-----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, WFCMSSUjdZqIh1CMJfKEfzIV318xLYstRoUL7r8RVXJ4bVt0kWdj5eB/45JWOMJR QdHWvlkapaSElbIPzefTFQ== 0000826154-99-000001.txt : 19990408 0000826154-99-000001.hdr.sgml : 19990408 ACCESSION NUMBER: 0000826154-99-000001 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990406 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: 99588367 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: STREET 1: 77 EAST KING STREET CITY: SHIPPANSBURG STATE: PA ZIP: 17257 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, 1998 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 February 28, 1999, 2,057,799 shares of the registrant's common stock were outstanding. The aggregate market value of such shares held by nonaffiliates on that date was $ 72,022,965. DOCUMENTS INCORPORATED BY REFERENCE Portions of the annual shareholders report for the year ended December 31, 1998 are incorporated by reference into Parts I and II. Portions of the Proxy Statement for 1998 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, 1998, Orrstown had 76 full-time and 36 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 5 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, 1998, Orrstown had total assets of approximately $ 236 million, total shareholders' equity of approximately $ 21 million and total deposits of approximately $ 184 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 page 21 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. FDICIA 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 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 depository institution does not meet such capital adequacy measures, - -6- 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. 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 also - -7- owns properties adjacent to the Orrstown and downtown Shippensburg offices 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 3/15/99 Joel R. Zullinger, Chairman of the Board 1991 (1) 50 Jeffrey W. Coy, Vice Chairman of The board 1988 (1) 47 Kenneth R. Shoemaker, President & CEO 1987 1986 51 Bradley S. Everly, Senior Vice President Senior Loan Officer 1997 1997 47 Stephen C. Oldt, Executive Vice President, Chief Operating Officer 1987 1987 56 Philip E. Fague, Vice President, Senior Trust Officer 1990 1988 39 Robert T. Henry, Secretary 1988 (1) 70 Benjamin Stoops, Vice President, Senior Operations Officer 1998 1998 47
(1) Mr. Henry, 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 3/15/99 Kenneth R. Shoemaker, President & Chief Executive Officer 1987 1988 51 Stephen C. Oldt, Executive Vice President & Chief Operating Officer 1987 1987 56 Philip E. Fague, Vice President/ 1990/ Senior Trust Officer 1993 1988 39 Bradley S. Everly, Senior Vice 1997/ President/Senior Loan Officer 1997 1997 47 Benjamin Stoops, Vice President, Senior Operations Officer 1998 1998 47
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, 1998, the approximate number of shareholders of record was approximately 1,666. 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) 1998 1997 High Low High Low First Quarter $ 24.00 $ 22.50 $ .115 $ 17.15 $ 16.19 $ .09 Second Quarter 26.00 22.13 .115 20.00 17.15 .095 Third Quarter 30.00 26.00 .12 21.00 20.00 .10 Fourth Quarter 32.00 27.50 .13 22.50 21.00 .155
(1) Note: Cash dividends per share have been restated after giving retroactive recognition to a 2 for 1 stock split effective November 21, 1998 and 5% stock dividend paid 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 22 of the annual shareholders' report for the year ended December 31, 1998 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 17 through 22 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 5 through 22 of the annual shareholders report for the year ended December 31, 1998 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 1998 Versus 1997 Increase (Decrease) Due to Change in Total Average Average Increase Volume Rate (Decrease) (000 omitted) Interest Income Loans (net of unearned discounts) $ 2,429 ($ 252) $ 2,177 Taxable investment securities 390 ( 80) 310 Nontaxable investment securities 170 ( 17) 153 Other short-term investments 131 ( 17) 114 Total interest income 3,120 ( 366) 2,754 Interest Expense Interest bearing demand 503 156 659 Savings deposits ( 35) ( 16) ( 51) Time deposits 344 32 376 Short-term borrowings 221 ( 29) 192 Long-term borrowings 379 ( 29) 350 Total interest expense 1,412 114 1,526 Net interest income $ 1,228
- -11- 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
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, 1998, 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 $ 2,511 $ 5,504 $ 1,056 $ 0 $ 9,071 Yield 5.89% 6.41% 6.06% 0% 6.22% U. S. Government agencies Book value 0 0 2,500 0 2,500 Yield 0% 0% 6.63% 0% 6.63% State and municipal Book value 0 1,139 0 16,836 17,975 Yield 0% 9.98% 0% 8.67% 8.74% Total book value $ 2,511 $ 6,643 $ 3,556 $ 16,836 $ 29,546 Yield 5.89% 7.02% 6.46% 8.67% 7.79% Mortgage-backed securities: Total book value $ 17,306 Yield 6.52% Equity Securities: Total book value $ 686 Yield 3.87% Total Investment Securities $ 47,538 Yield 7.27%
- -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: 1998 1997 1996 1995 1994 (000 omitted) Commercial, financial and agricultural $ 18,732 $ 10,275 $ 8,401 $ 8,211 $ 6,970 Real estate - Construction 11,182 5,961 4,304 5,706 5,038 Real estate - Mortgage 116,030 97,074 82,687 75,731 68,458 Installment and other personal loans (net of unearned discount) 12,688 15,021 13,534 13,209 10,373 Total loans $ 158,632 $ 128,331 $ 108,926 $ 102,857 $ 90,839
Presented below are the approximate maturities of the loan portfolio (excluding real estate mortgages, installments and credit cards) at December 31, 1998: Under One One to Over Five Year Five Years Years Total (000 omitted) Commercial, financial and agricultural $ 2,968 $ 3,560 $ 12,204 $ 18,732 Real estate - Construction 1,522 1,822 7,838 11,182 Total $ 4,490 $ 5,382 $ 20,042 $ 29,914
The following table presents the approximate amount of fixed rate loans and variable rate loans due as of December 31, 1998: Fixed Rate Variable Loans Rate Loans (000 omitted) Due within one year $ 15,292 $ 68,150 Due after one but within five years 27,666 0 Due after five years 47,524 0 Total $ 90,482 $ 68,150
- -13- ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY SUMMARY OF LOAN LOSS EXPERIENCE Years Ended December 31 1998 1997 1996 1995 1994 (000 omitted) Average total loans outstanding (net of unearned income) $ 144,013 $ 117,403 $ 105,779 $ 97,662 $ 81,740 Allowance for loan losses, beginning of period $ 1,767 $ 1,620 $ 1,433 $ 1,200 $ 1,125 Additions to provision for loan losses charged to operations 270 215 240 270 71 Loans charged off during the year Commercial 15 1 20 0 0 Personal credit lines 23 32 17 3 1 Installment 46 50 31 48 7 Total charge-off's 84 83 68 51 8 Recoveries of loans previously charged off: Commercial 3 2 3 0 0 Installment 10 12 12 14 12 Personal credit lines 5 1 0 0 0 Total recoveries 18 15 15 14 12 Net loans charged off (recovered) 66 68 53 37 ( 4) Allowance for loan losses, end of period $ 1,971 $ 1,767 $ 1,620 $ 1,433 $ 1,200 Ratio of net loans charged off to average loans outstanding .06% .06% .05% .04% 0.0%
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. 1998 1997 1996 1995 1994 (000 omitted) Nonaccrual loans $ 486 $ 473 $ 14 $ 132 $ 27 Accrual loans: Restructured $ 0 $ 0 $ 0 $ 0 $ 0 30 through 89 days past due 823 2,398 1,976 1,949 1,553 90 days or more past due 284 657 203 417 155 Total accrual loans $ 1,107 $ 3,055 $ 2,179 $ 2,366 $ 1,708
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, 1998. - -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 1998 1997 Percentage Percentage Allowance of Loans to Allowance of Loans to Amount Total Loans Amount Total Loans (000 omitted) Commercial, financial and agricultural $ 255 9.93% $ 31 8.00% Commercial, real estate secured 416 19.43 354 35.00 Real estate - Construction 0 7.05 0 4.64 Real estate - Mortgage 111 53.77 188 40.64 Installment 34 9.82 12 11.72 Unallocated 1,155 0.00 1,182 0.00 Total $ 1,971 100.00% $ 1,767 100.00% Years Ended December 31 1996 1995 Percentage Percentage Allowance of Loans to Allowance of Loans to Amount Total Loans Amount Total Loans (000 omitted) Commercial, financial and agricultural $ 125 7.71% $ 114 7.98% Commercial - Real estate secured 0 0.00 0 0.0 Real estate - Construction 64 3.95 80 5.55 Real estate - Mortgage 1,229 75.91 1,055 73.63 Installment 202 12.43 184 12.84 Unallocated 0 0.00 0 0.00 Total $ 1,620 100.00% $ 1,433 100.00%
- -16- Year Ended December 31 1994 Percentage Allowance of Loans to Amount Total Loans (000 omitted) Commercial, financial and agricultural $ 113 9.42% Commercial - Real estate secured 0 0.00 Real estate - Construction 67 5.58 Real estate - Mortgage 844 70.33 Installment 176 14.67 Unallocated 0 0.00 Total $ 1,200 100.00%
ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY DEPOSITS The average amounts of deposits are summarized below: Years Ended December 31 1998 1997 1996 (000 omitted) Demand deposits $ 20,433 $ 17,665 $ 16,078 Interest bearing demand deposits 55,454 37,535 27,601 Savings deposits 23,394 24,568 26,555 Time deposits 74,488 68,161 63,767 Total deposits $ 173,769 $ 147,929 $ 134,001
The following is a breakdown of maturities of time deposits of $ 100,000 or more as of December 31, 1998: Maturity (000 omitted) Certificates of Deposit Three months or less $ 2,605 Over three months through six months 6,178 Over six months through twelve months 1,241 Over twelve months 200 $ 10,224
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) 1998 1997 1996 Average assets $ 212,149 $ 172,366 $ 153,145 Net income $ 3,119 $ 2,606 $ 2,248 Average equity $ 19,523 $ 16,956 $ 15,076 Cash dividends paid $ 986 $ 903 $ 694 Return on assets 1.47% 1.51% 1.47% Return on equity 15.97% 15.37% 14.90% Dividend payout ratio 31.59% 34.65% 30.87% Equity to asset ratio 9.2% 9.84% 9.8%
