secondqtr2014.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, 2014
Or

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

For the transition period from_____________________ to ___________________

Commission file number 0-13222

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

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


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

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

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

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

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

Large accelerated filer ____                                                                                                   Accelerated filer _X__

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

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

The number of outstanding shares of the Registrant’s Common Stock, as of July 29, 2014, was 3,041,911.

 
 

 

 
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, 2014 and December 31, 2013
1
 
Consolidated Statement of Income for the Three and Six Months Ended June 30, 2014 and 2013
2
 
Consolidated Statement of Comprehensive Income for the Three and Six Months ended June 30, 2014 and 2013
3
 
Consolidated Statement of Cash Flows for the Six Months ended June 30, 2014 and 2013
4
 
Notes to Consolidated Financial Statements
5-28
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
29-50
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
50-51
Item 4.
Controls and Procedures
51
     
Part II
OTHER INFORMATION
 
Item 1.
Legal Proceedings
51
Item 1A.
Risk Factors
51
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
51-52
Item 3.
Defaults Upon Senior Securities
52
Item 4.
Mine Safety Disclosures
52
Item 5.
Other Information
52
Item 6.
Exhibits
52
 
Signatures
53

 
 

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED BALANCE SHEET
   
(UNAUDITED)
   
     
 
June 30
December 31
(in thousands except share data)
2014
2013
ASSETS:
   
Cash and due from banks:
   
  Noninterest-bearing
 $             14,742
 $            8,899
  Interest-bearing
                     998
               1,184
Total cash and cash equivalents
                15,740
             10,083
Interest bearing time deposits with other banks
                  2,480
               2,480
Available-for-sale securities
              312,322
           317,301
Loans held for sale
                     545
                  278
 
   
Loans (net of allowance for loan losses:
   
  2014, $6,751 and 2013, $7,098)
              533,126
           533,514
 
   
Premises and equipment
                11,501
             11,105
Accrued interest receivable
                  3,557
               3,728
Goodwill
                10,256
             10,256
Bank owned life insurance
                14,921
             14,679
Other assets
                  9,721
             11,510
 
 
 
TOTAL ASSETS
 $           914,169
 $        914,934
 
 
 
LIABILITIES:
   
Deposits:
   
  Noninterest-bearing
 $             94,434
 $          85,585
  Interest-bearing
              671,022
           662,731
Total deposits
              765,456
           748,316
Borrowed funds
                43,075
             66,932
Accrued interest payable
                     735
                  895
Other liabilities
                  6,664
               6,735
TOTAL LIABILITIES
              815,930
           822,878
STOCKHOLDERS' EQUITY:
   
Preferred Stock
   
  $1.00 par value; authorized 3,000,000 shares June 30, 2014 and December 31, 2013;
   
   none issued in 2014 or 2013
                          -
                      -
Common stock
   
  $1.00 par value; authorized 15,000,000 shares;  issued 3,335,235 at June 30, 2014 and
   
  3,305,517 at December 31, 2013
                  3,335
               3,306
Additional paid-in capital
                25,142
             23,562
Retained earnings
                76,925
             74,325
Accumulated other comprehensive income (loss)
                  1,100
             (1,225)
Treasury stock, at cost:  296,758 shares at June 30, 2014
   
  and 290,468 shares at December 31, 2013
                 (8,263)
             (7,912)
TOTAL STOCKHOLDERS' EQUITY
                98,239
             92,056
TOTAL LIABILITIES AND
   
   STOCKHOLDERS' EQUITY
 $           914,169
 $        914,934
     
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)
        2014
       2013
    2014
    2013
INTEREST INCOME:
       
Interest and fees on loans
 $        7,118
 $      7,141
 $       14,106
 $     14,278
Interest-bearing deposits with banks
                 13
                 9
                  26
               19
Investment securities:
   
 
 
    Taxable
               849
             936
             1,737
          1,899
    Nontaxable
               840
             844
             1,682
          1,713
    Dividends
                 69
               18
                119
               38
TOTAL INTEREST INCOME
           8,889
         8,948
          17,670
        17,947
INTEREST EXPENSE:
       
Deposits
           1,094
         1,287
             2,199
          2,615
Borrowed funds
               145
             310
                309
             668
TOTAL INTEREST EXPENSE
           1,239
         1,597
             2,508
          3,283
NET INTEREST INCOME
           7,650
         7,351
          15,162
        14,664
Provision for loan losses
               150
               75
                330
             225
NET INTEREST INCOME AFTER
       
    PROVISION FOR LOAN LOSSES
           7,500
         7,276
          14,832
        14,439
NON-INTEREST INCOME:
       
Service charges
           1,102
         1,114
             2,141
          2,168
Trust
               186
             169
                377
             370
Brokerage and insurance
               137
             121
                257
             213
Investment securities gains, net
                 75
               98
                246
             294
Gains on loans sold
                 30
               50
                  70
             161
Earnings on bank owned life insurance
               121
             126
                242
             250
Other
               104
             100
                209
             204
TOTAL NON-INTEREST INCOME
           1,755
         1,778
             3,542
          3,660
NON-INTEREST EXPENSES:
       
Salaries and employee benefits
           2,893
         2,795
             5,810
          5,600
Occupancy
               304
             312
                654
             654
Furniture and equipment
                 94
             113
                194
             215
Professional fees
               208
             188
                442
             417
FDIC insurance
               116
             113
                229
             225
Pennsylvania shares tax
               191
             182
                384
             365
Other
           1,194
         1,164
             2,378
          2,243
TOTAL NON-INTEREST EXPENSES
           5,000
         4,867
          10,091
          9,719
Income before provision for income taxes
           4,255
         4,187
             8,283
          8,380
Provision for income taxes
               890
             907
             1,742
          1,813
NET INCOME
 $        3,365
 $      3,280
 $         6,541
 $       6,567
 
       
PER COMMON SHARE DATA:
       
Net Income - Basic
 $          1.11
 $        1.07
 $            2.15
 $         2.14
Net Income - Diluted
 $          1.11
 $        1.07
 $            2.15
 $         2.14
Cash Dividends Paid
 $        0.385
 $      0.278
 $         0.770
 $       0.547
         
Number of shares used in computation - basic
   3,039,734
  3,060,998
     3,040,822
  3,062,210
Number of shares used in computation - diluted
   3,040,661
  3,062,576
     3,041,227
  3,062,991
         
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)
 
2014
 
2013
 
2014
 
2013
Net income
 
$  3,365
 
$  3,280
 
$   6,541
 
$ 6,567
Other comprehensive income (loss):
               
      Change in unrealized gains on available for sale securities
1,494
 
 (6,656)
 
3,743
 
(8,032)
 
      Income tax effect
 (508)
 
2,263
 
(1,272)
 
2,731
 
      Change in unrecognized pension cost
13
 
128
 
25
 
128
 
      Income tax effect
 (4)
 
 (44)
 
 (9)
 
 (44)
 
      Change in unrealized loss on interest rate swap
-
 
51
 
-
 
101
 
      Income tax effect
-
 
 (17)
 
-
 
 (34)
 
      Less:  Reclassification adjustment for investment
 (75)
 
 (98)
 
 (246)
 
 (294)
 
                 security gains included in net income
               
      Income tax effect
26
 
33
 
84
 
100
 
Other comprehensive income (loss), net of tax
 
946
 
 (4,340)
 
2,325
 
(5,344)
Comprehensive income (loss)
 
$  4,311
 
$ (1,060)
 
$   8,866
 
$ 1,223
                 
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)
2014
2013
CASH FLOWS FROM OPERATING ACTIVITIES:
   
  Net income
 $          6,541
 $          6,567
  Adjustments to reconcile net income to net
   
   cash provided by operating activities:
   
    Provision for loan losses
                330
                225
    Depreciation and amortization
                233
                216
    Amortization and accretion of investment securities
             1,100
             1,234
    Deferred income taxes
                498
                    9
    Investment securities gains, net
              (246)
              (294)
    Earnings on bank owned life insurance
              (242)
              (250)
    Originations of loans held for sale
           (5,286)
         (11,801)
    Proceeds from sales of loans held for sale
             5,089
           12,624
    Realized gains on loans sold
                (70)
              (161)
    Decrease (increase) in accrued interest receivable
                171
                  (5)
    Decrease in accrued interest payable
              (160)
              (179)
    Other, net
           (1,107)
                413
      Net cash provided by operating activities
             6,851
             8,598
CASH FLOWS FROM INVESTING ACTIVITIES:
   
  Available-for-sale securities:
   
    Proceeds from sales
           12,151
           15,773
    Proceeds from maturity and principal repayments
           29,294
           49,651
    Purchase of securities
         (33,822)
         (72,372)
  Proceeds from redemption of regulatory stock
             2,216
                513
  Purchase of regulatory stock
           (1,484)
              (207)
  Net increase in loans
              (113)
         (13,246)
  Purchase of premises and equipment
              (145)
              (203)
  Proceeds from sale of foreclosed assets held for sale
                296
                    -
      Net cash provided by (used in) investing activities
             8,393
         (20,091)
CASH FLOWS FROM FINANCING ACTIVITIES:
   
  Net increase in deposits
           17,140
           10,918
  Proceeds from long-term borrowings
             4,010
                    -
  Repayments of long-term borrowings
           (4,200)
         (10,800)
  Net decrease in short-term borrowed funds
         (23,667)
           (1,333)
  Purchase of treasury and restricted stock
              (733)
              (380)
  Dividends paid
           (2,137)
           (1,675)
      Net cash used in financing activities
           (9,587)
           (3,270)
          Net (decrease) increase in cash and cash equivalents
             5,657
         (14,763)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
           10,083
           26,333
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 $        15,740
 $        11,570
     
Supplemental Disclosures of Cash Flow Information:
   
    Interest paid
 $          2,668
 $          3,462
    Income taxes paid
 $          1,885
 $          2,295
    Loans transferred to foreclosed property
 $             239
 $               54
    Premises and equipment transferred from other assets
 $             549
 $                 -
   
 
The accompanying notes are an integral part of these unaudited consolidated financial statements.

 
4

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

Note 1 - Basis of Presentation
 
Citizens Financial Services, Inc., (individually and collectively with its direct and indirect subsidiaries, the “Company”) is a Pennsylvania corporation organized as the holding company of its wholly owned subsidiary, First Citizens Community Bank (the “Bank”), and the Bank’s subsidiary, First Citizens Insurance Agency, Inc. (“First Citizens Insurance”).
 
The accompanying consolidated financial statements have been prepared pursuant to rules and regulations of the Securities and Exchange Commission (“SEC”) and in conformity with U.S. generally accepted accounting principles.  Because this report is based on an interim period, certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted.  Certain of the prior year amounts have been reclassified to conform with the current year presentation.  Such reclassifications had no effect on net income or stockholders’ equity.  All material inter-company balances and transactions have been eliminated in consolidation.
 
In the opinion of management of the Company, the accompanying interim financial statements for the periods ended June 30, 2014 and 2013 include all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the financial condition and the results of operations for the period.  In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. The financial performance reported for the Company for the six month period ended June 30, 2014 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, 2013.

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,
 
    2014
    2013
    2014
    2013
Net income applicable to common stock
$3,365,000
$3,280,000
$6,541,000
$6,567,000
         
Basic earnings per share computation
       
Weighted average common shares outstanding
   3,039,734
   3,060,998
     3,040,822
   3,062,210
Earnings per share - basic
$1.11
$1.07
$2.15
$2.14
         
Diluted earnings per share computation
       
Weighted average common shares outstanding for basic earnings per share
   3,039,734
   3,060,998
     3,040,822
   3,062,210
Add: Dilutive effects of restricted stock
             927
          1,578
               405
             781
Weighted average common shares outstanding for dilutive earnings per share
   3,040,661
   3,062,576
     3,041,227
   3,062,991
Earnings per share - diluted
$1.11
$1.07
$2.15
$2.14

For the three months ended June 30, 2014, there were 2,188 shares related to the restricted stock program that were excluded from the diluted earnings per share calculations since they were anti-dilutive. These anti-dilutive shares had prices ranging from $50.15-$50.50. There were no anti-dilutive securities for the three month period ended June 30, 2013. For the six months ended June 30, 2014 and 2013, 2,409 and 1,415 shares, respectively, related to the restricted stock program were excluded from the diluted earnings per share calculations since they were anti-dilutive. These anti-dilutive shares had prices ranging from $34.70-$50.50 for the six month period ended June 30, 2014 and prices ranging from $36.00-$44.50 for the six month period ended June 30, 2013.

 
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 tax credits.

Note 4 – Investments
 
The amortized cost and fair value of investment securities at June 30, 2014 and December 31, 2013 were as follows (in thousands):

   
       Gross
       Gross
 
 
       Amortized
       Unrealized
       Unrealized
       Fair
June 30, 2014
       Cost
       Gains
       Losses
       Value
Available-for-sale securities:
       
  U.S. agency securities
 $    147,871
 $                  664
 $         (1,200)
 $       147,335
  U.S. treasury securities
         11,868
                          -
               (364)
            11,504
  Obligations of state and
       
    political subdivisions
         98,825
                  3,182
               (380)
          101,627
  Corporate obligations
         13,992
                     282
                 (59)
            14,215
  Mortgage-backed securities in
       
    government sponsored entities
         35,293
                     549
                 (74)
            35,768
  Equity securities in financial
       
     institutions
           1,138
                     737
                   (2)
              1,873
Total available-for-sale securities
 $    308,987
 $               5,414
 $         (2,079)
 $       312,322
         
December 31, 2013
       
Available-for-sale securities:
       
  U.S. agency securities
 $    153,896
 $                  702
 $         (2,409)
 $       152,189
  U.S. treasury securities
         11,856
                          -
               (547)
            11,309
  Obligations of state and
       
    political subdivisions
         94,113
                  2,146
            (1,254)
            95,005
  Corporate obligations
         16,651
                     341
               (190)
            16,802
  Mortgage-backed securities in
       
    government sponsored entities
         40,405
                     566
               (300)
            40,671
  Equity securities in financial institutions
              542
                     783
                      -
              1,325
Total available-for-sale securities
 $    317,463
 $               4,538
 $         (4,700)
 $       317,301

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, 2014 and December 31, 2013 (in thousands). As of June 30, 2014, the Company owned 69 securities whose fair value was less than their cost basis.
 
 
6

 
 
June 30, 2014
    Less than Twelve Months
    Twelve Months or Greater
   Total
     
    Gross
 
    Gross
 
    Gross
   
    Fair
    Unrealized
    Fair
    Unrealized
    Fair
    Unrealized
   
    Value
    Losses
    Value
    Losses
    Value
    Losses
U.S. agency securities
 $        36,001
 $           (225)
 $        43,305
 $           (975)
 $        79,306
 $        (1,200)
U.S. treasury securities
                     -
                     -
         11,503
            (364)
11,503
(364)
Obligations of state and
           
    political subdivisions
5,770
(79)
           11,357
              (301)
17,127
(380)
Corporate obligations
507
(1)
             7,855
                (58)
8,362
(59)
Mortgage-backed securities in
           
   government sponsored entities
                     -
                     -
4,977
(74)
4,977
(74)
Equity securities in financial
           
     institutions
 
487
(2)
                     -
                     -
                487
                  (2)
               
    Total securities
 $        42,765
 $           (307)
 $        78,997
 $        (1,772)
 $      121,762
 $        (2,079)
               
December 31, 2013 
             
U.S. agency securities
 $        98,356
 $        (2,212)
 $          2,825
 $           (197)
 $      101,181
 $        (2,409)
U.S. treasury securities
           11,309
              (547)
                     -
                     -
           11,309
              (547)
Obligations of states and
           
     political subdivisions
           24,201
              (865)
             6,491
              (389)
           30,692
           (1,254)
Corporate obligations
             6,103
              (124)
             2,251
                (66)
             8,354
              (190)
Mortgage-backed securities in
           
     government sponsored entities
           23,920
              (266)
             1,164
                (34)
           25,084
              (300)
               
    Total securities
 $      163,889
 $        (4,014)
 $        12,731
 $           (686)
 $      176,620
 $        (4,700)
 
As of June 30, 2014, 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, U.S treasuries, obligations of states and political subdivisions, corporate obligations, mortgage backed securities in government sponsored entities and equity securities in financial institutions. For fixed maturity investments management considers whether the present value of cash flows expected to be collected are less than the security’s amortized cost basis (the difference defined as the credit loss), the magnitude and duration of the decline, the reasons underlying the decline and the Company’s intent to sell the security or whether it is more likely than not that the Company would be required to sell the security before its anticipated recovery in market value, to determine whether the loss in value is other than temporary. Once a decline in value is determined to be other than temporary, if the Company does not intend to sell the security, and it is more likely than not that it will not be required to sell the security before recovery of the security’s amortized cost basis, the charge to earnings is limited to the amount of credit loss. Any remaining difference between fair value and amortized cost (the difference defined as the non-credit portion) is recognized in other comprehensive income, net of applicable taxes. Otherwise, the entire difference between fair value and amortized cost is charged to earnings. For equity securities where the fair value has been significantly below cost for one year, the Company’s policy is to recognize an impairment loss unless sufficient evidence is available that the decline is not other than temporary and a recovery period can be predicted.  The Company has concluded that any impairment of its investment securities portfolio outlined in the above table is not other than temporary and is the result of interest rate changes, sector credit rating changes, or company-specific rating changes that are not expected to result in the non-collection of principal and interest during the period.

