2003 Annual Report & Form 10K2003 Annual Report & Form 10K 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25-39 SEC Form 10-K . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40-52 Management and Board of Directors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 Offices of Jersey Shore State Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54-55 1 To our Shareholders Dear Shareholders: Our financial performance during the past year illustrates the strength of Penns Woods Bancorp, Inc., and the changes implemented demonstrate our commitment to the future growth and continued success of our company. Strong Earnings Consolidated net earnings for the year ended December 31, 2003 were $11,174,000. This represents a 25.75% increase over the same period in 2002 when net earnings were $8,886,000. Operating earnings, excluding tax adjusted net security gains of $2,415,000, were $8,759,000 for the year ended 2003. This represents a 1.66% increase over operating earnings of $8,616,000 for the same period in 2002 excluding tax adjusted net security gains of $154,000 and a non-recurring income item of $116,000. Our diversified revenue stream, including net margin, security gains, service charges, and commissions from Jersey Shore State Bank’s subsidiary, The M Group, Inc., support the solid growth of consolidated net income. In response to the low interest rate environment, we reduced our cost of funds such that net interest income for 2003 increased $1,529,000 over 2002. Lower interest rates prompted refinancing, increasing secondary mortgage market income by $243,000. The securities portfolio was repositioned according to the current interest rate environment to increase interest income by $896,000 and minimize interest rate risk. Also, the second quarter of 2003 brought opportunities to take gains in the securities market and enhance total consolidated earnings by $3,659,000. Service charges improved $84,000 over last year. Additionally, The M Group, Inc., had another great year. Their net income contributed 4% of the bottom line. The bank has grown substantially over the year. The total asset increase of $55,175,000 is centered in loans and investment securities. Historically low interest rates offered opportunities to minimize future funding costs and enhance liability positioning. Additional borrowings, both long term and short term, are being utilized to take advantage of current spread opportunities while reducing interest rate risk. The above factors produced favorable results relative to prior years. Return on average assets (ROA) and return on average equity (ROE) for the year ended December 31, 2003 were 2.24% and 16.60%, respectively compared to ROA of 2.01% and ROE of 15.00% for the year 2002. Loan Growth Committed to steady growth in the Centre County market we added a mortgage representative and commercial lender to the State College Office. The dedication of our lenders helped increase net loans by $17,867,000 during 2003 without compromising loan quality. Non-performing loans to net loans at year end was .46%, a decrease of 40% from 2002. To facilitate our commitment to loan growth and quality of the portfolio, two individuals in the loan department were promoted. Ann M. Riles was named Senior Vice President and Chief Credit Officer and Steven M. Tasselli was named Senior Vice President and Commercial Loan Manager. With their leadership our lending team will continue to develop and thrive. Shareholder Value The Company’s strong performance provided cash dividends of $1.49 during the year, a 20% increase over 2002. A 10% stock dividend was also issued to Shareholders in October and 45% of net income was paid in cash dividends in 2003. Earnings per share increased 26% to $3.35 per basic and dilutive share. Book value per share at the end of the year increased 11% to $21.00 over last year. Although we are proud of our past performances, we are focused on the future. Our goal is to provide long term value to our Shareholders by investing in our core business of servicing the needs of consumers and small to medium size businesses and providing professional training to our staff. Moving Forward With competition intensifying it is imperative that we strive to build new contacts and strengthen existing customer relationships. In 2003, the commitment was made to educate our employees on the importance of cross selling products the company has to offer. To help drive our obligation of future growth and success, G. David Gundy was promoted to Senior Vice President and Customer Sales and Services Manager. Under this initiative, Company employees will receive additional training on identifying the best financial product to fit our customers’ needs. Management will be seeking regulatory approval to add a regional banking center in the State College market. It is anticipated that this will provide a significant presence from which to expand our opportunities in Centre County and the surrounding communities. Technology plays a pivotal role in our goal to provide unsurpassed service and quality products to help our customers reach their financial objectives. In 2004 we will implement teller machines, combined customer account statements, and a new platform system for loans. The platform system allows for immediate retrieval of information and documents. These new programs will allow us to become more efficient and enhance customer service. As a company we make every effort to provide our customers the best value at a fair price. It has never been our philosophy to “hide fees” or over charge. As we get ready to celebrate 70 years in business we want to assure you that we will continue to operate with the same ethical standards that our founding officers did 70 years ago. Thank you for your continued support. Very truly yours, Ronald A. Walko President and Chief Executive Officer 2 Theodore H. Reich Chairman Emeritus Three Year Financial Highlights YEAR-END DEPOSITS In Millions of Dollars $ 400 300 305 340 334 200 100 0 YEAR-END LOANS In Millions of Dollars DILUTED EARNINGS PER SHARE 252 258 276 $ 400 300 200 100 0 3.35 2.66 $4.00 3.00 2.30 2.00 1.00 0.00 ’01 ’02 ’03 ’01 ’02 ’03 ’01 ’02 ’03 DIVIDENDS PER SHARE RETURN ON AVERAGE ASSETS Percent RETURN ON AVERAGE EQUITY Percent $ 2.00 3.00 1.50 1.49 1.24 1.00 1.11 0.50 0.00 2.24 2.00 1.95 2.01 1.00 0.00 25.00 20.00 15.00 14.38 15.00 16.60 10.00 5.00 0.00 ’01 ’02 ’03 ’01 ’02 ’03 ’01 ’02 ’03 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, 2003 and 2002, 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, 2003. 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, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. Wexford, PA February 13, 2004 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 $701 and $1,289) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans, net of unearned discount of $940 and $769 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: Allowance for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 3,326,560 and 3,136,832 shares issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Treasury stock, at cost (5,000 and 105,503 shares) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TOTAL SHAREHOLDERS’ EQUITY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TOTAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 527,381 $ See Accompanying Notes to the Consolidated Financial Statements. December 31, 2003 2002 (in thousands) 10,230 210,611 $ $ $ 686 4,803 275,828 3,069 272,759 4,625 2,242 8,908 3,032 9,485 527,381 269,443 64,875 334,318 47,265 70,878 836 4,315 457,612 33,265 17,559 13,022 6,132 (209) 69,769 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) 63,142 472,206 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, 2003 2001 2002 (in thousands, except per share data) 19,963 $ 20,911 $ 21,919 6,370 2,608 111 29,052 5,656 428 3,181 9,265 19,787 255 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 FOR LOAN LOSSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,532 17,893 15,883 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Advertising 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,917 3,659 404 1,598 1,056 8,634 7,262 877 999 388 455 3,308 13,289 14,877 3,703 11,174 3.35 3.35 $ $ $ 1,833 233 416 1,807 1,164 5,453 6,944 831 837 372 411 2,818 12,213 11,133 2,247 8,886 2.66 2.66 $ $ $ 1,565 1,033 174 1,416 921 5,109 5,792 787 739 344 370 3,240 11,272 9,720 1,978 7,742 2.30 2.30 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, 2000 3,130,844 $ 31,308 $ 18,214 $ 2,974 $ (810 ) $ (1,172 ) $ 50,514 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, ($1.11 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, ($1.24 per share) Stock options exercised Treasury stock acquired, 13,449 shares 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 Balance, December 31, 2002 3,136,832 31,368 18,291 11,749 5,145 7,742 2,539 10,281 (3,729) 24 (1,838) 55,252 8,886 3,416 12,302 (4,124) 113 (401) 63,142 (1,838 ) (3,010 ) (401 ) (3,411 ) Stock split effective in the form of a 10% dividend Comprehensive Income: Net income Unrealized gain on available for sale securities, net of reclassification adjustments and tax $508 Total comprehensive income Dividends declared, ($1.49 per share) Stock options exercised Treasury stock acquired, 14,787 shares 187,143 1,871 (793 ) (4,900) 3,822 — 11,174 (5,001) 987 2,585 26 61 11,174 987 12,161 (5,001) 87 (620) $ 69,769 (620 ) (209 ) Balance, December 31, 2003 3,326,560 $ 33,265 $ 17,559 $ 13,022 $ 6,132 $ Components of comprehensive income: Change in net unrealized gain on investments available for sale Realized gains included in net income, net of tax $1,244, $79 and $351 Total 2003 2002 2001 $ 3,402 $ 3,570 $ 3,221 (2,415) ( 154) (682) $ 987 $ 3,416 $ 2,539 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: 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 . . . . . . . . . . . . . . . . . . . . . . Iincrease in all other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in all other liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . INVESTING ACTIVITIES: Investment securities available for sale: Proceeds from sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from calls and maturities . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 . . . . . . . . . . . . . . . . . . . . . . . . . . Gross proceeds from redemption of regulatory stock . . . . . . . . . . . . . . . Gross purchases of regulatory stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2003 Year Ended December 31, 2002 (in thousands) 2001 11,174 $ 8,886 $ 7,742 631 255 (194) (3,659) (15,983) 13,831 (404) (490) 1,276 6,437 82,489 48,046 (159,363) 520 (24) (18,390) (400) 341 – 1,507 (4,402) 526 365 (906) (233) (16,597) 17,939 (416) (1,465) 473 8,572 79,022 13,047 (130,328) 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) Net cash used for investing activities . . . . . . . . . . . . . . . . . . . . . . . . (49,676) ________________ (46,429) ________________ (23,758) ________________ FINANCING ACTIVITIES: Net increase (decrease) in interest-bearing deposits . . . . . . . . . . . . . . . . Net increase (decrease) in noninterest-bearing deposits . . . . . . . . . . . . . Net increase (decrease) in short-term borrowings . . . . . . . . . . . . . . . . . . Proceeds from other borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock options exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by financing activities. . . . . . . . . . . . . . . . . . . . . (3,344) (2,186) 33,702 19,100 (5,001) 87 (620) ________________ 41,738 ________________ 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 ________________ NET DECREASE IN CASH AND CASH EQUIVALENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . CASH AND CASH EQUIVALENTS, BEGINNING . . . . . . . . . . . . . . . . . . CASH AND CASH EQUIVALENTS, ENDING . . . . . . . . . . . . . . . . . . . . . . $ (1,501) 11,731 ________________ 10,230 ________________ ________________ (3,113) 14,844 ________________ $ 11,731 ________________ ________________ (474) 15,318 ________________ $ 14,844 ________________ ________________ SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: The Company paid approximately $9,521,000, $10,944,000 and $12,743,000 in interest on deposits and other borrowings during 2003, 2002, and 2001, respectively. The Company made income tax payments of approximately $3,500,000, $3,394,000 and $2,136,000 during 2003, 2002, and 2001, 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, trading or available for sale. 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, 2003 or 2002. 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. Loan origination and commitment fees as well as certain direct loan origination costs are being deferred and the net amount amortized as an adjustment to the related loan’s yield. These amounts are being amortized over the contractual lives of the related loans. 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 the loans. When foreclosure is probable, impairment is measured based on the fair value of the collateral. 9 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 cost or fair value minus estimated costs to sell. 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 years 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 On January 1, 2002, the Company adopted Statement of Financial Accounting Standards (“FAS”) No. 142, Goodwill and Other Intangible Assets. This statement changed the accounting for goodwill from an amortization method to an impairment-only approach. Thus, amortization of goodwill, including goodwill recorded in past business combinations, ceased upon adoption of this statement. This statement, among other things, 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 at the beginning of its fiscal year immediately stopped amortizing goodwill with a carrying value of $3.0 million. In addition, the Company performs an annual impairment analysis of goodwill. Based on fair value of the reporting unit, estimated using the expected present value of future cash flows, no impairment of goodwill was recognized in 2003 and 2002. Advertising Costs Advertising costs are generally expensed as incurred 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. Employee Benefits Pension and employee benefits include contributions, determined actuarially, to a defined benefit retirement plan covering the eligible employees of the Bank. The plan is funded on a current basis to the extend that it is deductible under existing federal tax regulations. Pension and other employee benefits also include contributions to a defined contribution Section 401(k) plan covering eligible employees. Contributions matching those made by eligible employees and an elective contribution are made annually at the discretion of the Board of Directors. 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 2003, 2002, and 2001. 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 shareholders’ equity. Recent Accounting Pronouncements In December 2003, the Financial Accounting Standards Board (“FASB”) revised FAS No. 132, Employers’ Disclosures about Pension and Other Postretirement Benefit. This statement retains the disclosures required by FAS No. 132, which standardized the disclosure requirements for pensions and other postretirement benefits to the extent practicable and requires additional information on changes in the benefit obligations and fair value of plan assets. Additional disclosures include information describing the types of plan assets, investment strategy, measurement date(s), plan obligations, cash flows, and components of net periodic benefit cost recognized during interim periods. This statement retains reduced disclosure requirements for nonpublic entities from FAS No. 132, and it includes reduced disclosure for certain of the new requirements. This statement is effective for financial statements with fiscal years ending after December 15, 2003. The interim disclosures required by this statement are effective for interim periods beginning after December 15, 2003. In August 2001, the FASB issued 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 was effective January 1, 2003, did not have a material effect on the Company’s financial position or results of operations. 10 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 is effective for exit or disposal activities initiated after December 31, 2002. The adoption of this statement did not have a material effect on the Company’s financial position or results of operations. 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 April 2003, the FASB issued FAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. This statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under FAS No. 133. The amendments set forth in FAS No. 149 improve financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. In particular, this statement clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative as discussed in FAS No. 133. In addition, it clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. FAS No. 149 amends certain other existing pronouncements. Those changes will result in more consistent reporting of contracts that are derivatives in their entirety or that contain embedded derivatives that warrant separate accounting. This statement is effective for contracts entered into or modified after September 30, 2003, except as stated below and for hedging relationships designated after September 30, 2003. The guidance should be applied prospectively. The provisions of this statement that relate to FAS No. 133 Implementation Issues that have been effective for fiscal quarters that began prior to September 15, 2003, should continue to be applied in accordance with their respective effective dates. In addition, certain provisions relating to forward purchases or sales of when-issued securities or other securities that do not yet exist, should be applied to existing contracts as well as new contracts entered into after September 30, 2003. The adoption of this statement did not have a material effect on the Company’s financial position or results of operations. In May 2003, the FASB issued FAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Such instruments may have been previously classified as equity. This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after September 15, 2003. The adoption of this statement did not have a material effect on the Company’s reported equity. 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. The adoption of this interpretation did not have a material effect on the Company’s financial position or results of operations. In December 2003, the FASB issued a revision to Interpretation No. 46, Consolidation of Variable Interest Entities, which established standards for identifying a variable interest entity (“VIE”) and for determining under what circumstances a VIE should be consolidated with its primary beneficiary. Application of this Interpretation is required in financial statements of public entities that have interests in special-purpose entities for periods ending after December 15, 2003. Application by public entities, other than small business issuers, for all other types of VIEs is required in financial statements for periods ending after March 15, 2004. Small business issuers must apply this Interpretation to all other types of VIEs at the end of the first reporting period ending after December 15, 2004. The adoption of this Interpretation has not and is not expected to have a material effect on the Company’s financial position or results of operations. 