,000 from 2003's level, as the Corporation recorded depreciation on the new
Williamsport facility and on building renovation costs that have taken place in
several locations. Total energy costs increased $68,000, primarily due to higher
utility rates in several locations, as well as the initial expenses associated
with the Williamsport and South Williamsport facilities during 2004.
Furniture and equipment expense increased $433,000, or 31.6%, in 2004 compared
to 2003. The largest increase within this category was in depreciation expense,
which increased $283,000. The depreciation expense related to the Corporation's
Management Information Systems function increased $180,000 in 2004, including
$143,000 related to software and hardware for the new core system that was
placed in service in October 2004. Depreciation expense also increased due to
the addition of computer equipment and furniture for the Williamsport and South
Williamsport locations.
- 16 -
In addition to the increase in depreciation, maintenance and repairs expense
increased $121,000 in 2004, mainly due to maintenance contracts associated with
the new software and hardware.
In total, other operating expense increased $1,363,000, or 25.9%, in 2004 over
2003. This category includes many different types of expenses. The most
significant changes within this category are as follows:
- Bank professional fees increased $374,000, to $745,000. Included in
this category was approximately $347,000 in expenses for training
and other professional services related to the core banking software
implementation.
- Supplies expense increased $204,000, to $645,000 in 2004. This
increase included costs associated with new locations and an
increased number of employees as well as supplies used in the new
core system training.
- Travel, lodging and meal expenses increased $171,000 to $284,000
mainly from costs related to teams of employees who traveled to the
vendor's headquarters for training on the new core system.
- Fees paid to Corporation, Bank and Advisory Board Directors
increased $106,000 in 2004, to $406,000. This reflected increases in
rates paid for meeting fees, and retainers, based on recommendations
from a competitive survey completed by a consultant early in 2004.
Prior to 2004, no Director fee rates had increased since 1999.
- Software-related expense increased $101,000 in 2004, to $250,000.
This increase was mainly attributable to costs associated with a new
Human Resources Information System that was installed in 2004.
- Advertising expense increased $90,000 in 2004, to $464,000, mainly
due to advertising programs in the Williamsport marketplace.
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 $248,000 in 2003 over 2002. Although the defined benefit pension plan
remained 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. Group health insurance expense increased $112,000 in 2003,
mainly due to increases in rates. Professional fees related to employee benefit
plan matters increased $113,000 in 2003 over 2002.
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.
- 17 -
- 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.
TABLE V - COMPARISON OF NONINTEREST EXPENSE
(IN THOUSANDS) 2004 % CHANGE 2003 % CHANGE 2002
Salaries and wages $ 11,248 16.0 $ 9,696 3.0 $ 9,418
Pensions and other employee benefits 3,404 2.6 3,317 25.1 2,651
Occupancy expense, net 1,664 28.5 1,295 18.4 1,094
Furniture and equipment expense 1,805 31.6 1,372 (10.4) 1,532
Expenses related to credit card operation 414 7.5 385 35.1 285
Pennsylvania shares tax 846 6.8 792 7.9 734
Other operating expense 6,620 25.9 5,257 2.4 5,135
-------- ---- -------- -------- --------
Total Other Expense $ 26,001 17.6 $ 22,114 6.1 $ 20,849
======== ==== ======== ======== ========
INCOME TAXES
The "Earnings Overview" section of Management's Discussion and Analysis includes
a discussion of the Corporation's income tax provision in 2004, 2003 and 2002.
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. That discussion provides useful
information regarding changes in the Corporation's balance sheet over the 2-year
period ended December 31, 2004, and is sufficient to explain the overall change
in the year-end balances of deposits and borrowed funds in 2004 compared to
2003. 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, 2004,
2003 and 2002. While the average balance of available-for-sale securities (at
amortized cost, as shown in Table II) was slightly higher in 2004 than in 2003,
the year-end balance (at fair value) fell to $475,085,000 at December 31, 2004
from $483,032,000 at December 31, 2003. Overall, management's decision to
maintain a securities portfolio that was approximately flat in size was
attributable to 2 primary factors: (1) substantial loan growth, and (2) the need
to manage interest rate risk within acceptable parameters. The overall lack of
growth in the securities portfolio continued a trend begun in 2003, as the
available-for-sale securities balance fell to $483,032,000 at December 31, 2003
from $512,175,000 at December 31, 2002. The Corporation's liquidity position is
discussed in a separate section of Management's Discussion and Analysis, and
interest rate risk is discussed in more detail in Section 7A.
As described in the Net Interest Margin section of Management's Discussion and
Analysis, loans outstanding grew substantially in both 2004 and 2003. In fact,
as reflected in Table VII, the year-end balance of loans, net of the allowance
for loan losses, has grown more than 10% compared to the previous year-end, for
each of the last 4 years. Table VIII
- 18 -
presents a table of loan maturities. Fixed rate loans are included in Table VIII
based on their contractually scheduled principal repayments, while variable rate
loans are included based on contractual principal repayments, with the remaining
balance reflected in the Table as of the date of the next change in rate. Table
VIII shows that the majority ($396,299,000 or 68%) of the loan portfolio is
fixed rate, including $225,575,000 or 39% fixed rate beyond 5 years. This
substantial investment in long-term, fixed rate loans is one of the major
concerns management attempts to address through interest rate risk management
practices. See Section 7A for a more detailed discussion of the Corporation's
interest rate risk.
Premises and equipment, net of accumulated depreciation, increased to
$16,725,000 at December 31, 2004 from $12,482,000 at December 31, 2003. The
total cost of premises and equipment purchases was $5,830,000 in 2004,
$3,360,000 in 2003 and $1,712,000 in 2002. In 2004, capital purchases for
Management Information System purposes totaled $2,624,000, including the new
core banking software, as well as related software, network servers and other
equipment. Also in 2004, the Corporation completed the renovation of the
Williamsport facility, and opened the branch in early June (Trust and Commercial
Lending staff moved in a few months prior to the opening of the branch). Total
cost allocated to the Williamsport land and building amounted to $2,428,000, of
which approximately $1,800,000 was incurred in 2003 with the remainder in 2004.
Capital purchases for furniture and equipment for operations in the Williamsport
facility amounted to $461,000 in 2004. Other significant capital purchases in
2004 included land and excavation costs related to a planned new administrative
building in Wellsboro, several new and replacement ATMs and related equipment,
remodeling and equipment for the new South Williamsport location and renovations
in the Athens branch. In 2003, the most significant projects 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. Depreciation
expense increased to $1,587,000 in 2004, from $1,211,000 in 2003 and $1,346,000
in 2002.
Total capital purchases for 2005 are estimated to range from $6 million to $8.5
million. More information concerning anticipated capital projects in 2005 is
provided in the "Outlook for 2005" section of Management's Discussion and
Analysis. In light of the Corporation's strong capital position and ample
sources of liquidity, management does not expect capital expenditures to have a
material, detrimental effect on the Corporation's financial condition or results
of operations in 2005.
TABLE VI - INVESTMENT SECURITIES
AS OF DECEMBER 31,
2004 2003 2002
AMORTIZED FAIR AMORTIZED FAIR AMORTIZED FAIR
COST VALUE COST VALUE COST VALUE
AVAILABLE-FOR-SALE SECURITIES:
Obligations of the U.S. Treasury $ - $ - $ - $ - $ - $ -
Obligations of other U.S. Government agencies 37,009 36,312 61,437 61,070 71,657 72,348
Obligations of states and political subdivisions 125,809 129,370 159,128 162,418 127,690 130,879
Other securities 100,871 103,107 45,992 47,648 62,296 63,592
Mortgage-backed securities 169,046 168,033 168,285 169,208 207,244 212,276
--------- ---------- --------- ---------- ----------- ----------
Total debt securities 432,735 436,822 434,842 440,344 468,887 479,095
Marketable equity securities 26,388 38,263 29,951 42,688 24,886 33,080
--------- ---------- --------- ---------- ----------- ----------
Total $ 459,123 $ 475,085 $ 464,793 $ 483,032 $ 493,773 $ 512,175
========= ========== ========= ========== =========== ==========
HELD-TO-MATURITY SECURITIES:
Obligations of the U.S. Treasury $ 316 $ 339 $ 319 $ 349 $ 321 $ 359
Obligations of other U.S. Government agencies 98 112 199 216 297 322
Mortgage-backed securities 19 20 42 44 89 93
--------- ---------- --------- ---------- ----------- ----------
Total $ 433 $ 471 $ 560 $ 609 $ 707 $ 774
========= ========== ========= ========== =========== ==========
- 19 -
TABLE VII - FIVE-YEAR SUMMARY OF LOANS BY TYPE
(IN THOUSANDS) 2004 % 2003 % 2002 % 2001 % 2000 %
Real estate - construction $ 4,178 0.72 $ 2,856 0.54 $ 103 0.02 $ 1,814 0.48 $ 452 0.14
Real estate - residential mortgage 347,705 59.98 330,807 63.03 292,136 64.76 245,997 64.87 207,100 63.08
Real estate - commercial mortgage 128,073 22.10 100,240 19.10 78,317 17.36 60,267 15.89 56,225 17.13
Consumer 31,702 5.47 33,977 6.47 31,532 6.99 29,284 7.72 28,141 8.57
Agricultural 2,872 0.50 2,948 0.56 3,024 0.67 2,344 0.62 1,983 0.60
Commercial 43,566 7.52 34,967 6.66 30,874 6.84 24,696 6.51 20,776 6.33
Other 1,804 0.31 1,183 0.23 2,001 0.44 1,195 0.32 948 0.29
Political subdivisions 19,713 3.40 17,854 3.40 13,062 2.90 13,479 3.55 12,462 3.80
Lease receivables - 0.00 65 0.01 96 0.02 152 0.04 218 0.07
-------- ------ -------- ------ -------- ------ --------- ------ --------- ------
Total 579,613 100.00 524,897 100.00 451,145 100.00 379,228 100.00 328,305 100.00
Less: unearned discount - - - - -
-------- -------- -------- --------- ---------
579,613 524,897 451,145 379,228 328,305
Less: allowance for loan losses (6,787) (6,097) (5,789) (5,265) (5,291)
-------- -------- -------- --------- ---------
Loans, net $572,826 $518,800 $445,356 $ 373,963 $ 323,014
======== ======== ======== ========= =========
TABLE VIII - LOAN MATURITY DISTRIBUTION
AS OF DECEMBER 31, 2004
VARIABLE OR ADJUSTABLE
FIXED RATE LOANS: RATE LOANS:
1 YEAR OR 1 YEAR OR
(IN THOUSANDS) LESS 1-5 YEARS > 5 YEARS TOTAL LESS 1-5 YEARS > 5 YEARS TOTAL
Real estate $ 25,132 $ 73,322 $ 180,983 $ 279,437 $ 29,210 $ 62,595 $ 10,887 $ 102,692
Commercial 13,384 34,650 39,454 87,488 69,178 605 386 70,169
Consumer 9,947 14,289 5,138 29,374 10,453 - - 10,453
-------- --------- --------- --------- --------- -------- -------- ---------
Total $ 48,463 $ 122,261 $ 225,575 $ 396,299 $ 108,841 $ 63,200 $ 11,273 $ 183,314
======== ========= ========= ========= ========= ======== ======== =========
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.
