10-K 1 l05566ae10vk.txt CITIZENS & NORTHERN CORPORATION SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K (Mark One) [x] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2003 Commission file number: 0-16084 CITIZENS & NORTHERN CORPORATION (Exact name of Registrant as specified in its charter) PENNSYLVANIA 23-2451943 ------------ ---------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 90-92 MAIN STREET, WELLSBORO, PA 16901 --------------------------------------------------- (Address of principal executive offices) (Zip code) 570-724-3411 ------------ (Registrant's telephone number including area code) Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to section 12(g) of the Act: COMMON STOCK Par Value $1.00 ---------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes [X] No [ ] The aggregate market value of the registrant's common stock held by non-affiliates at March 1, 2004 was $212,705,460. The number of shares of common stock outstanding at March 1, 2004 was 8,118,529. DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant's proxy statement for the annual meeting of its shareholders to be held April 20, 2004 are incorporated by reference into Parts III and IV of this report. 1 PART I ITEM 1. BUSINESS Citizens & Northern Corporation ("Corporation") is a one-bank holding company whose principal subsidiary is Citizens & Northern Bank ("Bank"). The Corporation's principal office is located in Wellsboro, Pennsylvania. The Corporation's other wholly-owned subsidiaries are Citizens & Northern Investment Corporation and Bucktail Life Insurance Company ("Bucktail"). Citizens & Northern Investment Corporation was formed in 1999 to engage in investment activities. Bucktail reinsures credit and mortgage life and accident and health insurance on behalf of the Bank. The Bank is a Pennsylvania banking institution that was formed by the consolidation of Northern National Bank of Wellsboro and Citizens National Bank of Towanda on October 1, 1971. Subsequent mergers included: First National Bank of Ralston in May 1972; Sullivan County National Bank in October 1977; Farmers National Bank of Athens in January 1984; and First National Bank of East Smithfield in May 1990. The Bank has held its current name since May 6, 1975, at which time the Bank changed its charter from a National bank to a Pennsylvania bank. The Bank provides an extensive range of banking services, including deposit and loan products for personal and commercial customers. The Bank also maintains a trust division that provides a wide range of financial services, such as 401(k) Plans, retirement planning, estate planning, estate settlements and asset management. In January 2000, the Bank formed a subsidiary, C&N Financial Services Corporation ("C&NFSC"). C&NFSC is a licensed insurance agency that provides insurance products to individuals and businesses. In 2001, C&NFSC added a broker-dealer division, which offers mutual funds, annuities, educational savings accounts and other investment products through registered agents. C&NFSC's operations are not significant in relation to the total operations of the Bank. All phases of the Bank's business are competitive. The Bank primarily competes in Tioga, Bradford, Sullivan and Lycoming counties. The Bank competes with local commercial banks headquartered in our market area as well as other commercial banks with branches in our market area. Some of the banks that have branches in the Bank's market area are larger in overall size than the Bank. With respect to lending activities and attracting deposits, the Bank also competes with savings banks, savings and loan associations, insurance companies, regulated small loan companies and credit unions. Also, the Bank competes with mutual funds for deposits. The Bank competes with insurance companies, investment counseling firms, mutual funds and other business firms and individuals for trust, investment management, broker dealer and insurance services. The Bank is generally competitive with all 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. The Bank serves a diverse customer base, and is not economically dependent on any small group of customers or on any individual industry. Although there have been no mergers or acquisitions within the last 5 years, the Bank has engaged in several ventures designed to improve customer service and generate financial growth. These ventures included the following major initiatives: - expanded trust and financial services capabilities, including investment management, employee benefits and insurance services; - established internet banking services in 1999; - constructed and opened a branch in Muncy, PA in 2000; and - purchased a former bank operations center in Williamsport, PA, in 2003, and began renovations with the intention of offering trust and financial management, commercial lending, branch banking and other services, starting in 2004. Another significant initiative that began in 2003 is evaluation of software systems to replace the core banking software system. For many years, the Bank has utilized a system that was written and updated on an ongoing basis by "in house" programmers. The company that provided the hardware platform that supports the in house software program announced that it would no longer support that platform, effective at the end of 2006. After considering various alternatives, management determined the most appropriate solution was to evaluate programs available from third party companies. Management's goal in this process is for the Bank's employees and customers to reap the benefits of new features and enhancements that will be available on a newer system, while retaining sufficient flexibility and control over programming changes that may be required or desired. Management expects to make a decision on a new core system, and for the conversion to occur, in 2004; however, no contractual commitment to purchase software has been made. 2 At December 31, 2003, the Bank had total assets of $1,038,575,000, total deposits of $658,589,000 and net loans outstanding of $518,800,000. At December 31, 2003, the Bank had a total of 293 full-time equivalent employees. Most of the activities of the Corporation and its subsidiaries are regulated by federal or state agencies. The primary regulatory relationships are described as follows: - The Corporation is a one-bank holding company formed under the provisions of Section 3 of the Federal Reserve Act. The Corporation is under the direct supervision of the Federal Reserve and must comply with the reporting requirements of the Federal Bank Holding Company Act. - The Bank is a state-chartered, nonmember bank, supervised by the Federal Deposit Insurance Corporation and the Pennsylvania Department of Banking. - C&NFSC is a Pennsylvania corporation. The Pennsylvania Department of Insurance regulates C&NFSC's insurance activities. Brokerage products are offered through a third party networking agreement between the Bank and UVEST Financial Services, Inc. - Bucktail is incorporated in the state of Arizona and supervised by the Arizona Department of Insurance. A copy of the Corporation's annual report on Form 10-K, quarterly reports on Form 10-Q, current events reports on Form 8-K, and amendments to these reports, will be furnished without charge upon written request to the Corporation's Treasurer at P.O. Box 58, Wellsboro, PA 16901. Copies of these reports will be furnished as soon as reasonably possible, after they are filed electronically with the Securities and Exchange Commission. The information is also available through the Corporation's web site at www.cnbankpa.com. ITEM 2. PROPERTIES The Bank owns each of its properties, except for the facility located at 68 Main Street, Wellsboro, which is leased. All of the properties are in good condition. In 2001, the Bank entered into a lease of the property at 68 Main Street, Wellsboro. This facility is used for C&NFSC's operations and for training. As described in Item 1, the Williamsport location is expected to open in 2004. None of the owned properties are subject to encumbrance. A listing of properties is as follows: Main administrative office: 90-92 Main Street Wellsboro, PA 16901 Branch offices: 428 S. Main Street Main Street 41 Main Street Athens, PA 18810 Liberty, PA 16930 Tioga, PA 16946 111 Main Street 1085 S. Main Street 428 Main Street Dushore, PA 18614 Mansfield, PA 16933 Towanda, PA 18848 Main Street Route 220 Courthouse Square East Smithfield, PA 18817 Monroeton, PA 18832 Troy, PA 16947 104 Main Street 3461 Route 405 Highway 90-92 Main Street Elkland, PA 16920 Muncy, PA 17756 Wellsboro, PA 16901 102 E. Main Street Thompson Street 130 Court Street Knoxville, PA 16928 Ralston, PA 17763 Williamsport, PA 17701 Main Street 503 N. Elmira Street Route 6 Laporte, PA 18626 Sayre, PA 18840 Wysox, PA 18854 3 Other offices: Bankcard Services Facilities Management RR7 Box 503 One Brewery Lane Wellsboro, PA 16901 Wellsboro, PA 16901 C&N Financial Services Corp. Audit and Compliance 68 Main Street Water Street Wellsboro, PA 16901 Wellsboro, PA 16901 ITEM 3. LEGAL PROCEEDINGS The Corporation and the Bank are involved in various legal proceedings incidental to their business. Management believes the aggregate liability, if any, resulting from such pending and threatened legal proceedings will not have a material, adverse effect on the Corporation's financial condition or results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of 2003, no matters were submitted to a vote of security holders, through the solicitation of proxies or otherwise. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS QUARTERLY SHARE DATA Trades of the Corporation's stock are executed through various brokers who maintain a market in the Corporation's stock. Information regarding sales prices of the Corporation's stock is available through the OTC Bulletin Board (www.otcbb.com). The Corporation's stock is not listed or traded on Nasdaq or a national securities exchange. As of March 1, 2004, there were 2,432 shareholders of record of the Corporation's common stock. The following table sets forth the approximate high and low sales prices of the common stock during 2003 and 2002. Amounts for 2002 and the first quarter 2003 have been retroactively adjusted for the effects of a 3-for-2 stock split issued in April 2003.
2003 2002 Dividend Dividend Declared Declared per per High Low Quarter High Low Quarter ------------------------------------------------------------------------------------ First quarter $ 21.63 $ 20.37 $ 0.21 $ 19.00 $ 16.33 $ 0.1867 Second quarter 26.95 21.00 0.21 20.00 18.43 0.1867 Third quarter 26.95 25.80 0.21 21.67 19.53 0.2000 Fourth quarter 27.00 25.80 0.22 22.00 20.10 0.2000 plus 1% plus 1% stock dividend stock dividend
Known "market makers" who handle Citizens & Northern Corporation stock transactions are: Boenning & Scattergood, Inc. Monroe Securities, Inc. RBC Dain Rauscher 4 Tower Bridge, Suite 300 343 West Erie 1211 Avenue of the Americas 200 Barr Harbor Drive Suite 410 New York, NY 10036 West Conshohocken, PA 19428 Chicago, IL 60610 Ferris, Baker, Watts, Inc. Knight Equity Markets, LP Ryan Beck & Co. 250 West Pratt Street 525 Washington Blvd Livingston, NJ 07039 Baltimore, MD 21201 29th Floor 220 South Orange Avenue Jersey City, NJ 07310
4 Hill Thompson Magid & Co., Inc. Pershing Trading Company, LP Sandler, O'Neill & Partners, LP 15 Exchange Place 1 Pershing Plaza 919 Third Avenue Eighth Floor Jersey City, NJ 07399 Sixth Floor Jersey City, NJ 07302 New York, NY 10022 Janney Montgomery Scott, LLC EE Powell & Company, Inc. Schwab Capital Markets, LP 1801 Market Street 1100 Gulf Tower 111 Pavonia Avenue Philadelphia, PA 19103 Pittsburgh, PA 15219 Jersey City, NJ 07310
INVESTOR INFORMATION ANNUAL MEETING OF SHAREHOLDERS STOCK TRANSFER AGENT INDEPENDENT AUDITORS The Annual Meeting of Shareholders AMERICAN STOCK TRANSFER & will be held at the Arcadia Theatre in TRUST CO. PARENTE RANDOLPH, PC Wellsboro, PA, at 2:00 p.m. on Tuesday, 59 Maiden Lane, Plaza Level 400 Market Street April 20, 2004. New York, NY 10038 Williamsport, PA 17701 (800) 278-4353
GENERAL SHAREHOLDER INQUIRIES SHOULD BE SENT TO: CITIZENS & NORTHERN CORPORATION 90-92 Main Street, P.O. Box 58 Wellsboro, PA 16901 EQUITY COMPENSATION PLAN INFORMATION The following table sets forth information concerning the Stock Incentive Plan and Independent Directors Stock Incentive Plan, both of which have been approved by the Corporation's shareholders. The figures shown in the table below are as of December 31, 2003.
NUMBER OF NUMBER OF WEIGHTED- SECURITIES SECURITIES TO BE AVERAGE REMAINING ISSUED UPON EXERCISE FOR FUTURE EXERCISE OF PRICE OF ISSUANCE UNDER OUTSTANDING OUTSTANDING EQUITY COMPEN- OPTIONS OPTIONS SATION PLANS ---------------- ----------- -------------- EQUITY COMPENSATION PLANS APPROVED BY SHAREHOLDERS 213,058 $ 18.81 229,026 EQUITY COMPENSATION PLANS NOT APPROVED BY SHAREHOLDERS 0 N/A 0
Effective January 2, 2004, the Corporation granted options to purchase a total of 33,249 shares of common stock through the Stock Incentive and Independent Directors Stock Incentive Plans. The exercise price for these options is $26.59 per share, which was the market price at the date of grant. Also, effective January 2, 2004, the Corporation awarded a total of 3,714 shares of restricted stock under the Stock Incentive and Independent Directors Stock Incentive Plans. The stock options and restricted stock awards that were awarded in January 2004 are not included in the tables above. More details related to the Corporation's equity compensation plans are provided in Notes 1 and 12 to the consolidated financial statements. 5 ITEM 6. SELECTED FINANCIAL DATA
INCOME STATEMENT (IN THOUSANDS) 2003 2002 2001 2000 1999 Interest income $ 55,223 $ 57,285 $ 54,661 $ 51,643 $ 48,036 Interest expense 23,537 26,315 28,356 30,145 24,571 ----------- ----------- ----------- ----------- ----------- Interest margin 31,686 30,970 26,305 21,498 23,465 Provision for loan losses 1,100 940 600 676 760 ----------- ----------- ----------- ----------- ----------- Interest margin after provision for loan losses 30,586 30,030 25,705 20,822 22,705 Other income 6,595 6,624 6,120 5,002 6,823 Securities gains 4,799 2,888 1,920 1,377 3,043 Other expenses 22,114 20,849 18,671 16,906 17,732 ----------- ----------- ----------- ----------- ----------- Income before income tax provision 19,866 18,693 15,074 10,295 14,839 Income tax provision 3,609 3,734 3,022 1,819 3,354 ----------- ----------- ----------- ----------- ----------- Net income $ 16,257 $ 14,959 $ 12,052 $ 8,476 $ 11,485 =========== =========== =========== =========== =========== BALANCE SHEET AT YEAR END (IN THOUSANDS) Total securities (1) $ 484,825 $ 513,597 $ 437,398 $ 343,596 $ 356,287 Gross loans, excluding unearned discount 524,897 451,145 379,228 328,305 310,892 Total assets 1,066,901 1,018,768 866,999 719,335 705,898 Total deposits 658,065 640,304 576,274 528,967 500,474 Stockholders' equity, excluding accumulated other comprehensive income 113,306 103,691 94,903 88,887 85,507 Total stockholders' equity 125,343 115,837 100,187 88,969 76,623 AVERAGE BALANCE SHEET (IN THOUSANDS) Total securities, at amortized cost (1) 474,406 470,764 412,654 371,360 349,133 Gross loans, excluding unearned discount 485,150 410,670 346,353 318,382 301,584 Earning assets 959,556 881,434 759,007 689,743 650,717 Total assets 1,034,720 943,001 805,229 704,221 680,864 Total assets, excluding unrealized gains/ losses (4) 1,014,424 930,539 798,590 717,052 672,999 Total deposits 651,026 613,392 544,579 503,848 483,858 Stockholders' equity, excluding accumulated other comprehensive income (4) 108,876 99,361 91,703 87,258 81,767 Stockholders' equity 122,271 107,595 96,021 78,792 87,143 COMMON STOCK AND PER SHARE DATA Net income per share - basic $ 2.01 $ 1.85 $ 1.49 $ 1.04 $ 1.41 Net income per share - diluted 2.00 1.84 1.49 1.04 1.41 Cash dividends declared per share (2) 0.85 0.77 0.71 0.65 0.60 Stock dividend 1% 1% 1% 1% 1% Stockholders' equity per share (2) 15.48 14.32 12.38 10.95 9.43 Stockholders' equity per share, excluding accumulated other comprehensive income (loss) (2) 14.00 12.82 11.73 10.94 10.52 Weighted average shares outstanding - basic 8,089,753 8,089,266 8,103,679 8,125,296 8,124,734 Weighted average shares outstanding - diluted 8,138,468 8,111,154 8,105,935 8,127,044 8,133,012 Number of shares outstanding at year-end 8,014,625 5,285,606 5,234,800 5,207,244 5,153,729 Number of shares authorized 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000
6
FINANCIAL RATIOS 2003 2002 2001 2000 1999 Return on stockholders' equity, excluding accumulated other comprehensive income (3), (4) 14.93% 15.06% 13.14% 9.71% 14.05% Return on stockholders' equity (3) 13.30% 13.90% 12.55% 10.76% 13.18% Return on assets (3) 1.57% 1.59% 1.50% 1.20% 1.69% Stockholders' equity to assets, excluding accumulated other comprehensive income (3), (4) 10.73% 10.68% 11.48% 12.17% 12.15% Stockholders' equity to assets (3) 11.82% 11.41% 11.92% 11.19% 12.80% Stockholders' equity to loans (3) 25.20% 26.20% 27.72% 24.75% 28.90% Net income to: Total interest income 29.44% 26.11% 22.05% 16.41% 23.91% Interest margin 51.31% 48.30% 45.82% 39.43% 48.95% Dividends as a % of net income 41.96% 41.17% 46.08% 60.19% 40.39%
(1) Includes available-for-sale and held-to-maturity securities, and interest-bearing cash and due from banks. (2) For purposes of this computation, the number of outstanding shares has been increased for the effects of a 3-for-2 stock split issued in April 2003 and for 1% stock dividends issued in January following each year-end. (3) Ratios calculated using average balance sheet data. (4) Generally accepted accounting principles ("GAAP") require that available-for-sale securities be reported at fair value, with unrealized gains and losses excluded from earnings and reported separately through stockholders' equity, net of tax. Management believes there is an inherent mismatch between the income statement and balance sheet related to unrealized gains/losses that may create a material inconsistency in earnings-based ratios. Further, the amount of unrealized gains/losses may vary widely from period-to-period, depending on the financial markets as a whole and interest rate movements. Therefore, management has provided these "non-GAAP" amounts and ratios because we believe they provide meaningful information for evaluating the Corporation's financial position and results of operations. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain statements in this section and elsewhere in this Annual Report on Form 10-K are forward-looking statements. Citizens & Northern Corporation and its wholly-owned subsidiaries (collectively, the Corporation) intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995. Forward-looking statements, which are not historical facts, are based on certain assumptions and describe future plans, business objectives and expectations, and are generally identifiable by the use of words such as, "believe", "expect", "intend", "anticipate", "estimate", "project", and similar expressions. These forward-looking statements are subject to risks and uncertainties that are difficult to predict, may be beyond management's control and could cause results to differ materially from those currently anticipated. Factors which could have a material, adverse impact on the operations and future prospects of the Corporation include, but are not limited to, the following: - changes in monetary and fiscal policies of the Federal Reserve Board and the U.S. Government, particularly related to changes in interest rates - changes in general economic conditions - legislative or regulatory changes - downturn in demand for loan, deposit and other financial services in the Corporation's market area - increased competition from other banks and non-bank providers of financial services - technological changes and increased technology-related costs - changes in accounting principles, or the application of generally accepted accounting principles. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. EARNINGS OVERVIEW The Corporation posted its third consecutive year of record-high net income in 2003, at $16,257,000, or $2.01 per share - basic and $2.00 per share - diluted. Net income for 2003 was $1,298,000, or 8.7%, higher than the $14,959,000 ($1.85 per share - basic and $1.84 per share - diluted) recorded in 2002. In comparing earnings for 2003 with 2002's results, it is important to note the higher level of realized securities gains generated in 2003, as described below. Assuming an income tax rate of 34%, the higher securities gains in 2003 increased net income for 2003 by $1,261,000 over 2002. Excluding the effects of higher securities gains, net income for 2003 was approximately even with the amount recorded in 2002. In 2001, net income totaled $12,052,000 ($1.49 per share - basic and diluted). 7 The most significant income statement changes are as follows: 2003 VS. 2002 - The interest margin increased $716,000, or 2.3%, to $31,686,000 in 2003 from $30,970,000 in 2002. In 2003, interest rates were at very low levels by historical standards. In that rate environment, on average, interest earning assets repriced faster than interest-bearing liabilities, which had the effect of driving down the Corporation's net interest margin. However, substantial growth in loans generated higher interest income, which more than offset the effects of lower rates on the net interest margin. As you can calculate from the table of "Selected Financial Data " (Item 6), gross loans increased 16.3% as of December 31, 2003, as compared to the balance one year earlier. In fact, 2003 was the Corporation's third consecutive year with an increase in gross loans of more than 15%, when comparing the amount outstanding at year-end to the corresponding balance as of the prior year-end. The "Net Interest Margin" section of Management's Discussion and Analysis provides a more detailed discussion of factors that affected interest income and interest expense. - Realized securities gains, net of realized losses, increased $1,911,000, to $4,799,000 in 2003 from $2,888,000 in 2002. In both 2003 and 2002, the Corporation sold selected bank stocks that management believed to be fully valued, generating substantial realized gains. Net gains from sales of equity securities, which consisted primarily of bank stocks, amounted to $3,384,000 in 2003 and $2,090,000 in 2002. Net gains from sales and calls of debt securities amounted to $1,415,000 in 2003 and $798,000 in 2002. - Other (noninterest) operating expenses increased $1,265,000, or 6.1%, in 2003 over 2002. This increase includes higher employee benefits and payroll costs. As described in more detail in the "Noninterest expense" section of Management's Discussion and Analysis, these cost increases reflect a higher number of employees, as well as increases in expense related to the defined benefit pension and employee health insurance plans. - Although pre-tax income was higher in 2003 than in 2002, the income tax provision decreased to $3,609,000 in 2003 from $3,734,000 in 2002. The income tax provision, as a percentage of pre-tax income, was 18.17% in 2003, down from 19.98% in 2002. This lower effective tax rate reflects management's decision to increase the weighting of tax-exempt investment securities as a percentage of total assets. Note 13 to the Consolidated Financial Statements presents more detail concerning the Corporation's accounting for income taxes. 