FORM 10-K SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 (X) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2002 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED) For the transition period from ___________________to___________ Commission file number 0-17077 PENNS WOODS BANCORP, INC. (exact name of registrant as specified in its charter) Pennsylvania 23-2226454 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 300 Market Street, P.O. Box 967 Williamsport, Pennsylvania 17703-0967 (Address of principal executive offices) Registrant's telephone number, including area code(570) 322-1111 Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange which registered None None Securities to be registered pursuant to Section 12(g) of the Act: Common Stock, par value $10 per share (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the 1 Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes X No Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ X } Indicate by check mark whether the registrant is an accelerated filed (as defined in Rule 12b-2 of the Act). Yes [ X ] No [ ] As of June 30, 2002, the aggregate market value of the voting and non-voting common stock of the registrant held by non- affiliates computed by reference to the price at which the common stock was last sold was approximately $95,174,842 million. Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class Outstanding at March 5, 2000 Common Stock, $10 Par Value 3,030,128 Shares 2 DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant's definitive proxy statement prepared in connection with its annual meeting of shareholders to be held on April 30, 2003 are incorporated by reference in Part III hereof. INDEX PART I ITEM PAGE Item 1. Business...................................... 5 Item 2. Properties.................................... 17 Item 3. Legal Proceedings............................. 18 Item 4. Submission of Matters to a Vote of Security Holders....................................... 18 PART II Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters.. ............... 19 Item 6. Selected Financial Data....................... 20 Item 7. Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations................................. 22 Item 7.A Quantitative and Qualitative Disclosure About Market Risk................................... 51 Item 8. Financial Statements and Supplementary Data... 52 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.................................... 95 PART III Item 10. Directors and Executive Officers of the Registrant.................................... 96 Item 11. Executive Compensation........................ 96 Item 12. Security Ownership and Certain Beneficial Owners and Management......................... 96 Item 13. Certain Relationships and Related Transactions.................................. 97 3 Item 14. Controls and Procedures....................... 98 PART IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K........................... 99 Index to Exhibits....................................... 100 Signatures and Certifications........................... 102 4 PART I ITEM 1 BUSINESS A. General Development of Business and History On January 7, 1983, Penns Woods Bancorp, Inc. (the "Company") was incorporated under the laws of the Commonwealth of Pennsylvania as a bank holding company. The Jersey Shore State Bank (the "Bank") became a wholly owned subsidiary of the Company, and each outstanding share of Bank common stock was converted into one share of Company common stock. This transaction was approved by the shareholders of the Bank on April 11, 1983 and was officially effective on July 12, 1983. The Company's business has consisted primarily of managing and supervising the Bank, and its principal source of income has been dividends paid by the Bank. The Company's two other wholly-owned subsidiaries are Woods Real Estate Development Co., Inc. and Woods Investment Co., Inc. The Bank is engaged in commercial and retail banking and the taking of time and regular savings and demand deposits, the making of commercial and consumer loans and mortgage loans, and safe deposit services. Auxiliary services, such as cash management, are provided to commercial customers. The Bank operates full banking services with eleven branch offices and a Mortgage/Loan Center in Northcentral Pennsylvania. In October 2000, the Bank acquired The M Group, Inc. D/B/A The Comprehensive Financial Group ("The M Group"). The M Group, which operates as a subsidiary of the Bank, offers insurance and securities brokerage services. Securities are offered by The M Group through Locust Street Securities, Inc., a registered broker-dealer. Neither the Company nor the Bank anticipates that compliance with environmental laws and regulations will have any material effect on capital expenditures, earnings, or on its competitive position. The Bank is not dependent on a single customer or a few customers, the loss of whom would have a material effect on the business of the Bank. The Bank employed approximately 146 persons as of December 31, 2002. The Company does not have any employees. The principal officers of the Bank also serve as officers of the Company. 5 B. Regulation and Supervision The Company is also subject to the provisions of the Bank Holding Company Act of 1956, as amended (the "BHCA") and to supervision and examination by the Board of Governors of the Federal Reserve System (the "FRB"). The Bank is subject to the supervision and examination by the Federal Deposit Insurance Corporation (the "FDIC"), as its primary federal regulator and as the insurer of the Bank's deposits. The Bank is also regulated and examined by the Pennsylvania Department of Banking (the "Department"). The insurance activities of The M Group are subject to regulation by the insurance departments of the various states in which The M Group conducts business including principally the Pennsylvania Department of Insurance. The securities brokerage activities of The M Group are subject to regulation by federal and state securities commissions. The FRB has issued regulations under the BHCA that require a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. As a result, the FRB, pursuant to such regulations, may require the Company to stand ready to use its resources to provide adequate capital funds to the Bank during periods of financial stress or adversity. The BHCA requires the Company to secure the prior approval of the FRB before it can acquire all or substantially all of the assets of any bank, or acquire ownership or control of 5% or more of any voting shares of any bank. Such a transaction would also require approval of the Department. A bank holding company is prohibited under the BHCA from engaging in, or acquiring direct or indirect control of, more than 5% of the voting shares of any company engaged in non- banking activities unless the FRB, by order or regulation, has found such activities to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. Under the BHCA, the FRB has the authority to require a bank holding company to terminate any activity or relinquish control of a non-bank subsidiary (other than a non-bank subsidiary of a bank) upon the FRB's determination that such activity or control constitutes a serious risk to the financial soundness and stability of any bank subsidiary of the bank holding company. 6 Bank holding companies are required to comply with the FRB's risk-based capital guidelines. The risk-based capital rules are designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks and bank holding companies and to minimize disincentives for holding liquid assets. Currently, the required minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) is 8%. At least half of the total capital is required to be Tier 1 capital, consisting principally of common shareholders' equity, less certain intangible assets. The remainder ("Tier 2 capital") may consist of certain preferred stock, a limited amount of subordinated debt, certain hybrid capital instruments and other debt securities, 45% of net unrealized gains on marketable equity securities and a limited amount of the general loan loss allowance. The risk-based capital guidelines are required to take adequate account of interest rate risk, concentration of credit risk, and risks of nontraditional activities. In addition to the risk-based capital guidelines, the FRB requires each bank holding company to comply with the leverage ratio, under which the bank holding company must maintain a minimum level of Tier 1 capital to average total consolidated assets of 3% for those bank holding companies which have the highest regulatory examination ratings and are not contemplating or experiencing significant growth or expansion. All other bank holding companies are expected to maintain a leverage ratio of at least 4% to 5%. The Bank is subject to similar capital requirements adopted by the FDIC. C. Regulation of the Bank From time to time, various types of federal and state legislation have been proposed that could result in additional regulation of, and restrictions of, the business of the Bank. It cannot be predicted whether any such legislation will be adopted or how such legislation would affect the business of the Bank. As a consequence of the extensive regulation of commercial banking activities in the United States, the Bank's business is particularly susceptible to being affected by federal legislation and regulations that may increase the costs of doing business. Prompt Corrective Action - The FDIC has specified the levels at which an insured institution will be considered "well- capitalized," "adequately capitalized," "undercapitalized," and 7 "critically undercapitalized." In the event an institution's capital deteriorates to the "undercapitalized" category or below, the Federal Deposit Insurance Act (the "FDIA") and FDIC regulations prescribe an increasing amount of regulatory intervention, including: (1) the institution of a capital restoration plan by a bank and a guarantee of the plan by a parent institution; and (2) the placement of a hold on increases in assets, number of branches or lines of business. If capital has reached the significantly or critically undercapitalized levels, further material restrictions can be imposed, including restrictions on interest payable on accounts, dismissal of management and (in critically undercapitalized situations) appointment of a receiver. For well-capitalized institutions, the FDIA provides authority for regulatory intervention where the institution is deemed to be engaging in unsafe or unsound practices or receives a less than satisfactory examination report rating for asset quality, management, earnings or liquidity. Deposit Insurance - There are two deposit insurance funds administered by the FDIC - the Savings Association Insurance Fund ("SAIF") and the Bank Insurance Fund ("BIF"). The Bank's deposits are insured under the BIF; however, the deposits assumed by the Bank in connection with the merger of Lock Haven Savings Bank are treated and assessed as SAIF-insured deposits. The FDIC has implemented a risk-related premium schedule for all insured depository institutions that results in the assessment of premiums based on capital and supervisory measure. Under the risk-related premium schedule, the FDIC assigns, on a semiannual basis, each institution to one of three capital groups (well-capitalized, adequately capitalized or undercapitalized) and further assigns such institution to one of three subgroups within a capital group. The institution's subgroup assignment is based upon the FDIC's judgment of the institution's strength in light of supervisory evaluations, including examination reports, statistical analyses and other information relevant to gauging the risk posed by the institution. Only institutions with a total capital to risk- adjusted assets ratio of 10.0% or greater, a Tier 1 capital to risk-adjusted assets ratio of 6.0% or greater and a Tier 1 leverage ratio of 5.0% or greater, are assigned to the well- capitalized group. As of December 31, 2002, the Bank's ratios were well above required minimum ratios. Both the BIF and SAIF are presently fully funded at more than the minimum amount required by law. Accordingly, the BIF 8 and SAIF assessment rates range from zero for those institutions with the least risk, to $0.27 for every $100 of insured deposits for institutions deemed to have the highest risk. The Bank is in the category of institutions that presently pay nothing for deposit insurance. The FDIC adjusts the rates every six months. The FDIC indicated that all banks may again be required to pay deposit insurance premiums in the future if the current trend of the size of the deposit insurance funds relative to all insured deposits continues. While the Bank presently pays no premiums for deposit insurance, it is subject to assessments to pay the interest on Financing Corporation ("FICO") bonds. FICO was created by Congress to issue bonds to finance the resolution of failed thrift institutions. The annual FICO assessment for the Bank (and all banks) is $.0168 for each $100 of BIF deposits. Other Legislation On July 30, 2002, the President signed into law the Sarbanes-Oxley Act of 2002. The stated goals of this sweeping legislation are to enhance penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures under the federal securities laws. The Sarbanes- Oxley Act generally applies to all companies, including the Company, that file or are required to file periodic reports with the Securities and Exchange Commission under the Securities Exchange Act of 1934, or the Exchange Act. The legislation includes provisions, among other things, governing the services that can be provided by a public company's independent auditors and the procedures for approving such services, requiring the chief executive officer and chief financial officer to certify certain matters relating to the company's periodic filings under the Exchange Act, requiring expedited filings of reports by insiders of their securities transactions and containing other provisions relating to insider conflicts of interest, increasing disclosure requirements relating to critical financial accounting policies and their application, increasing penalties for securities law