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EX-31.1 - CERTIFICATION OF CHIEF EXECUTIVE OFFICER - CITIZENS FINANCIAL SERVICES INCceocert.htm
EX-32.1 - SECTION 350 CERTIFICATIONS - CITIZENS FINANCIAL SERVICES INCcertification.htm
EX-31.2 - CERTIFICATION OF CHIEF FINANCIAL OFFICER - CITIZENS FINANCIAL SERVICES INCcfocert.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10‑Q

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

For the quarterly period ended June 30, 2017
Or

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

For the transition period from_____________________ to ___________________

Commission file number 0‑13222

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

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

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

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

N/A
(Former Name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes __X__ No_____

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

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

Large accelerated filer                                                                                    ____                                                      Accelerated filer  _X__

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


If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

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

The number of outstanding shares of the Registrant's Common Stock, as of August 1, 2017, was 3,493,270.


Citizens Financial Services, Inc.
Form 10-Q

INDEX

   
PAGE
Part I
FINANCIAL INFORMATION
 
Item 1.
Financial Statements (unaudited):
 
 
Consolidated Balance Sheet as of June 30,2017 and
December 31, 2016
1
 
Consolidated Statement of Income for the Three and Six Months            
Ended June 30, 2017 and 2016
2
 
Consolidated Statement of Comprehensive Income for the Three
and Six Months ended June 30, 2017 and 2016
3
 
Consolidated Statement of Cash Flows for the Six
Months ended June 30, 2017 and 2016
4
 
Notes to Consolidated Financial Statements
5-31
Item 2.
Management's Discussion and Analysis of Financial
Condition and Results of Operations
32-54
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
54
Item 4.
Controls and Procedures
54
     
Part II
OTHER INFORMATION
 
Item 1.
Legal Proceedings
54-55
Item 1A.
Risk Factors
55
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
55
Item 3.
Defaults Upon Senior Securities
55
Item 4.
Mine Safety Disclosures
55
Item 5.
Other Information
55
Item 6.
Exhibits
55-56
 
Signatures
57

CITIZENS FINANCIAL SERVICES, INC.
           
CONSOLIDATED BALANCE SHEET
           
(UNAUDITED)
           
 
           
 
 
June 30
   
December 31
 
(in thousands except share data)
 
2017
   
2016
 
ASSETS:
           
Cash and due from banks:
           
  Noninterest-bearing
 
$
18,298
   
$
16,854
 
  Interest-bearing
   
1,064
     
900
 
Total cash and cash equivalents
   
19,362
     
17,754
 
Interest bearing time deposits with other banks
   
8,791
     
6,955
 
Available-for-sale securities
   
275,208
     
314,017
 
Loans held for sale
   
393
     
1,827
 
                 
Loans (net of allowance for loan losses:
               
  2017, $9,979 and 2016, $8,886)
   
878,070
     
790,725
 
                 
Premises and equipment
   
16,771
     
17,030
 
Accrued interest receivable
   
3,697
     
4,089
 
Goodwill
   
21,089
     
21,089
 
Bank owned life insurance
   
26,556
     
26,223
 
Other intangibles
   
1,945
     
2,096
 
Other investment sale receivable
   
-
     
7,759
 
Other assets
   
12,974
     
13,454
 
 
               
TOTAL ASSETS
 
$
1,264,856
   
$
1,223,018
 
 
               
LIABILITIES:
               
Deposits:
               
  Noninterest-bearing
 
$
156,374
   
$
147,425
 
  Interest-bearing
   
894,835
     
858,078
 
Total deposits
   
1,051,209
     
1,005,503
 
Borrowed funds
   
69,998
     
79,662
 
Accrued interest payable
   
628
     
720
 
Other liabilities
   
15,251
     
13,865
 
TOTAL LIABILITIES
   
1,137,086
     
1,099,750
 
STOCKHOLDERS' EQUITY:
               
Preferred Stock
               
  $1.00 par value; authorized 3,000,000 shares at June 30, 2017 and December 31, 2016;
               
   none issued in 2017 or 2016
   
-
     
-
 
Common stock
               
  $1.00 par value; authorized 15,000,000 shares;  issued 3,869,939 at June 30, 2017 and
               
   3,704,375 at December 31, 2016
   
3,870
     
3,704
 
Additional paid-in capital
   
51,085
     
42,250
 
Retained earnings
   
86,170
     
91,278
 
Accumulated other comprehensive loss
   
(969
)
   
(1,392
)
Treasury stock, at cost:  380,775 shares at June 30, 2017
               
  and 384,671 shares at December 31, 2016
   
(12,386
)
   
(12,572
)
TOTAL STOCKHOLDERS' EQUITY
   
127,770
     
123,268
 
TOTAL LIABILITIES AND
               
   STOCKHOLDERS' EQUITY
 
$
1,264,856
   
$
1,223,018
 
 
               
The accompanying notes are an integral part of these unaudited consolidated financial statements.
         



1

 
CITIZENS FINANCIAL SERVICES, INC.
                       
