10-Q 1 firstqtr2012.htm FORM 10-Q FOR FIRST QUARTER 2012 firstqtr2012.htm

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


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

For the quarterly period ended March 31, 2012
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 May 2, 2012, was 2,897,313.

 
 

 

 
 
Citizens Financial Services, Inc.
Form 10-Q

INDEX
 
 
   
PAGE
Part I
FINANCIAL INFORMATION
 
Item 1.
Financial Statements (unaudited):
 
 
Consolidated Balance Sheet as of March 31, 2012 and December 31, 2011
1
 
Consolidated Statement of Income for the Three Months Ended March 31, 2012 and 2011
2
 
Consolidated Statement of Comprehensive Income for the Three Months Ended March 31, 2012 and 2011
3
 
Consolidated Statement of Cash Flows for the Three Months Ended March 31, 2012 and 2011
4
 
Notes to Consolidated Financial Statements
5-26
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
27-46
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
46
Item 4.
Controls and Procedures
46
     
Part II
OTHER INFORMATION
 
Item 1.
Legal Proceedings
47
Item 1A.
Risk Factors
47
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
47
Item 3.
Defaults Upon Senior Securities
47
Item 4.
Mine Safety Disclosures
48
Item 5.
Other Information
48
Item 6.
Exhibits
48
 
Signatures
49

 
 

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED BALANCE SHEET
   
(UNAUDITED)
   
     
 
March 31
December 31
(in thousands except share data)
2012
2011
ASSETS:
   
Cash and due from banks:
   
  Noninterest-bearing
 $             11,835
 $            9,960
  Interest-bearing
                         2
             20,472
Total cash and cash equivalents
                11,837
             30,432
     
Available-for-sale securities
              362,148
           318,823
 
   
Loans (net of allowance for loan losses:
   
  2012, $6,545 and 2011, $6,487)
              484,747
           481,022
 
   
Premises and equipment
                11,582
             11,702
Accrued interest receivable
                  4,305
               3,621
Goodwill
                10,256
             10,256
Bank owned life insurance
                13,794
             13,669
Other assets
                10,757
               9,042
 
 
 
TOTAL ASSETS
 $           909,426
 $        878,567
 
 
 
LIABILITIES:
   
Deposits:
   
  Noninterest-bearing
 $             89,806
 $          85,605
  Interest-bearing
              653,020
           648,388
Total deposits
              742,826
           733,993
Borrowed funds
                72,768
             53,882
Accrued interest payable
                  1,320
               1,512
Other liabilities
                  8,736
               7,712
TOTAL LIABILITIES
              825,650
           797,099
STOCKHOLDERS' EQUITY:
   
Preferred Stock
   
  $1.00 par value; authorized 3,000,000 shares March 31, 2012 and December 31, 2011;
   
   none issued in 2012 or 2011
                          -
                      -
Common stock
   
  $1.00 par value; authorized 15,000,000 shares;  issued 3,132,866 at March 31, 2012 and
   
  December 31, 2011
                  3,133
               3,133
Additional paid-in capital
                15,445
             15,313
Retained earnings
                65,931
             63,337
Accumulated other comprehensive income
                  4,612
               4,949
Treasury stock, at cost:  232,433 shares at March 31, 2012
   
  and 230,203 shares at December 31, 2011
                 (5,345)
             (5,264)
TOTAL STOCKHOLDERS' EQUITY
                83,776
             81,468
TOTAL LIABILITIES AND
   
   STOCKHOLDERS' EQUITY
 $           909,426
 $        878,567
     
The accompanying notes are an integral part of these unaudited consolidated financial statements.
 


 
1

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED STATEMENT OF INCOME
   
(UNAUDITED)
   
 
Three Months Ended
 
March 31
(in thousands, except share and per share data)
2012
2011
INTEREST INCOME:
   
Interest and fees on loans
 $        7,465
 $      7,395
Interest-bearing deposits with banks
                   5
               22
Investment securities:
   
    Taxable
           1,197
         1,172
    Nontaxable
               954
             865
    Dividends
                 16
               15
TOTAL INTEREST INCOME
           9,637
         9,469
INTEREST EXPENSE:
   
Deposits
           1,666
         2,088
Borrowed funds
               413
             445
TOTAL INTEREST EXPENSE
           2,079
         2,533
NET INTEREST INCOME
           7,558
         6,936
Provision for loan losses
               105
             225
NET INTEREST INCOME AFTER
   
    PROVISION FOR LOAN LOSSES
           7,453
         6,711
NON-INTEREST INCOME:
   
Service charges
           1,078
             945
Trust
               173
             157
Brokerage and insurance
               150
               95
Investment securities gains, net
               108
             120
Gains on loans sold
                 54
               41
Earnings on bank owned life insurance
               124
             121
Other
               156
             140
TOTAL NON-INTEREST INCOME
           1,843
         1,619
NON-INTEREST EXPENSES:
   
Salaries and employee benefits
           2,753
         2,515
Occupancy
               310
             390
Furniture and equipment
               106
             117
Professional fees
               268
             157
FDIC insurance
               123
             250
Pennsylvania shares tax
               166
             147
Other
           1,129
         1,204
TOTAL NON-INTEREST EXPENSES
           4,855
         4,780
Income before provision for income taxes
           4,441
         3,550
Provision for income taxes
               992
             720
NET INCOME
 $        3,449
 $      2,830
 
   
PER COMMON SHARE DATA:
   
Net Income - Basic
 $          1.19
 $        0.97
Net Income - Diluted
 $          1.19
 $        0.97
Cash Dividends Paid
 $        0.295
 $      0.260
     
The accompanying notes are an integral part of these unaudited consolidated financial statements.


 
2

 

CITIZENS FINANCIAL SERVICES, INC.
       
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
       
(UNAUDITED)
       
 
Three Months Ended
 
March 31,
(in thousands)
 
2012
 
2011
Net income
 
 $     3,449
 
 $    2,830
Other comprehensive income:
       
      Change in unrealized gains on available for sale securities
          (424)
 
          892
 
      Income tax effect
           144
 
         (303)
 
      Change in unrealized loss on interest rate swap
             21
 
            60
 
      Income tax effect
              (7)
 
           (20)
 
      Less:  Reclassification adjustment for gain included in net income
          (108)
 
         (120)
 
      Income tax effect
             37
 
            41
 
Other comprehensive (loss) income, net of tax
 
         (337)
 
          550
Comprehensive income
 
 $     3,112
 
 $    3,380
         
The accompanying notes are an integral part of these unaudited consolidated financial statements.
   




 
3

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED STATEMENT OF CASH FLOWS
   
(UNAUDITED)
Three Months Ended
 
March 31,
(in thousands)
       2012
    2011
CASH FLOWS FROM OPERATING ACTIVITIES:
   
  Net income
 $          3,449
 $          2,830
  Adjustments to reconcile net income to net
   
   cash provided by operating activities:
   
    Provision for loan losses
                105
                225
    Depreciation and amortization
                105
                142
    Amortization and accretion of investment securities
                595
                439
    Deferred income taxes
                  42
                  34
    Investment securities gains, net
              (108)
              (120)
    Earnings on bank owned life insurance
              (124)
              (121)
    Originations of loans held for sale
           (4,404)
           (3,045)
    Proceeds from sales of loans held for sale
             4,458
             3,086
    Realized gains on loans sold
                (54)
                (41)
    Increase in accrued interest receivable
              (684)
              (598)
    Decrease in accrued interest payable
              (192)
              (189)
    Other, net
                925
                795
      Net cash provided by operating activities
             4,113
             3,437
CASH FLOWS FROM INVESTING ACTIVITIES:
   
  Available-for-sale securities:
   
    Proceeds from sales
           11,236
             3,189
    Proceeds from maturity and principal repayments of securities
           26,048
             7,557
    Purchase of securities
         (81,628)
         (44,025)
  Proceeds from redemption of regulatory stock
                  25
                175
  Purchase of regulatory stock
           (1,405)
                    -
  Net (increase) decrease  in loans
           (3,841)
             6,384
  Purchase of premises and equipment
                (33)
                (63)
  Proceeds from sale of foreclosed assets held for sale
                108
                  81
      Net cash used in investing activities
         (49,490)
         (26,702)
CASH FLOWS FROM FINANCING ACTIVITIES:
   
  Net increase in deposits
             8,833
           23,818
  Proceeds from long-term borrowings
                    5
                    5
  Repayments of long-term borrowings
              (109)
                    -
  Net increase in short-term borrowed funds
           18,990
             1,114
  Purchase of treasury and restricted stock
                (81)
              (361)
  Dividends paid
              (856)
              (752)
      Net cash provided by financing activities
           26,782
           23,824
          Net (decrease) increase in cash and cash equivalents
         (18,595)
                559
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
           30,432
           43,995
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 $        11,837
 $        44,554
     
Supplemental Disclosures of Cash Flow Information:
   
    Interest paid
 $          2,271
 $          2,722
    Income taxes paid
 $             210
 $                 -
    Loans transferred to foreclosed property
 $               72
 $             335
The accompanying notes are an integral part of these unaudited consolidated financial statements.

 
4

 

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


Note 1 - Basis of Presentation
 
Citizens Financial Services, Inc., (individually and collectively with its direct and indirect subsidiaries, the “Company”) is a Pennsylvania corporation organized as the holding company of its wholly owned subsidiary, First Citizens National Bank (the “Bank”), and the Bank’s subsidiary, First Citizens Insurance Agency, Inc. (“First Citizens Insurance”).
 
The accompanying consolidated financial statements have been prepared pursuant to rules and regulations of the Securities and Exchange Commission (“SEC”) and in conformity with U.S. generally accepted accounting principles.  Because this report is based on an interim period, certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted.  Certain of the prior year amounts have been reclassified to conform with the current year presentation.  Such reclassifications had no effect on net income or stockholders’ equity.  All material inter-company balances and transactions have been eliminated in consolidation.
 
In the opinion of management of the Company, the accompanying interim financial statements for the periods ended March 31, 2012 and 2011 include all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the financial condition and the results of operations for the period.  In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. The financial performance reported for the Company for the three month period ended March 31, 2012 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, 2011.

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
 
March 31,
 
       2012
       2011
Basic earnings per share computation
   
Net income applicable to common stock
$3,449,000
$2,830,000
Weighted average common shares outstanding
                  2,895,810
                  2,917,353
Earnings per share - basis
$1.19
$0.97
     
Diluted earnings per share computation
   
Net income applicable to common stock
$3,449,000
$2,830,000
Weighted average common shares outstanding for basic earnings per share
                  2,895,810
                  2,917,353
Add: Dilutive effects of restricted stock
                            165
                                -
Weighted average common shares outstanding for dilutive earnings per share
                  2,895,975
                  2,917,353
Earnings per share - dilutive
$1.19
$0.97

Restricted stock grants that were anti-dilutive were excluded from net income per share calculations. For the three months ended March 31, 2012 and 2011, 3,073 and 10,389 shares, respectively, related to the restricted stock program were excluded from the diluted earnings per share calculations since they were anti-dilutive.
 
 
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 March 31, 2012 and December 31, 2011 were as follows (in thousands):


   
Gross
Gross
 
 
Amortized
Unrealized
Unrealized
Fair
March 31, 2012
Cost
Gains
Losses
Value
Available-for-sale securities:
       
  U.S. Agency securities
 $    172,233
 $               1,853
 $            (456)
 $     173,630
  U.S. Treasury securities
           3,916
                       42
                      -
            3,958
  Obligations of state and
       
    political subdivisions
         95,606
                  5,170
                 (10)
        100,766
  Corporate obligations
         10,843
                     328
                   (8)
          11,163
  Mortgage-backed securities in
       
    government sponsored entities
         69,293
                  2,330
               (226)
          71,397
  Equity securities in financial
       
     institutions
              771
                     463
                      -
            1,234
Total available-for-sale securities
 $    352,662
 $             10,186
 $            (700)
 $     362,148
         
   
Gross
Gross
 
 
Amortized
Unrealized
Unrealized
Fair
December 31, 2011
Cost
Gains
Losses
Value
Available-for-sale securities:
       
  U.S. Agency securities
 $    166,534
 $               2,087
 $              (21)
 $     168,600
  Obligations of state and
       
    political subdivisions
         96,556
                  4,996
                   (5)
        101,547
  Corporate obligations
           8,263
                     197
                      -
            8,460
  Mortgage-backed securities in
       
    government sponsored entities
         36,630
                  2,356
                 (12)
          38,974
  Equity securities in financial institutions
              823
                     420
                   (1)
            1,242
Total available-for-sale securities
 $    308,806
 $             10,056
 $              (39)
 $     318,823
 
The following table shows the Company’s gross unrealized losses and fair value of the Company’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time, that the individual securities have been in a continuous unrealized loss position, at March 31, 2012 and December 31, 2011 (in thousands). As of March 31, 2012, the Company owned 31 securities whose fair value was less than their cost basis, respectively.
 