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 2003 3,430,302 (99,717) 2002 3,445,477 (109,165) 2001 3,443,930 (72,085) Weighted average common shares and common stock equivalents used to calculate basic earnings per share 3,330,585 3,336,312 3,371,845 Additional common stock equivalents (stock options) used to calculate diluted earnings per share Weighted average common shares and common stock equivalents 3,213 2,937 2,241 used to calculate diluted earnings per share 3,333,798 3,339,249 3,374,086 Options to purchase 10,890 shares of common stock at a price of $48.35 were outstanding during 2003 and 22,385 shares of common stock at prices from $38.18 to $48.35 were outstanding during 2002 and 2001, 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): 2003 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. . . . . . . . . . . . . . . . . . . . . $ GROSS AMORTIZED UNREALIZED UNREALIZED GAINS LOSSES GROSS COST 150,218 $ 31,364 1,581 183,163 18,158 201,321 $ 75 $ 347 264 686 $ (1,015) $ (22) (4) (1,041) (26) (1,067) $ (1) $ — — (1) $ 626 $ 2,510 75 3,211 7,146 10,357 $ — $ 16 — 16 $ 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 $ 1,856 $ 3,596 46 5,498 2,989 8,487 $ — $ 109 — 109 $ — $ (234) (2) (236) (456) (692) $ — $ — (1) (1) $ FAIR VALUE 149,829 33,852 1,652 185,333 25,278 210,611 74 363 264 701 FAIR VALUE 88,998 70,681 1,810 161,489 14,947 176,436 94 905 290 1,289 The following table shows the Company’s gross unrealized losses and fair value, aggregated by investment category and length of time, that the individual securities have been in a continuous unrealized loss position, at December 31, 2003 (in thousands): Less than Twelve Months Twelve Months or Greater Total Fair Value Gross Unrealized Losses Fair Value Gross Unrealized Losses Fair Value Gross Unrealized Losses U.S. Government and agency securities . . . . . . . . . . . . . . . . $ State and political securities . . . . . . . . . . . . . . . . . . . . . . . . . Other debt securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total debt securites . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,605 $ 198 196 80,999 203 1,015 $ 22 4 1,041 3 62 $ — — 62 405 1 $ — — 1 23 80,667 $ 198 196 81,061 608 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 81,202 $ 1,044 $ 467 $ 24 $ 81,669 $ 1,016 22 4 1,042 26 1,068 The Company’s investment securities portfolio contains unrealized losses of direct obligations of the U.S. government, including mortgage-related instruments issued or backed by the full faith and credit of the United States government or are generally viewed as having the implied guarantee of the U.S. government, debt obligations of U.S. states and political subdivisions, corporate entities, and equity securities of common stock in publicly traded companies. On a monthly basis, the Company evaluates the severity and duration of impairment for its investment securities portfolio unless the Company has the ability to hold the security to maturity without incurring a loss. Generally, impairment is considered other than temporary when an investment security has sustained a decline of ten percent or more for one year. The Company has concluded that any impairment of its investment securities portfolio as of December 31, 2003 is not other than temporary but is the result of interest rate changes that are not expected to result in the noncollection of principal and interest, during the period. 12 The amortized cost and fair value of debt securities at December 31, 2003, 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. . . . . . . . . . . . . . . . . . . . . . . . . . 3,087 — $ 4,785 125 44,387 139 133,074 437 ____________________ ____________________ ____________________ _________________ $ 185,333 701 $ ____________________ ____________________ ____________________ _________________ ____________________ ____________________ ____________________ _________________ 3,032 $ 4,779 44,538 130,814 183,163 $ — $ 125 139 422 686 $ Total gross proceeds from sales of securities available for sale were $82,489,000, $79,022,000 and $22,156,000 for 2003, 2002 and 2001, respectively. The following table represents gross realized gains and gross realized losses on those transactions (in thousands): Gross realized gains: 2003 2002 2001 U.S. Government and agency securities. . . . . . . . . . . . . . . . . . . . . . $ State and political securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other debt securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254 $ 3,345 27 1,195 204 $ 2,234 6 1,803 133 20 — 1,226 $ ____________________ ____________________ 4,821 $ ___________________ ___________________ 4,247 $ 1,379 ________________ ________________ Gross realized losses: U.S. Government and agency securities. . . . . . . . . . . . . . . . . . . . . . $ State and political securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other debt securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 742 $ 50 2 368 $ 1,162 $ 125 $ 67 — 3,822 4,014 $ 13 149 — 184 346 In 2003, the Company recorded an investment security gain of $24,000 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 $292,000 was recorded in 2003 and $2,083,000 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 $34,059,000 and $34,914,000 at December 31, 2003 and 2002, 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: Net deferred loan fees Allowance for loan losses Loans, net CURRENT 23,105 $ 144,102 82,156 7,637 14,738 _________________ $ 271,738 _________________ _________________ 940 3,069 267,729 $ 2003 PAST DUE 90 DAYS OR MORE & STILL ACCRUING 21 $ PAST DUE 30 TO 90 DAYS $ 215 NON- ACCRUAL $ 182 2,625 667 15 252 _________________ 3,774 $ _________________ _________________ 383 15 — 10 _________________ $ 429 _________________ _________________ 587 58 — — _________________ $ 827 _________________ _________________ TOTAL $ 23,523 147,697 82,896 7,652 15,000 _______________ $ 276,768 _______________ _______________ 940 3,069 272,759 $ 13 Commercial and agricultural. . . . . . . . . . Real estate mortgage: Residential . . . . . . . . . . . . . . . . . . . . Commercial . . . . . . . . . . . . . . . . . . . Construction . . . . . . . . . . . . . . . . . . . Installment loans to individuals . . . . . . . Less: Net deferred loan fees Allowance for loan losses Loans, net CURRENT 22,652 $ 137,271 74,317 3,335 14,581 _________________ $ 252,156 _________________ _________________ 769 2,953 248,434 $ 2002 PAST DUE 90 DAYS OR MORE & STILL ACCURING 7 $ PAST DUE 30 TO 90 DAYS $ 769 NON- ACCRUAL $ 280 2,752 504 21 316 _________________ $ 4,362 _________________ _________________ 175 1,006 — 37 _________________ $ 1,225 _________________ _________________ 526 65 — — _________________ $ 871 _________________ _________________ TOTAL $ 23,708 140,724 75,892 3,356 14,934 _______________ $ 258,614 _______________ _______________ 769 2,953 254,892 $ Loans on which the accrual of interest has been discontinued or reduced amounted to approximately $827,000 and $871,000 at December 31, 2003 and 2002, respectively. If interest had been recorded at the original rate on those loans, such income would have approximated $55,000, $24,000, and $28,000 for the years ended December 31, 2003, 2002 and 2001, respectively. Interest income on such loans, which is recorded as received, amounted to approximately $7,000, $17,000, and $19,000 for the years ended December 31, 2003, 2002 and 2001, 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,953 255 (216) 77 $ 2,927 365 (402) 63 Balance, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,069 $ 2,953 $ 2,879 372 (358) 34 2,927 2003 2002 2001 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, 2003 or December 31, 2002. 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, 2003 and 2002, a substantial portion of its debtors’ ability to honor their contracts is dependent on the economic conditions within this region. NOTE E - PREMISES AND EQUIPMENT Major classifications of premises and equipment are summarized as follows at December 31, (in thousands): 2003 2002 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Premises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Furniture and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leasehold improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 566 4,883 6,348 867 __________________ 12,664 8,039 __________________ 4,625 __________________ __________________ $ 566 4,855 6,001 842 ________________ 12,264 7,408 ________________ $ 4,856 ________________ ________________ Depreciation charges to operations for the years ended 2003, 2002 and 2001 was $631,000, $526,000, and $489,000, respectively. 14 NOTE F - GOODWILL As of December 31, 2003 and 2002, goodwill has a gross carrying value amount of $3,308,000 and an accumulated amortization amount of $276,000 resulting in a net carrying amount of $3,032,000. The goodwill amortization for 2001 was $221,000 with a net income of $146,000 or $.04 per share resulting in an adjusted diluted earnings per share of $2.34. The gross carrying amount of goodwill is tested for impairment in the third quarter. Based on fair value of the reporting unit, estimated using the expected present value of future cash flows, no goodwill impairment loss was recognized in the current year. NOTE G - DEPOSITS Time deposits of $100,000 or more totaled approximately $27,386,000 on December 31, 2003 and $29,126,000 on December 31, 2002. Interest expense related to such deposits was approximately $829,000, $1,098,000, and $1,913,000, for the years ended December 31, 2003, 2002 and 2001, respectively. Maturities on time deposits of $100,000 or more are as follows (in thousands): 2003 Three months or less Three months to six months Six months to twelve months Over twelve months Total $ $ 5,891 4,960 5,427 11,108 27,386 Time deposits at December 31, 2003 mature as follows: 2004 - $75,977,000; 2005 - $25,794,000; 2006 - $12,422,000; 2007 - $8,312,000; 2008 – $1,346,000; thereafter - $1,049,000. 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): 2003 2002 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short Term FHLB: 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,225 $ 15,665 13,214 1.91% 2.07% 36,140 $ 36,140 11,537 1.06% 1.16% 900 $ 900 695 1.40% 1.42% 11,723 20,870 14,819 2.68% 3.17% 1,840 8.510 1,646 1.31% 1.96% — — — — — 15 NOTE I - OTHER BORROWINGS Other borrowings are comprised of advances from the FHLB. A schedule of other borrowings as of December 31, 2003 and 2002 is summarized as follows (in thousands): Description Convertible Bullet Fixed Fixed Maturity Range to from 4/30/07 3/24/05 10/17/11 3/25/13 3/26/07 5/26/15 Weighted Int Rate 4.71% 2.59% 6.61% Stated Interest Rate to from 3.14% 2.02% 5.87% 6.65% $ 3.13% 6.92% $ 2003 2002 64,600 $ 4,500 1,778 70,878 $ 40,000 — 11,778 51,778 Maturities of other borrowings at December 31, 2003 are summarized as follows (in thousands): Year Ending 2005 2006 2007 2008 2009 and after Amount $ $ 1,400 1,600 6,500 29,600 31,778 70,878 Weighted Yield 2.02% 2.58% 4.18% 4.77% 4.79% 4.72% The terms of the convertible borrowings allow the Federal Home Loan Bank (“FHLB”) to convert the interest rate to an adjustable rate based on the three-month London Interbank Offered Rate (“LIBOR”) at a predttermined anniversary date of the borrowing’s origination, ranging from three months to five years. These remaining conversion dates range from February 2004 thorugh August 2005. 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 $166.9 million at December 31, 2003, 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. NOTE J - INCOME TAXES The following temporary differences gave rise to the net deferred tax liability at December 31, 2003 and 2002 (in thousands): 2003 2002 Deferred tax asset: Allowance for loan losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Deferred compensation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Contingencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pension . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loan fees and costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment securities allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 693 716 337 346 20 22 371 429 261 320 92 119 ________________ __________________ 1,774 1,952 __________________ ________________ Deferred tax liability: Bond accretion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrealized gains on available for sale securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 192 — 2,650 __________________ ________________ 2,873 __________________ ________________ 28 260 150 3,159 3,597 Deferred tax liability, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (1,099) __________________ ________________ __________________ ________________ (1,645) $ No valuation allowance was established at December 31, 2003 and 2002, 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, 2003 2002 2001 Currently payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Deferred expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,666 37 ________________ 3,703 ________________ ________________ $ 2,363 (116) ________________ 2,247 $ ________________ ________________ $ 2,117 (139) ___________________ 1,978 $ ___________________ ___________________ 16 The effective federal income tax rate for the years ended December 31, 2003, 2002, and 2001 was 24.9 percent, 20.2 percent, and 20.3 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): 2003 2002 2001 Provision at expected rate. . . . . . $ Decrease in tax AMOUNT 5,058 % 34.0% AMOUNT 3,785 % 34.0% AMOUNT 3,305 $ % 34.0 % resulting from: Tax-exempt income . . . . . . Other, net . . . . . . . . . . . . Effective income tax (964) (391) (6.4) (2.7) (1,367) (171) (12.3) (1.5) (1,103) (224) (11.4) (2.3) and rates $ 3,703 24.9% $ 2,247 20.2% $ 1,978 20.3% 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): 2003 2002 Change in benefit obligation: Benefit obligation at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . $ Service cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amendments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Actuarial loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expenses paid. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fair value of plan assets at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . Funded status. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrecognized net actuarial loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrecognized prior service cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrecognized transition asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Accrued Benefit Cost Recognized . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,473 443 384 — 43 (198) 7,145 3,131 620 506 (198) (17) 4,042 (3,103) 1,609 255 (22) (1,261) $ $ 4,976 381 342 97 753 (76) 6,473 3,115 (384) 499 (76) (23) 3,131 (3,342) 1,996 280 (24) (1,090) The accumulated benefit obligation for the defined benefit pension plan was $4,913,000 and $4,409,000 at December 31, 2003 and 2002, respectively. Amounts recognized in the Statement of Income consist of (in thousands): 2003 2002 2001 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 443 384 (256) (3) 26 83 677 $ $ 381 342 (246) (3) 26 19 519 $ $ 298 271 (286) (3) 20 (15) 285 17 The following information relates to the Plan’s projected benefit obligation, accumulated benefit obligation, and Plan assets at December 31, (in thousands): Projected benefit obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Accumulative benefit obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fair value of plan assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,145 4,913 4,042 6,473 4,409 3,131 2003 2002 Assumptions Weighted-average assumptions used to determine benefit obligations at December 31: 2003 Discount rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.00% Rate of compensation increase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.00% 2002 6.00% 5.00% Weighted-average assumptions used to determine net periodic cost for years ended December 31: 2003 Discount rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.00% Expected long-term return on plan assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.00% Rate of compensation increase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.00% 2002 6.50% 8.00% 5.00% 2001 7.00% 5.00% 2001 7.00% 8.00% 5.00% The expected long-term rate of return was estimated using market benchmarks by which the plan assets would outperform the market value in the future, based on historical experience adjusted for changes in asset allocation and expectations for overall lower future returns on similar investments compared to past periods. Plan Assets The Company’s pension plan weighted-average asset allocations at December 31 by asset category are as follows: Asset Category 2003 2002 0.3% Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.6% 40.6% Fixed income securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38.7% 59.1% Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60.7% 100% 100% Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The investment objective for the defined benefit penson plan is to maximize total return with tolerance for slightly above average risk, meaning the fund is able to tolerate short-term volatility to achieve above-average returns over the long term. The portfolio’s target exposure to equities is 60%, primarily invested in mid and large capitalization domestic equities. Exposure to small capitalization and international stocks may be allowed. Asset allocation favors equities, with a target allocation of approximately 60% equity securities, 37.5% fixed income securities and 2.5% cash. Due to violatility in the market, the target allocation is not always desirable and asset allocations will fluctuate between the acceptable ranges. It is management’s intent to give the investment managers flexibility within the overall guidelines with respect to investment decisions and their timing. However, certain investments require specific review and approval by management. Management is also informed of anticipated, significant modifications of any previously approved investment, or anticipated use of derivatives to execute investment strategies. The following benefit payments, which reflect expected future cost, are expected to be paid during the year ending December 31, 2003 (in thousands): 2004 . . . . . . . . . . . . . . . . . . . . . . $ 2005 . . . . . . . . . . . . . . . . . . . . . . 2006 . . . . . . . . . . . . . . . . . . . . . . 2007 . . . . . . . . . . . . . . . . . . . . . . 2008 . . . . . . . . . . . . . . . . . . . . . . 2009-2013 . . . . . . . . . . . . . . . . . . . . 169 194 241 274 275 2,130 The company expects to contribute $560,000 to its Pension Plan in 2004. 