XOTC:CZFS Citizens Financial Services Inc Quarterly Report 10-Q Filing - 8/9/2012

Effective Date 8/9/2012

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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 June 30, 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 August 1, 2012, was 2,917,540.

 
 

 

 
 
Citizens Financial Services, Inc.
Form 10-Q

INDEX
 
 
   
PAGE
Part I
FINANCIAL INFORMATION
 
Item 1.
Financial Statements (unaudited):
 
 
Consolidated Balance Sheet as of June 30, 2012 and
December 31, 2011
1
 
Consolidated Statement of Income for the Three Months and Six             Months Ended June 30, 2012 and 2011
2
 
Consolidated Statement of Comprehensive Income for the Three
Months and Six months Ended June 30, 2012 and 2011
3
 
Consolidated Statement of Cash Flows for the
Six months Ended June 30, 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
27-50
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
50
Item 4.
Controls and Procedures
50
     
Part II
OTHER INFORMATION
 
Item 1.
Legal Proceedings
51
Item 1A.
Risk Factors
51
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
51
Item 3.
Defaults Upon Senior Securities
51
Item 4.
Mine Safety Disclosures
51
Item 5.
Other Information
51
Item 6.
Exhibits
52
 
Signatures
53

 
 

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED BALANCE SHEET
   
(UNAUDITED)
   
     
 
June 30
December 31
(in thousands except share data)
2012
2011
ASSETS:
   
Cash and due from banks:
   
  Noninterest-bearing
 $             12,525
 $            9,960
  Interest-bearing
                  5,243
             20,472
Total cash and cash equivalents
                17,768
             30,432
     
Available-for-sale securities
              323,131
           318,823
 
   
Loans (net of allowance for loan losses:
   
  2012, $6,650 and 2011, $6,487)
              490,482
           481,022
 
   
Premises and equipment
                11,515
             11,702
Accrued interest receivable
                  3,800
               3,621
Goodwill
                10,256
             10,256
Bank owned life insurance
                13,919
             13,669
Other assets
                10,479
               9,042
 
 
 
TOTAL ASSETS
 $           881,350
 $        878,567
 
 
 
LIABILITIES:
   
Deposits:
   
  Noninterest-bearing
 $             86,218
 $          85,605
  Interest-bearing
              652,549
           648,388
Total deposits
              738,767
           733,993
Borrowed funds
                47,066
             53,882
Accrued interest payable
                  1,222
               1,512
Other liabilities
                  7,754
               7,712
TOTAL LIABILITIES
              794,809
           797,099
STOCKHOLDERS' EQUITY:
   
Preferred Stock
   
  $1.00 par value; authorized 3,000,000 shares June 30, 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 June 30, 2012 and
   
  December 31, 2011
                  3,133
               3,133
Additional paid-in capital
                15,364
             15,313
Retained earnings
                68,813
             63,337
Accumulated other comprehensive income
                  4,990
               4,949
Treasury stock, at cost:  243,784 shares at June 30, 2012
   
  and 230,203 shares at December 31, 2011
                 (5,759)
             (5,264)
TOTAL STOCKHOLDERS' EQUITY
                86,541
             81,468
TOTAL LIABILITIES AND
   
   STOCKHOLDERS' EQUITY
 $           881,350
 $        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
Six Months Ended
 
June 30,
June 30,
(in thousands, except share and per share data)
2012
2011
2012
2011
INTEREST INCOME:
       
Interest and fees on loans
 $        7,439
 $      7,463
 $     14,904
 $    14,858
Interest-bearing deposits with banks
                   1
               20
                   6
               42
Investment securities:
 
 
 
 
    Taxable
           1,237
         1,176
           2,434
         2,348
    Nontaxable
               920
             892
           1,874
         1,757
    Dividends
                 16
               14
                32
               29
TOTAL INTEREST INCOME
           9,613
         9,565
        19,250
       19,034
INTEREST EXPENSE:
       
Deposits
           1,555
         2,046
           3,221
         4,134
Borrowed funds
               393
             443
              806
             888
TOTAL INTEREST EXPENSE
           1,948
         2,489
           4,027
         5,022
NET INTEREST INCOME
           7,665
         7,076
        15,223
       14,012
Provision for loan losses
               105
             150
              210
             375
NET INTEREST INCOME AFTER
       
