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EX-31.2 - CERTIFICATION OF CHIEF FINANCIAL OFFICER - CITIZENS FINANCIAL SERVICES INCcfocert.htm
EX-31.1 - CERTFICATION OF CHIEF EXECUTIVE OFFICER - CITIZENS FINANCIAL SERVICES INCceocert.htm
EX-32.1 - SECTION 1350 CERTIFICATIONS - CITIZENS FINANCIAL SERVICES INCcertification.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q


[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2011
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 0-13222

CITIZENS FINANCIAL SERVICES, INC.
(Exact name of registrant as specified in its charter)

                PENNSYLVANIA                                                                      23-2265045
   (State or other jurisdiction of incorporation or organization)                                (I.R.S. Employer Identification No.)
 


15 South Main Street
Mansfield, Pennsylvania 16933
(Address of principal executive offices)(Zip Code)

Registrant's telephone number, including area code: (570) 662-2121

Indicate by check mark whether the registrant (1) has filed all reports 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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes _____ No_____

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ____                                                                                                   Accelerated filer ____

Non-accelerated filer ____                                                                                                   Smaller reporting company __X__
(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes____ No __X__

The number of outstanding shares of the Registrant’s Common Stock, as of May 4, 2011, was 2,886,482.

 
 

 

 
 
Citizens Financial Services, Inc.
Form 10-Q

INDEX
 
 
   
PAGE
Part I
FINANCIAL INFORMATION
 
Item 1.
Financial Statements (unaudited):
 
 
Consolidated Balance Sheet as of March 31, 2011 and December 31, 2010
1
 
Consolidated Statement of Income for the Three Months Ended March 31, 2011 and 2010
2
 
Consolidated Statement of Comprehensive Income for the Three Months Ended March 31, 2011 and 2010
3
 
Consolidated Statement of Cash Flows for the Three Months Ended March 31, 2011 and 2010
4
 
Notes to Consolidated Financial Statements
5-22
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
23-42
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
42
Item 4.
Controls and Procedures
42-43
     
Part II
OTHER INFORMATION
 
Item 1.
Legal Proceedings
44
Item 1A.
Risk Factors
44
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
44
Item 3.
Defaults Upon Senior Securities
44
Item 4.
[Removed and Reserved]
44
Item 5.
Other Information
44
Item 6.
Exhibits
45
 
Signatures
46

 
 

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED BALANCE SHEET
   
(UNAUDITED)
   
     
 
March 31
December 31
(in thousands except share data)
2011
2010
ASSETS:
   
Cash and due from banks:
   
  Noninterest-bearing
 $              9,272
 $            9,541
  Interest-bearing
               35,282
             34,454
Total cash and cash equivalents
               44,554
            43,995
     
Available-for-sale securities
            285,034
          251,303
 
   
Loans (net of allowance for loan losses:
   
  2011, $6,068 and 2010, $5,915)
            460,700
          467,602
 
   
Premises and equipment
               12,395
            12,503
Accrued interest receivable
                 4,053
              3,455
Goodwill
               10,256
            10,256
Bank owned life insurance
               13,292
            13,171
Other assets
                 9,964
            10,241
 
 
 
TOTAL ASSETS
 $         840,248
 $       812,526
 
 
 
LIABILITIES:
   
Deposits:
   
  Noninterest-bearing
 $           80,696
 $         75,589
  Interest-bearing
            623,833
          605,122
Total deposits
            704,529
          680,711
Borrowed funds
               57,115
            55,996
Accrued interest payable
                 1,590
              1,779
Other liabilities
                 5,971
              5,350
TOTAL LIABILITIES
            769,205
          743,836
STOCKHOLDERS' EQUITY:
   
Preferred Stock
   
  $1.00 par value; authorized 3,000,000 shares March 31, 2011 and December 31, 2010;
   
   none issued in 2011 or 2010
                          -
                      -
Common stock
   
  $1.00 par value; authorized 10,000,000 shares; issued 3,104,434 shares at
   
  March 31, 2011 and December 31, 2010, respectively
                 3,104
              3,104
Additional paid-in capital
               14,172
            14,235
Retained earnings
               57,010
            54,932
Accumulated other comprehensive income
                 1,603
              1,054
Treasury stock, at cost:  217,952 shares at March 31, 2011
   
  and 212,067 shares at December 31, 2010
               (4,846)
             (4,635)
TOTAL STOCKHOLDERS' EQUITY
               71,043
            68,690
TOTAL LIABILITIES AND
   
   STOCKHOLDERS' EQUITY
 $         840,248
 $       812,526
     
The accompanying notes are an integral part of these unaudited consolidated financial statements.
 


 
1

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED STATEMENT OF INCOME
   
(UNAUDITED)
   
 
Three Months Ended
 
March 31,
(in thousands, except per share data)
2011
2010
INTEREST INCOME:
   
Interest and fees on loans
 $     7,395
 $      7,734
Interest-bearing deposits with banks
              22
               14
Investment securities:
   
    Taxable
        1,172
         1,335
    Nontaxable
            865
             641
    Dividends
              15
                 6
TOTAL INTEREST INCOME
        9,469
         9,730
INTEREST EXPENSE:
   
Deposits
        2,088
         2,542
Borrowed funds
            445
             441
TOTAL INTEREST EXPENSE
        2,533
         2,983
NET INTEREST INCOME
        6,936
         6,747
Provision for loan losses
            225
             305
NET INTEREST INCOME AFTER
   
    PROVISION FOR LOAN LOSSES
        6,711
         6,442
NON-INTEREST INCOME:
   
Service charges
            841
             853
Trust
            157
             146
Brokerage and insurance
              95
               82
Investment securities gains, net
            120
               64
Earnings on bank owned life insurance
            121
             124
Other
            181
             121
TOTAL NON-INTEREST INCOME
        1,515
         1,390
NON-INTEREST EXPENSES:
   
Salaries and employee benefits
        2,515
         2,441
Occupancy
            390
             306
Furniture and equipment
            117
             106
Professional fees
            157
             180
Federal Depository Insurance
            250
             237
Other
        1,247
         1,058
TOTAL NON-INTEREST EXPENSES
        4,676
         4,328
Income before provision for income taxes
        3,550
         3,504
Provision for income taxes
            720
             758
NET INCOME
 $     2,830
 $      2,746
 
   
Earnings Per Share
 $       0.98
 $        0.95
Cash Dividends Paid Per Share
 $       0.26
 $        0.25
     
Weighted average number of shares outstanding
  2,888,921
  2,898,662
     
The accompanying notes are an integral part of these unaudited consolidated financial statements.



 
2

 

CITIZENS FINANCIAL SERVICES, INC.
       
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
       
(UNAUDITED)
       
 
            Three Months Ended
 
            March 31
(in thousands)
 
2011
 
2010
Net income
 
 $   2,830
 
 $    2,746
Other comprehensive income:
       
      Unrealized gains on available for sale securities
          892
 
          409
 
      Change in unrealized loss on interest rate swap
             60
 
           (97)
 
       Less:  Reclassification adjustment for gain included in net income
        (120)
 
           (64)
 
Other comprehensive income, before tax
 
          832
 
          248
Income tax expense related to other comprehensive income
 
          283
 
            84
Other comprehensive income, net of tax
 
          549
 
          164
Comprehensive income
 
 $   3,379
 
 $    2,910
         
The accompanying notes are an integral part of these unaudited consolidated financial statements.
   




 
3

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED STATEMENT OF CASH FLOWS
   
(UNAUDITED)
Three Months Ended
 
March 31,
(in thousands)
2011
2010
CASH FLOWS FROM OPERATING ACTIVITIES:
   
  Net income
 $        2,830
 $         2,746
  Adjustments to reconcile net income to net
   
   cash provided by operating activities:
   
    Provision for loan losses
               225
                305
    Depreciation and amortization
               142
                103
    Amortization and accretion of investment securities
               439
                171
    Deferred income taxes
                 34
                (33)
    Investment securities gains, net
             (120)
                (64)
    Earnings on bank owned life insurance
             (121)
              (124)
    Stock Awards
                 87
                  65
    Originations of loans held for sale
         (3,045)
              (744)
    Proceeds from sales of loans held for sale
            3,086
                757
    Increase in accrued interest receivable
             (598)
              (397)
    Decrease in accrued interest payable
             (189)
              (210)
    Other, net
               667
                (39)
      Net cash provided by operating activities
            3,437
            2,536
     
CASH FLOWS FROM INVESTING ACTIVITIES:
   
  Available-for-sale securities:
   
    Proceeds from sales of available-for-sale securities
            3,189
            5,855
    Proceeds from maturity and principal repayments of securities
            7,557
          10,052
    Purchase of securities
       (44,025)
         (34,056)
  Proceeds from redemption of regulatory Stock
               175
                    -
  Net decrease (increase) in loans
            6,384
           (8,582)
  Purchase of premises and equipment
               (63)
              (384)
  Proceeds from sale of foreclosed assets held for sale
                 81
                253
      Net cash used in investing activities
       (26,702)
         (26,862)
     
CASH FLOWS FROM FINANCING ACTIVITIES:
   
  Net increase in deposits
         23,818
          18,838
  Proceeds from long-term borrowings
                    5
            1,155
  Repayments of long-term borrowings
                    -
           (2,110)
  Net increase in short-term borrowed funds
            1,114
                269
  Purchase of treasury and restricted stock
             (361)
                (45)
  Dividends paid
             (752)
              (718)
      Net cash provided by financing activities
         23,824
          17,389
     
          Net increase (decrease) in cash and cash equivalents
               559
           (6,937)
     
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
         43,995
          31,449
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 $      44,554
 $       24,512
     
Supplemental Disclosures of Cash Flow Information:
   
    Interest paid
 $        2,722
 $         3,193
     
    Income taxes paid
 $                 -
 $             100
     
    Loans transferred to foreclosed property
 $            335
 $             350
   
 
The accompanying notes are an integral part of these unaudited consolidated financial statements.

 
4

 

CITIZENS FINANCIAL SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


Note 1 - Basis of Presentation
 
Citizens Financial Services, Inc., (individually and collectively with its direct and indirect subsidiaries, the “Company”) is a Pennsylvania corporation organized as the holding company of its wholly owned subsidiary, First Citizens National Bank (the “Bank”), and the Bank’s subsidiary, First Citizens Insurance Agency, Inc. (“First Citizens Insurance”).
 