 
6

 
 

March 31, 2012
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
 $        45,982
 $           (456)
 $                  -
 $                  -
 $        45,982
 $           (456)
Obligations of state and
           
    political subdivisions
520
(10)
                     -
                     -
520
(10)
Corporate obligations
2,611
(8)
                     -
                     -
2,611
(8)
Mortgage-backed securities in
           
   government sponsored entities
34,501
(226)
                     -
                     -
34,501
(226)
               
    Total securities
 $        83,614
 $           (700)
 $                  -
 $                  -
 $        83,614
 $           (700)

December 31, 2011
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
 $        10,018
 $             (21)
 $                  -
 $                  -
 $        10,018
 $             (21)
Obligations of states and
           
     political subdivisions
             1,057
                  (3)
                771
                  (2)
             1,828
                  (5)
Mortgage-backed securities in
           
     government sponsored entities
             3,164
                (12)
                     -
                     -
             3,164
                (12)
Equity securities in financial institutions
                  39
                  (1)
                     -
                     -
                  39
                  (1)
               
    Total securities
 $        14,278
 $             (37)
 $             771
 $               (2)
 $        15,049
 $             (39)

As of March 31, 2012, the Company’s investment securities portfolio contained unrealized losses on agency securities issued or backed by the full faith and credit of the United States government or are generally viewed as having the implied guarantee of the U.S. government, obligations of states and political subdivisions, corporate obligations and  mortgage backed securities in government sponsored entities. For fixed maturity investments management considers whether the present value of cash flows expected to be collected are less than the security’s amortized cost basis (the difference defined as the credit loss), the magnitude and duration of the decline, the reasons underlying the decline and the Company’s intent to sell the security or whether it is more likely than not that the Company would be required to sell the security before its anticipated recovery in market value, to determine whether the loss in value is other than temporary. Once a decline in value is determined to be other than temporary, if the Company does not intend to sell the security, and it is more-likely-than-not that it will not be required to sell the security, before recovery of the security’s amortized cost basis, the charge to earnings is limited to the amount of credit loss. Any remaining difference between fair value and amortized cost (the difference defined as the non-credit portion) is recognized in other comprehensive income, net of applicable taxes. Otherwise, the entire difference between fair value and amortized cost is charged to earnings. For equity securities where the fair value has been significantly below cost for one year, the Company’s policy is to recognize an impairment loss unless sufficient evidence is available that the decline is not other than temporary and a recovery period can be predicted.  The Company has concluded that any impairment of its investment securities portfolio outlined in the above table is not other than temporary and is the result of interest rate changes, sector credit rating changes, or company-specific rating changes that are not expected to result in the non-collection of principal and interest during the period.
 
Proceeds from sales of securities available-for-sale for the three months ended March 31, 2012 and 2011 were $11,236,000 and $3,189,000, respectively.  The gross gains and losses were as follows (in thousands):

 
7

 
 

 
 
Three Months Ended
 
 March 31,
 
2012
2011
Gross gains
 $      108
 $       149
Gross losses
          -
        (29)
Net gains
 $      108
 $       120
 
Investment securities with an approximate carrying value of $174.1 million and $177.9 million at March 31, 2012 and December 31, 2011, 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 March 31, 2012, by contractual maturity, are shown below (in thousands):

 
Amortized
   
 
Cost
 
Fair Value
Available-for-sale debt securities:
     
  Due in one year or less
 $      13,357
 
 $         13,556
  Due after one year through five years
         81,125
 
            82,641
  Due after five years through ten years
         59,967
 
            60,783
  Due after ten years
       197,442
 
          203,934
Total
 $    351,891
 
 $       360,914

Note 5 – Loans

The Company makes commercial, industrial, agricultural, residential, construction and consumer loans primarily to customers throughout North Central Pennsylvania and Southern New York.  Although the Company had a diversified loan portfolio at March 31, 2012 and December 31, 2011, 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 the allowance for loan losses as of March 31, 2012 and December 31, 2011 (in thousands):

March 31, 2012
 
Total Loans
Individually evaluated for impairment
Collectively evaluated for impairment
Real estate loans:
       
     Residential
 
 $                 183,703
 $                       93
 $                183,610
     Commercial and agricultural
 
                    186,815
                     8,374
                   178,441
     Construction
 
                        8,912
                             -
                       8,912
Consumer
 
                      10,405
                             -
                     10,405
Commercial and other loans
 
                      45,620
                        459
                     45,161
State and political subdivision loans
 
                      55,837
                             -
                    55,837
Total
 
                    491,292
 $                  8,926
 $                482,366
 Less allowance for loan losses
 
                        6,545
   
 Net loans
 
 $                 484,747
   


 
8

 





December 31, 2011
 
Total Loans
Individually evaluated for impairment
Collectively evaluated for impairment
Real estate loans:
       
     Residential
 
 $                 184,034
 $                       94
 $                183,940
     Commercial and agricultural
 
                    185,050
                     8,270
                   176,780
     Construction
 
                        8,481
                             -
                      8,481
Consumer
 
                      10,746
                             -
                     10,746
Commercial and other loans
 
                      44,299
                        517
                    43,782
State and political subdivision loans
 
                      54,899
                             -
                    54,899
Total
 
                    487,509
 $                  8,881
 $                478,628
 Less allowance for loan losses
 
                        6,487
   
 Net loans
 
 $                 481,022
   
 
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 equities are installment loans or lines of credit secured by a mortgage which is often a second lien on residential real estate with terms of 15 years or less. Commercial real estate loans are business purpose loans secured by a mortgage on commercial real estate. Agricultural real estate loans are loans secured by a mortgage on real estate used in agriculture production. Construction real estate loans are loans secured by residential or commercial real estate used during the construction phase of residential and commercial projects. Consumer loans are typically unsecured or primarily secured by something other than real estate and overdraft lines of credit connected with customer deposit accounts. Commercial and other loans are loans for commercial purposes primarily secured by non-real estate collateral. Other agricultural loans are loans for agricultural purposes primarily secured by non-real estate collateral. State and political subdivisions are loans for state and local municipalities for capital and operating expenses or tax free loans used to finance commercial development.
 
Management considers commercial loans, other agricultural loans, commercial real estate loans and agricultural real estate loans which are 90 days or more past due to be impaired. 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. These loans are analyzed to determine if it is probable that all amounts will not be collected according to the contractual terms of the loan agreement. If management determines that the value of the impaired loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized through an allowance estimate or a charge-off to the allowance.
 
The following table includes the recorded investment unpaid principal balances and the associated allowance amount, if applicable for impaired financing receivables by class, (in thousands):

 
 
9

 


   
Recorded
Recorded
       
 
Unpaid
Investment
Investment
Total
 
Average
Interest
 
Principal
With No
With
Recorded
Related
Recorded
Income
March 31, 2012
Balance
Allowance
Allowance
Investment
Allowance
Investment
Recognized
Real estate loans:
             
     Mortgages
 $           -
 $               -
 $               -
 $               -
 $             -
 $               -
 $                -
     Home Equity
           93
               53
               40
               93
             15
               93
                  1
     Commercial
      9,617
          5,514
          2,860
          8,374
           563
          8,228
                18
     Agricultural
              -
                  -
                  -
                  -
                -
                  -
                   -
     Construction
              -
                  -
                  -
                  -
                -
                  -
                   -
Consumer
              -
                  -
                  -
                  -
                -
                  -
                   -
Commercial and other loans
         505
               29
             430
             459
             23
             479
                   -
Other Agricultural Loans
              -
                  -
                  -
                  -
                -
                  -
                   -
State and political
             
   subdivision loans
              -
                  -
                  -
                  -
                -
                  -
                   -
Total
 $ 10,215
 $       5,596
 $       3,330
 $       8,926
 $        601
 $       8,800
 $             19
               
   
Recorded
Recorded
       
 
Unpaid
Investment
Investment
Total
 
Average
Interest
 
Principal
With No
With
Recorded
Related
Recorded
Income
December 31, 2011
Balance
Allowance
Allowance
Investment
Allowance
Investment
Recognized
Real estate loans:
             
     Mortgages
 $           -
 $               -
 $               -
 $               -
 $             -
 $               -
 $                -
     Home Equity
           94
               36
               58
               94
             13
               36
                  1
     Commercial
      9,394
          5,663
          2,607
          8,270
           433
          8,585
                65
     Agricultural
              -
                  -
                  -
                  -
                -
             371
                37
     Construction
              -
                  -
                  -
                  -
                -
                  -
                   -
Consumer
              -
                  -
                  -
                  -
                -
                  -
                   -
Commercial and other loans
         574
               30
             487
             517
             48
             501
                   -
Other Agricultural Loans
              -
                  -
                  -
                  -
                -
             160
                20
State and political
             
   subdivision loans
              -
                  -
                  -
                  -
                -
                  -
                   -
Total
 $ 10,062
 $       5,729
 $       3,152
 $       8,881
 $        494
 $       9,653
 $           123

Credit Quality Information
 
For commercial real estate, agricultural real estate, construction, commercial and other and other agricultural 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.
 
 
10

 
 
·  
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 and agricultural 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 60% of the dollar volume of the commercial loan portfolio on an annual basis, 2) review new loans originated in the last year, 3) review all relationships in aggregate over $500,000, 4) review all aggregate loan relationships over $100,000 which are over 90 days past due, classified Special Mention, Substandard, Doubtful, or Loss, and 5) such other loans which management or the consultant deems appropriate.
 
The following tables represent credit exposures by internally assigned grades as of March 31, 2012 and December 31, 2011 (in thousands):

 March 31, 2012
Pass
Special Mention
Substandard
Doubtful
Loss
Ending Balance
Real estate loans:
           
     Commercial
 $          141,407
 $           9,272
 $                  16,905
 $                   -
 $              -
 $          167,584
     Agricultural
               14,676
              2,394
                       2,161
                      -
                 -
               19,231
     Construction
                 8,912
                      -
                              -
                      -
                 -
                 8,912
Commercial and other loans
               36,730
              1,629
                          907
                   17
                 -
               39,283
Other Agricultural Loans
                 4,361
                 770
                       1,206
                      -
                 -
                 6,337
State and political
           
   subdivision loans
               54,690
                      -
                       1,147
                      -
                 -
               55,837
Total
 $          260,776
 $         14,065
 $                  22,326
 $                17
 $              -
 $          297,184


 December 31, 2011
Pass
Special Mention
Substandard
Doubtful
Loss
Ending Balance
Real estate loans:
           
     Commercial
 $          138,409
 $         10,372
 $                  17,045
 $                   -
 $              -
 $          165,826
     Agricultural
               14,628
              2,412
                       2,184
                      -
                 -
               19,224
     Construction
                 8,481
                      -
                              -
                      -
                 -
                 8,481
Commercial and other loans
               34,606
              2,203
                          921
                   17
                 -
               37,747
Other Agricultural Loans
                 4,509
                 809
                       1,234
                      -
                 -
                 6,552
State and political
           
   subdivision loans
               53,733
                      -
                       1,166
                      -
                 -
               54,899
Total
 $          254,366
 $         15,796
 $                  22,550
 $                17
 $              -
 $          292,729
 
For residential real estate mortgages, home equities 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 March 31, 2012 and December 31, 2011 (in thousands):
 
 
11

 

March 31, 2012
Performing
Non-performing
Total
Real estate loans:
     
     Mortgages
 $          104,340
 $              439
 $                104,779
     Home Equity
               78,613
                 311
                     78,924
Consumer
               10,402
                     3
                     10,405
Total
 $          193,355
 $              753
 $                194,108
       
       
December 31, 2011
Performing
Non-performing
Total
Real estate loans:
     
     Mortgages
 $          102,238
 $              473
 $                102,711
     Home Equity
               81,143
                 180
                     81,323
Consumer
               10,746
                      -
                     10,746
Total
 $          194,127
 $              653
 $                194,780

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 March 31, 2012 and December 31, 2011 (in thousands):

   
30-59 Days
60-89 Days
90 Days
Total Past
 
Total Financing
90 Days and
March 31, 2012
Past Due
Past Due
Or Greater
Due
Current
Receivables
Accruing
Real estate loans:
             
     Mortgages
 $        548
 $          74
 $        307
 $        929
 $   103,850
 $           104,779
 $              58
     Home Equity
             60
                -
           311
           371
        78,553
                78,924
               102
     Commercial
           424
                -
        2,743
        3,167
      164,417
              167,584
               180
     Agricultural
                -
                -
                -
                -
        19,231
                19,231
                   -
     Construction
                -
                -
                -
                -
          8,912
                  8,912
                   -
Consumer
             64
                -
               3
             67
        10,338
                10,405
                   3
Commercial and other loans
             14
                -
           446
           460
        38,823
                39,283
                   -
Other Agricultural Loans
                -
                -
                -
                -
          6,337
                  6,337
                   -
State and political
             
   subdivision loans
                -
                -
                -
                -
        55,837
                55,837
                   -
                 
 
Total
 $     1,110
 $          74
 $     3,810
 $     4,994
 $   486,298
 $           491,292
 $            343
                 
Loans considered non-accrual
 $        336
 $          74
 $     3,467
 $     3,877
 $       5,366
 $               9,243
 
