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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-K

(X)     ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2002,
                                                                                                         or
( ) TRANSITION REPORT PURSUANT TO SECTION 13 or 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ______ to ______

Commission file number 0-23863

Registrant's telephone number, including area code      (570) 879-2175

Securities registered pursuant to Section 12(b) of the Act:      NONE

Securities registered pursuant to Section 12(g) of the Act:      COMMON STOCK ($2 Par Value)
(Title 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 period that the registrant was required to file such reports, and (2) has been subject to such filing requirements for the past 90 days. Yes X No____

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X]

Indicate by check mark whether the registrant is an accelerated filer. Yes _____ No X

The aggregate market value of voting stock held by non-affiliates of the registrant is $ 62,840,320

The aggregate dollar amount of the voting stock set forth equals the number of shares of the registrant’s Common Stock outstanding, reduced by the amount of Common stock held be executive officers, directors, and shareholders owning in excess of 10% of the registrant’s Common Stock, multiplied by the last sale price for the registrant’s Common Stock on February 28, 2003. The information provided shall in no way be construed as an admission that the officer, director, or 10% shareholder in the registrant may be deemed an affiliate of the registrant or that such person is the beneficial owner of the shares reported as being held by him, and any such inference is hereby disclaimed. The information provided herein is included solely for the record keeping purpose of the Securities and Exchange Commission.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the 2002 Proxy Statement for the Registrant are incorporated by reference into Part III of this report.

TABLE OF CONTENTS

PART I

ITEM 1        BUSINESS

BRIEF HISTORY

Peoples Financial Services Corp. was incorporated under the laws of the Commonwealth of Pennsylvania on February 6, 1986, and is a one-bank holding company headquartered in Hallstead, Pennsylvania.

The company is engaged primarily in commercial and retail banking services and in businesses related to banking services through its sole subsidiary, Peoples National Bank (“PNB” or the “Bank”). PNB was chartered in Hallstead, Pennsylvania in 1905 under the name of The First National Bank of Hallstead. In 1965, the Hop Bottom National Bank (chartered in 1910) merged with and into the First National Bank of Hallstead to form Peoples National Bank of Susquehanna County. In 2001, the Bank changed its name to Peoples National Bank. PNB is currently in its 97th year of operation.

OPERATING SEGMENTS

The company has one reportable operating segment, Community Banking, which consists of commercial and retail banking, and other non-reportable operating segments, as described in Note 1 of the Notes to Consolidated Financial Statements included at page 57 of this Report. The Segment Reporting information in Note 1 is incorporated by reference into this Item 1.

SUPERVISION AND REGULATION

The company and PNB are extensively regulated under federal and state law. Generally, these laws and regulations are intended to protect depositors, not shareholders. The following is a summary description of certain provisions of law that affect the regulation of bank holding companies and banks. This discussion is qualified in its entirety by reference to applicable laws and regulations. Changes in law and regulation may have a material effect on the business and prospects of the company and PNB.

The company is a bank holding company within the meaning of the Bank Holding company Act of 1956, as amended, and is subject to regulation, supervision, and examination by the Federal Reserve Bank (“FRB”). The company is required to file annual and quarterly reports with the FRB and to provide the FRB with such additional information as the FRB may require. The FRB also conducts examinations of the company.

With certain limited exceptions, the company is required to obtain prior approval from the FRB before acquiring direct or indirect ownership or control of more than 5% of any voting securities or substantially all of the assets of a bank or bank holding company, or before merging or consolidating with another bank holding company. Additionally, with certain exceptions, any person or entity proposing to acquire control through direct or indirect ownership of 25% or more of any voting securities of the company is required to give 60 days written notice of the acquisition to the FRB, which may prohibit the transaction, and to publish notice to the public.

The company’s banking subsidiary is a federally chartered national banking association regulated by the Office of the Comptroller of the Currency (“OCC”). The OCC may prohibit the institution over which it has supervisory authority from engaging in activities or investments that the agency believes constitute unsafe or unsound banking practices. Federal banking regulators have extensive enforcement authority over the institutions they regulate to prohibit or correct activities that violate law; regulation or a regulatory agreement or which are deemed to constitute unsafe or unsound practices.

Enforcement actions may include:

PNB is subject to certain restrictions on extensions of credit to executive officers, directors, principal shareholders or any related interests of such persons which generally require that such credit extensions be made on substantially the same terms as are available to third persons dealing with PNB and not involving more than the normal risk of repayment. Other laws tie the maximum amount that may be loaned to any one customer and its related interests to capital levels of the bank.

Limitations on Dividends and Other Payments
The company’s current ability to pay dividends is largely dependent upon the receipt of dividends from its banking subsidiary, PNB. Both federal and state laws impose restrictions on the ability of the company to pay dividends. The FRB has issued a policy statement that provides that, as a general matter, insured banks and bank holding companies may pay dividends only out of prior operating earnings. Under the National Bank Act, a national bank such as PNB, may pay dividends only out of the current year’s net profits and the net profits of the last two years. In addition to these specific restrictions, bank regulatory agencies in general, also have the ability to prohibit proposed dividends by a financial institution that would otherwise be permitted under applicable regulations if the regulatory body determines that such distribution would constitute an unsafe or unsound practice.

Permitted Non-Banking Activities
Generally, a bank holding company may not engage in any activities other than banking, managing, or controlling its bank and other authorized subsidiaries, and providing service to those subsidiaries. With prior approval of the FRB, the company may acquire more than 5% of the assets or outstanding shares of a company engaging in non-bank activities determined by the FRB to be closely related to the business of banking or of managing or controlling banks. The FRB provides expedited procedures for expansion into approved categories of non-bank activities.

Subsidiary banks of a bank holding company are subject to certain quantitative and qualitative restrictions:

These regulations and restrictions may limit the company’s ability to obtain funds from PNB for its cash needs, including funds for the payment of dividends, interest and operating expenses. Further, subject to certain exceptions, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. For example, PNB may not generally require a customer to obtain other services from itself or the company, and may not require that a customer promise not to obtain other services from a competitor as a condition to an extension of credit to the customer.

Under FRB policy, a bank holding company is expected to act as a source of financial strength to its subsidiary banks and to make capital injections into a troubled subsidiary bank, and the FRB may charge the bank holding company with engaging in unsafe and unsound practices for failure to commit resources to a subsidiary bank when required. A required capital injection may be called for at a time when the holding company does not have the resources to provide it. In addition, depository institutions insured by the FDIC can be held liable for any losses incurred by, or reasonably anticipated to be incurred by, the FDIC in connection with the default of or assistance provided to, a commonly controlled FDIC-insured depository institution. Accordingly, in the event that any insured subsidiary of the company causes a loss to the FDIC, other insured subsidiaries of the company could be required to compensate the FDIC by reimbursing it for the estimated amount of such loss. Such cross guarantee liabilities generally are superior in priority to the obligation of the depository institutions to its stockholders due solely to their status as stockholders and obligations to other affiliates.

Pennsylvania Law
As a Pennsylvania bank holding company, the company is subject to various restrictions on its activities as set forth in Pennsylvania law. This is in addition to those restrictions set forth in federal law. Under Pennsylvania law, a bank holding company that desires to acquire a bank or bank holding company that has its principal place of business in Pennsylvania must obtain permission from the Pennsylvania Department of Banking.

Interstate Banking Legislation
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 was enacted into law on September 29, 1994. The law provides that, among other things, substantially all state law barriers to the acquisition of banks by out-of-state bank holding companies were eliminated effective September 29, 1995. The law also permits interstate branching by banks effective as of June 1, 1997, subject to the ability of states to opt-out completely or to set an earlier effective date.