violations, and creating a new public accounting oversight board, a regulatory body subject to SEC jurisdiction with broad powers to set auditing, quality control and ethics standards for accounting firms. The legislation also requires the national securities exchanges and NASDAQ to adopt rules relating to certain matters, including the independence of members of a company's audit committee as a condition to listing 9 or continued listing. Given the extensive SEC role in implementing rules relating to many of the new requirements, the final scope of these requirements remains to be determined at this time, although the Company does not believe that the application of these new rules to the Company as they become effective will have a material effect on its results of operations. In addition, Congress is often considering some financial industry legislation. The Company cannot predict how any new legislation, or new rules adopted by the federal banking agencies, may affect its business in the future. In addition to federal banking law, the Bank is subject to the Pennsylvania Banking Code. The Banking Code was amended in late 2000 to provide more complete "parity" in the powers of state-chartered institutions compared to national banks and federal savings banks doing business in Pennsylvania. Pennsylvania banks have all the same ability to form financial subsidiaries authorized by the Gramm-Leach-Bliley Act, as do national banks. Environmental Laws Environmentally related hazards have become a source of high risk and potential liability for financial institutions relating to their loans. Environmentally contaminated properties owned by an institution's borrowers may result in a drastic reduction in the value of the collateral securing the institution's loans to such borrowers, high environmental clean up costs to the borrower affecting its ability to repay the loans, the subordination of any lien in favor of the institution to a state or federal lien securing clean up costs, and liability to the institution for clean up costs if it forecloses on the contaminated property or becomes involved in the management of the borrower. The Company is not aware of any borrower who is currently subject to any environmental investigation or clean up proceeding which is likely to have a material adverse effect on the financial condition or results of operations of the Company. Effect of Government Monetary Policies The earnings of the Company are and will be affected by domestic economic conditions and the monetary and fiscal policies of the United States Government and its agencies. The 10 monetary policies of the FRB have had, and will likely continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to curb inflation or combat a recession. The FRB has a major effect upon the levels of bank loans, investments and deposits through its open market operations in the United States Government securities and through its regulation of, among other things, the discount rate on borrowing of member banks and the reserve requirements against member bank deposits. It is not possible to predict the nature and impact of future changes in monetary and fiscal policies. DESCRIPTION OF BANK a. History and Business Jersey Shore State Bank ("Bank") was incorporated under the laws of the Commonwealth of Pennsylvania as a state bank in 1934 and became a wholly owned subsidiary of the Company on July 12, 1983. As of December 31, 2002, the Bank had total assets of $468,782,000; total shareholders' equity of $51,019,000 and total deposits of $340,472,000. The Bank's deposits are insured by the Federal Deposit Insurance Corporation for the maximum amount provided under current law. The Bank engages in business as a commercial bank, doing business at several locations in Lycoming, Clinton and Centre Counties, Pennsylvania. The Bank offers insurance and securities brokerage services through its wholly owned subsidiary, The M Group, Inc. D/B/A The Comprehensive Financial Group. Services offered by the Bank include accepting time, demand and savings deposits including Super NOW accounts, regular savings accounts, money market accounts, investment certificates, fixed rate certificates of deposit and club accounts. Its services also include making secured and unsecured commercial and consumer loans, financing commercial transactions, making construction and mortgage loans and the renting of safe deposit facilities. Additional services include making residential mortgage loans, revolving credit loans with overdraft protection, small business loans, etc. Business loans 11 include seasonal credit collateral loans and term loans, as well as accounts receivable and inventory financing. The Bank's loan portfolio mix can be classified into four principal categories of real estate, agricultural, commercial and consumer. Real estate loans can be further segmented into construction and land development, farmland, one-to-four family residential, multi-family and commercial or industrial. Qualified borrowers are defined by policy or by industry underwriting standards. Owner provided equity requirements range from 20% to 30% with a first lien status required. Terms are restricted to between 10 and 20 years with the exception of construction and land development, which is limited to one to five years. Appraisals, verifications and visitations comply with industry standards. Financial information that is required on all commercial mortgages includes the most current three years' balance sheets and income statements and projections on income to be developed through the project. In the case of corporations and partnerships, the principals are often asked to indebt themselves personally as well. Residential mortgages, repayment ability is determined from information contained in the application and recent income tax returns. Emphasis is on credit, employment, income and residency verification. Broad hazard insurance is always required and flood insurance where applicable. In the case of construction mortgages, builders risk insurance is requested. Agricultural loans for the purchase or improvement of real estate must meet the Bank's real estate underwriting criteria. The only permissible exception is when a Farmers Home Loan Administration guaranty is obtained. Agricultural loans made for the purchase of equipment are usually payable in five years, but never more than seven, depending upon the useful life of the purchased asset. Minimum borrower equity required is 20%. Livestock financing criteria depends upon the nature of the operation. A dairy herd could be financed over three years, but a feeder operation would require cleanup in intervals of less than one year. Agricultural loans are also made for crop production purposes. Such loans are structured to repay within the production cycle and not carried over into a subsequent year. General purpose working capital loans are also a possibility with repayment expected within one year. It is also a general policy to collateralize non-real estate loans with not 12 only the asset purchased but also junior liens on all other available assets. Insurance and credit criteria is the same as mentioned previously. In addition, annual visits are made to our agricultural customers to determine the general condition of assets. Personal credit requirements are handled as consumer loans. Commercial loans are made for the acquisition and improvement of real estate, purchase of equipment and for working capital purposes on a seasonal or revolving basis. Criteria was discussed under real estate financing for such loans, but it is important to note that such loans may be made in conjunction with the Pennsylvania Industrial Development Authority. Caution is also exercised in taking industrial property for collateral by requiring, on a selective basis, environmental audits. Equipment loans are generally amortized over three to seven years, with an owner equity contribution required of at least 20% of the purchase price. Unusually expensive pieces may be financed for a longer period depending upon the asset's useful life. The increased cash flow resulting from the additional piece, through improved income or greater depreciation expense, serves in establishing the terms. Insurance coverage with the Bank as loss payee is required, especially in the case where the equipment is rolling stock. Seasonal and revolving lines of credit are offered for working capital purposes. Collateral for such a loan includes the pledge of inventory and/or receivables. Drawing availability is usually 50% of inventory and 75% of eligible receivables. Eligible receivables are defined as invoices less than 90 days delinquent. Exclusive reliance is very seldom placed on such collateral, therefore, other lienable assets are also taken into the collateral pool. Where reliance is placed on inventory and accounts receivable, the applicant must provide financial information including agings on a monthly basis. In addition, the guaranty of the principals is usually obtained. It is unusual for the Bank to make unsecured commercial loans. But when such a loan is a necessity, credit information in the file must support that decision. Letter of Credit availability is limited to standbys where the customer is well known to the Bank. Credit criteria is the same as that utilized in making a direct loan and collateral is 13 obtained in most cases, and whenever the expiration date is for more than one year. Consumer loan products include second mortgages, automobile financing, small loan requests, overdraft check lines and PHEAA referral loans. Our policy includes standards used in the industry on debt service ratios and terms are consistent with prudent underwriting standards and the use of proceeds. Verifications are made of employment and residency, along with credit history. Second mortgages are confined to equity borrowing and home improvements. Terms are generally ten years or less and rates are fixed. Loan to collateral value criteria is 80% or less and verifications are made to determine values. Automobile financing is generally restricted to four years and done on a direct basis. The Bank, as a practice, does not floor plan and therefore does not discount dealer paper. Small loan requests are to accommodate personal needs such as the purchase of small appliances or for the payment of taxes. Overdraft check lines are limited to $5,000 or less. The Bank's investment portfolio is analyzed and priced on a monthly basis. Investments are made in U.S. Treasuries, U.S. Agency issues, bank qualified municipal bonds, corporate bonds and corporate stocks which consist of Pennsylvania bank stocks. Bonds with BAA or better ratings are used, unless a local issue is purchased that has a lesser or no rating. Factors taken into consideration when investments are made include liquidity, the Company's tax position and the policies of the Asset/Liability Committee. The Bank has experienced deposit growth in the range of ..96% to 11.37% over the last five years. This growth has primarily come in the form of core deposits. Although the Bank has regular opportunities to bid on pools of funds of $100,000 or more in the hands of municipalities, hospitals and others, it does not rely on these monies to fund loans on intermediate or longer-term investments. Minor seasonal growth in deposits is experienced at or near the year-end. It is the policy of the Bank to generally maintain a rate sensitive asset (RSA) to rate sensitive liability (RSL) ratio of 200% of equity for a 6-month time horizon, 200% of equity for a 2-year time horizon and 200% of equity for a 5-year time horizon. 14 The Bank operates eleven full service offices in Lycoming, Clinton, and Centre Counties, Pennsylvania, and a Mortgage/Loan Center in Centre County, Pennsylvania. The economic base of the region is developed around service, light manufacturing industries and agriculture. The banking environment in Lycoming, Clinton and Centre Counties, Pennsylvania is highly competitive. The Bank competes for loans and deposits with commercial banks, savings and loan associations and other financial institutions. The Bank has a relatively stable deposit base and no material amount of deposits is obtained from a single depositor or group of depositors (including federal, state and local governments). The Bank has not experienced any significant seasonal fluctuations in the amount of its deposits. b. Supervision and Regulation The earnings of the Bank are affected by the policies of regulatory authorities including the FDIC and the FRB. An important function of the FRB is to regulate the money supply and interest rates. Among the instruments used to implement these objectives are open market operations in U.S. Government Securities, changes in reserve requirements against member bank deposits and limitations on interest rates that member banks may pay on time and savings deposits. These instruments are used in varying combinations to influence overall growth and distribution of bank loans, investments on deposits, and their use may also affect interest rates charged on loans or paid for deposits. The policies and regulations of the FRB have had and will probably continue to have a significant effect on the Bank's deposits, loans and investment growth, as well as the rate of interest earned and paid, and are expected to affect the Bank's operation in the future. The effect of such policies and regulations upon the future business and earnings of the Bank cannot accurately be predicted. 15 EXECUTIVE OFFICERS OF THE REGISTRANT: NAME AGE FIVE-YEAR ANALYSIS OF DUTIES - ------------------ --- ------------------------------------- Ronald A. Walko 56 President and Chief Executive Officer of the Company; the Bank; The M Group; and Woods Investment Company, Inc.; Vice President of Woods Real Estate Development Co, Inc.; and Federal Bank examiner prior to 1986 for an eighteen-year period. Hubert A. Valencik 61 Senior Vice President of the Company; Senior Vice President and Operations Officer of the Bank; Vice President of Woods Real Estate Development Co, Inc.; Vice President - Operations of The M Group; Vice President with another bank prior to 1985 for a fourteen-year period. Sonya E. Scott 43 Secretary of the Company; Vice President and Chief Financial Officer of the Bank; Secretary and Treasurer of Woods Real Estate Development Co, Inc.; Woods Investment Co., Inc.; and The M Group. 