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 Credit Administration Department,
other Branch and Lending Staff, and the President. 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 the evaluation of each Watch List relationship with an outstanding
balance of $200,000 or more. This evaluation 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).
- 20 -
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.
As indicated in Table XI, total impaired loans amounted to $8,261,000 at
December 31 2004. This amount of impaired loans is higher than the December 31,
2003 amount of $4,621,000. Table XI also shows that the amount of loans
classified as nonaccrual increased to $7,796,000 at December 31, 2004 from
$1,145,000 at December 31, 2003. These fluctuations resulted mainly from certain
large commercial loan relationships, including one commercial loan relationship
with total outstanding loan balances of approximately $3.7 million as of
December 31, 2004. In 2004, management moved most of the loans outstanding
related to this large relationship, as well as certain other commercial loans,
into nonaccrual status. As of December 31, 2004, management has established a
valuation allowance of $173,000 related to this large relationship. In total,
the valuation allowance related to impaired loans decreased to $1,378,000 at
December 31, 2004, from $1,542,000 at December 31, 2003. Management believes it
has been conservative in its decisions concerning identification of impaired
loans, estimates of loss and nonaccrual status. However, the actual losses
realized from these relationships could vary materially from the allowances
calculated as of December 31, 2004. Management continues to closely monitor
these commercial loan relationships, and will adjust its estimates of loss and
decisions concerning nonaccrual status, if appropriate.
The allowance for loan losses was $6,787,000 at December 31, 2004, an increase
of $690,000 from the balance at December 31, 2003. As reflected in Table X, the
increase in the allowance included an increase in the unallocated portion to
$2,578,000 at December 31, 2004 from $2,117,000 at December 31, 2003.
Management's decision to increase the unallocated allowance in 2004 resulted
primarily from concerns stemming from the increase in impaired loans in 2004, as
discussed above.
Table IX shows that gross charge-offs totaled $786,000, and net charge-offs
totaled $710,000, in 2004. These amounts were lower than the corresponding
totals for 2003 of $968,000 (gross charge-offs) and $792,000 (net charge-offs).
The provision for loan losses amounted to $1,400,000 in 2004, $1,100,000 in 2003
and $940,000 in 2002. 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 IX through XII present historical data related to the allowance for loan
losses.
- 21 -
TABLE IX - ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES
YEARS ENDED DECEMBER 31,
(IN THOUSANDS) 2004 2003 2002 2001 2000
-------- -------- -------- -------- --------
Balance, beginning of year $ 6,097 $ 5,789 $ 5,265 $ 5,291 $ 5,131
-------- -------- -------- -------- --------
Charge-offs:
Real estate loans 375 168 123 144 272
Installment loans 217 326 116 138 77
Credit cards and related plans 178 171 190 200 214
Commercial and other loans 16 303 123 231 53
-------- -------- -------- -------- --------
Total charge-offs 786 968 552 713 616
-------- -------- -------- -------- --------
Recoveries:
Real estate loans 3 75 30 6 26
Installment loans 32 52 30 27 23
Credit cards and related plans 23 17 18 20 28
Commercial and other loans 18 32 58 34 23
-------- -------- -------- -------- --------
Total recoveries 76 176 136 87 100
-------- -------- -------- -------- --------
Net charge-offs 710 792 416 626 516
Provision for loan losses 1,400 1,100 940 600 676
-------- -------- -------- -------- --------
Balance, end of year $ 6,787 $ 6,097 $ 5,789 $ 5,265 $ 5,291
======== ======== ======== ======== ========
TABLE X - ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES BY TYPE
(IN THOUSANDS) 2004 2003 2002 2001 2000
Commercial $ 1,909 $ 1,578 $ 1,315 $ 1,837 $ 1,612
Consumer 404 378 494
409 471
Consumer mortgage 456 460 674
513 952
Impaired loans 1,378 1,542 1,877
73 273
Unallocated 2,578 2,117 1,759 2,187 1,983
------- ------- ------- ------- -------
Total Allowance $ 6,787 $ 6,097 $ 5,789 $ 5,265 $ 5,291
======= ======= ======= ======= =======
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 XI - PAST DUE AND IMPAIRED LOANS
(IN THOUSANDS) 2004 2003 2002
Impaired loans without a valuation allowance $ 3,552 $ 114 $ 675
Impaired loans with a valuation allowance 4,709 4,507 3,039
------- ------- -------
Total impaired loans $ 8,261 $ 4,621 $ 3,714
======= ======= =======
Valuation allowance related to impaired loans $ 1,378 $ 1,542 $ 1,877
Total nonaccrual loans $ 7,796 $ 1,145 $ 1,252
Total loans past due 90 days or more and
still accruing $ 1,307 $ 2,546 $ 2,318
- 22 -
TABLE XII - FIVE-YEAR HISTORY OF LOAN LOSSES (IN THOUSANDS)
2004 2003 2002 2001 2000 AVERAGE
Average gross loans $ 551,352 $ 485,150 $ 410,670 $ 346,353 $ 318,382 $ 422,381
Year-end gross loans 579,613 524,897 451,145 379,228 328,305 452,638
Year-end allowance for loan losses 6,787 6,097 5,789 5,265 5,291 5,846
Year-end nonaccrual loans 7,796 1,145 1,252 1,050 1,608 2,570
Year-end loans 90 days or more
past due and still accruing 1,307 2,546 2,318 2,067 1,221 1,892
Net charge-offs 710 792 416 626 516 612
Provision for loan losses 1,400 1,100 940 600 676 943
Earnings coverage of charge-offs 20.9 20.5 36.0 19.3 16.4 21.8
Allowance coverage of charge-offs 9.6 7.7 13.9 8.4 10.3 9.6
Net charge-offs as a % of
provision for loan losses 50.71% 72.00% 44.26% 104.33% 76.33% 64.90%
Net charge-offs as a % of
average gross loans 0.13% 0.16% 0.10% 0.18% 0.16% 0.14%
CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS
Table XIII presents the Corporation's significant fixed and determinable
contractual obligations as of December 31, 2004, by payment date. The payment
amounts represent the principal amounts of time deposits and borrowings, and do
not include interest. Operating leases and software maintenance commitments are
presented at the amounts due to the recipients, and are not discounted to
present value.
TABLE XIII - CONTRACTUAL OBLIGATIONS
(IN THOUSANDS) 1 YEAR 1-3 3-5 OVER 5
CONTRACTUAL OBLIGATIONS OR LESS YEARS YEARS YEARS TOTAL
- --------------------------- --------- --------- -------- --------- --------
Time deposits $ 168,450 $ 104,024 $ 26,404 $ 1 $298,879
Short-term borrowings:
Federal Home Loan Bank of
Pittsburgh 8,000 - - - 8,000
Repurchase agreements 5,000 - - - 5,000
Long-term borrowings:
Federal Home Loan Bank of
Pittsburgh 40,000 124,767 25,884 17,790 208,441
Repurchase agreements 15,666 34,720 12,000 - 62,386
Operating leases 94 106 33 - 233
Software maintenance 360 720 660 - 1,740
--------- --------- -------- -------- --------
Total $ 237,570 $ 264,337 $ 64,981 $ 17,791 $584,679
========= ========= ======== ======== ========
In addition to the amounts described in Table XIII, the Corporation has
obligations related to deposits without a stated maturity with outstanding
principal balances totaling $377,666,000 at December 31, 2004. The Corporation
also has obligations related to overnight customer repurchase agreements with
principal balances totaling $21,178,000 at December 31, 2004.
As described more fully in Note 16 to the consolidated financial statements, the
Corporation has a contingent obligation to pay additional licensing fees, based
on the Bank's asset size, through October 2009.
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.
- 23 -
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, 2004, the Corporation had unused borrowing
availability with correspondent banks and FHLB - Pittsburgh totaling
approximately $154,000,000. 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, 2004, this
ratio was 85%, which is an average 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 79% at
December 31, 2003, 70% at December 31, 2002 and 65% at December 31, 2001.
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. At December 31, 2004, the
carrying value of non-pledged securities was $289,063,000.
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 18 to the consolidated financial statements. As
reflected in Note 18, at December 31, 2004 and 2003, 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 $13,361,000 in 2004, $16,148,000 in
2003 and $21,821,000 in 2002. Other comprehensive income (loss) amounted to
($1,502,000) in 2004, ($109,000) in 2003 and $6,862,000 in 2002.
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.