Loans still accruing
           774
                -
           343
        1,117
      480,932
              482,049
 
 
Total
 $     1,110
 $          74
 $     3,810
 $     4,994
 $   486,298
 $           491,292
 


 
12

 

 

   
30-59 Days
60-89 Days
90 Days
Total Past
 
Total Financing
90 Days and
December 31, 2011
Past Due
Past Due
Or Greater
Due
Current
Receivables
Accruing
Real estate loans:
             
     Mortgages
 $        428
 $          91
 $        398
 $        917
 $   101,794
 $           102,711
 $              60
     Home Equity
           339
                -
           180
           519
        80,804
                81,323
                 39
     Commercial
           319
           412
        2,794
        3,525
      162,301
              165,826
               176
     Agricultural
           143
                -
                -
           143
        19,081
                19,224
                   -
     Construction
                -
                -
                -
                -
          8,481
                  8,481
                   -
Consumer
             86
               7
                -
             93
        10,653
                10,746
                   -
Commercial and other loans
               9
                -
           503
           512
        37,235
                37,747
                   -
Other Agricultural Loans
                -
                -
                -
                -
          6,552
                  6,552
                   -
State and political
             
   subdivision loans
                -
                -
                -
                -
        54,899
                54,899
                   -
                 
 
Total
 $     1,324
 $        510
 $     3,875
 $     5,709
 $   481,800
 $           487,509
 $            275
                 
Loans considered non-accrual
 $             -
 $             -
 $     3,600
 $     3,600
 $       5,565
 $               9,165
 
Loans still accruing
        1,324
           510
           275
        2,109
      476,235
              478,344
 
 
Total
 $     1,324
 $        510
 $     3,875
 $     5,709
 $   481,800
 $           487,509
 

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 nonaccrual status as of March 31, 2012 and December 31, 2011, respectively. The balances are presented by class of financing receivable (in thousands):

   
March 31, 2012
 
December 31, 2011
Real estate loans:
     
     Mortgages
 $                381
 
 $                   413
     Home Equity
                   209
 
                      141
     Commercial
                8,194
 
                   8,094
     Agricultural
                      -
 
                        -
     Construction
                     -
 
                        -
Consumer
                     -
 
                        -
Commercial and other
                   459
 
                      517
Other Agricultural
                     -
 
                        -
State and political subdivision
                     -
 
                        -
   
 $             9,243
 
 $                9,165

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 TDR’s, 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.

 
13

 
 
Loan modifications that are considered TDR’s completed during the three months ended March 31, 2012 and 2011 were as follows:

 
For the Three Months Ended March 31, 2012
 
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
(Dollar amounts in thousands)
         
Real estate loans:
           
     Commercial
                     -
                   2
 $                        -
 $               98
 $                  -
 $               98
Total
                     -
                    2
 $                        -
 $               98
 $                  -
 $               98

 
For the Three Months Ended March 31, 2011
 
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
(Dollar amounts in thousands)
           
Real estate loans:
           
     Commercial
                    5
                          -
 $             5,912
 $                  -
 $          5,912
 $                  -
Total
                    5
                          -
 $             5,912
 $                  -
 $          5,912
 $                  -

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. Loan modifications considered TDR’s made during the twelve months ended March 31, 2012, that defaulted during the three month period ended March 31, 2012 were as follows:

(Dollar amounts in thousands)
Number of contracts
Recorded investment
Real estate loans:
   
     Commercial
               1
 $              48
Total recidivism
               1
 $              48

Allowance for Loan Losses

The following tables roll forward the balance of the ALLL by portfolio segment for the three month periods ended March 31, 2012 and 2011, respectively, and segregates the ending balance into the amount required for loans individually evaluated for impairment and the amount required for loans collectively evaluated for impairment as of March 31, 2012 (in thousands):
 
 
14

 

 
Balance at December 31, 2011
Charge-offs
Recoveries
Provision
Balance at March 31, 2012
Individually evaluated for impairment
Collectively evaluated for impairment
Real estate loans:
             
     Residential
 $         805
 $          (49)
 $              -
 $         (3)
 $         753
 $             15
 $             738
     Commercial and agricultural
         4,132
               (2)
                 -
          206
         4,336
              563
             3,773
     Construction
              15
                 -
                 -
              1
              16
                   -
                  16
Consumer
            111
               (8)
                9
          (16)
              96
                   -
                  96
Commercial and other loans
            674
                 -
                3
            (6)
            671
                23
                648
State and political
             
  subdivision loans
            235
                 -
                 -
            10
            245
                   -
                245
Unallocated
            515
                 -
                 -
          (87)
            428
                   -
                428
Total
 $      6,487
 $          (59)
 $           12
 $       105
 $      6,545
 $           601
 $          5,944
               
 
Balance at December 31, 2010
Charge-offs
Recoveries
Provision
Balance at March 31, 2011
Individually evaluated for impairment
Collectively evaluated for impairment
Real estate loans:
             
     Residential
 $         969
 $          (60)
 $              -
 $         12
 $         921
 $                -
 $             921
     Commercial and agricultural
         3,380
             (17)
                 -
          335
         3,698
              433
             3,265
     Construction
              22
                 -
                 -
            (9)
              13
                   -
                  13
Consumer
            108
             (16)
              17
          (22)
              87
                   -
                  87
Commercial and other loans
            983
                 -
                4
          (86)
            901
                   -
                901
State and political
             
  subdivision loans
            137
                 -
                 -
              2
            139
                   -
                139
Unallocated
            316
                 -
                 -
            (7)
            309
                   -
                309
Total
 $      5,915
 $          (93)
 $           21
 $       225
 $      6,068
 $           433
 $          5,635
 
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) commercial and other loans; (vii) consumer loans; (viii) other agricultural loans and (ix) state and political subdivision loans. Factors considered in this process include general loan terms, collateral, and availability of historical data to support the analysis. Historical loss percentages are calculated and used as the basis for calculating allowance allocations. Certain qualitative factors are evaluated to determine additional inherent risks in the loan portfolio, which are not necessarily reflected in the historical loss percentages. These factors are then added to the historical allocation percentage to get the adjusted factor to be applied to non classified loans. The following qualitative factors are analyzed:

·  
Level of and trends in delinquencies, impaired/classified loans
§
  Change in volume and severity of past due loans
§
  Volume of non-accrual loans
§
  Volume and severity of classified, adversely or graded loans;
·  
Level of and trends in charge-offs and recoveries;
·  
Trends in volume, terms and nature of the loan portfolio;
·  
Effects of any changes in risk selection and underwriting standards and any other changes in lending and recovery policies, procedures and practices;
·  
Changes in the quality of the Bank’s loan review system;
·  
Experience, ability and depth of lending management and other relevant staff;
·  
National, state, regional and local economic trends and business conditions
§
  General economic conditions
§
  Unemployment rates
§
  Inflation / CPI
§
  Changes in values of underlying collateral for collateral-dependent loans;
·  
Industry conditions including the effects of external factors such as competition, legal, and regulatory requirements on the level of estimated credit losses; and
·  
Existence and effect of any credit concentrations, and changes in the level of such concentrations.
 
 
 
15

 
 
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 TDR’s 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, an 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. During the second quarter of 2011, management made a determination that special mention and substandard loans should have additional qualitative adjustments applied to them in comparison to pass graded loans. As a result of this and other factors discussed below, the following factors experienced changes during the first three months of 2012:
 
 
·  
The qualitative factor for changes in values of underlying collateral was decreased for residential and commercial real estate loans due to the fact that the impact from the serious flooding experienced in our primary market in the third quarter of 2011 was not as severe as originally expected.
·  
The qualitative factors for changes in levels of and trends in delinquencies, impaired/classified loans were increased for residential real estate and commercial real estate due to the increase in non-performing loans for residential real estate and due to the increase in the Company’s internal watch list for commercial real estate loans since December 31, 2011.
·  
The qualitative factor for the existence and effect of any credit concentrations and changes in the level of such concentrations was increased for commercial real estate and other commercial loans due to the fact that certain companies associated with the natural gas industry appear to be leaving our area due to the current spot price for the natural gas produced in our primary market.
·  
The qualitative factors for changes in industry conditions was increased for agricultural real estate loans and other agricultural loans due to the decrease in milk prices.
 
Based on these qualitative factor changes for the three month period ended March 31, 2012 and the changes in size of the loan portfolios since December 31, 2011, we recorded a credit provision for residential real estate, consumer and other commercial loans. These changes also resulted in a decrease in the unallocated reserve.

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 March 31, 2012 and December 31, 2011, the Bank holds $4,407,000 and $3,027,000, 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 for by management.  The stock’s value is determined by the ultimate recoverability of the par value rather than by recognizing temporary declines. The determination of whether the par value will ultimately be recovered is influenced by criteria such as the following: (a) The significance of the decline in net assets of the 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.
 
The FHLB has incurred a significant cumulative loss in regards to comprehensive income in the three years ended December 31, 2011 and had suspended the payment of dividends; however, due to improved results in 2011 and 2010 over 2009, a dividend was paid in February 2012.  The cumulative losses were primarily attributable to impairment of investment securities associated with the distressed economic conditions during 2008 and 2009.  Management evaluated the stock and concluded that the stock was not impaired for the periods presented herein.  Management considered that the FHLB’s regulatory capital ratios have improved in the most recent quarters, 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 through the first quarter of 2012 and has reinstituted the dividend in 2012.
 
 
16

 
 
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 2011 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 months ended March 31, 2012 and 2011, respectively (in thousands):

 
Three Months Ended
 
March 31,
 
2012
2011
Service cost
 $         113
 $      114
Interest cost
           139
   139
Expected return on plan assets
        (206)
  (206)
Net amortization and deferral
           16
      16
Net periodic benefit cost
 $          62
 $       63
 
The Company expects to contribute $575,000 to the Pension Plan in 2012.

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 $52,000 and $50,000 for the three months ended March 31, 2012 and 2011, respectively.
 
Directors’ Deferred Compensation Plan
 
The Company’s directors may elect to defer all or portions of their fees until their retirement or termination from service.  Amounts deferred under the plan earn interest based upon the highest current rate offered to certificate of deposit customers.  Amounts deferred under the plan are not guaranteed and represent a general liability of the Company.  Amounts included in interest expense on the deferred amounts totaled $4,000 and $6,000 for the three months ended March 31, 2012 and 2011, respectively.

 
17

 
 
Restricted Stock Plan
 
The Company maintains a Restricted Stock Plan (the “Plan”) whereby employees and non-employee corporate directors are eligible to receive awards of restricted stock based upon performance related requirements.  Awards granted under the Plan are in the form of the Company’s common stock and are subject to certain vesting requirements including continuous employment or service with the Company.  100,000 shares of the Company’s common stock have been authorized under the Plan.  The Plan assists the Company in attracting, retaining and motivating employees to make substantial contributions to the success of the Company and to increase the emphasis on the use of equity as a key component of compensation.
 
For the three months ended March 31, 2012 and 2011, 0 and 3,968 shares of restricted stock were awarded and 3,641 and 2,318 shares vested, respectively.  Compensation cost related to restricted stock is recognized based on the market price of the stock at the grant date over the vesting period. Compensation expense related to restricted stock was $33,000 for the three months ended March 31, 2012 and 2011.
 
Supplemental Executive Retirement Plan
 
The Company maintains a non-qualified supplemental executive retirement plan (“SERP”) for certain executives to compensate those executive participants in the Company’s noncontributory defined benefit pension plan whose benefits are limited by compensation limitations under current tax law. At March 31, 2012 and December 31, 2011, an obligation of $832,000 and $809,000, respectively, was included in other liabilities for this plan in the consolidated balance sheet.  Expenses related to this plan totaled $23,000 and $15,000 for the three months ended March 31, 2012 and 2011, respectively.

Note 8 – Borrowings

 
Securities
       
 
Sold Under
   
 
Total
 
Agreements to
FHLB
Notes
Term
Borrowed
 
Repurchase(a)
Advances(b)
Payable(c,d)
Loans(e)
Funds
March 31, 2012
         
Balance at March 31, 2012
 $                10,930
 $        19,338
 $       7,500
 $    35,000
 $    72,768
Highest balance at any month-end
                   11,382
           19,338
          7,500
       35,000
       73,220
Average balance
                   11,264
             4,799
          7,500
       35,000
       58,563
Weighted average interest rate:
         
    Paid during the period
0.79%
0.25%
5.87%
3.13%
2.84%
    As of period-end
0.82%
0.25%
5.87%
3.13%
2.29%
December 31, 2011
         
Balance at December 31, 2011
 $                11,382
 $                 -
 $       7,500
 $    35,000
 $    53,882
Highest balance at any month-end
                   11,382
                    -
          7,500
       39,000
       57,882
Average balance
                   10,484
                    3
          7,500
       37,496
       55,483
Weighted average interest rate:
         
    Paid during the year
0.82%
0.68%
5.87%
3.22%
3.13%
    As of year-end
0.79%
0.00%
5.87%
3.13%
3.01%

(a) Securities sold under agreements to repurchase mature within 5 years. As of March 31, 2012 and December 31, 2011, repurchase agreements with original maturities of less than one year totaled $9,252,000 and $9,602,000, respectively. As of March 31, 2012 and December 31, 2011, repurchase agreements with original maturities greater than one year totaled $1,678,000 and $1,780,000, respectively. The carrying value of the underlying securities pledged at March 31, 2012 and December 31, 2011 was $15,291,000 and $15,631,000, respectively.
 
