-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, RY8WvY8mikiq6YQ/5XboFflzewWTX5j2Sse/qNGEz3NUEOW+OdTxMfbkUo4oiqVB M2M+pl29xiMkuLf3hCK+Qg== 0000826154-98-000001.txt : 19980330 0000826154-98-000001.hdr.sgml : 19980330 ACCESSION NUMBER: 0000826154-98-000001 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980327 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: ORRSTOWN FINANCIAL SERVICES INC CENTRAL INDEX KEY: 0000826154 STANDARD INDUSTRIAL CLASSIFICATION: STATE COMMERCIAL BANKS [6022] IRS NUMBER: 232530374 STATE OF INCORPORATION: PA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 033-18888 FILM NUMBER: 98576683 BUSINESS ADDRESS: STREET 1: 77 E KING STREET STREET 2: P O BOX 250 CITY: SHIPPENSBURG STATE: PA ZIP: 17257 BUSINESS PHONE: 7175326114 MAIL ADDRESS: ZIP: 00000 10-K 1 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1997 Commission file number: 33-18888 ORRSTOWN FINANCIAL SERVICES, INC. (Exact name of registrant as specified in its charter) Pennsylvania 23-2530374 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 77 East King Street P. O. Box 250, Shippensburg, Pennsylvania 17257 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (717) 532-6114 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Title of each class Common Stock, No Par Value The Common Stock is not registered on any exchange. 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 As of March 19, 1998, 1,025,094 shares of the registrant's common stock were outstanding. The aggregate market value of such shares held by nonaffiliates on that date was $ 48,179,418. DOCUMENTS INCORPORATED BY REFERENCE Portions of the annual shareholders report for the year ended December 31, 1997 are incorporated by reference into Parts I and II. Portions of the Proxy Statement for 1997 Annual Meeting of Security Holders are incorporated by reference in Part III of this Form 10-K. - -1- Item 1. Business. History and Business Orrstown Financial Services, Inc. (OFS) is a bank holding company registered under the Bank Holding Company Act of 1956, as amended. Orrstown Financial Services, Inc. was organized on November 17, 1987, under the laws of the Commonwealth of Pennsylvania for the purpose of acquiring Orrstown Bank ("Orrstown"), Shippensburg, Pennsylvania, and such other banks and bank related activities as are permitted by law and desirable. On March 8, 1988, Orrstown Financial Services, Inc. acquired 100% ownership of Orrstown, issuing 131,455 shares of Orrstown Financial Services, Inc.'s common stock to the former Orrstown shareholders. Orrstown Financial Services, Inc.'s primary activity consists of owning and supervising its subsidiary, Orrstown Bank, which is engaged in providing banking and bank related services in South Central Pennsylvania, principally Franklin and Cumberland Counties, where its seven branches are located in Shippensburg (2), Carlisle (2), Spring Run, Orrstown, and Chambersburg, Pennsylvania. The day-to-day management of Orrstown Bank is conducted by the subsidiary's officers. Orrstown Financial Services, Inc. derives a majority of its current income from Orrstown. Orrstown Financial Services, Inc. has no employees other than its six officers who are also employees of Orrstown, its subsidiary. On December 31, 1997, Orrstown had 72 full-time and 30 part-time employees. Business of Orrstown Orrstown was organized as a state-chartered bank in 1987 as part of an agreement and plan of merger between Orrstown Financial Services, Inc. and Orrstown Bank, the predecessor of Orrstown, under which Orrstown became a wholly-owned subsidiary of Orrstown Financial Services, Inc. As indicated, Orrstown is the successor to Orrstown Bank which was originally organized in 1919. - -2- Orrstown is engaged in commercial banking and trust business as authorized by the Pennsylvania Banking Code of 1965. This involves accepting demand, time and savings deposits and granting loans. The Bank grants agribusiness, commercial and residential loans to customers in South Central Pennsylvania, principally Franklin and Cumberland Counties. The concentrations of credit by type of loan are set forth on the face of the balance sheet (page 2 of the annual report to shareholders). The Bank maintains a diversified loan portfolio and evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon the extension of credit, is based on management's credit evaluation of the customer and collateral standards established in the Bank's lending policies and procedures. All secured loans are supported with appraisals of collateral. Business equipment and machinery, inventories, accounts receivable, and farm equipment are considered appropriate security, provided they meet acceptable standards for liquidity and marketability. Loans secured by equipment and/or other nonreal estate collateral normally do not exceed 70% of appraised value or cost, whichever is lower. Loans secured by real estate do not exceed 80% of the appraised value of the property which is the maximum loan to collateral value established in the Bank's lending policy. Loan to collateral values are monitored as part of the loan review, and appraisals are updated as deemed appropriate in the circumstances. Administration and supervision over the lending process is provided by the Bank's Credit Administration Department via loan reviews. The loan review process is continuous, commencing with the approval of a loan. Each new loan is reviewed by the Credit Administration Department for compliance with banking regulations and lending policy requirements for documentation, collateral standards, and approvals. The Credit Administration Department continues to monitor and evaluate loan customers utilizing risk-rating criteria established in the lending policy in order to spot deteriorating trends and detect conditions which might indicate potential problem loans. - -3- Reports of the results of the loan reviews are submitted quarterly to the Directors' Credit Administration Committee for approval and provide the basis for evaluating the adequacy of the allowance for loan losses. Through its trust department, Orrstown renders services as trustee, executor, administrator, guardian, managing agent, custodian, investment advisor and other fiduciary activities authorized by law. As of December 31, 1997, Orrstown had total assets of approximately $ 190 million, total shareholders' equity of approximately $ 18.2 million and total deposits of approximately $ 161 million. Regulation and Supervision Orrstown Financial Services (OFS) is a bank holding company within the meaning of the Bank Holding Company Act of 1956 (BHC Act), and is registered as such with the Board of Governors of the Federal Reserve System (FRB). OFS is subject to examination by the FRB and is restricted in its acquisitions, certain of which are prohibited and certain of which are subject to approval by the FRB. Under the BHC Act, a bank holding company is, with limited exceptions, prohibited from (i) acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank or (ii) engaging in any activity other than managing or controlling banks. With the prior approval of the FRB, however, a bank holding company may own shares of a company engaged in activities which the FRB determines to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In addition, federal law imposes certain restrictions on transactions between OFS and its subsidiary, Orrstown Bank. As an affiliate of Orrstown Bank OFS is subject, with certain exceptions, to provisions of federal law imposing limitations on, and requiring collateral for, extensions of credit by Orrstown Bank to its affiliates. - -4- The operations of Orrstown are subject to federal and state statutes applicable to banks chartered under the banking laws of the United States, and to banks whose deposits are insured by the Federal Deposit Insurance Corporation. Bank operations are also subject to regulations of the Pennsylvania Department of Banking, the Federal Reserve Board and the Federal Deposit Insurance Corporation. The primary supervisory authority of Orrstown is the Pennsylvania Department of Banking, who regularly examines such areas as reserves, loans, investments, management practices and other aspects of bank operations. These examinations are designed primarily for the protection of the Bank depositors. Federal and state banking laws and regulations govern, among other things, the scope of a bank's business, the investments a bank may make, the reserves against deposits a bank must maintain, the loans a bank makes and collateral it takes, the maximum interest rates a bank may pay on deposits, the activities of a bank with respect to mergers and consolidations, and the establishment of branches, and management practices and other aspects of banking operations. See Note 14 of the Notes to Financial Statements for a discussion of the limitations on the availability of Orrstown Financial Services' subsidiary's undistributed earnings for the payment of dividends due to such regulation and other reasons. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) provides that a financial institution insured by the Federal Deposit Insurance Corporation (FDIC) sharing common ownership with a failed institution can be required to indemnify the FDIC for its losses resulting from the insolvency of the failed institution, even if such indemnification causes the affiliated institution also to become insolvent. OFS currently has only one subsidiary and as a result has not been significantly affected by the aforementioned provisions of FIRREA. - -5- Regulatory authorities have issued guidelines that establish risk-based capital and leverage standards. These capital requirements of bank regulators, are discussed on pages 37 to 39 of the annual report to shareholders under "Capital Adequacy and Regulatory Matters". Failure to meet applicable capital guidelines could subject a bank to a variety of enforcement remedies available to the regulatory authorities. Depending upon circumstances, the regulatory agencies may require an institution to develop a "capital plan" to increase its capital to levels established by the agency. In 1991, the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") was enacted. Among other things, FDICIA provides increased funding for the Bank Insurance Fund of the FDIC by granting authority for special assessments against insured deposits through a general risk-based assessment systems. FDICIA also contains provisions limiting activities and business methods of depository institutions. FDICIA requires the primary federal banking regulators to promulgate regulations setting forth standards relating to, among other things, internal controls and audit systems; credit underwriting and loan documentation; interest rate exposure and other off-balance sheet assets and liabilities; and compensation of directors and officers. FDICIA also contains provisions limiting the acceptance of brokered deposits by certain depository institutions, placing restrictions on the terms of "bank investment contracts" that may be offered by depository institutions and provisions requiring the FDIC to study the current rules applicable to the aggregation of accounts of depositors at an institution that is entitled to FDIC insurance. Finally, FDICIA provides for expanded regulation of depository institutions and their affiliates, including parent holding companies, by such institutions' primary federal banking regulator. Each primary federal banking regulator is required to specify, by regulation, capital standards for measuring the capital adequacy of the depository institutions it supervises and, depending upon the extent to which a - -6- depository institution does not meet such capital adequacy measures, the primary federal banking regulator may prohibit such institution from paying dividends or may require such institution to take other steps to become adequately capitalized. The earnings of Orrstown Bank, and therefore the earnings of Orrstown Financial Services, are affected by general economic conditions, management policies, and the legislative and governmental actions of various regulatory authorities including the FRB, the FDIC and the Pennsylvania Department of Banking. In