CONSOLIDATED STATEMENT OF INCOME
                       
(UNAUDITED)
                       
 
 
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
(in thousands, except share and per share data)
 
2017
   
2016
   
2017
   
2016
 
INTEREST INCOME:
                       
Interest and fees on loans
 
$
10,304
   
$
8,587
   
$
20,021
   
$
17,183
 
Interest-bearing deposits with banks
   
45
     
64
     
80
     
135
 
Investment securities:
                               
    Taxable
   
775
     
959
     
1,579
     
1,903
 
    Nontaxable
   
601
     
755
     
1,269
     
1,526
 
    Dividends
   
53
     
61
     
129
     
141
 
TOTAL INTEREST INCOME
   
11,778
     
10,426
     
23,078
     
20,888
 
INTEREST EXPENSE:
                               
Deposits
   
1,143
     
1,072
     
2,188
     
2,146
 
Borrowed funds
   
231
     
183
     
489
     
366
 
TOTAL INTEREST EXPENSE
   
1,374
     
1,255
     
2,677
     
2,512
 
NET INTEREST INCOME
   
10,404
     
9,171
     
20,401
     
18,376
 
Provision for loan losses
   
625
     
135
     
1,240
     
270
 
NET INTEREST INCOME AFTER
                               
    PROVISION FOR LOAN LOSSES
   
9,779
     
9,036
     
19,161
     
18,106
 
NON-INTEREST INCOME:
                               
Service charges
   
1,120
     
1,128
     
2,178
     
2,230
 
Trust
   
188
     
182
     
409
     
378
 
Brokerage and insurance
   
114
     
158
     
305
     
367
 
Gains on loans sold
   
148
     
70
     
249
     
116
 
Investment securities gains, net
   
23
     
128
     
195
     
155
 
Earnings on bank owned life insurance
   
167
     
172
     
333
     
342
 
Other
   
128
     
145
     
254
     
311
 
TOTAL NON-INTEREST INCOME
   
1,888
     
1,983
     
3,923
     
3,899
 
NON-INTEREST EXPENSES:
                               
Salaries and employee benefits
   
4,324
     
3,900
     
8,643
     
7,782
 
Occupancy
   
477
     
455
     
1,004
     
900
 
Furniture and equipment
   
146
     
171
     
285
     
328
 
Professional fees
   
258
     
266
     
568
     
553
 
FDIC insurance
   
95
     
160
     
200
     
317
 
Pennsylvania shares tax
   
243
     
240
     
524
     
390
 
Amortization of intangibles
   
73
     
82
     
149
     
164
 
ORE expenses
   
82
     
212
     
172
     
305
 
Other
   
1,468
     
1,815
     
2,812
     
3,474
 
TOTAL NON-INTEREST EXPENSES
   
7,166
     
7,301
     
14,357
     
14,213
 
Income before provision for income taxes
   
4,501
     
3,718
     
8,727
     
7,792
 
Provision for income taxes
   
1,033
     
687
     
1,956
     
1,478
 
NET INCOME
 
$
3,468
   
$
3,031
   
$
6,771
   
$
6,314
 
                                 
PER COMMON SHARE DATA:
                               
Net Income - Basic
 
$
1.00
   
$
0.86
   
$
1.95
   
$
1.80
 
Net Income - Diluted
 
$
1.00
   
$
0.86
   
$
1.95
   
$
1.80
 
Cash Dividends Paid
 
$
0.405
   
$
0.392
   
$
0.810
   
$
0.783
 
 
                               
Number of shares used in computation - basic
   
3,480,122
     
3,508,818
     
3,479,653
     
3,515,477
 
Number of shares used in computation - diluted
   
3,481,310
     
3,509,227
     
3,480,263
     
3,515,682
 
 
                               
The accompanying notes are an integral part of these unaudited consolidated financial statements.
                 


2

 
CITIZENS FINANCIAL SERVICES, INC.
                                               
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
                                     
(UNAUDITED)
                                               
 
 
Three Months Ended
   
Six Months Ended
 
 
 
June 30,
   
June 30,
 
(in thousands)
       
2017
         
2016
         
2017
         
2016
 
Net income
       
$
3,468
         
$
3,031
         
$
6,771
         
$
6,314
 
Other comprehensive income:
                                                       
      Unrealized gains on available for sale securities
   
654
             
1,794
             
724
             
3,489
         
      Income tax effect
   
(222
)
           
(610
)
           
(246
)
           
(1,188
)
       
      Change in unrecognized pension cost
   
52
             
60
             
112
             
121
         
      Income tax effect
   
(17
)
           
(21
)
           
(38
)
           
(42
)
       
      Less:  Reclassification adjustment for investment
                                                               
                 security gains included in net income
   
(23
)
           
(128
)
           
(195
)
           
(155
)
       
      Income tax effect
   
8
             
44
             
66
             
53
         
Other comprehensive income, net of tax
           
452
             
1,139
             
423
             
2,278
 
Comprehensive income
         
$
3,920
           
$
4,170
           
$
7,194
           
$
8,592
 
 
                                                               
The accompanying notes are an integral part of these unaudited consolidated financial statements.
                                 