- 24 -
RECENT ACCOUNTING PRONOUNCEMENTS
In April 2003, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards (SFAS) 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
133. The amendments set forth in SFAS 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 133. In addition,
it clarifies when a derivative contains a financing component that warrants
special reporting in the statement of cash flows. SFAS 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 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 46, "Consolidation of Variable
Interest Entities." The FASB then revised Interpretation 46 in December 2003.
Interpretation 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 became 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 March 2004, the FASB issued Emerging Issues Task Force (EITF) Issue 03-1, The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments. This statement provides guidance for evaluating whether an
investment is other-than-temporarily impaired and was effective for the
other-than-temporary impairment evaluations made in the reporting periods
beginning after June 15, 2004. The FASB staff has issued a proposed
Board-directed FASB Staff Position, FSP EITF Issue 03-1-a, Implementation
Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1. The
proposed FSP would provide implementation guidance with respect to debt
securities that are impaired solely due to interest rates and/or sector spreads
and analyzed for other-than-temporary impairment under paragraph 16 of Issue
03-1. In September 2004, based on comment letters received by constituents, the
Board decided to further consider whether application guidance is necessary for
all securities analyzed for impairment under paragraphs 10-20 of Issue 03-1. The
delay did not include the disclosure provisions, which will remain in effect
until the full reconsideration of Issue 03-01 guidance is completed. The
Corporation will delay the effective application until the implementation
guidance is finalized.
In December 2004, the FASB issued SFAS 123R, which replaces SFAS 123, Accounting
for Stock-Based Compensation, and supersedes APB Opinion 25, Accounting for
Stock Issued to Employees. SFAS 123R will require the Corporation to record
stock option expense based on estimated fair value determined using an option
valuation model. SFAS 123R applies to new awards granted, and to modifications
of existing awards, on or after July 1, 2005.
- 25 -
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
The Corporation's two major categories of market risk, interest rate risk 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 expenses. 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. In September 2004, the Bank's policy was expanded to provide
policy limits at +/- 100, 200 and 300 basis points from current rates (the prior
policy included limits based on +/- 200 basis points change from current rates).
The new policy limits for fluctuations in net interest income are tiered from
the baseline one-year scenario. The new policy limits for market value variances
are also tiered from the baseline values based on current rates. The most
sensitive scenario presented in Table XIV presented below is the "+300 basis
points" scenario. As the table shows, as of December 31, 2004, if interest rates
were to immediately rise 300 basis points, the Bank's calculations based on the
model show that although the change in net interest income is within the policy
threshold, the market value of portfolio equity would decrease 49.2%, which
exceeds the policy limit of 45%. Management will continue to evaluate whether to
make any changes to asset or liability holdings in an effort to reduce exposure
to decline in market value or net interest income in a rising interest rate
environment.
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.
- 26 -
TABLE XIV - THE EFFECT OF HYPOTHETICAL CHANGES IN INTEREST RATES
DECEMBER 31, 2004 DATA
(IN THOUSANDS)
PERIOD ENDING DECEMBER 31, 2005
INTEREST INTEREST NET INTEREST NII NII
BASIS POINT CHANGE IN RATES INCOME EXPENSE INCOME (NII) % CHANGE RISK LIMIT
+300 62,724 34,583 28,141 -16.8% 20.0%
+200 61,066 30,840 30,226 -10.7% 15.0%
+100 59,327 27,098 32,229 -4.7% 10.0%
0 57,343 23,510 33,833 0.0% 0.0%
-100 54,581 20,676 33,905 0.2% 10.0%
-200 51,800 17,924 33,876 0.1% 15.0%
-300 49,090 16,850 32,240 -4.7% 20.0%
MARKET VALUE OF PORTFOLIO EQUITY
AT DECEMBER 31, 2004
PRESENT PRESENT PRESENT
VALUE VALUE VALUE
BASIS POINT CHANGE IN RATES EQUITY % CHANGE RISK LIMIT
+300 71,244 -49.2% 45.0%
+200 94,088 -32.9% 35.0%
+100 117,491 -16.2% 25.0%
0 140,168 0.0% 0.0%
-100 153,026 9.2% 25.0%
-200 162,400 15.9% 35.0%
-300 171,463 22.3% 45.0%
PERIOD ENDING DECEMBER 31, 2004
DECEMBER 31, 2003 DATA
(IN THOUSANDS)
INTEREST INTEREST NET INTEREST NII NII
BASIS POINT CHANGE IN RATES INCOME EXPENSE INCOME (NII) % CHANGE RISK LIMIT
+300 60,287 29,227 31,060 -7.1% 20.0%
+200 58,319 26,047 32,272 -3.5% 15.0%
+100 56,293 23,003 33,290 -0.5% 10.0%
0 54,126 20,676 33,450 0.0% 0.0%
-100 50,844 18,349 32,495 -2.9% 10.0%
-200 48,386 16,343 32,043 -4.2% 15.0%
-300 46,232 15,645 30,587 -8.6% 20.0%
MARKET VALUE OF PORTFOLIO EQUITY
AT DECEMBER 31,2003
PRESENT PRESENT PRESENT
VALUE VALUE VALUE
BASIS POINT CHANGE IN RATES EQUITY % CHANGE RISK LIMIT
+300 59,637 -51.7% 45.0%
+200 79,649 -35.5% 35.0%
+100 101,318 -18.0% 25.0%
0 123,499 0.0% 0.0%
-100 138,591 12.2% 25.0%
-200 152,462 23.5% 35.0%
-300 171,534 38.9% 45.0%
- 27 -
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 $6,130,000 at December 31, 2004 and
$11,347,000 at December 31, 2003.
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.
Equity securities held as of December 31, 2004 and 2003 are as follows:
HYPOTHETICAL HYPOTHETICAL
10% 20%
DECLINE IN DECLINE IN
(IN THOUSANDS) FAIR MARKET MARKET
AT DECEMBER 31, 2004 COST VALUE VALUE VALUE
Banks and bank holding companies $ 17,426 $ 29,880 $ (2,988) $ (5,976)
Other equity securities 8,962 8,383 (838) (1,677)
-------- -------- ----------- ------------
Total $ 26,388 $ 38,263 $ (3,826) $ (7,653)
======== ======== =========== ============
HYPOTHETICAL HYPOTHETICAL
10% 20%
DECLINE IN DECLINE IN
(IN THOUSANDS) 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)
======== ======== =========== ============
- 28 -
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
CONSOLIDATED BALANCE SHEET DECEMBER 31, DECEMBER 31,
(In Thousands Except Share Data) 2004 2003
ASSETS
Cash and due from banks:
Noninterest-bearing $ 14,845 $ 13,938
Interest-bearing 4,108 1,233
------------ ------------
Total cash and cash equivalents 18,953 15,171
Available-for-sale securities 475,085 483,032
Held-to-maturity securities 433 560
Loans, net 572,826 518,800
Bank-owned life insurance 18,083 17,473
Accrued interest receivable 5,094 5,632
Bank premises and equipment, net 16,725 12,482
Foreclosed assets held for sale 497 101
Other assets 15,306 13,650
------------ ------------
TOTAL ASSETS $ 1,123,002 $ 1,066,901
============ ============
LIABILITIES
Deposits:
Noninterest-bearing $ 80,378 $ 75,616
Interest-bearing 596,167 582,449
------------ ------------
Total deposits 676,545 658,065
Dividends payable 1,864 1,763
Short-term borrowings 34,178 37,763
Long-term borrowings 270,827 235,190
Accrued interest and other liabilities 8,003 8,777
------------ ------------
TOTAL LIABILITIES 991,417 941,558
------------ ------------
STOCKHOLDERS' EQUITY
Common stock, par value $1.00 per share; authorized 20,000,000 shares in 2004 and
10,000,000 shares in 2003; issued 8,307,305 in 2004 and 8,226,033 in 2003 8,307 8,226
Stock dividend distributable 2,188 2,164
Paid-in capital 22,456 20,104
Retained earnings 90,484 84,940
------------ ------------
Total 123,435 115,434
Accumulated other comprehensive income 10,535 12,037
Unamortized stock compensation (46) (54)
Treasury stock, at cost:
204,659 shares at December 31, 2004 (2,339)
211,408 shares at December 31, 2003 (2,074)
------------ ------------
TOTAL STOCKHOLDERS' EQUITY 131,585 125,343
------------ ------------
TOTAL LIABILITIES & STOCKHOLDERS' EQUITY $ 1,123,002 $ 1,066,901
============ ===========
The accompanying notes are an integral part of the consolidated financial
statements.