addition, there are numerous governmental requirements and regulations that affect the activities of Orrstown Financial Services. Competition Orrstown's principal market area consists of Franklin County and Cumberland County, Pennsylvania. It services a substantial number of depositors in this market area, with the greatest concentration within a radius of Shippensburg and Carlisle, Pennsylvania. Orrstown, like other depository institutions, has been subjected to competition from less heavily regulated entities such as brokerage firms, money market funds, consumer finance and credit card companies and other commercial banks, many of which are larger than Orrstown Bank. Orrstown Bank is generally competitive with all competing financial institutions in its service area with respect to interest rates paid on time and savings deposits, service charges on deposit accounts and interest rates charged on loans. Item 2. Properties. Orrstown Bank owns buildings in Orrstown, Pennsylvania, Shippensburg, Pennsylvania (3), Carlisle, Pennsylvania, Spring Run, Pennsylvania and Chambersburg, Pennsylvania. Offices of the bank are located in each of these buildings. In 1996 the Bank began leasing building space for a second office location in Carlisle, Pennsylvania, which opened in January 1997. One of the offices located in Shippensburg is an "Operations Center" which does not operate as a branch, but rather as an accounting office. The bank completed the - -7- renovation of a property located adjacent to the downtown office, which expanded its trust department and certain administrative facilities. In November 1997, the Bank opened its seventh office, located in Chambersburg, Pennsylvania. The Bank also owns property adjacent to the Orrstown office which it intends to hold for future expansion purposes. Item 3. Legal Proceedings. Orrstown Financial Services, Inc. is an occasional party to legal actions arising in the ordinary course of its business. In the opinion of Orrstown Financial Services, Inc.'s management, Orrstown Financial Services, Inc. has adequate legal defenses and/or insurance coverage respecting any and each of these actions and does not believe that they will materially affect Orrstown Financial Services, Inc.'s operations or financial position. Item 4. Submission of Matters to Vote of Security Holders. None Executive Officers of Registrant The following table sets forth selected information about the principal officers of the holding company, each of whom is elected by the Board of Directors and each of whom holds office at the discretion of the Board. Age Held Bank Employee as of Name/Office Held Since Since 3/15/98 Galen L. Myers, Chairman of Board 1989 (1) 59 Joel R. Zullinger, Vice Chairman of the Board 1991 (1) 49 Jeffrey W. Coy, Secretary 1988 (1) 46 Kenneth R. Shoemaker, President 1987 1986 50 Stephen C. Oldt, Executive Vice President 1987 1987 55 Philip E. Fague, Vice President 1990 1988 38 Robert B. Russell, Vice President and Treasurer 1988 1982 44
(1) Mr. Myers, Mr. Zullinger and Mr. Coy are not employees of the Bank. - -8- Senior Operating Officers of the Bank Held Bank Employee Age Name/Office Held Since Since as of 3/15/98 Kenneth R. Shoemaker, President & Chief Executive Officer 1987 1988 50 Stephen C. Oldt, Executive Vice President & Chief Operating Officer 1987 1987 55 Philip E. Fague, Vice President/ 1990/ Senior Trust Officer 1993 1988 38 Bradley S. Gerlach, Vice President Director of Sales & Marketing 1995 1995 38 Bradley S. Everly, Senior Vice 1997/ President/Senior Loan Officer 1997 1997 46 Robert B. Russell, Vice President/ 1982/ Chief Accounting Officer 1993 1982 44 Patricia A. Corwell, Vice President and Assistant Secretary 1982 1954 63 James B. Dubbs, Vice President & 1983/ Cashier/Community Office Manager 1982 1976 39 Charles E. Ferguson, Vice President Human Resource Manager 1995 1995 61 Barbara E. Brobst, Vice President & Trust Officer 1997 1997 39
Part II Item 5. Market for Registrant's Common Stock and Related Security Holder Matters. Orrstown Financial Services, Inc.'s common stock is not traded on a national securities exchange, but is traded inactively through the local and over the counter local markets. At December 31, 1997, the approximate number of shareholders of record was approximately 1,600. The price ranges for Orrstown Financial Services, Inc. common stock set forth below are the approximate bid prices obtained from brokers who make a market in the stock. Market Cash Market Cash Price Dividend Price Dividend Dividend (1) 1997 1996 High Low High Low First Quarter $ 34.29 $ 32.28 $ .181 $ 30.48 $ 28.57 $ .162 Second Quarter 40.00 34.29 .190 31.43 30.48 .162 Third Quarter 42.00 40.00 .200 32.38 31.43 .171 Fourth Quarter 45.00 42.00 .310 32.38 32.38 .181
(1) Note: Cash dividends per share prior to the 2nd quarter of 1997 have been restated after giving retroactive recognition to a 5% stock dividend issued May 15, 1997. See Note 14 to the financial statements for restrictions on the payment of dividends. - -9- Item 6. Selected Financial Data. The selected five-year financial data on page 21 of the annual shareholders' report for the year ended December 31, 1997 is incorporated herein by reference. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Management's discussion and analysis of financial condition and results of operations, on pages 23 through 39 of the annual shareholders' report are incorporated herein by reference. Item 8. Financial Statements and Supplementary Data. The financial statements and supplementary data, some of which is required under Guide 3 (statistical disclosures by bank holding companies) are shown on pages 2 through 39 of the annual shareholders report for the year ended December 31, 1997 and are incorporated herein by reference. Additional schedules required in addition to those included in the annual shareholders report are submitted herewith. - -10- ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY CHANGES IN NET INTEREST INCOME TAX EQUIVALENT YIELDS 1997 Versus 1996 Increase (Decrease) Due to Change in Total Average Average Increase Volume Rate (Decrease) (000 omitted) Interest Income Loans (net of unearned discounts) $ 1,062 ($ 12) $ 1,050 Taxable investment securities 285 6 291 Nontaxable investment securities 563 ( 57) 506 Other short-term investments ( 229) 9 ( 220) Total interest income 1,681 ( 54) 1,627 Interest Expense Interest bearing demand 245 130 375 Savings deposits ( 41) ( 4) ( 45) Time deposits 207 ( 23) 184 Short-term borrowings 12 0 12 Long-term borrowings 180 ( 23) 157 Total interest expense 603 80 683 Net interest income $ 944
- -11- 1996 Versus 1995 Increase (Decrease) Due to Change in Total Average Average Increase Volume Rate (Decrease) (000 omitted) Interest Income Loans (net of unearned discounts) $ 750 ($ 113) $ 637 Taxable investment securities 150 100 250 Nontaxable investment securities 131 ( 22) 109 Other short-term investments 481 ( 293) 188 Total interest income 1,512 ( 328) 1,184 Interest Expense Interest bearing demand 63 1 64 Savings deposits 73 ( 40) 33 Time deposits 579 ( 44) 535 Short-term borrowings ( 44) 0 ( 44) Long-term borrowings ( 1) 10 92 Total interest expense 670 ( 73) 597 Net interest income $ 587
Changes which are attributed in part to volume and in part to rate are allocated in proportion to their relationships to the amounts of changes. ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY The following table shows the maturities of investment securities at book value as of December 31, 1997, and weighted average yields of such securities. Yields are shown on a tax equivalent basis, assuming a 34% federal income tax rate. After 1 year After 5 years Within but within but within After 1 year 5 years 10 years 10 years Total (000 omitted) Bonds: U. S. Treasury Book value $ 1,743 $ 8,030 $ 1,064 $ 0 $ 10,837 Yield 5.92% 6.24% 6.06% 0% 6.17% U. S. Government agencies Book value 0 0 2,000 0 2,000 Yield 0% 0% 7.42% 0% 7.42% State and municipal Book value 0 1,784 2,839 12,988 17,611 Yield 0% 9.09% 10.25% 8.78% 8.83% Total book value $ 1,743 $ 9,814 $ 5,903 $ 12,988 $ 30,448 Yield 5.92% 6.76% 8.54% 8.78% 7.79% Mortgage-backed securities: Total book value $ 13,812 Yield 7.01% Equity Securities: Total book value $ 480 Yield 3.0% Total Investment Securities $ 44,740 Yield 8.02%
- -12- ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY LOAN PORTFOLIO The following table presents the loan portfolio at the end of each of the last five years: 1997 1996 1995 1994 1993 (000 omitted) Commercial, financial and agricultural $ 10,275 $ 8,401 $ 8,211 $ 6,970 $ 5,281 Real estate - Construction 5,961 4,304 5,706 5,038 3,758 Real estate - Mortgage 97,074 82,687 75,731 68,458 57,278 Installment and other personal loans (net of unearned discount) 15,021 13,534 13,209 10,373 9,257 Total loans $ 128,331 $ 108,926 $ 102,857 $ 90,839 $ 75,574
Presented below are the approximate maturities of the loan portfolio (excluding real estate mortgages, installments and credit cards) at December 31, 1997: Under One One to Over Five Year Five Years Years Total (000 omitted) Commercial, financial and agricultural $ 1,611 $ 1,932 $ 6,732 $ 10,275 Real estate - Construction 826 989 4,146 5,961 Total $ 2,437 $ 2,921 $ 10,878 $ 16,236
The following table presents the approximate amount of fixed rate loans and variable rate loans due as of December 31, 1997: Fixed Rate Variable Loans Rate Loans (000 omitted) Due within one year $ 8,467 $ 76,543 Due after one but within five years 22,251 0 Due after five years 21,070 0 Total $ 51,788 $ 76,543
- -13- ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY SUMMARY OF LOAN LOSS EXPERIENCE Years Ended December 31 1997 1996 1995 1994 1993 (000 omitted) Average total loans outstanding (net of unearned income) $ 117,403 $ 105,779 $ 97,662 $ 81,740 $ 72,576 Allowance for loan losses, beginning of period $ 1,620 $ 1,433 $ 1,200 $ 1,125 $ 1,042 Additions to provision for loan losses charged to operations 215 240 270 71 121 Loans charged off during the year Commercial 1 20 0 0 17 Personal credit lines 32 17 3 1 3 Installment 50 31 48 7 31 Total charge-off's 83 68 51 8 51 Recoveries of loans previously charged off: Commercial 2 3 0 0 0 Installment 12 12 14 12 13 Personal credit lines 1 0 0 0 0 Total recoveries 15 15 14 12 13 Net loans charged off (recovered) 68 53 37 ( 4) 38 Allowance for loan losses, end of period $ 1,767 $ 1,620 $ 1,433 $ 1,200 $ 1,125 Ratio of net loans charged off to average loans outstanding .06% .05% .04% 0.0% .05%
The provision is based on an evaluation of the adequacy of the allowance for possible loan losses. The evaluation includes, but is not limited to, review of net loan losses for the year, the present and prospective financial condition of the borrowers and evaluation of current and projected economic conditions. - -14- ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY LOANS The following table sets forth the outstanding balances of those loans on a nonaccrual status and those on accrual status which are contractually past due as to principal or interest payments for 30 days or more at December 31. 1997 1996 1995 1994 1993 (000 omitted) Nonaccrual loans $ 473 $ 14 $ 132 $ 27 $ 0 Accrual loans: Restructured $ 0 $ 0 $ 0 $ 0 $ 0 30 through 89 days past due 2,398 1,976 1,949 1,553 1,468 90 days or more past due 657 203 417 155 150 Total accrual loans $ 3,055 $ 2,179 $ 2,366 $ 1,708 $ 1,618
See Note 7 of the notes to consolidated financial statements for details of income recognized and foregone revenue on nonaccrual loans for the past three years, and discussion concerning impaired loans at December 31, 1997. - -15- ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY The following is an allocation by loan categories of the allowance for loan losses at December 31 for the last five years. In retrospect the specific allocation in any particular category may prove excessive or inadequate and consequently may be reallocated in the future to reflect the then current conditions. Accordingly, the entire allowance is available to absorb losses in any category: Years Ended December 31 1997 1996 Percentage Percentage Allowance of Loans to Allowance of Loans to Amount Total Loans Amount Total Loans (000 omitted) Commercial, financial and agricultural $ 31 8.00% $ 125 7.71% Commercial, real estate secured 354 35.00 0 0.00 Real estate - Construction 0 4.64 64 3.95 Real estate - Mortgage 188 40.64 1,229 75.91 Installment 12 11.72 202 12.43 Unallocated 1,182 0 0.00 Total $ 1,767 100.00% $ 1,620 100.00% Years Ended December 31 1995 1994 Percentage Percentage Allowance of Loans to Allowance of Loans to Amount Total Loans Amount Total Loans (000 omitted) Commercial, financial and agricultural $ 114 7.98% $ 113 9.42% Commercial - Real estate secured 0 0.0 0 0.0 Real estate - Construction 80 5.55 67 5.58 Real estate - Mortgage 1,055 73.63 844 70.33 Installment 184 12.84 176 14.67 Unallocated 0 0.00 0 0.00 Total $ 1,433 100.00% $ 1,200 100.00%