- -17- ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY CONSOLIDATED SUMMARY OF OPERATIONS Years Ended December 31 1998 1997 1996 1995 1994 (000 omitted) Interest income $ 16,109 $ 13,450 $ 12,018 $ 10,829 $ 8,571 Interest expense 7,348 5,822 5,139 4,542 3,241 Net interest income 8,761 7,628 6,879 6,287 5,330 Provision for loan losses 270 215 240 270 71 Net interest income after provision for loan losses 8,491 7,413 6,639 6,017 5,259 Other income: Trust and brokerage services 818 490 384 297 185 Service charges - Deposits 646 601 477 375 349 Other service charges, collection and exchange, charges, commission fees 667 341 258 218 180 Other operating income (loss) 122 119 121 45 146 Total other income 2,253 1,551 1,240 935 860 Income before operating expense 10,744 8,964 7,879 6,952 6,119 Operating expenses: Salaries and employees benefits 3,491 2,901 2,621 2,326 2,115 Occupancy and equipment expense 859 764 665 559 486 Other operating expenses 2,095 1,719 1,507 1,371 1,363 Total operating expenses 6,445 5,384 4,793 4,256 3,964 Income before income taxes 4,299 3,580 3,086 2,696 2,155 Income tax 1,180 974 838 742 520 Net income applicable to common stock $ 3,119 $ 2,606 $ 2,248 $ 1,954 $ 1,635 Per share data: Earnings per common share $ 1.52 $ 1.27 $ 1.10 $ .95 $ .80 Cash dividend - Common $ .48 $ .44 $ .34 $ .29 $ .25 Weighted average number of common shares 2,051,831 2,050,646 2,051,412 2,052,614 2,052,614
- -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 1999 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, 1998, are incorporated by reference in Item 8: Consolidated balance sheets - December 31, 1998 and 1997 Consolidated statements of income - Years ended December 31, 1998, 1997 and 1996 Consolidated statements of stockholders' equity - Years ended December 31, 1998, 1997, and 1996 Consolidated statements of cash flows - Years ended December 31, 1998, 1997, and 1996 Notes to consolidated financial statements - December 31, 1998 (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 (10) Material contracts Exhibit (13) Annual report to security holders Exhibit (21) Subsidiaries of the registrant Exhibit (23) Consent of independent auditors 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. Filed herewith. (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 herewith. (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). (10) Change in control agreement between Orrstown Financial Services, Inc. and its chief executive officer. Incorporated by reference to Exhibit 99 of the registrant's Form 10-K filed March 17, 1997 for the year ended December 31, 1996. (13) Annual report to security holders - filed herewith - -23- (21) Subsidiaries of the registrant - filed herewith (23.1) Consent of independent auditors 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 26, 1999 (Duly authorized officer) By /s/ Robert B. Russell 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 , 1999 Kenneth R. Shoemaker Director /s/ Anthony F. Ceddia Director March 26 , 1999 Dr. Anthony F. Ceddia /s/ Robert T. Henry Secretary and Robert T. Henry Director March 26 , 1999 /s/ Gregory A. Rosenberry Director March 26 , 1999 Gregory A. Rosenberry /s/ Joel R. Zullinger Chairman of the March 26 , 1999 Joel R. Zullinger Board and Director /s/ Jeffrey W. Coy Vice Chairman March 26 , 1999 Jeffrey W. Coy of the Board and Director Director Deceased January Ned R. Fogelsonger 20, 1999 /s/ Denver L. Tuckey________ Director March 26 , 1999 Denver L. Tuckey /s/ Andrea Pugh_____________ Director March 26 , 1999 Andrea Pugh - -25- Exhibit 3(i) COMMONWEALTH OF PENNSYLVANIA DEPARTMENT OF STATE CORPORATION BUREAU The undersigned desiring to incorporate a business corporation under the provisions of the Business Corporation Law of the Commonwealth of Pennsylvania (Act of May 5, 1933, P.L. 364, as amended) does hereby certify: ARTICLES OF INCORPORATION: 1. The name of the Corporation is: Orrstown Financial Services, Inc. 2. The location and post office address of its initial registered office in the Commonwealth of Pennsylvania is: 3580 Orrstown Road Orrstown, Franklin County, Pennsylvania 17244 3. The purpose or purposes for which the Corporation is incorporated are: To have unlimited power to engage in and do any lawful acts concerning any or all lawful business for which corporations may be incorporated under the provisions of the Business Corporation Law of the Commonwealth of Pennsylvania. The Corporation is incorporated under the provisions of the Business Corporation Law of the Commonwealth of Pennsylvania (Act of May 5, 1933, P.L. 364, as amended). 4. The term for which the Corporation is to exist is perpetual. 5. The shareholders of the Corporation shall not have the right to cumulate their shares in voting for the election of directors. 6. (a) The aggregate number of shares which the Corporation shall have authority to issue is: (i) 10,000,000 shares of Common Stock with no par value; and (*) (ii) 500,000 shares of Preferred Stock with a par value of $1.25 per share. (b) The relative rights, preferences and designations of the Preferred stock shall be as follows: The Board of Directors may issue, in one or more series, the shares of Preferred Stock, with full, limited, multiple, fractional or no voting rights, and with such designations, preferences, qualifications, privileges, limitations, restrictions, options, conversion rights or other special or relative rights as shall be fixed from time to time by resolution of the Board of Directors. 7. A. The Board of Directors may, if it deems advisable, recommend or oppose a tender or other offer for the Corporation's securities, whether the offer is in cash or in the securities of a corporation or otherwise. When considering whether to recommend or oppose an offer, the Board of Directors may, but is not legally obligated to, consider any pertinent issue. By way of illustration, but not limitation, the Board of Directors may, but shall not be legally obligated to, consider any or all of the following: (1) whether the offer price is acceptable based on the historical and present operating results or financial condition of the Corporation; (2) whether a more favorable price could be obtained for the Corporation's securities in the future; (3) the impact which an acquisition of the Corporation would have on the employees, depositors and customers of the Corporation and its subsidiaries and the community which they serve; (4) the reputation and business practices of the offeror and its management and affiliates as they would affect the employees, depositors and customers of the Corporation and its subsidiaries and the future value of the Corporation's stock; (5) the value of the securities (if any) which the offeror is offering in exchange for the Corporation's securities, based on an analysis of the worth of the Corporation as compared to the corporation or other entity whose securities are being offered; (6) any antitrust or other legal and regulatory issues that are raised by the offer. - -2- (B) If the Board of Directors determines that an offer should be opposed, it may take any lawful action for that purpose, including, but not limited to, any, or all of the following: advising shareholders not to accept the offer; litigation against the offeror; filing complaints with all governmental and regulatory authorities; acquiring the Corporation's securities; selling or otherwise issuing authorized but unissued securities or treasury stock or granting options, warrants or rights with respect thereto; making defensive acquisitions; and obtaining a more favorable offer from another individual or entity. 8. Any business combination (including a plan of merger or consolidation) or sale or transfer of all or substantially all of the assets of the Corporation with or to a shareholder of the Corporation who, directly or indirectly, has voting control over 10% or more of any class of shares of the Corporation or with or to an entity which, directly or indirectly, is controlled by such a shareholder, shall require the approval by the Board of Directors of the Corporation and approval by shareholders entitled to cast at least three-fourths of the votes which all shareholders are entitled to cast thereon; provided, however, if such business combination or sale or transfer is approved by at least three-fourths of the Directors of the Corporation, then approval by shareholders entitled to cast a majority of the votes which all shareholders are entitled to cast shall be sufficient. 9. If any person (including any individual, corporation, partnership or other entity) directly or indirectly acquires shares of the Corporation entitling the owner to cast at least 10% of the votes which all shareholders would be entitled to cast in the election of Directors of the Corporation, then any business combination (including a plan of merger or consolidation) with such person or an entity directly or indirectly controlled by such person shall require such person to offer to pay the other shareholders of the Corporation at least the highest price paid directly or indirectly by such person for any of the shares then directly or indirectly owned by such person. For purposes of this provision "price" shall mean the sum of any cash and the fair value of any other consideration paid for any of such shares. 10. These Articles of Incorporation may be amended by the affirmative vote of shareholders entitled to cast at least three-fourths of the votes which all shareholders are entitled to cast unless approved by three-fourths of the Directors of the Corporation, in which case approval by shareholders entitled to cast a majority of the votes which all shareholders are entitled to cast shall be sufficient. - -3- 11. Section 910 of the Pennsylvania Business Corporation Law shall not be applicable to the Corporation. 