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EX-32.2 - SECTION 1350 CERTIFICATION OF CHIEF FINANCIAL OFFICER - CITIZENS FINANCIAL SERVICES INCcertcfo.htm
EX-31.2 - CERTIFICATION OF CHIEF FINANCIAL OFFICER - CITIZENS FINANCIAL SERVICES INCcfocert.htm
EX-32.1 - SECTION 1350 CERTIFICATION OF CHIEF EXECUTIVE OFFICER - CITIZENS FINANCIAL SERVICES INCcertceo.htm
EX-31.1 - CERTIFICATION OF CHIEF EXECUTIVE OFFICER - CITIZENS FINANCIAL SERVICES INCceocert.htm
EX-21 - LIST OF SUBSIDIARIES - CITIZENS FINANCIAL SERVICES INCsubsidiaries.htm
EX-23 - CONSENT OF SR SNODGRASS CERTIFIED PUBLIC ACCOUNTANTS - CITIZENS FINANCIAL SERVICES INCsnodgrassconsent.htm


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

FORM 10-K
(Mark One)

     ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended
 
     December 31, 2015

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
     000-13222

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
         
Securities registered pursuant to Section 12(b) of the Act:
None
 
         
Securities registered pursuant to Section 12(g) of the Act:
         
Common Stock, par value $1.00 per share
(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
  Yes       No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
  Yes       No
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
  Yes       No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
                
 
Indicate by check mark whether the registrant is 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. (Check one):
 
 
Large accelerated filer  o                                                                                     Accelerated filer  
 
 
Non-accelerated filer  o                                                                           Smaller reporting company  o
 
(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 Act).
      Yes       No

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $131,083,374 as of June 30, 2015.
 
As of February 23, 2016, there were 3,335,876 shares of the registrant’s common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE
 
Certain information required by Part III is incorporated by reference to the Registrant’s Definitive Proxy Statement for the 2016 Annual Meeting of Shareholders.



 
 

 

 

 
Citizens Financial Services, Inc.
Form 10-K
INDEX
 
Page
PART I
 
ITEM 1 – BUSINESS
1 – 8
ITEM 1A – RISK FACTORS
8 – 14
ITEM 1B – UNRESOLVED STAFF COMMENTS
14
ITEM 2 – PROPERTIES
14
ITEM 3 – LEGAL PROCEEDINGS
14
ITEM 4 – MINE SAFETY DISCLOSURES
14
PART II
 
ITEM 5 – MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
15 – 16
ITEM 6 – SELECTED FINANCIAL DATA
17
ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS  OF OPERATIONS
18 – 47
ITEM 7A – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
47
ITEM 8 – FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
48 – 100
ITEM 9 – CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
101
ITEM 9A – CONTROLS AND PROCEDURES
101
ITEM 9B– OTHER INFORMATION
101
PART III
 
ITEM 10 – DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
102
ITEM 11 – EXECUTIVE COMPENSATION
102
ITEM 12 – SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
102 – 103
ITEM 13 – CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
103
ITEM 14 – PRINCIPAL ACCOUNTANT FEES AND SERVICES
103
PART IV
 
ITEM 15 – EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
104 – 105
SIGNATURES
106

 
 

 
 
PART I
 
ITEM 1 – BUSINESS.
 
CITIZENS FINANCIAL SERVICES, INC.
 
Citizens Financial Services, Inc. (the “Company”), a Pennsylvania corporation, was incorporated on April 30, 1984 to be the holding company for First Citizens Community Bank (the “Bank”), which until 2012, and in connection with its conversion from a national bank to a Pennsylvania-chartered bank and trust company, operated under the name First Citizens National Bank. The Company is primarily engaged in the ownership and management of the Bank and the Bank’s wholly-owned insurance agency subsidiary, First Citizens Insurance Agency, Inc. On December 11, 2015, the Company completed the acquisition of The First National Bank of Fredericksburg (“FNB”) by merging FNB into the Bank, with the Bank as the resulting institution.
 
AVAILABLE INFORMATION
 
A copy of the Company’s annual report on Form 10-K, quarterly reports on Form 10-Q, current events reports on Form 8-K, and amendments to these reports, filed or furnished pursuant to Section 13(a) or 15(d)  of the Securities Exchange Act of 1934, as amended, are made available free of charge through the Company’s web site at www.firstcitizensbank.com as soon as reasonably practicable after such reports are filed with or furnished to  the Securities and Exchange Commission. Information on our website shall not be considered as incorporated by reference into this Form 10-K.
 
FIRST CITIZENS COMMUNITY BANK
 
The Bank is a full-service bank engaged in a broad range of banking activities and services for individual, business, governmental and institutional customers.  These activities and services principally include checking, savings, and time deposit accounts; residential, commercial and agricultural real estate, commercial and industrial, state and political subdivision and consumer loans; and a variety of other specialized financial services.  The Trust and Investment division of the Bank offers a full range of client investment, estate, mineral management and retirement services.
 
The Bank’s main office is located at 15 South Main Street, Mansfield, (Tioga County) Pennsylvania.  The Bank’s primary market area consists of the Pennsylvania Counties of Bradford, Clinton, Potter and Tioga in north central Pennsylvania.  It also includes Allegany, Steuben, Chemung and Tioga Counties in Southern New York.  With the completion of the FNB acquisition, the Bank has added seven additional banking offices in south central Pennsylvania; four offices in Lebanon Country, two offices in Schuylkill County, and one office in Berks County. The economy of the Bank’s market areas are diversified and include manufacturing industries, wholesale and retail trade, service industries, agricultural and the production of natural resources of gas and timber.  We are dependent geographically upon the economic conditions in both north central and south central Pennsylvania, as well as the southern tier of New York.  In addition to the main office in Mansfield and the additional seven offices acquired from FNB, the Bank has 16 other full service branch offices in its market areas.
 
As of December 31, 2015, the Bank had 229 full time employees and 51 part-time employees, resulting in 246 full time equivalent employees at our corporate offices and other banking locations.
 
COMPETITION
 
The banking industry in the Bank’s service area is intensely competitive, both among commercial banks and with financial service providers such as consumer finance companies, thrifts, investment firms, mutual funds, insurance companies, credit unions, mortgage banking firms, financial companies, financial affiliates of industrial companies, internet entities, and government sponsored agencies, such as Freddie Mac and Fannie Mae, provide additional competition for loans and other financial services.  The overall economy, which continues to be sluggish, has also increased competitive pressures particularly for entities seeking loan growth.  Additionally, north central Pennsylvania has benefited from additional wealth resulting from the exploration for natural gas in our primary market.  This has resulted in increased competition from brokerage firms and retirement fund management firms.  The Bank is generally competitive with all competing financial institutions in its service areas with respect to interest rates paid on time and savings deposits, service charges on deposit accounts and interest rates charged on loans.
 
 
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Additional information related to our business and competition is included in Part II, Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations”.
 
SUPERVISION AND REGULATION

GENERAL
 
The Bank is subject to extensive regulation, examination and supervision by the Pennsylvania Department of Banking (“PDB”) and, as a member of the Federal Reserve System, by the Board of Governors of the Federal Reserve System (the “FRB”).  Federal and state banking laws and regulations govern, among other things, the scope of a bank’s business, the investments a bank may make, the reserves against deposits a bank must maintain, terms of deposit accounts, loans a bank makes, the interest rates a bank charges and collateral a bank takes, the activities of a bank with respect to mergers and consolidations and the establishment of branches.  The Company is registered as a bank holding company and is subject to supervision and regulation by FRB under the Bank Holding Company Act of 1956, as amended (the “BHCA”).

PENNSYLVANIA BANKING LAWS
 
The Pennsylvania Banking Code (“Banking Code”) contains detailed provisions governing the organization, location of offices, rights and responsibilities of directors, officers, and employees, as well as corporate powers, savings and investment operations and other aspects of the Bank and its affairs. The Banking Code delegates extensive rule-making power and administrative discretion to the PDB so that the supervision and regulation of state chartered banks may be flexible and readily responsive to changes in economic conditions and in savings and lending practices.
 
Pennsylvania law also provides Pennsylvania state chartered institutions elective parity with the power of national banks, federal thrifts, and state-chartered institutions in other states as authorized by the FDIC, subject to a required notice to the PDB. The Federal Deposit Insurance Corporation Act (“FDIA”), however, prohibits state chartered banks from making new investments, loans, or becoming involved in activities as principal and equity investments which are not permitted for national banks unless (1) the FDIC determines the activity or investment does not pose a significant risk of loss to the Deposit Insurance Fund and (2) the bank meets all applicable capital requirements. Accordingly, the additional operating authority provided to the Bank by the Banking Code is restricted by the FDIA.
 
In April 2008, banking regulators in the States of New Jersey, New York, and Pennsylvania entered into a Memorandum of Understanding (the “Interstate MOU”) to clarify their respective roles, as home and host state regulators, regarding interstate branching activity on a regional basis pursuant to the Riegle-Neal Amendments Act of 1997. The Interstate MOU establishes the regulatory responsibilities of the respective state banking regulators regarding bank regulatory examinations and is intended to reduce the regulatory burden on state chartered banks branching within the region by eliminating duplicative host state compliance exams.  Under the Interstate MOU, the activities of branches we established in New York would be governed by Pennsylvania state law to the same extent that federal law governs the activities of the branch of an out-of-state national bank in such host states. Issues regarding whether a particular host state law is preempted are to be determined in the first instance by the PDB. In the event that the PDB and the applicable host state regulator disagree regarding whether a particular host state law is pre-empted, the PDB and the applicable host state regulator would use their reasonable best efforts to consider all points of view and to resolve the disagreement.
 
COMMUNITY REINVESTMENT ACT
 
The Community Reinvestment Act, (“CRA”), as implemented by FRB regulations, provides that the Bank has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods.  The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA.  The CRA requires the FRB, in connection with its examination of the Bank, to assess the institution’s record of meeting the credit needs of its community and to take such record into account in its evaluation of certain corporate applications by such institution, such as mergers and branching.  The Bank’s most recent rating was “Satisfactory.”  Various consumer laws and regulations also affect the operations of the Bank.  In addition to the impact of regulation, commercial banks are affected significantly by the actions of the FRB as it attempts to control the money supply and credit availability in order to influence the economy.
 
 
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THE DODD-FRANK ACT
 
The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) has significantly changed the current bank regulatory structure and will affect it into the immediate future the lending and investment activities and general operations of depository institutions and their holding companies.
 
The Dodd-Frank Act requires the FRB to establish minimum consolidated capital requirements for bank holding companies that are as stringent as those required for insured depository institutions; the components of Tier 1 capital would be restricted to capital instruments that are currently considered to be Tier 1 capital for insured depository institutions. In addition, the proceeds of trust preferred securities are excluded from Tier 1 capital unless (i) such securities are issued by bank holding companies with assets of less than $500 million or (ii) such securities were issued prior to May 19, 2010 by bank or savings and loan holding companies with less than $15 billion of assets. The exclusion of such proceeds are phased in over a three year period beginning in 2013.
 
The Dodd-Frank Act also created a new Consumer Financial Protection Bureau with extensive powers to implement and enforce consumer protection laws. The Consumer Financial Protection Bureau has broad rulemaking authority for a wide range of consumer protection laws that apply to all banks, among other things, including the authority to prohibit “unfair, deceptive or abusive” acts and practices. However, institutions of less than $10 billion in assets, such as the Bank, will continue to be examined for compliance with consumer protection and fair lending laws and regulations by, and be subject to the enforcement authority of, their prudential regulators.
 
The Dodd-Frank Act created a new supervisory structure for oversight of the U.S. financial system, including the establishment of a new council of regulators, the Financial Stability Oversight Council, to monitor and address systemic risks to the financial system. Non-bank financial companies that are deemed to be significant to the stability of the U.S. financial system and all bank holding companies with $50 billion or more in total consolidated assets will be subject to heightened supervision and regulation. The FRB will implement prudential requirements and prompt corrective action procedures for such companies.
 
The Dodd-Frank Act made many other changes in banking regulation. Those include allowing depository institutions, for the first time, to pay interest on business checking accounts, requiring originators of securitized loans to retain a percentage of the risk for transferred loans, establishing regulatory rate-setting for certain debit card interchange fees and establishing a number of reforms for mortgage originations. Effective October 1, 2011, the debit-card interchange fee was capped at $0.21 per transaction, plus an additional 5 basis point charge to cover fraud losses. These fees are much lower than the current market rates. Although the regulation only impacts banks with assets above $10 billion, we believe that the provisions could result in a reduction in interchange revenue in the future.
 
The Dodd-Frank Act also broadened the base for FDIC insurance assessments. The FDIC was required to promulgate rules revising its assessment system so that it is based on the average consolidated total assets less tangible equity capital of an insured institution instead of deposits. That rule took effect April 1, 2011. The Dodd-Frank Act also permanently increased the maximum amount of deposit insurance for banks, savings institutions and credit unions to $250,000 per depositor, retroactive to January 1, 2008.
 
Under provisions of the Dodd-Frank Act referred to as the “Volcker Rule” certain limitations are placed on the ability of bank holding companies and their affiliates to engage in sponsoring, investing in and transacting with certain investment funds, including hedge funds and private equity funds (collectively “covered funds”). The Volcker Rule also places restrictions on proprietary trading, which could impact certain hedging activities. The Volcker Rule became fully effective in July 2015. We do not expect this rule to have a material impact on the Company.
 
 
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The Dodd-Frank Act requires various federal agencies to promulgate numerous and extensive implementing regulations. Although the substance and scope of many of these regulations cannot be determined at this time, particularly those provisions relating to the new Consumer Financial Protection Bureau, the Dodd-Frank Act and implementing regulations may have a material impact on operations through, among other things, increased compliance costs, heightened regulatory supervision, and higher interest expense.
 
CURRENT CAPITAL REQUIREMENTS
 
Federal regulations require FDIC-insured depository institutions, including state-chartered, FRB-member banks, to meet several minimum capital standards.  These capital standards were effective January 1, 2015, and result from a final rule implementing regulatory amendments based on recommendations of the Basel Committee on Banking Supervision and certain requirements of the Dodd-Frank Act.
 
The capital standards require the maintenance of common equity Tier 1 capital, Tier 1 capital and total capital to risk-weighted assets of at least 4.5%, 6.0% and 8.0%, respectively, and a leverage ratio of at least 4% of Tier 1 capital.  Common equity Tier 1 capital is generally defined as common stockholders’ equity and retained earnings.  Tier 1 capital is generally defined as common equity Tier 1 and Additional Tier 1 capital.  Additional Tier 1 capital generally includes certain noncumulative perpetual preferred stock and related surplus and minority interests in equity accounts of consolidated subsidiaries.  Total capital includes Tier 1 capital (common equity Tier 1 capital plus Additional Tier 1 capital) and Tier 2 capital.  Tier 2 capital is comprised of capital instruments and related surplus meeting specified requirements, and may include cumulative preferred stock and long-term perpetual preferred stock, mandatory convertible securities, intermediate preferred stock and subordinated debt.  Also included in Tier 2 capital is the allowance for loan and lease losses limited to a maximum of 1.25% of risk-weighted assets and, for institutions that have exercised an opt-out election regarding the treatment of Accumulated Other Comprehensive Income (“AOCI”), up to 45% of net unrealized gains on available-for-sale equity securities with readily determinable fair market values.  The Company has exercised the AOCI opt-out option and therefore AOCI is not incorporated into common equity Tier 1 capital.  Calculation of all types of regulatory capital is subject to deductions and adjustments specified in the regulations.
 