 
7

 
 
Proceeds from sales of securities available-for-sale for the six months ended June 30, 2014 and 2013 were $12,151,000 and $15,773,000, respectively.  For the three months ended June 30, 2014 and 2013, there were sales of $6,595,000 and $11,917,000, respectively, of available-for-sale securities. The gross gains and losses were as follows (in thousands):


 
    Three Months Ended
    Six Months Ended
 
     June 30,
     June 30,
 
    2014
    2013
    2014
    2013
Gross gains
 $             75
 $          238
 $              246
 $              434
Gross losses
                   -
         (140)
                      -
               (140)
Net gains
 $             75
 $            98
 $              246
 $              294
 
Investment securities with an approximate carrying value of $185.6 million and $194.7 million at June 30, 2014 and December 31, 2013, 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 at June 30, 2014, by contractual maturity, are shown below (in thousands):

 
    Amortized
 
 
    Cost
    Fair Value
Available-for-sale debt securities:
   
  Due in one year or less
 $      12,560
 $             12,712
  Due after one year through five years
       123,887
              124,167
  Due after five years through ten years
         66,528
                66,174
  Due after ten years
       104,874
              107,396
Total
 $    307,849
 $           310,449

Note 5 – Loans
 
The Company grants loans primarily to customers throughout North Central Pennsylvania and Southern New York.  Although the Company had a diversified loan portfolio at June 30, 2014 and December 31, 2013, 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, 2014 and December 31, 2013 (in thousands):

June 30, 2014
 
    Total Loans
    Individually
    evaluated for
    impairment
    Collectively
    evaluated for
    impairment
Real estate loans:
       
     Residential
 
 $                 187,183
 $                        330
 $                 186,853
     Commercial and agricultural
 
                    210,786
                        7,069
                    203,717
     Construction
 
                        3,474
                                -
                        3,474
Consumer
 
                        8,692
                             15
                        8,677
Other commercial and agricultural loans
                      58,090
                        2,323
                      55,767
State and political subdivision loans
 
                      71,652
                                -
                      71,652
Total
 
                    539,877
 $                     9,737
 $                 530,140
Allowance for loan losses
 
                        6,751
   
Net loans
 
 $                 533,126
   

 
8

 
 
December 31, 2013
 
    Total Loans
    Individually
    evaluated for
    impairment
    Collectively
    evaluated for
     impairment
Real estate loans:
       
     Residential
 
 $                 187,101
 $                        342
 $                 186,759
     Commercial and agricultural
 
                    215,088
                        8,310
                    206,778
     Construction
 
                        8,937
                                -
                        8,937
Consumer
 
                        9,563
                             15
                        9,548
Other commercial and agricultural loans
 
                      54,029
                        1,733
                      52,296
State and political subdivision loans
 
                      65,894
                                -
                      65,894
Total
 
                    540,612
 $                   10,400
 $                 530,212
Allowance for loan losses
 
                        7,098
   
Net loans
 
 $                 533,514
   
 
The segments of the Bank’s loan portfolio are disaggregated into classes to a level that allows management to monitor risk and performance. Residential real estate mortgages consists 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 secured by a mortgage which is often a second lien on residential real estate with terms of 15 years or less. Commercial real estate loans are business purpose loans secured by a mortgage on commercial real estate. Agricultural real estate loans are loans secured by a mortgage on real estate used in agriculture production. Construction real estate loans are loans secured by residential or commercial real estate used during the construction phase of residential and commercial projects. Consumer loans are typically unsecured or primarily secured by something other than real estate and overdraft lines of credit connected with customer deposit accounts. 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 subdivisions are loans for state and local municipalities for capital and operating expenses or tax free loans used to finance commercial development.
 
Management considers commercial loans, other agricultural loans, 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.
 
The following table includes the recorded investment and unpaid principal balances for impaired financing receivables by class, with the associated allowance amount, if applicable (in thousands):

 
9

 

 
   
    Recorded
    Recorded
   
 
    Unpaid
    Investment
    Investment
    Total
 
 
    Principal
    With No
    With
    Recorded
    Related
June 30, 2014
    Balance
    Allowance
    Allowance
    Investment
    Allowance
Real estate loans:
         
     Mortgages
 $       226
 $          131
 $            68
 $          199
 $          14
     Home Equity
          132
               64
               67
             131
             13
     Commercial
       9,283
          6,161
             908
          7,069
           101
     Agricultural
               -
                  -
                  -
                  -
                -
     Construction
               -
                  -
                  -
                  -
                -
Consumer
            15
               15
                  -
               15
                -
Other commercial loans
       2,535
          1,434
             889
          2,323
             30
Other agricultural loans
               -
                  -
                  -
                  -
                -
State and political
         
   subdivision loans
               -
                  -
                  -
                  -
                -
Total
 $  12,191
 $       7,805
 $       1,932
 $       9,737
 $        158
           
December 31, 2013
         
Real estate loans:
         
     Mortgages
 $       232
 $          138
 $            70
 $          208
 $          14
     Home Equity
          134
               65
               69
             134
             13
     Commercial
       9,901
          6,335
          1,975
          8,310
           305
     Agricultural
               -
                  -
                  -
                  -
                -
     Construction
               -
                  -
                  -
                  -
                -
Consumer
            15
               15
                  -
               15
                -
Other commercial loans
       1,794
          1,679
               54
          1,733
               1
Other agricultural loans
               -
                  -
                  -
                  -
                -
State and political
         
   subdivision loans
               -
                  -
                  -
                  -
                -
Total
 $  12,076
 $       8,232
 $       2,168
 $     10,400
 $        333
 
The following tables includes the average balance of impaired financing receivables by class and the income recognized on impaired loans for the three and six month periods ended June 30, 2014 and 2013(in thousands):
 
 
 For the Six Months ended
 
June 30, 2014
June 30, 2013
     
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
 $       202
 $              4
 $               -
 $          330
 $            4
 $               -
     Home Equity
          132
                 2
                  -
             137
               2
                  -
     Commercial
       8,039
               44
                  -
          8,595
             84
35
     Agricultural
               -
                  -
                  -
                  -
                -
                  -
     Construction
               -
                  -
                  -
                  -
                -
                  -
Consumer
            15
                  -
                  -
                  -
                -
                  -
Other commercial loans
       2,000
               46
                  -
          1,786
             41
                  -
Other agricultural loans
               -
                  -
                  -
                  -
                -
                  -
State and political
           
   subdivision loans
               -
                  -
                  -
                  -
                -
                  -
Total
 $  10,388
 $            96
 $               -
 $     10,848
 $        131
 $            35


 
10

 
 
 
 For the Three Months Ended
 
June 30, 2014
June 30, 2013
     
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
 $       200
 $              2
 $               -
 $          352
 $            2
 $               -
     Home Equity
          131
                 1
                  -
             136
               1
                  -
     Commercial
       7,544
               18
                  -
          8,406
             39
               21
     Agricultural
               -
                  -
                  -
                  -
                -
                  -
     Construction
               -
                  -
                  -
                  -
                -
                  -
Consumer
            15
                  -
                  -
                  -
                -
                  -
Other commercial loans
       2,108
               13
                  -
          1,916
             22
                  -
Other agricultural loans
               -
                  -
                  -
                  -
                -
                  -
State and political
           
   subdivision loans
               -
                  -
                  -
                  -
                -
                  -
Total
 $    9,998
 $            34
 $               -
 $     10,810
 $          64
 $            21

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 point internal risk rating system to monitor the 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 loan as agreed, the Bank’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, agricultural and municipal loans are reviewed annually to ensure the appropriateness of the loan grade. In addition, the Bank engages an external consultant on at least an annual basis. The external consultant is engaged to 1) review a minimum of 55% of the dollar volume of the commercial loan portfolio on an annual basis, 2) review new loans originated in the last year, 3) review all relationships in aggregate over $500,000, 4) review all aggregate loan relationships over $100,000 which are over 90 days past due or classified Special Mention, Substandard, Doubtful, or Loss, and 5) such other loans which management or the consultant deems appropriate.

 
11

 
 
The following tables represent credit exposures by internally assigned grades as of June 30, 2014 and December 31, 2013 (in thousands):
 
June 30, 2014
Pass
Special Mention
Substandard
Doubtful
Loss
Ending Balance
Real estate loans:
           
     Commercial
 $          162,474
 $           9,735
 $                  14,768
 $                   -
 $              -
 $          186,977
     Agricultural
               18,657
              2,991
                       2,161
                      -
                 -
               23,809
     Construction
                 3,474
                      -
                              -
                      -
                 -
                 3,474
Other commercial loans
               39,143
              5,233
                       3,574
                   58
                 -
               48,008
Other agricultural loans
                 7,667
                 468
                       1,947
                      -
                 -
               10,082
State and political
           
   subdivision loans
               71,652
                      -
                              -
                      -
                 -
               71,652
Total
 $          303,067
 $         18,427
 $                  22,450
 $                58
 $              -
 $          344,002
             
December 31, 2013
           
Real estate loans:
           
     Commercial
 $          166,956
 $           4,645
 $                  21,284
 $              202
 $              -
 $          193,087
     Agricultural
               15,923
              1,910
                       4,168
                      -
                 -
               22,001
     Construction
                 8,937
                      -
                              -
                      -
                 -
                 8,937
Other commercial loans
               40,798
              1,747
                       1,938
                     5
                 -
               44,488
Other agricultural loans
                 7,431
                 153
                       1,957
                      -
                 -
                 9,541
State and political
           
   subdivision loans
               65,894
                      -
                              -
                      -
                 -
               65,894
Total
 $          305,939
 $           8,455
 $                  29,347
 $              207
 $              -
 $          343,948
 
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. The following table presents the recorded investment in those loan classes based on payment activity as of June 30, 2014 and December 31, 2013 (in thousands):

June 30, 2014
       Performing
       Non-
       performing
       Total
Real estate loans:
     
     Mortgages
 $          121,682
 $              793
 $                122,475
     Home Equity
               64,557
                 151
                     64,708
Consumer
                 8,658
                   34
                       8,692
Total
 $          194,897
 $              978
 $                195,875
       
December 31, 2013
     
Real estate loans:
     
     Mortgages
 $          119,075
 $              809
 $                119,884
     Home Equity
               66,989
                 228
                     67,217
Consumer
                 9,547
                   16
                       9,563
Total
 $          195,611
 $           1,053
 $                196,664

 
12

 
 
Age Analysis of Past Due Financing Receivables
 
Management further monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a recorded payment is past due. The following table includes an aging analysis of the recorded investment of past due financing receivables as of June 30, 2014 and December 31, 2013 (in thousands):

   
30-59 Days
60-89 Days
90 Days
Total Past
 
Total Financing
90 Days and
June 30, 2014
Past Due
Past Due
Or Greater
Due
Current
Receivables
Accruing
Real estate loans:
             
     Mortgages
 $        575
 $        168
 $        535
 $     1,278
 $   121,197
 $           122,475
 $                -
     Home Equity
           605
           247
           119
           971
        63,737
                64,708
                 46
     Commercial
             88
             12
        2,021
        2,121
      184,856
              186,977
               301
     Agricultural
                -
                -
                -
                -
        23,809
                23,809
                   -
     Construction
                -
                -
                -
                -
          3,474
                  3,474
                   -
Consumer
             33
             90
             15
           138
          8,554
                  8,692
                   -
Other commercial loans
             55
           408
           485
           948
        47,060
                48,008
                   -
Other agricultural loans
           437
                -
                -
           437
          9,645
                10,082
                   -
State and political
             
   subdivision loans
                -
                -
                -
                -
        71,652
                71,652
                   -
 
Total
 $     1,793
 $        925
 $     3,175
 $     5,893
 $   533,984
 $           539,877
 $            347
                 
Loans considered non-accrual
 $        112
 $        407
 $     2,828
 $     3,347
 $       4,214
 $               7,561
 
Loans still accruing
        1,681
           518
           347
        2,546
      529,770
              532,316
 
 
Total
 $     1,793
 $        925
 $     3,175
 $     5,893
 $   533,984
 $           539,877
 
                 
December 31, 2013
             
Real estate loans:
             
     Mortgages
 $        362
 $          40
 $        739
 $     1,141
 $   118,743
 $           119,884
 $            301
     Home Equity
           632
               2
           229
           863
        66,354
                67,217
                 51
     Commercial
             88
           319
        3,091
        3,498
      189,589
              193,087
               344
     Agricultural
                -
                -
                -
                -
        22,001
                22,001
                   -
     Construction
                -
                -
                -
                -
          8,937
                  8,937
                   -
Consumer
             96
             36
             16
           148
          9,415
                  9,563
                   1
Other commercial loans
             29
             28
             49
           106
        44,382
                44,488
                   -
Other agricultural loans
                -
                -
                -
                -
          9,541
                  9,541
                   -
State and political
             
   subdivision loans
                -
                -
                -
                -
        65,894
                65,894
                   -
 
Total
 $     1,207
 $        425
 $     4,124
 $     5,756
 $   534,856
 $           540,612
 $            697
                 
Loans considered non-accrual
 $          98
 $        164
 $     3,427
 $     3,689
 $       4,408
 $               8,097
 
Loans still accruing
        1,109
           261
           697
        2,067
      530,448
              532,515
 
 
Total
 $     1,207
 $        425
 $     4,124
 $     5,756
 $   534,856
 $           540,612
 

Nonaccrual Loans
 
Loans are considered for non-accrual status upon reaching 90 days delinquency, although the Company may be receiving partial payments of interest and partial repayments of principal on such loans or if full payment of principal and interest is not expected. Additionally, if management is made aware of other information including bankruptcy, repossession, death, or legal proceedings, the loan may be placed on non-accrual status. If a loan is 90 days or more past due and is well secured and in the process of collection, it may still be considered accruing.
 
The following table reflects the financing receivables on non-accrual status as of June 30, 2014 and December 31, 2013, respectively. The balances are presented by class of financing receivable (in thousands):

 
13

 
 
   
June 30 2014
 
December 31, 2013
Real estate loans:
     
     Mortgages
 $                793
 
 $                   508
     Home Equity
                   105
 
                      177
     Commercial
                5,703
 
                   7,247
     Agricultural
                   -
 
                        -
     Construction
                   -
 
                        -
Consumer
                     34
 
                        15
Other commercial loans
                   926
 
                      150
Other agricultural loans
                      -
 
                        -
State and political subdivision
                   -
 
                        -
   
 $             7,561
 
 $                8,097

Troubled Debt Restructurings
 
In situations where, for economic or legal reasons related to a borrower's financial difficulties, management may grant a concession for other than an insignificant period of time to the borrower that would not otherwise be considered, the related loan is classified as a Troubled Debt Restructuring (TDR). Management strives to identify borrowers in financial difficulty early and work with them to modify more affordable terms before their loan reaches nonaccrual status. These modified terms may include rate reductions, principal forgiveness, payment forbearance and other actions intended to minimize the economic loss and to avoid foreclosure or repossession of the collateral. In cases where borrowers are granted new terms that provide for a reduction of either interest or principal, management measures any impairment on the restructuring by calculating the present value of the revised loan terms and comparing this balance to the Company’s investment in the loan prior to the restructuring. As these loans are individually evaluated, they are excluded from pooled portfolios when calculating the allowance for loan and lease losses and a separate allocation within the allowance for loan and lease losses is provided. Management continually evaluates loans that are considered TDRs, including payment history under the modified loan terms, the borrower’s ability to continue to repay the loan based on continued evaluation of their operating results and cash flows from operations.  Based on this evaluation management would no longer consider a loan to be a TDR when the relevant facts support such a conclusion. As of June 30, 2014 and December 31, 2013, included within the allowance for loan losses are reserves of $30,000 and $28,000 respectively, that are associated with loans modified as TDRs.
 