12. The name and post office address of the incorporator and the number and class of shares subscribed by him are: Name Address Number & Class of Share Michael A. Budin, 12th Floor Packard Esq. Bldg. One share of Philadelphia, PA 19102 common stock IN TESTIMONY WHEREOF, the incorporator has signed and sealed these Articles of Incorporation this 12th day of November, 1987. /s/ Michael A. Budin(SEAL) Incorporator Filed this 17th day of November A.D. 1987 Commonwealth of Pennsylvania Department of State /s/ James J. Hagerty Secretary of the Commonwealth (*) Amended May 24, 1989 to eliminate par value as to shares of common stock; amended May 27, 1998 to increase number of authorized shares of common stock from 2,000,000 shares to 10,000,000 shares. - -4- EXHIBIT 21 SUBSIDIARIES OF THE REGISTRANT 1. Orrstown Bank, Orrstown, Pennsylvania; a state-chartered bank organized under the Pennsylvania Banking Code of 1965. Exhibit 23.1 Independent Auditor's Consent Board of Directors and Shareholders Orrstown Financial Services, Inc. We consent to the incorporation by reference in Registration Statements (Form S-4 No. 33-18888 and Form S-3 No. 333-53405) of Orrstown Financial Services, Inc. of our report dated January 29, 1999, appearing in this annual report on Form 10-K of Orrstown Financial Services, Inc. for the year ended December 31, 1998. SMITH ELLIOTT KEARNS & COMPANY, LLC Chambersburg, Pennsylvania March 24, 1999 EX-13 2 It is our mission to be the premier financial institution in the markets we serve. We will seek to maximize shareholder value by achieving superior financial performance. Our focus is to provide unmatched customer service and quality products that meet the credit, investment, and associated needs of our customers. We will be an active corporate citizen that is committed to employing the resources and leadership needed to enhance the quality of life of all our constituents. LETTER TO SHAREHOLDERS t Some years ago there was a popular song that included the words: "You've got to accentuate the positive. Eliminate the negative. Latch on to the affirmative. Don't mess with Mr. In-between." How true. How true. They have become words to live by! During the last year, we continued to accentuate our positive position as a strong, local, independent bank, through stellar financial performance, sound operations, and superior customer service. Mergers of some of our major competitors into large national and regional con- glomerates facilitated our ability to compete, and we latched on to the affirmative message that hometown banking offers big advantages. 1998 was a landmark year for financial performance at Orrstown Financial Services, Inc. Our strong relationships with shareholders, customers, and employees enabled the company to achieve record earnings for the 11th consecutive year. Net income increased 19.7% to a record $3,119,000 or $1.52 per share. These results represent a return on average assets of 1.47% and a return on average shareholder's equity of 15.97%. Both of these important ratios exemplify that Orrstown Financial Services, Inc., is outperforming its peer groups by a wide margin. Accentuate the Positive! The primary reasons for our record-setting performance were stellar growth in loans and deposits, pristine asset quality, and substantial improvement in fee income. At year end, total assets had grown to $235,822,000-an increase of 24% over the previous year end totals. Loan demand was very strong throughout the year, with total outstandings reaching $158,632,000-an increase of 23.6% over figures reported at the end of 1997. Deposit growth was strong as well, increasing 14.4% to $183,764,000. We were extremely pleased that the majority of this growth occurred in core accounts, with non-interest bearing deposits increasing 24.8%. Lead by the tremendous popularity of our Hometown Investment Account, interest bearing transaction accounts advanced 29.2% over the previous year for a total increase of nearly $18,000,000. Shareholders' equity grew 15.4% or $2,816,000, increasing the corporation's total capital to $21,080,000. Even though the company grew significantly during 1998, the 8.94% equity to assets ratio continues to exceed regulatory guidelines by a comfortable margin. The book value per share of our stock grew 15.2%, from $8.91 on December 31, 1997 to $10.26 on December 31, 1998. Orrstown Financial Services, Inc. shareholders enjoyed a superior return on their investment in 1998! Based upon the excellent financial performance achieved during the year, the cash dividend was increased on several occasions which resulted in a gain of 9.1% over the amount distributed in 1997. On November 21, 1997, a two-for-one stock split was effected to bring the market price into a more favorable trading range. The corporation's stock closed the year at $28.00 per share, compared to the 1997 year end price of $22.50. In other words, the market value of Orrstown Financial Services, Inc. stock increased 24.4% in 1998! Latch on to the affirmative. Taking an historical look at the company, Orrstown's consistent payment of stock dividends and periodic stock splits have produced an exceptional return for shareholders. On December 31, 1981, 100 shares of Orrstown common stock were valued at $12,000. An investor who simply held onto those shares would, as of December 31, 1998, own 9,916 shares valued at $277,648.00-a compounded annual rate of return of 19% over the 17-year period. And that's without counting the cash dividends! Not too bad for a little bank with its roots in Orrstown! Our Asset Management and Trust division continues to surpass our expectations. Assets under management at year end stood at more than $150,000,000. Unlike trust departments of many financial institutions, ours is making a substantial contribution to the company's bottom line. Headed by Philip Fague, Senior Vice President, this division is positioned to enjoy stellar growth in the years ahead. The officer staff of this important department was made even stronger during 1998 with the addition of Bradley Gerlach, Vice President, who transferred from another area of the bank, and Joseph Bowden, Trust Officer. Both of these individuals share a deep commitment to providing quality service to their clients, and we are pleased that they are a part of our Trust team. Sound operations will play a key role in the years ahead as we strive to maintain our record of success. In November of 1998, we were fortunate to add a quality individual to our senior management team in the person of Benjamin Stoops. Ben is responsible for the management of various areas of bank operations, and is charged with evaluating and implementing computer hardware and software. During the first quarter of 1999, new equipment will be installed that will provide a more efficient operating environment for all data processing requirements. Eliminate the negative. Under the leadership of Stephen Oldt, Executive Vice President, our company has been working diligently to make sure that all mission critical systems of our operation are compliant for the year 2000 issue. Our bank has taken the Y2K situation very seriously and is implementing remedial action where necessary. The new computer equipment mentioned previously will assist us in preparing for this century-ending event. We are confident in our ability to address this issue and every measure will be taken to prevent interruption of services. Going forward, the corporation will take advantage of technological opportunities to improve service to our clients and gain operating efficiencies. We were among the first banks in this area to enhance customer service by providing access to account information through telephone banking. Our company "homepage" provides bank information to anyone seeking it through the internet. We also anticipate being able to offer internet banking to interested customers before year end. Contact us at www.orrstown.com to learn more about your company! Don't mess with Mr. In-between. In July of 1998, we had the opportunity to purchase a building adjacent to our King Street facilities in Shippens-burg. Over the ensuing months, detailed plans were developed and evaluated that called for the demolition of this building to allow for the construction of a new customer support center. While this will be a major project for our company, it is necessary to accommodate the anticipated growth over the next decade. The new structure will allow our company to finally house most operational and administrative personnel at the same location, creating a much more efficient work environment. The building will also provide much needed space, including a dividable conference room for training and employee meetings. In addition, customer parking will be improved with the creation of approximately 40 additional spaces. We expect construction to begin in early spring. We have come a long way in the past two decades. But in my view, it's just the beginning. We have in place a company prepared to build on the momentum it has created. With increased emphasis on innovative products, superior service, consultative selling, and enhanced delivery channels, I believe our company has incredible potential. Opportunities for growth have never been better due to the competitive edge we've gained through other bank mergers. We have the unique distinction of being able to offer our customers the very best in banking products, along with friendly, hometown service. However, we can't just be competitive. We have to be the best at everything that is important to the customer. Focus on the things we know how to do well. Relentlessly. That's how we will achieve our maximum potential! It is important that we pay tribute to Galen L. Myers who retired from our Board of Directors in April after 20 years of dedicated service. Galen provided valuable guidance as a Director and was instrumental in helping our company achieve success by serving as Chairman of the Board for nine years. Galen continues to be a positive influence on our company through his role as Director Emeritus. With tremendous sadness, we note the passing of Director Ned Fogelsonger, who died on January 20, 1999. Ned's insight, energetic support, and sense of humor will be missed by everyone associated with our company. As a local businessman, he was a pillar of the community and gave selflessly of his time to many organizations. Ned was also a close friend and in many ways, my personal