- 29 -
CONSOLIDATED STATEMENT OF INCOME
(IN THOUSANDS EXCEPT PER SHARE DATA)
YEARS ENDED DECEMBER 31,
2004 2003 2002
INTEREST INCOME
Interest and fees on loans $ 34,251 $ 32,235 $ 30,641
Interest on balances with depository institutions 11 10 17
Interest on loans to political subdivisions 952 781 587
Interest on federal funds sold 10 8 42
Income from available-for-sale and held-to-maturity securities:
Taxable 13,999 13,686 19,051
Tax-exempt 7,256 7,335 5,799
Dividends 1,443 1,168 1,148
-------- -------- --------
Total interest and dividend income 57,922 55,223 57,285
-------- -------- --------
INTEREST EXPENSE
Interest on deposits 12,545 14,561 17,215
Interest on short-term borrowings 542 487 916
Interest on long-term borrowings 9,519 8,489 8,184
-------- -------- --------
Total interest expense 22,606 23,537 26,315
-------- -------- --------
Interest margin 35,316 31,686 30,970
Provision for loan losses 1,400 1,100 940
-------- -------- --------
Interest margin after provision for loan losses 33,916 30,586 30,030
-------- -------- --------
OTHER INCOME
Service charges on deposit accounts 1,717 1,746 1,725
Service charges and fees 308 287 258
Trust and financial management revenue 2,105 1,733 1,755
Insurance commissions, fees and premiums 439 391 577
Increase in cash surrender value of life insurance 610 715 853
Fees related to credit card operation 773 784 631
Other operating income 970 939 825
-------- -------- --------
Total other income before realized gains on securities, net 6,922 6,595 6,624
Realized gains on securities, net 2,877 4,799 2,888
-------- -------- --------
Total other income 9,799 11,394 9,512
-------- -------- --------
OTHER EXPENSES
Salaries and wages 11,248 9,696 9,418
Pensions and other employee benefits 3,404 3,317 2,651
Occupancy expense, net 1,664 1,295 1,094
Furniture and equipment expense 1,805 1,372 1,532
Expenses related to credit card operation 414 385 285
Pennsylvania shares tax 846 792 734
Other operating expense 6,620 5,257 5,135
-------- -------- --------
Total other expenses 26,001 22,114 20,849
-------- -------- --------
Income before income tax provision 17,714 19,866 18,693
Income tax provision 2,851 3,609 3,734
-------- -------- --------
NET INCOME $ 14,863 $ 16,257 $ 14,959
======== ======== ========
NET INCOME PER SHARE - BASIC $ 1.82 $ 1.99 $ 1.83
======== ======== ========
NET INCOME PER SHARE - DILUTED $ 1.81 $ 1.98 $ 1.83
======== ======== ========
The accompanying notes are an integral part of the consolidated financial
statements
-30-
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(IN THOUSANDS EXCEPT PER SHARE DATA)
STOCK ACCUM. OTHER UNAMORTIZED
COMMON DIVIDEND PAID-IN RETAINED COMPREHENSIVE STOCK TREASURY
STOCK DISTRIBUTABLE CAPITAL EARNINGS INCOME COMPENSATION STOCK TOTAL
------- ------------- -------- -------- ------------- ------------ -------- ---------
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, $0.85 per
share (6,821) (6,821)
Treasury stock purchased (174) (174)
Amortization of restricted stock 102 102
Shares issued from treasury related to
exercise of stock options 78 119 197
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
Comprehensive income:
Net income 14,863 14,863
Unrealized loss on securities,
net of reclassification adjustment
and tax effects (1,502) (1,502)
------------- ---------
Total comprehensive income 13,361
---------
Cash dividends declared, $.89 per share (7,214) (7,214)
Treasury stock purchased (575) (575)
Shares issued from treasury related to
exercise of stock options 245 283 528
Amortization of restricted stock 85 85
Tax benefit from employee benefit plan 83 83
Stock dividend issued 81 (2,164) 2,057 (26)
Stock dividend declared, 1% 2,188 (2,188) -
Restricted stock granted 62 (99) 37 -
Forfeiture of restricted stock (12) 22 (10) -
-------- ------------ -------- ---------
BALANCE, DECEMBER 31, 2004 $ 8,307 $ 2,188 $ 22,456 $ 90,484 $ 10,535 $ (46) $ (2,339) $ 131,585
======= ============= ======== ======== ============= ============ ======== =========
The accompanying notes are an integral part of the consolidated financial
statements.
- 31 -
CONSOLIDATED STATEMENT OF CASH FLOWS
(IN THOUSANDS)
YEARS ENDED DECEMBER 31,
2004 2003 2002
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 14,863 $ 16,257 $ 14,959
Adjustments to reconcile net income to net cash provided by
operating activities:
Provision for loan losses 1,400 1,100 940
Realized gains on securities, net (2,877) (4,799) (2,888)
Gain on sale of foreclosed assets, net (9) (105) (39)
Depreciation expense 1,587 1,211 1,346
Accretion and amortization, net 718 1,241 (376)
Increase in cash surrender value of life insurance (610) (715) (853)
Amortization of restricted stock 85 102 80
Deferred income taxes 96 (25) (284)
(Increase) Decrease in accrued interest receivable and other assets (424) 487 (958)
Increase (Decrease) in accrued interest payable and other liabilities 78 (164) 669
--------- --------- ---------
Net Cash Provided by Operating Activities 14,907 14,590 12,596
--------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from maturity of held-to-maturity securities 122 145 731
Proceeds from sales of available-for-sale securities 111,585 53,562 29,345
Proceeds from calls and maturities of available-for-sale securities 96,265 178,682 155,811
Purchase of available-for-sale securities (200,015) (199,705) (249,693)
Purchase of Federal Home Loan Bank of Pittsburgh stock (3,299) (1,855) (3,943)
Redemption of Federal Home Loan Bank of Pittsburgh stock 2,514 482 1,870
Net increase in loans (56,015) (74,824) (72,819)
Purchase of premises and equipment (5,830) (3,360) (1,712)
Proceeds from sale of foreclosed assets 202 340 648
--------- --------- ---------
Net Cash Used in Investing Activities (54,471) (46,533) (139,762)
--------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits 18,480 17,761 64,030
Net decrease in short-term borrowings (3,585) (5,872) (14,429)
Proceeds from long-term borrowings 84,112 64,500 117,653
Repayments of long-term borrowings (48,475) (37,524) (35,023)
Purchase of treasury stock (575) (174) (239)
Sale of treasury stock 528 197 76
Dividends paid (7,139) (6,674) (6,038)
--------- --------- ---------
Net Cash Provided by Financing Activities 43,346 32,214 126,030
--------- --------- ---------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 3,782 271 (1,136)
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 15,171 14,900 16,036
--------- --------- ---------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 18,953 $ 15,171 $ 14,900
========= ========= =========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Assets acquired through foreclosure of real estate loans $ 589 $ 280 $ 486
Interest paid $ 22,070 $ 23,736 $ 26,424
Income taxes paid $ 2,999 $ 3,195 $ 4,509
The accompanying notes are an integral part of the consolidated financial
statements.
- 32 -
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
accounting principles generally accepted in the United States of America
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.
- 33 -
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.
INTEREST COSTS - The Corporation capitalizes interest as a component of the cost
of premises and equipment constructed or acquired for its own use. In 2004,
total interest incurred was $22,649,000, of which $22,606,000 was charged to
expense and $43,000 was capitalized. Total interest incurred amounted to
$23,537,000 in 2003 and $26,315,000 in 2002, all of which was charged to
expense.
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, alternate minimum tax,
investments in limited partnerships and amortization of loan origination fees
and costs.
STOCK COMPENSATION PLANS - As permitted by Accounting Principles Board (APB)
Opinion 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 (SFAS) 123, "Accounting for Stock-based
Compensation," to stock options.
- 34 -
(NET INCOME IN THOUSANDS) 2004 2003 2002
Net income, as reported $ 14,863 $ 16,257 $ 14,959
Deduct: Total stock option compensation
expense determined under fair value
method for all awards, net of tax effects (90) (124) (191)
--------- -------- --------
Pro forma net income $ 14,773 $ 16,133 $ 14,768
========= ======== ========
Earnings per share-basic
As reported $ 1.82 $ 1.99 $ 1.83
Pro forma $ 1.80 $ 1.97 $ 1.81
Earnings per share-diluted
As reported $ 1.81 $ 1.98 $ 1.83
Pro forma $ 1.79 $ 1.96 $ 1.80
In December 2004, the Financial Accounting Standards Board issued SFAS 123R,
which replaces SFAS 123 and supersedes APB Opinion 25. SFAS 123R will require
the Corporation to record stock option expense based on estimated fair value
determined using an option valuation model. SFAS 123R applies to new awards
granted, and to modifications of existing awards, on or after July 1, 2005.
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) 2004 2003 2002
Unrealized holding gains on available-for-sale securities $ 600 $ 4,636 $ 13,283
Less: Reclassification adjustment for gains realized in income (2,877) (4,799) (2,888)
-------- -------- --------
Net unrealized (losses) gains (2,277) (163) 10,395
Tax effect 775 54 (3,533)
-------- -------- --------
Net-of-tax amount $ (1,502) $ (109) $ 6,862
======== ======== ========
- 35 -
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.
WEIGHTED-
AVERAGE EARNINGS
NET COMMON PER
INCOME SHARES SHARE
------ ------ -----
2004
Earnings per share - basic $ 14,863,000 8,185,466 $ 1.82
Dilutive effect of potential common stock
arising from stock options:
Exercise of outstanding stock options 188,514
Hypothetical share repurchase at $25.39 (139,988)
------------ --------- -----------
Earnings per share - diluted $ 14,863,000 8,233,992 $ 1.81
============ ========= ===========
2003
Earnings per share - basic $ 16,257,000 8,170,651 $ 1.99
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 8,219,366 $ 1.98
============ ========= ===========
2002
Earnings per share - basic $ 14,959,000 8,170,159 $ 1.83
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 8,192,047 $ 1.83
============ ========= ===========
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 2004 ranged from $2,984,000 to $4,541,000. For 2003, theses balances ranged
from $2,402,000 to $4,434,000. Average daily cash balances with the Federal
Reserve Bank required for services provided to the Bank were $2,500,000 in 2004
and 2003. Total balances restricted amounted to $6,248,000 at December 31, 2004
and $6,324,000 at December 31, 2003.
- 36 -
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.