 
18

 
 
(b) FHLB Advances consist of an “Open RepoPlus” agreement with the Federal Home Loan Bank of Pittsburgh. FHLB “Open RepoPlus” advances are short-term borrowings that bear interest based on the Federal Home Loan Bank discount rate or Federal Funds rate, whichever is higher.  The Company has a borrowing limit of $225,702,000, inclusive of any outstanding advances. FHLB advances are secured by a blanket security agreement that includes the Company’s FHLB stock, as well as certain investment and mortgage-backed securities held in safekeeping at the FHLB and certain residential and commercial mortgage loans.  At March 31, 2012 and December 31, 2011, the approximate carrying value of the securities collateral was $10,713,000 and $11,196,000, respectively.
 
(c) In December 2003, the Company formed a special purpose entity (“Entity”) to issue $7,500,000 of floating rate obligated mandatory redeemable securities as part of a pooled offering.  The rate was determined quarterly and floated based on the 3 month LIBOR plus 2.80.   The Entity may redeem them, in whole or in part, at face value after December 17, 2008, and on a quarterly basis thereafter.  The Company borrowed the proceeds of the issuance from the Entity in December 2003 in the form of a $7,500,000 note payable.  Debt issue costs of $75,000 have been capitalized and fully amortized as of December 31, 2008.  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.
 
(d) In December, 2008, the Company entered into an interest rate swap agreement to convert floating-rate debt to fixed rate debt on a notional amount of $7,500,000. The interest rate swap instrument involves an agreement to receive a floating rate and pay a fixed rate, at specified intervals, calculated on the agreed-upon notional amount. The differentials paid or received on interest rate swap agreements are recognized as adjustments to interest expense in the period. The interest rate swap agreement was entered into on December 17, 2008 and expires December 17, 2013.  The fair value of the interest rate swap at March 31, 2012 and December 31, 2011 was a liability of $327,000 and $348,000, respectively, and is included within other liabilities on the consolidated balance sheets.
 
(e) Term Loans consist of separate loans with a third party bank and the Federal Home Loan Bank of Pittsburgh as follows (in thousands):
 
   
March 31
December 31,
Interest Rate
Maturity
2012
2011
Fixed:
     
3.57%
May 7, 2012
             2,000
             2,000
3.36%
May 9, 2012
             2,000
             2,000
3.89%
September 5, 2012
             1,000
             1,000
2.72%
March 31, 2013
             1,150
             1,150
2.58%
April 28, 2013
             2,000
             2,000
2.37%
May 5, 2013
             2,000
             2,000
3.75%
May 6, 2013
             2,000
             2,000
3.55%
May 9, 2013
             2,000
             2,000
2.26%
May 15, 2013
             1,650
             1,650
3.42%
December 2, 2013
             5,000
             5,000
3.52%
December 5, 2013
             5,000
             5,000
2.31%
January 27, 2014
             1,000
             1,000
2.80%
April 17, 2014
             3,200
             3,200
2.29%
October 2, 2017
             2,000
             2,000
2.72%
July 12, 2018
             1,000
             1,000
3.52%
July 12, 2021
             2,000
             2,000
 
Total term loans
 $        35,000
 $        35,000


 
19

 


Following are maturities of borrowed funds as of March 31, 2012 (in thousands):

2012
 
 $                41,592
2013
 
                   20,800
2014
 
                     4,200
2015
 
                        642
2016
 
                        534
Thereafter
 
                     5,000
Total borrowed funds
 
 $                72,768

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.
   
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. In cases where significant credit valuation adjustments are incorporated into the estimation of fair value, reported amounts are classified as Level III inputs.
 
 
20

 
 
Currently, we use an interest rate swap, which is a derivative, to manage our interest rate risk related to the trust preferred security. The valuation of this instrument is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative and classified as Level II. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including LIBOR rate curves. We also obtain dealer quotations for these derivatives for comparative purposes to assess the reasonableness of the model valuations.
 
The following tables present the assets and liabilities reported on the consolidated balance sheet at their fair value on a recurring basis as of March 31, 2012 and December 31, 2011 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.

   
March 31, 2012
   
Level I
 
Level II
 
Level III
   
Total
Fair value measurements on a recurring basis:
                 
Assets
                 
  Securities available for sale:
                 
     U.S. Agency securities
 
 $                -
 
 $             173,630
 
 $                    -
   
 $             173,630
     U.S. Treasury securities
     
3,958
       
3,958
     Obligations of state and
                 
        political subdivisions
 
                   -
 
100,766
 
                       -
   
100,766
     Corporate obligations
 
                   -
 
11,163
 
                       -
   
11,163
     Mortgage-backed securities in
                 
       government sponsored entities
 
                   -
 
71,397
 
                       -
   
71,397
     Equity securities in financial
                 
       institutions
 
           1,234
 
                            -
 
                       -
   
1,234
Liabilities
                 
   Trust Preferred Interest Rate Swap
 
                   -
 
(327)
 
                       -
   
(327)

   
December 31, 2011
   
Level I
 
Level II
 
Level III
   
Total
Fair value measurements on a recurring basis:
                 
Assets
                 
  Securities available for sale:
                 
     U.S. Agency securities
 
 $                -
 
 $             168,600
 
 $                    -
   
 $             168,600
     Obligations of state and
                 
          political subdivisions
 
                   -
 
101,547
 
                       -
   
101,547
     Corporate obligations
 
                   -
 
8,460
 
                       -
   
8,460
     Mortgage-backed securities in
                 
          government sponsored entities
 
                   -
 
38,974
 
                       -
   
38,974
     Equity securities in financial
                 
          institutions
 
1,242
 
                            -
 
                       -
   
1,242
Liabilities
                 
   Trust Preferred Interest Rate Swap
 
                   -
 
(348)
 
                       -
   
(348)

Financial Instruments Recorded at Fair Value on a Nonrecurring Basis
 
The Company may be required, from time to time, to measure certain financial assets and financial liabilities at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principles. These include assets that are measured at the lower of cost or market value that were recognized at fair value below cost at the end of the period.
 
Impaired Loans- Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. The fair value of impaired loans is estimated using one of several methods, including collateral value, liquidation value and discounted cash flows. For those loans valued utilizing collateral value or liquidation value consideration is given to the time since an appraisal was performed, selling costs including legal fees and the length of time it will take to sell the collateral. 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 II inputs based on observable market data or Level III 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.
 
 
21

 
 
Non-Financial Assets and Non-Financial Liabilities Recorded at Fair Value
 
The Corporation has no non-financial assets or non-financial liabilities measured at fair value on a recurring basis. Certain non-financial assets measured at fair value on a non-recurring basis include foreclosed assets (upon initial recognition or subsequent impairment), non-financial assets and non-financial liabilities measured at fair value in the second step of a goodwill impairment test, and intangible assets and other non-financial long-lived assets measured at fair value for impairment assessment. Non-financial assets measured at fair value on a non-recurring basis during 2012 and 2011 include certain foreclosed assets which, upon initial recognition, were remeasured and reported at fair value through a charge-off to the allowance for possible loan losses and certain foreclosed assets which, subsequent to their initial recognition, were remeasured at fair value through a write-down included in other non-interest expense. The fair value of a foreclosed asset is estimated using Level III inputs based on customized discounting criteria. The criteria utilized includes an external appraisal, length of time since the appraisal was obtained, selling costs including legal fees and the length of time it will take to sell the collateral.
 
Assets measured at fair value on a nonrecurring basis as of March 31, 2012 and December 31, 2011 are included in the table below (in thousands):

   
March 31, 2012
   
Level I
 
Level II
 
Level III
   
Total
                   
Impaired Loans
 
 $                -
 
 $                         -
 
 $            8,325
   
 $                 8,325
Other real estate owned
 
                   -
 
                            -
 
836
   
836
                   
   
December 31, 2011
   
Level I
 
Level II
 
Level III
   
Total
                   
Impaired Loans
 
 $                -
 
 $                         -
 
 $            8,387
   
 $                 8,387
Other real estate owned
 
                   -
 
                            -
 
                  860
   
860
 
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.


 
22

 
 

Quantitative Information about Level III Fair Value Measurements
 
Fair Value at March 31, 2012
Valuation Technique(s)
Unobservable input
Range
Impaired Loans
 $      5,395
   Discounted Cash Flows
Probability of Default
0%-5%
     
Change in interest rates
0-7%
         
 
         2,930
   Appraised Collateral Values
Discount for time since appraisal
0-20%
     
Selling costs
0%-10%
     
Holding period
0 - 18 months
         
Other real estate owned
836
   Appraised Collateral Values
Discount for time since appraisal
0-20%
     
Selling costs
0%-10%
     
Holding period
0 - 18 months
 
The fair values of the Company’s financial instruments are as follows (in thousands):

 
Carrying
         
March 31, 2012
Amount
Fair Value
Level I
Level II
Level III
Total
Financial assets:
           
Cash and due from banks
 $    11,837
 $    11,837
 $    11,837
 $              -
 $              -
 $    11,837
Available-for-sale securities
     362,148
     362,148
         1,234
     360,914
                 -
     362,148
Net loans
     484,747
     527,358
                 -
                 -
     527,358
     527,358
Bank owned life insurance
       13,794
       13,794
       13,794
                 -
                 -
       13,794
Regulatory stock
         4,681
         4,681
         4,681
                 -
                 -
         4,681
Accrued interest receivable
         4,305
         4,305
4,305
                 -
                 -
         4,305
             
Financial liabilities:
           
Deposits
 $  742,826
 $  749,160
 $  446,172
 $              -
 $  302,988
 $  749,160
Borrowed funds
       72,768
       70,466
                 -
       70,466
                 -
       70,466
Trust preferred interest rate swap
            327
            327
                 -
            327
                 -
            327
Accrued interest payable
         1,320
         1,320
1,320
                 -
                 -
         1,320
             
    Carrying      
 
 
December 31, 2011
  Amount   Fair Value    
 
 
Financial assets:
           
Cash and cash equivalents
$ 30,432  $ 30,432     
 
 
Available-for-sale securities
318,823  318,823     
    
     
Net loans
481,022  527,724     
    
     
Bank owned life insurance
13,669  13,669     
      
       
Regulatory stock
3,301  3,301     
        
       
Accrued interest receivable
3,621  3,621     
        
        
             
Financial liabilities:
           
Deposits
$ 733,993 
$ 740,839
   
 
 
Borrowed funds
 53,882  51,437     
       
      
Trust preferred interest rate swap
 348   348     
           
            
Accrued interest payable
 1,512   1,512     
         
         
 
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.

 
23

 
 
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.

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

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

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


 
24

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

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

Trust Preferred Interest Rate Swap:

The fair value of the trust preferred interest rate swap is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative and classified as Level II. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including LIBOR rate curves. We also obtain dealer quotations for these derivatives for comparative purposes to assess the reasonableness of the model valuations.
 
Note 10 – Recent Accounting Pronouncements
 
In April 2011, the FASB issued ASU 2011-03, Transfers and Services (Topic 860): Reconsideration of Effective Control for Repurchase Agreements.  The main objective in developing this Update is to improve the accounting for repurchase agreements (repos) and other agreements that both entitle and obligate a transferor to repurchase or redeem financial assets before their maturity.  The amendments in this Update remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation guidance related to that criterion.  The amendments in this Update apply to all entities, both public and nonpublic.  The amendments affect all entities that enter into agreements to transfer financial assets that both entitle and obligate the transferor to repurchase or redeem the financial assets before their maturity.  The guidance in this Update is effective for the first interim or annual period beginning on or after December 15, 2011 and should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date.  Early adoption is not permitted.  This ASU did not have a significant impact on the Company’s financial statements.
 
In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement (Topic 820):  Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.  The amendments in this Update result in common fair value measurement and disclosure requirements in U.S. GAAP and IFRSs.  Consequently, the amendments change the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements.  The amendments in this Update are to be applied prospectively.  For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011.  For nonpublic entities, the amendments are effective for annual periods beginning after December 15, 2011.  Early application by public entities is not permitted. This Company has provided the necessary disclosures in Note 9.
 
In June 2011, the FASB issued ASU 2011-05, Comprehensive Income (Topic 220):  Presentation of Comprehensive Income.  The amendments in this Update improve the comparability, clarity, consistency, and transparency of financial reporting and increase the prominence of items reported in other comprehensive income.  To increase the prominence of items reported in other comprehensive income and to facilitate convergence of U.S. GAAP and IFRS, the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity was eliminated.  The amendments require that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements.  In the two-statement approach, the first statement should present total net income and its components followed consecutively by a second statement that should present total other comprehensive income, the components of other comprehensive income, and the total of comprehensive income.  All entities that report items of comprehensive income, in any period presented, will be affected by the changes in this Update.  For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011.  For nonpublic entities, the amendments are effective for fiscal years ending after December 15, 2012, and interim and annual periods thereafter.  The amendments in this Update should be applied retrospectively, and early adoption is permitted. The Company has provided the necessary disclosure in the Consolidated Statement of Comprehensive Income.
 