FIRREA        (Financial Institution Reform, Recovery, and Enforcement Act)
FIRREA was enacted into law in order to address the financial condition of the Federal Savings and Loan Insurance Corporation, to restructure the regulation of the thrift industry, and to enhance the supervisory and enforcement powers of the Federal bank and thrift regulatory agencies. As the primary federal regulator of the bank, the OCC is responsible for the supervision of the bank. When dealing with capital requirements, the OCC and FDIC have the flexibility to impose supervisory agreements on institutions that fail to comply with regulatory requirements. The imposition of a capital plan, termination of deposit insurance, and removal or temporary suspension of an officer, director or other institution-affiliated person may cause enforcement actions.

There are three levels of civil penalties under FIRREA.

Criminal penalties are increased to $1 million per violation and may be up to $5 million for continuing violations or for the actual amount of gain or loss. These penalties may be combined with prison sentences of up to five years.

FDICIA        (Federal Deposit Insurance Corporation Improvement Act of 1991)
In December 1991, Congress enacted FDICIA which substantially revised the bank regulatory and funding provisions of the Federal Deposit Insurance Act and made significant revisions to several other federal banking statutes. FDICIA provides for, among other things,

FDICIA also provides for increased funding of the FDIC insurance funds and the implementation of risk based premiums.

A central feature of FDICIA is the requirement that the federal banking agencies take “prompt corrective action” with respect to depository institutions that do not meet minimum capital requirements. Pursuant to FDICIA, the federal bank regulatory authorities have adopted regulations setting forth a five-tiered system for measuring the capital adequacy of the depository institutions that they supervise. Under these regulations, a depository institution is classified in one of the following capital categories:

PNB is currently classified as “well capitalized.” An institution may be deemed by the regulators to be in a capitalization category that is lower than is indicated by its actual capital position if, among other things, it receives an unsatisfactory examination rating with respect to asset quality, management, earnings or liquidity.

FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a cash dividend) or paying any management fees to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans. If a depository fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. Significantly undercapitalized depository institutions may be subject to a number of other requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and stop accepting deposits from correspondent banks. Critically undercapitalized institutions are subject to the appointment of a receiver or conservator, generally within 90 days of the date such institution is determined to be critically under capitalized.

FDICIA provides the federal banking agencies with significantly expanded powers to take enforcement action against institutions that fail to comply with capital or other standards. Such actions may include the termination of deposit insurance by the FDIC or the appointment of a receiver or conservator for the institution. FDICIA also limits the circumstances under which the FDIC is permitted to provide financial assistance to an insured institution before appointment of a conservator or receiver.

Under FDICIA each federal banking agency is required to prescribe, by regulation, non-capital safety and soundness standards for institutions under its authority. The federal banking agencies, including the OCC, have adopted standards covering:

Any institution that fails to meet these standards may be required by the agency to develop a plan acceptable to the agency, specifying the steps that the institutions will take to meet the standards. Failure to submit or implement such a plan may subject the institution to regulatory sanctions. The company, on behalf of PNB, believes that it meets substantially all the standards that have been adopted. FDICIA also imposed new capital standards on insured depository institutions. Before establishing new branch offices, PNB must meet certain minimum capital stock and surplus requirements and must obtain OCC approval.

Risk-Based Capital Requirements
The federal banking regulators have adopted certain risk-based capital guidelines to assist in the assessment of the capital adequacy of a banking organization’s operations for both transactions reported on the balance sheet as assets and transactions, such as letters of credit, and recourse agreements, which are recorded as off balance sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain US Treasury securities, to 100% for assets with relatively high credit risk, such as business loans.

A banking organization’s risk based capital ratios are obtained by dividing its qualifying capital by its total risk adjusted assets. The regulators measure risk-adjusted assets, which include off balance sheet items, against both total qualifying capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and Tier 1 capital.

Banks and bank holding companies subject to the risk-based capital guidelines are required to maintain a ratio of Tier 1 capital to risk-weighted assets of at least 4% and a ratio of total capital to risk-weighted assets of at least 8%. The appropriate regulatory authority may set higher capital requirements when particular circumstances warrant. As of December 31, 2002, PFSC’s ratio of Tier 1 capital to risk-weighted assets stood at 14.43% and its ratio of total capital to risk- weighted assets stood at 15.26%. In addition to risk-based capital, banks and bank holding companies are required to maintain a minimum amount of Tier 1 capital to total assets, referred to as the leverage capital ratio, of at least 4%. As of December 31, 2002, the company’s leverage capital ratio was 9.91%.

Failure to meet applicable capital guidelines could subject a banking organization to a variety of enforcement actions including:

In addition, future changes in regulations or practices could further reduce the amount of capital recognized for purposes of capital adequacy. Such a change could affect the ability of PNB to grow and could restrict the amount of profits, if any, available for the payment of dividends to the company.

Interest Rate Risk
In August 1995 and May 1996, the federal banking agencies adopted final regulations specifying that the agencies will include, in their evaluations of a bank’s capital adequacy, an assessment of the bank’s interest rate risk (“IRR”) exposure. The standards for measuring the adequacy and effectiveness of a banking organization’s IRR management includes a measurement of Board of Directors and senior management oversight, and a determination of whether a banking organization’s procedures for comprehensive risk management are appropriate to the circumstances of the specific banking organization. PNB has internal IRR models that are used to measure and monitor IRR. In addition, an outside source also assesses IRR using its model on a quarterly basis. Additionally, the regulatory agencies have been assessing IRR on an informal basis for several years. For these reasons, the company does not expect the IRR evaluation in the agencies’ capital guidelines to result in significant changes in capital requirements for PNB.

FDIC Insurance Assessments
As a FDIC member institution, PNB’s deposits are insured to a maximum of $100,000 per depositor through the Bank Insurance Fund (“BIF”) that is administered by the FDIC and each institution is required to pay semi-annual deposit insurance premium assessments to the FDIC. The PNB assessment for 2002 was $41,810. These figures can be compared to FDIC assessments in 2001 of $42,947 and in 2000 of $44,063. Prior to 1997, only thrift institutions were subject to assessments to raise funds to pay the Financing Corporate bonds. On September 30, 1996, as part of the Omnibus Budget Act, Congress enacted the Deposit Insurance Funds Act of 1996, which recapitalized the Savings Association Insurance Fund (“SAIF”) and provided that BIF deposits would be subject to 1/5 of the assessment to which SAIF deposits are subject for FICO bond payments through 1999. Beginning in 2000, BIF deposits and SAIF deposits were subject to the same assessment for FICO bonds. The FICO assessment for PNB for 2002 was $ 0.0170 for each $100 of BIF deposits.

Community Reinvestment Act
The Community Reinvestment Act of 1977, (the CRA) is designed to create a system for bank regulatory agencies to evaluate a depository institution’s record in meeting the credit needs of its community. Until May 1995, a depository institution was evaluated for CRA compliance based on twelve assessment factors.

The CRA regulations were completely revised as of July 1, 1995, (the revised CRA regulation) to establish new performance-based standards for use in examining for compliance.

The Bank had its last CRA compliance examination in 2002 and received a “satisfactory” rating.

Concentration
Payment risk is a function of the economic climate in which the Bank’s lending activities are conducted. Economic downturns in the economy generally or in a particular sector could cause cash flow problems for customers and make loan payments more difficult. The Bank attempts to minimize this risk by avoiding loan concentrations to a single customer or to a small group of customers whose loss would have a materially adverse effect on the financial condition of the Bank.