There were no loan modifications that were considered TDRs during the three months ended June 30, 2013. Loan modifications that are considered TDRs completed during the six months ended June 30, 2014 and 2013 and the three months ended June 30, 2014, were as follows (dollars in thousands):

 
For the Three Months Ended June 30, 2014
 
Number of contracts
Pre-modification Outstanding
Recorded Investment
Post-Modification Outstanding
Recorded Investment
 
    Interest
    Modification
    Term
    Modification
    Interest
    Modification
    Term
    Modification
    Interest
    Modification
    Term
    Modification
Real estate loans:
           
     Commercial
                     -
                          1
$                   -
$                28
$                  -
$             28
Total
                     -
                          1
 $                   -
 $                28
 $                  -
 $             28

 
14

 
 
 
For the Six Months Ended June 30, 2014
 
Number of contracts
Pre-modification Outstanding
Recorded Investment
Post-Modification Outstanding
Recorded Investment
 
    Interest
    Modification
    Term
    Modification
    Interest
    Modification
    Term
    Modification
    Interest
    Modification
    Term
    Modification
Real estate loans:
           
     Commercial
                     -
2
$                   -
$                153
$                  -
$             153
Total
                     -
                         2
 $                   -
 $                153
 $                  -
 $             153


 
For the Six Months Ended June 30, 2013
 
Number of contracts
Pre-modification Outstanding Recorded Investment
Post-Modification Outstanding Recorded Investment
 
    Interest
    Modification
    Term
    Modification
    Interest
    Modification
    Term
    Modification
    Interest 
    Modification
    Term
    Modification
Real estate loans:
           
     Mortgages
                    1
                       -
 $                     72
 $                   -
 $               72
 $                  -
     Commercial
                     -
                      2
                           -
              1,365
                     -
             1,365
Other commercial loans
                     -
                      2
                           -
              1,530
                     -
             1,530
Total
                    1
                       4
 $                     72
 $           2,895
 $               72
 $          2,895

Recidivism, or the borrower defaulting on its obligation pursuant to a modified loan, results in the loan once again becoming a non-accrual loan. Recidivism occurs at a notably higher rate than do defaults on new origination loans, so modified loans present a higher risk of loss than do new origination loans. The following table presents the recorded investment in loans that were modified as TDRs during each 12-month period prior to the current reporting periods, which begin January 1, 2014 and 2013 (six month periods) and April 1, 2014 and 2013 (3 month periods), respectively, and that subsequently defaulted during these reporting periods (dollars in thousands):

 
For the Three Months Ended
For the Six Months Ended
 
June 30, 2014
June 30, 2013
June 30, 2014
June 30, 2013
 
    Number of
    contracts
    Recorded
    investment
   Number of
  contracts
    Recorded
    investment
Number of contracts
    Recorded
    investment
Number of
contracts
Recorded
 investment
Real estate loans:
               
     Commercial
                   -
 $              -
             1
 $              535
             1
 $              483
                   -
 $              -
Total recidivism
                   -
 $              -
             1
 $              535
             1
 $              483
                   -
 $              -

Allowance for Loan Losses
 
The following table segregates the allowance for loan losses (ALLL) into the amount required for loans individually evaluated for impairment and the amount required for loans collectively evaluated for impairment as of June 30, 2014 and December 31, 2013, respectively (in thousands):
 
 
June 30, 2014
 
 December 31, 2013
 
Individually evaluated for impairment
Collectively evaluated for impairment
Total
 
Individually evaluated for impairment
Collectively evaluated for impairment
Total
Real estate loans:
             
     Residential
 $           27
 $         852
 $         879
 
 $           27
 $           919
 $             946
     Commercial and agricultural
            101
         3,708
3,809
 
            305
           4,253
             4,558
     Construction
                 -
              13
13
 
                 -
                50
                  50
Consumer
                 -
              86
86
 
                 -
              105
                105
Other commercial and agricultural loans
              30
         1,121
1,151
 
                1
              941
                942
State and political
             
  subdivision loans
                 -
            455
455
 
                 -
              330
                330
Unallocated
                 -
            358
358
 
                 -
              167
                167
Total
 $         158
 $      6,593
 $      6,751
 
 $         333
 $        6,765
 $          7,098
 
 
15

 

The following tables roll forward the balance of the ALLL by portfolio segment for the three and six month periods ended June 30, 2014 and 2013, respectively (in thousands):
 
 
       Balance at 
       March 31, 2014
Charge-offs
Recoveries
Provision
Balance at
June 30, 2014
Real estate loans:
         
     Residential
 $         886
 $            (7)
 $              -
 $            -
 $         879
     Commercial and agricultural
         4,530
           (465)
                3
        (259)
         3,809
     Construction
                8
                 -
                 -
              5
              13
Consumer
              83
               (6)
                6
              3
              86
Other commercial and agricultural loans
         1,173
           (163)
                 -
          141
         1,151
State and political
         
  subdivision loans
            396
                 -
                 -
            59
            455
Unallocated
            157
                 -
                 -
          201
            358
Total
 $      7,233
 $        (641)
 $             9
 $       150
 $      6,751
           
 
       Balance at 
       December 31, 2013
Charge-offs
Recoveries
Provision
Balance at 
June 30, 2014
Real estate loans:
         
     Residential
 $         946
 $          (45)
 $              -
 $       (22)
 $         879
     Commercial and agricultural
         4,558
           (475)
                5
        (279)
         3,809
     Construction
              50
                 -
                 -
          (37)
              13
Consumer
            105
             (14)
              15
          (20)
              86
Other commercial and agricultural loans
            942
           (163)
                 -
          372
         1,151
State and political
         
  subdivision loans
            330
                 -
                 -
          125
            455
Unallocated
            167
                 -
                 -
          191
            358
Total
 $      7,098
 $        (697)
 $           20
 $       330
 $      6,751
           
 
       Balance at
       March 31, 2013
Charge-offs
Recoveries
Provision
Balance at
June 30, 2013
Real estate loans:
         
     Residential
 $         913
 $          (13)
 $              -
 $         34
 $         934
     Commercial and agricultural
         4,416
                 -
                 -
        (176)
         4,240
     Construction
              78
                 -
                 -
            13
              91
Consumer
            118
             (10)
                9
            (3)
            114
Other commercial and agricultural loans
            700
                 -
                 -
          257
            957
State and political
         
  subdivision loans
            303
                 -
                 -
              7
            310
Unallocated
            400
                 -
                 -
          (57)
            343
Total
 $      6,928
 $          (23)
 $             9
 $         75
 $      6,989
           
 
       Balance at 
       December 31, 2012
Charge-offs
Recoveries
Provision
Balance at 
June 30, 2013
Real estate loans:
         
     Residential
 $         875
 $          (13)
 $             2
 $         70
 $         934
     Commercial and agricultural
         4,437
                 -
                 -
        (197)
         4,240
     Construction
              38
                 -
                 -
            53
              91
Consumer
            119
             (30)
              21
              4
            114
Other commercial and agricultural loans
            728
                 -
                 -
          229
            957
State and political
         
  subdivision loans
            271
                 -
                 -
            39
            310
Unallocated
            316
                 -
                 -
            27
            343
Total
 $      6,784
 $          (43)
 $           23
 $       225
 $      6,989
 
 
 
16

 
The Company allocates the ALLL based on the factors described below, which conform to the Company’s loan classification policy and credit quality measurements. In reviewing risk within the Bank’s loan portfolio, management has determined there to be several different risk categories within the loan portfolio. The ALLL consists of amounts applicable to: (i) residential real estate loans; (ii) residential real estate home equity loans; (iii) commercial real estate loans; (iv) agricultural real estate loans; (v) real estate construction loans; (vi) other commercial and agricultural loans; (vii) consumer loans; (viii) other agricultural loans and (ix) state and political subdivision loans. Factors considered in this process include general loan terms, collateral, and availability of historical data to support the analysis. Historical loss percentages are calculated and used as the basis for calculating allowance allocations. Certain qualitative factors are evaluated to determine additional inherent risks in the loan portfolio, which are not necessarily reflected in the historical loss percentages. These factors are then added to the historical allocation percentage to get the adjusted factor to be applied to non-classified loans. The following qualitative factors are analyzed:

·  
Level of and trends in delinquencies, impaired/classified loans
 
Change in volume and severity of past due loans
 
Volume of non-accrual loans
 
Volume and severity of classified, adversely or graded loans;
·  
Level of and trends in charge-offs and recoveries;
·  
Trends in volume, terms and nature of the loan portfolio;
·  
Effects of any changes in risk selection and underwriting standards and any other changes in lending and recovery policies, procedures and practices;
·  
Changes in the quality of the Bank’s loan review system;
·  
Experience, ability and depth of lending management and other relevant staff;
·  
National, state, regional and local economic trends and business conditions
 
General economic conditions
 
Unemployment rates
 
Inflation / Consumer Price Index
 
Changes in values of underlying collateral for collateral-dependent loans;
·  
Industry conditions including the effects of external factors such as competition, legal, and regulatory requirements on the level of estimated credit losses; and
·  
Existence and effect of any credit concentrations, and changes in the level of such concentrations.
·  
Any change in the level of board oversight
 
The Company also maintains an unallocated allowance to account for any factors or conditions that may cause a potential loss but are not specifically addressed in the process described above. The Company analyzes its loan portfolio each quarter to determine the appropriateness of its allowance for loan losses.
 
Loans determined to be TDRs are impaired and for purposes of estimating the ALLL must be individually evaluated for impairment. In calculating the impairment, the Company calculates the present value utilizing an analysis of discounted cash flows. If the present value calculated is below the recorded investment of the loan, impairment is recognized by a charge to the provision for loan and lease losses and a credit to the ALLL.
 
 We continually review the model utilized in calculating the required allowance. The following qualitative factors experienced changes during the first six months of 2014:
 
·  
The qualitative factor for national, state, regional and local economic trends and business conditions was decreased for all loan categories due to a decrease in the unemployment rates in the local economy.
·  
The qualitative factors for changes in levels of and trends in delinquencies, impaired/classified loans were decreased for commercial and agricultural real estate due to the decrease in the Company’s classified loans to its lowest level in three years.
·  
The qualitative factors for changes in levels of and trends in delinquencies, impaired/classified loans were increased for other commercial loans due to an increase in classified loans during the quarter.
·  
The qualitative factor for levels of and trends in charge-offs and recoveries was increased for commercial real estate and other commercial loans due to the increase in charge-offs compared to historical norms for the Bank.
·  
The qualitative factor for experience, ability and depth of lending management and other relevant staff was decreased for all loan categories due to the length of time employees involved throughout the loan process have been in their positions.

 
17

 
 
The following qualitative factors experienced changes during the three months ended June 30, 2014:

·  
The qualitative factor for national, state, regional and local economic trends and business conditions was decreased for all loan categories due to a decrease in the unemployment rates in the local economy.
·  
The qualitative factor for levels of and trends in charge-offs and recoveries was increased for commercial real estate and other commercial loans due to the increase in charge-offs compared to historical norms for the Bank.
·  
The qualitative factor for experience, ability and depth of lending management and other relevant staff was decreased for all loan categories due to the length of time employees involved throughout the loan process have been in their positions.
·  
The qualitative factors for changes in levels of and trends in delinquencies, impaired/classified loans were decreased for commercial real estate due to the decrease in the Company’s classified loans.
·  
The qualitative factors for changes in levels of and trends in delinquencies, impaired/classified loans were increased for other commercial loans due to an increase in classified loans during the quarter.
 
The primary factor that resulted in negative provisions for certain portfolio segments for the three and six month periods ended June 30, 2014 is due to decreases in the outstanding balances for certain portfolio segments compared to December 31, 2013, a reduction in the amount of substandard loans and the decrease in the qualitative factor associated with the improvement in unemployment rates noted above.
 
The following qualitative factors experienced changes during the first six months of 2013:
 
·  
The qualitative factor for national, state, regional and local economic trends and business conditions was increased for all loan categories due to rising unemployment rates in the local economy as a result of the slowdown in Marcellus shale natural gas exploration activities.
·  
The qualitative factor for trends in volume, terms and nature of the loan portfolio was increased for commercial and agricultural real estate, other commercial and agricultural loans and state and political subdivision loan categories due to the increase of the number of loans that are participations that were purchased from other banks and therefore subject to different underwriting standards.
·  
The qualitative factor for the existence and effect of any credit concentrations and changes in the level of such concentrations was increased for other commercial and agricultural loans and was lowered for commercial and agricultural real estate as the loan growth has slowed in 2013.
 
The following qualitative factors experienced changes during the three months ended June 30, 2013:

·  
The qualitative factor for trends in volume, terms and nature of the loan portfolio was increased for commercial and agricultural real estate, other commercial and agricultural loans and state and political subdivision loan categories due to the increase of the number of loans that are participations that were purchased from other banks and therefore subject to different underwriting standards.
·  
The qualitative factor for the existence and effect of any credit concentrations and changes in the level of such concentrations was increased for other commercial and agricultural loans and was lowered for commercial and agricultural real estate as the loan growth has slowed in 2013.

 
18

 
 
Note 6 – Federal Home Loan Bank Stock
 
The Bank is a member of the FHLB of Pittsburgh and as such, is required to maintain a minimum investment in stock of the FHLB that varies with the level of advances outstanding with the FHLB. As of June 30, 2014 and December 31, 2013, the Bank holds $2,920,200 and $3,652,100, respectively. The stock is bought from and sold to the FHLB based upon its $100 par value.  The stock does not have a readily determinable fair value and as such is classified as restricted stock, carried at cost and evaluated by management.  The stock’s value is determined by the ultimate recoverability of the par value rather than by recognizing temporary declines. The determination of whether the par value will ultimately be recovered is influenced by criteria such as the following: (a) A significant decline in net assets of the FHLB as compared to the capital stock amount and the length of time this situation has persisted (b) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance (c) the impact of legislative and regulatory changes on the customer base of the FHLB and (d) the liquidity position of the FHLB. Management evaluated the stock and concluded that the stock was not impaired for the periods presented herein.  Management considered that the FHLB’s regulatory capital ratios have improved, liquidity appears adequate, new shares of FHLB stock continue to exchange hands at the $100 par value and the FHLB has repurchased shares of excess capital stock from its members and has reinstituted the dividend.

Note 7 - Employee Benefit Plans
 
For additional detailed disclosure on the Company's pension and employee benefits plans, please refer to Note 11 of the Company's Consolidated Financial Statements included in the 2013 Annual Report on Form 10-K.
 
Noncontributory Defined Benefit Pension Plan
 
The Bank sponsors a noncontributory defined benefit pension plan (“Pension Plan”) covering substantially all employees and officers.  The Bank’s funding policy is to make annual contributions, if needed, based upon the funding formula developed by the plan’s actuary. Any employee with a hire date of January 1, 2007 or later is not eligible to participate in the Pension Plan. In lieu of the Pension Plan, employees with a hire date of January 1, 2007 or later are eligible to receive, after meeting certain length of service requirements, an annual discretionary 401(k) plan contribution from the Bank equal to a percentage of an employee’s base compensation.  The contribution amount, if any, is placed in a separate account within the 401(k) plan and is subject to a vesting requirement.
 
For employees who are eligible to participate in the Pension Plan, the Pension Plan requires benefits to be paid to eligible employees based primarily upon age and compensation rates during employment.  Upon retirement or other termination of employment, employees can elect either an annuity benefit or a lump sum distribution of vested benefits in the Pension Plan.
 
The following sets forth the components of net periodic benefit costs of the Pension Plan for the three and six months ended June 30, 2014 and 2013, respectively (in thousands):

 
    Three Months Ended
    Six Months Ended
 
     June 30,
     June 30,
 
    2014
    2013
    2014
    2013
Service cost
 $               63
 $       76
 $             153
 $            177
Interest cost
                111
          79
                207
               185
Expected return on plan assets
              (215)
       (169)
              (393)
            (343)
Net amortization and deferral
                (43)
          86
                   25
               128
         
Net periodic benefit expense (income)
 $             (84)
 $       72
 $               (8)
 $            147

 
19

 
 
The Company expects to contribute $300,000 to the Pension Plan in 2014.
 
Defined Contribution Plan
 
The Company sponsors a voluntary 401(k) savings plan which eligible employees can elect to contribute up to the maximum amount allowable not to exceed the limits of IRS Code Sections 401(k).  Under the plan, the Company also makes required contributions on behalf of the eligible employees.  The Company’s contributions vest immediately. Contributions by the Company totaled $146,000 and $147,000 for the six months ended June 30, 2014 and 2013, respectively. For the three months ended June 30, 2014 and 2013, contributions by the Company totaled $88,000 and $92,000, respectively.
 
Directors’ Deferred Compensation Plan
 
The Company’s directors may elect to defer all or portions of their fees until their retirement or termination from service.  Amounts deferred under the plan earn interest based upon the highest current rate offered to certificate of deposit customers.  Amounts deferred under the plan are not guaranteed and represent a general liability of the Company.  At June 30, 2014 and December 31, 2013, an obligation of $956,000 and $981,000, respectively, was included in other liabilities for this plan in the Consolidated Balance Sheet. Amounts included in interest expense on the deferred amounts totaled $6,000 and $3,000 for each of the three months ended June 30, 2014 and 2013. For the six months ended June 30, 2014 and 2013, amounts included in interest expense on the deferred amounts totaled $11,000 and $7,000, respectively.
 
Restricted Stock Plan
 
The Company maintains a Restricted Stock Plan (the “Plan”) whereby employees and non-employee corporate directors are eligible to receive awards of restricted stock based upon performance related requirements.  Awards granted under the Plan are in the form of the Company’s common stock and are subject to certain vesting requirements including continuous employment or service with the Company.  A total of 100,000 shares of the Company’s common stock have been authorized under the Plan. As of June 30, 2014, 64,158 shares remain available to be issued under the Plan.  The Plan assists the Company in attracting, retaining and motivating employees to make substantial contributions to the success of the Company and to increase the emphasis on the use of equity as a key component of compensation.
 