The accompanying consolidated financial statements have been prepared pursuant to rules and regulations of the Securities and Exchange Commission (“SEC”) and in conformity with U.S. generally accepted accounting principles.  Because this report is based on an interim period, certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted.  Certain of the prior year amounts have been reclassified to conform with the current year presentation.  Such reclassifications had no effect on net income or stockholders’ equity.  All material inter-company balances and transactions have been eliminated in consolidation.
 
In the opinion of management of the Company, the accompanying interim financial statements for the periods ended March 31, 2011 and 2010 include all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the financial condition and the results of operations for the period.  In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. The financial performance reported for the Company for the three-month period ended March 31, 2011 is not necessarily indicative of the results to be expected for the full year.  This information should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

Note 2 - Earnings per Share
 
The following table sets forth the computation of earnings per share.  Earnings per share calculations give retroactive effect to stock dividends declared by the Company.  The Company has no dilutive securities.
 
 
 
Three months ended
 
March 31,
 
2011
2010
 
   
Net income applicable to common stock
$2,830,000
$2,746,000
Weighted average common shares outstanding
2,888,921
2,898,662
     
Earnings per share
$0.98
$0.95

Note 3 - Income Tax Expense
 
Income tax expense is less than the amount calculated using the statutory tax rate, primarily as a result of tax-exempt income earned from state and municipal securities and loans and investments in tax credits.

Note 4 – Investments
 
The amortized cost and fair value of investment securities at March 31, 2011 and December 31, 2010 were as follows (in thousands):

 
5

 

   
Gross
Gross
 
 
Amortized
Unrealized
Unrealized
Fair
March 31, 2011
Cost
Gains
Losses
Value
Available-for-sale securities:
       
  U.S. Agency securities
 $    147,512
 $         1,208
 $           (555)
 $     148,165
  Obligations of state and
       
    political subdivisions
         87,106
               958
              (790)
          87,274
  Corporate obligations
           8,377
               264
                  (4)
            8,637
  Mortgage-backed securities in
       
    government sponsored entities
         37,122
            2,519
                    -
          39,641
  Equity securities in financial
       
     institutions
              909
               412
                  (4)
            1,317
Total available-for-sale securities
 $    281,026
 $         5,361
 $        (1,353)
 $     285,034
         
   
Gross
Gross
 
 
Amortized
Unrealized
Unrealized
Fair
December 31, 2010
Cost
Gains
Losses
Value
Available-for-sale securities:
       
  U.S. Agency securities
 $    117,390
 $         1,535
 $           (441)
 $     118,484
  Obligations of state and
       
    political subdivisions
         78,164
               603
           (1,845)
          76,922
  Corporate obligations
           8,415
               268
                  (2)
            8,681
  Mortgage-backed securities in
       
    government sponsored entities
         43,183
            2,832
                    -
          46,015
  Equity securities in financial
       
     institutions
              914
               303
                (16)
            1,201
Total available-for-sale securities
 $    248,066
 $         5,541
 $        (2,304)
 $     251,303

The following table shows the Company’s gross unrealized losses and fair value of the Company’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time, that the individual securities have been in a continuous unrealized loss position, at March 31, 2011 and December 31, 2010 (in thousands). As of March 31, 2011 and December 31, 2010, the Company owned 84 and 85 securities whose fair value was less than their cost basis, respectively.
 
 
 
6

 
 
 
March 31, 2011
Less than Twelve Months
Twelve Months or Greater
Total
     
Gross
 
Gross
 
Gross
   
Fair
Unrealized
2010
Unrealized
Fair
Unrealized
   
Value
Losses
Value
Losses
Value
Losses
U.S. Agency securities
 $        66,318
 $           (555)
 $                  -
 $                  -
 $        66,318
 $           (555)
Obligations of state and
           
    political subdivisions
38,783
(725)
1,042
(65)
39,825
(790)
Corporate obligations
2,224
(4)
                     -
                     -
2,224
(4)
Equity securities in financial
           
   institutions
85
(4)
                     -
                     -
85
(4)
               
    Total securities
 $      107,410
 $        (1,288)
 $          1,042
 $             (65)
 $      108,452
 $        (1,353)
               
               
December 31, 2010
Less than Twelve Months
Twelve Months or Greater
Total
     
Gross
 
Gross
 
Gross
   
Fair
Unrealized
Fair
Unrealized
Fair
Unrealized
   
Value
Losses
Value
Losses
Value
Losses
U.S. Agency securities
 $        38,502
 $           (441)
 $                  -
 $                  -
 $        38,502
 $           (441)
Obligations of states and
           
     political subdivisions
           45,335
           (1,784)
                526
                (61)
           45,861
           (1,845)
Corporate obligations
             1,157
                  (2)
                     -
                     -
             1,157
                  (2)
Equity securities in financial
           
   institutions
                139
                (16)
                     -
                     -
                139
                (16)
               
    Total securities
 $        85,133
 $        (2,243)
 $             526
 $             (61)
 $        85,659
 $        (2,304)

As of March 31, 2011, the Company’s investment securities portfolio contained unrealized losses on obligations of U.S Agency securities, states and political subdivisions, corporate obligations and certain financial institutions equity securities. For fixed maturity investments management considers whether the present value of cash flows expected to be collected are less than the security’s amortized cost basis (the difference defined as the credit loss), the magnitude and duration of the decline, the reasons underlying the decline and the Company’s intent to sell the security or whether it is more likely than not that the Company would be required to sell the security before its anticipated recovery in market value, to determine whether the loss in value is other than temporary. Once a decline in value is determined to be other than temporary, if the Company does not intend to sell the security, and it is more likely than not that it will not be required to sell the security, before recovery of the security’s amortized cost basis, the charge to earnings is limited to the amount of credit loss. Any remaining difference between fair value and amortized cost (the difference defined as the non-credit portion) is recognized in other comprehensive income, net of applicable taxes. Otherwise, the entire difference between fair value and amortized cost is charged to earnings. For equity securities where the fair value has been significantly below cost for one year, the Company’s policy is to recognize an impairment loss unless sufficient evidence is available that the decline is not other than temporary and a recovery period can be predicted.  The Company has concluded that any impairment of its investment securities portfolio outlined in the above table is not other than temporary and is the result of interest rate changes, sector credit rating changes, or company-specific rating changes that are not expected to result in the non-collection of principal and interest during the period.
 
Proceeds from sales of securities available-for-sale for the three months ended March 31, 2011 and 2010 were $3,189,000 and $5,855,000, respectively. The gross gains and losses were as follows (in thousands):
 
 
7

 

 
 
Three Months Ended
 
 March 31,
 
2011
2010
Gross gains
 $           149
 $              64
Gross losses
               (29)
                    -
Net gains
 $           120
 $              64

Investment securities with an approximate carrying value of $177,236,000 and $162,742,000 at March 31, 2011 and December 31, 2010, respectively, were pledged to secure public funds and certain other deposits as provided by law.
 
Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.   The amortized cost and fair value of debt securities at March 31, 2011, by contractual maturity, are shown below (in thousands):

 
Amortized
   
 
Cost
 
Fair Value
Available-for-sale debt securities:
     
  Due in one year or less
 $        5,528
 
 $         5,571
  Due after one year through five years
         98,720
 
          99,093
  Due after five years through ten years
         32,564
 
          33,444
  Due after ten years
       143,305
 
        145,609
Total
 $    280,117
 
 $     283,717

Note 5 – Loans
 
The Company grants commercial, industrial, agricultural, residential, and consumer loans primarily to customers throughout North Central Pennsylvania and Southern New York.  Although the Company has a diversified loan portfolio at March 31, 2011 and December 31, 2010, a substantial portion of its debtors’ ability to honor their contracts is dependent on the economic conditions within these regions. The following table summarizes the primary segments of the loan portfolio as of March 31, 2011 and December 31, 2010 (in thousands):


 
8

 
 

March 31, 2011
 
Total Loans
Individually evaluated for impairment
Collectively evaluated for impairment
Real estate loans:
       
     Residential
 
 $  179,186
 $      170
 $  179,016
     Commercial and agricultural
    172,787
      8,541
    164,246
     Construction
 
      5,674
          -
      5,674
Consumer
 
     10,915
          -
     10,915
Commercial and other loans
     48,468
        400
     48,068
State and political subdivision loans
     49,738
          -
     49,738
Total
 
 $  466,768
 $    9,111
 $  457,657
December 31, 2010
 
Total Loans
Individually evaluated for impairment
Collectively evaluated for impairment
Real estate loans:
       
     Residential
 
 $  185,012
 $      172
 $  184,840
     Commercial and agricultural
 
    171,577
      9,976
    161,601
     Construction
 
      9,766
          -
      9,766
Consumer
 
     11,285
          -
     11,285
Commercial and other loans
 
     47,156
      1,374
     45,782
State and political subdivision loans
 
     48,721
          -
     48,721
Total
 
 $  473,517
 $   11,522
 $  461,995
 
The segments of the Bank’s loan portfolio are disaggregated into classes to a level that allows management to monitor risk and performance. Residential real estate mortgages consists of 15 to 30 year first mortgages on residential real estate, while residential real estate home equities are consumer purpose installment loans or lines of credit secured by a mortgage which is often a second lien on residential real estate with terms of 15 years or less. Commercial real estate loans are business purpose loans secured by a mortgage on commercial real estate. Agricultural real estate loans are loans secured by a mortgage on real estate used in agriculture production. Construction real estate loans are loans secured by residential or commercial real estate used during the construction phase of residential and commercial projects. Consumer loans are typically unsecured or primarily secured by something other than real estate and overdraft lines of credit connected with customer deposit accounts. Commercial and other loans are loans for commercial purposes primarily secured by non-real estate collateral. Other agricultural loans are loans for agricultural purposes primarily secured by non real estate collateral. State and political subdivisions are loans for state and local municipalities for capital and operating expenses or tax free loans used to finance commercial development.
 
Management considers commercial loans, other agricultural loans, commercial real estate loans and agricultural real estate loans which are 90 days or more past due to be impaired. These loans are analyzed to determine if it is probable that all amounts will not be collected according to the contractual terms of the loan agreement. If management determines that the value of the impaired loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized through an allowance estimate or a charge-off to the allowance.
 