 
 
25

 
 
In September 2011, the FASB issued ASU 2011-08, Intangibles – Goodwill and Other Topics (Topic 350), Testing Goodwill for Impairment.  The objective of this update is to simplify how entities, both public and nonpublic, test goodwill for impairment.  The amendments in the Update permit an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in Topic 350.  The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent.  Under the amendments in this Update, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount.  The amendments in this Update apply to all entities, both public and nonpublic, that have goodwill reported in their financial statements and are effective for interim and annual goodwill impairment tests performed for fiscal years beginning after December 15, 2011.  Early adoption is permitted, including for annual and interim goodwill impairment tests performed as of a date before September 15, 2011, if an entity’s financial statements for the most recent annual or interim period have not yet been issued or, for nonpublic entities, have not yet been made available for issuance.  This ASU did not have a significant impact on the Company’s financial statements.
 
In December 2011, the FASB issued ASU 2011-11, Balance Sheet (Topic 210):  Disclosures about Offsetting Assets and Liabilities.  The amendments in this Update affect all entities that have financial instruments and derivative instruments that are either (1) offset in accordance with either Section 210-20-45 or Section 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement.  The requirements amend the disclosure requirements on offsetting in Section 210-20-50.  This information will enable users of an entity's financial statements to evaluate the effect or potential effect of netting arrangements on an entity's financial position, including the effect or potential effect of rights of setoff associated with certain financial instruments and derivative instruments in the scope of this Update.  An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods.  An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented.  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 December 2011, the FASB issued ASU 2011-12, Comprehensive Income (Topic 220):  Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.  In order to defer only those changes in Update 2011-05 that relate to the presentation of reclassification adjustments, the paragraphs in this Update supersede certain pending paragraphs in Update 2011-05.  Entities should continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect before Update 2011-05.  All other requirements in Update 2011-05 are not affected by this Update, including the requirement to report comprehensive income either in a single continuous financial statement or in two separate but consecutive financial statements. Public entities should apply these requirements for fiscal years, and interim periods within those years, beginning after December 15, 2011. Nonpublic entities should begin applying these requirements for fiscal years ending after December 15, 2012, and interim and annual periods thereafter.  The Company has provided the necessary disclosure in the Consolidated Statement of Comprehensive Income. 

 
26

 

 
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Forward-Looking Statements
 
We have made forward-looking statements in this document, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of operations of Citizens Financial Services, Inc., First Citizens National Bank, First Citizens Insurance Agency, Inc. or the combined Company. When we use words such as “believes,” “expects,” “anticipates,” or similar expressions, we are making forward-looking statements.  For a variety of reasons, actual results could differ materially from those contained in or implied by forward-looking statements.  The Company would like to caution readers that the following important factors, among others, may have affected and could in the future affect the Company’s actual results and could cause the Company’s actual results for subsequent periods to differ materially from those expressed in any forward-looking statement:
 
·  
Interest rates could change more rapidly or more significantly than we expect.
·  
The economy could change significantly in an unexpected way, which would cause the demand for new loans and the ability of borrowers to repay outstanding loans to change in ways that our models do not anticipate.
·  
The stock and bond markets could suffer a significant disruption, which may have a negative effect on our financial condition and that of our borrowers, and on our ability to raise money by issuing new securities.
·  
It could take us longer than we anticipate 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 management has not anticipated.
·  
We may become subject to new legal obligations or the resolution of litigation may have a negative effect on our financial condition.
·  
We may become subject to new and unanticipated accounting, tax, or regulatory practices, regulations or requirements, including the costs of compliance with such changes.
·  
We could experience greater loan delinquencies than anticipated, adversely affecting our earnings and financial condition.  We could also experience greater losses than expected due to the ever increasing volume of information theft and fraudulent scams impacting our customers and the banking industry.
·  
We could lose the services of some or all of our key personnel, which would negatively impact our business because of their business development skills, financial expertise, lending experience, technical expertise and market area knowledge.
·  
Exploration and drilling of the natural gas reserves in the Marcellus Shale in our market area may be affected by federal, state and local laws and regulations such as restrictions on production, permitting, changes in taxes and environmental protection, which could negatively impact our customers and, as a result, negatively impact our loan and deposit volume and loan quality.
·  
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 2011 Annual Report on Form 10-K under “Item 1.A/ Risk Factors.”  Except as required by applicable law and regulation, we assume no obligation to update or revise any forward-looking statements after the date on which they are made.

Introduction
 
The following is management's discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in 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 months ended March 31, 2012 are not necessarily indicative of the results you may expect for the full year.

 
27

 
 
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 19 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 a loan production office in Lock Haven, Pennsylvania. In New York, we have a branch office in Wellsville, Allegany County.

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

Competition
 
The banking industry in the Bank’s service area continues to be extremely competitive, both among commercial banks and with financial service providers such as consumer finance companies, thrifts, investment firms, mutual funds, insurance companies, credit unions and internet 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.  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.

 
28

 
 
Trust and Investment Services; Oil and Gas Services
 
Our Investment and Trust Services Department offers professional trust administration, investment management services, estate planning and administration, and custody of securities.  Assets held by the Company in a fiduciary or agency capacity for its customers are not included in the consolidated financial statements since such items are not assets of the Company.  Revenues and fees of the Trust Department are reflected in the Company’s financial statements.  As of March 31, 2012 and December 31, 2011, the Trust Department had $99.8 and $94.7 million of assets under management, respectively.  The $5.1 million increase is primarily attributable to fluctuations in the stock market since December 31, 2011.

Our Investment Representatives offer full service brokerage services and financial planning throughout the Bank’s market area.  Products such as mutual funds, annuities, health and life insurance are made available through our insurance subsidiary, First Citizens Insurance.  The assets associated with these products are not included in the consolidated financial statements since such items are not assets of the Company. Assets owned and invested by customers of the Bank through the Bank’s Investment Representatives increased from $78.1 million at December 31, 2011 to $87.3 million at March 31 2012. Fee income from the sale of these products is reflected in the Company’s financial statements as a component of non-interest income in the Consolidated Statement of Income.
 
In addition to the trust and investment services offered we have created an oil and gas 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 mineral management expertise and services to customers in our market who have been impacted by the Marcellus Shale exploration and drilling activities. Through this relationship, we are able to assist customers with the negotiation of lease payments and royalty percentages, protect their property, resolve leasing issues, account for and ensure the accuracy of royalty checks, distribute revenue to satisfy investment objectives and provide customized reports outlining payment and distribution information.

Results of Operations

Overview of the Income Statement
 
The Company had net income of $3,449,000 for the first three months of 2012 compared to earnings of $2,830,000 for last year’s comparable period, an increase of $619,000 or 21.9%. Earnings per share for the first three months of 2012 were $1.19, compared to $0.97 for last year’s comparable period, representing a 22.7% increase.  Annualized return on assets and return on equity for the three months of 2012 were 1.57% and 17.76%, respectively, compared with 1.38% and 16.57% for last year’s comparable period.

Net Interest Income
 
Net interest income, the most significant component of the Company’s earnings, is the amount by which interest income generated from interest-earning assets exceeds interest expense on interest-bearing liabilities.
 
Net interest income for the first three months of 2012 was $7,558,000, an increase of $622,000, or 9.0%, compared to the same period in 2011.  For the first three months of 2012, the provision for loan losses totaled $105,000, a decrease of $120,000 over the comparable period in 2011.  Consequently, net interest income after the provision for loan losses was $7,453,000 compared to $6,711,000 during the first three months of 2011.

The following table sets forth the average balances of, and the interest earned or incurred on, for each principal category of assets, liabilities and stockholders’ equity, the related rates, net interest income and rate “spread” created for the three months ended March 31, 2012 and 2011 on a tax equivalent basis:


 
29

 

 
Analysis of Average Balances and Interest Rates (1)
 
March 31, 2012
March 31, 2011
 
Average
 
Average
Average
 
Average
 
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
(dollars in thousands)
$
$
%
$
$
%
ASSETS
           
Short-term investments:
           
   Interest-bearing deposits at banks
           7,565
                   5
0.27
          33,249
                22
0.27
Total short-term investments
           7,565
                   5
0.27
          33,249
                22
0.27
Investment securities:
           
  Taxable
      231,069
           1,212
2.10
        184,952
            1,187
2.57
  Tax-exempt (3)
        95,845
           1,446
6.03
          84,702
            1,311
6.19
  Total investment securities
      326,914
           2,658
3.25
        269,654
            2,498
3.71
Loans:
           
  Residential mortgage loans
      193,818
           3,151
6.54
        188,887
            3,243
6.96
  Commercial & farm loans
      230,834
           3,640
6.34
        221,502
            3,486
6.38
  Loans to state & political subdivisions (3)
        55,474
              656
4.76
          48,671
              638
5.32
  Other loans
        10,296
              218
8.52
          10,942
              230
8.52
  Loans, net of discount (2)(3)(4)
      490,422
           7,665
6.29
        470,002
            7,597
6.56
Total interest-earning assets
      824,901
        10,328
5.04
        772,905
          10,117
5.31
Cash and due from banks
           9,826
   
            9,844
   
Bank premises and equipment
        11,667
   
          12,469
   
Other assets
        30,969
   
          27,965
   
Total non-interest earning assets
        52,462
   
          50,278
   
Total assets
      877,363
   
        823,183
   
LIABILITIES AND STOCKHOLDERS' EQUITY
         
Interest-bearing liabilities:
           
  NOW accounts
      197,544
              202
             0.41
        181,592
              238
             0.53
  Savings accounts
        81,531
                40
             0.20
          65,058
                49
             0.31
  Money market accounts
        68,215
                79
             0.47
          52,989
                70
              0.54
  Certificates of deposit
      298,357
           1,345
             1.81
        316,308
            1,731
              2.22
Total interest-bearing deposits
      645,647
           1,666
             1.04
        615,947
            2,088
              1.37
Other borrowed funds
        58,563
              413
             2.84
          57,204
              445
              3.15
Total interest-bearing liabilities
      704,210
           2,079
             1.19
        673,151
            2,533
              1.53
Demand deposits
        84,615
   
          74,409
   
Other liabilities
        10,844
   
            7,305
   
Total non-interest-bearing liabilities
        95,459
   
          81,714
   
Stockholders' equity
        77,694
   
          68,318
   
Total liabilities & stockholders' equity
      877,363
   
        823,183
   
Net interest income
 
           8,249
   
            7,584
 
Net interest spread (5)
   
3.85%
   
3.78%
Net interest income as a percentage
           
  of average interest-earning assets
   
4.02%
   
3.98%
Ratio of interest-earning assets
           
  to interest-bearing liabilities
   
             1.17
   
              1.15
             
(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.
       

 
 
30

 

Tax exempt revenue is shown on a tax-equivalent basis for proper comparison using a statutory, federal income tax rate of 34%.  For purposes of the comparison, as well as the discussion that follows, this presentation facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the Company’s 34% Federal statutory rate.  The following table represents the adjustment to convert net interest income to net interest income on a fully taxable equivalent basis for the periods ending March 31, 2012 and 2011(in thousands):
 
 
For the Three Months
 
Ended March 31
 
2012
2011
Interest and dividend income from investment securities
   
   and interest bearing deposits at banks (non-tax adjusted)
 $             2,172
 $              2,074
Tax equivalent adjustment
                   491
                   446
Interest and dividend income from investment securities
   
   and interest bearing deposits at banks (tax equivalent basis)
 $             2,663
 $              2,520
     
Interest and fees on loans (non-tax adjusted)
 $             7,465
 $              7,395
Tax equivalent adjustment
                   200
                   202
Interest and fees on loans (tax equivalent basis)
 $             7,665
 $              7,597
     
Total interest income
 $             9,637
 $              9,469
Total interest expense
                2,079
                2,533
Net interest income
                7,558
                6,936
Total tax equivalent adjustment
                   691
                   648
Net interest income (tax equivalent basis)
 $             8,249
 $              7,584
 
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 March 31, 2012 vs. 2011
 
 Change in
 Change
 Total
 
 Volume
 in Rate
 Change
Interest Income:
     
Short-term investments:
     
  Interest-bearing deposits at banks
 $               (17)
 $                   -
 $               (17)
Investment securities:
     
  Taxable
                   94
                  (69)
                   25
  Tax-exempt
                 167
                  (32)
                 135
Total investments
                 261
                (101)
                 160
Loans:
     
  Residential mortgage loans
                 116
                (208)
                  (92)
  Commercial & farm loans
                 176
                  (22)
                 154
  Loans to state & political subdivisions
                   57
                  (39)
                   18
  Other loans
                  (12)
                      -
                  (12)
Total loans, net of discount
                 337
                (269)
                   68
Total Interest Income
                 581
                (370)
                 211
Interest Expense:
     
Interest-bearing deposits:
     
  NOW accounts
                   26
                  (62)
                  (36)
  Savings accounts
                   24
                  (33)
                    (9)
  Money Market accounts
                   16
                    (7)
                     9
  Certificates of deposit
                  (81)
                (305)
                (386)
Total interest-bearing deposits
                  (15)
                (407)
                (422)
Other borrowed funds
                   15
                  (47)
                  (32)
Total interest expense
                      -
                (454)
                (454)
Net interest income
 $              581
 $                84
 $              665
(1) The portion of the total change attributable to both volume and rate changes, which cannot be separated, has been
      allocated proportionally to the change due to volume and the change due to rate prior to allocation.
 