16 ITEM 2 PROPERTIES The Company owns and leases its properties. Listed herewith are the locations of properties owned or leased, in which the banking offices and Financial Center are located; all properties are in good condition and adequate for the Bank's purposes: Office Address - ------------- ---------------------------------- Main 115 South Main Street Owned P.O. Box 5098 Jersey Shore, Pennsylvania 17740 Bridge Street 112 Bridge Street Owned Jersey Shore, Pennsylvania 17740 DuBoistown 2675 Euclid Avenue Under Lease DuBoistown, Pennsylvania 17702 Williamsport 300 Market Street Owned P.O. Box 967 Williamsport, Pennsylvania 17703-0967 Montgomery 9094 Rt. 405 Highway Under Lease Montgomery, Pennsylvania 17752 Lock Haven 4 West Main Street Owned Lock Haven, Pennsylvania 17745 Mill Hall (Inside Wal-Mart), Under Lease 167 Hogan Boulevard Mill Hall, Pennsylvania 17751 Spring Mills Ross Hill Road, P.O. Box 66 Owned Spring Mills, Pennsylvania 16875 Centre Hall 2842 Earlystown Road Land Under Centre Hall, Pennsylvania 16828 Lease Zion 100 Cobblestone Road Under Lease Bellefonte, Pennsylvania 16823 17 Jersey Shore 1952 Waddle Road, Suite 106 Under Lease State Bank State College, Pennsylvania 16803 Financial Center State College The M Group, 705 Washington Boulevard Under Lease Inc. D/B/A The Williamsport, Pennsylvania 17701 Comprehensive Financial Group State College (Inside Wal-Mart) Under Lease 1665 North Atherton Place State College, Pennsylvania 16803 ITEM 3 LEGAL PROCEEDINGS In the normal course of business, various lawsuits and claims arise against the Company and its subsidiary. There are no such legal proceedings or claims currently pending or threatened. ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 2002. 18 PART II ITEM 5 MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The Registrant's Common Stock is traded locally. The following table sets forth (1) the quarterly high and low prices for a share of the Registrant's Common Stock during the periods indicated as reported by the management of the Registrant, and (2) quarterly dividends on a share of the Common Stock with respect to each quarter since January 1, 2000. The following quotations represent prices between buyers and sellers and do not include retail markup, markdown or commission. They may not necessarily represent actual transactions. Dividends HIGH LOW Declared ---- --- --------- 2000 First quarter $41.00 $29.00 $0.23 Second quarter 31.00 26.00 0.23 Third quarter 32.00 26.00 0.23 Fourth quarter 33.50 28.00 0.41 2001 First quarter $33.50 $27.25 $0.25 Second quarter 33.00 27.25 0.25 Third quarter 32.00 30.75 0.25 Fourth quarter 35.50 31.15 0.47 2002 First quarter $35.00 $32.33 $0.27 Second quarter 36.37 33.00 0.27 Third quarter 35.70 32.20 0.27 Fourth quarter 36.85 33.00 0.55 The Bank has paid cash dividends since December 31, 1941. The Registrant has paid dividends since the effective date of its formation as a bank holding company. It is the present intention of the Registrant's Board of Directors to continue the dividend payment policy; however, further dividends must necessarily depend upon earnings, financial condition, appropriate legal restrictions and other factors relevant at the time the Board of Directors of the Registrant considers dividend policy. Cash available for dividend distributions to 19 shareholders of the Registrant must initially come from dividends paid by the Bank to the Registrant. Therefore, the restrictions on the Bank's dividend payments are directly applicable to the Registrant. Under the Pennsylvania Business Corporation Law of 1988 a corporation may not pay a dividend, if after giving effect thereto, the corporation would be unable to pay its debts as they become due in the usual course of business and after giving effect thereto the total assets of the corporation would be less than the sum of its total liabilities plus the amount that would be needed, if the corporation were to be dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution of the shareholders whose preferential rights are superior to those receiving the dividend. As of March 5, 2003, the Registrant had approximately 1,215 shareholders of record. ITEM 6 SELECTED FINANCIAL DATA The following table sets forth certain financial data as of and for each of the years in the five-year period ended December 31, 2002. 20 <table> <caption> 2002 2001 2000 1999 1998 -------- -------- -------- -------- -------- (Dollars in thousands, except per share amounts) <s> <c> <c> <c> <c> <c> Consolidated Statement of Income Data: Interest income $ 29,104 $ 28,736 $ 28,454 $ 26,030 $ 25,096 Interest expense 10,846 12,481 12,778 10,518 10,529 ---------- ---------- ---------- ---------- ---------- Net interest income 18,258 16,255 15,676 15,512 14,567 Provision for loan losses 365 372 286 286 305 ---------- ---------- ---------- ---------- ---------- Net interest income after provision for loan losses 17,893 15,883 15,390 15,226 14,262 ---------- ---------- ---------- ---------- ---------- Other income 5,453 5,109 2,615 3,527 3,435 Other expense 12,213 11,272 9,820 9,339 9,065 ---------- ---------- ---------- ---------- ---------- Income before income taxes 11,133 9,720 8,185 9,414 8,632 Applicable income taxes 2,247 1,978 1,619 2,224 2,164 ---------- ---------- ---------- ---------- ---------- Net Income $ 8,886 $ 7,742 $ 6,566 $ 7,190 $ 6,468 ========== ========== ========== ========== ========== Consolidated Balance Sheet at End of Period: Total assets $ 472,206 $ 424,810 $ 394,913 $ 373,742 $ 341,601 Loans 257,845 251,623 244,798 231,815 214,798 Allowance for loan losses (2,953) (2,927) (2,879) (2,823) (2,681) Deposits 339,848 305,150 278,134 255,573 253,134 Long-term debt -- other 51,778 41,778 31,778 27,278 22,778 Shareholders' equity 63,142 55,252 50,514 46,085 49,896 Per Share Data: Net income Earnings per share - Basic $ 2.93 $ 2.53 $ 2.10 $ 2.30 $ 2.08 Earnings per share - Diluted 2.93 2.53 2.10 2.30 2.07 Cash dividends declared 1.36 1.22 1.10 1.01 0.88 Book value 20.83 18.18 16.31 14.75 15.97 Number of shares outstanding, at end of period 3,031,329 3,039,590 3,097,293 3,123,372 2,837,167 Average number of shares outstanding 3,033,011 3,065,314 3,119,540 3,121,413 3,114,376 Selected financial ratios: Return on average shareholders' equity 15.00% 14.38% 13.77% 14.96% 13.06% Return on average total assets 2.01% 1.95% 1.74% 1.99% 1.94% Net interest income to average interest earning assets 4.45% 4.39% 4.35% 4.63% 4.77% Dividend payout ratio 46.40% 48.17% 52.18% 44.20% 42.59% Average shareholders' equity to average total assets 13.39% 13.54% 12.62% 13.81% 15.04% Loans to deposits, at end of period 76.65% 83.77% 88.62% 90.39% 84.49% </table> Per share data and number of shares outstanding have been adjusted in each reporting period to give retroactive effect to a stock split effected in the form of a 100% stock dividend issued January 15, 1998, and a 10% stock dividend issued June 8, 1999. In addition, all financial data has been adjusted for the acquisition of the First National Bank of Spring Mills in 1999. 21 ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS NET INTEREST INCOME Net interest income is determined by calculating the difference between the yields earned on interest-earning assets and the rates paid on interest-bearing liabilities. 2002 vs 2001 Fully taxable equivalent net interest income increased $2,053,000 or 11.44% to $19,997,000 during the year 2002. The net interest income growth was the result of an increase in interest income of $418,000 and a decrease in interest expense of $1,635,000. The effective interest differential increased 3 basis points to 4.87% from December 31, 2001 to December 31, 2002. Prime rates and federal funds rates held steady most of the year declining 50 basis points in November. The low rates had a greater impact on the repricing of deposits than they had on loans and investment securities. The Company's assets and liabilities were positioned to benefit from the rate environment. Overall, rates had a positive impact on earnings. Although interest-earning assets suffered a reduction in income due to rates of $2,033,000, interest expense relating to interest-bearing liabilities also declined by $2,326,000. The net effect was an increase in income of $293,000 due to rates. Total average interest earning assets increased $39,805,000 during 2002 which contributed $2,451,000 to net interest income. Interest income on loans decreased during 2002 by $1,055,000. This was the result of a decrease 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 of interest income of 22 $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 securities 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. 2001 vs 2000 Taxable equivalent net interest income increased 5.9% or $992,000, to $17,944,000 from year-end 2000 to year-end 2001. The increase in net interest income is due to a $695,000 increase in interest income and a reduction of $297,000 in 23 interest expense. Tax-exempt investment securities contributed the most to interest income adding $1,374,000 in income of which $1,298,000 was due to volume and $76,000 due to rate. Taxable investment securities partially offset the gain in interest income declining $998,000. Again, the decrease was mainly due to the reduction in volume that amounted to $752,000. Rates caused a reduction of $246,000 of income on taxable investment securities. The average balance of state and political subdivisions increased $16,471,000 while the average balances of U.S. Treasury and federal agencies and other securities declined $10,883,000 and $2,006,000, respectively. The shift to tax- exempt securities was to take advantage of their higher after- tax yields. The average rate of state and political subdivisions was 7.88% as opposed to 6.41% on U.S. Treasury and federal agency securities and 3.89% on other securities. Loan interest income contributed $319,000 to total interest income. The increase was caused by the net effect of a $622,000 increase due to volume and a $303,000 decrease due to rates. The average balance of total loans increased $6,938,000 to $246,907,000 during 2001. Prime rate reductions resulting from Federal Open Markets Committees' monetary policy initiatives during 2001 affected income collected on loans negatively. Total expense on interest-bearing liabilities declined $297,000 in 2001 due to the net effect of a $963,000 decrease in expense on short-term borrowings, an increase of $438,000 on other time deposits and interest expense increases on savings deposits and other borrowings of $54,000 and $174,000, respectively. Interest expense related to volume increased $831,000 while rates contributed a net decrease of $1,128,000. Total average interest bearing liabilities increased $9,236,000 to $292,923,000 in 2001. Average other time deposits contributed the most to the total, increasing $14,396,000. The interest expense due to the volume on other time deposits increased $770,000. Average balances of savings, and other borrowings added $2,063,000 and $4,468,000 respectively. Savings and other borrowings also added $43,000 and $258,000 in interest expense related to volume. The average balances on short-term borrowings decreased $11,691,000, resulting in an expense reduction due to volume of $240,000. The bank successfully attracted time deposits resulting in the substantial increase in average other time deposits. This caused less need for short-term borrowings, which consists of overnight Federal Home Loan Bank borrowings. Short-term borrowings experienced a decline in its average balance in 2001. 24 Although interest expense on short-term deposits declined, interest expense on other time deposits more than offset the reduction. Overall, interest rates declined considerably in 2001. This resulted in a reduction in interest expense related to rates in every category except savings deposits. Interest rates on savings deposits change only minimally year-to-year. This explains the $11,000 increase in expense related to rates, even with other deposit rates declining considerably. Interest expense related to rates on short-term borrowings decreased the most of the four categories. Short-term borrowings consisting of overnight Federal Home Loan Bank advances, naturally, are affected much more by the federal funds target rate set by the Federal Open Markets Committee. Interest on other time deposits, other borrowings and short term borrowings due to rate decreased $332,000, $84,000 and $723,000, respectively. The effective interest differential increased 13 basis points during 2001. The increase was due to the net effect of a five basis point interest rate decrease in total average earning assets and an 18 basis point rate decrease in total average interest bearing liabilities. The shape of the economy in 2001 was such that the Federal Open Markets Committee (FOMC) felt the need to reduce its federal funds target rate 475 basis points. Rates on both deposits and loans have fallen in response to the FOMC's policy objective. Rates have affected liabilities positively. This has allowed earning assets to increase $10,520,000 to $370,481,000 while interest expense decreased, resulting in an interest expense/earning assets ratio of 18 points less than 2000. 25 AVERAGE BALANCES AND INTEREST RATES (IN THOUSANDS) The following tables set forth certain information relating to the Company's average balance sheet and reflects the average yield on assets and average cost of liabilities for the periods indicated and the average yields earned and rates paid. Such yields and costs are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods presented. 26 <table> <caption> 2002 --------------------------- AVERAGE INTEREST AVERAGE BALANCE RATE -------- -------- ------ <s> <c> <c> <c> ASSETS: Interest-earning assets: Securities: U.S. Treasury and federal agency......... $ 54,690 $ 2,923 5.34% State and political subdivisions(4)...... 77,216 6,034 7.81% Other.................................... 24,452 912 3.73% -------- ------- Total securities....................... 156,358 9,869 6.31% -------- ------- LOANS: Tax-exempt loans(4).......................... 2,309 185 8.01% All other loans, net of discount where applicable................................. 