2002 VS. 2001 - The interest margin increased to $30,970,000 in 2002 from $26,305,000 in 2001, an increase of $4,665,000 or 17.7%. As discussed in more detail in the "Net Interest Margin" section of Management's Discussion and Analysis, the Corporation achieved significant growth in loans and deposits in 2002. Also, management identified opportunities to borrow funds and invest the proceeds in securities at positive spreads. Changes in interest rates also had a significant, positive impact on operating results in 2002, as interest rates continued their fall to levels at or near historical record lows, resulting in a lower cost of funds for the Corporation. - Other (noninterest) income (excluding securities gains) was $6,624,000 in 2002, an increase of $504,000 (8.2%) over 2001. As described in more detail later in Management's Discussion and Analysis, the major sources of increased noninterest revenue in 2002 were from Service Charges on Deposit Accounts and Trust and Financial Management services. - Net realized securities gains amounted to $2,888,000 in 2002, up from $1,920,000 in 2001. As in 2003, most of the gains realized in 2002 were from sales of bank stocks. - Other (noninterest) operating expenses increased $2,178,000, or 11.7%, in 2002 over 2001. Higher operating expenses resulted from increases in payroll costs, professional fees, depreciation and maintenance expense associated with computer hardware and software. These types of costs have increased as a result of the need to add personnel and supplement existing systems to keep up with expansions of services and growth in lending activity over the last few years. - The income tax provision increased to $3,734,000 in 2002 from $3,022,000 in 2001, primarily because pre-tax income was higher. The income tax provision, as a percentage of pre-tax income, was 19.98% in 2002 and 20.05% in 2001. 8 OUTLOOK FOR 2004 Overall, management expects financial results for 2004 to be relatively comparable to 2003. Continued growth in loans is expected, although perhaps at a slightly slower pace than the 15% or greater growth levels of the past three years. The ongoing national economic recovery may be an indicator that interest rates will increase in 2004. Historically, interest rates have usually not risen in presidential election years; however, it remains to be seen whether that will hold true in 2004. Overall, in planning the budget for 2004, management assumed a slightly rising rate environment, beginning mid-year. The impact of such a rising rate scenario would be a slight "squeeze" on the net interest margin, as (on average) deposits and borrowings would be expected to reprice slightly faster than loans and debt securities. Another major variable that affects the Corporation's earnings is securities gains and losses. Management's decisions regarding sales of securities are based on a variety of factors, with the overall goal of maximizing portfolio return over a long-term horizon. Management may sell some bank stocks in 2004, as many of the Corporation's holdings are priced fairly high in comparison to historical "P/E" standards. However, it is difficult to predict, with much precision, the amount of net securities gains and losses that will be realized in 2004. Total capital purchases for 2004 are estimated to range from $5 million to $8 million. In addition to several other substantial projects, this amount includes estimated costs related to two very significant initiatives that are currently underway: (1) renovation of the Corporation's eighteenth branch, on Market Street in downtown Williamsport, and (2) evaluation of alternatives to replace the core banking software system. The Williamsport office is expected to open in 2004, with Trust and Financial Management, Commercial Lending, Branch Banking and other services to be provided from that location. At this time, management is evaluating alternatives for replacement of the core banking system, with a decision and conversion expected to occur in 2004; however, no contractual commitment to purchase software has been made. Although the amount of capital spending expected for 2004 is high by the Corporation's normal standards, it is not expected to have a material, adverse impact on the Corporation's financial position or results of operations in 2004. CRITICAL ACCOUNTING POLICIES The presentation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect many of the reported amounts and disclosures. Actual results could differ from these estimates. A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses. Management believes that the allowance for loan losses is adequate and reasonable. The Corporation's methodology for determining the allowance for loan losses is described in a separate section later in Management's Discussion and Analysis. Given the very subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make materially different assumptions, and could, therefore calculate a materially different allowance value. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation's allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination. In 2003, the American Institute of Certified Public Accountants (AICPA) issued an exposure draft of a statement of position that provided detailed implementation guidance for calculating the allowance for loan losses. Implementation of that detailed implementation guidance, if it had been approved, could have resulted in an adjustment to the Corporation's allowance in 2004. However, in January 2004, the AICPA decided to abandon issuance of the statement of position in that form, and decided to move forward with development of a statement of position that would require only additional disclosures about the allowance. The AICPA has not yet issued public comment about a time frame for issuing a new statement of position related to allowance for loan losses disclosures. Another material estimate is the calculation of fair values of the Corporation's debt securities. The Corporation receives estimated fair values of debt securities from an independent valuation service, or from brokers. In developing these fair values, the valuation service and the brokers use estimates of cash flows, based on historical performance of similar instruments in similar interest rate environments. Based on experience, management is aware that estimated fair values of debt securities tend to vary among brokers and other valuation services. Accordingly, when selling debt securities, management typically obtains price quotes from more than one source. As described in Notes 1 and 11 of the consolidated financial statements, the large majority of the Corporation's securities are classified as available-for-sale. Accordingly, these securities are carried at fair value on the consolidated balance sheet, with unrealized gains and losses excluded from earnings and reported separately through accumulated other comprehensive income (included in stockholders' equity). 9 NET INTEREST MARGIN 2003/2002/2001 The Corporation's primary source of operating income is represented by the net interest margin. The net interest margin is equal to the difference between the amounts of interest income and interest expense. Tables I, II and III include information regarding the Corporation's net interest margin in 2003, 2002 and 2001. In each of these tables, the amounts of interest income earned on tax-exempt securities and loans have been adjusted to a fully taxable-equivalent basis. Accordingly, the net interest margin amounts presented in these tables exceed the amounts presented in the consolidated financial statements. The discussion that follows is based on amounts in the Tables. The 2001-2003 time period was one of declining interest rates (dramatically in 2001, then more slowly in 2002 and 2003). Over the course of this time period, the Corporation's cost of funds has declined to a historically low level. Another product of this low rate environment has been the "refinancing boom," with consumers and businesses refinancing their mortgages and other loans to lower rates, and in many instances, borrowing more money than ever before. Lower interest rates had the effect of driving down the Corporation's rate of return on earning assets over the course of this time period, particularly from mid-2002 through the end of the third quarter 2003. In 2001 and 2002, the overall impact of lower rates was a benefit to the Corporation's "Interest Rate Spread" (excess of average rate of return on interest-earning assets over average cost of funds on interest-bearing liabilities). By 2003, interest rates on deposits had fallen to such a low level that there was little room for further decline, and the overall result of lower market rates was a slight decrease in the Corporation's Interest Rate Spread. As shown in Table II, the Interest Rate Spread was 3.31% in 2003, 3.38% in 2002 and 3.17% in 2001. Though not shown in the Tables, the Interest Rate Spread was 2.53% in 2000. The net interest margin, on a taxable-equivalent basis, was $35,482,000 in 2003, an increase of $1,519,000 or 4.5% over 2002. As reflected in Table III, the increase in net interest margin was caused by the growth in volume. Increased interest income from higher volumes of earning assets exceeded increases in interest expense attributable to higher volumes of interest-bearing liabilities by $4,129,000 in 2003 compared to 2002. Table III also shows that interest rate changes had the effect of decreasing net interest income $2,610,000 in 2003 compared to 2002. In 2002, the net interest margin of $33,963,000 was $5,413,000, or 19.0%, higher than the net interest margin in 2001. In 2002, the increase in net interest margin resulted mainly from increases in volume of earning assets, and from declining interest rates on the Corporation's deposits and borrowed funds. Table III shows that changes in volume of earning assets and interest-bearing liabilities resulted in an increase in net interest income of $4,264,000 in 2002, while changes in rates increased net interest income $1,149,000. Interest rate risk is always present in the banking industry. At this time of very low interest rates, the risk exists that, should rates rise significantly and rapidly, the Corporation would experience an increase in cost of funds, while long-term earning assets, such as fixed rate loans and investment securities, would continue to generate income at their current (low) rates. Management has taken actions to try to mitigate some of the risk associated with rising interest rates, without unduly sacrificing current earnings. Among the actions taken, management has attempted to "shorten" the average term to repricing of the mortgage-backed securities portion of the securities portfolio, and has attempted to "lengthen" the average term to repricing of borrowed funds. More information concerning the Corporation's interest rate risk position and monitoring procedures is provided in the "Interest Rate Risk" portion of Item 7A. INTEREST INCOME AND EARNING ASSETS The Corporation's major categories of interest-bearing assets are available-for-sale investment securities and loans. As shown in Table I, total interest income decreased to $59,019,000 in 2003 from $60,278,000 in 2002, a decline of 2.1%. Declining interest rates caused a decrease in interest and dividends from available-for-sale securities of $3,073,000, or 10.7%, despite a small increase in average balance for the year. Interest and fees on loans, on the other hand, increased $1,880,000, or 6.0%, in 2003 over 2002, as the positive earnings effect of higher average balances more than offset the dampening effect of a lower average rate of return. Total interest income increased $3,372,000, or 5.9%, in 2002 over 2001. Interest and dividends from available-for-sale securities increased $1,758,000, or 6.5%, and interest and fees from loans increased $1,864,000, or 6.3%. Higher average balances of available-for-sale securities and loans in 2002 than in 2001 resulted in increases in interest income in 2002, despite lower average rates of return. 10 Throughout virtually all of 2001-2003, there was a "steep yield curve" (longer-term interest rates much higher than shorter-term rates). Several times in 2001 and 2002, management took advantage of the steep yield curve by borrowing funds and investing the proceeds in securities at a positive spread. This is reflected in Table II, which shows an increase in the average balance of the available-for-sale investment portfolio (at amortized cost) to $465,650,000 in 2002 from $395,908,000 in 2001. Although the steep yield curve was still present in 2003, management elected not to pursue opportunities for leveraged securities purchases to as great an extent as in the previous 2 years. In fact, the available-for-sale securities portfolio gradually shrunk over the course of 2003, with the proceeds used to help fund the very substantial growth in loans. Overall, the average balance of available-for-sale securities increased slightly in 2003, to $471,453,000. As can be expected in a declining rate environment, the average rate of return on available-for-sale securities portfolio declined, to 5.43% in 2003 from 6.16% in 2002 and 6.80% in 2001. Table II also shows the composition of the available-for-sale securities portfolio, based on average balances. The most striking change over the 2001-2003 time period is the increased weighting in municipal bonds. In 2003, the average balance of municipal bonds was $146,371,000, or 31% of the total portfolio, up from 24% in 2002 and 20% in 2001. On a taxable equivalent basis, municipal bonds are the highest yielding category of available-for-sale security. The Corporation determines the levels of its municipal bond holdings based on income tax planning and other considerations. The Corporation's other major categories of available-for-sale securities are mortgage-backed securities, U.S. Government agency bonds, equity securities and other securities. Throughout much of 2001-2003, the Corporation experienced very rapid repayment of mortgage-backed securities. New mortgage-backed purchases in 2002 and 2003 consisted almost exclusively of "Hybrid ARMs," which are mortgage-backed securities issued by U.S. Government agencies. Hybrid ARMs have a fixed rate for some period of time (fixed rates on the Corporation's holdings range from 3-10 years), then reprice once a year thereafter, based on changes in a market rate (index), subject to annual and lifetime caps. Looking ahead to the possibility of a rising interest rate environment, Hybrid ARMs would typically provide a shorter average life, and faster principal repayments, than longer-term, fixed rate mortgage-backed securities. Equity securities consist mainly of bank stocks, and are discussed in more detail in the "Equity Securities" section of Item 7A. Other securities consist of corporate obligations, mainly "Trust Preferred Securities" issued by financial institutions. Trust Preferred Securities are long-term obligations (usually 20-40 year maturities, often callable at the issuer's option after 5-10 years) that bear interest at fixed or variable rates. In 2003, the average balance of loans outstanding "passed" the average balance of available-for-sale securities, and became the largest component of the earning asset base. Average loans outstanding increased $74,480,000, or 18.1%, in 2003, and $64,317,000, or 18.6%, in 2002. Much of the growth in the loan portfolio in 2003 and 2002 has been in real estate secured loans, including commercial as well as residential real estate loans. Lower market interest rates, which have spurred significant levels of refinancing, have resulted in many individuals' and businesses' willingness to take on more debt. Also, the Corporation's loan growth is attributable to the opening of the Muncy office in October 2000, along with the hiring of several additional lending personnel. Traditionally, because the Corporation's market area consists mainly of small rural communities, one-to-four family mortgage loans and other consumer loans have made up most of the loan portfolio. The mix between consumer and commercial loans has changed just slightly in recent years to a larger concentration in commercial loans. Based on an internal report from the Bank's loan system, total commercial loans outstanding, plus commitments, made up 43% of total loans and commitments as of December 31, 2003, up from 41% as of December 31, 2002 and 39% as of the end of 2001. In addition to its other consumer and commercial loan portfolios, the Corporation has a credit card operation, which is operated for the Corporation's customers and for other banks. The average return on the total loan portfolio for 2003 was 6.88%, down from 7.67% in 2002 and 8.56% in 2001. The lower returns in 2003 and 2002 resulted mainly from significant levels of mortgage refinancings, and by lower returns on commercial loans with variable or adjustable rates. INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES Interest expense fell to $23,537,000 in 2003 from $26,315,000 in 2002 and $28,356,000 in 2001. As reflected in Table III, lower average rates had the effect of lowering interest expense $5,069,000 in 2003 and $7,184,000 in 2002. The impact of lower rates more than offset the effects on interest expense of higher average balances of interest-bearing liabilities. As shown in Table II, the average balance of total interest-bearing liabilities increased 9.1%, to $829,889,000 in 2003, and 18.1%, to $760,738,000 in 2002. 11 As reflected in Table III, interest expense from certificates of deposit (CDs) decreased $1,793,000 in 2003 and $1,532,000 in 2002. Most of the lower interest expense from CDs in 2003 was rate-related. However, the average balance also fell slightly, to $190,019,000 in 2003 from $195,099,000 in 2002. The lower average balance of CDs in 2003 was impacted by a few large withdrawals by not-for-profit and governmental entities for building projects. Although less quantifiable, management believes the lower average balance of CDs in 2003 may have resulted, in part, from individuals' willingness to invest funds in the improving U.S. stock market. The trend of decreasing CD balances may continue in 2004, depending on investors' perceptions of the attractiveness of alternative investment options. In 2002, the decrease in interest expense on CDs was rate-related, as the average balance of CDs increased 15.3%. The average rate incurred on CDs was 3.14% in 2003, 3.97% in 2002 and 5.48% in 2001. Table III shows that interest expense from money market accounts decreased $1,258,000 in 2003, and $1,392,000 in 2002. Money market accounts are repriced weekly, and thus are highly rate sensitive. As shown in Table II, the average cost of money market funds was 1.43% in 2003, 2.31% in 2002 and 3.49% in 2001. Table II shows that the average balance of money market deposits increased 10.7%, to $190,161,000 in 2003, and 11.7%, to $171,767,000, in 2002. In contrast to the other major types of deposits, interest expense from Individual Retirement Accounts (IRAs) increased $654,000 in 2003 and $455,000 in 2002. As shown in Table II, the average balance of IRAs increased 16.9%, to $106,216,000 in 2003, and 14.3%, to $90,856,000 in 2002. Throughout 2003 and 2002, the Corporation offered the highest IRA rate in its marketplace, which was instrumental in this growth. For several years, the Corporation's IRA product was adjustable rate, repriced quarterly based on an index, with a floor of 5%. Effective September 1, 2002, the Corporation made changes to its IRA products, including: (1) for new IRAs, reduced the floor to 3%, and removed the tie to an external index, on the quarterly repricing IRA product, and (2) began to offer the Index Powered CD as an additional IRA product. (Index Powered CDs are described in detail in Note 10 to the consolidated financial statements.) Many of the 5% IRAs will reprice in April 2004. Management will consider the current state of markets rates, as well as competitors' pricing, in determining the new IRA rate at that time. The average rate incurred on IRAs was 4.88% in 2003, 4.98% in 2002 and 5.12% in 2001. Interest expense on borrowed funds is presented in Table I in 2 categories - "Overnight borrowings" and "Other borrowed funds." Overnight borrowings include federal funds purchased from other banks and overnight repurchase agreements with FHLB - Pittsburgh. Other borrowed funds include overnight repurchase agreements with customers (the Corporation's "RepoSweep" accounts), borrowings from FHLB - Pittsburgh and other repurchase agreements. Interest expense on average other borrowed funds decreased $171,000 in 2003, after increasing $1,278,000 in 2002. Average other borrowed funds balances increased to $242,358,000 in 2003 from $211,092,000 in 2002 and $151,615,000 in 2001. In 2003, new borrowings were required to help fund growth in loans and to sustain management's desired level of available-for-sale securities. As discussed in the "Interest Income - Earning Assets" section above, the Corporation borrowed funds in 2002, mainly to fund purchases of available-for-sale securities. Because of a favorable interest rate environment, throughout 2003 and 2002 the Corporation extended the terms of many its borrowings to establish a "ladder" of staggered maturities extending out (primarily) over 5 years. Note 9 to the consolidated financial statements presents more details regarding the composition of borrowed funds as of December 31, 2003 and 2002. Average interest rates on other borrowed funds fell to 3.67% in 2003, from 4.29% in 2002 and 5.13% in 2001. 12 TABLE I - ANALYSIS OF INTEREST INCOME AND EXPENSE
