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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Commission file number 0-12126

FRANKLIN FINANCIAL SERVICES CORPORATION
(Exact name of registrant as specified in its charter)

(717) 264-6116
(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 per share
(Title of class)

        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 periods that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý    No o

        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. ý

        The aggregate market value of the 2,358,751 shares of the Registrant's common stock held by nonaffiliates of the Registrant as of February 29, 2004, based on the price of such shares, was $81,046,684. There were 2,692,452 outstanding shares of the Registrant's common stock as of February 29, 2004.

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes o    No ý

        The aggregate market value of the 2,340,726 shares of the Registrant's common stock held by nonaffiliates of the Registrant as of June 30, 2003 based on the price of such shares, was $73,732,869.

DOCUMENTS INCORPORATED BY REFERENCE

        Portions of the definitive annual proxy statement to be filed, pursuant to Reg. 14A within 120 days after December 31, 2003, are incorporated into Part III.

FRANKLIN FINANCIAL SERVICES CORPORATION
FORM 10-K
INDEX

Part I

Item 1. Business

General

        Franklin Financial Services Corporation (the "Corporation") was organized as a Pennsylvania business corporation on June 1, 1983 and is a registered bank holding company under the Bank Holding Company Act of 1956, as amended (the "BHCA"). On January 16, 1984, pursuant to a plan of reorganization approved by the shareholders of Farmers and Merchants Trust Company of Chambersburg ("F&M Trust" or "the Bank") and the appropriate regulatory agencies, the Corporation acquired all the shares of F&M Trust and issued its own shares to former F&M Trust shareholders on a share-for-share basis.

        The Corporation conducts substantially all of its business through its direct banking subsidiary, F&M Trust, which is wholly owned. Another direct subsidiary, Franklin Financial Properties Corp. was organized in 2002 as a "qualified real estate subsidiary." F&M Trust, established in 1906, is a full-service, Pennsylvania-chartered commercial bank and trust company, which is not a member of the Federal Reserve System. F&M Trust, which operates 15 full service offices in Franklin and Cumberland Counties, Pennsylvania, engages in general commercial, retail banking and trust services normally associated with community banks and its deposits are insured (up to applicable limits) by the Federal Deposit Insurance Corporation (the "FDIC"). A wide variety of banking services are offered by F&M Trust to businesses, individuals, and governmental entities. These services include, but are not necessarily limited to, accepting and maintaining checking, savings, and time deposit accounts, providing investment and trust services, making loans and providing safe deposit facilities. Franklin Financial Properties Corp. was established to hold real estate assets used by F&M Trust in its banking operations.

        The Corporation's banking subsidiary is not dependent upon a single customer or a few customers for a material part of its business. Thus, the loss of any customer or identifiable group of customers would not materially affect the business of the Corporation or F&M Trust in an adverse manner. Also, none of the Corporation's business is seasonal. The Bank's lending activities consist primarily of commercial real estate, agricultural, commercial and industrial loans, installment and revolving loans to consumers, residential mortgage loans, and construction loans. Secured and unsecured commercial and industrial loans, including accounts receivable and inventory financing, and commercial equipment financing, are made to small and medium-sized businesses, individuals, governmental entities, and non-profit organizations. F&M Trust also participates in Pennsylvania Higher Education Assistance Act student loan programs and Pennsylvania Housing Finance Agency programs.

        Installment loans involve both direct loans to consumers and the purchase of consumer obligations from dealers and others who have sold or financed the purchase of merchandise, including automobiles and mobile homes, to their customers. The Bank's mortgage loans include long-term loans to individuals and to businesses secured by mortgages on the borrower's real property. Construction loans are made to finance the purchase of land and the construction of buildings thereon, and are secured by mortgages on real estate. In certain situations, the Bank acquires properties through foreclosure on delinquent mortgage loans. The Bank holds these properties until such time as they are sold.

        F&M Trust's Investment and Trust Services Department offers all of the personal and corporate trust services normally associated with trust departments of area banks including: estate planning and administration, corporate and personal trust fund management, pension, profit sharing and other employee benefits funds management, and custodial services. F&M Trust's Personal Investment Center sells mutual funds, annuities and selected insurance products.

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Competition

        The Corporation and its banking subsidiary operate in a competitive environment that has intensified in the past few years as they have been compelled to share their market with institutions that are not subject to the regulatory restrictions on domestic banks and bank holding companies. Profit margins in the traditional banking business of lending and gathering deposits have declined as deregulation has allowed nonbanking institutions to offer alternative services to many of F&M Trust's customers.

        The principal market of F&M Trust is in Franklin County and western Cumberland County, Pennsylvania. The majority of the Bank's loan and deposit customers are in Franklin County. There are many commercial bank competitors in this region, in addition to credit unions, savings and loan associations, mortgage banks, brokerage firms and other competitors. The Bank competes with various strategies including customer service and convenience, a wide variety of products and services, and the pricing of loans and deposits. F&M Trust is the largest financial institution headquartered in Franklin County and had total assets of approximately $550.0 million on December 31, 2003.

Staff

        As of December 31, 2003, the Corporation and its banking subsidiary had 192 full-time equivalent employees. The officers of the Corporation are employees of the bank. Most employees participate in pension, profit sharing/bonus, and employee stock purchase plans and are provided with group life, health and major medical insurance. Management considers employee relations to be excellent.

Supervision and Regulation

        Various requirements and restrictions under the laws of the United States and under Pennsylvania law affect the Corporation and its subsidiary.

General

        The Corporation is registered as a bank holding company and is subject to supervision and regulation by the Board of Governors of the Federal Reserve System under the Bank Holding Act of 1956, as amended. The Corporation has also made an effective election to be treated as a "financial holding company." Financial holding companies are bank holding companies that meet certain minimum capital and other standards and are therefore entitled to engage in financially related activities on an expedited basis; see further discussion below. As a financial holding company, the Corporation's activities and those of its bank subsidiary are limited to the business of banking and activities closely related or incidental to banking. Bank holding companies are required to file periodic reports with and are subject to examination by the Federal Reserve Board. The Federal Reserve Board has issued regulations under the Bank Holding Company Act that require a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. As a result, the Federal Reserve Board, pursuant to such regulations, may require the Corporation to stand ready to use its resources to provide adequate capital funds to its bank subsidiary during periods of financial stress or adversity.