The following table includes the recorded investment and unpaid principal balances for impaired financing receivables by class, with the associated allowance amount, if applicable (in thousands):


 
9

 
 

   
Recorded
Recorded
       
 
Unpaid
Investment
Investment
Total
 
Average
Interest
 
Principal
With No
With
Recorded
Related
Recorded
Income
 
Balance
Allowance
Allowance
Investment
Allowance
Investment
Recognized
March 31, 2011
             
Real estate loans:
             
     Mortgages
 $      132
 $          129
 $               -
 $          129
 $             -
 $          130
 $                -
     Home Equity
           73
               41
                  -
               41
                -
               41
                   -
     Commercial
      9,371
          1,619
          6,922
          8,541
           433
          8,939
                16
     Agricultural
              -
                  -
                  -
                  -
                -
          1,482
                37
     Construction
              -
                  -
                  -
                  -
                -
                  -
                   -
Consumer
              -
                  -
                  -
                  -
                -
                  -
                   -
Commercial and other loans
         452
             400
                  -
             400
                -
             400
                   -
Other Agricultural Loans
              -
                  -
                  -
                  -
                -
             639
                20
State and political
              -
                  -
                  -
                  -
                -
                  -
                   -
   subdivision loans
              -
                  -
                  -
                  -
                -
                  -
                   -
Total
 $ 10,028
 $       2,189
 $       6,922
 $       9,111
 $        433
 $     11,631
 $             73
               
   
Recorded
Recorded
       
 
Unpaid
Investment
Investment
Total
 
Average
Interest
 
Principal
With No
With
Recorded
Related
Recorded
Income
 
Balance
Allowance
Allowance
Investment
Allowance
Investment
Recognized
December 31, 2010
             
Real estate loans:
             
     Mortgages
 $      132
 $               -
 $          131
 $          131
 $          21
 $            55
 $                -
     Home Equity
           72
               41
                  -
               41
                -
               56
                   -
     Commercial
      8,540
          1,682
          6,053
          7,735
           167
          5,445
                67
     Agricultural
      2,421
          2,241
                  -
          2,241
                -
          2,373
                64
     Construction
              -
                  -
                  -
                  -
                -
                  -
                   -
Consumer
              -
                  -
                  -
                  -
                -
                  -
                   -
Commercial and other loans
         455
             404
                  -
             404
                -
             469
                  1
Other Agricultural Loans
      1,040
             970
                  -
             970
                -
             958
                11
State and political
             
   subdivision loans
              -
                  -
                  -
                  -
                -
                  -
                   -
Total
 $ 12,660
 $       5,338
 $       6,184
 $     11,522
 $        188
 $       9,356
 $           143

Credit Quality Information
 
Management uses a nine point internal risk rating system to monitor the credit quality of the overall loan portfolio. The first five categories are considered not criticized and are aggregated as “Pass” rated. The criticized rating categories utilized by management generally follow bank regulatory definitions. The definitions of each rating are defined below:
 
·  
Pass (Grades 1-5) – These loans are to customers with credit quality ranging from an acceptable to very high quality and are protected by the current net worth and paying capacity of the obligor or by the value of the underlying collateral.
 
·  
Special Mention (Grade 6) – This loan grade is in accordance with regulatory guidance and includes loans where a potential weakness or risk exists, which could cause a more serious problem if not corrected.
 
·  
Substandard (Grade 7) – This loan grade is in accordance with regulatory guidance and includes loans that have a well-defined weakness based on objective evidence and be characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.
 
 
 
10

 
 
·  
Doubtful (Grade 8) – This loan grade is in accordance with regulatory guidance and includes loans that have all the weaknesses inherent in a substandard asset.  In addition, these weaknesses make collection or liquidation in full highly questionable and improbable, based on existing circumstances.
 
·  
Loss  (Grade 9) – This loan grade is in accordance with regulatory guidance and includes loans that are considered uncollectible, or of such value that continuance as an asset is not warranted.
 
To help ensure that risk ratings are accurate and reflect the present and future capacity of borrowers to repay loan as agreed, the Bank’s loan rating process includes several layers of internal and external oversight. Generally, residential real estate mortgages and home equities and loans to individuals for household, family and other purchases are included in the pass category, unless a specific action, such as bankruptcy, repossession, death or significant delay in payment occurs to raise awareness of a possible credit event. The Company’s loan officers are responsible for the timely and accurate risk rating of the loans in each of their portfolios at origination and on an ongoing basis under the supervision of management.  All commercial and agricultural loans are reviewed annually to ensure that appropriateness of the loan grade. In addition, the Bank engages an external consultant on at least an annual basis. The external consultant is engaged to 1) review a minimum of 60% of the dollar volume of the commercial loan portfolio on an annual basis, 2) review new loans originated in the last year, 3) review all relationships in aggregate over $500,000, 4) review all aggregate loan relationships over $100,000 which are over 90 days past due, classified Special Mention, Substandard, Doubtful, or Loss, and 5) such other loans which management or the consultant deems appropriate.
 
The following tables represent credit exposures by internally assigned grades as of March 31, 2011 and December 31, 2010 (in thousands):

 
Pass
Special Mention
Substandard
Doubtful
Loss
Ending Balance
March 31, 2011
           
Real estate loans:
           
     Mortgages
 $ 94,253
 $   416
 $      465
 $     -
 $   -
 $ 95,134
     Home Equity
   83,587
     175
        290
       -
     -
   84,052
     Commercial
  123,965
  13,431
     16,821
       -
     -
  154,217
     Agricultural
   12,620
     594
      5,356
       -
     -
   18,570
     Construction
    5,674
       -
          -
       -
     -
    5,674
Consumer
   10,902
       1
         12
       -
     -
   10,915
Commercial and other loans
   38,242
   2,683
        886
      22
     -
   41,833
Other Agricultural Loans
    4,271
     118
      2,246
       -
     -
    6,635
State and political
           
   subdivision loans
   48,516
       -
      1,222
       -
     -
   49,738
Total
 $422,030
 $17,418
 $   27,298
 $    22
 $   -
 $466,768
             
 
Pass
Special Mention
Substandard
Doubtful
Loss
Ending Balance
December 31, 2010
           
Real estate loans:
           
     Mortgages
 $ 96,218
 $   628
 $      397
 $     -
 $   -
 $ 97,243
     Home Equity
   87,359
     175
        202
      33
     -
   87,769
     Commercial
  120,344
  15,570
     16,585
       -
     -
  152,499
     Agricultural
   12,007
   1,063
      6,008
       -
     -
   19,078
     Construction
    9,766
       -
          -
       -
     -
    9,766
Consumer
   11,265
       4
         16
       -
     -
   11,285
Commercial and other loans
   36,784
   2,545
        848
      24
     -
   40,201
Other Agricultural Loans
    4,024
     469
      2,462
       -
     -
    6,955
State and political
           
   subdivision loans
   47,482
       -
      1,239
       -
     -
   48,721
Total
 $425,249
 $20,454
 $   27,757
 $    57
 $   -
 $473,517

 
 
11

 
 
Age Analysis of Past Due Financing Receivables by Class
 
Management further monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a recorded payment is past due. The following table includes an aging analysis of the recorded investment of past due financing receivables as of March 31, 2011 and December 31, 2010 (in thousands):

   
30-59 Days
60-89 Days
90 Days
Total Past
 
Total Financing
90 Days and
   
Past Due
Past Due
Or Greater
Due
Current
Receivables
Accruing
March 31, 2011
             
                 
Real estate loans:
             
     Mortgages
 $        156
 $        100
 $        480
 $        736
 $     94,398
 $             95,134
 $            103
     Home Equity
           243
             91
           295
           629
        83,423
                84,052
                 71
     Commercial
           477
           163
        2,635
        3,275
      150,942
              154,217
               125
     Agricultural
                -
                -
                -
                -
        18,570
                18,570
                   -
     Construction
                -
                -
                -
                -
          5,674
                  5,674
                   -
Consumer
                -
               9
               3
             12
        10,903
                10,915
                   3
Commercial and other loans
             38
               4
           358
           400
        41,433
                41,833
                   -
Other Agricultural Loans
                -
                -
                -
                -
          6,635
                  6,635
                   -
State and political subdivision loans
                -
                -
                -
                -
        49,738
                49,738
                   -
                 
 
Total
 $        914
 $        367
 $     3,771
 $     5,052
 $   461,716
 $           466,768
 $            302
                 
                 
   
30-59 Days
60-89 Days
90 Days
Total Past
 
Total Financing
90 Days and
   
Past Due
Past Due
Or Greater
Due
Current
Receivables
Accruing
December 31, 2010
               
                 
Real estate loans:
               
     Mortgages
 $        518
 $          50
 $        412
 $        980
 $     96,263
 $             97,243
 $            104
     Home Equity
           762
           139
           262
        1,163
        86,606
                87,769
               116
     Commercial
           188
        1,647
        1,827
        3,662
      148,837
              152,499
               426
     Agricultural
                -
                -
                -
                -
        19,078
                19,078
                   -
     Construction
                -
                -
                -
                -
          9,766
                  9,766
                   -
Consumer
             83
               3
               7
             93
        11,192
                11,285
                   6
Commercial and other loans
           111
               6
           398
           515
        39,686
                40,201
                 40
Other Agricultural Loans
               5
                -
                -
               5
          6,950
                  6,955
 
State and political subdivision loans
                -
                -
                -
                -
        48,721
                48,721
                   -
                 
 
Total
 $     1,667
 $     1,845
 $     2,906
 $     6,418
 $   467,099
 $           473,517
 $            692

Nonaccrual Loans
 
Loans are considered for nonaccrual status upon reaching 90 days delinquency, unless the loan is well secured and in the process of collection, although the Company may be receiving partial payments of interest and partial repayments of principal on such loans or if full payment of principal and interest is not expected.
 