- -16- Year Ended December 31 1993 Percentage Allowance of Loans to Amount Total Loans (000 omitted) Commercial, financial and agricultural $ 78 6.99% Commercial - Real estate secured 0 0.00 Real estate - Construction 56 4.97 Real estate - Mortgage 853 75.79 Installment 138 12.25 Unallocated 0 0.00 Total $ 1,042 100.00%
ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY DEPOSITS The average amounts of deposits are summarized below: Years Ended December 31 1997 1996 1995 (000 omitted) Demand deposits $ 17,665 $ 16,078 $ 13,833 Interest bearing demand deposits 37,535 27,601 25,048 Savings deposits 24,568 26,555 24,200 Time deposits 68,161 63,767 53,350 Total deposits $ 147,929 $ 134,001 $ 116,431
The following is a breakdown of maturities of time deposits of $ 100,000 or more as of December 31, 1997: Maturity (000 omitted) Certificates of Deposit Three months or less $ 3,410 Over three months through six months 2,543 Over six months through twelve months 4,082 Over twelve months 200 $ 10,235
RETURN ON EQUITY AND ASSETS (APPLYING DAILY AVERAGE BALANCES) The following table presents a summary of significant earnings and capital ratios: (dollar amounts in thousands) 1997 1996 1995 Average assets $ 172,366 $ 153,145 $ 135,648 Net income $ 2,606 $ 2,248 $ 1,954 Average equity $ 16,956 $ 15,076 $ 13,570 Cash dividends paid $ 903 $ 694 $ 613 Return on assets 1.51% 1.47% 1.44% Return on equity 15.37% 14.90% 14.40% Dividend payout ratio 34.65% 30.90% 30.7% Equity to asset ratio 9.84% 9.8% 10.0%
- -17- ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY CONSOLIDATED SUMMARY OF OPERATIONS Years Ended December 31 1997 1996 1995 1994 1993 (000 omitted) Interest income $ 13,450 $ 12,018 $ 10,829 $ 8,571 $ 8,250 Interest expense 5,822 5,139 4,542 3,241 3,129 Net interest income 7,628 6,979 6,287 5,330 5,121 Provision for loan losses 215 240 270 71 121 Net interest income after provision for loan losses 7,413 6,639 6,017 5,259 5,000 Other income: Trust 490 384 297 185 157 Service charges - Deposits 601 477 375 349 308 Other service charges, collection and exchange, charges, commission fees 341 258 218 180 163 Other operating income (loss) 119 121 45 146 ( 26) Total other income 1,551 1,240 935 860 602 Income before operating expense 8,964 7,879 6,952 6,119 5,602 Operating expenses: Salaries and employees benefits 2,901 2,621 2,326 2,115 1,908 Occupancy and equipment expense 764 665 559 486 405 Other operating expenses 1,719 1,507 1,371 1,363 1,280 Total operating expenses 5,384 4,793 4,256 3,964 3,593 Income before income taxes 3,580 3,086 2,696 2,155 2,009 Income tax 974 838 742 520 525 Net income applicable to common stock $ 2,606 $ 2,248 $ 1,954 $ 1,635 $ 1,484 Per share data: Earnings per common share $ 2.54 $ 2.19 $ 1.91 $ 1.59 $ 1.45 Cash dividend - Common $ .88 $ .68 $ .58 $ .50 $ .45 Weighted average number of common shares 1,025,323 1,025,706 1,026,307 1,026,307 1,026,812
- -18- Item 9. Disagreements on Accounting and Financial Disclosures. Not applicable. - -19- PART III The information required by Items 10, 11, 12 and 13 is incorporated by reference from Orrstown Financial Services, Inc.'s definitive proxy statement for the 1998 Annual Meeting of Shareholders filed pursuant to Regulation 14A. - -20- PART IV Item 14. Exhibits, Financial Statement Schedules and Reports of Form 8-K. (a) (1) - List of Financial Statements The following consolidated financial statements of Orrstown Financial Services, Inc. and its subsidiary, included in the annual report of the registrant to its shareholders for the year ended December 31, 1997, are incorporated by reference in Item 8: Consolidated balance sheets - December 31, 1997 and 1996 Consolidated statements of income - Years ended December 31, 1997, 1996 and 1995 Consolidated statements of stockholders' equity - Years ended December 31, 1997, 1996, and 1995 Consolidated statements of cash flows - Years ended December 31, 1997, 1996, and 1995 Notes to consolidated financial statements - December 31, 1997 (2) List of Financial Statement Schedules Schedule I - Changes in net interest income tax equivalent yields Schedule II - Investment portfolio Schedule III - Loan portfolio - -21- Schedule IV - Summary of loan loss experience Schedule V - Nonaccrual, delinquent and impaired loans Schedule VI - Allocation of allowance for loan losses Schedule VII - Deposits and return on equity and assets Schedule VIII - Consolidated summary of operations All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted. (3) Listing of Exhibits Exhibit (3) (i) Articles of incorporation Exhibit (3) (ii) Bylaws Exhibit (4) Instruments defining the rights of security holders including indentures Exhibit (13) Annual report to security holders Exhibit (21) Subsidiaries of the registrant Exhibit (27) Financial data schedule All other exhibits for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted. - -22- (b) Reports on Form 8-K filed None. (c) Exhibits (3)(i) Articles of incorporation. Incorporated by reference to Exhibit 3.1 to the Registrant's Registration Statement on Form S-4, Registration No. 33-18888. (ii) By-laws. Incorporated by reference to Exhibit 3.2 to the Registrant's Registration Statement on Form S-4, Registration No. 33-18888. (4) Instruments defining the rights of security holders including indentures. The rights of the holders of Registrant's common stock are contained in: (i) Articles of Incorporation of Orrstown Financial Services, Inc., filed as Exhibit 3.1 to Registrant's Registration Statement on Form S-4 (Registration No. 33-18888). (ii) By-laws of Orrstown Financial Services, Inc., filed as Exhibit 3.2 to the Registrant's Registration Statement on Form S-4 (Registration No. 33-18888). (13) Annual report to security holders - filed herewith - -23- (21) Subsidiaries of the registrant - filed herewith (27) Financial data schedule - filed herewith (d) Financial statement schedules The following financial statement schedules required under Article 9 Industry Guide 3 have been included on pages 11 to 18 under Item 8 of this report: Schedule I - Changes in net interest income tax equivalent yields. Schedule II - Investment portfolio Schedule III - Loan portfolio Schedule IV - Summary of loan loss experience Schedule V - Nonaccrual delinquent and impaired loans Schedule VI - Allocation of allowance for loan losses Schedule VII - Deposits and return on equity and assets Schedule VIII - Consolidated summary of operations - -24- SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ORRSTOWN FINANCIAL SERVICES, INC. (Registrant) By /s/ Kenneth R. Shoemaker Kenneth R. Shoemaker, President Dated: March _____, 1998 (Duly authorized officer) By ______________________________ Robert B. Russell, Controller (Principal Accounting Officer) Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date /s/ Kenneth R. Shoemaker President and March 26 , 1998 Kenneth R. Shoemaker Director /s/ Anthony F. Ceddia Director March 26 , 1998 Dr. Anthony F. Ceddia /s/ Robert T. Henry Director March 26 , 1998 Robert T. Henry /s/ Gregory A. Rosenberry Director March 26 , 1998 Gregory A. Rosenberry /s/ Joel R. Zullinger Vice Chairman of the March 26 , 1998 Joel R. Zullinger Board and Director /s/ Jeffrey W. Coy Secretary and Chairman March 26 , 1998 Jeffrey W. Coy of Executive Committee and Director /s/ Ned R. Fogelsonger Director March 26 , 1998 Ned R. Fogelsonger /s/ Galen L. Myers Chairman of the March 26 , 1998 Galen L. Myers Board and Director /s/ Denver L. Tuckey________ Director March 26 , 1998 Denver L. Tuckey /s/ Andrea Pugh_____________ Director March 26 , 1998 Andrea Pugh - -25- EXHIBIT 21 SUBSIDIARIES OF THE REGISTRANT 1. Orrstown Bank, Orrstown, Pennsylvania; a state-chartered bank organized under the Pennsylvania Banking Code of 1965. EX-13 2 C O N T E N T S Page INDEPENDENT AUDITOR'S REPORT 1 CONSOLIDATED FINANCIAL STATEMENTS Balance sheets 2 Statements of income 3 Statements of changes in stockholders' equity 4 Statements of cash flows 5 and 6 Notes to consolidated financial statements 7 - 20 ACCOMPANYING FINANCIAL INFORMATION Selected five year financial data 21 Summary of quarterly financial data 22 Management's discussion and analysis INDEPENDENT AUDITOR'S REPORT Board of Directors Orrstown Financial Services, Inc. Orrstown, Pennsylvania We have audited the accompanying consolidated balance sheets of Orrstown Financial Services, Inc. and its wholly- owned subsidiary as of December 31, 1997 and 1996 and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the three years ended December 31, 1997. These consolidated financial statements are the responsibility of the corporation's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated 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 Orrstown Financial Services, Inc. and its wholly-owned subsidiary as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the three years ended December 31, 1997 in conformity with generally accepted accounting principles. Chambersburg, Pennsylvania January 29, 1998 ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY CONSOLIDATED BALANCE SHEETS December 31, 1997 and 1996 ASSETS 1997 1996 (000 omitted) Cash and due from banks $ 5,963 $ 5,236 Interest bearing deposits with banks 16 1,554 Federal funds sold 2,858 2,936 Securities available for sale 46,208 33,421 Federal Home Loan Bank, Federal Reserve and Atlantic Central Bankers Bank stock, at cost which approximates market value 983 934 56,028 44,081 Loans Commercial, financial and agricultural 10,275 8,401 Real estate - Mortgages 97,074 82,687 Real estate - Construction and land development 5,961 4,304 Consumer 15,021 13,534 128,331 108,926 Less: Allowance for loan losses ( 1,767) ( 1,620) 126,564 107,306 Bank premises and equipment, net 5,130 3,916 Accrued interest receivable 1,299 929 Other assets 1,221 1,324 Total assets $ 190,242 $ 157,556 LIABILITIES AND STOCKHOLDERS' EQUITY Deposits Non-interest bearing $ 17,649 $ 16,322 Interest bearing 142,931 120,937 160,580 137,259 Federal funds purchased and securities sold under agreements to repurchase 235 0 Other borrowed funds 8,334 2,339 Accrued interest and other liabilities 2,828 2,102 Total liabilities 171,977 141,700 Stockholders' equity Common stock: No par value - $ .2083 stated value per share, 10,000,000 shares authorized with 1,025,094 shares issued at December 31, 1997; 976,863 shares issued at December 31, 1996 214 20 4 Additional paid-in capital 12,352 10,625 Retained earnings 4,730 4,786 Unrealized holding gains, net of tax - $ 499 - 1997 and $ 124 - 1996 969 241 Total stockholders' equity 18,265 15,856 Total liabilities and stockholders' equity $ 190,242 $ 157,556 The Notes to Consolidated Financial Statements are an integral part of these statements. - -2- ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY CONSOLIDATED STATEMENTS OF INCOME Years Ended December 31, 1997, 1996 and 1995 1997 1996 1995 (000 omitted) Interest and Dividend Income Interest and fees on loans $ 10,702 $ 9,675 $ 8,996 Interest and dividends on investment securities U.S. Government and agencies 1,548 1,265 1,083 Exempt from federal income tax 935 601 529 Other investment income 265 477 221 Total interest and dividend income 13,450 12,018 10,829 Interest Expense Interest on deposits 5,495 4,981 4,349 Interest on borrowed money 327 158 193 Total interest expense 5,822 5,139 4,542 Net interest income 7,628 6,879 6,287 Provision for loan losses 215 240 270 Net interest income after provision for loan losses 7,413 6,639 6,017 Other Income Service charges on deposit accounts 