YEARS ENDED DECEMBER 31, INCREASE(DECREASE) (IN THOUSANDS) 2003 2002 2001 03/02 02/01 INTEREST INCOME Available-for-sale securities: U.S. Treasury securities $ - $ 75 $ 151 $ (75) $ (76) Securities of other U.S. Government agencies and corporations 3,174 4,728 7,718 (1,554) (2,990) Mortgage-backed securities 7,427 11,097 9,487 (3,670) 1,610 Obligations of states and political subdivisions 10,768 8,641 6,216 2,127 2,425 Equity securities 1,168 1,148 1,090 20 58 Other securities 3,054 2,975 2,244 79 731 ------- ------- ------- ------- ------- Total available-for-sale securities 25,591 28,664 26,906 (3,073) 1,758 ------- ------- ------- ------- ------- Held-to-maturity securities: U.S. Treasury securities 17 27 40 (10) (13) Securities of other U.S. Government agencies and corporations 11 20 43 (9) (23) Mortgage-backed securities 3 9 16 (6) (7) ------- ------- ------- ------- ------- Total held-to-maturity securities 31 56 99 (25) (43) ------- ------- ------- ------- ------- Interest-bearing due from banks 10 17 82 (7) (65) Federal funds sold 8 42 184 (34) (142) Loans: Real estate loans 27,116 25,454 23,431 1,662 2,023 Consumer 2,834 2,974 3,055 (140) (81) Agricultural 199 199 190 - 9 Commercial/industrial 2,025 1,934 1,831 91 103 Other 56 69 68 (13) 1 Political subdivisions 1,144 858 1,043 286 (185) Leases 5 11 17 (6) (6) ------- ------- ------- ------- ------- Total loans 33,379 31,499 29,635 1,880 1,864 ------- ------- ------- ------- ------- Total Interest Income 59,019 60,278 56,906 (1,259) 3,372 ------- ------- ------- ------- ------- INTEREST-BEARING LIABILITIES Interest checking 266 425 651 (159) (226) Money market 2,712 3,970 5,362 (1,258) (1,392) Savings 425 504 1,012 (79) (508) Certificates of deposit 5,959 7,752 9,284 (1,793) (1,532) Individual Retirement Accounts 5,182 4,528 4,073 654 455 Other time deposits 17 36 35 (19) 1 Overnight borrowings 91 44 161 47 (117) Other borrowed funds 8,885 9,056 7,778 (171) 1,278 ------- ------- ------- ------- ------- Total Interest Expense 23,537 26,315 28,356 (2,778) (2,041) ------- ------- ------- ------- ------- Net Interest Income $35,482 $33,963 $28,550 $ 1,519 $ 5,413 ======= ======= ======= ======= =======
(1) Interest income from tax-exempt securities and loans has been adjusted to a fully taxable-equivalent basis, using the Corporation's marginal federal income tax rate of 34%. (2) Fees on loans are included with interest on loans and amounted to $1,323,000 in 2003, $1,268,000 in 2002 and $1,054,000 in 2001. 13 TABLE II - ANALYSIS OF AVERAGE DAILY BALANCES AND RATES
2003 2002 2001 RATE OF RATE OF RATE OF RETURN/ RETURN/ RETURN/ COST OF COST OF COST OF AVERAGE FUNDS AVERAGE FUNDS AVERAGE FUNDS (DOLLARS IN THOUSANDS) BALANCE % BALANCE % BALANCE % EARNING ASSETS Available-for-sale securities, at amortized cost: U.S. Treasury securities $ - 0.00 $ 1,241 6.04 $ 2,506 6.03 Securities of other U.S. Government agencies and corporations 67,218 4.72 75,646 6.25 113,186 6.82 Mortgage-backed securities 176,800 4.20 209,539 5.30 150,838 6.29 Obligations of states and political subdivisions 146,371 7.36 113,540 7.61 78,741 7.89 Equity securities 28,084 4.16 21,858 5.25 21,060 5.18 Other securities 52,980 5.76 43,826 6.79 29,577 7.59 ---------- ---- -------- ----- -------- ----- Total available-for-sale securities 471,453 5.43 465,650 6.16 395,908 6.80 ---------- ---- -------- ----- -------- ----- Held-to-maturity securities: U.S. Treasury securities 320 5.31 511 5.28 742 5.39 Securities of other U.S. Government agencies and corporations 220 5.00 331 6.04 680 6.32 Mortgage-backed securities 64 4.69 131 6.87 205 7.80 ---------- ---- -------- ----- -------- ----- Total held-to-maturity securities 604 5.13 973 5.76 1,627 6.08 ---------- ---- -------- ----- -------- ----- Interest-bearing due from banks 1,669 0.60 1,444 1.18 2,659 3.08 Federal funds sold 680 1.18 2,698 1.56 5,064 3.63 Loans: Real estate loans 399,353 6.79 338,133 7.53 279,828 8.37 Consumer 32,386 8.75 29,720 10.01 28,062 10.89 Agricultural 2,924 6.81 2,556 7.79 2,070 9.18 Commercial/industrial 32,909 6.15 28,182 6.86 22,212 8.24 Other 851 6.58 1,028 6.71 892 7.62 Political subdivisions 16,649 6.87 10,929 7.85 13,108 7.96 Leases 78 6.41 122 9.02 181 9.39 ---------- ---- -------- ----- -------- ----- Total loans 485,150 6.88 410,670 7.67 346,353 8.56 ---------- ---- -------- ----- -------- ----- Total Earning Assets 959,556 6.15 881,435 6.84 751,611 7.57 Cash 13,583 13,318 11,871 Unrealized gain/loss on securities 20,296 12,462 6,639 Allowance for loan losses (5,908) (5,453) (5,370) Bank premises and equipment 11,090 10,246 9,602 Other assets 36,103 30,993 30,876 ---------- -------- -------- Total Assets $1,034,720 $943,001 $805,229 ========== ======== ======== INTEREST-BEARING LIABILITIES Interest checking $ 37,647 0.71 $ 37,984 1.12 $ 37,192 1.75 Money market 190,161 1.43 171,767 2.31 153,738 3.49 Savings 54,789 0.78 49,779 1.01 46,750 2.16 Certificates of deposit 190,019 3.14 195,099 3.97 169,275 5.48 Individual Retirement Accounts 106,216 4.88 90,856 4.98 79,482 5.12 Other time deposits 1,666 1.02 1,814 1.98 1,916 1.83 Overnight borrowings 7,033 1.29 2,347 1.87 4,012 4.01 Other borrowed funds 242,358 3.67 211,092 4.29 151,615 5.13 ---------- ---- -------- ----- -------- ----- Total Interest-bearing Liabilities 829,889 2.84 760,738 3.46 643,980 4.40 Demand deposits 70,528 66,093 56,226 Other liabilities 12,032 8,575 9,002 ---------- -------- -------- Total Liabilities 912,449 835,406 709,208 ---------- -------- -------- Stockholders' equity, excluding other comprehensive income/loss 108,876 99,361 91,703 Other comprehensive income/loss 13,395 8,234 4,318 ---------- -------- -------- Total Stockholders' Equity 122,271 107,595 96,021 ---------- -------- -------- Total Liabilities and Stockholders' Equity $1,034,720 $943,001 $805,229 ========== ======== ======== Interest Rate Spread 3.31 3.38 3.17 Net Interest Income/Earning Assets 3.70 3.85 3.80
(1) Rates of return on tax-exempt securities and loans are calculated on a fully-taxable equivalent basis, using the Corporation's marginal federal income tax rate of 34%. (2) Nonaccrual loans are included in the loan balances above. 14 TABLE III - THE EFFECT OF VOLUME AND RATE CHANGES ON INTEREST INCOME AND INTEREST EXPENSE
YEARS ENDED 12/31/03 VS. 02 YEARS ENDED 12/31/02 VS. 01 CHANGE IN CHANGE IN TOTAL CHANGE IN CHANGE IN TOTAL (IN THOUSANDS) VOLUME RATE CHANGE VOLUME RATE CHANGE EARNING ASSETS Available-for-sale securities: U.S. Treasury securities $ (38) $ (37) $ (75) $ (76) $ - $ (76) Securities of other U.S. Government agencies and corporations (487) (1,067) (1,554) (2,389) (601) (2,990) Mortgage-backed securities (1,579) (2,091) (3,670) 3,277 (1,667) 1,610 Obligations of states and political subdivisions 2,424 (297) 2,127 2,655 (230) 2,425 Equity securities 288 (268) 20 42 16 58 Other securities 567 (488) 79 987 (256) 731 -------- -------- ------- -------- -------- ------- Total available-for-sale securities 1,175 (4,248) (3,073) 4,496 (2,738) 1,758 -------- -------- ------- -------- -------- ------- Held-to-maturity securities: U.S. Treasury securities (10) - (10) (12) (1) (13) Securities of other U.S. Government agencies and corporations (6) (3) (9) (21) (2) (23) Mortgage-backed securities (4) (2) (6) (5) (2) (7) -------- -------- ------- -------- -------- ------- Total held-to-maturity securities (20) (5) (25) (38) (5) (43) -------- -------- ------- -------- -------- ------- Interest-bearing due from banks 2 (9) (7) (27) (38) (65) Federal funds sold (26) (8) (34) (64) (78) (142) Loans: Real estate loans 4,316 (2,654) 1,662 4,550 (2,527) 2,023 Consumer 253 (393) (140) 174 (255) (81) Agricultural 27 (27) - 41 (32) 9 Commercial/industrial 304 (213) 91 442 (339) 103 Other (12) (1) (13) 9 (8) 1 Political subdivisions 404 (118) 286 (171) (14) (185) Leases (3) (3) (6) (5) (1) (6) -------- -------- ------- -------- -------- ------- Total loans 5,289 (3,409) 1,880 5,040 (3,176) 1,864 -------- -------- ------- -------- -------- ------- Total Interest Income 6,420 (7,679) (1,259) 9,407 (6,035) 3,372 -------- -------- ------- -------- -------- ------- INTEREST-BEARING LIABILITIES Interest checking (4) (155) (159) 14 (240) (226) Money market 389 (1,647) (1,258) 574 (1,966) (1,392) Savings 47 (126) (79) 62 (570) (508) Certificates of deposit (197) (1,596) (1,793) 1,277 (2,809) (1,532) Individual Retirement Accounts 751 (97) 654 570 (115) 455 Other time deposits (3) (16) (19) (2) 3 1 Overnight borrowings 65 (18) 47 (51) (66) (117) Other borrowed funds 1,243 (1,414) (171) 2,699 (1,421) 1,278 -------- -------- ------- -------- -------- ------- Total Interest Expense 2,291 (5,069) (2,778) 5,143 (7,184) (2,041) -------- -------- ------- -------- -------- ------- Net Interest Income $ 4,129 $ (2,610) $ 1,519 $ 4,264 $ 1,149 $ 5,413 ======== ======== ======= ======== ======== =======
(1) Changes in interest income on tax-exempt securities and loans are presented on a fully taxable-equivalent basis, using the Corporation's marginal federal income tax rate of 34%. (2) The change in interest due to both volume and rates has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. 15 NONINTEREST INCOME 2003/2002/2001 Total noninterest income increased $1,882,000, or 19.8%, in 2003 over 2002. In 2002, total noninterest income increased $1,472,000, or 18.3%, compared to 2001. The increases in net realized security gains in 2003 and 2002 are discussed in the "Earnings Overview" section of Management's Discussion and Analysis. Other items of significance are as follows: 2003 VS. 2002 - Insurance commissions and fees dropped $186,000, or 32.2%, for 2003 compared to 2002. The decrease in insurance-related revenues had 2 components: (1) a decrease in revenues of $135,000 from Bucktail Life Insurance Company ("Bucktail"), a subsidiary of the Corporation that reinsures credit and mortgage life and accident and health insurance, and (2) a decrease in revenues of $51,000 from the insurance division of C & N Financial Services Corporation ("C&NFSC"). The decrease in Bucktail revenues is mainly attributed to timing items which are not expected to be indicative of a long-term decline. The chief reason for the decline in Bucktail revenues is the implementation of credit insurance changes to comply with the Home Owners Equity Protection Act (HOEPA) that became effective October 1, 2002. Under HOEPA, it is necessary to provide insurance protection on an outstanding daily balance method, rather than on a single premium basis. C&NFSC, a subsidiary of Citizens & Northern Bank, began its insurance agency operations in 2000, with limited activity to date. C&NFSC insurance revenues amounted to $110,000 in 2003 and $161,000 in 2002. Management continues to explore opportunities to expand insurance related revenues. - The increase in cash surrender value of life insurance fell $138,000 to $715,000 in 2003 from $853,000 in 2002. The Corporation's policy return is determined, in part, by the amount of earnings generated from a pooled separate investment trust held by the life insurance company. In 2003, earnings on that pooled separate trust fund have been lower than in 2002, which is reflective of lower market yields on debt securities. - Credit card fee income has increased mainly due to the formation of a "Reward Card Program" which pays users a rebate for using their credit card. This program was started in April 2003 and has had the desired effect of raising card usage. This, along with an increased rate on interchange fees, has raised overall credit card fees 24.2% in 2003. - Other operating income increased 13.8% due mainly to an increase in gains from the sales of other real estate of $51,000 and from the receipt of a grant of $33,000 for staff training. 2002 VS. 2001 - Service charges on deposit accounts increased $349,000, or 25.4%. This increase resulted from growth in deposits, as well as fee increases implemented in the second half of 2001 on certain types of services. - Trust and financial management revenue increased $179,000, or 11.4%. This increase resulted from fee increases implemented in the latter part of 2001, and from receipt of certain fees for services provided prior to 2002. Trust revenue is recorded on a cash basis, which does not vary materially from the accrual basis. TABLE IV - COMPARISON OF NONINTEREST INCOME
(IN THOUSANDS) 2003 % CHANGE 2002 % CHANGE 2001 Service charges on deposit accounts $ 1,746 1.2 $ 1,725 25.4 $ 1,376 Service charges and fees 287 11.2 258 4.5 247 Trust and financial management revenue 1,733 (1.3) 1,755 11.4 1,576 Insurance commissions, fees and premiums 391 (32.2) 577 (0.9) 582 Increase in cash surrender value of life insurance 715 (16.2) 853 (5.7) 905 Fees related to credit card operation 784 24.2 631 14.7 550 Other operating income 939 13.8 825 (6.7) 884 ------- ----- ------- ---- ------- Total other income before realized gains on securities, net 6,595 (0.4) 6,624 8.2 6,120 Realized gains on securities, net 4,799 66.2 2,888 50.4 1,920 ------- ----- ------- ---- ------- Total Other Income $11,394 19.8 $ 9,512 18.3 $ 8,040 ======= ===== ======= ==== =======
16 OTHER NONINTEREST EXPENSE 2003/2002/2001 Total noninterest expense increased 6.1% in 2003, to $22,114,000. In 2002, total noninterest expense was $20,849,000, or 11.7% higher than in 2001. 2003 VS. 2002 Salaries and wages increased $278,000, or 3.0%, for 2003 compared to 2002. The increase is mainly the result of annual merit raises, generally ranging from 2%-5%, and an increase in number of employees. Included in salaries and wages expense is incentive bonus expense. The incentive bonus plan provides for compensation to be paid to certain key officers, with the payment amounts based on a combination of personal and corporate performance. Incentive bonus expense for 2003 decreased $423,000 from the 2002 amount, as a lower amount of growth in noninterest revenue (as defined) limited the amount of bonuses attributable to overall corporate performance. Excluding incentive bonus expense, salaries and wages increased 8.4% in 2003 over 2002. Pensions and other employee benefits increased $666,000, or 25.1%, in 2003 over 2002. Pension expense from the Corporation's defined benefit pension plan increased $232,000 in 2003 over 2002. Although the defined benefit pension plan remains adequately funded, a decline in the market value of plan assets, along with an increased number of covered employees, contributed to the increase in expense in 2003. Note 12 to the consolidated financial statements provides more information related to the defined benefit pension plan. Group health insurance expense increased $112,000 in 2003, mainly due to increases in rates. Included in this category is professional fees related to employee benefit plan matters. In 2003, these professional fees increased $113,000. Occupancy expense increased $201,000, or 18.4%, in 2003 over 2002. The greatest portion of the increase in occupancy expense is attributable to increased costs of $57,000 for building maintenance and repairs. Depreciation expense also rose $47,000 from 2002's level, as the Corporation recorded depreciation on building renovation costs that have taken place in several locations. Total energy costs increased $44,000, primarily due to higher utility rates in several locations, as well as the initial expenses associated with the Williamsport facility during the latter portion of 2003. Furniture and equipment expense decreased $160,000, or 10.4%, in 2003 compared to 2002. The largest decrease within this category was in depreciation expense, which decreased $182,000 or 19.9%. There were several substantial capital expenditures, which became fully depreciated in 2002, reducing the expense for 2003. In total, other expense increased $122,000, or 2.4%, in 2003 over 2002. This category includes many different types of expenses. The most significant changes within this category are as follows: - Bank professional fees increased $94,000, to $371,000. Included in this category was approximately $80,000 in expenses for a consulting firm that has assisted with the core banking software evaluation and search. - Telephone - data line expenses increased $68,000, to $325,000. These expenses increased due to upgrades of several lines. - Marketing research expenses increased $54,000, to $68,000. In 2003, increased expenses were incurred for demographic and other marketing-related data. - Expenses of Bucktail Life Insurance Company decreased $230,000, to $105,000. In 2003, a lower amount of life insurance claims were incurred than in 2002. In addition to the direct effect of lower claims, the lower amount of claims also had the effect of lowering reserves for future claims. - Expenses related to maintaining other real estate properties decreased $50,000, to $33,000. 2002 VS. 2001 Salaries and wages increased $925,000, or 10.9%, in 2002 compared to 2001. The increase is the result of annual merit raises ranging from 2%-5%, an increase in the number of employees and an increase in incentive bonus expense. Total incentive bonus expense increased $185,000 in 2002. Excluding incentive bonus expense, salaries and wages expense increased 9.7% in 2002 over 2001. 17 Pensions and other employee benefits increased $438,000, or 19.8%, in 2002 over 2001. A portion of this increase is directly related to the increase in salaries and wages. Also, pension expense from the Corporation's defined benefit pension plan increased $245,000 in 2002 over 2001. A decline in the market value of plan assets was the main cause of the increase in expense in 2002. Other expense increased $704,000, or 15.9%, in 2002 over 2001. The most significant changes within this category are as follows: - Expenses of Bucktail Life Insurance Company, increased $111,000, to $335,000. This increase resulted mainly from a larger amount of life insurance claims incurred. - Professional fees increased $101,000, to $276,000. This increase reflected costs associated with organizational and product profitability consultants, human resources consultants and other consultants related to various aspects of the Corporation's operations. - Office and other supplies increased $77,000, to $502,000, as a result of increased volumes of employees and customers. - Restricted stock amortization increased $58,000, to $80,000. This category of expense included amortization associated with 2 years of awards to Directors and certain employees in 2002, compared to only 1 year in 2001 (the first year for which there were restricted stock awards). Stock-based compensation plans are described in more detail in Note 12 to the financial statements. - In 2002, the Corporation wrote off asset-liability reporting software of $41,000, due to management's decision to change to an outsourcing provider of asset-liability reports. TABLE V - COMPARISON OF NONINTEREST EXPENSE
(IN THOUSANDS) 2003 % CHANGE 2002 % CHANGE 2001 Salaries and wages $ 9,696 3.0 $ 9,418 10.9 $ 8,493 Pensions and other employee benefits 3,317 25.1 2,651 19.8 2,213 Occupancy expense, net 1,295 18.4 1,094 7.5 1,018 Furniture and equipment expense 1,372 (10.4) 1,532 7.1 1,431 Expenses related to credit card operation 385 35.1 285 (3.4) 295 Pennsylvania shares tax 792 7.9 734 (7.1) 790 Other operating expense 5,257 2.4 5,135 15.9 4,431 -------- ----- ------- ---- ------- Total Other Expense $ 22,114 6.1 $20,849 11.7 $18,671 ======== ===== ======= ==== =======
INCOME TAXES The "Earnings Overview" section of Management's Discussion and Analysis includes a discussion of the Corporation's income tax provision in 2003, 2002 and 2001. A more complete analysis of income taxes is presented in Note 13 to the consolidated financial statements. FINANCIAL CONDITION Significant changes in the average balances of the Corporation's earning assets and interest-bearing liabilities are described in the "NET INTEREST MARGIN" section of Management's Discussion and Analysis. In particular, the discussion of changes in available-for-sale securities, loans, deposits and borrowed funds in 2003 is sufficient to explain the overall change in the year-end balances in 2003 compared to 2002. Other significant balance sheet items - the allowance for loan losses and stockholders' equity - are discussed in separate sections of Management's Discussion and Analysis. Table VI shows the composition of the investment portfolio at December 31, 2003, 2002 and 2001. 18 Premises and equipment, net of accumulated depreciation, increased to $12,482,000 at December 31, 2003 from $10,333,000 at December 31, 2002. The total cost of premises and equipment purchases was $3,360,000 in 2003, $1,712,000 in 2002 and $1,935,000 in 2001. In 2003, the Corporation purchased the land and building, and began renovations, for the Williamsport facility that is expected to open in 2004. Through December 31, 2003, the total cost of the Williamsport project was approximately $1.8 million. Other significant capital projects in 2003 included remodeling and addition to the Sayre facility, remodeling of the Elkland facility, and purchases of an additional 80 thin client computer stations for teller lines throughout the branch network. In 2002, the most significant capital projects included renovations to the Tioga and Athens offices, and completion of renovations to a leased facility in Wellsboro. Other major categories of capital purchases in 2002 included purchases of computer hardware and software, and purchase and demolition of property adjacent to the Wysox office. In 2001, the most significant capital purchases were for new proof of deposit software, renovations to branches and a new telephone system. Depreciation expense amounted to $1,211,000 in 2003, $1,346,000 in 2002 and $1,300,000 in 2001. Management expects the total cost of capital expenditures for 2004 to be quite high in comparison to the Corporation's historical standards, in the range of $5 million to $8 million. More information concerning possible capital projects in 2004 is provided in the "Outlook for 2004" section of Management's Discussion and Analysis. As stated in the "Outlook for 2004" section, management does not expect capital expenditures, though high, to have a material, detrimental effect on the Corporation's financial condition or results of operations in 2004. TABLE VI - INVESTMENT SECURITIES
AS OF DECEMBER 31, 2003 2002 2001 AMORTIZED FAIR AMORTIZED FAIR AMORTIZED FAIR COST VALUE COST VALUE COST VALUE AVAILABLE-FOR-SALE SECURITIES: Obligations of the U.S. Treasury $ - $ - $ - $ - $ 2,503 $ 2,557 Obligations of other U.S. Government agencies 61,437 61,070 71,657 72,348 75,295 75,172 Obligations of states and political subdivisions 159,128 162,418 127,690 130,879 95,835 95,261 Other securities 45,992 47,648 62,296 63,592 34,315 34,532 Mortgage-backed securities 168,285 169,208 207,244 212,276 198,269 198,975 --------- -------- --------- --------- --------- -------- Total debt securities 434,842 440,344 468,887 479,095 406,217 406,497 Marketable equity securities 29,951 42,688 24,886 33,080 19,745 27,472 --------- -------- --------- --------- --------- -------- Total $ 464,793 $483,032 $ 493,773 $ 512,175 $ 425,962 $433,969 ========= ======== ========= ========= ========= ======== HELD-TO-MATURITY SECURITIES: Obligations of the U.S. Treasury $ 319 $ 349 $ 321 $ 359 $ 726 $ 735 Obligations of other U.S. Government agencies 199 216 297 322 547 561 Mortgage-backed securities 42 44 89 93 175 181 --------- -------- --------- --------- --------- -------- Total $ 560 $ 609 $ 707 $ 774 $ 1,448 $ 1,477 ========= ======== ========= ========= ========= ========