 
 
31

 
 
Tax equivalent net interest income increased from $7,584,000 for the three months ended March 31, 2011 to $8,249,000 for the same period in 2012, an increase of $665,000.  The tax equivalent net interest margin increased from 3.98% for the first three months of 2011 to 4.02% for the comparable period in 2012.
 
Total tax equivalent interest income for the three month period increased $211,000. The increase was primarily a result of an increase of $581,000 due to the change in volume as average interest earning assets increased $52.0 million. The increase was offset by a decrease of $370,000 due to change in rate, as the yield on interest earning assets decreased from 5.31% to 5.04% for the comparable periods.
 
Tax equivalent investment income for the three months ended March 31, 2012 increased $160,000 over the same period last year.  The average balance of total investment securities for the three months ended March 31, 2012 increased by $57.3 million as compared to the three months ended March 31, 2011 as a result of investing excess cash from increased deposit levels, and leveraging of overnight borrowings to purchase additional securities at higher interest rates than the overnight borrowings to replace securities the Company expects will be called or mature in the last three quarters of 2012.
 
·  
The average balance of taxable securities increased by $46.1 million while tax-exempt securities increased by $11.1 million, which had the effect of increasing interest income by $94,000 and $167,000, respectively, due to volume.
 
·  
The increase attributable to volume of securities was offset by a decrease in the yield on investment securities of 46 basis points from 3.71% to 3.25%, which corresponds to a decrease in interest income of $101,000. The majority of this decrease is attributable to the change in yield on taxable securities, which decreased 47 basis points from 2.57% to 2.10%. The yield on investments declined due to the amount of purchases we made in the current low interest rate environment as a result of our increased deposit levels and limited loan opportunities. 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 our effective tax rate as well as the overall yield on our interest earning assets.
 
Total loan interest income increased $68,000 for the three months ended March 31, 2012 compared to the same period last year.
 
·  
The average balance of commercial and agricultural loans increased $9.3 million from a year ago as we grow this segment of the loan portfolio utilizing disciplined underwriting standards, while meeting the needs of our customers. This had a positive impact of $176,000 on total interest income due to volume, which was offset by a decrease in rate of $22,000.
 
·  
Interest income on residential mortgage loans decreased $92,000 of which $208,000 was due to rate, partially offset by an increase of $116,000 as a result of volume. The average balance increased $4.9 million due to the Company’s fourth quarter decision to not sell certain conforming rate loans that historically it has sold for interest rate risk management purposes, due to decline in non-conforming residential real estate loans and the current interest rate environment for investments.
 
Total interest expense decreased $454,000 for the three months ended March 31, 2012 compared with last year.  This decrease is solely due to a change in rate, accounting for the entire $454,000 decrease in our interest expense.  The average interest rate on interest-bearing liabilities decreased 34 basis points, from 1.53% to 1.19%. The continued low interest rate environment prompted by the Federal Reserve and current economic conditions 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. (see also “Financial Condition – Deposits”).
 
·  
Interest expense on certificates of deposits decreased $386,000 over the same period last year. The average balance of certificates of deposit decreased $18.0 million causing a decrease in interest expense of $81,000. In addition, there was a decrease in the average rate on certificates of deposit from 2.22% to 1.81% resulting in a decrease in interest expense of $305,000.
 
 
 
32

 
 
Provision for Loan Losses 
 
For the three month period ending March 31, 2012, we recorded a provision for loan losses of $105,000, which represents a decrease of $120,000 from the $225,000 provision recorded in the corresponding three months of last year. In comparison to March 31, 2011, non-performing assets decreased $371,000 as of March 31, 2012. In addition, there has been a reduction in loans graded as Special Mention and Substandard, which has resulted in a lower provision for the comparable periods. (see “Financial Condition – Allowance for Loan Losses and Credit Quality Risk”).

Non-interest Income
 
The following table shows the breakdown of non-interest income for the three months ended March 31, 2012 and 2011 (in thousands):

 
Three months ended
   
 
March 31,
Change
 
2012
2011
Amount
%
Service charges
 $                 1,078
 $                  945
 $                133
               14.1
Trust
                       173
                     157
                     16
               10.2
Brokerage and insurance
                       150
                       95
                     55
               57.9
Investment securities gains, net
                       108
                     120
                    (12)
              (10.0)
Gains on loans sold
                         54
                       41
                     13
               31.7
Earnings on bank owned life insurance
                       124
                     121
                       3
                 2.5
Other
                       156
                     140
                     16
               11.4
Total
 $                 1,843
 $               1,619
 $                224
               13.8
 
Non-interest income for the three months ended March 31, 2012 totaled $1,843,000, an increase of $224,000 when compared to the same period in 2011. During the first three months of 2012, gains on the sales of investment securities amounted to $108,000 compared to $120,000 last year.  We sold four mortgage backed securities in government sponsored entities for gains totaling $50,000 and a portion of a financial institution equity holding for a gain of $58,000 due to favorable market conditions. In 2011, we sold two municipal bonds at a gain of $1,000, eight mortgage backed securities in government sponsored entities for gains totaling $108,000 and a portion of a financial institution equity holding for a gain of $11,000.
 
For the first three months of 2012, account service charges totaled $1,078,000, an increase of $133,000 or 14.1%, when compared to the same period in 2011. There was an increase of $56,000 attributable to customers’ usage of their debit cards, which continues to become a larger percentage of service charge income as the Company is encouraging its customers to use their debit cards for making purchases by providing a deposit product that rewards customers for their usage. ATM income increased $30,000 as a result of an increase in the Bank’s fees and increased activity associated with non-customers use of the Bank’s ATMs. Part of the increased usage by non-customers is associated with an influx of workers working for companies’ associated with the exploration of the Marcellus Shale, who have not established permanent residency in the Company’s primary market. Finally, there was a $40,000 increase attributable to fees charged to customers for non-sufficient funds. Management continues to monitor regulatory changes associated with the Dodd-Frank Act to determine the level of impact that these regulations will have on the fees that the Company realizes.
 
Trust, brokerage and insurance income increased $71,000 due to the increased number of customers utilizing our services and one large annuity purchase in the first quarter of 2012.

Non-interest Expense
 
The following tables reflect the breakdown of non-interest expense for the three months ended March 31, 2012 and 2011 (in thousands):
 

 
 
33

 
 
 
Three months ended
   
 
March 31,
Change
 
 
2012
2011
Amount
%
Salaries and employee benefits
 $                 2,753
 $               2,515
 $                 238
                   9.5
Occupancy
                       310
                     390
                    (80)
               (20.5)
Furniture and equipment
                       106
                     117
                    (11)
                 (9.4)
Professional fees
                       268
                     157
                    111
                 70.7
FDIC insurance
                       123
                     250
                  (127)
               (50.8)
Pennsylvania shares tax
                       166
                     147
                      19
                 12.9
ORE expenses
                         84
                     156
                    (72)
               (46.2)
Other
                    1,045
                  1,048
                      (3)
                 (0.3)
Total
 $                 4,855
 $               4,780
 $                   75
                   1.6
 
Non-interest expenses increased $75,000, or 1.6% for the three months ended March 31, 2012 compared to the same period in 2011. Salaries and employee benefits increased $238,000 or 9.5%. Merit increases effective the beginning of 2012 and a slight increase in full time equivalent employees, accounted for an increase of approximately $151,000. Other increases included an increase of $16,000 for expenses related to providing employee’s insurance, a $64,000 increase related to profit sharing expense and an increase of $8,000 in the Company’s Supplemental Executive Retirement Plan (SERP) plan expense.
 
Occupancy expenses decreased as a result of milder winter weather conditions in 2012. ORE expenses decreased as a result of selling certain properties late in 2011 and in 2012. FDIC insurance decreased $127,000 in 2012 primarily due to changes in the FDIC assessment base and the assessment formula implemented in the second quarter of 2011. Professional fees increased by $111,000 primarily due to the Bank’s charter conversion from a nationally chartered bank to a state chartered bank.

Provision for Income Taxes
 
The provision for income taxes was $992,000 for three month period ended March 31, 2012 compared to $720,000 for the same period in 2011.  The increase is primarily attributable to an increase in income before provision for income taxes of $891,000. Through management of our municipal loan and bond portfolios, management is focused on minimizing our effective tax rate.  Our effective tax rate was 22.3% and 20.3% for the first three months of 2012 and 2011, respectively, compared to the statutory rate of 34%.

We have invested in four limited partnership agreements that established low-income housing projects in our market areas. We anticipate recognizing an aggregate of $1.7 million of tax credits over the next eleven years, with an additional $43,000 to be recognized during 2012.

Financial Condition
 
Total assets were $909.4 million at March 31, 2012, an increase of $30.8 million, or 3.5% from $878.6 million at December 31, 2011.  Investment securities increased 13.6% to $362.1 million and net loans increased 0.8% to $484.7 million at March 31, 2012.  Total deposits increased $8.8 million or 1.2% to $742.8 million since year-end 2011. Borrowed funds increased $18.9 million to $72.8 million compared with $53.9 million at year-end.

Cash and Cash Equivalents
 
Cash and cash equivalents totaled $11.8 million at March 31, 2012 compared to $30.4 million at December 31, 2011, a decrease of $18.6 million. The decrease in cash is due to the Company’s decision as discussed in more detail below to purchase additional investments in the first quarter of 2012. Management actively measures and evaluates its liquidity through our Asset – Liability committee and believes its liquidity needs are satisfied by the current balance of cash and cash equivalents, readily available access to traditional funding sources, Federal Home Loan Bank financing, federal funds lines with correspondent banks, brokered certificates of deposit and the portion of the investment and loan portfolios that mature within one year.  Management expects that these sources of funds will permit us to meet cash obligations and off-balance sheet commitments as they come due.
 
 
34

 

Investments
 
The following table shows the composition of the investment portfolio as of March 31, 2012 and December 31, 2011 (dollars in thousands):

 
March 31, 2012
December 31, 2011
 
Amount
%
Amount
%
Available-for-sale:
       
  U. S. Agency securities
 $              173,630
             48.0
 $        168,600
          52.9
  U. S. Treasury notes
                     3,958
               1.1
                       -
              -
  Obligations of state & political
       
     subdivisions
                 100,766
             27.8
           101,547
          31.9
  Corporate obligations
                   11,163
               3.1
               8,460
            2.7
  Mortgage-backed securities in
       
    government sponsored entities
                   71,397
             19.7
             38,974
          12.2
  Equity securities in financial
       
     institutions
                     1,234
               0.3
               1,242
            0.3
Total
 $              362,148
           100.0
 $        318,823
        100.0
 
     
 
March 31, 2012/
 
 December 31, 2011
 
        Change
 
Amount
%
Available-for-sale:
   
  U. S. Agency securities
 $                  5,030
               3.0
  U. S. Treasury notes
                     3,958
 N/A
  Obligations of state & political
   
     subdivisions
                       (781)
             (0.8)
  Corporate obligations
                     2,703
             32.0
  Mortgage-backed securities in
   
    government sponsored entities
                   32,423
             83.2
  Equity securities in financial
   
     institutions
                           (8)
             (0.6)
Total
 $                43,325
             13.6
 
Our investment portfolio increased by $43.3 million or 13.6% from December 31, 2011 to March 31, 2012.  During 2012, we purchased approximately $38.4 million of U.S. agency obligations, $3.9 million of U.S. Treasury notes, $35.4 million of mortgage backed securities in government sponsored entities, $1.3 million of state and local obligations and $2.6 million of corporate obligations, which helped offset the $2.6 million of principal repayments and $23.4 million of calls and maturities that occurred during the three month period. We also sold $11.1 million of mortgage backed securities in government sponsored entities and certain financial institutions equity securities at a gain of $108,000. The overall market value of our investment portfolio decreased approximately $531,000 due to market fluctuations since year end. Excluding our short-term investments consisting of monies held primarily at the Federal Reserve for liquidity purposes, our investment portfolio for the three month period ending March 31, 2012 yielded 3.25% compared to 3.71% for the same period in 2011 on a tax equivalent basis.
 