hero. I salute his contributions to our success. I also want to acknowledge the support and encouragement of our current Board of Directors. Their guidance and strong business acumen is extremely valuable in charting the strategic course for our company. Being a strong proponent of a team management style, it is fitting that I commend and thank our senior officers for their contributions during the past year. These committed professionals work together to constantly raise the bar, and that's what it's all about! Accentuate the positive. There is nothing more positive to accentuate than the dedication of our entire staff. None of our success would be possible without their effort. I am proud to extend my sincere appreciation to them for making it happen! Kenneth R. Shoemaker President and Chief Executive Officer t CONSOLIDATED FINANCIAL STATEMENTS Consolidated Balance Sheets ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY ASSETS Dec. 31, 1998 Dec. 31, 1997 (000 omitted) (000 omitted) Cash and due from banks $7,028 $5,963 Interest bearing deposits with banks 27 16 Federal funds sold 8,072 2,858 Securities available for sale 49,852 46,208 Federal Home Loan Bank, Federal Reserve and Atlantic Central Bankers Bank stock, at cost which approximates market value 1,285 983 66,264 56,028 Loans Commercial, financial and agricultural 18,732 10,275 Real estate-Mortgages 116,030 97,074 Real estate-Construction and land development 11,182 5,961 Consumer 12,688 15,021 158,632 128,331 Less:Allowance for loan losses ( 1,971) (1,767) 156,661 126,564 Bank premises and equipment, net 5,224 5,130 Accrued interest receivable 1,235 1,299 Cash surrender value of life insurance 5,099 258 Other assets 1,339 963 Total assets $235,822 $190,242 LIABILITIES AND SHAREHOLDERS' EQUITY Deposits Non-interest bearing $22,020 $17,649 Interest bearing 161,744 142,931 183,764 160,580 Federal funds purchased and securities sold under agreements to repurchase 6,234 235 Other borrowed funds 20,828 8,334 Accrued interest and other liabilities 3,916 2,828 Total liabilities 214,742 171,977 Shareholders' equity Common stock:No par value-$.1041 stated value per share, 1998; and $.2083 stated value per share, 1997; 10,000,000 shares authorized with 2,055,315 shares issued at December 31, 1998; 1,025,094 shares issued at December 31, 1997 214 214 Additional paid-in capital 12,476 12,352 Retained earnings 6,863 4,730 Accumulated other comprehensive income 1,527 969 Total shareholders' equity 21,080 18,265 Total liabilities and shareholders' equity $ 235,822 $ 190,242 Consolidated Statements of Income ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY Years Ended December 31, 1998 1997 1996 (000 omitted) Interest and Dividend Income Interest and fees on loans $ 12,836 $ 10,702 $ 9,675 Interest and dividends on investment securities U.S. Government and agencies 1,840 1,548 1,265 Exempt from federal income tax 1,036 935 601 Other investment income 397 265 477 Total interest and dividend income 16,109 13,450 12,018 Interest Expense Interest on deposits 6,479 5,495 4,981 Interest on borrowed money 869 327 158 Total interest expense 7,348 5,822 5,139 Net interest income 8,761 7,628 6,879 Provision for loan losses 270 215 240 Net interest income after provision for loan losses 8,491 7,413 6,639 Other Income Service charges on deposit accounts 646 601 477 Other service charges, commissions, and fees 667 341 258 Trust department income 656 490 384 Brokerage income 162 59 64 Securities gains (losses) ( 9) 3 (5) Other income 131 57 62 Total other income 2,253 1,551 1,240 Net interest income and other income 10,744 8,964 7,879 Other Expenses Salaries and employee benefits 3,491 2,901 2,621 Occupancy expense of bank premises, net, and furniture and equipment expenses 859 764 665 FDIC insurance premiums 20 17 2 Other operating expenses 2,075 1,702 1,505 Total other expenses 6,445 5,384 4,793 Income before income tax 4,299 3,580 3,086 Applicable income tax 1,180 974 838 Net income $ 3,119 $ 2,606 $ 2,248 Per share data Net income $1.52 $ 1.27 $ 1.10 Dividends $.48 $ .44 $ .34 Weighted average shares outstanding 2,051,831 2,050,646 2,051,412 Consolidated Statements of Changes in Shareholders' Equity ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY Years Ended December 31, 1998, 1997, and 1996 (000 omitted) Balance, December 31, 1995 $ 204 $10,625 $3,232 $572 $ 14,633 Comprehensive Income Net income 0 0 2,248 0 2,248 Change in unrealized loss on investment securities available for sale, net of tax of $171 0 0 0 (331) (331) Total comprehensive income 0 0 0 0 1,917 Cash dividends ($ .34 per share) 0 0 ( 694) 0 (694) Balance, December 31, 1996 204 10,625 4,786 241 15,856 Comprehensive Income Net income 0 0 2,606 0 2,606 Change in unrealized gain on investment securities available for sale, net of tax of $375 0 0 0 728 728 Total comprehensive income 0 0 0 0 3,334 Cash dividends ($.44 per share) 0 0 (903) 0 (903) Stock dividends issued 10 1,727 (1,737) 0 0 Cash paid in lieu of fractional stock dividends 0 0 (22) 0 (22) Balance, December 31, 1997 214 12,352 4,730 969 18,265 Comprehensive Income Net income 0 0 3,119 0 3,119 Change in unrealized gain on investment securities available for sale, net of tax of $287 0 0 0 558 558 Total comprehensive income 0 0 0 0 3,677 Cash dividends ($.48 per share) 0 0 (986) 0 (986) Issuance of stock through dividend reinvestment plan 0 124 0 0 124 Balance, December 31, 1998 $214 $12,476 $6,863 $1,527 $21,080 Consolidated Statements of Cash Flows ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY Years Ended December 31, 1998 1997 1996 (000 omitted) Cash flows from operating activities: Net income $3,119 $2,606 $2,248 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 438 364 329 Provision for loan losses 270 215 240 Deferred income taxes 27 (7) (62) (Gain) loss on disposal of other real estate 0 0 5 (Gain) loss on disposal of bank premises and equipment 0 0 (20) Securities (gains) losses 9 (3) 5 (Increase) decrease in accrued interest receivable 64 (370) 64 Increase (decrease) in accrued interest payable 483 480 278 Other net (152) (59) 64 Net cash provided by operating activities 4,258 3,226 3,151 Cash flows from investing activities: Net (increase) decrease in interest bearing deposits with banks ( 11) 1,538 (265) Sales of available for sale securities 8,923 15 2,392 Maturities of available for sale securities 2,390 3,114 3,508 Purchases of available for sale securities ( 14,120) ( 14,811) (9,134) Purchases of FHLB stock ( 302) (49) ( 65) Net (increase) in loans (30,367) ( 19,473) ( 6,291) Proceeds from sale of bank premises and equipment 0 0 36 Proceeds from disposal of other real estate 0 0 142 Purchases of bank premises and equipment ( 491) ( 1,537) (1,178) Investment in cash surrender value of life insurance (4,816) 0 0 Net cash (used) by investing activities (38,794) (31,203) (10,855) Cash flows from financing activities: Net increase in deposits 23,184 23,321 9,929 Net increase in federal funds purchased and securities sold under agreements to repurchase 5,999 235 0 Proceeds from debt 12,500 6,000 0 Payment on debt (6) (5) ( 6) Cash dividends paid (986) ( 903) ( 694) Cash paid in lieu of fractional stock dividends 0 (22) 0 Proceeds from sale of stock 124 0 0 Net cash provided by financing activities 40,815 28,626 9,229 Net increase in cash and cash equivalents 6,279 649 1,525 Cash and cash equivalents, beginning balance 8,821 8,172 6,647 Cash and cash equivalents, ending balance $15,100 $8,821 $8,172 Supplemental disclosure of cash flows information: Cash paid during the year for:Interest $6,865 $5,343 $5,418 Income taxes 1,200 974 892 Supplemental schedule of noncash investing and financing activities: Other real estate acquired in settlement of loans 264 0 169 Unrealized gain (loss) on investment securities available for sale (net of tax effects) 558 728 (331) 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 as a net amount in other comprehensive income. 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 other comprehensive income, 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 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 expenses were $154,000, $149,000, and $87,000 for 1998, 1997 and 1996, respectively. 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 collater-alized. 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. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on such loans are applied as a reduction of loan principal balance. Interest income on other impaired loans is recognized only to the extent of interest payments received. 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 2,051,831 in 1998; 2,050,646 in 1997; and 2,051,412 in 1996 after giving retroactive recognition to 5% stock dividend issued in May 1997, and 2 for-1 stock split in November 1998. 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 Note10 for further details. 