PROVISION AND ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is maintained at a level which, in management's judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management's evaluation of the collectibility of the loan portfolio. In evaluating collectibility, management considers a number of factors, including the status of specific impaired loans, trends in historical loss experience, delinquency trends, credit concentrations, comparison of historical loan loss data to that of other financial institutions and economic conditions within the Corporation's market area. Allowances for impaired loans are determined based on collateral values or the present value of estimated cash flows. The allowance is increased by a provision for loan losses, which is charged to expense, and reduced by charge-offs, net of recoveries. 19 Each quarter, management performs a detailed assessment of the allowance and provision for loan losses. This assessment is conducted under the direction of the Bank's Chief Financial Officer and Executive Vice President in charge of Commercial Lending, with input from the Bank's President and other Branch and Lending Staff. The assessment process includes review of identified risk elements in the loan portfolio, including the "Watch List", past due reports and other information. The "Watch List" is a collection of loans that have a history of delinquency, collateral deficiency, cash flow problems, or other factors that have come to management's attention to create the need for special monitoring. One of the key aspects of the quarterly assessment is a meeting including the Chief Financial Officer, Executive Vice President in charge of Commercial Lending and the applicable Loan Officer responsible for each Watch List relationship with an outstanding balance of $200,000 or more. This meeting includes an updated assessment of collection activities and planning for each such relationship, as well as evaluation of the Bank's probable loss (if any). The Bank also engages a consulting firm each year to perform an independent credit review. Their review is performed annually on credit relationships of $250,000 and higher as well as other selected credit relationships. Management gives substantial consideration to the classifications and recommendations of the independent credit reviewer in determining the allowance for loan losses. The allowance for loan losses includes two components, allocated and unallocated. The allocated component of the allowance for loan losses reflects expected losses resulting from the analysis of individual (Watch List) loans and historical loss experience, as modified for identified trends and concerns, for each loan category. The historical loan loss experience element is determined based on the ratio of net charge-offs to average loan balances over a five-year period, for each significant type of loan, modified for risk adjustment factors identified by management for each type of loan. The charge-off ratio, as modified, is then applied to the current outstanding loan balance for each type of loan (net of Watch List loans that are individually evaluated). The unallocated portion of the allowance is determined based on management's assessment of general economic conditions as well as specific economic factors in the market area. This determination inherently involves a higher degree of uncertainty and considers current risk factors that may not have yet manifested themselves in the Bank's historical loss factors used to determine the allocated component of the allowance, and it recognizes that management's knowledge of specific losses within the portfolio may be incomplete. Table IX reflects an allowance for losses related to impaired loans of $1,542,000 at December 31, 2003. This amount reflects management's evaluations of impairment associated with specific loan relationships. Management believes it has been conservative, but reasonable, in its loan impairment calculations. However, the actual losses realized from these relationships could vary materially from the allowances calculated as of December 31, 2003. As noted in Table IX, the unallocated portion of the allowance for loan losses was $2,117,000 at December 31, 2003 and $1,759,000 at December 31, 2002. The unallocated balances ranged from $1,759,000 to $2,219,000 in 2003 and $1,759,000 to $2,222,000 in 2002. In evaluating the unallocated portion of the allowance, management considers several trends, including comparisons of loan loss data to other financial institutions and tracking of delinquency and charge-off trends. Total 90 day or more past due loans, plus nonaccrual loans, amounted to $3,691,000 (0.70% of total loans) at December 31, 2003, which is fairly consistent with the corresponding amount at December 31, 2002 of $3,570,000 (0.79% of total loans). Total 30-89 day past due loans amounted to $12,208,000 (2.33% of total loans) at December 31, 2003, up from $8,853,000 (1.96% of total loans) at December 31, 2002. Management is monitoring the increase in 30-89 day past due loans to determine whether it is a sustainable trend, and will increase the allowance in 2004 if appropriate. As reflected in Table VIII, gross and net charge-offs were higher in 2003 than in any of the previous 4 years. Gross charge-offs of $968,000 included approximately $300,000 from charge-offs related to 2 commercial loan relationships during the 1st quarter 2003. These 2 relationships had been identified as impaired, with allowances fully provided, at December 31, 2002. The allocation of the allowance for loan losses at December 31, 2001 and 2000, as presented in Table IX, reflects reclassifications of amounts among categories compared to amounts presented in prior years. These reclassifications reflect an increase in the amount of allowance presented for impaired loans, and decreases in the allowance amounts for other categories. 20 The provision for loan losses amounted to $1,100,000 in 2003, $940,000 in 2002 and $600,000 in 2001. The amount of the provision in each year is determined based on the amount required to maintain an appropriate allowance in light of the factors described above. Tables VII, VIII, IX and X present an analysis of the loan portfolio, the allowance for loan losses, the allocation of the allowance and a five-year summary of loans by type. TABLE VII - FIVE-YEAR HISTORY OF LOAN LOSSES (IN THOUSANDS)
2003 2002 2001 2000 1999 AVERAGE Year-end gross loans, excluding unearned discount $524,897 $451,145 $379,228 $328,305 $310,892 $398,893 Year-end allowance for loan Losses 6,097 5,789 5,265 5,291 5,131 5,515 Year-end nonaccrual loans 1,145 1,252 1,050 1,608 1,956 1,402 Year-end loans 90 days or more past due and still accruing 2,546 2,318 2,067 1,221 1,797 1,990 Net charge-offs 792 416 626 516 449 560 Provision for loan losses 1,100 940 600 676 760 815 Earnings coverage of charge- Offs 20.5 36.0 19.3 16.4 25.6 22.6 Allowance coverage of charge- Offs 7.7 13.9 8.4 10.3 11.4 9.8 Net charge-offs as a % of provision for loan losses 72.0% 44.3% 104.3% 76.3% 59.1% 68.7%
TABLE VIII - ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES (IN THOUSANDS)
YEARS ENDED DECEMBER 31, 2003 2002 2001 2000 1999 Balance, beginning of year $ 5,789 $ 5,265 $ 5,291 $ 5,131 $ 4,820 -------- -------- -------- -------- -------- Charge-offs: Real estate loans 168 123 144 272 81 Installment loans 326 116 138 77 138 Credit cards and related plans 171 190 200 214 192 Commercial and other loans 303 123 231 53 219 -------- -------- -------- -------- -------- Total charge-offs 968 552 713 616 630 -------- -------- -------- -------- -------- Recoveries: Real estate loans 75 30 6 26 81 Installment loans 52 30 27 23 60 Credit cards and related plans 17 18 20 28 30 Commercial and other loans 32 58 34 23 10 -------- -------- -------- -------- -------- Total recoveries 176 136 87 100 181 -------- -------- -------- -------- -------- Net charge-offs 792 416 626 516 449 Provision for loan losses 1,100 940 600 676 760 -------- -------- -------- -------- -------- Balance, end of year $ 6,097 $ 5,789 $ 5,265 $ 5,291 $ 5,131 ======== ======== ======== ======== ========
21 TABLE IX - ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES BY TYPE (IN THOUSANDS)
2003 2002 2001 2000 1999 Commercial $ 1,578 $ 1,315 $ 852 $ 441 $ 2,081 Consumer mortgage 456 460 188 187 834 Impaired loans 1,542 1,877 1,736 2,393 609 Consumer 404 378 302 287 437 All other commitments - - - - 150 Unallocated 2,117 1,759 2,187 1,983 1,020 ------- ------- ------- ------- ------- Total Allowance $ 6,097 $ 5,789 $ 5,265 $ 5,291 $ 5,131 ======= ======= ======= ======= =======
The above allocation is based on estimates and subjective judgments and is not necessarily indicative of the specific amounts or loan categories in which losses may occur. TABLE X - FIVE-YEAR SUMMARY OF LOANS BY TYPE (IN THOUSANDS)
2003 % 2002 % 2001 % 2000 % 1999 % Real estate - construction $ 2,856 0.54 $ 103 0.02 $ 1,814 0.48 $ 452 0.14 $ 649 0.21 Real estate - mortgage 431,047 82.13 370,453 82.12 306,264 80.76 263,325 80.21 247,604 79.64 Consumer 33,977 6.47 31,532 6.99 29,284 7.72 28,141 8.57 29,140 9.37 Agricultural 2,948 0.56 3,024 0.67 2,344 0.62 1,983 0.60 1,899 0.61 Commercial 34,967 6.66 30,874 6.84 24,696 6.51 20,776 6.33 18,050 5.81 Other 1,183 0.23 2,001 0.44 1,195 0.32 948 0.29 1,025 0.33 Political subdivisions 17,854 3.40 13,062 2.90 13,479 3.55 12,462 3.80 12,332 3.97 Lease receivables 65 0.01 96 0.02 152 0.04 218 0.07 222 0.07 --------- ------ -------- ------ -------- ------ -------- ------ -------- ------ Total 524,897 100.00 451,145 100.00 379,228 100.00 328,305 100.00 310,921 100.00 Less: unearned discount - - - - (29) --------- -------- -------- -------- -------- 524,897 451,145 379,228 328,305 310,892 Less: allowance for loan losses (6,097) (5,789) (5,265) (5,291) (5,131) --------- -------- -------- -------- -------- Loans, net $ 518,800 $445,356 $373,963 $323,014 $305,761 ========= ======== ======== ======== ========
CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS Table XI presents the Corporation's significant fixed and determinable contractual obligations as of December 31, 2003, by payment date. The payment amounts represent those amounts due to the recipients, including interest, and are not discounted to present value. TABLE XI - CONTRACTUAL OBLIGATIONS (IN THOUSANDS)
1 YEAR 1-3 3-5 OVER 5 CONTRACTUAL OBLIGATIONS OR LESS YEARS YEARS YEARS TOTAL ----------------------- -------- --------- -------- -------- -------- Time deposits $185,736 $ 88,083 $ 36,312 $ 168 $310,299 Short-term borrowings - Federal Home Loan Bank of Pittsburgh 7,558 - - - 7,558 Long-term borrowings: Federal Home Loan Bank of Pittsburgh 34,883 94,536 57,933 19,821 207,173 Repurchase agreements 21,199 27,107 4,725 - 53,031 -------- --------- -------- -------- -------- Total $249,376 $ 209,726 $ 98,970 $ 19,989 $578,061 ======== ========= ======== ======== ========
22 In addition to the amounts described in Table XI, the Corporation has obligations related to deposits without a stated maturity with outstanding principal balances totaling $362,242,000 at December 31, 2003. The Corporation also has obligations related to overnight borrowings with the Federal Home Loan Bank of Pittsburgh and overnight customer repurchase agreements with principal balances totaling $30,263,000 at December 31, 2003. The Corporation has no capital leases as of December 31, 2003, and commitments related to operating leases and other purchase commitments are not significant. The Corporation's significant off-balance sheet arrangements consist of commitments to extend credit and standby letters of credit. Off-balance sheet arrangements are described in Note 15 to the consolidated financial statements. LIQUIDITY Liquidity is the ability to quickly raise cash at a reasonable cost. An adequate liquidity position permits the Corporation to pay creditors, compensate for unforeseen deposit fluctuations and fund unexpected loan demand. The Corporation maintains overnight borrowing facilities with several correspondent banks that provide a source of day-to-day liquidity. Also, the Corporation maintains borrowing facilities with FHLB - Pittsburgh, secured by various securities and mortgage loans. At December 31, 2003, the Corporation had unused borrowing availability with correspondent banks and FHLB - Pittsburgh totaling approximately $218,000,000. Additionally, the Corporation uses repurchase agreements placed with brokers to borrow short-term funds secured by investment assets, and uses "RepoSweep" arrangements to borrow funds from commercial banking customers on an overnight basis. Historically, one of the tools used to monitor a bank's longer-term liquidity situation has been the loan-to-deposit ratio. As of December 31, 2003, this ratio was 79%, which is a moderate-to-low ratio by banking industry standards, but much higher than the Corporation's position has been in many years. The higher than historical level of loans-to-deposits reflects the Corporation's very strong loan growth over the past few years. The loan-to-deposit ratio was 70% at December 31, 2002, 65% at December 31, 2001 and 61% at December 31, 2000. Management believes the current, higher loan-to-deposit ratio is an indicator that some of the Corporation's historical liquidity "cushion" has been reduced; however, the current position continues to provide sufficient funds for maintenance of a substantial investment securities portfolio. If required to raise cash in an emergency situation, the Corporation could sell non-pledged investment securities to meet its obligations. Management believes the combination of its strong capital position (discussed in the next section), ample available borrowing facilities and moderate - to-low loan to deposit ratio have placed the Corporation in a position of minimal short-term and long-term liquidity risk. STOCKHOLDERS' EQUITY AND CAPITAL ADEQUACY The Corporation and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. For many years, the Corporation and the Bank have maintained extremely strong capital positions. Details concerning the Corporation's and the Bank's regulatory capital amounts and ratios are presented in Note 17 to the consolidated financial statements. As reflected in Note 17, at December 31, 2003 and 2002, the ratios of total capital to risk-weighted assets, tier 1 capital to risk-weighted assets and tier 1 capital to average total assets are well in excess of regulatory capital requirements. The Corporation's total stockholders' equity is affected by fluctuations in the fair values of available-for-sale securities. The difference between amortized cost and fair value of available-for-sale securities, net of deferred income tax, is classified as "Accumulated Other Comprehensive Income" within stockholders' equity. Changes in accumulated other comprehensive income are excluded from earnings and directly increase or decrease stockholders' equity. COMPREHENSIVE INCOME Comprehensive income is a measure of all changes in the equity of a corporation, excluding transactions with owners in their capacity as owners (such as proceeds from issuances of stock and dividends). The difference between net income and comprehensive income is termed "Other Comprehensive Income". For the Corporation, other comprehensive income consists of unrealized gains and losses on available-for-sale securities, net of deferred income tax. Comprehensive income should not be construed to be a measure of net income. The amount of unrealized gains or losses reflected in comprehensive income may vary widely from period-to-period, depending on the financial markets as a whole and how the portfolio of available-for-sale securities is affected by interest rate movements. Total comprehensive income was $16,148,000 in 2003, $21,821,000 in 2002 and $17,254,000 in 2001. Other comprehensive income (loss) amounted to ($109,000) in 2003, $6,862,000 in 2002 and $5,202,000 in 2001. 23 INFLATION Over the last several years, direct inflationary pressures on the Corporation's payroll-related and other noninterest costs have been modest. The Corporation is significantly affected by the Federal Reserve Board's efforts to control inflation through changes in interest rates. Management monitors the impact of economic trends, including any indicators of inflationary pressures, in managing interest rate and other financial risks. RECENT ACCOUNTING PRONOUNCEMENTS In December 2002, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard ("SFAS") No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - An Amendment of FASB Statement No. 123." This statement amends SFAS No. 123, "Accounting for Stock-Based Compensation," to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. The statement also amends the disclosure requirements of SFAS No. 123 to require additional, prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. This statement announces, "in the near future, the Board plans to consider whether it should propose changes to the U.S. standards on accounting for stock-based compensation." The Corporation first adopted the disclosure requirements of SFAS No. 148 in the 2002 annual financial statements, and in interim financial statements issued in 2003. However, as permitted by SFAS No. 148, the Corporation continues to use the intrinsic value method of accounting for stock options (rather than the fair value method). Notes 1 and 12 to the consolidated financial statements present more details concerning the Corporation's stock-based compensation plans. In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." This statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. The amendments set forth in SFAS No. 149 require that contracts with comparable characteristics be accounted for similarly. In particular, this statement clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative as discussed in SFAS No. 133. In addition, it clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. SFAS No. 149 amends certain other existing pronouncements. Those changes will result in more consistent reporting of contracts that are derivatives in their entirety or that contain embedded derivatives that warrant separate accounting. This statement was effective for contracts entered into or modified after June 30, 2003, with certain exceptions. The adoption of this statement did not have an effect on the Corporation's earnings, financial condition or equity. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." This statement establishes how an issuer classifies financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify these financial instruments as a liability (or, in certain circumstances, an asset). Previously, these financial instruments would have been classified entirely as equity, or between the liabilities and equity section of the balance sheet. This statement also addresses questions about the classification of certain financial instruments that embody obligations to issue equity shares. The provisions of this statement were effective for interim periods beginning after June 15, 2003. The adoption of this statement did not have an effect on the Corporation's earnings, financial condition or equity. In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities." The FASB then revised Interpretation No. 46 in December 2003. Interpretation No. 46, as revised, is intended to expand upon and strengthen existing accounting guidance that addresses when a company should include in its financial statements the assets, liabilities and activities of another entity. Prior to this interpretation, as revised, one company generally has included another entity in its consolidated financial statements only if it controlled the entity through voting interests. This interpretation, as revised, changes that by requiring a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity's activities or entitled to receive a majority of the entity's residual returns or both. Certain of the requirements of this interpretation, as revised, were effective in 2003, while other requirements will become effective in 2004. The adoption of the interpretation, as revised, did not have an effect on the Corporation's earnings, financial condition or equity in 2003, and management does not expect any impact in 2004. 24 In December 2003, the FASB issued a revision to SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits." The revision retains the requirements of the original version of SFAS No. 132, and adds additional disclosure requirements, such as descriptions of types of plan assets, investment strategy, measurement dates, plan obligations, cash flows and components of net periodic benefit costs recognized during interim periods. Adoption of the revision to SFAS No. 132 did not have an effect on the Corporation's earnings, financial condition or equity. Most of the additional disclosure requirements became effective for the Corporation's December 31, 2003, financial statements, and are included in the description of defined benefit plans in Note 12 to the consolidated financial statements. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK MARKET RISK The Corporation's two major categories of market risk, interest rate and equity securities risk, are discussed in the following sections. INTEREST RATE RISK Business risk arising from changes in interest rates is an inherent factor in operating a bank. The Corporation's assets are predominantly long-term, fixed rate loans and debt securities. Funding for these assets comes principally from shorter-term deposits and borrowed funds. Accordingly, there is an inherent risk of lower future earnings or decline in fair value of the Corporation's financial instruments when interest rates change. The Bank uses a simulation model to calculate the potential effects of interest rate fluctuations on net interest income and the market value of portfolio equity. Only assets and liabilities of the Bank are included in management's monthly simulation model calculations. Since the Bank makes up more than 90% of the Corporation's total assets and liabilities, and because the Bank is the source of the most volatile interest rate risk, management does not consider it necessary to run the model for the remaining entities within the consolidated group. For purposes of these calculations, the market value of portfolio equity includes the fair values of financial instruments, such as securities, loans, deposits and borrowed funds, and the book values of other assets and liabilities, such as premises and equipment and accrued interest. The model measures and projects potential changes in net interest income, and calculates the discounted present value of anticipated cash flows of financial instruments, assuming an immediate increase or decrease in interest rates. Management ordinarily runs a variety of scenarios within a range of plus or minus 50-300 basis points of current rates. The Bank's Board of Directors has established policy guidelines for acceptable levels of interest rate risk, based on an immediate increase or decrease in interest rates of 200 basis points. The policy limit for fluctuation in net interest income is minus 20% from the baseline one-year scenario. The policy limit for market value variance is minus 30% from the baseline one-year scenario. As reflected in the table that follows, as of December 31, 2003, the Bank's net interest income calculations show a decrease of 3.5% in the +200 basis point scenario and a decrease of 4.2% in the - 200 basis point scenario. Both of these levels are well within the policy threshold. However, if interest rates were to immediately increase 200 basis points, the Bank's calculations based on the model show that the market value of portfolio equity would decrease 35.5%, which exceeds the policy threshold and is indicative of a long-term sensitivity to rising rates. At this time, in light of the small amount of exposure to decline in net interest income over the next 12 months, as well as the strong capital and liquidity positions of the Bank and the Corporation, management does not intend to restructure the financial assets and liabilities to reduce the market value of portfolio equity exposure to fall within the Board policy mark. However, management will continue to monitor the market value of portfolio equity position on a monthly basis, and will continue to consider options for reducing exposure to rising rates. The table that follows was prepared using the simulation model described above. The model makes estimates, at each level of interest rate change, regarding cash flows from principal repayments on loans and mortgage-backed securities and call activity on other investment securities. Actual results could vary significantly from these estimates, which could result in significant differences in the calculations of projected changes in net interest margin and market value of portfolio equity. Also, the model does not make estimates related to changes in the composition of the deposit portfolio that could occur due to rate competition and the table does not necessarily reflect changes that management would make to realign the portfolio as a result of changes in interest rates. 25 THE EFFECT OF HYPOTHETICAL CHANGES IN INTEREST RATES