The following table reflects the financing receivables on nonaccrual status as of March 31, 2011 and December 31, 2010, respectively. The balances are presented by class of financing receivable (in thousands):
 
 
12

 

 
   
March 31, 2011
 
December 31, 2010
Real estate loans:
       
     Mortgages
 
 $                378
 
 $                      309
     Home Equity
 
                   260
 
                         193
     Commercial
 
                8,541
 
                      7,735
     Agricultural
 
                      -
 
                      2,241
     Construction
 
                      -
 
                            -
Consumer
 
                      -
 
                             1
Commercial and other
 
                   400
 
                         404
Other Agricultural
 
                      -
 
                         970
State and political subdivision
 
                      -
 
                            -
   
 $             9,579
 
 $                 11,853

Allowance for Loan Losses

The following table rolls forward the balance of the allowance for loan and lease losses for the periods ended March 31, 2011 and 2010(in thousands):

 
Three Months Ended
 
March 31,
 
2011
2010
Balance, at beginning of period
 $        5,915
 $        4,888
  Provision charged to income
             225
             305
  Recoveries on loans previously
   
    charged against the allowance
               21
               43
 
           6,161
           5,236
  Loans charged against the allowance
              (93)
            (85)
Balance, at end of year
 $        6,068
 $        5,151
 
The Company allocates the allowance based on the factors described below, which conform to the Company’s loan classification policy. In reviewing risk within the Bank’s loan portfolio, management has determined there to be several different risk categories within the loan portfolio. The allowance for loan losses consists of amounts applicable to: (i) residential real estate loans; (ii) residential real estate home equity loans; (iii) commercial real estate loans; (iv) agricultural real estate loans; (v) real estate construction loans; (vi) commercial and other loans; (vii) consumer loans; (viii) other agricultural loans and (ix) state and political subdivision loans. Factors considered in this process include general loan terms, collateral, and availability of historical data to support the analysis. Historical loss percentages are calculated and used as the basis for calculating allowance allocations. Certain qualitative factors are evaluated to determine additional inherent risks in the loan portfolio, which are not necessarily reflected in the historical loss percentages. These factors are then added to the historical allocation percentage to get the adjusted factor to be applied to non classified loans. The following qualitative factors are analyzed:

·  
Level of and trends in delinquencies, impaired/classified loans
§  
Change in volume and severity of past due loans
§  
Volume of non-accrual loans
§  
Volume and severity of classified, adversely or graded loans;
·  
Level of and trends in charge-offs and recoveries;
·  
Trends in volume, terms and nature of the loan portfolio;
·  
Effects of any changes in risk selection and underwriting standards and any other changes in lending and recovery policies, procedures and practices;
·  
Changes in the quality of the Bank’s loan review system;
·  
Experience, ability and depth of lending management and other relevant staff
·  
National, state, regional and local economic trends and business conditions
§  
General economic conditions
§  
Unemployment rates
§  
Inflation / CPI
§  
Changes in values of underlying collateral for collateral-dependent loans
·  
Industry conditions including the effects of external factors such as competition, legal, and regulatory requirements on the level of estimated credit losses; and
·  
Existence and effect of any credit concentrations, and changes in the level of such concentrations.

 
 
13

 
 
The Company also maintains an unallocated allowance to account for any factors or conditions that may cause a potential loss but are not specifically addressed in the process described above. The Company analyzes its loan portfolio each quarter to determine the appropriateness of its allowance for loan losses.
 
The following are qualitative factors that experienced changes during the first quarter of 2011:
 
·  
The qualitative factors for changes in levels of and trends in delinquencies, impaired/classified loans were decreased for consumer, other commercial and agricultural related loans due to decreases in nonaccrual loans, which has resulted in a negative provision for the first quarter 2011 for these categories. This factor was increased for commercial real estate loans due to an increase in nonaccrual loans.
·  
The qualitative factor for changes in the trends of charge-offs and recoveries were decreased for consumer loans due to reduced losses over the most recent three year period.
·  
The qualitative factor for changes in portfolio volumes during 2011 were reduced for agricultural loans due to a general improvement of the loan portfolio.
 
The following table rolls forward the balance of the allowance for loan and lease losses by portfolio segment from December 31, 2010 to March 31, 2011 and segregates the ending balance into the amount required for loans individually evaluated for impairment and the amount required for loans collectively evaluated for impairment as of March 31, 2011 (in thousands):
 
 
Balance at December 31, 2010
Charge-offs
Recoveries
Provision
Balance at March 31, 2011
Individually evaluated for impairment
Collectively evaluated for impairment
Real estate loans:
             
     Residential
 $         969
 $          (60)
 $              -
 $         12
 $         921
 $                -
 $             921
     Commercial and agricultural
         3,380
             (17)
                 -
          335
         3,698
              433
             3,265
     Construction
              22
                 -
                 -
            (9)
              13
                   -
                  13
Consumer
            108
             (16)
              17
          (22)
              87
                   -
                  87
Commercial and other loans
            983
                 -
                4
          (86)
            901
                   -
                901
State and political
     
               -
     
  subdivision loans
            137
                 -
                 -
              2
            139
                   -
                139
Unallocated
            316
                 -
                 -
            (7)
            309
                   -
                309
Total
 $      5,915
 $          (93)
 $           21
 $       225
 $      6,068
 $           433
 $          5,635

Note 6 – Federal Home Loan Bank (FHLB) Stock
 
The Bank is a member of the Federal Home Loan Bank of Pittsburgh and as such, is required to maintain a minimum investment in stock of the Federal Home Loan Bank that varies with the level of advances outstanding with the Federal Home Loan Bank. As of March 31, 2011 and December 31, 2010, the Bank holds $3,323,000 and $3,498,000, respectively of FHLB stock. The stock is bought from and sold to the Federal Home Loan Bank based upon its $100 par value.  The stock does not have a readily determinable fair value and as such is classified as restricted stock, carried at cost and evaluated for impairment by management.  The stock’s value is determined by the ultimate recoverability of the par value rather than by recognizing temporary declines. The determination of whether the par value will ultimately be recovered is influenced by criteria such as the following: (a) the significance of the decline in net assets of the Federal Home Loan Bank as compared to the capital stock amount and the length of time this situation has persisted (b) commitments by the Federal Home Loan Bank to make payments required by law or regulation and the level of such payments in relation to the operating performance (c) the impact of legislative and regulatory changes on the customer base of the Federal Home Loan Bank and (d) the liquidity position of the Federal Home Loan Bank.

 
14

 
 
The Federal Home Loan Bank of Pittsburgh has incurred a significant cumulative loss in regards to comprehensive income and net income in the three years ended December 31, 2010 and has suspended the payment of dividends; however, the results for 2010 were significantly improved from those of 2008 and 2009.  The cumulative losses are primarily attributable to impairment of investment securities associated with the distressed economic conditions during 2008 and 2009.  Management evaluated the stock and concluded that the stock was not impaired for the periods presented herein.  More consideration was given to the long-term prospects for the Federal Home Loan Bank as opposed to the stress caused by the economic conditions the world faced during 2008 and 2009.  Management also considered that the Federal Home Loan Bank’s regulatory capital ratios have increased from the prior year, liquidity appears adequate, and new shares of FHLB Stock continue to exchange hands at the $100 par value and the Federal Home Loan Bank has repurchased shares of excess capital stock from its members in the two quarters ended March 31, 2011 and December 31, 2010.

Note 7 - Employee Benefit Plans
 
For a detailed disclosure on the Company's pension and employee benefits plans, please refer to Note 11 of the Company's Consolidated Financial Statements included in the 2010 Annual Report on Form 10-K.
 
Noncontributory Defined Benefit Pension Plan
 
The Bank sponsors a noncontributory defined benefit pension plan (“Pension Plan”) covering substantially all employees and officers.  The Bank’s funding policy is to make annual contributions, if needed, based upon the funding formula developed by the plan’s actuary.
 
Any employee with a hire date of January 1, 2008 or later is not eligible to participate in the pension plan. In lieu of the Pension Plan, employees with a hire date of January 1, 2008 or later are eligible to receive, after meeting certain length of service requirements, an annual discretionary 401(k) plan contribution from the Bank equal to a percentage of an employee’s base compensation.  The contribution amount, if any, is placed in a separate account within the 401(k) plan and is subject to a vesting requirement.
 
For employees who are eligible to participate in the Pension Plan, the Pension Plan requires benefits to be paid to eligible employees based primarily upon age and compensation rates during employment.  Upon retirement or other termination of employment, employees can elect either an annuity benefit or a lump sum distribution of vested benefits in the Pension Plan.
 
The following sets forth the components of net periodic benefit costs of the Pension Plan for the three months ended March 31, 2011 and 2010, respectively (in thousands):

 
Pension Benefits
       
 
2011
 
2010
Service cost
 $    114
 
 $   170
Interest cost
      139
 
      223
Expected return on plan assets
     (206)
 
     (292)
Net amortization and deferral
       16
 
        24
       
Net periodic benefit cost
 $     63
 
 $     125

The Company expects to contribute $500,000 to the Pension Plan in 2011.

 
 
15

 
Defined Contribution Plan
 
The Company sponsors a voluntary 401(k) savings plan which eligible employees can elect to contribute up to the maximum amount allowable not to exceed the limits of IRS Code Sections 401(k).  Under the plan, the Company also makes required contributions on behalf of the eligible employees.  The Company’s contributions vest immediately.  Contributions by the Company totaled $50,000 and $56,000 for the three months ended March 31, 2011 and 2010, respectively.
 
Directors’ Deferred Compensation Plan
 
The Company’s directors may elect to defer all or portions of their fees until their retirement or termination from service.  Amounts deferred under the plan earn interest based upon the highest current rate offered to certificate of deposit customers.  Amounts deferred under the plan are not guaranteed and represent a general liability of the Company.  Amounts included in interest expense on the deferred amounts totaled $6,000 and $8,000 for the three months ended March 31, 2011 and 2010, respectively.
 
Restricted Stock Plan
 
The Company maintains a Restricted Stock Plan (the Plan) whereby employees and non-employee corporate directors are eligible to receive awards of restricted stock based upon performance related requirements.  Awards granted under the Plan are in the form of the Company’s common stock and are subject to certain vesting requirements including continuous employment or service with the Company.  100,000 shares of the Company’s common stock have been authorized under the Plan, which terminates April 18, 2016.  The Plan assists the Company in attracting, retaining and motivating employees to make substantial contributions to the success of the Company and to increase the emphasis on the use of equity as a key component of compensation.
 
For the three months ended March 31, 2011 and 2010, 3,968 and 0 shares of restricted stock were awarded and 2,318 and 2,446 shares were vested, respectively.  Compensation cost related to restricted stock is recognized based on the market price of the stock at the grant date over the vesting period. Compensation expense related to restricted stock was $33,000 and $27,000 for the three months ended March 31, 2011 and 2010, respectively.
 