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. Comprehensive income In 1998 the Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 130-Reporting Comprehensive Income. Under SFAS No. 130, comprehensive income is defined as the change in equity from transactions and other events from nonowner sources. It includes all changes in equity except those resulting from investments by shareholders and distributions to shareholders. Comprehensive income includes net income and certain elements of "other comprehensive income" such as foreign currency transactions; accounting for futures contracts; employers accounting for pensions; and accounting for certain investments in debt and equity securities. The Corporation has elected to report its comprehensive income in the statement of shareholders' equity. The only element of "other comprehensive income" that the Corporation has is the unrealized gain or loss on available for sale securities. The 1997 financial statements have been reclassified to reflect these changes in reporting format. The components of the change in net unrealized gains (losses) on securities were as follows: 1998 1997 1996 (000 omitted) Gross unrealized holding gains (losses) arising during the year $ 836 $1,106 ($ 507) Reclassification adjustment for (gains) losses realized in net income 9 ( 3) 5 Net unrealized holding gains (losses) before taxes 845 1,103 (502) Tax effect ( 287) ( 375) 171 Net change $ 558 $ 728 ($ 331) NOTE 2.INVESTMENTS At December 31, 1998 and 1997 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 December31 were: (000 omitted) 1998 U. S. Treasury securities and obligations of U. S. Government corporations and agencies $14,508 $311 $22 $14,797 Obligations of states and political subdivisions 17,975 1,087 0 19,062 Mortgage-backed securities 14,369 166 11 14,524 Equity securities 686 804 21 1,469 Totals $47,538 $ 2,368 $54 $49,852 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 The amortized cost and fair values of investment securities available for sale at December31, 1998, 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 $2,511 $ 2,524 Due after one year through five years 7,700 8,038 Due after five years through ten years 10,218 10,603 Due after ten years 12,054 12,694 Mortgage-backed securities 14,369 14,524 Equity securities 686 1,469 $47,538 $ 49,852 Proceeds from sales of securities available for sale during 1998, 1997 and 1996 were $8,923,000, $15,000 and $2,392,000, respectively. Gross gains and losses on 1998 sales were $14,386 and $23,779, 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. The bank owns $1,041,500 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, 1998. At December31, 1997 the bank's stock ownership was $739,800 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 $27,254,000 and $19,198,000 at December31, 1998 and 1997, 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: 1998 1997 1996 (000 omitted) Balance at beginning of period $1,767 $1,620 $1,433 Recoveries 18 15 15 Provision for loan losses charged to income 270 215 240 Total 2,055 1,850 1,688 Losses 84 83 68 Balance at the end of period $1,971 $1,767 $1,620 NOTE 5.BANK PREMISES AND EQUIPMENT A summary of bank premises and equipment is as follows: 1998 1997 (000 omitted) Land $ 606 $ 606 Buildings and improvements 3,785 3,749 Leasehold improvements 173 173 Furniture and equipment 3,050 2,840 Construction in progress 236 0 Total 7,850 7,368 Less accumulated depreciation and amortization 2,626 2,238 Bank premises and equipment, net $5,224 $5,130 Depreciation expense amounted to $397,246 in 1998, $323,652 in 1997, and $287,624 in 1996. 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 $1,888,000 at December31, 1998 and $1,507,000 at December 31, 1997. During 1998, 1,159,000 of new loans were made and repayments totaled $778,000. Outstanding loans to bank employees totaled $1,424,000 at December 31, 1998. NOTE 7.NONACCRUAL LOANS The following table shows the principal balances of nonaccrual loans as of December31: 1998 1997 1996 Nonaccrual loans $486,000 $473,000 $ 14,000 Interest income that would have been accrued at original contract rates $39,878 $30,835 $560 Amount recognized as interest income 5,579 5,829 0 Foregone revenue $34,299 $25,006 $560 Impairment of loans having recorded investments of $404,678 at December 31, 1998 and 1997 has been recognized in accordance with Statements of Financial Accounting Standards No. 114 and 118. The average recorded investment in impaired loans during 1998 and 1997 was $404,678 and $405,262, respectively. Total allowance for loan losses related to impaired loans was $60,702 and $60,750 at December 31, 1998 and 1997. Interest income on impaired loans of $0 and $5,829 was recognized for cash payments received in 1998 and 1997. The corporation had no impairment of loans during 1996 as defined by Statement of Financial Accounting Standard No. 114. 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 National Amount 1998 1997 (000 omitted) Financial instruments whose contract amounts represent credit risk at December 31: Commitments to extend credit $36,653 $23,852 Standby letters of credit and financial guarantees written 3,863 2,811 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 contributions charged to operations were $371,621, $319,182 and $306,379 for 1998, 1997, and 1996, 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 is included in other liabilities, amounted to $166,214 and $166,237 at December31, 1998 and 1997, respectively. Total annual expense for this deferred compensation plan was $19,064 for 1998 and 1997, and $20,153 for 1996. 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 $30,725, $46,425 and $55,950 for 1998, 1997 and 1996, respectively. During 1998 the bank adopted four new supplemental retirement and salary continuation plans for directors and executive officers. These plans are funded with single premium life insurance on the plan participants. 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 totaled $41,151 at December 31, 1998 which is included in other liabilities. Total annual expense for these plans amounted to $41,151 for 1998. NOTE 10.INCOME TAXES The components of federal income tax expense are summarized as follows: 1998 1997 1996 (000 omitted) Current year provision $1,153 $981 $900 Deferred income taxes (benefits) 27 ( 7) ( 62) Net federal income tax expense $1,180 $974 $838 Federal income taxes were computed after reducing pretax accounting income for non-taxable income in the amount of $1,154,199, $969,000, and $661,000 for 1998, 1997, and 1996, respectively. A reconciliation of the effective applicable income tax rate to the federal statutory rate is as follows: 1998 1997 1996 Federal income tax rate 34.0% 34.0% 34.0% Reduction resulting from: Nontaxable interest income 6.5 6.8 6.8 Effective income tax rate 27.5% 27.2% 27.2% 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 : 1998 1997 Total deferred tax assets $723,000 $625,000 Total deferred tax liabilities (1,108,000) (696,000) Net deferred tax asset (liability) ($385,000) ($71,000) 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 December31 are NOW and Super NOW account balances totaling $28,844,000 and $22,721,000 for 1998 and 1997, respectively. Also included in interest bearing deposits at December31, 1998 and 1997 are money market account balances totaling $35,299,000 and $23,423,000, respectively. At December31, 1998 and 1997 time deposits of $100,000 and over aggregated $10,224,000 and $10,235,000, respectively. Interest expense on time deposits of $100,000 and over was $572,000; $497,000; and $ 373,000 for 1998, 1997 and 1996, respectively. At December 31, 1998 the scheduled maturities of certificates of deposit are as follows: 1999 153,416,000 2000 14,481,000 2001 2,484,000 2002 1,123,000 2003 1,650,000 2004 and thereafter 901,000 $74,055,000 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 $888,000 and $965,000 at December31, 1998 and 1997, 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: 1998 1997 Average balance during the year $4,139,000 $49,400 Average interest rate during the year 4.81% 4.94% Maximum month-end balance during the year $6,234,000 $500,000 Securities underlying the agreements at year-end: Carrying value $6,182,000 $485,280 Estimated fair value $6,303,000 $515,600 At December 31, the corporation had long-term notes outstanding with the Federal Home Loan Bank of Pittsburgh as follows: Amount 1998 1997 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 3,000,000 3/02 5.51% 3,000,000 3,000,000 10/02 5.73% 7,500,000 0 9/08 5.06% 5,000,000 0 10/08 4.66% $20,500,000 $8,000,000 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 1998 1997 Maturity Date Rate $ 0 $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% $328,250 $334,113 In addition, the bank has available a $ 10 million 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 $70,480,000 at December31, 1998. The corporation also has available an unused line of credit with Atlantic Central Bankers Bank of $3.5 million at December31, 1998. Total interest on the aforementioned borrowings charged to operations was $655,025, $308,405 and $148,859 for 1998, 1997 and 1996, 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 1998 1997 (000 omitted) Cash $ 109 $ 115 Securities available for sale 1,469 726 Investment in Orrstown Bank 19,740 17,507 Furniture and equipment (net of depreciation) 2 0 Other assets 26 0 Total assets $21,346 $18,348 Liabilities Deferred taxes $ 266 $ 83 Total liabilities 266 83 Shareholders' Equity Common stock: No par value-$ .1041 stated value per share, 1998; and $ .2083 stated value per share, 1997; 10,000,000 shares authorized with 2,055,315 shares issued at December 31, 1998; 1,025,094 shares issued at December 31, 1997 214 214 Additional paid-in capital 12,476 12,352 Retained earnings 6,863 4,730 Accumulated other comprehensive income 1,527 969 Total shareholders' equity 21,080 18,265 Total liabilities and shareholders' equity $21,346 $18,348 Income Statements Years Ended December 31 1998 1997 1996 (000 omitted) Interest and dividend income $ 23 $ 16 $ 17 Net gain on sale of investment 0 10 0 Cash dividends from wholly-owned subsidiary 1,110 1,064 796 Equity in undistributed income of subsidiary 2,030 1,570 1,531 3,163 2,660 2,344 Less: Operating expenses 44 54 96 Net income $3,119 $2,606 $2,248 Statements of Cash Flows Years Ended December 31 1998 1997 1996 (000 omitted) Cash flows from operating activities: Net income $3,119 $2,606 $2,248 Adjustments to reconcile net income to cash provided by operating activities: Security (gains) 0 (10) 0 Equity in undistributed income of subsidiary (2,030) ( 1,570) ( 1,531) Increase (decrease) in other liabilities 0 (40) 0 (Increase) decrease in other assets ( 26) 0 0 Net cash provided by operating activities 1,063 986 717 Cash flows from investing activities: Purchase of available for sale securities (207) (75) (102) Sales of available for sale securities 0 22 0 Net cash (used) by investing activities ( 207) ( 53) ( 102) Cash flows from financing activities: Cash dividends paid ($986) ($903) ($694) Cash paid in lieu of fractional stock dividends 0 (22) 0 Proceeds from sale of stock 124 0 0 Net cash (used) by financing activities ( 862) ( 925) ( 694) Net increase (decrease) in cash (6) 8 ( 79) Cash, beginning balance 115 107 186 Cash, ending balance $ 109 $ 115 $ 107 Supplemental disclosure of cash flows information: Cash paid during the year for: Income taxes $ 0 $ 0 $ 8 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 $12,431,000 in its retained earnings at December31, 1998 is fully available for cash dividends. Orrstown Financial Services' balance of retained earnings at December31, 1998 is $6,863,000 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. 