    PROVISION FOR LOAN LOSSES
           7,560
         6,926
        15,013
       13,637
NON-INTEREST INCOME:
       
Service charges
           1,129
         1,128
           2,207
         2,073
Trust
               151
             146
              324
             303
Brokerage and insurance
                 75
             123
              225
             218
Gains on loans sold
               131
               34
              185
               75
Investment securities gains, net
               213
             114
              321
             234
Earnings on bank owned life insurance
               126
             124
              250
             245
Other
               116
             129
              261
             269
TOTAL NON-INTEREST INCOME
           1,941
         1,798
           3,773
         3,417
NON-INTEREST EXPENSES:
       
Salaries and employee benefits
           2,668
         2,518
           5,421
         5,033
Occupancy
               314
             329
              624
             719
Furniture and equipment
                 96
             106
              202
             223
Professional fees
               224
             172
              492
             329
FDIC insurance
               115
             250
              238
             500
Pennsylvania shares tax
               160
             146
              326
293
Other
           1,000
         1,189
           2,118
         2,393
TOTAL NON-INTEREST EXPENSES
           4,577
         4,710
           9,421
         9,490
Income before provision for income taxes
           4,924
         4,014
           9,365
         7,564
Provision for income taxes
           1,171
             867
           2,163
         1,587
NET INCOME
 $        3,753
 $      3,147
 $       7,202
 $      5,977
 
       
PER COMMON SHARE DATA:
       
Net Income - Basic
 $          1.30
 $        1.08
 $          2.49
 $        2.05
Net Income - Diluted
 $          1.30
 $        1.08
 $          2.49
 $        2.05
Cash Dividends Paid
 $        0.300
 $      0.265
 $       0.595
 $      0.525
         
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
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands)
 
2012
 
2011
   
2012
 
2011
Net income
 
 $ 3,753
 
 $ 3,147
   
 $      7,202
 
 $ 5,977
Other comprehensive income:
                 
      Increase in unrealized gains on available for sale securities
   741
 
  2,660
   
   318
 
   3,551
 
      Income tax effect related to unrealized gains on available for sale securities
  (252)
 
   (905)
   
  (108)
 
  (1,208)
 
      Decrease (increase) in unrealized loss on interest rate swap
     45
 
     (59)
   
     66
 
          1
 
      Income tax effect related to unrealized loss on interest rate swap
    (15)
 
       20
   
    (23)
 
           -
 
      Less:  Reclassification adjustment for gain included in net income
  (213)
 
   (114)
   
  (321)
 
     (234)
 
      Income tax effect related to reclassification adjustment for gain included in net income
     72
 
       39
   
   109
 
        80
 
Other comprehensive income, net of tax
 
       378
 
    1,641
   
              41
 
    2,190
Comprehensive income
 
 $ 4,131
 
 $ 4,788
   
 $      7,243
 
 $ 8,167
                   
The accompanying notes are an integral part of these unaudited consolidated financial statements.
             




 
3

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED STATEMENT OF CASH FLOWS
   
(UNAUDITED)
Six Months Ended
 
June 30,
(in thousands)
2012
2011
CASH FLOWS FROM OPERATING ACTIVITIES:
   
  Net income
 $          7,202
 $          5,977
  Adjustments to reconcile net income to net
   
   cash provided by operating activities:
   
    Provision for loan losses
                210
                375
    Depreciation and amortization
                211
                272
    Amortization and accretion of investment securities, net
             1,196
                940
    Deferred income taxes
                  28
                192
    Investment securities gains, net
              (321)
              (234)
    Earnings on bank owned life insurance
              (250)
              (245)
    Originations of loans held for sale
         (14,241)
           (5,316)
    Proceeds from sales of loans held for sale
           14,426
             5,391
    Realized gains on loans sold
              (185)
                (75)
    Increase in accrued interest receivable
              (179)
              (262)
    Decrease in accrued interest payable
              (290)
              (223)
    Other, net
              (269)
              45
      Net cash provided by operating activities
             7,538
             6,837
CASH FLOWS FROM INVESTING ACTIVITIES:
   