Supplemental Executive Retirement Plan
 
The Company maintains a non-qualified supplemental executive retirement plan (“SERP”) for certain executives to compensate those executive participants in the Company’s noncontributory defined benefit pension plan whose benefits are limited by compensation limitations under current tax law. At March 31, 2011 and December 31, 2010, an obligation of $763,000 and $747,000, respectively, was included in other liabilities for this plan in the consolidated balance sheet.  Expenses related to this plan totaled $15,000 and $59,000 for the three months ended March 31, 2011 and 2010, respectively.

Note 8 – Fair Value Measurements
 
The Company established a hierarchal disclosure framework associated with the level of pricing observability utilized in measuring assets and liabilities at fair value. The three broad levels defined by this hierarchy are as follows:
 
Level I:
Quoted prices are available in active markets for identical assets or liabilities as of the reported date.
 
Level II:
Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these assets and liabilities include items for which quoted prices are available but traded less frequently, and items that are fair valued using other financial instruments, the parameters of which can be directly observed.
   
Level III:
Assets and liabilities that have little to no pricing observability as of the reported date. These items do not have two-way markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.
 
 
 
16

 
 
A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.
 
In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality, the Company's creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. Our valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally coincides with the Company’s monthly and/or quarterly valuation process

Financial Instruments Recorded at Fair Value on a Recurring Basis
 
The fair values of securities available for sale are determined by quoted prices in active markets, when available, and classified as Level 1. If quoted market prices are not available, the fair value is determined by a matrix pricing, which is a mathematical technique, widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities and classified as Level 2. The fair values consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. In cases where significant credit valuation adjustments are incorporated into the estimation of fair value, reported amounts are classified as Level 3 inputs.
 
Currently, we use an interest rate swap, which is a derivative, to manage our interest rate risk related to the trust preferred security. The valuation of this instrument is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative and classified as Level 2. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including LIBOR rate curves. We also obtain dealer quotations for these derivatives for comparative purposes to assess the reasonableness of the model valuations.
 
The following tables present the assets reported on the consolidated balance sheet at their fair value  on a recurring basis as of March 31, 2011 and December 31, 2010 by level within the fair value hierarchy. Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.


(In thousands)
 
March 31, 2011
   
Level 1
 
Level II
 
Level III
   
Total
Fair value measurements on a recurring basis:
                 
  Securities available for sale:
                 
     U.S. Agency securities
 
 $                  -
 
 $           148,165
 
 $                   -
   
 $           148,165
     Obligations of state and
                 
        political subdivisions
 
                     -
 
87,274
 
                      -
   
87,274
     Corporate obligations
 
                     -
 
8,637
 
                      -
   
8,637
     Mortgage-backed securities in
                 
       government sponsored entities
 
                     -
 
39,641
 
                      -
   
39,641
     Equity securities in financial
                 
       institutions
 
1,317
 
                         -
 
                      -
   
1,317
                   
   Trust Preferred Interest Rate Swap
 
                     -
 
(349)
 
                      -
   
(349)
                   
 
 
17

 
 
 
(In thousands)
 
December 31, 2010
   
Level 1
 
Level II
 
Level III
   
Total
Fair value measurements on a recurring basis:
                 
  Securities available for sale:
                 
     U.S. Agency securities
 
 $                  -
 
 $           118,484
 
 $                   -
   
 $           118,484
     Obligations of state and
                 
          political subdivisions
 
                     -
 
76,922
 
                      -
   
76,922
     Corporate obligations
 
                     -
 
8,681
 
                      -
   
8,681
     Mortgage-backed securities in
                 
          government sponsored entities
 
                     -
 
46,015
 
                      -
   
46,015
     Equity securities in financial
                 
          institutions
 
1,201
 
                         -
 
                      -
   
1,201
                   
   Trust Preferred Interest Rate Swap
 
                     -
 
(409)
 
                      -
   
(409)

Financial Instruments Recorded at Fair Value on a Nonrecurring Basis
 
The Company may be required, from time to time, to measure certain financial assets and financial liabilities at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principles. These include assets that are measured at the lower of cost or market value that were recognized at fair value below cost at the end of the period.
 
· Impaired Loans. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with ASC Topic 310. The fair value of impaired loans is estimated using one of several methods, including collateral value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. Collateral values are estimated using Level 2 inputs based on observable market data or Level 3 inputs based on customized discounting criteria. For a majority of impaired real estate related loans, the Company obtains a current external appraisal. Other valuation techniques are used as well, including internal valuations, comparable property analysis and contractual sales information.
 
Non-Financial Assets and Non-Financial Liabilities Recorded at Fair Value
 
The Corporation has no non-financial assets or non-financial liabilities measured at fair value on a recurring basis. Certain non-financial assets measured at fair value on a non-recurring basis include foreclosed assets (upon initial recognition or subsequent impairment), non-financial assets and non-financial liabilities measured at fair value in the second step of a goodwill impairment test, and intangible assets and other non-financial long-lived assets measured at fair value for impairment assessment. Non-financial assets measured at fair value on a non-recurring basis during 2011 and 2010 include certain foreclosed assets which, upon initial recognition, were remeasured and reported at fair value through a charge-off to the allowance for possible loan losses and certain foreclosed assets which, subsequent to their initial recognition, were remeasured at fair value through a write-down included in other non-interest expense. The fair value of a foreclosed asset is estimated using Level 2 inputs based on observable market data or Level 3 inputs based on customized discounting criteria.
 
Assets measured at fair value on a nonrecurring basis as of March 31, 2011 and December 31, 2010 are included in the table below:
 
 
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(In thousands)
 
March 31, 2011
   
Level 1
 
Level II
 
Level III
   
Total
                   
Impaired Loans
 
 $       -
 
 $             -
 
 $  8,678
   
 $     8,678
Other real estate owned
         
912
   
912
                   
(In thousands)
 
December 31, 2010
   
Level 1
 
Level II
 
Level III
   
Total
                   
Impaired Loans
 
 $       -
 
 $     2,238
 
 $  9,096
   
 $   11,334
Other real estate owned
     
693
       
693

The fair values of the Company’s financial instruments are as follows (in thousands):

 
March 31
 
December 31
 
2011
 
2010
 
Carrying
Estimated
 
Carrying
Estimated
 
Amount
Fair Value
 
Amount
Fair Value
Financial assets:
         
Cash and due from banks
 $    44,554
 $    44,554
 
 $    43,995
 $    43,995
Available-for-sale securities
     285,034
     285,034
 
     251,303
     251,303
Net loans
     460,700
     484,576
 
     467,602
     494,098
Bank owned life insurance
       13,292
       13,292
 
       13,171
       13,171
Regulatory stock
         3,597
         3,597
 
         3,773
         3,773
Accrued interest receivable
         4,053
         4,053
 
         3,455
         3,455
           
           
Financial liabilities:
         
Deposits
 $  704,529
 $  710,141
 
 $  680,711
 $  683,315
Borrowed funds
       57,115
       53,951
 
       55,996
       52,820
Trust preferred interest rate swap
            349
            349
 
            409
            409
Accrued interest payable
         1,590
         1,590
 
         1,779
         1,779

Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument.  These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument.  Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions can significantly affect the estimates.
 
Fair values have been determined by the Company using historical data, as generally provided in the Company’s regulatory reports, and an estimation methodology suitable for each category of financial instruments. The Company’s fair value estimates, methods and assumptions are set forth below for the Company’s other financial instruments.

Cash and Cash Equivalents:
 
The carrying amounts for cash and due from banks approximate fair value because they have original maturities of 90 days or less and do not present unanticipated credit concerns.

Accrued Interest Receivable and Payable:
 
The carrying amounts for accrued interest receivable and payable approximate fair value because they are generally received or paid in 90 days or less and do not present unanticipated credit concerns.

 
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Available-For-Sale Securities:
 
The fair values of available-for-sale securities are based on quoted market prices as of the balance sheet date.  For certain instruments, fair value is estimated by obtaining quotes from independent dealers.

Loans:
 
Fair values are estimated for portfolios of loans with similar financial characteristics.  The fair value of performing loans has been estimated by discounting expected future cash flows. The discount rate used in these calculations is derived from the Treasury yield curve adjusted for credit quality, operating expense and prepayment option price, and is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The estimate of maturity is based on the Company’s historical experience with repayments for each loan classification, modified as required by an estimate of the effect of current economic and lending conditions.
 
Fair value for significant nonperforming loans is based on recent external appraisals. If appraisals are not available, estimated cash flows are discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows, and discount rates are judgmentally determined using available market information and specific borrower information.

Bank Owned Life Insurance:
 
The carrying value of bank owned life insurance approximates fair value based on applicable redemption provisions.

Regulatory Stock:
 
The carrying value of regulatory stock approximates fair value based on applicable redemption provisions.

Deposits:
 
The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, savings and NOW accounts, and money market accounts, is equal to the amount payable on demand. The fair value of certificates of deposit is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.
 
The deposits’ fair value estimates do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market, commonly referred to as the core deposit intangible.

Borrowed Funds:
 
Rates available to the Company for borrowed funds with similar terms and remaining maturities are used to estimate the fair value of borrowed funds.

Trust Preferred Interest Rate Swap:
 
The fair value of the trust preferred interest rate swap is based on a pricing model that utilizes a yield curve and information contained in the swap agreement.

Note 9 – Recent Accounting Pronouncements
 
In January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. ASU 2010-06 amends Subtopic 820-10 to clarify existing disclosures, require new disclosures, and includes conforming amendments to guidance on employers’ disclosures about postretirement benefit plan assets. ASU 2010-06 is effective for interim and annual periods beginning after December 15, 2009, except for disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years.  The Company has presented the necessary disclosures in the Note 8 herein.
 
 
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In July 2010, FASB issued ASU No. 2010-20, Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.  ASU 2010-20 is intended to provide additional information to assist financial statement users in assessing an entity’s credit risk exposures and evaluating the adequacy of its allowance for credit losses. The disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010.  The amendments in ASU 2010-20 encourage, but do not require, comparative disclosures for earlier reporting periods that ended before initial adoption. However, an entity should provide comparative disclosures for those reporting periods ending after initial adoption.  The Company has presented the necessary disclosures in the Note 5 herein.
 