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 1998 1997 Requirements Leverage ratio 8.9% 9.7% 3% Risk-based capital ratio Tier I (core capital) 11.8% 12.7% 4% Combined Tier I and Tier II (core capital plus allowance for loan losses) 12.9% 14.0% 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 1999 through 2003. Total rent expense charged to operations in connection with these leases was $24,803, $22,350 and $14,260 for 1998, 1997, and 1996, respectively. The total minimum rental commitment under operating leases at December31, 1998 is as follows: Due in the year ending December 31: 1999 $24,866 2000 25,828 2001 26,990 2002 24,113 2003 22,123 NOTE 16.COMPENSATING BALANCE ARRANGEMENTS Required deposit balances at the Federal Reserve were $168,000 and $65,000 at December31, 1998 and 1997, respectively. Required deposit balances at Atlantic Central Bankers Bank were $585,000 at December31, 1998 and 1997. These balances are maintained to cover processing costs and service charges. An additional $28,080 is on deposit with First Union National Bank of Florida as a reserve for potential clearing losses related to the credit card operations. NOTE 17.COMMITMENTS During 1998 the bank entered into a construction contract for the renovation of a property acquired in 1998 that is adjacent to its downtown Shippensburg office. The total amount of the contract is $252,000, of which $232,000 remained open at December 31, 1998. NOTE 18.FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair values of the corporation's financial instruments were as follows at December31: 1998 1997 Carrying Fair Carrying Fair Amount Value Amount Value (000 omitted) Financial Assets Cash and short-term investments $15,127 $15,127 $8,837 $8,837 Securities available for sale 49,852 49,852 46,208 46,208 Restricted bank stocks 1,285 1,285 983 983 Loans 158,632 128,331 Allowance for loan loses (1,971) (1,767) Net loans 156,661 157,486 126,564 128,164 Accrued interest receivable 1,235 1,235 1,299 1,299 Total financial assets $224,160 $224,985 $183,891 $185,491 Financial Liabilities Deposits $183,764 $184,131 $160,580 $160,807 Short-term borrowed funds 6,234 6,234 235 235 Long-term borrowed funds 20,828 20,903 8,334 8,369 Accrued interest payable 2,129 2,129 1,645 1,645 Total financial liabilities $212,955 $213,397 $170,794 $171,056 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 December31, 1998 and 1997 and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the three years ended December31, 1998. 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 December31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years ended December31, 1998 in conformity with generally accepted accounting principles. Smith Elliott Kearns & Company, LLC Certified Public Accountants & Consultants Chambersburg, Pennsylvania January 29, 1999 Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY 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, 1998, Orrstown Financial Services, Inc. (the Corporation) and its wholly owned subsidiary Orrstown Bank (the Bank) recorded net income of $3,119,000, an increase of 19.7% over 1997 earnings of $2,606.000, which was a 15.9% increase over net income of $2,248,000 in 1996. Net income per share (EPS) has increased over this time period from $1.10 in 1996 to $1.27 in 1997 and $1.52 in 1998. 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 (ROA) and the return on average equity (ROE). The return on average assets was 1.47% in 1998, 1.51% in 1997 and 1.47% in 1996. The return on average equity has steadily increased from 14.90% in 1996, to 15.37% in 1997 and 15.97% in 1998. 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 commercial bank profits despite the continued industry wide push to build noninterest income streams. For the year ended December 31, 1998, net interest income totaled $ 8,761,000, an increase of $1,133,000, or 14.9%, over 1997. The 1997 total was $7,628,000, or 10.9%, over 1996. On a taxable equivalent basis, net interest income increased by 15.1% in 1998 and 13.1% in 1997. The use of tax exempt assets increased significantly in 1997 and 1998 enhancing taxable equivalent gains. Marginal tax rates used in the taxable equivalent equation were 34% for all three years presented. The Corporation's taxable equivalent net interest spread was 4.28% in 1996, 4.32% in 1997, and 4.05% in 1998. The net interest margin, which factors in noninterest bearing funds sources, has moved from 4.98% to 5.01% to 4.70%, 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 steady pace even while opening two new branch banking offices during 1997 and purchasing a property in 1998 that will be refurbished to act as an operations center during 1999. Volume factors were responsible for essentially all net interest income growth during 1997 and 1998. On an average daily basis assets grew 23.1% during 1998 and 12.6% during 1997. Earning assets grew 22.8% and 12.4% during 1998 and 1997, respectively. Average daily loan growth of 22.7% in 1998 and 11.0% in 1997 was achieved without lowering credit standards and allowed net interest margins to hold at above peer group levels despite increased rate competition for good credits and lowering rates. The declining interest rate environment, highlighted by three 25 basis point cuts in the prime lending rate during 1998's fourth quarter, served to lower net interest margins from 1997 levels. The net interest spread generated in 1998 declined 27 basis points from 1997 levels. Similarly, net interest margin tightened by 31 basis points. Planned investment securities purchases funded by Federal Home Loan Bank borrowings contributed approximately 12 basis points of this tightening but generated earnings and EPS while enhancing ROE. The remaining tightening was caused by lowered asset yields (31 basis points) in a declining rate environment and an increased cost of funds (10 basis points) due to mix. Liability side rate cuts in certain transaction accounts and a continued shifting of the loan portfolio mix toward a heavier commercial loan weighting helped increase spread and margin during late November and December 1998. The heavier emphasis on commercial lending has also afforded opportunities to record noninterest bearing deposit balances that also enhance spreads. Management is poised to keep a very close eye on margins moving into 1999. Increased asset yields fueled by loan growth helped generate a 4 basis point increase in net interest spread and the 3 basis point increase in net interest margin for 1997 over 1996 levels. ANALYSIS OF NET INTEREST INCOME Average Balances and Interest Rates Taxable Equivalent Basis (Dollars In Thousands) 1998 1997 1996 ASSETS: Interest Earning Assets: Federal funds sold and interest-bearing bank balances $ 5,706 $ 303 5.31% $3,372 $ 189 5.60% $7,637 $ 409 5.36% Investment securities: Taxable investment securities 31,450 1,934 6.15 25,360 1,624 6.40 20,899 1,333 6.38 Tax-exempt investment securities 17,890 1,570 8.77 15,983 1,417 8.86 9,881 911 9.22 Total investment securities 49,340 3,504 7.10 41,343 3,041 7.35 30,780 2,244 7.29 Loans: Taxable loans 142,019 12,717 8.96 116,811 10,669 9.13 104,783 9,578 9.14 Tax-exempt loans 1,994 179 8.97 592 50 8.45 996 91 9.13 Total loans 144,013 12,896 8.96 117,403 10,719 9.13 105,779 9,669 9.14 Total interest-earning assets 199,059 16,703 8.39 162,118 13,949 8.60 144,196 12,322 8.55 Non-interest Earning Assets: Cash and due from banks 5,699 5,008 4,520 Bank premises and equipment 5,148 4,443 3,486 Other assets 4,158 2,486 2,471 Less allowance for loan losses ( 1,915) (1,689) (1,528 ) TOTAL $212,149 $172,366 $153,145 LIABILITIES AND SHAREHOLDERS' EQUITY: Interest Bearing Liabilities: Interest-bearing demand deposits $55,454 1,715 3.09 $37,535 1,056 2.81 $27,601 681 2.47 Savings deposits 23,394 677 2.89 24,568 728 2.96 25,934 773 2.98 Time deposits 74,488 4,087 5.49 68,161 3,711 5.44 64,388 3,527 5.48 Short term borrowings 4,237 204 4.81 218 12 5.50 0 0 0 Long term borrowings 11,726 665 5.67 5,322 315 5.92 2,486 158 6.36 Total interest-bearing liabilities 169,299 7,348 4.34 135,804 5,822 4.28 120,409 5,139 4.27 Non-interest Bearing Liabilities: Demand deposits 20,433 17,665 16,078 Other 2,894 1,941 1,582 Total liabilities 192,626 155,410 138,069 Shareholders' Equity 19,523 16,956 15,076 TOTAL/Cost of funds $212,149 3.69 $172,366 3.59 $153,145 3.57 Net interest income/net interest spread $9,355 4.05% $8,127 4.32% $7,183 4.28% Net interest margin 4.70% 5.01% 4.98% Noninterest Income and Expenses Other income increased $702,000,or 45.3% in 1998 due primarily to significant increases in fees from trust department services and retail brokerage activities, service charges on lending activities, fees generated from merchant services, ATM activity fees and revenue generated from debit card usage. Service charges on deposit accounts rose modestly during 1998 because service charge schedules were not modified. The corporation typically has very little securities gain or loss activity. Management has made a concerted effort, in recent years, to locate new sources of noninterest income and price them accordingly. Deposit service charge schedules were being reviewed as 1998 drew to a close with revisions during 1999 likely. Other expenses rose $1,061,000,or 19.7% in 1998. With commercial bank totals growing at a 20% plus pace over each of the last two years and trust department totals growing at a 30% plus pace during the same period, some growth in operating expenses is to be expected. In addition, two new branches were opened during 1997, a second Carlisle branch