3

 
CITIZENS FINANCIAL SERVICES, INC.
           
CONSOLIDATED STATEMENT OF CASH FLOWS
           
(UNAUDITED)
 
Six Months Ended
 
 
 
June 30,
 
(in thousands)
 
2017
   
2016
 
CASH FLOWS FROM OPERATING ACTIVITIES:
           
  Net income
 
$
6,771
   
$
6,314
 
  Adjustments to reconcile net income to net
               
   cash provided by operating activities:
               
    Provision for loan losses
   
1,240
     
270
 
    Provision for off-balance sheet items
   
-
     
30
 
    Depreciation and amortization
   
199
     
175
 
    Amortization and accretion of investment securities
   
735
     
1,148
 
    Deferred income taxes
   
(105
)
   
81
 
    Investment securities and interest bearing time deposit gains, net
   
(195
)
   
(155
)
    Earnings on bank owned life insurance
   
(333
)
   
(342
)
    Originations of loans held for sale
   
(10,247
)
   
(8,580
)
    Proceeds from sales of loans held for sale
   
11,840
     
7,995
 
    Realized gains on loans sold
   
(249
)
   
(116
)
    Increase in accrued interest receivable
   
392
     
35
 
    Decrease in accrued interest payable
   
(92
)
   
(90
)
    Other, net
   
(166
)
   
(519
)
      Net cash provided by operating activities
   
9,790
     
6,246
 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
  Available-for-sale securities:
               
    Proceeds from sales
   
25,407
     
12,077
 
    Proceeds from maturity and principal repayments
   
36,510
     
21,561
 
    Purchase of securities
   
(13,829
)
   
(32,507
)
  Purchase of interest bearing time deposits with other banks
   
(4,069
)
   
-
 
  Proceeds from matured interest bearing time deposits with other banks
   
496
     
744
 
  Proceeds from sale of interest bearing time deposits with other banks
   
1,745
     
-
 
  Proceeds from redemption of regulatory stock
   
4,303
     
184
 
  Purchase of regulatory stock
   
(3,487
)
   
(132
)
  Net increase in loans
   
(88,468
)
   
(14,135
)
  Purchase of premises and equipment
   
(131
)
   
(398
)
  Proceeds from sale of foreclosed assets held for sale
   
237
     
374
 
      Net cash used in investing activities
   
(41,286
)
   
(12,232
)
CASH FLOWS FROM FINANCING ACTIVITIES:
               
  Net increase in deposits
   
45,706
     
15,451
 
  Proceeds from long-term borrowings
   
5
     
539
 
  Repayments of long-term borrowings
   
-
     
(534
)
  Net decrease in short-term borrowed funds
   
(9,669
)
   
(2,850
)
  Purchase of treasury and restricted stock
   
(509
)
   
(1,482
)
  Dividends paid
   
(2,429
)
   
(2,700
)
      Net cash provided by financing activities
   
33,104
     
8,424
 
          Net increase in cash and cash equivalents
   
1,608
     
2,438
 
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
   
17,754
     
24,384
 
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 
$
19,362
   
$
26,822
 
 
               
Supplemental Disclosures of Cash Flow Information:
               
    Interest paid
 
$
2,769
   
$
2,602
 
    Income taxes paid
 
$
2,075
   
$
1,400
 
    Loans transferred to foreclosed property
 
$
335
   
$
519
 
    Investments purchased and not settled
 
$
1,541
   
$
-
 
 
               
The accompanying notes are an integral part of these unaudited consolidated financial statements.
 

4

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

Note 1 - Basis of Presentation

Citizens Financial Services, Inc. (individually and collectively with its direct and indirect subsidiaries, the "Company") is a Pennsylvania corporation and the holding company of its wholly owned subsidiary, First Citizens Community Bank (the "Bank"), and of the Bank's wholly owned subsidiary, First Citizens Insurance Agency, Inc. ("First Citizens Insurance").

The accompanying consolidated financial statements have been prepared pursuant to rules and regulations of the Securities and Exchange Commission ("SEC") and in conformity with U.S. generally accepted accounting principles.  Because this report is based on an interim period, certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted.  Certain of the prior year amounts have been reclassified to conform with the current year presentation.  Such reclassifications had no effect on net income or stockholders' equity.  All material inter‑company balances and transactions have been eliminated in consolidation.

In the opinion of management of the Company, the accompanying interim financial statements at June 30, 2017 and for the periods ended June 30, 2017 and 2016 include all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the financial condition and the results of operations for the periods. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. The financial performance reported for the Company for the six month period ended June 30, 2017 is not necessarily indicative of the results to be expected for the full year.  This information should be read in conjunction with the Company's Annual Report on Form 10-K for the year ended December 31, 2016.

Note 2 - Earnings per Share

The following table sets forth the computation of earnings per share. Earnings per share calculations give retroactive effect to stock dividends declared by the Company.