251,619 20,789 8.26% -------- ------- Total loans(1),(3)..................... 253,928 20,974 8.26% -------- ------- Total interest-earning assets.......... 410,286 $30,843 7.52% ======= Other assets................................. 31,977 -------- TOTAL ASSETS......................... $442,263 ======== LIABILITIES AND SHAREHOLDERS' EQUITY: Interest-bearing liabilities: Deposits: Savings.................................. $129,244 $ 2,701 2.09% Other time............................... 136,813 5,156 3.77% -------- ------- Total interest-bearing deposits........ 266,057 7,857 2.95% Short-term borrowings........................ 16,465 501 3.04% Other borrowings............................. 46,299 2,488 5.37% -------- ------- Total interest-bearing liabilities..... 328,821 $10,846 3.30% ======= Demand deposits.............................. 50,877 Other liabilities............................ 3,334 Shareholders' equity......................... 59,231 -------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY............... $442,263 ======== Interest rate margin....................... 4.22% ----- Effective interest differential............ $19,997 4.87% ======= ===== </table> 27 <table> <caption> 2001 --------------------------- AVERAGE INTEREST AVERAGE BALANCE RATE -------- -------- ------ <s> <c> <c> <c> ASSETS: Interest-earning assets: Securities: U.S. Treasury and federal agency......... $ 22,877 $ 1,466 6.41% State and political subdivisions(4)...... 75,556 5,951 7.88% Other.................................... 25,141 979 3.89% -------- ------- Total securities....................... 123,574 8,396 6.79% -------- ------- LOANS: Tax-exempt loans(4).......................... 3,935 322 8.18% All other loans, net of discount where applicable................................. 242,972 21,707 8.93% -------- ------- Total loans(1),(3)..................... 246,907 22,029 8.92% -------- ------- Total interest-earning assets.......... 370,481 $30,425 8.21% ======= Other assets................................. 27,081 -------- TOTAL ASSETS......................... $397,562 ======== LIABILITIES AND SHAREHOLDERS' EQUITY: Interest-bearing liabilities: Deposits: Savings.................................. $ 93,351 $ 1,961 2.10% Other time............................... 145,823 7,696 5.28% -------- ------- Total interest-bearing deposits........ 239,174 9,657 4.04% Short-term borrowings........................ 20,122 903 4.49% Other borrowings............................. 33,627 1,921 5.71% -------- ------- Total interest-bearing liabilities..... 292,923 $12,481 4.26% ======= Demand deposits.............................. 46,594 Other liabilities............................ 4,214 Shareholders' equity......................... 53,831 -------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY............... $397,562 ======== Interest rate margin....................... 3.95% ----- Effective interest differential............ $17,944 4.84% ======= ===== </table> 28 <table> <caption> 2000 --------------------------- AVERAGE INTEREST AVERAGE BALANCE RATE -------- -------- ------ <s> <c> <c> <c> ASSETS: Interest-earning assets: Securities: U.S. Treasury and federal agency......... $ 33,760 $ 2,361 6.99% State and political subdivisions(4)...... 59,085 4,577 7.75% Other.................................... 27,147 1,082 3.99% -------- ------- Total securities....................... 119,992 8,020 6.68% -------- ------- LOANS: Tax-exempt loans(4).......................... 5,164 412 7.98% All other loans, net of discount where applicable................................. 234,805 21,298 9.07% -------- ------- Total loans(1),(3)..................... 239,969 21,710 9.05% -------- ------- Total interest-earning assets.......... 359,961 $29,730 8.26% ======= Other assets................................. 18,027 -------- TOTAL ASSETS......................... $377,988 ======== LIABILITIES AND SHAREHOLDERS' EQUITY: Interest-bearing liabilities: Deposits: Savings.................................. $ 91,288 $ 1,907 2.09% Other time............................... 131,427 7,258 5.52% -------- ------- Total interest-bearing deposits........ 222,715 9,165 4.12% Short-term borrowings........................ 31,813 1,866 5.87% Other borrowings............................. 29,159 1,747 5.99% -------- ------- Total interest-bearing liabilities..... 283,687 $12,778 4.50% ======= Demand deposits.............................. 42,765 Other liabilities............................ 3,837 Shareholders' equity......................... 47,699 -------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY............... $377,988 ======== Interest rate margin....................... 3.75% ----- Effective interest differential............ $16,952 4.71% ======= ===== </table> 29 1. Fees on loans are included with interest on loans. Loan fees are included in interest income as follows: 2002, $803,000, 2001, $668,000, 2000, $411,000. 2. Information on this table has been calculated using average daily balance sheets to obtain average balances. 3. Nonaccrual loans have been included with loans for the purpose of analyzing net interest earnings. 4. Income and rates on a fully taxable equivalent basis include an adjustment for the difference between annual income from tax-exempt obligations and the taxable equivalent of such income at the standard 34% tax rate (derived by dividing tax-exempt interest by 66%). 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. 30 <table> <caption> Year Ended December 31 ------------------------------------------------------------ 2002 vs 2001 2001 vs 2000 Increase (Decrease) Increase (Decrease) Due to Due to ----------------------------- ------------- Volume Rate Net Volume Rate Net ------- -------- -------- ------- -------- ------- <s> <c> <c> <c> <c> <c> <c> Interest income: Taxable investment securities $1,707 $ (317) $ 1,390 $ (752) $ (246) $ (998) Tax-exempt investment securities 130 (47) 83 1,298 76 1,374 Loans 614 (1,669) (1,055) 622 (303) 319 ------ ------- ------- ------ ------- ------ Total interest-earning assets $2,451 $(2,033) $ 418 $1,168 $ (473) $ 695 ====== ======= ======= ====== ======= ====== Interest expenses: Savings deposits $ 750 $ (10) $ 740 $ 43 $ 11 $ 54 Other time deposits (514) (2,026) (2,540) 770 (332) 438 Short-term borrowings (232) (170) (402) (240) (723) (963) Other borrowings 687 (120) 567 258 (84) 174 ------ ------- ------- ------ ------- ------- Total interest-bearing liabilities $ 691 $(2,326) $(1,635) $ 831 $(1,128) $ (297) ====== ======= ======= ====== ======= ======= Change in net interest income $1,760 $ 293 $ 2,053 $ 337 $ 655 $ 992 ====== ======= ======= ====== ======= ======= </table> PROVISION FOR LOAN LOSSES 2002 vs 2001 The provision for loan losses is based upon management's quarterly review of the loan portfolio. The purpose of the review is to assess loan quality, identify impaired loans, analyze delinquencies, ascertain loan growth, evaluate potential charge-offs and recoveries, and assess general economic conditions in the markets served. An external independent loan review is also performed annually for the Bank. Management remains committed to an aggressive program of problem loan identification and resolution. The allowance is calculated by applying loss factors to outstanding loans by type, excluding loans for which a specific allowance has been determined. Loss factors are based on management's consideration of the nature of the portfolio segments, changes in mix and volume of the loan portfolio, and historical loan loss experience. In addition, management considers industry standards and trends with respect to nonperforming loans and its knowledge and experience with specific lending segments. Although management believes that it uses the best information available to make such determinations and that the 31 allowance for loan losses was adequate at December 31, 2002, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making the initial determinations. A downturn in the local economy, employment and delays in receiving financial information from borrowers could result in increased levels of nonperforming assets and charge-offs, increased loan loss provisions and reductions in income. Additionally, as an integral part of the examination process, bank regulatory agencies periodically review the Bank's loan loss allowance. The banking agencies could require the recognition of additions to the loan loss allowance based on their judgement of information available to them at the time of their examination. The allowance for loan losses increased 0.9% or $26,000 from fiscal 2001 after net charge-offs of $339,000 contributing to a year-end allowance for loan losses of $2,953,000 or 1.1% of total loans. This percentage is consistent with the guidelines of regulators and peer banks. Management's conclusion is that the provision for loan loss is adequate. 2001 vs 2000 The allowance for loan losses increased 1.7% or $48,000 from fiscal 2000 after net charge-offs of $324,000 contributing to a year-end allowance for loan losses of $2,927,000 or 1.2% of total loans. 32 <table> <caption> YEAR ENDED DECEMBER 31, ------------------------------------------ (IN THOUSANDS) 2002 2001 2000 1999 1998 ------ ------ ------ ------ ------ <s> <c> <c> <c> <c> <c> Balance at beginning of period............... $2,927 $2,879 $2,823 $2,681 $2,579 ------ ------ ------ ------ ------ Charge-offs: Domestic: Real estate............................ 262 154 165 50 - Commercial and industrial.............. 80 122 38 28 91 Installment loans to individuals....... 60 82 66 98 180 ------ ------ ------ ------ ------ Total charge-offs.................... 402 358 269 176 271 ------ ------ ------ ------ ------ Recoveries: Real estate............................ 25 9 8 4 - Commercial and industrial.............. 21 8 20 11 29 Installment loans to individuals....... 17 17 11 17 39 ------ ------ ------ ------ ------ Total recoveries..................... 63 34 39 32 68 ------ ------ ------ ------ ------ Net charge-offs............................ 339 324 230 144 203 ------ ------ ------ ------ ------ Additions charged to operations............ 365 372 286 286 305 ------ ------ ------ ------ ------ Balance at end of period................... $2,953 $2,927 $2,879 $2,823 $2,681 ====== ====== ====== ====== ====== Ratio of net charge-offs during the period to average loans outstanding during the period............ 0.13% 0.13% 0.10% 0.06% 0.09% </table> OTHER INCOME 2002 vs 2001 Total other income for 2002 was $5,453,000, an increase of $344,000 from the prior year. Excluding security gains of $233,000 in 2002 and $1,033,000 in 2001, other income increased $1,144,000. Service charges increased 17.12% or $268,000 to $1,833,000 in 2002. The rate charged for overdraft fees was increased in 2002 which resulted in $229,000 additional service charge income. Other operating income increased $876,000 from 2001 to 2002. Commission income growth from the sale of financial products sold by the Bank's subsidiary, The M Group, account for $401,000 of the total increase of other operating income. Income on cash surrender value adjustments on bank owned life insurance increased $242,000. The year 2002 was the first full year the life insurance policies were in effect, resulting in a greater adjustment. Life insurance proceeds also added 33 $102,000. The remaining contributors were credit card merchant machine processing fees, debit card fees and ATM surcharge revenue. 2001 vs 2000 Total other income for the year ended December 31, 2001 of $5,109,000 grew from $2,615,000 in 2000, an increase of $2,494,000 or 95.37%. Most of the $2,494,000 increase of other operating income is due to the growth of $1,313,000 commission income recognized from the sale of various financial products, sold by the Bank's subsidiary, The M Group. The substantial increase in commission is due to comparing an entire year's commission in 2001 and a partial year for the newly acquired subsidiary in 2000. The Company realized security gains of $1,033,000 versus $269,000 in 2001, an increase of $764,000. The majority of the gains taken were due to the liquidation of equity securities that had reached, in management's opinion, their peak performance. Service charges increased $208,000, or 15.3%, which is mostly attributable to an increase on deposits and in fees collected on deposit accounts. OTHER EXPENSES 2002 vs 2001 Total other expenses increased $941,000 or 8.35% from the year ended December 31, 2001 to December 31, 2002. Salaries and employee benefits increased $1,152,000, the most substantial of the other expenses category. Employee salaries and benefits increased more than $500,000 as a result of increased salaries that correspond with the growth in sales of financial products offered by The M Group and the cost of staff at the new State College Wal-Mart Branch. The Bank's pension expense increased $320,000 in 2002. The remaining expenses were due to normal wage increases. The new branch also caused the majority of the $44,000 increase to occupancy expense. The Bank has substantially upgraded its computer networking capabilities which has resulted in most of the $98,000 increase to furniture and equipment expense. Other operating expenses decreased $353,000. The elimination of goodwill amortization as per the adoption of FAS No. 142 represents $221,000 of the decrease in expenses. Bookkeeping expenses increased due to securities transactions and maintenance. The other miscellaneous operating expenses decrease was additionally offset by a $55,000 expense as a result of a check kiting incident. 34 2001 vs 2000 Other expenses at year-end December 31, 2001 increased $1,452,000 or 14.79%. The majority of the other operating expense increase of $870,000 is due to a full year of expenses of the Bank's subsidiary, The M Group, an entry fee of $53,000 for The NASDAQ National Market, audit and consulting fees in excess of $50,000, additional advertising expenses and other miscellaneous operating expenses. The salaries and employee benefits expense increase of $656,000 or 12.77% is attributable to the normal wage increases and the additional salaries expense of the Bank's subsidiary for a full year. Occupancy expense increased $42,000 or 5.64%. Most of the expense was also produced by a full year of The M Group's occupancy expenses. Furniture and equipment expenses were $19,000 less in 2001 than in 2000. INCOME TAXES 2002 vs 2001 The provision for income taxes for the year ended December 31, 2002 resulted in an effective income tax rate of 20.2% compared to 20.3% for 2001. 2001 vs 2000 The provision for income taxes for the year ended December 31, 2001 resulted in an effective income tax rate of 20.3% compared to 19.8% for 2000. FINANCIAL CONDITION INVESTMENTS 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- 35 end 2002 comprised of 50.2% U.S. Government agency and Treasury securities, 40.2% state and political subdivisions, 8.4% equity securities, and 1.2% other bonds, notes and debentures. Held to maturity securities had a carrying value of $1,181,000. Available for sale securities occupied 99% of the total portfolio and had an amortized cost of $168,641,000 with an estimated market value of $176,436,000. The unrealized gain of $7,795,000 effected shareholders' equity by $5,145,000, net of deferred taxes. 2001 The investment portfolio increased $17,015,000 or 14.6% in 2001. The bank borrowed $10,000,000 in long-term FHLB advances to purchase state and political bonds and take advantage of interest rate imbalances in the market. Deposits grew greater than loan demand with the excess funding the purchase of additional investment securities. Most of the increase is attributable to an increase of $15,591,000 in the state and political subdivisions category and corporate stock of $2,791,000 and a decrease of $2,136,000 in the U.S. Government agencies category. U.S. Treasury securities also increased $1,080,000, and other bonds, notes and debentures decreased $311,000. The investment portfolio at year end 2001 comprised of 19.5% U.S. Government agency and Treasury securities, 63.1% state and political subdivisions, 16.6% equity securities and ..8% other bonds, notes and debentures. Held to maturity securities had a carrying value of $1,302,000. Available for sale securities occupied 99% of the total portfolio and had an amortized cost of $129,365,000 with an estimated market value of $131,985,000. The unrealized gain of $2,620,000 effected shareholders' equity by $1,729,000, net of deferred taxes. The carrying amounts of investment securities at the dates indicated are summarized as follows (in thousands): 36 <table> <caption> DECEMBER 31, ------------------------------ 2002 2001 2000 -------- -------- -------- <s> <c> <c> <c> U.S. Treasury securities: Available for Sale $ 4,296 $ 4,126 $ 3,046 U.S. Government agencies: Held to Maturity 94 196 206 Available for Sale 84,702 21,694 23,820 State and political subdivisions: Held to Maturity 796 796 2,712 Available for Sale 70,681 83,256 65,749 Other bonds, notes and debentures: Held to Maturity 291 310 310 Available for Sale 1,810 816 1,127 -------- -------- -------- Total bonds, notes and debentures 162,670 111,194 96,970 Corporate stock - Available for Sale 14,947 22,093 19,302 -------- -------- -------- Total $177,617 $133,287 $116,272 ======== ======== ======== </table> The following table shows the maturities and repricing of investment securities at December 31, 2002 and the weighted average yields (for tax-exempt obligations on a fully taxable basis assuming a 34% tax rate) of such securities (in thousands): 37 <table> <caption> WITHIN AFTER ONE AFTER FIVE AFTER ONE BUT WITHIN BUT WITHIN TEN YEAR FIVE YEARS TEN YEARS YEARS ------- ---------- ---------- -------- <s> <c> <c> <c> <c> U.S. Treasury securities: AFS Amount $1,019 $ 3,277 $ - $ - Yield 6.36% 4.04% - - U.S. Government agencies: HTM Amount - - - 94 Yield - - - 8.84% AFS Amount 1,067 7,257 27,566 48,812 Yield 4.96% 4.34% 5.08% 5.75% State and political subdivisions: HTM Amount 250 - - 546 Yield 4.55% - - 5.20% AFS Amount - 120 - 70,561 Yield - 9.63% - 5.18% Other bonds, notes and debentures: HTM Amount 50 100 141 - Yield 5.75% 7.15% 6.85% - AFS Amount - - - 1,810 Yield - - - 6.11% ------ -------- ------- -------- Total Amount $2,386 $10,754 $27,707 $121,823 ====== ======= ======= ======== Total Yield 5.53% 4.34% 5.10% 5.43% </table> All yields represent weighted average yields expressed on a tax equivalent basis. They are calculated on the basis of the cost, adjusted for amortization of premium and accretion of discount and effective yields weighted for the scheduled maturity of each security. The taxable equivalent adjustment represents the difference between annual income from tax-exempt obligations and the taxable equivalent of such income at the standard 34% tax rate (derived by dividing tax-exempt interest by 66%). LOAN PORTFOLIO 2002 Gross loans for the year ended December 31, 2002, were $257,845,000 or $6,222,000 (2.47%) more than the prior year. Real estate mortgages increased $8,128,000 as a whole with residential and commercial real estate loans increasing $49,000 and $8,800,000, respectively. Construction real estate mortgages decreased $721,000. Commercial and agricultural loans increased $1,079,000, while installment loans to individuals decreased $2,985,000. 38 2001 At December 31, 2001 gross loans totaled $251,623,000, an increase of $6,825,000 or 2.8% over year-end 2000. While commercial, agricultural, construction real estate mortgages and installment loans to individuals decreased from 2000, loans secured by residential and commercial real estate grew by $14,964,000 or 7.8%. Residential real estate mortgages increased $8,823,000 or (6.7%). Commercial real estate mortgages grew by 10.1% or $6,141,000. Commercial and agricultural loans decreased $3,842,000 or (14.5%). Construction real estate mortgages declined $671,000 or 14.1% and installment loans to individuals decreased 16.8% or $3,626,000. The amount of loans outstanding at the indicated dates are shown in the following table according to type of loan (in thousands): <table> <caption> December 31, ---------------------------------------------------- 2002 2001 2000 1999 1998 -------- -------- -------- -------- -------- <s> <c> <c> <c> <c> <c> Domestic: Commercial and agricultural $ 23,708 $ 22,629 $ 26,471 $ 31,735 $ 32,920 Real estate mortgage: Residential 140,272 140,223 131,400 121,384 109,937 Commercial 75,563 66,763 60,622 51,445 43,562 Construction 3,356 4,077 4,748 3,732 3,874 Installment loans to individuals 14,946 17,931 21,557 23,519 24,505 -------- -------- -------- -------- -------- Gross loans $257,845 $251,623 $244,798 $231,815 $214,798 ======== ======== ======== ======== ======== </table> The amount of domestic loans at December 31, 2002 are presented below by category and maturity (in thousands): 39 <table> <caption> COMMERCIAL INSTALLMENT AND LOANS TO REAL ESTATE OTHER INDIVIDUALS TOTAL ----------- ---------- ----------- ------- <s> <c> <c> <c> <c> Loans with floating interest rates: 1 year or less $ 6,020 $ 7,424 $ 1,298 $14,742 1 through 5 years 6,309 2,294 25 8,628 5 through 10 years 15,692 1,227 17 16,936 After 10 years 74,771 2,193 2 76,966 -------- ------- ------- -------- Sub Total 102,792 13,138 1,342 117,272 -------- ------- ------- -------- Loans with predetermined interest rates: 1 year or less 4,094 1,309 1,601 7,004 1 through 5 years 21,122 6,678 10,323 38,123 5 through 10 years 30,589 1,788 942 33,319 After 10 years 60,594 795 738 62,127 -------- ------- ------- -------- Sub Total 116,399 10,570 13,604 140,573 -------- ------- ------- -------- Total $219,191 $23,708 $14,946 $257,845 ======== ------- ======= ======== </table> (1) The loan maturity information is based upon original loan terms and is not adjusted for "rollovers." In the ordinary course of business, loans maturing within one year may be renewed, in whole or in part, as to principal amount at interest rates prevailing at the date of renewal. (2) Scheduled repayments are reported in maturity categories in which the payment is due. The Bank does not make loans that provide for negative amortization nor do any loans contain conversion features. The Bank does not have any foreign loans outstanding at December 31, 2002. ALLOWANCE FOR LOAN LOSSES 2002 The allowance for loan losses represents the amount that management estimates is adequate to provide for probable losses inherent in the loan portfolio as of the balance sheet date. Accordingly, all loan losses are charged to the allowance, and all recoveries are credited to it. The allowance for loan losses is established through a provision for loan losses, which is charged to operations. The provision is based on management's quarterly evaluation of the adequacy of the 40 allowance for loan losses, taking into account the overall risk characteristics of the various portfolio segments, past experience with losses, the impact of economic conditions on borrowers, and other relevant factors. Underwriting continues to emphasize the need for security and adequate collateral margins. The total allowance for loan losses is a combination of a specific allowance for identified problem loans, a homogeneous pool allowance, and off balance sheet risk allowance. At December 31, 2002, the allowance for loan losses as a percent of gross loans declined from December 31, 2001 to 1.1%. Gross loans increased by $6,222,000 from $251,623,000 at December 31, 2001 to $257,845,000 at December 31, 2002. Nonaccruing loans increased $590,000 to $871,000 from year- end 2001. Overall nonperforming loans increased $1,477,000 to $2,096,000 from fiscal 2001. Based on management's loan-by-loan review, the past performance of the borrowers and current economic conditions, including recent business closures and bankruptcy levels, management does not anticipate any current losses related to nonaccrual, nonperforming, or classified loans above that have already been considered in its overall judgment of the adequacy of the reserve. 2001 At December 31, 2001, the allowance for loan losses as a percent of gross loans remained unchanged from December 31, 2000, at 1.2%. Gross loans increased by $6,825,000 from $244,798,000 at December 31, 2000 to $251,623,000 at December 31, 2001. Nonaccruing loans decreased $496,000 (63.8%) to $281,000 from year-end 2000. Overall nonperforming loans decreased $185,000 (23.0%) to $619,000 from fiscal 2000. Based on management's loan-by-loan review, the past performance of the borrowers and current economic conditions, including recent plant closures and bankruptcy levels, management does not anticipate any current losses related to nonaccrual, nonperforming, or classified loans above that have already been considered in its overall judgment of the adequacy of the reserve. 41 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. TOTAL NONPERFORMING LOANS (IN THOUSANDS) -------------------------- 90 DAYS NONACCRUAL PAST DUE ---------- -------- 2002 $871 $1,225 2001 $281 $ 338 2000 $777 $ 27 1999 $284 $ 241 1998 $646 $ 60 If interest had been recorded at the original rate on those loans, such income would have approximated $24,000, $28,000, and $86,000 for the years ended December 31, 2002, 2001, and 2000, respectively. Interest income on such loans, which is recorded as received, amounted to approximately $17,000, $19,000 and $45,000 for the years ended December 31, 2002, 2001 and 2000, respectively. The level of nonaccruing loans continues to fluctuate annually and is attributed to the various economic factors 42 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 AMOUNT TOTAL LOANS ------ ----------- DECEMBER 31, 2002: Balance at end of period applicable to: Domestic: Commercial and agricultural $ 471 9.2% Real estate mortgage: Residential 1,162 54.4% Commercial 1,082 29.3% Construction 66 1.3% Installment loans to individuals 172 5.8% ------ ----- Total $2,953 100.0% ====== ===== 43 DECEMBER 31, 2001: Balance at end of period applicable to: Domestic: Commercial and agricultural $ 414 9.0% Real estate mortgage: Residential 1,379 55.8% Commercial 763 26.5% Construction 74 1.6% Installment loans to individuals 271 7.1% Unallocated general allowance 26 - ------ ----- Total $2,927 100.0% ====== ===== DECEMBER 31, 2000: Balance at end of period applicable to: Domestic: Commercial and agricultural $ 541 10.8% Real estate mortgage: Residential 1,211 53.7% Commercial 723 24.8% Construction 71 1.9% Installment loans to individuals 306 8.8% Unallocated general allowance 27 - ------ ----- Total $2,879 100.0% ====== ===== DECEMBER 31, 1999: Balance at end of period applicable to: Domestic: Commercial and agricultural $ 531 13.7% Real estate mortgage: Residential 1,186 52.4% Commercial 710 22.2% Construction 70 1.6% Installment loans to individuals 300 10.1% Unallocated general allowance 26 - ------ ----- Total $2,823 100.0% ====== ===== 44 DECEMBER 31, 1998: Balance at end of period applicable to: Domestic: Commercial and agricultural $ 505 15.3% Real estate mortgage: Residential 1,126 51.2% Commercial 673 20.3% Construction 67 1.8% Installment loans to individuals 284 11.4% Unallocated general allowance 26 - ------ ----- Total $2,681 100.0% ====== ===== DEPOSITS 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. 2001 Total average deposits increased $20,288,000 during 2001. The most significant growth occurred in time deposits. Time deposits increased $14,396,000. Demand and savings deposits increased $4,519,000 and $1,373,000, respectively. Time deposits increased 11.0% from 2000 mostly due to successful marketing strategies and penetration into the Centre County market. In addition to growth, the downward rate environment in 2001 caused the average rate paid on time deposits to decline. 