In determining the amount of risk-weighted assets for purposes of calculating risk-based capital ratios, assets, including certain off-balance sheet assets (e.g., recourse obligations, direct credit substitutes, residual interests) are multiplied by a risk weight factor assigned by the regulations based on the risks believed inherent in the type of asset.  Higher levels of capital are required for asset categories believed to present greater risk.  For example, a risk weight of 0% is assigned to cash and U.S. government securities, a risk weight of 50% is generally assigned to prudently underwritten first lien one- to four-family residential mortgages, a risk weight of 100% is assigned to commercial and consumer loans, a risk weight of 150% is assigned to certain past due loans and a risk weight of between 0% to 600% is assigned to permissible equity interests, depending on certain specified factors.
 
In addition to establishing the minimum regulatory capital requirements, the regulations limit capital distributions by the institution and certain discretionary bonus payments to management if an institution does not hold a “capital conservation buffer” consisting of 2.5% of common equity Tier 1 capital to risk-weighted assets above the amount necessary to meet its minimum risk-based capital requirements.  The capital conservation buffer requirement is being phased in beginning January 1, 2016 at 0.625% of risk-weighted assets and increasing each year until fully implemented at 2.5% on January 1, 2019.
 
The FRB has authority to establish individual minimum capital requirements in appropriate cases upon a determination that an institution’s capital level is or may become inadequate in light of the particular risks or circumstances.
 
As of December 31, 2015, we met all applicable capital adequacy requirements.
 
PROMPT CORRECTIVE ACTION RULES
 
Federal law establishes a system of prompt corrective action to resolve the problems of undercapitalized institutions.  The law requires that certain supervisory actions be taken against undercapitalized institutions, the severity of which depends on the degree of undercapitalization.  The FRB has adopted regulations to implement the prompt corrective action legislation as to state member banks.  The regulations were amended to incorporate the previously mentioned increased regulatory capital standards that were effective January 1, 2015.  An institution is deemed to be “well capitalized” if it has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 8.0% or greater, a leverage ratio of 5.0% or greater and a common equity Tier 1 ratio of 6.5% or greater.  An institution is “adequately capitalized” if it has a total risk-based capital ratio of 8.0% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, a leverage ratio of 4.0% or greater and a common equity Tier 1 ratio of 4.5% or greater.  An institution is “undercapitalized” if it has a total risk-based capital ratio of less than 8.0%, a Tier 1 risk-based capital ratio of less than 6.0%, a leverage ratio of less than 4.0% or a common equity Tier 1 ratio of less than 4.5%.  An institution is deemed to be “significantly undercapitalized” if it has a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 4.0%, a leverage ratio of less than 3.0% or a common equity Tier 1 ratio of less than 3.0%.  An institution is considered to be “critically undercapitalized” if it has a ratio of tangible equity (as defined in the regulations) to total assets that is equal to or less than 2.0%.
 
 
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Subject to a narrow exception, a receiver or conservator must be appointed for an institution that is “critically undercapitalized” within specified time frames.  The regulations also provide that a capital restoration plan must be filed with the FRB within 45 days of the date an institution is deemed to have received notice that it is “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” Compliance with the capital restoration plan must be guaranteed by any parent holding company up to the lesser of 5% of the depository institution’s total assets when it was deemed to be undercapitalized or the amount necessary to achieve compliance with applicable capital requirements.  In addition, numerous mandatory supervisory actions become immediately applicable to an undercapitalized institution including, but not limited to, increased monitoring by regulators and restrictions on growth, capital distributions and expansion.  The FRB could also take any one of a number of discretionary supervisory actions, including the issuance of a capital directive and the replacement of senior executive officers and directors.  Significantly and critically undercapitalized institutions are subject to additional mandatory and discretionary measures.
 
STANDARDS FOR SAFETY AND SOUNDNESS
 
The federal banking agencies have adopted Interagency Guidelines prescribing Standards for Safety and Soundness in various areas such as internal controls and information systems, internal audit, loan documentation and credit underwriting, interest rate exposure, asset growth and quality, earnings and compensation, fees and benefits.  The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired.  If the FRB determines that a state member bank fails to meet any standard prescribed by the guidelines, the FRB may require the institution to submit an acceptable plan to achieve compliance with the standard.
 
ENFORCEMENT
 
The PDB maintains enforcement authority over the Bank, including the power to issue cease and desist orders and civil money penalties and remove directors, officers or employees.  The PDB also has the power to appoint a conservator or receiver for a bank upon insolvency, imminent insolvency, unsafe or unsound condition or certain other situations.  The FRB has primary federal enforcement responsibility over FRB-member state banks and has authority to bring actions against the institution and all institution-affiliated parties, including shareholders, who knowingly or recklessly participate in wrongful actions likely to have an adverse effect on the bank. Formal enforcement action may range from the issuance of a capital directive or a cease and desist order, to removal of officers and/or directors.  Civil penalties cover a wide range of violations and can amount to $25,000 per day, or even $1 million per day in especially egregious cases.  The FDIC, as deposit insurer, has the authority to recommend to the FRB that enforcement action be taken with respect to a member bank.  If the FRB does not take action, the FDIC has authority to take such action under certain circumstances.  In general, regulatory enforcement actions occur with respect to situations involving unsafe or unsound practices or conditions, violations of law or regulation or breaches of fiduciary duty.  Federal and Pennsylvania law also establish criminal penalties for certain violations.
 
REGULATORY RESTRICTIONS ON BANK DIVIDENDS
 
The Bank may not declare a dividend without approval of the FRB, unless the dividend to be declared by the Bank's Board of Directors does not exceed the total of:  (i) the Bank's net profits for the current year to date, plus (ii) its retained net profits for the preceding two years, less any required transfers to surplus.
 
 
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Under Pennsylvania law, the Bank may only declare and pay dividends from its accumulated net earnings.  In addition, the Bank may not declare and pay dividends from the surplus funds that Pennsylvania law requires that it maintain.  Under these policies and subject to the restrictions applicable to the Bank, the Bank could have declared, during 2015, without prior regulatory approval, aggregate dividends of approximately $9.2 million, plus net profits earned to the date of such dividend declaration.
 
BANK SECRECY ACT
 
Under the Bank Secrecy Act (BSA), banks and other financial institutions are required to retain records to assure that the details of financial transactions can be traced if investigators need to do so.  Banks are also required to report most cash transactions in amounts exceeding $10,000 made by or on behalf of their customers.  Failure to meet BSA requirements may expose the Bank to statutory penalties, and a negative compliance record may affect the willingness of regulating authorities to approve certain actions by the Bank requiring regulatory approval, including new branches.
 
INSURANCE OF DEPOSIT ACCOUNTS
 
The Bank’s deposits are insured up to applicable limits by the Deposit Insurance Fund (DIF) of the FDIC.  Under the FDIC’s risk-based assessment system, insured institutions are assigned to one of four risk categories based on supervisory evaluations, regulatory capital levels and certain other factors, with less risky institutions paying lower assessments.  An institution’s assessment rate depends upon the category to which it is assigned, and certain adjustments specified by FDIC regulations.  Until recently, assessment rates ranged from seven to 77.5 basis points of assessable deposits.
 
As required by the Dodd-Frank Act, the FDIC has issued final rules implementing changes to the assessment rules. The rules change the assessment base used for calculating deposit insurance assessments from deposits to total assets less tangible (Tier 1) capital. Since the new base is larger than the previous base, the FDIC also lowered assessment rates so that the rule would not significantly alter the total amount of revenue collected from the industry. The range of adjusted assessment rates is now 2.5 to 45 basis points of the new assessment base. The rule is expected to benefit smaller financial institutions, which typically rely more on deposits for funding, and shift more of the burden for supporting the insurance fund to larger institutions, which are thought to have greater access to nondeposit funding. No institution may pay a dividend if it is in default of its assessments.  As a result of the Dodd-Frank Act, deposit insurance per account owner is $250,000 for all types of accounts.
 
The Dodd-Frank Act increased the minimum target DIF ratio from 1.15% of estimated insured deposits to 1.35% of estimated insured deposits.  The FDIC must seek to achieve the 1.35% ratio by September 30, 2020.  Insured institutions with assets of $10 billion or more are supposed to fund the increase.  The Dodd-Frank Act eliminated the 1.5% maximum fund ratio, instead leaving it to the discretion of the FDIC. The FDIC has recently exercised that discretion by establishing a long range fund ratio of 2%.
 
The FDIC has authority to increase insurance assessments. A significant increase in insurance premiums would likely have an adverse effect on the operating expenses and results of operations of the Bank.  Management cannot predict what insurance assessment rates will be in the future.
 
Insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or regulatory condition imposed in writing.  The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance.
 
FEDERAL RESERVE SYSTEM
 
Under FRB regulations, the Bank is required to maintain reserves against its transaction accounts (primarily NOW and regular checking accounts). For 2016, the Bank is required to maintain average daily reserves equal to 3% on aggregate transaction accounts of up to $110.0 million, plus 10% on the remainder, and the first $15.2 million of otherwise reservable balances will be exempt. These reserve requirements are subject to annual adjustment by the FRB.  The Bank is in compliance with the foregoing requirements.
 
 
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ACQUISITION OF THE HOLDING COMPANY
 
Under the Federal Change in Bank Control Act (the “CIBCA”), a notice must be submitted to the FRB if any person (including a company), or group acting in concert, seeks to acquire 10% or more of the Company’s shares of outstanding common stock, unless the FRB has found that the acquisition will not result in a change in control of the Company. Under the CIBCA, the FRB generally has 60 days within which to act on such notices, taking into consideration certain factors, including the financial and managerial resources of the acquirer, the convenience and needs of the communities served by the Company and the Bank, and the anti-trust effects of the acquisition. Under the BHCA, any company would be required to obtain prior approval from the FRB before it may obtain “control” of the Company within the meaning of the BHCA. Control generally is defined to mean the ownership or power to vote 25% or more of any class of voting securities of the Company or the ability to control in any manner the election of a majority of the Company’s directors. An existing bank holding company would be required to obtain the FRB’s prior approval under the BHCA before acquiring more than 5% of the Company’s voting stock.
 
HOLDING COMPANY REGULATION
 
The Company, as a bank holding company, is subject to examination, supervision, regulation, and periodic reporting under the BHCA, as administered by the FRB.  The Company is required to obtain the prior approval of the FRB to acquire all, or substantially all, of the assets of any bank or bank holding company.  Prior FRB approval would be required for the Company to acquire direct or indirect ownership or control of any voting securities of any bank or bank holding company if it would, directly or indirectly, own or control more than 5% of any class of voting shares of the bank or bank holding company.
 
A bank holding company is generally prohibited from engaging in, or acquiring, direct or indirect control of more than 5% of the voting securities of any company engaged in nonbanking activities.  One of the principal exceptions to this prohibition is for activities found by the FRB to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.  Some of the principal activities that the FRB has determined by regulation to be closely related to banking are: (i) making or servicing loans; (ii) performing certain data processing services; (iii) providing securities brokerage services; (iv) acting as fiduciary, investment or financial advisor; (v) leasing personal or real property under certain conditions; (vi) making investments in corporations or projects designed primarily to promote community welfare; and (vii) acquiring a savings association.
 
A bank holding company that meets specified conditions, including that its depository institutions subsidiaries are “well capitalized” and “well managed,” can opt to become a “financial holding company.” A “financial holding company” may engage in a broader array of financial activities than permitted a typical bank holding company.  Such activities can include insurance underwriting and investment banking.  The Company does not anticipate opting for “financial holding company” status at this time.
 
The Company is subject to the FRB’s consolidated capital adequacy guidelines for bank holding companies.  Traditionally, those guidelines have been structured similarly to the regulatory capital requirements for the subsidiary depository institutions, but were somewhat more lenient.  For example, the holding company capital requirements allowed inclusion of certain instruments in Tier 1 capital that are not includable at the institution level.  As previously noted, the Dodd-Frank Act requires that the guidelines be amended so that they are at least as stringent as those required for the subsidiary depository institutions.  See  “—The Dodd-Frank Act.”
 
A bank holding company is generally required to give the FRB prior written notice of any purchase or redemption of then outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of the Company’s consolidated net worth.  The FRB may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe and unsound practice, or would violate any law, regulation, FRB order or directive, or any condition imposed by, or written agreement with, the FRB.  The FRB has adopted an exception to that approval requirement for well-capitalized bank holding companies that meet certain other conditions.
 
The FRB has issued a policy statement regarding the payment of dividends by bank holding companies.  In general, the FRB’s policies provide that dividends should be paid only out of current earnings and only if the prospective rate of earnings retention by the bank holding company appears consistent with the organization’s capital needs, asset quality and overall financial condition.  The FRB’s policies also require that a bank holding company serve as a source of financial strength to its subsidiary banks by using available resources to provide capital funds during periods of financial stress or adversity and by maintaining the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks where necessary.  The Dodd-Frank Act codified the source of strength policy and requires the promulgation of implementing regulations.  Under the prompt corrective action laws, the ability of a bank holding company to pay dividends may be restricted if a subsidiary bank becomes undercapitalized.  These regulatory policies could affect the ability of the Company to pay dividends or otherwise engage in capital distributions.
 
 
7

 
 
The Federal Deposit Insurance Act makes depository institutions liable to the Federal Deposit Insurance Corporation for losses suffered or anticipated by the insurance fund in connection with the default of a commonly controlled depository institution or any assistance provided by the Federal Deposit Insurance Corporation to such an institution in danger of default.  That law would have potential applicability if the Company ever held as a separate subsidiary a depository institution in addition to the Bank.
 
The status of the Company as a registered bank holding company under the Bank Holding Company Act will not exempt it from certain federal and state laws and regulations applicable to corporations generally, including, without limitation, certain provisions of the federal securities laws.
 
EFFECT OF GOVERNMENT MONETARY POLICIES
 
The earnings and growth of the banking industry are affected by the credit policies of monetary authorities, including the Federal Reserve System.  An important function of the Federal Reserve System is to regulate the national supply of bank credit in order to control recessionary and inflationary pressures.  Among the instruments of monetary policy used by the Federal Reserve to implement these objectives are open market activities in U.S. government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against member bank deposits.  These operations are used in varying combinations to influence overall economic growth and indirectly, bank loans, securities, and deposits.  These variables may also affect interest rates charged on loans or paid on deposits.  The monetary policies of the Federal Reserve authorities have had a significant effect on the operating results of commercial banks in the past and are expected to continue to have such an effect in the future.
 
In view of the changing conditions in the national economy and in the money markets, as well as the effect of actions by monetary and fiscal authorities including the Federal Reserve System, no prediction can be made as to possible changes in interest rates, deposit levels, loan demand or their effect on the business and earnings of the Company and the Bank.   Additional information is included under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing in this Annual Report on Form 10-K.
 
ITEM 1A – RISK FACTORS.
 
Changing interest rates may decrease our earnings and asset values.
 
Our net interest income is the interest we earn on loans and investments less the interest we pay on our deposits and borrowings.  Our net interest margin is the difference between the yield we earn on our assets and the interest rate we pay for deposits and our other sources of funding.  Changes in interest rates—up or down—could adversely affect our net interest margin and, as a result, our net interest income.  Although the yield we earn on our assets and our funding costs tend to move in the same direction in response to changes in interest rates, one can rise or fall faster than the other, causing our net interest margin to expand or contract.  Our liabilities tend to be shorter in duration than our assets, so they may adjust faster in response to changes in interest rates.  As a result, when interest rates rise, our funding costs may rise faster than the yield we earn on our assets, causing our net interest margin to contract until the asset yields catch up.   Changes in the slope of the “yield curve”—or the spread between short-term and long-term interest rates—could also reduce our net interest margin.  Normally, the yield curve is upward sloping, meaning short-term rates are lower than long-term rates.  Because our liabilities tend to be shorter in duration than our assets, when the yield curve flattens or even inverts, we could experience pressure on our net interest margin as our cost of funds increases relative to the yield we can earn on our assets.
 