   
Three months ended
   
Six months ended
 
   
June 30,
   
June 30,
 
   
2017
   
2016
   
2017
   
2016
 
Net income applicable to common stock
 
$
3,468,000
   
$
3,031,000
   
$
6,771,000
   
$
6,314,000
 
 
                               
Basic earnings per share computation
                               
Weighted average common shares outstanding
   
3,480,122
     
3,508,818
     
3,479,653
     
3,515,477
 
Earnings per share - basic
 
$
1.00
   
$
0.86
   
$
1.95
   
$
1.80
 
 
                               
Diluted earnings per share computation
                               
Weighted average common shares outstanding for basic earnings per share
   
3,480,122
     
3,508,818
     
3,479,653
     
3,515,477
 
Add: Dilutive effects of restricted stock
   
1,188
     
409
     
610
     
205
 
Weighted average common shares outstanding for dilutive earnings per share
   
3,481,310
     
3,509,227
     
3,480,263
     
3,515,682
 
Earnings per share - diluted
 
$
1.00
   
$
0.86
   
$
1.95
   
$
1.80
 

For the three months ended June 30, 2017 and 2016, there were 1,562 and 4,521 shares, respectively, related to the restricted stock plan that were excluded from the diluted earnings per share calculations since they were anti-dilutive. These anti-dilutive shares had per share prices ranging from $49.87-$53.15 for the three month period ended June 30, 2017 and per share prices ranging from $46.69-$53.15 for the three month period ended June 30, 2016. For the six months ended June 30, 2017 and 2016, 4,921 and 4,521 shares, respectively, related to the restricted stock plan were excluded from the diluted earnings per share calculations since they were anti-dilutive. These anti-dilutive shares had prices ranging from $47.81-$53.15 for the six month period ended June 30, 2017 and prices ranging from $46.69-$53.15 for the six month period ended June 30, 2016.

5

Note 3 - Income Tax Expense

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

Investments in Qualified Affordable Housing Projects

As of June 30, 2017 and December 31, 2016, the Company was invested in four partnerships that provide affordable housing. The balance of the investments, which is included within other assets in the Consolidated Balance Sheet, was $631,000 and $700,000 as of June 30, 2017 and December 31, 2016, respectively. Investments purchased prior to January 1, 2015, are accounted for utilizing the effective yield method. As of June 30, 2017, the Company had $775,000 of tax credits remaining that will be recognized over 5.50 years. Tax credits of $35,000 and $49,000 were recognized as a reduction of tax expense during the three months ended Jun 30, 2017 and 2016, respectively. For the six months ended June 30, 2017 and 2016, tax credits of $70,000 and $99,000, respectively, were recognized as a reduction of tax expense. Amortization of the investment included in other expenses on the Consolidated Statement of Income was $40,000 and $64,000 during the three months ended June 30, 2017 and 2016, respectively. Amortization of the investment included in other expenses on the Consolidated Statement of Income was $80,000 and $129,000 during the six months ended June 30, 2017 and 2016, respectively.

Note 4 – Investments

The amortized cost, gross unrealized gains and losses, and fair value of investment securities at June 30, 2017 and December 31, 2016 were as follows (in thousands):

         
Gross
   
Gross
       
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
 
June 30, 2017
 
Cost
   
Gains
   
Losses
   
Value
 
Available-for-sale securities:
                       
  U.S. agency securities
 
$
142,581
   
$
315
   
$
(146
)
 
$
142,750
 
  Obligations of state and
                               
    political subdivisions
   
84,731
     
1,578
     
(93
)
   
86,216
 
  Corporate obligations
   
3,000
     
111
     
-
     
3,111
 
  Mortgage-backed securities in
                               
    government sponsored entities
   
41,489
     
147
     
(176
)
   
41,460
 
  Equity securities in financial institutions
   
900
     
771
     
-
     
1,671
 
Total available-for-sale securities
 
$
272,701
   
$
2,922
   
$
(415
)
 
$
275,208
 
                                 
December 31, 2016
                               
Available-for-sale securities:
                               
  U.S. agency securities
 
$
170,276
   
$
407
   
$
(269
)
 
$
170,414
 
  U.S. treasury securities
   
2,999
     
1
     
-
     
3,000
 
  Obligations of state and
                               
    political subdivisions
   
95,956
     
1,463
     
(493
)
   
96,926
 
  Corporate obligations
   
3,000
     
50
     
-
     
3,050
 
  Mortgage-backed securities in
                               
    government sponsored entities
   
37,987
     
88
     
(347
)
   
37,728
 
  Equity securities in financial institutions
   
1,821
     
1,078
     
-
     
2,899
 
Total available-for-sale securities
 
$
312,039
   
$
3,087
   
$
(1,109
)
 
$
314,017
 

The following table shows the Company's gross unrealized losses and fair value of the Company's investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time, which individual securities have been in a continuous unrealized loss position, at June 30, 2017 and December 31, 2016 (in thousands). As of June 30, 2017, the Company owned 63 securities whose fair value was less than their cost basis.
 