In December, 2010, the FASB issued ASU 2010-28, When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts.  This ASU modifies Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts.  For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists.  In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating an impairment may exist.  The qualitative factors are consistent with the existing guidance, which requires that goodwill of a reporting unit be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount.  For public entities, the amendments in this Update are effective for fiscal year, and interim periods within those years, beginning after December 15, 2010.  Early adoption is not permitted.  For nonpublic entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011.  Nonpublic entities may early adopt the amendments using the effective date for public entities.  This ASU is not expected to have a significant impact on the Company’s financial statements.
 
In December 2010, the FASB issued ASU 2010-29, Disclosure of Supplementary Pro Forma Information for Business Combinations.  The amendments in this update specify that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only.  The amendments also expand the supplemental pro forma disclosures under Topic 805 to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings.   The amendments in this Update are effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. Early adoption is permitted.  This ASU is not expected to have a significant impact on the Company’s financial statements.
 
In January 2011, the FASB issued ASU 2011-01, Receivables (Topic 310):  Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20.  The amendments in this Update temporarily delay the effective date of the disclosures about troubled debt restructurings in Update 2010-20, enabling public-entity creditors to provide those disclosures after the FASB clarifies the guidance for determining what constitutes a troubled debt restructuring.  The deferral in this Update will result in more consistent disclosures about troubled debt restructurings.  This amendment does not defer the effective date of the other disclosure requirements in Update 2010-20.  In the proposed Update for determining what constitutes a troubled debt restructuring, the FASB proposed that the clarifications would be effective for interim and annual periods ending after June 15, 2011.  For the new disclosures about troubled debt restructurings in Update 2010-20, those clarifications would be applied retrospectively to the beginning of the fiscal year in which the proposal is adopted.  The adoption of this guidance is not expected to have a significant impact on the Company’s financial statements.
 
 
21

 
 
In April 2011, the FASB issued ASU 2011-02, Receivables (Topic 310):  A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.  The amendments in this Update provide additional guidance or clarification to help creditors in determining whether a creditor has granted a concession and whether a debtor is experiencing financial difficulties for purposes of determining whether a restructuring constitutes a troubled debt restructuring.  The amendments in this Update are effective for the first interim or annual reporting period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning annual period of adoption.  As a result of applying these amendments, an entity may identify receivables that are newly considered impaired.  For purposes of measuring impairment of those receivables, an entity should apply the amendments prospectively for the first interim or annual period beginning on or after June 15, 2011.  The Company is currently evaluating the impact the adoption of the standard will have on the Company’s financial position or results of operations.
 
 
22

 
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements
 
We have made forward-looking statements in this document, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of operations of Citizens Financial Services, Inc., First Citizens National Bank, First Citizens Insurance Agency, Inc. or the combined Company. When we use words such as “believes,” “expects,” “anticipates,” or similar expressions, we are making forward-looking statements.  For a variety of reasons, actual results could differ materially from those contained in or implied by forward-looking statements.  The Company would like to caution readers that the following important factors, among others, may have affected and could in the future affect the Company’s actual results and could cause the Company’s actual results for subsequent periods to differ materially from those expressed in any forward-looking statement:
 
·  
Interest rates could change more rapidly or more significantly than we expect.
·  
The economy could change significantly in an unexpected way, which would cause the demand for new loans and the ability of borrowers to repay outstanding loans to change in ways that our models do not anticipate.
·  
The stock and bond markets could suffer a significant disruption, which may have a negative effect on our financial condition and that of our borrowers, and on our ability to raise money by issuing new securities.
·  
It could take us longer than we anticipate implementing strategic initiatives designed to increase revenues or manage expenses, or we may not be able to implement those initiatives at all.
·  
Acquisitions and dispositions of assets could affect us in ways that management has not anticipated.
·  
We may become subject to new legal obligations or the resolution of litigation may have a negative effect on our financial condition.
·  
We may become subject to new and unanticipated accounting, tax, or regulatory practices, regulations or requirements, including the costs of compliance with such changes.
·  
We could experience greater loan delinquencies than anticipated, adversely affecting our earnings and financial condition.  We could also experience greater losses than expected due to the ever increasing volume of information theft and fraudulent scams impacting our customers and the banking industry.
·  
We could lose the services of some or all of our key personnel, which would negatively impact our business because of their business development skills, financial expertise, lending experience, technical expertise and market area knowledge.
·  
Exploration and drilling of the natural gas reserves in the Marcellus Shale in our market area may be affected by federal, state and local laws and regulations such as restrictions on production, permitting, changes in taxes and environmental protection, which could negatively impact our customers and, as a result, negatively impact our loan and deposit volume and loan quality.

Additional factors that may affect our results are discussed under “Part II – Item 1A – Risk Factors” in this report and in the Company’s Annual Report on Form 10-K under “Item 1.A/ Risk Factors.”  Except as required by applicable law and regulation, we assume no obligation to update or revise any forward-looking statements after the date on which they are made.

Introduction
 
The following is management's discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in its accompanying consolidated financial statements for the Company.  Our Company's consolidated financial condition and results of operations consist almost entirely of the Bank’s financial condition and results of operations. Management’s discussion and analysis should be read in conjunction with the preceding financial statements presented under Part I.  The results of operations for the three months ended March 31, 2011 are not necessarily indicative of the results you may expect for the full year.

 
23

 
 
Our Company currently engages in the general business of banking throughout our service area of Potter, Tioga and Bradford counties in North Central Pennsylvania and Allegany, Steuben, Chemung and Tioga counties in Southern New York. We maintain our main office in Mansfield, Pennsylvania. Presently we operate 19 banking facilities.  In Pennsylvania, we have branch offices located in Mansfield, Blossburg, Ulysses, Genesee, Wellsboro, Troy, Sayre, Canton, Gillett, Millerton, LeRaysville, Towanda, Rome, the Wellsboro Weis Market store and the Mansfield Wal-Mart Super Center. We also have a loan production office in Lock Haven, Pennsylvania. In New York, we have a branch office in Wellsville, Allegany County.

Risk Management
 
Risk identification and management are essential elements for the successful management of the Company.  In the normal course of business, the Company is subject to various types of risk, including interest rate, credit, liquidity, reputational and regulatory risk.
 
Interest rate risk is the sensitivity of net interest income and the market value of financial instruments to the direction and frequency of changes in interest rates.  Interest rate risk results from various re-pricing frequencies and the maturity structure of the financial instruments owned by the Company.  The Company uses its asset/liability and funds management policy to control and manage interest rate risk.
 
Credit risk represents the possibility that a customer may not perform in accordance with contractual terms.  Credit risk results from loans with customers and the purchasing of securities.  The Company’s primary credit risk is in the loan portfolio.  The Company manages credit risk by adhering to an established credit policy and through a disciplined evaluation of the adequacy of the allowance for loan losses.  Also, the investment policy limits the amount of credit risk that may be taken in the investment portfolio.
 
Liquidity risk represents the inability to generate or otherwise obtain funds at reasonable rates to satisfy commitments to borrowers and obligations to depositors.  The Company has established guidelines within its asset/liability and funds management policy to manage liquidity risk.  These guidelines include, among other things, contingent funding alternatives.
 
Reputational risk, or the risk to our business, earnings, liquidity, and capital from negative public opinion, could result from our actual or alleged conduct in a variety of areas, including legal and regulatory compliance, lending practices, corporate governance, litigation, ethical issues, or inadequate protection of customer information. We expend significant resources to comply with regulatory requirements. Failure to comply could result in reputational harm or significant legal or remedial costs. Damage to our reputation could adversely affect our ability to retain and attract new customers, and adversely impact our earnings and liquidity.
 
Regulatory risk represents the possibility that a change in law, regulations or regulatory policy may have a material effect on the business of the Company and its subsidiary.  We cannot predict what legislation might be enacted or what regulations might be adopted, or if adopted, the effect thereof on our operations.

Competition
 
The banking industry in the Bank’s service area continues to be extremely competitive, both among commercial banks and with financial service providers such as consumer finance companies, thrifts, investment firms, mutual funds, insurance companies, credit unions and internet banks.  The increased competition has resulted from changes in the legal and regulatory guidelines as well as from economic conditions, specifically, the additional wealth resulting from the exploration of the Marcellus Shale in our primary market.  Mortgage banking firms, financial companies, financial affiliates of industrial companies, brokerage firms, retirement fund management firms and even government agencies provide additional competition for loans and other financial services.  The Bank is generally competitive with all competing financial institutions in its service area with respect to interest rates paid on time and savings deposits, service charges on deposit accounts and interest rates charged on loans.

 
24

 

Trust and Investment Services; Oil and Gas Services
 
Our Investment and Trust Services Department offers professional trust administration, investment management services, estate planning and administration, and custody of securities.  Assets held by the Company in a fiduciary or agency capacity for its customers are not included in the consolidated financial statements since such items are not assets of the Company.  Revenues and fees of the Trust Department are reflected in the Company’s financial statements.  As of March 31, 2011 and December 31, 2010, the Trust Department had $96.8 and $95.1 million of assets under management, respectively.  The $1.7 million increase is primarily attributable to net additions of $1.6 million with the remaining increase the result of fluctuations in the stock market.

Our Investment Representatives offer full service brokerage services and financial planning throughout the Bank’s market area.  Products such as mutual funds, annuities, health and life insurance are made available through our insurance subsidiary, First Citizens Insurance.  The assets associated with these products are not included in the consolidated financial statements since such items are not assets of the Company. Assets owned and invested by customers of the Bank through the Bank’s Investment Representatives increased from $70.1 million at December 31, 2010 to $76.2 million at March 31, 2011. Fee income from the sale of these products is reflected in the Company’s financial statements as a component of non-interest income in the Consolidated Statement of Income.
 
In addition to the Trust and Investment services offered we have created an oil and gas management team, which serves as a network of experts to assist our customers through various oil and gas specific leasing matters from lease negotiations to establishing a successful approach to personal wealth management.  We have partnered with a professional firm to provide mineral management expertise and services to customers in our market who have been impacted by the Marcellus Shale exploration and drilling activities. Through this relationship, we are able to assist customers negotiate lease payments and royalty percentages, protect their property, resolve leasing issues, account for and ensure the accuracy of royalty checks, distribute revenue to satisfy investment objectives and provide customized reports outlining payment and distribution information.