601 477 375 Other service charges, commissions, and fees 341 258 218 Trust department income 490 384 297 Securities gains (losses) 3 ( 5) ( 45) Other income 116 126 90 Total other income 1,551 1,240 935 Net interest income and other income 8,964 7,879 6,952 Other Expenses Salaries and employee benefits 2,901 2,621 2,326 Occupancy expense of bank premises, net, and furniture and equipment expenses 764 665 559 FDIC insurance premiums 17 2 125 Other operating expenses 1,702 1,505 1,246 Total other expenses 5,384 4,793 4,256 Income before income tax 3,580 3,086 2,696 Applicable income tax 974 838 742 Net income $ 2,606 $ 2,248 $ 1,954 Per share data Net income $ 2.54 $ 2.19 $ 1.91 Dividends $ .881 $ .676 $ .584 Weighted average shares outstanding 1,025323 1,025,706` 1,026,307 The Notes to Consolidated Financial Statements are an integral part of these statements. - -3- ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY Years Ended December 31, 1997, 1996 and 1995 Unrealized Additional Holding Common Paid-In Retained Gains Stock Capital Earnings (Losses) (000 omitted) Balance, December 31, 1994 $ 194 $ 9,393 $ 3,133 ($ 367) Net income 0 0 1,954 0 Cash dividends ($ .584 per share) 0 0 ( 599) 0 Stock dividends issued 10 1,232 ( 1,242) 0 Cash paid in lieu of fractional stock dividends 0 0 ( 14) 0 Unrealized gain on investment securities available for sale 0 0 0 939 Balance, December 31, 1995 204 10,625 3,232 572 Net income 0 0 2,248 0 Cash dividends ($ .676 per share) 0 0 ( 694) 0 Unrealized loss on investment securities available for sale 0 0 0 ( 331) Balance, December 31, 1996 204 10,625 4,786 241 Net income 0 0 2,606 0 Cash dividends ($ .881 per share) 0 0 ( 903) 0 Stock dividends issued 10 1,727 ( 1,737) 0 Cash paid in lieu of fractional stock dividends 0 0 ( 22) 0 Unrealized gain on investment securities available for sale 0 0 0 728 Balance, December 31, 1997 $ 214 $ 12,352 $ 4,730 $ 969 The Notes to Consolidated Financial Statements are an integral part of these statements. - -4- ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 1997, 1996 and 1995 1997 1996 1995 (000 omitted) Cash flows from operating activities: Net income $ 2,606 $ 2,248 $ 1,954 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 364 329 265 Provision for loan losses 215 240 270 Deferred income taxes ( 7) ( 62) ( 78) (Gain) loss on disposal of other real estate 0 5 ( 4) (Gain) loss on disposal of bank premises and equipment 0 ( 20) 1 Securities (gains) losses ( 3) 5 45 (Increase) decrease in accrued interest receivable ( 370) 64 ( 260) Increase (decrease) in accrued interest payable 480 278 290 Other net ( 59) 64 ( 2) Net cash provided by operating activities 3,226 3,151 2,481 Cash flows from investing activities: Net (increase) decrease in interest bearing deposits with banks 1,538 ( 265) ( 1,039) Sales of available for sale securities 15 2,392 6,387 Maturities of available for sale securities 3,114 3,508 6,694 Purchases of available for sale securities ( 14,811) ( 9,134) ( 18,843) Purchases of FHLB stock ( 49) ( 65) ( 61) Net (increase) in loans ( 19,473) ( 6,291) ( 12,055) Proceeds from sale of bank premises and equipment 0 36 0 Proceeds from disposal of other real estate 0 142 22 Purchases of bank premises and equipment ( 1,537) ( 1,178) ( 266) Net cash (used) by investing activities ( 31,203) ( 10,855) ( 19,161) Cash flows from financing activities: Net increase in deposits 23,321 9,929 19,997 Net increase (decrease) in federal funds purchased and securities sold under agreements to repurchase 235 0 ( 644) Proceeds from debt 6,000 0 0 Payment on debt ( 5) ( 6) ( 6) Cash dividends paid ( 903) ( 694) ( 599) Cash paid in lieu of fractional stock dividends ( 22) 0 ( 14) Net cash provided by financing activities 28,626 9,229 18,734 Net increase in cash and cash equivalents 649 1,525 2,054 Cash and cash equivalents, beginning balance 8,172 6,647 4,593 Cash and cash equivalents, ending balance $ 8,821 $ 8,172 $ 6,647 The Notes to Consolidated Financial Statements are an integral part of these statements. - -5- ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) Years Ended December 31, 1997, 1996 and 1995 1997 1996 1995 (000 omitted) Supplemental disclosure of cash flows information: Cash paid during the year for: Interest $ 5,343 $ 5,418 $ 4,252 Income taxes 974 892 800 Supplemental schedule of noncash investing and financing activities: Other real estate acquired in settlement of loans 0 169 22 Unrealized gain (loss) on investment securities available for sale (net of tax effects) 728 ( 331) 939 Other real estate transferred to bank premises 0 0 136 Property, equipment and other assets purchased with assumption of deposit liabilities in connection with branch acquisition 0 0 968 The Notes to Consolidated Financial Statements are an integral part of these statements. - -6- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Summary of Significant Accounting Policies Nature of operations Orrstown Financial Services, Inc.'s primary activity consists of owning and supervising its subsidiary, Orrstown Bank, which is engaged in providing banking and bank related services in South Central Pennsylvania, principally Franklin and Cumberland Counties. Its seven branches are located in Shippensburg (2), Carlisle (2), Spring Run, Orrstown, and Chambersburg, Pennsylvania. Principles of consolidation The consolidated financial statements include the accounts of the corporation and its wholly-owned subsidiary, Orrstown Bank. All significant intercompany transactions and accounts have been eliminated. Use of estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for losses on loans and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowances for losses on loans and foreclosed real estate, management obtains independent appraisals for significant properties. While management uses available information to recognize losses on loans and foreclosed real estate, future additions to the allowances may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the corporation's allowances for losses on loans and foreclosed real estate. Such agencies may require the corporation to recognize additions to the allowances based on their judgments about information available to them at the time of their examination. Because of these factors, management's estimate of credit losses inherent in the loan portfolio and the related allowance may change in the near term. Investment securities In accordance with Statement of Financial Accounting Standards No. 115 (SFAS 115) the Bank may segregate their investment portfolio into three specific categories: "securities held to maturity", "trading securities" and "securities available for sale". Securities held to maturity are to be accounted for at their amortized cost; securities classified as trading securities are to be accounted for at their current market value with unrealized gains and losses on such securities included in current period earnings; and securities classified as available for sale are to be accounted for at their current market value with unrealized gains and losses on such securities to be excluded from earnings and reported net as a separate component of stockholders' equity. - -7- Note 1. Summary of Significant Accounting Policies (Continued) Investment securities (Continued) Management determines the appropriate classification of securities at the time of purchase. If management has the intent and the corporation has the ability at the time of purchase to hold securities until maturity or on a long- term basis, they are classified as securities held to maturity and carried at amortized historical cost. Securities to be held for indefinite periods of time and not intended to be held to maturity or on a long-term basis are classified as available for sale and carried at fair value. Securities held for indefinite periods of time include securities that management intends to use as part of its asset and liability management strategy and that may be sold in response to changes in interest rates, resultant prepayment risk and other factors related to interest rate and resultant prepayment risk changes. The corporation has classified all of its investment securities as "available for sale". Realized gains and losses on dispositions are based on the net proceeds and the adjusted book value of the securities sold, using the specific identification method. Unrealized gains and losses on investment securities available for sale are based on the difference between book value and fair value of each security. These gains and losses are credited or charged to shareholders' equity, whereas realized gains and losses flow through the corporation's results of operations. Cash flows For purposes of the Statements of Cash Flows, the corporation has defined cash and cash equivalents as those amounts included in the balance sheet captions "Cash and Due From Banks" and "Federal Funds Sold". As permitted by Statement of Financial Accounting Standards No. 104, the corporation has elected to present the net increase or decrease in deposits in banks, loans, and time deposits in the Statements of Cash Flows. Premises, equipment, furniture and fixtures and depreciation Buildings, improvements, equipment, furniture and fixtures are carried at cost less accumulated depreciation. Depreciation has been provided generally on the straight-line method and is computed over the estimated useful lives of the various assets as follows: Years Buildings and improvements 10-40 Equipment, furniture and fixtures 3-15 Repairs and maintenance are charged to operations as incurred. Computer software is amortized over 3-5 years. Advertising The corporation follows the policy of charging costs of advertising to expense as incurred. Advertising expense was $ 148,654, $ 86,910 and $ 54,224 for 1997, 1996 and 1995, respectively. - -8- Note 1. Summary of Significant Accounting Policies (Continued) Loans and allowance for loan losses Loans are stated at the amount of unpaid principal, reduced by an allowance for loan losses. Interest on loans is calculated by using the simple interest method on daily balances of the principal amount outstanding. Loan origination and commitment fees and certain direct costs are deferred and the net amount amortized over the contractual life of the loan as an adjustment of the loan's yield. If a loan is sold, any deferred fees not yet amortized are recognized as an adjustment to the gain or loss on sale. The allowance for loan losses is established through a provision for loan losses charged to expenses. Loans are charged against the allowance when management believes that the collectibility of the principal is unlikely. The allowance is an amount that management believes will be adequate to absorb possible losses on existing loans that may become uncollectible, based on evaluations of the collectibility of loans and prior loan loss experience. The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current economic conditions that may affect the borrowers' ability to pay. Nonaccrual loans The accrual of interest income on loans ceases when principal or interest is past due 90 days or more and collateral is inadequate to cover principal and interest or immediately if, in the opinion of management, full collection is unlikely. Interest accrued but not collected as of the date of placement on nonaccrual status is reversed and charged against current income unless fully collateralized. Subsequent payments received either are applied to the outstanding principal balance or recorded as interest income, depending on management's assessment of the ultimate collectibility of principal. Foreclosed real estate Real estate properties acquired through, or in lieu of, loan foreclosure are to be sold and are initially recorded at the lower of carrying value or fair value less cost to sell of the underlying collateral. After foreclosure, valuations are periodically performed by management and the real estate is carried at the lower of carrying amount or fair value less cost to sell. Earnings per share of common stock Earnings per share of common stock were computed based on a weighted average shares of common stock outstanding of 1,025,323 in 1997; 1,025,706 in 1996 and 1,026,307 in 1995 after giving retroactive recognition to 5% stock dividends issued in May 1997, and June 1995. Federal income taxes For financial reporting purposes the provision for loan losses charged to operating expense is based on management's judgment, whereas for federal income tax purposes, the amount allowable under present tax law is deducted. Additionally, deferred compensation is charged to operating expense in the period the liability is incurred for financial reporting purposes, whereas for federal income tax purposes, these expenses are deducted when paid. As a result of these, and timing differences in depreciation expense, deferred income taxes are provided in the financial statements. See Note 10 for further details. - -9- Note 1. Summary of Significant Accounting Policies (Continued) Fair values of financial instruments Statement of Financial Accounting Standards No. 107, Disclosures About Fair Value of Financial Instruments, requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet. 