 
8

 
 
Changes in interest rates also affect the value of the Bank’s interest-earning assets, and in particular the Bank’s securities portfolio.  Generally, the value of fixed-rate securities fluctuates inversely with changes in interest rates.  Unrealized gains and losses on securities available for sale are reported as a separate component of shareholder equity, net of tax.  Decreases in the fair value of securities available for sale resulting from increases in interest rates could have an adverse effect on shareholders’ equity.
 
Local economic conditions are impacted by the exploration and drilling activities for natural gas in the in the Marcellus and Utica Shale formations.
 
Our market area is predominately centered in the Marcellus and Utica Shale natural gas exploration and drilling area, and as a result, the economy in north central Pennsylvania has become increasingly influenced by the natural gas industry.  Loan demand, deposit levels and the market value of local real estate have been impacted by this activity.  While the Company does not lend to the various entities directly engaged in exploration, drilling or production activities, many of our customers provide transportation and other services and products that support natural gas exploration and production activities.  Therefore, our customers could be negatively impacted by the market price for natural gas as a significant downturn in this industry could impact the ability of our borrowers to repay their loans in accordance with their terms.  Additionally, exploration and drilling activities may be affected by federal, state and local laws and regulations such as restrictions on production, permitting, changes in taxes and environmental protection.  Regulatory and market pricing of natural gas could also impact and/or reduce demand for loans and deposit levels.  These factors could have a material adverse effect on our business, prospects, financial condition and results of operations.
 
Higher loan losses could require us to increase our allowance for loan losses through a charge to earnings.
 
When we loan money we incur the risk that our borrowers do not repay their loans. We reserve for loan losses by establishing an allowance through a charge to earnings. The amount of this allowance is based on our assessment of loan losses inherent in our loan portfolio. The process for determining the amount of the allowance is critical to our financial results and condition. It requires subjective and complex judgments about the future, including forecasts of economic or market conditions that might impair the ability of our borrowers to repay their loans. We might underestimate the loan losses inherent in our loan portfolio and have loan losses in excess of the amount reserved. We might increase the allowance because of changing economic conditions. For example, in a rising interest rate environment, borrowers with adjustable-rate loans could see their payments increase. There may be a significant increase in the number of borrowers who are unable or unwilling to repay their loans, resulting in our charging off more loans and increasing our allowance. In addition, when real estate values decline, the potential severity of loss on a real estate-secured loan can increase significantly, especially in the case of loans with high combined loan-to-value ratios. A decline in the national economy and the local economies of the areas in which the loans are concentrated could result in an increase in loan delinquencies, foreclosures or repossessions resulting in increased charge-off amounts and the need for additional loan loss allowances in future periods. In addition, bank regulators may require us to make a provision for loan losses or otherwise recognize further loan charge-offs following their periodic review of our loan portfolio, our underwriting procedures, and our loan loss allowance. Any increase in our allowance for loan losses or loan charge-offs as required by such regulatory authorities could have a material adverse effect on our financial condition and results of operations.
 
Our allowance for loan losses amounted to $7.1 million, or 1.02% of total loans outstanding and 99.3% of nonperforming loans, at December 31, 2015. Our allowance for loan losses at December 31, 2015 may not be sufficient to cover future loan losses. A large loss could deplete the allowance and require increased provisions to replenish the allowance, which would decrease our earnings. In addition, at December 31, 2015, we had a total of 29 loan relationships with outstanding balances that exceeded $3.0 million, 28 of which were performing according to their original terms. However, the deterioration of one or more of these loans could result in a significant increase in our nonperforming loans and our provision for loan losses, which would negatively impact our results of operations.
 
Our emphasis on commercial real estate, agricultural, construction and municipal lending may expose us to increased lending risks.
 
At December 31, 2015, we had $237.5 million in loans secured by commercial real estate, $57.8 million in agricultural loans, $15.0 million in construction loans and $98.5 million in municipal loans. Commercial real estate loans, agricultural, construction and municipal loans represented 34.2%, 8.3%, 2.2% and 14.1%, respectively, of our loan portfolio.  At December 31, 2015, we had $4.4 million of reserves specifically allocated to these loan types.  While commercial real estate, agricultural, construction and municipal loans are generally more interest rate sensitive and carry higher yields than do residential mortgage loans, these types of loans generally expose a lender to greater risk of non-payment and loss than single-family residential mortgage loans because repayment of the loans often depends on the successful operation of the property, the income stream of the borrowers and, for construction loans, the accuracy of the estimate of the property’s value at completion of construction and the estimated cost of construction.  Such loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to single-family residential mortgage loans.
 
 
9

 

Loan participations have been a significant source of loan originations in recent periods and a decline in loan participation volume could hurt profits and slow loan growth.

We have actively engaged in loan participations in recent periods whereby we are invited to participate in loans, primarily commercial real estate and municipal loans, originated by another financial institution known as the lead lender.  We have participated with other financial institutions in both our primary markets and out of market areas. Loan participations accounted for approximately $14.3 million, $14.4 million and $13.1 million, or 37.6%, 100% and 50.4% of the Company’s net organic loan growth during 2013, 2014 and 2015, respectively.  Our profits and loan growth could be significantly and adversely affected if the volume of loan participations would materially decrease, whether because loan demand declines, loan payoffs, lead lenders may come to perceive us as a potential competitor in their respective market areas, or otherwise.
 
If we conclude that the decline in value of any of our investment securities is other than temporary, we are required to write down the value of that security through a charge to earnings.
 
We review our investment securities portfolio monthly and at each quarter-end reporting period to determine whether the fair value is below the current carrying value. When the fair value of any of our investment securities has declined below its carrying value, we are required to assess whether the decline is other than temporary. If we conclude that the decline is other than temporary, we are required to write down the value of that security through a charge to earnings. As of December 31, 2015, our investment portfolio included available for sale investment securities with an amortized cost of $356.4 million and a fair value of $359.7 million, which included unrealized losses on 91 securities totaling $801,000.  Changes in the expected cash flows of these securities and/or prolonged price declines may result in our concluding in future periods that the impairment of these securities is other than temporary, which would require a charge to earnings to write down these securities to their fair value. Any charges for other-than-temporary impairment would not impact cash flow, tangible capital or liquidity.
 
Failure to resolve the Pennsylvania state budget impasse could hurt our profits, asset values and liquidity.
 
The Company makes loans to, invests in securities issued by, and maintains deposit accounts of Pennsylvania municipalities, primarily school districts.  Until funding was distributed in January 2016, the state budget impasse resulted in the non-receipt by municipalities of state subsidies, which is a significant source of cash flow needed to meet their financial obligations.  If the budget impasse remains unresolved, we may incur losses on loans granted to municipalities as well as incur losses, including impairment losses as a result of credit rating downgrades or otherwise, on municipal securities in which we invest.  The continuing budget impasse may also reduce municipal funds on deposit with the Company, which could hurt our liquidity and our earnings if we would have to resort to higher cost funding sources to meet our liquidity needs.
 
Income from secondary mortgage market operations is volatile, and we may incur losses or charges with respect to our secondary mortgage market operations which would negatively affect our earnings.
 
We generally sell in the secondary market the longer term fixed-rate residential mortgage loans that we originate, earning non-interest income in the form of gains on sale. When interest rates rise, the demand for mortgage loans tends to fall and may reduce the number of loans available for sale. Furthermore, the prolonged low interest rate environment has reduced the demand for loans available for sale.  In addition to interest rate levels, weak or deteriorating economic conditions also tend to reduce loan demand. Although we sell loans in the secondary market without recourse, we are required to give customary representations and warranties to the buyers. If we breach those representations and warranties, the buyers can require us to repurchase the loans and we may incur a loss on the repurchase. Because we generally retain the servicing rights on the loans we sell in the secondary market, we are required to record a mortgage servicing right asset, which we test annually for impairment. The value of mortgage servicing rights tends to increase with rising interest rates and to decrease with falling interest rates. If we are required to take an impairment charge on our mortgage servicing rights our earnings would be adversely affected.
 
 
10

 
 
As a result of the acquisition of FNB, the Bank acquired a portfolio of loans sold to the FHLB, which were sold under the Mortgage Partnership Finance Program ("MPF"). The Bank is no longer an active participant in the MPF program. The MPF portfolio balance was $40,437,000 at December 31, 2015, respectively. The FHLB maintains a first-loss position for the MPF portfolio that totals $104,000. Should the FHLB exhaust its first-loss position, recourse to the Bank's credit enhancement would be up to the next $4,345,000 of losses. The Bank has not experienced any losses for the MPF portfolio.
 
The Company’s financial condition and results of operations are dependent on the economy in the Bank’s market area.
 
The Bank’s primary market area consists of the Pennsylvania Counties of Bradford, Clinton, Potter, and Tioga in north central Pennsylvania and Allegany, Steuben, Chemung and Tioga Counties in southern New York.  With the acquisition of FNB, south central Pennsylvania counties of Lebanon, Schuylkill and Berks represents a new market area.  As of December 31, 2015, management estimates that approximately 92.1% of deposits and 77.0% of loans came from households whose primary address is located in the Bank’s primary market area.  Because of the Bank’s concentration of business activities in its market area, the Company’s financial condition and results of operations depend upon economic conditions in its market area.  Adverse economic conditions in our market areas could reduce our growth rate, affect the ability of our customers to repay their loans and generally affect our financial condition and results of operations.  Conditions such as inflation, recession, unemployment, high interest rates and short money supply and other factors beyond our control may adversely affect our profitability.  We are less able than a larger institution to spread the risks of unfavorable local economic conditions across a large number of diversified economies.  Any sustained period of increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions in the States of Pennsylvania and New York could adversely affect the value of our assets, revenues, results of operations and financial condition.  Moreover, we cannot give any assurance we will benefit from any market growth or favorable economic conditions in our primary market areas if they do occur.
 
A return of recessionary conditions could result in increases in our level of nonperforming loans and/or reduce demand for our products and services, which could have an adverse effect on our results of operations.
 
Although the U.S. economy is not currently in a recession, economic growth has been slow and uneven, and the percentage of people out of the workforce or uemployed remains elevated. A return to prolonged deteriorating economic conditions and/or continued negative developments in the domestic and international credit markets could significantly affect the markets in which we do business, the value of our loans and investments, and our ongoing operations, costs and profitability. These events may cause us to incur losses and may adversely affect our financial condition and results of operations.
 
We may fail to realize all of the anticipated benefits of the acquisition of FNB.
 
With the FNB acquisition, the Company entered into a new banking market area.  The success of the FNB acquisition will depend upon, in part, the Company’s ability to realize the anticipated benefits and cost savings from combining the businesses of the Company and FNB.  To realize these anticipated benefits and cost savings, the businesses must be successfully combined and operated.  If the Company is not able to achieve these objectives, the anticipated benefits, including growth and cost savings related to the combined businesses, may not be realized at all or may take longer to realize than expected.  If the Company fails to realize the anticipated benefits of the acquisition, the Company’s results of operations could be adversely affected.
 
Regulation of the financial services industry is undergoing major changes, and future legislation could increaseour cost of doing business or harm our competitive position.
 
We are subject to extensive regulation, supervision and examination by the FRB and the PDB, our primary regulators, and by the FDIC, as insurer of our deposits. Such regulation and supervision governs the activities in which an institution and its holding company may engage and are intended primarily for the protection of the insurance fund and the depositors and borrowers of the Bank rather than for holders of our common stock. Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on our operations, the classification of our assets and determination of the level of our allowance for loan losses. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, legislation or supervisory action, may have a material impact on our profitability and operations. Future legislative changes could require changes to business practices or force us to discontinue businesses and potentially expose us to additional costs, liabilities, enforcement action and reputational risk.
 
 
11

 
 
We are periodically subject to examination and scrutiny by a number of banking agencies and, depending upon the findings and determinations of these agencies, we may be required to make adjustments to our business that could adversely affect us.
 
Federal and state banking agencies periodically conduct examinations of our business, including compliance with applicable laws and regulations. If, as a result of an examination, a banking agency was to determine that the financial condition, capital resources, asset quality, asset concentration, earnings prospects, management, liquidity, sensitivity to market risk or other aspects of any of our operations has become unsatisfactory, or that we or our management is in violation of any law or regulation, it could take a number of different remedial actions as it deems appropriate. These actions include the power to enjoin “unsafe or unsound” practices, to require affirmative actions to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in our capital, to restrict our growth, to change the asset composition of our portfolio or balance sheet, to assess civil monetary penalties against our officers or directors, to remove officers and directors and, if it is concluded that such conditions cannot be corrected or there is an imminent risk of loss to depositors, to terminate our deposit insurance.  If we become subject to such regulatory actions, our business, results of operations and reputation may be negatively impacted.
 
Strong competition within the Bank’s market areas could hurt profits and slow growth.
 
The Bank faces intense competition both in making loans and attracting deposits.  This competition has made it more difficult for the Bank to make new loans and at times has forced the Bank to offer higher deposit rates.  Price competition for loans and deposits might result in the Bank earning less on loans and paying more on deposits, which would reduce net interest income.  Competition also makes it more difficult to increase the volume of our loan and deposit portfolios.  As of June 30, 2015, which is the most recent date for which information is available, we held 35.5% of the FDIC insured deposits in Bradford, Potter and Tioga Counties, Pennsylvania, which was the largest share of deposits out of eight financial institutions with offices in the area, and 6.1% of the FDIC insured deposits in Allegany County, New York, which was the fourth largest share of deposits out of five financial institutions with offices in this area. As of June 30, 2015, which is prior to the acquisition by the Company, FNB held 6.9% of the deposits in Lebanon County, Pennsylvania. This data does not include deposits held by credit unions. Competition also makes it more difficult to hire and retain experienced employees.  Some of the institutions with which the Bank competes have substantially greater resources and lending limits than the Bank has and may offer services that the Bank does not provide.  Management expects competition to increase in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry.  The Bank’s profitability depends upon its continued ability to compete successfully in its market area.
 
We rely on our management and other key personnel, and the loss of any of them may adversely affect our operations.
 
We are and will continue to be dependent upon the services of our executive management team. In addition, we will continue to depend on our ability to retain and recruit key commercial loan officers. The unexpected loss of services of any key management personnel or commercial loan officers could have an adverse effect on our business and financial condition because of their skills, knowledge of our market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.
 
Environmental liability associated with lending activities could result in losses.
 
In the course of our business, we may foreclose on and take title to properties securing our loans.  If hazardous substances were discovered on any of these properties, we could be liable to governmental entities or third parties for the costs of remediation of the hazard, as well as for personal injury and property damage.  Many environmental laws can impose liability regardless of whether we knew of, or were responsible for, the contamination.  In addition, if we arrange for the disposal of hazardous or toxic substances at another site, we may be liable for the costs of cleaning up and removing those substances from the site even if we neither own nor operate the disposal site.  Environmental laws may require us to incur substantial expenses and may materially limit use of properties we acquire through foreclosure, reduce their value or limit our ability to sell them in the event of a default on the loans they secure.  In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability.
 
 
12

 
 
Our ability to pay dividends is limited by law.
 
Our ability to pay dividends to our shareholders largely depends on our receipt of dividends from the Bank. The amount of dividends that the Bank may pay to us is limited by federal and state laws and regulations. We also may decide to limit the payment of dividends even when we have the legal ability to pay them in order to retain earnings for use in our business.
 
Federal and state banking laws, our articles of incorporation and our by-laws may have an anti-takeover effect.
 
Federal law imposes restrictions, including regulatory approval requirements, on persons seeking to acquire control over us.  Pennsylvania law also has provisions that may have an anti-takeover effect.  These provisions may serve to entrench management or discourage a takeover attempt that shareholders consider to be in their best interest or in which they would receive a substantial premium over the current market price.
 