Monetary Policy
The earnings of a bank holding company are affected by the policies of regulatory authorities, including the FRB, in connection with the FRB’s regulation of the money supply. Various methods employed by the FRB are

These methods are used in varying combinations to influence overall growth and distribution of bank loans, investments, and deposits, and their use may also affect interest rates charged on loans or paid on deposits. The monetary policies of the FRB have had a significant effect on the operating results of commercial banks in the past and are expected to do so in the future.

RECENT LEGISLATION

USA Patriot Act of 2001
In October 2001, the USA Patriot Act of 2001 was enacted in response to the terrorist attacks in New York, Pennsylvania and Washington D.C. which occurred on September 11, 2001. The Patriot Act is intended to strengthen U.S. law enforcement’s and the intelligence communities’ abilities to work cohesively to combat terrorism on a variety of fronts. The potential impact of the Patriot Act on financial institutions of all kinds is significant and wide ranging. The Patriot Act contains sweeping anti-money laundering and financial transparency laws and imposes various regulations, including standards for verifying client identification at account opening, and rules to promote cooperation among financial institutions, regulators and 1aw enforcement entities in identifying parties that may be involved in terrorism or money laundering.

Financial Services Modernization Legislation
In November 1999, the Gramm-Leach-Bliley Act of 1999, or the GLB was enacted. The GLB repeals provisions of the Glass-Steagall Act which restricted the affiliation of Federal Reserve member banks with firms “engaged principally” in specified securities activities, and which restricted officer, director or employee interlocks between a member bank and any company or person “primarily engaged” in specified securities activities.

In addition, the GLB also contains provisions that expressly preempt any state law restricting the establishment of financial affiliations, primarily related to insurance. The general effect of the law is to establish a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms and other financial service providers by revising and expanding the Bank Holding Company Act framework to permit a holding company to engage in a full range of financial activities through a new entity known as a “financial holding company.” “Financial activities” is broadly defined to include not only banking, insurance and securities activities, but also merchant banking and additional activities that the Federal Reserve Board, in consultation with the Secretary of the Treasury, determines to be financial in nature, incidental to such financial activities or complementary activities that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.

The GLB also permits national banks to engage in expanded activities through the formation of financia1 subsidiaries. A national bank may have a subsidiary engaged in any activity authorized for national banks directly or any financial activity, except for insurance underwriting, insurance investments, real estate investment or development, or merchant banking, which may only be conducted through a subsidiary of a financial holding company. Financial activities include all activities permitted under new sections of the Bank Holding Company Act or permitted by regulation.

To the extent that the GLB permits banks, securities firms and insurance companies to affiliate, the financial services industry may experience further consolidation. The GLB is intended to grant to community banks certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis and which unitary savings and loan holding companies already possess. Nevertheless, the GLB may have the result of increasing the amount of competition that the Registrant faces from larger institutions and other types of companies offering financial products, many of which may have substantially more financial resources than the Registrant has.

Sarbanes-Oxley Act of 2002
        On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002, or the SOA. The stated goals of the SOA are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws.

The SOA is the most far-reaching U.S. securities legislation enacted in some time. The SOA generally applies to all companies, both U.S. and non-U.S., that file or are required to file periodic reports with the Securities and Exchange Commission (the “SEC”) under the Securities Exchange Act of 1934, or the Exchange Act. Given the extensive SEC role in implementing rules relating to many of the SOA’s new requirements, the final scope of these requirements remains to be determined.

The SOA includes very specific additional disclosure requirements and new corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules and mandates further studies of certain issues by thc SEC. The SOA represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees.

The SOA addresses, among other matters:

The SOA contains provisions which became effective upon enactment on July 30, 2002 and provisions which will become effective from within 30 days to one year from enactment. The SEC has been delegated the task of enacting rules to implement various provisions with respect to, among other matters, disclosure in periodic filings pursuant to the Exchange Act.

Regulation W
Transactions between a bank and its “affiliates” are quantitatively and qualitatively restricted under the Federal Reserve Act. The Federal Deposit Insurance Act applies Sections 23A and 23B to insured nonmember banks in thc same manner and to the same extent as if they were members of the Federal Reserve System. The Federal Reserve Board has also recently issued Regulation W, which codifies prior regulations under Sections 23A and 23B of the Federal Reserve Act and interpretative guidance with respect to affiliate transactions. Regulation W incorporates the exemption from the affiliate transaction rules but expands the exemption to cover the purchase of any type of loan or extension of credit from an affiliate. Affiliates of a bank include, among other entities, the bank’s holding company and companies that are under common control with the bank. The company is considered to be an affiliate of the bank. In general, subject to certain specified exemptions, a bank or its subsidiaries are limited in their ability to engage in “covered transactions” with affiliates:

In addition, a bank and its subsidiaries may engage in covered transactions and other specified transactions only on terms and under circumstances that are substantially the same, or at least as favorable to the bank or its subsidiary, as those prevailing at the time for comparable transactions with nonaffiliated companies. A “covered transaction” includes:

In addition, under Regulation W:

Regulation W generally excludes all non-bank and non-savings association subsidiaries of banks from treatment as affiliates, except to the extent that the Federal Reserve Board decides to treat these subsidiaries as affiliates.

Concurrently with the adoption of Regulation W, the Federal Reserve Board has proposed a regulation which would further limit the amount of loans that could be purchased by a bank from an affiliate to not more than 100% of the bank’s capital and surplus.

Legislation and Regulatory Changes
From time to time, legislation is enacted that effects the cost of doing business or limits the activities of a financial institution. We cannot predict the likelihood of any major changes or the impact those changes may have on the company.

MARKET AREAS

The PNB market areas are in the northeastern part of Pennsylvania with the primary focus being Susquehanna and Wyoming Counties. Since Susquehanna County borders the State of New York, the southern portion of Broome County, New York is also considered part of the market area of PNB. In addition, parts of Lackawanna, Wayne, and Bradford Counties in Pennsylvania that border Susquehanna and Wyoming Counties are also considered part of the PNB market area.

In March of 2002, a supermarket branch bank was purchased from Mohawk Community Bank. The branch is located in Norwich, Chenango County, New York. This office is approximately 55 miles from Hallstead and this factor, along with high lease payments and lack of growth opportunities for our Bank in that area, caused the Bank to reassess its decision. Notice was given in December of 2002 to close the office, effective March 31, 2003.

A decision was made to apply for permission to establish a branch office in New York but closer to Hallstead. Property was purchased in Conklin, New York, approximately 10 miles from Hallstead. Permission to establish a branch was approved and the Conklin office will be operational in March of 2003. PNB purchased property in Deposit, New York, on December 12, 2002. At this time regulatory approval to establish a branch at this location is still pending. With a presence in New York, the Bank will be better able to serve its present customers as well as add new customers. However, the market areas will be substantially the same.

The PNB market area is situated between:

Susquehanna County could best be described as a bedroom county with a high percentage of its residents commuting to work in Broome County, New York, or to the Scranton, Pennsylvania, area. The southern part of Susquehanna County tends to gravitate south for both employment and shopping while the northern part of the county goes north to Broome County, New York. The western part of Susquehanna County gravitates south and west to and through Wyoming County. Wyoming County is home to a Proctor & Gamble manufacturing facility. This is an economic stimulus to Wyoming County and the surrounding areas.

Our offices are located in counties that would be considered sparsely populated as they are made up of many small towns and villages. The latest population figures show Susquehanna County at approximately 42,000 and Wyoming County at approximately 30,000 residents. Both counties are experiencing growth, but not robust growth. Broome County has approximately 208,000 residents and the Town of Conklin has approximately 7,000 residents. The economy of Broome County has overall been hit hard and has lost many manufacturing jobs in the past ten years. This trend continues. Fortunately, the new employment centers are in the Town of Conklin and the neighboring Town of Kirkwood. Both towns border Susquehanna County, Pennsylvania. Interstate 81 runs north and south through the eastern half of Susquehanna County and has brought an influx of people from New Jersey and the Philadelphia area. These people have purchased homes and land to build homes that are used as vacation/recreation retreats and, quite often, become retirement homes.