        The Bank Holding Company Act prohibits the Corporation from acquiring direct or indirect control of more than 5% of the outstanding shares of any class of voting stock, or substantially all of the assets of, any bank, or from merging or consolidating with another bank holding company, without prior approval of the Federal Reserve Board. Additionally, the Bank Holding Company Act prohibits the Corporation from engaging in or from acquiring ownership or control of more than 5% of the outstanding shares of any class of voting stock of any company engaged in a non-banking business, unless such business is determined by the Federal Reserve Board to be so closely related to banking as

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to be a proper incident thereto. The types of businesses that are permissible for bank holding companies to own have been expanded by recent federal legislation; see discussion below.

        As a Pennsylvania bank holding company for purposes of the Pennsylvania Banking Code, the Corporation is also subject to regulation and examination by the Pennsylvania Department of Banking.

        The Bank is a state chartered bank that is not a member of the Federal Reserve System, and its deposits are insured (up to applicable limits) by the Federal Deposit Insurance Corporation (the "FDIC"). Accordingly, the Bank's primary federal regulator is the FDIC, and the Bank is subject to extensive regulation and examination by the FDIC and the Pennsylvania Department of Banking. The Bank is also subject to requirements and restrictions under federal and state law, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and the interest that may be charged thereon, and limitations on the types of investments that may be made and the types of services that may be offered. The Community Reinvestment Act requires the Bank to help meet the credit needs of the entire community where the Bank operates, including low and moderate-income census tracts. The Bank's rating under the Community Reinvestment Act, assigned by the FDIC pursuant to an examination of the Bank, is important in determining whether the bank may receive approval for, or utilize certain streamlined procedures in, applications to engage in new activities. Various consumer laws and regulations also affect the operations of the Bank. In addition to the impact of regulation, commercial banks are affected significantly by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability in order to influence the economy.

Capital Adequacy Guidelines

        Bank holding companies are required to comply with the Federal Reserve Board's risk-based capital guidelines. The required minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) is 8%. At least half of the total capital is required to be "Tier 1 capital," consisting principally of common shareholders' equity, less certain intangible assets. The remainder ("Tier 2 capital") may consist of certain preferred stock, a limited amount of subordinated debt, certain hybrid capital instruments and other debt securities, and a limited amount of the general loan loss allowance. The risk-based capital guidelines are required to take adequate account of interest rate risk, concentration of credit risk, and risks of nontraditional activities.

        In addition to the risk-based capital guidelines, the Federal Reserve Board requires a bank holding company to maintain a leverage ratio of a minimum level of Tier 1 capital (as determined under the risk-based capital guidelines) equal to 3% of average total consolidated assets for those bank holding companies which have the highest regulatory examination ratings and are not contemplating or experiencing significant growth or expansion. All other bank holding companies are required to maintain a ratio of at least 1% to 2% above the stated minimum. The Bank is subject to almost identical capital requirements adopted by the FDIC. In addition to FDIC capital requirements, the Pennsylvania Department of Banking also requires state chartered banks to maintain a 6% leverage capital level and 10% risk based capital, defined substantially the same as the federal regulations.

Prompt Corrective Action Rules

        The federal banking agencies have regulations defining the levels at which an insured institution would be considered "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." The applicable federal bank regulator for a depository institution could, under certain circumstances, reclassify a "well-capitalized" institution as "adequately capitalized" or require an "adequately capitalized" or "undercapitalized" institution to comply with supervisory actions as if it were in the next lower category. Such a reclassification could be made if the regulatory agency determines that the institution is in an unsafe or unsound condition

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(which could include unsatisfactory examination ratings). At December 31, 2003, the Corporation and the Bank each satisfied the criteria to be classified as "well capitalized" within the meaning of applicable regulations.

Regulatory Restrictions on Dividends

        Dividend payments by the Bank to the Corporation are subject to the Pennsylvania Banking Code, the Federal Deposit Insurance Act, and the regulations of the FDIC. Under the Banking Code, no dividends may be paid except from "accumulated net earnings" (generally, retained earnings). The Federal Reserve Board and the FDIC have formal and informal policies which provide that insured banks and bank holding companies should generally pay dividends only out of current operating earnings, with some exceptions. The Prompt Corrective Action Rules, described above, further limit the ability of banks to pay dividends, because banks which are not classified as well capitalized or adequately capitalized may not pay dividends.

        Under these policies and subject to the restrictions applicable to the Bank, the Bank could declare, during 2004, without prior regulatory approval, aggregate dividends of approximately $28.5 million, plus net profits earned to the date of such dividend declaration.

FDIC Insurance Assessments

        The FDIC has implemented a risk-related premium schedule for all insured depository institutions that results in the assessment of premiums based on capital and supervisory measures. Under the risk-related premium schedule, the FDIC assigns, on a semiannual basis, each depository institution to one of three capital groups (well-capitalized, adequately capitalized or undercapitalized) and further assigns such institution to one of three subgroups within a capital group. The institution's subgroup assignment is based upon the FDIC's judgment of the institution's strength in light of supervisory evaluations, including examination reports, statistical analyses and other information relevant to measuring the risk posed by the institution. Only institutions with a total capital to risk-adjusted assets ratio of 10% or greater, a Tier 1 capital to risk-based assets ratio of 6% or greater, and a Tier 1 leverage ratio of 5% or greater, are assigned to the well-capitalized group. As of December 31, 2003, the Bank was well capitalized for purposes of calculating insurance assessments.