in late January and a Chambersburg branch in November. Additional personnel were needed to staff those branches which operated for their first full year in 1998. In addition, the robust growth has created the need for additional operations personnel. Computer networks have been expanded with further expansion slated for 1999. Management has been acutely aware of the pressure to increase overhead expenditures but has managed to improve (lower) the Corporation's efficiency ratio annually from 56.4% in 1996 to 55.2% in 1997 and, finally, to 55.0% in 1998. The maintenance of efficiency ratios below 60% in a banking company with less than $500 million in assets places the Corporation well above peer averages. The Corporation has been in the midst of Year 2000 (Y2K) preparedness for data processing issues for approximately two years and has completed the assessment stage. The renovation and testing stage is currently in process with the last mission critical installation set to be addressed with the installation of a new check processing solution scheduled for April, 1999. This project addresses more than Y2K issues as many backroom efficiencies will be gained via the installation of an IBM AS- 400 minicomputer and the addition of image capabilities for our backroom operation. The addition of an image ready reader/sorter will add efficiency to the research and check clearing operations and enable the Bank to easily handle the growth that has recently been experienced. Most of the original $100,000 that was budgeted for Y2K efforts has been expended to date and approximately $500,000 of primarily capitalized costs will be expended on the AS-400/image project but these outlays will replace costs incurred during 1998 under systems that were less efficient. Thus, the Corporation does not expect Y2K expenses recorded in 1999 to have a material effect on its liquidity. capital position or results of operations. The table that follows provides additional information regarding noninterest income and noninterest expense increases over the past three years: ANALYSES OF NONINTEREST INCOME AND EXPENSES Year Ended December 31 % Change (in thousands) Other income: Service charges on deposit accounts $ 646 $ 601 $ 477 7.5% 26.0% Loan service charges and fees 275 137 138 100.7% -0.7% Other service charges, commissions and fees 392 204 120 92.2% 70.0% Trust department income 656 490 384 33.9% 27.6% Brokerage income 162 59 64 174.6% -7.8% Securities gains (losses) (9) 3 (5) -400.0% -160.0% Other operating income 131 57 62 129.8% -8.1% $2,253 $1,551 $1,240 45.3% 25.1% Other expenses: Salaries $2,478 $2,076 $1,847 19.4% 12.4% Employee benefits 1,013 825 774 22.8% 6.6% Occupancy and equipment expenses 859 764 665 12.4% 14.9% Data processing expenses 493 390 324 26.4% 20.4% Printing and supplies 178 161 149 10.6% 8.1% Directors Fees 154 151 154 2.0% -1.9% Advertising 154 149 87 3.4% 71.3% Pennsylvania shares tax 145 132 119 9.8% 10.9% Other operating expenses 971 736 674 31.9% 9.2% $6,445 $5,384 $4,793 19.7% 12.3% Noninterest income as a % of noninterest expense 35.0% 28.8% 25.9% Federal Income Taxes The Corporation's effective federal income tax rate for 1998 was 27.5%, as compared to 27.2% in 1997 and 1996. Corporate income tax rates for 1998 are forecast to stay near 1998 levels. The Corporation is firmly entrenched in the 34% bracket so all taxable income will be taxed at 34% in 1999. This, along with anticipated growth, is expected to increase the Corporation's effective federal income tax rate to approximately 28% in 1999, assuming no retroactive change in rates during 1999. Asset Quality and Credit 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 minimi- zation of risk associated with the investments. Credit 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 .05% of average outstanding loans during 1998 and .06% of average 1997 loans. Nonperforming loans, as represented by nonaccrual and restructured items, were only .31% and .37% of outstanding loans at December 31, 1998 and 1997, respectively. Loans 90 days or more past due and still accruing represented .18% and .51% of outstanding loans at December 31, 1998 and 1997, 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 $270,000, $215,000 and $240,000 for 1998, 1997 and 1996, respectively. These provisions compared to net charge-offs of $66,000, $68,000 and $53,000 for 1998, 1997 and 1996, respectively. The allowance for loan losses was increased 11.5% during 1998 while loans increased 23.6%. The reserve at December 31, 1998 represented 1.24% of loans outstanding. Net charge-offs for 1997 represented only .05% of average loans outstanding. The reserve at December 31, 1998 represented 29.9 years of coverage based upon 1998 net charge- offs and 405.6% of nonaccrual loans. In addition, approximately 58% of the allowance was unallocated under internal evaluation procedures as of December 31, 1998. SUMMARY OF LOAN LOSS EXPERIENCE Year Ended December 31 1998 1997 1996 1995 1994 Amount of loans outstanding at end of period $158,632 $128,331 $108,926 $102,857 $90,839 Daily average loans outstanding $144,013 $117,403 $105,779 $97,662 $81,740 Balance of allowance for possible loan losses at beginning of period $1,767 $1,620 $1,433 $1,200 $1,125 Loans charged off 84 83 68 51 8 Recoveries of loans previously charged off 18 15 15 14 12 Net loans charged off (recovered) 66 68 53 37 (4) Additions to allowance charged to expense 270 215 240 270 71 Balance at end of period $1,971 $1,767 $1,620 $1,433 $1,200 Ratio of net charge-offs to average loans outstanding 0.05% 0.06% 0.05% 0.04% -0.01% Ratio of reserve to gross loans outstanding at year end 1.24% 1.38% 1.49% 1.39% 1.32% 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 much better than peer standards and analysis of the current credit risk position is favorable. The allowance for loan losses is ample given the current composition of the loan portfolio and adequately covers the credit risk management sees under present economic conditions. Approximately 58% of the reserve balance is unallocated under current procedures with 32% allocated to credit risk and 10% allocated to Year 2000 (Y2K) risk. Management is prepared to make any reserve adjustments that may become necessary as economic conditions change. NONPERFORMING ASSETS December 31 1998 1997 1996 1995 1994 (in thousands) Loans on nonaccrual (cash) basis $486 $473 $14 $132 $1 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 311 49 49 27 27 Total nonperforming loans and OREO $797 $522 $63 $159 $28 Ratio of nonperforming assets to total loans and OREO 0.50% 0.41% 0.06% 0.15% 0.03% Ratio of nonperforming assets to total assets 0.34% 0.27% 0.04% 0.11% 0.02% OTHER CREDIT RISK ELEMENTS Loans past due 90 or more days and still accruing $284 $657 $203 $417 $262 Ratio of other credit risk elements to total loans and OREO 0.18% 0.51% 0.19% 0.41% 0.29% Ratio of other credit risk elements to total assets 0.12% 0.35% 0.13% 0.29% 0.21% TOTAL NONPERFORMING AND OTHER RISK ASSETS $ 1,081 $ 1,179 $266 $576 $290 Ratio of total risk assets to total loans and OREO 0.68% 0.92% 0.24% 0.56% 0.32% Ratio of total risk assets to total assets 0.46% 0.50% 0.11% 0.24% 0.12% Future Impact of Recently Issued Accounting Standards: In June, 1998 the Financial Accounting Standards Board (FASB) issued SFAS No. 133-"Accounting for Derivative Instruments and Hedging Activities". This Statement establishes accounting and reporting standards for derivatives and hedging activities. In October 1998, the FASB issued SFAS No. 134-"Accounting for Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise". This statement requires entities that are engaged in mortgage banking activities to classify mortgage-backed securities as trading securities following the securitization of mortgage loans held for sale. The Corporation has no derivative instruments and does not engage in hedging activities. The Corporation has no loans held for sale nor does it engage in securitization of loans. Therefore, the adoption of either of the aforementioned standards is not expected to have a material impact on the Corporation's operating results or capital resources. Liquidity, Rate Sensitivity, and Interest Rate Risk Analysis: 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 while largely matching maturities, 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, quarterly rate shocks and periodic simulation. 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, and standard credit arrangements available to FHLB members provide increased liquidity. RATE SENSITIVITY ANALYSIS AT DECEMBER 31, 1998 (Dollars in thousands) Interest Sensitivity Period After 1 After 3 After 6 Within Within 3 Within 6 Within 12 After 1 Month Months Months Months 1 Year Total RATE SENSITIVE ASSETS (RSA): Loans $51,002 $11,245 $19,273 $36,266 $40,846 $158,632 Investment securities 5,525 1,685 1,460 2,409 40,057 51,136 Other earning assets 8,099 0 0 0 0 8,099 Total RSA 64,626 12,930 20,733 38,675 80,903 217,867 RATE SENSITIVE LIABILITIES (RSL): Interest bearing deposits 38,639 10,771 15,092 15,996 81,246 161, 744 Short term borrowed funds 6,234 0 0 0 0 6,234 Long term borrowed funds 0 6,006 0 0 14,822 20,828 Total RSL 44,873 16,777 15,092 15,996 96,068 188,806 RATE SENSITIVITY GAP: Period $19,753 $ (3,847) $5,641 $22,679 $ (15,165) $ 29,061 Cumulative 19,753 15,906 21,547 44,226 29,061 GAP AS A PERCENT OF TOTAL ASSETS: Period 8.38% -1.63% 2.39% 9.62% Cumulative 8.38% 6.74% 9.14% 18.75% RSA/RSL Cumulative 1.44 1.26 1.28 1.48 The asset biased, or positive, gap position indicates that earnings are naturally enhanced, or more easily maintained, in a rising rate environment but the position is balanced closely enough to react to a declining rate environment. This conclusion is further supported by 200 basis point rate shock tests projecting a 2% or less contraction in net interest income on a downward shock, the riskiest direction for this balance sheet. 