5. SECURITIES
Amortized cost and fair value of securities at December 31, 2004 and 2003 are
summarized as follows:
DECEMBER 31, 2004
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 37,009 67 (764) 36,312
Obligations of states and political subdivisions 125,809 4,147 (586) 129,370
Other securities 100,871 2,675 (439) 103,107
Mortgage-backed securities 169,046 1,002 (2,015) 168,033
-------- ------- ------- --------
Total debt securities 432,735 7,891 (3,804) 436,822
Marketable equity securities 26,388 12,874 (999) 38,263
-------- ------- ------- --------
Total $459,123 $20,765 $(4,803) $475,085
======== ======= ======= ========
HELD-TO-MATURITY SECURITIES:
Obligations of the U.S. Treasury $ 316 $ 23 $ - $ 339
Obligations of other U.S. Government agencies 98 14 - 112
Mortgage-backed securities 19 1 - 20
-------- ------- ------- --------
Total $ 433 $ 38 $ - $ 471
======== ======= ======= ========
DECEMBER 31, 2004
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
======== ======= ======= ========
- 37 -
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,
2004:
(IN THOUSANDS) LESS THAN 12 MONTHS 12 MONTHS OR MORE TOTAL
FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED
VALUE LOSSES VALUE LOSSES VALUE LOSSES
AVAILABLE-FOR-SALE SECURITIES:
Obligations of the U.S. Treasury $ - $ - $ - $ - $ - $ -
Obligations of other U.S. Government agencies 19,675 (325) 9,550 (439) 29,225 (764)
Obligations of states and political subdivisions 15,497 (260) 12,265 (326) 27,762 (586)
Other securities 41,837 (316) 4,975 (123) 46,812 (439)
Mortgage-backed securities 94,435 (1,440) 25,646 (575) 120,081 (2,015)
-------- ------- ------- ------- -------- -------
Total debt securities 171,444 (2,341) 52,436 (1,463) 223,880 (3,804)
Marketable equity securities 1,366 (52) 4,958 (947) 6,324 (999)
-------- ------- ------- ------- -------- -------
Total temporarily impaired available-for-sale
securities $172,810 $(2,393) $57,394 $(2,410) $230,204 $(4,803)
======== ======= ======= ======= ======== =======
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-sponsored agencies or state and political
subdivisions, management believes the Corporation's debt securities at December
31, 2004 were not other-than-temporarily impaired.
Of the total $999,000 unrealized losses on equity securities at December 31,
2004, $870,000 was from a preferred stock issued by an U.S. Government-sponsored
agency. Management believes this security's fair value is affected primarily by
volatility in interest rates, and although not guaranteed by the U.S.
Government, 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, 2004, 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,
2004 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.
- 38 -
(IN THOUSANDS)
DECEMBER 31, 2004
-----------------------
AMORTIZED FAIR
COST VALUE
AVAILABLE-FOR-SALE SECURITIES:
Due in one year or less $ 342 $ 348
Due after one year through five years 2,052 2,084
Due after five years through ten years 46,110 45,753
Due after ten years 384,231 388,637
-------- --------
Total $432,735 $436,822
======== ========
HELD-TO-MATURITY SECURITIES:
Due in one year or less $ - $ -
Due after one year through five years 11 11
Due after five years through ten years 414 452
Due after ten years 8 8
-------- --------
Total $ 433 $ 471
======== ========
The following table shows the amortized cost and maturity distribution of the
debt securities portfolio at December 31, 2004:
(IN THOUSANDS, EXCEPT FOR PERCENTAGES)
WITHIN ONE - FIVE - AFTER
ONE FIVE TEN TEN
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 - - - - 22,018 3.99% 14,991 5.19% 37,009 4.48%
Obligations of states and political
subdivisions 335 6.55% 2,040 5.15% 2,609 5.79% 120,825 4.76% 125,809 4.79%
Other securities - - - - 13,177 4.99% 87,694 5.63% 100,871 5.55%
Mortgage-backed securities 7 8.41% 12 8.50% 8,306 3.26% 160,721 4.54% 169,046 4.48%
----- ---- ------- ---- --------- ---- ---------- ---- -------- ----
Total $ 342 6.59% $ 2,052 5.17% $ 46,110 4.25% $ 384,231 4.88% $432,735 4.82%
===== ==== ======= ==== ========= ==== ========== ==== ======== ====
HELD-TO-MATURITY SECURITIES:
Obligations of the U.S. Treasury $ - - $ - - $ 316 5.30% $ - - $ 316 5.30%
Obligations of other U.S. Government
agencies - - - 98 7.16% - - 98 7.16%
Mortgage-backed securities - - 11 6.38% - - 8 5.12% 19 5.89%
----- ---- ------- ---- --------- ---- ---------- ---- -------- ----
Total $ - - $ 11 6.38% $ 414 5.74% $ 8 5.12% $ 433 5.75%
===== ==== ======= ==== ========= ==== ========== ==== ======== ====
Investment securities carried at $89,158,000 at December 31, 2004 and
$80,308,000 at December 31, 2003, 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 2004, 2003 and
2002 were as follows:
(IN THOUSANDS)
2004 2003 2002
Gross realized gains $ 3,880 $ 4,860 $ 2,926
Gross realized losses (1,003) (61) (38)
------- ------- -------
Net realized gains $ 2,877 $ 4,799 $ 2,888
======= ======= =======
Income tax provision related to net realized gains $ 978 $ 1,632 $ 982
======= ======= =======
- 39 -
6. LOANS
Major categories of loans and leases included in the loan portfolio are as
follows:
DECEMBER 31, % OF DECEMBER 31, % OF
(IN THOUSANDS) 2004 TOTAL 2003 TOTAL
Real estate - construction $ 4,178 0.72% $ 2,856 0.54%
Real estate - residential mortgage 347,705 59.99% 330,807 63.02%
Real estate - commercial mortgage 128,073 22.09% 100,240 19.10%
Consumer 31,702 5.47% 33,977 6.47%
Agricultural 2,872 0.50% 2,948 0.56%
Commercial 43,566 7.52% 34,967 6.66%
Other 1,804 0.31% 1,183 0.23%
Political subdivisions 19,713 3.40% 17,854 3.40%
Lease receivables - 0.00% 65 0.01%
--------- ------ --------- ------
Total 579,613 100.00% 524,897 100.00%
Less: allowance for loan losses (6,787) (6,097)
--------- ---------
Loans, net $ 572,826 $ 518,800
========= =========
Net unamortized loan fees and costs of $1,704,000 at December 31, 2004 and
$1,629,000 at December 31, 2003 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, 2004.
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.
Transactions in the allowance for loan losses were as follows:
(IN THOUSANDS) 2004 2003 2002
Balance at beginning of year $ 6,097 $ 5,789 $ 5,265
Provision charged to operations 1,400 1,100 940
Loans charged off (786) (968) (552)
Recoveries 76 176 136
------- ------- -------
Balance at end of year $ 6,787 $ 6,097 $ 5,789
======= ======= =======
Information related to impaired and nonaccrual loans, and loans past due 90 days
or more, as of December 31, 2004 and 2003 is as follows:
(IN THOUSANDS) 2004 2003
Impaired loans without a valuation allowance $ 3,552 $ 114
Impaired loans with a valuation allowance 4,709 4,507
------- -------
Total impaired loans $ 8,261 $ 4,621
======= =======
Valuation allowance related to impaired loans $ 1,378 $ 1,542
Total nonaccrual loans $ 7,796 $ 1,145
Total loans past due 90 days or more and
still accruing $ 1,307 $ 2,546
- 40 -
The following is a summary of information related to impaired loans for 2004,
2003 and 2002:
(IN THOUSANDS) 2004 2003 2002
Average investment in impaired loans $7,458 $3,425 $3,838
====== ====== ======
Interest income recognized on impaired loans $ 352 $ 313 $ 247
====== ====== ======
Interest income recognized on a cash basis
on impaired loans $ 352 $ 313 $ 247
====== ====== ======
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:
DECEMBER 31,
(IN THOUSANDS) 2004 2003
Land $ 1,449 $ 1,275
Buildings and improvements 15,734 13,125
Furniture and equipment 13,539 9,663
Construction in progress 874 1,807
-------- --------
Total 31,596 25,870
Less: accumulated depreciation (14,871) (13,388)
-------- --------
Net $ 16,725 $ 12,482
======== ========
Depreciation expense included in occupancy expense and furniture and equipment
expense was as follows:
(IN THOUSANDS) 2004 2003 2002
Occupancy expense $ 572 $ 479 $ 432
Furniture and equipment expense 1,015 732 914
------- ------- -------
Total $ 1,587 $ 1,211 $ 1,346
======= ======= =======
8. DEPOSITS
At December 31, 2004, the scheduled maturities of time deposits are as follows:
(IN THOUSANDS)
2005 $168,450
2006 75,742
2007 28,282
2008 15,024
2009 11,380
THEREAFTER 1
--------
$298,879
========
- 41 -
Included in interest-bearing deposits are time deposits in the amount of
$100,000 or more. As of December 31, 2004, the remaining maturities or repricing
frequency of time deposits of $100,000 or more are as follows:
(IN THOUSANDS)
Three months or less $39,959
Over 3 months through 12 months 12,020
Over 1 year through 3 years 13,128
Over 3 years 7,546
-------
Total $72,653
=======
Interest expense from deposits of $100,000 or more amounted to $2,214,000 in
2004, $2,693,000 in 2003 and $3,238,000 in 2002.
9. BORROWED FUNDS
SHORT-TERM BORROWINGS
Short-term borrowings include the following:
AT DECEMBER 31,
(IN THOUSANDS) 2004 2003
Overnight borrowings (a) $ - $ 6,900
Federal Home Loan Bank of Pittsburgh borrowings (b) 8,000 7,500
Customer repurchase agreements (c) 21,178 23,363
Other repurchase agreements (d) 5,000 -
------- -------
Total short-term borrowings $34,178 $37,763
======= =======
The weighted average interest rate on total short-term borrowings outstanding
was 1.72% at December 31, 2004 and 1.21% at December 31, 2003. The maximum
amount of total short-term borrowings outstanding at any month-end was
$55,278,000 in 2004 and $45,166,000 in 2003.
(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 $17,100,000 in 2004, $16,950,000 in 2003
and $14,350,000 in 2002. The average amount of such borrowings was $6,258,000 in
2004, $6,044,000 in 2003 and $2,347,000 in 2002. Weighted average interest rates
were 1.59% in 2004, 1.50% in 2003 and 1.86% in 2002.