        The Bank Insurance Fund is presently fully funded at more than the minimum amount required by law. Accordingly, the 2004 Bank Insurance Fund assessment rates range from zero for those institutions with the least risk, to $0.27 for every $100 of insured deposits for institutions deemed to have the highest risk. The Bank is in the category of institutions that presently pay nothing for deposit insurance. The FDIC adjusts the rates every six months.

        While the Bank presently pays no premiums for deposit insurance, it is subject to assessments to pay the interest on Financing Corporation bonds. The Financing Corporation was created by Congress to issue bonds to finance the resolution of failed thrift institutions. Commercial banks and thrifts are subject to the same assessment for Financing Corporation bonds. The FDIC sets the Financing Corporation assessment rate every quarter. The Financing Corporation assessment for the Bank (and all other banks) for the first quarter of 2004 is an annual rate of $.0154 for each $100 of deposits.

New Legislation

        No significant legislation in the financial services area was enacted in 2003. The Gramm-Leach-Bliley Act, enacted in 1999, changed certain banking laws that had been in effect since the early part of the 20^th century. The most radical changes were that the separation between banking and the securities businesses mandated by the Glass-Steagall Act was removed, and the provisions of any state law that prohibits affiliation between banking and insurance entities were preempted. The provisions of federal law that preclude banking entities from engaging in non-financially related activities, such as

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manufacturing, were not changed. The Gramm-Leach-Bliley Act also contained a number of additional provisions, including the Right to Financial Privacy Act that directly affects banks and their customers.

        The USA PATRIOT Act, enacted in direct response to the terrorist attacks on September 11, 2001, strengthens the anti-money laundering provisions of the Bank Secrecy Act. Most of the new provisions added by the Act apply to accounts at or held by foreign banks, or accounts of or transactions with foreign entities. The Bank does not have a significant foreign business and does not expect this Act to materially affect its operations. The Act does, however, require the banking regulators to consider a bank's record of compliance under the Bank Secrecy Act in acting on any application filed by a bank. As the Bank is subject to the provisions of the Bank Secrecy Act (i.e., reporting of cash transactions in excess of $10,000), the Bank's record of compliance in this area will be an additional factor in any applications filed by it in the future. To the Bank's knowledge, its record of compliance in this area is satisfactory.

        The Sarbanes-Oxley Act was enacted in 2002. This Act is not a banking law, but applies to all public companies, including the Corporation. Sarbanes-Oxley is designed to restore investor confidence. Sarbanes-Oxley adopts new standards of corporate governance and imposes new requirements on the board and management of public companies. The chief executive officer and chief financial officer of a public company must now certify the financial statements of the company. New definitions of "independent directors" have been adopted, and new responsibilities and duties have been established for the audit and other committees of the board. In addition, the reporting requirements for insider stock transactions have been revised, requiring most transactions to be reported within two business days. While complying with Sarbanes-Oxley will result in increased costs to the Corporation, the additional costs have not been completely quantified. These costs may add significant expense to the Corporation.

        Congress is often considering some financial industry legislation, and the federal banking agencies routinely propose new regulations. New legislation and regulation may include dramatic changes to the federal deposit insurance system. The Corporation cannot predict how any new legislation, or new rules adopted by the federal banking agencies, may affect its business in the future.

Selected Statistical Information

        Certain statistical information is included in this report as part of Management's Discussion and Analysis of Financial Condition and Results of Operations.

Item 2. Properties

        The Corporation's headquarters is located in the main office of F&M Trust at 20 South Main Street, Chambersburg, Pennsylvania. The Corporation owns one property in Chambersburg, Pennsylvania. This property was previously used by F&M Trust for bank operations. It is no longer used for this purpose and is now listed for sale with a local realtor.

        F&M Trust's headquarters is at 20 South Main Street, Chambersburg, Pennsylvania. This location houses a community banking office as well as operational support services. F&M Trust owns or leases twenty-four properties in Franklin (19) and Cumberland (5) Counties, Pennsylvania as described below:

        F&M Trust will be opening its sixteenth community banking office in a leased facility in March 2004.

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Item 3. Legal Proceedings

        None

Item 4. Submission of Matters to a Vote of Security Holders

        None

Part II

Item 5. Market for Registrant's Common Equity and Related Shareholder Matters

Market and Dividend Information

        The Corporation's common stock is not actively traded in the over-the-counter market. The Corporation's stock is listed under the symbol "FRAF" on the OTC Electronic Bulletin Board, an automated quotation service. Current price information is available from account executives at most brokerage firms as well as the registered market makers of Franklin Financial Services Corporation common stock as listed below under Shareholders' Information.

        The range of high and low bid prices is shown below for the years 2003 and 2002, as well as cash dividends paid for those periods. The bid quotations reflect interdealer quotations, do not include retail mark-ups, mark-downs or commissions, and may not necessarily represent actual transactions. The closing price of Franklin Financial Services Corporation common stock recorded from an actual transaction on December 31, 2003, was $34.50. The Corporation had 1,945 shareholders of record as of December 31, 2003.

Market and Dividend Information
Bid Price Range Per Share

*

includes $.25 per share special dividend declared in the second quarter of 2002

        The information related to equity compensation plans is incorporated by reference to the materials set forth under the heading "Equity Compensation Plan Information" on Page 24 of the Corporation's Proxy Statement for the 2004 Annual Meeting of Shareholders.

Shareholders' Information

Dividend Reinvestment Plan:

        Franklin Financial Services Corporation offers a dividend reinvestment program whereby shareholders with stock registered in their own names may reinvest their dividends in additional shares of the Corporation. Information concerning this optional program is available by contacting the Corporate Secretary at 20 South Main Street, P.O. Box 6010, Chambersburg, PA 17201-6010, telephone 717/264-6116.

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Dividend Direct Deposit Program:

        Franklin Financial Services Corporation offers a dividend direct deposit program whereby shareholders with registered stock in their own names may choose to have their dividends deposited directly into the bank account of their choice on the dividend payment date. Information concerning this optional program is available by contacting the Corporate Secretary at 20 South Main Street, P.O. Box 6010, Chambersburg, PA 17201-6010, telephone 717/264-6116.

