Penns Woods Bancorp, Inc.
Annual Report 2002

Plain-text annual report

2002 Annual Report BUSINESS OF PENNS WOODS BANCORP, INC. Penns Woods Bancorp, Inc. is a bank holding company incorporated on January 7, 1983, under the Pennsylvania Business Corporation Law. Jersey Shore State Bank, the principal subsidiary of Penns Woods Bancorp, Inc., is a full-service commercial bank offering a wide range of commercial and consumer banking services to individual, business, public and institutional customers. Currently, Jersey Shore State Bank operates eleven banking offices in Jersey Shore, Duboistown, Williamsport, Montgomery, Mill Hall, Lock Haven, Spring Mills, Centre Hall, State College and Zion, as well as a Financial Center in State College. MISSION STATEMENT Jersey Shore State Bank is a locally owned, independent, community bank with emphasis on servicing the needs of consumers and small to medium size businesses at a profit, thereby enhancing shareholder value through a professionally-trained and dedicated staff with sound financial resources. We are committed to community leadership and growth. TABLE OF CONTENTS Letter to Shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Three Year Financial Highlights. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Report of Independent Auditors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consolidated Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consolidated Statement of Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consolidated Statement of Changes in Shareholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . . . Consolidated Statement of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 3 4 5 6 7 8 Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9-24 Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25-38 1 To our Shareholders Dear Shareholders: PROFITABILITY, HONESTY, QUALITY and LOYALTY. These are the core values of Penns Woods Bancorp, Inc. and the principles that define who we are. PROFITABILITY. It was another great year for Penns Woods Bancorp, Inc. Record net income of $8,886,000 or $2.93 per basic and dilutive share is a product of our hard work and dedication. This compares to consolidated net income for the same period in 2001 of $7,742,000 or $2.53 per basic and dilutive share representing an increase of 14.78%. Operating earnings alone increased an impressive 23.68% from year end 2001 to 2002. Strong earnings have produced favorable results in Penns Woods Bancorp, Inc.’s key financial ratios, which have surpassed our results of the prior year. Our return on average assets and return on average equity for the year ended December 31, 2002 were 2.01% and 15.00%, respectively. At December 31, 2001 return on average assets and return on average equity were 1.95% and 14.38%, respectively. The M Group, Inc., D/B/A The Comprehensive Financial Group, has greatly contributed to our success and has had a positive impact on all stakeholders. Aside from the four registered representatives in our branches, several Jersey Shore State Bank employees are now licensed, and are selling a variety of investment products. The development of this relationship has produced favorable results that have substantially added to our bottom line. The M Group, Inc. has added $549,000 to net income representing a 17% rate of return on our original investment. Success is also measured by the growth in shareholder value. Total dividends paid for 2002 were $1.36, or $0.14 more than the previous year of $1.22. This represents an 11.48% increase from last year and a current dividend payout of more than 46% of earnings. Book value per share of Penns Woods Bancorp, Inc. stock has increased 14.58% from the previous year to $20.83. In addition, our stock repurchase program extended to August 8, 2003 has bought back more than 101,000 shares to date. HONESTY. We take pride in not only our results, but also the path we take to achieve them. In 2002, investor confidence in the stock market as a whole was justifiably low due to a few large corporate scandals. The banking industry is already one of the more heavily regulated industries in this country, which has prepared us well to respond to new corporate regulations. QUALITY. Excellent financial performance and enhanced shareholder value are byproducts of providing quality service to our customers and community. Over the past few years, the Bank has expanded considerably into the Centre County market in an effort to spread our quality service to more consumers and communities. State College’s efficient and productive economy supports growth, which makes it attractive for business development. In 2002, we continued our expansion into the region with the opening of our fifth Centre County branch office. The State College Wal-Mart branch opened in May 2002. Our first office in State College, the Jersey Shore State Bank Financial Center, continues to excel in the market. In 2002, 40% of the bank’s closed mortgage loans were generated from the Financial Center. Technology continues to be an important issue in the banking industry and a top priority for our company. In order to provide quality service to our customers, technological advancements are vital. New technology is being used everyday to provide quick and easy access of information to our customers. For example, internet banking now offers the option to view check images in addition to bill payment services and the ability to view and download your statements. Internet banking has proven to be a useful tool to customers. The number of internet banking users has increased every week for more than one hundred consecutive weeks. Recently, we installed a wide area network. This will allow us to implement the most up to date technology throughout our branch system and reduce costs due to more efficient processing. In addition, it offers the ability for our branch personnel to communicate and advise customers with information not previously available. LOYALTY. Last year we wrote about the strong foundation of Penns Woods Bancorp, Inc., built upon our loyal employees, customers and shareholders. Loyalty to a company is a waning quality in many organizations but in 2002 we had 31 employees with over 20 years of experience with the company. To mention employee loyalty and devotion and not include Theodore H. Reich would be an oversight. As a force behind the success of Penns Woods Bancorp, Inc. Mr. Reich stepped away from his duties as Chairman of the Board on December 31, after 32 years of service. He will continue to support the company as an investment portfolio consultant. We have many things for which to be thankful including our loyal customers, shareholders and staff. It takes everyone working together to insure success. We look forward to meeting the challenges for the future with enthusiasm and confidence in the ability of our company. Very truly yours, Theodore H. Reich Chairman Emeritus 2 Ronald A. Walko President and Chief Executive Officer Three Year Financial Highlights YEAR-END DEPOSITS In Millions of Dollars YEAR-END LOANS In Millions of Dollars 340 305 278 $ 400 300 200 100 0 252 258 245 $ 400 300 200 100 0 DILUTED EARNINGS PER SHARE $4.00 3.00 2.93 2.53 2.10 2.00 1.00 0.00 ’00 ’01 ’02 ’00 ’01 ’02 ’00 ’01 ’02 DIVIDENDS PER SHARE $ 2.00 1.50 1.36 1.22 1.10 1.00 0.50 0.00 RETURN ON AVERAGE ASSETS Percent 3.00 RETURN ON AVERAGE EQUITY Percent 25.00 20.00 2.00 1.74 1.95 2.01 15.00 13.77 14.38 15.00 1.00 0.00 10.00 5.00 0.00 ’00 ’01 ’02 ’00 ’01 ’02 ’00 ’01 ’02 3 REPORT OF INDEPENDENT AUDITORS Board of Directors and Shareholders Penns Woods Bancorp, Inc. We have audited the accompanying consolidated balance sheet of Penns Woods Bancorp, Inc. and subsidiaries, as of December 31, 2002 and 2001, and the related consolidated statements of income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2002. These consolidated financial statements are the responsibility of the Company’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 Penns Woods Bancorp, Inc. and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. Wexford, PA February 14, 2003 4 Penns Woods Bancorp, Inc. Consolidated Balance Sheet $ $ $ ASSETS: Cash and due from banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities held to maturity (fair value of $1,289 and $1,312) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans, net of unearned discount of $769 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: Allowance for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bank premises and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bank-owned life insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TOTAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . LIABILITIES: Interest-bearing deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Noninterest-bearing deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TOTAL DEPOSITS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short-term borrowings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other borrowings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TOTAL LIABILITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . SHAREHOLDERS’ EQUITY: Common stock, par value $10; 10,000,000 shares authorized 3,136,832 and 3,131,644 shares issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Treasury stock, at cost (105,503 and 92,054 shares) . . . . . . . . . . . . . . . . . . . . . . . . . . . . TOTAL SHAREHOLDERS’ EQUITY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TOTAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 472,206 $ See Accompanying Notes to the Consolidated Financial Statements. December 31, 2002 2001 (in thousands) 11,731 176,436 $ $ $ 1,181 2,651 257,845 2,953 254,892 4,856 2,460 8,537 3,032 6,430 472,206 272,787 67,061 339,848 13,563 51,778 1,092 2,783 409,064 31,368 18,291 11,749 5,145 (3,411) 63,142 14,844 131,985 1,302 3,993 251,623 2,927 248,696 4,478 2,685 8,126 3,032 5,669 424,810 249,873 55,277 305,150 19,105 41,778 1,190 2,335 369,558 31,316 18,230 6,987 1,729 (3,010) 55,252 424,810 5 Penns Woods Bancorp, Inc. Consolidated Statement of Income INTEREST AND DIVIDEND INCOME: Interest and fees on loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Interest and dividends on investments: Taxable interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tax-exempt interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other dividend income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TOTAL INTEREST AND DIVIDEND INCOME . . . . . . . . . . . . . . . INTEREST EXPENSE: Interest on deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest on short-term borrowings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest on other borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TOTAL INTEREST EXPENSE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . NET INTEREST INCOME . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . PROVISION FOR LOAN LOSSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . NET INTEREST INCOME AFTER PROVISION Year Ended December 31, 2002 2000 2001 (in thousands, except per share data) 20,911 $ 21,919 $ 21,570 4,314 3,252 627 29,104 7,857 501 2,488 10,846 18,258 365 3,112 3,066 639 28,736 9,657 903 1,921 12,481 16,255 372 3,954 2,205 725 28,454 9,165 1,866 1,747 12,778 15,676 286 FOR LOAN LOSSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,893 15,883 15,390 OTHER INCOME: Service charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities gains, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings on bank-owned life insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Insurance commissions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other operating income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TOTAL OTHER INCOME . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . OTHER EXPENSES: Salaries and employee benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Occupancy expense, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Furniture and equipment expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pennsylvania shares tax expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TOTAL OTHER EXPENSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . INCOME BEFORE INCOME TAX PROVISION . . . . . . . . . . . . . . . . . . INCOME TAX PROVISION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . NET INCOME. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ EARNINGS PER SHARE – BASIC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ EARNINGS PER SHARE – DILUTED . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,833 233 416 1,807 1,164 5,453 6,944 831 837 411 3,190 12,213 11,133 2,247 8,886 2.93 2.93 $ $ $ 1,565 1,033 174 1,416 921 5,109 5,792 787 739 370 3,584 11,272 9,720 1,978 7,742 2.53 2.53 $ $ $ 1,357 269 97 368 524 2,615 5,136 745 758 334 2,847 9,820 8,185 1,619 6,566 2.10 2.10 See Accompanying Notes to the Consolidated Financial Statements. 6 Penns Woods Bancorp, Inc. Consolidated Statement of Changes In Shareholders’ Equity . . .COMMON STOCK. . . SHARES AMOUNT ADDITIONAL PAID-IN CAPITAL RETAINED EARNINGS ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) TOTAL TREASURY SHAREHOLDERS’ STOCK EQUITY (in thousands, except per share data) Balance, December 31, 1999 3,128,332 $ 31,283 $ 18,165 $ (166) $ (2,927 ) $ (270 ) $ 46,085 Comprehensive Income: Net income Unrealized gain on available for sale securities, net of reclassification adjustments and tax $1,091 Total comprehensive income Dividends declared, ($1.10 per share) Stock options exercised Treasury stock acquired, 28,591 shares Balance, December 31, 2000 Comprehensive Income: Net income Unrealized gain on available for sale securities, net of reclassification adjustments and tax of $1,308 Total comprehensive income Dividends declared, ($1.22 per share) Stock options exercised Treasury stock acquired, 58,503 shares Balance, December 31, 2001 Comprehensive Income: Net income Unrealized gain on available for sale securities, net of reclassification adjustments and tax of $1,760 Total comprehensive income Dividends declared, ($1.36 per share) Stock options exercised Treasury stock acquired, 13,449 shares 6,566 (3,426) 2,117 2,512 25 49 3,130,844 31,308 18,214 2,974 (810 ) 7,742 (3,729) 2,539 800 8 16 3,131,644 31,316 18,230 6,987 1,729 8,886 (4,124) 3,416 5,188 52 61 6,566 2,117 8,683 (3,426) 74 (902) 50,514 7,742 2,539 10,281 (3,729) 24 (1,838) 55,252 8,886 3,416 12,302 (4,124) 113 (401) (902 ) (1,172 ) (1,838 ) (3,010 ) (401 ) Balance, December 31, 2002 3,136,832 $ 31,368 $ 18,291 $ 11,749 $ 5,145 $ (3,411 ) $ 63,142 Components of comprehensive income: Change in net unrealized gain on investments available for sale Realized gains included in net income, net of tax $79, $351 and $91 Total 2002 2001 2000 $ 3,570 $ 3,221 $ 2,295 (154) (682) (178) $ 3,416 $ 2,539 $ 2,117 See Accompanying Notes to the Consolidated Financial Statements 7 Penns Woods Bancorp, Inc. Consolidated Statement of Cash Flows OPERATING ACTIVITIES: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Adjustments to reconcile net income to net cash provided by operating activities: 2002 Year Ended December 31, 2001 (in thousands) 2000 8,886 $ 7,742 $ 6,566 Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accretion and amortization of investment security discounts and premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities gains, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Originations of loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds of loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings on bank-owned life insurance . . . . . . . . . . . . . . . . . . . . . . Decrease (increase) in all other assets . . . . . . . . . . . . . . . . . . . . . . . Increase in all other liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . 526 365 (906) (233) (16,597) 17,939 (416) (1,465) 473 8,572 INVESTING ACTIVITIES: Investment securities available for sale: Proceeds from sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from calls and maturities . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79,022 13,047 (130,328) Investment securities held to maturity: Proceeds from calls and maturities . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net increase in loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Acquisition of bank premises and equipment . . . . . . . . . . . . . . . . . . . . . Proceeds from the sale of foreclosed assets . . . . . . . . . . . . . . . . . . . . . . Purchase of bank-owned life insurance . . . . . . . . . . . . . . . . . . . . . . . . . . Acquisition of a subsidiary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross proceeds from redemption of regulatory stock . . . . . . . . . . . . . . . Gross purchases of regulatory stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137 (41) (6,800) (992) 344 – – 1,262 (2,080) 489 372 (843) (1,033) (24,311) 22,006 (174) (577) 59 3,730 22,156 12,765 (48,151) 1,963 (25) (7,148) (323) 592 (5,589) – 943 (941) 551 286 (610) (269) (14,022) 14,342 (97) 588 309 7,644 53,301 6,142 (57,973) 58 (273) (13,213) (390) 168 (1,298) (3,321) – (179) Net cash used for investing activities . . . . . . . . . . . . . . . . . . . . . . . . (46,429) ________________ (23,758) ________________ (16,978) ________________ FINANCING ACTIVITIES: Net increase in interest-bearing deposits . . . . . . . . . . . . . . . . . . . . . . . . . Net increase in noninterest-bearing deposits . . . . . . . . . . . . . . . . . . . . . . Net decrease in short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from other borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repayment of other borrowings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock options exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by financing activities. . . . . . . . . . . . . . . . . . . . . 22,914 11,784 (5,542) 10,000 – (4,124) 113 (401) ________________ 34,744 ________________ 19,208 7,808 (11,916) 10,000 – (3,729) 21 (1,838) ________________ 19,554 ________________ 18,138 4,423 (10,620) 5,000 (500) (3,426) 65 (902) ________________ 12,178 ________________ NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . CASH AND CASH EQUIVALENTS, BEGINNING . . . . . . . . . . . . . . . . . . CASH AND CASH EQUIVALENTS, ENDING . . . . . . . . . . . . . . . . . . . . . . $ (3,113) 14,844 ________________ 11,731 ________________ ________________ (474) 15,318 ________________ $ 14,844 ________________ ________________ 2,844 12,474 ________________ $ 15,318 ________________ ________________ SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: The Company paid approximately $10,944,000, $12,743,000, and $12,449,000 in interest on deposits and other borrowings during 2002, 2001, and 2000, respectively. The Company made income tax payments of approximately $3,394,000, $2,136,000, and $2,008,000 during 2002, 2001, and 2000, respectively. Transfers from loans to foreclosed assets held for sale amounted to approximately $254,000, $493,000, and $294,000 in 2002, 2001, and 2000, respectively. See Accompanying Notes to the Consolidated Financial Statements 8 PENNS WOODS BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE A — NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The accompanying consolidated financial statements include the accounts of Penns Woods Bancorp, Inc. and its wholly-owned subsidiaries, Jersey Shore State Bank (the “Bank”), Woods Real Estate Development Co., Inc., Woods Investment Company, Inc. and The M Group Inc. D/B/A The Comprehensive Financial Group (“The M Group”), a wholly-owned subsidiary of the Bank (collectively, the “Company”). All significant intercompany balances and transactions have been eliminated. Nature of Business The Bank engages in a full-service commercial banking business, making available to the community a wide range of financial services including, but not limited to, installment loans, credit cards, mortgage and home equity loans, lines of credit, construction financing, farm loans, community development loans, loans to nonprofit 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. Deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”) to the extent provided by law. The financial services are provided by the bank to individuals, partnerships, non-profit organizations and corporations through its eleven offices and Financial Center located in Clinton, Lycoming, and Centre Counties, Pennsylvania. Woods Real Estate Development Co., Inc. engages in real estate transactions on behalf of Penns Woods Bancorp, Inc. and the Bank. Woods Investment Company, Inc. is engaged in investing activities. The M Group engages in securities brokerage and insurance activities. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses and the valuation of real estate acquired through, or in lieu of, foreclosure on settlement of debt. Investment Securities Investment securities are classified as held to maturity, available for sale, or trading. Securities held to maturity include bonds, notes, and debentures for which the Company has the positive intent and ability to hold to maturity and are reported at amortized cost. Trading account securities are recorded at their fair values. Unrealized gains and losses on trading account securities are included in other income. The Company has no trading account securities as of December 31, 2002 or 2001. Available for sale securities consist of bonds, notes, debentures, and certain equity securities not classified as trading securities nor as held to maturity securities. Unrealized holding gains and losses, net of tax, on available for sale securities are reported as a net amount in a separate component of shareholders’ equity until realized. Gains and losses on the sale of equity securities are determined using the average cost method, while all other investment securities use the specific cost method. Declines in the fair value of individual securities held to maturity and available for sale below their cost that are other than temporary result in write-downs of the individual securities to their fair value and are included in earnings as realized losses. Premiums and discounts on all securities are recognized in interest income using the interest method over the period to maturity. The fair value of investments and mortgage-backed securities, except certain state and political securities, is estimated based on bid prices published in financial newspapers, quotations received from securities dealers, or, in the case of equity securities, the closing price of the day as listed on the Internet. The fair value of certain state and political securities is not readily available through market sources other than dealer quotations, therefore these fair value estimates are then based on quoted market prices of similar instruments, adjusted for differences between the quoted instruments and the instruments being valued. Loans Loans are stated at the principal amount outstanding, net of unearned discount, unamortized loan fees and costs, and the allowance for loan losses. Interest on loans is recognized as income when earned on the accrual method. The Company’s general policy has been to stop accruing interest on loans when it is determined a reasonable doubt exists as to the collectibility of additional interest. Income is subsequently recognized only to the extent that cash payments are received provided the loan is not delinquent in payment and, in management’s judgment, the borrower has the ability and intent to make future principal payments. Allowance for Loan Losses The allowance for loan losses represents the amount which management estimates is adequate to provide for probable losses inherent in its loan portfolio, as of the balance sheet date. The allowance method is used in providing for loan losses. Accordingly, all loan losses are charged to the allowance and all recoveries are credited to it. The allowance for loan losses is established through a provision for loan losses charged to operations. The provision for loan losses is based on management’s periodic evaluation of individual loans, economic factors, past loan loss experience, changes in the composition and volume of the portfolio, and other relevant factors. The estimates used in determining the adequacy of the allowance for loan losses, including the amounts and timing of future cash flows expected on impaired loans, are particularly susceptible to changes in the near term. Impaired loans are commercial and commercial real estate loans for which it is probable the Company will not be able to collect all amounts due according to the contractual terms of the loan agreement. The Company individually evaluates such loans for impairment and does not aggregate loans by major risk classifications. The definition of “impaired loans” is not the same as the definition of “nonaccrual loans,” although the two categories overlap. The Company may choose to place a loan on nonaccrual status due to payment delinquency or uncertain collectibility, while not classifying the loan as impaired if the loan is not a commercial or commercial real estate loan. Factors considered by management in determining impairment include payment status and collateral value. The amount of impairment for these types of impaired loans is determined by the difference between the present value of the expected cash flows related to the loan, using the original interest rate, and its recorded value, or as a practical expedient in the case of collateralized loans, the difference between the fair value of the collateral and the recorded amount of 9 the loans. When foreclosure is probable, impairment is measured based on the fair value of the collateral. Mortgage loans on one-to-four family properties and all consumer loans are large groups of smaller-balance homogeneous loans and are measured for impairment collectively. Loans that experience insignificant payment delays, which are defined as 90 days or less, generally are not classified as impaired. Management determines the significance of payment delays on a case-by-case basis taking into consideration all circumstances surrounding the loan and the borrower including the length of the delay, the borrower’s prior payment record, and the amount of shortfall in relation to the principal and interest owed. Loans Held for Sale In general, fixed rate residential mortgage loans originated by the Bank are held for sale and are carried at the aggregate lower of cost or market. Such loans sold are not serviced by the Bank. Foreclosed Assets Held for Sale Foreclosed assets held for sale are carried at the lower of fair value minus estimated costs to sell or cost. Prior to foreclosure, the value of the underlying loan is written down to the fair value of the real estate to be acquired by a charge to the allowance for loan losses, if necessary. Any subsequent write-downs are charged against operating expenses. Operating expenses of such properties, net of related income, and gains and losses on their disposition are included in other expenses. Bank Premises and Equipment Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed using straight-line and accelerated methods over the estimated useful lives of the related assets, which range from five to seven years for furniture, fixtures and equipment and thirty- one and a half for buildings and improvements. Costs incurred for routine maintenance and repairs are charged to operations as incurred. Costs of major additions and improvements are capitalized. Goodwill Goodwill is the excess cost over the fair market value of assets acquired in connection with business acquisitions and was being amortized on the straight-line method over fifteen years, prior to October 1, 2001. On October 1, 2001, the Company adopted FAS No. 142, Goodwill and Other Intangible Assets, which changed the accounting for goodwill from an amortization method to an impairment-only approach. This statement eliminates the regularly scheduled amortization of goodwill and replaces this method with a two-step process for testing the impairment of goodwill on at least an annual basis. This approach could cause more volatility in the Company’s reported net income because impairment losses, if any, could occur irregularly and in varying amounts. The Company, upon adoption of this statement, stopped amortizing existing goodwill of $3.0 million. In addition, the Company performed its initial impairment analysis of goodwill and other intangible assets and determined that the estimated fair value exceeded the carrying amount. Income Taxes Deferred tax assets and liabilities result from temporary differences in financial and income tax methods of accounting, and are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Earnings Per Share The Company provides dual presentation of basic and diluted earnings per share. Basic earnings per share is calculated utilizing net income as reported in the numerator and average shares outstanding in the denominator. The computation of diluted earnings per share differs in that the dilutive effects of any stock options are adjusted in the denominator. Stock Options The Company maintains a stock option plan for the directors, officers and employees. When the exercise price of the Company’s stock options is greater than or equal to the market price of the underlying stock on the date of the grant, no compensation expense is recognized in the Company’s financial statements. Pro forma net income and earnings per share are presented to reflect the impact of the stock option plan assuming compensation expense had been recognized based on the fair value of the stock options granted under the plan. The Company applies Accounting Principles Board Opinion No. 25 and related interpretations in accounting for these options. Accordingly, compensation expense is recognized on the grant date, in the amount equivalent to the intrinsic value of the options (stock price less exercise price, at measurement date). Had compensation costs for these options been determined based on the fair values at the grant dates for awards consistent with the method of FAS No. 123, there would be no effect on the Company’s net income and earnings per share for 2002, 2001, and 2000 would have been insignificant. For purposes of the calculations required by FAS No. 123, the fair value of each option grant is estimated on the date of the grant using the Black-Scholes option-pricing model with the following weighted-average assumptions for grants issued in 2000, 1999 and 1998, respectively: dividend yield of 1.03 percent, 1.03 percent, and 1.85 percent, respectively; risk-free interest rates of 4.95 percent, 4.95 percent, and 6.75 percent, respectively; expected option lives of three years and expected volatility of 23.81 percent, 23.81 percent, and 18.73 percent, respectively. Comprehensive Income The Company is required to present comprehensive income in a full set of general-purpose financial statements for all periods presented. Other comprehensive income is comprised exclusively of unrealized holding gains (losses) on the available for sale securities portfolio. The Company has elected to report the effects of other comprehensive income as part of the Consolidated Statement of Changes in Shareholders’ Equity. Cash Flows The Company utilizes the net reporting of cash receipts and cash payments for deposit and lending activities. The Company considers amounts due from banks as cash equivalents. Reclassification of Comparative Amounts Certain items previously reported have been reclassified to conform to the current year’s reporting format. Such reclassifications did not affect net income or stockholders’ equity. Recent Accounting Pronouncements In August 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“FAS”) No. 143, Accounting for Asset Retirement Obligations, which requires that the fair value of a liability be recognized when incurred for the retirement of a long-lived asset and the value of the asset be increased by that amount. The statement also requires that the liability be maintained at its present value in subsequent periods and outlines certain disclosures for such obligations. The adoption of this statement, which is effective January 1, 2003, is not expected to have a material effect on the Company’s financial statements. In October 2001, the FASB issued FAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. FAS No. 144 supercedes FAS No. 121 and applies to all long-lived assets (including discontinued operations) and consequently amends APB Opinion No. 30, Reporting Results of Operations-Reporting the Effects of Disposal of a Segment of a Business. FAS No. 144 requires that long-lived assets that are to be disposed of by sale be measured at the lower of book value or fair value less costs to sell. FAS No. 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001 and, generally, its provisions are to be applied prospectively. The adoption of this statement did not have a material effect on the Company’s financial statements. 10 In April 2002, the FASB issued FAS No. 145, Recission of FASB Statement No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections. FAS No. 145 rescinds FAS No. 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. As a result, the criteria in APB Opinion No. 30 will now be used to classify those gains and losses. This statement also amends FAS No. 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. This statement also makes technical corrections to existing pronouncements, which are not substantive but in some cases may change accounting practice. The provisions of this statement related to the rescission of FAS No. 4 shall be applied in fiscal years beginning after May 15, 2002. Any gain or loss on extinguishments of debt that was classified as an extraordinary item in prior periods presented that does not meet the criteria in APB Opinion No. 30 for classification as an extraordinary item shall be reclassified. Early adoption of the provisions of this statement related to FAS No. 13 shall be effective for transactions occurring after May 15, 2002. All other provisions of this statement shall be effective for financial statements issued on or after May 15, 2002. Early application of this statement is encouraged. The adoption of the effective portions of this statement did not have an impact on the Company’s financial position or results of operations. The adoption of the remaining portions of this statement is not expected to have an impact on the Company’s financial position or results of operations. In July 2002, the FASB issued FAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. This statement replaces EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring). The new statement will be effective for exit or disposal activities initiated after December 31, 2002, the adoption of which is not expected to have a material effect on the Company’s financial statements. On October 1, 2002, FASB issued FAS No. 147, Acquisitions of Certain Financial Institutions, effective for all business combinations initiated after October 1, 2002. This statement addresses the financial accounting and reporting for the acquisition of all or part of a financial institution, except for a transaction between two or more mutual enterprises. This statement removes acquisitions of financial institutions, other than transactions between two or more mutual enterprises, from the scope of FAS No. 72, Accounting for Certain Acquisitions of Banking or Thrift Institutions, and FASB Interpretation No. 9, Applying APB Opinions No. 16 and 17 When a Savings and Loan Association or a Similar Institution Is Acquired in a Business Combination Accounted for by the Purchase Method. The acquisition of all or part of a financial institution that meets the definition of a business combination shall be accounted for by the purchase method in accordance with FAS No. 141, Business Combinations, and FAS No. 142, Goodwill and Other Intangible Assets. This statement also provides guidance on the accounting for the impairment or disposal of acquired long-term customer-relationship intangible assets (such as depositor- and borrower-relationship intangible assets and credit cardholder intangible assets), including those acquired in transactions between two or more mutual enterprises. The adoption of this statement did not have a material effect on the Company’s financial statements. On December 31, 2002, the FASB issued FAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, which amends FAS No. 123, Accounting for Stock-Based Compensation. FAS No. 148 amends the disclosure requirements of FAS No. 123 to require more prominent and more frequent disclosures in financial statements about the effects of stock-based compensation. Under the provisions of FAS No. 123, companies that adopted the preferable, fair value based method were required to apply that method prospectively for new stock option awards. This contributed to a “ramp-up” effect on stock-based compensation expense in the first few years following adoption, which caused concern for companies and investors because of the lack of consistency in reported results. To address that concern, FAS No. 148 provides two additional methods of transition that reflect an entity’s full complement of stock-based compensation expense immediately upon adoption, thereby eliminating the ramp-up effect. FAS No. 148 also improves the clarity and prominence of disclosures about the pro forma effects of using the fair value based method of accounting for stock-based compensation for all companies—regardless of the accounting method used—by requiring that the data be presented more prominently and in a more user-friendly format in the footnotes to the financial statements. In addition, the statement improves the timeliness of those disclosures by requiring that this information be included in interim as well as annual financial statements. The transition guidance and annual disclosure provisions of FAS No. 148 are effective for fiscal years ending after December 15, 2002, with earlier application permitted in certain circumstances. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002. In November, 2002, the FASB issued Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. This interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. This interpretation clarifies that a guarantor is required to disclose (a) the nature of the guarantee, including the approximate term of the guarantee, how the guarantee arose, and the events or circumstances that would require the guarantor to perform under the guarantee; (b) the maximum potential amount of future payments under the guarantee; (c) the carrying amount of the liability, if any, for the guarantor’s obligations under the guarantee; and (d) the nature and extent of any recourse provisions or available collateral that would enable the guarantor to recover the amounts paid under the guarantee. This interpretation also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the obligations it has undertaken in issuing the guarantee, including its ongoing obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur. The objective of the initial measurement of that liability is the fair value of the guarantee at its inception. The initial recognition and initial measurement provisions of this interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The disclosure requirements in this interpretation are effective for financial statements of interim or annual periods ending after December 15, 2002. NOTE B - PER SHARE DATA There are no convertible securities, which would affect the numerator in calculating basic and dilutive earnings per share, therefore, net income as presented on the consolidated statement of income will be used as the numerator. The following table sets forth the composition of the weighted average common shares (denominator) used in the basic and dilutive per share computation. Weighted average common shares outstanding Average treasury stock shares 2002 3,132,252 (99,241) 2001 3,130,846 (65,532) 2000 3,130,178 (10,638) Weighted average common shares and common stock equivalents used to calculate basic earnings per share 3,033,011 3,065,314 3,119,540 Additional common stock equivalents (stock options) used to calculate diluted earnings per share Weighted average common shares and common stock equivalents 2,670 2,037 — used to calculate diluted earnings per share 3,035,681 3,067,351 3,119,540 Options to purchase 20,350 shares of common stock at prices from $42.00 to $53.18 were outstanding during 2002 and 2001, and 30,350 shares at prices from $32.63 to $53.18 were outstanding during 2000, but were not included in the computation of diluted earnings per share because to do so would have been anti-dilutive. 11 NOTE C - INVESTMENT SECURITIES The amortized cost of investment securities and their approximate fair values are as follows (in thousands): 2002 GROSS AMORTIZED UNREALIZED UNREALIZED GAINS LOSSES GROSS COST 87,142 $ 67,319 1,766 156,227 12,414 168,641 $ 94 $ 796 291 1,181 $ — $ (234) (2) (236) (456) (692) $ — $ — (1) (1) $ 1,856 $ 3,596 46 5,498 2,989 8,487 $ — $ 109 — 109 $ 2001 GROSS AMORTIZED UNREALIZED UNREALIZED GAINS LOSSES GROSS COST 25,851 $ 81,559 817 108,227 21,138 129,365 $ 196 $ 796 310 1,302 $ 130 $ 2,494 3 2,627 2,911 5,538 $ 7 $ 23 — 30 $ (161) $ (797) (4) (962) (1,956) (2,918) $ — $ (20) — (20) $ FAIR VALUE 88,998 70,681 1,810 161,489 14,947 176,436 94 905 290 1,289 FAIR VALUE 25,820 83,256 816 109,892 22,093 131,985 203 799 310 1,312 Available for Sale: U.S. Government and agency securities. . . . . . $ State and political securities. . . . . . . . . . . . . . . Other debt securities. . . . . . . . . . . . . . . . . . . . . Total debt securities Equity securities . . . . . . . . . . . . . . . . . . . . . . . . $ Held to Maturity: U.S. Government and agency securities. . . . . . $ State and political securities. . . . . . . . . . . . . . . Other debt securities. . . . . . . . . . . . . . . . . . . . . $ Available for Sale: U.S. Government and agency securities. . . . . . $ State and political securities. . . . . . . . . . . . . . . Other debt securities. . . . . . . . . . . . . . . . . . . . . Total debt securities Equity securities . . . . . . . . . . . . . . . . . . . . . . . . $ Held to Maturity: U.S. Government and agency securities. . . . . . $ State and political securities. . . . . . . . . . . . . . . Other debt securities. . . . . . . . . . . . . . . . . . . . . $ 12 The amortized cost and fair value of debt securities at December 31, 2002, by contractual maturity, are shown below (in thousands). Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. HELD TO MATURITY AVAILABLE FOR SALE AMORTIZED COST FAIR VALUE AMORTIZED COST FAIR VALUE Due in one year or less . . . . . . . . . . . . . . . . . . . . . . $ Due after one year to five years. . . . . . . . . . . . . . . . Due after five years to ten years . . . . . . . . . . . . . . . Due after ten years. . . . . . . . . . . . . . . . . . . . . . . . . . 2,087 306 $ 10,654 100 27,566 141 121,182 742 ____________________ ____________________ ____________________ _________________ $ 161,489 1,289 $ ____________________ ____________________ ____________________ _________________ ____________________ ____________________ ____________________ _________________ 2,017 $ 10,377 27,149 116,684 156,227 $ 300 $ 100 141 640 1,181 $ Total gross proceeds from sales of securities available for sale were $79,022,000, $22,156,000 and $53,301,000 for 2002, 2001 and 2000, respectively. The following table represents gross realized gains and gross realized losses on those transactions (in thousands): Gross realized gains: 2002 2001 2000 U.S. Government and agency securities. . . . . . . . . . . . . . . . . . . . . . $ State and political securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other debt securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204 $ 2,234 6 1,803 133 $ 20 — 1,226 36 170 — 1,577 Gross realized losses: U.S. Government and agency securities. . . . . . . . . . . . . . . . . . . . . . $ State and political securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125 $ 67 3,822 13 $ 149 184 731 30 753 $ ____________________ ____________________ 4,247 $ ___________________ ___________________ 1,379 $ 1,783 ________________ ________________ $ ____________________ ____________________ 4,014 $ ___________________ ___________________ 346 $ 1,514 ________________ ________________ In 2002, the Company recorded an investment security gain of $69,000 resulting from a business combination where the Company received the common stock of the acquirer in a non-monetary exchange. This gain is included in the above table. A charge of $270,000 was recorded in 2002 to recognize other than temporary declines in the value of marketable equity securities. This loss is included in the above table. Investment securities with a carrying value of approximately $34,914,000 and $36,539,000 at December 31, 2002 and 2001, respectively, were pledged to secure certain deposits, security repurchase agreements, and for other purposes as required by law. There is no concentration of investments that exceed ten percent of shareholders’ equity for any individual issuer, excluding those guaranteed by the U.S. Government. NOTE D - LOANS Major loan classifications are summarized as follows (in thousands): Commercial and agricultural. . . . . . . . . . Real estate mortgage: Residential . . . . . . . . . . . . . . . . . . . . Commercial . . . . . . . . . . . . . . . . . . . Construction . . . . . . . . . . . . . . . . . . . Installment loans to individuals . . . . . . . Less: Allowance for loan losses Loans, net CURRENT 22,652 $ 136,819 73,988 3,335 14,593 _________________ $ 251,387 _________________ _________________ 2,953 248,434 $ 2002 PAST DUE 30 TO 90 DAYS $ 769 PAST DUE 90 DAYS OR MORE $ 7 NON- ACCRUAL $ 280 2,752 504 21 316 _________________ 4,362 $ _________________ _________________ 175 1,006 — 37 _________________ $ 1,225 _________________ _________________ 526 65 — — _________________ $ 871 _________________ _________________ TOTAL $ 23,708 140,272 75,563 3,356 14,946 _______________ $ 257,845 _______________ _______________ 2,953 254,892 $ 13 Commercial and agricultural. . . . . . . . . . Real estate mortgage: Residential . . . . . . . . . . . . . . . . . . . . Commercial . . . . . . . . . . . . . . . . . . . Construction . . . . . . . . . . . . . . . . . . . Installment loans to individuals . . . . . . . Less: Allowance for loan losses Loans, net CURRENT 22,233 $ 136,361 64,051 4,042 17,583 _________________ $ 244,270 _________________ _________________ 2,927 241,343 $ 2001 PAST DUE 30 TO 90 DAYS $ 334 PAST DUE 90 DAYS OR MORE $ 36 NON- ACCRUAL $ 26 3,311 2,712 35 342 _________________ $ 6,734 _________________ _________________ 296 — — 6 _________________ $ 338 _________________ _________________ 255 — — — _________________ $ 281 _________________ _________________ TOTAL $ 22,629 140,223 66,763 4,077 17,931 _______________ $ 251,623 _______________ _______________ 2,927 248,696 $ Loans on which the accrual of interest has been discontinued or reduced amounted to approximately $871,000 and $281,000 at December 31, 2002 and 2001, respectively. If interest had been recorded at the original rate on those loans, such income would have approximated $24,000, $28,000 and $86,000 for the years ended December 31, 2002, 2001 and 2000, respectively. Interest income on such loans, which is recorded as received, amounted to approximately $17,000, $19,000 and $45,000 for the years ended December 31, 2002, 2001 and 2000, respectively. Changes in the allowance for loan losses for the years ended December 31, are as follows (in thousands): Balance, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Provision charged to operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans charged off . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,927 365 (402) 63 $ 2,879 372 (358) 34 Balance, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,953 $ 2,927 $ 2,823 286 (269) 39 2,879 2002 2001 2000 The Company had no concentration of loans to borrowers engaged in similar businesses or activities which exceed five percent of total assets at December 31, 2002 or December 31, 2001. The Company grants commercial, industrial, residential, and installment loans to customers throughout North-central Pennsylvania. Although the Company has a diversified loan portfolio at December 31, 2002 and 2001, a substantial portion of its debtors’ ability to honor their contracts is dependent on the economic conditions within this region. NOTE E - BANK PREMISES AND EQUIPMENT Major classifications of Bank premises and equipment are summarized as follows at December 31, (in thousands): 2002 2001 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Bank premises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Furniture and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leasehold improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 566 4,668 5,292 834 ________________ 11,360 6,882 ________________ $ 4,478 ________________ ________________ Depreciation charges to operations for the years ended 2002, 2001 and 2000 was $526,000, $489,000 and $551,000, respectively. 566 4,855 6,001 842 __________________ 12,264 7,408 __________________ 4,856 __________________ __________________ Net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 14 NOTE F - GOODWILL A summary of goodwill is as follows: Gross carrying amount. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Less accumulated amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net carrying amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,308 (276) __________________ 3,032 __________________ __________________ 3,308 $ (276) ________________ $ 3,032 ________________ ________________ Amortization expense amounted to $221,000 for 2001. The gross carrying amount of goodwill was tested for impairment in the second quarter. The Company performed its initial impairment analysis of goodwill noting that the estimated fair value exceeded the carrying amount. The following tables sets forth a comparison of net income and basic and diluted earnings per share adjusted for the adoption of FAS No. 142, Goodwill and Other Intangible Assets: 2002 2001 Goodwill amortization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ — $ 221 $ 55 2002 2001 (Dollars in thousands, except per share amounts) 2000 Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Addback: Goodwill amortizaton (net of tax) . . . . . . . . . . . . . . . . . . . . . . . Adjusted net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Basic earnings per share: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Goodwill amortization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjusted basic earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Diluted earnings per share: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Goodwill amortization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjusted diluted earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,886 — ________________ 8,886 ________________ ________________ 2.93 — ________________ 2.93 ________________ ________________ 2.93 — ________________ 2.93 ________________ ________________ $ 7,742 146 ________________ $ 7,888 ________________ ________________ $ 6,566 36 ___________________ $ 6,602 ___________________ ___________________ $ 2.53 0.04 ________________ $ 2.57 ________________ ________________ $ 2.10 0.01 ___________________ $ 2.11 ___________________ ___________________ $ 2.53 0.04 ________________ $ 2.57 ________________ ________________ $ 2.10 0.01 ___________________ $ 2.11 ___________________ ___________________ NOTE G - DEPOSITS Time deposits of $100,000 or more totaled approximately $29,126,000 on December 31, 2002 and $32,646,000 on December 31, 2001. Interest expense related to such deposits was approximately $1,098,000, $1,913,000 and $1,571,000 for the years ended December 31, 2002, 2001 and 2000, respectively. Maturities on time deposits of $100,000 or more are as follows: Three months or less Three months to six months Six months to twelve months Over twelve months Total $ $ 2002 6,770 7,436 6,093 8,827 29,126 Time deposits at December 31, 2002 mature as follows: 2003 - $85,397,000; 2004 - $20,365,000; 2005 - $15,168,000; 2006 - $10,627,000; 2007 – $1,169,000; thereafter - $1,054,000. 15 NOTE H - SHORT-TERM BORROWINGS Short-term borrowings consist of securities sold under agreements to repurchase and FHLB advances which generally represent overnight or less than 30-day borrowings. The outstanding balances and related information for short-term borrowings are summarized as follows (in thousands): Open Repo Plus: Balance at year end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Maximum amount outstanding at any month end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average balance outstanding during the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Weighted-average interest rate: At year end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Paid during the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repurchase Agreements: Balance at year end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Maximum amount outstanding at any month end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average balance outstanding during the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Weighted-average interest rate: At year end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Paid during the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2002 2001 $ $ 1,840 8,510 1,646 1.31% 1.96% 11,723 20,870 14,819 2.68% 3.17% 8,830 16,861 4,425 1.20% 3.48% 10,275 18,825 15,697 3.76% 4.77% NOTE I - OTHER BORROWINGS Other borrowings are comprised of advances from the FHLB. A schedule of other borrowings by maturity as of December 31, 2002 and 2001 is summarized as follows (in thousands): Description FHLB Borrowing Convertible Select Advance Convertible Select Advance Convertible Select Advance Convertible Select Advance Convertible Select Advance FHLB Borrowing Convertible Select Advance FHLB Borrowing FHLB Borrowing FHLB Borrowing Maturity April 30, 2007 April 7, 2008 June 16, 2008 February 26, 2009 August 10, 2010 October 15, 2011 October 17, 2011 November 5, 2011 October 10, 2012 June 24, 2013 May 25, 2015 (7) (1) (2) (3) (4) (5) (6) (8) Interest Rate 4.49% 5.54% 5.56% 5.06% 6.65% 4.72% 6.92% 4.25% 3.68% 5.87% 6.92% 2002 2001 $ 5,000 $ 10,000 10,000 5,000 5,000 5,000 500 5,000 5,000 528 750 — 10,000 10,000 5,000 5,000 5,000 500 5,000 — 528 750 41,778 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 51,778 $ The Bank maintains a credit arrangement, which includes a revolving line of credit with FHLB. Under this credit arrangement, the Bank has a remaining borrowing capacity of approximately $153,147,000 at December 31, 2002, is subject to annual renewal, and typically incurs no service charges. Under terms of a blanket agreement, collateral for the FHLB borrowings must be secured by certain qualifying assets of the Bank which consist principally of first mortgage loans. (1) The FHLB has the option to convert this interest rate to an adjustable rate based on the three-month LIBOR at the five-year anniversary date of the borrowings origination, which will occur in the third quarter of 2003. (2) The FHLB has the option to convert this interest rate to an adjustable rate based on the three-month LIBOR at the five-year anniversary date of the borrowings origination, which will occur in the second quarter of 2003. (3) The FHLB has the option to convert this interest rate to an adjustable rate based on the three-month LIBOR at the five-year anniversary date of the borrowings origination, which will occur in the first quarter of 2004. (4) The FHLB has the option to convert this interest rate to an adjustable rate based on the three-month LIBOR at the five-year anniversary date of the borrowings origination, which will occur in the third quarter of 2005. (5) The FHLB has the option to convert this interest rate to an adjustable rate based on the three-month LIBOR at the two-year anniversary date of the borrowings origination, which will occur in the fourth quarter of 2003. (6) The FHLB has the option to convert this interest rate to an adjustable rate based on the three-month LIBOR at the three-year anniversary date of the borrowings origination, which will occur in the fourth quarter of 2004. (7) The FHLB has the option to convert this interest rate to an adjustable rate based on the three-month LIBOR at the one-year anniversary date of the borrowings origination, which will occur in the second quarter of 2003. (8) The FHLB has the option to convert this interest rate to an adjustable rate based on the three-month LIBOR at the two-year anniversary date of the borrowings origination, which will occur in the fourth quarter of 2004. 16 NOTE J - INCOME TAXES The following temporary differences gave rise to the net deferred tax asset at December 31, 2002 and 2001 (in thousands): 2002 2001 Deferred tax asset: Allowance for loan losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Deferred compensation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Contingencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pension . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loan fees and costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment securities allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 668 693 303 337 55 20 348 371 215 261 92 — __________________ ________________ 1,589 1,774 __________________ ________________ Deferred tax liability: Bond accretion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrealized gains on available for sale securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 129 891 __________________ ________________ 1,045 __________________ ________________ 31 192 2,650 2,873 Deferred tax asset (liability), net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 544 __________________ ________________ __________________ ________________ (1,099) $ No valuation allowance was established at December 31, 2002 and 2001, in the view of the Company’s ability to carry back taxes paid in previous years and certain tax strategies, coupled with the anticipated future taxable income as evidenced by the Company’s earning potential. The provision for income taxes is comprised of the following (in thousands): YEAR ENDED DECEMBER 31, 2002 2001 2000 Currently payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Deferred benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,363 (116) ________________ 2,247 ________________ ________________ $ 2,117 (139) ________________ $ 1,978 ________________ ________________ $ 1,730 (111) ___________________ $ 1,619 ___________________ ___________________ The effective federal income tax rate for the years ended December 31, 2002, 2001 and 2000 was 20.2 percent, 20.3 percent, and 19.8 percent, respectively. A reconciliation between the expected income tax and rate and the effective income tax and rate on income before income tax provision follows (in thousands): Provision at expected rate. . . . . . $ Decrease in tax AMOUNT 3,785 % 34.0% AMOUNT 3,305 $ % 34.0% AMOUNT 2,783 $ % 34.0% 2002 2001 2000 resulting from: Tax-exempt income . . . . . . Other, net . . . . . . . . . . . . Effective income tax (1,367) (171) (12.3) (1.5) (1,103) (224) (11.4) (2.3) (837) (327) (10.2) (4.0) and rates $ 2,247 20.2% $ 1,978 20.3% $ 1,619 19.8% 17 NOTE K - EMPLOYEE BENEFIT PLANS DEFINED BENEFIT PENSION PLAN The Company has a noncontributory defined benefit pension plan (the “Plan”) for all employees meeting certain age and length of service requirements. Benefits are based primarily on years of service and the average annual compensation during the highest five consecutive years within the final ten years of employment. The following tables show the funded status and components of net periodic benefit cost from this defined benefit plan (in thousands): CHANGE IN BENEFIT OBLIGATION: Benefit obligation at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . $ Service cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amendments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Actuarial adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Benefits paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Benefit obligation at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . CHANGE IN PLAN ASSETS: Fair value of plan assets at beginning of year . . . . . . . . . . . . . . . . . . . . . Actual loss on plan assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Employer contribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Benefits paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fair value of plan assets at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . Funded status. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrecognized net actuarial gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrecognized transition asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrecognized prior service cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued benefit payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ WEIGHTED-AVERAGE ASSUMPTIONS AS OF DECEMBER 31: Discount rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected return on plan assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Rate of compensation increase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2002 2001 4,976 381 342 97 753 (76) 6,473 3,115 (407) 499 (76) 3,131 (3,342) 1,996 (24) 280 (1,090) $ $ 3,935 298 271 — 524 (52) 4,976 3,597 (430) — (52) 3,115 (1,861) 609 (27) 209 (1,070) 6.00% 8.00% 5.00% 6.50% 8.00% 5.00% 2002 2001 2000 COMPONENTS OF NET PERIODIC BENEFIT COST: Service cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Interest cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected return on plan assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of transition asset. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of prior service cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recognized net actuarial (gain) loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net periodic benefit cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 381 342 (246) (3) 26 19 519 $ $ 298 271 (286) (3) 20 (15) 285 $ $ 256 242 (291) (3) 20 (33) 191 The plan assets are invested primarily in bonds, stocks, equity funds, and mortgages under the control of the plan’s trustees as of December 31, 2002. 401(k) SAVINGS PLAN The Company also offers a 401(k) savings plan in which eligible participating employees may elect to contribute up to a maximum percentage allowable not to exceed the limits of Code Sections 401(k), 404 and 415. The Company may make matching contributions equal to a discretionary percentage to be determined by the Company. Participants are at all times fully vested in their contributions and vest over a period of five years in the employer contribution. Contribution expense was approximately $80,000, $65,000 and $67,000 for the years ended December 31, 2002, 2001 and 2000, respectively. DEFERRED COMPENSATION PLAN The Company has a deferred compensation plan whereby participating directors elected to forego directors’ fees for a period of five years. Under this plan, the Company will make payments for a ten-year period beginning at age 65 in most cases or at death, if earlier, at which time payments would be made to their designated beneficiaries. To fund benefits under the deferred compensation plan, the Company has acquired corporate-owned life insurance policies on the lives of the participating directors for which insurance benefits are payable to the Company. The total expense charged to other expenses was $98,000, $67,000 and $66,000 for the years ended December 31, 2002, 2001 and 2000, respectively. Benefits paid under the plan were approximately $51,000 in 2002 and $51,000 in 2001 and $53,000 in 2000. 18 NOTE L - STOCK OPTIONS Prior to 1998, the Company granted a select group of its officers options to purchase shares of its common stock. These options, which are immediately exercisable, expire within three to ten years after having been granted. Also, in 1998, the Company adopted the “1998 Stock Option Plan” for key employees and directors. Incentive stock options and nonqualified stock options may be granted to eligible employees of the Bank and nonqualified options may be granted to directors of the Company. In addition, non- employee directors are eligible to receive grants of nonqualified stock options. Incentive nonqualified stock options granted under the 1998 Plan may be exercised not later than ten years after the date of grant. Each option granted under the 1998 Plan shall be exercisable only after the expiration of six months following the date of grant of such options. A summary of the status of the Company’s common stock option plans are presented below: Outstanding, beginning of year . . . Granted . . . . . . . . . . . . . . . . . . . . . . Exercised. . . . . . . . . . . . . . . . . . . . . Forfeited . . . . . . . . . . . . . . . . . . . . . Outstanding, end of year . . . . . . . . SHARES 41,501 — 5,188 5,963 30,350 Options exercisable at year-end . . . 30,350 2002 WEIGHTED- AVERAGE EXERCISE PRICE $ $ $ 38.60 — 25.98 25.98 42.56 42.56 2001 WEIGHTED- AVERAGE EXERCISE PRICE $ $ $ 37.87 — 25.98 — 38.10 38.10 SHARES 42,301 — 800 — 41,501 41,501 The following table summarizes information about nonqualified and incentive stock options outstanding at December 31, 2002: Exercise Price 53.18 $ 42.00 $ 32.63 $ Shares 9,900 10,450 10,000 Outstanding Average Life 6 7 8 Average Exercise Price $ $ $ 53.18 42.00 32.63 Exercisable Average Exercise Price $ $ $ 53.18 42.00 32.63 Shares 9,900 10,450 10,000 NOTE M - RELATED PARTY TRANSACTIONS Certain directors and executive officers of the Company and the Bank, including their immediate families and companies in which they are principal owners (more than ten percent), are indebted to the Company. Such indebtedness was incurred in the ordinary course of business on the same terms and at those rates prevailing at the time for comparable transactions with others. A summary of loan activity with executive officers, directors, principal shareholders, and associates of such persons is listed below (in thousands): BEGINNING BALANCE ADDITIONS PAYMENTS ENDING BALANCE YEAR 2002 $ 5,192 $ 3,234 $ 1,641 $ 6,785 NOTE N - COMMITMENTS AND CONTINGENT LIABILITIES The following schedule of future minimum rental payments under operating leases with noncancellable terms in excess of one year as of December 31, 2002 (in thousands): YEAR ENDING DECEMBER 31, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 237 218 205 179 149 76 __________________ 1,064 __________________ __________________ Total rental expense for all operating leases for the years ended December 31, 2002, 2001 and 2000 approximated $258,000, $270,000 and $213,000, respectively. The Company is subject to lawsuits and claims arising out of its business. In the opinion of management, after review and consultation with counsel, any proceedings that may be assessed will not have a material adverse effect on the consolidated financial position of the Company. 19 NOTE O - OFF-BALANCE SHEET RISK The Company 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 standby letters of credit. These instruments involve, to varying degrees, elements of credit, interest rate or liquidity risk in excess of the amount recognized in the consolidated balance sheet. The contract amounts of these instruments express the extent of involvement the Company has in particular classes of financial instruments. The Company’s exposure to credit loss from nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The Company may require collateral or other security to support financial instruments with off-balance sheet credit risk. Financial instruments whose contract amounts represent credit risk are as follows at December 31 (in thousands): Commitments to extend credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Standby letters of credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2002 2001 $ $ 29,497 741 $ $ 29,490 348 Commitments to extend credit are legally binding agreements to lend to customers. Commitments generally have fixed expiration dates or other termination clauses and may require payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future liquidity requirements. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company, on extension of credit is based on management’s credit assessment of the counterparty. Standby letters of credit represent conditional commitments issued by the Company to guarantee the performance of a customer to a third party. These instruments are issued primarily to support bid or performance related contracts. The coverage period for these instruments is typically a one year period with an annual renewal option subject to prior approval by management. Fees earned from the issuance of these letters are recognized over the coverage period. For secured letters of credit, the collateral is typically Bank deposit instruments or customer business assets. NOTE P - CAPITAL REQUIREMENTS Federal regulations require the Company and the Bank to maintain minimum amounts of capital. Specifically, each is required to maintain certain minimum dollar amounts and ratios of Total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average total assets. In addition to the capital requirements, the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”) established five capital categories ranging from “well capitalized” to “critically undercapitalized.” Should any institution fail to meet the requirements to be considered “adequately capitalized,” it would become subject to a series of increasingly restrictive regulatory actions. As of December 31, 2002 and 2001, the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be classified as a well capitalized financial institution, Total risk-based, Tier 1 risk-based and Tier 1 leverage capital ratios must be at least 10%, 6%, and 5%, respectively. 20 The Company’s and the Bank’s actual capital ratios are presented in the following tables, which shows that both met all regulatory capital requirements. The Company’s actual capital amounts and ratios are presented in the following table (in thousands): Total Capital (to Risk-weighted Assets) Actual For Capital Adequacy Purposes To Be Well Capitalized Tier 1 Capital (to Risk-weighted Assets) Actual For Capital Adequacy Purposes To Be Well Capitalized Tier 1 Capital (to Average Assets) Actual For Capital Adequacy Purposes To Be Well Capitalized 2002 2001 Amount Ratio Amount Ratio $ $ $ 58,953 21,236 26,545 54,915 10,618 15,927 54,915 18,310 22,888 22.2% 8.0 10.0 20.7% 4.0 6.0 12.0% 4.0 5.0 $ $ $ 53,281 21,208 26,510 49,936 10,604 15,906 49,936 15,880 19,805 20.1% 8.0 10.0 18.8% 4.0 6.0 12.6% 4.0 5.0 The Bank’s actual capital amounts and ratios are presented in the following table (in thousands): Total Capital (to Risk-weighted Assets) Actual For Capital Adequacy Purposes To Be Well Capitalized Tier 1 Capital (to Risk-weighted Assets) Actual For Capital Adequacy Purposes To Be Well Capitalized Tier 1 Capital (to Average Assets) Actual For Capital Adequacy Purposes To Be Well Capitalized 2002 2001 Amount Ratio Amount Ratio $ $ $ 47,232 20,616 25,770 43,723 10,308 15,462 43,723 17,970 22,462 18.3% 8.0 10.0 17.0% 4.0 6.0 9.7% 4.0 5.0 $ $ $ 41,409 20,390 25,488 38,100 10,195 15,293 38,100 15,727 19,659 16.3% 8.0 10.0 15.0% 4.0 6.0 9.7% 4.0 5.0 NOTE Q - REGULATORY RESTRICTIONS The Pennsylvania Banking Code restricts the availability of capital funds for payment of dividend by all state-chartered banks to the additional paid in capital of the Bank. Accordingly, at December 31, 2002, the balance in the additional paid in capital account totaling approximately $11,700,000 is unavailable for dividends. The Bank is subject to regulatory restrictions, which limit its ability to loan funds to Penns Woods Bancorp, Inc. At December 31, 2002, the regulatory lending limit amounted to approximately $4,676,000. Cash and Due from Banks Included in cash and due from banks are reserves required by the district Federal Reserve Bank of $1,152,000 and $1,523,000 at December 31, 2002 and 2001. The required reserves are computed by applying prescribed ratios to the classes of average deposit balances. These are held in the form of cash on hand and a balance maintained directly with the Federal Reserve Bank. NOTE R - ACQUISITION On October 1, 2000, the Bank acquired The M Group in a business acquisition accounted for as a purchase. The M Group is engaged in the insurance business. The results of operations of The M Group are included in the accompanying consolidated financial statements since the date of acquisition. The total cost of the acquisition was $3,321,000, which exceeds the fair value of the net assets of The M Group by $3,308,000 which was allocated to goodwill. NOTE S - ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS The Company is required to disclose estimated fair values for its financial instruments. Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Also, it is the Company’s general practice and intention to hold most of its financial instruments to maturity and not to engage in trading or sales activities. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk 21 characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions can significantly affect the estimates. Estimated fair values have been determined by the Company using historical data and an estimation methodology suitable for each category of financial instruments. The estimated fair value of the Company’s investment securities is described in Note A. The Company’s fair value estimates, methods, and assumptions are set forth below for the Company’s other financial instruments. As certain assets and liabilities, such as deferred tax assets, premises and equipment, and many other operational elements of the Company, are not considered financial instruments but have value, this estimated fair value of financial instruments would not represent the full market value of the Company. The estimated fair values of the Company’s financial instruments are as follows: 2002 2001 Carrying Value Fair Value Carrying Value Fair Value Financial assets: Cash and due from banks. . . . . . . . . . . . . . . . . . . . . . . . . . . Investment securities: Available for sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Held to maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bank-owned life insurance. . . . . . . . . . . . . . . . . . . . . . . . . . Regulatory stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . $ 11,731 $ 11,731 $ 14,844 $ 14,844 176,436 1,181 2,651 254,892 8,537 3,963 2,460 176,436 1,289 2,651 267,563 8,537 3,963 2,460 131,985 1,302 3,993 248,696 8,126 2,875 2,685 131,985 1,312 3,993 257,062 8,126 2,875 2,685 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 461,851 $ 474,630 $ 414,506 $ 422,882 Financial liabilities: Interest-bearing deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . Noninterest-bearing deposits . . . . . . . . . . . . . . . . . . . . . . . . Short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 272,787 67,061 13,563 51,778 1,092 $ 276,881 67,061 13,563 56,384 1,092 $ 249,873 55,277 19,105 41,778 1,190 251,955 55,277 19,105 42,369 1,190 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 406,281 $ 414,981 $ 367,223 $ 369,896 Cash and due from banks, loans held for sale, regulatory stock, accrued interest receivable, short-term borrowings, and accrued interest payable: The fair value is equal to the carrying value. Investment securities: The fair value of investment securities available for sale and held to maturity is equal to the available quoted market price. If no quoted market price is available, fair value is estimated using the quoted market price for similar securities. Loans: Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, commercial real estate, residential mortgage, credit card, and other consumer. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories. The fair value of performing loans, except residential mortgage and credit card loans, is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The estimate of maturity is based on the Company’s historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions. For performing residential mortgage loans, fair value is estimated by discounting contractual cash flows adjusted for prepayment estimates using discounted rates based on secondary market sources adjusted to reflect differences in servicing and credit costs. For credit card loans, cash flows and maturities are estimated based on contractual interest rates and historical experience and are discounted using secondary market rates adjusted for differences in servicing and credit costs. Fair value for significant nonperforming loans is based on recent external appraisals. If appraisals are not available, estimated cash flows are discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows, and discounted rates are judgmentally determined using available market information and specific borrower information. Bank-owned life insurance: The fair value is equal to the Cash Surrender Value of life insurance policies. 22 Deposits: The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, savings and NOW accounts, and money market and checking accounts, is equal to the amount payable on demand as of December 31, 2002 and 2001. The fair value of certificates of deposit is based on the discounted value of contractual cash flows. The fair value estimates above do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market, commonly referred to as the core deposit intangible. Other borrowings: The fair value of other borrowings is based on the discounted value of contractual cash flows. Commitments to extend credit, standby letters of credit, and financial guarantees written: There is no material difference between the notional amount and the estimated fair value of off-balance sheet items at December 31, 2002 and 2001 respectively. The contractual amounts of unfunded commitments and letters of credit are presented in Note O. NOTE T - PARENT COMPANY ONLY FINANCIAL STATEMENTS Condensed financial information for Penns Woods Bancorp, Inc. follows: CONDENSED BALANCE SHEET, DECEMBER 31, ASSETS: Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment in subsidiaries: Bank. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Nonbank. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . LIABILITIES AND SHAREHOLDERS’ EQUITY: Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities and shareholders’ equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2002 2001 (in thousands) $ 481 $ 151 43,371 11,938 29 __________________ ________________ $ 55,489 __________________ ________________ __________________ ________________ 51,019 11,760 20 63,280 $ $ 237 $ 55,252 __________________ ________________ $ 55,489 __________________ ________________ __________________ ________________ 138 63,142 63,280 $ CONDENSED STATEMENT OF INCOME FOR THE YEARS ENDED DECEMBER 31, Operating income: Dividends from subsidiaries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity in undistributed net income of subsidiaries . . . . . . . . . . . . . . . . . Other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2002 (IN THOUSANDS) 2001 2000 $ 4,878 $ 4,121 — (113) 6,220 443 2 (99) ___________________ __________________ _________________ $ 6,566 ___________________ __________________ _________________ ___________________ __________________ _________________ 5,984 $ 1,899 — (141) 7,742 $ 8,886 $ CONDENSED STATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, OPERATING ACTIVITIES: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net income to net cash $ provided by operating activities: 2002 (IN THOUSANDS) 2001 2000 8,886 $ 7,742 $ 6,566 Equity in undistributed net income of subsidiaries . . . . . . . . . . . . . Other, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by operating activities . . . . . . . . . . . . . . . . . . INVESTING ACTIVITIES: Additional investment in subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . FINANCING ACTIVITIES: Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from exercise of stock options . . . . . . . . . . . . . . . . . . . . . . . . . Purchase of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash used in financing activities . . . . . . . . . . . . . . . . . . . . . . NET INCREASE (DECREASE) IN CASH . . . . . . . . . . . . . . . . . . . . . . . . . . CASH, BEGINNING OF YEAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . CASH, END OF YEAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (443) 21 ___________________ __________________ _________________ 6,144 (1,899) (26) 5,817 (4,121) (23) 4,742 (1,752) ___________________ __________________ _________________ (276) — (3,426) 65 (902) ___________________ __________________ _________________ (4,263) ___________________ __________________ _________________ 129 27 ___________________ __________________ _________________ $ 156 ___________________ __________________ _________________ ___________________ __________________ _________________ (3,729) 21 (1,838) (5,546) (5) 156 151 $ (4,124) 113 (401) (4,412) 330 151 481 $ 23 NOTE U - CONSOLIDATED QUARTERLY FINANCIAL DATA (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE DATA) 2002 Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities gains (losses), net . . . . . . . . . . . . . . . . . . . . . . . . Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income tax provision . . . . . . . . . . . . . . . . . . Income tax provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings per share - basic . . . . . . . . . . . . . . . . . . . . . . . . . . FOR THE THREE MONTHS ENDED MARCH 31, $ 7,076 2,719 _________________ 4,357 105 1,401 (119) 2,952 _________________ 2,582 485 _________________ $ 2,097 _________________ _________________ 0.69 $ JUNE 30, SEPT. 30, $ 7,199 2,740 _________________ 4,459 80 1,317 (72) 3,056 _________________ 2,568 528 _________________ $ 2,040 _________________ _________________ 0.67 $ $ 7,399 2,715 _________________ 4,684 90 1,231 281 3,070 _________________ 3,036 660 _________________ $ 2,376 _________________ _________________ 0.78 $ DEC. 31, $ 7,430 2,672 _______________ 4,758 90 1,271 143 3,135 _______________ 2,947 574 _______________ $ 2,373 _______________ _______________ 0.79 $ Earnings per share - diluted . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.69 $ 0.67 $ 0.78 $ 0.79 2001 Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities gains, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income tax provision . . . . . . . . . . . . . . . . . . Income tax provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings per share - basic . . . . . . . . . . . . . . . . . . . . . . . . . . FOR THE THREE MONTHS ENDED MARCH 31, $ 7,103 3,293 _________________ 3,810 93 907 135 2,684 _________________ 2,075 391 _________________ $ 1,684 _________________ _________________ 0.55 $ JUNE 30, SEPT. 30, $ 7,150 3,197 _________________ 3,953 93 906 211 2,739 _________________ 2,238 432 _________________ $ 1,806 _________________ _________________ 0.58 $ $ 7,229 3,055 _________________ 4,174 93 1,058 369 2,796 _________________ 2,712 586 _________________ $ 2,126 _________________ _________________ 0.70 $ DEC. 31, $ 7,254 2,936 _______________ 4,318 93 1,205 318 3,053 _______________ 2,695 569 _______________ $ 2,126 _______________ _______________ 0.70 $ Earnings per share - diluted . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.55 $ 0.58 $ 0.70 $ 0.70 24 Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations ITEM 7 NET INTEREST INCOME RESULTS OF OPERATIONS Net interest income is determined by calculating the difference between the yields earned on interest-earning assets and the rates paid on interest- bearing liabilities. 2002 vs 2001 Fully taxable equivalent net interest income increased $2,053,000 or 11.44% to $19,997,000 during the year 2002. The net interest income growth was the result of an increase in interest income of $418,000 and a decrease in interest expense of $1,635,000. The effective interest differential increased 3 basis points to 4.87% from December 31, 2001 to December 31, 2002. Prime rates and federal funds rates held steady most of the year declining 50 basis points in November. The low rates had a greater impact on the repricing of deposits than they had on loans and investment securities. The Company’s assets and liabilities were positioned to benefit from the rate environment. Overall, rates had a positive impact on earnings. Although interest-earning assets suffered a reduction in income due to rates of $2,033,000, interest expense relating to interest-bearing liabilities also declined by $2,326,000. The net effect was an increase in income of $293,000 due to rates. Total average interest-earning assets increased $39,805,000 during 2002 which contributed $2,451,000 to net interest income. Interest income on loans decreased during 2002 by $1,055,000. This was the result of a decrease of interest income of $1,669,000 due to rate offset by an increase of interest income of $614,000 due to volume. Total average loans increased from 2001 to 2002 by $7,021,000 which contributed to the volume increase. Although the volume increased, as loans were paid off and new loans originated, low prime rates caused a reduction in interest income. Bank prime rates remained relatively low in 2002 compared to historical standards and were directly responsible for the decline of interest income of $1,669,000. This is evident by the decline of the average rate on total loans from 8.92% in 2001 to 8.26% in 2002. Investment securites interest income contributed $1,473,000 of additional income in 2002 relative to 2001. Taxable securities income represented the majority of the increase at $1,390,000 while tax-exempt investment securities added $83,000. Together, an increase of investment securities income of $1,837,000 due to volume more than offset a decrease of $364,000 due to rates. Total average securities increased $32,784,000 or 26.53% from 2001 to 2002. This increase explains the substantial increase in income related to volume. Total average interest-bearing liabilities increased $35,898,000 or 12.26% during 2002. The interest expense related to volume increased $691,000 while rates subtracted interest expenses totaling, $2,326,000. Due to successful marketing strategies and market penetration in the Centre County region, the bank increased total average deposits by $31,166,000. Average savings deposits increased $35,893,000 while average time deposits decreased $9,010,000. Noninterest-bearing demand deposits increased $4,283,000. Deposit rates held steady through most of 2002. Savings deposits had little change in average rate while other time deposits repriced throughout the year into the current low rates. The average rate on other time deposits declined from 5.28% in 2001 to 3.77% in 2002. The increase in funding due to deposits added to an increase in average other borrowings of $12,672,000 and offset the reduction of average short- term borrowings of $3,657,000. The bank had less need for overnight borrowings to fund assets with the increase of deposits and other borrowings. The bank acquired two loans totaling $10,000,000 with the Federal Home Loan Bank that are reflected in the increase of other borrowings. The Federal Home Loan Bank borrowings were intended to match investment security purchases that generate long-term interest income with minimal risk. 2001 vs 2000 Taxable equivalent net interest income increased 5.9% or $992,000, to $17,944,000 from year-end 2000 to year-end 2001. The increase in net interest income is due to a $695,000 increase in interest income and a reduction of $297,000 in interest expense. Tax-exempt investment securities contributed the most to interest income adding $1,374,000 in income of which $1,298,000 was due to volume and $76,000 due to rate. Taxable investment securities partially offset the gain in interest income declining $998,000. Again, the decrease was mainly due to the reduction in volume that amounted to $752,000. Rates caused a reduction of $246,000 of income on taxable investment securities. The average balance of state and political subdivisions increased $16,471,000 while the average balances of U.S. Treasury and federal agencies and other securities declined $10,883,000 and $2,006,000, respectively. The shift to tax-exempt securities was to take advantage of their higher after-tax yields. The average rate of state and political subdivisions was 7.88% as opposed to 6.41% on U.S. Treasury and federal agency securities and 3.89% on other securities. Loan interest income contributed $319,000 to total interest income. The increase was caused by the net effect of a $622,000 increase due to volume and a $303,000 decrease due to rates. The average balance of total loans increased $6,938,000 to $246,907,000 during 2001. Prime rate reductions resulting from Federal Open Markets Committees’ monetary policy initiatives during 2001 affected income collected on loans negatively. Total expense on interest-bearing liabilities declined $297,000 in 2001 due to the net effect of a $963,000 decrease in expense on short-term borrowings, an increase of $438,000 on other time deposits and interest expense increases on savings deposits and other borrowings of $54,000 and $174,000, respectively. Interest expense related to volume increased $831,000 while rates contributed a net decrease of $1,128,000. Total average interest bearing liabilities increased $9,236,000 to $292,923,000 in 2001. Average other time deposits contributed the most to the total, increasing $14,396,000. The interest expense due to the volume on other time deposits increased $770,000. Average balances of savings, and other borrowings added $2,063,000 and $4,468,000 respectively. Savings and other borrowings also added $43,000 and $258,000 in interest expense related to volume. The average balances on short-term borrowings decreased $11,691,000, resulting in an expense reduction due to volume of $240,000. The bank successfully attracted time deposits resulting in the substantial increase in average other time deposits. This caused less need for short-term borrowings, which consists of overnight Federal Home Loan Bank borrowings. Short-term borrowings experienced a decline in its average balance in 2001. Although interest expense on short-term deposits declined, interest expense on other time deposits more than offset the reduction. Overall, interest rates declined considerably in 2001. This resulted in a reduction in interest expense related to rates in every category except savings deposits. Interest rates on savings deposits change only minimally year-to-year. This explains the $11,000 increase in expense related to rates, even with other deposit rates declining considerably. Interest expense related to rates on short-term borrowings decreased the most of the four categories. Short-term borrowings consisting of overnight Federal Home Loan Bank advances, naturally, are affected much more by the federal funds target rate set by the Federal Open Markets Committee. Interest on other time deposits, other borrowings and short term borrowings due to rate decreased $332,000, $84,000 and $723,000, respectively. The effective interest differential increased 13 basis points during 2001. The increase was due to the net effect of a five basis point interest rate decrease in total average earning assets and an 18 basis point rate decrease in total average interest-bearing liabilities. The shape of the economy in 2001 was such that the Federal Open Markets Committee (FOMC) felt the need to reduce its federal funds target rate 475 basis points. Rates on both deposits and loans have fallen in response to the FOMC’s policy objective. Rates have affected liabilities positively. This has allowed earning assets to increase $10,520,000 to $370,481,000 while interest expense decreased, resulting in an interest expense/earning assets ratio of 18 points less than 2000. 25 AVERAGE BALANCES AND INTEREST RATES (IN THOUSANDS) The following tables set forth certain information relating to the Company’s average balance sheet and reflects the average yield on assets and average cost of liabilities for the periods indicated and the average yields earned and rates paid. Such yields and costs are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods presented. AVERAGE BALANCE 2002 INTEREST AVERAGE RATE ASSETS: Interest-earning assets: Securities: U.S. Treasury and federal agency . . . . . . . . . . . . . . . . . . . $ State and political subdivisions (4) . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54,690 77,216 24,452 ____________________ 156,358 $ 2,923 6,034 912 ___________________ 9,869 LOANS: Tax-exempt loans (4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . All other loans, net of discount where applicable. . . . . . . . . . . Total loans (1), (3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,309 251,619 ____________________ 253,928 185 20,789 ___________________ 20,974 Total interest-earning assets . . . . . . . . . . . . . . . . . . . . . . . . 410,286 $ 30,843 ___________________ ___________________ Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TOTAL ASSETS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 31,977 ____________________ 442,263 ____________________ ____________________ LIABILITIES AND SHAREHOLDERS’ EQUITY: Interest-bearing liabilities: Deposits: Savings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Other time. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest-bearing deposits . . . . . . . . . . . . . . . . . . . . 129,244 136,813 ____________________ 266,057 Short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest-bearing liabilities . . . . . . . . . . . . . . . . . . . Demand deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders’ equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,465 46,299 ____________________ 328,821 50,877 3,334 59,231 ____________________ TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY. . . . . . . . . . . . . . . . . . . $ 442,263 ____________________ ____________________ Interest rate margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Effective interest differential . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,701 5,156 ___________________ 7,857 501 2,488 ___________________ $ 10,846 ___________________ ___________________ 5.34% 7.81% 3.73% 6.31% 8.01% 8.26% 8.26% 7.52% 2.09% 3.77% 2.95% 3.04% 5.37% 3.30% $ 19,997 ___________________ ___________________ 4.22% 4.87% ___________________ ___________________ 1. Fees on loans are included with interest on loans. Loan fees are included in interest income as follows: 2002, $803,000, 2001, $668,000, 2000, $411,000. 2. Information on this table has been calculated using average daily balance sheets to obtain average balances. 3. Nonaccrual loans have been included with loans for the purpose of analyzing net interest earnings. 4. Income and rates on a fully taxable equivalent basis include an adjustment for the difference between annual income from tax-exempt obligations and the taxable equivalent of such income at the standard 34% tax rate (derived by dividing tax-exempt interest by 66%). 26 AVERAGE BALANCES AND INTEREST RATES (IN THOUSANDS) AVERAGE BALANCE 2001 INTEREST AVERAGE RATE AVERAGE BALANCE 2000 INTEREST AVERAGE RATE $ 22,877 75,556 25,141 ____________________ 123,574 ____________________ $ 1,466 5,951 979 ___________________ 8,396 ___________________ 322 21,707 ___________________ 22,029 ___________________ $ 30,425 ___________________ ___________________ 3,935 242,972 ____________________ 246,907 ____________________ 370,481 27,081 ____________________ 397,562 $ ____________________ ____________________ $ 93,351 145,823 ____________________ 239,174 $ 1,961 7,696 ___________________ 9,657 903 1,921 ___________________ $ 12,481 ___________________ ___________________ 20,122 33,627 ____________________ 292,923 46,594 4,214 53,831 ____________________ $ 397,562 ____________________ ____________________ 6.41% 7.88% 3.89% 6.79% 8.18% 8.93% 8.92% 8.21% 2.10% 5.28% 4.04% 4.49% 5.71% 4.26% $ 33,760 59,085 27,147 ____________________ 119,992 ____________________ $ 2,361 4,577 1,082 ___________________ 8,020 ___________________ 412 21,298 ___________________ 21,710 ___________________ $ 29,730 ___________________ ___________________ 5,164 234,805 ____________________ 239,969 ____________________ 359,961 18,027 ____________________ 377,988 $ ____________________ ____________________ $ 91,288 131,427 ____________________ 222,715 $ 1,907 7,258 ___________________ 9,165 1,866 1,747 ___________________ $ 12,778 ___________________ ___________________ 31,813 29,159 ____________________ 283,687 42,765 3,837 47,699 ____________________ $ 377,988 ____________________ ____________________ 6.99% 7.75% 3.99% 6.68% 7.98% 9.07% 9.05% 8.26% 2.09% 5.52% 4.12% 5.87% 5.99% 4.50% ___________________ $ 17,944 ___________________ ___________________ 3.95% ___________________ 4.84% ___________________ ___________________ ___________________ $ 16,952 ___________________ ___________________ 3.75% ___________________ 4.71% ___________________ ___________________ 27 SUMMARY OF CHANGES IN INTEREST EARNED AND INTEREST PAID (IN THOUSANDS) Rate/Volume Analysis The table below sets forth certain information regarding changes in our interest income and interest expense for the periods indicated. For interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (changes in average volume multiplied by old rate); (ii) changes in rates (changes in rate multiplied by old average volume). Increases and decreases due to both rate and volume, which cannot be separated, have been allocated proportionally to the change due to volume and the change due to rate. Year Ended December 31, 2002 vs 2001 Increase (Decrease) Due to Rate Volume Net 2001 vs 2000 Increase (Decrease) Due to Rate Volume Interest income: Taxable investment securities . . . . . . . . . . . . $ Tax-exempt investment securities . . . . . . . . . Loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,707 $ 130 614 (317) $ (47) (1,669) 1,390 83 (1,055) Total interest-earning assets. . . . . . . . . . . . $ 2,451 $ (2,033) $ 418 Interest expenses: Savings deposits . . . . . . . . . . . . . . . . . . . . . . $ Other time deposits . . . . . . . . . . . . . . . . . . . . Short-term borrowings . . . . . . . . . . . . . . . . . Other borrowings . . . . . . . . . . . . . . . . . . . . . 750 $ (514) (232) 687 (10) $ (2,026) (170) (120) 740 (2,540) (402) 567 Total interest-bearing liabilities . . . . . . . . . $ 691 $ (2,326) $ (1,635) Change in net interest income . . . . . . . . . . . $ 1,760 $ 293 $ 2,053 $ $ $ $ $ (752) $ 1,298 622 1,168 $ (246) $ 76 (303) (473) $ Net (998) 1,374 319 695 43 $ 770 (240) 258 11 $ (332) (723) (84) 831 $ (1,128) $ 54 438 (963) 174 (297) 337 $ 655 $ 992 PROVISION FOR LOAN LOSSES 2002 vs 2001 The provision for loan losses is based upon management’s quarterly review of the loan portfolio. The purpose of the review is to assess loan quality, identify impaired loans, analyze delinquencies, ascertain loan growth, evaluate potential charge-offs and recoveries, and assess general economic conditions in the markets served. An external independent loan review is also performed annually for the Bank. Management remains committed to an aggressive program of problem loan identification and resolution. The allowance is calculated by applying loss factors to outstanding loans by type, excluding loans for which a specific allowance has been determined. Loss factors are based on management’s consideration of the nature of the portfolio segments, changes in mix and volume of the loan portfolio, and historical loan loss experience. In addition, management considers industry standards and trends with respect to nonperforming loans and its knowledge and experience with specific lending segments. Although management believes that it uses the best information available to make such determinations and that the allowance for loan losses was adequate at December 31, 2002, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making the initial determinations. A downturn in the local economy, employment and delays in receiving financial information from borrowers could result in increased levels of nonperforming assets and charge- offs, increased loan loss provisions and reductions in income. Additionally, as an integral part of the examination process, bank regulatory agencies periodically review the Bank’s loan loss allowance. The banking agencies could require the recognition of additions to the loan loss allowance based on their judgement of information available to them at the time of their examination. The allowance for loan losses increased 0.9% or $26,000 from fiscal 2001 after net charge-offs of $339,000 contributing to a year-end allowance for loan losses of $2,953,000 or 1.1% of total loans. This percentage is consistent with the guidelines of regulators and peer banks. Management’s conclusion is that the provision for loan loss is adequate. 2001 vs 2000 The allowance for loan losses increased 1.7% or $48,000 from fiscal 2000 after net charge-offs of $324,000 contributing to a year-end allowance for loan losses of $2,927,000 or 1.2% of total loans. 28 YEAR ENDED DECEMBER 31, (IN THOUSANDS) 2002 2001 2000 1999 1998 Balance at beginning of period . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,927 $ 2,879 $ 2,823 $ 2,681 $ 2,579 Charge-offs: Domestic: Real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and industrial . . . . . . . . . . . . . . . . . . . . Installment loans to individuals. . . . . . . . . . . . . . . . . Total charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries: Real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and industrial . . . . . . . . . . . . . . . . . . . . Installment loans to individuals. . . . . . . . . . . . . . . . . Total recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . Net charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additions charged to operations . . . . . . . . . . . . . . . . . . . . . 262 80 60 402 25 21 17 63 339 365 154 122 82 358 9 8 17 34 324 372 165 38 66 269 8 20 11 39 230 286 50 28 98 176 4 11 17 32 144 286 — 91 180 271 — 29 39 68 203 305 Balance at end of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,953 $ 2,927 $ 2,879 $ 2,823 $ 2,681 Ratio of net charge-offs during the period to average loans outstanding during the period . . . . . . . . . . . . . . . . . . . . . . . 0.13% 0.13% 0.10% 0.06% 0.09% OTHER INCOME 2002 vs 2001 Total other income for 2002 was $5,453,000, an increase of $344,000 from the prior year. Excluding security gains of $233,000 in 2002 and $1,033,000 in 2001, other income increased $1,144,000. Service charges increased 17.12% or $268,000 to $1,833,000 in 2002. The rate charged for overdraft fees was increased in 2002 which resulted in $229,000 additional service charge income. Other operating income increased $876,000 from 2001 to 2002. Commission income growth from the sale of financial products sold by the Bank’s subsidiary, The M Group, account for $401,000 of the total increase of other operating income. Income on cash surrender value adjustments on bank owned life insurance increased $242,000. The year 2002 was the first full year the life insurance policies were in effect, resulting in a greater adjustment. Life insurance proceeds also added $102,000. The remaining contributors were credit card merchant machine processing fees, debit card fees and ATM surcharge revenue. 2001 vs 2000 Total other income for the year ended December 31, 2001 of $5,109,000 grew from $2,615,000 in 2000, an increase of $2,494,000 or 95.37%. Most of the $2,494,000 increase of other operating income is due to the growth of $1,313,000 commission income recognized from the sale of various financial products, sold by the Bank’s subsidiary, The M Group. The substantial increase in commission is due to comparing an entire year’s commission in 2001 and a partial year for the newly acquired subsidiary in 2000. The Company realized security gains of $1,033,000 versus $269,000 in 2001, an increase of $764,000. The majority of the gains taken were due to the liquidation of equity securities that had reached, in management’s opinion, their peak performance. Service charges increased $208,000, or 15.3%, which is mostly attributable to an increase on deposits and in fees collected on deposit accounts. OTHER EXPENSES 2002 vs 2001 Total other expenses increased $941,000 or 8.35% from the year ended December 31, 2001 to December 31, 2002. Salaries and employee benefits increased $1,152,000, the most substantial of the other expenses category. Employee salaries and benefits increased more than $500,000 as a result of increased salaries that correspond with the growth in sales of financial products offered by The M Group and the cost of staff at the new State College Wal-Mart Branch. The Bank’s pension expense increased $320,000 in 2002. The remaining expenses were due to normal wage increases. The new branch also caused the majority of the $44,000 increase to occupancy expense. The Bank has substantially upgraded its computer networking capabilities which has resulted in most of the $98,000 increase to furniture and equipment expense. Other operating expenses decreased $353,000. The elimination of goodwill amortization as per the adoption of FAS No. 142 represents $221,000 of the decrease in expenses. Bookkeeping expenses increased due to securities transactions and maintenance. The other miscellaneous operating expenses decrease was additionally offset by a $55,000 expense as a result of a check kiting incident. 