  Available-for-sale securities:
   
    Proceeds from sales
           16,654
             7,821
    Proceeds from maturity and principal repayments
           68,914
           32,063
    Purchase of securities
         (90,754)
         (72,496)
  Proceeds from redemption of regulatory stock
                245
                312
  Purchase of regulatory stock
           (1,405)
                    -
  Net increase in loans
           (9,679)
           (3,925)
  Purchase of premises and equipment
              (117)
                (65)
  Purchase of land for potential future expansion
                     -
              (545)
  Proceeds from sale of foreclosed assets held for sale
                345
                371
      Net cash used in investing activities
         (15,797)
         (36,464)
CASH FLOWS FROM FINANCING ACTIVITIES:
   
  Net increase in deposits
             4,774
           32,416
  Proceeds from long-term borrowings
                  28
                    9
  Repayments of long-term borrowings
           (4,110)
           (1,000)
  Net (decrease) increase in short-term borrowed funds
           (2,734)
                403
  Purchase of treasury and restricted stock
              (637)
              (360)
  Dividends paid
           (1,726)
           (1,404)
      Net cash (used in) provided by financing activities
           (4,405)
           30,064
          Net (decrease) increase in cash and cash equivalents
         (12,664)
                437
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
           30,432
           43,995
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 $        17,768
 $        44,432
Supplemental Disclosures of Cash Flow Information:
   
    Interest paid
 $          4,317
 $          5,245
    Income taxes paid
 $          2,095
 $          1,300
    Loans transferred to foreclosed property
 $             123
 $             490
    Premises and equipment transferred to other assets
 $                  -
 $             282
    Investments purchased and not settled included in other liabilities
 $                  -
 $          2,085
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 Community Bank (the “Bank”), and the Bank’s subsidiary, First Citizens Insurance Agency, Inc. (“First Citizens Insurance”). On June 29, 2012, the Bank completed the conversion from a national bank into a Pennsylvania state-chartered bank and trust company and changed its name from First Citizens National Bank to First Citizens Community Bank.
 
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 June 30, 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 six month period ended June 30, 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
Six months ended
 
June 30,
June 30,
 
2012
2011
2012
2011
 
       
Basic earnings per share computation:
       
Net income applicable to common stock
$3,753,000
$3,147,000
$7,202,000
$5,977,000
Weighted average common shares outstanding for basic earnings per share
       2,886,012
       2,915,708
   2,890,849
  2,916,526
Earnings per share - basic
$1.30
$1.08
$2.49
$2.05
         
Diluted earnings per share computation:
       
Net income applicable to common stock
$3,753,000
$3,147,000
$7,202,000
$5,977,000
         
Weighted average common shares outstanding for basic earnings per share
        2,886,012
        2,915,708
     2,890,849
   2,916,526
Add: Dilutive effects of restricted stock
              1,409
                      -
               624
                 -
Weighted average common shares outstanding for dilutive earnings per share
        2,887,421
       2,915,708
     2,891,473
   2,916,526
Earnings per share - dilutive
$1.30
$1.08
$2.49
$2.05
 
 
 
5

 
Restricted stock grants that were anti-dilutive were excluded from net income per share calculations. For the three months ended June 30, 2012 and 2011, 2,447 and 8,847 shares, respectively, related to the restricted stock program were excluded from the diluted earnings per share calculations since they were anti-dilutive. For the six months ended June 30, 2012 and 2011, 4,115 and 8,847 shares, respectively, related to the restricted stock program were excluded from the diluted earnings per share calculations since they were anti-dilutive.