Due to the Federal Reserve announcement that rates would likely remain extremely low through late 2014, the Company’s investment strategy changed slightly in the first quarter of 2012. The previous strategy employed by the Company had resulted in a relatively short duration in the investment portfolio. As a result of the Federal Reserve’s commitment to a low rate policy, the Company implemented a strategy to increase portfolio duration through the purchase of certain mortgage backed securities and longer term agencies to provide additional interest income. This strategy maintained a defensive posture to future rising rates by selecting securities that had limited extension risk.  By increasing duration with defensive securities the bank was able to increase interest income with minimal additional interest rate risk. In addition, due to the expected cash flows in the final three quarters of 2012, and the Federal Reserve’s commitment to low rates, the Company purchased certain investment securities utilizing overnight borrowings, which will be repaid as other investment securities mature or are called. We believe this strategy, while having a positive impact on 2012 earnings, will also enable us to reinvest cash flows in the next two to five years with anticipated improved investment opportunities.

 
35

 
 
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 March 31, 2012 and December 31, 2011 (dollars in thousands):

 
March 31,
December 31,
 
2012
2011
 
Amount
%
Amount
%
Real estate:
       
  Residential
 $          183,703
           37.4
 $         184,034
           37.7
  Commercial
             167,584
           34.1
            165,826
           34.0
  Agricultural
               19,231
             3.9
              19,224
             3.9
  Construction
                 8,912
             1.8
                8,481
             1.7
Consumer
               10,405
             2.1
              10,746
             2.2
Commercial and other loans
               45,620
             9.3
              44,299
             9.1
State & political subdivision loans
               55,837
           11.4
              54,899
           11.4
Total loans
             491,292
         100.0
            487,509
         100.0
Less allowance for loan losses
                 6,545
 
                6,487
 
Net loans
 $          484,747
 
 $         481,022
 
 
     
 
March 31, 2012/
 
 December 31, 2011
 
Change
 
Amount
%
Real estate:
   
  Residential
 $               (331)
           (0.2)
  Commercial
                 1,758
             1.1
  Agricultural
                        7
             0.0
  Construction
                    431
             5.1
Consumer
                  (341)
           (3.2)
Commercial and other loans
                 1,321
             3.0
State & political subdivision loans
                    938
             1.7
Total loans
 $              3,783
             0.8
 
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 generated primarily from direct loans to our existing customer base, with new customers generated by referrals from real estate brokers, building contractors, attorneys, accountants and existing customers.
 
Total loans increased approximately $3.8 million or 0.8% during the first three months of 2012. Commercial real estate, construction, commercial and other loans and state and political subdivisions increased $1.8 million, $431,000, $1.3 million and $938,000, respectively.  Residential real estate and consumer loans decreased $331,000 and $341,000, respectively.
 
 
 
36

 
 
We continue to recognize the opportunities created by the Marcellus Shale natural gas exploration efforts, but pursue these opportunities prudently and cautiously. The growth in commercial real estate lending and other commercial loans reflects the Company’s focus on commercial lending as a means to increase loan growth and obtain deposits from farmers and small businesses throughout our market area. The increase in state and political subdivision loans is the result of several relationships in Bradford County. We work closely with local municipalities and school districts to meet their needs that otherwise would be provided by the municipal bond market.  Commercial real estate and other commercial loan demand is subject to significant competitive pressures, the local economy which is currently being impacted significantly by the Marcellus Shale gas exploration area, the yield curve and the strength of the overall regional and national economy.
 
During the first three months of 2012, we continued to experience lower demand for non-conforming residential real estate and consumer loans. Factors impacting this decline include demand for conforming rate loans and recessionary pressures outside of the local Marcellus Shale gas region. Loan demand for conforming mortgages, which the Company generally sells on the secondary market, has increased as qualified customers continue to take advantage of the low interest rate environment. Through the first three months of 2012, we have sold $4.4 million of loans in the secondary market compared to $3.0 million through the same period last year.  The Company recognizes fee income for servicing these sold loans, which is included in non-interest income in the Consolidated Statement of Income.  Management continues to look for ways to encourage our customers to choose the Company for their mortgage needs. This includes partnering with a third party to provide access to government supported loan programs sponsored by the Federal Housing Administration and the U.S. Department of Veteran Affairs and implementing technologies, which make it easier and more efficient for customers to obtain a mortgage.

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 three months ended March 31, 2012 and for the years ended December 31, 2011, 2010, 2009, and 2008 (dollars in thousands):

 
37

 
 

 
March 31,
December 31,
 
2012
2011
2010
2009
2008
Balance
         
  at beginning of period
 $          6,487
 $          5,915
 $          4,888
 $          4,378
 $          4,197
Charge-offs:
         
  Real estate:
         
     Residential
                  49
                101
                147
                  76
                  31
     Commercial
                    2
                  29
                  53
                236
                  36
     Agricultural
                     -
                     -
                     -
                    1
                  20
  Consumer
                    8
                  71
                  35
                  80
                  44
  Commercial and other loans
                     -
                    6
                173
                153
                115
Total loans charged-off
                  59
                207
                408
                546
                246
Recoveries:
         
  Real estate:
         
     Residential
                     -
                     -
                    4
                    1
                    6
     Commercial
                     -
                  15
                  11
                    1
                     -
     Agricultural
                     -
                     -
                     -
                     -
                  20
  Consumer
                    9
                  57
                  45
                  52
                  19
  Commercial and other loans
                    3
                  32
                120
                  77
                  52
Total loans recovered
                  12
                104
                180
                131
                  97
Net loans charged-off
                  47
                103
                228
                415
                149
Provision charged to expense
                105
                675
             1,255
                925
                330
Balance at end of year
 $          6,545
 $          6,487
 $          5,915
 $          4,888
 $          4,378
           
Loans outstanding at end of period
 $      491,292
 $      487,509
 $      473,517
 $      456,384
 $      432,814
Average loans outstanding, net
 $      490,422
 $      474,972
 $      468,620
 $      442,921
 $      423,382
Non-performing assets:
         
    Non-accruing loans
 $          9,243
 $          9,165
 $        11,853
 $          5,871
 $          2,202
    Accrual loans - 90 days or more past due
                343
                275
                692
                884
                383
      Total non-performing loans
 $          9,586
 $          9,440
 $        12,545
 $          6,755
 $          2,585
    Foreclosed assets held for sale
                836
                860
                693
                302
                591
      Total non-performing assets
 $        10,422
 $        10,300
 $        13,238
 $          7,057
 $          3,176
           
Annualized net charge-offs to average loans
0.04%
0.02%
0.05%
0.09%
0.04%
Allowance to total loans
1.33%
1.33%
1.25%
1.07%
1.01%
Allowance to total non-performing loans
68.28%
68.72%
47.15%
72.36%
169.36%
Non-performing loans as a percent of loans
         
   net of unearned income
1.95%
1.94%
2.65%
1.48%
0.60%
Non-performing assets as a percent of loans
       
  net of unearned income
2.12%
2.11%
2.80%
1.55%
0.73%

The Company utilizes a disciplined and thorough loan review process based upon our internal loan policy approved by the Company’s Board of Directors.  The purpose of the review is to assess loan quality, analyze delinquencies, identify problem loans, evaluate potential charge-offs and recoveries, and assess general overall economic conditions in the markets served.  An external independent loan review is performed on our commercial portfolio semi-annually. The external consultant is engaged to 1) review a minimum of 60% of the dollar volume of the commercial loan portfolio (commercial and agricultural real estate, commercial and other loans and state and political subdivision loans) on an annual basis, 2) review a sample of new commercial/agricultural loans originated in the last year, 3) review all relationships in aggregate over $500,000, 4) review all aggregate loan relationships over $100,000 which are over 90 days past due, classified Special Mention, Substandard, Doubtful, or Loss, and 5) such other loans which management or the consultant deems appropriate. As part of this review, our underwriting process and loan grading system is evaluated.

 
38

 
 
Management believes it uses the best information available to make such determinations and that the allowance for loan losses is adequate as of March 31, 2012.  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, continued high unemployment rates, significant changes in the value of collateral and delays in receiving financial information from borrowers could result in increased levels of non-performing assets, charge-offs, loan loss provisions and reduction in income. Additionally, bank regulatory agencies periodically examine the Bank’s allowance for loan losses.  The banking agencies could require the recognition of additions to the allowance for loan losses based upon their judgment of information available to them at the time of their examination.
 
On a monthly basis, problem loans are identified and updated primarily using internally prepared past due reports.  Based on data surrounding the collection process of each identified loan, the loan may be added or deleted from the monthly watch list.  The watch list includes loans graded special mention, substandard, doubtful, and loss, as well as additional loans that management may 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 adequacy of the allowance for loan losses is subject to a formal, quarterly analysis by management of the Company.  In order to better analyze the risks associated with the loan portfolio, the entire portfolio is divided into several categories.  As stated above, loans on non-accrual status are specifically reviewed for impairment and given a specific reserve, if appropriate.  Loans evaluated and not found to be impaired are included with other performing loans, by category, by their respective homogenous pools.  Three year average historical loss factors are calculated for each pool and applied to the performing portion of the loan category. The historical loss factors for both reviewed and homogeneous pools are adjusted based upon the following qualitative factors:
 
·  
Level of and trends in delinquencies, impaired/classified loans
§
   Change in volume and severity of past due loans
§
   Volume of non-accrual loans
§
   Volume and severity of classified, adversely or graded loans
·  
Level of and trends in charge-offs and recoveries
·  
Trends in volume, terms and nature of the loan portfolio
·  
Effects of any changes in risk selection and underwriting standards and any other changes in lending and recovery policies, procedures and practices
·  
Changes in the quality of the Bank’s loan review system
·  
Experience, ability and depth of lending management and other relevant staff
·  
National, state, regional and local economic trends and business conditions
§
   General economic conditions
§
   Unemployment rates
§
   Inflation / CPI
§
   Changes in values of underlying collateral for collateral-dependent loans
·  
Industry conditions including the effects of external factors such as competition, legal, and regulatory requirements on the level of estimated credit losses.
·  
Existence and effect of any credit concentrations, and changes in the level of such concentrations
 
The balance in the allowance for loan losses was $6,545,000 or 1.33% of total loans as of March 31, 2012 as compared to $6,487,000 or 1.33% of loans as of December 31, 2011.  The $58,000 increase is a result of a $105,000 provision for the first three months less net charge-offs of $47,000.  Gross charge-offs for the first three months of 2012 were $59,000. Gross charge-offs for the first three months of 2011 were $93,000 and for all of 2011 were $207,000. 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 the three months ended March 31, 2012 and for the years ended December 31, 2011, 2010, 2009 and 2008:

 
39

 

 
March 31
December 31
 
2012
2011
2010
2009
2008
 
Amount
%
Amount
%
Amount
%
Amount
%
Amount
%
Real estate loans:
                   
  Residential
 $    753
  37.4
 $    805
    37.7
 $    969
    39.1
 $    801
    42.7
 $    694
    46.0
  Commercial, agricultural
    4,336
  38.0
    4,132
    37.9
    3,380
    36.2
    2,864
    33.6
    2,303
    28.8
  Construction
         16
    1.8
         15
      1.7
         22
      2.1
         20
      1.2
           5
      2.6
Consumer
         96
    2.1
       111
      2.2
       108
      2.4
       131
      2.6
       449
      2.7
Commercial and other loans
       671
    9.3
       674
      9.1
       983
    10.0
       918
      9.7
       807
      8.8
State & political subdivision loans
       245
  11.4
       235
    11.4
       137
    10.2
         93
    10.2
         19
    11.1
Unallocated
       428
 N/A
       515
 N/A
       316
 N/A
         61
 N/A
       101
 N/A
Total allowance for loan losses
 $ 6,545
100.0
 $ 6,487
  100.0
 $ 5,915
  100.0
 $ 4,888
  100.0
 $ 4,378
  100.0
 
As a result of previous loss experiences and other the risk factors utilized in determining the allowance, the Bank’s allocation of the allowance does not directly correspond to the actual balances of the loan portfolio. While commercial and agricultural real estate total 38% of the loan portfolio, 66.3% of the allowance is assigned to this segment of the loan portfolio as these loans have more inherent risks than residential real estate or loans to state and political subdivisions.
 
The following table identifies amounts of loans contractually past due 30 to 90 days and non-performing loans by loan category, as well as the change from December 31, 2011 to March 31, 2012 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.