The following table details the vesting, awarding and forfeiting of restricted shares during 2014 and 2013:

 
Three months ended June 30,
Six months ended June 30,
 
2014
2013
2014
2013
   
Weighted
 
Weighted
 
Weighted
 
Weighted
 
Unvested
Average
Unvested
Average
Unvested
Average
Unvested
Average
 
Shares
Market Price
Shares
Market Price
Shares
Market Price
Shares
Market Price
Outstanding, beginning of period
6,240
 $          43.55
   7,269
 $       35.16
7,172
 $          42.02
   8,646
 $       35.51
Granted
3,206
             53.10
   3,027
          48.21
3,598
             52.82
   3,027
          48.21
Forfeited
-
                     -
           -
                  -
-
                     -
       (55)
          37.10
Vested
 (2,259)
             42.06
  (2,830)
          31.35
 (3,583)
             40.30
  (4,152)
          33.26
Outstanding, end of period
7,187
 $          48.28
   7,466
 $       41.89
7,187
 $          48.28
   7,466
 $       41.89

Compensation cost related to restricted stock is recognized based on the market price of the stock at the grant date over the vesting period. Compensation expense related to restricted stock was $73,000 and $77,000 for the six months ended June 30, 2014 and 2013, respectively. For the three months ended June 30, 2014 and 2013, compensation expense totaled $37,000 and $39,000, respectively.
 
 
20

 
 
Supplemental Executive Retirement Plan
 
The Company maintains a non-qualified supplemental executive retirement plan (“SERP”) for certain executives to compensate those executive participants in the Company’s noncontributory defined benefit pension plan whose benefits are limited by compensation limitations under current tax law. At June 30, 2014 and December 31, 2013, an obligation of $1,122,000 and $1,046,000, respectively, was included in other liabilities for this plan in the Consolidated Balance Sheet. Expenses related to this plan totaled $76,000 and $72,000 for the six months ended June 30, 2014 and 2013, respectively. For the three months ended June 30, 2014 and 2013, expenses totaled $38,000 and $36,000, respectively.

Note 8 – Accumulated Comprehensive Income
 
The following tables present the changes in accumulated other comprehensive (loss) income by component net of tax for the three and six months ended June 30, 2014 and 2013 (in thousands):

 
Three months ended June 30, 2014
 
Unrealized gain (loss) on
available for sale securities
(a)
Unrealized gain
(loss) on interest
rate swap (a)
Defined Benefit
Pension Items (a)
Total
Balance as of March 31, 2014
 $                     1,264
 $                     -
 $             (1,110)
 $         154
Other comprehensive income before reclassifications (net of tax)
                           986
                        -
                        -
            986
Amounts reclassified from accumulated other
       
     comprehensive income (loss) (net of tax)
                           (49)
                        -
                         9
             (40)
Net current period other comprehensive income
                           937
                        -
                         9
            946
Balance as of June 30, 2014
 $                     2,201
 $                     -
 $             (1,101)
 $      1,100

 
Six months ended June 30, 2014
 
Unrealized gain (loss) on
available for sale securities (a)
Unrealized gain
(loss) on interest
rate swap (a)
Defined Benefit
Pension Items (a)
Total
Balance as of December 31, 2013
 $                      (108)
 $                     -
 $             (1,117)
 $     (1,225)
Other comprehensive income before reclassifications (net of tax)
                        2,471
                        -
                        -
         2,471
Amounts reclassified from accumulated other
       
     comprehensive income (loss) (net of tax)
                         (162)
                        -
                       16
           (146)
Net current period other comprehensive income
                2,309
                 -
                16
     2,325
Balance as of June 30, 2014
 $                     2,201
 $                     -
 $             (1,101)
 $      1,100
         
 
Three months ended June 30, 2013
 
Unrealized gain (loss) on available for sale securities
(a)
Unrealized gain (loss)
on interest rate swap
 (a)
Defined Benefit
Pension Items (a)
Total
Balance as of March 31, 2013
 $                     5,717
 $                  (99)
 $             (1,991)
 $      3,627
Other comprehensive income (loss) before reclassifications (net of tax)
                      (4,393)
                       34
                        -
        (4,359)
Amounts reclassified from accumulated other
       
     comprehensive income (loss) (net of tax)
                           (65)
                        -
                       84
              19
Net current period other comprehensive income (loss)
               (4,458)
                34
                84
    (4,340)
Balance as of June 30, 2013
 $                     1,259
 $                  (65)
 $             (1,907)
 $        (713)
         
 
 
21

 
 
 
Six months ended June 30, 2013
 
Unrealized gain (loss) on available for sale securities
(a)
Unrealized gain (loss)
on interest rate swap (a)
Defined Benefit
Pension Items (a)
Total
Balance as of December 31, 2012
 $                     6,754
 $                (132)
 $             (1,991)
 $      4,631
Other comprehensive income (loss) before reclassifications (net of tax)
                      (5,301)
                       67
                        -
        (5,234)
Amounts reclassified from accumulated other
       
     comprehensive income (loss) (net of tax)
                         (194)
                        -
                       84
           (110)
Net current period other comprehensive income (loss)
               (5,495)
                67
                84
    (5,344)
Balance as of June 30, 2013
 $                     1,259
 $                  (65)
 $             (1,907)
 $        (713)
         
(a) Amounts in parentheses indicate debits
       
 
The following table presents the significant amounts reclassified out of each component of accumulated other comprehensive income for the three and six months ended June 30, 2014 and 2013 (in thousands):

Details about accumulated other comprehensive income (loss)
Amount reclassified from
accumulated comprehensive income
(loss) (a)
 
Affected line item in the statement
where net Income is presented
 
       Three Months Ended  June 30,
   
 
          2014
       2013
   
Unrealized gains and losses on available for sale securities
       
 
 $                       75
 $                 98
 
Investment securities gains, net
 
 (26)
 (33)
 
Provision for income taxes
 
49
65
 
Net of tax
Defined benefit pension items
       
 
 (13)
 (128)
 
Salaries and employee benefits
 
4
44
 
Provision for income taxes
 
 (9)
 (84)
 
Net of tax
Total reclassifications
 $                       40
 $               (19)
   
         
 
       Six Months Ended  June 30,
   
 
          2014
       2013
   
Unrealized gains and losses on available for sale securities
       
 
 $                     246
 $               294
 
Investment securities gains, net
 
 (84)
 (100)
 
Provision for income taxes
 
162
194
 
Net of tax
Defined benefit pension items
       
 
 (25)
 (128)
 
Salaries and employee benefits
 
9
44
 
Provision for income taxes
 
 (16)
 (84)
 
Net of tax
Total reclassifications
 $                     146
 $               110
   
         
(a) Amounts in parentheses indicate debits to profit/loss
       

Note 9 – Fair Value Measurements
 
The Company established a hierarchal disclosure framework associated with the level of pricing observability utilized in measuring assets and liabilities at fair value. The three broad levels defined by this hierarchy are as follows:
 
Level I:
Quoted prices are available in active markets for identical assets or liabilities as of the reported date.
 
Level II:
Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these assets and liabilities include items for which quoted prices are available but traded less frequently, and items that are fair valued using other financial instruments, the parameters of which can be directly observed.
 
 
22

 
 
Level III:
Assets and liabilities that have little to no pricing observability as of the reported date. These items do not have two-way markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.
 
A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.
 
In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality, the Company's creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. Our valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally coincides with the Company’s monthly and/or quarterly valuation process.

Financial Instruments Recorded at Fair Value on a Recurring Basis
 
The fair values of securities available for sale are determined by quoted prices in active markets, when available, and classified as Level I. If quoted market prices are not available, the fair value is determined by a matrix pricing, which is a mathematical technique, widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities and classified as Level II. The fair values consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.
 
The following tables present the assets and liabilities reported on the consolidated balance sheet at their fair value on a recurring basis as of June 30, 2014 and December 31, 2013 by level within the fair value hierarchy (in thousands). Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

June 30, 2014
 
    Level I
 
    Level II
 
    Level III
   
    Total
Fair value measurements on a recurring basis:
                 
Assets
                 
  Securities available for sale:
                 
     U.S. agency securities
 
 $                -
 
 $             147,335
 
 $                    -
   
 $             147,335
     U.S. treasury securities
 
                   -
 
11,504
 
                   -
   
11,504
     Obligations of state and
                 
        political subdivisions
 
                   -
 
101,627
 
                       -
   
101,627
     Corporate obligations
 
                   -
 
14,215
 
                       -
   
14,215
     Mortgage-backed securities in
                 
       government sponsored entities
 
                   -
 
35,768
 
                       -
   
35,768
     Equity securities in financial institutions
 
           1,873
 
                            -
 
                       -
   
1,873
 
 
23

 
                   
December 31, 2013
      Level I           Level II        Level III             Total
Fair value measurements on a recurring basis:
                 
Securities available for sale:
                 
     U.S. agency securities
 
 $                -
 
 $             152,189
 
 $                    -
   
 $             152,189
     U.S. treasuries securities
 
                    -
 
11,309
 
                    -
   
11,309
     Obligations of state and
                 
       political subdivisions
 
                    -
 
95,005
 
                    -
   
95,005
     Corporate obligations
 
                    -
 
16,802
 
                    -
   
16,802
     Mortgage-backed securities in
                 
       government sponsored entities
 
                    -
 
40,671
 
                    -
   
40,671
     Equity securities in financial institutions
 
           1,325
 
                            -
 
                       -
   
1,325

Financial Instruments, Non-Financial Assets and Non-Financial Liabilities Recorded at Fair Value on a Nonrecurring Basis
 
The Company may be required, from time to time, to measure certain financial assets, financial liabilities, non-financial assets and non-financial liabilities at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principles. These include assets that are measured at the lower of cost or market value that were recognized at fair value below cost at the end of the period. Certain non-financial assets measured at fair value on a non-recurring basis include foreclosed assets (upon initial recognition or subsequent impairment), non-financial assets and non-financial liabilities measured at fair value in the second step of a goodwill impairment test, and intangible assets and other non-financial long-lived assets measured at fair value for impairment assessment. Non-financial assets measured at fair value on a non-recurring basis during 2014 and 2013 include certain foreclosed assets which, upon initial recognition, were remeasured and reported at fair value through a charge-off to the allowance for possible loan losses and certain foreclosed assets which, subsequent to their initial recognition, were remeasured at fair value through a write-down included in other non-interest expense.

·  
Impaired Loans - Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment using one of several methods, including collateral value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. Collateral values are estimated using Level 2 inputs based on observable market data and Level 3 inputs based on customized discounting criteria. For a majority of impaired real estate related loans, the Company obtains a current external appraisal. Other valuation techniques are used as well, including internal valuations, comparable property analysis and contractual sales information.
·  
Other Real Estate owned – Other real estate owned, which is obtained through the Bank’s foreclosure process is valued utilizing the appraised collateral value. Collateral values are estimated using Level 2 inputs based on observable market data and Level III inputs based on customized discounting criteria. At the time the foreclosure is completed, the Company obtains an updated external appraisal.
 
 Assets measured at fair value on a nonrecurring basis as of June 30, 2014 and December 31, 2013 are included in the table below (in thousands):

June 30, 2014
 
    Level I
 
    Level II
 
    Level III
   
       Total
Impaired Loans
 
 $                -
 
 $                         -
 
 $            9,579
   
 $                 9,579
Other real estate owned
 
                   -
 
                            -
 
1,295
   
1,295
                   
December 31, 2013
                 
Impaired Loans
 
 $                -
 
 $                         -
 
 $          10,067
   
 $               10,067
Other real estate owned
 
                   -
 
                            -
 
               1,360
   
1,360
 
The following table provides a listing of the significant unobservable inputs used in the fair value measurement process for items valued utilizing level III techniques.

 
24

 
 
 
    Fair Value at 
    June 30, 2014
    Fair Value at
   December 31,
2013
 
Valuation Technique(s)
Unobservable input
Range
Impaired Loans
 $         253
 $         263
 
Discounted Cash Flows
Probability of Default
0%
         
Change in interest rates
0-7%
             
 
         9,326
         9,804
 
Appraised Collateral Values
Discount for time since appraisal
0-30%
         
Selling costs
4%-10%
         
Holding period
0 - 18 months
             
Other real estate owned
         1,295
         1,360
 
Appraised Collateral Values
Discount for time since appraisal
0-30%
         
Selling costs
4%-10%
         
Holding period
0 - 18 months
 
The fair values of the Company’s financial instruments are as follows (in thousands):

 
Carrying
       
June 30, 2014
Amount
Fair Value
Level I
Level II
Level III
Financial assets:
         
Cash and due from banks
 $   15,740
 $   15,740
 $   15,740
 $          -
 $             -
Interest bearing time deposits with other banks
2,480
2,484
             -
             -
2,484
Available-for-sale securities
    312,322
    312,322
        1,873
 310,449
 
Loans held for sale
           545
           545
           545
   
Net loans
    533,126
    549,986
                -
             -
    540,585
Bank owned life insurance
      14,921
      14,921
      14,921
             -
                -
Regulatory stock
        3,195
        3,195
        3,195
             -
                -
Accrued interest receivable
        3,557
        3,557
3,557
             -
                -
           
Financial liabilities:
         
Deposits
 $ 765,456
 $ 766,870
 $ 508,041
 $          -
 $ 258,829
Borrowed funds
      43,075
      39,867
                -
   39,867
                -
Accrued interest payable
           735
           735
735
             -
                -
           
December 31, 2013
         
Financial assets:
         
Cash and due from banks
 $   10,083
 $   10,083
 $   10,083
 $          -
 $             -
Interest bearing time deposits with other banks
        2,480
        2,474
                -
             -
        2,474
Available-for-sale securities
    317,301
    317,301
        1,325
 315,976
                -
Loans held for sale
           278
           278
           278
             -
                -
Net loans
    533,514
    547,405
                -
             -
    547,405
Bank owned life insurance
      14,679
      14,679
      14,679
             -
                -
Regulatory stock
        3,926
        3,926
        3,926
             -
                -
Accrued interest receivable
        3,728
        3,728
        3,728
             -
                -
           
Financial liabilities:
         
Deposits
 $ 748,316
 $ 750,172
 $ 481,957
 $          -
 $ 268,215
Borrowed funds
      66,932
      63,500
                -
   63,500
                -
Accrued interest payable
           895
           895
895
             -
                -
 
 
 
25

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

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

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

Interest bearing time deposits with other banks:
 
The fair value of interest bearing time deposits with other banks is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.

Available-For-Sale Securities:
 
The fair values of securities available for sale are determined by quoted prices in active markets, when available, and classified as Level I. If quoted market prices are not available, the fair value is determined by a matrix pricing, which is a mathematical technique, widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities and classified as Level II. The fair values consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.

Loans held for sale
 
The carrying amount for loans held for sale approximates fair value as the loans are only held for less than a week from origination.

Loans:
 
Fair values are estimated for portfolios of loans with similar financial characteristics.  The fair value of performing loans has been estimated by discounting expected future cash flows. The discount rate used in these calculations is derived from the Treasury yield curve adjusted for credit quality, operating expense and prepayment option price, and is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The estimate of maturity is based on the Company’s historical experience with repayments for each loan classification, modified as required by an estimate of the effect of current economic and lending conditions.

 
26

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

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

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

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

Note 10 – Commitments
 
The Company has entered into agreements for the construction of a new branch totaling $941,000 as of June 30, 2014. Construction started late in the second quarter of 2014.

Note 11 – Recent Accounting Pronouncements
 
In January 2014, FASB issued ASU 2014-01, Investments – Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects. The amendments in this Update permit reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense (benefit).  The amendments in this Update should be applied retrospectively to all periods presented. A reporting entity that uses the effective yield method to account for its investments in qualified affordable housing projects before the date of adoption may continue to apply the effective yield method for those preexisting investments. The amendments in this Update are effective for public business entities for annual periods and interim reporting periods within those annual periods, beginning after December 15, 2014.  Early adoption is permitted. The Company is currently evaluating the impact the adoption of the standard will have on the Company’s financial position or results of operations.
 
In January 2014, the FASB issued ASU 2014-04, Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure. The amendments in this Update clarify that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendments require interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. The amendments in this Update are effective for public business entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. An entity can elect to adopt the amendments in this Update using either a modified retrospective transition method or a prospective transition method. The Company is currently evaluating the impact the adoption of the standard will have on the Company’s financial position or results of operations.

 
27

 
 
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (a new revenue recognition standard). The Update’s core principle is that a company will recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In addition, this update specifies the accounting for certain costs to obtain or fulfill a contract with a customer and expands disclosure requirements for revenue recognition. This Update is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. The Company is evaluating the effect of adopting this new accounting Update.
 
In June 2014, the FASB issued ASU 2014-10, Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures.  The amendments in this Update change the accounting for repurchase-to-maturity transactions to secured borrowing accounting.  For repurchase financing arrangements, the amendments require separate accounting for a transfer of a financial asset executed contemporaneously with a repurchase agreement with the same counterparty, which will result in secured borrowing accounting for the repurchase agreement.  The amendments also require enhanced disclosures. The accounting changes in this Update are effective for the first interim or annual period beginning after December 15, 2014.  An entity is required to present changes in accounting for transactions outstanding on the effective date as a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption. Earlier application is prohibited.  The disclosure for certain transactions accounted for as a sale is required to be presented for interim and annual periods beginning after December 15, 2014, and the disclosure for repurchase agreements, securities lending transactions, and repurchase-to-maturity transactions accounted for as secured borrowings is required to be presented for annual periods beginning after December 15, 2014, and for interim periods beginning after March 15, 2015. The disclosures are not required to be presented for comparative periods before the effective date.  The Company is currently evaluating the impact the adoption of the standard will have on the Company’s financial position or results of operations.
 