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 June 30, 2012 and December 31, 2011 were as follows (in thousands):

   
Gross
Gross
 
 
Amortized
Unrealized
Unrealized
Fair
June 30, 2012
Cost
Gains
Losses
Value
Available-for-sale securities:
       
  U.S. agency securities
 $    144,214
 $               2,157
 $                 (7)
 $     146,364
  Obligations of state and
       
    political subdivisions
         93,130
                  5,089
                  (72)
          98,147
  Corporate obligations
         10,790
                     276
                  (20)
          11,046
  Mortgage-backed securities in
       
    government sponsored entities
         64,072
                  2,223
                (101)
          66,194
  Equity securities in financial
       
     institutions
              911
                     469
                      -
            1,380
Total available-for-sale securities
 $    313,117
 $             10,214
 $             (200)
 $     323,131
         
   
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 June 30, 2012 and December 31, 2011 (in thousands). As of June 30, 2012, the Company owned 13 securities whose fair value was less than their cost basis.
 
 
6

 
 
 

June 30, 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
 $          4,010
 $               (7)
 $                  -
 $                  -
 $          4,010
 $               (7)
Obligations of state and
           
    political subdivisions
3,437
(72)
                     -
                     -
3,437
(72)
Corporate obligations
2,585
(20)
                     -
                     -
2,585
(20)
Mortgage-backed securities in
           
   government sponsored entities
9,360
(101)
                     -
                     -
9,360
(101)
               
    Total securities
 $        19,392
 $           (200)
 $                  -
 $                  -
 $        19,392
 $           (200)
               
               
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 June 30, 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 six months ended June 30, 2012 and 2011 were $16,654,000 and $7,821,000, respectively.  For the three months ended June 30, 2012 and 2011, there were sales of $5,418,000 and $4,632,000, respectively, of available-for-sale securities. The gross gains and losses were as follows (in thousands):

 
7

 
 

 
 
Three Months Ended
Six Months Ended
 
 June 30,
 June 30,
 
2012
2011
2012
2011
Gross gains
 $           213
 $                  114
 $              321
 $            263
Gross losses
                   -
                          -
                         -
                (29)
Net gains
 $           213
 $                  114
 $              321
 $            234
 
Investment securities with an approximate carrying value of $174.1 million and $177.9 million at June 30, 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 June 30, 2012, by contractual maturity, are shown below (in thousands):

 
Amortized
   
 
Cost
 
Fair Value
Available-for-sale debt securities:
     
  Due in one year or less
 $      15,878
 
 $         16,028
  Due after one year through five years
         83,752
 
            85,499
  Due after five years through ten years
         47,862
 
            49,081
  Due after ten years
       164,714
 
          171,143
Total
 $    312,206
 
 $       321,751

Note 5 – Loans
 
The Company grants commercial, industrial, agricultural, residential, and consumer loans primarily to customers throughout North Central Pennsylvania and Southern New York.  Although the Company had a diversified loan portfolio at June 30, 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 as of June 30, 2012 and December 31, 2011 (in thousands):

June 30, 2012
 
Total Loans
Individually
evaluated for
impairment
Collectively
evaluated for
impairment
Real estate loans:
       
     Residential
 
 $                 181,409
 $                        351
 $                 181,058
     Commercial and agricultural
 
                    189,705
                        7,475
                    182,230
     Construction
 
                      10,328
                                -
                      10,328
Consumer
 
                      11,160
                                -
                      11,160
Other commercial and agricultural loans
                      47,067
                           457
                      46,610
State and political subdivision loans
 
                      57,463
                                -
                      57,463
Total
 
                    497,132
 $                     8,283
 $                 488,849
Allowance for loan losses
 
                        6,650
   
Net loans
 
 $                 490,482
   


 
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
Other commercial and agricultural loans
 
                      44,299
                           517
                      43,782
State and political subdivision loans
 
                      54,899
                                -
                      54,899
Total
 
                    487,509
 $                     8,881
 $                 478,628
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 consumer purpose 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. Other commercial 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 and unpaid principal balances for impaired financing receivables by class, with the associated allowance amount, if applicable (in thousands):

 
 
9

 

 

   
Recorded
Recorded
       
 
Unpaid
Investment
Investment
Total
 
Average
Interest
 
Principal
With No
With
Recorded
Related
Recorded
Income
June 30, 2012
Balance
Allowance
Allowance
Investment
Allowance
Investment
Recognized
Real estate loans:
             