PERIOD ENDING DECEMBER 31, 2004 CURRENT PLUS 200 MINUS 200 (IN THOUSANDS) INTEREST BASIS BASIS DECEMBER 31, 2003 DATA RATES POINTS POINTS SCENARIO AMOUNT % CHANGE AMOUNT % CHANGE Interest income $ 54,126 $ 58,319 $ 48,386 Interest expense 20,676 26,047 16,343 -------- -------- --------- Net Interest Income $ 33,450 $ 32,272 -3.5% $ 32,043 -4.2% ======== ======== ==== ========= ==== Market Value of Portfolio Equity at Dec. 31, 2003 $123,499 $ 79,649 -35.5% $ 152,462 23.5% ======== ======== ==== ========= ====
PERIOD ENDING DECEMBER 31, 2004 CURRENT PLUS 200 MINUS 200 (IN THOUSANDS) INTEREST BASIS BASIS DECEMBER 31, 2002 DATA RATES POINTS POINTS SCENARIO AMOUNT % CHANGE AMOUNT % CHANGE Interest income $ 54,989 $ 59,608 $ 49,607 Interest expense 24,132 29,320 19,083 -------- -------- ----- --------- Net Interest Income $ 30,857 $ 30,288 -1.8% $ 30,524 -1.1% ======== ======== ===== ========= ==== Market Value of Portfolio Equity at Dec. 31, 2002 $108,144 $ 71,117 -34.2% $ 130,764 20.9% ======== ======== ===== ========= ====
EQUITY SECURITIES RISK The Corporation's equity securities portfolio consists primarily of investments in stocks of banks and bank holding companies, mainly based in Pennsylvania. The Corporation also owns some other stocks and mutual funds. Included in "Other equity securities" in the table that follows are preferred stocks issued by U.S. Government agencies with a fair value of $11,347,000 at December 31, 2003 and $6,997,000 at December 31, 2002. Investments in bank stocks are subject to the risk factors affecting the banking industry generally, including competition from non-bank entities, credit risk, interest rate risk and other factors that could result in a decline in market prices. Also, losses could occur in individual stocks held by the Corporation because of specific circumstances related to each bank. Further, because of the concentration of its holdings in Pennsylvania banks, these investments could decline in value if there were a downturn in the state's economy. The Corporation's management monitors its risk associated with its equity securities holdings by reviewing its holdings on a detailed, individual security basis, at least monthly, considering all of the factors described above. 26 Equity securities held as of December 31, 2003 and 2002 are as follows: (IN THOUSANDS)
HYPOTHETICAL HYPOTHETICAL 10% 20% DECLINE IN DECLINE IN FAIR MARKET MARKET AT DECEMBER 31, 2003 COST VALUE VALUE VALUE Banks and bank holding companies $ 16,375 $ 29,288 $ (2,929) $ (5,858) Other equity securities 13,576 13,400 (1,340) (2,680) -------- -------- -------- --------- Total $ 29,951 $ 42,688 $ (4,269) $ (8,538) ======== ======== ======== =========
HYPOTHETICAL HYPOTHETICAL 10% 20% DECLINE IN DECLINE IN FAIR MARKET MARKET AT DECEMBER 31, 2002 COST VALUE VALUE VALUE Banks and bank holding companies $ 16,336 $ 24,511 $ (2,451) $ (4,902) Other equity securities 8,550 8,569 (857) (1,714) -------- -------- -------- --------- Total $ 24,886 $ 33,080 $ (3,308) $ (6,616) ======== ======== ========= =========
27 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CONSOLIDATED BALANCE SHEET
DECEMBER 31, DECEMBER 31, (In Thousands Except Share Data) 2003 2002 ASSETS Cash and due from banks: Noninterest-bearing $ 13,938 $ 14,185 Interest-bearing 1,233 715 ---------- ---------- Total cash and cash equivalents 15,171 14,900 Available-for-sale securities 483,032 512,175 Held-to-maturity securities 560 707 Loans, net 518,800 445,356 Bank-owned life insurance 17,473 16,758 Accrued interest receivable 5,632 5,960 Bank premises and equipment, net 12,482 10,333 Foreclosed assets held for sale 101 56 Other assets 13,650 12,523 ---------- ---------- TOTAL ASSETS $1,066,901 $1,018,768 ========== ========== LIABILITIES Deposits: Noninterest-bearing $ 75,616 $ 70,824 Interest-bearing 582,449 569,480 ---------- ---------- Total deposits 658,065 640,304 Dividends payable 1,763 1,586 Short-term borrowings 37,763 43,635 Long-term borrowings 235,190 208,214 Accrued interest and other liabilities 8,777 9,192 ---------- ---------- TOTAL LIABILITIES 941,558 902,931 ---------- ---------- STOCKHOLDERS' EQUITY Common stock, par value $1.00 per share; authorized 10,000,000 shares; issued 8,226,033 in 2003 and 5,431,021 in 2002 8,226 5,431 Stock dividend distributable 2,164 1,639 Paid-in capital 20,104 21,153 Retained earnings 84,940 77,584 ---------- ---------- Total 115,434 105,807 Accumulated other comprehensive income 12,037 12,146 Unamortized stock compensation (54) (49) Treasury stock, at cost: 211,408 shares at December 31, 2003 (2,074) 145,415 shares at December 31, 2002 (2,067) ---------- ---------- TOTAL STOCKHOLDERS' EQUITY 125,343 115,837 ---------- ---------- TOTAL LIABILITIES & STOCKHOLDERS' EQUITY $1,066,901 $1,018,768 ========== ==========
The accompanying notes are an integral part of the consolidated financial statements. 28 CONSOLIDATED STATEMENT OF INCOME (IN THOUSANDS EXCEPT PER SHARE DATA)
YEARS ENDED DECEMBER 31, 2003 2002 2001 INTEREST INCOME Interest and fees on loans $ 32,235 $ 30,641 $ 28,592 Interest on balances with depository institutions 10 17 82 Interest on loans to political subdivisions 781 587 719 Interest on federal funds sold 8 42 184 Income from available-for-sale and held-to-maturity securities: Taxable 13,686 19,051 19,752 Tax-exempt 7,335 5,799 4,242 Dividends 1,168 1,148 1,090 -------- -------- -------- Total interest and dividend income 55,223 57,285 54,661 -------- -------- -------- INTEREST EXPENSE Interest on deposits 14,561 17,215 20,417 Interest on short-term borrowings 487 916 3,944 Interest on long-term borrowings 8,489 8,184 3,995 -------- -------- -------- Total interest expense 23,537 26,315 28,356 -------- -------- -------- Interest margin 31,686 30,970 26,305 Provision for loan losses 1,100 940 600 -------- -------- -------- Interest margin after provision for loan losses 30,586 30,030 25,705 -------- -------- -------- OTHER INCOME Service charges on deposit accounts 1,746 1,725 1,376 Service charges and fees 287 258 247 Trust and financial management revenue 1,733 1,755 1,576 Insurance commissions, fees and premiums 391 577 582 Increase in cash surrender value of life insurance 715 853 905 Fees related to credit card operation 784 631 550 Other operating income 939 825 884 -------- -------- -------- Total other income before realized gains on securities, net 6,595 6,624 6,120 Realized gains on securities, net 4,799 2,888 1,920 -------- -------- -------- Total other income 11,394 9,512 8,040 -------- -------- -------- OTHER EXPENSES Salaries and wages 9,696 9,418 8,493 Pensions and other employee benefits 3,317 2,651 2,213 Occupancy expense, net 1,295 1,094 1,018 Furniture and equipment expense 1,372 1,532 1,431 Expenses related to credit card operation 385 285 295 Pennsylvania shares tax 792 734 790 Other operating expense 5,257 5,135 4,431 -------- -------- -------- Total other expenses 22,114 20,849 18,671 -------- -------- -------- Income before income tax provision 19,866 18,693 15,074 Income tax provision 3,609 3,734 3,022 -------- -------- -------- NET INCOME $ 16,257 $ 14,959 $ 12,052 ======== ======== ======== NET INCOME PER SHARE - BASIC $ 2.01 $ 1.85 $ 1.49 ======== ======== ======== NET INCOME PER SHARE - DILUTED $ 2.00 $ 1.84 $ 1.49 ======== ======== ========
The accompanying notes are an integral part of the consolidated financial statements 29 CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (IN THOUSANDS EXCEPT PER SHARE DATA)
ACCUMULATED STOCK OTHER UNAMORTIZED COMMON DIVIDEND PAID-IN RETAINED COMPREHENSIVE STOCK TREASURY STOCK DISTRIBUTABLE CAPITAL EARNINGS INCOME COMPENSATION STOCK TOTAL ------ ------------- ------- -------- ------------- ------------ -------- -------- BALANCE, DECEMBER 31, 2000 $5,325 $ 1,054 $18,756 $65,206 $ 82 $ (35) $ (1,419) $ 88,969 Comprehensive income: Net income 12,052 12,052 Unrealized gain on securities, net of reclassification adjustment and tax effects 5,202 5,202 -------- -------- Total comprehensive income 17,254 -------- Cash dividends declared, $0.7067 per share (5,554) (5,554) Treasury stock purchased (521) (521) Amortization of restricted stock 22 22 Tax benefit from employee benefit plan 17 17 Stock dividend issued 53 (1,054) 1,001 - Stock dividend declared, 1% 1,369 (1,369) - Restricted stock granted 1 (4) 3 - ------- ------- -------- -------- BALANCE, DECEMBER 31, 2001 5,378 1,369 19,758 70,352 5,284 (17) (1,937) 100,187 Comprehensive income: Net income 14,959 14,959 Unrealized gain on securities, net of reclassification adjustment and tax effects 6,862 6,862 -------- -------- Total comprehensive income 21,821 -------- Cash dividends declared, $0.7733 per share (6,158) (6,158) Treasury stock purchased (239) (239) Amortization of restricted stock 80 80 Shares issued from treasury related to exercise of stock options 26 50 76 Tax benefit from employee benefit plan 70 70 Stock dividend issued 53 (1,369) 1,316 - Stock dividend declared, 1% 1,639 (1,639) - Restricted stock granted 55 (116) 61 - Forfeiture of restricted stock (2) 4 (2) - ------- ------- -------- -------- BALANCE, DECEMBER 31, 2002 5,431 1,639 21,153 77,584 12,146 (49) (2,067) 115,837 Comprehensive income: Net income 16,257 16,257 Unrealized loss on securities, net of reclassification adjustment and tax effects (109) (109) -------- -------- Total comprehensive income 16,148 -------- Cash dividends declared, $.85 per share (6,821) (6,821) Treasury stock purchased (174) (174) Shares issued from treasury related to exercise of stock options 78 119 197 Amortization of restricted stock 102 102 Tax benefit from employee benefit plan 84 84 Stock dividend issued 53 (1,639) 1,556 (30) 3-for-2 stock split, April 2003 2,742 (2,742) - Stock dividend declared, 1% 2,164 (2,164) - Restricted stock granted 59 (107) 48 - ------- ------- -------- -------- BALANCE, DECEMBER 31, 2003 $8,226 $ 2,164 $20,104 $84,940 $ 12,037 $ (54) $ (2,074) $125,343 ====== ========= ======= ======= ======== ======= ======== ========
The accompanying notes are an integral part of the consolidated financial statements. 30 CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS)
YEARS ENDED DECEMBER 31, 2003 2002 2001 CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 16,257 $ 14,959 $ 12,052 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 1,100 940 600 Realized gains on securities, net (4,799) (2,888) (1,920) Gain on sale of foreclosed assets, net (105) (39) (88) Depreciation expense 1,211 1,346 1,300 Accretion and amortization, net 1,241 (376) (1,869) Increase in cash surrender value of life insurance (715) (853) (905) Amortization of restricted stock 102 80 22 Deferred income taxes (25) (284) (349) Decrease (Increase) in accrued interest receivable and other assets 487 (958) (126) (Decrease) Increase in accrued interest payable and other liabilities (164) 669 579 --------- --------- --------- Net Cash Provided by Operating Activities 14,590 12,596 9,296 --------- --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from maturity of held-to-maturity securities 145 731 1,083 Purchase of held-to-maturity securities - - (626) Proceeds from sales of available-for-sale securities 53,562 29,345 25,788 Proceeds from calls and maturities of available-for-sale securities 178,682 155,811 152,568 Purchase of available-for-sale securities (199,705) (249,693) (261,148) Purchase of Federal Home Loan Bank of Pittsburgh stock (1,855) (3,943) (1,750) Redemption of Federal Home Loan Bank of Pittsburgh stock 482 1,870 869 Net increase in loans (74,824) (72,819) (51,984) Purchase of low-income housing partnerships - - (306) Purchase of premises and equipment (3,360) (1,712) (1,935) Proceeds from sale of foreclosed assets 340 648 660 --------- --------- --------- Net Cash Used in Investing Activities (46,533) (139,762) (136,781) --------- --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Net increase in deposits 17,761 64,030 47,307 Net decrease in short-term borrowings (5,872) (14,429) (36,627) Proceeds from long-term borrowings 64,500 117,653 125,000 Repayments of long-term borrowings (37,524) (35,023) (21) Purchase of treasury stock (174) (239) (521) Sale of treasury stock 197 76 - Dividends paid (6,674) (6,038) (5,441) --------- --------- --------- Net Cash Provided by Financing Activities 32,214 126,030 129,697 --------- --------- --------- INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 271 (1,136) 2,212 CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 14,900 16,036 13,824 --------- --------- --------- CASH AND CASH EQUIVALENTS, END OF YEAR $ 15,171 $ 14,900 $ 16,036 ========= ========= ========= SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Assets acquired through foreclosure of real estate loans $ 280 $ 486 $ 435 Interest paid $ 23,736 $ 26,424 $ 28,665 Income taxes paid $ 3,195 $ 4,509 $ 2,961
The accompanying notes are an integral part of the consolidated financial statements. 31 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF CONSOLIDATION - The consolidated financial statements include the accounts of Citizens & Northern Corporation ("Corporation"), and its subsidiaries, Citizens & Northern Bank ("Bank"), Bucktail Life Insurance Company and Citizens & Northern Investment Corporation. The consolidated financial statements also include the accounts of the Bank's wholly-owned subsidiary, C&N Financial Services Corporation. All material intercompany balances and transactions have been eliminated in consolidation. NATURE OF OPERATIONS - The Corporation is primarily engaged in providing a full range of banking and mortgage services to individual and corporate customers in Northcentral Pennsylvania. Lending products include mortgage loans, commercial loans, consumer loans and credit cards, as well as specialized instruments such as commercial letters-of-credit. Deposit products include various types of checking accounts, passbook and statement savings, money market accounts, interest checking accounts, individual retirement accounts and certificates of deposit. The Corporation also offers non-insured "Repo Sweep" accounts. The Corporation provides Trust and Financial Management services, including administration of trusts and estates, retirement plans, and other employee benefit plans, and investment management services. The Corporation offers a variety of personal and commercial insurance products through C&N Financial Services Corporation. C&N Financial Services Corporation also has a broker-dealer division, which offers mutual funds, annuities, educational savings accounts and other investment products through registered agents. The Corporation is subject to competition from other financial institutions. It is also subject to regulation by certain federal and state agencies and undergoes periodic examination by those regulatory authorities. USE OF ESTIMATES - The presentation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect reported amounts and disclosures. Actual results could differ from these estimates. A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses. Management believes that the allowance for loan losses is adequate and reasonable. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation's allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination. INVESTMENT SECURITIES - Investment securities are accounted for as FOLLOWS: HELD-TO-MATURITY SECURITIES - includes debt securities that the Corporation has the positive intent and ability to hold to maturity. These securities are reported at cost adjusted for amortization of premiums and accretion of discounts, computed using the level-yield method. AVAILABLE-FOR-SALE SECURITIES - includes debt securities not classified as held-to-maturity and unrestricted equity securities. Such securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported separately through accumulated other comprehensive income, net of tax. Amortization of premiums and accretion of discounts on available-for-sale securities are recorded using the level yield method over the remaining contractual life of the securities, adjusted for actual prepayments. Realized gains and losses on sales of available-for-sale securities are computed on the basis of specific identification of the adjusted cost of each security. RESTRICTED EQUITY SECURITIES - Restricted equity securities consist primarily of Federal Home Loan Bank of Pittsburgh stock, and are carried at cost and evaluated for impairment. Holdings of restricted equity securities are included in Other Assets in the Consolidated Balance Sheet, and dividends received on restricted securities are included in Other Income in the Consolidated Statement of Income. LOANS - Loans are stated at unpaid principal balances, less the allowance for loan losses and net deferred loan fees. Loan origination and commitment fees, as well as certain direct origination costs, are deferred and amortized as a yield adjustment over the lives of the related loans using the interest method. Amortization of deferred loan fees is discontinued when a loan is placed on nonaccrual status. 32 Loans are placed on nonaccrual status when, in the opinion of management, collection of interest is doubtful. Any unpaid interest previously accrued on those loans is reversed from income. Interest income is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on such loans are applied as a reduction of the loan principal balance. Interest income on other nonaccrual loans is recognized only to the extent of interest payments received. The allowance for loan losses is maintained at a level which, in management's judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management's evaluation of the collectibility of the loan portfolio, based on factors such as credit concentrations, past due or delinquency status, trends in historical loss experience, specific impaired loans, and economic conditions. Past due or delinquency status of loans is computed based on the contractual terms of the loans. Allowances for impaired loans are determined based on collateral values or the present value of estimated cash flows. The allowance is increased by a provision for loan losses, which is charged to expense, and reduced by charge-offs, net of recoveries. Loan balances are charged off when it becomes evident that such balances are not fully collectible. BANK PREMISES AND EQUIPMENT - Bank premises and equipment are stated at cost less accumulated depreciation. Repair and maintenance expenditures which extend the useful lives of assets are capitalized, and other repair and maintenance expenditures are expensed as incurred. Depreciation expense is computed using the straight-line method. FORECLOSED ASSETS HELD FOR SALE - Foreclosed assets held for sale consist of real estate acquired by foreclosure and are carried at estimated fair value, less selling cost. INCOME TAXES - Provisions for deferred income taxes are made as a result of temporary differences in financial and income tax methods of accounting. These differences relate principally to loan losses, securities gains or losses, depreciation, pension and other postretirement benefits and amortization of loan origination fees and costs. STOCK COMPENSATION PLANS - As permitted by Accounting Principles Board Opinion No. 25, the Corporation uses the intrinsic value method of accounting for stock compensation plans. Utilizing the intrinsic value method, compensation cost is measured by the excess of the quoted market price of the stock as of the grant date (or other measurement date) over the amount an employee or director must pay to acquire the stock. Stock options issued under the Corporation's stock option plans have no intrinsic value, and accordingly, no compensation cost is recorded for them. The Corporation has also made awards of restricted stock. Compensation cost related to restricted stock is recognized based on the market price of the stock at the grant date over the vesting period. The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-based Compensation," to stock options. The number of shares used in each computation of earnings per share has been restated for the effects of 1% stock dividends issued in January of each year, and for the effects of a 3-for-2 stock split issued in April 2003. (NET INCOME IN THOUSANDS)
2003 2002 2001 Net income, as reported $16,257 $14,959 $12,052 Deduct: Total stock option compensation expense determined under fair value method for all awards, net of tax effects (124) (191) (63) ------- ------- ------- Pro forma net income $16,133 $14,768 $11,989 ======= ======= ======= Earnings per share-basic As reported $ 2.01 $ 1.85 $ 1.49 Pro forma $ 1.99 $ 1.83 $ 1.48 Earnings per share-diluted As reported $ 2.00 $ 1.84 $ 1.49 Pro forma $ 1.98 $ 1.82 $ 1.48