Annual Meeting:

        The Annual Shareholders' Meeting will be held on Tuesday, April 27, 2004, at the Lighthouse Restaurant, 4301 Philadelphia Avenue, Chambersburg, Pennsylvania. The Business Meeting will begin at 10:30 a.m. followed by a luncheon.

Website:

        www.franklinfin.com

Stock Information:

        The following brokers are registered as market makers of Franklin Financial Services Corporation's common stock:

Registrar and Transfer Agent:

        The registrar and transfer agent for Franklin Financial Services Corporation is Fulton Bank, P.O. Box 4887, Lancaster, PA 17604.

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Item 6. Selected Financial Data

Summary of Selected Financial Data

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

Application of Critical Accounting Policies:

        Disclosure of the Corporation's significant accounting policies is included in Note 1 to the consolidated financial statements. Certain of these policies are particularly sensitive requiring significant judgements, estimates and assumptions to be made by management. Senior management has discussed the development of such estimates, and related Management Discussion and Analysis disclosure, with the audit committee of the board of directors. The following accounting policies are the ones identified by management to be critical to the results of operations:

        Allowance for Loan Losses—The allowance for loan losses is the estimated amount considered adequate to cover credit losses inherent in the outstanding loan portfolio at the balance sheet date.

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The allowance is established through the provision for loan losses, charged against income. In determining the allowance for loan losses, management makes significant estimates and, accordingly, has identified this policy as probably the most critical for the Corporation.

        Management performs a monthly evaluation of the adequacy of the allowance for loan losses. Consideration is given to a variety of factors in establishing this estimate including, but not limited to, current economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, borrowers' actual or perceived financial and managerial strengths, the adequacy of the underlying collateral (if collateral dependent) and other relevant factors. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant change, including the amounts and timing of future cash flows expected to be received on impaired loans.

        The analysis has two components, specific and general allocations. Collateral values discounted for market conditions and selling costs are used to establish specific allocations. The Bank's historical loan loss experience, loan administration factors, delinquency rates and general economic conditions are used to establish general allocations for the remainder of the portfolio. The analysis produces a low to high range for the adequacy of the allowance. At December 31, 2003, the low range for the allowance for loan losses was $2.2 million while the high range was $3.9 million. The allowance for loan losses totaled $3.75 million at December 31, 2003.

        Management monitors the adequacy of the allowance for loan losses on an ongoing basis and reports its adequacy assessment monthly to the Board of Directors, and quarterly to the Audit Committee.

        Mortgage Servicing Rights—The Bank lends money to finance residential properties for its customers. Due to the high dollar volume of mortgage loans originated annually by the Bank, the Bank chooses not to keep all of these loans on its balance sheet. As a result, many of the originated mortgage loans are sold on the secondary market, primarily to Federal National Mortgage Association (FNMA). Although the Bank has chosen to sell these loans, its practice is to retain the servicing of these loans. This means that the customers whose loans have been sold to the secondary market make their monthly payments to the Bank.

        As required by Statement of Financial Accounting Standard No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities", upon the sale of mortgage loans, the Bank capitalizes the value allocated to the servicing rights in other assets and makes a corresponding entry to other income from mortgage banking activities. The capitalized servicing rights are amortized against noninterest income in proportion to, and over the periods of, the estimated net servicing income of the underlying financial assets.

        Capitalized servicing rights are evaluated for impairment monthly based upon the fair value of the rights as compared to amortized cost. The rights are deemed to be impaired when the fair value of the rights is less than the amortized cost. If impaired, the Bank records a charge against noninterest income from mortgage banking activities through a mortgage servicing rights valuation allowance. The amount charged to the valuation allowance can be reversed in future periods if the rights are determined to no longer be impaired. However, the amount of impairment reversed may not exceed the balance of the valuation allowance.

        The fair value of the servicing rights is determined by using quoted prices for similar assets with similar characteristics, when available, or estimated based on projected discounted cash flows using market based assumptions. The Bank primarily uses the discounted cash flow method. In determining the fair value of the rights, the bank stratifies the mortgage-servicing portfolio into homogeneous pools based on rate and term. A discount rate and prepayment speed are then assigned to each pool. The present value of the future cash flows from the servicing rights are then calculated and are deemed to represent the fair value of the servicing rights. The Bank believes that the discount rate and

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prepayment speed assumptions are the most critical components of the fair value calculation. Due to the nature of these assumptions, a change in either the discount rate or prepayment speed could cause the fair value of the servicing rights to change substantially in future periods.

        At December 31, 2003, the fair value of the servicing rights was $1,029,000. The amortized cost of the rights was $1,384,000, with a valuation allowance of ($355,000). The valuation allowance reflects the impairment charges, net of reversals, recognized over time. The rights had an amortized cost of $1,039,000 on December 31, 2002, with a valuation allowance of ($335,000).

        In determining the fair value at December 31, 2003, the Bank used a weighted-average discount rate of 5.67% and a weighted-average constant prepayment speed of 19.9%. If different assumptions were made for these factors, the fair value of the rights could be significantly different. The impact of changing these assumptions is shown below:

        The changes in the fair value were calculated by changing one variable of the December 31, 2003 calculation and holding all others constant. The Bank believes the assumptions used in calculating the fair value of the mortgage servicing rights on December 31, 2003, are reasonable.

        Management monitors the fair value of mortgage servicing rights monthly and reports any impairment concerns to the Board of Directors when they arise.

        Financial Derivatives—As part of its interest rate risk management strategy, the Bank has entered into interest rate swap agreements. A swap agreement is a contract between two parties to exchange cash flows based upon an underlying notional amount. Under the swap agreements, the Bank pays a fixed rate and receives a variable rate from an unrelated financial institution serving as counter-party to the agreements. The swaps are designated as cash flow hedges and are designed to minimize the variability in cash flows of the Bank's variable-rate money market deposit liabilities attributable to changes in interest rates. The swaps in effect convert a portion of variable rate deposits to fixed rate liabilities.