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. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Statement No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the corporation. The following methods and assumptions were used by the corporation in estimating fair values of financial instruments as disclosed herein: Cash and Cash Equivalents. The carrying amounts of cash and short-term instruments approximate their fair value. Securities to be Held to Maturity and Securities Available for Sale. Fair values for investment securities are based on quoted market prices. Loans Receivable. For variable-rate loans that reprice frequently and have no significant change in credit risk, fair values are based on carrying values. Fair values for fixed rate loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Fair values for impaired loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable. Deposit Liabilities. The fair values disclosed for demand deposits are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts). The carrying amounts of variable-rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date. Fair values for fixed-rate certificates of deposits and IRA's are estimated using a discounted cash flow calculation that applies interest rates currently being offered to a schedule of aggregated expected maturities on time deposits. Short-Term Borrowings. The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings maturing within 90 days approximate their fair values. Fair values of other short-term borrowings are estimated using discounted cash flow analyses based on the Bank's current incremental borrowing rates for similar types of borrowing arrangements. Long-Term Borrowings. The fair value of the Bank's long-term debt is estimated using a discounted cash flow analysis based on the Bank's current incremental borrowing rate for similar types of borrowing arrangements. Accrued Interest. The carrying amounts of accrued interest approximate their fair values. Off-Balance-Sheet Instruments. The Bank generally does not charge commitment fees. Fees for standby letters of credit and their off-balance-sheet instruments are not significant. - -10- Note 2. Investments At December 31, 1997 and 1996 the investment securities portfolio was comprised of securities classified as "available for sale", resulting in investment securities being carried at fair value. The amortized cost and fair values of investment securities available for sale at December 31 were: Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value (000 omitted) 1997 U. S. Treasury securities and obligations of U. S. Government corporations and agencies $ 12,837 $ 174 $ 1 $ 13,010 Obligations of states and political subdivisions 17,611 961 0 18,572 Mortgage-backed securities 13,812 122 34 13,900 Equity securities 480 246 0 726 Totals $ 44,740 $ 1,503 $ 35 $ 46,208 1996 U. S. Treasury securities and obligations of U. S. Government corporations and agencies $ 10,830 $ 65 $ 36 $ 10,859 Obligations of states and political subdivisions 11,397 381 10 11,768 Mortgage-backed securities 10,413 37 149 10,301 Equity securities 417 78 2 493 Totals $ 33,057 $ 561 $ 197 $ 33,421 The amortized cost and fair values of investment securities available for sale at December 31, 1997, by expected maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Amortized Cost Fair Value (000 omitted) Due in one year or less $ 1,743 $ 1,747 Due after one year through five years 9,814 10,018 Due after five years through ten years 5,903 6,185 Due after ten years 12,988 13,632 Mortgage-backed securities 13,812 13,900 Equity securities 480 726 $ 44,740 $ 46,208 - -11- Note 2. Investments (Continued) Proceeds from sales of securities available for sale during 1997, 1996 and 1995 were $ 22,371, $ 2,391,746 and $ 6,369,602, respectively. Gross gains and losses on 1997 sales were $ 10,045 and $ 6,660, respectively. Gross gains and losses on 1996 sales were $ 16,440 and $ 21,455, respectively. Gross gains and losses on 1995 sales were $ 37,559 and $ 53,389, respectively. The bank owns $ 739,800 of Federal Home Loan Bank stock, $ 54,000 of Atlantic Central Bankers Bank stock and $ 189,000 of Federal Reserve Bank stock at December 31, 1997. At December 31, 1996 the bank's stock ownership was $ 691,200 of Federal Home Loan Bank stock, $ 54,000 of Atlantic Central Bankers Bank stock and $ 189,000 of Federal Reserve Bank stock. Market value approximates cost since none of the stocks are actively traded. Securities carried at $ 19,198,000 and $ 10,517,000 at December 31, 1997 and 1996, respectively, were pledged to secure public funds and for other purposes as required or permitted by law. Note 3. Concentration of Credit Risk The bank grants agribusiness, commercial, residential and consumer loans to customers in South Central Pennsylvania, principally Franklin and Cumberland Counties. The concentrations of credit by type of loan are set forth on the face of the balance sheet. The bank maintains a diversified loan portfolio and evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the bank upon the extension of credit, is based on management's credit evaluation of the customer. Collateral held varies but generally includes equipment and real estate. Note 4. Allowance for Loan Losses Activity in the allowance for loan losses is summarized as follows: 1997 1996 1995 (000 omitted) Balance at beginning of period $ 1,620 $ 1,433 $ 1,200 Recoveries 15 15 14 Provision for loan losses charged to income 215 240 270 Total 1,850 1,688 1,484 Losses 83 68 51 Balance at the end of period $ 1,767 $ 1,620 $ 1,433 - -12- Note 5. Bank Premises and Equipment A summary of bank premises and equipment is as follows: 1997 1996 (000 omitted) Land $ 606 $ 424 Buildings and improvements 3,749 3,107 Leasehold improvements 173 0 Furniture and equipment 2,840 2,202 Construction in progress 0 120 Total 7,368 5,853 Less accumulated depreciation and amortization 2,238 1,937 Bank premises and equipment, net $ 5,130 $ 3,916 Depreciation expense amounted to $ 323,652 in 1997, $ 287,624 in 1996, and $ 250,769 in 1995. Note 6. Loans to Related Parties The bank has granted loans to the officers and directors of the corporation and its subsidiary and to their associates. Related party loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons and do not involve more than normal risk of collectibility. The aggregate dollar amount of these loans was $ 2,350,000 and $ 2,005,000 at December 31, 1997 and 1996, respectively. During 1997, $ 1,313,000 of new loans were made and repayments totalled $ 968,000. During 1996, $ 830,000 of new loans were made and repayments totalled $ 793,000. Outstanding loans to bank employees totalled $ 750,000 and $ 610,000 for years ended December 31, 1997 and 1996, respectively. Note 7. Nonaccrual Loans The following table shows the principal balances of nonaccrual loans as of December 31: 1997 1996 1995 Nonaccrual loans $ 473,000 $ 14,000 $ 132,000 Interest income that would have been accrued at original contract rates $ 30,835 $ 560 $ 1,616 Amount recognized as interest income 5,829 0 0 Foregone revenue $ 25,006 $ 560 $ 1,616 Impairment of loans having recorded investments of $ 404,678 at December 31, 1997 has been recognized in accordance with Statements of Financial Accounting Standards No. 114 and 118. The average recorded investment in impaired loans during 1997 was $ 405,262. Total allowance for loan losses related to impaired loans was $ 60,750 at December 31, 1997. Interest income on impaired loans of $ 5,829 was recognized for cash payments received in 1997. The corporation had no impairment of loans during 1996 as defined by Statement of Financial Accounting Standard No. 114. - -13- Note 8. Financial Instruments With Off-Balance-Sheet Risk The bank 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 and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets. The contract amounts of those instruments reflect the extent of involvement the bank has in particular classes of financial instruments. The bank's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual amount of those instruments. The bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Contract or Notional Amount 1997 1996 (000 omitted) Financial instruments whose contract amounts represent credit risk at December 31: Commitments to extend credit $ 23,852 $ 20,691 Standby letters of credit and financial guarantees written 2,811 3,014 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The bank evaluates each customer's creditworthiness on a case- by-case basis. The amount of collateral obtained if deemed necessary by the bank upon extension of credit is based on management's credit evaluation of the customer. Collateral held varies but may include accounts receivable, inventory, real estate, equipment, and income-producing commercial properties. Standby letters of credit and financial guarantees written are conditional commitments issued by the bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The bank holds collateral supporting those commitments when deemed necessary by management. Note 9. Employee Benefit Plans The bank maintains a 401(k) profit-sharing plan for those employees who meet the eligibility requirements set forth in the plan. Employer contributions to the plan are based on bank performance and are at the discretion of the bank's Board of Directors. In addition, there is a provision for an employer match of 50 cents on the dollar for employee contributions up to 6% of the employees' eligible compensation. Substantially all of the bank's employees are covered by the plan and the contribution charged to operations was $ 319,182, $ 306,379, and $ 260,334 for 1997, 1996, and 1995, respectively. The bank has a deferred compensation arrangement with certain present and former board directors whereby a director or his beneficiaries will receive a monthly retirement benefit at age 65. The arrangement is funded by an amount of life insurance on the participating director calculated to meet the bank's obligations under the compensation agreement. The cash value of the life insurance policies is an unrestricted asset of the bank. The estimated present value of future benefits to be paid, which are included in other liabilities, amounted to $ 166,237 and $ 171,331 at December 31, 1997 and 1996, respectively. Total annual expense for this deferred compensation plan was $ 19,064 for 1997, $ 20,153 for 1996 and $ 19,064 for 1995. - -14- Note 9. Employee Benefit Plans (Continued) The bank also has a supplemental discretionary deferred compensation plan for executive officers and directors. The plan is funded annually with salary and fee reductions which are placed in a trust account invested by the Bank's trust department. Total amount contributed to the plan was $ 46,425, $ 55,950 and $ 48,273 for 1997, 1996 and 1995, respectively. Note 10. Income Taxes The components of federal income tax expense are summarized as follows: 1997 1996 1995 (000 omitted) Current year provision $ 981 $ 900 $ 820 Deferred income taxes (benefits) ( 7) ( 62) ( 78) Net federal income tax expense $ 974 $ 838 $ 742 Federal income taxes were computed after reducing pretax accounting income for non-taxable income in the amount of $ 