     Residential mortgages
 $      258
 $          118
 $          140
 $          258
 $          14
 $            83
 $               1
     Home equity
           93
               18
               75
               93
             15
               93
                  2
     Commercial
      8,816
          5,366
          2,109
          7,475
           512
          8,138
                39
     Agricultural
              -
                  -
                  -
                  -
                -
                  -
                   -
     Construction
              -
                  -
                  -
                  -
                -
                  -
                   -
Consumer
              -
                  -
                  -
                  -
                -
                  -
                   -
Other commercial loans
         504
               28
             429
             457
             21
             468
                   -
Other agricultural loans
              -
                  -
                  -
                  -
                -
                  -
                   -
State and political
             
   subdivision loans
              -
                  -
                  -
                  -
                -
                  -
                   -
Total
 $   9,671
 $       5,530
 $       2,753
 $       8,283
 $        562
 $       8,782
 $             42
               
   
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:
             
     Residential 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
              -
                  -
                  -
                  -
                -
                  -
                   -
Other commercial 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, other agricultural loans and state and political subdivision 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 or 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 June 30, 2012 and December 31, 2011 (in thousands):

June 30, 2012
Pass
Special Mention
Substandard
Doubtful
Loss
Ending Balance
Real estate loans:
           
     Commercial
 $          141,568
 $         10,496
 $                  18,739
 $                75
 $              -
 $          170,878
     Agricultural
               16,219
                 623
                       1,985
                      -
                 -
               18,827
     Construction
               10,328
                      -
                              -
                      -
                 -
               10,328
Other commercial loans
               36,982
              1,806
                       1,016
                   16
                 -
               39,820
Other agricultural loans
                 5,849
                 425
                          973
                      -
                 -
                 7,247
State and political
           
   subdivision loans
               56,335
                      -
                       1,128
                      -
                 -
               57,463
Total
 $          267,281
 $         13,350
 $                  23,841
 $                91
 $              -
 $          304,563

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
Other commercial 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 June 30, 2012 and December 31, 2011 (in thousands):

 
11

 
 

June 30, 2012
Performing
Non-performing
Total
Real estate loans:
     
     Residential mortgages
 $          104,600
 $              558
 $                105,158
     Home equity
               76,080
                 171
                     76,251
Consumer
               11,160
                      -
                     11,160
Total
 $          191,840
 $              729
 $                192,569
       
December 31, 2011
Performing
Non-performing
Total
Real estate loans:
     
     Residential 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 June 30, 2012 and December 31, 2011 (in thousands):

   
30-59 Days
60-89 Days
90 Days
Total Past
 
Total Financing
90 Days and
June 30, 2012
Past Due
Past Due
Or Greater
Due
Current
Receivables
Accruing
Real estate loans:
             
     Residential mortgages
 $        164
 $            9
 $        455
 $        628
 $   104,530
 $           105,158
 $              57
     Home equity
           360
             88
           161
           609
        75,642
                76,251
                 21
     Commercial
           717
           104
        2,063
        2,884
      167,994
              170,878
               180
     Agricultural
                -
                -
                -
                -
        18,827
                18,827
                   -
     Construction
                -
                -
                -
                -
        10,328
                10,328
                   -
Consumer
             45
                -
                -
             45
        11,115
                11,160
                   -
Other commercial loans
                -
                -
           445
           445
        39,375
                39,820
                   -
Other agricultural loans
           100
                -
                -
           100
          7,147
                  7,247
                   -
State and political
             
   subdivision loans
                -
                -
                -
                -
        57,463
                57,463
                   -
                 
 
Total
 $     1,386
 $        201
 $     3,124
 $     4,711
 $   492,421
 $           497,132
 $            258
                 
Loans considered non-accrual
 $             -
 $             -
 $     2,866
 $     2,866
 $       5,537
 $               8,403
 
Loans still accruing
        1,386
           201
           258
        1,845
      486,884
              488,729
 
 
Total
 $     1,386
 $        201
 $     3,124
 $     4,711
 $   492,421
 $           497,132
 

 
 
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:
             
     Residential 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
                   -
Other commercial 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 June 30, 2012 and December 31, 2011, respectively. The balances are presented by class of financing receivable (in thousands):
 