Results of Operations

Overview of the Income Statement
 
The Company had net income of $2,830,000 for the first three months of 2011 compared to earnings of $2,746,000 for last year’s comparable period, an increase of $84,000 or 3.1%. Earnings per share for the first three months of 2011 were $0.98, compared to $0.95 last year, representing a 3.2% increase.  Annualized return on assets and return on equity for the three months of 2011 were 1.38% and 16.57%, respectively, compared with 1.50% and 18.22% for last year’s comparable period.

Net Interest Income
 
Net interest income, the most significant component of the Company’s earnings, is the amount by which interest income generated from interest-earning assets exceeds interest expense on interest-bearing liabilities.
 
Net interest income for the first three months of 2011 was $6,936,000, an increase of $189,000, or 2.8%, compared to the same period in 2010.  For the first three months of 2011, the provision for loan losses totaled $225,000, a decrease of $80,000 over the comparable period in 2010.  Consequently, net interest income after the provision for loan losses was $6,711,000 for the first three months of 2011 compared to $6,442,000 for the first three months of 2010.

The following table sets forth the average balances of, and the interest earned or incurred on, for each principal category of assets, liabilities and stockholders’ equity, the related rates, net interest income and rate “spread” created for the three months ended March 31, 2011 and 2010 on a tax equivalent basis:

 
25

 

 
 
Analysis of Average Balances and Interest Rates (1)
             
 
March 31, 2011
March 31, 2010
 
Average
 
Average
Average
 
Average
 
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
(dollars in thousands)
$
$
%
$
$
%
ASSETS
           
Short-term investments:
           
   Interest-bearing deposits at banks
     33,249
          22
0.27
    19,143
           14
0.30
Total short-term investments
     33,249
          22
0.27
    19,143
           14
0.30
Investment securities:
           
  Taxable
   184,952
    1,187
2.57
  143,087
      1,340
3.75
  Tax-exempt (3)
     84,702
    1,311
6.19
    60,139
         972
6.47
  Total investment securities
   269,654
    2,498
3.71
  203,226
      2,312
4.55
Loans:
           
  Residential mortgage loans
   188,887
    3,243
6.96
  200,650
      3,549
7.17
  Commercial & farm loans
   221,502
    3,486
6.38
  200,342
      3,465
7.01
  Loans to state & political subdivisions
     48,671
        638
5.32
    46,748
         693
6.01
  Other loans
     10,942
        230
8.52
    11,530
         250
8.79
  Loans, net of discount (2)(3)(4)
   470,002
    7,597
6.56
  459,270
      7,957
7.03
Total interest-earning assets
   772,905
  10,117
5.31
  681,639
    10,283
6.12
Cash and due from banks
        9,844
   
      9,062
   
Bank premises and equipment
     12,469
   
    12,265
   
Other assets
     27,965
   
    28,611
   
Total non-interest earning assets
     50,278
   
    49,938
   
Total assets
   823,183
   
  731,577
   
LIABILITIES AND STOCKHOLDERS' EQUITY
         
Interest-bearing liabilities:
           
  NOW accounts
   181,592
        238
      0.53
  137,109
         267
    0.79
  Savings accounts
     65,058
          49
      0.31
    50,396
           38
    0.31
  Money market accounts
     52,989
          70
      0.54
    41,092
           61
    0.60
  Certificates of deposit
   316,308
    1,731
      2.22
  322,548
      2,176
    2.74
Total interest-bearing deposits
   615,947
    2,088
      1.37
  551,145
      2,542
    1.87
Other borrowed funds
     57,204
        445
      3.15
    53,430
         441
    3.34
Total interest-bearing liabilities
   673,151
    2,533
      1.53
  604,575
      2,983
    2.00
Demand deposits
     74,409
   
    59,053
   
Other liabilities
        7,305
   
      7,681
   
Total non-interest-bearing liabilities
     81,714
   
    66,734
   
Stockholders' equity
     68,318
   
    60,268
   
Total liabilities & stockholders' equity
   823,183
   
  731,577
   
Net interest income
 
    7,584
   
      7,300
 
Net interest spread (5)
   
3.78%
   
4.12%
Net interest income as a percentage
           
  of average interest-earning assets
   
3.98%
   
4.34%
Ratio of interest-earning assets
           
  to interest-bearing liabilities
   
      1.15
   
    1.13
             
(1) Averages are based on daily averages.
         
(2) Includes loan origination and commitment fees.
         
(3) Tax exempt interest revenue is shown on a tax equivalent basis for proper comparison using
 
       a statutory federal income tax rate of 34%.
     
(4) Income on non-accrual loans is accounted for on a cash basis, and the loan balances are included in interest-earning assets.
(5) Interest rate spread represents the difference between the average rate earned on interest-earning assets
      and the average rate paid on interest-bearing liabilities.
       


 
26

 

Tax exempt revenue is shown on a tax-equivalent basis for proper comparison using a statutory, federal income tax rate of 34%.  For purposes of the comparison, as well as the discussion that follows, this presentation 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 Company’s 34% Federal statutory rate.  The following table represents the adjustment to convert net interest income to net interest income on a fully taxable equivalent basis for the periods ending March 31, 2011 and 2010:
 

 
For the Three Months
 
Ended March 31
 
2011
2010
Interest and dividend income from investment securities
   
    and short term investments (non-tax adjusted)
 $        2,074
 $          1,996
Tax equivalent adjustment
               446
               330
Interest and dividend income from investment
   
    securities and short term investments (tax equivalent basis)
 $        2,520
 $          2,326
     
     
     
Interest and fees on loans (non-tax adjusted)
 $        7,395
 $          7,734
Tax equivalent adjustment
               202
               223
Interest and fees on loans (tax equivalent basis)
 $        7,597
 $          7,957
     
     
     
Total interest income
 $        9,469
 $          9,730
Total interest expense
            2,533
             2,983
Net interest income
            6,936
             6,747
Total tax equivalent adjustment
               648
               553
Net interest income (tax equivalent basis)
 $        7,584
 $          7,300

The following table shows the tax-equivalent effect of changes in volume and rate on interest income and expense.

Analysis of Changes in Net Interest Income on a Tax-Equivalent Basis (1)
       
 
 2011 vs. 2010
 
 Change in
 Change
 Total
 
 Volume
 in Rate
 Change
Interest Income:
     
Short-term investments:
     
  Interest-bearing deposits at banks
 $             9
 $          (1)
 $             8
Investment securities:
     
  Taxable
        2,020
      (2,173)
         (153)
  Tax-exempt
           378
           (39)
           339
Total investment securities
        2,398
      (2,212)
           186
Loans:
     
  Residential mortgage loans
         (204)
         (102)
         (306)
  Commercial & farm loans
           142
         (121)
              21
  Loans to state & political subdivisions
              30
           (85)
           (55)
  Other loans
           (13)
              (7)
           (20)
Total loans, net of discount
           (45)
         (315)
         (360)
Total Interest Income
        2,362
      (2,528)
         (166)
 
 
27

 
 
Interest Expense:
     
Interest-bearing deposits:
     
  NOW accounts
        2,582
      (2,611)
           (29)
  Savings accounts
              11
                 -
              11
  Money Market accounts
              14
              (5)
                9
  Certificates of deposit
           (41)
         (404)
         (445)
Total interest-bearing deposits
        2,566
      (3,020)
         (454)
Other borrowed funds
              22
           (18)
                4
Total interest expense
        2,588
      (3,038)
         (450)
Net interest income
 $      (226)
 $        510
 $        284
       
(1) The portion of the total change attributable to both volume and rate changes, which can not be separated, has been
     allocated proportionally to the change due to volume and the change due to rate prior to allocation.

Tax equivalent net interest income increased from $7,300,000 for the three months ended March 31, 2010 to $7,584,000 for the same time period in 2011, an increase of $284,000.  The tax equivalent net interest margin decreased from 4.34% for the first three months of 2010 to 3.98% for the comparable period in 2011.
 
Total tax equivalent interest income for the three month period decreased $166,000. This decrease was primarily a result of a decrease of $2,528,000 due to change in rate, as the yield on interest earning assets decreased from 6.12% to 5.31% or 81 basis points for the comparable periods. The decrease was offset by an increase of $2,362,000 due to volume as the average balance of interest earning assets increased by $91.3 million.
 
Tax equivalent investment income for the three months ended March 31, 2011 increased $186,000 over the same period last year.  The average balance of total investment securities for the three months ended March 31, 2011 increased by $66.4 million from March 31, 2010 as a result of investing excess cash from increased deposits.
 
·  
The average balance of taxable securities increased by $41.9 million while tax-exempt securities increased by $24.5 million, which had the effect of increasing interest income by $2,020,000 and $378,000, respectively, due to volume.
 
·  
This increase attributable to volume of securities was offset by a decrease in the yield on investment securities of 84 basis points from 4.55% to 3.71%, which corresponds to a decrease in interest income of $2,212,000. The majority of this decrease is attributable to the change in yield on taxable securities, which decreased 118 basis points from 3.75% to 2.57%. The yield on investments declined due to the amount of purchases we made in the current low interest rate environment as a result of our increased deposits and investment cash flows. As a result of this environment our strategy has been to invest primarily in short-term agency bonds as well as a limited amount of longer-term municipal bonds (See also “Financial Condition – Investments”).
 
The purchase of tax-exempt securities, along with municipal loans, allows us to manage our effective tax rate as well as the overall yield on our interest earning assets.
 
Total loan interest income decreased $360,000 for the three months ended March 31, 2011 compared to the same period last year.
 
·  
Interest income on residential mortgage loans decreased $306,000 of which $204,000 was due to volume and $102,000 was due to a decrease in rate.  The average balance decreased $11.8 million due to the fact that more customers are qualifying for conforming loans, which the Bank sells, and local economic conditions related to the exploration of the Marcellus Shale, which has limited the borrowing needs of some of the residents in our primary market. Additionally, management believes the demand for home equity loans has decreased due to the rate environment for conforming loans, which are sold on the secondary market as discussed above.
 
·  
The average balance of commercial and farm loans increased $21.2 million from a year ago as we grow this segment of the loan portfolio utilizing disciplined underwriting standards, while meeting the needs of our customers. This had a positive impact of $142,000 on total interest income due to volume, which was offset by a reduction due to a decrease in rate of $121,000.
 