33 PENSIONS AND OTHER POSTRETIREMENT BENEFIT PLANS - Effective December 31, 2003, the Corporation adopted Statement of Financial Accounting Standards No. 132 (revised 2003), "Employers' Disclosures about Pensions and Other Postretirement Benefits" ("Revised SFAS No. 132"). Revised SFAS No. 132 requires additional disclosures about defined benefit plans and other postretirement plans. It does not change the measurement or recognition of those plans. Applicable prior year disclosures have been restated to conform to Revised SFAS No. 132 requirements. OFF-BALANCE SHEET FINANCIAL INSTRUMENTS - In the ordinary course of business, the Corporation has entered into off-balance sheet financial instruments consisting of commitments to extend credit and standby letters of credit. Such financial instruments are recorded in the financial statements when they become payable. CASH FLOWS - The Corporation utilizes the net reporting of cash receipts and cash payments for certain deposit and lending activities. The Corporation considers all cash and amounts due from depository institutions, interest-bearing deposits in other banks, and federal funds sold to be cash equivalents. TRUST ASSETS AND INCOME - Assets held by the Corporation in a fiduciary or agency capacity for its customers are not included in the financial statements since such items are not assets of the Corporation. Trust income is recorded on a cash basis, which is not materially different from the accrual basis. 2. COMPREHENSIVE INCOME Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income. The components of other comprehensive income and the related tax effects are as follows:
YEARS ENDED DECEMBER 31, (IN THOUSANDS) 2003 2002 2001 Unrealized holding gains on available-for-sale securities $ 4,636 $ 13,283 $ 9,802 Less: Reclassification adjustment for gains realized in income (4,799) (2,888) (1,920) ------- -------- ------- Net unrealized (losses) gains (163) 10,395 7,882 Tax effect 54 (3,533) (2,680) ------- -------- ------- Net-of-tax amount $ (109) $ 6,862 $ 5,202 ======= ======== =======
3. PER SHARE DATA Net income per share is based on the weighted-average number of shares of common stock outstanding. The number of shares used in calculating net income and cash dividends per share reflect the retroactive effect of a 3-for-2 stock split issued in April 2003, as well as 1% stock dividends declared in the fourth quarter of each year presented, payable in the first quarter of the following year. The following data show the amounts used in computing basic and diluted net income per share. The dilutive effect of stock options is computed as the weighted-average common shares available from the exercise of all dilutive stock options, less the number of shares that could be repurchased with the proceeds of stock option exercises based on the average share price of the Corporation's common stock during the period. 34
WEIGHTED- AVERAGE EARNINGS NET COMMON PER INCOME SHARES SHARE 2003 Earnings per share - basic $ 16,257,000 8,089,753 $2.01 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 195,624 Hypothetical share repurchase at $24.27 (146,909) --------------------------------------------------------------------------------------------------- Earnings per share - diluted $ 16,257,000 8,138,468 $2.00 =================================================================================================== 2002 Earnings per share - basic $ 14,959,000 8,089,266 $1.85 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 139,374 Hypothetical share repurchase at $19.45 (117,486) --------------------------------------------------------------------------------------------------- Earnings per share - diluted $ 14,959,000 8,111,154 $1.84 =================================================================================================== 2001 Earnings per share - basic $ 12,052,000 8,103,679 $1.49 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 35,733 Hypothetical share repurchase at $14.43 (33,477) --------------------------------------------------------------------------------------------------- Earnings per share - diluted $ 12,052,000 8,105,935 $1.49 ===================================================================================================
4. CASH AND DUE FROM BANKS Banks are required to maintain reserves consisting of vault cash and deposit balances with the Federal Reserve Bank in their district. The reserves are based on deposit levels during the year and account activity and other services provided by the Federal Reserve Bank. Average daily currency, coin, and cash balances with the Federal Reserve Bank needed to cover reserves against deposits for 2003 ranged from $2,402,000 to $4,434,000. For 2002, theses balances ranged from $2,161,000 to $6,458,000. Average daily cash balances with the Federal Reserve Bank required for services provided to the Bank were $2,500,000 in 2003 and 2002. Total balances restricted amounted to $6,324,000 at December 31, 2003 and $6,332,000 at December 31, 2002. Deposits with one financial institution are insured up to $100,000. The Corporation maintains cash and cash equivalents with certain financial institutions in excess of the insured amount. 35 5. SECURITIES Amortized cost and fair value of securities at December 31, 2003 and 2002 are summarized as follows:
DECEMBER 31, 2003 GROSS GROSS UNREALIZED UNREALIZED AMORTIZED HOLDING HOLDING FAIR (IN THOUSANDS) COST GAINS LOSSES VALUE AVAILABLE-FOR-SALE SECURITIES: Obligations of the U.S. Treasury $ - $ - $ - $ - Obligations of other U.S. Government agencies 61,437 562 (929) 61,070 Obligations of states and political subdivisions 159,128 4,791 (1,501) 162,418 Other securities 45,992 1,764 (108) 47,648 Mortgage-backed securities 168,285 1,933 (1,010) 169,208 ---------------------------------------------------------------------------------------------------------------------------- Total debt securities 434,842 9,050 (3,548) 440,344 Marketable equity securities 29,951 13,609 (872) 42,688 ---------------------------------------------------------------------------------------------------------------------------- Total $ 464,793 $ 22,659 $(4,420) $ 483,032 ============================================================================================================================ HELD-TO-MATURITY SECURITIES: Obligations of the U.S. Treasury $ 319 $ 30 $ - $ 349 Obligations of other U.S. Government agencies 199 17 - 216 Mortgage-backed securities 42 2 - 44 ---------------------------------------------------------------------------------------------------------------------------- Total $ 560 $ 49 $ - $ 609 ============================================================================================================================
DECEMBER 31, 2002 GROSS GROSS UNREALIZED UNREALIZED AMORTIZED HOLDING HOLDING FAIR (IN THOUSANDS) COST GAINS LOSSES VALUE AVAILABLE-FOR-SALE SECURITIES: Obligations of the U.S. Treasury $ - $ - $ - $ - Obligations of other U.S. Government agencies 71,657 1,624 (933) 72,348 Obligations of states and political subdivisions 127,690 3,482 (293) 130,879 Other securities 62,296 1,398 (102) 63,592 Mortgage-backed securities 207,244 5,188 (156) 212,276 ------------------------------------------------------------------------------------------------------------------------ Total debt securities 468,887 11,692 (1,484) 479,095 Marketable equity securities 24,886 8,959 (765) 33,080 ------------------------------------------------------------------------------------------------------------------------ Total $ 493,773 $ 20,651 $(2,249) $ 512,175 ======================================================================================================================== HELD-TO-MATURITY SECURITIES: Obligations of the U.S. Treasury $ 321 $ 38 $ - $ 359 Obligations of other U.S. Government agencies 297 25 - 322 Mortgage-backed securities 89 4 - 93 ------------------------------------------------------------------------------------------------------------------------ Total $ 707 $ 67 $ - $ 774 ========================================================================================================================
36 The following table presents gross unrealized losses and fair value of investments aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2003:
LESS THAN 12 MONTHS 12 MONTHS OR MORE TOTAL FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED (IN THOUSANDS) VALUE LOSSES VALUE LOSSES VALUE LOSSES AVAILABLE-FOR-SALE SECURITIES: Obligations of the U.S. Treasury $ - $ - $ - $ - $ - $ - Obligations of other U.S. Government agencies 17,059 (929) - - 17,059 (929) Obligations of states and political subdivisions 41,764 (1,478) 2,451 (23) 44,215 (1,501) Other securities 3,190 (33) 5,025 (75) 8,215 (108) Mortgage-backed securities 89,256 (1,010) - - 89,256 (1,010) -------------------------------------------------------------------------------------------------------------------------------- Total debt securities 151,269 (3,450) 7,476 (98) 158,745 (3,548) Marketable equity securities 4,979 (751) 1,208 (121) 6,187 (872) -------------------------------------------------------------------------------------------------------------------------------- Total temporarily impaired available-for-sale securities $156,248 $ (4,201) $ 8,684 $ (219) $ 164,932 $ (4,420) ================================================================================================================================ HELD-TO-MATURITY SECURITIES: Obligations of the U.S. Treasury $ - $ - $ - $ - $ - $ - Obligations of other U.S. Government agencies - - - - - - Mortgage-backed securities - - - - - - -------------------------------------------------------------------------------------------------------------------------------- Total temporarily impaired held-to-maturity securities $ - $ - $ - $ - $ - $ - ================================================================================================================================
The unrealized losses on debt securities are primarily the result of volatility in interest rates. Based on the credit worthiness of the issuers, which are almost exclusively U.S. Government agencies or state and political subdivisions, management believes the Corporation's debt securities at December 31, 2003 were not other-than-temporarily impaired. Of the total $872,000 unrealized losses on equity securities at December 31, 2003, $655,000 was from a preferred stock issued by an U.S. Government agency. Management believes this security's fair value is affected primarily by volatility in interest rates, and that there is very little credit risk associated with this security. For the remaining equity securities for which fair value was less than cost at December 31, 2003, management believes the financial condition and near-term prospects of those issuers indicate those securities were not other-than-temporarily impaired. The amortized cost and fair value of investment debt securities at December 31, 2003 follow. Maturities of debt securities (including mortgage-backed securities) are presented based on contractual maturities. Expected maturities differ from contractual maturities because monthly principal payments are received from mortgage-backed securities, and because borrowers may have the right to prepay obligations with or without prepayment penalties. 37
DECEMBER 31, 2003 AMORTIZED FAIR (IN THOUSANDS) COST VALUE AVAILABLE-FOR-SALE SECURITIES: Due in one year or less $ 1,166 $ 1,169 Due after one year through five years 4,389 4,635 Due after five years through ten years 69,051 69,088 Due after ten years 360,236 365,452 --------- --------- Total $ 434,842 $ 440,344 ========= ========= HELD-TO-MATURITY SECURITIES: Due in one year or less $ - $ - Due after one year through five years - - Due after five years through ten years 547 596 Due after ten years 13 13 --------- --------- Total $ 560 $ 609 ========= =========
The following table shows the amortized cost and maturity distribution of the debt securities portfolio at December 31, 2003:
WITHIN ONE - FIVE - AFTER ONE FIVE TEN TEN (IN THOUSANDS, EXCEPT FOR PERCENTAGES) YEAR YIELD YEARS YIELD YEARS YIELD YEARS YIELD TOTAL YIELD AVAILABLE-FOR-SALE SECURITIES: Obligations of the U.S. Treasury $ - - $ - - $ - - $ - - $ - - Obligations of other U.S. Government agencies - - 2,500 4.25% 35,139 4.52% 23,798 5.00% 61,437 4.69% Obligations of states and political subdivisions 166 7.09% 1,866 6.57% 3,153 5.82% 153,943 4.80% 159,128 4.84% Other securities 1,000 9.25% - - 11,000 5.15% 33,992 6.42% 45,992 6.18% Mortgage-backed securities 23 8.11% 19,759 4.24% 148,503 4.59% 168,285 4.55% ------- ----- ------- ----- -------- ----- --------- ----- --------- ----- Total $ 1,166 8.94% $ 4,389 5.26% $ 69,051 4.60% $ 360,236 4.88% $ 434,842 4.85% ======= ===== ======= ===== ======== ===== ========= ===== ========= ===== HELD-TO-MATURITY SECURITIES: Obligations of the U.S. Treasury $ - - $ - - $ 319 5.30% $ - - $ 319 5.30% Obligations of other U.S. Government agencies - - - 199 6.76% - - 199 6.76% Mortgage-backed securities - - - 29 6.18% 13 3.33% 42 5.30% ------- ----- ------- ----- -------- ----- --------- ----- --------- ----- Total $ - - $ - - $ 547 5.88% $ 13 3.33% $ 560 5.82% ======= ===== ======= ===== ======== ===== ========= ===== ========= =====
Investment securities carried at $80,308,000 at December 31, 2003 and $90,655,000 at December 31, 2002, were pledged as collateral for public deposits, trusts and certain other deposits as provided by law. Also, see Note 9 for information concerning securities pledged to secure borrowing arrangements. Gross realized gains and losses from the sales of available-for-sale securities, and the income tax provision related to net realized gains, for 2003, 2002 and 2001 were as follows:
(IN THOUSANDS) 2003 2002 2001 Gross realized gains $ 4,860 $ 2,926 $ 2,408 Gross realized losses (61) (38) (488) --------- --------- --------- Net realized gains $ 4,799 $ 2,888 $ 1,920 ========= ========= ========= Income tax provision related to net realized gains $ 1,632 $ 982 $ 653 ========= ========= =========
38 6. LOANS Major categories of loans and leases included in the loan portfolio are as follows:
(IN THOUSANDS) DECEMBER 31, % OF DECEMBER 31, % OF 2003 TOTAL 2002 TOTAL Real estate - construction $ 2,856 0.54% $ 103 0.02% Real estate - mortgage 431,047 82.13% 370,453 82.11% Consumer 33,977 6.47% 31,532 6.99% Agricultural 2,948 0.56% 3,024 0.67% Commercial 34,967 6.66% 30,874 6.84% Other 1,183 0.23% 2,001 0.44% Political subdivisions 17,854 3.40% 13,062 2.90% Lease receivables 65 0.01% 96 0.02% ------------ ------ ------------ ------ Total 524,897 100.00% 451,145 100.00% Less: allowance for loan losses (6,097) (5,789) ------------ ------------ Loans, net $ 518,800 $ 445,356 ============ ============
Net unamortized loan fees and costs of $1,629,000 at December 31, 2003 and $1,564,000 at December 31, 2002 have been offset against the carrying value of loans. There is no concentration of loans to borrowers engaged in similar businesses or activities that exceed 10% of total loans at December 31, 2003. The Corporation grants commercial, residential and personal loans to customers primarily in Tioga, Bradford, Sullivan and Lycoming Counties. Although the Corporation has a diversified loan portfolio, a significant portion of its debtors' ability to honor their contracts is dependent on the local economic conditions within the region. LOAN MATURITY DISTRIBUTION (IN THOUSANDS)
FIXED RATE LOANS: VARIABLE OR ADJUSTABLE RATE LOANS: 1 YEAR OR 1 YEAR OR LESS 1-5 YEARS > 5 YEARS TOTAL LESS 1-5 YEARS > 5 YEARS TOTAL Real estate - construction $ 2,856 $ - $ - $ 2,856 $ - $ - $ - $ - Real estate - mortgage 56,314 127,437 109,572 293,323 25,507 20,049 92,168 137,724 Consumer 8,430 13,173 2,346 23,949 9,443 274 311 10,028 Agricultural 615 1,087 62 1,764 404 572 208 1,184 Commercial 3,846 6,668 2,129 12,643 14,008 4,033 4,283 22,324 Other 328 341 416 1,085 98 - - 98 Political subdivisions 1,619 5,088 11,147 17,854 - - - - Lease receivables 16 49 - 65 - - - - --------- --------- --------- -------- --------- --------- --------- -------- Total $ 74,024 $ 153,843 $ 125,672 $353,539 $ 49,460 $ 24,928 $ 96,970 $171,358 ========= ========= ========= ======== ========= ========= ========= ========
Loans in the preceding table that are due on demand are shown as one year or less. 39 Transactions in the allowance for loan losses were as follows: (IN THOUSANDS)
2003 2002 2001 Balance at beginning of year $ 5,789 $ 5,265 $ 5,291 Provision charged to operations 1,100 940 600 Loans charged off (968) (552) (713) Recoveries 176 136 87 ------- ------- ------- Balance at end of year $ 6,097 $ 5,789 $ 5,265 ======= ======= =======
Information related to impaired and nonaccrual loans, and loans past due 90 days or more, as of December 31, 2003 and 2002 is as follows: (IN THOUSANDS)
2003 2002 Impaired loans without a valuation allowance $ 114 $ 675 Impaired loans with a valuation allowance 4,507 3,039 ------- ------- Total impaired loans $ 4,621 $ 3,714 ======= ======= Valuation allowance related to impaired loans $ 1,542 $ 1,877 Total nonaccrual loans $ 1,145 $ 1,252 Total loans past due 90 days or more and still accruing $ 2,546 $ 2,318
The following is a summary of information related to impaired loans for 2003, 2002 and 2001: (IN THOUSANDS)
2003 2002 2001 Average investment in impaired loans $3,425 $3,838 $781 ====== ====== ==== Interest income recognized on impaired loans $ 313 $ 247 $ 14 ====== ====== ==== Interest income recognized on a cash basis on impaired loans $ 313 $ 247 $ 14 ====== ====== ====
No additional funds are committed to be advanced in connection with impaired loans. 7. BANK PREMISES AND EQUIPMENT Bank premises and equipment are summarized as follows: (IN THOUSANDS)
DECEMBER 31, 2003 2002 Land $ 1,275 $ 1,275 Buildings and improvements 13,125 12,295 Furniture and equipment 9,663 9,022 Construction in progress 1,807 - -------- -------- Total 25,870 22,592 Less: accumulated depreciation (13,388) (12,259) -------- -------- Net $ 12,482 $ 10,333 ======== ========
Depreciation expense included in occupancy expense and furniture and equipment expense was as follows: 40 (IN THOUSANDS)
2003 2002 2001 Occupancy expense $ 479 $ 432 $ 401 Furniture and equipment expense 732 914 899 ------- ------- ------- Total $ 1,211 $ 1,346 $ 1,300 ======= ======= =======
8. DEPOSITS Balances and maturities of time deposits are as follows: (IN THOUSANDS)
DECEMBER 31, 2003 2004 2005 2006 2007 2008 THEREAFTER TOTAL Certificates of Deposit $103,044 $ 26,914 $ 17,094 $ 21,678 $ 13,137 $ 162 $ 182,029 Yield 2.07% 3.27% 4.05% 4.65% 3.64% 3.73% 2.86% Individual Retirement Accounts 74,881 38,657 - 199 57 - 113,794 Yield 4.82% 4.82% - 4.59% 4.18% - 4.82% -------- --------- -------- --------- -------- ---------- ----------- Total Time Deposits $177,925 $ 65,571 $ 17,094 $ 21,877 $ 13,194 $ 162 $ 295,823 -------- --------- -------- --------- -------- ---------- ----------- Yield 3.23% 4.18% 4.05% 4.65% 3.64% 3.73% 3.61% ======== ========= ======== ========= ======== ========== ===========
DECEMBER 31, 2002 2003 2004 2005 2006 2007 THEREAFTER TOTAL Certificates of Deposit $127,796 $ 20,369 $ 14,648 $ 10,878 $ 19,743 $ 251 $ 193,685 Yield 3.18% 3.75% 4.38% 4.84% 4.83% 4.47% 3.59% Individual Retirement Accounts 76,875 22,690 - - 169 - 99,734 Yield 5.00% 5.00% - - 4.62% - 5.00% -------- --------- -------- --------- -------- ---------- ----------- Total Time Deposits $204,671 $ 43,059 $ 14,648 $ 10,878 $ 19,912 $ 251 $ 293,419 -------- --------- -------- --------- -------- ---------- ----------- Yield 3.86% 4.41% 4.38% 4.84% 4.83% 4.47% 4.07% ======== ========= ======== ========= ======== ========== ===========
Included in interest-bearing deposits are time deposits in the amount of $100,000 or more. As of December 31, 2003, the remaining maturities or repricing frequency of time deposits of $100,000 or more are as follows: (IN THOUSANDS) Three months or less $37,136 Over 3 months through 12 months 16,276 Over 1 year through 3 years 5,468 Over 3 years 10,356 ------ Total $69,236 =======
Interest expense from deposits of $100,000 or more amounted to $2,693,000 in 2003, $3,238,000 in 2002 and $3,220,000 in 2001. 41 9. BORROWED FUNDS SHORT-TERM BORROWINGS Short-term borrowings include the following: (IN THOUSANDS)
AT DECEMBER 31, 2003 2002 Overnight borrowings (a) $ 6,900 $ 14,350 Federal Home Loan Bank of Pittsburgh borrowings (b) 7,500 2,500 Customer repurchase agreements (c) 23,363 20,218 Other repurchase agreements (d) - 6,567 -------- -------- Total short-term borrowings $ 37,763 $ 43,635 ======== ========
The weighted average interest rate on total short-term borrowings outstanding was 1.21% at December 31, 2003 and 1.77% at December 31, 2002. The maximum amount of total short-term borrowings outstanding at any month-end was $45,166,000 in 2003 and $43,635,000 in 2002. (a) Overnight borrowings include federal funds purchased overnight from correspondent banks and overnight borrowings from the Federal Home Loan Bank of Pittsburgh (FHLB-Pittsburgh) on the "Open Repo Plus" facility. The maximum month-end amount of such borrowings was $16,950,000 in 2003, $14,350,000 in 2002 and $20,000,000 in 2001. The average amount of such borrowings was $6,044,000 in 2003, $2,347,000 in 2002 and $4,012,000 in 2001. Weighted average interest rates were 1.50% in 2003, 1.86% in 2002 and 4.58% in 2001. (b) Short-term FHLB - Pittsburgh loans are as follows: (IN THOUSANDS)
AT DECEMBER 31, 2003 2002 Fixed Rate 1.51% matured February 19, 2003 $ - $ 1,000 Fixed Rate 1.68% matured November 19, 2003 - 1,500 Fixed Rate 1.33% maturing April 28, 2004 2,000 - Fixed Rate 1.28% maturing May 13, 2004 2,500 - Fixed Rate 1.25% maturing June 29, 2004 1,500 - Fixed Rate 1.26% maturing July 28, 2004 1,500 - -------- -------- Total short-term FHLB - Pittsburgh borrowings $ 7,500 $ 2,500 ======== ========
Collateral for FHLB - Pittsburgh loans is described under the "Long-term Borrowings" section of this note. (c) Customer repurchase agreements mature overnight, and are collateralized by securities with a carrying value of $35,680,000 at December 31, 2003 and $23,305,000 at December 31, 2002. (d) Other repurchase agreements included in short-term borrowings are as follows: (IN THOUSANDS)
AT DECEMBER 31, 2003 2002 Fixed Rate 2.91% matured March 25, 2003 $ - $ 6,567 ------ -------- Total other repurchase agreements $ - $ 6,567 ====== ========
The terms and collateral related to repurchase agreements are described under the "Long-term Borrowings" section of this note. 42 LONG-TERM BORROWINGS Long-term borrowings are as follows: (IN THOUSANDS)
AT DECEMBER 31, 2003 2002 FHLB - Pittsburgh borrowings (e) $ 185,037 $ 170,061 Repurchase agreements (f) 50,153 38,153 --------- --------- Total long-term borrowings $ 235,190 $ 208,214 ========= =========