   
June 30, 2012
 
December 31, 2011
Real estate loans:
     
     Residential mortgages
 $                501
 
 $                   413
     Home equity
                   150
 
                      141
     Commercial
                7,295
 
                   8,094
     Agricultural
                     -
 
                        -
     Construction
                      -
 
                        -
Consumer
                      -
 
                        -
Other commercial loans
                   457
 
                      517
Other agricultural loans
                      -
 
                        -
State and political subdivision
                      -
 
                        -
   
 $             8,403
 
 $                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 and six months ended June 30, 2012 and 2011 were as follows (dollars in thousands):

 
For the Three Months Ended June 30, 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
Real estate loans:
           
     Residential mortgage
                    1
                      1
 $                       48
 $                71
 $              48
 $              71
Total
                    1
                       1
 $                       48
 $                71
 $              48
 $              71

 
For the Six Months Ended June 30, 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
Real estate loans:
           
     Residential mortgage
1
1
$                       48
$                 71
 $               48
$                 71
     Commercial
                     -
                       2
                             -
98
                     -
                98
Total
                    1
                       3
 $                       48
 $              169
 $               48
 $             169

 
For the Three Months Ended June 30, 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
Real estate loans:
           
     Commercial
                     -
                      -
 $                          -
 $                  -
 $                  -
 $                  -
Total
                     -
                      -
 $                          -
 $                  -
 $                  -
 $                  -

 
For the Six Months Ended June 30, 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
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 June 30, 2012, that defaulted during the three and six month periods ended June 30, 2012 were as follows (dollars in thousands):
 
 
14

 

 
 
For the Three Months Ended
For the Six Months Ended
 
June 30, 2012
June 30, 2011
June 30, 2012
June 30, 2011
 
Number of contracts
Recorded investment
Number of contracts
Recorded investment
Number of contracts
Recorded investment
Number of contracts
Recorded investment
Real estate loans:
               
     Commercial
             -
 $              -
                     -
 $              -
            1
 $               48
                 -
 $               -
Total recidivism
             -
 $              -
                     -
 $              -
            1
 $               48
                 -
 $               -

Allowance for Loan Losses

The following table segregates the allowance for loan losses (ALLL) into the amount required for loans individually evaluated for impairment and the amount required for loans collectively evaluated for impairment as of June 30, 2012 and December 31, 2011, respectively (in thousands):
 
June 30, 2012
 
December 31, 2011
 
Individually evaluated for impairment
Collectively evaluated for impairment
Total
 
Individually evaluated for impairment
Collectively evaluated for impairment
Total
Real estate loans:
             
     Residential
 $                 29
 $               758
 $         786
 
 $                 13
 $               792
 $     805
     Commercial and agricultural
                  512
               3,893
         4,405
 
                  433
              3,699
     4,132
     Construction
                       -
                    19
              19
 
                       -
                    15
          15
Consumer
                       -
                  108
            108
 
                       -
                  111
        111
Other commercial and agricultural loans
                    21
                  663
            685
 
                    48
                  626
        674
State and political
             
  subdivision loans
                       -
                  246
            246
 
                       -
                 235
        235
Unallocated
                       -
                  401
            401
 
                       -
                 515
        515
Total
 $               562
 $            6,088
 $      6,650
 
 $               494
 $            5,993
 $  6,487
 
The following tables roll forward the balance of the ALLL by portfolio segment for the three and six month periods ended June 30, 2012 and 2011, respectively (in thousands):
 
 
15

 

 

 
Balance at
March 31, 2012
Charge-offs
Recoveries
Provision
Balance at
June 30, 2012
Real estate loans:
         
     Residential
 $         753
 $              -
 $              -
 $         33
 $         786
     Commercial and agricultural
         4,336
                 -
                6
            63
         4,405
     Construction
              16
                 -
                 -
              3
              19
Consumer
              96
             (16)
                7
            21
            108
Other commercial and agricultural loans
            671
                 -
                3
            11
            685
State and political
     
 
 
  subdivision loans
            245
                 -
                 -
              1
            246
Unallocated
            428
                 -
                 -
          (27)
            401
Total
 $      6,545
 $          (16)
 $           16
 $       105
 $      6,650
           