969,000, $ 661,000, and $ 599,000 for 1997, 1996, and 1995, respectively. A reconciliation of the effective applicable income tax rate to the federal statutory rate is as follows: 1997 1996 1995 Federal income tax rate 34.0% 34.0% 34.0% Reduction resulting from: Nontaxable interest income and deferred taxes 6.8 6.8 6.5 Effective income tax rate 27.2% 27.2% 27.5% Deferred tax liabilities have been provided for taxable temporary differences related to accumulated depreciation and unrealized gains on available for sale securities. Deferred tax assets have been provided for deductible temporary differences related to the allowance for loan losses, directors' deferred compensation and unrealized losses on available for sale securities. The net deferred tax assets (liabilities) included in the accompanying consolidated balance sheets include the following components: 1997 1996 Total deferred tax assets $ 625,000 $ 553,000 Total deferred tax liabilities ( 696,000) ( 256,000) Net deferred tax asset (liability) ($ 71,000) $ 297,000 The corporation has not recorded a valuation allowance for deferred tax assets as they feel that it is more likely than not that they will be ultimately realized. Note 11. Deposits Included in interest bearing deposits at December 31 are NOW and Super NOW account balances totalling $ 22,721,000 and $ 18,163,000 for 1997 and 1996, respectively. Also included in interest bearing deposits at December 31, 1997 and 1996 are money market account balances totalling $ 23,423,000 and $ 10,569,000, respectively. At December 31, 1997 and 1996 time deposits of $ 100,000 and over aggregated $ 10,235,000 and $ 7,767,000, respectively. Interest expense on time deposits of $ 100,000 and over was $ 497,000; $ 373,000; and $ 337,000 for 1997, 1996 and 1995, respectively. - -15- Note 11. Deposits (Continued) At December 31, 1997 the scheduled maturities of certificates of deposit are as follows: 1998 $ 43,378,000 1999 22,193,000 2000 4,518,000 2001 1,158,000 2002 1,036,000 2003 and thereafter 906,000 $ 73,189,000 The bank accepts deposits of the officers and directors of the corporation and its subsidiary on the same terms, including interest rates, as those prevailing at the time for comparable transactions with unrelated persons. The aggregate dollar amount of deposits of officers and directors totaled $ 965,000 and $ 1,103,000 at December 31, 1997 and 1996, respectively. Note 12. Liabilities For Borrowed Money Federal funds purchased and securities sold under agreements to repurchase generally mature within one day from the transaction date. Information concerning securities sold under agreements to repurchase is summarized as follows: 1997 1996 Average balance during the year $ 49,400 $ 0 Average interest rate during the year 4.94% 0 Maximum month-end balance during the year $ 500,000 $ 0 Securities underlying the agreements at year-end: Carrying value $ 485,280 $ 0 Estimated fair value $ 515,600 $ 0 At December 31, the corporation had long-term notes outstanding with the Federal Home Loan Bank of Pittsburgh as follows: - - - - - - - Amount - - - - - - - 1997 1996 Maturity Date Interest Rate $ 1,000,000 $ 1,000,000 1/04 6.42% 1,000,000 1,000,000 4/03 6.58% 3,000,000 0 3/02 5.51% 3,000,000 0 10/02 5.73% $ 8,000,000 $ 2,000,000 Interest rates are fixed and interest only is paid on a monthly basis. The notes contain prepayment penalty charges, but management has no intention to pay off early. In addition to the aforementioned long-term notes the bank obtained a term loan in 1994 totaling $ 350,000 with the Federal Home Loan Bank of Pittsburgh. The maturity dates and applicable fixed interest rates on the remaining balance at December 31 are as follows: - - - - - - Amount - - - - - - - 1997 1996 Maturity Date Rate $ 0 $ 5,570 2/97 4.61% 5,863 5,863 2/98 5.00% 6,173 6,173 2/99 5.21% 6,498 6,498 2/00 5.48% 315,579 315,579 2/01 5.58% $ 334,113 $ 339,683 - -16- Note 12. Liabilities For Borrowed Money (Continued) In addition, the bank has available a $ 10,000,000 line of credit with the Federal Home Loan Bank of Pittsburgh. Collateral for outstanding advances and the line consists of certain securities and the corporation's 1-4 family mortgage loans totaling $ 65,971,000 at December 31, 1997. The corporation also has available an unused line of credit with Atlantic Central Bankers Bank of $ 3.5 million at December 31, 1997. Total interest on the aforementioned borrowings charged to operations was $ 308,405, $ 148,859 and $ 149,083, for 1997, 1996 and 1995, respectively. Note 13. Orrstown Financial Services, Inc. (Parent Company Only) Financial Information The following are the condensed balance sheets, income statements and statements of cash flows for the parent company: Balance Sheets December 31 Assets 1997 1996 (000 omitted) Cash $ 115 $ 107 Securities available for sale 726 493 Investment in Orrstown Bank 17,507 15,321 Furniture and equipment (net of depreciation) 0 1 Total assets $ 18,348 $ 15,922 Liabilities Accrued management fee $ 0 $ 40 Other liabilities 83 26 Total liabilities 83 66 Stockholders' Equity Common stock, no par value - $ .2083 stated value per share, 10,000,000 shares authorized with 1,025,094 shares issued at December 31, 1997; 976,863 shares issued at December 31, 1996 214 204 Additional paid-in capital 12,352 10,625 Retained earnings 4,730 4,786 Unrealized holding gains 969 241 Total stockholders' equity 18,265 15,856 Total liabilities and stockholders' equity $ 18,348 $ 15,922 Income Statements Years Ended December 31 1997 1996 1995 (000 omitted) Interest and dividend income $ 16 $ 17 $ 20 Net gain on sale of investment 10 0 0 Cash dividends from wholly-owned subsidiary 1,064 796 614 Equity in undistributed income of subsidiary 1,570 1,531 1,401 2,660 2,344 2,035 Less: Operating expenses 54 96 81 Net income $ 2,606 $ 2,248 $ 1,954 - -17- Note 13. Orrstown Financial Services, Inc. (Parent Company Only) Financial Information (Continued) Statements of Cash Flows Years Ended December 31 1997 1996 1995 (000 Omitted) Cash flows from operating activities: Net income $ 2,606 $ 2,248 $ 1,954 Adjustments to reconcile net income to cash provided by operating activities: Security (gains) ( 10) 0 0 Equity in undistributed income of subsidiary ( 1,570) ( 1,531) ( 1,401) Increase (decrease) in other liabilities ( 40) 0 34 Net cash provided by operating activities 986 717 587 Cash flows from investing activities: Net decrease in interest-bearing deposits with banks 0 0 250 Purchase of available for sale securities ( 75) ( 102) ( 52) Sales of available for sale securities 22 0 0 Net cash provided (used) by investing activities ( 53) ( 102) 198 Cash flows from financing activities: Cash dividends paid ( 903) ( 694) ( 599) Cash paid in lieu of fractional stock dividends ( 22) 0 ( 14) Net cash (used) by financing activities ( 925) ( 694) ( 613) Net increase (decrease) in cash 8 ( 79) 172 Cash, beginning balance 107 186 14 Cash, ending balance $ 115 $ 107 $ 186 Supplemental disclosure of cash flows information: Cash paid during the year for: Income taxes $ 0 $ 8 $ 6 Note 14. Regulatory Matters Dividends paid by Orrstown Financial Services, Inc. are generally provided from the bank's dividends to the parent company. Under provisions of the Pennsylvania Banking Code, cash dividends may be paid from accumulated net earnings (retained earnings) as long as minimum capital requirements are met. The minimum capital requirements stipulate that the bank's surplus or additional paid-in capital be equal to the amount of capital. Orrstown Bank is well above these requirements and the balance of $ 10,402,000 in its retained earnings at December 31, 1997 is fully available for cash dividends. Orrstown Financial Services' balance of retained earnings at December 31, 1997 is $ 4,730,000 and would be available for cash dividends, although payment of dividends to such extent would not be prudent or likely. The Federal Reserve Board, which regulates bank holding companies, establishes guidelines which indicate that cash dividends should be covered by current period earnings. - -18- Note 14. Regulatory Matters (Continued) Regulatory authorities have established capital guidelines in the form of the "leverage ratio" and "risk-based capital ratios". The leverage ratio compares capital to total balance sheet assets, while the risk-based ratios compare capital to risk-weighted assets and off-balance-sheet activity in order to make capital levels more sensitive to risk profiles of individual banks. A comparison of Orrstown Financial Services' capital ratios to regulatory minimums at December 31 is as follows: Orrstown Financial Services Regulatory Minimum 1997 1996 Requirements Leverage ratio 9.7% 9.8% 3% Risk-based capital ratio Tier I (core capital) 12.7% 13.2% 4% Combined Tier I and Tier II (core capital plus allowance for loan losses) 14.0% 14.6% 8% Note 15. Leases The bank leases land and building space associated with its downtown Carlisle office and various remote automated teller machines under agreements which expire at various times from 1998 through 2002. Total rent expense charged to operations in connection with these leases was $ 22,350, $ 14,260, and $ 16,920 for 1997, 1996, and 1995, respectively. The total minimum rental commitment under operating leases at December 31, 1997 is as follows: Due in the year ending December 31: 1998 $ 23,203 1999 24,266 2000 25,228 2001 25,115 2002 5,900 Note 16. Compensating Balance Arrangements Required deposit balances at the Federal Reserve were $ 65,000 at December 31, 1997 and 1996. Required deposit balances at Atlantic Central Bankers Bank were $ 585,000 at December 31, 1997 and 1996. These balances are maintained to cover processing costs and service charges. An additional $ 22,800 is on deposit with First Union National Bank of Florida as a reserve for potential clearing losses related to the credit card operations. - -19- Note 17. Fair Value of Financial Instruments The estimated fair values of the corporation's financial instruments were as follows at December 31: - - - - - - 1997 - - - - - - - - - - - - - 1996 - - - - - - Carrying Fair Carrying Fair Amount Value Amount Value (000 Omitted) FINANCIAL ASSETS Cash and short-term investments $ 8,837 $ 8,837 $ 9,726 $ 9,726 Securities available for sale 46,208 46,208 33,421 33,421 Restricted bank stocks 983 983 934 934 Loans 128,331 108,926 Allowance for loan loses ( 1,767) ( 1,620) Net loans 126,564 128,164 107,306 108,774 Accrued interest receivable 1,299 1,299 929 929 Total financial assets $ 183,891 $ 185,491 $ 152,316 $ 153,784 FINANCIAL LIABILITIES Deposits $ 160,580 $ 160,807 $ 137,259 $ 137,451 Borrowed funds 8,569 8,604 2,339 2,348 Accrued interest payable 1,645 1,645 1,165 1,165 Total financial liabilities $ 170,794 $ 171,056 $ 140,763 $ 140,964 - -20- ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY SELECTED FIVE-YEAR FINANCIAL DATA 1997 1996 1995 1994 1993 Income (000 omitted) Interest income $ 13,450 $ 12,018 $ 10,829 $ 8,571 $ 8,250 Interest expense 5,822 5,139 4,542 3,241 3,129 Provision for loan losses 215 240 270 71 121 Net interest income after provision for loan losses 7,413 6,639 6,017 5,259 5,000 Securities gains (losses) 3 ( 5) ( 45) 95 ( 5) Other operating income 1,548 1,245 980 765 607 Other operating expenses 5,384 4,793 4,256 3,964 3,593 Income before income taxes 3,580 3,086 2,696 2,155 2,009 Applicable income tax 974 838 742 520 525 Net income $ 2,606 $ 2,248 $ 1,954 $ 1,635 $ 1,484 Per share amounts are based on following weighted averages: 1997 - 1,025,323 1995 - 1,026,307 1993 - 1,026,812 1996 - 1,025,706 1994 - 1,026,307 Income before income taxes $ 3.49 $ 3.01 $ 2.62 $ 2.10 $ 1.96 Applicable income taxes .95 .82 .72 .51 .51 Net income 2.54 2.19 1.91 1.59 1.45 Cash dividend paid .88 .68 .58 .50 .45 Book value 17.82 15.46 14.27 12.04 11.31 Year-End Balance Sheet Figures (000 omitted) Total assets $ 190,242 $ 157,556 $ 145,998 $ 123,004 $ 113,581 Total loans 128,331 108,926 102,857 90,839 75,5 74 Total investment securities 47,191 34,355 31,563 24,318 30,3 81 Deposits-noninterest bearing 17,649 16,322 13,962 13,262 13,4 17 Deposits-interest bearing 142,931 120,937 113,368 93,103 85,1 65 Total deposits 160,580 137,259 127,330 106,365 98,582 Liabilities for