(b) Short-term FHLB - Pittsburgh loans are as follows:
AT DECEMBER 31,
(IN THOUSANDS) 2004 2003
Fixed Rate 1.47% maturing February 23, 2005 $3,000
Fixed Rate 2.67% maturing March 17, 2005 5,000
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 $8,000 $7,500
====== ======
Collateral for FHLB - Pittsburgh loans is described under the "Long-term
Borrowings" section of this note.
- 42 -
(c) Customer repurchase agreements mature overnight, and are collateralized by
securities with a carrying value of $26,336,000 at December 31, 2004 and
$35,680,000 at December 31, 2003.
(d) Other repurchase agreements included in short-term borrowings are as
follows:
AT DECEMBER 31,
(IN THOUSANDS) 2004 2003
Fixed Rate 1.45% matures April 26, 2005 $ 5,000 $ -
-------- ---
Total other repurchase agreements $ 5,000 $ -
======== ===
The terms and collateral related to repurchase agreements are described under
the "Long-term Borrowings" section of this note.
LONG-TERM BORROWINGS
Long-term borrowings are as follows:
AT DECEMBER 31,
(IN THOUSANDS) 2004 2003
FHLB - Pittsburgh borrowings (e) $ 208,441 $ 185,037
Repurchase agreements (f) 62,386 50,153
--------- ---------
Total long-term borrowings $ 270,827 $ 235,190
========= =========
(e) Long-term borrowings from FHLB - Pittsburgh are as follows:
AT DECEMBER 31,
(IN THOUSANDS) 2004 2003
Loans matured in 2004 with rates ranging from 2.16% to 4.65% $ - $ 28,000
Loans maturing in 2005 with rates ranging from 1.64% to 5.05% 40,000 40,000
Loans maturing in 2006 with rates ranging from 2.07% to 4.83% 50,700 40,000
Loans maturing in 2007 with rates ranging from 2.68% to 4.58% 74,067 45,000
Loans maturing in 2008 with rates ranging from 2.07% to 3.67% 19,500 14,500
Loans maturing in 2009 with rates ranging from 3.60% to 3.62% 6,384 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% 453 476
Loan maturing in 2017 with a rate of 6.83% 58 61
Loan maturing in 2020 with a rate of 4.79% 2,279 -
--------- ---------
Total long-term FHLB - Pittsburgh borrowings $ 208,441 $ 185,037
========= =========
The FHLB - Pittsburgh loan facilities are collateralized by qualifying
securities and mortgage loans with a book value totaling $350,935,000 at
December 31, 2004. 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
$12,360,000 at December 31, 2004 and $11,575,000 at December 31, 2003.
- 43 -
(f) Repurchase agreements included in long-term borrowings are as follows:
AT DECEMBER 31,
(IN THOUSANDS) 2004 2003
Agreements matured in 2004 with rates ranging from 1.62% to 3.96% $ - $19,767
Agreements maturing in 2005 with rates ranging from 2.01% to 4.63% 15,666 15,666
Agreements maturing in 2006 with rates ranging from 2.02% to 4.63% 20,220 10,220
Agreements maturing in 2007 with rates ranging from 2.53% to 3.23% 14,500 2,500
Agreements maturing in 2008 with rates ranging from 3.00% to 3.60% 12,000 2,000
------- -------
Total long-term repurchase agreements $62,386 $50,153
======= =======
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 $70,528,000 at December 31, 2004 and $58,086,000
at December 31, 2003. Average daily repurchase agreement borrowings amounted to
$58,663,000 in 2004, $40,333,000 in 2003 and $36,482,000 in 2002. During 2004,
2003 and 2002, the maximum amounts of outstanding borrowings under repurchase
agreements with broker-dealers were $67,386,000, $50,153,000 and $44,720,000.
The weighted average interest rate on repurchase agreements was 3.20% in 2004,
3.68% in 2003 and 3.72% in 2002.
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):
- 44 -
AT DECEMBER 31,
2004 2003
Contractual amount of IPCDs (equal
to notional amount of Swap contracts) $4,045 $3,593
Carrying value of IPCDs 3,695 3,160
Carrying value of embedded derivative liabilities 297 298
Carrying value of Swap contract liabilities 42 130
FOR THE YEARS ENDED DECEMBER 31,
2004 2003 2002
Interest expense $ 143 $ 112 $ 88
Other expense 9 10 8
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.
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, 2004 and 2003. 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.
- 45 -
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, 2004 DECEMBER 31, 2003
CARRYING FAIR CARRYING FAIR
AMOUNT VALUE AMOUNT VALUE
Financial assets:
Cash and cash equivalents $ 18,953 $ 18,953 $ 15,171 $ 15,171
Available-for-sale securities 475,085 475,085 483,032 483,032
Held-to-maturity securities 433 471 560 609
Restricted equity securities 12,360 12,360 11,575 11,575
Loans, net 572,826 578,720 518,800 524,407
Accrued interest receivable 5,094 5,094 5,632 5,632
Financial liabilities:
Deposits 676,545 677,182 658,065 661,141
Short-term borrowings 34,178 34,133 37,763 37,762
Long-term borrowings 270,827 270,015 235,190 240,527
Accrued interest payable 1,639 1,639 1,105 1,105
Embedded derivative liabilities -
IPCDs 297 297 298 298
Equity option Swap contracts -
IPCDs 42 42 130 130
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,
2004 and 2003, and will not affect the Corporation's future expenses.
The Corporation uses a December 31 measurement date for its plans.
- 46 -
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
2004 2003 2004 2003
CHANGE IN BENEFIT
OBLIGATION:
Benefit obligation at beginning of year $ 10,086 $ 8,769 $ 1,029 $ 886
Service cost 474 394 43 32
Interest cost 620 590 63 60
Plan participants' contributions - - 164 147
Actuarial loss (gain) 478 755 46 105
Benefits paid (463) (422) (216) (201)
---------- ---------- ---------- ----------
Benefit obligation at end of year $ 11,195 $ 10,086 $ 1,129 $ 1,029
========== ========== ========== ==========
CHANGE IN PLAN ASSETS:
Fair value of plan assets at
beginning of year $ 8,654 $ 7,668 $ - $ -
Actual return on plan assets 794 1,013 - -
Employer contribution 328 395 52 54
Plan participants' contributions - - 164 147
Benefits paid (463) (422) (216) (201)
---------- ---------- ---------- ----------
Fair value of plan assets at end of year $ 9,313 $ 8,654 $ - $ -
========== ========== ========== ==========
Funded status $ (1,882) $ (1,432) $ (1,129) $ (1,029)
Unrecognized net actuarial loss (gain) 2,364 1,997 105 61
Unrecognized transition (asset) obligation (137) (160) 292 328
---------- ---------- ---------- ----------
Prepaid (accrued) benefit cost $ 345 $ 405 $ (732) $ (640)
========== ========== ========== ==========
The accumulated benefit obligation for the defined benefit pension plan was
$8,380,000 at December 31, 2004 and $7,595,000 at December 31, 2003.
The components of net periodic benefit costs from these defined benefit plans
are as follows:
(IN THOUSANDS)
PENSION BENEFITS POSTRETIREMENT BENEFITS
2004 2003 2002 2004 2003 2002
Service cost $ 474 $ 394 $ 349 $ 43 $ 32 $ 24
Interest cost 620 590 553 63 60 57
Expected return on plan assets (748) (615) (702) - - -
Amortization of transition (asset) obligation (23) (22) (23) 36 37 36
Recognized net actuarial loss (gain) 65 86 8 2 1 1
------- ------- ------- ------- ------- -------
Net periodic benefit cost (benefit) $ 388 $ 433 $ 185 $ 144 $ 130 $ 118
======= ======= ======= ======= ======= =======
- 47 -
The weighted-average assumptions used to determine benefit obligations as of
December 31, 2004 and 2003 are as follows:
PENSION POSTRETIREMENT
BENEFITS BENEFITS
2004 2003 2004 2003
Discount rate 6.00% 6.25% 6.00% 6.25%
Expected return on plan assets 8.50% 8.50% N/A N/A
Rate of compensation increase 4.50% 4.50% 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 2002, 2003 and 2004, is reasonable.
Management has calculated the average annual return on pension plan assets over
the period 1991-2004 to be 9.45%, 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, 2004 and 2003 are as follows:
2004 2003
Cash and cash equivalents 5% 3%
Debt securities 34% 40%
Equity securities 61% 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.
The Corporation expects to contribute $365,000 to the defined benefit pension
plan, and $61,000 to the postretirement benefit plan, in 2005.
Estimated future benefit payments (including, for the postretirement plan, only
the estimated employer contributions), which reflect expected future service,
are as follows:
(IN THOUSANDS)
PENSION POSTRETIREMENT
BENEFITS BENEFITS
2005 $ 419 $ 61
2006 412 61
2007 420 61
2008 439 67
2009 492 69
2010-2014 2,970 407
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.
- 48 -
The Corporation has not yet determined whether benefits provided under the
postretirement plan are actuarially equivalent to benefits that will be
available under Medicare Part D. Accordingly, the financial statement amounts
and disclosures related to the postretirement benefits plan do not reflect the
effects of the Act.
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 $727,000 in 2004, $728,000 in 2003 and $667,000 in 2002.
The profit sharing/401(k) Plan includes 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, 2004, 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, 2004, the ESOP held 292,614 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 $385,000 in 2004, $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 $4,000 in 2004, $45,000 in 2003 and $44,000 in 2002.
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, 2003 and 2004, there were awards of Incentive Stock
Options and restricted stock. The Incentive Stock Options granted in 2000, 2002,
2003 and 2004 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. 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 3, 2005, the Corporation granted options to purchase a total
of 37,176 shares of common stock through the Stock Incentive and Independent
Directors Stock Incentive Plans. The exercise price for these options is $27.00
per share, which was the market price at the date of grant. Also, effective
January 3, 2005, the Corporation awarded a total of 4,128 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 2005
are not included in the tables that follow.
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.