29 2001 vs 2000 Other expenses at year-end December 31, 2001 increased $1,452,000 or 14.79%. The majority of the other operating expense increase of $870,000 is due to a full year of expenses of the Bank’s subsidiary, The M Group, an entry fee of $53,000 for The NASDAQ National Market, audit and consulting fees in excess of $50,000, additional advertising expenses and other miscellaneous operating expenses. The salaries and employee benefits expense increase of $656,000 or 12.77% is attributable to the normal wage increases and the additional salaries expense of the Bank’s subsidiary for a full year. Occupancy expense increased $42,000 or 5.64%. Most of the expense was also produced by a full year of The M Group’s occupancy expenses. Furniture and equipment expenses were $19,000 less in 2001 than in 2000. INCOME TAXES 2002 vs 2001 The provision for income taxes for the year ended December 31, 2002 resulted in an effective income tax rate of 20.2% compared to 20.3% for 2001 2001 vs 2000 The provision for income taxes for the year ended December 31, 2001 resulted in an effective income tax rate of 20.3% compared to 19.8% for 2000. 30 INVESTMENTS 2002 FINANCIAL CONDITION The investment portfolio increased $44,330,000 or 33.3% in 2002. Deposits grew faster than loan demand with the excess funding the purchase of additional investment securities. Most of the increase is attributable to an increase of $62,906,000 in U.S. Government agencies category, $975,000 in other bonds, notes and debentures and $170,000 in U.S. Treasury securities category. State and Political subdivisions category decreased $12,575,000 and a $7,146,000 decrease was also found in the equity securities category. The investment portfolio at year-end 2002 comprised of 50.2% U.S. Government agency and Treasury securities, 40.2% state and political subdivisions, 8.4% equity securities, and 1.2% other bonds, notes and debentures. Held to maturity securities had a carrying value of $1,181,000. Available for sale securities occupied 99% of the total portfolio and had an amortized cost of $168,641,000 with an estimated market value of $176,436,000. The unrealized gain of $7,795,000 effected shareholders’ equity by $5,145,000 net of deferred taxes. 2001 The investment portfolio increased $17,015,000 or 14.6% in 2001. The bank borrowed $10,000,000 in long-term FHLB advances to purchase state and political bonds and take advantage of interest rate imbalances in the market. Deposits grew greater than loan demand with the excess funding the purchase of additional investment securities. Most of the increase is attributable to an increase of $15,591,000 in the state and political subdivisions category and corporate stock of $2,791,000 and a decrease of $2,136,000 in the U.S. Government agencies category. U.S. Treasury securities also increased $1,080,000, and other bonds, notes and debentures decreased $311,000. The investment portfolio at year end 2001 comprised of 19.5% U.S. Government agency and Treasury securities, 63.1% state and political subdivisions, 16.6% equity securities and .8% other bonds, notes and debentures. Held to maturity securities had a carrying value of $1,302,000. Available for sale securities occupied 99% of the total portfolio and had an amortized cost of $129,365,000 with an estimated market value of $131,985,000. The unrealized gain of $2,620,000 effected shareholders’ equity by $1,729,000, net of deferred taxes. The carrying amounts of investment securities at the dates indicated are summarized as follows (in thousands): 2002 DECEMBER 31, 2001 2000 U.S. Treasury securities: Available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,296 $ 4,126 $ 3,046 U.S. Government agencies: Held to maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State and political subdivisions: Held to maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other bonds, notes and debentures: Held to maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total bonds, notes and debentures . . . . . . . . . . . . . . . . . . . . . . . . . . . Corporate stock - Available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94 84,702 796 70,681 291 1,810 162,670 14,947 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 177,617 $ 196 21,694 796 83,256 310 816 111,194 22,093 133,287 206 23,820 2,712 65,749 310 1,127 96,970 19,302 $ 116,272 31 The following table shows the maturities and repricing of investment securities at December 31, 2002 and the weighted average yields (for tax-exempt obligations on a fully taxable basis assuming a 34% tax rate) of such securities (in thousands): U.S. Treasury securities: AFS Amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Yield. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,019 6.36% $ 3,277 4.04% $ — $ — — — WITHIN ONE YEAR AFTER ONE AFTER FIVE BUT WITHIN BUT WITHIN TEN YEARS FIVE YEARS AFTER TEN YEARS U.S. Government agencies: HTM Amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Yield. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . AFS Amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Yield. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State and political subdivisions: HTM Amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Yield. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . AFS Amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Yield. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other bonds, notes and debentures: HTM Amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Yield. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . AFS Amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Yield. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — — 1,067 4.96% 250 4.55% — — 50 5.75% — — — — 7,257 4.34% — — 120 9.63% 100 7.15% — — — — 27,566 5.08% — — — — 141 6.85% — — 94 8.84% 48,812 5.75% 546 5.20% 70,561 5.18% — — 1,810 6.11% Total Amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,386 $ 10,754 $ 27,707 $ 121,823 Total Yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.53% 4.34% 5.10% 5.43% All yields represent weighted average yields expressed on a tax equivalent basis. They are calculated on the basis of the cost, adjusted for amortization of premium and accretion of discount and effective yields weighted for the scheduled maturity of each security. The taxable equivalent adjustment represents the difference between annual income from tax-exempt obligations and the taxable equivalent of such income at the standard 34% tax rate (derived by dividing tax-exempt interest by 66%). LOAN PORTFOLIO 2002 Gross loans for the year ended December 31, 2002, were $257,845,000 or $6,222,000 (2.47%) more than the prior year. Real estate mortgages increased $8,128,000 as a whole with residential and commercial real estate loans increasing $49,000 and $8,800,000, respectively. Construction real estate mortgages decreased $721,000. Commercial and agricultural loans increased $1,079,000, while installment loans to individuals decreased $2,985,000. 2001 At December 31, 2001, gross loans totaled $251,623,000, an increase of $6,825,000 or 2.8% over year-end 2000. While commercial, agricultural, construction real estate mortgages and installment loans to individuals decreased from 2000, loans secured by residential and commercial real estate grew by $14,964,000 or 7.8%. Residential real estate mortgages increased $8,823,000 or (6.7%). Commercial real estate mortgages grew by 10.1% or $6,141,000. Commercial and agricultural loans decreased $3,842,000 or (14.5%). Construction real estate mortgages declined $671,000 or 14.1% and installment loans to individuals decreased 16.8% or $3,626,000. The amount of loans outstanding at the indicated dates are shown in the following table according to type of loan (in thousands): Domestic: Commercial and agricultural . . . . . $ Real estate mortgage: Residential . . . . . . . . . . . . . . . . . Commercial . . . . . . . . . . . . . . . . Construction . . . . . . . . . . . . . . . . Installment loans to individuals. . . Gross loans. . . . . . . . . . . . . . . . . . . $ 2002 2001 DECEMBER 31, 2000 1999 1998 23,708 $ 22,629 $ 26,471 $ 31,735 $ 32,920 140,272 75,563 3,356 14,946 257,845 $ 140,223 66,763 4,077 17,931 251,623 $ 131,400 60,622 4,748 21,557 244,798 $ 121,384 51,445 3,732 23,519 231,815 $ 109,937 43,562 3,874 24,505 214,798 32 The amount of domestic loans at December 31, 2002 are presented below by category and maturity (in thousands): Loans with floating interest rates: REAL ESTATE COMMERCIAL INSTALLMENT AND OTHER LOANS TO INDIVIDUALS TOTAL 1 year or less . . . . . . . . . . . . . . . . . . . . . . . $ 1 through 5 years. . . . . . . . . . . . . . . . . . . . 5 through 10 years. . . . . . . . . . . . . . . . . . . After 10 years . . . . . . . . . . . . . . . . . . . . . . Sub Total . . . . . . . . . . . . . . . . . . . . . . Loans with predetermined interest rates: 1 year or less . . . . . . . . . . . . . . . . . . . . . . . 1 through 5 years. . . . . . . . . . . . . . . . . . . . 5 through 10 years. . . . . . . . . . . . . . . . . . . After 10 years . . . . . . . . . . . . . . . . . . . . . . Sub Total . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . $ 6,020 6,309 15,692 74,771 ___________________ 102,792 ___________________ 4,094 21,122 30,589 60,594 ___________________ 116,399 219,191 ___________________ ___________________ $ 7,424 2,294 1,227 2,193 _____________________ 13,138 _____________________ $ 1,298 25 17 2 ____________________ 1,342 ____________________ $ 14,742 8,628 16,936 76,966 _____________________ 117,272 _____________________ 1,309 6,678 1,788 795 _____________________ 10,570 23,708 $ _____________________ _____________________ 1,601 10,323 942 738 ____________________ 13,604 14,946 $ ____________________ ____________________ 7,004 38,123 33,319 62,127 _____________________ 140,573 257,845 $ _____________________ _____________________ (1) The loan maturity information is based upon original loan terms and is not adjusted for “rollovers.” In the ordinary course of business, loans maturing within one year may be renewed, in whole or in part, as to principal amount at interest rates prevailing at the date of renewal. (2) Scheduled repayments are reported in maturity categories in which the payment is due. The Bank does not make loans that provide for negative amortization nor do any loans contain conversion features. The Bank does not have any foreign loans outstanding at December 31, 2002. ALLOWANCE FOR LOAN LOSSES 2002 The allowance for loan losses represents the amount that management estimates is adequate to provide for probable losses inherent in the loan portfolio as of the balance sheet date. Accordingly, all loan losses are charged to the allowance, and all recoveries are credited to it. The allowance for loan losses is established through a provision for loan losses, which is charged to operations. The provision is based on management’s quarterly evaluation of the adequacy of the allowance for loan losses, taking into account the overall risk characteristics of the various portfolio segments, past experience with losses, the impact of economic conditions on borrowers, and other relevant factors. Underwriting continues to emphasize the need for security and adequate collateral margins. The total allowance for loan losses is a combination of a specific allowance for identified problem loans, a homogeneous pool allowance, and off balance sheet risk allowance. At December 31, 2002, the allowance for loan losses as a percent of gross loans declined from December 31, 2001, to 1.1%. Gross loans increased by $6,222,000 from $251,623,000 at December 31, 2001 to $257,845,000 at December 31, 2002. Nonaccruing loans increased $590,000 to $871,000 from year-end 2001. Overall nonperforming loans increased $1,477,000 to $2,096,000 from fiscal 2001. Based on management’s loan-by-loan review, the past performance of the borrowers and current economic conditions, including recent business closures and bankruptcy levels, management does not anticipate any current losses related to nonaccrual, nonperforming, or classified loans above that have already been considered in its overall judgment of the adequacy of the reserve. 2001 At December 31, 2001, the allowance for loan losses as a percent of gross loans remained unchanged from December 31, 2000, at 1.2%. Gross loans increased by $6,825,000 from $244,798,000 at December 31, 2000 to $251,623,000 at December 31, 2001. Nonaccruing loans decreased $496,000 (63.8%) to $281,000 from year-end 2000. Overall nonperforming loans decreased $185,000 (23.0%) to $619,000 from fiscal 2000. Based on management’s loan-by-loan review, the past performance of the borrowers and current economic conditions, including recent plant closures and bankruptcy levels, management does not anticipate any current losses related to nonaccrual, nonperforming, or classified loans above that have already been considered in its overall judgment of the adequacy of the reserve. The following table presents information concerning nonperforming loans. The accrual of interest will be discontinued when the principal or interest of a loan is in default for 90 days or more, or as soon as payment is questionable, unless the loan is well secured and in the process of collection. Consumer loans and residential real estate loans secured by 1 to 4 family dwellings shall ordinarily not be subject to those guidelines. The reversal of previously accrued but uncollected interest applicable to any loan placed in a nonaccrual status and the treatment of subsequent payments of either principal or interest will be handled in accordance with accounting principles generally accepted in the United States of America. These principles do not require a write-off of previously accrued interest if principal and interest are ultimately protected by sound collateral values. A nonperforming loan may be restored to an accruing status when: 1. Principal and interest is no longer due and unpaid. 2. It becomes well secured and in the process of collection. 3. Prospects for future contractual payments are no longer in doubt. 33 TOTAL NONPERFORMING LOANS (IN THOUSANDS) 2002 . . . . . . . . . . . . . . . . . . . . . . . . $ 2001 . . . . . . . . . . . . . . . . . . . . . . . . $ 2000 . . . . . . . . . . . . . . . . . . . . . . . . $ 1999 . . . . . . . . . . . . . . . . . . . . . . . . $ 1998 . . . . . . . . . . . . . . . . . . . . . . . . $ NONACCRUAL 871 281 777 284 646 90 DAYS PAST DUE 1,225 338 27 241 60 $ $ $ $ $ If interest had been recorded at the original rate on those loans, such income would have approximated $24,000, $28,000 and $86,000 for the years ended December 31, 2002, 2001, and 2000, respectively. Interest income on such loans, which is recorded as received, amounted to approximately $17,000, $19,000 and $45,000 for the years ended December 31, 2002, 2001 and 2000, respectively. The level of nonaccruing loans continues to fluctuate annually and is attributed to the various economic factors experienced both regionally and nationally. Overall the portfolio is well secured with a majority of the balance making regular payments or scheduled to be satisfied in the near future. Presently there are no significant amounts of loans where serious doubts exist as to the ability of the borrower to comply with the current loan payment terms which are not included in the nonperforming categories as indicated above. Management’s judgment in determining the amount of the additions to the allowance charged to operating expense considers the following factors: 1. Economic conditions and the impact on the loan portfolio. 2. Analysis of past loan charge-offs experienced by category and comparison to outstanding loans. 3. Problem loans on overall portfolio quality. 4. Reports of examination of the loan portfolio by the Pennsylvania State Banking Department and the Federal Deposit Insurance Corporation. ALLOCATION IN THE ALLOWANCE FOR LOAN LOSSES (IN THOUSANDS): PERCENT OF LOANS IN EACH CATEGORY TO TOTAL LOANS AMOUNT DECEMBER 31, 2002: Balance at end of period applicable to: Domestic: Commercial and agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate mortgage: Residential. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Installment loans to individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 471 1,162 1,082 66 172 9.2% 54.4% 29.3% 1.3% 5.8% Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . DECEMBER 31, 2001: Balance at end of period applicable to: Domestic: Commercial and agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate mortgage: Residential. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Installment loans to individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unallocated general allowance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 $ _____________________ ______________________ _____________________ ______________________ 2,953 100.0% $ 414 9.0% 1,379 763 74 271 26 55.8% 26.5% 1.6% 7.1% — _____________________ ______________________ $ _____________________ ______________________ _____________________ ______________________ 100.0% 2,927 DECEMBER 31, 2000: Balance at end of period applicable to: Domestic: Commercial and agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate mortgage: Residential. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Installment loans to individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unallocated general allowance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . DECEMBER 31, 1999: Balance at end of period applicable to: Domestic: $ 541 10.8% 1,211 723 71 306 27 53.7% 24.8% 1.9% 8.8% — _____________________ ______________________ $ _____________________ ______________________ _____________________ ______________________ 100.0% 2,879 Commercial and agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate mortgage: Residential. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Installment loans to individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unallocated general allowance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 531 13.7% 52.4% 22.2% 1.6% 10.1% — _____________________ ______________________ $ 100.0% _____________________ ______________________ _____________________ ______________________ 1,186 710 70 300 26 2,823 DECEMBER 31, 1998: Balance at end of period applicable to: Domestic: Commercial and agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate mortgage: Residential. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Installment loans to individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unallocated general allowance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . DEPOSITS 2002 $ 505 15.3% 1,126 673 67 284 26 51.2% 20.3% 1.8% 11.4% — _____________________ ______________________ $ _____________________ ______________________ _____________________ ______________________ 100.0% 2,681 Total average deposits were $316,934,000 for 2002, an increase of $31,166,000 or 10.9%. Unlike the previous year, the majority of the increase was in the demand deposit category. Total demand deposits increased $29,903,000. Noninterest-bearing demand deposits increased $4,283,000 and interest-bearing demand deposits increased $25,620,000. Savings deposits increased $10,273,000 while time deposits decreased $9,010,000. The Bank continues to penetrate into the Centre County market with the opening of a new branch office inside the State College Wal-Mart on North Atherton Street. Historically low rate levels have influenced investors away from longer term commitments which has resulted in a decrease in time deposits and a significant increase in more liquid accounts such as demand deposits and savings. The shift from time deposits to demand and savings deposits have also had a positive impact on earnings. More details pertaining to the changes in interest expense are stated in the Net Interest Income discussion. 2001 Total average deposits increased $20,288,000 during 2001. The most significant growth occurred in time deposits. Time deposits increased $14,396,000. Demand and savings deposits increased $4,519,000 and $1,373,000, respectively. Time deposits increased 11.0% from 2000 mostly due to successful marketing strategies and penetration into the Centre County market. In addition to growth, the downward rate environment in 2001 caused the average rate paid on time deposits to decline. Noninterest bearing deposits increased 9.0% to $46,594,000. Interest-bearing demand deposits also increased minimally to $46,154,000 (1.5%). Time deposits of $100,000 or more totaled approximately $29,126,000 on December 31, 2002 and $32,646,000 on December 31, 2001. Interest expense related to such deposits was approximately $1,098,000, $1,913,000 and $1,571,000 for the years ended December 31, 2002, 2001 and 2000, respectively. 35 Maturities on time deposits of $100,000 or more are as follows: Three months or less Three months to six months Six months to twelve Over twelve months Total 2002 6,770 7,436 6,093 8,827 29,126 $ $ Time deposits at December 31, 2002 mature as follows: 2003 - $85,397,000; 2004 - $20,365,000; 2005 - $15,168,000; 2006 - $10,627,000; 2007 - $1,169,000; thereafter - $1,054,000. The average amount and the average rate paid on deposits are summarized below (in thousands): 2002 AVERAGE 2001 AVERAGE AMOUNT RATE AMOUNT RATE 2000 AVERAGE AMOUNT RATE DEPOSITS IN DOMESTIC BANK OFFICES: Demand deposits: Noninterest-bearing . . . . . . . . . Interest-bearing . . . . . . . . . . . . Savings deposits . . . . . . . . . . . . . . Time deposits . . . . . . . . . . . . . . . . Total average deposits . . . . $ 50,877 71,774 57,470 136,813 __________________ $ 316,934 __________________ __________________ 0.00% 2.13% 2.04% 3.77% $ 46,594 46,154 47,197 145,823 _________________ $ 285,768 _________________ _________________ 0.00% 2.17% 2.03% 5.28% $ 42,765 0.00% 45,464 2.17% 45,824 2.00% 131,427 5.52% _________________ $ 265,480 _________________ _________________ SHAREHOLDERS’ EQUITY 2002 Shareholders’ equity is evaluated in relation to total assets and the risks associated with those assets. A company is more likely to meet its cash obligations and absorb unforeseen losses when the capital resources are greater. Total shareholders’ equity at December 31, 2002 was $63,142,000, increasing $7,890,000 from the balance at December 31, 2001 of $55,252,000. Net income and the exercising of stock options contributed $8,886,000 and $113,000, respectively, to shareholders’ equity. The unrealized appreciation on securities also added $3,416,000 to total equity. Reductions to shareholders’ equity included $4,124,000 that was paid out in dividends and $401,000 for the purchase of treasury stock. 2001 Total shareholders’ equity at December 31, 2001 was $55,252,000, increasing $4,738,000 from the balance at December 31, 2000 of $50,514,000. Net income and the exercising of stock options contributed $7,742,000 and $24,000, respectively, to shareholders’ equity. The unrealized appreciation on securities also added $2,539,000 to total equity. Reductions to shareholders’ equity included $3,729,000 that was paid out in dividends and $1,838,000 for the purchase of treasury stock. Bank regulators have risk based capital guidelines. Under these guidelines, banks are required to maintain minimum ratios of core capital and total qualifying capital as a percentage of risk weighted assets and certain off-balance sheet items. At December 31, 2002, the Company’s required ratios were well above the minimum ratios as follows: Tier 1 capital ratio Total capital ratio Company 20.7% 22.2% 2002 Minimum Standards 4.0% 8.0% For a more comprehensive discussion of these requirements, see “Regulations and Supervision” on the Form 10-K. Management believes that the Company will continue to exceed regulatory capital requirements. RETURN ON EQUITY AND ASSETS: The ratio of net income to average total assets and average shareholders’ equity and certain ratios are presented as follows: Percentage of net income to: Average total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average shareholders’ equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Percentage of dividends declared per common share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Percentage of average shareholders’ equity to average total assets . . . . . . . . . . . . . . . . . . . 2.01% 15.00% 46.40% 13.39% 1.95% 14.38% 48.17% 13.54% 1.74% 13.77% 52.18% 12.62% 2002 2001 2000 36 LIQUIDITY, INTEREST RATE SENSITIVITY AND MARKET RISK Fundamental objectives of the Company’s asset/liability management process are to maintain adequate liquidity while minimizing interest rate risk. The maintenance of adequate liquidity provides the Company with the ability to meet its financial obligations to depositors, loan customers and stockholders. Additionally, it provides funds for normal operating expenditures and business opportunities as they arise. The objective of interest rate sensitivity management is to increase net interest income by managing interest sensitive assets and liabilities in such a way that they can be repriced in response to changes in market interest rates. The Company, like other financial institutions, must have sufficient funds available to meet its liquidity needs for deposit withdrawals, loan commitments and expenses. In order to control cash flow, the bank estimates future flows of cash from deposits and loan payments. The primary sources of funds are deposits, principal and interest payments on loans and mortgage-backed securities, as well as Federal Home Loan Bank borrowings. Funds generated are used principally to fund loans and purchase investment securities. Management believes the Company has adequate resources to meet its normal funding requirements. Management monitors the Company’s liquidity on both a long and short-term basis thereby, providing management necessary information to react to current balance sheet trends. Cash flow needs are assessed and sources of funds are determined. Funding strategies consider both customer needs and economical cost. Both short and long term funding needs are addressed by maturities and sales of available for sale investment securities, loan repayments and maturities, and liquidating money market investments such as federal funds sold. The use of these resources, in conjunction with access to credit provides core ingredients to satisfy depositor, borrower and creditor needs. Management monitors and determines the desirable level of liquidity. Consideration is given to loan demand, investment opportunities, deposit pricing and growth potential as well as the current cost of borrowing funds. The Company has a current borrowing capacity at the Federal Home Loan Bank of $153,147,000. In addition to this credit arrangement the Company has additional lines of credit with correspondent banks of $10,500,000. The Company’s management believes that it has sufficient liquidity to satisfy estimated short-term and long-term funding needs. Federal Home Loan Bank advances totaled $53,618,000 as of December 31, 2002. Interest rate sensitivity, which is closely related to liquidity management, is a function of the repricing characteristics of the Company’s portfolio of assets and liabilities. Asset/liability management strives to match maturities and rates between loan and investment security assets with the deposit liabilities and borrowings that fund them. Successful asset/liability management results in a balance sheet structure which can cope effectively with market rate fluctuations. The matching process is affected by segmenting both assets and liabilities into future time periods (usually 12 months, or less) based upon when repricing can be effected. Repriceable assets are subtracted from repriceable liabilities, for a specific time period to determine the “gap”, or difference. Once known, the gap is managed based on predictions about future market interest rates. Intentional mismatching, or gapping, can enhance net interest income if market rates move as predicted. However, if market rates behave in a manner contrary to predictions, net interest income will suffer. Gaps, therefore, contain an element of risk and must be prudently managed. In addition to gap management, the Company has an asset liability management policy which incorporates a market value at risk calculation which is used to determine the effects of interest rate movements on shareholders’ equity and a simulation analysis to monitor the effects of interest rate changes on the Company’s balance sheets. INTEREST RATE SENSITIVITY The following table sets forth the Company’s interest rate sensitivity as of December 31, 2002: WITHIN ONE YEAR AFTER ONE BUT WITHIN TWO YEARS AFTER TWO BUT WITHIN FIVE YEARS AFTER FIVE YEARS Earning assets: Investment securities (1) . . . . . . . . . . . . . . $ Loans (2) . . . . . . . . . . . . . . . . . . . . . . . . . . 15,080 81,782 69,839 35,395 ____________________ _______________________ ____________________ _____________________ 105,234 52,097 106,062 32,929 37,257 158,159 96,862 70,186 $ $ $ Total earning assets. . . . . . . . . . . . . . . . . . . . . . Interest-bearing liabilities: Deposits (3) . . . . . . . . . . . . . . . . . . . . . . . . Borrowings . . . . . . . . . . . . . . . . . . . . . . . . Total interest-bearing liabilities . . . . . . . . . . . . Net noninterest-bearing funding (4) . . . . . . . . . 103,031 43,554 41,645 1,787 ____________________ _______________________ ____________________ _____________________ 43,432 41,584 15,000 86,529 5,000 146,585 56,584 91,529 46,156 ____________________ _______________________ ____________________ _____________________ 27,693 9,231 9,231 Total net funding sources . . . . . . . . . . . . . . . . . $ Excess assets (liabilities) . . . . . . . . . . . . . . . . . Cumulative excess assets (liabilities) . . . . . . . . 155,816 (58,954) (58,954) $ 65,815 4,371 (54,583) $ 119,222 38,937 (15,646) 89,588 15,646 — (1) Investment balances reflect estimated prepayments on mortgage-backed securities. (2) Loan balances include annual repayment assumptions based on projected cash flow from the loan portfolio. The cash flow projections are based on the terms of the credit facilities and estimated prepayments on fixed rate mortgage loans. Loans include loans held for sale. 37 (3) Adjustments to the interest sensitivity of Savings, NOW and MMDA account balances reflect managerial assumptions based on historical experience, expected behavior in future rate environments and the Company’s positioning for these products. (4) Net noninterest-bearing funds are the sum of noninterest-bearing liabilities and shareholders’ equity minus noninterest- earning assets and reflect managerial assumptions as to the appropriate investment maturity categories. In this analysis the Company examines the result of a 100 and 200 basis point change in market interest rates and the effect on net interest income. It is assumed that the change is instantaneous and that all rates move in a parallel manner. Assumptions are also made concerning prepayment speeds on mortgage loans and mortgage securities. The following is a rate shock analysis for the period indicated: Changes in Rates -200 -100 +100 +200 December 31, 2002 Net Interest Income Change (After Tax) (In thousands) (350) (226) 140 6 $ $ $ $ The model utilized to create the report presented above makes various estimates at each level of interest rate change regarding cash flow from principal repayment on loans and mortgage-backed securities and or call activity on investment securities. Actual results could differ significantly from these estimates which would result in significant differences in the calculated projected change. In addition, the limits stated above do not necessarily represent the level of change under which management would undertake specific measures to realign its portfolio in order to reduce the projected level of change. Generally, management believes the Company is well positioned to respond expeditiously when the market interest rate outlook changes. INFLATION The asset and liability structure of a financial institution is primarily monetary in nature, therefore, interest rates rather than inflation have a more significant impact on the Company’s performance. Interest rates are not always affected in the same direction or magnitude as prices of other goods and services, but are reflective of fiscal policy initiatives or economic factors that are not measured by a price index. COMPREHENSIVE INCOME Comprehensive income is a measure of all the changes in equity of a corporation. It excludes transactions with owners in their capacity as owners (i.e. stock options granted or exercised, repurchase of treasury stock transactions and dividends to shareholders). Other comprehensive income is the difference between net income and comprehensive income. The Company’s other comprehensive income is composed of unrealized gains and losses on available for sale securities, net of deferred income tax. Comprehensive income is not a measure of net income. Net income would be affected by other comprehensive income only in the event that the entire securities portfolio was sold on the statement date. Unrealized gains or losses reflected in the Company’s comprehensive income may vary widely at statement dates as a result of changing markets and /or interest rate movements. Other comprehensive income for the years ended December 31, 2002, 2001 and 2000 were $3,416,000, $2,539,000 and $2,117,000, respectively. CAUTIONARY STATEMENT FOR PURPOSES OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 This Report contains certain “forward-looking statements” including statements concerning plans, objectives, future events or performance and assumptions and other statements which are other than statements of historical fact. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. In order to comply with the terms of the safe harbor, the Company notes that a variety of factors could cause the Company’s actual results and experience to differ materially from the anticipated results or other expectations expressed in the Company’s forward-looking statements. The risks and uncertainties that may affect the operations, performance, development and results of the Company’s business include the following: general economic conditions and changes in interest rates including their impact on capital expenditures; business conditions in the banking industry; the regulatory environment; rapidly changing technology and evolving banking industry standards; the effect of changes in accounting policies and practices, including increased competition with community, regional and national financial institutions; new service and product offerings by competitors and price pressures; changes in the Company’s organization, compensation and benefit plans; and similar items. Item 7A. Quantitative and Qualitative Disclosure About Market Risk Market risk for the Company is comprised primarily from interest rate risk exposure and liquidity risk. Interest rate risk and liquidity risk management is performed at the Bank level as well as the Company level. The Company’s interest rate sensitivity is monitored by management through selected interest rate risk measures produced internally. Additional information and details are provided in the Interest Sensitivity section of Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Generally, management believes the Company is well positioned to respond expeditiously when the market interest rate outlook changes. 38 

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