BUSINESS

Lending Activities
PNB provides a full range of retail and commercial banking services designed to meet the borrowing and depository needs of small and medium sized businesses and consumers in its market areas. Substantially all of PNB’s loans are to customers located within its service areas. PNB has no foreign loans or highly leveraged transaction loans, as defined by the FRB. Substantially all of the loans in PNB’s portfolio have been originated by PNB. Policies adopted by the Board of Directors are the basis by which PNB conducts its lending activities. These loan policies grant individual lending officers authority to make secured and unsecured loans in specific dollar amounts. Larger loans must be approved by senior officers or by the Board of Directors. PNB’s management information systems and loan review policies are designed to monitor lending sufficiently to ensure adherence to PNB’s loan policies.

        The commercial loans offered by PNB include

PNB’s commercial real estate loans are used to provide financing for retail operations, manufacturing operations, farming operations, multi-family housing units, and churches. Commercial real estate secured loans are generally written for a term of 15 years or less or amortized over a longer period with balloon payments at shorter intervals. Personal guarantees are obtained on nearly all commercial loans. Credit analysis, loan review, and an effective collections process are also used to minimize any potential losses. PNB employs three full-time commercial lending officers. These three people are augmented by branch managers who are authorized to make smaller, less complex, commercial loans.

Payment risk is a function of the economic climate in which PNB’s lending activities are conducted; economic downturns in the economy generally or in a particular sector could cause cash flow problems for customers and make loan payments more difficult. PNB attempts to minimize this risk by avoiding concentrations of credit to single borrowers or borrowers in a particular industry. Interest rate risk would occur if PNB were to make loans at fixed rates in an environment in which rates were rising thereby preventing PNB from making loans at the higher prevailing rates. PNB attempts to mitigate this risk by making adjustable rate commercial loans and, when extending fixed rate commercial loans, fixing loan maturities at five years or less. Finally, collateral risk can occur if PNB’s position in collateral taken as security for loan repayment is not adequately secured. PNB attempts to minimize collateral risk by avoiding loan concentrations to particular borrowers, by perfecting liens on collateral and by obtaining appraisals on property prior to extending loans.

Consumer loans offered by PNB include:

PNB offers credit cards as an agent bank through another correspondent bank.

Risks applicable to consumer lending are similar to those applicable to commercial lending. PNB attempts to mitigate payment risk in consumer lending by limiting consumer lending products to a term of five years or less. To the extent that PNB extends unsecured consumer loans, there is greater collateral risk; however, credit checks and borrower history are obtained in all consumer loan transactions.

Residential mortgage products include adjustable-rate as well as conventional fixed-rate loans. Terms vary from 1, 5, 7 and 10-year adjustable rate loans to 5, 10, 15, 20, and 30-year fully amortized fixed rate loans. Bi-weekly payment plans are also available. Personal secured and unsecured revolving lines of credit with variable interest rates and principal amounts ranging from $1,000 to $10,000 are offered to credit-worthy customers. The largest segment of PNB’s installment loan portfolio is fixed-rate loans. Most are secured either by automobiles, motorcycles, snowmobiles, boats, other personal property, or by liens filed against real estate. These loans are generally available in terms of up to 15 years with automobile loans having maturities of up to 60 months and real estate loans having maturities up to 15 years. Loans secured by other collateral usually require a maturity of less than 60 months. Home equity products include both fixed-rate term products and also an open-end revolving line of credit with a maximum loan-to-value ratio of 80% of current appraisal. A special MGIC program now offered through the Bank, allows for loans of up to 100% of the appreciated value for qualified applicants. Credit checks, credit scoring, and debt-to-income ratios within preset parameters are used to qualify borrowers.

Mortgage loans have historically had a longer average life than commercial or consumer loans. Accordingly, payment and interest rate risks are greater in some respects with mortgage loans than with commercial or consumer lending. Deposits, which are used as the primary source to fund mortgage lending, tend to be of shorter duration than the average maturities on residential mortgage loans and are more susceptible to interest rate changes. Historical records indicate that our mortgage loans, no matter what maturity, have an average life of less than seven years. However, at the present time, we are not selling mortgages in the secondary market although we do write terms with fixed rates as long as 30 years. The 30-year fixed rate product is payable bi-weekly and therefore, reduces the final maturity to approximately 23 years. Mortgages are also written with adjustable rates. Mortgage lending is also subject to economic downturns, in that increases in unemployment could adversely affect the ability of borrowers to repay mortgage loans and decreases in property values could affect the value of the real estate serving as collateral for the loan.

Low interest rates and a more aggressive posture allowed the good growth in loans in 2002 to continue with an increase of over 14% from the year ended 2001. Industry standard debt-to-income ratios and credit checks are used to qualify borrowers on all consumer loans. Managers, assistant managers, and customer service officers have retail lending authorities at each of the full-service branch office locations. PNB has centralized loan administration at its operations/administrative offices where mortgage underwriting and loan review and analysis take place.

Loan Approval
Individual loan authorities are established by PNB’s Board of Directors upon recommendation by the senior credit officer. In establishing an individual’s loan authority, the experience of the lender is taken into consideration, as well as the type of lending in which the individual is involved. The President of PNB has the authority to approve loans up to $500,000 following an analysis and review by loan administration and a written recommendation by the Chief Credit Officer. The full Board of Directors reviews on a monthly basis, all loans approved by individual lenders and the officers loan committee. All loan requests which are either complex in nature or exceed $500,000 must be analyzed and reviewed by loan administration and presented with a recommendation to the full Board of Directors for approval or denial.

PNB generally requires that loans secured by first mortgages or real estate have loan-to-value ratios within specified limits, ranging from 75% for loans secured by raw land to 80% for improved property, with the exception of secondary market programs which allow loan-to-value ratios as high as 100%. In addition, in some instances for qualified borrowers, private mortgage insurance is available for purchase that allows loan-to-value ratios to go as high as 100%. PNB also participates in a guaranteed mortgage insurance program. This allows PNB to make loans secured by second mortgages on real estate up to 100% of the value of the property. Adjustable rate mortgage products, as well as conventional fixed-rate products, are also available at PNB.

Deposit Activities
PNB also offers a full range of deposit and personal banking services insured by the FDIC, including commercial checking and small business checking products, cash management services, retirement accounts such as Individual Retirement Accounts (“IRA”), retail deposit services such as certificates of deposit, money market accounts, saving accounts, a variety of checking account products, automated teller machines (“ATM’s”), point of sale and other electronic services such as automated clearing house (“ACH”) originations, and other personal miscellaneous services. These miscellaneous services would include

The principal sources of funds for PNB are core deposits that include demand deposits, interest bearing transaction accounts, money market accounts, savings deposits, and certificates of deposit. These deposits are solicited from individuals, businesses, non-profit entities, and government authorities. Substantially all of PNB’s deposits are from the local market areas surrounding each of its offices.

Investment Products
In 1999, PNB entered into an agreement with T.H.E. Financial Services to hire a joint employee to sell investment products. An agent was hired and has an office located in the Bank’s Hallstead Plaza building.

Insurance Products
In April of 2001, PNB purchased an equity interest in Community Bankers Insurance Agency. This investment gives the Bank a referral avenue to provide insurance, broadening our available lines of financial services

Investment Portfolio and Activities
PNB’s investment portfolio has several objectives.

