XOTC:CZFS Citizens Financial Services Inc Quarterly Report 10-Q Filing - 5/10/2012

Effective Date 5/10/2012

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


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

For the quarterly period ended March 31, 2012
Or

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

For the transition period from_____________________ to ___________________

Commission file number 0-13222

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

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


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

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

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

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

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

Large accelerated filer ____                                                                                                   Accelerated filer __X__

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

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

The number of outstanding shares of the Registrant’s Common Stock, as of May 2, 2012, was 2,897,313.

 
 

 

 
 
Citizens Financial Services, Inc.
Form 10-Q

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

 
 

 

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


 
1

 

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


 
2

 

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




 
3

 

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

 
4

 

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


Note 1 - Basis of Presentation
 
Citizens Financial Services, Inc., (individually and collectively with its direct and indirect subsidiaries, the “Company”) is a Pennsylvania corporation organized as the holding company of its wholly owned subsidiary, First Citizens National Bank (the “Bank”), and the Bank’s subsidiary, First Citizens Insurance Agency, Inc. (“First Citizens Insurance”).
 
The accompanying consolidated financial statements have been prepared pursuant to rules and regulations of the Securities and Exchange Commission (“SEC”) and in conformity with U.S. generally accepted accounting principles.  Because this report is based on an interim period, certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted.  Certain of the prior year amounts have been reclassified to conform with the current year presentation.  Such reclassifications had no effect on net income or stockholders’ equity.  All material inter-company balances and transactions have been eliminated in consolidation.
 
In the opinion of management of the Company, the accompanying interim financial statements for the periods ended March 31, 2012 and 2011 include all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the financial condition and the results of operations for the period.  In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. The financial performance reported for the Company for the three month period ended March 31, 2012 is not necessarily indicative of the results to be expected for the full year.  This information should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

Note 2 - Earnings per Share
 
The following table sets forth the computation of earnings per share.  Earnings per share calculations give retroactive effect to stock dividends declared by the Company.
 
 
 
 
 
Three months ended
 
March 31,
 
       2012
       2011
Basic earnings per share computation
   
Net income applicable to common stock
$3,449,000
$2,830,000
Weighted average common shares outstanding
                  2,895,810
                  2,917,353
Earnings per share - basis
$1.19
$0.97
     
Diluted earnings per share computation
   
Net income applicable to common stock
$3,449,000
$2,830,000
Weighted average common shares outstanding for basic earnings per share
                  2,895,810
                  2,917,353
Add: Dilutive effects of restricted stock
                            165
                                -
Weighted average common shares outstanding for dilutive earnings per share
                  2,895,975
                  2,917,353
Earnings per share - dilutive
$1.19
$0.97

Restricted stock grants that were anti-dilutive were excluded from net income per share calculations. For the three months ended March 31, 2012 and 2011, 3,073 and 10,389 shares, respectively, related to the restricted stock program were excluded from the diluted earnings per share calculations since they were anti-dilutive.
 
 
5

 
Note 3 - Income Tax Expense
 
Income tax expense is less than the amount calculated using the statutory tax rate, primarily as a result of tax-exempt income earned from state and municipal securities and loans and investments in tax credits.

Note 4 – Investments
 
The amortized cost and fair value of investment securities at March 31, 2012 and December 31, 2011 were as follows (in thousands):


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

 
 

March 31, 2012
Less than Twelve Months
Twelve Months or Greater
Total
     
Gross
 
Gross
 
Gross
   
Fair
Unrealized
Fair
Unrealized
Fair
Unrealized
   
Value
Losses
Value
Losses
Value
Losses
U.S. Agency securities
 $        45,982
 $           (456)
 $                  -
 $                  -
 $        45,982
 $           (456)
Obligations of state and
           
    political subdivisions
520
(10)
                     -
                     -
520
(10)
Corporate obligations
2,611
(8)
                     -
                     -
2,611
(8)
Mortgage-backed securities in
           
   government sponsored entities
34,501
(226)
                     -
                     -
34,501
(226)
               
    Total securities
 $        83,614
 $           (700)
 $                  -
 $                  -
 $        83,614
 $           (700)

December 31, 2011
Less than Twelve Months
Twelve Months or Greater
Total
     
Gross
 
Gross
 
Gross
   
Fair
Unrealized
Fair
Unrealized
Fair
Unrealized
   
Value
Losses
Value
Losses
Value
Losses
U.S. Agency securities
 $        10,018
 $             (21)
 $                  -
 $                  -
 $        10,018
 $             (21)
Obligations of states and
           
     political subdivisions
             1,057
                  (3)
                771
                  (2)
             1,828
                  (5)
Mortgage-backed securities in
           
     government sponsored entities
             3,164
                (12)
                     -
                     -
             3,164
                (12)
Equity securities in financial institutions
                  39
                  (1)
                     -
                     -
                  39
                  (1)
               