 
Balance at
December 31, 2011
Charge-offs
Recoveries
Provision
Balance at
June 30, 2012
Real estate loans:
         
     Residential
 $         805
 $          (49)
 $              -
 $         30
 $         786
     Commercial and agricultural
         4,132
               (2)
                6
          269
         4,405
     Construction
              15
                 -
                 -
              4
              19
Consumer
            111
             (24)
              16
              5
            108
Other commercial and agricultural loans
            674
                 -
                6
              5
            685
State and political
         
  subdivision loans
            235
                 -
                 -
            11
            246
Unallocated
            515
                 -
                 -
        (114)
            401
Total
 $      6,487
 $          (75)
 $           28
 $       210
 $      6,650
           
 
Balance at
March 31, 2011
Charge-offs
Recoveries
Provision
Balance at
June 30, 2011
Real estate loans:
         
     Residential
 $         921
 $          (41)
 $              -
 $     (202)
 $         678
     Commercial and agricultural
         3,698
             (12)
                 -
          226
         3,912
     Construction
              13
                 -
                 -
               -
              13
Consumer
              87
             (17)
              12
            27
            109
Other commercial and agricultural loans
            901
                 -
                3
        (192)
            712
State and political
         
  subdivision loans
            139
                 -
                 -
          (20)
            119
Unallocated
            309
                 -
                 -
          311
            620
Total
 $      6,068
 $          (70)
 $           15
 $       150
 $      6,163
           
 
Balance at
December 31, 2010
Charge-offs
Recoveries
Provision
Balance at
June 30, 2011
Real estate loans:
         
     Residential
 $         969
 $        (101)
 $              -
 $     (190)
 $         678
     Commercial and agricultural
         3,380
             (29)
                 -
          561
         3,912
     Construction
              22
                 -
                 -
            (9)
              13
Consumer
            108
             (33)
              29
              5
            109
Other commercial and agricultural loans
            983
                 -
                7
        (278)
            712
State and political
         
  subdivision loans
            137
                 -
                 -
          (18)
            119
Unallocated
            316
                 -
                 -
          304
            620
Total
 $      5,915
 $        (163)
 $           36
 $       375
 $      6,163

 
 
16

 
 
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.
 
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. The following factors experienced changes during the first six 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 commercial real estate due to the increase in the Company’s internal watch list for commercial real estate loans since December 31, 2011.
·  
The qualitative factors for changes in industry conditions were increased for agricultural real estate and other agricultural loans due to decreases in milk prices from December 31, 2011 to June 30, 2012.
 
 
 
17

 
 
During the second quarter of 2012, there were no significant changes in any qualitative factor. As a result, the change in the allocation of the allowance from March 31, 2012, is mainly attributable to the changes in the loan portfolio balances since that date.

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 June 30, 2012 and December 31, 2011, the Bank holds $4,187,000 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 the first and second quarters of 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 second quarter of 2012 and has reinstituted the dividend in 2012.

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 and six months ended June 30, 2012 and 2011, respectively (in thousands):

 
18

 


 
Three Months Ended
Six Months Ended
 
 June 30,
 June 30,
 
2012
2011
2012
2011
Service cost
 $               54
 $      71
 $             167
 $             185
Interest cost
                   35
      87
                174
                226
Expected return on plan assets
                (80)
  (130)
            (286)
              (336)
Net amortization and deferral
                   52
      10
                 68
                  26
         
Net periodic benefit cost
 $               61
 $      38
 $             123
 $             101
 
The Company expects to contribute $750,000 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 $132,000 and $124,000 for the six months ended June 30, 2012 and 2011, respectively. For the three months ended June 30, 2012 and 2011, contributions by the Company totaled $80,000 and $74,000, 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.  At June 30, 2012 and December 31, 2011, an obligation of $996,000 and $1,030,000, respectively, was included in other liabilities for this plan in the consolidated balance sheet. Amounts included in interest expense on the deferred amounts totaled $8,000 and $12,000 for the six months ended June 30, 2012 and 2011, respectively.
 