In view of the above objectives, the portfolio is treated conservatively by management and only securities that pass those criteria are purchased.

Competition
PNB operates in a fairly competitive environment, competing for deposits and loans with commercial banks, thrifts, credit unions, and finance and mortgage companies. Some of these competitors possess substantially greater financial resources than those available to PNB. Also, certain of these institutions have significantly higher lending limits than PNB and may provide various services for their customers, such as trust services, that are not presently available at PNB.

Financial institutions generally compete on the basis of rates and service. PNB is subject to increasing competition from credit unions, finance companies, and mortgage companies that may not be subject to the same regulatory restrictions and taxations as commercial banks.

PNB will seek to remain competitive with interest rates that it charges on its loans and offers on deposits. It also believes that its success has been, and will continue to be, due to its emphasis on community involvement, customer services, and relationships. With consolidation continuing in the financial industry, and particularly in PNB’s markets, smaller profitable banks are gaining opportunities where larger institutions exit markets that are only marginally profitable for them.

The financial services industry in the company’s service area is extremely competitive. The company’s competitors within its service area include banks and bank holding companies with substantially greater resources. Many competitors have substantially higher legal lending limits.

In addition, savings banks, savings and loan associations, credit unions, money market and other mutual funds, mortgage companies, leasing companies, finance companies, and other financial services companies offer products and services similar to those offered by the company and PNB, on competitive terms.

Many bank holding companies have elected to become financial holding companies under the Gramm-Leach-Bliley Act, which gives them a broader range of products with which we must compete. Although the long-range effects of this development cannot be predicted, most probably it will further narrow the differences and intensify competition among commercial banks, investment banks, insurance firms and other financial services companies.

SEASONALITY

Management does not feel that the deposits or the business of PNB in general are seasonal in nature. The deposits may, however, vary with local and national economic conditions but should not have a material effect on planning and policy making.

SIGNIFICANT ACCOUNTING POLICIES

Disclosure of the company’s significant accounting policies is included in Note 1 to the Consolidated Financial Statements. Some of these policies are particularly sensitive requiring significant judgements, estimates and assumptions to be made by management. Additional information is contained in Management’s Discussion and Analysis for the most sensitive of these issues, including the provision and allowance for loan losses, which are located in Note 4 to the Consolidated Financial Statements.

Significant estimates are made by management in determining the allowance for loan losses. Consideration is given to a variety of factors in establishing this estimate. In estimating the allowance for loan losses, management considers current economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan review, financial and managerial strengths of borrowers, adequacy of collateral, if collateral dependent, or present value of future cash flows and other relevant factors.

STATISTICAL DISCLOURES

The following statistical disclosures are included in Management’s Discussion and Analysis, Item 8 hereof, and are incorporated by reference in this Item 1:

ITEM 2        PROPERTIES

PNB has four full-service banking offices in Susquehanna County that are located in:

PNB’s presence in Wyoming County, Pennsylvania had been limited to a de novo branch in Nicholson, which reopened in 1992 until the purchase of the two Mellon offices in 1997. The Wyoming County locations are:

The administrative/operations office of the company and PNB is located at 50 Main Street, Hallstead, Pennsylvania. The following departments are located at that office:

The Bank has an office located in the Price Chopper Super Market in Norwich, Chenango County, New York. This office was purchased from Mohawk Community Bank, Amsterdam, New York, in March of 2002. A decision was made to close this office effective March 31, 2003, because of distance from Hallstead, high lease payments, and lack of growth opportunity for our Bank.

Subsequently, real estate was purchased in Conklin, New York, approximately 10 miles from Hallstead. Regulators approved permission to establish an office at that site and it will be operational in March of 2003.

Also, on December 12, 2002, property was purchased at 108 Second Street, Town of Sanford, Village of Deposit, Broome County, New York. At the time of this report, the Bank has not received regulatory approval to locate a branch at this location.

All offices are owned in fee title by PNB with the exception of the Hallstead Plaza office and the Meshoppen office. The Hallstead Plaza and Meshoppen offices are subject to ground leases. Each lease is either long-term expiring in September 2028 or includes renewal options. Current lease payments range from $2,535 to $17,760 annually. The leases provide that the Bank pay property taxes, insurance, and maintenance costs. Six of the seven offices provide drive-up banking services and five offices have 24-hour ATM services.

ITEM 3        LEGAL PROCEEDINGS

On October 23, 2001, the Securities and Exchange Commission filed suit against Robert L. Bentley, his d/b/a Entrust Group and Bentley Financial Services, Inc. alleging fraud in the sales of securities to financial institutions. Specifically, the Commission alleged that the defendants were representing to investors that they were selling bank-issued, federally insured certificates of deposit when they were actually selling uninsured securities issued by the defendants. The Commission alleged that the defendants have violated the broker-dealer registration and the antifraud provisions of the federal securities laws. The Commission’s action seeks permanent injunctions prohibiting future violations of these provisions and others, disgorgement of the defendants’ ill-gotten gains plus prejudgment interest, and civil penalties against each defendant. Additionally, the Commission’s action sought emergency injunctive and equitable relief consisting principally of a temporary restraining order, an order freezing each defendant’s assets and an order appointing a receiver. The Court granted the Commission’s request on October 24, 2001 for a temporary restraining order and, on November 7, 2001, appointed a receiver for Robert L. Bentley, Entrust Group and Bentley Financial Services, Inc. (collectively the Bentley Receivership Entities). The receiver obtained control of all investments and assets of the Bentley Receivership Entities. Peoples regularly invested through Entrust Group for certificates of deposit that the company had understood were bank issued, federally insured and the Entrust Group was holding in safekeeping for them. As of December 31, 2002, the Bank had $1,980,000 of these investments outstanding with Entrust Group. Based on preliminary information, management estimates the loss to be approximately $297,000, which has been charged against operations for the years ended December 31, 2001 and 2002 in the amounts of $139,000 and $158,000, respectively, and the asset has been written down to $1,683,000. Since the ultimate resolution of this matter is presently unknown, it is reasonably possible that the loss estimate could change and the change could be material. The $1,683,000 net claim with the receiver is included in other assets on the consolidated balance sheet of the company as of December 31, 2002.

The nature of the company’s business generates a certain amount of litigation involving matters arising out of the ordinary course of business. In the opinion of management, there are no other legal proceedings that might have a material effect on the results of operations, liquidity, or the financial position of the company at this time.

ITEM 4        SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

NONE

PART II

ITEM 5         MARKET FOR REGISTRANT'S COMMON EQUITY
                      AND RELATED STOCKHOLDER MATTERS

The company’s Common Stock is not listed on an exchange or quoted on the National Association of Securities Dealers, Inc. Automated Quotation system (NASDAQ). The company’s Common Stock is traded sporadically in the over-the-counter market and, accordingly, there is no established public trading market at this time. The company’s stock is listed on the OTC Bulletin Board under the symbol PFIS. The cusip number is 711040-10-5. The investment firms of RBC Dain Rauscher from Lancaster, Pennsylvania, and Ferris, Baker Watts, Incorporated from Baltimore, Maryland, make a limited market in the company’s Common Stock. The company and previously the Bank has continuously paid dividends for more than 90 years and it is the intention to pay dividends in the future. However, future dividends must necessarily depend upon earnings, financial condition, appropriate legal restrictions, and other factors at the time that the Board of Directors considers dividend payments. As of December 31, 2002, there were 52,770 outstanding options to purchase the company’s common stock. See Note 9 of the Consolidated Financial Statements for more information. Book value of common stock at December 31, 2002, was $18.25 and on December 31, 2001, it was $16.03. As of December 31, 2002, the company had approximately 836 shareholders of record. At such date, 2,100,000 shares of Common Stock were outstanding.