    Total securities
 $        14,278
 $             (37)
 $             771
 $               (2)
 $        15,049
 $             (39)

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

 
7

 
 

 
 
Three Months Ended
 
 March 31,
 
2012
2011
Gross gains
 $      108
 $       149
Gross losses
          -
        (29)
Net gains
 $      108
 $       120
 
Investment securities with an approximate carrying value of $174.1 million and $177.9 million at March 31, 2012 and December 31, 2011, respectively, were pledged to secure public funds and certain other deposits.
 
Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.   The amortized cost and fair value of debt securities at March 31, 2012, by contractual maturity, are shown below (in thousands):

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

Note 5 – Loans

The Company makes commercial, industrial, agricultural, residential, construction and consumer loans primarily to customers throughout North Central Pennsylvania and Southern New York.  Although the Company had a diversified loan portfolio at March 31, 2012 and December 31, 2011, a substantial portion of its debtors’ ability to honor their contracts is dependent on the economic conditions within these regions. The following table summarizes the primary segments of the loan portfolio and the allowance for loan losses as of March 31, 2012 and December 31, 2011 (in thousands):

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


 
8

 





December 31, 2011
 
Total Loans
Individually evaluated for impairment
Collectively evaluated for impairment
Real estate loans:
       
     Residential
 
 $                 184,034
 $                       94
 $                183,940
     Commercial and agricultural
 
                    185,050
                     8,270
                   176,780
     Construction
 
                        8,481
                             -
                      8,481
Consumer
 
                      10,746
                             -
                     10,746
Commercial and other loans
 
                      44,299
                        517
                    43,782
State and political subdivision loans
 
                      54,899
                             -
                    54,899
Total
 
                    487,509
 $                  8,881
 $                478,628
 Less allowance for loan losses
 
                        6,487
   
 Net loans
 
 $                 481,022
   
 
The segments of the Bank’s loan portfolio are disaggregated into classes to a level that allows management to monitor risk and performance. Residential real estate mortgages consists primarily of 15 to 30 year first mortgages on residential real estate, while residential real estate home equities are installment loans or lines of credit secured by a mortgage which is often a second lien on residential real estate with terms of 15 years or less. Commercial real estate loans are business purpose loans secured by a mortgage on commercial real estate. Agricultural real estate loans are loans secured by a mortgage on real estate used in agriculture production. Construction real estate loans are loans secured by residential or commercial real estate used during the construction phase of residential and commercial projects. Consumer loans are typically unsecured or primarily secured by something other than real estate and overdraft lines of credit connected with customer deposit accounts. Commercial and other loans are loans for commercial purposes primarily secured by non-real estate collateral. Other agricultural loans are loans for agricultural purposes primarily secured by non-real estate collateral. State and political subdivisions are loans for state and local municipalities for capital and operating expenses or tax free loans used to finance commercial development.
 
Management considers commercial loans, other agricultural loans, commercial real estate loans and agricultural real estate loans which are 90 days or more past due to be impaired. Management will also consider a loan impaired based on other factors it becomes aware of, including the customer’s results of operations and cash flows. These loans are analyzed to determine if it is probable that all amounts will not be collected according to the contractual terms of the loan agreement. If management determines that the value of the impaired loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized through an allowance estimate or a charge-off to the allowance.
 
The following table includes the recorded investment unpaid principal balances and the associated allowance amount, if applicable for impaired financing receivables by class, (in thousands):

 
 
9

 


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

Credit Quality Information
 
For commercial real estate, agricultural real estate, construction, commercial and other and other agricultural loans, management uses a nine point internal risk rating system to monitor the credit quality. The first five categories are considered not criticized and are aggregated as “Pass” rated. The criticized rating categories utilized by management generally follow bank regulatory definitions. The definitions of each rating are defined below:
 
·  
Pass (Grades 1-5) – These loans are to customers with credit quality ranging from an acceptable to very high quality and are protected by the current net worth and paying capacity of the obligor or by the value of the underlying collateral.
 
·  
Special Mention (Grade 6) – This loan grade is in accordance with regulatory guidance and includes loans where a potential weakness or risk exists, which could cause a more serious problem if not corrected.
 