        The interest rate swaps are recorded on the balance sheet as an asset or liability at fair value. To the extent the swaps are effective in accomplishing their objectives, changes in the fair value are recorded in other comprehensive income. To the extent the swaps are not effective, changes in fair value are recorded in interest expense. Cash flow hedges are determined to be highly effective when the Bank achieves offsetting changes in the cash flows of the risk being hedged. The Bank measures the effectiveness of the hedges on a quarterly basis and it has determined the hedges are highly effective. Fair value is heavily dependent upon the market's expectations for interest rates over the remaining term of the swaps. For example, at December 31, 2003, outstanding interest rate swaps were valued at negative $1,285,000. If the implied overall rate inherent in the computation was increased by 100 basis points, the value of the derivative would improve to negative $767,000.

        Stock-based Compensation—The Corporation has two stock compensation plans in place consisting of an Employee Stock Purchase Plan (ESPP) and an Incentive Stock Option Plan (ISOP).

        The Corporation follows the disclosure requirements of Statement of Financial Accounting Standard No. 123, "Accounting for Stock-Based Compensation." Accordingly, no compensation expense for the ESPP or the ISOP has been recognized in the financial statements of the Corporation. If compensation cost of the plans had been recognized, net income for 2003 would have been reduced by $68,000 from $5.840 million to $5.772 million. Consequently, basic earnings per share would have fallen to $2.15 from $2.18.

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        The Corporation calculates the compensation cost of the options by using the Black-Scholes method to determine the fair value of the options granted. In calculating the fair value of the options, the Corporation makes assumptions regarding the risk-free rate of return, the expected volatility of the Corporation's common stock and the expected life of the option. These assumptions are made independently for the ESPP and the ISOP and if changed would impact the compensation cost of the options and the pro-forma impact to net income. Management anticipates that it will begin recognizing expense associated with such plans beginning in 2005, subject to final direction from Financial Accounting Standards Board (FASB).

        The following discussion and analysis is intended to assist the reader in reviewing the financial information presented and should be read in conjunction with the consolidated financial statements and other financial data presented elsewhere herein.

Results of Operations: Management's Overview

        Franklin Financial Services Corporation reported net income of $5.84 million in 2003 and basic earnings per common share of $2.18, an increase from net income of $5.57 million and basic earnings per common share of $2.08 reported for 2002. In 2001, the Corporation reported net income of $5.59 million and basic earnings per common share of $2.09.

        The return on average assets for 2003 was 1.09% compared with 1.07% in 2002 and 1.14% for 2001. The return on average shareholders' equity decreased to 11.80% in 2003 from 12.04% in 2002 and 12.51% in 2001. The Corporation's strong equity position coupled with flat to modest increases in net income over the three years is responsible for the decreasing return on average equity during the three-year period. Management uses tools such as stock buy-back programs and special cash dividends in addition to regular quarterly dividends to manage its equity position.

        Faced with ever increasing new competition and constant pressure on its net interest margin, the Corporation's management looks for new sources of revenue to enhance net income. Recent initiatives include investments in several start-up banks, a captive reinsurance company owned by a group of Pennsylvania community banks, a mortgage company and a title insurance agency established by the Pennsylvania Bankers Association and several central Pennsylvania banks as a lender-owned title insurance agency. Fee revenues from these investments amounted to $110,000 in 2003 compared to $26,000 and $27,000 in 2002 and 2001, respectively, and came primarily from the title insurance agency. In addition to being a source of new fee revenues, the Corporation's investment in the start-up banks has opened up opportunities for the Bank to purchase or sell commercial loan participations, which generate interest and fee income.

        One of the most recent initiatives was the Bank's investment in a mortgage banking company serving the Virginia and Maryland markets. This investment is expected to generate income for the Corporation beginning in 2004 but generated a loss of $25,000 in 2003. The Bank provides temporary funding for mortgage loans originated by the mortgage company; these loans will be sold on the secondary market within 30 days of funding. In addition to fee income for this service, the Bank receives interest income on the funded balances. In 2003, total loans funded by the Bank for the mortgage company was $11.0 million.

        Net interest income on a tax-equivalent basis for the Corporation in 2003 totaled $17.1 million and represented an increase of $199,000, or 1.18%, from $16.9 million in 2002. Net interest income was flat for the three-year period reported largely due to the very low interest rate environment. The Corporation recorded an increase in net interest income from balance sheet growth during 2003; however, the low interest rate environment partially offset this increase. As a result, the Corporation experienced a narrowing of its net interest margin. Included in interest expense was interest expense paid on three interest rate swaps that the Bank entered into in 2001. The Bank entered into the swaps to hedge against rising interest rates. The events of September 11, 2001, caused interest rates to decline

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significantly and resulted in interest expense related to the swaps totaling $781,000, $655,000 and $238,000 in 2003, 2002 and 2001, respectively. One of the swaps, with a notional amount of $5.0 million, matures in July 2004. Interest expense related to the swaps is expected to be approximately $700,000 in 2004. The Corporation's net interest margin on a tax-equivalent basis was 3.45% in 2003, down from 3.49% and 3.69% in 2002 and 2001, respectively.

        An ongoing concern for financial institutions is funding. The Corporation's primary source of funding is deposits and securities sold under agreements to repurchase (Repos). An alternate source of funding for the Corporation is the Federal Home Loan Bank of Pittsburgh which, at December 31, 2003, could provide additional funding to the Corporation totaling $122.9 million. Deposits and repos averaged $416.5 million in 2003 compared to $412.1 million and $399.6 million in 2002 and 2001, respectively. With new financial institution entrants (three in 2003 and 2004) into the Corporation's primary market area and with stiff competition driven by the very low interest rate environment and deposit run-off concerns, the Corporation has expanded its market area into neighboring Cumberland County. In 2003, one new community office was opened in Cumberland County and another community office is expected to open in the first quarter of 2004. This brings the Cumberland County community offices to a total of six. In addition to the new community office opened in Cumberland County, a new community office was also opened in a local retirement community in Franklin County. The addition of community offices in strategic market areas positions the Corporation well for future loan and deposit growth. The Cumberland County community offices have made an important contribution to the Corporation's balance sheet for loans and deposits in the short time they have been open.