In June 2014, the FASB issued ASU 2014-12, Compensation-Stock Compensation (Topic 718): Accounting for Share-Based Payments when the Terms of an Award Provide that a Performance Target Could Be Achieved After the Requisite Service Period.  The amendments require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. The amendments in this Update are effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. Earlier adoption is permitted. Entities may apply the amendments in this Update either (a) prospectively to all awards granted or modified after the effective date or (b) retrospectively to all awards with performance targets that are outstanding as of the beginning of the earliest annual period presented in the financial statements and to all new or modified awards thereafter. If retrospective transition is adopted, the cumulative effect of applying this Update as of the beginning of the earliest annual period presented in the financial statements should be recognized as an adjustment to the opening retained earnings balance at that date. Additionally, if retrospective transition is adopted, an entity may use hindsight in measuring and recognizing the compensation cost.  The Company is currently evaluating the impact the adoption of the standard will have on the Company’s financial position or results of operations.
 
 
28

 

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Forward-Looking Statements
 
We have made forward-looking statements in this document, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of operations of Citizens Financial Services, Inc., First Citizens Community Bank, First Citizens Insurance Agency, Inc. or the combined Company. When we use words such as “believes,” “expects,” “anticipates,” or similar expressions, we are making forward-looking statements. For a variety of reasons, actual results could differ materially from those contained in or implied by forward-looking statements.  The Company would like to caution readers that the following important factors, among others, could in the future affect the Company’s actual results and could cause the Company’s actual results for subsequent periods to differ materially from those expressed in any forward-looking statement:
 
·  
Interest rates could change more rapidly or more significantly than we expect.
·  
The economy could change significantly in an unexpected way, which would cause the demand for new loans and the ability of borrowers to repay outstanding loans to change in ways that our models do not anticipate.
·  
The 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 to implement strategic initiatives designed to increase revenues or manage expenses, or we may not be able to implement those initiatives at all.
·  
Acquisitions and dispositions of assets could affect us in ways that we have not anticipated.
·  
We may become subject to new legal obligations or the resolution of litigation may have a negative effect on our financial condition.
·  
We may become subject to new and unanticipated accounting, tax, or regulatory practices, regulations or requirements, including the costs of compliance with such changes.
·  
We could experience greater loan delinquencies than anticipated, adversely affecting our earnings and financial condition.
·  
We could also experience greater losses than expected due to the ever increasing volume of information theft and fraudulent scams impacting our customers and the banking industry.
·  
We could lose the services of some or all of our key personnel, which would negatively impact our business because of their business development skills, financial expertise, lending experience, technical expertise and market area knowledge.
·  
Exploration and drilling of the natural gas reserves in the Marcellus Shale in our market area may be affected by federal, state and local laws and regulations such as restrictions on production, permitting, changes in taxes and environmental protection, which could negatively impact our customers and, as a result, negatively impact our loan and deposit volume and loan quality.
·  
Similarly, customers dependent on 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 our customers.
 
Additional factors that may affect our results are discussed under “Part II – Item 1A – Risk Factors” in this report and in the Company’s 2013 Annual Report on Form 10-K under “Item 1.A/ Risk Factors.”  Except as required by applicable law and regulation, we assume no obligation to update or revise any forward-looking statements after the date on which they are made.
 
 Introduction
 
The following is management's discussion and analysis of the financial condition and results of operations presented in the accompanying consolidated financial statements for the Company.  Our Company's consolidated financial condition and results of operations consist almost entirely of the Bank’s financial condition and results of operations. Management’s discussion and analysis should be read in conjunction with the preceding financial statements presented under Part I.  The results of operations for the three and six months ended June 30, 2014 are not necessarily indicative of the results you may expect for the full year.

 
29

 
 
The Company currently engages in the general business of banking throughout our service area of Potter, Tioga and Bradford counties in North Central Pennsylvania and Allegany, Steuben, Chemung and Tioga counties in Southern New York. We maintain our main office in Mansfield, Pennsylvania. Presently we operate 20 banking facilities, 17 of which operate as bank branches.  In Pennsylvania, we have branch offices located in Mansfield, Blossburg, Ulysses, Genesee, Wellsboro, Troy, Sayre, Canton, Gillett, Millerton, LeRaysville, Towanda, Rome, the Wellsboro Weis Market store and the Mansfield Wal-Mart Super Center. We also have loan production offices in Lock Haven and Dallas, Pennsylvania. In New York, we have a branch office in Wellsville, Allegany County. We have started construction on a full service branch in the Lock Haven market, which will replace the loan production office currently located there, when completed.
 
 Risk Management
 
Risk identification and management are essential elements for the successful management of the Company.  In the normal course of business, the Company is subject to various types of risk, including interest rate, credit, liquidity, reputational and regulatory risk.
 
Interest rate risk is the sensitivity of net interest income and the market value of financial instruments to the direction and frequency of changes in interest rates.  Interest rate risk results from various re-pricing frequencies and the maturity structure of the financial instruments owned by the Company.  The Company uses its asset/liability and funds management policy to control and manage interest rate risk.
 
Credit risk represents the possibility that a customer may not perform in accordance with contractual terms.  Credit risk results from loans with customers and the purchasing of securities.  The Company’s primary credit risk is in the loan portfolio.  The Company manages credit risk by adhering to an established credit policy and through a disciplined evaluation of the adequacy of the allowance for loan losses.  Also, the investment policy limits the amount of credit risk that may be taken in the investment portfolio.
 
Liquidity risk represents the inability to generate or otherwise obtain funds at reasonable rates to satisfy commitments to borrowers and obligations to depositors.  The Company has established guidelines within its asset/liability and funds management policy to manage liquidity risk.  These guidelines include, among other things, contingent funding alternatives.
 
Reputational risk, or the risk to our business, earnings, liquidity, and capital from negative public opinion, could result from our actual or alleged conduct in a variety of areas, including legal and regulatory compliance, lending practices, corporate governance, litigation, ethical issues, or inadequate protection of customer information. We expend significant resources to comply with regulatory requirements. Failure to comply could result in reputational harm or significant legal or remedial costs. Damage to our reputation could adversely affect our ability to retain and attract new customers, and adversely impact our earnings and liquidity.
 
Regulatory risk represents the possibility that a change in law, regulations or regulatory policy may have a material effect on the business of the Company.  We cannot predict what legislation might be enacted or what regulations might be adopted, or if adopted, the effect thereof on our operations.

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

 
30

 
 
Trust and Investment Services; Oil and Gas Services
 
Our Investment and Trust Services Department offers professional trust administration, investment management services, estate planning and administration, and custody of securities.  Assets held by the Company in a fiduciary or agency capacity for its customers are not included in the consolidated financial statements since such items are not assets of the Company.  Revenues and fees of the Trust Department are reflected in the Company’s financial statements. As of June 30, 2014 and December 31, 2013, the Trust Department had $101.0 and $99.4 million of assets under management, respectively.

 Our Investment Representatives offer full service brokerage services and financial planning throughout the Bank’s market area. Products such as mutual funds, annuities, health and life insurance are made available through our insurance subsidiary, First Citizens Insurance Agency, Inc.  The assets associated with these products are not included in the consolidated financial statements since such items are not assets of the Company. Assets owned and invested by customers of the Bank through the Bank’s Investment Representatives increased from $102.5 million at December 31, 2013 to $108.5 million at June 30, 2014. Fee income from the sale of these products is reflected in the Company’s financial statements as a component of non-interest income in the Consolidated Statement of Income. Management believes that there are opportunities to increase non-interest income through these products and services, and as such, has added additional resources to support this growth.
 
In addition to the trust and investment services offered we have an oil and gas 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. We have partnered with a professional firm to provide additional expertise and services to customers in our market who have been impacted by the Marcellus Shale exploration and drilling activities.  As of June 30, 2014, customers owning approximately 8,200 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

Overview of the Income Statement
 
The Company had net income of $6,541,000 for the first six months of 2014 compared to $6,567,000 for last year’s comparable period, a decrease of $26,000 or 0.4%. Basic earnings per share for the first six months of 2014 were $2.15, compared to $2.14 last year, representing a 0.5% increase.  Annualized return on assets and return on equity for the six months of 2014 were 1.45% and 13.63%, respectively, compared with 1.50% and 14.99% for last year’s comparable period.
 
Net income for the three months ended June 30, 2014 was $3,365,000 compared to $3,280,000 in the comparable 2013 period, an increase of $85,000 or 2.6%. Basic earnings per share for the three months ended June 30, 2014 were $1.11, compared to $1.07 last year, representing a 3.7% increase. Annualized return on assets and return on equity for the quarter ended June 30, 2014 was 1.49% and 13.88%, respectively, compared with 1.49% and 14.77% for the same 2013 period.

Net Interest Income
 
Net interest income, the most significant component of the Company’s earnings, is the amount by which interest income generated from interest-earning assets exceeds interest expense on interest-bearing liabilities.

 
31

 
 
Net interest income for the first six months of 2014 was $15,162,000, an increase of $498,000, or 3.4%, compared to the same period in 2013.  For the first six months of 2014, the provision for loan losses totaled $330,000, an increase of $105,000 over the comparable period in 2013.  Consequently, net interest income after the provision for loan losses was $14,832,000 compared to $14,439,000 during the first six months of 2013.
 
For the three months ended June 30, 2014, net interest income was $7,650,000 compared to $7,351,000, an increase of $299,000, or 4.1% over the comparable period in 2013. The provision for loan losses this quarter was $150,000 compared to $75,000 for last year’s second quarter.  Consequently, net interest income after the provision for loan losses was $7,500,000 for the quarter ended June 30, 2014 compared to $7,276,000 in 2013.
 
 The following table sets forth the average balances of, and the interest earned or incurred on, for each principal category of assets, liabilities and stockholders’ equity, the related rates, net interest income and interest rate spread created for the six months and three months ended June 30, 2014 and 2013 on a tax equivalent basis (dollars in thousands):

 
32

 
 
 
Analysis of Average Balances and Interest Rates (1)
 
Six Months Ended
 
June 30, 2014
June 30, 2013
 
Average
 
Average
Average
 
Average
 
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
(dollars in thousands)
$
$
%
$
$
%
ASSETS
           
Short-term investments:
           
   Interest-bearing deposits at banks
         5,701
                 1
0.04
        20,030
                19
0.19
Total short-term investments
         5,701
                 1
0.04
        20,030
                19
0.19
Interest bearing time deposits at banks
         2,480
               25
2.02
                  -
                  -
                  -
Investment securities:
           
  Taxable
     217,369
         1,856
1.71
      211,226
          1,937
1.83
  Tax-exempt (3)
       95,832
         2,548
5.32
        91,518
          2,595
5.67
  Total investment securities
     313,201
         4,404
2.81
      302,744
          4,532
2.99
Loans:
           
  Residential mortgage loans
     186,727
         5,284
5.71
      179,547
          5,463
6.14
  Construction
         5,383
             123
4.61
        12,065
              304
5.08
  Commercial & agricultural loans
     270,348
         7,320
5.46
      247,749
          7,215
5.87
  Loans to state & political subdivisions
       64,911
         1,522
4.73
        59,199
          1,316
4.48
  Other loans
         8,862
             359
8.17
          9,917
              406
8.26
  Loans, net of discount (2)(3)(4)
     536,231
       14,608
5.49
      508,477
        14,704
5.83
Total interest-earning assets
     857,613
       19,038
4.48
      831,251
        19,255
4.67
Cash and due from banks
         3,777
   
          3,673
   
Bank premises and equipment
       11,122
   
        11,452
   
Other assets
       29,174
   
        31,113
   
Total non-interest earning assets
       44,073
   
        46,238
   
Total assets
     901,686
   
      877,489
   
LIABILITIES AND STOCKHOLDERS' EQUITY
         
Interest-bearing liabilities:
           
  NOW accounts
     218,528
             388
            0.36
      202,540
              381
            0.38
  Savings accounts
       98,444
               55
            0.11
        91,231
                76
            0.17
  Money market accounts
       84,579
             189
            0.45
        83,092
              192
            0.47
  Certificates of deposit
     261,932
         1,567
            1.21
      274,431
          1,966
            1.44
Total interest-bearing deposits
     663,483
         2,199
            0.67
      651,294
          2,615
            0.81
Other borrowed funds
       45,569
             309
            1.37
        43,350
              668
            3.11
Total interest-bearing liabilities
     709,052
         2,508
            0.71
      694,644
          3,283
            0.95
Demand deposits
       89,396
   
        86,430
   
Other liabilities
         7,252
   
          8,781
   
Total non-interest-bearing liabilities
       96,648
   
        95,211
   
Stockholders' equity
       95,986
   
        87,634
   
Total liabilities & stockholders' equity
     901,686
   
      877,489
   
Net interest income
 
       16,530
   
        15,972
 
Net interest spread (5)
   
3.77%
   
3.72%
Net interest income as a percentage
           
  of average interest-earning assets
   
3.89%
   
3.87%
Ratio of interest-earning assets
           
  to interest-bearing liabilities
   
121%
   
120%
             
(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.
       
 
 
33

 
 
 
Analysis of Average Balances and Interest Rates (1)
 
 Three Months Ended
 
June 30, 2014
June 30, 2013
 
Average
 
Average
Average
 
Average
 
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
(dollars in thousands)
$
$
%
$
$
%
ASSETS
           
Short-term investments:
           
   Interest-bearing deposits at banks
           6,122
                   -
0.03
          16,897
                   9
0.21
Total short-term investments
           6,122
                   -
0.03
          16,897
                   9
0.21
Interest bearing time deposits at banks
           2,480
                13
2.02
                    -
                    -
                    -
Investment securities:
           
  Taxable
      212,143
              918
1.73
        210,996
               954
1.81
  Tax-exempt (3)
        96,282
           1,272
5.28
          90,873
            1,278
5.63
  Total investment securities
      308,425
           2,190
2.84
        301,869
            2,232
2.96
Loans:
           
  Residential mortgage loans
      187,129
           2,654
5.69
        179,823
            2,722
6.07
  Construction
           3,450
                41
4.77
          12,294
               149
4.86
  Commercial & agricultural loans
      272,525
           3,703
5.45
        253,493
            3,637
5.75
  Loans to state & political subdivisions
        66,335
              812
4.91
          59,205
               646
4.38
  Other loans
           8,716
              176
8.10
            9,812
               200
8.18
  Loans, net of discount (2)(3)(4)
      538,155
           7,386
5.50
        514,627
            7,354
5.73
Total interest-earning assets
      855,182
           9,589
4.50
        833,393
            9,595
4.62
Cash and due from banks
           3,771
   
            3,791
   
Bank premises and equipment
        11,174
   
          11,412
   
Other assets
        31,121
   
          30,183
   
Total non-interest earning assets
        46,066
   
          45,386
   
Total assets
      901,248
   
        878,779
   
LIABILITIES AND STOCKHOLDERS' EQUITY
         
Interest-bearing liabilities:
           
  NOW accounts
      220,310
              194
             0.35
        206,553
               197
              0.38
  Savings accounts
      100,025
                27
             0.11
          92,123
                 36
              0.16
  Money market accounts
        85,869
                95
             0.44
          82,844
                 95
              0.46
  Certificates of deposit
      259,344
              778
             1.20
        272,794
               959
              1.41
Total interest-bearing deposits
      665,548
           1,094
             0.66
        654,314
            1,287
              0.79
Other borrowed funds
        39,990
              145
             1.45
          40,488
               310
              3.07
Total interest-bearing liabilities
      705,538
           1,239
             0.70
        694,802
            1,597
              0.92
Demand deposits
        91,798
   
          86,942
   
Other liabilities
           6,924
   
            8,184
   
Total non-interest-bearing liabilities
        98,722
   
          95,126
   
Stockholders' equity
        96,988
   
          88,851
   
Total liabilities & stockholders' equity
      901,248
   
        878,779
   
Net interest income
 
           8,350
   
            7,998
 
Net interest spread (5)
   
3.80%
   
3.70%
Net interest income as a percentage
           
  of average interest-earning assets
   
3.92%
   
3.85%
Ratio of interest-earning assets
           
  to interest-bearing liabilities
   
121%
   
120%
             
(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.
       