·  
Substandard (Grade 7) – This loan grade is in accordance with regulatory guidance and includes loans that have a well-defined weakness based on objective evidence and be characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.
 
·  
Doubtful (Grade 8) – This loan grade is in accordance with regulatory guidance and includes loans that have all the weaknesses inherent in a substandard asset. In addition, these weaknesses make collection or liquidation in full highly questionable and improbable, based on existing circumstances.
 
 
10

 
 
·  
Loss (Grade 9) – This loan grade is in accordance with regulatory guidance and includes loans that are considered uncollectible, or of such value that continuance as an asset is not warranted.
 
To help ensure that risk ratings are accurate and reflect the present and future capacity of borrowers to repay loan as agreed, the Bank’s loan rating process includes several layers of internal and external oversight. The Company’s loan officers are responsible for the timely and accurate risk rating of the loans in each of their portfolios at origination and on an ongoing basis under the supervision of management.  All commercial and agricultural loans are reviewed annually to ensure the appropriateness of the loan grade. In addition, the Bank engages an external consultant on at least an annual basis. The external consultant is engaged to 1) review a minimum of 60% of the dollar volume of the commercial loan portfolio on an annual basis, 2) review new loans originated in the last year, 3) review all relationships in aggregate over $500,000, 4) review all aggregate loan relationships over $100,000 which are over 90 days past due, classified Special Mention, Substandard, Doubtful, or Loss, and 5) such other loans which management or the consultant deems appropriate.
 
The following tables represent credit exposures by internally assigned grades as of March 31, 2012 and December 31, 2011 (in thousands):

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


 December 31, 2011
Pass
Special Mention
Substandard
Doubtful
Loss
Ending Balance
Real estate loans:
           
     Commercial
 $          138,409
 $         10,372
 $                  17,045
 $                   -
 $              -
 $          165,826
     Agricultural
               14,628
              2,412
                       2,184
                      -
                 -
               19,224
     Construction
                 8,481
                      -
                              -
                      -
                 -
                 8,481
Commercial and other loans
               34,606
              2,203
                          921
                   17
                 -
               37,747
Other Agricultural Loans
                 4,509
                 809
                       1,234
                      -
                 -
                 6,552
State and political
           
   subdivision loans
               53,733
                      -
                       1,166
                      -
                 -
               54,899
Total
 $          254,366
 $         15,796
 $                  22,550
 $                17
 $              -
 $          292,729
 
For residential real estate mortgages, home equities and consumer loans, credit quality is monitored based on whether the loan is performing or non-performing, which is typically based on the aging status of the loan and payment activity, unless a specific action, such as bankruptcy, repossession, death or significant delay in payment occurs to raise awareness of a possible credit event. Non-performing loans include those loans that are considered nonaccrual, described in more detail below and all loans past due 90 or more days. The following table presents the recorded investment in those loan classes based on payment activity as of March 31, 2012 and December 31, 2011 (in thousands):
 
 
11

 

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

Age Analysis of Past Due Financing Receivables
 
Management further monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a recorded payment is past due. The following table includes an aging analysis of the recorded investment of past due financing receivables as of March 31, 2012 and December 31, 2011 (in thousands):

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


 
12

 

 

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

Nonaccrual Loans
 
Loans are considered for non-accrual status upon reaching 90 days delinquency, although the Company may be receiving partial payments of interest and partial repayments of principal on such loans or if full payment of principal and interest is not expected. Additionally, if management is made aware of other information including bankruptcy, repossession, death, or legal proceedings, the loan may be placed on non-accrual status. If a loan is 90 days or more past due and is well secured and in the process of collection, it may still be considered accruing.
 
The following table reflects the financing receivables on nonaccrual status as of March 31, 2012 and December 31, 2011, respectively. The balances are presented by class of financing receivable (in thousands):

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

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

 
13

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

 
For the Three Months Ended March 31, 2012
 
Number of contracts
Pre-modification Outstanding
Recorded Investment
Post-Modification
Outstanding Recorded
 Investment
 
Interest Modification
Term Modification
Interest Modification
Term Modification
Interest Modification
Term Modification
(Dollar amounts in thousands)
         
Real estate loans:
           
     Commercial
                     -
                   2
 $                        -
 $               98
 $                  -
 $               98
Total
                     -
                    2
 $                        -
 $               98
 $                  -
 $               98

 
For the Three Months Ended March 31, 2011
 
Number of contracts
Pre-modification Outstanding
Recorded Investment
Post-Modification
Outstanding Recorded
Investment
 
Interest Modification
Term Modification
Interest Modification
Term Modification
Interest Modification
Term Modification
(Dollar amounts in thousands)
           
Real estate loans:
           
     Commercial
                    5
                          -
 $             5,912
 $                  -
 $          5,912
 $                  -
Total
                    5
                          -
 $             5,912
 $                  -
 $          5,912
 $                  -

Recidivism, or the borrower defaulting on its obligation pursuant to a modified loan, results in the loan once again becoming a non-accrual loan. Recidivism occurs at a notably higher rate than do defaults on new origination loans, so modified loans present a higher risk of loss than do new origination loans. Loan modifications considered TDR’s made during the twelve months ended March 31, 2012, that defaulted during the three month period ended March 31, 2012 were as follows:

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

Allowance for Loan Losses

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

 

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

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

 
 
The Company also maintains an unallocated allowance to account for any factors or conditions that may cause a potential loss but are not specifically addressed in the process described above. The Company analyzes its loan portfolio each quarter to determine the appropriateness of its allowance for loan losses.
 
Loans determined to be TDR’s are impaired and for purposes of estimating the ALLL must be individually evaluated for impairment. In calculating the impairment, the Company calculates the present value utilizing an analysis of discounted cash flows. If the present value calculated is below the recorded investment of the loan, an impairment is recognized by a charge to the provision for loan and lease losses and a credit to the ALLL.
 
We continually review the model utilized in calculating the required allowance. During the second quarter of 2011, management made a determination that special mention and substandard loans should have additional qualitative adjustments applied to them in comparison to pass graded loans. As a result of this and other factors discussed below, the following factors experienced changes during the first three months of 2012:
 
 
·  
The qualitative factor for changes in values of underlying collateral was decreased for residential and commercial real estate loans due to the fact that the impact from the serious flooding experienced in our primary market in the third quarter of 2011 was not as severe as originally expected.
·  
The qualitative factors for changes in levels of and trends in delinquencies, impaired/classified loans were increased for residential real estate and commercial real estate due to the increase in non-performing loans for residential real estate and due to the increase in the Company’s internal watch list for commercial real estate loans since December 31, 2011.
·  
The qualitative factor for the existence and effect of any credit concentrations and changes in the level of such concentrations was increased for commercial real estate and other commercial loans due to the fact that certain companies associated with the natural gas industry appear to be leaving our area due to the current spot price for the natural gas produced in our primary market.
·  
The qualitative factors for changes in industry conditions was increased for agricultural real estate loans and other agricultural loans due to the decrease in milk prices.
 
Based on these qualitative factor changes for the three month period ended March 31, 2012 and the changes in size of the loan portfolios since December 31, 2011, we recorded a credit provision for residential real estate, consumer and other commercial loans. These changes also resulted in a decrease in the unallocated reserve.

Note 6 – Federal Home Loan Bank Stock

The Bank is a member of the FHLB of Pittsburgh and as such, is required to maintain a minimum investment in stock of the FHLB that varies with the level of advances outstanding with the FHLB. As of March 31, 2012 and December 31, 2011, the Bank holds $4,407,000 and $3,027,000, respectively. The stock is bought from and sold to the FHLB based upon its $100 par value.  The stock does not have a readily determinable fair value and as such is classified as restricted stock, carried at cost and evaluated for by management.  The stock’s value is determined by the ultimate recoverability of the par value rather than by recognizing temporary declines. The determination of whether the par value will ultimately be recovered is influenced by criteria such as the following: (a) The significance of the decline in net assets of the FHLB as compared to the capital stock amount and the length of time this situation has persisted (b) Commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance (c) The impact of legislative and regulatory changes on the customer base of the FHLB and (d) The liquidity position of the FHLB.
 
The FHLB has incurred a significant cumulative loss in regards to comprehensive income in the three years ended December 31, 2011 and had suspended the payment of dividends; however, due to improved results in 2011 and 2010 over 2009, a dividend was paid in February 2012.  The cumulative losses were primarily attributable to impairment of investment securities associated with the distressed economic conditions during 2008 and 2009.  Management evaluated the stock and concluded that the stock was not impaired for the periods presented herein.  Management considered that the FHLB’s regulatory capital ratios have improved in the most recent quarters, liquidity appears adequate, new shares of FHLB stock continue to exchange hands at the $100 par value and the FHLB has repurchased shares of excess capital stock from its members through the first quarter of 2012 and has reinstituted the dividend in 2012.
 
 
16

 
 
Note 7 - Employee Benefit Plans
 
For additional detailed disclosure on the Company's pension and employee benefits plans, please refer to Note 11 of the Company's Consolidated Financial Statements included in the 2011 Annual Report on Form 10-K.
 
Noncontributory Defined Benefit Pension Plan
 
The Bank sponsors a noncontributory defined benefit pension plan (“Pension Plan”) covering substantially all employees and officers.  The Bank’s funding policy is to make annual contributions, if needed, based upon the funding formula developed by the plan’s actuary.
 
Any employee with a hire date of January 1, 2007 or later is not eligible to participate in the Pension Plan. In lieu of the Pension Plan, employees with a hire date of January 1, 2007 or later are eligible to receive, after meeting certain length of service requirements, an annual discretionary 401(k) plan contribution from the Bank equal to a percentage of an employee’s base compensation.  The contribution amount, if any, is placed in a separate account within the 401(k) plan and is subject to a vesting requirement.
 
For employees who are eligible to participate in the Pension Plan, the Pension Plan requires benefits to be paid to eligible employees based primarily upon age and compensation rates during employment.  Upon retirement or other termination of employment, employees can elect either an annuity benefit or a lump sum distribution of vested benefits in the Pension Plan.
 
The following sets forth the components of net periodic benefit costs of the Pension Plan for the three months ended March 31, 2012 and 2011, respectively (in thousands):

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

Defined Contribution Plan
 
The Company sponsors a voluntary 401(k) savings plan which eligible employees can elect to contribute up to the maximum amount allowable not to exceed the limits of IRS Code Sections 401(k).  Under the plan, the Company also makes required contributions on behalf of the eligible employees.  The Company’s contributions vest immediately.  Contributions by the Company totaled $52,000 and $50,000 for the three months ended March 31, 2012 and 2011, respectively.
 
Directors’ Deferred Compensation Plan
 
The Company’s directors may elect to defer all or portions of their fees until their retirement or termination from service.  Amounts deferred under the plan earn interest based upon the highest current rate offered to certificate of deposit customers.  Amounts deferred under the plan are not guaranteed and represent a general liability of the Company.  Amounts included in interest expense on the deferred amounts totaled $4,000 and $6,000 for the three months ended March 31, 2012 and 2011, respectively.

 
17

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

Note 8 – Borrowings

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

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

 
 
(b) FHLB Advances consist of an “Open RepoPlus” agreement with the Federal Home Loan Bank of Pittsburgh. FHLB “Open RepoPlus” advances are short-term borrowings that bear interest based on the Federal Home Loan Bank discount rate or Federal Funds rate, whichever is higher.  The Company has a borrowing limit of $225,702,000, inclusive of any outstanding advances. FHLB advances are secured by a blanket security agreement that includes the Company’s FHLB stock, as well as certain investment and mortgage-backed securities held in safekeeping at the FHLB and certain residential and commercial mortgage loans.  At March 31, 2012 and December 31, 2011, the approximate carrying value of the securities collateral was $10,713,000 and $11,196,000, respectively.
 
(c) In December 2003, the Company formed a special purpose entity (“Entity”) to issue $7,500,000 of floating rate obligated mandatory redeemable securities as part of a pooled offering.  The rate was determined quarterly and floated based on the 3 month LIBOR plus 2.80.   The Entity may redeem them, in whole or in part, at face value after December 17, 2008, and on a quarterly basis thereafter.  The Company borrowed the proceeds of the issuance from the Entity in December 2003 in the form of a $7,500,000 note payable.  Debt issue costs of $75,000 have been capitalized and fully amortized as of December 31, 2008.  Under current accounting rules, the Company’s minority interest in the Entity was recorded at the initial investment amount and is included in the other assets section of the balance sheet.  The Entity is not consolidated as part of the Company’s consolidated financial statements.
 
(d) In December, 2008, the Company entered into an interest rate swap agreement to convert floating-rate debt to fixed rate debt on a notional amount of $7,500,000. The interest rate swap instrument involves an agreement to receive a floating rate and pay a fixed rate, at specified intervals, calculated on the agreed-upon notional amount. The differentials paid or received on interest rate swap agreements are recognized as adjustments to interest expense in the period. The interest rate swap agreement was entered into on December 17, 2008 and expires December 17, 2013.  The fair value of the interest rate swap at March 31, 2012 and December 31, 2011 was a liability of $327,000 and $348,000, respectively, and is included within other liabilities on the consolidated balance sheets.
 
(e) Term Loans consist of separate loans with a third party bank and the Federal Home Loan Bank of Pittsburgh as follows (in thousands):
 
   
March 31
December 31,
Interest Rate
Maturity
2012
2011
Fixed:
     
3.57%
May 7, 2012
             2,000
             2,000
3.36%
May 9, 2012
             2,000
             2,000
3.89%
September 5, 2012
             1,000
             1,000
2.72%
March 31, 2013
             1,150
             1,150
2.58%
April 28, 2013
             2,000
             2,000
2.37%
May 5, 2013
             2,000
             2,000
3.75%
May 6, 2013
             2,000
             2,000
3.55%
May 9, 2013
             2,000
             2,000
2.26%
May 15, 2013
             1,650
             1,650
3.42%
December 2, 2013
             5,000
             5,000
3.52%
December 5, 2013
             5,000
             5,000
2.31%
January 27, 2014
             1,000
             1,000
2.80%
April 17, 2014
             3,200
             3,200
2.29%
October 2, 2017
             2,000
             2,000
2.72%
July 12, 2018
             1,000
             1,000
3.52%
July 12, 2021
             2,000
             2,000
 
Total term loans
 $        35,000
 $        35,000


 
19

 


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

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

Note 9 – Fair Value Measurements
 
The Company established a hierarchal disclosure framework associated with the level of pricing observability utilized in measuring assets and liabilities at fair value. The three broad levels defined by this hierarchy are as follows:
 
Level I:
Quoted prices are available in active markets for identical assets or liabilities as of the reported date.
 
Level II:
Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these assets and liabilities include items for which quoted prices are available but traded less frequently, and items that are fair valued using other financial instruments, the parameters of which can be directly observed.
   
Level III:
Assets and liabilities that have little to no pricing observability as of the reported date. These items do not have two-way markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.
 
A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.
 
In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality, the Company's creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. Our valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally coincides with the Company’s monthly and/or quarterly valuation process

Financial Instruments Recorded at Fair Value on a Recurring Basis
 
The fair values of securities available for sale are determined by quoted prices in active markets, when available, and classified as Level I. If quoted market prices are not available, the fair value is determined by a matrix pricing, which is a mathematical technique, widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities and classified as Level II. The fair values consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. In cases where significant credit valuation adjustments are incorporated into the estimation of fair value, reported amounts are classified as Level III inputs.
 
 
20

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

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

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

Financial Instruments Recorded at Fair Value on a Nonrecurring Basis
 
The Company may be required, from time to time, to measure certain financial assets and financial liabilities at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principles. These include assets that are measured at the lower of cost or market value that were recognized at fair value below cost at the end of the period.
 
Impaired Loans- Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. The fair value of impaired loans is estimated using one of several methods, including collateral value, liquidation value and discounted cash flows. For those loans valued utilizing collateral value or liquidation value consideration is given to the time since an appraisal was performed, selling costs including legal fees and the length of time it will take to sell the collateral. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. Collateral values are estimated using Level II inputs based on observable market data or Level III inputs based on customized discounting criteria. For a majority of impaired real estate related loans, the Company obtains a current external appraisal. Other valuation techniques are used as well, including internal valuations, comparable property analysis and contractual sales information.
 
 
21

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

   
March 31, 2012
   
Level I
 
Level II
 
Level III
   
Total
                   
Impaired Loans
 
 $                -
 
 $                         -
 
 $            8,325
   
 $                 8,325
Other real estate owned
 
                   -
 
                            -
 
836
   
836
                   
   
December 31, 2011
   
Level I
 
Level II
 
Level III
   
Total
                   
Impaired Loans
 
 $                -
 
 $                         -
 
 $            8,387
   
 $                 8,387
Other real estate owned
 
                   -
 
                            -
 
                  860
   
860
 
The following table provides a listing of the significant unobservable inputs used in the fair value measurement process for items valued utilizing level III techniques.