borrowed money 8,569 2,339 2,345 2,350 1,000 Total stockholders' equity 18,265 15,856 14,633 12,353 11,597 Ratios Average equity/average assets 9.84 9.80 10.00 10.34 10.23 Return on average equity 15.37 14.90 14.40 13.36 13.24 Return on average assets 1.51 1.47 1.44 1.38 1.36 - -21- ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY SUMMARY OF QUARTERLY FINANCIAL DATA The unaudited quarterly results of operations for the years ended December 31, 1997 and 1996 are as follows: 1997 1996 ($ 000 omitted Quarter Ended Quarter Ended except per share) Mar. 31 June 30 Sept. 30 Dec. 31 Mar. 31 June 30 Sept. 30 Dec. 31 Interest income $ 3,103 $ 3,316 $ 3,474 $ 3,557 $ 2,906 $ 2,994 $ 3,054 $ 3,064 Interest expense 1,300 1,418 1,504 1,600 1,260 1,286 1,297 1,296 Net interest income 1,803 1,898 1,970 1,957 1,646 1,708 1,757 1,768 Provision for loan losses 45 45 45 80 60 60 60 60 Net interest income after provision for loan losses 1,758 1,853 1,925 1,877 1,586 1,648 1,697 1,708 Securities gains (losses) ( 5) 9 5 ( 6) ( 4) 8 ( 7) ( 2) Other income 345 381 351 471 260 293 325 367 Other expenses 1,307 1,254 1,297 1,526 1,101 1,184 1,134 1,374 Operating income before income taxes 791 989 984 816 741 765 881 699 Applicable income taxes 232 270 256 216 207 227 273 131 Net income $ 559 $ 719 $ 728 $ 600 $ 534 $ 538 $ 608 $ 568 Net income applicable to common stock Per share data: Net income $ .55 $ .70 $ .71 $ .58 $ .52 $ .52 $ .60 $ .55 - -22- Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations The following discussion and analysis should be read in conjunction with the selected supplementary financial information presented in this report. Summary For the year ended December 31, 1997, Orrstown Financial Services, Inc. (the Corporation) and its wholly-owned subsidiary Orrstown Bank (the Bank) recorded net income of $2,606,000, an increase of 15.9% over 1996 earnings of $2,248,000, which was a 15.0% increase over net income of $1,954,000 in 1995. Net income per share has increased over this time period from $1.91 in 1995 to $2.19 in 1996 and $2.54 in 1997. The Corporation's earnings performance continues to be well above peer group averages as measured by various ratio analyses. Two widely recognized performance indicators are the return on average assets and the return on average equity. The return on average assets was 1.51% in 1997, 1.47% in 1996 and 1.44% in 1995. The return on average equity was 15.37% in 1997, 14.90% in 1996 and 14.40% in 1995. A detailed discussion of elements contributing to the above average and improving earnings performance is contained in the paragraphs that follow. Net Interest Income Net interest income is the amount by which interest income on earning assets exceeds interest paid on interest bearing liabilities. The amount of net interest income is affected by changes in interest rates, account balances or volume and the mix of earning assets and interest bearing liabilities. Net interest income is still the primary source of bank profits despite the industry wide push to enhance noninterest income over the past several years. For the year ended December 31, 1997, net interest income totaled $7,413,000, an increase of $774,000, or 11.7%, over 1996. The 1996 total was $6,639,000, or 10.3%, over 1995. On a taxable equivalent basis, net interest income increased by 13.1% in 1997 to $8,127,000, following an 8.9% increase in 1996. 1997 gains are enhanced by increased utilization of tax exempt investments versus previous years. Marginal tax rates used in the taxable equivalent equation were 34% for all three years presented. - -23- 1997 1996 1995 Average Tax Tax Tax Tax Tax Tax (Dollars in Average Equivalent Equivalent Average Equivalent Interest Average Equivalent Equivalent thousands) Balance Interest Rate Balance Interest Rate Balance Interest Rate ASSETS: Interest earning Assets: Federal funds sold and interest bearing bank balances 3,372 189 5.60% 7,637 409 5.36% 2,406 221 9.19% Investment securities: Taxable investment securities 25,360 1,624 6.40% 20,899 1,333 6.38% 18,35 5 1,083 5.90% Tax exempt investment securities 15,983 1,417 8.86% 9,881 911 9.22% 8,488 802 9.44% Total investment securities 41,343 3,041 7.35% 30,780 2,244 7.29% 26,843 1,885 7.02% LOANS: Taxable loans 116,811 10,669 9.13% 104,783 9,578 9.14% 96,45 5 8,926 9.25% Tax exempt loans 592 50 8.45% 996 91 9.13% 1,207 106 8.79% Total loans 117,403 10,719 9.13% 105,779 9,669 9.14% 97,662 9,032 9.25% Total interest earning assets 162,118 13,949 8.60% 144,196 12,322 8.55% 126,9 11 11,138 8.78% Noninterest earning Assets: Cash and due from banks 5,008 4,520 3,143 Bank premises and equipment 4,443 3,486 2,727 Other assets 2,486 2,471 4,124 Less allowance for loan losses ( 1,689) ( 1,528) ( 1,257) Total 172,366 153,145 135,648 Liabilities & Stockholders' Equity Interest bearing Liabilities: Interest bearing demand deposits 37,535 1,056 2.81% 27,601 681 2.47% 25,04 8 617 2.46% Savings deposits 24,568 728 2.96% 25,934 773 2.98% 23,597 740 3.14% Time deposits 68,161 3,711 5.44% 64,388 3,527 5.48% 53,95 3 2,992 5.55% Short term borrowings 218 12 5.50% 0 0 0 715 44 6.15% - -24- 1997 1996 1995 Average Tax Tax Tax Tax Tax Tax (Dollars in Average Equivalent Equivalent Average Equivalent Interest Average Equivalent Equivalent thousands) Balance Interest Rate Balance Interest Rate Balance Interest Rate Long term borrowings 5,322 315 5.92% 2,486 158 6.36% 2,474 149 6.02% Total interest bearing liabilities 135,804 5,822 4.28% 120,409 5,139 4.27% 105,787 4,542 4.30% Noninterest bearing Liabilities: Demand deposits 17,665 16,078 13,833 Other 1,941 1,582 2,458 Total liabilities 155,410 138,069 122,078 Stockholders' Equity 16,956 15,076 13,570 TOTAL / Cost of funds 172,366 3.59% 153,145 3.57% 135,648 3.58% Net interest income/net interest spread 8,127 4.32% 7,183 4.28% 6,596 4.48% Net interest margin 5.01% 4.98% 5.20%
- -25- The Corporation's taxable equivalent net interest spread was 4.48% in 1995, 4.28% in 1996, and 4.32% in 1997. The net interest margin, which factors in noninterest bearing funds sources, has moved from 5.20% to 4.98% to 5.01%, respectively. Earning assets represented 94.1% of total assets in 1997, 94.2% in 1996 and 93.6% in 1995. The allocation of growth dollars to interest bearing categories has been maintained at a very steady pace even while opening two new branch banking offices during 1997. Volume factors were responsible for essentially all net interest income growth during 1996 and 1997. The successful establishment of two new offices in 1997, a second Carlisle office in January and a Chambersburg office in November, helped fuel record deposit growth. Each new office exceeded its 1997 deposit goal and the five previously existing offices also enjoyed a good growth year. Deposits were up 10.4% during 1997 on an average daily basis but increased 17.0% between December 31, 1996 and December 31, 1997 yearends. Interest bearing liabilities increased 12.8% on average but 22.9% between December 31, 1996 and 1997. Noninterest demand deposits grew 9.9% on average during 1997 and 8.1% between yearends. Interest bearing liabilities, representing deposits and purchased funds, increased 12.8% on average during 1997 but 22.9% between yearends. Growth escalated in the latter half of 1997, as demonstrated by the aforementioned statistics. Mergers of local competitors have provided market opportunities for a solid community bank with a competitive array of products and the Bank has been able to fill that role. On an average daily basis, assets grew 12.6% during 1997 and 12.9% during 1996. Earning assets grew 12.4% and 13.6% during 1997 and 1996, respectively. Average daily loan growth represented only 47.0% of interest bearing asset growth and 46.4% of total asset growth during 1996 but increased to 64.9% of interest bearing asset growth and 60.5% of total asset growth during 1997. The increased flow of funds to the loan portfolio during 1997 fueled the 4 basis point increase in net interest spread and the 3 basis point increase in net interest margin. Loans outstanding increased by $11.6 million, or 11%, during 1997 and the loan portfolio yield held at 9.13% versus the 9.14% returned in 1996, despite significant refinancing activity during the last half of 1997. The slower loan portfolio growth realized in 1996 helped to account for the tightening of 1996's net interest margin by 22 basis points from 1995 levels. Increased use of tax exempt securities at attractive taxable equivalent yields and 10.6% growth in average daily free funds (interest earning assets less interest paying liabilities) also contributed to 1997's spread and margin increases. Noninterest Income and Expense Peer group data available within the industry show the Corporation operating annually with overhead expenditures near industry averages. The generation of noninterest income at above average levels and the growth of such income at a rate exceeding the growth rate of noninterest expenses have enabled the Corporation to increase its net noninterest position as measured by the percentage coverage that noninterest income achieves versus noninterest expense. In addition, the Corporation has been able to improve its efficiency ratio (operating expenses as a percentage of noninterest income and tax equivalent net interest income thus, a lower percentage is better) to 55.2%, for 1997, versus 56.4% and 56.0% for 1996 and 1995, respectively. - -26- Many banking industry analysts consider this the single best indicator of operating performance and the Corporation has succeeded in improving this ratio to an above average level when compared to both size and geographic peers. - -27- Other income increased $311,000, or 25.1% in 1997 due primarily to similar increases in fees from fiduciary activities, service charges on deposit accounts and other service charges. The Corporation typically has very little securities gain or loss activity. The growth of trust department revenue has been steady and significant in recent years. All service charges and other sources of noninterest income are reviewed annually to help maintain current pricing levels. Other expenses rose $591,000, or 12.3% in 1997 with roughly similar increases across all categories. This represents a lower rate of growth than the Corporation has experienced in its balance sheet and has contributed to the aforementioned efficiency ratio improvement. Noninterest expense growth during 1997 was due primarily to the opening of two new full service branches and the increased furniture, equipment and staffing requirements that come with such a move. Robust growth at previously existing branches and an expanded computer network have also contributed to operating expense increases. The Corporation has begun to prepare for year 2000 data processing issues. A year 2000 task force has been formed and began working during the second quarter of 1997. The Corporation maintains no software source code. All operating software is licensed from third party providers. Vendors that provide software have been contacted and evaluation and testing has begun. Currently, there are neither material problems nor material expenditures anticipated. In addition, the Bank has sponsored a year 2000 seminar for commercial customers and may sponsor more during 1998. - -28- ANALYSIS OF NONINTEREST INCOME AND EXPENSE Year Ended December 31 % Change (Dollars in thousands) 1997 1996 1995 1997-1996 1996-1995 OTHER INCOME: Service charges on deposit accounts $ 601 $ 477 $ 375 26.0% 27.2% Other service charges, commissions and fees 341 258 218 32.2% 18.3% Fiduciary income 490 384 297 27.6% 29.3% Securities gains (losses) 3 (5) (45) -160.0% -88.9% Other operating income 116 126 90 -7.9% 40.0% $ 1,551 $ 1,240 $ 935 25.1% 32.6% OTHER EXPENSE: Salaries $ 2,076 $ 1,847 $ 1,628 12.4% 13.5% Employee benefits 825 774 698 6.6% 10.9% Occupancy and equipment expense 764 665 559 14.9% 19.0% FDIC insurance premiums 17 2 125 850.0% -98.4% Pennsylvania shares tax 132 119 107 10.9% 11.2% Other operating expense 1,570 1,386 1,139 13.3% 21.7% $ 5,384 $ 4,793 $ 4,256 12.3% 12.6% Noninterest income as a % of noninterest expense 28.8% 25.9% 22.0%