 
 
34

 
 
Tax exempt revenue is shown on a tax-equivalent basis for proper comparison using a statutory, federal income tax rate of 34%.  For purposes of the comparison, as well as the discussion that follows, this presentation facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the Company’s 34% Federal statutory rate.  The following table represents the adjustment to convert net interest income to net interest income on a fully taxable equivalent basis for the periods ending June 30, 2014 and 2013 (in thousands):
 
 
For the Three Months
 
For the Six Months
 
Ended June 30
 
Ended June 30
 
2014
2013
 
2014
2013
Interest and dividend income from investment securities
         
   and interest bearing deposits at banks (non-tax adjusted)
 $             1,771
 $              1,807
 
 $        3,564
 $     3,669
Tax equivalent adjustment
                   432
                    434
 
               866
            882
Interest and dividend income from investment securities
         
   and interest bearing deposits at banks (tax equivalent basis)
 $             2,203
 $              2,241
 
 $        4,430
 $     4,551
           
Interest and fees on loans (non-tax adjusted)
 $             7,118
 $              7,141
 
 $       14,106
 $   14,278
Tax equivalent adjustment
                   268
                    213
 
               502
            426
Interest and fees on loans (tax equivalent basis)
 $             7,386
 $              7,354
 
 $      14,608
 $   14,704
           
Total interest income
 $             8,889
 $              8,948
 
 $      17,670
 $   17,947
Total interest expense
                1,239
                 1,597
 
            2,508
        3,283
Net interest income
                7,650
                 7,351
 
         15,162
      14,664
Total tax equivalent adjustment
                   700
                    647
 
            1,368
        1,308
Net interest income (tax equivalent basis)
 $             8,350
 $              7,998
 
 $      16,530
 $   15,972
 
The following table shows the tax-equivalent effect of changes in volume and rate on interest income and expense (in thousands):

 
Analysis of Changes in Net Interest Income on a Tax-Equivalent Basis (1)
 
 Three months ended June 30, 2014 vs. 2013 (1)
 
 Six months ended June 30, 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
 $            (4)
 $            (5)
 $        (9)
 
 $          (8)
 $        (10)
 $      (18)
Interest bearing time deposits at banks
13
-
13
 
25
-
25
Investment securities:
             
  Taxable
5
             (41)
 (36)
 
59
 (140)
 (81)
  Tax-exempt
304
         (310)
 (6)
 
146
 (193)
 (47)
Total investments
              309
         (351)
 (42)
 
            205
 (333)
 (128)
Loans:
             
  Residential mortgage loans
123
           (191)
 (68)
 
            239
 (418)
 (179)
  Construction
           (105)
 (3)
 (108)
 
 (155)
 (26)
 (181)
  Commercial & agricultural loans
             224
    (158)
66
 
            457
 (352)
105
  Loans to state & political subdivisions
                82
84
166
 
            132
74
206
  Other loans
              (22)
 (2)
 (24)
 
 (43)
 (4)
 (47)
Total loans, net of discount
              302
           (270)
32
 
            630
 (726)
 (96)
Total Interest Income
               620
           (626)
 (6)
 
            852
 (1,069)
 (217)
Interest Expense:
             
Interest-bearing deposits:
             
  NOW accounts
               20
             (23)
 (3)
 
25
 (18)
7
  Savings accounts
                 4
             (13)
 (9)
 
6
 (27)
 (21)
  Money Market accounts
                 3
              (3)
-
 
3
 (6)
 (3)
  Certificates of deposit
              (46)
          (135)
 (181)
 
 (86)
 (313)
 (399)
Total interest-bearing deposits
              (19)
           (174)
 (193)
 
 (52)
(364)
 (416)
Other borrowed funds
                (4)
(161)
 (165)
 
36
 (395)
 (359)
Total interest expense
              (23)
 (335)
 (358)
 
 (16)
 (759)
 (775)
Net interest income
 $            643
 $        (291)
 $       352
 
 $         868
 $      (310)
 $       558
               
 
(1) The portion of the total change attributable to both volume and rate changes, which can not be separated, has been allocated proportionally to the change due to volume and the change due to rate prior to allocation.
 
 
 
35

 
 
Tax equivalent net interest income increased from $15,972,000 for the 2013 six month period ended June 30, 2013 to $16,530,000 for the 2014 six month period ended June 30, 2014, an increase of $558,000. The tax equivalent net interest margin increased from 3.87% for the first six months of 2013 to 3.89% in 2014.
 
Total tax equivalent interest income for the 2014 six month period decreased $217,000 as compared to the 2013 six month period. This decrease was primarily a result of a decrease of $1,069,000 due to a change in rate, as the yield on interest earning assets decreased from 4.67% to 4.48% or 19 basis points for the comparable periods. This decrease was offset by an increase of $852,000 as a result of an increase in the average balance of interest earning assets of $26.4 million for the comparable periods. While the Bank has been able to add interest earning assets, the new assets are priced at lower rates than assets that have matured due to the prolonged low interest rate environment. Additionally, assets repriced at lower rates during the quarter.
 
Tax equivalent investment income for the six months ended June 30, 2014 decreased $128,000 over the same period last year. The primary cause of this decrease was a decrease in the yield earned on investments of 18 basis points, which caused a decrease in tax equivalent investment income of $333,000. The average balance of total investment securities for the six months ended June 30, 2014 increased by $10.5 million from June 30, 2013, which resulted in additional income of $205,000.
 
·  
The average balance of taxable securities increased by $6.1 million while tax-exempt securities increased by $4.3 million, which had the effect of increasing interest income by $59,000 and $146,000, respectively, due to volume.
 
·  
The yield on taxable securities decreased 12 basis points from 1.83% to 1.71%, which corresponds to a decrease in interest income of $140,000. The yield on tax-exempt securities decreased 35 basis points, which corresponds to a decrease in interest income of $193,000. The yield on investments declined due to the amount of purchases we made in the current low interest rate environment. For a discussion of the Company’s current investment strategy, see the “Financial Condition – Investments”.
 
The purchase of tax-exempt securities, along with municipal loans and investment tax credits, allows us to manage and reduce our effective tax rate as well as the overall yield on our interest earning assets.
 
Total loan interest income decreased $96,000 for the six months ended June 30, 2014 compared to the same period last year.
 
·  
Interest income on residential mortgage loans decreased $179,000 as a result of change in rates, which resulted in a decrease of $418,000. The yield earned on residential loans decreased 43 basis points compared to 2013. This was offset by an increase attributed to volume of $239,000 as the average balance increased $7.2 million for the comparable periods.
 
·  
Interest income on construction loans decreased $181,000, primarily due to a change in volume, as the average balance decreased $6.7 million or 55.4%, as projects were completed and transferred primarily to commercial real estate and state and political subdivision loans. .
 
·  
The average balance of commercial and agricultural loans increased $22.6 million from a year ago as we continue to focus on this segment of the loan portfolio, utilizing an experienced lending staff. This had a positive impact of $457,000 on total interest income due to volume, which was offset by a decrease of $352,000 due to rate, as the yield earned decreased from 5.87% to 5.46% due to the continued low rate environment and increased competition.
 
·  
The average balance of state and political subdivision loans increased $5.7 million from a year ago. This had a positive impact of $132,000 on total interest income due to volume. In addition, the yield earned increased 25 basis points to 4.73%, which increased loan interest income $74,000.
 
 
36

 
 
Total interest expense decreased $775,000 for the six months ended June 30, 2014 compared with last year. The decrease is primarily attributable to a change in average rate from .95% in 2013 to .71% in the comparable 2014 period, which had the effect of decreasing interest expense by $759,000. The continued low interest rate environment prompted by the Federal Reserve had the effect of decreasing our short-term borrowing costs as well as rates on all deposit products. While the Company’s rates on 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 $14.4 million from June 30, 2013 to June 30, 2014. Increases were experienced in NOW accounts of $16.0 million, savings accounts of $7.2 million, money market accounts of $1.5 million and other borrowed funds of $2.2 million. The cumulative effect of these increases was an increase in interest expense of $70,000. Certificates of deposit decreased $12.5 million, which resulted in a decrease in interest expense due to volume of $86,000. (see also “Financial Condition – Deposits”).
 
·  
Interest expense on certificates of deposits decreased $399,000 over the same period last year. There was a decrease in the average rate on certificates of deposit from 1.44% to 1.21% resulting in a decrease in interest expense of $313,000. Additionally, the average balance of certificates of deposit decreased $12.5 million causing a decrease in interest expense of $86,000.
 
·  
Interest expense on other borrowed funds decreased $359,000 over the same period last year. The primary cause of the decrease was the average rate on other borrowed funds decreasing 174 basis points resulting in a decrease in interest expense of $395,000. The decrease in rate on the other borrowed funds is a result of the significant maturities of borrowings in 2013 that were either refinanced long term at a lower rate or that were replaced with overnight borrowings. The average balance of other borrowed funds increased $2.2 million causing an increase in interest expense of $36,000.
 
Tax equivalent net interest income for the three months ended June 30, 2014 was $8,350,000 which compares to $7,998,000 for the same period last year.  This represents an increase of $352,000 or 4.4%.
 
Total tax equivalent interest income was $9,589,000 for the 2014 three month period ended June 30, 2014, compared with $9,595,000 for the comparable period last year, a decrease of $6,000. Of this amount, $626,000 was a result of a decrease of 12 basis points on our yield on interest earning assets from 4.62% to 4.50%:
 
·  
Total investment income decreased by $42,000 compared to same period last year.  This was due to a 12 point decrease in rate on investments from 2.96% to 2.84%, which equates to $351,000 decrease in income. This was offset by an increase in income of $309,000 as a result of a $6.6 million increase in the average balance of investment securities.
 
·  
Total loan interest income increased $32,000 compared to last year. This was predominantly due to a change in volume of $302,000 as a result of a $27.8 million increase in average loans outstanding, offset by $270,000 as a result of a decrease in rate of 23 points from 5.73% to 5.50%.
 
Total interest expense decreased $358,000 for the three months ended June 30, 2014 compared with last year as a result of a decrease in the average rate on interest-bearing liabilities of 22 basis points from 0.92% to 0.70% accounting for a $335,000 decrease in interest expense. Additionally, due to a $13.5 million decrease in the average balance of certificates of deposit, there was a $46,000 decrease in interest expense.
 
Provision for Loan Losses
 
For the six month period ending June 30, 2014, we recorded a provision for loan losses of $330,000, which represents an increase of $105,000 from the $225,000 provision recorded in the corresponding six months of last year. The provision was higher in 2014 than 2013 primarily due to the increase in loan charged-offs in the first six months of 2014. see “Financial Condition – Allowance for Loan Losses and Credit Quality Risk”).
 
For the three months ending June 30, 2014, we recorded a provision of $150,000 compared to $75,000 in 2013.

 
37

 
 
Non-interest Income
 
The following table shows the breakdown of non-interest income for the three and six months ended June 30, 2014 and 2013 (in thousands):
 
 
Six months ended June 30,
Change
 
2014
2013
Amount
%
Service charges
 $                 2,141
 $               2,168
 $                 (27)
                (1.2)
Trust
                       377
                     370
                       7
                 1.9
Brokerage and insurance
                       257
                     213
                     44
               20.7
Investment securities gains, net
                       246
                     294
                    (48)
              (16.3)
Gains on loans sold
                         70
                     161
                    (91)
              (56.5)
Earnings on bank owned life insurance
                       242
                     250
                      (8)
                (3.2)
Other
                       209
                     204
                       5
                 2.5
Total
 $                 3,542
 $               3,660
 $               (118)
                (3.2)
         
 
Three months ended June 30,
Change
 
2014
2013
Amount
%
Service charges
 $                 1,102
 $               1,114
 $                 (12)
                (1.1)
Trust
                       186
                     169
                     17
               10.1
Brokerage and insurance
                       137
                     121
                     16
               13.2
Investment securities gains, net
                         75
                       98
                    (23)
              (23.5)
Gains on loans sold
                         30
                       50
                    (20)
              (40.0)
Earnings on bank owned life insurance
                       121
                     126
                      (5)
                (4.0)
Other
                       104
                     100
                       4
                 4.0
Total
 $                 1,755
 $               1,778
 $                 (23)
                (1.3)
 
Non-interest income for the six months ended June 30, 2014 totaled $3,542,000, a decrease of $118,000 when compared to the same period in 2013. During the first six months of 2014, investment security gains amounted to $246,000 compared to gains of $294,000 last year. We sold five agency securities for gains totaling $95,000, three mortgage backed securities in government sponsored entities for gains totaling $78,000, and a portion of a financial institution equity holding for a gain of $73,000 due to favorable market conditions. In 2013, we sold eight mortgage backed securities that were repaying quickly for a net gain of $104,000, four municipal securities for gains totaling $87,000, four agency securities for gains totaling $46,000 that were maturing later in 2013, portions of two financial institution equity holdings for gains totaling $55,000 and a corporate obligation for a gain of $2,000.
 
Gains on loans sold decreased $91,000, or 56.5% for the six months ended June 30, 2014 to $70,000. The decrease is due to the significant refinancing activity of secondary market loans that occurred as a result of the low interest rate environment in place in the first half of 2013 compared to the rates during the first half of 2014. This slowdown in secondary market loans is not limited to our primary market, but is occurring across numerous markets throughout the United States. During the first six months of 2014, the Company received proceeds of $5.1 million from the sale of conforming loans compared to $12.6 million of proceeds for the comparable 2013 period.
 
For the three month period ended June 30, 2014, the decrease experienced in gains on loans sold are consistent with the year to date decreases described above. The increase in trust revenues is the result of an estate settling in the second quarter in 2014. The increase in brokerage revenue in the second quarter is attributable to the Bank’s hiring of an additional broker, which has resulted in increased sales.

 
38

 
 
Non-interest Expense
 
The following tables reflect the breakdown of non-interest expense for the three and six months ended June 30, 2014 and 2013 (in thousands):

 
Six months ended
   
 
June 30,
Change
 
 
2014
2013
Amount
%
Salaries and employee benefits
 $                 5,810
 $               5,600
 $                 210
                   3.8
Occupancy
                       654
                     654
                        -
                     -
Furniture and equipment
                       194
                     215
                    (21)
                 (9.8)
Professional fees
                       442
                     417
                      25
                   6.0
FDIC insurance
                       229
                     225
                        4
                   1.8
Pennsylvania shares tax
                       384
                     365
                      19
                   5.2
Other
                    2,378
                  2,243
                    135
                   6.0
Total
 $               10,091
 $               9,719
 $                 372
                   3.8
         
 
Three months ended
   
 
June 30,
Change
 
 
2014
2013
Amount
%
Salaries and employee benefits
 $                 2,893
 $               2,795
 $                   98
                   3.5
Occupancy
                       304
                     312
                      (8)
                 (2.6)
Furniture and equipment
                         94
                     113
                    (19)
               (16.8)
Professional fees
                       208
                     188
                      20
                 10.6
FDIC insurance
                       116
                     113
                        3
                   2.7
Pennsylvania shares tax
                       191
                     182
                        9
                   4.9
Other
                    1,194
                  1,164
                      30
                   2.6
Total
 $                 5,000
 $               4,867
 $                 133
                   2.7
 
Non-interest expenses increased $372,000 for the six months ended June 30, 2014 compared to the same period in 2013. Salaries and employee benefits increased $210,000 or 3.8%. Merit increases effective at the beginning of 2014 and an increase in full time equivalent employees, as part of implementing the Bank’s strategic plan, accounted for an increase in non-interest expenses of approximately $223,000.
 
Other expenses increased $135,000 primarily due to an increase in expenses associated with our other real estate owned properties of approximately $63,000 and a $31,000 increase in charge-offs associated with fraudulent customer account activity as a result of several national data breaches reported in the news in late 2013 and the first quarter of 2014.
 
For the three months ended, June 30, 2014, salaries and employee benefits increased by $98,000 due to the reasons described above, which include merit increases and an increase in full time equivalent employees.

Provision for Income Taxes
 
The provision for income taxes was $1,742,000 for the six month period ended June 30, 2014 compared to $1,813,000 for the same period in 2013.  The decrease is primarily attributable to a decrease in income before provision for income taxes of $97,000. Through management of our municipal loan and bond portfolios, management is focused on minimizing our effective tax rate.  Our effective tax rate was 21.0% and 21.6% for the first six months of 2014 and 2013, respectively, compared to the statutory rate of 34%.
 
For the three months ended June 30, 2014, the provision for income taxes was $890,000 compared to $907,000 for the same period in 2013. The decrease is primarily attributable to an increase in the proportion of non-taxable interest income to total income for the 2014 three month period. Our effective tax rate was 20.9% and 21.7% for the three months ended June 30, 2014 and 2013, respectively, compared to the statutory rate of 34%.
 
 
39

 
 
We have invested in four limited partnership agreements that established low-income housing projects in our market areas. We anticipate recognizing an aggregate of $1.3 million of tax credits over the next ten years, with an additional $99,000 to be recognized during 2014.
 
 Financial Condition
 
Total assets were $914.2 million at June 30, 2014, a decrease of $765,000, or 0.1% from $914.9 million at December 31, 2013.  Cash and cash equivalents increased $5.6 million or 56.1% to $15.7 million. Investment securities decreased to $312.3 million and net loans decreased 0.1% to $533.1 million at June 30, 2014.  Total deposits increased $17.1 million to $765.5 million since year-end 2013, while borrowed funds decreased $23.9 million to $43.1 million.