 
March 31, 2012
 
December 31, 2011
   
Non-Performing Loans
   
Non-Performing Loans
 
30 - 90 Days Past Due
90 Days Past  Due Accruing
Non-accrual
Total Non-Performing
 
30 - 90 Days Past Due
90 Days Past Due Accruing
Non-accrual
Total Non-Performing
Real estate:
                 
  Residential
 $      581
 $           160
 $    590
 $          750
 
 $        859
 $             99
 $      554
 $          653
  Commercial
         115
              180
8,194
8,374
 
           731
              176
8,094
8,270
  Agricultural
             -
                   -
            -
                  -
 
           143
                   -
             -
                 -
  Construction
             -
                   -
            -
                  -
 
               -
                   -
             -
                 -
Consumer
          64
                  3
            -
3
 
             93
                   -
             -
                 -
Commercial and other loans
           14
                   -
459
459
 
               8
                   -
517
517
Total nonperforming loans
 $      774
 $           343
 $ 9,243
 $       9,586
 
 $     1,834
 $           275
 $   9,165
 $       9,440
                   
 
 Change in Non-Performing Loans March 31, 2012 /December 31, 2011
             
 
Amount
%
             
Real estate:
                 
  Residential
 $        97
             14.9
             
  Commercial
         104
               1.3
             
  Agricultural
             -
 N/A
             
  Construction
             -
 N/A
             
Consumer
            3
 N/A
             
Commercial and other loans
        (58)
            (11.2)
             
Total nonperforming loans
 $      146
               1.5
             
 

 
 
40

 
 
For the three month period ending March 31, 2012, we recorded a provision for loan losses of $105,000, which compares to $225,000 for the same time period in 2011.  The decrease is attributable to the fact that total non-performing loans have remained consistent from year-end and March 31, 2011. Additionally, based on the rating system described above, there has been an improvement in the quality of the loan portfolio since December 31, 2011 and March 31, 2011. Approximately 83.2% of the Bank’s non-performing loans are associated with the following three customer relationships:

·  
A commercial customer with a total loan relationship of $5.2 million secured by 165 residential properties and one commercial building is considered non-accrual as of March 31, 2012. In the first quarter of 2011, the Company and Borrower entered into a forbearance agreement to restructure the debt. The loan remained current throughout 2011 and 2012. Management continues to monitor the financial condition of this borrower and is awaiting the financial statements and tax returns for 2011 to update the trend analysis for this customer. As a result of the loan being considered non-accrual and payments being made on the loans through March 31, 2012, there is no specific reserve allocation as of March 31, 2012.
·  
A commercial customer with a relationship of approximately $1.8 million is considered non-accrual as of March 31, 2012. $1.5 million of the relationship is subject to USDA guarantees. The current economic conditions related to the timber industry have significantly impacted the cash flows from the customer’s activities. Management reviewed the collateral and guarantees and determined that a specific reserve allocation of $186,000 was required as of March 31, 2012 based on the appraised value of collateral.
·  
A commercial customer with a relationship of approximately $1.0 million is considered non-accrual as of March 31, 2012. The current recessionary economic conditions have significantly impacted the cash flows from the customer’s activities. Management reviewed the collateral and determined that a specific reserve allocation of $259,000 was required as of March 31, 2012 based on the appraised value of collateral. The customer has indicated a willingness to provide additional collateral in order to borrow additional funds to complete the project associated with this loan, which management is currently evaluating.

Management of the Bank believes that the allowance for loan losses is adequate, which is based on the following factors:
 
·  
While non-performing loans are still higher than the Company’s historical levels, 54.5% of this balance is associated with one customer, whose debt is current through April 30, 2012.
 
·  
Net and gross charge-offs continue to be low in relation to the size of the Bank’s loan portfolio and compared to our peer group.
 
·  
We have not experienced 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.  While parts of our market area were impacted by flooding in the third quarter of 2011, a review of the impacted collateral did not identify any widespread decreases in the collateral values. Additionally, our market area is predominately centered in the Marcellus Shale natural gas exploration and drilling area. These natural gas exploration and drilling activities have significantly impacted the overall interest in real estate in our market area due to the related lease and royalty revenues associated with it.  The natural gas activities have had 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 March 31, 2012, the cash surrender value of this life insurance is $13,794,000, which has resulted in income recognized in the three months ended March 31, 2012 of $124,000 compared to $121,000 for the same period in 2011. 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.

 
41

 
 
Premises and Equipment
 
Premises and equipment decreased approximately $120,000 from $11.7 million at December 31, 2011 to $11.6 million at March 31, 2012. This occurred primarily as a result of depreciation for 2012 of $153,000 offset by purchases totaling approximately $33,000.

Deposits
 
The following table shows the composition of deposits as of March 31, 2012 and December 31, 2011 (dollars in thousands):

 
March 31
December 31,
 
2012
2011
 
Amount
%
Amount
%
Non-interest-bearing deposits
 $                89,806
             12.1
 $          85,605
          11.6
NOW accounts
                 199,571
             26.9
           200,897
          27.4
Savings deposits
                   85,256
             11.5
             79,659
          10.8
Money market deposit accounts
                   71,539
               9.6
             67,223
            9.2
Certificates of deposit
                 296,654
             39.9
           300,609
          41.0
Total
 $              742,826
           100.0
 $        733,993
        100.0
 
     
 
March 31,  2012/
 
 December 31, 2011
 
        Change
 
Amount
%
Non-interest-bearing deposits
 $                  4,201
               4.9
NOW accounts
                    (1,326)
             (0.7)
Savings deposits
                     5,597
               7.0
Money market deposit accounts
                     4,316
               6.4
Certificates of deposit
                    (3,955)
             (1.3)
Total
 $                  8,833
               1.2
 
Deposits increased $8.8 million or 1.2%, since December 31, 2011. The increase in deposits is due to several reasons. Our market continues to be impacted by the Marcellus Shale gas exploration activities and we have developed products specifically targeting customers that have benefited from this activity.  Furthermore, our customers appear to be reluctant to invest in other financial markets again due to concerns over the United States’ credit rating (which was downgraded by Standard & Poor’s), the European sovereign debt crisis, and continued high unemployment in the United States, among other economic indicators which have contributed to increased volatility in the capital markets and diminished expectations for the economy. Additionally, the current interest rate environment limits the options in which our customers can invest while maintaining a similar risk profile to depositing funds with the Company. We believe that our historical financial performance, reputation as a strong, local community bank, acquisitions of local competitors from institutions outside of our general market area and our focus on developing relationships with the local municipalities has positioned the Company as a leading financial institution within our service area with the ability to meet our customers’ needs and expectations.

As of March 31, 2012, non-interest-bearing deposits, savings accounts and money market deposit accounts, increased by $4.2 million, $5.6 million and $4.3 million, respectively, from December 31, 2011. Certificates of deposit decreased $4.0 million since December 31, 2011, due to the low rate environment for certificates of deposits and the transfer of customer funds to more liquid interest bearing accounts. The Bank currently does not have any outstanding brokered certificates of deposit.

Borrowed Funds
 
Borrowed funds increased $18.8 million or 35.1% from December 31, 2011. The majority of this increase is the result of $19.3 million of overnight FHLB advances utilized to make the investment purchases discussed above. The Bank’s current strategy for borrowings is to repay the overnight borrowings with funds received from the maturities or calls of various investment securities and for long-term borrowings to consider replacing any maturities with five to ten year borrowings due to the current 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.

 
42

 
 
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.
 
In December, 2008, the Company entered into an interest rate swap agreement to convert the above mentioned floating-rate debt to fixed rate debt on a notional amount of $7.5 million. The interest rate swap instrument involves an agreement to receive a floating rate and pay a fixed rate, at specified intervals, calculated on the agreed-upon notional amount. The differentials paid or received on interest rate swap agreements are recognized as adjustments to interest expense in the period. The interest rate swap agreement was entered into on December 17, 2008 and expires December 17, 2013.  The fair value of the interest rate swap at March 31, 2012 was a liability of $327,000 and is included within other liabilities on the Consolidated Balance Sheet.

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.
 
Total stockholders’ equity was $83.8 million at March 31, 2012 compared to $81.5 million at December 31, 2011, an increase of $2.3 million or 2.8%.  Excluding accumulated other comprehensive income, stockholder’s equity increased $2.6 million, or 3.5%.  In the first three months of 2012, the Company had net income of $3.4 million and paid dividends of $856,000, representing a dividend payout ratio of 24.8%.  The Company purchased 2,230 shares of treasury stock at a weighted average cost of $36.17 per share.
 
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.  Accumulated other comprehensive income decreased $337,000 from December 31, 2011 as a result of market value fluctuations.
 
The Company has also 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):

 
43

 
 

 
March 31
December 31,
 
2012
2011
Total capital (to risk-weighted assets)
Amount
 
Ratio
Amount
 
Ratio
Company
 $              85,017
 
16.25%
 $        82,050
 
16.23%
For capital adequacy purposes
                 41,856
 
8.00%
           40,432
 
8.00%
To be well capitalized
                 52,319
 
10.00%
           50,540
 
10.00%
             
Tier I capital (to risk-weighted assets)
           
Company
 $              78,267
 
14.96%
 $        75,541
 
14.95%
For capital adequacy purposes
                 20,928
 
4.00%
           20,216
 
4.00%
To be well capitalized
                 31,392
 
6.00%
           30,324
 
6.00%
             
Tier I capital (to average assets)
           
Company
 $              78,267
 
9.00%
 $        75,541
 
8.83%
For capital adequacy purposes
                 34,793
 
4.00%
           34,223
 
4.00%
To be well capitalized
                 43,492
 
5.00%
           42,779
 
5.00%
 
The Bank’s computed risk-based capital ratios are as follows (dollars in thousands):

 
March 31
December 31,
 
2012
2011
Total capital (to risk-weighted assets)
Amount
 
Ratio
Amount
 
Ratio
Bank
 $              79,928
 
15.32%
 $        77,051
 
15.29%
For capital adequacy purposes
                 41,748
 
8.00%
           40,326
 
8.00%
To be well capitalized
                 52,185
 
10.00%
           50,408
 
10.00%
             
Tier I capital (to risk-weighted assets)
           
Bank
 $              73,388
 
14.06%
 $        70,729
 
14.03%
For capital adequacy purposes
                 20,874
 
4.00%
           20,163
 
4.00%
To be well capitalized
                 31,311
 
6.00%
           30,245
 
6.00%
             
Tier I capital (to average assets)
           
Bank
 $              73,388
 
8.45%
 $        70,729
 
8.28%
For capital adequacy purposes
                 34,741
 
4.00%
           34,166
 
4.00%
To be well capitalized
                 43,426
 
5.00%
           42,708
 
5.00%

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 March 31, 2012 (in thousands):

Commitments to extend credit
$107,631
Standby letters of credit
3,517
 
$111,148
 
We also offer limited overdraft protection as a non-contractual courtesy which is available to demand deposit accounts in good standing for personal accounts. Effective in the third quarter of 2010, 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 March 31, 2012 was $12,564,000.  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 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.

 
44

 
 
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 the deposits that are primarily core.  Repayment of principal on outstanding loans and cash flows created from the investment portfolio also a factor 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 during the first three months of 2012 were $33,000, compared to $63,000 during the same time period in 2011.
 
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 $225.7 million, of which $55.3 million was outstanding at March 31, 2012. 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 borrower in custody line with the Federal Reserve Bank of approximately $14.2 million, which also is not drawn upon as of March 31, 2012.
 
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.  The Bank may not, under the National Bank Act, declare a dividend without approval of the OCC, 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.  In addition, the Bank can only pay dividends to the extent that its retained net profits (including the portion transferred to surplus) exceed its bad debts.  The Federal Reserve Board, the OCC 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 March 31, 2012, Citizens Financial had liquid assets of $3.9 million.

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 .3% 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).
 
 
 
45

 
 
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.
 
Our Company 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 process that will effectively identify, measure, and monitor our Company's risk exposure.
 
We use numerous interest rate simulations employing a variety of assumptions to evaluate our interest rate risk exposure.  Various analysis performed in the first quarter ranging from a decrease in interest rates of 100 to an increase in interest rates of 500 would have a minor impact on our Company's anticipated net interest income over the next twelve to twenty-four months.

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, 2011.

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 three months ended March 31, 2012 that have materially affected, or are reasonable likely to materially affect, the Company’s internal control over financial reporting.

 
46

 

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, 2011, which could materially affect our business, financial condition or future results. At March 31, 2012, 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.

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)
         
1/1/12 to 1/31/12
                                  -
$0.00
                                           -
                               152,615
2/1/12 to 2/29/12
                          2,230
$36.17
                                   2,230
                               150,385
3/1/12 to 3/31/12
                                -
$0.00
                                         -
                               150,385
Total
                          2,230
$36.17
                                   2,230
                               150,385
 
(1)  
On January 7, 2006, the Company announced that the Board of Directors authorized the Company to repurchase up to 140,000 shares.  The repurchases will be conducted through open-market purchases or privately negotiated transactions and will be made from time to time depending on market conditions and other factors.  No time limit was placed on the duration of the share repurchase program.  Any repurchased shares will be held as treasury stock and will be available for general corporate purposes.
 
(2)  
On 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.

 
47

 
 
Item 4 – Mine Safety Disclosures
 
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
 
Instrument defining the rights of security holders.(3)
 
 
4.2
 
No long term debt instrument issued by the Company exceeds 10% of consolidated assets or is registered.  In accordance with paragraph 4(iii) of Item 601(b) of Regulation S-K, the Company will furnish the Securities and Exchange Commission copies of long-term debt instruments and related agreements upon request.
       
 
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 March 31, 2012, 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.





 
48

 
 
Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the undersigned Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.


 
Citizens Financial Services, Inc.
(Registrant)
 
       
May 10, 2012
By:
/s/ Randall E. Black  
    Randall E. Black  
   
Chief Executive Officer and President
(Principal Executive Officer)
 
       
     
       
May 10, 2012
By:
/s/ Mickey L. Jones  
    Mickey L. Jones  
   
Chief Financial Officer
(Principal Accounting Officer)
 
       

 


 
49