6


   
Less than Twelve Months
   
Twelve Months or Greater
   
Total
 
         
Gross
         
Gross
         
Gross
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
  June 30, 2017
 
Value
   
Losses
   
Value
   
Losses
   
Value
   
Losses
 
U.S. agency securities
 
$
53,010
   
$
(142
)
 
$
995
   
$
(4
)
 
$
54,005
   
$
(146
)
Obligations of state and
                                               
    political subdivisions
   
7,811
     
(40
)
   
5,171
     
(53
)
   
12,982
     
(93
)
Mortgage-backed securities in
                                               
   government sponsored entities
   
18,873
     
(149
)
   
1,377
     
(27
)
   
20,250
     
(176
)
    Total securities
 
$
79,694
   
$
(331
)
 
$
7,543
   
$
(84
)
 
$
87,237
   
$
(415
)
                                                 
December 31, 2016
                                               
U.S. agency securities
 
$
50,947
   
$
(269
)
 
$
-
   
$
-
   
$
50,947
   
$
(269
)
Obligations of states and
                                               
     political subdivisions
   
28,398
     
(472
)
   
767
     
(21
)
   
29,165
     
(493
)
Mortgage-backed securities in
                                               
   government sponsored entities
   
26,717
     
(330
)
   
753
     
(17
)
   
27,470
     
(347
)
    Total securities
 
$
106,062
   
$
(1,071
)
 
$
1,520
   
$
(38
)
 
$
107,582
   
$
(1,109
)

As of June 30, 2017 and December 31, 2016, the Company's investment securities portfolio contained unrealized losses on agency securities issued or backed by the full faith and credit of the United States government or are generally viewed as having the implied guarantee of the U.S. government, obligations of states and political subdivisions and mortgage backed securities issued by government sponsored entities. For fixed maturity investments management considers whether the present value of cash flows expected to be collected are less than the security's amortized cost basis (the difference defined as the credit loss), the magnitude and duration of the decline, the reasons underlying the decline and the Company's intent to sell the security or whether it is more likely than not that the Company would be required to sell the security before its anticipated recovery in market value, to determine whether the loss in value is other than temporary. Once a decline in value is determined to be other than temporary, if the Company does not intend to sell the security, and it is more likely than not that it will not be required to sell the security before recovery of the security's amortized cost basis, the charge to earnings is limited to the amount of credit loss. Any remaining difference between fair value and amortized cost (the difference defined as the non-credit portion) is recognized in other comprehensive income, net of applicable taxes. Otherwise, the entire difference between fair value and amortized cost is charged to earnings. For equity securities where the fair value has been significantly below cost for one year, the Company's policy is to recognize an impairment loss unless sufficient evidence is available that the decline is not other than temporary and a recovery period can be predicted.  The Company has concluded that any impairment of its investment securities portfolio outlined in the above table is not other than temporary and is the result of interest rate changes, sector credit rating changes, or issuer-specific rating changes that are not expected to result in the non-collection of principal and interest during the period.

Proceeds from sales of securities available-for-sale for the six months ended June 30, 2017 and 2016 were $25,407,000 and $12,077,000, respectively.  For the three months ended June 30, 2017 and 2016, sales of available-for-sale securities were $6,641,000 and $7,057,000, respectively. The gross gains and losses were as follows (in thousands):

   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
 
 
2017
   
2016
   
2017
   
2016
 
Gross gains
 
$
30
   
$
128
   
$
202
   
$
155
 
Gross losses
   
(7
)
   
-
     
(7
)
   
-
 
Net gains
 
$
23
   
$
128
   
$
195
   
$
155
 
 
 
7

Investment securities with an approximate carrying value of $233.4 million and $206.3 million at June 30, 2017 and December 31, 2016, respectively, were pledged to secure public funds and certain other deposits.

Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.   The amortized cost and fair value of debt securities (excludes equity securities) at June 30, 2017, by contractual maturity, are shown below (in thousands):

   
Amortized
       
 
 
Cost
   
Fair Value
 
Available-for-sale debt securities:
           
  Due in one year or less
 
$
46,659
   
$
46,812
 
  Due after one year through five years
   
130,797
     
131,827
 
  Due after five years through ten years
   
37,314
     
37,598
 
  Due after ten years
   
57,031
     
57,300
 
Total
 
$
271,801
   
$
273,537
 

Note 5 – Loans

The Company grants loans primarily to customers throughout north central, central and south central Pennsylvania and the southern tier of New York.  Although the Company had a diversified loan portfolio at June 30, 2017 and December 31, 2016, a substantial portion of its debtors' ability to honor their contracts is dependent on the economic conditions within these regions. The following table summarizes the primary segments of the loan portfolio and how those segments are analyzed within the allowance for loan losses as of June 30, 2017 and December 31, 2016 (in thousands):

June 30, 2017
 
Total Loans
   
Individually
evaluated for impairment
   
Loans acquired
with deteriorated
credit quality
   
Collectively
evaluated for impairment
 
Real estate loans:
                       