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 $2,815,000 during 1998, an increase of 15.4% for the year. This followed growth of 15.2% and 8.4% during 1997 and 1996, respectively. The increasing earnings stream during this period has allowed the Corporation to steadily increase cash dividends paid to stockholders. In 1998 cash dividends rose $81,000, or 9.0% over 1997 levels while net income rose 19.7% during the period. This followed a 30.1% increase in dividend payout for 1997 versus 1996. The Bank enjoyed rapid asset growth during 1998 which caused a moderation in the Corporation's dividend increase for the year in order to assure an adequate capital base to accommodate such growth in the future. Dividends per share have moved from .34 to .44 to .48 for 1996 through 1998, respectively. CAPITAL AND DIVIDEND RATIOS 1998 1997 1996 At December 31: (amounts in thousands) Shareholders' Equity $21,080 $18,265 $15,856 Equity/Assets 8.94% 9.60% 10.06% For the Year: Average Equity/Average Assets 9.20% 9.84% 9.84% Dividend payout 31.59% 34.65% 30.87% Return on Average Equity 15.97% 15.37% 14.90% Dividends paid $984 $903 $694 Regulatory Regulatory Capital Measures: Minimums Tier I Capital Ratio 11.8% 12.7% 13.2% 4.0% Total (Tier II) Capital Ratio 12.9% 14.0% 14.6% 8.0% Leverage Ratio 8.9% 10.0% 10.0% 3.0% The maintenance of a strong capital base, above regulatory risk based minimums and industry averages, has been an integral part of the Corporation's operating philosophy. Management forsees no problem in maintaining capital ratios well in excess of regulatory requirements. Capital has been purposely leveraged in recent years by the use of matched investment securities transactions approximating $8 million. These transactions are generating approximately $100,000 of annual net income while still maintaining a comfortable capital base. The Corporation and the Bank are subject to periodic examinations by one or more of the various regulatory agencies. During 1998, two examinations were conducted that included, but were not limited to, procedures designed to review Year 2000 (Y2K) preparedness and transfer agent 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. Summary of Quarterly Financial Data The unaudited quarterly results of operations for the years ended December 1998 and 1997 are as follows: 1998 1997 ($000 omitted except per share) Quarter Ended Quarter Ended March June September December March June September December Interest income $3,715 $3,979 $4,138 $4,277 $3,103 $3,316 $3,474 $3,557 Interest expense 1,707 1,800 1,857 1,984 1,300 1,418 1,504 1,600 Net interest income 2,008 2,179 2,281 2,293 1,803 1,898 1,970 1,957 Provisions for loan losses 75 75 75 45 45 45 45 80 Net interest income after provision for loan losses 1,933 2,104 2,206 2,248 1,758 1,853 1,925 1,877 Securities gains (losses) ( 10) ( 2) 11 ( 8) ( 5) 9 5 ( 6) Other income 491 535 550 686 345 381 351 471 Other expenses 1,527 1,556 1,567 1,795 1,307 1,254 1,297 1,526 Operating income before income taxes 887 1,081 1,200 1,131 791 989 984 816 Applicable income taxes 245 296 335 304 232 270 256 216 Net income $ 642 $ 785 $ 865 $ 827 $ 559 $ 719 $ 728 $ 600 *Per common share data: Net income $.32 $.38 $.42 $.40 $.27 $.35 $.36 $.29 Dividends .115 .115 .12 .13 .09 .095 .10 .155 Performance Statistics: Return on Average Assets 1.33% 1.51% 1.60% 1.42% 1.42% 1.70% 1.63% 1.30% Return on Average Equity 13.99% 16.61% 17.42% 15.77% 14.03% 17.69% 16.78% 13.21% Average Equity/Average Assets 9.52% 9.11% 9.19% 9.04% 10.15% 9.61% 9.73% 9.81% Selected Five-Year Financial Data ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARY 1998 1997 1996 1995 1994 Income (000 omitted) Interest income $16,109 $13,450 $12,018 $10,829 $8,571 Interest expense 7,348 5,822 5,139 4,542 3,241 Provision for loan losses 270 215 240 270 71 Net interest income after provision for loan losses 8,491 7,413 6,639 6,017 5,259 Securities gains (losses) (9) 3 (5) ( 45) 95 Other operating income 2,262 1,548 1,245 980 765 Other operating expenses 6,445 5,384 4,793 4,256 3,964 Income before income taxes 4,299 3,580 3,086 2,696 2,155 Applicable income tax 1,180 974 838 742 520 Net income $3,119 $2,606 $2,248 $1,954 $1,635 *Per share amounts are based on following weighted averages: 1998-2,051,831 1996-2,051,412 1994-2,052,614 1997-2,050,646 19952,052,614 Income before income taxes $2.09 $1.75 $1.51 $1.31 $1.05 Applicable income taxes .57 .48 .41 .36 .25 Net income 1.52 1.27 1.10 .95 .80 Cash dividend paid .48 .44 .34 .29 .25 Book value 10.26 8.91 7.73 7.14 6.02 Year-End Balance Sheet Figures (000 omitted) Total assets $235,822 $190,242 $157,556 $145,998 $123,004 Total loans 158,632 128,331 108,926 102,857 90,839 Total investment securities 51,137 47,191 34,355 31,563 24,318 Deposits-noninterest bearing 22,020 17,649 16,322 13,962 13,262 Deposits-interest bearing 161,744 142,931 120,937 113,368 93,103 Total deposits 183,764 160,580 137,259 127,330 106,365 Liabilities for borrowed money 27,062 8,569 2,339 2,345 2,350 Total shareholders' equity 21,080 18,265 15,856 14,633 12,353 Trust assets under management-market value 152,000 108,000 83,000 66,000 50,000 Ratios Average equity/average assets 9.20% 9.84% 9.84% 10.00% 10.34% Return on average equity 15.97% 15.37% 14.90% 14.40% 13.36% Return on average assets 1.47% 1.51% 1.47% 1.44% 1.38% *Per share amounts have been restated to reflect: The 2 for 1 stock split effective November 21, 1998. The 5% stock dividend paid May 15, 1997. The 5% stock dividend paid July 21, 1995. t BANK DIRECTORY From left to right: Benjamin Stoops, Philip Fague, Bradley Everly, Kenneth Shoemaker, and Stephen Oldt Executive Officers Kenneth R. Shoemaker President and Chief Executive Officer Officer since January 1986 Stephen C. Oldt Executive Vice President and Chief Operating Officer Officer since August 1987 Bradley S. Everly Senior Vice President and Chief Financial Officer Officer since July 1997 Philip E. Fague Senior Vice President and Senior Trust Officer Officer since October 1988 Benjamin S. Stoops Vice President and Senior Operations Officer Officer since November 1998 Operating Officers Barbara E. Brobst Vice President and Trust Officer Patricia A. Corwell Vice President and Assistant Secretary/Shareholder Relations Officer James B. Dubbs Vice President and Cashier, Branch Executive Officer, King Street Office Jeffrey W. Embly Vice President and Commercial Loan Officer Charles E. Ferguson Vice President and Human Resources Manager Bradley S. Gerlach Vice President and Trust Officer Robert B. Russell Vice President and Chief Accounting Officer Frank E. Koser II Assistant Vice President and Branch Executive Officer, Stonehedge Office Ann E. McCrae Assistant Vice President and Data/Deposit Operations Manager Karen J. Shearer Assistant Vice President and Branch Executive Officer, Chambersburg Office Wilma M. Rosenberry Assistant to the President Jeffrey S. Gayman Branch Executive Officer, South Hanover Street Office Phyllis A. Nye Trust Officer Anita L. Ocker Branch Executive Officer, Orrstown Office Teresa F. Ott Branch Executive Officer, Fannett-Metal Office Debra A. Ramsey Assistant Secretary and Branch Executive Officer, Lurgan Avenue Office Judith L. Clayton Customer Service Officer, Fannett-Metal Office Alice A. Dubbs Loan Processing Supervisor Lisa D. Gutshall EFT Processing Supervisor Sondra K. Mellinger Auditor Marie A. Mitchell Deposit Processing Supervisor Sheryl E. Perkins Customer Service Officer, Chambersburg Office Albert H. Shuller, Jr. Security Officer Jennifer A. Zullinger Management Information Systems Officer Directors Emeriti Richard M. Diffenbaugh Stoey W. Forrester Eldon E. Funk Frank S. Heberlig William O. Hykes Raymond C. Martin Galen L. Myers Raymond I. Pugh Glenn C. Rosenberry Kenneth M. Upperman President's Advisory Council Frances M. Banks Karen L. Bender Benedict John E. Clinton Thomas Colley Duaine A. Collier Kathy J. Frazer Lester E. Funk Bonnie L. Hoffman Paul E. Hornbaker Dale F. Kuhn Jerry S. Lyons William E. Naugle Kathryn E. Poe Jean C. Ritchie Glenn W. Snoke Carlisle Advisory Council Robert Davis Robert G. Frey John W. Gleim, Jr. Zane R. Highlands William M. Kronenberg Gilmore B. Seavers Dale F. Shughart, Jr. Patricia H. Vance Chambersburg Advisory Council Thomas J. Barra Thomas G. Burkey Robert K. Gonder Shirley U. Lehman Richard W. Mackey, Jr. Adrian Simpson William C. Stake Todd Stonesifer This report is dedicated in honor of Ned R. Fogelsonger who passed away January 20, 1999. He was appointed to the Board of Orrstown Bank on June 24, 1986. t BOARD OF DIRECTORS From left to right: Gregory Rosenberry, Denver Tuckey, Andrea Pugh, Jeffrey Coy, Kenneth Shoemaker, Joel Zullinger, Anthony Ceddia, and Robert Henry Absent from photo: Ned R. Fogelsonger Joel R. Zullinger Attorney-at-Law Chairman of the Board Board Committees: Audit Committee Executive Committee Trust Committee Jeffrey W. Coy State Representative Vice Chairman of the Board Board Committees: Executive Committee, Chairman Property Committee Kenneth R. Shoemaker President and CEO, Orrstown Bank Board Committees: ALCO Committee, Chairman Executive Committee Robert T. Henry Retired Pharmacist and Businessman Secretary Board Committees: Credit Administration Committee, Chairman Executive Committee Property Committee Anthony F. Ceddia President, Shippensburg University Board Committees: Credit Administration Committee Trust Committee Ned R. Fogelsonger President, Fogelsonger Agency, Inc. Board Committees: Trust Committee, Chairman ALCO Committee Audit Committee Andrea Pugh Self-employed, PharmCare Consultant Board Committees: Audit Committee, Chairperson Credit Administration Committee Gregory A. Rosenberry President and Owner, Tri-Valley Forestry Board Committees: ALCO Committee Property Committee Denver L. Tuckey Retired Businessman Board Committees: Property Committee, Chairman ALCO Committee Credit Administration Committee EX-27 3
9 12-MOS DEC-31-1998 DEC-31-1998 7,028 27 8,072 0 47,538 47,538 49,852 158,632 1,971 235,822 183,764 6,234 3,916 20,828 0 0 214 19,339 235,822 12,836 2,876 397 16,109 6,479 7,348 8,761 270 (9) 6,445 4,299 3,119 0 0 3,119 1.52 1.52 4.70 486 284 0 405 1,767 84 18 1,971 1,971 0 0
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