We are subject to certain risks in connection with our use of technology
 
Communications and information systems are essential to the conduct of our business, as we use such systems to manage our customer relationships, our general ledger, our deposits, our loans, and to deliver on-line and electronic banking services. Our operations rely on the secure processing, storage, and transmission of confidential and other information in our computer systems and networks. Although we take protective measures and endeavor to modify them as circumstances warrant, the security of our computer systems, software, and networks may be vulnerable to breaches, unauthorized access, misuse, computer viruses, or other malicious code and cyber attacks that could have a security impact.
 
In addition, breaches of security may occur through intentional or unintentional acts by those having authorized or unauthorized access to our confidential or other information or the confidential or other information of our customers, clients, or counterparties. If one or more of such events were to occur, the confidential and other information processed and stored in, and transmitted through, our computer systems and networks could potentially be jeopardized, or could otherwise cause interruptions or malfunctions in our operations or the operations of our customers, clients, or counterparties. This could cause us significant reputational damage or result in our experiencing significant losses from fraud or otherwise.
 
Furthermore, we may be required to expend significant additional resources to modify our protective measures or to investigate and remediate vulnerabilities or other exposures arising from operational and security risks. Also, we may be subject to litigation and financial losses that are either not insured against or not fully covered through any insurance we maintain.
 
In addition, we routinely transmit and receive personal, confidential, and proprietary information by e-mail and other electronic means. We have discussed and worked with our customers, clients, and counterparties to develop secure transmission capabilities, but we do not have, and may be unable to put in place, secure capabilities with all of these constituents, and we may not be able to ensure that these third parties have appropriate controls in place to protect the confidentiality of such information. Any interception, misuse, or mishandling of personal, confidential, or proprietary information being sent to or received from a customer, client, or counterparty could result in legal liability, regulatory action, and reputational harm, and could have a significant adverse effect on our competitive position, financial condition, and results of operations.
 
Our risk management framework may not be effective in mitigating risks and/or losses to us.
 
We have implemented a risk management framework to manage our risk exposure. This framework is comprised of various processes, systems and strategies, and is designed to manage the types of risk to which we are subject, including, among others, credit, market, liquidity, interest rate and compliance. Our framework also includes financial or other modeling methodologies which involve management assumptions and judgment. There is no assurance that our risk management framework will be effective under all circumstances or that it will adequately mitigate any risk or loss to us. If our framework is not effective, we could suffer unexpected losses and our business, financial condition, results of operations or prospects could be materially and adversely affected. We may also be subject to potentially adverse regulatory consequences.
 
 
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ITEM 1B – UNRESOLVED STAFF COMMENTS.
 
Not applicable.
 
ITEM 2 – PROPERTIES.
 
The headquarters of the Company and Bank are located at 15 South Main Street, Mansfield, Pennsylvania. The building contains the central offices of the Company and Bank. Our bank owns twenty one banking facilities and leases four other facilities. All buildings owned by the Bank are free of any liens or encumbrances.
 
The net book value of owned banking facilities and leasehold improvements totaled $16,317,000 as of December 31, 2015.  The properties are adequate to meet the needs of the employees and customers. We have equipped all of our facilities with current technological improvements for data processing.
 
ITEM 3 - LEGAL PROCEEDINGS.
 
The Company is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business.  Such routine legal proceedings in the aggregate are believed by management to be immaterial to the Company's financial condition or results of operations.

ITEM 4 – MINE SAFETY DISCLOSURES
 
Not applicable.

 
14

 
 
PART II
 
ITEM 5 - MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
 
The Company's stock is not listed on any stock exchange, but it is quoted on the OTC Pink Market under the trading symbol CZFS.  Prices presented in the table below are bid prices between broker-dealers published by the OTC Pink Market and the Pink Sheets Electronic Quotation Service.  The prices do not include retail markups or markdowns or any commission to the broker-dealer.  The bid prices do not necessarily reflect prices in actual transactions.  Cash dividends are declared on a quarterly basis and are summarized in the table below
 
 
Dividends
   
Dividends
 
2015
declared
2014
declared
 
High
Low
per share
High
Low
per share
First quarter
 $      53.63
 $      49.39
 $      0.405
 $    52.56
 $     47.00
 $        0.385
Second quarter
         50.14
         48.00
         0.405
       53.56
        50.02
           0.385
Third quarter
         49.89
         45.50
         0.510
       52.59
        50.86
           1.000
Fourth quarter
         49.22
         45.50
         0.410
       53.34
        51.51
           0.400
 
The Company has paid dividends since April 30, 1984, the effective date of our formation as a bank holding company. The Company's Board of Directors expects that comparable cash dividends will continue to be paid by the Company in the future; however, future dividends necessarily depend upon earnings, financial condition, appropriate legal restrictions and other factors in existence at the time the Board of Directors considers a dividend policy. Cash available for dividend distributions to stockholders of the Company comes primarily from dividends paid to the Company by the Bank. Therefore, restrictions on the ability of the Bank to make dividend payments are directly applicable to the Company.  Under the Pennsylvania Business Corporation Law of 1988, the Company may pay dividends only if, after payment, the Company would be able to pay debts as they become due in the usual course of our business and total assets will be greater than the sum of total liabilities.  These regulatory policies could affect the ability of the Company to pay dividends or otherwise engage in capital distributions. Also see “Supervision and Regulation – Regulatory Restrictions on Bank Dividends,” “Supervision and Regulation – Holding Company Regulation,” and “Note 14 – Regulatory Matter” to the consolidated financial statements.
 
As of February 23, 2016, the Company had approximately 1,738 stockholders of record.  The computation of stockholders of record excludes investors whose shares were held for them by a bank or broker at that date. The following table presents information regarding the Company’s stock repurchases during the three months ended December 31, 2015:
 
Period
Total Number of
Shares (or units
Purchased)
Average Price
Paid per
Share (or
Unit)
Total Number of Shares (or
Units) Purchased as Part of
Publicly Announced Plans of
Programs
Maximum Number (or
Approximate Dollar Value) of
Shares (or Units) that May Yet Be
Purchased Under the Plans or
Programs (1)
         
10/1/15 to 10/31/15
                                 1
$48.15
                                          1
                                 176,746
11/1/15 to 11/31/15
                          3,147
$46.00
                                   3,147
                                 173,599
12/1/15 to 12/31/15
                               63
$46.00
                                        63
                                 173,536
Total
                          3,211
$46.00
                                   3,211
                                 173,536
 
(1)  
On January 17, 2012, the Company announced that the Board of Directors authorized the Company to repurchase up to 140,000 shares.  The repurchases will be conducted through open-market purchases or privately negotiated transactions and will be made from time to time depending on market conditions and other factors.  No time limit was placed on the duration of the share repurchase program.  Any repurchased shares will be held as treasury stock and will be available for general corporate purposes.
 
(2)  
On October 20, 2015, the Company announced that the Board of Directors authorized the Company to repurchase up to an additional 150,000 shares.  The repurchases will be conducted through open-market purchases or privately negotiated transactions and will be made from time to time depending on market conditions and other factors.  No time limit was placed on the duration of the share repurchase program.  Any repurchased shares will be held as treasury stock and will be available for general corporate purposes.
 
 
15

 
 
Set forth below is a line graph comparing the yearly dollar changes in the cumulative shareholder return on the Company’s common stock against the cumulative total return of the S&P 500 Stock index, SNL Mid-Atlantic Bank Index and SNL Bank $500 Million to $1 Billion index for the period of seven fiscal years assuming the investment of $100.00 on December 31, 2008 and assuming the reinvestment of dividends. The $1 Billion to $5 Billion Index was added to the chart in 2015 due to the Company exceeding $1.0 billion in assets in December as a result of the FNB acquisition.  The shareholder return shown on the graph below is not necessarily indicative of future performance and was obtained from SNL Financial LC, Charlottesville, VA.
 
 
 
Period Ending
       
Index
12/31/08
12/31/09
12/31/10
12/31/11
12/31/12
12/31/13
12/31/14
12/31/15
Citizens Financial Services, Inc.
100.00
139.87
210.87
204.87
268.13
362.46
378.63
358.26
S&P 500
100.00
126.46
145.51
148.59
172.37
228.19
259.43
263.02
SNL Mid-Atlantic Bank
100.00
105.27
122.81
92.26
123.59
166.59
181.49
188.30
 SNL Bank $1B-$5B       100.00 71.68  81.25  74.10  91.37  132.87  138.93  155.51
SNL Bank $500M-$1B
100.00
95.24
103.96
91.46
117.25
152.05
166.81
188.27
 
 
16

 
 
ITEM 6 - SELECTED FINANCIAL DATA.
 
The following table sets forth certain financial data as of and for each of the years in the five year period ended December 31, 2015:
 
(in thousands, except share data)
2015
2014
2013
2012
2011
Interest and dividend income
 $     35,653
 $      35,291
 $     36,234
 $     38,085
 $    38,293
Interest expense
4,820
4,953
          6,315
          7,659
          9,683
Net interest income
30,833
30,338
        29,919
        30,426
        28,610
Provision for loan losses
 480
585
              405
              420
             675
Net interest income after provision
         
  for loan losses
30,353
29,753
        29,514
        30,006
        27,935
Non-interest income
6,994
6,740
          6,982
          7,364
          6,625
Investment securities gains, net
429
616
              441
              604
             334
Non-interest expenses
23,429
20,165
        19,810
        19,428
        18,452
Income before provision for income taxes
14,347
16,944
        17,127
        18,546
        16,442
Provision for income taxes
2,721
3,559
          3,752
          4,331
          3,610
Net income
 $     11,626
 $      13,385
 $     13,375
 $     14,215
 $    12,832
           
Per share data:
         
Net income - Basic (1)
 $         3.84
 $          4.41
 $         4.38
 $         4.61
 $         4.12
Net income - Diluted (1)
3.83
4.40
             4.38
             4.60
            4.12
Cash dividends declared (1)
1.73
2.17
             1.21
             1.49
            1.08
Stock dividend
0%
1%
5%
1%
1%
Book value (1) (2)
35.97
32.83
          30.64
          27.62
          24.64
           
End of Period Balances:
         
Total assets
 $1,162,984
 $    925,048
 $  914,934
 $  882,427
 $  878,567
Total investments
359,737
306,146
      317,301
      310,252
     318,823
Loans
695,031
554,105
      540,612
      502,463
     487,509
Allowance for loan losses
7,106
6,815
          7,098
          6,784
          6,487
Total deposits
988,031
773,933
      748,316
      737,096
     733,993
Total borrowings
41,631
41,799
        66,932
        46,126
        53,882
Stockholders' equity
119,760
100,528
        92,056
        89,475
        81,468
           
Key Ratios
         
Return on assets (net income to average total assets)
1.22%
1.48%
1.51%
1.62%
1.52%
Return on equity (net income to average total equity)
11.20%
13.73%
14.89%
17.48%
17.86%
Equity to asset ratio (average equity to average total assets,
         
  excluding other comprehensive income)
10.91%
10.74%
10.13%
9.26%
8.49%
Net interest margin
3.76%
3.84%
3.87%
3.99%
3.94%
Efficiency
54.50%
48.61%
48.12%
46.10%
46.23%
Dividend payout ratio (dividends declared divided by net income)
46.00%
49.32%
27.63%
32.37%
26.30%
Tier 1 leverage
11.01%
10.99%
10.42%
9.70%
8.83%
Common equity risk based capital
14.14%
N/A
N/A
N/A
N/A
Tier 1 risk-based capital
15.20%
17.30%
16.44%
16.21%
14.94%
Total risk-based capital
16.23%
18.55%
17.75%
17.50%
16.23%
Nonperforming assets/total loans
1.22%
1.67%
1.88%
1.83%
2.11%
Nonperforming loans/total loans
1.03%
1.34%
1.63%
1.71%
1.94%
Allowance for loan losses/total loans
1.02%
1.23%
1.31%
1.35%
1.33%
Net charge-offs/average loans
0.03%
0.16%
0.02%
0.02%
0.02%
           
(1) Amounts were adjusted to reflect stock dividends.
         
(2) Calculation excludes accumulated other comprehensive income (loss).
       
 
 
17

 

ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
 
CAUTIONARY STATEMENT
 
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 the Company, the Bank, First Citizens Insurance Agency, Inc. or the Company on a consolidated basis. When we use words such as “believes,” “expects,” “anticipates,” or similar expressions, we are making forward-looking statements.  Forward-looking statements may prove inaccurate. For a variety of reasons, actual results could differ materially from those contained in or implied by forward-looking statements:
 
 
·
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 financial 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 be unable 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 or operating results.
 
·
We may become subject to new and unanticipated accounting, tax, or regulatory practices or requirements.
 
·
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.
 
·
The agricultural economy is subject to extreme swings in both the costs of resources and the prices received from the sale of products, which could negatively impact our customers.
 
·
The budget impasse in the Commonwealth of Pennsylvania could impact our asset values, liquidity and profitability.
 
·
Companies providing support services related to the exploration and drilling of the natural gas reserves 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. Additionally, the activities the companies providing support services related to the exploration and drilling of the natural gas reserves may be dependent on the market price of natural gas.  As a result, decreases in the market price of natural gas could also negatively impact these companies, our customers.
 
Additional factors are discussed in this Annual Report on Form 10-K under “Item 1A. Risk Factors.”  These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.  Forward-looking statements speak only as of the date they are made and the Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date of the forward-looking statements or to reflect the occurrence of unanticipated events. Accordingly, past results and trends should not be used by investors to anticipate future results or trends.
 
INTRODUCTION
 
The following is management’s discussion and analysis of the significant changes in financial condition, 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 audited consolidated financial statements and related notes. Except as noted, tabular information is presented in thousands of dollars.
 
 
18

 
 
Our Company currently engages in the general business of banking throughout our service area of Potter, Tioga, Clinton and Bradford counties in north central Pennsylvania, Lebanon, Berks and Schuylkill counties in south central Pennsylvania and Allegany county in southern New York. We maintain our central office in Mansfield, Pennsylvania. Presently we operate 25 banking facilities, 24 of which operate as bank branches.  In Pennsylvania, these offices are located in Mansfield, Blossburg, Ulysses, Genesee, Wellsboro, Troy, Sayre, Canton, Gillett, Millerton, LeRaysville, Towanda, Rome, the Mansfield Wal-Mart Super Center, Mill Hall, Schuylkill Haven, Friedensburg, Mt. Aetna, Fredericksburg and three branches near the city of Lebanon, Pennsylvania. In New York, our office is in Wellsville.
 
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 policies 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, which could include identify theft, or theft of customer information through third parties. 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.  We cannot anticipate additional requirements or additional compliance efforts regarding the Bank Secrecy Act, Dodd-Frank Act or USA Patriot Act, or regulatory burdens regarding the ever increasing information theft and fraudulent activities impacting our customers and the banking industry in general.
 
Readers should carefully review the risk factors described in other documents our Company files with the SEC, including the annual reports on Form 10-K, the quarterly reports on Form 10-Q and any current reports on Form 8-K filed by us.
 
TRUST AND INVESTMENT SERVICES; OIL AND GAS SERVICES
 
Our Investment and Trust Division is committed to helping our customers meet their financial goals.  The Trust Division offers professional trust administration, investment management services, estate planning and administration, custody of securities and individual retirement accounts.  Assets held by the Bank 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 Bank. As of December 31, 2015 and 2014, assets owned and invested by customers of the Bank through the Bank’s investment representatives totaled $119.7 million and $111.7 million, respectively.  Additionally, as summarized in the table below, the Trust Department had assets under management as of December 31, 2015 and 2014 of $110.2 million and $100.7 million, respectively. The increase in assets under management is due to several factors with the primary increased being due to the acquisition of FNB, which increased assets under management by $12.4 million. The Company also assigned a value to mineral rights in 2015 that resulted in a $2.8 million increase. These increases were offset by net withdrawals/account closings of $6.2 million. Changes in market values resulted in an approximately $500,000 increase in assets under management.
 