Cash and Cash Equivalents
 
Cash and cash equivalents totaled $15.7 million at June 30, 2014 compared to $10.1 million at December 31, 2013, an increase of $5.6 million. 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 including the Bank’s core deposits, 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 composition of the investment portfolio as of June 30 31, 2014 and December 31, 2013 (dollars in thousands):

 
June 30, 2014
December 31, 2013
 
Amount
%
Amount
%
Available-for-sale:
       
  U. S. Agency securities
 $              147,335
             47.2
 $        152,189
          48.0
  U. S. Treasury notes
                   11,504
               3.7
             11,309
            3.6
  Obligations of state & political
       
     subdivisions
                 101,627
             32.5
             95,005
          29.9
  Corporate obligations
                   14,215
               4.6
             16,802
            5.3
  Mortgage-backed securities in
       
    government sponsored entities
                   35,768
             11.5
             40,671
          12.8
  Equity securities in financial
       
     institutions
                     1,873
               0.5
               1,325
            0.4
Total
 $              312,322
           100.0
 $        317,301
        100.0
 
 
June 30, 2014/
   
 
 December 31, 2013
   
 
        Change
   
(dollars in thousands)
Amount
%
   
Available-for-sale:
       
  U. S. Agency securities
 $                 (4,854)
             (3.2)
   
  U. S. Treasury notes
                        195
               1.7
   
  Obligations of state & political
       
     subdivisions
                     6,622
               7.0
   
  Corporate obligations
                    (2,587)
           (15.4)
   
  Mortgage-backed securities in
       
    government sponsored entities
                    (4,903)
           (12.1)
   
  Equity securities in financial
       
     institutions
                        548
             41.4
   
Total
 $                 (4,979)
             (1.6)
   

 
40

 
 
Our investment portfolio decreased by $5.0 million, or 1.6%, from December 31, 2013 to June 30, 2014.  During 2014, we purchased approximately $24.5 million of U.S. agency obligations, $8.7 million of state and local obligations and $601,000 of equity securities in financial institutions, which helped offset the $3.6 million of principal repayments and $25.7 million of calls and maturities that occurred during the six month period. We also sold $12.1 million of various securities at a gain of $246,000. Excluding our short-term investments consisting of monies held primarily at the Federal Reserve for liquidity purposes, our investment portfolio for the six month period ending June 30, 2014 yielded 2.81% compared to 2.99% for the same period in 2013 on a tax equivalent basis.
 
As a result of the Federal Reserve’s commitment to a low rate policy, investment yields are significantly below historical levels. The Company’s investment strategy in 2014 has been to purchase agency securities with maturities of less than five years and high quality municipal bonds with high coupons. Due to the steepness of the yield curve of maturities between two to five years, the Bank believes it has provided itself protection to rising interest rates, if they occur. Additionally, high coupon municipal bonds have less price volatility in rising rate scenarios than similar lower coupon bonds. We believe this strategy will enable us to reinvest cash flows in the next two to five years when and if investment opportunities improve.
 
Management continues to monitor the earnings performance and the liquidity of the investment portfolio on a regular basis.  Through active balance sheet management and analysis of the securities portfolio, the Company believes it maintains sufficient liquidity to satisfy depositor requirements and various credit needs of its customers.

Loans
 
The following table shows the composition of the loan portfolio as of June 30, 2014 and December 31, 2013 (dollars in thousands):

 
June 30,
December 31,
 
2014
2013
 
Amount
%
Amount
%
Real estate:
       
  Residential
 $          187,183
           34.7
 $         187,101
           34.6
  Commercial
             186,977
           34.6
            193,087
           35.7
  Agricultural
               23,809
             4.4
              22,001
             4.1
  Construction
                 3,474
             0.6
                8,937
             1.7
Consumer
                 8,692
             1.6
                9,563
             1.7
Other commercial and agricultural loans
               58,090
           10.8
              54,029
           10.0
State & political subdivision loans
               71,652
           13.3
              65,894
           12.2
Total loans
             539,877
         100.0
            540,612
         100.0
Less allowance for loan losses
                 6,751
 
                7,098
 
Net loans
 $          533,126
 
 $         533,514
 
 
 
June 30, 2014/
   
 
 December 31, 2013
   
 
Change
   
 
Amount
%
   
Real estate:
       
  Residential
 $                   82
             0.0
   
  Commercial
               (6,110)
           (3.2)
   
  Agricultural
                 1,808
             8.2
   
  Construction
               (5,463)
         (61.1)
   
Consumer
                  (871)
           (9.1)
   
Other commercial and agricultural loans
                 4,061
             7.5
   
State & political subdivision loans
                 5,758
             8.7
   
Total loans
 $               (735)
           (0.1)
   

 
41

 
 
The Company’s lending is focused in the north central Pennsylvania market and the southern tier of New York.  The composition of our loan portfolio consists principally of retail lending, which includes single-family residential mortgages and other consumer lending, and commercial lending primarily to locally owned small businesses.  New loans are primarily direct loans to our existing customer base, with new customers generated by referrals from real estate brokers, building contractors, attorneys, accountants and existing customers and the efforts and expertise of our business development officers and the opening of loan production offices.
 
Total loans decreased $735,000 or 0.1% during the first six months of 2014. The decrease in loans was primarily driven by several large pay-offs, particularly of participation commercial real estate loans during the first part of the year. The decrease in construction loans was the result of transfers to commercial real estate and municipal loans upon the completion of two projects. In addition to the transfer from construction, we did develop several new relationships with municipal customers during the year. The increase in commercial and other loans was primarily the result of two customers with lines of credit that increased $2.5 million.

 During the first part of 2014, we have experienced soft loan demand for commercial related loans throughout our primary market. As a result of this soft demand, there has also been an increase in pricing pressure for the loan demand that we are seeing in our markets. This increased competition has resulted in the Bank changing terms of loans in order to maintain the relationship. While obtaining and maintaining commercial relationships has become more competitive, the Company is still focused on growing commercial real estate, commercial and agricultural and state and political subdivision loans as a means to increase loan growth and obtain deposits from farmers, small businesses and municipalities throughout our market area.  As a community bank, we strive to meet the unique needs and provide solutions to customers within our service area.  The local economy has been impacted by the Marcellus Shale gas exploration activities, which are impacted by regulations and changes in the market price of natural gas. Due to the low price for natural gas, exploration activities have been curtailed in the first part of 2014. We work closely with local municipalities and school districts to meet their needs that otherwise would be provided by the municipal bond market.
 
Loan demand for conforming mortgages, which the Company typically sells on the secondary market, also decreased in comparison to the prior year. Due to the decline in demand for non-conforming mortgages and the difficult investment environment, the Company decided during the first part of 2014 and 2013 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 the first six months of 2014 and 2013, the Company decided not to sell $1.5 million and $4.3 million, respectively, of residential mortgages that met secondary market standards. During the first six months of 2014, $5.3 million of loans were originated to be sold on the secondary market, which compares to $11.8 million for the comparable period in 2013. 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 explore new competitively priced products and to build technologies which make it easier and more efficient for customers to choose the Company for their mortgage needs.

Allowance for Loan Losses
 
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 allowance for loan losses and non-performing loans and assets as of and for the six months ended June 30, 2014 and for the years ended December 31, 2013, 2012, 2011 and 2010 (dollars in thousands):

 
42

 
 

 
June 30,
December 31,
 
2014
2013
2012
2011
2010
Balance
         
  at beginning of period
 $          7,098
 $          6,784
 $          6,487
 $          5,915
 $          4,888
Charge-offs:
         
  Real estate:
         
     Residential
                  45
                  17
                  95
                101
                147
     Commercial
                475
                  62
                    2
                  29
                  53
  Consumer
                  14
                  54
                  54
                  71
                  35
  Other commercial and agricultural loans
                163
                    1
                  21
                    6
                173
Total loans charged-off
                697
                134
                172
                207
                408
Recoveries:
         
  Real estate:
         
     Residential
                     -
                    5
                     -
                     -
                    4
     Commercial
                    5
                    5
                    9
                  15
                  11
  Consumer
                  15
                  33
                  33
                  57
                  45
  Other commercial and agricultural loans
                     -
                     -
                    7
                  32
                120
Total loans recovered
                  20
                  43
                  49
                104
                180
           
Net loans charged-off
                677
                  91
                123
                103
                228
Provision charged to expense
                330
                405
                420
                675
             1,255
Balance at end of period
 $          6,751
 $          7,098
 $          6,784
 $          6,487
 $          5,915
           
Loans outstanding at end of period
 $      539,877
 $      540,612
 $      502,463
 $      487,509
 $      473,517
Average loans outstanding, net
 $      536,231
 $      516,748
 $      496,822
 $      474,972
 $      468,620
Non-performing assets:
         
    Non-accruing loans
 $          7,561
 $          8,097
 $          8,067
 $          9,165
 $        11,853
    Accrual loans - 90 days or more past due
                347
                697
                506
                275
                692
      Total non-performing loans
 $          7,908
 $          8,794
 $          8,573
 $          9,440
 $        12,545
    Foreclosed assets held for sale
             1,295
             1,360
                616
                860
                693
      Total non-performing assets
 $          9,203
 $        10,154
 $          9,189
 $        10,300
 $        13,238
           
Annualized net charge-offs to average loans
0.25%
0.02%
0.02%
0.02%
0.05%
Allowance to total loans
1.25%
1.31%
1.35%
1.33%
1.25%
Allowance to total non-performing loans
85.37%
80.71%
79.13%
68.72%
47.15%
Non-performing loans as a percent of loans
         
   net of unearned income
1.46%
1.63%
1.71%
1.94%
2.65%
Non-performing assets as a percent of loans
       
  net of unearned income
1.70%
1.88%
1.83%
2.11%
2.80%

Management believes it uses the best information available when estimating the allowance for loan losses and that the allowance for loan losses is adequate as of June 30, 2014.  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.

 
43

 
 
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 chose to include.  Watch list loans are continually monitored going forward until satisfactory conditions exist that allow management to upgrade and remove the loan.  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 other commercial loans, on non-accrual are evaluated quarterly for impairment.
 
 The balance in the allowance for loan losses was $6,751,000 or 1.25% of total loans as of June 30, 2014 as compared to $7,098,000 or 1.31% of loans as of December 31, 2013.  The $347,000 decrease is a result of a $330,000 provision for the first six months offset by net charge-offs of $677,000. The net charge-offs for 2014 are significantly higher than historical charge-offs for the Bank, primarily as a result of two relationships. In June, we recorded charge-offs for these two relationships of $463,000 and $145,000, respectively, which in the prior quarter had been specifically reserved for as part of the allowance calculation. Net charge-offs for all of 2013 were $91,000. 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 June 30, 2014 and December 31, 2013, 2012, 2011 and 2010:

 
June 30
December 31
 
2014
2013
2012
2011
2010
 
Amount
%
Amount
%
Amount
%
Amount
%
Amount
%
Real estate loans:
                   
  Residential
 $    879
34.7
 $    946
34.6
 $   875
35.4
 $   805
37.7
 $   969
39.1
  Commercial, agricultural
    3,809
39.0
    4,558
39.8
4,437
38.8
4,132
37.9
3,380
36.2
  Construction
         13
0.6
         50
1.7
38
2.4
15
1.7
22
2.1
Consumer
         86
1.6
       105
1.7
119
2.1
111
2.2
108
2.4
Other commercial and
                   
     agricultural loans
    1,151
10.8
       942
10.0
728
9.5
674
9.1
983
10.0
State & political subdivision
                   
     loans
       455
13.3
       330
12.2
271
11.8
235
11.4
137
10.2
Unallocated
       358
 N/A
       167
 N/A
316
 N/A
515
 N/A
316
 N/A
Total allowance for loan losses
 $ 6,751
100.0
 $ 7,098
100.0
 $6,784
100.0
 $6,487
100.0
 $5,915
100.0
 
As a result of previous loss experiences and other 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 total 39.0% of the loan portfolio, 56.4% 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.
 
The following table identifies amounts of loans contractually past due 30 to 89 days and non-performing loans by loan category, as well as the change from December 31, 2013 to June 30, 2014 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.

 
44

 
 
 
June 30, 2014
 
December 31, 2013
   
Non-Performing Loans
   
Non-Performing Loans
 
30 - 89 Days
       
30 - 89 Days
     
 
Past Due
90 Days Past
Non-
Total Non-
 
Past Due
90 Days Past
Non-
Total Non-
(in thousands)
Accruing
Due Accruing
accrual
Performing
 
Accruing
Due Accruing
accrual
Performing
Real estate:
                 
  Residential
 $     1,523
 $             46
 $    898
 $          944
 
 $       1,006
 $             352
 $       685
 $     1,037
  Commercial
             78
              301
5,703
6,004
 
            215
               344
7,247
7,591
  Agricultural
                -
                   -
            -
                  -
 
                -
                   -
              -
                -
  Construction
                -
                   -
            -
                  -
 
                -
                   -
              -
                -
Consumer
           105
                   -
         34
34
 
            132
                   1
            15
             16
Other commercial and
                 
      agricultural loans
           493
                   -
926
926
 
              17
                   -
150
150
Total nonperforming loans
 $     2,199
 $           347
 $ 7,561
 $       7,908
 
 $     1,370
 $           697
 $   8,097
 $     8,794

 
Change in Non-Performing Loans
 
 June 30, 2014 /December 31, 2013
(in thousands)
Amount
%
Real estate:
   
  Residential
 $         (93)
              (9.0)
  Commercial
       (1,587)
            (20.9)
  Agricultural
                -
 N/A
  Construction
                -
 N/A
Consumer
             18
           112.5
Other commercial and agricultural loans
           776
           517.3
Total nonperforming loans
 $       (886)
            (10.1)
 
For the six month period ending June 30, 2014, we recorded a provision for loan losses of $330,000, which compares to $225,000 for the same time period in 2013. Non-performing loans decreased $886,000 or 10.1%, from December 31, 2013 to June 30, 2014. The decrease was primarily attributable to the charge-offs of two relationships previously mentioned and a foreclosure completed in the second quarter. Approximately 60.5% of the Bank’s non-performing loans are associated with the following three customer relationships:

·  
A commercial customer with a total loan relationship of $3.8 million secured by 164 residential properties was considered non-accrual as of June 30, 2014. In the first quarter of 2011, the Company and borrower entered into a forbearance agreement to restructure the debt. In July of 2013, the customer filed for bankruptcy under Chapter 11 and a Trustee was appointed in January of 2014. Through June 30, 2014 all loan payments in accordance with the forbearance agreement have been made, which has resulted in no specific reserve allocation as of June 30, 2014. We continue to monitor the bankruptcy proceedings to identify potential changes in the customer’s operations and the impact these would have on the loan payments for our loans to the customer and the underlying collateral that supports these loans.
·  
A commercial customer with a relationship of approximately $473,000 after a charge-off of $463,000 during the second quarter of 2014, secured by real estate was considered non-accrual as of June 30, 2014. The current economic conditions have significantly impacted the cash flows from the customer’s activities. Management reviewed the collateral and in the second quarter charged-off of a portion of the balance associated with this customer, which was based on the appraised value of collateral and as a result there is no specific reserve as of June 30, 2014.
·  
A commercial customer with a relationship of approximately $506,000 secured by real estate was considered non-accrual as of June 30, 2014. The slowdown in the exploration for natural gas has significantly impacted the cash flows of the customer. Management reviewed the collateral, which resulted in no specific reserve as of June 30, 2014.
 
 
45

 
 
Management of the Bank believes that the allowance for loan losses is adequate, which is based on the following factors:
 
·  
One loan relationship comprises 48.2% of the non-performing loan balance, whose debt is current through June 30, 2014.
·  
Net and gross charge-offs continue to be comparable to the Bank’s peer group, even though they are higher than the Bank’s historical standard. Annualized net charge-offs for 2014 are 0.25% of the total loan portfolio, which is higher than 2013’s ratio of 0.02%.
·  
The primary market of the Bank has a relatively stable real estate market and did not experience the significant decrease in the collateral values of local residential, commercial or agricultural real estate loan portfolios as seen in other parts of the country. The local real estate market also did not realize the significant, and sometimes speculative, increases seen in other parts of the country. Finally, our market area is predominately centered in the Marcellus Shale natural gas exploration and drilling area, and while the activities associated with this exploration are cyclical, it has provided a positive impact on the value of local real estate.
 
Bank Owned Life Insurance
 
The Company purchased bank owned life insurance to offset future employee benefit costs.  As of June 30, 2014, the cash surrender value of this life insurance is $14,921,000, which has resulted in income recognized in the first six months of 2014 of $242,000 compared to $250,000 during the comparable period in 2013. The use of life insurance policies provides the Bank with an asset that will generate earnings to partially offset the current costs of benefits and eventually (at the death of the individuals) provides partial recovery of cash outflows associated with the benefits.

Premises and Equipment
 
Premises and equipment increased from $11.1 million at December 31, 2013 to $11.5 million at June 30, 2014. This occurred primarily as a result of transfer from other assets for land held for expansion, as the Bank has recently started construction of a branch in the Lock Haven market. There were other purchases of equipment totaling $145,000 and depreciation of $273,000 in 2014.