- 49 -
(NET INCOME IN THOUSANDS)
2004 2003 2002
Net income
As reported $ 14,863 $ 16,257 $ 14,959
Pro forma $ 14,773 $ 16,133 $ 14,768
Earnings per share-basic
As reported $ 1.82 $ 1.99 $ 1.83
Pro forma $ 1.80 $ 1.97 $ 1.81
Earnings per share-diluted
As reported $ 1.81 $ 1.98 $ 1.83
Pro forma $ 1.79 $ 1.96 $ 1.80
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:
2004 2003 2002
Volatility 15% 15% 17%
Expected option lives 6 Years 6 Years 6 Years
Risk-free interest rate 3.87% 3.55% 5.00%
Dividend yield 4.46% 4.30% 4.16%
A summary of the status of the Corporation's stock option plans is presented
below:
2004 2003 2002
---- ---- ----
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
Outstanding, beginning of year 213,058 $ 18.81 180,722 $ 18.11 124,842 $ 18.49
Granted 33,249 $ 26.59 46,411 $ 20.73 61,223 $ 17.00
Exercised (29,795) $ 18.32 (12,066) $ 16.28 (5,343) $ 13.98
Forfeited (4,049) $ 21.80 (2,009) $ 16.19 - $ -
--------- --------- --------- --------- --------- ---------
Outstanding, end of year 212,463 $ 20.03 213,058 $ 18.81 180,722 $ 18.11
========= ========= ========= ========= ========= =========
Options exercisable at year-end 212,463 $ 20.03 207,898 $ 18.82 165,824 $ 17.97
Fair value of options granted $ 2.57 $ 2.11 $ 2.45
- 50 -
The following table summarizes information about stock options outstanding as of
December 31, 2004:
OUTSTANDING EXERCISABLE
AT REMAINING AT
DECEMBER 31, CONTRACTUAL DECEMBER 31,
EXERCISE PRICES 2004 LIFE IN YEARS 2004
$ 13.33 1,818 1 1,818
$ 17.00 5,850 2 5,850
$ 18.03-$ 22.17 16,119 3 16,119
$ 24.25-$ 24.33 21,900 4 21,900
$ 18.00-$ 22.08 25,440 5 25,440
$ 13.50-$ 16.67 21,108 6 21,108
$ 17.00 49,732 7 49,732
$ 20.73 39,117 8 39,117
$ 26.59 31,379 9 31,379
------- -- -------
212,463 212,463
======= =======
The following table summarizes restricted stock awards in 2004, 2003 and 2002:
2004 2003 2002
Number of shares awarded 3,714 5,166 6,647
Market price of stock at date of grant $ 26.59 $ 20.73 $ 17.00
Compensation expense related to restricted stock was $85,000 in 2004, $102,000
in 2003 and $80,000 in 2002.
13. INCOME TAXES
The following temporary differences gave rise to the net deferred tax liability
at December 31, 2004 and 2003:
(IN THOUSANDS)
2004 2003
Deferred tax liabilities:
Depreciation $ 1,151 $ 340
Prepaid pension 120 142
Accretion on securities 8 9
Investments in limited partnerships - 13
Realized gains on securities 75 62
Interest expense - Index Powered CDs 16 -
Unrealized holding gains on securities 5,427 6,201
-------- --------
Total 6,797 6,767
-------- --------
Deferred tax assets:
Allowance for loan losses (2,375) (2,134)
Credit for alternative minimum tax paid (300) -
Postretirement and sick benefits (276) (243)
Investments in limited partnerships (125) -
Loan fees and costs (60) (63)
Supplemental executive retirement plan (178) (182)
Restricted stock compensation (48) (32)
-------- --------
Total (3,362) (2,654)
-------- --------
Deferred tax liability, net $ 3,435 $ 4,113
======== ========
-51-
Tax provision:
2004 2003 2002
Currently payable $ 2,755 $ 3,634 $ 4,018
Deferred 96 (25) (284)
------- ------- -------
Total provision $ 2,851 $ 3,609 $ 3,734
======= ======= =======
Reconciliation of tax provision:
2004 2003 2002
AMOUNT % AMOUNT % AMOUNT %
Expected provision $ 6,200 35.00% $ 6,953 35.00% $ 6,543 35.00%
Tax-exempt interest income (2,790) (15.75) (2,766) (13.92) (2,223) (11.89)
Nondeductible interest expense 238 1.34 242 1.22 239 1.28
Dividends received deduction (347) (1.96) (284) (1.43) (280) (1.50)
Increase in cash surrender value of
life insurance (214) (1.21) (250) (1.26) (299) (1.60)
Surtax exemption (84) (0.47) (185) (0.93) (176) (0.94)
Other, net (152) (0.86) (101) (0.51) (70) (0.37)
-------- -------- -------- -------- -------- --------
Effective income tax provision $ 2,851 16.09% $ 3,609 18.17% $ 3,734 19.98%
======== ======== ======== ======== ======== ========
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 THOUSAND
BEGINNING NEW OTHER ENDING
BALANCE LOANS REPAYMENTS CHANGES BALANCE
13 directors, 5 executive officers 2004 $ 7,193 $ 1,501 $ (2,054) $ 1,055 $ 7,695
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
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 $1,887,000 at
December 31, 2004 and $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.
-52-
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, 2004 and 2003 are as follows:
(IN THOUSANDS) 2004 2003
Commitments to extend credit $ 226,121 $ 111,843
Standby letters of credit 17,049 14,064
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, 2004 and 2003.
Financial standby letters of credit as of December 31, 2004 expire as follows:
(IN THOUSANDS)
Year of Expiration Amount
- ------------------ -------
2005 $11,568
2006 5,051
2007 430
-------
Total $17,049
=======
16. OPERATING LEASES AND OTHER PURCHASE COMMITMENTS
The Corporation leases facilities and office equipment under operating leases
expiring through 2009. Rental expense under these operating leases totaled
approximately $89,000 in 2004. Minimum future rental payments under
non-cancelable operating leases having remaining terms in excess of 1 year as of
December 31, 2004 are as follows:
(IN THOUSANDS)
2005 $ 94
2006 75
2007 31
2008 22
2009 11
THEREAFTER -
The facility leases contain renewal options for an additional 5-15 years at
rental amounts established in the leases.
-53-
In 2004, the Corporation purchased the license to utilize banking software, and
entered into contractual commitments to pay annual maintenance fees associated
with the software. Maintenance expense amounted to $60,000 in 2004, and
maintenance fees payable will be approximately $360,000 per year through 2008
and $300,000 in 2009. Through October 2009, the Corporation would also be
required to pay additional software license fees, based on the Bank's asset
size, determined based on the following schedule (additional licensing fees in
thousands):
ASSET SIZE ADDITIONAL LICENSING FEE
- ----------------------------- -----------------------------------------------
$1.75 BILLION TO $2 BILLION $ 250
$2 BILLION TO $2.25 BILLION 150 in addition to the $250 noted above
$2.25 BILLION TO $2.5 BILLION 250 in addition to the $400 noted above
ABOVE $2.5 BILLION Based on the vendor's then-current fee schedule
Effective in October 2007, the Corporation has the right to terminate its
contractual commitment to the software vendor, subject to payment of 25% of any
remaining annual maintenance fees.
The agreement between the software vendor and the Corporation contains options
for an unlimited number of additional 5-year renewals. The agreement includes
formulas to determine the amounts of maintenance fees and additional licensing
fees, if the Corporation exercises the renewal options.
17. CONTINGENCIES
In the normal course of business, the Corporation is subject to pending and
threatened litigation in which claims for monetary damages are asserted. In
management's opinion, the Corporation's financial position and results of
operations would not be materially affected by the outcome of these legal
proceedings.
18. 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,
2004 and 2003, 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.
-54-
(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, 2004:
Total capital to
risk-weighted assets:
Consolidated $133,181 18.89% $ 56,399 >or=8% $ n/a n/a
Bank 107,974 15.66% 55,172 >or=8% 68,965 >or=10%
Tier 1 capital to
risk-weighted assets:
Consolidated 121,050 17.17% 28,200 >or=4% n/a n/a
Bank 98,637 14.30% 27,586 >or=4% 41,379 >or=6%
Tier 1 capital to
average assets:
Consolidated 121,050 10.69% 45,276 >or=4% n/a n/a
Bank 98,637 8.95% 44,103 >or=4% 55,129 >or=5%
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 93,289 15.83% 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 93,289 9.13% 40,854 >or=4% 51,068 >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 2005 may not exceed $17,085,000, plus consolidated
net income for 2005. 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 $88,610,000 at December 31, 2004, 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 $9,864,000 at December 31,
2004.
-55-
19. PARENT COMPANY ONLY
The following is condensed financial information for Citizens & Northern
Corporation.