 
19

 
 
(market values - in thousands)
2015
2014
INVESTMENTS:
   
Bonds
 $         16,425
 $         15,558
Stock
            18,574
            17,925
Savings and Money Market Funds
            12,437
            12,395
Mutual Funds
            58,644
            53,456
Mineral interests
              2,781
                      -
Mortgages
                 686
                 701
Real Estate
                 565
                 637
Miscellaneous
                   68
                   49
TOTAL
 $       110,180
 $       100,721
ACCOUNTS:
   
Trusts
            26,746
            21,268
Guardianships
              1,274
              1,684
Employee Benefits
            46,888
            41,289
Investment Management
            35,268
            36,478
Custodial
                     4
                     2
TOTAL
 $       110,180
 $       100,721
 
Our financial consultants offer full service brokerage and financial planning services throughout the Bank’s market areas.  Appointments can be made at any Bank branch.  Products such as mutual funds, annuities, health and life insurance are made through our insurance subsidiary, First Citizens Insurance Agency, Inc.
 
In addition to the trust and investment services offered we have a mineral management division, 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. As of December 31, 2015, customers owning 6,653 acres have signed agreements with the Bank that provide for the Bank to manage oil and gas matters related to the customers land, which may include negotiating lease payments and royalty percentages, resolving leasing issues, accounting for and ensuring the accuracy of royalty checks, distributing revenue to satisfy investment objectives and providing customized reports outlining payment and distribution information.
 
RESULTS OF OPERATIONS
 
Net income for the year ended December 31, 2015 was $11,626,000, which represents a decrease of $1,759,000, or 13.1%, when compared to the 2014 related period.  Net income for the year ended December 31, 2014 was $13,385,000, which represents an increase of $10,000, or 0.1%, when compared to the 2013 related period.  Basic earnings per share were $3.84, $4.41, and $4.38 for the years ended 2015, 2014 and 2013, respectively. Diluted earnings per share were $3.83, $4.40 and  $4.38 for the years ended 2015, 2014 and 2013, respectively.
 
Net income is influenced by five key components: net interest income, provision for loan losses, non-interest income, non-interest expenses, and the provision for income taxes.
 
Net Interest Income
 
The most significant source of revenue is net interest income; the amount of interest earned on interest-earning assets exceeding interest paid on interest-bearing liabilities.  Factors that influence net interest income are changes in volume of interest-earning assets and interest-bearing liabilities as well as changes in the associated interest rates.
 
The following table sets forth our Company’s average balances of, and the interest earned or incurred on, each principal category of assets, liabilities and stockholders’ equity, the related rates, net interest income and rate “spread” created. It should be noted that average balances and rates for 2015 were slightly impacted by the acquisition of FNB, which closed on December 11, 2015:
 
 
20

 
 
Analysis of Average Balances and Interest Rates
 
2015
2014
2013
 
Average
 
Average
Average
 
Average
Average
 
Average
 
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
(dollars in thousands)
$
$
%
$
$
%
$
$
%
ASSETS
                 
Short-term investments:
                 
   Interest-bearing deposits at banks
       12,218
           20
0.16
        8,479
9
0.11
      15,024
         25
0.17
Total short-term investments
       12,218
           20
0.16
        8,479
9
0.11
      15,024
         25
0.17
Interest bearing time deposits at banks
          6,215
        122
1.97
        3,651
73
2.00
           743
         15
2.02
Investment securities:
                 
  Taxable
     202,991
     3,320
1.64
    212,338
3,531
1.66
    215,746
    3,807
1.76
  Tax-exempt (3)
       97,852
     4,776
4.88
      96,954
5,082
5.24
      92,911
    5,159
5.55
  Total investment securities
     300,843
     8,096
2.69
    309,292
8,613
2.78
    308,657
    8,966
2.90
Loans:
                 
  Residential mortgage loans
     182,877
   10,059
5.50
    187,057
10,582
5.66
    181,887
  10,941
6.02
  Construction loans
          8,518
        438
5.14
        5,237
247
4.71
      13,098
       647
4.94
  Commercial & agricultural loans
     292,518
   15,294
5.23
    270,164
14,618
5.41
    252,242
  14,794
5.87
  Loans to state & political subdivisions
       85,631
     3,815
4.45
      69,440
3,225
4.64
      59,759
    2,647
4.43
  Other loans
          8,448
        676
8.00
        8,643
703
8.13
        9,762
       802
8.22
  Loans, net of discount (2)(3)(4)
     577,992
   30,282
5.24
    540,541
29,375
5.43
    516,748
  29,831
5.77
Total interest-earning assets
     897,268
   38,520
4.29
    861,963
38,070
4.42
    841,172
  38,837
4.62
Cash and due from banks
          4,197
   
        3,781
   
        3,750
   
Bank premises and equipment
       12,837
   
      11,454
   
      11,375
   
Other assets
       36,781
   
      30,152
   
      29,905
   
Total non-interest earning assets
       53,789
   
      45,387
   
      45,030
   
Total assets
     951,083
   
    907,350
   
    886,202
   
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Interest-bearing liabilities:
                 
  NOW accounts
     230,675
        801
       0.35
    219,473
764
      0.35
    209,275
       791
      0.38
  Savings accounts
     119,021
        144
       0.12
    101,639
119
      0.12
      92,095
       146
      0.16
  Money market accounts
       98,452
        481
       0.49
      91,373
 424
      0.46
      85,688
       405
      0.47
  Certificates of deposit
     250,952
     2,687
       1.07
    257,723
3,040
      1.18
    271,862
    3,765
      1.38
Total interest-bearing deposits
     699,100
     4,113
       0.59
    670,208
4,347
      0.65
    658,920
    5,107
      0.78
Other borrowed funds
       36,700
        707
       1.93
      39,209
606
      1.55
      42,214
    1,208
      2.86
Total interest-bearing liabilities
     735,800
     4,820
       0.66
    709,417
4,953
      0.70
    701,134
    6,315
      0.90
Demand deposits
     102,977
   
      92,878
   
      87,496
   
Other liabilities
          8,510
   
        7,578
   
        7,767
   
Total non-interest-bearing liabilities
     111,487
   
    100,456
   
      95,263
   
Stockholders' equity
     103,796
   
      97,477
   
      89,805
   
Total liabilities & stockholders' equity
     951,083
   
    907,350
   
    886,202
   
Net interest income
 
   33,700
   
33,117
   
  32,522
 
Net interest spread (5)
   
3.63%
   
3.72%
   
3.72%
Net interest income as a percentage
                 
  of average interest-earning assets
   
3.76%
   
3.84%
   
3.87%
Ratio of interest-earning assets
                 
  to interest-bearing liabilities
   
       1.22
   
      1.22
   
      1.20
                   
(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.
             
 
 
21

 
 
Tax exempt interest 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 34% Federal statutory rate.  Accordingly, tax equivalent adjustments for investments and loans have been made accordingly to the previous table for the years ended December 31, 2015, 2014 and 2013, respectively (in thousands):
 
 
2015
2014
2013
Interest and dividend income from investment securities,
     
    interest bearing time deposits and short-term investments (non-tax adjusted)
 $          6,614
 $          6,967
 $        7,252
Tax equivalent adjustment
             1,624
             1,728
           1,754
Interest and dividend income from investment securities,
     
    interest bearing time deposits and short-term investments (tax equivalent basis)
 $          8,238
 $          8,695
 $        9,006
       
 
2015
2014
2013
Interest and fees on loans (non-tax adjusted)
 $        29,039
 $        28,324
 $      28,982
Tax equivalent adjustment
             1,243
             1,051
              849
Interest and fees on loans (tax equivalent basis)
 $        30,282
 $        29,375
 $      29,831
       
 
2015
2014
2013
Total interest income
 $        35,653
 $        35,291
 $      36,234
Total interest expense
             4,820
             4,953
           6,315
Net interest income
           30,833
           30,338
         29,919
Total tax equivalent adjustment
             2,867
             2,779
           2,603
Net interest income (tax equivalent basis)
 $        33,700
 $        33,117
 $      32,522

 
22

 

The following table shows the tax-equivalent effect of changes in volume and rates on interest income and expense (in thousands):

Analysis of Changes in Net Interest Income on a Tax-Equivalent Basis
 
 2015 vs. 2014 (1)
 2014 vs. 2013 (1)
 
 Change in
 Change
 Total
 Change in
 Change
 Total
 
 Volume
 in Rate
 Change
 Volume
 in Rate
 Change
Interest Income:
           
Short-term investments:
           
  Interest-bearing deposits at banks
 $              5
 $              6
 $            11
 $            (9)
 $             (7)
 $          (16)
Interest bearing time deposits at banks
               50
               (1)
               49
              58
                 -
              58
Investment securities:
           
  Taxable
             (154)
              (57)
            (211)
             (59)
            (217)
           (276)
  Tax-exempt
               47
            (353)
            (306)
            270
            (347)
             (77)
Total investment securities
             (107)
            (410)
            (517)
            211
            (564)
           (353)
Total investment income
              (52)
            (405)
            (457)
            260
            (571)
           (311)
Loans:
           
  Residential mortgage loans
             (234)
            (289)
            (523)
            328
            (687)
           (359)
  Construction loans
              166
               25
             191
           (371)
              (29)
           (400)
  Commercial & agricultural loans
           1,141
            (465)
             676
          1,947
         (2,123)
           (176)
  Loans to state & political subdivisions
              715
            (125)
             590
            445
             133
            578
  Other loans
              (16)
              (11)
              (27)
             (91)
               (8)
             (99)
Total loans, net of discount
           1,772
            (865)
             907
          2,258
         (2,714)
           (456)
Total Interest Income
           1,720
         (1,270)
             450
          2,518
         (3,285)
           (767)
Interest Expense:
           
Interest-bearing deposits:
           
  NOW accounts
               39
               (2)
               37
              43
              (70)
             (27)
  Savings accounts
               21
                4
               25
              18
              (45)
             (27)
  Money Market accounts
               34
               23
               57
              26
               (7)
              19
  Certificates of deposit
              (77)
            (276)
            (353)
           (188)
            (537)
           (725)
Total interest-bearing deposits
               17
            (251)
            (234)
           (101)
            (659)
           (760)
Other borrowed funds
              (35)
             136
             101
             (81)
            (521)
           (602)
Total interest expense
              (18)
            (115)
            (133)
           (182)
         (1,180)
        (1,362)
Increase (decrease) in net interest income
 $        1,738
 $       (1,155)
 $          583
 $       2,700
 $       (2,105)
 $         595
             
(1) The portion of the total change attributable to both volume and rate changes during the year has been allocated
 
      to volume and rate components based upon the absolute dollar amount of the change in each component prior to allocation.

2015 vs. 2014
 
Tax equivalent net interest income for 2015 was $33,700,000 compared with $33,117,000 for 2014, an increase of $583,000 or 1.8%. Total interest income increased $450,000, as loan interest income increased $907,000, which was offset by a decrease in total investment income of $457,000. Interest expense decreased $133,000 from 2014.
 
Total tax equivalent interest income from investment securities decreased $517,000 in 2015 from 2014.  The average tax-effected yield on our investment portfolio decreased from 2.78% in 2014 to 2.69% in 2015.  This had the effect of decreasing interest income by $410,000 due to rate, the majority of which was related to non-taxable securities whose yield decreased from 5.24% in 2014 to 4.88% in 2015. The average balance of investment securities decreased $8.4 million, which had an effect of decreasing interest income by $107,000 due to volume. During 2015, there were significant fluctuations in the yield on investments as a result of economic indicators in the United States and global markets, turbulence in foreign markets and comments made by the Federal Reserve about raising the Fed funds rate and the actual increase in the Fed funds rate of 25 bps in late 2015. These factors led to a further flattening of the yield curve in late 2015, which has continued into 2016. Prior to the acquisition close, we chose to fund a portion of our loan growth from the cash flows from the investment portfolio, which were not reinvested in the bond market. For the investment cash flows that were reinvested, we monitored the trading ranges for various investment products and limited purchases to times when yields were in the top third of the trading range. Additionally, for the purchases made prior to the acquisition, the investment strategy in 2015 was to purchase agency securities with maturities of less than five years and high quality municipal bonds with high coupons. The acquisition of FNB increased the liquidity during this time of volatility in the investment markets. Due to the amount of liquidity obtained as part of the acquisition, purchases made subsequent to the acquisition included US treasury securities as the spread between agency and treasuries on the short end of the curve was insignificant and therefore treasury securities were purchased. Additionally, mortgage backed securities were purchased to provide a higher yield than agencies. The Bank believes its investment strategy has appropriately mitigated its interest rate risk exposure in the event of rising interest rates, while also providing sufficient cashflows to fund loan growth expected as a result of the acquisition. The investment strategy benefits from the fact that high coupon municipal bonds generally have less price volatility in rising rate scenarios than similar lower coupon municipal bonds.
 
 
23

 
 
In total, loan interest income increased $907,000 in 2015 from 2014.  The average balance of our loan portfolio increased by $37.5 million in 2015 compared to 2014, which resulted in an increase in interest income of $1,772,000 due to volume.  Offsetting this was a decrease in average yield on total loans from 5.43% in 2014 to 5.24% in 2015 resulting in a decrease in interest income of $865,000 due to rate.
 
Interest income on residential mortgage loans decreased $523,000. The change due to rate was a decrease of $289,000 as the average yield on residential mortgages decreased from 5.66% in 2014 to 5.50% in 2015. Additionally, the average balance of residential mortgage loans decreased $4.2 million, resulting in a decrease of $234,000 due to volume. Loan demand for conforming mortgages in 2015 increased over demand in 2014 as a result of a decrease in interest rates in the secondary market. Additionally, demand for nonconforming loans remained limited. Due to the decrease in rates in the secondary market, we did not portfolio as many loans that qualified for sale in 2015 as we did in 2014. In 2015, the Company added to its portfolio $2.0 million of conforming mortgages with maturities of less than 15 years compared to $5.1 million of similar loans in 2014.  The Company originated loans to be sold of $18.9 million during 2015, which compares to $11.1 million originated and sold in 2014. Currently, all loans sold by the Bank are sold without recourse, with servicing retained. As a result of the acquisition completed in 2015, the Bank obtained a portfolio of serviced loans that include recourse, which totaled $40.4 million at December 31, 2015.
 
The average balance of construction loans increased $3.3 million from 2014 to 2015, due to several large projects in progress during 2015, which resulted in an increase of $166,000 in interest income. Additionally, the average yield on construction loans increased from 4.71% to 5.14%, which correlated to a $25,000 increase in interest income.
 
The Company attributes the increase in state and political loans, other commercial and agricultural, commercial real estate and agricultural real estate loans to the Company’s experienced lenders and their ability to identify and meet the needs of our customers while providing growth opportunities for the Company’s loan portfolio.  We also look at commercial relationships as a way to obtain deposits from farmers, small businesses and municipalities throughout our market area. During 2015, there was an increase in pricing pressure for loans that has resulted in the Bank reducing loan rates and/or changing the terms of loans in order to maintain the relationship. We believe our lenders are adept at customizing and structuring loans to customers that meet their needs and satisfy our commitment to credit quality. In many cases, the Bank works with the United States Department of Agriculture’s (USDA) and Small Business Administration (SBA) guaranteed loan programs to offset risk and to further promote economic growth in our market area. During 2015, despite these competitive pressures, the average balance of commercial and agricultural loans increased $22.4 million which had a positive impact of $1,141,000 on total interest income due to volume.  Offsetting the increase due to volume, the average yield on commercial and agricultural loans decreased from 5.41% in 2014 to 5.23% in 2015, decreasing interest income by $465,000. The average balance of loans to state and political subdivisions increased $16.2 million from 2014 to 2015 which had a positive impact of $715,000 on total interest income due to volume. The average tax equivalent yield on loans to state and political subdivisions decreased from 4.64% in 2014 to 4.45% in 2015, decreasing interest income by $125,000.
 