        While funding is of utmost importance to the Corporation, use of the funds is just as important. Total loans averaged $331.3 million in 2003 and accounted for almost 67% of the total interest-earning assets of the Corporation. During 2003, the Corporation saw strong growth in its mortgage loan portfolio. Mortgage loans averaged $108.4 million in 2003 versus $94.7 million in 2002 and consisted primarily of first mortgage residential loans. With the extremely low mortgage rate environment in 2003, mortgage refinances were at an all time high for the Corporation. In addition to growing its own mortgage portfolio by just over 14% in 2003, mortgage sales on the secondary market for the same period totaled over $49 million, an increase of 47% over the volume of mortgage loans sold on the secondary market in 2002. Income generated from the sale of mortgage loans in 2003 equaled $985,000 versus $465,000 in 2002 and $348,000 in 2001. The origination of mortgage loans in 2003 totaled almost $92 million compared to $78 million in 2002. The Corporation anticipates a decrease in the volume of mortgage loan activity in 2004 and, accordingly, a corresponding decrease in income. The Corporation's commercial loan portfolio grew almost 3% in 2003 and averaged $166.3 million for the year compared to $161.7 million in 2002. Growth in the commercial portfolio came mostly from loans participated with other financial institutions. Consumer loans in 2003 decreased $1.8 million, or 3%, and averaged $56.3 million compared to $58.1 million in 2002. Strong interest rate competition from local financial institutions and credit unions and zero interest rate financing from automobile manufacturers have made the Corporation's growth in consumer loans very slow. Management monitors its consumer loan pricing monthly and makes interest rate adjustments as appropriate. The tax-equivalent yield on the Corporation's total loan portfolio in 2003 was 6.12%, a decrease from the 6.90% and 7.95% yields recorded in 2002 and 2001, respectively. In 2004, the Corporation expects to temporarily fund a significant volume of mortgage loans originated by the mortgage banking company in which the Corporation has an ownership interest.

        Another significant use of funds for the Corporation is its investment portfolio. In 2003, investment securities averaged $156.7 million and represented almost 32% of total interest-earning assets. Included in the Corporation's investment portfolio is a convertible debenture with a fair value of $2.8 million at December 31, 2003. In the second quarter of 2004, the Corporation anticipates that it

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will convert the debenture into common stock of the underlying corporation. The Corporation expects to generate recurring income in 2004 and beyond as a result of this conversion

        An important factor for the Corporation is the quality of its assets, particularly the quality of its loans. At December 31, 2003, the ratio of nonperforming loans to total loans was .22% versus 1.07% at December 31, 2002. The improvement in the ratio of nonperforming loans to total loans is largely attributable to significant charge-offs during the year, primarily in commercial loans. Net charge-offs in 2003 totaled $2.25 million compared to $936,000 in 2002; net charge offs in 2003 were related primarily to two commercial loans. Commercial loan net charge-offs totaled $2.2 million and represented 97.4% of total net charge-offs in 2003 versus $761,000 and $855,000 in 2002 and 2001, respectively. The Corporation charged $1.7 million to earnings in 2003 for loan losses compared to $1.2 million and $1.5 million in 2002 and 2001, respectively. Because of its aggressive charge-off actions in 2003, Management of the Corporation believes that it has responded to any significant credit issues in the commercial portfolio and expects much lower charge-offs in 2004. The allowance for loan losses totaled $3.7 million at December 31, 2003 and represented 1.12% of total loans. With nonperforming loans totaling $767,000 at December 31, 2003, the allowance for loan losses provided coverage for nonperforming loans at almost 5 times.

        Noninterest income, excluding securities gains, increased 32.5% over 2002 to $7.2 million in 2003 from $5.5 million and $5.4 million in 2002 and 2001, respectively. Retail overdraft fees, which generated $1.2 million in fee income in 2003 versus $759,000 in 2002 and fee income generated from mortgage banking activities, which added $992,000 in 2003 versus $190,000 in 2002, accounted for most of this growth. The implementation of a new retail overdraft program and, an unprecedented mortgage-refinancing boom in 2003, accounted for the strong growth. Settlements from two unrelated claims added approximately $310,000 to noninterest income. Securities gains from the Corporation's equities portfolio totaled $488,000 in 2003 compared to $430,000 and $267,000 in 2002 and 2001, respectively.

        A significant source of noninterest income for the Bank is Investment and Trust Services. In 2003, fee income from this source totaled $2.48 million compared to $2.3 million and $2.2 million in 2002 and 2001, respectively. Trust assets under management, which are not reflected in the Corporation's assets, had a market value of $337.8 million at December 31, 2003 compared to $352.0 million at December 31, 2002. Although the department did record growth in assets under management during 2003, the loss of one significant account in the third quarter of 2003 more than offset that growth. Fee income from Investment and Trust Services is generated primarily from traditional trust account management, estate settlements and commissions from the sale of mutual funds, annuities and selected insurance products through its Personal Investment Center.

        Noninterest expense grew $1.1 million, or 8.3%, to $14.7 million in 2003 compared to $13.5 million and $12.9 million in 2002 and 2001, respectively. Items contributing to the increase in noninterest expense in 2003 were: the addition of two new community offices in 2003 which added staff and occupancy expense, higher health insurance, pension and advertising costs. In addition, a new scholarship program, funded for $100,000, was established to benefit the children of employees.