(e) Long-term borrowings from FHLB - Pittsburgh are as follows: (IN THOUSANDS)
AT DECEMBER 31, 2003 2002 Loans matured in 2003 with rates ranging from 4.63% to 4.82% $ - $ 30,000 Loans maturing in 2004 with rates ranging from 2.16% to 4.65% 28,000 28,000 Loans maturing in 2005 with rates ranging from 1.64% to 5.05% 40,000 29,500 Loans maturing in 2006 with rates ranging from 2.07% to 4.83% 45,000 32,000 Loans maturing in 2007 with rates ranging from 2.93% to 4.58% 45,000 35,000 Loans maturing in 2008 with rates ranging from 2.97% to 3.67% 9,500 - Loan maturing in 2009 with a rate of 3.62% 2,000 - Loan maturing in 2011 with a rate of 4.98% 5,000 5,000 Loan maturing in 2012 with a rate of 4.54% 10,000 10,000 Loan maturing in 2016 with a rate of 6.86% 476 498 Loan maturing in 2017 with a rate of 6.83% 61 63 --------- --------- Total long-term FHLB - Pittsburgh borrowings $ 185,037 $ 170,061 ========= =========
The FHLB - Pittsburgh loan facilities are collateralized by qualifying securities and mortgage loans with a book value totaling $398,584,000 at December 31, 2003. Also, the FHLB - Pittsburgh loan facilities require the Corporation to invest in established amounts of FHLB - Pittsburgh stock. The carrying values of the Corporation's holdings of FHLB - Pittsburgh stock were $11,575,000 at December 31, 2003 and $10,202,000 at December 31, 2002. (f) Repurchase agreements included in long-term borrowings are as follows: (IN THOUSANDS)
AT DECEMBER 31, 2003 2002 Agreement matured in 2003 with a rate of 2.53% $ - $ 7,500 Agreements maturing in 2004 with rates ranging from 1.62% to 3.96% 19,767 14,067 Agreements maturing in 2005 with rates ranging from 2.01% to 4.63% 15,666 11,766 Agreements maturing in 2006 with rates ranging from 2.79% to 4.63% 10,220 4,820 Agreement maturing in 2007 with a rate of 3.23% 2,500 - Agreement maturing in 2008 with a rate of 3.60% 2,000 - -------- -------- Total long-term repurchase agreements $ 50,153 $ 38,153 ======== ========
Securities sold under repurchase agreements were delivered to the broker-dealers who arranged the transactions. The broker-dealers may have sold, loaned or otherwise disposed of such securities to other parties in the normal course of their operations, and have agreed to resell to the Corporation substantially identical securities at the maturities of the agreements. The carrying value of the underlying securities was $58,086,000 at December 31, 2003 and $54,763,000 at December 31, 2002. Average daily repurchase agreement borrowings amounted to $40,333,000 in 2003, $36,482,000 in 2002 and $14,217,000 in 2001. During 2003, 2002 and 2001, the maximum amounts of outstanding borrowings under repurchase agreements with broker-dealers were $50,153,000, $44,720,000 and $19,450,000. The weighted average interest rate on repurchase agreements was 3.68% in 2003, 3.72% in 2002 and 6.20% in 2001. 43 10. DERIVATIVE FINANCIAL INSTRUMENTS The Corporation utilizes derivative financial instruments related to a certificate of deposit product called the "Index Powered Certificate of Deposit" (IPCD). IPCDs have a term of 5 years, with interest paid at maturity based on 90% of the appreciation (as defined) in the S&P 500 index. There is no guaranteed interest payable to a depositor of an IPCD - however, assuming an IPCD is held to maturity, a depositor is guaranteed the return of his or her principal, at a minimum. Statement of Financial Accounting Standards No. 133 requires the Corporation to separate the amount received from each IPCD issued into 2 components: (1) an embedded derivative, and (2) the principal amount of each deposit. Embedded derivatives are derived from the Corporation's obligation to pay each IPCD depositor a return based on appreciation in the S&P 500 index. Embedded derivatives are carried at fair value, and are included in other liabilities in the consolidated balance sheet. Changes in fair value of the embedded derivative are included in other expense in the consolidated income statement. The difference between the contractual amount of each IPCD issued, and the amount of the embedded derivative, is recorded as the initial deposit (included in interest-bearing deposits in the consolidated balance sheet). Interest expense is added to principal ratably over the term of each IPCD at an effective interest rate that will increase the principal balance to equal the contractual IPCD amount at maturity. In connection with IPCD transactions, the Corporation has entered into Equity Indexed Call Option (Swap) contracts with FHLB-Pittsburgh. Under the terms of the Swap contracts, the Corporation must pay FHLB-Pittsburgh quarterly amounts calculated based on the contractual amount of IPCDs issued times a negotiated rate. In return, FHLB-Pittsburgh is obligated to pay the Corporation, at the time of maturity of the IPCDs, an amount equal to 90% of the appreciation (as defined) in the S&P 500 index. If the S&P 500 index does not appreciate over the term of the related IPCDs, the FHLB-Pittsburgh would make no payment to the Corporation. The effect of the Swap contracts is to limit the Corporation's cost of IPCD funds to the market rate of interest paid to FHLB-Pittsburgh. (In addition, the Corporation pays a fee of 0.75% to a consulting firm at inception of each deposit. This fee is amortized to interest expense over the term of the IPCDs.) Swap liabilities are carried at fair value, and included in other liabilities in the consolidated balance sheet. Changes in fair value of swap liabilities are included in other expense in the consolidated income statement. Amounts recorded related to IPCDs are as follows (in thousands):
AT DECEMBER 31, 2003 2002 Contractual amount of IPCDs (equal to notional amount of Swap contracts) $ 3,593 $ 3,028 Carrying value of IPCDs 3,160 2,572 Carrying value of embedded derivative liabilities 298 156 Carrying value of Swap contract liabilities 130 309
FOR THE YEARS ENDED DECEMBER 31, 2003 2002 2001 Interest expense $ 112 $ 88 $ 17 Other expense 10 8 7
11. FAIR VALUE OF FINANCIAL INSTRUMENTS The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Corporation's financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. SFAS No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Therefore, the aggregate fair value amounts presented may not represent the underlying fair value of the Corporation. The Corporation used the following methods and assumptions in estimating fair value disclosures for financial instruments: CASH AND CASH EQUIVALENTS - The carrying amounts of cash and short-term instruments approximate fair values. 44 SECURITIES - Fair values for securities, excluding restricted equity securities, are based on quoted market prices. The carrying value of restricted equity securities approximates fair value based on applicable redemption provisions. LOANS - Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, commercial real estate, residential mortgage, credit card and other consumer. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories. The fair value of performing loans, except residential mortgage and credit card loans, 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 loans. The estimate of maturity is based on the Corporation's historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions. For performing residential mortgage loans, fair value is estimated by discounting contractual cash flows adjusted for prepayment estimates based on historical experience. For credit card loans, cash flows and maturities are estimated based on contractual interest rates and historical experience. Fair value of nonperforming loans is based on recent appraisals or estimates prepared by the Corporation's lending officers. DEPOSITS - The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, savings, money market and interest checking accounts, is (by definition) equal to the amount payable on demand at December 31, 2003 and 2002. The fair value of all other deposit categories 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 fair value estimates of deposits 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 - The fair value of borrowings is estimated using discounted cash flow analyses based on rates currently available to the Corporation for similar types of borrowing arrangements. ACCRUED INTEREST - The carrying amounts of accrued interest receivable and payable approximate fair values. EMBEDDED DERIVATIVE LIABILITIES - IPCDs - The fair values of embedded derivatives are calculated by a third party. Factors that affect the fair value of embedded derivatives include term to maturity, market interest rates and other market factors that affect the present value of the Corporation's obligation to pay each IPCD depositor a return based on appreciation in the S&P 500 index. EMBEDDED DERIVATIVE LIABILITIES - EQUITY OPTION SWAP CONTRACTS - The fair values of equity option Swap contracts are calculated by a third party. Factors that affect the fair value of equity option Swap contracts include: (1) the negotiated rate associated with the Corporation's obligation to make quarterly payments to the FHLB-Pittsburgh over the term of each IPCD; and (2) term to maturity, market interest rates and other market factors that affect the present value of the FHLB-Pittsburgh's obligation to pay the Corporation a return based on appreciation in the S&P 500 index. The estimated fair values, and related carrying amounts, of the Corporation's financial instruments are as follows: (IN THOUSANDS)
DECEMBER 31, 2003 DECEMBER 31, 2002 CARRYING FAIR CARRYING FAIR AMOUNT VALUE AMOUNT VALUE FINANCIAL ASSETS: Cash and cash equivalents $ 15,171 $ 15,171 $ 14,900 $ 14,900 Available-for-sale securities 483,032 483,032 512,175 512,175 Held-to-maturity securities 560 609 707 774 Restricted equity securities 11,575 11,575 10,202 10,202 Loans, net 518,800 524,407 445,356 447,382 Accrued interest receivable 5,632 5,632 5,960 5,960 FINANCIAL LIABILITIES: Deposits 658,065 661,141 640,304 643,305 Short-term borrowings 37,763 37,762 43,635 43,662 Long-term borrowings 235,190 240,527 208,214 215,875 Accrued interest payable 1,105 1,105 1,307 1,307 Embedded derivative liabilities - IPCDs 298 298 156 156 Equity option Swap contracts - IPCDs 130 130 309 309
45 12. EMPLOYEE AND POSTRETIREMENT BENEFIT PLANS DEFINED BENEFIT PLANS The Corporation has a noncontributory defined benefit pension plan for all employees meeting certain age and length of service requirements. Benefits are based primarily on years of service and the average annual compensation during the highest five consecutive years within the final ten years of employment. Also, the Corporation sponsors a defined benefit health care plan that provides postretirement medical benefits and life insurance to employees who meet certain age and length of service requirements. This plan contains a cost-sharing feature, which causes participants to pay for all future increases in costs related to benefit coverage. Accordingly, actuarial assumptions related to health care cost trend rates do not affect the liability balance at December 31, 2003 and 2002, and will not affect the Corporation's future expenses. The Corporation uses a December 31 measurement date for its plans. The following tables show the funded status and amounts recognized in the consolidated balance sheet from these defined benefit plans: (IN THOUSANDS)
PENSION POSTRETIREMENT BENEFITS BENEFITS 2003 2002 2003 2002 CHANGE IN BENEFIT OBLIGATION: Benefit obligation at beginning of year $ 8,769 $ 7,679 $ 886 $ 888 Service cost 394 349 32 24 Interest cost 590 553 60 57 Plan participants' contributions - - 147 115 Actuarial loss (gain) 755 617 105 (25) Benefits paid (422) (429) (201) (173) -------- -------- ------- ------ Benefit obligation at end of year $ 10,086 $ 8,769 $ 1,029 $ 886 ======== ======== ======= ======
2003 2002 2003 2002 CHANGE IN PLAN ASSETS: Fair value of plan assets at beginning of year $ 7,668 $ 8,423 $ - $ - Actual return on plan assets 1,013 (326) - - Employer contribution 395 - 54 58 Plan participants' contributions - - 147 115 Benefits paid (422) (429) (201) (173) -------- -------- ------- ------ Fair value of plan assets at end of year $ 8,654 $ 7,668 $ - $ - ======== ======== ======= ====== Funded status $ (1,432) $ (1,101) $(1,029) $ (886) Unrecognized net actuarial loss (gain) 1,997 1,726 61 (43) Unrecognized transition (asset) obligation (160) (182) 328 365 -------- -------- ------- ------ Prepaid (accrued) benefit cost $ 405 $ 443 $ (640) $ (564) ======== ======== ======= ======
The accumulated benefit obligation for the defined benefit pension plan was $7,595,000 at December 31, 2003 and $6,695,000 at December 31, 2002. 46 The components of net periodic benefit costs from these defined benefit plans are as follows: (IN THOUSANDS)
PENSION BENEFITS POSTRETIREMENT BENEFITS 2003 2002 2001 2003 2002 2001 Service cost $ 394 $ 349 $ 271 $ 32 $ 24 $ 19 Interest cost 590 553 497 60 57 58 Expected return on plan assets (615) (702) (787) - - - Amortization of transition (asset) obligation (22) (23) (23) 37 36 37 Recognized net actuarial loss (gain) 86 8 (30) 1 1 1 ------ ------ ------ ------ ------ ------ Net periodic benefit cost (benefit) $ 433 $ 185 $ (72) $ 130 $ 118 $ 115 ====== ====== ====== ====== ====== ======
The weighted-average assumptions used to determine benefit obligations as of December 31, 2003 and 2002 are as follows:
PENSION POSTRETIREMENT BENEFITS BENEFITS 2003 2002 2003 2002 Discount rate 6.25% 6.75% 6.25% 6.75% Expected return on plan assets 8.50% 8.50% N/A N/A Rate of compensation increase 4.50% 4.75% N/A N/A
The expected return on pension plan assets is a significant assumption used in the calculation of net periodic benefit cost. This assumption reflects the average long-term rate of earnings expected on the funds invested or to be invested to provide for the benefits included in the projected benefit obligation. The selected rate considers the historical and expected future investment trends of the present and expected future assets in the plan. Management believes the assumed 8.50% return on plan assets, which was used for net periodic benefit cost calculations in 2001, 2002 and 2003, is reasonable. Management has calculated the average annual return on pension plan assets over the period 1991-2003 to be 9.50%, with annual returns ranging from a low of -7.23% to a high of +19.87% over that period. The Corporation's pension plan weighted-average asset allocations at December 31, 2003 and 2002 are as follows:
2003 2002 Cash and cash equivalents 3% 1% Debt securities 40% 42% Equity securities 57% 57% ---- ---- Total 100% 100% ==== ====
The Bank's Trust and Financial Management Department manages the investment of pension plan assets. The targeted asset allocation for the pension plan is 60% equity securities, 35% debt securities and 5% cash. This targeted asset allocation reflects a balanced approach, considering the need for growth of plan assets to meet future demand, as well as the need for ongoing liquidity to fund benefit payments. Specifically, the Trust Department attempts to match the maturities of zero-coupon bonds with the estimated amounts of benefit payments over the ensuing 10-year period. Within the equity portion of pension plan investments, the Trust Department employs a strategy of diversification. Holdings include large capitalization stocks from many different industries, as well as mid-cap and foreign mutual funds. The pension plan's assets do not include any shares of the Corporation's common stock. At this time, management cannot provide a reasonable estimate of the amount, if any, of the Corporation's 2004 pension contribution. The estimated amount of 2004 postretirement contribution is $60,000. 47 In December 2003, the Medicare Prescription Drug, Improvement and Modernization Act (the "Act") was signed into law. The Act introduces a prescription drug benefit under Medicare (Medicare Part D) as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least "actuarially equivalent" to Medicare Part D. As permitted by FASB Staff Position No. 106-1, the Corporation has elected to defer accounting for the effects of the Act. Accordingly, the financial statement amounts and disclosures related to the postretirement benefits plan do not reflect the effects of the Act on the plan. At this time, detailed regulations necessary to implement the Act have not been issued, including those that would specify the manner in which actuarial equivalency would be determined. Specific authoritative guidance on the accounting for the federal subsidy is pending and that guidance, when issued, could require the Corporation to change previously reported information. PROFIT SHARING AND DEFERRED COMPENSATION PLANS The Corporation has a profit sharing plan that incorporates the deferred salary savings provisions of Section 401(k) of the Internal Revenue Code. The Corporation's matching contributions to the Plan depend upon the tax deferred contributions of employees. The Corporation's total basic and matching contributions were $728,000 in 2003, $667,000 in 2002 and $588,000 in 2001. Effective December 31, 2001, the Corporation amended the 401(k) Plan to convert the "Basic Stock Fund" component of the Plan to an Employee Stock Ownership Plan (ESOP). A portion of the Corporation's basic contributions to the Plan are made to the ESOP, and the Plan uses these funds to purchase Corporation stock for the accounts of Plan participants. These purchases are made on the market (not directly from the Corporation), and employees are not permitted to purchase Corporation stock under the Plan. The Plan includes a diversification feature which permits Plan participants, upon reaching age 55 and 10 years of service (as defined), to sell up to 50% of their Corporation shares back to the Plan over a period of 6 years. As of December 31, 2003, there were no shares allocated for repurchase by the Plan. Dividends paid on shares held by the ESOP are charged to retained earnings. All Corporation shares owned through the ESOP are included in the calculation of weighted-average shares outstanding for purposes of calculating earnings per share - basic and diluted. As of December 31, 2003, the ESOP held 301,243 shares of Corporation stock, all of which had been allocated to Plan participants. The Corporation's contributions to the ESOP portion of the Plan (included in total contributions reported above) totaled $377,000 in 2003 and $343,000 in 2002. The Corporation also has a nonqualified supplemental deferred compensation arrangement with its key officers. Charges to expense for officers' supplemental deferred compensation were $45,000 in 2003, $44,000 in 2002 and $38,000 in 2001. STOCK-BASED COMPENSATION PLANS The Corporation has a Stock Incentive Plan for a selected group of senior officers. A total of 400,000 shares of common stock may be issued under the Stock Incentive Plan. Awards may be made under the Stock Incentive Plan in the form of qualified options ("Incentive Stock Options," as defined in the Internal Revenue Code), nonqualified options, stock appreciation rights or restricted stock. Through 1999, all awards under the Stock Incentive Plan were Incentive Stock Options, with exercise prices equal to the market price of the stock at the date of grant, ratable vesting over 5 years and a contractual expiration of 10 years. In 2000, 2002 and 2003, there were awards of Incentive Stock Options and restricted stock. The Incentive Stock Options granted in 2000, 2002 and 2003 have an exercise price equal to the market value of the stock at the date of grant, vest after 6 months and expire after 10 years. The restricted stock awards vest ratably over 3 years. Also, the Corporation has an Independent Directors Stock Incentive Plan. This plan permits awards of nonqualified stock options and/or restricted stock to non-employee directors. As adjusted for the 3-for-2 stock split in April 2003, a total of 75,000 shares of common stock may be issued under the Independent Directors Stock Incentive Plan. The recipients' rights to exercise stock options under this plan expire 10 years from the date of grant. The exercise prices of all stock options awarded under the Independent Directors Stock Incentive Plan are equal to market value as of the dates of grant. The restricted stock awards vest ratably over 3 years. Effective January 2, 2004, the Corporation granted options to purchase a total of 33,249 shares of common stock through the Stock Incentive and Independent Directors Stock Incentive Plans. The exercise price for these options is $26.59 per share, which was the market price at the date of grant. Also, effective January 2, 2004, the Corporation awarded a total of 3,714 shares of restricted stock under the Stock Incentive and Independent Directors Stock Incentive Plans. The stock options and restricted stock awards that were awarded in January 2004 are not included in the tables that follow. 48 As described in Note 1, the Corporation applies Accounting Principles Board Opinion 25 and related interpretations in accounting for stock options. Accordingly, no compensation expense has been recognized for the stock options. Had compensation cost for the stock options been determined based on the fair value at the grant dates for awards consistent with the method of SFAS No. 123, the effect on the Corporation's net income and earnings per share would have been adjusted to the pro forma amounts indicated in the following table. (NET INCOME IN THOUSANDS)
2003 2002 2001 Net income As reported $16,257 $14,959 $12,052 Pro forma $16,133 $14,768 $11,989 Earnings per share-basic As reported $ 2.01 $ 1.85 $ 1.49 Pro forma $ 1.99 $ 1.83 $ 1.48 Earnings per share-diluted As reported $ 2.00 $ 1.84 $ 1.49 Pro forma $ 1.98 $ 1.82 $ 1.48
For purposes of the calculations of SFAS No. 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:
2003 2002 2001 Volatility 15% 17% 17% Expected option lives 6 Years 6 Years 6 Years Risk-free interest rate 3.55% 5.00% 5.08% Dividend yield 4.30% 4.16% 3.57%
A summary of the status of the Corporation's stock option plans is presented below:
2003 2002 2001 ------------------ ------------------- ------------------- WEIGHTED WEIGHTED WEIGHTED AVERAGE AVERAGE AVERAGE EXERCISE EXERCISE EXERCISE SHARES PRICE SHARES PRICE SHARES PRICE Outstanding, beginning of year 180,722 $ 18.11 124,842 $ 18.49 151,203 $ 18.69 Granted 46,411 $ 20.73 61,223 $ 17.00 2,964 $ 14.17 Exercised (12,066) $ 16.28 (5,343) $ 13.98 - $ - Forfeited (2,009) $ 16.19 - $ - (29,325) $ 19.15 ------- -------- -------- -------- -------- -------- Outstanding, end of year 213,058 $ 18.81 180,722 $ 18.11 124,842 $ 18.49 ======= ======== ======== ======== ======== ======== Options exercisable at year-end 207,898 $ 18.82 165,824 $ 17.97 97,359 $ 17.96 Fair value of options granted $ 2.11 $ 2.45 $ 2.32