Total interest expense decreased $133,000 in 2015 compared to 2014.  The decrease is primarily attributable to a change in average rate from .70% in 2014 to .66% in 2015, which had the effect of decreasing interest expense by $115,000. The continued low interest rate environment prompted by the Federal Reserve had the effect of decreasing our rates on certificate of deposit products. While the Company’s rates on certificate of deposit products are below historical averages they are competitive with rates paid by other institutions in the marketplace. The average balance of interest bearing liabilities increased $26.4 million from 2014 to 2015. Certificates of deposit and other borrowed funds decreased $6.8 million and $2.5 million, respectively, which resulted in a decrease in interest expense due to volume of $112,000. These decreases were offset by increases in NOW accounts of $11.2 million, savings accounts of $17.4 million and money market accounts of $7.1 million. The cumulative effect of these increases was an increase in interest expense of $94,000.
 
 
24

 
 
The average balance of certificates of deposit decreased $6.8 million causing a decrease in interest expense of $77,000.  In addition, as a result of the continued low rate environment, there was a decrease in the average rate on certificates of deposit from 1.18% to 1.07% resulting in a decrease in interest expense of $276,000. The continued low interest rate environment, both short-term and longer-term rates, has contributed to the decline in certificate of deposit balances.  Customers, who typically utilize certificate of deposits as a means of generating income or as a longer term investment option, continue to move funds into money market and savings accounts in order to maintain flexibility for potentially rising interest rates.
 
The average balance of other borrowed funds decreased $2.5 million causing a decrease in interest expense of $35,000. Offsetting this decrease, there was an increase in the average rate on other borrowed funds from 1.55% to 1.93% resulting in an increase in interest expense of $136,000.  The increase in rate on borrowed funds was the result of the taking out a long term borrowing during the first quarter of 2015 and a decrease in the amount of funds borrowed overnight from the Federal Home Loan Bank of Pittsburgh as a result of an increase in deposit levels.
 
Our net interest spread for 2015 and 2014 was 3.63%.  The current economic situation has resulted in a flattening of the yield curve. It should be noted that there is currently more downward pressure on the pricing of interest earning assets than there is on interest bearing liabilities due to the rates that are currently being offered. Should short or long-term interest rates move in such a way that results in a further flattened or inverted yield curve, we would anticipate additional pressure on our margin.

2014 vs. 2013
 
Tax equivalent net interest income for 2014 was $33,117,000 compared with $32,522,000 for 2013, an increase of $595,000 or 1.8%. Total interest income decreased $767,000, as total investment income decreased $311,000 and loan interest income decreased $456,000. Offsetting the decrease in interest income, interest expense decreased $1,362,000 from 2013.
 
Total tax equivalent interest income from investment securities decreased $353,000 in 2014 from 2013.  The average tax-effected yield on our investment portfolio decreased from 2.90% in 2013 to 2.78% in 2014.  This had the effect of decreasing interest income by $564,000 due to rate, the majority of which was related to non-taxable securities whose yield decreased from 5.55% in 2013 to 5.24% in 2014. The average balance of investment securities increased $635,000, which had an effect of increasing interest income by $211,000 due to volume.  During 2014, there was a flattening of the treasury yield curve as a result of a rise in rates on the short end of the yield curve with no corresponding increase in long term rates. In fact, rates related to longer term instruments decreased during 2014. The increase in short term rates was due to an expectation of a rise in the federal fund rates with the ending of the Federal Reserve’s quantitative easing. As a result, the investment strategy during 2014 was to purchase agency securities with maturities of less than four years, which was the steepest part of the yield curve during 2014, and high quality municipal bonds with high coupons.
 
In total, loan interest income decreased $456,000 in 2014 from 2013.  The average balance of our loan portfolio increased by $23.8 million in 2014 compared to 2013, which resulted in an increase in interest income of $2,258,000 due to volume.  Offsetting this was a decrease in average yield on total loans from 5.77% in 2013 to 5.43% in 2014 resulting in a decrease in interest income of $2,714,000 due to rate.
 
Interest income on residential mortgage loans decreased $359,000. The change due to rate was a decrease of $687,000 as the average yield on residential mortgages decreased from 6.02% in 2013 to 5.66% in 2014. Offsetting this decrease was an increase of $328,000 due to volume as the average balance of residential mortgage loans increased $5.2 million. During 2014, the Company added to its portfolio $5.1 million of conforming mortgages with maturities of less than 15 years that would typically be sold due to lower nonconforming loan demand. The Company originated and sold $11.1 million of conforming mortgages in 2014.
 
 
25

 
 
The average balance of construction loans decreased $7.9 million from 2013 to 2014, due to the completion of several projects, which resulted in a decrease of $371,000 in interest income. Additionally, the average yield on construction loans decreased from 4.94% to 4.71%, which correlated to a $29,000 decrease in interest income.
 
During 2014, the average balance of commercial and agricultural loans increased $17.9 million which had a positive impact of $1,947,000 on total interest income due to volume.  Offsetting the increase due to volume, the average yield on commercial and agricultural loans decreased from 5.87% in 2013 to 5.41% in 2014, decreasing interest income by $2,123,000. The Company focus during 2014 was to grow its commercial and agricultural loan portfolio, utilizing its strong and experienced team of business development lenders.
 
The average balance of loans to state and political subdivisions increased $9.7 million from 2013 to 2014 which had a positive impact of $445,000 on total interest income due to volume.  Part of the growth during 2014 was the result of municipalities in our area that continued to borrow funds to ensure compliance with U.S. Environmental Protection Agency laws and regulations impacting the Chesapeake Bay watershed. Additionally, the Company participated in hospital loans with other community banks, both in and out of our primary markets, to meet the needs of these customers. The average tax equivalent yield on loans to state and political subdivisions increased from 4.43% in 2013 to 4.64% in 2014, increasing interest income by $133,000.
 
Total interest expense decreased $1,362,000 in 2014 compared to 2013.  The decrease is primarily attributable to a change in average rate from .90% in 2013 to .70% in 2014, which had the effect of decreasing interest expense by $1,180,000. The low interest rate environment had the effect of decreasing our short and long term borrowing costs as well as rates on all deposit products. The average balance of interest bearing liabilities increased $8,283,000 from 2013 to 2014. Certificates of deposit and other borrowed funds decreased $14.1 million and $3.0 million, respectively, which resulted in a decrease in interest expense due to volume of $269,000. These decreases were offset by increases in NOW accounts of $10.2 million, savings accounts of $9.5 million and money market accounts of $5.7 million. The cumulative effect of these increases was an increase in interest expense of $87,000.
 
The average balance of certificates of deposit decreased $14.1 million causing a decrease in interest expense of $188,000.  In addition, as a result of the continued low rate environment, there was a decrease in the average rate on certificates of deposit from 1.38% to 1.18% resulting in a decrease in interest expense of $537,000. The average balance of other borrowed funds decreased $3.0 million causing a decrease in interest expense of $81,000. In addition, there was a decrease in the average rate on other borrowed funds from 2.86% to 1.55% resulting in a decrease in interest expense of $521,000.  The decrease in rate on borrowed funds was the result of the interest rate swap for the trust preferred securities maturing in December of 2013. This resulted in the interest rate on the trust preferred securities decreasing from 5.82% to 3.09%.
 
Our net interest spread for 2014 and 2013 was 3.72%.

PROVISION FOR LOAN LOSSES
 
For the year ended December 31, 2015, we recorded a provision for loan losses of $480,000. The provision for 2015 was $105,000, or 18.0%, lower than the provision in 2014. The decrease in the provision for loan losses was primarily the result of the decrease in charge-offs the Company recorded in 2015 compared to 2014. (see also “Financial Condition – Allowance for Loan Losses and Credit Quality Risk”).
 
For the year ended December 31, 2014, we recorded a provision for loan losses of $585,000. The provision for 2014 was $180,000, or 44.4%, higher than the same time period in 2013. The increase in the provision for loan losses was primarily the result of the increase in charge-offs the Company recorded in 2014. (see also “Financial Condition – Allowance for Loan Losses and Credit Quality Risk”).
 
NON-INTEREST INCOME
 
The following table reflects non-interest income by major category for the periods ended December 31 (dollars in thousands):
 
 
26

 
 
 
2015
2014
2013
Service charges
 $          4,126
 $          4,297
 $          4,453
Trust
                673
                688
                694
Brokerage and insurance
                720
                567
                444
Investment securities gains, net
                429
                616
                441
Gains on loans sold
                404
                236
                443
Earnings on bank owned life insurance
                628
                507
                502
Other
                443
                445
                446
Total
 $          7,423
 $          7,356
 $          7,423
 
         
 
 2015/2014
 2014/2013
 
Change
Change
 
Amount
%
Amount
%
Service charges
 $            (171)
                (4.0)
 $            (156)
                (3.5)
Trust
                 (15)
                (2.2)
                   (6)
                (0.9)
Brokerage and insurance
                153
               27.0
                123
               27.7
Investment securities gains, (losses), net
               (187)
              (30.4)
                175
               39.7
Gains on loans sold
                168
               71.2
               (207)
              (46.7)
Earnings on bank owned life insurance
                121
               23.9
                    5
                 1.0
Other
                   (2)
                (0.4)
                   (1)
                (0.2)
Total
 $               67
                 0.9
 $              (67)
                (0.9)
 
2015 vs. 2014
 
Non-interest income increased $67,000 in 2015 from 2014, or 0.9%.  We recorded investment securities gains totaling $429,000 compared with net gains of $616,000 in 2014. During 2015, we sold five agency securities for gains totaling $196,000, five mortgage backed securities in government sponsored entities for gains totaling $69,000, seven municipal bonds for gains totaling $99,000, a financial institution equity holding for a gain of $76,000 and a US Treasury note for a loss of $11,000 in order to take advantage of interest rate market conditions. As a result of the acquisition, we sold seven agency securities and three mortgage backed securities, as a result of their risk profile in a rising interest rate environment. These securities were sold upon the acquisition date and as a result no gains or losses were recorded on the sale. During 2014 we elected to sell eight agency securities, seven mortgage backed securities, several lots of an equity security, and one municipal security for gains of $177,000, $197,000, $101,000 and $172,000, respectively. We also sold two US Treasury securities for a loss of $31,000.
 
Gains on loans sold increased $168,000 compared to last year, which is the result of an increased level of refinancing activities in 2015 versus 2014 for conforming loans. During 2015, the Bank generated $19.2 million of loan sale proceeds, which was $8.1 million, or 72.6% more than the proceeds received in 2014.
 
Service charge income decreased by $171,000 in 2015 compared to 2014, but still continues to be the Company’s primary source of non-interest income. The largest decrease was in fees charged to customers for insufficient funds, which experienced a decrease of $139,000. ATM income decreased $22,000 in 2015 compared to 2014 due to decreased usage of the Company’s ATM machines by non-customers. Management continues to monitor regulatory changes to determine the level of impact that these regulations will have on the Company.
 
The increase in earnings on bank owned life insurance of $121,000 is primarily due to purchases of an additional $5.0 million of insurance made late in the fourth quarter of 2014. The increase in brokerage and insurance revenues of $153,000 is primarily due to sales to a new customer, with a large brokerage balance.
 
2014 vs. 2013
 
Non-interest income decreased $67,000 in 2014 from 2013, or 0.9%.  We recorded investment securities gains totaling $616,000 compared with net gains of $441,000 in 2013. During 2014 we elected to sell eight agency securities, seven mortgage backed securities, several lots of an equity security, and one municipal security for gains of $177,000, $197,000, $101,000 and $172,000, respectively. We also sold two US Treasury securities for a loss of $31,000. During 2013 we elected to sell seven agency securities, nine mortgage backed securities, portions of three equity securities, four municipal securities and one corporate security for gains of $86,000, $356,000, $296,000, $87,000 and $2,000, respectively. We also sold one corporate security and two mortgage backed securities for losses of $246,000 and $140,000, respectively.
 
 
27

 
 
Gains on loans sold in 2014 decreased $207,000 compared to 2013, which is the result of a lower level of refinancing activities in 2014 versus 2013 for conforming loans. During 2014, the Bank generated $11.1 million of loan sale proceeds, but this was $10.8 million or 49.0% less than the proceeds received in 2013.
 
Service charge income decreased by $156,000 in 2014 compared to 2013. The largest decrease was in fees charged to customers for insufficient funds, which experienced a decrease of $153,000. ATM income decreased $18,000 in 2014 compared to 2013 due to decreased usage of the Company’s ATM machines by non-customers. Service charge fees related to customers’ usage of their debit cards increased by $22,000.
 
The increase in brokerage and insurance revenues was the result of hiring additional brokers in 2014 that resulted in additional business. There was also an in increase in brokerage activity as a result of increases in the stock market during 2014 as customers had renewed interest in non-bank investments in the low interest rate environment.
 
Non-interest Expenses
 
The following tables reflect the breakdown of non-interest expense by major category for the periods ended December 31 (dollars in thousands):
 
 
2015
2014
2013
Salaries and employee benefits
 $       12,504
 $       11,505
 $       11,392
Occupancy
            1,424
            1,287
            1,271
Furniture and equipment
               506
               362
               492
Professional fees
               846
               820
               781
FDIC insurance
               464
               461
               450
ORE expenses
               969
               299
               191
Pennsylvania shares tax
               713
               686
               640
Merger and acquisition
            1,103
               237
                 55
Other
            4,900
            4,508
            4,538
Total
 $       23,429
 $       20,165
 $       19,810
 
         
 
 2015/2014
 2014/2013
 
Change
Change
 
Amount
%
Amount
%
Salaries and employee benefits
 $            999
                8.7
 $            113
                1.0
Occupancy
               137
              10.6
                 16
                1.3
Furniture and equipment
               144
              39.8
             (130)
            (26.4)
Professional fees
                 26
                3.2
                 39
                5.0
FDIC insurance
                   3
                0.7
                 11
                2.4
ORE expenses
               670
            224.1
               108
              56.5
Pennsylvania shares tax
                 27
                3.9
                 46
                7.2
Merger and acquisition
               866
            365.4
               182
            330.9
Other
               392
                8.7
               (30)
              (0.7)
Total
 $         3,264
              16.2
 $            355
                1.8
 
2015 vs. 2014
 
Non-interest expenses for 2015 totaled $23,429,000, which represents an increase of $3,264,000, compared with 2014 expenses of $20,165,000.  Salary and benefit costs increased $999,000.  Base salaries and related payroll taxes increased $597,000, primarily due to merit increases and additional head count as a result of continuing to implement the Company’s strategic and expansion plans and, to a lesser extent, increased headcount as a result of the FNB acquisition.  Full time equivalent staffing was 195 and 189 employees for 2015 and 2014, respectively. Health insurance related expenses increased $128,418 from 2014 due to increased claims experience in 2015. Retirement expenses increased $192,000 compared to 2014 as a result of actuarial changes and a decrease in earnings on pension plan assets.
 
 
28

 
 
The increases in occupancy and furniture and equipment was primarily related to the opening of the Mill Hall branch in the first quarter of 2015, which includes some one-time costs incurred as part of the opening. The increase in ORE expenses was primarily the result of recording several properties to fair value based on updated appraisals. During 2015, the Company experienced losses on ORE properties of $409,000 compared to losses of $16,400 in 2014. The other large increase in ORE expenses was the result of an increase in legal fees and real estate taxes on certain properties and loans in foreclosure.
 
The increase in merger and acquisition costs was the result of the completed FNB acquisition in 2015, which resulted in severance costs, professional fees to assist with the completion of the merger, and system conversion costs to combine financial systems and records.
 
The largest driver of the increase in other expenses is charge-offs related to fraudulent charges on our customers debit cards. In addition, increases in other expenses included office and printing supplies for the new Mill Hall branch and the acquired branches as part of the FNB transaction, travel related expenses as a result of opening the new Mill Hall branch and the acquisition, and amortization of the core deposit intangible associated with the acquisition.
 
2014 vs. 2013
 
Non-interest expenses for 2014 totaled $20,165,000 which represents an increase of $355,000, compared with 2013 expenses of $19,810,000.  Salary and benefit costs increased $113,000.  Base salaries and related payroll taxes increased $375,000, primarily due to merit increases and additional head count.  Full time equivalent staffing was 189 and 186 employees for 2014 and 2013, respectively. Health insurance related expenses decreased $182,000 from 2013 due to significantly improved claims experience in 2014. Incentive costs increased $213,000 compared to 2013.  Retirement expenses decreased $295,000 compared to 2013 mostly due to improved earnings on pension plan assets and a decrease in the net amortization and deferral of actuarial gains and losses.
 
The increase in merger and acquisition costs was the result of investigating merger targets during 2014, but did not result in a completed transaction. The increase in ORE expenses is due to the increase in foreclosed properties owned by the Company in 2014. Furniture and equipment costs decreased as a result of purchasing equipment for the online teller system implemented during 2013 and additional assets becoming fully depreciated.
 
Provision for Income Taxes
 
The provision for income taxes was $2,721,000, $3,559,000 and $3,752,000 for 2015, 2014 and 2013, respectively. The effective tax rates for 2015, 2014 and 2013 were 19.0%, 21.0%, and 21.9%, respectively.
 
Income before the provision for income taxes decreased by $2,597,000 in 2015 compared to 2014. As the result of this decrease and an increase in non-taxable investment and loan interest income, the provision for income taxes decreased by $838,000 when compared to 2014. We have managed our effective tax rate by remaining invested in tax-exempt municipal loans and bonds and investments in certain partnerships that provide the Company with tax credits.
 
Income before the provision for income taxes decreased by $183,000 in 2014 compared to 2013. As the result of this decrease and an increase in non-taxable investment and loan interest income, the provision for income taxes decreased by $193,000 when compared to 2013.
 
We are involved in four limited partnership agreements that established low-income housing projects in our market area. During 2015, 2014 and 2013, we recognized tax credits related to two of the four partnerships. The tax credits for the other two projects were fully utilized by December 31, 2012. We anticipate recognizing an aggregate of $1.0 million of tax credits over the next seven years.
 
 
29

 
 
FINANCIAL CONDITION
 
The following table presents ending balances (dollars in millions), growth and the percentage change during the past two years:

 
 2015
 
 %
 2014
 
 %
 2013
 
 Balance
 Increase
 Change
 Balance
 Increase
 Change
 Balance
 Total assets
 $     1,163.0
 $         238.0
           25.7
 $      925.0
 $           10.1
             1.1
 $      914.9
 Total investments
           359.7
              53.6
           17.5
         306.1
            (11.2)
            (3.5)
         317.3
 Total loans, net
           687.9
            140.6
           25.7
         547.3
              13.8
             2.6
         533.5
 Total deposits
           988.0
            214.1
           27.7
         773.9
              25.6
             3.4
         748.3
 Total stockholders' equity
           119.8
              19.3
           19.2
         100.5
                8.4
             9.1
           92.1
 
Cash and Cash Equivalents
 
Cash and cash equivalents totaled $24.4 million at December 31, 2015 compared with $11.4 million at December 31, 2014. The increase in cash and cash equivalents is the result of the Company’s acquisition of FNB in December of 2015, which resulted in a significant cash increase. 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
 
The following table shows the year-end composition of the investment portfolio for the five years ended December 31 (dollars in thousands):
 
 
2015
% of
2014
% of
2013
% of
2012
% of
2011
% of
 
Amount
Total
Amount
Total
Amount
Total
Amount
Total
Amount
Total
Available-for-sale:
                   
  U. S. Agency securities
 $    199,591
      55.5
 $ 150,885
      49.3
 $ 152,189
    48.0
 $ 127,234
    41.0
 $ 168,600
      52.9
  U.S. Treasuries
         10,082
        2.8
        4,849
        1.6
      11,309
      3.6
        4,947
      1.6
                -
          -
  Obligations of state & political
                   
     subdivisions
       102,863
      28.6
    105,036
      34.3
      95,005
    29.9
    100,875
    32.5
    101,547
      31.9
  Corporate obligations
         14,565
        4.0
      13,958
        4.6
      16,802
      5.3
      22,109
      7.1
        8,460
        2.7
  Mortgage-backed securities
         30,204
        8.4
      29,728
        9.6
      40,671
    12.8
      53,673
    17.3
      38,974
      12.2
  Equity securities
           2,432
        0.7
        1,690
        0.6
        1,325
      0.4
        1,414
      0.5
        1,242
        0.3
Total
 $    359,737
    100.0
 $ 306,146
    100.0
 $ 317,301
  100.0
 $ 310,252
  100.0
 $ 318,823
    100.0

2015
 
The Company’s investment portfolio increased by $53.6 million, or 17.5%, during the past year primarily due to the acquisition of FNB. As part of the acquisition, we acquired $17.8 million of U.S. agency obligations, $1.2 million of mortgage backed securities, $1.8 million of state and local obligations and $3.0 million of corporate obligations. In addition, during 2015, we purchased $10.1 million of U.S treasuries, $74.5 million of U.S. agencies, $6.8 million of mortgage backed securities, $19.1 million of state and local obligations and $901,000 of equity securities, which helped to offset the $5.7 million of principal repayments and $42.5 million of calls and maturities that occurred during the year. We also sold $30.5 million of bonds and equities at a net gain of $429,000. The market value of our investment portfolio decreased approximately $1.3 million in 2015 due to interest rate fluctuations. Excluding our short term investments consisting of monies held primarily at the Federal Reserve, the effective yield on our investment portfolio for 2015 was 2.69% compared to 2.78% for 2014 on a tax equivalent basis.
 
During 2015, rates on the short end of the Treasury yield curve experienced an increase, as the result of the increase in the federal funds rate and the potential for additional increases in the federal funds rate in the near future, while the long end of the curve experienced significant volatility throughout the year and ended the year up slightly from 2014. The investment strategy in 2015 prior to the acquisition of FNB was to purchase agency securities with maturities of less than five years and high quality municipal bonds with high coupons. Due to the amount of liquidity obtained as part of the acquisition, purchases made subsequently included US Treasury securities as the spread between agency and treasuries on the short end of the curve was insignificant and thus the Treasury security was purchased. Additionally, mortgage backed securities were purchased to provide a higher yield than agencies. The Bank believes its investment strategy has appropriately mitigated its interest rate risk exposure in the event of rising interest rates while providing sufficient cashflows to fund loan growth expected as a result of the acquisition.
 
 
30

 
 
At December 31, 2015, the Company did not own any securities, other than government-sponsored and government-guaranteed mortgage-backed securities, that had an aggregate book value in excess of 10% of its stockholders’ equity at that date.
 
The expected principal repayments (amortized cost) and average weighted yields for the investment portfolio (excluding equity securities) as of December 31, 2015, are shown below (dollars in thousands). Expected principal repayments, which include prepayment speed assumptions for mortgage-backed securities, are significantly different than the contractual maturities detailed in Note 3 of the consolidated financial statements. Yields on tax-exempt securities are presented on a fully taxable equivalent basis, assuming a 34% tax rate.
 
     
After One Year
After Five Years
       
 
One Year or Less
to Five years
to Ten Years
After Ten Years
Total
 
Amortized
Yield
Amortized
Yield
Amortized
Yield
Amortized
Yield
Amortized
Yield
 
Cost
%
Cost
%
Cost
%
Cost
%
Cost
%
Available-for-sale securities:
                   
  U.S. agency securities
 $            16,753
0.9
 $           179,937
1.4
 $           3,059
      2.0
 $             -
-
 $    199,749
      1.4
  U.S. treasuries
                 2,119
0.7
7,984
1.0
-
        -
-
-
         10,103
      0.9
  Obligations of state & political
 
 
 
 
 
 
 
 
 
 
    subdivisions
                 4,601
4.2
63,563
4.0
16,419
      4.8
15,273
5.8
         99,856
      4.4
  Corporate obligations
                 6,536
2.8
8,047
5.3
-
        -
-
-
         14,583
      4.1
  Mortgage-backed securities
                 7,809
2.0
14,017
2.1
6,936
      2.2
1,345
2.4
         30,107
      2.1
Total available-for-sale
 $            37,818
1.8
 $           273,548
2.1
 $         26,414
      3.8
 $   16,618
5.5
 $    354,398
      2.4
 
At December 31, 2015, approximately 87.9% of the amortized cost of debt securities is expected to mature, call or pre-pay within five years or less.  The Company expects that earnings from operations, the levels of cash held at the Federal Reserve and other correspondent banks, the high liquidity level of the available-for-sale securities, growth of deposits and the availability of borrowings from the Federal Home Loan Bank and other third party banks will be sufficient to meet future liquidity needs.

2014
 
The Company’s investment portfolio decreased by $11.2 million, or 3.5%, during the past year.  During 2014, we purchased $40.5 million of U.S. agency obligations, $15.2 million of state and local obligations and $602,000 of equity securities, which helped to offset the $6.7 million of principal repayments and $35.0 million of calls and maturities that occurred during the year. We also selectively sold $29.0 million of bonds and equities at a net gain of $616,000. The market value of our investment portfolio increased approximately $4.8 million in 2014 due to interest rate fluctuations. Excluding our short term investments consisting of monies held primarily at the Federal Reserve, the effective yield on our investment portfolio for 2014 was 2.78% compared to 2.90% for 2013 on a tax equivalent basis.
 
During 2014, rates on the short end of the Treasury yield curve experienced an increase, as the result of an expected rise in the federal funds rate in the near future due to the end of the quantitative easing program by the Federal Reserve, while the long end of the curve, particularly the 10 year treasury, experienced a decrease in excess of 80 basis points. These changes resulted in the market value of the investment portfolio increasing. As a result of these items, the investment strategy during 2014 was to purchase agency securities with maturities of less than four years and high quality municipal bonds with high coupons.
 
 
31

 
 
At December 31, 2014, the Company did not own any securities, other than government-sponsored and government-guaranteed mortgage-backed securities, that had an aggregate book value in excess of 10% of its stockholders’ equity at that date.
 
Loans
 
The Bank’s lending efforts have historically focused on north central Pennsylvania and southern New York. With the acquisition of FNB, this focus will change to include opportunities in the Lebanon, Schuylkill and Berks County markets of south central, Pennsylvania. We originate loans primarily through direct loans to our existing customer base, with new customers generated by referrals from real estate brokers, building contractors, attorneys, accountants, corporate and advisory board members, existing customers and the Bank’s website.  The Bank offers a variety of loans although historically most of our lending has focused on real estate loans including residential, commercial, agricultural, and construction loans.  As of December 31, 2015, approximately 74.0% of our loan portfolio consisted of real estate loans.  All lending is governed by a lending policy that is developed and administered by management and approved by the Board of Directors.
 
The Bank primarily offers fixed rate residential mortgage loans with terms of up to 25 years and adjustable rate mortgage loans (with amortization schedules based up to 30 years) with interest rates and payments that adjust based on one, three, and five year fixed periods.  Loan to value ratios are usually 80% or less with exceptions for individuals with excellent credit and low debt to income and/or high net worth. Adjustable rate mortgages are tied to a margin above the comparable Federal Home Loan Bank of Pittsburgh borrowing rate.  Home equity loans are written with terms of up to 15 years at fixed rates.  Home equity lines of credit are variable rate loans tied to the Prime Rate generally with a ten year draw period followed by a ten year repayment period. Home equity loans are typically written with a maximum 80% loan to value.
 
Commercial real estate loan terms are generally 20 years or less, with one to five year adjustable interest rates.  The adjustable rates are typically tied to a margin above the comparable Federal Home Loan Bank of Pittsburgh borrowing rate with a maximum loan to value ratio of 80%. Where feasible, the Bank works with the United States Department of Agriculture’s (USDA) and Small Business Administration (SBA) guaranteed loan programs to offset risk and to further promote economic growth in our market area.  During 2015, we originated $5.5 million in USDA and SBA guaranteed commercial real estate loans.
 
Agriculture, and particularly dairy farming, is an important industry in our market area. Therefore, the Bank has developed an agriculture lending team with significant experience that has a thorough understanding of this industry. Agricultural loans focus on character, cash flow and collateral, while also taking into account the particular risks of the industry.  Loan terms are generally 20 years or less, with one to five year adjustable interest rates.  The adjustable rates are typically tied to a margin above the comparable Federal Home Loan Bank of Pittsburgh borrowing rate with a maximum loan to value of 80%. The Bank is a preferred lender under the USDA’s Farm Service Agency (FSA) and participates in the FSA guaranteed loan program.
 
The Bank, as part of its commitment to the communities it serves, is an active lender for projects by our local municipalities and school districts. These loans range from short term bridge financing to 20 year term loans for specific projects. These loans are typically written at rates that adjust at least every five years. Due to the size of certain municipal loans, we have developed participation lending relationships with other community banks that allow us to meet regulatory compliance issues, while meeting the needs of the customer. At December 31, 2015, the aggregate balance of our participation loans with other lenders totaled $86.3 million.
 
Activity associated with exploration for natural gas significantly decreased in 2015 due to the low price of natural gas produced in our area. While the Bank has loaned to companies that service the exploration activities, the Bank did not originate any loans to Companies performing the actual drilling and exploration activities. Loans made by the Company were to service industry customers which included trucking companies, stone quarries and other support businesses. We also originated loans to businesses and individuals for restaurants, hotels and apartment rentals that were developed and expanded to meet the housing and living needs of the gas workers. Due to our understanding of the industry and its cyclical nature, the loans made for natural gas-related activities were originated in a prudent and cautious manner and were subject to specific policies and procedures for lending to these entities, which included lower loan to value thresholds, shortened amortization periods, and expansion of our monitoring of loan concentrations associated with this activity.
 
 
32

 
 
The following table shows the year-end composition of the loan portfolio for the five years ended December 31 (dollars in thousands):
 
 
2015
2014
2013
2012
2011
 
Amount
%
Amount
%
Amount
%
Amount
%
Amount
%
Real estate:
                   
  Residential
 $ 203,407
29.3
 $ 185,438
33.5
 $ 187,101
34.6
 $  178,080
35.4
$ 184,034
37.7
  Commercial
237,542
34.2
     190,945
34.5
    193,087
35.7
     176,710
35.2
165,826
34.0
  Agricultural
57,822
8.3
       24,639
4.4
      22,001
4.1
       18,015
3.6
19,224
3.9
  Construction
15,011
2.2
         6,353
1.1
        8,937
1.7
       12,011
2.4
8,481
1.7
Consumer
11,543
1.7
         8,497
1.5
       9,563
1.7
      10,559
2.1
10,746
2.2
Other commercial and agricultural loans
71,206
10.2
      58,516
10.6
      54,029
10.0
       47,880
9.5
44,299
9.1
State & political subdivision loans
98,500
14.1
       79,717
14.4
      65,894
12.2
       59,208
11.8
54,899
11.4
Total loans
695,031
100.0
     554,105
100.0
    540,612
100.0
     502,463
100.0
487,509
100.0
Less allowance for loan losses
7,106
 
         6,815
 
        7,098
 
         6,784
 
6,487
 
Net loans
 $ 687,925
 
 $ 547,290
 
 $ 533,514
 
 $  495,679
 
 $ 481,022
 
 
         
 
 2015/2014
 2014/2013
 
Change
Change
 
Amount
%
Amount
%
Real estate:
       
  Residential
 $   17,969
9.7
 $   (1,663)
 (0.9)
  Commercial
46,597
24.4
 (2,142)
 (1.1)
  Agricultural
33,183
134.7
         2,638
12.0
  Construction
       8,658
136.3
 (2,584)
(28.9)
Consumer
3,046
35.8
      (1,066)
(11.1)
Other commercial and agricultural loans
12,690
21.7
        4,487
8.3
State & political subdivision loans
18,783
23.6
      13,823
21.0
Total loans
 $ 140,926
25.4
 $    13,493
2.5

2015
 
Total loans grew $140.9 million in 2015 from $554.1 million at the end of 2014 to $695.0 million at the end of 2015. The primary driver of the increase was $115.2 million in loans acquired from the acquisition of FNB as of December 11, 2015. The remaining growth was the result of our continued emphasis on growing commercial, agricultural and municipal relationships through well collateralized loans to meet our customers’ needs.
 
During 2015, exclusive of the FNB acquisition, the Company experienced growth in agricultural real estate loans of $13.1 million, state and political subdivision loans of $8.9 million, construction loans of $5.8 million, other commercial and agricultural loans of $5.7 million and commercial real estate loans of $2.1 million. The increase in agricultural real estate, state and political loans, other commercial and agricultural loans and commercial real estate loans is attributable to the Company’s experienced lenders and their ability to identify and meet the needs of our customers while providing growth opportunities for the Company’s loan portfolio. We work closely with local municipalities and school districts to meet their needs that otherwise would be provided by the municipal bond market. We also look at commercial relationships as a way to obtain deposits from farmers, small businesses and municipalities throughout our market area. Commercial loan demand is subject to significant competitive pressures, the yield curve, and the strength of the overall national, regional and local economies. The opening of the Mill Hall branch resulted in loan growth of $13.1 million and was the primary contributor to the increase in agricultural loans independent of the acquisition of FNB. Commercial loan demand is subject to significant competitive pressures, the yield curve, the strength of the overall regional and national economy and the local economy.
 
Excluding the FNB acquisition, residential real estate loans experienced a decrease of $9.6 million during 2015. This decrease is attributable to an increase in loan demand for conforming mortgages, which the Company typically sells on the secondary market. During 2015, $18.9 million of loans were originated for sale on the secondary market, which compares to $11.1 million for 2014.  In addition to the loans originated for sale, the Company added in 2015 $2.0 million to its residential real estate portfolio in 2015 of certain 15 year mortgage loans that met secondary market standards. During 2014, the Company did not sell $5.1 million of residential mortgages that met secondary market standards. For loans sold on the secondary market, the Company recognizes fee income for servicing these sold loans, which is included in non-interest income.  Management continues to build technologies which make it easier and more efficient for customers to choose the Company for their mortgage needs.
 
 
33

 
 
2014
 
Total loans grew $13.5 million in 2014 from a balance of $540.6 million at the end of 2013 to $554.1 million at the end of 2014.  Total loans grew 2.5% in 2014 compared with a 7.6% loan growth rate in 2013.
 
During 2014, the Company experienced growth in state and political subdivision loans, which increased $13.8 million or 21.0%, other commercial and agricultural loans which increased $4.5 million or 8.3% and agricultural real estate loans which increased $2.6 million or 12.0%. The Company did have several large commercial real estate loans payoff during 2014, which resulted in a decrease of $2.1 million, or 1.1%.
 
Residential real estate loans decreased $1.7 million during 2014. Loan demand for conforming mortgages slowed during 2014 when compared to 2013. During 2014, $11.1 million of loans were originated and sold on the secondary market, which compares to $20.2 million for 2013. Due to the decline in demand for non-conforming mortgages and the difficult investment environment, the Company decided that certain 15 year mortgage loans that met secondary market standards would not be sold on the secondary market, but would instead be held as part of the Bank’s residential real estate portfolio. During 2014, the Company did not sell $5.1 million of residential mortgages that met secondary market standards. In 2013, the Company did not sell $7.5 million of loans, which met secondary market standards.
 
The decrease in construction loans of $2.6 million is attributable to transfers out of construction at completion to commercial, state and political subdivision loans and residential real estate during 2014.
The following table shows the maturity of commercial business and agricultural, state and political subdivision loans,  commercial real estate loans, and construction loans as of December 31, 2015, classified according to the sensitivity to changes in interest rates within various time intervals (in thousands).  The table does not include any estimate of prepayments which significantly shorten the average life of all loans and may cause our actual repayment experience to differ from that shown below.  Demand loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less.

 
Commercial,
   
 
municipal,
Real estate
 
 
agricultural
construction
Total
Maturity of loans:
     
  One year or less
 $           22,265
 $             2,208
 $           24,473
  Over one year through five years
              61,325
                4,937
              66,262
  Over five years
            381,480
                7,866
            389,346
Total
 $         465,070
 $           15,011
 $         480,081
Sensitivity of loans to changes in interest
     
   rates - loans due after December 31, 2016:
     
  Predetermined interest rate
 $           96,839
 $             6,178
 $         103,017
  Floating or adjustable interest rate
            345,966
                6,625
            352,591
Total
 $         442,805
 $           12,803
 $         455,608
 
Allowance for Loan Losses and Credit Quality Risk
 
The allowance for loan losses is maintained at a level which, in management’s judgment, is adequate to absorb probable future loan losses inherent in the loan portfolio.  The provision for loan losses is charged against current income.  Loans deemed not collectable are charged-off against the allowance while subsequent recoveries increase the allowance.  The following table presents an analysis of the change in the allowance for loan losses and a summary of our non-performing assets for the years ended December 31, 2015, 2014, 2013, 2012 and 2011. All non-accruing troubled debt restructurings (TDRs) are also included the non-accruing loans totals.
 
 
34

 
 
 
December 31,
 
2015
2014
2013
2012
2011
Balance
         
  at beginning of period
 $          6,815
 $          7,098
 $          6,784
 $          6,487
 $          5,915
Charge-offs:
         
  Real estate:
         
     Residential
                  66
                  97
                  17
                  95
                101
     Commercial
                  84
                516
                  62
                    2
                  29
     Agricultural
                     -
                     -
                     -
                     -
                     -
  Consumer
                  47
                  47
                  54
                  54
                  71
  Other commercial and agricultural loans
                  41
                250
                    1
                  21
                    6
Total loans charged-off
                238
                910
                134
                172
                207
Recoveries:
         
  Real estate:
         
     Residential
                     -
                     -
                    5
                     -
                     -
     Commercial
                  14
                  15
                    5
                    9
                  15
     Agricultural
                     -
                     -
                     -
                     -
                     -
  Consumer
                  33
                  27
                  33
                  33
                  57
  Other commercial and agricultural loans
                    2
                     -
                     -
                    7
                  32
Total loans recovered
                  49
                  42
                  43
                  49
                104
           
Net loans charged-off
                189
                868
                  91
                123
                103
Provision charged to expense
                480
                585
                405
                420
                675
Balance at end of year
 $          7,106
 $          6,815
 $          7,098
 $          6,784
 $          6,487
           
Loans outstanding at end of period
 $      695,031
 $      554,105
 $      540,612
 $      502,463
 $      487,509
Average loans outstanding, net
 $      577,992
 $      540,541
 $      516,748
 $      496,822
 $      474,972
Non-performing assets:
         
    Non-accruing loans
 $          6,531
 $          6,599
 $          8,097
 $          8,067
 $          9,165
    Accrual loans - 90 days or more past due
                623
                836
                697
                506
                275
      Total non-performing loans
 $          7,154
 $          7,435
 $          8,794
 $          8,573
 $          9,440
    Foreclosed assets held for sale
             1,354
             1,792
             1,360
                616
                860
      Total non-performing assets
 $          8,508
 $          9,227
 $        10,154
 $          9,189
 $        10,300
           
Troubled debt restructurings (TDR)
         
    Non-accruing TDRs
 $          3,397
 $          3,654
 $          4,701
 $          4,834
 $          5,490
    Accrual TDRs
             2,243
             2,502
             2,510
                193
                123
      Total troubled debt restructurings
 $          5,640
 $          6,156
 $          7,211
 $          5,027
 $          5,613
Net charge-offs to average loans
0.03%
0.16%
0.02%
0.02%
0.02%
Allowance to total loans
1.02%
1.23%
1.31%
1.35%
1.33%
Allowance to total non-performing loans
99.33%
91.66%
80.71%
79.13%
68.72%
Non-performing loans as a percent of loans
         
   net of unearned income
1.03%
1.34%
1.63%
1.71%
1.94%
Non-performing assets as a percent of loans
       
  net of unearned income
1.22%
1.67%
1.88%
1.83%
2.11%
 
The Company utilizes a disciplined and thorough loan review process based upon our internal loan policy approved by the Company’s Board of Directors.  The purpose of the review is to assess loan quality, analyze delinquencies, identify problem loans, evaluate potential charge-offs and recoveries, and assess general overall economic conditions in the markets served.  An external independent loan review is performed on our commercial portfolio semi-annually for the Company.  The external consultant is engaged to 1) review a minimum of 55% (60% of loans prior to 2013) of the dollar volume of the commercial loan portfolio on an annual basis, 2) new loans originated for over $1.0 million in the last year, 3) a majority of borrowers with commitments greater than or equal to $1.0 million,  4) review selected loan relationships over $750,000 which are over 30 days past due, or classified Special Mention, Substandard, Doubtful, or Loss, and 5) such other loans which management or the consultant deems appropriate. As part of this review, our underwriting process and loan grading system is evaluated.
 
 
35

 
 
Management believes it uses the best information available to make such determinations and that the allowance for loan losses is adequate as of December 31, 2015.  However, future adjustments could be required if circumstances differ substantially from assumptions and estimates used in making the initial determination.  A prolonged downturn in the economy, high unemployment rates, significant changes in the value of collateral and delays in receiving financial information from borrowers could result in increased levels of non-performing assets, charge-offs, loan loss provisions and reduction in income.  Additionally, bank regulatory agencies periodically examine the Bank’s allowance for loan losses.  The banking agencies could require the recognition of additions to the allowance for loan losses based upon their judgment of information available to them at the time of their examination.
 
On a monthly basis, problem loans are identified and updated primarily using internally prepared past due reports.  Based on data surrounding the collection process of each identified loan, the loan may be added or deleted from the monthly watch list.  The watch list includes loans graded special mention, substandard, doubtful, and loss, as well as additional loans that management may choose to include.  Watch list loans are continually monitored going forward until satisfactory conditions exist that allow management to upgrade and remove the loan from the watchlist.  In certain cases, loans may be placed on non-accrual status or charged-off based upon management’s evaluation of the borrower’s ability to pay.  All commercial loans, which include commercial real estate, agricultural real estate, state and political subdivision loans and commercial business loans, on non-accrual are evaluated quarterly for impairment.
 
The adequacy of the allowance for loan losses is subject to a formal, quarterly analysis by management of the Company.  In order to better analyze the risks associated with the loan portfolio, the entire portfolio is divided into several categories.  As stated above, loans on non-accrual status are specifically reviewed for impairment and given a specific reserve, if appropriate.  Loans evaluated and not found to be impaired are included with other performing loans, by category, by their respective homogenous pools.  Three year average historical loss factors were calculated for each pool and applied to the performing portion of the loan category for each year presented. The historical loss factors for both reviewed and homogeneous pools are adjusted based upon the following qualitative factors:
 
·  
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.
·  
Existence and effect of any credit concentrations, and changes in the level of such concentrations
·  
Any change in the level of board oversight

 
36

 
 
See also “Note 4 – Loans and Related Allowance for Loan Losses” to the consolidated financial statements.
 
The allowance for loan losses was $7,106,000 or 1.02% of total loans as of December 31, 2015 as compared to $6,815,000 or 1.23% of loans as of December 31, 2014.  The $291,000 increase is a result of a $480,000 provision for loan losses less net charge-offs of $189,000. The decrease as a percent of loans is attributable to the increase in loans as part of the acquisition of FNB and the associated purchase accounting adjustments that were applied to the FNB loan portfolio. The following table shows the distribution of the allowance for loan losses and the percentage of loans compared to total loans by loan category (dollars in thousands) as of December 31:
 
 
2015
2014
2013
2012
2011
 
Amount
%
Amount
%
Amount
%
Amount
%
Amount
%
Real estate loans:
                   
  Residential
 $         905
29.3
 $    878
33.5
 $       946
      34.6
 $     875
      35.4
 $      805
      37.7
  Commercial, agricultural
         3,785
42.5
3,870
38.9
       4,558
      39.8
4,437
      38.8
4,132
      37.9
  Construction
              24
2.2
26
1.1
            50
        1.7
38
        2.4
15
        1.7
Consumer
            102
1.7
84
1.5
          105
        1.7
119
        2.1
111
        2.2
Other commercial and agricultural loans
         1,305
10.2
1,224
10.6
          942
      10.0
728
        9.5
674
        9.1
State & political subdivision loans
            593
14.1
545
14.4
          330
      12.2
271
      11.8
235
      11.4
Unallocated
            392
 N/A
188
 N/A
         167
 N/A
316
 N/A
515
 N/A
Total allowance for loan losses
 $      7,106
100.0
 $  6,815
100.0
 $    7,098
    100.0
 $  6,784
    100.0
 $   6,487
    100.0
 
As a result of previous loss experiences and other the risk factors utilized in determining the allowance, the Bank’s allocation of the allowance does not directly correspond to the actual balances of the loan portfolio. While commercial and agricultural real estate loans total 42.5% of the loan portfolio, 53.3% of the allowance is assigned to this segment of the loan portfolio as these loans have more inherent risks than residential real estate or loans to state and political subdivisions. Residential real estate loans comprise 29.3% of the loan portfolio as of December 31, 2015 and 12.7% of the allowance is assigned to this segment as generally there are less inherent risks then commercial and agricultural loans.
 
The following table identifies amounts of loans contractually past due 30 to 90 days and non-performing loans by loan category, as well as the change from December 31, 2014 to December 31, 2015 in non-performing loans (dollars in thousands).  Non-performing loans include those loans that are contractually past due 90 days or more and non-accrual loans.  Interest does not accrue on non-accrual loans.  Subsequent cash payments received are applied to the outstanding principal balance or recorded as interest income, depending upon management's assessment of its ultimate ability to collect principal and interest.
 
 
December 31, 2015
 
December 31, 2014
   
Non-Performing Loans
   
Non-Performing Loans
 
30 - 90 Days
90 Days Past
Non-
Total Non-
 
30 - 90 Days
90 Days Past
Non-
Total Non-
 
Past Due
Due Accruing
accrual
Performing
 
Past Due
Due Accruing
accrual
Performing
Real estate:
                 
  Residential
 $             1,273
 $               394
 $ 1,008
 $         1,402
 
 $         1,089
 $             346
 $    828
 $      1,174
  Commercial
                  859
60
4,422
4,482
 
147
                310
5,010
5,320
  Agricultural
                  344
                       -
34
34
 
-
                    -
-
                 -
  Construction
                      -
                       -
-
-
 
-
                    -
-
                 -
Consumer
                  262
9
55
64
 
75
                   6
47
53
Other commercial and agricultural loans
                  319
160
1,012
1,172
 
761
                174
714
888
Total nonperforming loans
 $             3,057
 $               623
 $ 6,531
 $         7,154
 
 $         2,072
 $             836
 $ 6,599
 $      7,435
 
 
37

 

 
 
Change in Non-Performing Loans
 
 2015 / 2014
 
Amount
%
Real estate:
   
  Residential
 $               228
                  19.4
  Commercial
                 (838)
                 (15.8)
  Agricultural
                    34
NA
  Construction
                      -
 -
Consumer
                    11
                  20.8