The following table reflects high bid and low asked prices for shares of the company’s Common Stock to the extent such information is available, and the dividends declared with respect thereto during the preceding two years.

COMPANY STOCK

The following table discloses the number of outstanding options, warrants and rights granted by the corporation to participants in equity compensation plans, as well as the number of securities remaining available for future issuance under these plans. The table provides this information separately for equity compensation plans that have and have not been approved by security holders.

* Securities for future issuance are not registered and are issued at the discretion of the Board of Directors on an annual basis.

ITEM 6        SELECTED FINANCIAL DATA

ITEM 7        MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
                      CONDITION AND RESULTS OF OPERATION

This consolidated review and analysis of Peoples Financial Services Corp. (the company) is intended to assist the reader in evaluating the company’s performance for the years ending December 2002, 2001, and 2000. The information should be read in conjunction with the consolidated financial statements and the accompanying notes to those statements.

Peoples Financial Services Corp. is the one-bank holding company of Peoples National Bank (the Bank), which is wholly owned by the company. The company and the Bank derive their primary income from the operation of a commercial bank, including earning interest on loans and investment securities. The Bank incurs interest expense in relation to deposits and other borrowings. The Bank operates seven full-service branches in the Hallstead Shopping Plaza, Hop Bottom, Montrose, Susquehanna, Nicholson, Tunkhannock, and Meshoppen, Pennsylvania. The Bank has on-site automated teller machines at all offices except Hop Bottom and Meshoppen. The administrative offices and operations offices are located in Hallstead, Pennsylvania. The Bank also operates one super market branch located in the Price Chopper in Norwich, Chenango County, New York. Principal market areas are Susquehanna and Wyoming Counties in Pennsylvania and the bordering areas of those counties. As of December 31, 2002, the Bank employed 89 full-time employees and 19 part-time employees.

Forward Looking Statements
When used in this discussion, the words “believes”, “anticipates”, “contemplated”, “expects”, or similar expressions are intended to identify forward looking statements. Such statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those projected. Those risks and uncertainties include changes in interest rates, the ability to control costs and expenses, and general economic conditions. The company undertakes no obligation to publicly release the results of any revisions to those forward looking statements that may be made to reflect events or circumstances after this date or to reflect the occurrence of unanticipated events.

Critical Accounting Policies
Note 1 to the company’s consolidated financial statements lists significant accounting policies used in the development and presentation of its financial statements. This discussion and analysis, the significant accounting policies, and other financial statement disclosures identify and address key variables and other qualitative and quantitative factors that are necessary for an understanding and evaluation of the bank and its results of operations.

The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require the bank to make estimates and assumptions. The bank believes that its determination of the allowance for loan losses involves a higher degree of judgment and complexity than the bank’s other significant accounting policies. Further, these estimates can be materially impacted by changes in market conditions or the actual or perceived financial condition of the bank’s borrowers, subjecting the bank to significant volatility of earnings.

The allowance for loan losses is established through the provision for loan losses, which is a charge against earnings. Provision for loan losses are made to reserve for estimated probable losses on loans. The allowance for loan losses is a significant estimate and is regularly evaluated by the bank for adequacy by taking into consideration factors such as changes in the nature and volume of the loan portfolio, trends in actual and forecasted credit quality, including delinquency, charge-off and bankruptcy rates, and current economic conditions that may affect a borrower’s ability to pay. The use of different estimates of assumptions could produce different provision for loan losses. For additional discussion concerning the bank’s allowance for loan losses and related matters, see “Provision for Loan Losses”.

As permitted by SFAS No. 123, the company accounts for stock-based compensation in accordance with Accounting Principals Board Opinion (APB) No. 25. Under APB No. 25, no compensation expense is recognized in the income statement related to any option granted under the company stock option plans. The pro forma impact to net income and earnings per share that would occur if compensation expense was recognized, based on the estimated fair value of the options on the date of the grant, is disclosed in the notes to the consolidated financial statement. The company intends to continue to account for stock-based compensation in this matter unless there is more specific guidance issued by the Financial Accounting Standards Board or unless a clear consensus develops in the financial services industry on the application of accounting methods.

RESULTS OF OPERATIONS

Net Interest Income
Net interest income is the main source of the company’s income. It is the difference between interest earned on assets and interest paid on liabilities. The discussion of net interest income should be read in conjunction with Table 2: “Distribution of Assets, Liabilities and Stockholders’ Equity; Interest Rates and Interest Differential”, and Table 3: “Rate/Volume Analysis of Changes in Net Interest Income.”

The following table shows the net interest income on a fully tax equivalent basis for each of the three years ending December 2002, 2001, and 2000.

TABLE 1

NET INTEREST INCOME

Table 2 includes the average balances, interest income and expense, and the average rates earned and paid for assets and liabilities. Yields on tax-exempt assets have not been calculated on a fully tax equivalent basis. For yield calculation purposes, nonaccruing loans are included in average loan balances. Table 3 analyzes the components contributing to the changes in net interest income in 2002 and indicates the impact in either changes in rate or changes in volume

TABLE 2
Distribution of Assets, Liabilities and Stockholders' Equity
Interest Rates and Interest Differential

TABLE 3

Rate/Volume Analysis of Changes in Net Interest Income

Interest income on total loans increased $430,000 from 2001 to 2002. This increase of 2.89% is attributable to growth in the loan portfolio during the Year 2002, and the decrease in overall yield on the loan portfolio. Average Total loans were $210,918,000 in 2002 compared to $180,833,000 in 2001 while Net loans increased 14.25% overall. Prime rate went from 4.75% to 4.25% during the year.

Interest income on taxable investments decreased $437,000 from 2001 due to lower interest rates during the year. Average Taxable investments were $72,492,000 in 2002 compared to $70,636,000 in 2001. Due to the lower rates however, interest income on investments dropped in 2002. Interest income on non-taxable investments decreased $199,000 from 2001 due to lower interest rates during 2002. Additionally, average non-taxable investments were $25,591,000 in 2002 compared to $28,745,000 in 2001. This also contributed to the decrease in interest income on non-taxable investments. Interest income from Federal Funds sold decreased $14,000 from 2001 to 2002 because of lower rates. Average Fed Funds Sold were $1,320,000 in 2002 compared to $806,000 in 2001. Again, as is the case with investments, interest income on Fed Funds decreased in 2002 due to lower rates. In addition, the growth in the loan portfolio did not provide for excess funds.

For comparison, interest income on loans increased $1,036,000 in 2001 from 2000. This increase of 7.5% was attributable to growth in the loan portfolio during the Year 2001. Net loans increased 12.72%. Although loan balances increased significantly, yields attributable to the loan portfolio were significantly lower in 2001 compared with 2000. Prime rate deceased from 9.5% to 4.75% during 2001, thus minimizing the increase in interest income.

Interest income on taxable investments decreased $58,000 from 2000 to 2001 due to lower interest rates during the year. Beginning in January 2001 and ending in December 2001, the Federal Reserve Bank decreased interest rates 11 times. In all, overnight rates fell 475 basis points in 2001.

During the Year 2002, this trend continued with an additional decrease of 50 basis points in the Fed Funds Rate. Since deposit account rates are closely related to short-term Fed notes and tend to move up and down in conjunction with the changes in the Fed Funds Rate, the Bank experienced an abnormal decrease in interest expense totaling $1,692,000 or 16.88% in 2002. Not only did deposits cost less, but borrowings were less expensive. Funding loan growth through borrowing was deemed more prudent than through aggressive certificate of deposit rates. Interest on deposits decreased $2,114,000 in 2002 while interest on borrowed funds increased $422,000. For comparison in 2001, the Bank experienced a decrease in interest expense of $447,000 or 4.3%. Interest on deposits decreased $616,000 in 2001.