 
22

 
 

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

 
Carrying
         
March 31, 2012
Amount
Fair Value
Level I
Level II
Level III
Total
Financial assets:
           
Cash and due from banks
 $    11,837
 $    11,837
 $    11,837
 $              -
 $              -
 $    11,837
Available-for-sale securities
     362,148
     362,148
         1,234
     360,914
                 -
     362,148
Net loans
     484,747
     527,358
                 -
                 -
     527,358
     527,358
Bank owned life insurance
       13,794
       13,794
       13,794
                 -
                 -
       13,794
Regulatory stock
         4,681
         4,681
         4,681
                 -
                 -
         4,681
Accrued interest receivable
         4,305
         4,305
4,305
                 -
                 -
         4,305
             
Financial liabilities:
           
Deposits
 $  742,826
 $  749,160
 $  446,172
 $              -
 $  302,988
 $  749,160
Borrowed funds
       72,768
       70,466
                 -
       70,466
                 -
       70,466
Trust preferred interest rate swap
            327
            327
                 -
            327
                 -
            327
Accrued interest payable
         1,320
         1,320
1,320
                 -
                 -
         1,320
             
    Carrying      
 
 
December 31, 2011
  Amount   Fair Value    
 
 
Financial assets:
           
Cash and cash equivalents
$ 30,432  $ 30,432     
 
 
Available-for-sale securities
318,823  318,823     
    
     
Net loans
481,022  527,724     
    
     
Bank owned life insurance
13,669  13,669     
      
       
Regulatory stock
3,301  3,301     
        
       
Accrued interest receivable
3,621  3,621     
        
        
             
Financial liabilities:
           
Deposits
$ 733,993 
$ 740,839
   
 
 
Borrowed funds
 53,882  51,437     
       
      
Trust preferred interest rate swap
 348   348     
           
            
Accrued interest payable
 1,512   1,512     
         
         
 
Fair value is determined, based on relevant market information and information about the financial instrument.  These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument.  Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions can significantly affect the estimates.

 
23

 
 
Fair values have been determined by the Company using historical data, as generally provided in the Company’s regulatory reports, and an estimation methodology suitable for each category of financial instruments. The Company’s fair value estimates, methods and assumptions are set forth below for the Company’s other financial instruments.

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

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

Available-For-Sale Securities:
 
The fair values of securities available for sale are determined by quoted prices in active markets, when available, and classified as Level I. If quoted market prices are not available, the fair value is determined by a matrix pricing, which is a mathematical technique, widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities and classified as Level II. The fair values consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. In cases where significant credit valuation adjustments are incorporated into the estimation of fair value, reported amounts are classified as Level III inputs.
 
Loans:
 
Fair values are estimated for portfolios of loans with similar financial characteristics.  The fair value of performing loans has been estimated by discounting expected future cash flows. The discount rate used in these calculations is derived from the Treasury yield curve adjusted for credit quality, operating expense and prepayment option price, and is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The estimate of maturity is based on the Company’s historical experience with repayments for each loan classification, modified as required by an estimate of the effect of current economic and lending conditions.
 
Fair value for significant nonperforming loans is based on recent external appraisals. If appraisals are not available, estimated cash flows are discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows, and discount rates are judgmentally determined using available market information and specific borrower information.

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

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


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

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

Trust Preferred Interest Rate Swap:

The fair value of the trust preferred interest rate swap is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative and classified as Level II. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including LIBOR rate curves. We also obtain dealer quotations for these derivatives for comparative purposes to assess the reasonableness of the model valuations.
 
Note 10 – Recent Accounting Pronouncements
 
In April 2011, the FASB issued ASU 2011-03, Transfers and Services (Topic 860): Reconsideration of Effective Control for Repurchase Agreements.  The main objective in developing this Update is to improve the accounting for repurchase agreements (repos) and other agreements that both entitle and obligate a transferor to repurchase or redeem financial assets before their maturity.  The amendments in this Update remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation guidance related to that criterion.  The amendments in this Update apply to all entities, both public and nonpublic.  The amendments affect all entities that enter into agreements to transfer financial assets that both entitle and obligate the transferor to repurchase or redeem the financial assets before their maturity.  The guidance in this Update is effective for the first interim or annual period beginning on or after December 15, 2011 and should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date.  Early adoption is not permitted.  This ASU did not have a significant impact on the Company’s financial statements.
 
In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement (Topic 820):  Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.  The amendments in this Update result in common fair value measurement and disclosure requirements in U.S. GAAP and IFRSs.  Consequently, the amendments change the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements.  The amendments in this Update are to be applied prospectively.  For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011.  For nonpublic entities, the amendments are effective for annual periods beginning after December 15, 2011.  Early application by public entities is not permitted. This Company has provided the necessary disclosures in Note 9.
 