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.  A total of 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 six months ended June 30, 2012 and 2011, 3,808 and 3,968 shares of restricted stock were awarded and 5,222 and 5,502 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 $66,000 and $73,000 for the six months ended June 30, 2012 and 2011, respectively. For the three months ended June 30, 2012 and 2011, compensation expense totaled $33,000 and $36,000, respectively.
 
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 June 30, 2012 and December 31, 2011, an obligation of $855,000 and $778,000, respectively, was included in other liabilities for this plan in the consolidated balance sheet.  Expenses related to this plan totaled $47,000 and $31,000 for the six months ended June 30, 2012 and 2011, respectively. For the three months ended June 30, 2012 and 2011, expenses totaled $24,000 and $16,000, respectively.

 
19

 
 
Note 8 – 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.
 
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.
 
 
20

 
 
The following tables present the assets and liabilities reported on the consolidated balance sheet at their fair value on a recurring basis as of June 30, 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.

   
June 30, 2012
   
Level I
 
Level II
 
Level III
   
Total
Fair value measurements on a recurring basis:
                 
Assets
                 
  Securities available for sale:
                 
     U.S. Agency securities
 
 $                -
 
 $             146,364
 
 $                    -
   
 $             146,364
     Obligations of state and
                 
        political subdivisions
 
                   -
 
98,147
 
                       -
   
98,147
     Corporate obligations
 
                   -
 
11,046
 
                       -
   
11,046
     Mortgage-backed securities in
                 
       government sponsored entities
 
                   -
 
66,194
 
                       -
   
66,194
     Equity securities in financial
                 
       institutions
 
           1,380
 
                            -
 
                       -
   
1,380
Liabilities
                 
   Trust Preferred Interest Rate Swap
 
                   -
 
(283)
 
                       -
   
(283)

   
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 June 30, 2012 and December 31, 2011 are included in the table below (in thousands):

 
June 30, 2012
 
 
Level 1
Level II
Level III
Total
         
Impaired Loans
 $                -
 $                         -
 $            7,721
 $                 7,721
Other real estate owned
                   -
                            -
742
742
         
 
December 31, 2011
 
 
Level 1
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.

Quantitative Information about Level 3 Fair Value Measurements
 
Fair Value at June 30, 2012
 
Valuation Technique(s)
Unobservable input
Range
Impaired Loans
 $      5,295
 
Discounted Cash Flows
Probability of Default
0%
       
Change in interest rates
0-7%
           
 
         2,426
 
Appraised Collateral Values
Discount for time since appraisal
0-20%
       
Selling costs
0%-10%
       
Holding period
0 - 18 months
           
Other real estate owned
            742
 
Appraised Collateral Values
Discount for time since appraisal
0-20%
       
Selling costs
6%-10%
       
Holding period
0 - 18 months

 
 
22

 

The fair values of the Company’s financial instruments are as follows (in thousands):

 
Carrying
         
June 30, 2012
Amount
Fair Value
Level I
Level II
Level III
Total
Financial assets:
           
Cash and due from banks
 $    17,768
 $    17,768
 $    17,768
 $              -
 $              -
 $    17,768
Available-for-sale securities
     323,131
     323,131
         1,380
     321,751
                 -
     323,131
Net loans
     490,482
     539,268
                 -
                 -
     539,268
     539,268
Bank owned life insurance
       13,919
       13,919
       13,919
                 -
                 -
       13,919
Regulatory stock
         4,461
         4,461
         4,461
                 -
                 -
         4,461
Accrued interest receivable
         3,800
         3,800
         3,800
                 -
                 -
         3,800
             
Financial liabilities:
           
Deposits
 $  738,767
 $  744,787
 $  446,307
 $              -
 $  298,480
 $  744,787
Borrowed funds
       47,066
       44,909
                 -
       44,909
                 -
       44,909
Trust preferred interest rate swap
            283
            283
                 -
            283
                 -
            283
Accrued interest payable
         1,222
         1,222
1,222
                 -
                 -
         1,222
 
       
 
Carrying
   
December 31, 2011
Amount
Fair Value
 
Financial assets: