MID PENN BANCORP, INC. SHAREHOLDER LETTER Dear Shareholder: I am pleased to present the 2003 Annual Report for Mid Penn Bancorp, Inc. During 2003, we experienced the lowest interest rate levels in 45 years, resulting in opportunities and challenges for your Bank. While operating in a challenging economic environment, we were still able to provide a solid year of performance. Net income for the year 2003 of $4,615,000 increased from $4,495,000 the prior year, a gain of 2.7%. Earnings per share of $1.45 increased from $1.41 the prior year. Increased earnings were favorably impacted by an increase in noninterest income from $2,022,000 to $2,707,000, an increase of 33.8% as service charges on deposits, investment security gains and gains on mortgage loan origination all contributed to the increase in noninterest income. Total assets as of December 31, 2003, were $373,466,000 an increase of $10,182,000 over the prior year. Loans of $233,627,000 increased from $223,203,000 the prior year. The growth rate in loans of 4.67% is lower than we have experienced in several years and is primarily explained by a weaker economy, lower demand for loans, and substantial loan refinancings. Stockholders’ equity of $37,361,000 increased by 6% over the prior year-end with average equity to average assets of 10% as of year end. This very strong capital position combined with the current favorable tax treatment of dividends resulted in a special dividend of $1.00 per share declared on January 28, 2004. We have received from shareholders a very favorable response to the special dividend. Mid Penn Bancorp, Inc. (AMEX - MBP) share price as of December 31, 2003 was $24.00 compared to $22.00 as of December 31, 2002, an increase of 9.09%. Shareholders received a 5% stock dividend and an $ .80 cash dividend resulting in a strong return for the year. Your Bank continues to invest in technology to allow us to provide a full range of competitive products and services. In the past year, we have installed a new mainframe computer, a check image system and expanded our wide area network. With these enhancements, we are prepared for future growth and can continue to offer the full range of products and services our customers expect. Mid Penn is looking forward to establishing its twelfth branch at the new Market Square Plaza, 17 North Second Street in Harrisburg. We are excited about participating in the resurgence in downtown Harrisburg and feel that we can experience success in expanding relationships with the business community with our local presence and local decision making. The new branch will open in early 2005. Mid Penn has also entered into a contract for the purchase of a site in the Capital Region to establish our thirteenth branch. Final approvals are being obtained, and a more detailed announcement will be provided in the coming months. The Capital Region has been a significant contributor to our growth, and we anticipate further expansion in the Capital Region in the coming years. In November 2003, A. James “Jim” Durica was appointed by our Board of Directors as a new board member. Jim is a CPA and meets the requirements of a financial expert under the Sarbanes-Oxley Act. Jim will serve as Audit Committee Chairman beginning in May 2004. We see continuing opportunities for your Bank in the coming years as larger bank consolidation continues and the economy expands. Both of these factors are favorable for a community bank like your Bank that provides high quality service, local decisions and support for the communities we serve. Thank you for your support and confidence. Please contact me at (717) 692-2133 or e-mail me at adakey@midpennbank.com if I can be of assistance to you in any way. Sincerely, Alan W. Dakey President and CEO MID PENN BANCORP, INC. FINANCIAL HIGHLIGHTS AASS OOFF AANNDD FFOORR YYEEAARRSS EENNDDEEDD DDEECCEEMMBBEERR 3311,, 22000033 AANNDD 22000022 (Dollars in thousands, except per share data.) Total Assets .......................................................................................................... Total Deposits...................................................................................................... Net Loans.............................................................................................................. Total Investments and Interest Bearing Balances .................................... Stockholders' Equity ......................................................................................... Net Income ........................................................................................................... Earnings Per Share ............................................................................................ Cash Dividend Per Share ................................................................................. Book Value Per Share ........................................................................................ $ Return on Average Stockholders’ Equity ..................................................... Return on Average Assets ................................................................................ Net Interest Margin ........................................................................................... Nonperforming Loans to Total Loans ........................................................... Mid Penn Bancorp, Inc. Stockholders' Information 2003 373,466 288,338 229,086 124,011 37,361 4,615 1.45 .79 11.72 12.69% 1.25% 3.63% 1.18% 2002 363,284 274,703 218,302 124,346 35,204 4,495 1.41 .76 11.04 13.60% 1.32% 3.91% 1.23% Percent Change +2.80% +4.96% +4.94% -0.27% +6.13% +2.67% +2.84% +3.95% +6.16% -6.69% -5.30% -7.16% -4.07% Market Value Per Share............................................................ $ 2003 2002 High 22.00 23.50 24.25 24.35 Low 21.00 21.25 21.10 22.00 High 19.00 18.55 19.00 23.70 Low 18.01 17.75 17.75 18.50 Quarter 1st 2nd 3rd 4th Market Value Information: The market share information was provided by the American Stock Exchange, New York, NY. Mid Penn Bancorp, Inc. common stock trades on the American Stock Exchange under the symbol: MBP. Prices previous to the 5% stock dividend are unadjusted. Transfer Agent: Wells Fargo Shareholder Services, P.O. Box 64854, St. Paul, MN 55164-0854. Phone: 1-800-468-9716. Number of Stockholders: At December 31, 2003, there were 1,023 stockholders. Dividends: A dividend of $.20 per share was paid during each quarter of 2003 and 2002. Mid Penn Bancorp, Inc. plans to continue a quarterly dividend payable in February, May, August and November. Dividend Reinvestment and Stock Purchases: Stockholders of Mid Penn Bancorp, Inc. may acquire additional shares of common stock by reinvesting their cash dividends under the Dividend Reinvestment Plan without paying a brokerage fee. Voluntary cash contributions may also be made under the Plan. For additional information about the Plan, contact the Transfer Agent. Form 10-K: A Copy of Mid Penn Bancorp, Inc.'s Annual Report on Form 10-K, as filed with the Securities and Exchange Commission, will be provided to stockholders without charge upon written request to: Secretary, Mid Penn Bancorp, Inc., 349 Union Street, Millersburg, PA 17061. Annual Meeting: The Annual Meeting of the Stockholders of Mid Penn Bancorp, Inc. will be held at 10:00 a.m. on Tuesday, April 27, 2004, at 349 Union Street, Millersburg, Pennsylvania. Accounting, Auditing and Internal Control Complaints: internal accounting controls or auditing matters is available at Mid Penn Bank's website: www.midpennbank.com Information on how to report a complaint regarding accounting, 2 MID PENN BANCORP, INC. UNAUDITED GRAPHS Total Assets (in millions) Total Deposits (in millions) 363.3 373.5 330.6 315.6 287.5 380 350 320 290 260 230 200 170 140 110 80 50 280 260 240 220 200 180 160 140 120 100 80 60 288.3 274.4 254.1 231.4 217.8 1999 2000 2001 2002 2003 1999 2000 2001 2002 2003 Net Income (in millions) Total Stockholders Equity (in millions) 4.62 4.50 4.23 3.88 3.95 4.5 4.0 3.5 3.0 2.5 2.0 37.4 35.2 31.7 29.6 26.6 35 30 25 20 15 10 1999 2000 2001 2002 2003 1999 2000 2001 2002 2003 Book Value Per Share (in dollars) Earnings Per Share (in dollars) 11.72 11.04 9.30 9.94 8.32 12 11 10 9 8 7 6 5 4 3 2 1.45 1.41 1.33 1.22 1.24 1.5 1.4 1.3 1.2 1.1 1.0 1999 2000 2001 2002 2003 1999 2000 2001 2002 2003 3 MID PENN BANCORP, INC. INDEPENDENT AUDITORS REPORT The Board of Directors and Stockholders Mid Penn Bancorp, Inc. Millersburg, Pennsylvania: We have audited the accompanying consolidated balance sheet of Mid Penn Bancorp, Inc. and subsidiaries (collectively, “Corporation”) as of December 31, 2003 and 2002, and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 2003. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mid Penn Bancorp, Inc. and subsidiaries as of December 31, 2003 and 2002, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. PARENTE RANDOLPH, PC Williamsport, Pennsylvania January 16, 2004 4 MID PENN BANCORP, INC. CONSOLIDATED BALANCE SHEETS DDEECCEEMMBBEERR 3311,, 22000033 AANNDD 22000022 (Dollars in thousands, except share data) 2003 2002 ASSETS Cash and due from banks ............................................................................. Interest-bearing balances with other financial institutions............. Available-for-sale investment securities.................................................. Loans ................................................................................................................. Less: Unearned income.............................................................................. Allowance for loan losses................................................................ Net loans ......................................................................................... Bank premises and equipment, net .......................................................... Foreclosed assets held for sale.................................................................... Accrued interest receivable ......................................................................... Deferred income taxes .................................................................................. Cash surrender value of life insurance..................................................... Other assets ..................................................................................................... Total Assets LIABILITIES AND STOCKHOLDERS' EQUITY Deposits: Noninterest-bearing demand.............................................................. Interest-bearing demand...................................................................... Money market ......................................................................................... Savings...................................................................................................... Time ........................................................................................................... Total Deposits Short-term borrowings ................................................................................. Accrued interest payable.............................................................................. Other liabilities .............................................................................................. Long-term debt................................................................................................ Total Liabilities Stockholders' Equity: Common stock, par value $1 per share; authorized 10,000,000 shares; 3,207,912 shares issued in 2003 and 3,056,501 shares in 2002 ............................. Additional paid-in capital .................................................................... Retained earnings.................................................................................. Accumulated other comprehensive income.................................... Treasury stock at cost (19,408 and 18,622 shares in 2003 and 2002, respectively) .................................................................... Stockholders' Equity, Net Total Liabilities and Stockholders' Equity $ $ $ 7,456 69,918 54,093 233,627 (1,549) (2,992) 229,086 3,920 1,117 1,763 303 4,953 857 373,466 30,762 36,917 45,457 27,754 147,448 288,338 9,688 1,045 1,350 35,684 336,105 3,208 23,472 9,805 1,415 (539) 37,361 373,466 $ The accompanying notes are an integral part of these consolidated financial statements. 8,095 65,487 58,859 223,203 (1,850) (3,051) 218,302 3,317 781 2,007 456 4,743 1,237 363,284 28,011 33,645 40,515 26,705 145,827 274,703 18,156 1,187 1,651 32,383 328,080 3,057 20,368 10,944 1,357 (522) 35,204 363,284 5 MID PENN BANCORP, INC. CONSOLIDATED STATEMENT OF INCOME FFOORR YYEEAARRSS EENNDDEEDD DDEECCEEMMBBEERR 3311,, 22000033,, 22000022 AANNDD 22000011 (Dollars in thousands, except share data) INTEREST INCOME Interest and fees on loans............................................................ Interest on interest-bearing balances ...................................... Interest and dividends on investment securities: U.S. Treasury and government agencies .............................. State and political subdivision obligations, tax-exempt. Other securities.......................................................................... Interest on federal funds sold and securities purchased under agreement to resell........................................................ Total Interest Income INTEREST EXPENSE Interest on deposits....................................................................... Interest on short-term borrowings............................................ Interest on long-term debt........................................................... Total Interest Expense Net Interest Income PROVISION FOR LOAN LOSSES......................................................... Net Interest Income After Provision for Loan Losses NONINTEREST INCOME Trust department income ............................................................ Service charges on deposits........................................................ Investment securities gains (losses), net ................................ Gain on sale of loans ..................................................................... Income on cash surrender value of life insurance ................ Other income................................................................................... Total Noninterest Income NONINTEREST EXPENSE Salaries and employee benefits.................................................. Occupancy expense, net................................................................ Equipment expense ....................................................................... Pennsylvania bank shares tax expense ................................... FDIC insurance premium............................................................. Marketing and advertising ......................................................... Loss on mortgage loan sales ....................................................... Other real estate expense............................................................. Other expenses................................................................................ Total Noninterest Expense $ 2003 15,470 2,099 559 1,783 64 9 19,984 6,117 128 2,189 8,434 11,550 290 11,260 202 1,227 261 45 210 762 2,707 4,496 423 602 266 45 100 146 135 1,886 8,099 2002 15,863 2,703 659 2,001 79 47 21,352 7,807 50 2,069 9,926 11,426 425 11,001 188 1,053 60 51 239 431 2,022 3,978 384 514 259 46 115 79 294 1,589 7,258 2001 16,340 3,092 1,349 1,806 193 84 22,864 9,192 441 2,102 11,735 11,129 500 10,629 158 921 (14) 16 216 548 1,845 4,012 392 461 262 44 127 125 43 1,560 7,026 INCOME BEFORE PROVISION FOR INCOME TAXES .................. Provision for income taxes.......................................................... Net Income Earnings Per Share Weighted Average Number of Shares Outstanding 5,868 1,253 4,615 1.45 3,188,504 $ $ 5,765 1,270 4,495 1.41 3,188,333 5,448 1,218 4,230 1.33 3,190,802 Earnings per share information has been restated to reflect the retroactive effect of a five percent stock dividend in the second quarter of 2003. The accompanying notes are an integral part of these consolidated financial statements. 6 MID PENN BANCORP, INC. CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS EQUITY FFOORR YYEEAARRSS EENNDDEEDD DDEECCEEMMBBEERR 3311,, 22000033,, 22000022 AANNDD 22000011 (Dollars in thousands, except share data) Additional Accumulated Other Common Paid-in Retained Comprehensive Treasury Stock Capital Earnings Income (Loss) Stock Total Balance, December 31, 2000....................................................... $ 3,057 20,368 7,078 (344) (533) 29,626 Comprehensive income: Net income............................................................................. Change in net unrealized gain (loss) on securities available for sale, net of reclassification adjustment and tax effects ........................................... Total comprehensive income Cash dividends ($ .80 per share, historical) ...................... Sale of treasury stock (8 shares) ......................................... 0 0 0 0 0 0 0 0 4,230 0 0 288 (2,428) 0 0 0 0 0 0 0 4,230 288 4,518 (2,428) 0 Balance, December 31, 2001 ....................................................... 3,057 20,368 8,880 (56) (533) 31,716 Comprehensive income: Net income............................................................................. Change in net unrealized gain (loss) on securities available for sale, net of reclassification adjustment and tax effects ........................................... Total comprehensive income Cash dividends ($ .80 per share, historical) ...................... Sale of treasury stock (443 shares) ..................................... 0 0 0 0 0 0 0 0 4,495 0 0 1,413 (2,431) 0 0 0 0 0 0 11 4,495 1,413 5,908 (2,431) 11 Balance, December 31, 2002 ....................................................... 3,057 20,368 10,944 1,357 (522) 35,204 Comprehensive income: Net income............................................................................. Change in net unrealized gain (loss) on securities available for sale, net of reclassification adjustment and tax effects ........................................... Total comprehensive income Cash dividends ($ .80 per share, historical) ...................... 5% stock dividend (additional 151,411 shares) .................. Purchase of treasury stock (786 shares)............................ 0 0 0 151 0 0 0 0 3,104 0 4,615 0 (2,499) (3,255) 0 0 58 0 0 0 0 0 0 0 (17) 4,615 58 4,673 (2,499) 0 (17) Balance, December 31, 2003....................................................... $ 3,208 23,472 9,805 1,415 (539) 37,361 The accompanying notes are an integral part of these consolidated financial statements. 7 MID PENN BANCORP, INC. CONSOLIDATED STATEMENT OF CASH FLOWS FFOORR YYEEAARRSS EENNDDEEDD DDEECCEEMMBBEERR 3311,, 22000033,, 22000022 AANNDD 22000011 (Dollars in thousands) Operating Activities: Net income........................................................................................ $ Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses....................................................... Depreciation............................................................................. Increase in cash surrender value of life insurance ....... Investment securities (gains) losses, net ......................... (Gain) loss on sale of foreclosed assets............................. Gain on sale of loans.............................................................. Deferred income taxes........................................................... Change in accrued interest receivable.............................. Change in other assets .......................................................... Change in accrued interest payable................................... Change in other liabilities ................................................... Net Cash Provided By Operating Activities Investing Activities: Net increase in interest-bearing balances ............................... Proceeds from the maturity of investment securities......... Proceeds from the sale of investment securities................... Purchases of investment securities .......................................... Proceeds from sale of loans ......................................................... Net increase in loans ..................................................................... Purchases of bank premises and equipment........................... Proceeds from the sale of foreclosed assets ............................ Capitalized additions - foreclosed assets ................................. Net Cash Used In Investing Activities Financing Activities: Net increase in deposits .............................................................. Net (decrease) increase in short-term borrowings ............... Cash dividends paid ...................................................................... Long-term debt repayment.......................................................... (Purchase) sale of treasury stock .............................................. Long-term borrowings.................................................................. Net Cash Provided By Financing Activities Net (decrease) increase in cash and due from banks .................... Cash and due from banks at January 1 .............................................. Cash and due from banks at December 31........................................ $ Supplemental Disclosures of Cash Flow Information: Interest paid..................................................................................... $ Income taxes paid........................................................................... $ Supplemental Noncash Disclosures: Loan charge-offs ............................................................................. $ Transfers to foreclosed assets held for sale ............................. $ 2003 4,615 290 426 (210) (261) (20) (45) 123 244 380 (142) (301) 5,099 (4,431) 15,635 5,793 (16,313) 1,710 (13,530) (1,029) 475 0 (11,690) 13,635 (8,468) (2,499) (5,199) (17) 8,500 5,952 (639) 8,095 7,456 8,576 1,410 349 791 2002 4,495 425 340 (239) (60) 54 (51) (147) 84 (712) (105) 307 4,391 (12,445) 8,163 3,176 (12,657) 983 (19,969) (262) 1,311 (163) (31,863) 20,598 8,546 (2,431) (185) 11 0 26,539 (933) 9,028 8,095 10,031 1,427 302 290 The accompanying notes are an integral part of these consolidated financial statements. 8 2001 4,230 500 336 (216) 14 (16) (16) (116) 411 (86) (254) 319 5,106 (10,666) 23,455 11,284 (15,780) 1,128 (21,884) (150) 81 0 (12,532) 22,697 (13,128) (2,428) (1,673) 0 5,000 10,468 3,042 5,986 9,028 11,989 1,250 489 1,688 MID PENN BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2003 (1 ) Basis of Presentation The accompanying consolidated financial statements include the accounts of Mid Penn Bancorp, Inc. and its wholly-owned subsidiaries Mid Penn Bank (“Bank”), Mid Penn Investment Corporation and Mid Penn Insurance Services, LLC, (collectively, “MPB”). All significant intercompany balances and transactions have been eliminated in consolidation. (2) Nature of Business The Bank engages in a full-service commercial banking and trust business, making available to the community a wide range of financial services, including, but not limited to, installment loans, mortgage and home equity loans, secured and unsecured commercial and consumer loans, lines of credit, construction financing, farm loans, community development loans, loans to non-profit entities and local government loans and various types of time and demand deposits, including but not limited to, checking accounts, savings accounts, clubs, money market deposit accounts, certificates of deposit and IRAs. In addition, the Bank provides a full range of trust services through its Trust Department. Deposits are insured by the Federal Deposit Insurance Corporation (FDIC) to the extent provided by law. The financial services are provided to individuals, partnerships, non-profit organizations and corporations through its eleven offices located in the northern portion of Dauphin County, Swatara Township in the lower portion of Dauphin County, the southern portion of Northumberland County, the western portion of Schuylkill County and Hampden Township in Cumberland County. Mid Penn Investment Corporation is engaged in investing activities. Mid Penn Insurance Services, LLC provides a range of personal and investment insurance products. (3) Summary of Significant Accounting Policies The accounting and reporting policies of MPB conform with accounting principles generally accepted in the United States of America and to general practice within the financial industry. The following is a description of the more significant accounting policies. (a) Use of Estimates The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. A material estimate that is particularly susceptible to significant change relates to the determination of the allowance for loan losses. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance for loan losses. Such agencies may require the Bank to recognize changes to the allowance based on their judgments about information available to them at the time of their examination. Because of these factors, it is reasonably possible that the allowance for loan losses may change materially in the near term. (b) Investment Securities Investments are accounted for as follows: Available-for-Sale Securities - includes debt and restricted equity securities. Debt securities are reported at fair value, with unrealized holding gains and losses excluded from earnings and reported, net of deferred income taxes, as a component of accumulated other comprehensive income (loss) within stockholders’ equity. Realized gains and losses on sales of investment securities are computed on the basis of specific identification of the cost of each security. Restricted equity securities are carried at cost and evaluated for impairment. (c) Loans Interest on loans is recognized on a method which approximates a level yield basis over the life of the loans. The accrual of interest on loans, including impaired loans, is discontinued when principal or interest has consistently been in default for a period of 90 days or more, or because of a deterioration in the financial condition of the borrower, 9 MID PENN BANCORP, INC. ANNUAL REPORT TO THE SHAREHOLDERS payment in full of principal or interest is not expected. Interest income is subsequently recognized only to the extent cash payments are received. The placement of a loan on the nonaccrual basis for revenue recognition does not necessarily imply a potential charge-off of loan principal. Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment of the yield of the related loan. (d) Allowance for Loan Losses The Bank's methodology for determining the allowance for loan losses establishes both a specific and a general component. The specific portion of the allowance represents the results of analysis of individual "watch list" loans (commercial, residential and consumer loans). The individual commercial loans are risk rated with specific attention to estimated loss exposure. Historical loan loss rates are applied to "problem" consumer credits, adjusted to reflect current conditions. Specific regular reviews of credits exceeding $500,000 are performed to monitor the major portfolio risk. The Bank analyzes all commercial loans in excess of $10,000 that are rated as watch list credits. Potential credit problems are monitored to determine whether specific loans are impaired, with impairment normally measured by reference to borrowers' collateral values and estimated cash flows. The general portion of the allowance for loan losses represents the results of measuring potential losses inherent in the portfolio that are not identified in the specific allowance analysis. This general portion is determined using historical loan loss experience adjusted by assessing changes in the Bank's underwriting criteria, growth and/or changes in the mix of loans originated, industry concentrations and evaluations, lending management changes, comparisons of certain factors to peer group banks and changes in economic conditions. Management believes the allowance for loan losses is adequate. Identification of specific losses is an ongoing process using available information. Specifically, quarterly management meetings to review "problem" loans are utilized to determine a plan for collection and, if necessary, a recommendation to the Board for loss. Future additions to the allowance for loan losses through a provision for loan losses will be made based on identified changes in the above factors coupled with loss experience. Various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses. These agencies may require the Bank to recognize changes to the allowance based on their judgment about information available to them at the time of their examinations. In addition, the Bank's auditors also review the Bank's methodology utilized in determining the adequacy of the allowance for loan losses. (e) Bank Premises and Equipment Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is provided on the straight-line basis. Maintenance and repairs are charged to expense when incurred. Gains and losses on dispositions are reflected in current operations. (f) Foreclosed Assets Held for Sale Foreclosed assets held for sale consist of real estate acquired through, or in lieu of, foreclosure in settlement of debt and are recorded at fair value at the date of transfer. Any valuation adjustments required at the date of transfer are charged to the allowance for loan losses. Subsequent to acquisition, foreclosed assets are carried at the lower of cost or fair value less costs of disposal, based upon periodic evaluations that consider changes in market conditions and development and disposition costs. Operating results from assets acquired in satisfaction of debt, including rental income less operating costs and gains or losses on the sale of or the periodic evaluation of foreclosed assets, are recorded in noninterest expense. (g) Income Taxes Certain items of income and expense are recognized in different accounting periods for financial reporting purposes than for income tax purposes. Deferred income tax assets and liabilities are provided in recognition of these timing differences at currently enacted income tax rates. As changes in tax laws or rates are enacted, deferred income tax assets and liabilities are adjusted through the provision for income taxes. (h) Marketing and Advertising Costs Marketing and advertising costs are expensed as incurred and were $100,000 in 2003, $115,000 in 2002 and $127,000 in 2001. 10 MID PENN BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT’D) (i) Pensions and Other Postretirement Benefit Plans Effective December 31, 2003, MPB adopted Statement of Financial Accounting Standards No. 132 (revised 2003), “Employers’ Disclosures about Pensions and Other Postretirement Benefits” (“Revised SFAS No. 132”). Revised SFAS No. 132 requires additional disclosures about defined benefit pension plans and other postretirement defined benefit plans. It does not change the measurement of recognition of those plans. Applicable prior year disclosures have been restated to conform to Revised SFAS No. 132 requirements. (j) Other Benefit Plan A funded contributory profit-sharing plan is maintained for substantially all employees. The cost of the Bank's profit-sharing plan is charged to current operating expenses and is funded annually. (k) Trust Assets and Income Assets held by the Bank in a fiduciary or agency capacity for customers of the Trust Department are not included in the consolidated financial statements since such items are not assets of the Bank. Trust income is recognized on the cash basis which is not materially different than if it were reported on the accrual basis. (l) Earnings Per Share Earnings per share is computed by dividing net income by the weighted average number of common shares outstanding during each of the years presented giving retroactive effect to stock dividends and stock splits. MPB’s basic and diluted earnings per share are the same since there are no potentially dilutive securities outstanding. (m) Statement of Cash Flows For purposes of cash flows, MPB considers cash and due from banks to be cash equivalents. (n) Reclassifications Certain prior year amounts have been reclassified to conform to the current year's classifications. (4) Comprehensive Income The components of other comprehensive income (loss) and related tax effects are as follows: (Dollars in thousands) Years Ended December 31, Unrealized holding gains on available-for-sale securities ................................... $ Less reclassification adjustment for (gains) losses realized in income .......... Net unrealized gains ...................................................................................................... Income tax expense ........................................................................................................ Net ...................................................................................................................................... $ 2003 349 (261) 88 (30) 58 2002 2,193 (60) 2,133 (720) 1,413 2001 422 14 436 (148) 288 (5) Restrictions on Cash and Due from Bank Accounts The Bank is required to maintain reserve balances with the Federal Reserve Bank of Philadelphia. The amounts of those required reserve balances were $549,000 at December 31, 2003 and $500,000 at December 31, 2002. (6) Investment Securities At December 31, 2003 and 2002, amortized cost, fair value, and unrealized gains and losses on investment securities are as follows: (Dollars in Thousands) December 31, 2003 Available-for-sale securities: U.S. Treasury and U.S. Amortized Cost Unrealized Gains Unrealized Losses Fair Value government agencies ................................... $ 10,564 Mortgage-backed U.S. government agencies .................................... State and political subdivision obligations ................................ Restricted equity securities ............................ 4,808 34,447 2,130 51,949 $ 191 64 1,972 0 2,227 49 31 3 0 83 10,706 4,841 36,416 2,130 54,093 11 MID PENN BANCORP, INC. ANNUAL REPORT TO THE SHAREHOLDERS (Dollars in Thousands) December 31, 2002 Available-for-sale securities: U.S. Treasury and U.S. Amortized Cost Unrealized Unrealized Gains Losses Fair Value government agencies ................................... $ Mortgage-backed U.S. government agencies .................................... State and political subdivision obligations ................................ Restricted equity securities ............................ $ 9,538 5,512 39,388 2,372 56,810 291 134 1,647 0 2,072 0 9 14 0 23 9,829 5,637 41,021 2,372 58,859 Estimated fair values of debt securities are based on quoted market prices, where applicable. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments, adjusted for differences between the quoted instruments and the instruments being valued. Restricted equity securities consist of stock in the Federal Home Loan Bank of Pittsburgh and Atlantic Central Bankers Bank and do not have a readily determinable fair value for purposes of SFAS No. 115, because their ownership is restricted and they lack a market. Investment securities having a fair value of $26,803,000 at December 31, 2003 and $26,909,000 at December 31, 2002, were pledged to secure public deposits and other borrowings. Gross gains (losses) from sales of investment securities, as determined on the basis of specific identification of the adjusted cost of each security sold, amounted to $261,000 in 2003, $60,000 in 2002 and ($14,000) in 2001. The proceeds from sales of investment securities were $5,793,000 in 2003, $3,176,000 in 2002 and $11,284,000 in 2001. Management reviewed the investment securities that resulted in unrealized losses of $83,000 at December 31, 2003 and $23,000 at December 31, 2002 and determined that the securities were not other-than-temporarily impaired. The following is a schedule of the maturity distribution of investment securities at amortized cost and fair value at December 31, 2003 and 2002: (Dollars in thousands) Due in 1 year or less ................................................................................ Due after 1 year but within 5 years .................................................... Due after 5 years but within 10 years ................................................ Due after 10 years.................................................................................... Mortgage-backed securities ................................................................. Restricted equity securities................................................................. December 31, 2003 Fair Value 844 10,900 11,782 23,596 47,122 Amortized Cost 814 10,646 11,165 22,386 45,011 December 31, 2002 Fair Amortized Value Cost 3,280 3,264 10,269 9,802 10,453 9,978 26,848 25,882 50,850 48,926 4,808 2,130 51,949 4,841 2,130 54,093 5,512 2,372 56,810 5,637 2,372 58,859 $ $ (7) Loans A summary of loans at December 31, 2003 and 2002 is as follows: (Dollars in thousands) Commercial real estate, construction and land development...... Commercial, industrial and agricultural........................................... Real estate - residential ......................................................................... Consumer................................................................................................... 2003 $ 154,296 25,567 43,384 10,380 $ 233,627 2002 146,325 22,398 41,502 12,978 223,203 Net unamortized loan fees and costs of $167,000 in 2003 and $114,152 in 2002 were deducted from loans. 12 MID PENN BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT’D) Loans to Bank executive officers, directors, and corporations in which such executive officers and directors have beneficial interests as stockholders, executive officers, or directors aggregated approximately $3,275,000 at December 31, 2003 and $1,935,000 at December 31, 2002. New loans extended were $2,328,000 in 2003 and $177,000 in 2002. Net payments on these loans equalled $988,000 during 2003. Net draws on these loans exceeded repayments by $178,000 in 2002. These loans were made on substantially the same basis, including interest rates and collateral as those prevailing for comparable transactions with other borrowers at the same time. (8) Allowance for Loan Losses Changes in the allowance for loan losses for the years 2003, 2002, and 2001 are summarized as follows: (Dollars in thousands) Balance, January 1.................................................................................... Provision for loan losses........................................................................ Loans charged off.................................................................................... Recoveries on loans charged off.......................................................... Balance, December 31 ............................................................................. 2003 3,051 290 (409) 60 2,992 $ $ 2002 2,856 425 (302) 72 3,051 2001 2,815 500 (489) 30 2,856 The recorded investment in loans that are considered impaired amounted to $439,000 and $1,077,000 (all in nonaccrual) on December 31, 2003 and December 31, 2002, respectively. By definition, impairment of a loan is considered when, based on current information and events, it is probable that all amounts due will not be collected according to the contractual terms of the loan agreement. The allowance for loan losses related to loans classified as impaired amounted to approximately $40,000 at December 31, 2003 and $425,000 at December 31, 2002. All impaired loans at the end of 2003 and 2002 had related allowances. The average balances of these loans amounted to approximately $983,000, $1,361,000 and $1,293,000 for the years 2003, 2002 and 2001, respectively. The Bank recognizes interest income on impaired loans on a cash basis. The following is a summary of cash receipts on these loans and how they were applied in 2003, 2002 and 2001. (Dollars in thousands) Cash receipts applied to reduce principal balance ......................... Cash receipts recognized as interest income .................................. Total cash receipts................................................................................... 2003 4 0 4 $ $ 2002 122 1 123 2001 238 31 269 Loans which were past due 90 days or more for which interest continued to be accrued amounted to approximately $661,000 at December 31, 2003 and $350,000 at December 31, 2002. The Bank has no commitments to loan additional funds to borrowers with impaired or nonaccrual loans. (9) Bank Premises and Equipment At December 31, 2003 and 2002, bank premises and equipment are as follows: (Dollars in thousands) Land ............................................................................................................ Buildings ................................................................................................... Furniture and fixtures........................................................................... Less accumulated depreciation ........................................................... 2003 838 4,001 4,720 9,559 5,639 3,920 $ $ 2002 838 3,976 3,716 8,530 5,213 3,317 Depreciation expense was $426,000 in 2003, $340,000 in 2002 and $336,000 in 2001. (10) Deposits At December 31, 2003 and 2002, time deposits in denominations of $100,000 or more amounted to $24,598,000 and $24,831,000, respectively. Interest expense on such certificates of deposit amounted to approximately $873,000, $1,112,000 and $1,454,000 for the years ended December 31, 2003, 2002 and 2001, respectively. Time deposits at December 31, 2003, mature as follows: (in thousands) 2004, $61,535; 2005, $29,705; 2006, $19,769; 2007, $21,612; 2008, $12,364; thereafter, $2,463. 13 MID PENN BANCORP, INC. ANNUAL REPORT TO THE SHAREHOLDERS Deposits and other funds from related parties held by MPB at December 31, 2003 and 2002 amounted to approximately $4,727,000 and $5,807,000, respectively. (11) Short-term Borrowings Short-term borrowings as of December 31, 2003 and 2002 consisted of: (Dollars in thousands) Federal funds purchased........................................................................ Repurchase agreements ........................................................................ Treasury, tax and loan note .................................................................. Due to broker ............................................................................................ 2003 6,000 3,246 254 188 9,688 $ $ 2002 14,200 2,550 1,058 348 18,156 Federal funds purchased represent overnight funds. Securities sold under repurchase agreements generally mature between one day and one year. Treasury, tax and loan notes are open-ended interest bearing notes payable to the U.S. Treasury upon call. All tax deposits accepted by the Bank are placed in the Treasury note option account. The due to broker balance represents previous day balances transferred from deposit accounts under a sweep account agreement. The Bank also has unused lines of credit with several banks amounting to $1 million dollars at December 31, 2003. (12) Long-term Debt The Bank is a member of the Federal Home Loan Bank of Pittsburgh (FHLB) and through its membership, the Bank can access a number of credit products which are utilized to provide various forms of liquidity. As of December 31, 2003, the Bank had long-term debt in the amount of $35,684,000 outstanding to the FHLB consisting of a $5,000,000 three year fixed rate advance at 5.20% which will mature on March 12, 2004; a $87,000 ten year amortizing advance at 7.30% which will mature on April 5, 2004; a $5,000,000 seven year fixed rate advance at 6.21% convertible at FHLB’s option to a LIBOR adjustable rate after three years which will mature November 30, 2006; a $5,000,000 five year fixed rate advance at 3.08% which will mature May 7, 2008; a $5,000,000 ten year fixed rate advance at 6.42% convertible at FHLB’s option to a LIBOR adjustable rate after five years which matures December 3, 2009; a $1,000,000 ten year fixed rate advance with an interest rate of 7.06% maturing on December 9, 2009; a $1,000,000 ten year fixed rate advance with an interest rate of 7.24% which matures December 17, 2009; a $5,000,000 ten year fixed rate advance at 6.28% convertible at FHLB’s option to a LIBOR adjustable rate after two years which is due January 14, 2010; a $5,000,000 ten year fixed rate advance at 6.71% convertible at FHLB’s option to a LIBOR adjustable rate after three years which is due February 22, 2010; a $1,500,000 ten year fixed rate advance at 4.08% which matures July 3, 2013; a $2,000,000 ten year fixed rate advance at 4.75% which matures August 29, 2013; and a $97,000 amortizing loan at a rate of 6.71% which matures February 22, 2027. The aggregate amounts of maturities of long-term debt subsequent to December 31, 2003 are $5,087,000 (2004), $5,000,000 (2006), $5,000,000 (2008), $20,597,000 thereafter. Most of the Bank’s investments and mortgage loans are pledged to secure FHLB borrowings. (13) Pension and Other Postretirement Benefit Plans MPB has an unfunded noncontributory defined benefit pension plan for directors. The plan provides defined benefits based on years of service. MPB also has other postretirement benefit plans covering full-time employees. These health care and life insurance plans are noncontributory. The significant aspects of each plan are as follows: (a) Health Insurance For full-time employees who retire after at least 20 years of service, MPB will pay premiums for major medical insurance (as provided to active employees) for a period ending on the earlier of the date the participant obtains other employment where major medical coverage is available or the date of the participant's death; however, in all cases payment of medical premiums by MPB will not exceed five years. If the retiree becomes eligible for Medicare within the five year period beginning on his/her retirement date, the Bank may pay, at its discretion, premiums for 65 Special coverage or a similar supplemental coverage. After the five year period has expired, all MPB paid benefits cease; however, the retiree may continue coverage through the Bank at his/her own expense. 14 MID PENN BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT’D) (b) Life Insurance For full-time employees who retire after at least 20 years of service, MPB will provide term life insurance. The amount of coverage prior to age 65 will be three times the participant's annual salary at retirement or $50,000, whichever is less. After age 65, the life insurance coverage amount will decrease by 10% per year, subject to a minimum amount of $2,000. (c) Retirement Plan MPB has an unfunded defined benefit retirement plan for directors with benefits based on years of service. The adoption of this plan generated unrecognized prior service cost of $274,000, which is being amortized based on the expected future years of service of active directors. The following tables provide a reconciliation of the changes in the plans’ health and life insurance benefit obligations and fair value of plan assets for the years ended December 31, 2003 and 2002 and a statement of the funded status at December 31, 2003 and 2002: (Dollars in thousands) Change in benefit obligations: Benefit obligations, January 1 ........................................................................... Service cost ........................................................................................................ Interest cost ........................................................................................................... Actuarial loss (gain) ............................................................................................. Benefit payments ............................................................................................. Benefit obligations, December 31 ..................................................................... Change in fair value of plan assets: Fair value of plan assets, January 1 .................................................................. Employer contributions.................................................................................. Benefit payments ............................................................................................. Fair value of plan assets, December 31 ............................................................ (Dollars in thousands) Funded status: Excess of the benefit obligation over the value of plan assets............ Unrecognized transition obligation ........................................................... Unrecognized gain ........................................................................................... Net amount recognized................................................................................... $ $ $ $ $ $ 2003 2002 450 30 30 10 (19) 501 0 19 (19) 0 377 24 28 45 (24) 450 0 24 (24) 0 December 31, 2003 2002 (501) 133 (88) (456) (450) 147 (101) (404) Amount recognized in the consolidated balance sheet at December 31, 2003 and 2002 is as follows: (Dollars in thousands) Accrued benefit liability ................................................................................ $ 2003 (456) 2002 (404) The accumulated benefit obligation for health and life insurance plans was $501 and $450 at December 31, 2003 and 2002, respectively. 15 MID PENN BANCORP, INC. ANNUAL REPORT TO THE SHAREHOLDERS The components of net periodic postretirement benefit cost for 2003, 2002 and 2001 are as follows: (Dollars in thousands) Service cost ........................................................................................................ Interest cost....................................................................................................... Amortization of transition obligation ....................................................... Amortization of net gain ............................................................................... Net periodic postretirement benefit cost.................................................. $ $ 2003 30 30 15 (3) 72 2002 24 28 15 (4) 63 2001 20 24 15 (7) 52 Assumptions used in the measurement of MPB’s benefit obligations at December 31, 2003 and 2002 are as follows: Weighted-average assumptions: Discount rate ................................................................................... Rate of compensation increase .................................................. 2003 6.00% 5.00% 2002 6.75% 5.00% Assumptions used in the measurement of MPB’s net periodic benefit cost for the years ended December 31, 2003, 2002 and 2001 are as follows: Weighted-average assumptions: Discount rate................................................................................................ Rate of compensation increase ............................................................... 2003 6.75% 5.00% Assumed health care cost trend rates at at December 31, 2003, 2002 and 2001 are as follows: Health care cost trend rate assumed for next year ................................. Rate to which the cost trend rate is assumed to decline (the ultimate trend rate) ....................................................................................................... Year that the rate reaches the ultimate trend rate ................................. 2003 5.50% 5.50% 2004 2002 7.00% 5.00% 2002 6.00% 6.00% 2003 2001 7.00% 5.00% 2001 6.00% 6.00% 2002 Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects: (Dollars in thousands) Effect on total of service and interest cost ............................. Effect on postretirement benefit obligation .......................... One-Percentage Point Increase Decrease 7 50 $ $ 9 60 MPB expects to contribute $19,706 to its postretirement benefit plan in 2004. 16 MID PENN BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT’D) The following tables provide a reconciliation of the changes in the directors’ defined benefit plan’s benefit obligations and fair value of plan assets for the years ended December 31, 2003 and 2002 and a statement of the funded status at December 31, 2003 and 2002: (Dollars in thousands) Change in benefit obligations: December 31, 2003 2002 Benefit obligations, January 1...................................................................... Service cost................................................................................................... Interest cost.................................................................................................. Actuarial (gain) loss ................................................................................... Change in assumptions ............................................................................. Benefit payments........................................................................................ Benefit obligations, December 31................................................................ Change in fair value of plan assets: Fair value of plan assets, January 1............................................................. Employer contributions ............................................................................ Benefit payments........................................................................................ Fair value of plan assets, December 31 Funded status: Excess of the benefit obligation over the value of plan assets ........... Unrecognized prior-service cost.................................................................. Unrecognized loss (gain) ............................................................................... Net amount recognized.................................................................................. $ $ $ $ $ $ 563 20 37 (10) 46 (9) 647 0 9 (9) 0 (647) 52 35 (560) 502 23 35 (1) 13 (9) 563 0 9 (9) 0 (563) 79 1 (483) Amounts recognized in the consolidated balance sheet at December 31, 2003 and 2002 are as follows: (Dollars in thousands) Accrued benefit liability ............................................................................... Intangible asset ............................................................................................... Net amount recognized.................................................................................. $ $ 2003 (573) 13 (560) 2002 (489) 6 (483) The accumulated benefit obligation for the retirement plan was $573,000 and $489,000 at December 31, 2003 and 2002, respectively. Other plan information at December 31, 2003 and 2002 is as follows: (Dollars in thousands) Projected benefit obligation ......................................................................... Accumulated benefit obligation .................................................................. Fair value of plan assets ................................................................................. $ 2003 647 573 0 The components of net periodic pension cost for 2003, 2002 and 2001 are as follows: (Dollars in thousands) Service cost ....................................................................................................... Interest cost ...................................................................................................... Amortization of prior-service cost ............................................................. Net periodic pension cost.............................................................................. $ $ 2003 20 37 26 83 2002 563 429 0 2002 23 35 26 84 2001 21 32 26 79 Assumptions used in the measurement of MPB’s benefit obligations at December 31, 2003 and 2002 are as follows: Weighted-average assumptions: Discount rate ................................................................................... Change in consumer price index................................................ 2003 6.00% 4.00% 2002 6.75% 4.00% 17 MID PENN BANCORP, INC. ANNUAL REPORT TO THE SHAREHOLDERS Assumptions used in the measurement of MPB’s net periodic benefit cost for the years ended December 31, 2003, 2002 and 2001 are as follows: Weighted-average assumptions: Discount rate................................................................................................ Rate of compensation increase............................................................... MPB expects to contribute $11,187 to its pension plan in 2004. 2003 6.75% 4.00% 2002 7.00% 4.00% 2001 7.00% 5.00% The Bank is the owner and beneficiary of insurance policies on the lives of certain officers and directors which informally fund the retirement plan obligation. The aggregate cash surrender value of these policies was approximately $1,605,000 and $1,670,000 at December 31, 2003 and 2002, respectively. (14) Other Benefit Plans (a) Profit-Sharing The Bank has a funded contributory profit-sharing plan covering substantially all employees. The Bank’s contribution to the plan was $401,000 for 2003, $353,000 for 2002 and $362,000 for 2001. (b) Deferred Compensation Plans The Bank has an executive deferred compensation plan which allows an executive officer to defer bonus compensation for a specified period in order to provide future retirement income. At December 31, 2003 and 2002, the Bank has accrued a liability of approximately $82,000 and $56,000, respectively, for this plan. The Bank also has a directors’ deferred compensation plan which allows directors to defer receipt of monthly fees for a specified period in order to provide future retirement income. At December 31, 2003 and 2002, the Bank has accrued a liability of approximately $154,000 and $117,000, respectively, for this plan. The Bank is the owner and beneficiary of insurance policies on the lives of the participating executive officer and directors which informally fund the benefit obligations. The aggregate cash surrender value of these policies was approximately $1,564,000 and $1,362,000 at December 31, 2003 and 2002, respectively. (c) Salary Continuation Agreement The Bank maintains a Salary Continuation Agreement (Agreement) for an executive officer. The Agreement provides the executive officer with a fixed annual benefit. The benefit is payable beginning at age 65 for a period of 15 years. If the executive officer terminates employment before the normal retirement date for reasons other than death, the annual benefit payable will be based on the vesting schedule as defined in the Agreement. Upon death or a change in control of the Bank, the executive officer or his beneficiary is entitled to the full fixed annual benefit. At December 31, 2003 and 2002, the Bank has accrued a liability of approximately $129,000 and $100,000, respectively, for the Agreement. The expense related to the Agreement was $30,000 for 2003, $28,000 for 2002 and $26,000 for 2001. The Bank is the owner and beneficiary of an insurance policy on the life of the participating executive officer which informally funds the benefit obligation. The aggregate cash surrender value of this policy was approximately $836,000 and $802,000 at December 31, 2003 and 2002, respectively. (d) Employee Stock Ownership Plan The Bank has an Employee Stock Ownership Plan (ESOP) covering substantially all employees. Contributions to the ESOP are made at the discretion of the Board of Directors. Total expense related to the Bank’s contribution to the ESOP for 2003, 2002 and 2001 was $134,000, $118,000 and $121,000, respectively. The ESOP held 27,941 and 21,496 shares of MPB stock as of December 31, 2003 and December 31, 2002, respectively, all of which were allocated to plan participants. Shares held by the ESOP are considered outstanding for purposes of calculating earnings per share. Dividends paid on shares held by the ESOP are charged to retained earnings. (e) Other At December 31, 2003 and 2002, the Bank had Split Dollar Life Insurance arrangements with two executives for which the aggregate collateral assignment and cash surrender values are approximately $948,000 and $909,000, respectively. 18 MID PENN BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT’D) (15) Federal Income Taxes The following temporary differences gave rise to the deferred tax asset at December 31, 2003 and 2002: (Dollars in thousands) Deferred tax assets: Allowance for loan losses ............................................................. Benefit plans ................................................................................... Nonaccrual interest ....................................................................... Other items ...................................................................................... Total (Dollars in thousands) Deferred tax liabilities: Depreciation .................................................................................... Loan fees........................................................................................... Bond accretion ................................................................................ Unrealized gain on securities ..................................................... Total Deferred tax asset, net....................................................................... The provision for income taxes consists of the following: (Dollars in thousands) Current provision................................................................................ Deferred provision .............................................................................. Provision for income taxes............................................................... 2003 863 460 37 - 1,360 2003 (170) (134) (24) (729) (1,057) 303 2003 1,130 123 1,253 $ $ $ $ $ $ $ A reconciliation of income tax at the statutory rate to MPB's effective rate is as follows: (Dollars in thousands) Provision at the expected statutory rate ..................................... Effect of tax-exempt income............................................................ Nondeductible interest...................................................................... Other items ........................................................................................... Provision for income taxes............................................................... 2003 1,995 (752) 53 (43) 1,253 $ $ 2002 883 390 75 63 1,411 2002 (93) (132) (31) (699) (955) 456 2002 1,417 (147) 1,270 2002 1,960 (824) 73 61 1,270 2001 1,334 (116) 1,218 2001 1,852 (753) 83 36 1,218 (16) Regulatory Matters The Bank is subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. The regulations require the Bank to meet specific capital adequacy guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital classification is also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of Tier I capital (as defined in the regulations) to total average assets (as defined), and minimum ratios of Tier I and total capital (as defined) to risk-weighted assets (as defined). To be considered adequately capitalized (as defined) under the regulatory framework for prompt corrective action, the Bank must maintain minimum Tier I leverage, Tier I risk-based and total risk-based ratios as set forth in the table. The Bank’s actual capital amounts and ratios are also presented in the table. 19 MID PENN BANCORP, INC. ANNUAL REPORT TO THE SHAREHOLDERS (Dollars in thousands) As of December 31, 2003: Tier I Capital (to Average Assets)...................... Tier I Capital (to Risk Weighted Assets)......... Total Capital (to Risk Weighted Assets).......... As of December 31, 2002: Tier I Capital (to Average Assets)...................... Tier I Capital (to Risk Weighted Assets)......... Total Capital (to Risk Weighted Assets).......... Capital Adequacy Actual Amount Ratio 7.5% 10.6% 11.8% $ 27,331 27,331 30,323 Required Amount Ratio 4.0% 4.0% 8.0% 14,565 10,301 20,602 To Be Well Capitalized Under Prompt Corrective Action Provisions: Amount Ratio 5.0% 18,206 15,452 6.0% 10.0% 25,753 $ 25,235 25,235 28,283 7.4% 10.4% 11.6% 13,712 9,754 19,507 4.0% 4.0% 8.0% 17,140 14,630 24,384 5.0% 6.0% 10.0% As of December 31, 2003, the Bank’s capital ratios are well in excess of the minimum and well-capitalized guide lines and MPB’s capital ratios are in excess of the Bank’s capital ratios. (17) Concentration of Risk and Off-Balance Sheet Risk The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and financial standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the borrower. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment, and income-producing commercial properties. The Bank's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and financial standby letters of credit written is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for direct, funded loans. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Financial standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The term of these financial standby letters of credit is generally one year or less. As of December 31, 2003, commitments to extend credit amounted to $48,786,000 and financial standby letters of credit amounted to $5,804,000. Significant concentration of credit risk may occur when obligations of the same parties engaged in similar activities occur and accumulate in significant amounts. In analyzing the Bank's exposure to significant concentration of credit risk, management set a parameter of 10% or more of the Bank's total net loans outstanding as the threshold in determining whether the obligations of the same or affiliated parties would be classified as significant concentration of credit risk. Concentrations by industry, product line, type of collateral, etc., are also considered. U.S. Treasury securities, obligations of U.S. government agencies and corporations, and any assets collateralized by the same were excluded. As of December 31, 2003, commercial real estate financing was the only similar activity that met the requirements to be classified as a significant concentration of credit risk. However, there is a geographical concentration in that most of the Bank's business activity is with customers located in Central Pennsylvania, specifically within the Bank's trading area made up of Dauphin County, lower Northumberland County, western Schuylkill County and Hampden Township in Cumberland County. 20 MID PENN BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT’D) The Bank's highest concentrations of credit are in the areas of commercial real estate office financings and mobile home park land. Outstanding credit to these sectors amounted to $23,867,000 or 10.4% and $16,960,000 or 7.4% of net loans outstanding as of December 31, 2003. (18) Commitments and Contingencies Litigation MPB is subject to lawsuits and claims arising out of its business. In the opinion of management, after consultation with legal counsel, the ultimate disposition of these matters is not expected to have a material adverse effect on the consolidated financial condition of MPB. Leases MPB has signed a lease to rent office space in downtown Harrisburg at 17 North Second Street in an office building, currently under construction, to be known as Market Square Plaza. Subject to regulatory approval, the 2,500 square foot, first story office space will be used as a full service banking facility including both commercial and trust services. A Spring 2005 grand opening is anticipated. (19) Parent Company Statements The condensed balance sheet, statement of income and statement of cash flows for Mid Penn Bancorp, Inc., parent only, are presented below: CONDENSED BALANCE SHEET December 31, 2003 and 2002 (Dollars in thousands) ASSETS Cash ........................................................................................................ Investment in Subsidiaries .............................................................. Total Assets LIABILITIES AND STOCKHOLDERS' EQUITY Stockholders' Equity ......................................................................... Less Treasury Stock ........................................................................... Total Liabilities and Equity CONDENSED STATEMENT OF INCOME For Years Ended December 31, 2003, 2002 and 2001 (Dollars in thousands) Dividends from Subsidiaries ........................................................... Other Income from Subsidiaries..................................................... Undistributed Earnings of Subsidiaries ...................................... Other Expenses.................................................................................... Net Income 2003 279 37,082 37,361 37,900 (539) 37,361 2003 2,566 24 2,097 (72) 4,615 $ $ $ $ $ $ 2002 277 34,927 35,204 35,726 (522) 35,204 2002 2,496 27 2,051 (79) 4,495 2001 1,544 25 2,733 (72) 4,230 21 MID PENN BANCORP, INC. ANNUAL REPORT TO THE SHAREHOLDERS CCOONNDDEENNSSEEDD SSTTAATTEEMMEENNTT OOFF CCAASSHH FFLLOOWWSS For Years Ended December 31, 2003, 2002 and 2001 (Dollars in thousands) CASH FLOWS FROM OPERATING ACTIVITIES Net Income ........................................................................................... Undistributed Earnings of Subsidiaries...................................... Net Cash Provided By Operating Activities CASH FLOWS USED BY INVESTING ACTIVITIES Funds used to capitalize Mid Penn Insurance ............................ CASH FLOWS FROM FINANCING ACTIVITIES Dividends Paid ..................................................................................... (Purchase) Sale of Treasury Stock.................................................. Net Cash Used By Financing Activities Net Increase (Decrease) in Cash ...................................................... Cash at Beginning of Period............................................................ Cash at End of Period......................................................................... (20) Fair Value of Financial Instruments 2003 4,615 (2,097) 2,518 2002 2001 4,495 (2,051) 2,444 4,230 (2,733) 1,497 0 0 (15) (2,499) (17) (2,516) 2 277 279 (2,431) 11 (2,420) 24 253 277 (2,428) 0 (2,428) (946) 1,199 253 $ $ SFAS No. 107, “Disclosures about Fair Value of Financial Instruments,” requires disclosures of fair value information about financial instruments, whether or not recognized in the consolidated balance sheet, for which it is practical to estimate that value. In cases where quoted market values are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets, and in many cases, could not be realized in immediate settlement of the instrument. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of MPB. The following methodologies and assumptions were used to estimate the fair value of MPB’s financial instruments: Cash and due from banks: The carrying value of cash and due from banks is considered to be a reasonable estimate of fair value. Interest-bearing balances with other financial institutions: The estimate of fair value was determined by comparing the present value of quoted interest rates on like deposits with the weighted average yield and weighted average maturity of the balances. Investment securities: As indicated in Note 6, estimated fair values of investment securities are based on quoted market prices, where applicable. If quoted market prices are not available, fair values are based on quoted market prices for comparable instruments, adjusted for differences between the quoted instruments and the instruments being valued. Loans: The loan portfolio was segregated into pools of loans with similar economic characteristics and was further segregated into fixed rate and variable rate and each pool was treated as a single loan with the estimated fair value based on the discounted value of expected future cash flows. Fair value of loans with significant collectibility concerns (that is, problem loans and potential problem loans) was determined on an individual basis using an internal rating system and appraised values of each loan. Assumptions regarding problem loans are judgmentally determined using specific borrower information. Deposits: The fair value for demand deposits (e.g., interest and noninterest checking, savings and money market deposit accounts) are by definition, equal to the amount payable on demand at the reporting date (i.e. their carrying amounts). Fair value for fixed-rate certificates of deposit was estimated using a discounted cash flow calculation by combining all fixed-rate certificates into a pool with a weighted average yield and a weighted average maturity for the pool and comparing the pool with interest rates currently being offered on a similar maturity. 22 MID PENN BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT’D) Short-term borrowings: Because of time to maturity, the estimated fair value of short-term borrowings approximates the book value. Long-term debt: The estimated fair values of long-term debt were determined using discounted cash flow analysis, based on borrowing rates for similar types of borrowing arrangements. Accrued interest: The carrying amounts of accrued interest approximates their fair values. Off-balance sheet financial instruments: There are no unearned fees outstanding on off-balance sheet financial instruments and the fair values are determined to be equal to the contractual values. The following table summarizes the book value and fair value of financial instruments at December 31, 2003 and 2002. (Dollars in thousands) Financial assets: Cash and due from banks.................................................................. Interest-bearing balances................................................................. Investment securities........................................................................ Net loans................................................................................................ (Dollars in thousands) Financial liabilities: Deposits ................................................................................................. Short-term borrowings...................................................................... Accrued interest.................................................................................. Long-term debt .................................................................................... Off-balance sheet financial instruments: $ December 31, 2003 Fair Value 7,456 69,918 54,093 239,812 Book Value 7,456 69,918 54,093 229,086 December 31, 2003 Fair Value 292,206 9,688 1,045 38,321 Book Value $ 288,338 9,688 1,045 35,684 December 31, 2002 Fair Value 8,095 65,487 58,859 234,783 Book Value 8,095 65,487 58,859 218,302 December 31, 2002 Book Value 274,703 18,156 1,187 32,383 Fair Value 280,514 18,156 1,187 35,724 Commitments to extend credit ...................................................... Financial standby letters of credit ................................................ $ 48,786 5,804 48,786 5,804 42,261 4,579 42,261 4,579 (21) Common Stock: MPB has reserved 50,000 of authorized, but unissued shares of its common stock for issuance under a Stock Bonus Plan (the “Plan”). Shares issued under the Plan are at the discretion of the board of directors. Under MPB’s amended and restated dividend reinvestment plan, (DRIP), two hundred thousand shares of MPB’s authorized but unissued common stock are reserved for issuance. The DRIP also allows for voluntary cash payments within specified limits, for the purchase of additional shares. 23 MID PENN BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT’D) (22) Summary of Quarterly Consolidated Financial Data (Unaudited): The following table presents summarized quarterly financial data for 2003, 2002 and 2001. (Dollars in Thousands, Except Per Share Data) Interest Income........................................................................................ Interest Expense...................................................................................... Net Interest Income ................................................................................ Provision for Loan Losses ..................................................................... Net Interest Income After Provision for Loan Losses ................... Other Income ............................................................................................ Securities Gains....................................................................................... Gain on Sale of Loans............................................................................. Other Expenses ........................................................................................ Income Before Income Tax Provision ................................................ Income Tax Provision............................................................................. Net Income ................................................................................................ Earnings Per Share ................................................................................. Interest Income........................................................................................ Interest Expense...................................................................................... Net Interest Income ................................................................................ Provision for Loan Losses ..................................................................... Net Interest Income After Provision for Loan Losses ................... Other Income ............................................................................................ Securities Gains....................................................................................... Gain on Sale of Loans............................................................................. Other Expenses ........................................................................................ Income Before Income Tax Provision ................................................ Income Tax Provision............................................................................. Net Income ................................................................................................ Earnings Per Share ................................................................................. (Dollars in Thousands, Except Per Share Data) Interest Income........................................................................................ Interest Expense...................................................................................... Net Interest Income ................................................................................ Provision for Loan Losses ..................................................................... Net Interest Income After Provision for Loan Losses ................... Other Income ............................................................................................ Securities Gains (Losses) ...................................................................... Other Expenses ........................................................................................ Income Before Income Tax Provision ................................................ Income Tax Provision............................................................................. Net Income ................................................................................................ Earnings Per Share ................................................................................. Mar. 31 5,139 2,281 2,858 190 2,668 598 0 0 1,948 1,318 266 1,052 0.33 Mar. 31 5,420 2,511 2,909 100 2,809 462 5 0 1,843 1,433 327 1,106 0.34 Mar. 31 5,783 3,147 2,636 75 2,561 449 (11) 1,737 1,262 291 971 0.30 $ $ $ $ $ $ 2003 Quarter Ended Sept. 30 June 30 4,902 5,089 2,034 2,108 2,868 2,981 75 25 2,793 2,956 585 570 88 170 0 0 2,077 2,025 1,389 1,671 303 404 1,086 1,267 0.34 0.40 2002 Quarter Ended Sept. 30 June 30 5,379 5,274 2,550 2,483 2,829 2,791 100 100 2,729 2,691 498 454 55 0 0 0 1,807 1,910 1,475 1,235 330 259 1,145 976 0.36 0.30 2001 Quarter Ended Sept. 30 June 30 5,671 5,840 2,885 3,021 2,786 2,819 100 75 2,686 2,744 475 444 4 (7) 1,798 1,852 1,367 1,329 303 312 1,064 1,017 0.34 0.31 Dec. 31 4,854 2,011 2,843 0 2,843 648 3 45 2,049 1,490 280 1,210 0.38 Dec. 31 5,279 2,382 2,897 125 2,772 497 0 51 1,698 1,622 354 1,268 0.41 Dec. 31 5,570 2,682 2,888 250 2,638 491 0 1,639 1,490 312 1,178 0.38 (23) Recent Accounting Pronouncements: The Financial Accounting Standards Board (“FASB”) issued Statements No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure - An Amendment of FASB Statement No. 123; No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities; No. 150 “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” and Interpretation No. 46 “Consolidation of Variable Interest Entities.” The adoption of these statements and the interpretation did not have an effect on MPB’s earnings, financial condition or equity. 24 MID PENN BANCORP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS The purpose of this discussion is to further detail the financial condition and results of operations of Mid Penn Bancorp, Inc. (MPB). MPB is not aware of any known trends, events, uncertainties or of any current recommendations by the regulatory authorities which, if they were to be implemented, would have a material effect on MPB’s liquidity, capital resources or operations. This discussion should be read along with the consolidated financial statements also appearing in this report. FFiinnaanncciiaall SSuummmmaarryy The consolidated earnings of MPB are derived primarily from the operations of its wholly-owned subsidiary, Mid Penn Bank. MPB earned net income of $4,615,000 for the year 2003, compared to $4,495,000 in 2002, which was an increase of $120,000 or 2.7%. This represents net income in 2003 of $1.45 per share compared to $1.41 per share in 2002 and $1.33 per share in 2001. Total assets of MPB continued to grow in 2003, reaching the level of $373,466,000, an increase of $10,182,000 or 2.8% over $363,284,000 at year end 2002. The majority of growth came from increases in commercial real estate loans, and an increase in our portfolio of investment certificates of deposit. These increases were funded primarily through retained earnings of the Bank as well as increased deposits, particularly money market deposit accounts. MPB continued to achieve a solid return on average shareholders’ equity, (ROE), a widely recognized performance indicator in the financial industry. The ROE was 12.69% in 2003, 13.60% in 2002 and 13.68% in 2001. Return on average assets (ROA), another performance indicator, was 1.25% in 2003, 1.32% in 2002 and 1.31% in 2001. Tier one capital (to risk weighted assets) of $27,331,000 or 10.6% and total capital (to risk weighted assets) of $30,323,000 or 11.8% at December 31, 2003, are well above the December 31, 2003 requirement, which is 4% for tier one capital and 8% for total capital. Tier one capital consists primarily of the bank’s stockholders' equity. Total capital includes qualifying subordinated debt, if any, and the allowance for loan losses, within permitted limits. Risk-weighted assets are determined by assigning various levels of risk to different categories of assets and off-balance sheet activities. CCrriittiiccaall AAccccoouunnttiinngg PPoolliicciieess Management of the Company considers the accounting policy relating to the allowance for loan losses to be a critical accounting policy given the uncertainty in evaluating the level of the allowance required to cover credit losses inherent in the loan portfolio and the material effect that such judgements can have on the results of operations. While management’s current evaluation of the allowance for loan losses indicates that the allowance is adequate, under adversely different conditions or assumptions, the allowance may need to be increased. For example, if historical loan loss experience significantly worsened or if current economic conditions significantly deteriorated, additional provisions for loan losses may be required to increase the allowance. In addition, the assumptions and estimates used in the internal reviews of the Company’s non-performing loans and potential problem loans have a significant impact on the overall analysis of the adequacy of the allowance for loan losses. While management has concluded that the current evaluation of collateral values is reasonable under the circumstances, if collateral evaluations were significantly lowered, the Company’s allowance for loan policy may also require additional provisions for loan losses. NNeett IInntteerreesstt IInnccoommee Net interest income, MPB's primary source of revenue, represents the difference between interest income and interest expense. Net interest income is affected by changes in interest rates and changes in average balances (volume) in the various interest-sensitive assets and liabilities. During 2003 net interest income increased $124,000 or 1.1% as compared to an increase of $297,000 or 2.7% in 2002. The average balances, effective interest differential and interest yields for the years ended December 31, 2003, 2002 and 2001 and the components of net interest income, are presented in Table 1. A comparative presentation of the changes in net interest income for 2003 compared to 2002, and 2002 compared to 2001, is given in Table 2. This analysis indicates the changes in interest income and interest expense caused by the volume and rate components of interest earning assets and interest bearing liabilities. 25 MID PENN BANCORP, INC. ANNUAL REPORT TO THE SHAREHOLDERS The yield on earning assets decreased to 6.08% in 2003 from 7.00% in 2002. The yield on earning assets for 2001 was 7.93%. The change in the yield on earning assets was due primarily to the repricing of commercial loans in a very competitive rate environment and changes in the “prime rate.” The average “prime rate” for 2003 was 4.12% as compared to 4.67% for 2002 and 6.91% for 2001. Interest expense decreased by $1,492,000 or 15.0% in 2003 as compared to a decrease of $1,809,000 or 15.4% in 2002. In order to maintain the spread between interest earning assets and interest bearing liabilities, management was forced to aggressively decrease the expense on deposits. Primarily resulting from the fluctuations in interest rates, the net interest margin, on a tax equivalent basis, in 2003 was 3.63% compared to 3.91% in 2002 and 4.04% in 2001. Management continues to closely monitor the net interest margin. TTAABBLLEE 11:: AAVVEERRAAGGEE BBAALLAANNCCEESS,, EEFFFFEECCTTIIVVEE IINNTTEERREESSTT DDIIFFFFEERREENNTTIIAALL AANNDD IINNTTEERREESSTT YYIIEELLDDSS INCOME AND RATES ON A TAXABLE EQUIVALENT BASIS FOR YEAR ENDED DECEMBER 31, 2003 (Dollars in thousands) ASSETS: Interest Bearing Balances .................... Investment Securities: Taxable................................................... Tax-Exempt................................................ Total Investment Securities Federal Funds Sold .................................. Loans, Net .................................................. Total Earning Assets............................... Cash and Due from Banks ..................... Other Assets.............................................. Total Assets LIABILITIES & STOCKHOLDERS' EQUITY: Interest Bearing Deposits: NOW ....................................................... Money Market ...................................... Savings .................................................. Time........................................................ Short-term Borrowings .......................... Long-term Debt ........................................ Total Interest Bearing Liabilities ....... Demand Deposits..................................... Other Liabilities ...................................... Stockholders' Equity .............................. Total Liabilities and Stockholders' Equity Net Interest Income.................................... Net Yield on Interest Earning Assets: Total Yield on Earning Assets .............. Rate on Supporting Liabilities ................ Net Interest Margin .................................... 26 Average Balance Interest Income/Expense Average Rates Earned/Paid $ 68,256 14,222 36,355 50,577 950 224,993 344,776 6,306 17,489 368,571 33,897 45,072 27,756 144,194 10,670 36,463 298,052 30,918 4,309 35,292 368,571 $ $ $ $ 2,099 559 2,702 9 15,598 20,967 82 638 165 5,232 128 2,189 8,434 12,533 3.08% 3.93% 7.43% 0.95% 6.93% 6.08% 0.24% 1.42% 0.59% 3.63% 1.20% 6.00% 2.83% 6.08% 2.45% 3.63% MID PENN BANCORP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS (CONT’D) TTAABBLLEE 11:: AAVVEERRAAGGEE BBAALLAANNCCEESS,, EEFFFFEECCTTIIVVEE IINNTTEERREESSTT DDIIFFFFEERREENNTTIIAALL AANNDD IINNTTEERREESSTT YYIIEELLDDSS ((ccoonntt’’dd)) INCOME AND RATES ON A TAXABLE EQUIVALENT BASIS FOR YEAR ENDED DECEMBER 31, 2002 (Dollars in thousands) Average Balance Interest Income/Expense Average Rates Earned/Paid ASSETS: Interest Bearing Balances .................... Investment Securities: Taxable................................................... Tax-Exempt................................................ Total Investment Securities Federal Funds Sold .................................. Loans, Net .................................................. Total Earning Assets............................... Cash and Due from Banks ..................... Other Assets.............................................. Total Assets LIABILITIES & STOCKHOLDERS' EQUITY: Interest Bearing Deposits: NOW ....................................................... Money Market ...................................... Savings .................................................. Time........................................................ Short-term Borrowings .......................... Long-term Debt ........................................ Total Interest Bearing Liabilities ....... Demand Deposits..................................... Other Liabilities ...................................... Stockholders' Equity .............................. Total Liabilities and Stockholders' Equity Net Interest Income.................................... Net Yield on Interest Earning Assets: Total Yield on Earning Assets .............. Rate on Supporting Liabilities ................ Net Interest Margin .................................... $ 57,454 14,460 39,937 54,397 2,786 207,028 321,665 6,350 13,745 341,760 32,480 36,390 26,662 144,353 4,821 32,469 277,175 28,069 3,475 33,041 341,760 $ $ $ $ 2,703 738 3,032 47 15,983 22,503 168 801 355 6,483 50 2,069 9,926 12,577 4.70% 5.10% 7.59% 1.69% 7.72% 7.00% 0.52% 2.20% 1.33% 4.49% 1.04% 6.37% 3.58% 7.00% 3.09% 3.91% 27 MID PENN BANCORP, INC. ANNUAL REPORT TO THE SHAREHOLDERS TTAABBLLEE 11:: AAVVEERRAAGGEE BBAALLAANNCCEESS,, EEFFFFEECCTTIIVVEE IINNTTEERREESSTT DDIIFFFFEERREENNTTIIAALL AANNDD IINNTTEERREESSTT YYIIEELLDDSS ((ccoonntt''dd)) INCOME AND RATES ON A TAXABLE EQUIVALENT BASIS FOR YEAR ENDED DECEMBER 31, 2001 (Dollars in thousands) Average Balance Interest Income/Expense Average Rates Earned/Paid ASSETS: Interest Bearing Balances .................... Investment Securities: Taxable................................................... Tax-Exempt................................................ Total Investment Securities Federal Funds Sold .................................. Loans, Net .................................................. Total Earning Assets............................... Cash and Due from Banks ..................... Other Assets.............................................. Total Assets LIABILITIES & STOCKHOLDERS' EQUITY: Interest Bearing Deposits: NOW ....................................................... Money Market ...................................... Savings .................................................. Time........................................................ Short-term Borrowings .......................... Long-term Debt ........................................ Total Interest Bearing Liabilities ....... Demand Deposits..................................... Other Liabilities ...................................... Stockholders' Equity .............................. Total Liabilities and Stockholders' Equity Net Interest Income.................................... Net Yield on Interest Earning Assets: Total Yield on Earning Assets .............. Rate on Supporting Liabilities ................ Net Interest Margin .................................... $ 49,013 23,706 35,929 59,635 2,435 190,558 301,641 6,044 12,263 319,948 29,427 23,342 25,661 139,928 9,822 32,704 260,884 25,709 2,431 30,924 319,948 $ $ $ $ 3,092 1,542 2,736 84 16,460 23,914 246 739 456 7,751 441 2,102 11,735 12,179 6.31% 6.50% 7.62% 3.45% 8.64% 7.93% 0.84% 3.17% 1.78% 5.54% 4.49% 6.43% 4.50% 7.93% 3.89% 4.04% Interest and average rates are presented on a fully taxable equivalent basis, using an effective tax rate of 34%. For purposes of calculating loan yields, average loan balances include nonaccrual loans. Loan fees of $612,000, $550,000 and $387,000 are included with interest income in Table 1 for the years 2003, 2002 and 2001, respectively. 28 MID PENN BANCORP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS (CONT’D) TTAABBLLEE 22:: VVOOLLUUMMEE AANNAALLYYSSIISS OOFF CCHHAANNGGEESS IINN NNEETT IINNTTEERREESSTT IINNCCOOMMEE (Dollars in thousands) 2003 Compared to 2002 Increase (Decrease) Due to Change In: 2002 Compared to 2001 Increase (Decrease) Due to Change In: Volume Rate Net Volume Rate Net 508 (1,112) (604) 533 (922) (389) Taxable Equivalent Basis INTEREST INCOME: Interest Bearing Balances................. $ Investment Securities: Taxable.................................................... Tax-Exempt............................................ Total Investment Securities Federal Funds Sold .............................. Loans, Net .............................................. Total Interest Income INTEREST EXPENSE: Interest Bearing Deposits: NOW ................................................... Money Market .................................. Savings .............................................. Time .................................................... Total Interest Bearing Deposits Short-term Borrowings ...................... Long-term Debt .................................... Total Interest Expense (12) (272) (284) (31) 1,387 1,580 7 191 15 (7) 206 61 254 521 (167) (58) (225) (7) (1,772) (3,116) (93) (354) (205) (1,244) (1,896) 17 (134) (2,013) (179) (330) (509) (38) (385) (1,536) (86) (163) (190) (1,251) (1,690) 78 120 (1,492) NET INTEREST INCOME ....................... $ 1,059 (1,103) (44) (601) 305 (296) 12 1,423 1,672 256 414 18 245 933 (225) (15) 693 979 (203) (9) (212) (49) (1,900) (3,083) (334) (352) (119) (1,513) (2,318) (166) (18) (2,502) (804) 296 (508) (37) (477) (1,411) (78) 62 (101) (1,268) (1,385) (391) (33) (1,809) (581) 398 The effect of changing volume and rate has been allocated entirely to the rate column. Tax-exempt income is shown on a tax equivalent basis assuming a federal income tax rate of 34%. PPrroovviissiioonn ffoorr LLooaann LLoosssseess The provision for loan losses charged to operating expense represents the amount deemed appropriate by management to maintain an adequate allowance for possible loan losses. Following its model for loan loss reserve adequacy, management made a $290,000 allocation in 2003 as well as a provision of $425,000 in 2002 and $500,000 in 2001. The allowance for loan losses as a percentage of average total loans was 1.33% at December 31, 2003, compared to 1.45% at December 31, 2002 and 1.48% at December 31, 2001, which continues to be higher than that of peer financial institutions due to MPB’s higher level of loans to finance commercial real estate. Reasons for the lower 2004 provision included a 16% decrease in non-performing loans as several troubled loans were resolved or moved to other real estate, and an improving economy. A summary of charge-offs and recoveries of loans is presented in Table 3. 29 MID PENN BANCORP, INC. ANNUAL REPORT TO THE SHAREHOLDERS TTAABBLLEE 33:: AANNAALLYYSSIISS OOFF TTHHEE AALLLLOOWWAANNCCEE FFOORR LLOOAANN LLOOSSSSEESS (Dollars in thousands) Balance, beginning of year ............................ Loans charged-off: Commercial real estate, construction and land development............................. Commercial, industrial and agricultural Real estate-residential ................................ Consumer........................................................ Total loans charged off Recoveries on loans previously charged-off: Commercial real estate, construction and land development............................. Commercial, industrial and agricultural Real estate-residential ................................ Consumer........................................................ Total recoveries 2003 3,051 $ Years ended December 31, 2001 2002 2,815 2,856 2000 2,505 171 140 0 98 409 0 14 0 46 60 41 113 0 148 302 17 0 0 55 72 249 118 0 122 489 0 1 0 29 30 459 500 2,856 1 12 0 61 74 28 5 0 26 59 15 325 2,815 1999 2,313 0 146 0 78 224 55 1 0 35 91 133 325 2,505 Net charge-offs .................................................. Provision for loan losses ................................ Balance, end of year ......................................... $ 349 290 2,992 230 425 3,051 Ratio of net charge-offs during the year to average loans outstanding during the year, net of unearned discount ................. Allowance for loan losses as a percentage of average total loans .................................. .14% .11% .24% .01% .08% 1.33% 1.45% 1.48% 1.58% 1.58% NNoonniinntteerreesstt IInnccoommee During 2003, MPB earned $2,707,000 in noninterest income, compared to $2,022,000 earned in 2002, and $1,845,000 earned in 2001. Realized securities gains, net of realized losses, increased $201,000, to $261,000 in 2003 from $60,000 in 2002. In 2003, MPB sold securities that management believed to be fully valued. Assuming an income tax rate of 34%, the higher securi- ties gains in 2003 increased net income for 2003 by $133,000 over 2002. Service charges on deposit accounts amounted to $1,227,000 for 2003, an increase of $174,000 or 16.5% over $1,053,000 for 2002, which showed an increase of $132,000 over 2001. The majority of this increase resulted from the increasing revenues from NSF charges. In 2001, MPB initiated a program which allows approved customers to overdraw their checking accounts and have the checks paid, up to an approved limit not to exceed $300. This program, coupled with a more restrictive policy on fee waivers, and an increase in demand accounts, has contributed to this substantial increase in fee income with a very controllable level of associated loss. MPB owns cash surrender value life insurance policies that provide funding for director retirement and salary continuation plans. The income on these policies amounted to $210,000 during the year 2003, $239,000 in 2002 and $216,000 in 2001. Trust department income for 2003 was $202,000, a $14,000 or 7.4% increase from the $188,000 in 2002, which was $30,000 or 19.0% increase from the $158,000 earned in 2001. Trust Department income can fluctuate from year to year, due to the number of estates being settled during the year. 30 MID PENN BANCORP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS (CONT’D) MPB also earned $21,000 in 2003, $64,000 in 2002 and $75,000 in 2001 in fees from Invest, the third-party provider of investments whose services the Bank has contracted. Other income amounted to $762,000 in 2003, $431,000 in 2002 and $548,000 in 2001, including gains on other real estate. Included in the increase in other income were a $100,000 increase in gains on mortgage originations and a $20,000 gain on the sale of a parcel of other real estate. The remainder of the increase is due to smaller increases in other fee areas throughout the bank as management continues to focus on non interest income. NNoonniinntteerreesstt EExxppeennssee A summary of the major components of noninterest expense for the years ended December 31, 2003, 2002 and 2001 is reflected in Table 4. Noninterest expense increased to $8,099,000 in 2003 from $7,258,000 in 2002 and $7,026,000 in 2001. The major component of noninterest expense is salaries and employee benefits. The number of full-time equivalent employees increased from 110 to 112 during 2003. Increases in the 2003 workforce included the addition of two experienced commercial loan officers. A major increase in noninterest expense was the increase in expenses, primarily in depreciation, associated with a new mainframe computer and imaging system. The new system will not only allow the bank to be compliant with the Check Truncation Act going into effect in October of 2004 but also allow for labor and storage efficiencies going forward. TTAABBLLEE 44:: NNOONNIINNTTEERREESSTT EEXXPPEENNSSEE (Dollars in thousands) Years ended December 31, Salaries and employee benefits.......................................... Occupancy, net......................................................................... Equipment ................................................................................ Postage and supplies ............................................................. FDIC insurance premium ..................................................... Marketing and advertising.................................................. Other real estate, net ............................................................. Pennsylvania bank shares tax ............................................ Professional services............................................................. Telephone.................................................................................. Loss on mortgage sales......................................................... Legal........................................................................................... Consultant ................................................................................ Other .......................................................................................... Total Noninterest Expense $ 2003 4,496 423 602 320 45 100 135 266 284 77 146 86 199 920 $ 8,099 IInnvveessttmmeennttss 2002 3,978 384 514 278 46 115 294 259 160 78 79 17 143 913 7,258 2001 4,012 392 461 280 44 127 43 262 213 78 125 29 75 885 7,026 MPB’s investment portfolio is utilized to improve earnings through investments of funds in higher-yielding assets, while maintaining asset quality, which provide the necessary balance sheet liquidity for MPB. MPB’s entire portfolio of investment securities is considered available for sale. As such, the investments are recorded at fair value. Our investments: US Treasury, Agency and Municipal securities are given a market price relative to investments of the same type with similar maturity dates. As the interest rate environment of these securities changes, our existing securities are valued differently in comparison. This difference in value, or unrealized gain, amounted to $1,415,000, net of tax, as of the end of the year. At December 31, 2003, SFAS No. 115 resulted in an increase of shareholders’ equity of $1,415,000 (unrealized gain on securities of $2,144,000 less estimated income tax expense of $729,000). As of December 31, 2002, SFAS No. 115 resulted in an increase in shareholders’ equity of $1,357,000 (unrealized gain on securities of $2,049,000, less estimated income 31 MID PENN BANCORP, INC. ANNUAL REPORT TO THE SHAREHOLDERS tax expense of $692,000), compared to a decrease in stockholders’ equity of $56,000 (unrealized loss on securities of $84,000, less estimated income tax benefit of $28,000) as of December 31, 2001. MPB does not have any significant concentrations of investment securities. Table 5 provides a history of the amortized cost of investment securities at December 31, for each of the past three years. The unrealized gains and losses on investment securities are outlined in Note 6 to the Consolidated Financial Statements. TTAABBLLEE 55:: AAMMOORRTTIIZZEEDD CCOOSSTT OOFF IINNVVEESSTTMMEENNTT SSEECCUURRIITTIIEESS (Dollars in thousands) U. S. Treasury and U.S. government agencies ...................... Mortgage-backed U.S. government agencies ....................... State and political subdivision obligations......................... Restricted equity securities .................................................... Total 2003 $ 10,564 4,808 34,447 2,130 $ 51,949 December 31, 2002 9,538 5,512 39,388 2,372 56,810 2001 9,028 4,674 39,760 1,970 55,432 LLooaannss At December 31, 2003, net loans totaled $229,086,000, an $10,784,000 or 4.9% increase from December 31, 2002. During 2003, MPB experienced a net increase in commercial real estate and commercial/industrial loans of approximately $11,140,000, the majority of which was generated in the greater Harrisburg region. The current environment in lending remains extremely competitive with financial institutions aggressively pursuing potential borrowers. At December 31, 2003, loans, net of unearned income, represented 64.3% of earning assets as compared to 64.4% on December 31, 2002 and 64.6% on December 31, 2001. The Bank's loan portfolio is diversified among individuals, farmers, and small and medium-sized businesses generally located within the Bank's trading area of Dauphin County, lower Northumberland County, western Schuylkill County and eastern Cumberland County. Commercial real estate, construction and land development loans are collateralized mainly by mortgages on the income-producing real estate or land involved. Commercial, industrial and agricultural loans are made to business entities and may be secured by business assets, including commercial real estate, or may be unsecured. Residential real estate loans are secured by liens on the residential property. Consumer loans include installment, lines of credit and home equity loans. A distribution of the Bank's loan portfolio according to major loan classification is shown in Table 6. TTAABBLLEE 66:: LLOOAANN PPOORRTTFFOOLLIIOO (Dollars in thousands) 2003 2002 December 31, 2001 2000 1999 Percent Percent Amount of Loans Amount of Loans Amount of Loans Amount of Loans Amount of Loans Percent Percent Percent Commercial real estate, construction and land development .......................... $ 154,296 Commercial, industrial and 66.5% 146,325 65.6% 130,983 63.8% 110,947 59.3% 105,328 60.3% agricultural ........................... Real estate-residential ............ Consumer.................................... 25,567 43,384 10,380 Total Loans $ 233,627 (1,549) Unearned income ..................... Loans net of unearned 22,398 11.0% 41,502 18.7% 3.8% 12,978 100% 233,203 (1,850) 23,107 10.0% 38,349 18.6% 5.8% 12,732 100% 205,101 (2,265) 26,274 11.3% 35,610 18.7% 6.2% 14,110 100% 186,941 (2,730) 14.1% 19.0% 7.6% 100% discount.................................. Allowance for loan losses ....... 232,078 (2,992) Net Loans $ 229,086 221,353 (3,051) 218,302 202,836 (2,856) 99,980 184,211 (2,815) 181,396 32 11.5% 18.6% 9.6% 100% 20,118 32,586 16,780 174,812 (2,518) 172,294 (2,505) 69,789 MID PENN BANCORP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS (CONT’D) AAlllloowwaannccee ffoorr LLooaann LLoosssseess The allowance for loan losses is maintained at a level believed adequate by Management to absorb potential loan losses in the loan portfolio. MPB has a loan review department that is charged with establishing a "watch list" of potential unsound loans, identifying unsound credit practices and suggesting corrective actions. A quarterly review and reporting process is in place for monitoring those loans that are on the "watch list." Each credit on the "watch list" is evaluated to estimate potential losses. In addition, estimates for each category of credit are provided based on Management's judgment which considers past experience, current economic conditions and other factors. For installment and real estate mortgages, specific allocations are based on past loss experience adjusted for recent portfolio growth and economic trends. The total of reserves resulting from this analysis are "specific" reserves. The amounts not specifically provided for individual classes of loans are considered "general." This amount is determined and based on judgments regarding economic conditions, trends and other factors. The allocation of the allowance for loan losses among the major classifications is shown in Table 7 as of December 31 of each of the past five years. The allowance for loan losses at December 31, 2003 was $2,992,000 or 1.29% of total loans less unearned discount as compared to $3,051,000 or 1.38% at December 31, 2002, and $2,856,000 or 1.41% at December 31, 2001. TTAABBLLEE 77:: AALLLLOOCCAATTIIOONN OOFF TTHHEE AALLLLOOWWAANNCCEE FFOORR LLOOAANN LLOOSSSSEESS (Dollars in thousands) Commercial real estate, construction and land development.................................. $ Commercial, industrial and agricultural .. Real estate-residential .................................... Consumer............................................................ General ................................................................ Total Loans $ 2003 2002 December 31, 2001 1,938 954 20 65 15 2,992 1,898 922 56 147 28 3,051 1,584 987 73 166 46 2,856 2000 1,318 1,008 209 93 187 2,815 1999 927 782 198 114 484 2,505 NNoonnppeerrffoorrmmiinngg AAsssseettss Nonperforming assets, other than consumer loans and 1-4 family residential mortgages, include impaired and nonaccrual loans, loans past due 90 days or more, restructured loans and other real estate (including residential property). Nonaccrual loans are loans on which we no longer recognize daily interest income. A loan is generally classified as nonaccrual when principal or interest has consistently been in default for a period of 90 days or more, or because of a deterioration in the financial condition of the borrower, payment in full of principal or interest is not expected. Loans past due 90 days or more and still accruing interest are loans that are generally well-secured and in the process of collection or repayment. Restructured loans are those loans whose terms have been modified to lower interest or principal payments because of borrower financial difficulties. Foreclosed assets held for sale include those assets that have been acquired through foreclosure for debts previously contracted, in settlement of debt. Consumer loans are generally recommended for charge-off when they become 120 days delinquent. All 1-4 family residential mortgages 90 days or more past due are reviewed quarterly by Management, and collection decisions are made in light of the analysis of each individual loan. The amount of consumer and residential mortgage loans past due 90 days or more at year-end was $533,000, $350,000 and $87,000 in 2003, 2002 and 2001, respectively. A presentation of nonperforming assets as of December 31, for each of the past five years is given in Table 8. Nonperforming assets at December 31, 2003, totaled $2,767,000 or 0.74% of total assets compared to $2,753,000 or 0.76% of total assets in 2002, and $4,744,000 or 1.44% of total assets in 2001. The foreclosed assets held for sale at December 31, 2003, consist of four parcels of commercial real estate including one mobile home park that MPB has available for sale. One of these parcels, carried at $180,000, was sold subsequently in January of 2004. 33 MID PENN BANCORP, INC. ANNUAL REPORT TO THE SHAREHOLDERS TTAABBLLEE 88:: NNOONNPPEERRFFOORRMMIINNGG AASSSSEETTSS (Dollars in thousands) December 31, Nonaccrual loans............................................... Past due 90 days or more ................................ Restructured loans ........................................... Total nonperforming loans Foreclosed assets held for sale ...................... Total nonperforming assets $ $ 2003 984 666 0 1,650 1,117 2,767 2002 1,164 808 0 1,972 781 2,753 2001 1,686 828 537 3,051 1,693 4,744 2000 1,116 504 622 2,242 70 2,312 1999 890 386 878 2,154 63 2,217 Percent of loans outstanding ........................ Percent of total assets ..................................... 1.18% 0.74% 1.23% 0.76% 2.31% 1.44% 1.24% 0.73% 1.27% 0.77% There are no loans classified for regulatory purposes that have not been included in Table 8. There are no trends or uncertainties which Management expects will materially impact future operating results, liquidity or capital resources, or no other material credits about which Management is aware of any information which causes Management to have serious doubts as to the ability of such borrowers to comply with loan repayment terms. Management is monitoring one large commercial relationship in the amount of approximately $3,800,000, which is not included in the table above. DDeeppoossiittss aanndd OOtthheerr FFuunnddiinngg SSoouurrcceess MPB's primary source of funds is its deposits. Deposits at December 31, 2003, increased by $13,635,000 or 5.0% over December 31, 2002, which also increased by $20,598,000 or 8.1% from December 31, 2001. Average balances and average interest rates applicable to the major classifications of deposits for the years ended December 31, 2003, 2002, and 2001 are presented in Table 9. Average short-term borrowings for 2003 were $10,670,000 as compared to $4,821,000 in 2002. These borrowings included customer repurchase agreements, treasury tax and loan option borrowings and federal funds purchased. TTAABBLLEE 99:: DDEEPPOOSSIITTSS BBYY MMAAJJOORR CCLLAASSSSIIFFIICCAATTIIOONN (Dollars in thousands) Noninterest-bearing demand deposits ...... $ Interest-bearing demand deposits.............. Money market .................................................. Savings............................................................... Time .................................................................... Total $ 2003 Average Average Balance 30,918 33,897 45,072 27,756 144,194 281,837 Rate 0.00% 0.24% 1.42% 0.59% 3.63% 2.17% Years ended December 31, 2002 Average Average Balance 28,069 32,480 36,390 26,662 144,353 267,954 Rate 0.00% 0.52% 2.20% 1.33% 4.49% 2.91% 2001 Average Average Balance 25,709 29,427 23,342 25,661 139,928 244,067 Rate 0.00% 0.84% 3.17% 1.78% 5.54% 3.77% CCaappiittaall RReessoouurrcceess Stockholders' equity, or capital, is evaluated in relation to total assets and the risk associated with those assets. The greater the capital resources, the more likely a corporation is to meet its cash obligations and absorb unforeseen losses. Too much capital, however, indicates that not enough of the company’s earnings have been paid to stockholders and the buildup makes it difficult for a company to offer a competitive return on the stockholders’ capital going forward. For these reasons capital adequacy has been, and will continue to be, of paramount importance. In 2003, capital was increased by $2,157,000 or 6.1%. In 2002, capital was increased by $3,488,000 or 11.0%. In 2001, capital was increased by $2,090,000 or 7.1%. Capital growth is achieved by retaining more in earnings than we pay out to our stockholders. MPB’s normal dividend payout allows for quarterly cash returns to its stockholders and provides earnings retention at a level sufficient to finance future growth. The dividend payout ratio, which represents the percentage of annual net income returned to the stockholders in the form of cash dividends, was 54% for 2003 compared to 54% for 2002 and 58% for 2001. 34 MID PENN BANCORP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS (CONT’D) At December 31, 2003, 19,408 shares of MPB’s common stock have been purchased back by MPB, held as treasury stock, and are available for issuance under the dividend reinvestment plan or the stock bonus plan. The treasury stock may also be used for the employee stock ownership plan. FFeeddeerraall IInnccoommee TTaaxxeess Federal income tax expense for 2003 was $1,253,000 compared to $1,270,000 and $1,218,000 in 2002 and 2001, respectively. The effective tax rate was 21% for 2003 and 22% for 2002 and 2001. LLiiqquuiiddiittyy MPB's asset-liability management policy addresses the management of MPB's liquidity position and its ability to raise sufficient funds to meet deposit withdrawals, fund loan growth and meet other operational needs. MPB utilizes its investment portfolio as a source of liquidity, along with deposit growth and increases in repurchase agreements and other short-term borrowings. (See Deposits and Other Funding Sources which appears earlier in this discussion.) Liquidity from investments is provided primarily through investments and interest bearing balances with maturities of one year or less. Funds are available to MPB through loans from the Federal Home Loan Bank and established federal funds (overnight) lines of credit. MPB's major source of funds is its core deposit base as well as its capital resources. The major sources of cash in 2003 came from operations and a net increase in deposits of $13,635,000. Deposits grew at a slower pace in 2003 due to improving equity markets. In addition, net long-term debt was increased by approximately $3,301,000 as the Bank locked into several new borrowings at the favorable current rate levels. In 2003, the major use of cash was for net loan growth of $13,530,000. Loan growth in 2003 was slower than the prior year, due to a slow economy and heightened competition for commercial loans. Excess cash generated was used to pay down short-term borrowings. The major sources of cash in 2002 came from operations and the influx of deposit dollars during the year. Demand and savings balances posted a net increase of $14,723,000 and time deposits increased by a net amount of $5,875,000 as bank customers returned to the safety of bank deposits during this time of uncertainty in the equity markets. The Bank used this cash to fund loans which increased by a net $19,969,000 during the year, as well as investing in short-term interest-bearing (certificate of deposit) balances in other banks. These jumbo certificates offer a competitive rate of return with no credit risk and little interest-rate risk due to their short terms. MMaarrkkeett RRiisskk -- AAsssseett--LLiiaabbiilliittyy MMaannaaggeemmeenntt aanndd IInntteerreesstt RRaattee SSeennssiittiivviittyy Interest rate sensitivity is a function of the repricing characteristics of MPB's portfolio of assets and liabilities. Each asset and liability reprices either at maturity or during the life of the instrument. Interest rate sensitivity is measured as the difference between the volume of assets and liabilities that are subject to repricing in a future period of time. These differences are known as interest sensitivity gaps. MPB manages the interest rate sensitivity of its assets and liabilities. The principal purpose of asset-liability management is to maximize net interest income while avoiding significant fluctuations in the net interest margin and maintaining adequate liquidity. Net interest income is increased by increasing the net interest margin and by increasing earning assets. MPB utilizes asset-liability management models to measure the impact of interest rate movements on its interest rate sensitivity position. The traditional maturity gap analysis is also reviewed regularly by MPB's management. MPB does not attempt to achieve an exact match between interest sensitive assets and liabilities because it believes that a controlled amount of interest rate risk is desirable. The maturity distribution and weighted average yields of investments is presented in Table 10. The maturity distribution and repricing characteristics of MPB's loan portfolio is shown in Table 11. Table 12 provides expected maturity information about MPB’s financial instruments that are sensitive to changes in interest rates. Except for the effects of prepayments on mortgage related assets, the table presents principal cash flows and related average interest rates on interest earning assets by contractual maturity. Residential loans are assumed to have annual payment rates between 12% and 18% of the portfolio. Loan and mortgage backed securities balances are not adjusted for unearned discounts, premiums, and deferred loan fees. 35 MID PENN BANCORP, INC. ANNUAL REPORT TO THE SHAREHOLDERS MPB assumes that 75% of savings and NOW accounts are core deposits and are, therefore, expected to reprice after 5 years. Transaction accounts, excluding money market accounts, are assumed to reprice after five years. Money market accounts are assumed to be variable accounts and are reported as maturing within the first twelve months. No roll-off is applied to certificates of deposit. Fixed maturity deposits reprice at maturity. The maturity distribution of time deposits of $100,000 or more is shown in Table 13. TTAABBLLEE 1100:: IINNVVEESSTTMMEENNTT MMAATTUURRIITTYY AANNDD YYIIEELLDD (Dollars in thousands) December 31, 2003 U.S. Treasury and U.S.government agencies............ State and political subdivision obligations............. Mortgage-backed U.S. government agencies ........... Equity securities............................................................. Total Weighted Average Yields U.S. Treasury and U.S. government agencies........... State and political subdivision obligations............. Mortgage-backed U.S. government............................. agencies ....................................................................... Equity securities............................................................. Total After One After Five One Year Year thru Years thru After Ten Five Years Ten Years and Less 500 500 $ 10,665 314 861 0 0 0 12,026 814 997 21,352 2,947 2,130 27,426 8,567 2,079 1,000 0 11,646 Years $ One Year and Less After One After Five Year thru Years thru After Ten Five Years Ten Years Years 6.44% 7.43 0 0 6.82% 3.62 7.28 5.49 0 4.44 3.50 6.94 6.23 0 6.75 4.02 7.02 4.50 2.25 6.31 Total 10,564 34,410 4,808 2,130 51,912 Total 3.80 7.01 5.02 2.25 5.99 TTAABBLLEE 1111:: LLOOAANN MMAATTUURRIITTYY AANNDD IINNTTEERREESSTT SSEENNSSIITTIIVVIITTYY (Dollars in thousands) December 31, 2003 After One One Year Year thru After Five and Less Five Years Years Total Commercial, real estate, construction and land development............................................... $ 67,137 67,413 19,746 154,296 Commercial, industrial and agricultural.................................................................. Real estate-residential mortgages ............................. Consumer.......................................................................... Total Loans Rate Sensitivity Predetermined rate........................................................ Floating or adjustable rate .......................................... Total 13,406 15,499 1,364 $ 97,406 11,587 17,951 6,491 103,442 $ 5,066 92,340 $ 97,406 25,330 78,112 103,442 574 9,934 976 31,230 29,282 1,948 31,230 25,567 43,384 8,831 232,078 59,678 172,400 232,078 36 MID PENN BANCORP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS (CONT’D) TTAABBLLEE 1122:: IINNTTEERREESSTT RRAATTEE SSEENNSSIITTIIVVIITTYY GGAAPP (Dollars in thousands) (As of December 31, 2003) Assets: Expected Maturity Year Ended December 31, 2004 2005 2006 2007 2008 Thereafter Total Fair Value Interest bearing balances ................ $ 51,855 2.40 814 6.37 92,340 5.31 5,066 7.28 Total $150,075 Average interest rate..................... Debt securities .................................... Average interest rate..................... Adjustable rate loans......................... Average interest rate..................... Fixed rate loans................................... Average interest rate..................... Interest liabilities: Variable rate savings and transaction accounts....................... $ 61,611 0.91 59,605 2.70 9,688 1.06 5,088 5.24 Total $ 135,992 Average interest rate..................... Certificates of deposit and IRAs .... Average interest rate..................... Short term borrowings ..................... Average interest rate..................... Long term fixed rate borrowings... Average interest rate .................... 12,180 2.89 4,064 6.13 16,502 6.91 5,823 7.61 38,569 0 - 29,705 4.08 0 - 0 - 29,705 297 6.68 1,927 5.51 17,954 6.79 5,727 7.29 25,905 0 - 19,769 3.48 0 - 5,000 6.21 24,769 99 5.05 662 5.41 15,145 6.60 6,912 7.05 22,818 0 - 21,612 4.29 0 - 0 - 21,612 5,487 3.73 4,994 3.36 28,510 5.99 6,867 6.45 45,858 0 - 12,364 3.55 0 - 0 - 12,364 0 - 37,322 6.62 1,949 5.01 29,283 7.05 68,554 79,279 0.18 2,463 3.91 0 - 25,596 5.84 107,338 69,918 2.61 49,783 6.19 172,400 5.84 59,678 7.08 351,779 69,918 54,093 172,400 67,412 363,823 140,890 140,890 0.50 145,518 3.42 9,688 1.06 35,684 5.81 331,780 151,316 9,688 38,321 340,215 Rate sensitive gap: Periodic gap ......................................... $ 14,083 Cumulative gap ................................... $ 14,083 8,864 22,947 1,136 24,083 1,206 25,289 33,494 58,783 (38,784) 19,999 Cumulative gap as a percentage of total assets ...................................... +3.7% +6.1% +6.4% +6.8% +15.7% +5.4% (Dollars in thousands) (As of December 31, 2002) Assets: Expected Maturity Year Ended December 31, 2003 2004 2005 2006 2007 Thereafter Total Fair Value Average interest rate..................... Debt securities .................................... Average interest rate..................... Adjustable rate loans......................... Average interest rate..................... Fixed rate loans................................... Average interest rate..................... Interest bearing balances ................ $ 55,189 3.66 3,325 2.43 68,945 5.47 9,104 7.72 Total $136,563 8,615 4.19 1,007 6.95 33,371 7.82 7,710 8.37 50,703 1,287 7.21 5,368 4.57 22,966 7.40 9,988 8.32 39,609 297 6.68 3,976 5.26 14,242 7.84 8,949 6.38 27,464 99 5.05 1,261 5.57 17,992 6.94 9,942 7.11 29,294 0 - 39,500 6.91 484 7.76 17,660 7.72 57,644 65,487 3.82 54,437 6.27 65,487 56,486 158,000 158,000 6.64 63,353 7.64 341,277 79,834 359,807 37 MID PENN BANCORP, INC. ANNUAL REPORT TO THE SHAREHOLDERS TTAABBLLEE 1122:: IINNTTEERREESSTT RRAATTEE SSEENNSSIITTIIVVIITTYY GGAAPP ((ccoonntt’’dd)) (Dollars in thousands) (As of December 31, 2002) Interest liabilities: Expected Maturity Year Ended December 31, 2003 2004 2005 2006 2007 Thereafter Total Fair Value Variable rate savings and transaction accounts....................... $ 55,602 1.44 62,026 3.81 18,156 1.40 5,197 6.61 Total $140,981 Average interest rate..................... Certificates of deposit and IRAs .... Average interest rate..................... Short term borrowings ..................... Average interest rate..................... Long term fixed rate borrowings... Average interest rate .................... 0 - 32,484 4.08 0 - 5,086 5.24 37,570 0 - 25,288 4.51 0 - 0 - 25,288 0 - 6,106 4.78 0 - 5,000 6.21 11,106 0 - 16,386 4.53 0 - 0 - 16,386 73,274 .39 2,853 4.73 0 - 17,100 6.55 93,227 128,876 .84 145,143 4.13 18,156 1.40 32,383 6.30 324,558 128,876 151,638 18,156 34,673 333,343 Rate sensitive gap: Periodic gap ......................................... $ (4,418) Cumulative gap ................................... $ (4,418) 13,133 8,715 14,321 23,036 16,358 39,394 12,908 52,302 (35,583) 16,719 Cumulative gap as a percentage of total assets ...................................... -1.2% +2.4% +6.3% +10.8% +14.4% +4.6% Duing 2003, Management analyzed interest rate risk using the Profit Star Asset-Liability Management Model. Using the computerized model, Management reviews interest rate risk on a monthly basis. This analysis includes an earnings scenario whereby interest rates are increased by 200 basis points and another whereby they are decreased by 200 basis points. These scenarios indicate that there would not be a significant variance in net interest income at the one-year time frame due to interest rate changes; however, actual results could vary significantly from the calculations prepared by Management. At December 31, 2003, all interest rate risk levels according to our model were within the tolerance guidelines set by Management. The model noted above utilized by Management to create the reports used for Table 12 makes various assumptions and estimates. Actual results could differ significantly from these estimates which would result in significant differences in cash flows. In addition, the table does not take into consideration changes which Management would make to realign its portfolio in the event of a changing rate environment. TTAABBLLEE 1133:: MMAATTUURRIITTYY OOFF TTIIMMEE DDEEPPOOSSIITTSS $$110000,,000000 OORR MMOORREE (Dollars in thousands) Three months or less ............................................................. Over three months to twelve months................................ Over twelve months ............................................................... Total 2003 4,821 7,104 12,673 24,598 $ $ December 31, 2002 5,757 6,179 12,895 24,831 2001 3,925 12,773 7,643 24,341 EEffffeeccttss ooff IInnffllaattiioonn A bank's asset and liability structure is substantially different from that of an industrial company in that virtually all assets and liabilities of a bank are monetary in nature. Management believes the impact of inflation on its financial results depends principally upon MPB's ability to react to changes in interest rates and, by such reaction, reduce the inflationary impact on performance. Interest rates do not necessarily move in the same direction or at the same magnitude as the prices of other goods and services. As discussed previously, Management seeks to manage the relationship between interest sensitive assets and liabilities in order to protect against wide interest rate fluctuations, including those resulting from inflation. Information shown elsewhere in this Annual Report will assist in the understanding of how MPB is positioned to react to changing interest rates and inflationary trends. In particular, the summary of net liabilities, the composition of loans, investments and deposits should be considered. 38 MID PENN BANCORP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS (CONT’D) OOffff--BBaallaannccee SShheeeett IItteemmss MPB makes contractual commitments to extend credit and extends lines of credit which are subject to MPB's credit approval and monitoring procedures. As of December 31, 2003, commitments to extend credit amounted to $48,786,000 as compared to $42,261,000 as of December 31, 2002. MPB also issues financial standby letters of credit to its customers. The risk associated with financial standby letters of credit is essentially the same as the credit risk involved in loan extensions to customers. Financial standby letters of credit increased to $5,804,000 at December 31, 2003, from $4,579,000 at December 31, 2002. CCoommpprreehheennssiivvee IInnccoommee Comprehensive Income is a measure of all changes in equity of a corporation, excluding transactions with owners in their capacity as owners (such as proceeds from issuances of stock and dividends). The difference between Net Income and Comprehensive Income is termed “Other Comprehensive Income.” For MPB, Other Comprehensive Income consists of unrealized gains and losses on available-for-sale securities, net of deferred income tax. Comprehensive Income should not be construed to be a measure of net income. The effect of Other Comprehensive Income would only be reflected in the income statement if the entire portfolio of available-for-sale securities were sold on the statement date. The amount of unrealized gains or losses reflected in Comprehensive Income may vary widely at statement dates depending on the markets as a whole and how the portfolio of available-for-sale securities is affected by interest rate movements. Other Comprehensive Income for the years ended December 31, 2003, 2002 and 2001 was $58,000, $1,413,000 and $288,000, respectively. 39 MID PENN BANCORP, INC. SUMMARY OF SELECTED FINANCIAL DATA (Dollars in thousands, except per share data) 2003 2002 2001 2000 1999 INCOME: $ Total Interest Income .................................. Total Interest Expense ................................ Net Interest Income..................................... Provision for Possible Loan Losses ......... Noninterest Income ..................................... Noninterest Expense ................................... Income Before Income Taxes..................... Provision for Income Taxes ....................... Net Income ..................................................... 19,984 8,434 11,550 290 2,707 8,099 5,868 1,253 4,615 COMMON STOCK DATA PER SHARE: Earnings Per Share ...................................... Cash Dividends Declared ............................ Stockholders' Equity ................................... $ 1.45 .80 11.72 21,352 9,926 11,426 425 2,022 7,258 5,765 1,270 4,495 1.41 .80 11.04 22,864 11,735 11,129 500 1,845 7,026 5,448 1,218 4,230 1.33 .80 9.94 22,053 11,455 10,598 325 1,556 6,656 5,203 1,255 3,948 1.24 .80 9.29 20,112 9,674 10,438 325 1,689 6,665 5,137 1,253 3,884 1.22 2.18 8.33 AVERAGE SHARES OUTSTANDING............. 3,188,504 3,188,333 3,190,802 3,187,807 3,189,875 AT YEAR-END: Investments ................................................... Loans, Net of Unearned Discount ............ Allowance for Loan Losses......................... Total Assets .................................................... Total Deposits................................................ Short-term Borrowings............................... Long-term Debt ............................................. Stockholders' Equity ................................... $ $ 54,093 232,078 2,992 373,466 288,338 9,688 35,684 37,361 RATIOS: Return on Average Assets .......................... Return on Average Stockholders' Equity Cash Dividend Payout Ratio ...................... Allowance for Loan Losses to Loans ....... Average Stockholders' Equity to 1.25 12.69 54.48 1.29 58,859 221,353 3,051 363,284 274,703 18,156 32,383 35,204 1.32 13.60 54.05 1.38 Average Assets.......................................... 9.97 9.67 55,348 202,836 2,856 330,635 254,105 9,610 32,568 31,716 1.31 13.68 57.55 1.41 9.67 73,885 184,211 2,815 315,584 231,408 22,738 29,241 29,626 1.34 14.64 61.54 1.53 9.15 64,099 172,294 2,505 287,542 217,840 24,636 16,400 26,565 1.40 14.68 170.91 1.45 9.50 40 DDIIRREECCTTOORRSS MMiidd PPeennnn BBaannccoorrpp,, IInncc.. MMiidd PPeennnn BBaannkk JJeerree MM.. CCooxxoonn Executive Vice President Penn Wood Products, Inc. AAllaann WW.. DDaakkeeyy President and CEO Mid Penn Bank AA.. JJaammeess DDuurriiccaa,, CCPPAA Consultant EEaarrll RR.. EEttzzwweeiilleerr Owner Etzweiler & Associates, Attorneys GGrreeggoorryy MM.. KKeerrwwiinn Senior Partner Kerwin & Kerwin, Attorneys CChhaarrlleess FF.. LLeebboo Retired Educator PA Dept. of Education TThheeooddoorree WW.. MMoowweerryy Partner Gunn-Mowery Insurance Group, Inc. WWiilllliiaamm GG.. NNeellssoonn President Hess Trucking Co., Inc. DDoonnaalldd EE.. SSaauuvvee Consultant Don’s Food Market, Inc. EEddwwiinn DD.. SScchhlleeggeell Retired Superintendent Millersburg Area School District EEuuggeennee FF.. SShhaaffffeerr Chairman Mid Penn Bank GGuuyy JJ.. SSnnyyddeerr,, JJrr.. President Snyder Fuels, Inc. DDIIRREECCTTOORRSS EEMMEERRIITTII GGuuyy FF.. BBuucchheerr HHaarrvveeyy JJ.. HHuummmmeell WWaarrrreenn AA.. MMiilllleerr CChhaarrlleess RR.. PPhhiilllliippss AAnnnnaa CC.. WWooooddssiiddee EEXXEECCUUTTIIVVEE OOFFFFIICCEERRSS MMiidd PPeennnn BBaannccoorrpp,, IInncc.. EEuuggeennee FF.. SShhaaffffeerr Chairman EEaarrll RR.. EEttzzwweeiilleerr Vice Chairman AAllaann WW.. DDaakkeeyy President and CEO KKeevviinn WW.. LLaauuddeennssllaaggeerr Treasurer CCiinnddyy LL.. WWeettzzeell Secretary SSEENNIIOORR MMAANNAAGGEEMMEENNTT MMiidd PPeennnn BBaannkk EEuuggeennee FF.. SShhaaffffeerr Chairman 47Years Banking Experience AAllaann WW.. DDaakkeeyy President and CEO 30Years Banking Experience KKeevviinn WW.. LLaauuddeennssllaaggeerr Executive Vice President and Chief Financial Officer 19Years Banking Experience EErriicc SS.. WWiilllliiaammss Executive Vice President and Senior Commercial Loan Officer 25Years Banking Experience RRaannddaallll LL.. KKlliinnggeerr Senior Vice President and Senior Credit Officer 30Years Banking Experience AAlllleenn JJ.. TTrraawwiittzz Executive Vice President 35Years Banking Experience KKaatthhyy II.. BBoorrddnneerr Vice President and Marketing Director 19Years Banking Experience NNeellssoonn EE.. CCaarrrr Vice President and Business Development Officer 43Years Banking Experience RRoobbeerrttaa AA.. HHooffffmmaann Vice President, Human Resources Officer and Asst. Secretary 28 Years Banking Experience MMiicchhaaeell TT.. LLeehhmmeerr Vice President and Senior Trust Officer 13Years Banking Experience SStteevveenn SS.. SShhuueeyy Vice President and Loan Review Officer 30Years Banking Experience LLiinnddaa MM.. SSiittlliinnggeerr Vice President and Sales Manager/Branch Administrator 24 Years Banking Experience DDeennnniiss EE.. SSppoottttss Vice President and Operations Officer 31 Years Banking Experience CCiinnddyy LL.. WWeettzzeell Vice President and Corporate Secretary 25Years Banking Experience CCAAPPIITTAALL AARREEAA AADDVVIISSOORRYY BBOOAARRDD MMiidd PPeennnn BBaannkk RRoobbeerrtt CC.. GGrruubbiicc NNoorrmmaann KK.. AA.. HHooffffeerr NNoorrmmaann LL.. HHoouusseerr TThheeooddoorree WW.. MMoowweerryy RRoobbeerrtt MM.. NNeewwbbuurryy DDaavviidd JJ.. RReemmmmeell RRoonnaalldd HH.. SSmmiitthh MILLERSBURG 349 Union Street Millersburg, PA 17061 (717) 692-2133 HARRISBURG 4098 Derry Street Harrisburg, PA 17111 (717) 558-2144 ELIZABETHVILLE 2 East Main Street Elizabethville, PA 17023 (717) 362-8147 CARLISLE PIKE 4622 Carlisle Pike Mechanicsburg, PA 17050 (717) 761-2480 DALMATIA PO Box 205, School Road Dalmatia, PA 17017 (570) 758-2711 HARRISBURG 2615 North Front Street Harrisburg, PA 17110 (717) 233-7380 TOWER CITY 545 East Grand Avenue Tower City, PA 17980 (717) 647-2157 DAUPHIN 1001 Peters Mountain Road Dauphin, PA 17018 (717) 921-8899 TREMONT 7-9 East Main Street Tremont, PA 17981 (570) 695-3358 HALIFAX Halifax Shopping Center 3763 Peters Mountain Road Halifax, PA 17032 (717) 896-8258 MINERS-LYKENS 550 Main Street Lykens, PA 17048 (717) 453-7185