 
28

 
 
Total interest expense decreased $450,000 for the three months ended March 31, 2011 compared with last year.  This decrease is primarily due to a change in rate, accounting for a $3,038,000 decrease in our interest expense.  The average interest rate on interest-bearing liabilities decreased 47 basis points, from 2.0% to 1.53%. The historically low interest rates supported by the Federal Reserve and current economic conditions had the effect of decreasing our short-term borrowing costs as well as rates on deposit products. Offsetting this, the average balance of interest-bearing liabilities increased $68.6 million resulting in an increase in interest expense of $2,588,000 (see also “Financial Condition – Deposits”).
 
·  
Interest expense on certificates of deposits decreased $445,000 over the same period last year. The average balance of certificates of deposit decreased $6.2 million causing a decrease in interest expense of $41,000. In addition, there was a decrease in the average rate on certificates of deposit from 2.74% to 2.22% resulting in a decrease in interest expense of $404,000.
 
·  
The average balance of NOW accounts increased $44.5 million accounting for an increase of $2,582,000 in interest expense. The change in the average rate from 79 basis points to 53 basis points, contributed to a decrease in interest expense of $2,611,000 resulting in a net decrease of $29,000.
 
Provision For Loan Losses
 
For the three month period ending March 31, 2011, we recorded a provision for loan losses of $225,000, which represents a decrease of $80,000 over the $305,000 provision recorded in the corresponding three months of last year. Although non-performing assets have increased from March 31, 2010, this increase occurred during 2010 and the related provisions were recorded during such time. Since December 31, 2010, our level of non-performing assets has improved. (see “Financial Condition – Allowance for Loan Losses and Credit Quality Risk”).

Non-interest Income
 
Non-interest income for the three months ended March 31, 2011 totaled $1,515,000, an increase of $125,000 when compared to the same period in 2010. During the first three months of 2011, gains on the sales of investment securities amounted to $120,000 compared to $64,000 last year.  We sold two municipal bonds at a gain of $1,000, eight mortgage backed securities in government sponsored entities for gains totaling $108,000 and a portion of a financial institution equity holding for a gain of $11,000 due to favorable market conditions. In 2010, we sold two agency bonds at a gain of $9,000 that were likely to be called later in the year and a mortgage backed security due to favorable market conditions for a gain of $55,000.
 
For the first three months of 2011, account service charges totaled $841,000, a decrease of $12,000 or 1.4%, when compared to the same period in 2010. There was a $64,000 decrease attributable to fees charged to customers for non-sufficient funds as a result of changes to Regulation E effective in August 2010 that limits the ability of the Bank to charge overdraft fees for debit card purchases and ATM withdrawals that are in excess of the customers deposit balance. This decrease was offset by a $57,000 increase attributable to customers’ usage of their debit cards due to continuing efforts on the Bank’s part to encourage customers to pay for items utilizing this payment method. Management continues to monitor regulatory changes including the Durbin amendment to the Dodd-Frank Act, which regulates the level of interchange fee income the Bank is able to charge on debit card transactions, to determine the level of impact that these regulations will have on the fees that the Company realizes.
 
Trust, Brokerage and insurance income increased $24,000 as we continue to increase the principal amounts invested through us by our customers by adding additional employees to serve our customers’ needs.  The increase in other income is attributable to an increase in gains on loans sold of $28,000 and an increase in rental income on other real estate owned of $34,000.

 
29

 
 
The following table shows the breakdown of non-interest income for the three months ended March 31, 2011 and 2010:

 
Three months ended
   
 
March 31,
Change
(dollars in thousands)
2011
2010
Amount
%
Service charges
 $     841
 $    853
 $    (12)
   (1.4)
Trust
       157
      146
       11
    7.5
Brokerage and insurance
        95
       82
       13
   15.9
Investment securities gains, net
       120
       64
       56
   87.5
Earnings on bank owned life insurance
       121
      124
       (3)
   (2.4)
Other
       181
      121
       60
   49.6
Total
 $   1,515
 $  1,390
 $    125
    9.0

Non-interest Expense
 
Non-interest expenses increased $348,000, or 8.0% for the three months ended March 31, 2011 compared to the same period in 2010. Salaries and employee benefits increased $74,000 or 3.0%. Merit increases effective the beginning of 2011 and a slight increase in full time equivalent employees, accounted for an increase of approximately $108,000. Other increases included an increase of $43,000 for expenses related to providing employee’s insurance and a $19,000 increase related to profit sharing expense. These increases were offset by decreases of $44,000 in the Company’s Supplemental Executive Retirement Plan (SERP) plan and a $63,000 decrease related to the Company’s defined benefit pension plan.
 
Occupancy and furniture and equipment expenses increased as a result of opening the new Wellsboro and Rome branches, as well as maintenance costs as a result of increased snowfall in 2011 versus 2010. ORE expenses have increased as a result of additional properties being owned by the Bank during the current period versus the same period last year. Professional fees decreased $23,000 due to certain fees being reimbursed by a customer. The largest increases in other expenses are losses on the sales of ORE properties of $35,000 and increased Pennsylvania shares tax expense.
 
The following tables reflect the breakdown of non-interest expense and professional fees for the three months ended March 31, 2011 and 2010:

 
Three months ended
   
 
March 31,
Change
(in thousands)
2011
2010
Amount
%
Salaries and employee benefits
$   2,515
$  2,441
 $     74
     3.0
Occupancy
           390
      306
       84
    27.5
Furniture and equipment
          117
      106
       11
    10.4
Professional fees
           157
      180
      (23)
   (12.8)
Amortization of intangibles
         4
        4
        -
      -
FDIC insurance
       250
      237
       13
     5.5
ORE expenses
       156
       81
       75
    92.6
Other
     1,087
      973
      114
    11.7
Total
 $   4,676
 $  4,328
 $    348
     8.0
 
 
30

 
 
 
 
Three months ended
   
 
March 31,
Change
(in thousands)
2011
2010
Amount
%
Other professional fees
 $     103
 $    103
$        - 
      -
Legal fees
         6
       22
      (16)
   (72.7)
Examinations and audits
        48
       55
       (7)
   (12.7)
Total
 $     157
 $    180
 $    (23)
   (12.8)

Provision For Income Taxes
 
The provision for income taxes was $720,000 for the three month period ended March 31, 2011 compared to $758,000 for the same period in 2010.  While the Bank had $46,000 more in pre-tax income for the three months ended March 31, 2011 compared to the same period last year, a larger portion was attributable to earnings from our municipal loan and bond portfolios, which are not subject to federal income tax, which resulted in a lower provision. Through management of our municipal loan and bond portfolios, management is focused on minimizing our effective tax rate.  Our effective tax rate was 20.3% and 21.7% for the first three months of 2011 and 2010,respectively, compared to the statutory rate of 34%.

We invest in three limited partnership agreements that established low-income housing projects in our market areas. As a result of these agreements, for tax purposes we have recognized the entire $913,000 of tax credits from one project in the Towanda area that began in October of 2000. We have recognized $356,000 out of a total $385,000 of tax credits on the second project in the Wellsboro market which was completed in November 2001.  In 2005, we entered into a third limited liability partnership for a low-income housing project for senior citizens in our Sayre market area.  We have recognized $244,000 out of a total $574,000 of tax credits.  We anticipate recognizing $359,000 of tax credits over the next six years, with a total $96,000 expected to be recognized in 2011.

Financial Condition
 
Total assets were $840.2 million at March 31, 2011, an increase of $27.7 million, or 3.4% from $812.5 million at December 31, 2010.  Net loans decreased 1.48% to $460.7 million and investment securities increased 13.4% to $285.0 million at March 31, 2011.  Total deposits increased $23.8 million or 3.5% to $704.5 million since year-end 2010. Borrowed funds have increased $1.1 million to $57.1 million compared with $56.0 million at year-end.

Cash and Cash Equivalents

Cash and cash equivalents totaled $44.6 million at March 31, 2011 compared to $44.0 million at December 31, 2010, an increase of $600,000. The Company has maintained a higher level of cash and cash equivalents than it has historically had as a result of the Company’s deposit growth and cash flows from the investment portfolio, as discussed in more detail below. Management actively measures and evaluates its liquidity through our Asset – Liability committee and believes its liquidity needs are satisfied by the current balance of cash and cash equivalents, readily available access to traditional funding sources, Federal Home Loan Bank financing, federal funds lines with correspondent banks, brokered certificates of deposit and the portion of the investment and loan portfolios that mature within one year.  Management expects that these sources of funds will permit us to meet cash obligations and off-balance sheet commitments as they come due.
 
Investments
 
Our investment portfolio increased by $33.7 million or 13.4% from $251,303 at December 31, 2010 to $285,034 at March 31, 2011.  During 2011 we purchased approximately $33.5 million of U.S. agency obligations and $10.5 million of state and local obligations, which help offset the $3.6 million of principal repayments and $3.9 million of calls and maturities that occurred during the year. We also sold $3.2 million of municipal bonds, mortgage backed securities in government sponsored entities and certain financial institutions equity securities at a net gain of $120,000. The overall market value of our investment portfolio increased approximately $771,000 due to market fluctuations since year end.  We have incurred significant unrealized gains in our state and local obligations since year end as a result of certain government programs ending December 31, 2010. Excluding our short-term investments consisting of monies held primarily at the Federal Reserve, our investment portfolio for the three month period ending March 31, 2011 yielded 3.71% compared to 4.55% for the same period in 2010 on a tax equivalent basis.

 
31

 
 
As mentioned above and seen in the table below, due to the continued low interest rate environment, we have experienced significant prepayments of our mortgage backed securities of $3.6 million and calls on our agency bonds of $3.6 million as well.  Due to the amount of cash flow from the investment portfolio as well as an increase in deposits and a lack of opportunities in other investment types, our strategy has been to reinvest funds mainly in short-term agency purchases (we purchased $33.5 million during the first quarter of 2011) and, when presented with the opportunity, high quality municipal bonds with final maturities of less than 20 years of which we purchased $10.5 million in the first three months of 2011.  We believe this strategy will enable us to reinvest cash flows in the next one to four years with improved investment opportunities.

 
March 31, 2011
December 31, 2010
(dollars in thousands)
Amount
%
Amount
%
Available-for-sale:
       
  U. S. Agency securities
 $              148,165
             52.0
 $        118,484
          47.1
  Obligations of state & political
       
     subdivisions
                   87,274