        The effective tax rate for the Corporation in 2003 was 19.0% compared to 17.7% and 18.7% in 2002 and 2001, respectively. Changes in the ratio of tax-exempt income to taxable income from year to year accounted for the movement in the Corporation's effective tax rate.

        A discussion of the areas that had the greatest impact on the reported results for 2003 follows.

Net Interest Income

2003 versus 2002:

        The most important source of the Corporation's earnings is net interest income which is defined as the difference between income on interest-earning assets and the expense of interest-bearing liabilities

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supporting those assets. Principal categories of interest-earning assets are loans and securities, while deposits, securities sold under agreements to repurchase (Repos), short-term borrowings and long-term debt are the principal categories of interest-bearing liabilities. For the purpose of this discussion, net interest income is adjusted for a fully taxable-equivalent basis (refer to Table 1). This adjustment facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the Corporation's 34% Federal statutory rate.

        Net interest income recorded an increase of $199,000 to $17.1 million in 2003 compared with $16.9 million in 2002. Interest income for 2003 decreased $2.5 million to $26.1 million compared with $28.7 million for 2002 while interest expense decreased $2.7 million to $9.1 million in 2003 versus $11.8 million in 2002. Average earning assets grew $10.4 million to $494.7 million in 2003 from $484.3 million in 2002. Because the Corporation was positioned for rising rates and was asset sensitive throughout the year, the low interest rate environment acted to slow the growth of net interest income in 2003. In addition, interest expense related to swaps purchased in 2001 to hedge against rising interest rates added $781,000 in 2003 versus $655,000 in 2002 to interest expense.

Table 1. Net Interest Income

        Net interest income, defined as interest income less interest expense, is shown in the following table:

        The Corporation's average yield on interest-earning assets in 2003 was 5.28%, down from 5.92% in 2002. The average rate paid on interest-bearing liabilities in 2003 was 2.14%, down from 2.81% in 2002. Net interest margin recorded a slight narrowing to 3.45% in 2003 from 3.49% in 2002.

2002 versus 2001:

        Net interest income remained stable at $16.89 million in 2002 compared with $16.83 million in 2001. Despite strong growth in the volume of average interest-earning assets outpacing strong growth in average interest-bearing liabilities by $5.6 million in 2002, it was not enough to maintain the Corporation's net interest margin. In addition, interest rate swaps entered into in 2001 to hedge against rising rates added $655,000 to interest expense in 2002 versus $238,000 in 2001.

        The Corporation's average yield on interest-earning assets in 2002 was 5.92%, down from 7.14% in 2001. The average rate paid on interest- bearing liabilities in 2002 was 2.81%, down from 3.96% in 2001. The net effect produced a lower net interest spread of 3.11% and a narrowing net interest margin of 3.49% for 2002 compared to 3.18% and 3.69%, respectively for 2001.

        For a more detailed picture of the components of net interest income please refer to Tables 1, 2, 3 and 14.

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Table 2. Rate-Volume Analysis of Net Interest Income

        Table 2 attributes increases and decreases in components of net interest income either to changes in average volume or to changes in average rates for interest-earning assets and interest-bearing liabilities. Numerous and simultaneous balance and rate changes occur during the year. The amount of change that is not due solely to volume or rate is allocated proportionally to both.

        Nonaccruing loans are included in the loan balances. All nontaxable interest income has been adjusted to a tax-equivalent basis, using a tax rate of 34%.

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Table 3. Analysis of Net Interest Income

All amounts have been adjusted to a tax-equivalent basis using a tax rate of 34%

Nonaccruing loans are included in the loan balances.

Provision for Loan Losses

        The provision for loan losses charged against earnings in 2003 was $1.70 million versus $1.19 million and $1.48 million in 2002 and 2001, respectively. Net charge-offs totaled approximately $2.25 million in 2003 versus $936,000 and $1.3 million in 2002 and 2001, respectively. Management performs a monthly analysis of the loan portfolio considering current economic conditions and other relevant factors to determine the adequacy of the allowance for loan losses. For more information, refer to the asset quality discussion and Tables 11, 12 and 13.

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Noninterest Income and Expense

2003 versus 2002:

        Noninterest income, excluding securities gains, increased 32.5% over 2002 to $7.25 million in 2003 from $5.47 million and $5.42 million in 2002 and 2001, respectively. Growth in service charges and fees was $505,000, or 21.0%, for a total of $2.86 million in 2003 and was primarily attributable to retail overdrafts and ATM, debit card and point-of-sale fee-based transactions. Fee income from mortgage banking activities increased $802,000, or 422%, to $992,000 in 2003 from $190,000 in 2002. Very robust mortgage refinancing activity in 2003 and subsequent sales of the mortgages originated on the secondary market was primarily responsible for this increase. Other income increased by $313,000 to $398,000 compared to $85,000 in 2002. Settlements from claims related to assets of the Bank were the factors behind the increase in other income. The Corporation generated securities gains from its equities portfolio of $488,000 in 2003 compared to $430,000 in 2002.

        Noninterest expense grew $1.13 million, or 8.3%, to $14.66 million in 2003 compared to $13.53 million in 2002. Pension and health insurance expense, which increased $275,000 and $55,000, respectively were the two largest contributors to the increase in noninterest expense. Additions to staff related to the opening of two new community offices and the related occupancy expense also added to noninterest expense in 2003. Another item contributing to the increase in noninterest expense was a new scholarship program established by the Bank and funded with $100,000. This program is for the benefit of employees' children to assist with the costs of higher education.