     Residential
 
$
205,725
   
$
1,254
   
$
35
   
$
204,436
 
     Commercial
   
271,342
     
13,680
     
1,989
     
255,673
 
     Agricultural
   
188,547
     
3,728
     
734
     
184,085
 
     Construction
   
25,569
     
-
     
-
     
25,569
 
Consumer
   
10,603
     
4
     
-
     
10,599
 
Other commercial loans
   
56,952
     
4,902
     
868
     
51,182
 
Other agricultural loans
   
32,974
     
1,466
     
-
     
31,508
 
State and political subdivision loans
   
96,337
     
-
     
-
     
96,337
 
Total
   
888,049
     
25,034
     
3,626
     
859,389
 
Allowance for loan losses
   
9,979
     
457
     
-
     
9,522
 
Net loans
 
$
878,070
   
$
24,577
   
$
3,626
   
$
849,867
 
 
                               
December 31, 2016
                               
Real estate loans:
                               
     Residential
 
$
207,423
   
$
957
   
$
35
   
$
206,431
 
     Commercial
   
252,577
     
5,742
     
1,969
     
244,866
 
     Agricultural
   
123,624
     
3,346
     
738
     
119,540
 
     Construction
   
25,441
     
-
     
-
     
25,441
 
Consumer
   
11,005
     
-
     
4
     
11,001
 
Other commercial loans
   
58,639
     
5,994
     
621
     
52,024
 
Other agricultural loans
   
23,388
     
1,654
     
-
     
21,734
 
State and political subdivision loans
   
97,514
     
-
     
-
     
97,514
 
Total
   
799,611
     
17,693
     
3,367
     
778,551
 
Allowance for loan losses
   
8,886
     
487
     
-
     
8,399
 
Net loans
 
$
790,725
   
$
17,206
   
$
3,367
   
$
770,152
 

8

Purchased loans acquired in The First National Bank of Fredericksburg (FNB) acquisition, completed in 2015, were recorded at fair value on their purchase date without a carryover of the related allowance for loan losses.

Upon acquisition, the Company evaluated whether an acquired loan was within the scope of ASC 310-30, Receivables-Loans and Debt Securities Acquired with Deteriorated Credit Quality. Purchased credit-impaired ("PCI") loans are loans that have evidence of credit deterioration since origination and it is probable at the date of acquisition that the Company will not collect all contractually required principal and interest payments. Based upon management's review, there were no material increases or decreases in the expected cash flows of these loans between December 11, 2015 (the "acquisition date") and June 30, 2017. The fair value of PCI loans, on the acquisition date, was determined, primarily based on the fair value of the loans' collateral. The carrying value of PCI loans was $3,626,000 and $3,367,000 at June 30, 2017 and December 31, 2016, respectively.

The carrying value of the PCI loans was determined by projected discounted contractual cash flows.

Changes in the accretable yield for PCI loans were as follows for the three and six months ended June 30, 2017 and 2016, respectively (in thousands):

 
 
Three months ended
   
Six months ended
 
 
 
June 30,
   
June 30,
 
 
 
2017
   
2016
   
2017
   
2016
 
Balance at beginning of period
 
$
275
   
$
551
   
$
389
   
$
637
 
Accretion
   
(108
)
   
(87
)
   
(222
)
   
(173
)
Balance at end of period
 
$
167
   
$
464
   
$
167
   
$
464
 

The following table presents additional information regarding loans acquired with specific evidence of deterioration in credit quality under ASC 310-30 (in thousands):

   
June 30, 2017
   
December 31, 2016
 
Outstanding balance
 
$
6,660
   
$
6,487
 
Carrying amount
   
3,626
     
3,367
 

The segments of the Company's loan portfolio are disaggregated into classes to a level that allows management to monitor risk and performance. Residential real estate mortgages consist primarily of 15 to 30 year first mortgages on residential real estate, while residential real estate home equity loans are consumer purpose installment loans or lines of credit with terms of 15 years or less secured by a mortgage which is often a second lien on residential real estate. Commercial real estate loans are business purpose loans secured by a mortgage on commercial real estate. Agricultural real estate loans are loans secured by a mortgage on real estate used in agriculture production. Construction real estate loans are loans secured by residential, commercial or agricultural real estate used during the construction phase of residential, commercial or agricultural projects. Consumer loans are typically unsecured or primarily secured by assets other than real estate and overdraft lines of credit are typically secured by customer deposit accounts. Other commercial loans are loans for commercial purposes primarily secured by non-real estate collateral. Other agricultural loans are loans for agricultural purposes primarily secured by non-real estate collateral. State and political subdivision loans are loans to state and local municipalities for capital and operating expenses or tax free loans used to finance commercial development.

Management considers other commercial loans, other agricultural loans, state and political subdivision loans, commercial real estate loans and agricultural real estate loans which are 90 days or more past due to be impaired. Management will also consider a loan impaired based on other factors it becomes aware of, including the customer's results of operations and cash flows or if the loan is modified in a troubled debt restructuring. In addition, certain residential mortgages, home equity and consumer loans that are cross collateralized with commercial relationships that are determined to be impaired may also be classified as impaired. Impaired loans are analyzed to determine if it is probable that all amounts will not be collected according to the contractual terms of the loan agreement. If management determines that the value of the impaired loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized through an allocation of the allowance for loan losses or a charge-off to the allowance for loan losses.