PROVISION FOR LOAN LOSS

The provision and allowance for loan losses are based on management’s ongoing assessment of the Corporation’s credit exposure and consideration of other relevant factors. The allowance for loan losses is a valuation reserve that is available to absorb future loan charge-offs. The provision for loan losses is the amount charged to earnings on an annual basis. The factors considered in management’s assessment of the reasonableness of the allowance for loan losses include prevailing and anticipated economic conditions, assigned risk ratings on loan exposures, the results of examinations and appraisals of the loan portfolio conducted by federal regulatory authorities and an independent loan review firm, the diversification and size of the loan portfolio, the level of and inherent risk in non-performing assets, and any other factors deemed relevant by management.

The provision for loan losses was $180,000, $20,000 and $240,000 for the years 2002, 2001, and 2000. Net charge-offs for 2002 were $61,000 compared to $122,000 in 2001. As of December 31, 2002, the allowance for loan loss was 0.87% of loans and at December 31, 2001, the ratio was 0.94% of loans. After allocation of reserves to all non-accrual and special mention loans as well as applying a percentage of outstanding loans based on the loss history of such loans in each category, the opinion of management was that the provision for loan loss was proper and sufficient. The ratio of allowance for loan loss to non-performing loans was 367.87% at year end 2002 compared to 306.28% at year end 2001 and 381.43% at year end 2000.

As of December 31, 2001, the allowance for loan loss was 0.94% of loans and at December 31, 2000, the ratio was 1.11% of loans.

OTHER INCOME

Non-Interest Income
Non-interest income includes items that are not related to interest rates, but rather, to services rendered and activities conducted in conjunction with the operation of a commercial bank. Service charges earned on deposit accounts is the largest single item in this category and represents fees related to deposit accounts including overdraft fees, minimum balance fees, and transaction fees. In 2002, service charges and fees increased $62,000 or 5.5% compared to an increase of $147,000 in 2001 compared to 2000 or 15%. Fees were not increased in 2002 and many accounts qualified for free checking.

The overall decrease in Other Income is $375,000 in 2002. This decrease of 21.99% is due primarily to a security loss of $850,000 on a $1,000,000 bond holding in WorldCom, Inc., in the second quarter of 2002. Without the security impairment, Other Income would show an increase of $475,000 or 27.86%. Components of Other Income, which reflect significant increases, are income realized on Bank Owned Life Insurance of $211,000 in 2002 compared to $124,000 in 2001, and realized gains from the sale of available for sale securities in 2002 of $324,000 compared to $32,000 in 2001. Other Income increased $253,000 from $1,452,000 in 2000, to $1,705,000 in 2001, an increase of 17.4%. Bank-owned life insurance in the amount of $4 million was added to assets at midyear and contributed $124,000.

The following table analyzes the increase in total other income by comparing the years ending 2002 and 2001:

TABLE 4

INCOME

OTHER EXPENSE

Non-Interest Expense
Total Non-interest expense increased $567,000 from $6,221,000 in 2001 to $6,788,000 in 2002. This is an increase of 9.11%.

Non-interest expense includes all other expenses associated with the company. Salaries and related benefits is the largest expense in this category and it increased $311,000 or 10.28% over year end 2001. Annual salary increases, an increase for health insurance, the addition of three branch salaries in conjunction with the purchase of the Norwich, New York branch, and the addition of one commercial sales position in the second quarter of 2002 were the reasons for this change. In comparison, the increase in this category from 2000 to 2001 was 7.34% or $207,000. New employees and annual salary increases, along with an increase for health insurance were the reasons for the 2001 increase.

Occupancy expense increased 26.67% or $84,000 in 2002 as compared to 2001, when occupancy expense decreased 6.8% or $23,000. The increase in 2002 can be attributed to the addition of the Norwich, New York branch office, as well as increases in taxes, utilities, and other costs associated with branch offices.

Furniture and equipment expense decreased in 2002 to $323,000 compared to 2001 at $385,000 which was consistent with 2000 expenses of $388,000. The decrease in 2002 is associated with depreciation expense decreases, as older furniture and fixtures become fully depreciated while remaining in service.

Professional fees, which includes outside service, continues to increase as management and the company find it efficient and cost effective to utilize outside services and consultants to facilitate management and operations. Professional fees and outside services were $229,000 in 2002 which compares to $231,000 in 2001 and $216,000 in 2000. This indicates a very small increase in professional fees over the last three-year period.

Computer services and supplies is another component of other expenses and it is as its name implies. This category covers the expense of data processing for the company. Each year dependence grows as does the resultant expense. In 2002 the expense was $477,000 compared to $394,000 in 2001 and $361,000 in 2000. Technology has proven to be expensive, but necessary to provide excellent customer service and maintain efficiencies.

Taxes, other than payroll and income, are another component and in 2002, this expense was $320,000 compared to $290,000 in 2001, an increase considered to be normal. In 2000 taxes were $255,000.

Every other non-interest expense is in the category of other. In 2002, this expense increased $133,000 and the total for this year is $1,574,000. The biggest components in this figure were the amortization of premiums on the purchase of the Tunkhannock, Meshoppen, and Norwich branch offices at $261,000; directors’ and associate directors’ fees, employee education costs of $219,000; stationery printing and supplies, $144,000; and postage at $139,000. All were deemed to be in line with budget expectations. Also included in non-interest expense for 2002 was a $158,000 estimated loss on the alleged fraud in the sale of securities by Bentley Financial Services, Inc. for funds the company had invested with them. Please refer to Note 12 to the Consolidated Financial Statements for a further discussion on this matter.

TABLE 5

EXPENSE

FEDERAL INCOME TAXES

The provision for income taxes was $1,553,000 in 2002 compared to $1,508,000 in 2001 and $1,097,000 in 2000. The effective tax rate, which is the ratio of income tax expense to income before taxes, was 24% in 2002, remaining flat from 24% in 2001 and up slightly from 22% in 2000. The tax rate for all periods was substantially less than the federal statutory rate of 34% primarily due to tax-exempt securities and tax-exempt loan income. Please refer to Note 10 of the Notes to Consolidated Financial Statements included as part of this report for further analysis of federal income tax expense for 2002.

QUARTERLY RESULTS

Interest Income increased steadily through the first three quarters of 2002. This was due to the growth in the loan portfolio through the first three quarters. The combination of falling interest rates in the fourth quarter and a slight increase in loan growth caused Interest Income to remain flat at $5,190,000, compared to $5,199,000 interest income for the third quarter of 2002. Compare this to 2001 where the decline in interest rates in the first quarter and slower loan growth caused a loss in interest income in the first quarter. Interest income increased during the second and third quarters of 2001 as the loan portfolio grew. The rate declines caused a downturn again by the fourth quarter. The combination of loan growth and lower interest rates allowed for steady increases in Net Interest Income in all four quarters of 2002. The case was similar in 2001 although rates decreased to a greater extent in 2001.

Interest Expense decreased in the third and fourth quarters of 2002. This was due to lower deposit costs as rates paid on core deposits were dropped, and also due to the lower cost of overnight funds in the second half of 2002 due to the Federal Reserve Bank lowering the target rate for Fed Funds. Compare this to 2001 when interest expense decreased each quarter of 2001 as interest rates dropped eleven times throughout the year.

Significant gains were taken in the available for sale (AFS) portfolio in 2002. Total gains on AFS sales were $324,000 for the year. AFS gains of $176,000 were taken in the fourth quarter of 2002. These gains were part of an effort to partially offset the security impairment experienced in the second quarter of 2002.