18 401(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 $75,000, $80,000, and $65,000 for the years ended December 31, 2003, 2002, and 2001, 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 $104,000, $98,000, and $67,000 for the years ended December 31, 2003, 2002 and 2001, respectively. Benefits paid under the plan were approximately $132,000 in 2003, $51,000 in 2002 and $51,000 in 2001. 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 33,385 — (2,778 ) — 30,607 Options exercisable at year-end . . . 30,607 2003 WEIGHTED- AVERAGE EXERCISE PRICE $ $ $ 38.69 — 30.93 — 39.39 39.39 2002 WEIGHTED- AVERAGE EXERCISE PRICE $ $ $ 35.09 — 23.62 23.62 38.69 38.69 SHARES 45,651 — (5,707) (6,559) 33,385 33,385 The following table summarizes information about nonqualified and incentive stock options outstanding at December 31, 2003: Exercise Price 48.35 $ 38.18 $ 29.66 $ Shares 10.890 11,082 8,635 Outstanding Average Life 5 6 7 Average Exercise Price $ $ $ 48.35 38.18 29.66 Exercisable Average Exercise Price $ $ $ 48.35 38.18 29.66 Shares 10,890 11,082 8,635 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 for the year ended December 31, 2003 (in thousands): BEGINNING BALANCE ADDITIONS PAYMENTS RETIRED/ RESIGNED ENDING BALANCE $ 6,785 $ 2,374 $ 1,791 $ 141 $ 7,227 19 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, 2003 (in thousands): YEAR ENDING DECEMBER 31, 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 262 248 221 189 89 53 __________________ 1,062 __________________ __________________ Total rental expense for all operating leases for the years ended December 31, 2003, 2002 and 2001 approximated $269,000, $258,000, and $270,000 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. 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2003 2002 $ $ 47,454 258 $ $ 29,497 741 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 upon expiration of 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, 2003 and 2002, 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 2003 2002 Amount Ratio Amount Ratio $ $ $ 66,820 23,225 29,031 60,547 11,613 17,419 60,547 20,922 26,153 23.0% 8.0 10.0 20.9% 4.0 6.0 11.6% 4.0 5.0 $ $ $ 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 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 2003 2002 Amount Ratio Amount Ratio $ $ $ 52,161 22,155 27,693 47,770 11,077 16,616 47,770 19,982 24,978 18.8% 8.0 10.0 17.3% 4.0 6.0 9.6% 4.0 5.0 $ $ $ 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 NOTE Q - REGULATORY RESTRICTIONS The Pennsylvania Banking Code restricts the availability of capital funds for payment of dividends by all state-chartered banks to the additional paid in capital of the Bank. Accordingly, at December 31, 2003, 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, 2003, the regulatory lending limit amounted to approximately $5,081,000. Cash and Due from Banks Included in cash and due from banks are reserves required by the district Federal Reserve Bank of $1,151,000 and $1,152,000 at December 31, 2003 and 2002. 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 - 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, riskcharacteristics 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. 21 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: 2003 2002 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 . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,230 $ 10,230 $ 11,731 $ 11,731 210,611 686 4,803 272,759 8,908 6,588 2,242 210,611 701 4,803 287,310 8,908 6,588 2,242 176,436 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 Financial liabilities: Interest-bearing deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . Noninterest-bearing deposits . . . . . . . . . . . . . . . . . . . . . . . . Short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 269,443 64,875 47,265 70,878 836 $ 271,200 64,875 47,265 74,027 836 $ 272,787 67,061 13,563 51,778 1,092 276,881 67,061 13,563 56,384 1,092 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 real estate, construction real estate, 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 is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The estimate of maturity is based on the Company’s historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions. Fair value for significant nonperforming loans is based on recent external appraisals. If appraisals are not available, estimated cash flows are discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows, and 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, 2003 and 2002. 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, 2003 and 2002, respectively. The contractual amounts of unfunded commitments and letters of credit are presented in Note O. NOTE S - 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. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2003 2002 (in thousands) $ 369 $ 481 51,019 11,760 20 __________________ ________________ $ 63,280 __________________ ________________ __________________ ________________ 54,133 15,307 91 69,900 $ $ 138 $ 63,142 __________________ ________________ $ 63,280 __________________ ________________ __________________ ________________ 131 69,769 69,900 $ CONDENSED STATEMENT OF INCOME FOR THE YEARS ENDED DECEMBER 31, Operating income: Dividends from subsidiaries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity in undistributed net income of subsidiaries . . . . . . . . . . . . . . . . . Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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: 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2003 2002 (in thousands) 2001 $ 6,651 $ 4,649 (126) 5,984 1,899 (141) ___________________ __________________ _________________ $ 7,742 ___________________ __________________ _________________ ___________________ __________________ _________________ 4,878 $ 4,121 (113) 11,174 $ 8,886 $ 2003 2002 (in thousands) 2001 $ 11,174 $ 8,886 $ 7,742 (1,899) (26) ___________________ __________________ _________________ 5,817 (4,121) (23) 4,742 (4,649) (64) 6,461 (276) ___________________ __________________ _________________ (1,039) — (3,729) 21 (1,838) ___________________ __________________ _________________ (5,546) ___________________ __________________ _________________ (5) 156 ___________________ __________________ _________________ $ 151 ___________________ __________________ _________________ ___________________ __________________ _________________ (4,124) 113 (401) (4,412) 330 151 481 $ (5,001) 87 (620) (5,534) (112) 481 369 $ 23 NOTE T - CONSOLIDATED QUARTERLY FINANCIAL DATA (UNAUDITED) 2003 FOR THE THREE MONTHS ENDED MARCH 31, JUNE 30, SEPT. 30, DEC. 31, (in thousands, except per share data ) 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 . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,092 2,386 _________________ 4,706 90 1,182 101 3,139 _________________ 2,760 573 _________________ $ 2,187 _________________ _________________ 0.72 $ $ 7,251 2,395 _________________ 4,856 45 1,195 1,750 3,186 _________________ 4,570 1,233 _________________ $ 3,337 _________________ _________________ 1.10 $ $ 7,281 2,327 _________________ 4,954 90 1,325 1,247 3,290 _________________ 4,146 1,135 _________________ $ 3,011 _________________ _________________ 1.00 $ $ 7,428 2,157 _______________ 5,271 30 1,273 561 3,674 _______________ 3,401 762 _______________ $ 2,639 _______________ _______________ 0.53 $ Earnings per share - diluted . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.72 $ 1.10 $ 0.99 $ 0.54 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, JUNE 30, SEPT. 30, DEC. 31, (in thousands, except per share data ) $ 7,076 2,719 _________________ 4,357 105 1,401 (119) 2,952 _________________ 2,582 485 _________________ $ 2,097 _________________ _________________ 0.62 $ $ 7,199 2,740 _________________ 4,459 80 1,317 (72) 3,056 _________________ 2,568 528 _________________ $ 2,040 _________________ _________________ 0.61 $ $ 7,399 2,715 _________________ 4,684 90 1,231 281 3,070 _________________ 3,036 660 _________________ $ 2,376 _________________ _________________ 0.71 $ $ 7,430 2,672 _______________ 4,758 90 1,271 143 3,135 _______________ 2,947 574 _______________ $ 2,373 _______________ _______________ 0.72 $ Earnings per share - diluted . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.62 $ 0.61 $ 0.71 $ 0.72 24 Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations 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. To compare the tax-exempt asset yields to taxable yields, amounts are adjusted to pretax equivalents based on the marginal corporate federal tax rate of 34%. The tax equivalent adjustment to net interest income for 2003, 2002, and 2001 were $1,367,000, $1,739,000, and $1,689,000, respectively. 2003 vs 2002 Reported net interest income increased $1,529,000 or 8.4% from year end 2002 to year end 2003. The decrease in total interest income of $52,000 is the result of an increase of $44,185,000 in the average balance of investment securities held for the current period relative to the same period a year ago offset by a decrease in the return on loans of approximately 62 basis points. Overall, interest income generated from the net increase in volume of interest earning assets was offset by a decline in rates of approximately 94 basis points. On a tax equivalent basis, net interest income increased 5.8% or $1,157,000, to $21,154,000 in a period when both average interest earning assets and average interest-bearing liabilities increased. The increase of taxable security income of $2,646,000 is due to the significant purchase of U.S. Government securities over the past year, with the average of these securities increasing $70,159,000, while the decrease in the average of tax-exempt State & Political securities decreased tax equivalent interest income $2,082,000. The investment portfolio has been repositioned from longer term assets to shorter term assets to take advantage of the cash flow opportunities for reinvestment in anticipation of rising rates. The net growth in the volume of investment holdings has generated additional interest income that has offset the 111 basis point decline in the overall portfolios weighted average interest rates. Within the loan portfolio, a 62 basis point decrease of the tax equivalent return on loans was partially offset by an increase of $7,612,000 in the average balance of loans when comparing the year 2003 to the year 2002. Variable rate loans within the portfolio and other new loan originations at lower effective rates aided in the reduction of new income compared to a year ago because of the historically low rates. For the year ended December 31, 2003, reported interest expense decreased $1,581,000 or 14.6% over the same period of 2002. Lower rates for all deposit accounts contribute the most substantial decrease in interest expense. The weighted average rate on interest paid on deposits declined 92 basis points for the year 2003 since the year end 2002. The overall average balance of savings deposits increased $17,925,000, offset by a decrease in the weighted average rate for a net decrease in the related interest expense of $997,000. Interest expense on time deposits decreased $1,204,000 due to both the 76 basis point decline in the weighted average rate and the decrease in the average balance of $5,453,000. Favorable long-term borrowing rates offer opportunities to reduce interest expenses over the coming years. Throughout 2003, the Company borrowed an additional $19.1 million in long term advances through the FHLB to minimize future borrowing costs and to enhance liability positioning. These additional borrowings were utilized by management to take advantage of current investment opportunities while minimizing interest rate risk. The $693,000 increase in expense on long-term borrowings is the result of these additional advances with average balances of $20,986,000 partially offset by the 64 basis point decline in the resulting weighted average interest rate for the year ending December 31, 2003 compared to the same period in 2002. Interest paid on short-term borrowings decreased $73,000 as a result of an overall decline in the weighted average interest rate of 131 basis points while the average balances outstanding during the year increased $8,322,000. The increase in short-term borrowings is the result of taking advantage of the opportunity to borrow from Federal Home Loan Bank at historically low rates. 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 in interest income of $1,669,000 due to rate offset by an increase in 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 in 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. Non-interest-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. 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. 2003 AVERAGE BALANCE (2) INTEREST AVERAGE RATE ASSETS: Interest-earning assets: Securities: U.S. Treasury and federal agency . . . . . . . . . . . . . . . . . . . $ State and political subdivisions (4) . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124,849 50,822 24,872 ____________________ 200,543 $ 5,584 3,952 897 ___________________ 10,433 LOANS: Tax-exempt loans (4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . All other loans, net of discount where applicable. . . . . . . . . . . Total loans (1), (3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,008 260,532 ____________________ 261,540 68 19,918 ___________________ 19,986 Total interest-earning assets . . . . . . . . . . . . . . . . . . . . . . . . 462,083 $ 30,419 ___________________ ___________________ Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TOTAL ASSETS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 36,297 ____________________ 498,380 ____________________ ____________________ LIABILITIES AND SHAREHOLDERS’ EQUITY: Interest-bearing liabilities: Deposits: Savings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Other time. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest-bearing deposits . . . . . . . . . . . . . . . . . . . . 147,169 131,360 ____________________ 278,529 Short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest-bearing liabilities . . . . . . . . . . . . . . . . . . . Demand deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders’ equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,787 67,285 ____________________ 370,601 56,672 3,780 67,327 ____________________ TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY. . . . . . . . . . . . . . . . . . . $ 498,380 ____________________ ____________________ Interest rate margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Effective interest differential . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,704 3,952 ___________________ 5,656 428 3,181 ___________________ $ 9,265 ___________________ ___________________ 4.47% 7.78% 3.61% 5.20% 6.75% 7.65% 7.64% 6.58% 1.16% 3.01% 2.03% 1.73% 4.73% 2.50% $ 21,154 ___________________ ___________________ 4.08% 4.58% ___________________ ___________________ 1. Fees on loans are included with interest on loans. Loan fees are included in interest income as follows: 2003 $1,032,000, 2002, $803,000, 2001, $668,000. 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(2) 2002 INTEREST AVERAGE RATE AVERAGE BALANCE (2) INTEREST AVERAGE RATE 2001 $ 54,690 77,216 24,452 ____________________ 156,358 ____________________ $ 2,923 6,034 912 ___________________ 9,869 ___________________ 185 20,789 ___________________ 20,974 ___________________ $ 30,843 ___________________ ___________________ 2,309 251,619 ____________________ 253,928 ____________________ 410,286 31,977 ____________________ 442,263 $ ____________________ ____________________ $ 129,244 136,813 ____________________ 266,057 $ 2,701 5,156 ___________________ 7,857 501 2,488 ___________________ $ 10,846 ___________________ ___________________ 16,465 46,299 ____________________ 328,821 50,877 3,334 59,231 ____________________ $ 442,263 ____________________ ____________________ 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% $ 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% ___________________ $ 19,997 ___________________ ___________________ 4.22% ___________________ 4.87% ___________________ ___________________ ___________________ $ 17,944 ___________________ ___________________ 3.95% ___________________ 4.84% ___________________ ___________________ 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, 2003 vs 2002 Increase (Decrease) Due to Rate Volume Net 2002 vs 2001 Increase (Decrease) Due to Rate Volume Net Interest income: Taxable investment securities . . . . . . . . . . . . $ Tax-exempt investment securities . . . . . . . . . Loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,223 $ (2,054) 616 (577) $ (28) (1,604) 2,646 (2,082) (988) $ 1,707 $ 130 614 (317) $ (47) (1,669) 1,390 83 (1,055) Total interest-earning assets. . . . . . . . . . . . $ 1,785 $ (2,209) $ (424) $ 2,451 $ (2,033) $ 418 Interest expenses: Savings deposits . . . . . . . . . . . . . . . . . . . . . . $ Other time deposits . . . . . . . . . . . . . . . . . . . . Short-term borrowings . . . . . . . . . . . . . . . . . Other borrowings . . . . . . . . . . . . . . . . . . . . . 335 $ (216) 194 1,021 (1,332) $ (988) (267) (328) (997) (1,204) (73) 693 Total interest-bearing liabilities . . . . . . . . . $ 1,334 $ (2,915) $ (1,581) Change in net interest income . . . . . . . . . . . $ 451 $ 706 $ 1,157 $ $ $ 750 $ (514) (232) 687 (10) $ (2,026) (170) (120) 740 (2,540) (402) 567 691 $ (2,326) $ (1,635) 1,760 $ 293 $ 2,053 PROVISION FOR LOAN LOSSES 2003 vs 2002 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, 2003, 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 judgment of information available to them at the time of their examination. The allowance for loan losses increased 3.9% or $116,000 from fiscal 2002 after net charge-offs of $139,000, contributing to a year-end allowance for loan losses of $3,069,000 or 1.1% of total loans. 2002 vs 2001 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. 28 YEAR ENDED DECEMBER 31, (IN THOUSANDS) 2003 2002 2001 2000 1999 Balance at beginning of period . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,953 $ 2,927 $ 2,879 $ 2,823 $ 2,681 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 . . . . . . . . . . . . . . . . . . . . . 63 37 116 216 42 16 19 77 139 255 262 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 Balance at end of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,069 $ 2,953 $ 2,927 $ 2,879 $ 2,823 Ratio of net charge-offs during the period to average loans outstanding during the period . . . . . . . . . . . . . . . . . . . . . . . 0.05% 0.13% 0.13% 0.10% 0.06% OTHER INCOME 2003 vs 2002 Total other income for 2003 was $8,634,000, an increase of $3,181,000 from the prior year. Excluding security gains of $3,659,000 in 2003 and $233,000 in 2002, other income decreased $245,000. Service charges increased 4.58% or $84,000 to $1,917,000 in 2003. Decreases in commission income from the sale of financial products sold by the Bank’s subsidiary, The M Group, accounted for $209,000 of the total decrease of other operating income. Other operating income decreased $108,000 primarily due to a non- recurring life insurance income item included in 2002, but not in 2003, resulting in a $116,000 decrease. 