49 The following table summarizes information about stock options outstanding as of December 31, 2003:
OUTSTANDING EXERCISABLE AT REMAINING AT DECEMBER 31, CONTRACTUAL DECEMBER 31, EXERCISE PRICES 2003 LIFE IN YEARS 2003 $13.33 3,068 2 3,068 $17.00 8,600 3 8,600 $18.03-$22.17 18,668 4 18,668 $24.25-$24.33 24,150 5 24,150 $18.00-$22.08 28,680 6 23,520 $13.50-$16.67 25,247 7 25,247 $17.00 58,234 8 58,234 $20.73 46,411 9 46,411 ------------ ------------- ------------ 213,058 207,898 ============ ============= ============
The following table summarizes restricted stock awards through December 31, 2003:
2003 2002 2001 Number of shares awarded 5,166 6,647 332 Market price of stock at date of grant $20.73 $17.00 $14.17
Compensation expense related to restricted stock was $102,000 in 2003, $80,000 in 2002 and $22,000 in 2001. 13. INCOME TAXES The following temporary differences gave rise to the net deferred tax liability at December 31, 2003 and 2002: (IN THOUSANDS)
2003 2002 Deferred tax liabilities: Depreciation $ 340 $ 275 Prepaid pension 142 155 Accretion on securities 9 6 Investments in limited partnerships 13 21 Realized gains on securities 62 - Unrealized holding gains on securities 6,201 6,257 ------- ------- Total 6,767 6,714 ------- ------- Deferred tax assets: Allowance for loan losses (2,134) (2,026) Postretirement and sick benefits (243) (216) Loan fees and costs (63) (76) Supplemental executive retirement plan (182) (175) Restricted stock compensation (32) (27) ------- ------- Total (2,654) (2,520) ------- ------- Deferred tax liability, net $ 4,113 $ 4,194 ======= =======
Tax provision:
2003 2002 2001 Currently payable $ 3,634 $ 4,018 $ 3,371 Deferred (25) (284) (349) ------- ------- ------- Total provision $ 3,609 $ 3,734 $ 3,022 ======= ======= =======
50 Reconciliation of tax provision:
2003 2002 2001 AMOUNT % AMOUNT % AMOUNT % Expected provision $ 6,953 35.00% $ 6,543 35.00% $ 5,276 35.00% Tax-exempt interest income (2,766) (13.92) (2,223) (11.89) (1,730) (11.48) Nondeductible interest expense 242 1.22 239 1.28 226 1.50 Dividends received deduction (284) (1.43) (280) (1.50) (267) (1.77) Increase in cash surrender value of life insurance (250) (1.26) (299) (1.60) (317) (2.10) Surtax exemption (185) (0.93) (176) (0.94) (151) (1.00) Other, net (101) (0.51) (70) (0.37) (15) (0.10) --------- ------ ------- ------ ------- ------ Effective income tax provision $ 3,609 18.17% $ 3,734 19.98% $ 3,022 20.05% ========= ====== ======= ====== ======= ======
14. RELATED PARTY TRANSACTIONS Loans to executive officers, directors of the Corporation and its subsidiaries and any associates of the foregoing persons are as follows: (IN THOUSANDS)
BEGINNING NEW OTHER ENDING BALANCE LOANS REPAYMENTS CHANGES BALANCE 13 directors, 5 executive officers 2003 $ 6,623 $ 612 (956) $ 914 $ 7,193 14 directors, 6 executive officers 2002 6,535 2,464 (2,722) 346 6,623 14 directors, 6 executive officers 2001 5,730 658 (1,833) 1,980 6,535
The above transactions were made in the ordinary course of business on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and do not involve more than normal risks of collectibility. Other changes represent net increases in existing lines of credit and transfers in and out of the related party category. Deposits from related parties held by the Corporation amounted to $3,078,000 at December 31, 2003. 15. OFF-BALANCE SHEET RISK The Corporation is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financial needs of its customers. These financial instruments include commitments to extend credit and financial standby letters of credit. These instruments involve, to varying degrees, elements of credit, interest rate or liquidity risk in excess of the amount recognized in the consolidated balance sheet. The contract amounts of these instruments express the extent of involvement the Corporation has in particular classes of financial instruments. The Corporation's exposure to credit loss from nonperformance by the other party to the financial instruments for commitments to extend credit and financial standby letters of credit is represented by the contractual amount of these instruments. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Financial instruments whose contract amounts represent credit risk at December 31, 2003 and 2002 are as follows: (IN THOUSANDS)
2003 2002 Commitments to extend credit $111,843 $ 103,138 Standby letters of credit 14,064 10,753
51 Commitments to extend credit are legally binding agreements to lend to customers. Commitments generally have fixed expiration dates or other termination clauses and may require payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future liquidity requirements. The Corporation evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation, for extensions of credit is based on management's credit assessment of the counterparty. Financial standby letters of credit are conditional commitments issued by the Corporation guaranteeing performance by a customer to a third party. Those guarantees are issued primarily to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Some of the financial standby letters of credit are collateralized by real estate or other assets, while others are unsecured. The extent to which proceeds from liquidation of collateral would be expected to cover the maximum potential amount of future payments related to financial standby letters of credit is not estimable. The Corporation has recorded no liability associated with financial standby letters of credit as of December 31, 2003 and 2002. Financial standby letters of credit as of December 31, 2003 expire as follows: (IN THOUSANDS)
Year of Expiration Amount ------------------ -------- 2004 $ 7,998 2005 1,481 2006 4,532 2007 53 ------------------ -------- Total $ 14,064 ================== ========
16. CONTINGENCIES In the normal course of business, the Corporation may be subject to pending and threatened lawsuits in which claims for monetary damages could be asserted. In management's opinion, the Corporation's financial position and results of operations would not be materially affected by the outcome of such legal proceedings. 17. REGULATORY MATTERS The Corporation (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Corporation's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies. Quantitative measures established by regulation to ensure capital adequacy require the Corporation and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2003 and 2002, that the Corporation and the Bank meet all capital adequacy requirements to which they are subject. To be categorized as well capitalized, an institution must maintain minimum total risk based, Tier I risk based and Tier I leverage ratios as set forth in the following table. The Corporation's and the Bank's actual capital amounts and ratios are also presented in the following table. 52 (DOLLARS IN THOUSANDS)
MINIMUM TO BE WELL MINIMUM CAPITALIZED UNDER CAPITAL PROMPT CORRECTIVE ACTUAL REQUIREMENT ACTION PROVISIONS AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO ---------- ------- ---------- -------- ---------- --------- DECEMBER 31, 2003: Total capital to risk- weighted assets: Consolidated $ 125,136 20.61% $ 48,564 > or = 8% n/a n/a Bank 102,050 17.31% 47,160 > or = 8% $58,950 > or = 10% Tier 1 capital to risk- weighted assets: Consolidated 113,307 18.67% 24,282 > or = 4% n/a n/a Bank 103,691 17.59% 23,580 > or = 4% 35,370 > or = 6% Tier 1 capital to average assets: Consolidated 113,307 10.80% 41,968 > or = 4% n/a n/a Bank 103,691 10.15% 40,854 > or = 4% 51,068 > or = 5% DECEMBER 31, 2002: Total capital to risk- weighted assets: Consolidated $ 113,168 20.09% $ 45,055 > or = 8% n/a n/a Bank 94,044 17.17% 43,825 > or = 8% $54,782 > or = 10% Tier 1 capital to risk- weighted assets: Consolidated 103,691 18.41% 22,528 > or = 4% n/a n/a Bank 86,140 15.72% 21,913 > or = 4% 32,869 > or = 6% Tier 1 capital to average assets: Consolidated 103,691 10.53% 39,372 > or = 4% n/a n/a Bank 86,140 8.94% 38,520 > or = 4% 48,150 > or = 5%
Restrictions imposed by Federal Reserve Regulation H limit dividend payments in any year to the current year's net income plus the retained net income of the prior two years without approval of the Federal Reserve Board. Accordingly, the Corporation's dividends in 2004 may not exceed $18,237,000, plus consolidated net income for 2004. Additionally, banking regulators limit the amount of dividends that may be paid by the Bank to the Corporation. Retained earnings against which dividends may be paid without prior approval of the banking regulators amounted to approximately $83,262,000 at December 31, 2003, subject to the minimum capital ratio requirements noted above. Restrictions imposed by federal law prohibit the Corporation from borrowing from the Bank unless the loans are secured in specific amounts. Such secured loans to the Corporation are generally limited to 10% of the Bank's stockholder's equity (excluding accumulated other comprehensive income) or $9,329,000 at December 31, 2003. 53 18. PARENT COMPANY ONLY The following is condensed financial information for Citizens & Northern Corporation. CONDENSED BALANCE SHEET (IN THOUSANDS)
DECEMBER 31, 2003 2002 ASSETS Cash $ 329 $ 592 Investment in subsidiaries: Citizens & Northern Bank 100,754 95,879 Citizens & Northern Investment Corporation 23,758 18,929 Bucktail Life Insurance Company 2,223 2,006 Other assets 54 45 -------- -------- TOTAL ASSETS $127,118 $117,451 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Dividends payable $ 1,763 $ 1,586 Other liabilities 12 28 Stockholders' equity 125,343 115,837 -------- -------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $127,118 $117,451 ======== ========
CONDENSED INCOME STATEMENT (IN THOUSANDS)
YEARS ENDED DECEMBER 31, 2003 2002 2001 Dividends from Citizens & Northern Bank $ 6,870 $ 7,063 $ 6,286 Other dividend income - 174 250 Expenses (183) (140) (74) -------- -------- ------- Income before equity in undistributed income of subsidiaries 6,687 7,097 6,462 Equity in undistributed income of subsidiaries 9,570 7,862 5,590 -------- -------- ------- NET INCOME $ 16,257 $ 14,959 $12,052 ======== ======== =======
54 CONDENSED STATEMENT OF CASH FLOWS (IN THOUSANDS)
YEARS ENDED DECEMBER 31, 2003 2002 2001 CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 16,257 $ 14,959 $12,052 Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed net income of subsidiaries (9,570) (7,862) (5,590) Amortization of restricted stock 102 80 22 (Increase) decrease in other assets (9) (32) 14 Increase in other liabilities 68 98 - -------- -------- ------- Net Cash Provided by Operating Activities 6,848 7,243 6,498 -------- -------- ------- CASH FLOWS FROM INVESTING ACTIVITIES, Investment in subsidiary (460) (783) (266) -------- -------- ------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from sale of treasury stock 197 76 - Purchase of treasury stock (174) (239) (521) Dividends paid (6,674) (6,038) (5,441) -------- -------- ------- Net Cash Used in Financing Activities (6,651) (6,201) (5,962) -------- -------- ------- (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (263) 259 270 CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 592 333 63 -------- -------- ------- CASH AND CASH EQUIVALENTS, END OF YEAR $ 329 $ 592 $ 333 ======== ======== =======
19. SUMMARY OF QUARTERLY CONSOLIDATED FINANCIAL DATA (UNAUDITED) The following table presents summarized quarterly financial data for 2003 and 2002:
2003 QUARTER ENDED (IN THOUSANDS, EXCEPT PER SHARE DATA) Mar. 31, June 30, Sept. 30, Dec. 31, Interest income $ 13,930 $ 13,943 $ 13,553 $ 13,797 Interest expense 6,243 6,089 5,655 5,550 -------- -------- --------- -------- Interest margin 7,687 7,854 7,898 8,247 Provision for loan losses 350 250 250 250 -------- -------- --------- -------- Interest margin after provision for loan losses 7,337 7,604 7,648 7,997 Other income 1,540 1,628 1,705 1,722 Securities gains 1,721 908 660 1,510 Other expenses 5,532 5,356 5,336 5,890 -------- -------- --------- -------- Income before income tax provision 5,066 4,784 4,677 5,339 Income tax provision 994 864 759 992 -------- -------- --------- -------- Net income $ 4,072 $ 3,920 $ 3,918 $ 4,347 ======== ======== ========= ======== Net income per share - basic $ 0.50 $ 0.48 $ 0.48 $ 0.54 ======== ======== ========= ======== Net income per share - diluted $ 0.50 $ 0.48 $ 0.48 $ 0.53 ======== ======== ========= ========
55
2002 QUARTER ENDED (IN THOUSANDS, EXCEPT PER SHARE DATA) Mar. 31, June 30, Sept. 30, Dec. 31, Interest income $ 13,642 $ 14,523 $ 14,675 $ 14,445 Interest expense 6,316 6,745 6,675 6,579 -------- -------- --------- -------- Interest margin 7,326 7,778 8,000 7,866 Provision for loan losses 180 180 280 300 -------- -------- --------- -------- Interest margin after provision for loan losses 7,146 7,598 7,720 7,566 Other income 1,687 1,681 1,642 1,614 Securities gains 1,226 781 489 392 Other expenses 5,106 5,248 5,310 5,185 -------- -------- --------- -------- Income before income tax provision 4,953 4,812 4,541 4,387 Income tax provision 1,115 992 831 796 -------- -------- --------- -------- Net income $ 3,838 $ 3,820 $ 3,710 $ 3,591 ======== ======== ========= ======== Net income per share - basic $ 0.47 $ 0.47 $ 0.46 $ 0.44 ======== ======== ========= ======== Net income per share - diluted $ 0.47 $ 0.47 $ 0.46 $ 0.44 ======== ======== ========= ========
56 INDEPENDENT AUDITORS' REPORT To the Stockholders and Board of Directors of Citizens & Northern Corporation: We have audited the accompanying consolidated balance sheet of Citizens & Northern Corporation and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2003. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Citizens & Northern Corporation and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. Parente Randolph, PC /s/ Williamsport, Pennsylvania February 13, 2004 57 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None ITEM 9A. CONTROLS AND PROCEDURES The Corporation's Chief Executive Officer and Chief Financial Officer carried out an evaluation of the design and effectiveness of the Corporation's disclosure controls and procedures as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Securities Exchange Act of 1934 as of the end of period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Corporation's disclosure controls and procedures are effective to ensure that information required to be disclosed in reports the Corporation files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms. There were no significant changes in the Corporation's internal control over financial reporting that occurred during the period covered by this report that has materially affected, or that is reasonably likely to affect, our internal control over financial reporting. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information concerning Directors and Executive Officers is incorporated herein by reference to disclosure under the captions "Proposal 1 - Election of Directors," "Corporation's and Bank's Executive Officers," "Section 16(a) Beneficial Ownership Reporting Compliance," "Board of Director Committees, Attendance at Meetings and Compensation of Directors" and "Stockholder Proposals" of the Corporation's proxy statement dated March 23, 2004 for the annual meeting of stockholders to be held on April 20, 2004. The Corporation's Board of Directors has adopted a Code of Ethics, available on the Corporation's web site at www.cnbankpa.com for the Corporation's employees, officers and directors. (The provisions of the Code of Ethics will be included in the Corporation's employee handbook, which is issued to all new employees and officers at the time of employment and reissued to existing employees and officers from time to time.) ITEM 11. EXECUTIVE COMPENSATION Information concerning executive compensation is incorporated herein by reference to disclosure under the caption "Executive Compensation" of the Corporation's proxy statement dated March 23, 2004 for the annual meeting of stockholders to be held on April 20, 2004. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED MATTERS Information concerning security ownership of certain beneficial owners and management is incorporated herein by reference to disclosure under the caption "Security Ownership of Management" of the Corporation's proxy statement dated March 23, 2004 for the annual meeting of stockholders to be held on April 20, 2004. "Equity Compensation Plan Information" as required by Item 201(d) of Regulation S-K is incorporated by reference herein from Item 5 (Market for Registrant's Common Equity and Related Stockholder Matters) of this Form 10-K. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information concerning loans and deposits with Directors and Executive Officers is provided in Note 14 to the Consolidated Financial Statements, which is included in Part II, Item 8 of this Annual Report on Form 10-K. Additional information is incorporated herein by reference to disclosure appearing under the caption "Certain Transactions" of the Corporation's proxy statement dated March 23, 2004 for the annual meeting of stockholders to be held on April 20, 2004. 58 ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES Information concerning services provided by the Corporation's independent auditors, Parente Randolph, PC, the audit committee's pre-approval policies and procedures for such services, and fees paid by the Corporation to that firm, is incorporated herein by reference to disclosure under the caption "Audit Committee" of the Corporation's proxy statement dated March 23, 2004 for the annual meeting of stockholders to be held on April 20, 2004. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1). The following consolidated financial statements are set forth in Part II, Item 8:
Page ------ Independent Auditors' Report 57 Financial Statements: Consolidated Balance Sheet - December 31, 2003 and 2002 28 Consolidated Statement of Income - Years Ended December 31, 2003, 2002 and 2001 29 Consolidated Statement of Changes in Stockholders' Equity - Years Ended December 31, 2003, 2002 and 2001 30 Consolidated Statement of Cash Flows - Years Ended December 31, 2003, 2002 and 2001 31 Notes to Consolidated Financial Statements 32- 56
(a)(2) Financial statement schedules are not applicable or included in the financial statements or related notes. (a)(3) Exhibits (numbered as in Item 601 of Regulation S-K): 2. Plan of acquisition, reorganization, arrangement, liquidation or succession Not applicable 3. (i) Articles of Incorporation Incorporated by reference to the exhibits filed with the Corporation's registration statement on Form S-4 on March 27, 1987. 3. (ii) By-laws Incorporated by reference to the exhibits filed with the Corporation's registration statement on Form S-4 on March 27, 1987. 4. Instruments defining the rights of security holders, including indentures Not applicable 9. Voting trust agreement Not applicable 10. Material contracts: 10.1 Change in Control Agreement dated December 31, 2003 between the Corporation and Craig G. Litchfield Filed herewith 10.2 Change in Control Agreement dated December 31, 2003 between the Corporation and Mark A. Hughes Filed herewith 59 10.3 Change in Control Agreement dated December 31, 2003 between the Corporation and Matthew P. Prosseda Filed herewith 10.4 Change in Control Agreement dated December 31, 2003 between the Corporation and Deborah E. Scott Filed herewith 10.5 Second Amendment to Citizens & Northern Corporation Stock Incentive Plan Filed herewith 10.6 First Amendment to Citizens & Northern Corporation Stock Incentive Plan Filed herewith 10.7 Citizens & Northern Corporation Stock Incentive Plan Filed herewith Citizens & Northern Corporation Incorporated by reference to the Independent Directors Stock exhibits filed with the Incentive Plan Corporation's proxy statement dated March 19, 2001 for the annual meeting of stockholders held on April 17, 2001. 11. Statement re: computation of Information concerning the per share earnings computation of earnings per share is provided in Note 3 to the Consolidated Financial Statements, which is included in Part II, Item 8 of Form 10-K. 12. Statements re: computation of ratios Not applicable 13. Annual report to security holders, Form 10-Q or quarterly report to security holders Not applicable 14. Code of ethics The Code of Ethics is available through the Corporation's website at www.cnbankpa.com. To access the Code of Ethics, click on "Shareholder News & Info.," followed by "Corporate Governance" and "Code of Ethics." 16. Letter re: change in certifying accountant Not applicable 18. Letter re: change in accounting principles Not applicable 21. Subsidiaries of the registrant Filed herewith 22. Published report regarding matters submitted to vote of security holders Not applicable 23. Consents of experts and counsel Not applicable 24. Power of attorney Not applicable 60 31. Rule 13a-14(a)/15d-14(a) certifications: 31.1 Certification of Chief Executive Officer Filed herewith 31.2 Certification of Chief Financial Officer Filed herewith 32. Section 1350 certifications Filed herewith 99. Additional exhibits: 99.1 Additional information mailed to stockholders with proxy statement and Form 10-K on March 23, 2004 Filed herewith (b) On October 9, 2003, a Current Report on Form 8-K, reported under Items 7 and 12, was filed to report the Corporation's consolidated earnings results for the three-month and nine-month periods ended September 30, 2003. (c) Exhibits - The required exhibits are listed under Part IV, Item 15(a)(3) of Form 10-K. (d) Financial statement schedules are omitted because the required information is not applicable or is included elsewhere in Form 10-K. 61 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Citizens & Northern Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized: CITIZENS & NORTHERN CORPORATION By: Craig G. Litchfield /s/ --------------------------- Craig G. Litchfield Chairman, President and Chief Executive Officer Date: March 10, 2004 By: Mark A. Hughes /s/ ---------------------- Treasurer and Principal Accounting Officer Date: March 10, 2004 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. BOARD OF DIRECTORS /s/ Dennis F. Beardslee /s/ Edward L. Learn Dennis F. Beardslee Edward L. Learn Date: March 10, 2004 Date: March 10, 2004 /s/ R. Robert DeCamp /s/ Craig G. Litchfield R. Robert DeCamp Craig G. Litchfield Date: March 10, 2004 Date: March 10, 2004 /s/ Jan E. Fisher /s/ Edward H. Owlett, III Jan E. Fisher Edward H. Owlett, III Date: March 10, 2004 Date: March 10, 2004 /s/ R. Bruce Haner /s/ Leonard Simpson R. Bruce Haner Leonard Simpson Date: March 10, 2004 Date: March 10, 2004 /s/ Susan E. Hartley /s/ James E. Towner Susan E. Hartley James E. Towner Date: March 10, 2004 Date: March 10, 2004 /s/ Karl W. Kroeck /s/ Ann M. Tyler Karl W. Kroeck Ann M. Tyler Date: March 10, 2004 Date: March 10, 2004 /s/ Leo F. Lambert Leo F. Lambert Date: March 10, 2004 62