Net Income was higher by $773,000 or 106.04% during the third quarter compared to $729,000 in the second quarter and by $75,000 or 4.99% during the fourth quarter compared to $1,502,000 in the third quarter. This was due to increased interest income on loans, as well as the gains taken on AFS. The second quarter Net Income was unusually low due to the security impairment discussed previously. The first quarter lagged behind the latter two quarters in terms of Net Income, mainly the result of less interest income realized as rates remained stable in the early part of 2002. Compare this to 2001 when Net Income was highest during the third quarter due to lower Other Expenses in the third quarter and good interest income. The fourth quarter showed a small decrease with net interest income improving significantly in that quarter but Other Expenses coming in higher to diminish the effect.

Earnings per common share showed steady growth through the year with the exception in the second quarter caused by the impaired security from World Com previously mentioned.

Basic earnings per common share increased by 4.82% to $2.39 per share, compared to $2.28 in 2001. Diluted earnings per common share were $2.38 for 2002 and $2.28 for 2001. Refer to Note 1 in the Notes to Consolidated Financial Statements for an analysis of earnings per share.

Earnings per share decreased $0.04 in the first quarter of 2002, due to the write down on the Bentley security impairment, with the second quarter decreasing significantly due to the World Com security impairment. The third quarter increased $0.37 with the fourth quarter increasing $0.03. Compare this to 2001 when Earnings per share increased $0.05 in the first quarter with the second quarter the same. The third quarter increased $0.08 with the fourth quarter the same. In 2000, there was a $0.03 increase in the second quarter, another $0.03 in the third quarter, and no increase or decrease in the fourth quarter.

TABLE 6

Quarterly Results of Operations

RETURN ON AVERAGE ASSETS AND AVERAGE EQUITY

Return on average assets (ROA) measures the company’s net income in relation to its total average assets. The company’s ROA for 2002 was 1.52%, compared to 1.62% in 2001.

Return on average equity (ROE) indicates how effectively the company can generate net income on the capital invested by its stockholders. ROE is calculated by dividing net income by average stockholders’ equity. For purposes of calculating ROE, average stockholders’ equity includes the effect of unrealized gains (losses), net of income taxes, on securities available for sale, reflected as accumulated other comprehensive income. Reference should be made to Note 3 in the Notes to Consolidated Financial Statements for an analysis of securities available for sale. The company’s ROE for 2002 was 14.30%, compared to 15.15% for 2001.

FINANCIAL CONDITION

The Corporation’s financial condition can be evaluated in terms of trends in its sources and uses of funds. The following table illustrates how the Corporation has managed its sources and uses of funds that are directly affected by outside economic factors, such as interest rate fluctuations:

TABLE 7

Sources, Uses of Funds

Total assets increased 9.99%, to $346,842,000 in the year ending December 31, 2002. There were increases in both borrowed funds and deposits on the liability side, which fueled this growth of assets. Loan and investment portfolios on the asset side reflected growth also, with the most significant growth occurring in loans. In 2001, total assets increased 9.64% to $315,347,000.

Investments at year-end 2002 totaled $105,972,000 compared to $100,783,000 on December 31, 2001.

To fund loan growth, short and long-term borrowings increased $6,519,000 or 15.77%. Short-term borrowings stood at $13,113,000 at year-end 2002 compared to $21,338,000 the previous year, while long-term borrowings grew to $34,744,000 at year-end 2002 compared to $20,000,000 at the end of 2001. With rates remaining low, and even decreasing in 2002, long-term borrowings have been attainable at attractive rates. Refer to the Consolidated Balance Sheet found in the financial statements for further information.

Loan Portfolio Types

In 2002 loans to commercial borrowers helped fuel the growth in net loans. Although mortgage loans increased slightly, lower interest rates and mortgage finance companies made growth in this part of our loan portfolio tougher. Consumer loans remained level with 2001.

TABLE 8

Loan Portfolio
(In thousands)

Loans continued to increase in 2002, ending the year with $219,258,000 in net loans compared to $191,913,000 at year-end 2001, an increase of 14.25%. Commercial loans and individual mortgages were the biggest gainers. Commercial loans were up 29.30% to close the year at $94,934,000 compared to $73,422,000 at year-end 2001. In 2001 loans grew 12.72%

Mortgages were up 5.71% to $107,756,000 compared to $101,934,000 on December 31, 2001, an increase of $5,822,000. Mortgage growth was higher in 2001 at 7.95%, an increase of $7,505,000.

With interest rates remaining low during 2002, there was a stronger demand for refinancing and mortgage modifications. The continued growth in commercial lending is due, in part, to a concerted effort on our part to increase our exposure to this segment and the hiring of a new commercial services officer.

Loan Maturities
Table 9 shows the breakdown in maturity and type of our loan portfolio.

The Bank has 17.36% of its loans maturing within the next year. Of those maturing within one year, most are commercial loans with the remainder split between mortgages and consumer loans. In the one to five year maturity range, the Bank has 27.00% of its portfolio. The over 5 year maturity group makes up 55.64% of the portfolio which reflects the Bank’s significant investment in mortgages. Mortgages are 48.83% of the total loan portfolio.

For comparison, at December 31, 2001, the Bank had 19.27% of its loans maturing within one year. Of those maturing within one year, most again were commercial loans with the remainder split between mortgages and consumer loans. In the one to five year maturity range, the Bank had 25.2% of its portfolio. The over 5 year maturity group made up 55.5% of the portfolio which again reflected the Bank’s significant investment in mortgages. Mortgages were 52.6% of the total loan portfolio.

TABLE 9

Table 10 reflects the Corporation’s non-accrual and past due loans for each of the past five years. A commercial loan is generally placed on non-accrual when the contractual payment of principal or interest has become 90 days past due or when management has serious doubts about further collectibility of principal or interest even though the loan is currently performing. Consumer loans, including mortgages, are generally placed on non-accrual at 120 days. A loan may remain on accrual status if it is in the process of collection and is either guaranteed or well secured.

TABLE 10

Non-performing Loans

(In thousands)

Allowance for Loan Losses
The balance in the allowance for loan losses is based on management’s assessment of the risk in the loan portfolio. Allocations to specific commercial loans are made in adherence to SFAS 114, Accounting by Creditors for Impairments of a Loan. These allocations are based upon the present value of expected future cash flows or the fair value of the underlying collateral. In addition, management reviews the other components of the loan portfolio through the loan review function and assigns internal grades to loans based upon the perceived risks inherent in each loan. In that determination, management reviews a number of factors including historical analysis of similar credits, delinquency reports, ratio analysis as compared to peers, concentration of credit risks, local economic conditions, and regulatory evaluation of the allowance for loan losses. Although the Bank has sold some mortgages on the secondary market in the past, the Bank did not sell any in 2002. Management expects this trend to continue. Therefore, allocation methods are the same for all mortgages. This evaluation is reviewed monthly by management and by the Board of Directors. Management believes that on December 31, 2002, the allowance for loan losses was adequate to absorb potential losses in the loan portfolio. However, this judgement is subjective and a significant degradation in loan quality could require a change in the estimates and therefore, a change in net income.

In 2002, asset quality remained high and past dues continued to remain level. Although trends continued to be positive, the Bank allotted $180,000 for provision for loan losses in 2002 due to loan growth particularly in commercial loans. This increase in the allowance for loan losses will likely continue due to the continued growth in commercial loans.

The following is a summary of loans charged off, recoveries and provisions to the allowance for loan losses for the periods presented.

TABLE 12

Summary of Loan Loss Experience

(In thousands)