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. OTHER EXPENSES 2003 vs 2002 Total other expenses increased $1,076,000 or 8.81% from the year ended December 31, 2002 to December 31, 2003. Salaries and employee benefits increased $318,000. This change was the result of the decline in commission earned by the M Group and the retirement of an executive officer offset by the standard cost of living salary increases and an extra pay paid in 2003 when compared to 2002. Expenses such as rent, maintenance, and utilities for the new State College Wal-Mart Branch caused the majority of the $46,000 increase to occupancy expense. The depreciation of a new Wide Area Network has resulted in most of the $162,000 increase to furniture and equipment expense. Advertising expense increased $16,000 due to a decrease in normal advertising expenses offset by the purchase of new brochures for $22,000. Other operating expenses increased $490,000 consistent with the addition of the aforementioned branch. 29 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. INCOME TAXES 2003 vs 2002 The provision for income taxes for the year ended December 31, 2003 resulted in an effective income tax rate of 24.9% compared to 20.2% for 2002. This increase is the result of management’s currrent inventment strategy of reinvesting proceeds from tax-exempt portfolio into other U.S. Goverment securities. 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. 30 INVESTMENTS 2003 FINANCIAL CONDITION The investment portfolio increased $33,680,000 or 19% in 2003. The growth is largely attributed to management’s strategic plan to benefit from the low borrowing rates by taking advantage of over a 200 basis point interest rate spread of investments with similar maturity periods. The bank borrowed $19,100,000 in long-term FHLB advances to purchase securities and take advantage of interest rate imbalances in the market. Short-term borrowing funded the balance of the additional investment securities purchased. Most of the increase is attributable to an increase of $61,980,000 in U.S. Government agencies category, and a $10,331,000 increase in the equity securities category. There was a $185,000 decrease in other bonds, notes and debentures, $1,168,000 decrease in U.S. Treasury securities category, and State and Political subdivisions catergory decreased $37,278,000. The investment portfolio at year end 2003 was comprised of 70.9% U.S. Government agency and Treasury securities, 16.2% state and political subdivisions, 12.0% equity securities, and .9% other bonds, notes and debentures. Held to maturity securities had a carrying value of $686,000. Available for sale securities occupied 99.66% of the total portfolio and had an amoritized cost of $201,321,000 with an estimated market value of $210,611,000. The unrealized gain of $9,290,000 effected shareholders’ equity by $6,132,000, net of deferred taxes. 2002 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. The carrying amounts of investment securities at the dates indicated are summarized as follows (in thousands): 2003 DECEMBER 31, 2002 2001 U.S. Treasury securities: Available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,128 $ 4,296 $ 4,126 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 146,701 347 33,852 264 1,652 186,019 25,278 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 211,297 $ 94 84,702 796 70,681 291 1,810 162,670 14,947 177,617 $ 196 21,694 796 83,256 310 816 111,194 22,093 133,287 31 The following table shows the maturities and repricing of investment securities at December 31, 2003 and the weighted average yields of such securities (in thousands): WITHIN ONE YEAR AFTER ONE AFTER FIVE BUT WITHIN BUT WITHIN TEN YEARS FIVE YEARS AFTER TEN YEARS U.S. Treasury securities: AFS Amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Yield. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,061 4.37% $ 1,067 3.43% $ — $ —% 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. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — —% 1,026 4.96% — —% — —% — —% — —% — —% 3,718 4.00% — —% — —% 125 7.05% — —% — —% 44,372 4.43% — —% 15 6.58% 139 7.04% — —% — —% 75 8.80% 97,585 5.25% 347 8.26% 33,837 7.67% — —% 1,652 7.36% Total Amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,087 $ 4,910 $ 44,526 $ 133,496 Total Yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.57% 3.95% 4.44% 5.90% 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 2003 Gross loans for the year ended December 31, 2003, were $275,828,000 or $17,983,000 (6.97%) more than the prior year. Real estate mortgages increased $18,103,000 as a whole with residential, commercial and construction real estate loans increasing $6,902,000, $6,905,000, and $4,296,000 respectively. Commercial and agricultural loans decreased $185,000, while installment loans to individuals increased $65,000. Given the current market conditions, management has directed its conservative lending approach toward well collateralized real estate loans. 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. 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. . . Less: Net deferred loan fees . . . . . 2003 2002 DECEMBER 31, 2001 2000 1999 23,523 $ 23,708 $ 22,629 $ 26,471 $ 31,735 147,697 82,896 7.652 15,000 940 140,724 75,892 3,356 14,934 769 140,614 67,038 4,077 17,896 631 131,761 60,856 4,748 21,503 541 121,734 51,641 3,732 23,470 497 231,815 Gross loans. . . . . . . . . . . . . . . . . . . $ 275,828 $ 257,845 $ 251,623 $ 244,798 $ 32 The amount of domestic loans at December 31, 2003 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 . . . . . . . . . . . . . . . . . . . . . . $ 11,859 6,180 26,730 112,351 ___________________ 157,120 ___________________ 3,822 22,060 23,488 30,804 ___________________ 80,174 237,294 ___________________ ___________________ $ 8,145 2,799 3,088 672 _____________________ 14,704 _____________________ $ 1,526 18 208 6 ____________________ 1,758 ____________________ $ 21,530 8,997 30,026 113,029 _____________________ 173,582 _____________________ 867 7,295 111 546 _____________________ 8,819 23,523 $ _____________________ _____________________ 1,146 10,532 1,561 14 ____________________ 13,253 15,011 $ ____________________ ____________________ 5,835 39,887 25,160 31,364 _____________________ 102,246 275,828 $ _____________________ _____________________ (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, 2003. ALLOWANCE FOR LOAN LOSSES 2003 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 and a homogeneous pool allowance. At December 31, 2003, the allowance for loan losses as a percent of gross loans remained the same as December 31, 2002 at 1.1%. Gross loans increased by $17,983,000 from $257,845,000 at December 31, 2002 to $275,828,000 at December 31, 2003. Nonaccruing loans decreased $44,000 from year-end 2002. Overall nonperforming loans decreased $840,000 to $1,256,000 from fiscal year end 2002. 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. 2002 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. 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) NONACCRUAL 2003 . . . . . . . . . . . . . . . . . . . . . . . . $ 2002 . . . . . . . . . . . . . . . . . . . . . . . . $ 2001 . . . . . . . . . . . . . . . . . . . . . . . . $ 2000 . . . . . . . . . . . . . . . . . . . . . . . . $ 1999 . . . . . . . . . . . . . . . . . . . . . . . . $ 827 871 281 777 284 90 DAYS PAST DUE & STILL ACCRUING $ $ $ $ $ 429 1,225 338 27 241 If interest had been recorded at the original rate on those loans, such income would have approximated $55,000, $24,000, and $28,000 for the years ended December 31, 2003, 2002, and 2001, respectively. Interest income on such loans, which is recorded as received, amounted to approximately $7,000, $17,000 and $19,000 for the years ended December 31, 2003, 2002 and 2001, 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, 2003: Balance at end of period applicable to: Domestic: Commercial and agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate mortgage: Residential. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Installment loans to individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 353 1,483 916 77 240 8.5% 53.4% 29.9% 2.8% 5.4% Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . DECEMBER 31, 2002: Balance at end of period applicable to: Domestic: $ _____________________ ______________________ _____________________ ______________________ 3,069 100.0% 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 $ _____________________ ______________________ _____________________ ______________________ 2,953 100.0% 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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: Commercial and agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate mortgage: Residential. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Installment loans to individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unallocated general allowance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . DEPOSITS 2003 $ 414 9.0% 1,379 763 74 271 26 55.8% 26.5% 1.6% 7.1% — _____________________ ______________________ $ _____________________ ______________________ _____________________ ______________________ 100.0% 2,927 $ 541 10.8% 1,211 723 71 306 27 53.7% 24.8% 1.9% 8.8% — _____________________ ______________________ $ _____________________ ______________________ _____________________ ______________________ 100.0% 2,879 $ 531 13.7% 1,186 710 70 300 26 52.4% 22.2% 1.6% 10.1% — _____________________ ______________________ $ _____________________ ______________________ _____________________ ______________________ 100.0% 2,823 Total average deposits were $335,201,000 for 2003, an increase of $18,267,000 or 5.76%. Total demand deposits increased $16,517,000. Noninterest-bearing demand deposits increased $5,795,000 and interest-bearing demand deposits increased $10,722,000. Savings deposits increased $7,203,000 while time deposits decreased $5,453,000. Historically low rate levels have influenced investors away from longer term commitments which has resulted in an increase in more liquid accounts such as demand deposits and savings and a decrease in time deposit accounts. 