9

The following table includes the recorded investment and unpaid principal balances for impaired financing receivables by class, excluding PCI loans, with the associated allowance amount, if applicable (in thousands):

 
       
Recorded
   
Recorded
             
 
 
Unpaid
   
Investment
   
Investment
   
Total
       
 
 
Principal
   
With No
   
With
   
Recorded
   
Related
 
June 30, 2017
 
Balance
   
Allowance
   
Allowance
   
Investment
   
Allowance
 
Real estate loans:
                             
     Mortgages
 
$
1,246
   
$
281
   
$
903
   
$
1,184
   
$
67
 
     Home Equity
   
70
     
16
     
54
     
70
     
10
 
     Commercial
   
16,037
     
13,093
     
587
     
13,680
     
58
 
     Agricultural
   
3,744
     
2,405
     
1,323
     
3,728
     
95
 
     Construction
   
-
     
-
     
-
     
-
     
-
 
Consumer
   
4
     
2
     
2
     
4
     
2
 
Other commercial loans
   
5,423
     
4,431
     
471
     
4,902
     
207
 
Other agricultural loans
   
1,466
     
1,448
     
18
     
1,466
     
18
 
State and political
                                       
   subdivision loans
   
-
     
-
     
-
     
-
     
-
 
Total
 
$
27,990
   
$
21,676
   
$
3,358
   
$
25,034
   
$
457
 
 
                                       
December 31, 2016
                                       
Real estate loans:
                         
 
 
         
     Mortgages
 
$
953
   
$
570
   
$
330
     $
900
   
$
22
 
     Home Equity
   
57
     
-
     
57
     
57
     
10
 
     Commercial
   
7,958
     
5,697
     
45
     
5,742
     
45
 
     Agricultural
   
3,347
     
2,000
     
1,347
     
3,347
     
54
 
     Construction
   
-
     
-
     
-
     
-
     
-
 
Consumer
   
-
     
-
     
-
     
-
     
-
 
Other commercial loans
   
6,159
     
5,135
     
859
     
5,994
     
326
 
Other agricultural loans
   
1,653
     
1,629
     
24
     
1,653
     
30
 
State and political
                                       
   subdivision loans
   
-
     
-
     
-
     
-
     
-
 
Total
 
$
20,127
   
$
15,031
   
$
2,662
   
$
17,693
   
$
487
 

The following tables includes the average balance of impaired financing receivables by class and the income recognized on these receivables for the three and six month periods ended June 30, 2017 and 2016(in thousands):
 
 
For the Three Months Ended
 
 
 
June 30, 2017
   
June 30, 2016
 
 
             
Interest
               
Interest
 
 
 
Average
   
Interest
   
Income
   
Average
   
Interest
   
Income
 
 
 
Recorded
   
Income
   
Recognized
   
Recorded
   
Income
   
Recognized
 
 
 
Investment
   
Recognized
   
Cash Basis
   
Investment
   
Recognized
   
Cash Basis
 
Real estate loans:
                                   
     Mortgages
 
$
986
   
$
3
   
$
-
   
$
460
   
$
5
   
$
-
 
     Home Equity
   
60
     
1
     
-
     
59
     
1
     
-
 
     Commercial
   
12,980
     
134
     
-
     
6,158
     
26
     
-
 
     Agricultural
   
3,641
     
32
     
-
     
165
     
3
     
-
 
     Construction
   
-
     
-
     
-
     
-
     
-
     
-
 
Consumer
   
3
     
-
     
-
     
-
     
-
     
-
 
Other commercial loans
   
5,029
     
37
     
17
     
5,933
     
68
     
2
 
Other agricultural loans
   
1,515
     
22
     
-
     
104
     
2
     
-
 
State and political
                                               
   subdivision loans
   
-
     
-
     
-
     
-
     
-
     
-
 
Total
 
$
24,214
   
$
229
   
$
17
   
$
12,879
   
$
105
   
$
2
 

10


 
 
For the Six Months ended
 
 
 
June 30, 2017
   
June 30, 2016
 
 
             
Interest
               
Interest
 
 
 
Average
   
Interest
   
Income
   
Average
   
Interest
   
Income
 
 
 
Recorded
   
Income
   
Recognized
   
Recorded
   
Income
   
Recognized
 
 
 
Investment
   
Recognized
   
Cash Basis
   
Investment
   
Recognized
   
Cash Basis
 
Real estate loans:
                                   