In June 2011, the FASB issued ASU 2011-05, Comprehensive Income (Topic 220):  Presentation of Comprehensive Income.  The amendments in this Update improve the comparability, clarity, consistency, and transparency of financial reporting and increase the prominence of items reported in other comprehensive income.  To increase the prominence of items reported in other comprehensive income and to facilitate convergence of U.S. GAAP and IFRS, the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity was eliminated.  The amendments require that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements.  In the two-statement approach, the first statement should present total net income and its components followed consecutively by a second statement that should present total other comprehensive income, the components of other comprehensive income, and the total of comprehensive income.  All entities that report items of comprehensive income, in any period presented, will be affected by the changes in this Update.  For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011.  For nonpublic entities, the amendments are effective for fiscal years ending after December 15, 2012, and interim and annual periods thereafter.  The amendments in this Update should be applied retrospectively, and early adoption is permitted. The Company has provided the necessary disclosure in the Consolidated Statement of Comprehensive Income.
 
 
 
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In September 2011, the FASB issued ASU 2011-08, Intangibles – Goodwill and Other Topics (Topic 350), Testing Goodwill for Impairment.  The objective of this update is to simplify how entities, both public and nonpublic, test goodwill for impairment.  The amendments in the Update permit an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in Topic 350.  The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent.  Under the amendments in this Update, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount.  The amendments in this Update apply to all entities, both public and nonpublic, that have goodwill reported in their financial statements and are effective for interim and annual goodwill impairment tests performed for fiscal years beginning after December 15, 2011.  Early adoption is permitted, including for annual and interim goodwill impairment tests performed as of a date before September 15, 2011, if an entity’s financial statements for the most recent annual or interim period have not yet been issued or, for nonpublic entities, have not yet been made available for issuance.  This ASU did not have a significant impact on the Company’s financial statements.
 
In December 2011, the FASB issued ASU 2011-11, Balance Sheet (Topic 210):  Disclosures about Offsetting Assets and Liabilities.  The amendments in this Update affect all entities that have financial instruments and derivative instruments that are either (1) offset in accordance with either Section 210-20-45 or Section 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement.  The requirements amend the disclosure requirements on offsetting in Section 210-20-50.  This information will enable users of an entity's financial statements to evaluate the effect or potential effect of netting arrangements on an entity's financial position, including the effect or potential effect of rights of setoff associated with certain financial instruments and derivative instruments in the scope of this Update.  An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods.  An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented.  The Company is currently evaluating the impact the adoption of the standard will have on the Company’s financial position or results of operations.
 
In December 2011, the FASB issued ASU 2011-12, Comprehensive Income (Topic 220):  Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.  In order to defer only those changes in Update 2011-05 that relate to the presentation of reclassification adjustments, the paragraphs in this Update supersede certain pending paragraphs in Update 2011-05.  Entities should continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect before Update 2011-05.  All other requirements in Update 2011-05 are not affected by this Update, including the requirement to report comprehensive income either in a single continuous financial statement or in two separate but consecutive financial statements. Public entities should apply these requirements for fiscal years, and interim periods within those years, beginning after December 15, 2011. Nonpublic entities should begin applying these requirements for fiscal years ending after December 15, 2012, and interim and annual periods thereafter.  The Company has provided the necessary disclosure in the Consolidated Statement of Comprehensive Income. 

 
26

 

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

Introduction
 
The following is management's discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in the accompanying consolidated financial statements for the Company.  Our Company's consolidated financial condition and results of operations consist almost entirely of the Bank’s financial condition and results of operations. Management’s discussion and analysis should be read in conjunction with the preceding financial statements presented under Part I.  The results of operations for the three months ended March 31, 2012 are not necessarily indicative of the results you may expect for the full year.

 
27

 
 
The Company currently engages in the general business of banking throughout our service area of Potter, Tioga and Bradford counties in North Central Pennsylvania and Allegany, Steuben, Chemung and Tioga counties in Southern New York. We maintain our main office in Mansfield, Pennsylvania. Presently we operate 19 banking facilities, 17 of which operate as bank branches.  In Pennsylvania, we have branch offices located in Mansfield, Blossburg, Ulysses, Genesee, Wellsboro, Troy, Sayre, Canton, Gillett, Millerton, LeRaysville, Towanda, Rome, the Wellsboro Weis Market store and the Mansfield Wal-Mart Super Center. We also have a loan production office in Lock Haven, Pennsylvania. In New York, we have a branch office in Wellsville, Allegany County.

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

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

 
28

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

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

Results of Operations

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

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

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


 
29

 

 
Analysis of Average Balances and Interest Rates (1)
 
March 31, 2012
March 31, 2011
 
Average
 
Average
Average
 
Average
 
Balance (1)
Interest
Rate
Balance (1)