CONDENSED BALANCE SHEET
DECEMBER 31,
(IN THOUSANDS) 2004 2003
ASSETS
Cash $ 725 $ 329
Investment in subsidiaries:
Citizens & Northern Bank 104,989 100,754
Citizens & Northern Investment Corporation 25,270 23,758
Bucktail Life Insurance company 2,373 2,223
Other assets 99 54
-------- --------
TOTAL ASSETS $133,456 $127,118
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Dividends payable $ 1,864 $ 1,763
Other liabilities 7 12
Stockholders' equity 131,585 125,343
-------- --------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $133,456 $127,118
======== ========
CONDENSED INCOME STATEMENT
YEARS ENDED DECEMBER 31,
(IN THOUSANDS) 2004 2003 2002
Dividends from Citizens & Northern Bank $ 7,582 $ 6,870 $ 7,063
Other dividend income and security gains 5 - 174
Expenses (123) (183) (140)
------- ------- -------
Income before equity in undistributed income
of subsidiaries 7,464 6,687 7,097
Equity in undistributed income of subsidiaries 7,399 9,570 7,862
------- ------- -------
NET INCOME $14,863 $16,257 $14,959
======= ======= =======
-56-
CONDENSED STATEMENT OF CASH FLOWS
YEARS ENDED DECEMBER 31,
(IN THOUSANDS) 2004 2003 2002
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $14,863 $16,257 $14,959
Adjustments to reconcile net income to net
cash provided by operating activities:
Equity in undistributed net income of
subsidiaries (7,399) (9,570) (7,862)
Amortization of restricted stock 85 102 80
(Increase) decrease in other assets (45) (9) (32)
Increase in other liabilities 78 68 98
------- ------- -------
Net Cash Provided by Operating Activities 7,582 6,848 7,243
------- ------- -------
CASH FLOWS FROM INVESTING ACTIVITIES,
Investment in subsidiary - (460) (783)
------- ------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from sale of treasury stock 528 197 76
Purchase of treasury stock (575) (174) (239)
Dividends paid (7,139) (6,674) (6,038)
------- ------- -------
Net Cash Used in Financing Activities (7,186) (6,651) (6,201)
------- ------- -------
INCREASE (DECREASE) IN CASH AND CASH
EQUIVALENTS 396 (263) 259
CASH AND CASH EQUIVALENTS, BEGINNING
OF YEAR 329 592 333
------- ------- -------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 725 $ 329 $ 592
======= ======= =======
20. SUMMARY OF QUARTERLY CONSOLIDATED FINANCIAL DATA (UNAUDITED)
The following table presents summarized quarterly financial data for 2003 and
2002:
(IN THOUSANDS, EXCEPT PER SHARE DATA) 2004 QUARTER ENDED
MAR. 31, JUNE 30, SEPT. 30, DEC. 31,
Interest income $ 14,015 $ 14,343 $ 14,573 $ 14,991
Interest expense 5,703 5,493 5,665 5,745
--------- --------- ---------- ---------
Interest margin 8,312 8,850 8,908 9,246
Provision for loan losses 350 350 350 350
--------- --------- ---------- ---------
Interest margin after provision for loan losses 7,962 8,500 8,558 8,896
Other income 1,625 1,855 1,627 1,815
Securities gains 964 321 459 1,133
Other expenses 6,228 6,289 6,738 6,746
--------- --------- ---------- ---------
Income before income tax provision 4,323 4,387 3,906 5,098
Income tax provision 617 698 501 1,035
--------- --------- ---------- ---------
Net income $ 3,706 $ 3,689 $ 3,405 $ 4,063
========= ========= ========== =========
Net income per share - basic $ 0.45 $ 0.45 $ 0.42 $ 0.50
========= ========= ========== =========
Net income per share - diluted $ 0.45 $ 0.45 $ 0.41 $ 0.49
========= ========= ========== =========
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(IN THOUSANDS, EXCEPT PER SHARE DATA) 2003 QUARTER ENDED
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 $ 0.53
========= ========= ========== ========
Net income per share - diluted $ 0.50 $ 0.48 $ 0.48 $ 0.53
========= ========= ========== ========
21. PENDING MERGER
In November 2004, the Corporation, along with Canisteo Valley Corporation
("Canisteo"), announced the signing of a definitive agreement and plan of
merger. Canisteo is the parent company of First State Bank; a New York State
chartered commercial bank with two offices in Steuben County, NY, and assets of
$42.5 million as of September 30, 2004.
Under the agreement, the Corporation will acquire Canisteo in an all-cash merger
transaction. The transaction, which has been approved by the Boards of Directors
of both companies, is expected to be completed during the third quarter 2005,
pending Canisteo stockholder approval, regulatory approval, and other customary
conditions of closing.
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
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, 2004 and 2003, 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, 2004.
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 the standards of the Public Company
Accounting Oversight Board (United States). 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, 2004 and 2003, and the results
of their operations and their cash flows for each of the three years in the
period ended December 31, 2004 in conformity with accounting principles
generally accepted in the United States of America.
Parente Randolph, LLC /s/
Williamsport, Pennsylvania
February 24, 2005
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ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None
ITEM 9A. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
The Corporation's management, under the supervision of and with the
participation of the Corporation's Chief Executive Officer and Chief Financial
Officer, has 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 have concluded that, as of the end of such
period, the Corporation's disclosure controls and procedures are effective to
ensure that all material 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.
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The Corporation's management is responsible for establishing and maintaining
adequate internal control over financial reporting, as that term is defined in
Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the
participation of the Corporation's management, including the principal executive
officer and principal financial officer, the Corporation is in the process of
conducting an evaluation of its internal control over financial reporting based
on the framework in Internal Control - Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission.
The Corporation's evaluation of its internal control over financial reporting
has not yet been completed. Accordingly, as permitted by Securities and Exchange
Act of 1934 Release No. 50754, management's annual report on internal control
over financial reporting and the related attestation report of the registered
public accounting firm are not included in this Form 10-K.
ITEM 9B. OTHER INFORMATION
There was no information the Corporation was required to disclose in a report on
Form 8-K during the fourth quarter 2004 that was not disclosed.
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 22, 2005 for the
annual meeting of stockholders to be held on April 19, 2005.
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 are also included
in the Corporation's employee handbook.)
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ITEM 11. EXECUTIVE COMPENSATION
Information concerning executive compensation is incorporated herein by
reference to disclosure under the captions "Executive Compensation," "Stock
Incentive plan," "Option Grants," "Aggregated Stock Options Exercised During
2004 and Year-end Option Values," "Pension Plan," "Savings Plan," "Incentive
Award Plan" and "Change in Control Agreements" of the Corporation's proxy
statement dated March 22, 2005 for the annual meeting of stockholders to be held
on April 19, 2005.
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 22, 2005 for the annual meeting of stockholders to be held on April 19,
2005.
"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 22, 2005 for the annual meeting of stockholders to be held on April 19,
2005.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information concerning services provided by the Corporation's independent
auditors, Parente Randolph, LLC, 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 22, 2005 for the
annual meeting of stockholders to be held on April 19, 2005.
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) (1). The following consolidated financial statements are set forth in Part
II, Item 8:
Page
-----
Report of Independent Registered Public Accounting Firm 59
Financial Statements:
Consolidated Balance Sheet - December 31, 2004 and 2003 29
Consolidated Statement of Income - Years Ended
December 31, 2004, 2003 and 2002 30
Consolidated Statement of Changes in Stockholders' Equity - Years
Ended December 31, 2004, 2003 and 2002 31
Consolidated Statement of Cash Flows - Years Ended
December 31, 2004, 2003 and 2002 32
Notes to Consolidated Financial Statements 33-58
(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):
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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 Exhibit
3.1 of the Corporation's Form 8-K
filed August 25, 2004
4. Instruments defining the rights of
security holders, including indentures Not applicable
9. Voting trust agreement Not applicable
10.Material contracts:
10.1 Form of Indemnification
Agreements dated May 2004 between
the Corporation and the Directors
and certain officers Filed herewith
10.2 Change in Control Agreement
dated December 31, 2003 between
the Corporation and Thomas L. Rudy,
Jr. Filed herewith
Change in Control Agreement dated Incorporated by reference to the
December 31, 2003 between the exhibits filed with the Corporation's
Corporation and Craig G. Form 10-K on March 10, 2004
Litchfield
Change in Control Agreement dated Incorporated by reference to the
December 31, 2003 between the exhibits filed with the Corporation's
Corporation and Mark A. Hughes Form 10-K on March 10, 2004
Change in Control Agreement dated Incorporated by reference to the
December 31, 2003 between the exhibits filed with the Corporation's
Corporation and Matthew P. Prosseda Form 10-K on March 10, 2004
Change in Control Agreement dated Incorporated by reference to the
December 31, 2003 between the exhibits filed with the Corporation's
Corporation and Deborah E. Scott Form 10-K on March 10, 2004
Second Amendment to Citizens & Incorporated by reference to the
Northern Corporation Stock exhibits filed with the Corporation's
Incentive Plan Form 10-K on March 10, 2004
First Amendment to Citizens & Incorporated by reference to the
Northern Corporation Stock exhibits filed with the Corporation's
Incentive Plan Form 10-K on March 10, 2004
Citizens & Northern Corporation Incorporated by reference to the
Stock Incentive Plan exhibits filed with the Corporation's
Form 10-K on March 10, 2004
- 62 -
Citizens & Northern Corporation Incorporated by reference to the
Independent Directors Incentive exhibits Stock filed with the
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 per Information concerning the computation
share earnings 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
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 22, 2005 Filed herewith
- 63 -
(b) Exhibits - The required exhibits are listed under Part IV, Item 15(a)(3) of
Form 10-K.
(c) Financial statement schedules are omitted because the required information
is not applicable or is included elsewhere in Form 10-K.
- 64 -
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:
By: Craig G. Litchfield /s/
- ---------------------------
Craig G. Litchfield
Chairman, President and Chief Executive Officer
Date: March 11, 2005
By: Mark A. Hughes /s/
- ----------------------
Treasurer and Principal Accounting Officer
Date: March 11, 2005
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 11, 2005 Date: March 11, 2005
/s/ R. Robert DeCamp /s/ Craig G. Litchfield
R. Robert DeCamp Craig G. Litchfield
Date: March 11, 2005 Date: March 11, 2005
/s/ Jan E. Fisher /s/ Edward H. Owlett, III
Jan E. Fisher Edward H. Owlett, III
Date: March 11, 2005 Date: March 11, 2005
/s/ R. Bruce Haner /s/ Leonard Simpson
R. Bruce Haner Leonard Simpson
Date: March 11, 2005 Date: March 11, 2005
/s/ Susan E. Hartley /s/ James E. Towner
Susan E. Hartley James E. Towner
Date: March 11, 2005 Date: March 11, 2005
/s/ Karl W. Kroeck /s/ Ann M. Tyler
Karl W. Kroeck Ann M. Tyler
Date: March 11, 2005 Date: March 11, 2005
/s/ Leo F. Lambert
Leo F. Lambert
Date: March 11, 2005
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