2002 versus 2001:

        Noninterest income, excluding securities gains, was stable in 2002 and totaled $5.47 million versus $5.42 million in 2001. Service charges and fees grew $97,000, or 4.30%, to $2.35 million and were primarily related to a new retail overdraft program implemented in the third quarter of 2002. Income from mortgage banking activities decreased $240,000, or 55.8%, to $190,000 in 2002 from $430,000 in 2001. The extremely low interest rate environment in the second half of 2002 resulted in an impairment charge of $335,000 against the Bank's mortgage servicing rights income versus none in 2001. The total charge against mortgage servicing rights income in 2002 was $475,000 including the impairment charge and the normal monthly amortization of the servicing rights versus $96,000 in 2001. In 2002 the Corporation recorded in other income a gain of $47,000 from a surrendered life insurance policy and a gain of $9,300 from the sale of foreclosed assets. In comparison, in 2001, the Corporation recorded a gain of approximately $70,000 from the sale of the Bank's credit card portfolio partially offset by losses totaling $40,000 from the sale of foreclosed assets. The Corporation realized security gains totaling $430,000 in 2002 versus $267,000 in 2001.

        Noninterest expense increased $680,000, or 5.29%, to $13.53 million in 2002 from $12.85 million in 2001. Salaries and benefits expense increased $371,000, or 5.6%, to $7.05 million largely as a result of increases in salaries, health insurance and pension expense. Net occupancy expense increased $110,000 in 2003, or 14.8%, to $855,000 from $745,000 in 2001 primarily due to depreciation expense associated with putting the new headquarters expansion in service in January 2002. Data processing expense, which increased $123,000, or 11.9%, to $1.03 million in 2003 versus $904,000 in 2001, was related largely to higher service bureau costs, maintenance costs and expensed software acquisitions.

Provision for Income Taxes

        Federal income tax expense equaled $1.37 million in 2003 versus $1.12 million and $1.29 million in 2002 and 2001, respectively. The Corporation's effective tax rate for the years ended December 31, 2003, 2002 and 2001 was 19.0%, 17.7% and 18.7%, respectively. Higher pretax earnings in relation to a lower level of tax-free income in 2003 were primarily responsible for the higher effective tax rate in 2003. Tax-free income for the Bank is primarily related to tax-free investments, tax-free loans and

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earnings on bank owned life insurance. For a more comprehensive analysis of Federal income tax expense refer to Note 11 of the accompanying financial statements.

Financial Condition

        One method of evaluating the Corporation's condition is in terms of its sources and uses of funds. Assets represent uses of funds while liabilities represent sources of funds. At December 31, 2003, total assets reached $549.7 million, an increase of $17.3 million, or 3.2% compared to $532.3 million at December 31, 2002. Table 3 presents average balances of the Corporation's assets and liabilities over a three-year period. The following discussion on financial condition will reference the average balance sheet in Table 3 unless otherwise noted.

Investment Securities:

        The Corporation invests in both taxable and tax-free securities as part of its asset/liability management. All securities were classified as available for sale at December 31, 2003 and 2002. In 2003, investment securities averaged $156.7 million versus $158.1 million in 2002. Taxable securities averaged $123.5 million and accounted for 79% of the investment portfolio while tax-free securities averaged $33.1 million and accounted for 21% of the portfolio. In 2002 the mix of the investment portfolio was 80% taxable and 20% tax-free. Matured taxable securities that were not replaced and higher market values for the tax-free securities accounted for the change in average balances between 2003 and 2002.

        In December 2002, the Corporation purchased a $2.745 million subordinated convertible debenture from American Home Bank, NA. The Corporation plans to convert this debenture to increase its ownership position to approximately 21% in the second quarter of 2004. With the exception of two non-rated securities with a book value of $3.4 million, one of which is the aforementioned debenture, the investment portfolio is made up of investment grade securities.

Table 4. Investment Securities at Amortized Cost

        The following tables present amortized costs of investment securities by type at December 31 for the past three years:

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Table 5. Maturity Distribution of Investment Portfolio

        The following presents an analysis of investment securities at December 31, 2003 by maturity, and the weighted average yield for each maturity presented. The yields presented in this table are presented on a tax-equivalent basis and have been calculated using the amortized cost.

Loans:

        Total loans averaged $331.4 million in 2003 versus $314.5 million in 2002, an increase of 5.3%. As reflected in Table 6, the growth in residential real estate loans in 2003 led the modest average growth in the loan portfolio. In 2003, the Bank made an investment in a Virginia-based mortgage company. Beginning in November 2003, the Bank began to temporarily fund residential real estate loans originated by the mortgage company. These loans will be funded for 60 to 90 days at which time they will be sold on the secondary market. Although the loans originated by the mortgage company had very little impact on average loans for the year, at December 31, 2003, the total of these loans was $11.0 million and accounted for almost half of the increase for loans on the balance sheet.

Table 6. Loan Portfolio

        The following table presents an analysis of the Bank's loan portfolio for each of the past five years:

        In 2003, the low interest rate environment continued as well as another unprecedented volume of mortgage originations, both purchase and refinance. Residential mortgages closed in 2003 totaled $91.2 million, an increase of 17% over the $77.9 million closed in 2002. During 2003, 49%, or $45 million, of the mortgage volume originated was sold on the secondary market, primarily Federal

20

National Mortgage Association (FNMA). The net impact of all mortgage activity during 2003, excluding the temporarily funded mortgage loans, resulted in growth in real estate loans totaling $7.58 million, or 7.3% to $110.9 million at December 31, 2003 versus $103.2 million at December 31, 2002.

        Commercial, industrial and agricultural loans were flat with an increase of $2.3 million, or 1.4%, to $165.9 million at year-end 2003 from $163.6 million at year-end 2001. Growth in this area came primarily from increased loans participated from other financial institutions.

        Consumer loans outstanding recorded an increase totaling $2.8 million, or 5.0%, to $58.2 million at December 31, 2003 from $55.5 million at December 31, 2002. Average consumer loans for the year recorded a decrease in 2003 of $1.8 million for an average for the year of $56.3 million compared to an average of $58.1 million in 2002. The zero and other very low interest rate financing offered by automobile manufacturers continued in 2003 and has slowed the Bank's consumer loan business.

Table 7. Maturities and Interest Rate Terms of Selected Loans

        Stated maturities (or earlier call dates) of selected loans as of December 31, 2003 are summarized in the table below. Residential mortgage and consumer loans are excluded from the presentation.