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. 2002 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. 35 The average amount and the average rate paid on deposits are summarized below (in thousands): 2003 AVERAGE 2002 AVERAGE AMOUNT RATE AMOUNT RATE 2001 AVERAGE AMOUNT RATE DEPOSITS IN DOMESTIC BANK OFFICES: Demand deposits: Noninterest-bearing . . . . . . . . . Interest-bearing . . . . . . . . . . . . Savings deposits . . . . . . . . . . . . . . Time deposits . . . . . . . . . . . . . . . . Total average deposits . . . . $ 56,672 82,496 64,673 131,360 __________________ $ 335,201 __________________ __________________ 0.00% 1.15% 1.17% 2.25% $ 50,877 71,774 57,470 136,813 _________________ $ 316,934 _________________ _________________ 0.00% 2.13% 2.04% 3.77% $ 46,594 0.00% 46,154 2.17% 47,197 2.03% 145,823 5.28% _________________ $ 285,768 _________________ _________________ 2003 SHAREHOLDERS’ EQUITY 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, 2003 was $69,769,000, increasing $6,627,000 from the balance at December 31, 2002 of $63,142,000. Net income and the exercising of stock options contributed $11,174,000 and $87,000, respectively, to shareholders’ equity. The unrealized appreciation on securities also added $987,000 to total equity. Shareholders’ equity was reduced by $5,001,000 that was paid out in dividends. 2002 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, 2003, the Company’s required ratios were well above the minimum ratios as follows: Tier 1 capital ratio Total capital ratio Company 20.9% 23.0% 2003 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 . . . . . . . . . . . . . . . . . . . 2.24% 16.60% 44.76% 13.51% 2.01% 15.00% 46.40% 13.39% 1.95% 14.38% 48.17% 13.54% 2003 2002 2001 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 $166,870,000. 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 $107,918,000 as of December 31, 2003. 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, 2003: WITHIN ONE YEAR AFTER ONE BUT WITHIN TWO YEARS AFTER TWO BUT WITHIN FIVE YEARS AFTER FIVE YEARS Earning assets: (1) (2) Investment securities (1) . . . . . . . . . . . . . . $ Loans (2) . . . . . . . . . . . . . . . . . . . . . . . . . . 42,246 70,067 58,056 46,709 ____________________ _______________________ ____________________ _____________________ 104,765 26,870 123,384 81,433 40,471 121,904 112,313 150,254 $ $ $ Total earning assets. . . . . . . . . . . . . . . . . . . . . . Deposits (3) . . . . . . . . . . . . . . . . . . . . . . . . Borrowings . . . . . . . . . . . . . . . . . . . . . . . . Total interest-bearing liabilities . . . . . . . . . . . . Net noninterest-bearing funding (4) . . . . . . . . . 94,565 47,225 43,022 31,790 ____________________ _______________________ ____________________ _____________________ 74,812 84,027 37,728 47,829 1,400 141,790 121,755 49,229 50,825 ____________________ _______________________ ____________________ _____________________ 10,165 30,495 10,165 Total net funding sources . . . . . . . . . . . . . . . . . $ Excess assets (liabilities) . . . . . . . . . . . . . . . . . Cumulative excess assets (liabilities) . . . . . . . . $ 151,955 (39,642) (39,642) $ 59,394 62,510 22,868 $ 152,250 (1,996) 20,872 125,637 (20,872) — (1) Investment balances reflect estimated prepayments on mortgage-backed securities and are inclusive of FHLB stock. (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. (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. 37 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, 2003 Net Interest Income Change (After Tax) (In thousands) (1,172) (397) 356 598 $ $ $ $ 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. CRITICAL ACCOUNTING POLICIES The Company’s accounting policies are integral to understanding the results reported. The accounting policies are described in detail in Note A of the consolidated financial statements. Our most complex accounting policies require management’s judgment to ascertain the valuation of assets, liabilities, commitments and contingencies. We have established detailed policies and control procedures that are intended to ensure valuation methods are well controlled and applied consistently from period to period. In addition, the policies and procedures are intended to ensure that the process for changing methodologies occurs in an appropriate manner. The following is a brief description of our current accounting policies involving significant management valuation judgments. Other Than Temporary Impairment of Equity Securities Equity securities are evaluated periodically to determine whether a decline in their value is other than temporary. management utilized criteria such as the magnitude and duration of the decline, in addition to the reason underlying the decline, to determine whether the loss in value is other than temporary. The term “other than temporary” is not intended to indicate that the decline is permanent. It indicates that the prospects for a near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the investment. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized. Allowance for Loan Losses Arriving at an appropriate level of allowance for loan losses involves a high degree of judgment. The Company’s allowance for loan losses provides for probable losses based upon evaluations of known, and inherent risks in the loan portfolio. Management uses historical information to assess the adequacy of the allowance for loan losses as well as the prevailing business environment; as it is affected by changing economic conditions and various external factors, which may impact the portfolio in ways currently unforeseen. The allowance is increased by provisions for loan losses and by recoveries of loans previously charged- off and reduced by loans charged-off. For a full discussion of the Company’s methodology of assessing the adequacy of the reserve for loan losses, refer to Note D of “Notes and Consolidated Financial Statements” commencing on page 13 of this Form 10-K. Goodwill and Other Intangible Assets As discussed in Note F of the consolidated financial statements, the Company must assess goodwill and other intangible assets each year for impairment. This assessment involves estimating cash flows for future periods. If the future cash flows were less than the recorded goodwill and other intangible assets balances, we would be required to take a charge against earnings to write down and assets to the lower value. Deferred Tax Assets We use an estimate of future earnings to support our position that the benefit of our deferred tax assets will be realized. If future income should prove non-existent or less that the amount of the deferred tax assets within the tax years to which they may be applied, the asset may not be realized and our net income will be reduced. Our deferred tax assets are described further in Note J of the consolidated financial statements. 38 CONTRACTUAL OBLIGATIONS, COMMITMENTS, CONTINGENT LIABILITIES, AND OFF-BALANCE SHEET ARRANGEMENTS The Corporation has various financial obligations, including contractual obligations and commitments, which may require future cash payments. Contractual Obligations: The following table presents in thousands, as of December 31, 2003, significant fixed and determinable contractual obligations to third parties by payment date. Further discussion of the nature of each obligation is included in the referenced note to be consolidated financial statements. Deposits without a stated maturity . . . . . . . . . . . . . . . . . . . Time deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Security repurchase agreements . . . . . . . . . . . . . . . . . . . . . Borrowed funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Payments Due in Three to Five Years Over Five Years One to Three Years Total — $ — $ 38,216 — — 3,000 469 9,658 — — 31,100 278 — $ 209,418 124,900 10,225 37,040 70,878 1,062 1,049 — — 36,778 53 One Year or Less $ 209,418 $ 75,977 10,225 37,040 — 262 The Corporation’s operating lease obligations represent short and long-term lease and rental payments for facilities, certain software and data processing and other equipment. Commitments: The following table details the amounts and expected maturities of significant commitments as of December 31, 2003, in thousands. Further discussion of these commitments is included in Note O to the consolidated financial statements. One Year or Less One to Three Years Three to Five Years Over Five Years Commitments to extend credit: Commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Standby letters of credit . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,589 $ 29,139 59 258 — $ 167 — — — $ 549 83 — — $ 4,455 2,413 — Total 10,589 34,310 2,555 258 Commitments to extend credit, including loan commitments, standby letters of credit, and commercial letters of credit do not necessarily represent future cash requirements, in that these commitments often expire without being drawn upon. 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. 39 Penns Woods Bancorp, Inc.P.O. Box 967300 Market StreetWilliamsport, PA 17703-0967