     Mortgages
 
$
940
   
$
6
   
$
-
   
$
425
   
$
9
   
$
-
 
     Home Equity
   
58
     
2
     
-
     
60
     
2
     
-
 
     Commercial
   
9,387
     
158
     
3
     
6,142
     
52
     
-
 
     Agricultural
   
3,513
     
63
     
-
     
165
     
5
     
-
 
     Construction
   
-
     
-
     
-
     
-
     
-
     
-
 
Consumer
   
2
     
-
     
-
     
-
     
-
     
-
 
Other commercial loans
   
5,313
     
77
     
27
     
5,942
     
134
     
3
 
Other agricultural loans
   
1,571
     
45
     
-
     
104
     
3
     
-
 
State and political
                                               
   subdivision loans
   
-
     
-
     
-
     
-
     
-
     
-
 
Total
 
$
20,784
   
$
351
   
$
30
   
$
12,838
   
$
205
   
$
3
 

Credit Quality Information

For commercial real estate, agricultural real estate, construction, other commercial, other agricultural and state and political subdivision loans, management uses a nine grade internal risk rating system to monitor credit quality. The first five categories are considered not criticized and are aggregated as "Pass" rated. The criticized rating categories utilized by management generally follow bank regulatory definitions. The definitions of each rating are defined below:
·
Pass (Grades 1-5) – These loans are to customers with credit quality ranging from an acceptable to very high quality and are protected by the current net worth and paying capacity of the obligor or by the value of the underlying collateral.
·
Special Mention (Grade 6) – This loan grade is in accordance with regulatory guidance and includes loans where a potential weakness or risk exists, which could cause a more serious problem if not corrected.
·
Substandard (Grade 7) – This loan grade is in accordance with regulatory guidance and includes loans that have a well-defined weakness based on objective evidence and be characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.
·
Doubtful (Grade 8) – This loan grade is in accordance with regulatory guidance and includes loans that have all the weaknesses inherent in a substandard asset. In addition, these weaknesses make collection or liquidation in full highly questionable and improbable, based on existing circumstances.
·
Loss (Grade 9) – This loan grade is in accordance with regulatory guidance and includes loans that are considered uncollectible, or of such value that continuance as an asset is not warranted.

To help ensure that risk ratings are accurate and reflect the present and future capacity of borrowers to repay the loan as agreed, the Company's loan rating process includes several layers of internal and external oversight. The Company's loan officers are responsible for the timely and accurate risk rating of the loans in each of their portfolios at origination and on an ongoing basis under the supervision of management.  All commercial and agricultural loans are reviewed annually to ensure the appropriateness of the loan grade. In addition, the Company engages an external consultant on at least an annual basis to 1) review a minimum of 55% of the dollar volume of the commercial loan portfolio on an annual basis, 2) review new loans originated for over $1.0 million in the last year, 3) review 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.

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The following tables represent credit exposures by internally assigned grades as of June 30, 2017 and December 31, 2016 (in thousands):

June 30, 2017
 
Pass
   
Special Mention
   
Substandard
   
Doubtful
   
Loss
   
Ending Balance
 
Real estate loans:
                                   
     Commercial
 
$
244,957
   
$
13,913
   
$
12,472
   
$
-
   
$
-
   
$
271,342
 
     Agricultural
   
176,551
     
5,457
     
6,539
     
-
     
-
     
188,547
 
     Construction
   
25,569
     
-
     
-
     
-
     
-
     
25,569
 
Other commercial loans
   
51,577
     
608
     
4,684
     
83
     
-
     
56,952
 
Other agricultural loans
   
30,641
     
195
     
2,138
     
-
     
-
     
32,974
 
State and political
                                               
   subdivision loans
   
82,665
     
2,926
     
10,746
     
-
     
-
     
96,337
 
Total
 
$
611,960
   
$
23,099
   
$
36,579
   
$
83
   
$
-
   
$
671,721
 

December 31, 2016
 
Pass
   
Special Mention
   
Substandard
   
Doubtful
   
Loss
   
Ending Balance
 
Real estate loans:
                                   
     Commercial
 
$
225,185
   
$
14,045
   
$
13,347
   
$
-
   
$
-
   
$
252,577
 
     Agricultural
   
110,785
     
8,231
     
4,608
     
-
     
-
     
123,624
 
     Construction
   
25,441
     
-
     
-
     
-
     
-
     
25,441
 
Other commercial loans
   
51,396
     
2,049
     
5,105
     
89
     
-
     
58,639
 
Other agricultural loans
   
20,178
     
1,733
     
1,477
     
-
     
-
     
23,388
 
State and political
                                               
   subdivision loans
   
83,620
     
13,066
     
828
     
-
     
-
     
97,514
 
Total
 
$
516,605
   
$
39,124
   
$
25,365
   
$
89
   
$
-
   
$
581,183
 

For residential real estate mortgages, home equity and consumer loans, credit quality is monitored based on whether the loan is performing or non-performing, which is typically based on the aging status of the loan and payment activity, unless a specific action, such as bankruptcy, repossession, death or significant delay in payment occurs to raise awareness of a possible credit event. Non-performing loans include those loans that are considered nonaccrual, described in more detail below, and all loans past due 90 or more days and still accruing. The following table presents the recorded investment in those loan classes based on payment activity as of June 30, 2017 and December 31, 2016 (in thousands):

June 30, 2017
 
Performing
   
Non-performing
   
PCI
   
Total
 
Real estate loans:
                       
     Mortgages
 
$
146,736
   
$
1,509
   
$
35
   
$
148,280
 
     Home Equity
   
57,256
     
189
     
-
     
57,445
 
Consumer
   
10,459
     
144
     
-
     
10,603
 
Total
 
$
214,451
   
$
1,842