Deposits
 
The following table shows the composition of deposits as of June 30, 2014 and December 31, 2013 (dollars in thousands):

 
June 30,
December 31,
 
2014
2013
 
Amount
%
Amount
%
Non-interest-bearing deposits
 $                      94,434
12.3
 $          85,585
          11.4
NOW accounts
                       220,151
28.8
           215,656
          28.8
Savings deposits
                       105,108
13.7
             95,678
          12.8
Money market deposit accounts
                         88,348
11.5
             85,038
          11.4
Certificates of deposit
                       257,415
33.7
           266,359
          35.6
Total
 $                    765,456
100.0
 $        748,316
        100.0
 
 
46

 
 
 
June 30,  2014/
 
 December 31, 2013
 
        Change
 
Amount
%
Non-interest-bearing deposits
 $                        8,849
10.3
NOW accounts
                           4,495
  2.1
Savings deposits
                           9,430
  9.9
Money market deposit accounts
                           3,310
  3.9
Certificates of deposit
                          (8,944)
 (3.4)
Total
 $                      17,140
   2.3
 
Deposits increased $17.1 million since December 31, 2013. The biggest increase was in savings accounts of $9.4 million, of which $4.7 million is associated with one customer who is in the middle of a construction project and has deposited construction funds with the Bank. The increase in non-interest bearing deposits of $8.8 million was a result of increases across numerous customers. The increase in NOW and money market accounts was primarily related to state and political organizations, which received impact fees associated with the extraction of the Marcellus shale. Similar to the prior year, as CD’s mature, some customers are converting the balances to other deposits accounts at the bank. This is occurring as customers are seeking more liquidity during this low rate environment. The Bank currently does not have any outstanding brokered certificates of deposit.

Borrowed Funds
 
Borrowed funds decreased $23.9 million during the first six months of 2014. The decrease was the result of repaying $4.2 million of maturing terms notes from the FHLB and $28.7 million of overnight borrowings from the FHLB. The repayments were offset by borrowing long term $4.0 million and short term $6.0 million from the FHLB. Additionally, there was a decrease of approximately $970,000 in the balances outstanding under repurchase agreements. The Bank’s current strategy for borrowings is to consider terms and structures to manage interest rate risk and liquidity in a potential rising interest rate environment. The Company's daily cash requirements or short-term investments are primarily met by using the financial instruments available through the Federal Home Loan Bank of Pittsburgh.
 
In December 2003, the Company formed a special purpose entity Citizens Financial Statutory Trust I (“the Entity”), to issue $7,500,000 of floating rate obligated mandatory redeemable securities as part of a pooled offering.  The rate is determined quarterly based on the 3 month LIBOR plus 2.80%.  The Entity may redeem them, in whole or in part, at face value at any time.  The Company borrowed the proceeds of the issuance from the Entity in December 2003 in the form of a $7,500,000 note payable, which is included within “Borrowed Funds” in the liabilities section of the Company’s balance sheet. Under current accounting rules, the Company’s minority interest in the Entity was recorded at the initial investment amount and is included in the other assets section of the balance sheet.  The Entity is not consolidated as part of the Company’s consolidated financial statements.

Stockholder’s Equity
 
We evaluate stockholders’ equity in relation to total assets and the risks associated with those assets.  The greater the capital resource, the more likely a corporation will meet its cash obligations and absorb unforeseen losses.  For these reasons, capital adequacy has been, and will continue to be, of paramount importance. As such, the Company has implemented policies and procedures to ensure that it has adequate capital levels. As part of this process, we routinely stress test our capital levels and identify potential risk and alternative sources of additional capital should the need arise.

 
47

 
 
Total stockholders’ equity was $98.2 million at June 30, 2014 compared to $92.1 million at December 31, 2013, an increase of $6.2 million or 6.7%.  Excluding accumulated other comprehensive income (loss) stockholders’ equity increased $3.9 million, or 4.1%. The Company purchased 10,759 shares of treasury stock at a weighted average cost of $52.34 per share.  The Company reissued 4,077 shares as part of the dividend reinvestment program at a weighted average cost of $47.47 and 392 shares that were awarded as part of the restricted stock plan at a weighted average cost of $48.36. In the first six months of 2014, the Company had net income of $6.5 million and declared cash dividends of $2.3 million, representing a cash dividend payout ratio of 35.8%.
 
All of the Company’s investment securities are classified as available-for-sale, making this portion of the Company’s balance sheet more sensitive to the changing market value of investments. As a result of changes in the interest rate environment, accumulated other comprehensive income (loss) associated with the change in investment securities increased $2.3 million from December 31, 2013 and accounts for the majority of the total change in accumulated other comprehensive income (loss) of $2.3 million.
 
The Company has complied with standards of being well capitalized mandated by the banking regulators. The Company’s primary regulators have established “risk-based” capital requirements designed to measure capital adequacy.  Risk-based capital ratios reflect the relative risks associated with various assets entities hold in their portfolios.  A weight category of 0% (lowest risk assets), 20%, 50%, or 100% (highest risk assets), is assigned to each asset on the balance sheet. The Company’s computed risk-based capital ratios are as follows (dollars in thousands):

 
June 30
December 31,
 
2014
2013
Total capital (to risk-weighted assets)
Amount
 
Ratio
Amount
 
Ratio
Company
 $            104,137
 
18.34%
 $      100,320
 
17.75%
For capital adequacy purposes
                 45,424
 
8.00%
           45,211
 
8.00%
To be well capitalized
                 56,780
 
10.00%
           56,514
 
10.00%
Tier I capital (to risk-weighted assets)
           
Company
 $              96,920
 
17.07%
 $        92,902
 
16.44%
For capital adequacy purposes
                 22,712
 
4.00%
           22,606
 
4.00%
To be well capitalized
                 34,068
 
6.00%
           33,908
 
6.00%
Tier I capital (to average assets)
           
Company
 $              96,920
 
10.85%
 $        92,902
 
10.42%
For capital adequacy purposes
                 35,764
 
4.00%
           35,669
 
4.00%
To be well capitalized
                 44,705
 
5.00%
           44,587
 
5.00%
 
The Bank’s computed risk-based capital ratios are as follows (dollars in thousands):

 
June 30
December 31,
 
2014
2013
Total capital (to risk-weighted assets)
Amount
 
Ratio
Amount
 
Ratio
Bank
 $            102,166
 
18.07%
 $        97,863
 
17.35%
For capital adequacy purposes
                 45,241
 
8.00%
           45,135
 
8.00%
To be well capitalized
                 56,552
 
10.00%
           56,418
 
10.00%
Tier I capital (to risk-weighted assets)
           
Bank
 $              95,096
 
16.82%
 $        90,639
 
16.07%
For capital adequacy purposes
                 22,621
 
4.00%
           22,567
 
4.00%
To be well capitalized
                 33,931
 
6.00%
           33,851
 
6.00%
Tier I capital (to average assets)
           
Bank
 $              95,096
 
10.66%
 $        90,639
 
10.18%
For capital adequacy purposes
                 35,718
 
4.00%
           35,615
 
4.00%
To be well capitalized
                 44,648
 
5.00%
           44,519
 
5.00%

 
48

 
 
Off Balance Sheet Activities
 
Some financial instruments, such as loan commitments, credit lines, and letters of credit are issued to meet customer financing needs.  The contractual amount of financial instruments with off-balance sheet risk was as follows at June 30, 2014 and December 31, 2013 (in thousands):
 
 
June 30, 2014
December 31, 2013
Commitments to extend credit
 $      105,601
 $        89,847
Standby letters of credit
10,606
12,014
 
 $      116,207
 $      101,861
 
We also offer limited overdraft protection as a non-contractual courtesy which is available to demand deposit accounts in good standing. Overdraft charges as a result of ATM withdrawals and one time point of sale (non-recurring) transactions require prior approval of the customer. The non-contractual amount of financial instruments with off-balance sheet risk at June 30, 2014 and December 31, 2013 was $12,365,000 and $12,450,000, respectively.  The Company reserves the right to discontinue this service without prior notice.

Liquidity
 
Liquidity is a measure of the Company's ability to efficiently meet normal cash flow requirements of both borrowers and depositors.  To maintain proper liquidity, we use funds management policies, which include liquidity target ratios, along with our investment policies to assure we can meet our financial obligations to depositors, credit customers and stockholders.  Liquidity is needed to meet depositors' withdrawal demands, extend credit to meet borrowers' needs, provide funds for normal operating expenses and cash dividends, and to fund other capital expenditures.
 
Cash generated by operating activities, investing activities and financing activities influences liquidity management. Our Company's historical activity in this area can be seen in the Consolidated Statement of Cash Flows.  The most important source of funds is core deposits.  Repayment of principal on outstanding loans and cash flows created from the investment portfolio are also factors in liquidity management.  Other sources of funding include brokered certificates of deposit and the sale of loans or investments, if needed.
 
The Company's use of funds is shown in the investing activity section of the Consolidated Statement of Cash Flows, where the net loan activity is presented.  Other significant uses of funds include purchasing stock from the Federal Home Loan Bank (FHLB) of Pittsburgh, as well as capital expenditures.  Capital expenditures (including software purchases), during the first six months of 2014 were $145,000, compared to $203,000 during the same time period in 2013.
 
Short-term debt from the FHLB supplements the Bank’s availability of funds.  The Bank achieves liquidity primarily from temporary or short-term investments in the Federal Reserve and the FHLB.  The Bank has a maximum borrowing capacity at the FHLB of approximately $261.7 million, of which $29.3 million was outstanding at June 30, 2014. Additionally, we have a Federal funds line totaling $10.0 million from a third party bank at market rates.  This line is not drawn upon. We also have a borrower in custody line with the Federal Reserve Bank of approximately $9.1 million, which also is not drawn upon as of June 30, 2014. The Company continues to evaluate its liquidity needs and as necessary finds additional sources.
 
 Citizens Financial Services, Inc. is a separate legal entity from the Bank and must provide for its own liquidity.  In addition to its operating expenses, Citizens Financial is responsible for paying any dividends declared to its shareholders.  Citizens Financial also has repurchased shares of its common stock.  Citizens Financial’s primary source of income is dividends received from the Bank.  Both federal and state laws impose restrictions on the ability of the Bank to pay dividends. In particular, the Bank may not, as a state-chartered bank which is a member of the Federal Reserve System, declare a dividend without approval of the Federal Reserve, 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 current years, less any required transfers to surplus.  The Federal Reserve Board and the FDIC have formal and informal policies which provide that insured banks and bank holding companies should generally pay dividends only out of current operating earnings, with some exceptions.  The Prompt Corrective Action Rules, described above, further limit the ability of banks to pay dividends, because banks which are not classified as well capitalized or adequately capitalized may not pay dividends and no dividend may be paid which would make the Bank undercapitalized after the dividend.  At June 30, 2014, Citizens Financial Services, Inc. had liquid assets of $692,000.

 
49

 

Interest Rate and Market Risk Management
 
The objective of interest rate sensitivity management is to maintain an appropriate balance between the stable growth of income and the risks associated with maximizing income through interest sensitivity imbalances and the market value risk of assets and liabilities.
 
Because of the nature of our operations, we are not subject to foreign currency exchange or commodity price risk and, since our Company has no trading portfolio, it is not subject to trading risk. Currently, our Company has equity securities that represent only .5% of our investment portfolio and, therefore, equity risk is not significant.
 
The primary components of interest-sensitive assets include adjustable-rate loans and investments, loan repayments, investment maturities and money market investments.  The primary components of interest-sensitive liabilities include maturing certificates of deposit, IRA certificates of deposit and short-term borrowings.  Savings deposits, NOW accounts and money market investor accounts are considered core deposits and are not short-term interest sensitive (except for the top-tier money market investor accounts which are paid current market interest rates).
 
 Gap analysis, one of the methods used by us to analyze interest rate risk, does not necessarily show the precise impact of specific interest rate movements on our Company's net interest income because the re-pricing of certain assets and liabilities is discretionary and is subject to competitive and other pressures.  In addition, assets and liabilities within the same period may, in fact, be repaid at different times and at different rate levels.  We have not experienced the kind of earnings volatility that might be indicated from gap analysis.
 
The Bank currently uses a computer simulation model to better measure the impact of interest rate changes on net interest income. We use the model as part of our risk management and asset liability management processes that we believe will effectively identify, measure, and monitor the Bank’s risk exposure.  In this analysis, the Bank examines the results of movements in interest rates with additional assumptions made concerning prepayment speeds on mortgage loans and mortgage securities.   Shock scenarios, which assume a parallel shift in interest rates and is instantaneous, typically have the greatest impact on net interest income. The following is a rate shock analysis and the impact on net interest income as of June 30, 2014 (dollars in thousands):
       
Change In
 % Change In
   
 Prospective One-Year
 
 Prospective
 Prospective
Changes in Rates
 
 Net Interest Income
 
Net Interest Income
 Net Interest Income
-100 Shock
 
 $                        29,451
 
 $                        (327)
                        (1.10)
Base
 
                           29,778
 
                                 -
                              -
+100 Shock
 
                           28,764
 
                        (1,014)
                        (3.41)
+200 Shock
 
                           27,929
 
                        (1,849)
                        (6.21)
+300 Shock
 
                           27,125
 
                        (2,653)
                        (8.91)
+400 Shock
 
                           26,273
 
                        (3,505)
                      (11.77)
 
The model makes estimates, at each level of interest rate change, regarding cash flows from principal repayments on loans and mortgage backed securities, call activity of other investment securities, and deposit selection, re-pricing and maturity structure.  Because of these assumptions, actual results could differ significantly from these estimates which would result in significant differences in the calculated projected change on net interest income. Additionally, the changes above do not necessarily represent the level of change under which management would undertake specific measures to realign its portfolio in order to reduce the projected level of change. It should be noted that the changes in net interest income noted above are in line with Bank policy for interest rate risk.

 
50

 
 
Item 3-Quantitative and Qualitative Disclosure about Market Risk
 
In the normal course of conducting business activities, the Company is exposed to market risk, principally interest rate risk, through the operations of its banking subsidiary.  Interest rate risk arises from market driven fluctuations in interest rates that affect cash flows, income, expense and values of financial instruments and was discussed previously in this Form 10-Q.  Management and a committee of the Board of Directors manage interest rate risk (see also “Interest Rate and Market Risk Management”).
 
No material changes in market risk strategy occurred during the current period.  A detailed discussion of market risk is provided in the SEC Form 10-K for the period ended December 31, 2013.

Item 4-Control and Procedures
 
 (a) Disclosure Controls and Procedures
 
The Company’s management, including the Company’s principal executive officer and principal financial officer, have evaluated the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”).  Based upon their evaluation, the principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective for the purpose of ensuring that the information required to be disclosed in the reports that the Company files or submits under the Exchange Act with the SEC (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.
 
(b) Changes to Internal Control over Financial Reporting
 
There were no changes in the Company’s internal control over financial reporting during the quarter ended June 30, 2014 that have materially affected, or are reasonable likely to materially affect, the Company’s internal control over financial reporting.

PART II - OTHER INFORMATION

Item 1 - Legal Proceedings
 
Management is not aware of any litigation that would have a material adverse effect on the consolidated financial position of the Company.  Any pending proceedings are ordinary, routine litigation incidental to the business of the Company and its subsidiary.  In addition, no material proceedings are pending or are known to be threatened or contemplated against the Company and its subsidiary by government authorities.

Item 1A – Risk Factors
 
In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1.A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2013, which could materially affect our business, financial condition or future results. At June 30, 2014 the risk factors of the Company have not changed materially from those reported in our Annual Report on Form 10-K.  However, the risks described in our Annual Report on Form 10-K are not the only risks that we face. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

 
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Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds

ISSUER PURCHASES OF EQUITY SECURITIES
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)
4/1/14 to 4/30/14
-
$0.00
-
86,036
5/1/14 to 5/31/14
-
$0.00
-
86,036
6/1/14 to 6/30/14
8,320
$53.18
8,320
77,716
Total
8,320
$53.18
8,320
77,716
         
 
(1)  
On January 17, 2012, the Company announced that the Board of Directors authorized the Company to repurchase up to an additional 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.
 
Item 3 - Defaults Upon Senior Securities
 
Not applicable.

Item 4 – Mine Safety Disclosure
 
Not applicable.

Item 5 - Other Information
 
None

Item 6 - Exhibits
 
(a)  The following documents are filed as a part of this report:
   
 
3.1
 
Articles of Incorporation of Citizens Financial Services, Inc., as amended (1)
 
 
3.2
 
Bylaws of Citizens Financial Services, Inc.(2)
 
 
4.1
 
Form of Common Stock Certificate.(3)
 
 
31.1
 
Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer
 
 
31.2
 
Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer
 
 
32.1
 
Section 1350 Certification of Chief Executive Officer and Chief Financial Officer
 
101 **
 
The following materials from the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2014, formatted in XBRL (Extensible Business Reporting Language): (i) The Consolidated Balance Sheet (unaudited), (ii) the Consolidated Statement of Income (unaudited), (iii) the Consolidated Statement of Comprehensive Income (unaudited), (iv) the Consolidated Statement of Cash Flows (unaudited) and (v) related notes (unaudited).

 (1)  Incorporated by reference to Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2010, as filed with the Commission on May 12, 2010.

(2)  Incorporated by reference to Exhibit 3.2 to the Company’s Current Report on Form 8-K, as filed with the Commission on December 24, 2009.

(3)  Incorporated by reference to Exhibit 4 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005, as filed with the Commission on March 14, 2006.

** Furnished, not filed.

 
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Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
Citizens Financial Services, Inc.
(Registrant)
 
       
Date:  August 7, 2014
By:
/s/ Randall E. black  
    Randall E. Black  
    President and Chief Executive Officer
(Principal Executive Officer)
 
       


  Company Name  
       
Date:  August 7, 2014
By:
/s/ Mickey L. Jones  
    Mickey L. Jones  
     Chief Financial Officer
(Principal Accounting Officer)
 
       


 
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