- -29- Federal Income Taxes The Corporation's effective federal income tax rate for 1997 was 27.2%, as compared to 27.2% in 1996 and 27.5% in 1995. Corporate income tax rates for 1998 are scheduled to stay at 1997 levels. The Corporation is firmly entrenched in the 34% bracket so all taxable income will be taxed at 34% in 1998. This, along with anticipated growth, is expected to increase the Corporation's effective federal income tax rate to approximately 28% in 1998, assuming no retroactive change in rates during 1998. Asset Quality/Risk Analysis The quality of the Corporation's asset structure continues to be strong. A substantial amount of time is devoted by management to overseeing the investment of funds in loans and securities and the formulation of policies directed toward the profitability and minimization of risk associated with such investments. Loan Risk Analysis The Bank follows generally conservative lending practices and continues to carry a high quality loan portfolio with no unusual or undue concentrations of credit. No loans are extended to non-domestic borrowers or governments, consistent with past practice and policy. Net charge-offs historically have been quite low, when compared to industry standards, and represented only .06% of average outstanding loans during 1997 and .05% of average 1996 loans. Nonperforming loans, as represented by nonaccrual and restructured items, were only .36% and .01% of outstanding loans at December 31, 1997 and 1996, respectively. Loans 90 days or more past due and still accruing represented .51% and .19% of outstanding loans at December 31, 1997 and 1996, respectively. Allowance for Loan Losses Historically, the Corporation has had an enviable record regarding its control of loan losses, but lending is a banking service that inherently contains elements of risk. In order to assess this risk, an ongoing loan review process continually evaluates the current financial condition of commercial borrowers, local and national economic conditions, and the current level of delinquencies. Through this process, an amount deemed adequate to meet current growth and future loss expectations is charged to operations. The provision for loan losses amounted to $215,000, $240,000 and $270,000 for 1997, 1996 and 1995, respectively. These provisions compared to net charge-offs of $83,000, $68,000 and $51,000 for 1997, 1996 and 1995, respectively. The allowance for loan losses was increased 9.1% during 1997 while loans increased 17.8%. The reserve at December 31, 1997 represented 1.38% of loans outstanding. Net charge-offs for 1997 represented only .06% of average loans outstanding. The reserve at December 31, 1997 represented 26 years of coverage based upon 1997 net charge-offs and 374% of nonaccrual loans. In addition, approximately 65% of the allowance was unallocated under internal evaluation techniques at December 31, 1997. - -30- SUMMARY OF LOAN LOSS EXPERIENCE Year Ended December 31 (Dollars in thousands) 1997 1996 1995 1994 1993 Amount of loans outstanding at end of period $ 128,331 $ 108,926 $ 102,857 $ 90,839 $ 75,574 Daily average loans outstanding $ 117,403 $ 105,779 $ 97,662 $ 81,740 $ 72,576 Balance of allowance for possible loan losses at beginning of period $ 1,620 $ 1,433 $ 1,200 $ 1,125 $ 1,042 Loans charged off 83 68 51 8 51 Recoveries of loans previously charged off 15 15 14 12 13 Net loans charged off (recovered) 68 53 37 (4) 38 Additions to allowance charged to expense 215 240 270 71 121 Balance at end of period $ 1,767 $ 1,620 $ 1,433 $ 1,200 $ 1,125 Ratio of net charge-offs to average loans outstanding 0.06% 0.05% 0.04% -0.01% 0.05% Ratio of reserve to gross loans outstanding at December 31 1.38% 1.49% 1.39% 1.32% 1.49%
- -31- Risk Elements Nonperforming assets are comprised of nonaccrual and restructured loans and real estate owned other than bank premises (OREO). OREO represents property acquired through foreclosure or settlements of loans and is carried at the lower of the principal amount of the loan outstanding at the time acquired or the estimated fair value of the property. The excess, if any, of the principal balance at the time acquired over the carrying amount is charged against the reserve for loan losses. The Bank's loan loss history has been quite good compared to industry standards and current risk analysis appears favorable. The allowance for loan losses is consistent with the current composition of the loan portfolio and adequately covers the risks management sees under present economic conditions. Approximately 65% of the reserve balance is unallocated under current techniques. Management is prepared to make any reserve adjustments that become necessary as economic conditions change. - -32- December 31 (Dollars in thousands) 1997 1996 1995 1994 1993 NONPERFORMING ASSETS Loans on nonaccrual (cash) basis $ 473 $ 14 $ 132 $ 1 $ 0 Loans whose terms have been renegotiated to provide a reduction or deferral of interest or principal because of a deterioration in the financial position of the borrower 0 0 0 0 0 OREO 49 49 27 27 27 Total nonperforming assets $ 522 $ 63 $ 159 $ 28 $ 27 Ratio of nonperforming assets to total loans and OREO 0.41% 0.06% 0.15% 0.03% 0.04% Ratio of nonperforming assets to total assets 0.27% 0.04% 0.11% 0.02% 0.02% OTHER RISK ELEMENTS Loans past due 90 or more days and still accruing $ 657 $ 203 $ 417 $ 262 $ 267 Percentage of total loans and OREO 0.51% 0.19% 0.41% 0.29% 0.35% Percentage of total assets 0.35% 0.13% 0.29% 0.21% 0.24%
- -33- Future Impact of Recently Issued Accounting Standards In June, 1997 the Financial Accounting Standards Board (FASB) issued SFAS 30 OReporting Comprehensive IncomeO, with the objective of disclosing an d reporting all changes in equity that result from recognized transactions; and other economic events of the period being reported. This statement is effective for fiscal years beginning after December 15, 1997, with quarterly reporting to begin March 31, 1998. The impact of this statement on the Corporation appears to be limited to reporting market value adjustments under SFAS 115 and disclosure of treasury stock activity. The adoption of the standard is not expected to have a material impact on the Corporation's operating results or capital resources. Liquidity and Rate Sensitivity The primary function of asset/liability management is to assure adequate liquidity and rate sensitivity. Liquidity management involves the ability to meet the cash flow requirements of customers who may be either depositors wanting to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. Interest rate sensitivity management requires the maintenance of an appropriate balance between interest sensitive assets and liabilities. Interest bearing assets and liabilities that are maturing or repricing should be adequately balanced to avoid fluctuating net interest margins and to enhance consistent growth of net interest income through periods of changing interest rates. The Corporation has consistently followed a strategy of pricing assets and liabilities according to prevailing market rates and matching maturities as prudently as possible, within the guidelines of sound marketing and competitive practices. The goal is to maintain a predominantly matched position with very few planned mismatches. Rate spreads will be sacrificed at times in order to enable the overall rate sensitivity position to stay within the guidelines called for by asset/liability management policy. Rate sensitivity is measured by monthly gap analysis and periodic simulation. - -34- Investment and pricing decisions are made using both liquidity and sensitivity analyses as tools. The schedule that follows reflects the degree to which the Corporation can adjust its various portfolios to meet interest rate changes. Additionally, the Bank is a Federal Home Loan Bank (FHLB) member. Standard credit arrangements available to FHLB members provide increased liquidity. The following table presents all interest bearing assets and liabilities at December 31, 1997. Nonaccrual loans are included as nonrate sensitive. Noninterest bearing assets and liabilities are not included. An asset sensitive, or positive gap, position is demonstrated at all time intervals, on a cumulative basis. The asset sensitive positions are all within guidelines and afford the opportunity to react effectively to interest rate movements in either direction. - -35- RATE SENSITIVITY ANALYSIS AT DECEMBER 31, 1997 Interest Sensitivity Period After 1 After 3 After 6 Within Within 3 Within 6 Within 12 After (Dollars in thousands) 1 Month Months Months Months 1 Year Total RATE SENSITIVE ASSETS (RSA): Loans $ 38,774 $ 9,419 $ 17,832 $ 33,137 $ 29,169 $ 128,331 Investment securities 2,706 226 749 1,410 42,100 47,191 Other earning assets 2,874 0 0 0 0 2,874 Total RSA 44,354 9,645 18,581 34,547 71,269 178,396 RATE SENSITIVE LIABILITIES (RSL): Interest bearing deposits 35,199 8,833 9,408 15,308 74,183 142,931 Other interest bearing liabilities 235 3,006 0 3,000 2,328 8,569 Total RSL 35,434 11,839 9,408 18,308 76,511 151,500 RATE SENSITIVITY GAP: Period 8,920 ( 2,194) 9,173 16,239 ( 5,242) 26,896 Cumulative 8,920 6,726 15,899 32,138 26,896 GAP AS A PERCENT OF TOTAL ASSETS: Period 4.69% -1.15% 4.82% 8.54% Cumulative 4.69% 3.54% 8.36% 16.89% RSA/RSL Cumulative 1.25 1.14 1.28 1.43
- -36- Capital Adequacy and Regulatory Matters The Corporation maintains a strong capital base which provides adequate resources to absorb both normal and unusual risks inherent to the banking business. Internal capital generation, net income retained after the declaration of dividends, has been the primary method employed to increase capital accounts. Total stockholders' equity rose $2,409,000 during 1997, an increase of 15.2% for the year. This followed growth of 8.4% and 18.5% during 1996 and 1995, respectively. The steadily increasing earnings stream during this period has allowed the Corporation to significantly increase cash dividends paid to stockholders. In 1997 cash dividends rose $209,000, or 30.1% over 1996 levels while net income rose 15.9% during - -37- the period. This followed a 15.9% increase in dividend payout for 1996 versus 1995. Dividends per share have moved from .58 to .68 to .88 for 1995 through 1997, respectively. The Corporation's Board of Directors made a conscious decision to raise the annual dividend payout from approximately the 30D31% of earnings level to the 35% level early in 1997. This decision accounted for steadily increasing quarterly dividends during 1997. Internal capital generation has been adequate to support the Corporation's recent robust growth and fund the increased dividend payout with very little erosion to capital ratios. The maintenance of a strong capital base, well above regulatory risk based minimums and industry averages, has been an integral part of the Corporation's operating philosophy. Management foresees no problem in maintaining capital ratios well in excess of regulatory requirements. The Corporation and the Bank are subject to periodic examinations by one or more of the various regulatory agencies. During 1997, two examinations were conducted that included, but were not limited to, procedures designed to review lending practices, credit quality, liquidity, capital adequacy and trust operations. No comments were received from regulatory bodies which, if implemented, would have a material effect on the Corporation's liquidity, capital resources or operations. - -38- CAPITAL AND DIVIDEND RATIOS (Dollars in thousands) AT DECEMBER 31: 1997 1996 1995 Stockholders' Equity $ 18,265 $ 15,856 $ 14,633 Equity/Assets 9.60% 10.06% 10.02% FOR THE YEAR: Average Equity/Average Assets 9.84% 9.80% 10.00% Dividend Payout 34.65% 30.87% 30.66% Return on Average Equity 15.37% 14.90% 14.40% Dividends Paid $ 903 $ 694 $ 599 Regulatory REGULATORY CAPITAL MEASURES: Minimums Tier I Capital Ratio 12.7% 13.2% 15.4% 4.0% Total (Tier II) Capital Ratio 14.0% 14.6% 17.1% 8.0% Leverage Ratio 9.7% 9.8% 10.0% 3.0%
- -39- EX-27 3
9 12-MOS DEC-31-1997 DEC-31-1997 5,963 16 2,858 0 44,740 44,740 46,208 128,331 1,767 190,242 160,580 235 2,828 8,334 0 0 214 17,082 190,242 10,702 2,483 265 13,450 5,495 5,822 7,628 215 3 5,384 3,580 2,606 0 0 2,606 2.54 2.54 5.01 473 657 0 405 1,620 83 15 1,767 1,767 0 0
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