45 Noninterest-bearing deposits increased 9.0% to $46,594,000. Interest-bearing demand deposits also increased minimally to $46,154,000 (1.5%). Time deposits of $100,000 or more totaled approximately $29,126,000 on December 31, 2002 and $32,646,000 on December 31, 2001. Interest expense related to such deposits was approximately $1,098,000, $1,913,000 and $1,571,000 for the years ended December 31, 2002, 2001 and 2000, respectively. Maturities on time deposits of $100,000 or more are as follows: 2002 ------- Three months or less $ 6,770 Three months to six months 7,436 Six months to twelve 6,093 Over twelve months 8,827 ------- Total $29,126 ======= Time deposits at December 31, 2002 mature as follows: 2003 - - $85,397,000; 2004 - $20,365,000; 2005 - $15,168,000; 2006 - $10,627,000; 2007 - $1,169,000; thereafter - $1,054,000. The average amount and the average rate paid on deposits are summarized below (in thousands): <table> <caption> 2002 2001 2000 ---------------- ---------------- ---------------- AVERAGE AVERAGE AVERAGE ---------------- ---------------- ---------------- AMOUNT RATE AMOUNT RATE AMOUNT RATE -------- ----- -------- ----- -------- ----- <s> <c> <c> <c> <c> <c> <c>% DEPOSITS IN DOMESTIC BANK OFFICES: Demand deposits: Noninterest-bearing $ 50,877 0.00% $ 46,594 0.00% $ 42,765 0.00% Interest-bearing 71,774 2.13% 46,154 2.17% 45,464 2.17% Savings deposits 57,470 2.04% 47,197 2.03% 45,824 2.00% Time deposits 136,813 3.77% 145,823 5.28% 131,427 5.52% -------- ---------------- -------- Total average deposits . . $316,934 $285,768 $265,480 ======== ======== ======== </table> 46 SHAREHOLDERS' EQUITY 2002 Shareholders' equity is evaluated in relation to total assets and the risks associated with those assets. A company is more likely to meet its cash obligations and absorb unforeseen losses when the capital resources are greater. Total shareholders' equity at December 31, 2002 was $63,142,000, increasing $7,890,000 from the balance at December 31, 2001 of $55,252,000. Net income and the exercising of stock options contributed $8,886,000 and $113,000, respectively, to shareholders' equity. The unrealized appreciation on securities also added $3,416,000 to total equity. Reductions to shareholders' equity included $4,124,000 that was paid out in dividends and $401,000 for the purchase of treasury stock. 2001 Total shareholders' equity at December 31, 2001 was $55,252,000, increasing $4,738,000 from the balance at December 31, 2000 of $50,514,000. Net income and the exercising of stock options contributed $7,742,000 and $24,000, respectively, to shareholders' equity. The unrealized appreciation on securities also added $2,539,000 to total equity. Reductions to shareholders' equity included $3,729,000 that was paid out in dividends and $1,838,000 for the purchase of treasury stock. Bank regulators have risk based capital guidelines. Under these guidelines, banks are required to maintain minimum ratios of core capital and total qualifying capital as a percentage of risk weighted assets and certain off-balance sheet items. At December 31, 2002, the Company's required ratios were well above the minimum ratios as follows: 2002 Minimum Company Standards ------- --------- Tier 1 capital ratio 20.7% 4.0% Total capital ratio 22.2% 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. 47 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: 2002 2001 2000 ------ ------ ------ Percentage of net income to: Average total assets 2.01% 1.95% 1.74% Average shareholders' equity 15.00% 14.38% 13.77% Percentage of dividends declared per common share 46.40% 48.17% 52.18% Percentage of average shareholders' equity to average total assets 13.39% 13.54% 12.62% 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 48 needs are assessed and sources of funds are determined. Funding strategies consider both customer needs and economical cost. Both short and long term funding needs are addressed by maturities and sales of available for sale investment securities, loan repayments and maturities, and liquidating money market investments such as federal funds sold. The use of these resources, in conjunction with access to credit provides core ingredients to satisfy depositor, borrower and creditor needs. Management monitors and determines the desirable level of liquidity. Consideration is given to loan demand, investment opportunities, deposit pricing and growth potential as well as the current cost of borrowing funds. The Company has a current borrowing capacity at the Federal Home Loan Bank of $153,147,000. In addition to this credit arrangement the Company has additional lines of credit with correspondent banks of $10,500,000. The Company's management believes that it has sufficient liquidity to satisfy estimated short-term and long- term funding needs. Federal Home Loan Bank advances totaled $53,618,000 as of December 31, 2002. Interest rate sensitivity, which is closely related to liquidity management, is a function of the repricing characteristics of the Company's portfolio of assets and liabilities. Asset/liability management strives to match maturities and rates between loan and investment security assets with the deposit liabilities and borrowings that fund them. Successful asset/liability management results in a balance sheet structure which can cope effectively with market rate fluctuations. The matching process is affected by segmenting both assets and liabilities into future time periods (usually 12 months, or less) based upon when repricing can be effected. Repriceable assets are subtracted from repriceable liabilities, for a specific time period to determine the "gap", or difference. Once known, the gap is managed based on predictions about future market interest rates. Intentional mismatching, or gapping, can enhance net interest income if market rates move as predicted. However, if market rates behave in a manner contrary to predictions, net interest income will suffer. Gaps, therefore, contain an element of risk and must be prudently managed. In addition to gap management, the Company has an asset liability management policy which incorporates a market value at risk calculation which is used to determine the effects of interest rate movements on shareholders' equity and a simulation analysis to monitor the effects of interest rate changes on the Company's balance sheets. 49 INTEREST RATE SENSITIVITY The following table sets forth the Company's interest rate sensitivity as of December 31, 2002: <table> <caption> AFTER ONE AFTER TWO AFTER WITHIN BUT WITHIN BUT WITHIN FIVE ONE YEAR TWO YEARS FIVE YEARS YEARS --------- ---------- ---------- -------- <s> <c> <c> <c> <c> Earning assets: Investment securities(1) $ 15,080 $ 32,929 $ 52,097 $ 69,839 Loans(2) 81,782 37,257 106,062 35,395 -------- -------- -------- -------- Total earning assets 96,862 70,186 158,159 105,234 Interest-bearing liabilities: Deposits(3) 103,031 41,584 86,529 41,645 Borrowings 43,554 15,000 5,000 1,787 -------- -------- -------- -------- Total interest-bearing liabilities 146,585 56,584 91,529 43,432 Net noninterest-bearing funding(4) 9,231 9,231 27,693 46,156 -------- -------- -------- -------- Total net funding sources $155,816 $ 65,815 $119,222 $89,588 Excess assets (liabilities) (58,954) 4,371 38,937 15,646 Cumulative excess assets (liabilities) (58,954) (54,583) (15,646) - </table> (1) Investment balances reflect estimated prepayments on mortgage-backed securities. (2) Loan balances include annual repayment assumptions based on projected cash flow from the loan portfolio. The cash flow projections are based on the terms of the credit facilities and estimated prepayments on fixed rate mortgage loans. Loans include loans held for sale. (3) Adjustments to the interest sensitivity of Savings, NOW and MMDA account balances reflect managerial assumptions based on historical experience, expected behavior in future rate environments and the Company's positioning for these products. (4) Net noninterest-bearing funds are the sum of noninterest- bearing liabilities and shareholders' equity minus noninterest-earning assets and reflect managerial assumptions as to the appropriate investment maturity categories. In this analysis the Company examines the result of a 100 and 200 basis point change in market interest rates and the 50 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: December 31, 2002 Net Interest Income Change (After Tax) Rates (In thousands) ----- ------------------------- -200 $(350) -100 $(226) +100 $ 140 +200 $ 6 The model utilized to create the report presented above makes various estimates at each level of interest rate change regarding cash flow from principal repayment on loans and mortgage-backed securities and or call activity on investment securities. Actual results could differ significantly from these estimates which would result in significant differences in the calculated projected change. In addition, the limits stated above do not necessarily represent the level of change under which management would undertake specific measures to realign its portfolio in order to reduce the projected level of change. Generally, management believes the Company is well positioned to respond expeditiously when the market interest rate outlook changes. INFLATION The asset and liability structure of a financial institution is primarily monetary in nature, therefore, interest rates rather than inflation have a more significant impact on the Company's performance. Interest rates are not always affected in the same direction or magnitude as prices of other goods and services, but are reflective of fiscal policy initiatives or economic factors that are not measured by a price index. COMPREHENSIVE INCOME Comprehensive income is a measure of all the changes in equity of a corporation. It excludes transactions with owners in 51 their capacity as owners (i.e. stock options granted or exercised, repurchase of treasury stock transactions and dividends to shareholders). Other comprehensive income is the difference between net income and comprehensive income. The Company's other comprehensive income is composed of unrealized gains and losses on available for sale securities, net of deferred income tax. Comprehensive income is not a measure of net income. Net income would be affected by other comprehensive income only in the event that the entire securities portfolio was sold on the statement date. Unrealized gains or losses reflected in the Company's comprehensive income may vary widely at statement dates as a result of changing markets and /or interest rate movements. Other comprehensive income for the years ended December 31, 2002, 2001 and 2000 were $3,416,000, $2,539,000 and $2,117,000, respectively. CAUTIONARY STATEMENT FOR PURPOSES OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 This Report contains certain "forward-looking statements" including statements concerning plans, objectives, future events or performance and assumptions and other statements which are other than statements of historical fact. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. In order to comply with the terms of the safe harbor, the Company notes that a variety of factors could cause the Company's actual results and experience to differ materially from the anticipated results or other expectations expressed in the Company's forward-looking statements. The risks and uncertainties that may affect the operations, performance, development and results of the Company's business include the following: general economic conditions and changes in interest rates including their impact on capital expenditures; business conditions in the banking industry; the regulatory environment; rapidly changing technology and evolving banking industry standards; the effect of changes in accounting policies and practices, including increased competition with community, regional and national financial institutions; new service and product offerings by competitors and price pressures; changes in the Company's organization, compensation and benefit plans; and similar items. 52 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK Market risk for the Company is comprised primarily from interest rate risk exposure and liquidity risk. Interest rate risk and liquidity risk management is performed at the Bank level as well as the Company level. The Company's interest rate sensitivity is monitored by management through selected interest rate risk measures produced internally. Additional information and details are provided in the Interest Sensitivity section of Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. Generally, management believes the Company is well positioned to respond expeditiously when the market interest rate outlook changes. 53 ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT AUDITORS Board of Directors and Shareholders Penns Woods Bancorp, Inc. We have audited the accompanying consolidated balance sheet of Penns Woods Bancorp, Inc. and subsidiaries, as of December 31, 2002 and 2001, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2002. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Penns Woods Bancorp, Inc. and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. /s/ S.R. Snodgrass, A.C. - ---------------------------------- Wexford, PA February 14, 2003 54 PENNS WOODS BANCORP, INC. CONSOLIDATED BALANCE SHEET December 31, --------------------- 2002 2001 --------- --------- (in thousands) ASSETS: Cash and due from banks $ 11,731 $ 14,844 Securities available for sale 176,436 131,985 Securities held to maturity (fair value of $1,289 and $1,312) 1,181 1,302 Loans held for sale 2,651 3,993 Loans, net of unearned discount of $769 257,845 251,623 Less: Allowance for loan losses 2,953 2,927 -------- -------- Loans, net 254,892 248,696 Bank premises and equipment, net 4,856 4,478 Accrued interest receivable 2,460 2,685 Bank-owned life insurance 8,537 8,126 Goodwill 3,032 3,032 Other assets 6,430 5,669 -------- -------- TOTAL $472,206 $424,810 ======== ======== LIABILITIES: Interest-bearing deposits $272,787 $249,873 Noninterest-bearing deposits 67,061 55,277 -------- -------- TOTAL DEPOSITS 339,848 305,150 Short-term borrowings 13,563 19,105 Other borrowings 51,778 41,778 Accrued interest payable 1,092 1,190 Other liabilities 2,783 2,335 -------- -------- TOTAL LIABILITIES 409,064 369,558 -------- -------- SHAREHOLDERS' EQUITY: Common stock, par value $10; 10,000,000 shares authorized 3,136,832 and 3,131,644 shares issued 31,368 31,316 Additional paid-in capital 18,291 18,230 Retained earnings 11,749 6,987 Accumulated other comprehensive income 5,145 1,729 Treasury stock, at cost (105,503 and 92,054 shares) (3,411) (3,010) -------- -------- TOTAL SHAREHOLDERS' EQUITY 63,142 55,252 -------- -------- TOTAL $472,206 $424,810 ======== ======== See Accompanying Notes to the Consolidated Financial Statements. 55 PENNS WOODS BANCORP, INC. CONSOLIDATED STATEMENT OF INCOME <table> <caption> Year Ended December 31, --------------------------- 2002 2001 2000 ------- ------- ------- (in thousands, except per share data) <s> <c> <c> <c> INTEREST AND DIVIDEND INCOME: Interest and fees on loans $20,911 $21,919 $21,570 Interest and dividends on investments: Taxable interest 4,314 3,112 3,954 Tax-exempt interest 3,252 3,066 2,205 Other dividend income 627 639 725 ------- ------- ------- TOTAL INTEREST AND DIVIDEND INCOME 29,104 28,736 28,454 ------- ------- ------- INTEREST EXPENSE: Interest on deposits 7,857 9,657 9,165 Interest on short-term borrowings 501 903 1,866 Interest on other borrowings 2,488 1,921 1,747 ------- ------- ------- TOTAL INTEREST EXPENSE 10,846 12,481 12,778 ------- ------- ------- NET INTEREST INCOME 18,258 16,255 15,676 PROVISION FOR LOAN LOSSES 365 372 286 ------- ------- ------- NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 17,893 15,883 15,390 ------- ------- ------- OTHER INCOME: Service charges 1,833 1,565 1,357 Securities gains, net 233 1,033 269 Earnings on bank-owned life insurance 416 174 97 Insurance commissions 1,807 1,416 368 Other operating income 1,164 921 524 ------- ------- ------- TOTAL OTHER INCOME 5,453 5,109 2,615 ------- ------- ------- OTHER EXPENSES: Salaries and employee benefits 6,944 5,792 5,136 Occupancy expense, net 831 787 745 Furniture and equipment expense 837 739 758 Pennsylvania shares tax expense 411 370 334 Other operating expenses 3,190 3,584 2,847 ------- ------- ------- TOTAL OTHER EXPENSES 12,213 11,272 9,820 ------- ------- ------- INCOME BEFORE INCOME TAX PROVISION 11,133 9,720 8,185 INCOME TAX PROVISION 2,247 1,978 1,619 ------- ------- ------- NET INCOME $ 8,886 $ 7,742 $ 6,566 ======= ======= ======= EARNINGS PER SHARE - BASIC $ 2.93 $ 2.53 $ 2.10 EARNINGS PER SHARE - DILUTED $ 2.93 $ 2.53 $ 2.10 </table> See accompanying notes to the consolidated financial statements. 56 PENNS WOODS BANCORP, INC. CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY <table> <caption> Accumu- lated Other Compre- Total Common Stock Additional hensive Share- ------------------- Paid-in Retained Income Treasury holders' Shares Amount Capital Earnings (Loss) Stock Equity --------- ------- --------- -------- -------- -------- -------- (in thousands, except per share data) <s> <c> <c> <c> <c> <c> <c> <c> Balance, December 31, 1999 3,128,332 $31,283 $18,165 $ (166) $(2,927) $ (270) $46,085 Comprehensive income: Net income 6,566 6,566 Unrealized gain on available for sale securities, net of reclassification adjustments and tax of $1,091 2,117 2,117 ------- Total comprehensive income 8,683 ------- Dividends declared, ($1.10 per share) (3,426) (3,426) Stock options exercised 2,512 25 49 74 Treasury stock acquired, 28,591 shares (902) (902) --------- ------- ------- ------- ------- ------- ------- Balance, December 31, 2000 3,130,844 31,308 18,214 2,974 (810) (1,172) 50,514 Comprehensive income: Net income 7,742 7,742 Unrealized gain on available for sale securities, net of reclassification adjustments and tax of $1,308 2,539 2,539 ------- Total comprehensive income 10,281 ------- Dividends declared, ($1.22 per share) (3,729) (3,729) Stock options exercised 800 8 16 24 Treasury stock acquired, 58,503 shares (1,838) (1,838) --------- ------- ------- ------- ------- ------- ------- Balance, December 31, 2001 3,131,644 31,316 18,230 6,987 1,729 (3,010) 55,252 Comprehensive income: Net income 8,886 8,886 Unrealized gain on available for sale securities, net of reclassification adjustments and tax of $1,760 3,416 3,416 ------- Total comprehensive income 12,302 ------- Dividends declared, ($1.36 per share) (4,124) (4,124) Stock options exercised 5,188 52 61 113 Treasury stock acquired, 13,449 shares (401) (401) --------- ------- ------- ------- ------- ------- ------- Balance, December 31, 2002 3,136,832 $31,368 $18,291 $11,749 $ 5,145 $(3,411) $63,142 ========= ======= ======= ======= ======= ======= ======= </table> <table> <caption> 2002 2001 2000 ------- ------- ------- <s> <c> <c> <c> Components of comprehensive income: Change in net unrealized gain on investments available for sale $3,570 $3,221 $2,295 Realized gains included in net income, net of tax $79, $351, and $91 (154) (682) (178) ------ ------ ------ Total $3,416 $2,539 $2,117 </table> See accompanying notes to the consolidated financial statements. 57 PENNS WOODS BANCORP, INC. CONSOLIDATED STATEMENT OF CASH FLOWS <table> <caption> Year Ended December 31, ---------------------------------- 2002 2001 2000 ---------- --------- --------- (in thousands) <s> <c> <c> <c> OPERATING ACTIVITIES Net income $ 8,886 $ 7,742 $ 6,566 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 526 489 551 Provision for loan losses 365 372 286 Accretion and amortization of investment security discounts and premiums (906) (843) (610) Securities gains, net (233) (1,033) (269) Originations of loans held for sale (16,597) (24,311) (14,022) Proceeds of loans held for sale 17,939 22,006 14,342 Earnings on bank-owned life insurance (416) (174) (97) Decrease (increase) in all other assets (1,465) (577) 588 Increase in all other liabilities 473 59 309 --------- -------- -------- Net cash provided by operating activities 8,572 3,730 7,644 --------- -------- -------- INVESTING ACTIVITIES Investment securities available for sale: Proceeds from sales 79,022 22,156 53,301 Proceeds from calls and maturities 13,047 12,765 6,142 Purchases (130,328) (48,151) (57,973) Investment securities held to maturity: Proceeds from calls and maturities 137 1,963 58 Purchases (41) (25) (273) Net increase in loans (6,800) (7,148) (13,213) Acquisition of bank premises and equipment (992) (323) (390) Proceeds from the sale of foreclosed assets 344 592 168 Purchase of bank-owned life insurance - (5,589) (1,298) Acquisition of a subsidiary - - (3,321) Gross proceeds from redemption of regulatory stock 1,262 943 - Gross purchases of regulatory stock (2,080) (941) (179) --------- -------- -------- Net cash used for investing activities (46,429) (23,758) (16,978) --------- -------- -------- FINANCING ACTIVITIES Net increase in interest-bearing deposits 22,914 19,208 18,138 Net increase in noninterest-bearing deposits 11,784 7,808 4,423 Net decrease in short-term borrowings (5,542) (11,916) (10,620) Proceeds from other borrowings 10,000 10,000 5,000 Repayment of other borrowings - - (500) Dividends paid (4,124) (3,729) (3,426) Stock options exercised 113 21 65 Purchase of treasury stock (401) (1,838) (902) --------- -------- -------- Net cash provided by financing activities 34,744 19,554 12,178 --------- -------- -------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (3,113) (474) 2,844 CASH AND CASH EQUIVALENTS, BEGINNING 14,844 15,318 12,474 --------- -------- -------- CASH AND CASH EQUIVALENTS, ENDING $ 11,731 $ 14,844 $ 15,318 ========= ======== ======== </table> 58 SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: The Company paid approximately $10,944,000, $12,743,000, and $12,449,000 in interest on deposits and other borrowings during 2002, 2001, and 2000, respectively. The Company made income tax payments of approximately $3,394,000, $2,136,000, and $2,008,000 during 2002, 2001, and 2000, respectively. Transfers from loans to foreclosed assets held for sale amounted to approximately $254,000, $493,000, and $294,000 in 2002, 2001, and 2000, respectively. See accompanying notes to the consolidated financial statements. 59 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. 60 Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses and the valuation of real estate acquired through, or in lieu of, foreclosure on settlement of debt. Investment Securities Investment securities are classified as held to maturity, available for sale, or trading. Securities held to maturity include bonds, notes, and debentures for which the Company has the positive intent and ability to hold to maturity and are reported at amortized cost. Trading account securities are recorded at their fair values. Unrealized gains and losses on trading account securities are included in other income. The Company has no trading account securities as of December 31, 2002 or 2001. Available for sale securities consist of bonds, notes, debentures, and certain equity securities not classified as trading securities nor as held to maturity securities. Unrealized holding gains and losses, net of tax, on available for sale securities are reported as a net amount in a separate component of shareholders' equity until realized. Gains and losses on the sale of equity securities are determined using the average cost method, while all other investment securities use the specific cost method. Declines in the fair value of individual securities held to maturity and available for sale below their cost that are other than temporary result in write-downs of the individual securities to their fair value and are included in earnings as realized losses. 61 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 bid, quotations received from securities dealers, or, in the case of equity securities, the closing price of the day as listed on the Internet. The fair value of certain state and political securities is not readily available through market sources other than dealer quotations, therefore these fair value estimates are then based on quoted market prices of similar instruments, adjusted for differences between the quoted instruments and the instruments being valued. Loans Loans are stated at the principal amount outstanding, net of unearned discount, unamortized loan fees and costs, and the allowance for loan losses. Interest on loans is recognized as income when earned on the accrual method. The Company's general policy has been to stop accruing interest on loans when it is determined a reasonable doubt exists as to the collectibility of additional interest. Income is subsequently recognized only to the extent that cash payments are received provided the loan is not delinquent in payment and, in management's judgment, the borrower has the ability and intent to make future principal payments. Allowance for Loan Losses The allowance for loan losses represents the amount which management estimates is adequate to provide for probable losses inherent in its loan portfolio, as of the balance sheet date. The allowance method is used in providing for loan losses. Accordingly, all loan losses are charged to the allowance and all recoveries are credited to it. The allowance for loan losses is established through a provision for loan losses charged to operations. The provision for loan losses is based on management's periodic evaluation of individual loans, economic factors, past loan loss experience, changes in the composition and volume of the portfolio, and other relevant factors. The estimates used in determining the adequacy of the allowance for loan losses, including the amounts and timing of future cash flows expected on impaired loans, are particularly susceptible to changes in the near term. 62 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. Mortgage loans on one-to-four family properties and all consumer loans are large groups of smaller-balance homogeneous loans and are measured for impairment collectively. Loans that experience insignificant payment delays, which are defined as 90 days or less, generally are not classified as impaired. Management determines the significance of payment delays on a case-by-case basis taking into consideration all circumstances surrounding the loan and the borrower including the length of the delay, the borrower's prior payment record, and the amount of shortfall in relation to the principal and interest owed. Loans Held for Sale In general, fixed rate residential mortgage loans originated by the Bank are held for sale and are carried at the aggregate lower of cost or market. Such loans sold are not serviced by the Bank. Foreclosed Assets Held for Sale Foreclosed assets held for sale are carried at the lower of fair value minus estimated costs to sell or cost. Prior to foreclosure, the value of the underlying loan is written down to 63 the fair value of the real estate to be acquired by a charge to the allowance for loan losses, if necessary. Any subsequent write-downs are charged against operating expenses. Operating expenses of such properties, net of related income, and gains and losses on their disposition are included in other expenses. Bank Premises and Equipment Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed using straight-line and accelerated methods over the estimated useful lives of the related assets, which range from five to seven years for furniture, fixtures and equipment and thirty-one and a half for buildings and improvements. Costs incurred for routine maintenance and repairs are charged to operations as incurred. Costs of major additions and improvements are capitalized. Goodwill Goodwill is the excess cost over the fair market value of assets acquired in connection with business acquisitions and was being amortized on the straight-line method over fifteen years, prior to October 1, 2001. On October 1, 2001, the Company adopted FAS No. 142, Goodwill and Other Intangible Assets, which changed the accounting for goodwill from an amortization method to an impairment-only approach. This statement eliminates the regularly scheduled amortization of goodwill and replaces this method with a two-step process for testing the impairment of goodwill on at least an annual basis. This approach could cause more volatility in the Company's reported net income because impairment losses, if any, could occur irregularly and in varying amounts. The Company, upon adoption of this statement, stopped amortizing existing goodwill of $3.0 million. In addition, the Company performed its initial impairment analysis of goodwill and other intangible assets and determined that the estimated fair value exceeded the carrying amount. Income Taxes Deferred tax assets and liabilities result from temporary differences in financial and income tax methods of accounting, and are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. 64 Earnings Per Share The Company provides dual presentation of basic and diluted earnings per share. Basic earnings per share is calculated utilizing net income as reported in the numerator and average shares outstanding in the denominator. The computation of diluted earnings per share differs in that the dilutive effects of any stock options are adjusted in the denominator. Stock Options The Company maintains a stock option plan for the directors, officers and employees. When the exercise price of the Company's stock options is greater than or equal to the market price of the underlying stock on the date of the grant, no compensation expense is recognized in the Company's financial statements. Pro forma net income and earnings per share are presented to reflect the impact of the stock option plan assuming compensation expense had been recognized based on the fair value of the stock options granted under the plan. The Company applies Accounting Principles Board Opinion No. 25 and related interpretations in accounting for these options. Accordingly, compensation expense is recognized on the grant date, in the amount equivalent to the intrinsic value of the options (stock price less exercise price, at measurement date). Had compensation costs for these options been determined based on the fair values at the grant dates for awards consistent with the method of FAS No. 123, there would be no effect on the Company's net income and earnings per share for 2002, 2001, and 2000 would have been insignificant. For purposes of the calculations required by FAS No. 123, the fair value of each option grant is estimated on the date of the grant using the Black-Scholes option-pricing model with the following weighted-average assumptions for grants issued in 2000, 1999 and 1998, respectively: dividend yield of 1.03 percent, 1.03 percent, and 1.85 percent, respectively; risk-free interest rates of 4.95 percent, 4.95 percent, and 6.75 percent, respectively; expected option lives of three years and expected volatility of 23.81 percent, 23.81 percent, and 18.73 percent, respectively. 65 Comprehensive Income The Company is required to present comprehensive income in a full set of general-purpose financial statements for all periods presented. Other comprehensive income is comprised exclusively of unrealized holding gains (losses) on the available for sale securities portfolio. The Company has elected to report the effects of other comprehensive income as part of the Consolidated Statement of Changes in Shareholders' Equity. Cash Flows The Company utilizes the net reporting of cash receipts and cash payments for deposit and lending activities. The Company considers amounts due from banks as cash equivalents. Reclassification of Comparative Amounts Certain items previously reported have been reclassified to conform to the current year's reporting format. Such reclassifications did not affect net income or stockholders' equity. Recent Accounting Pronouncements In August 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("FAS") No. 143, Accounting for Asset Retirement Obligations, which requires that the fair value of a liability be recognized when incurred for the retirement of a long-lived asset and the value of the asset be increased by that amount. The statement also requires that the liability be maintained at its present value in subsequent periods and outlines certain disclosures for such obligations. The adoption of this statement, which is effective January 1, 2003, is not expected to have a material effect on the Company's financial statements. In October 2001, the FASB issued FAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. FAS No. 144 supercedes FAS No. 121 and applies to all long-lived assets (including discontinued operations) and consequently amends APB Opinion No. 30, Reporting Results of Operations- Reporting the Effects of Disposal of a Segment of a Business. 66 FAS No. 144 requires that long-lived assets that are to be disposed of by sale be measured at the lower of book value or fair value less costs to sell. FAS No. 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001 and, generally, its provisions are to be applied prospectively. The adoption of this statement did not have a material effect on the Company's financial statements. In April 2002, the FASB issued FAS No. 145, Rescission of FASB Statement No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections. FAS No. 145 rescinds FAS No. 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. As a result, the criteria in APB Opinion No. 30 will now be used to classify those gains and losses. This statement also amends FAS No. 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. This statement also makes technical corrections to existing pronouncements, which are not substantive but in some cases may change accounting practice. The provisions of this statement related to the rescission of FAS No. 4 shall be applied in fiscal years beginning after May 15, 2002. Any gain or loss on extinguishments of debt that was classified as an extraordinary item in prior periods presented that does not meet the criteria in APB Opinion No. 30 for classification as an extraordinary item shall be reclassified. Early adoption of the provisions of this statement related to FAS No. 13 shall be effective for transactions occurring after May 15, 2002. All other provisions of this statement shall be effective for financial statements issued on or after May 15, 2002. Early application of this statement is encouraged. The adoption of the effective portions of this statement did not have an impact on the Company's financial position of results of operations. The adoption of the remaining portions of this statement is not expected to have an impact on the Company's financial position or results of operations. In July 2002, the FASB issued FAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. This statement replaces EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to 67 Exit an Activity (Including Certain Costs Incurred in a Restructuring). The new statement will be effective for exit or disposal activities initiated after December 31, 2002, the adoption of which is not expected to have a material effect on the Company's financial statements. On October 1, 2002, FASB issued FAS No. 147, Acquisitions of Certain Financial Institutions, effective for all business combinations initiated after October 1, 2002. This statement addresses the financial accounting and reporting for the acquisition of all or part of a financial institution, except for a transaction between two or more mutual enterprises. This statement removes acquisitions of financial institutions, other than transactions between two or more mutual enterprises, from the scope of FAS No. 72, Accounting for Certain Acquisitions of Banking or Thrift Institutions, and FASB Interpretation No. 9, Applying APB Opinions No. 16 and 17 When a Savings and Loan Association or a Similar Institution Is Acquired in a Business Combination Accounted for by the Purchase Method. The acquisition of all or part of a financial institution that meets the definition of a business combination shall be accounted for by the purchase method in accordance with FAS No. 141, Business Combinations, and FAS No. 142, Goodwill and Other Intangible Assets. This statement also provides guidance on the accounting for the impairment or disposal of acquired long-term customer- relationship intangible assets (such as depositor- and borrower- relationship intangible assets and credit cardholder intangible assets), including those acquired in transactions between two or more mutual enterprises. The adoption of this statement did not have a material effect on the Company's financial statements. On December 31, 2002, the FASB issued FAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, which amends FAS No. 123, Accounting for Stock-Based Compensation. FAS No. 148 amends the disclosure requirements of FAS No. 123 to require more prominent and more frequent disclosures in financial statements about the effects of stock- based compensation. Under the provisions of FAS No. 123, companies that adopted the preferable, fair value based method were required to apply that method prospectively for new stock option awards. This contributed to a "ramp-up" effect on stock- based compensation expense in the first few years following adoption, which caused concern for companies and investors because of the lack of consistency in reported results. To address that concern, FAS No. 148 provides two additional methods of transition that reflect an entity's full complement 68 of stock-based compensation expense immediately upon adoption, thereby eliminating the ramp-up effect. FAS No. 148 also improves the clarity and prominence of disclosures about the pro forma effects of using the fair value based method of accounting for stock-based compensation for all companies-regardless of the accounting method used-by requiring that the data be presented more prominently and in a more user-friendly format in the footnotes to the financial statements. In addition, the statement improves the timeliness of those disclosures by requiring that this information be included in interim as well as annual financial statements. The transition guidance and annual disclosure provisions of FAS No. 148 are effective for fiscal years ending after December 15, 2002, with earlier application permitted in certain circumstances. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002. In November, 2002, the FASB issued Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. This interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. This interpretation clarifies that a guarantor is required to disclose (a) the nature of the guarantee, including the approximate term of the guarantee, how the guarantee arose, and the events or circumstances that would require the guarantor to perform under the guarantee; (b) the maximum potential amount of future payments under the guarantee; (c) the carrying amount of the liability, if any, for the guarantor's obligations under the guarantee; and (d) the nature and extent of any recourse provisions or available collateral that would enable the guarantor to recover the amounts paid under the guarantee. This interpretation also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the obligations it has undertaken in issuing the guarantee, including its ongoing obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur. The objective of the initial measurement of that liability is the fair value of the guarantee at its inception. The initial recognition and initial measurement provisions of this interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor's fiscal year-end. The disclosure 69 requirements in this interpretation are effective for financial statements of interim or annual periods ending after December 15, 2002. NOTE B - PER SHARE DATA There are no convertible securities, which would affect the numerator in calculating basic and dilutive earnings per share, therefore, net income as presented on the consolidated statement of income will be used as the numerator. The following table sets forth the composition of the weighted average common shares (denominator) used in the basic and dilutive per share computation. <table> <caption> 2002 2001 2000 ---------- ---------- ---------- <s> <c> <c> <c> Weighted average common shares outstanding 3,132,252 3,130,846 3,130,178 Average treasury stock shares (99,241) (65,532) (10,638) --------- --------- --------- Weighted average common shares and common stock equivalents used to calculate basic earnings per share 3,033,011 3,065,314 3,119,540 Additional common stock equivalents (stock options) used to calculate diluted earnings per share 2,670 2,037 - --------- --------- --------- Weighted average common shares and common stock equivalents used to calculate diluted earnings per share 3,035,681 3,067,351 3,119,540 ========= ========= ========= </table> Options to purchase 20,350 shares of common stock at prices from $42.00 to $53.18 were outstanding during 2002 and 2001, and 30,350 shares at prices from $32.63 to $53.18 were outstanding during 2000, but were not included in the computation of diluted earnings per share because to do so would have been anti- dilutive. NOTE C - INVESTMENT SECURITIES The amortized cost of investment securities and their approximate fair values are as follows (in thousands): 70 <table> <caption> 2002 ---------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value --------- ---------- ---------- -------- <s> <c> <c> <c> <c> Available for Sale U.S. Government and agency securities $ 87,142 $1,856 $ - $ 88,998 State and political securities 67,319 3,596 (234) 70,681 Other debt securities 1,766 46 (2) 1,810 -------- ------ ------ -------- Total debt securities 156,227 5,498 (236) 161,489 Equity securities 12,414 2,989 (456) 14,947 -------- ------ ------- -------- $168,641 $8,487 $ (692) $176,436 ======== ====== ======= ======== Held to Maturity U.S. Government and agency securities $ 94 $ - $ - $ 94 State and political securities 796 109 - 905 Other debt securities 291 - (1) 290 -------- ------ ------- -------- $ 1,181 $ 109 $ (1) $ 1,289 ======== ====== ======= ======== <caption> 2001 ---------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value --------- ---------- ---------- -------- <s> <c> <c> <c> <c> Available for Sale U.S. Government and agency securities $ 25,851 $ 130 $ (161) $ 25,820 State and political securities 81,559 2,494 (797) 83,256 Other debt securities 817 3 (4) 816 -------- ------ ------- -------- Total debt securities 108,227 2,627 (962) 109,892 Equity securities 21,138 2,911 (1,956) 22,093 -------- ------ ------- -------- $129,365 $5,538 $(2,918) $131,985 ======== ====== ======= ======== Held to Maturity U.S. Government and agency securities $ 196 $ 7 $ - $ 203 State and political securities 796 23 (20) 799 Other debt securities 310 - - 310 -------- ------ ------- -------- $ 1,302 $ 30 $ (20) $ 1,312 ======== ====== ======= ======== </table> The amortized cost and fair value of debt securities at December 31, 2002, by contractual maturity, are shown below (in thousands). Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. 71 Held to Maturity Available for Sale ------------------ -------------------- Amortized Fair Amortized Fair Cost Value Cost Value --------- ------ --------- -------- Due in one year or less $ 300 $ 306 $ 2,017 $ 2,087 Due after one year to five years 100 100 10,377 10,654 Due after five years to ten years 141 141 27,149 27,566 Due after ten years 640 742 116,684 121,182 ------ ------ -------- -------- $1,181 $1,289 $156,227 $161,489 ====== ====== ======== ======== Total gross proceeds from sales of securities available for sale were $79,022,000, $22,156,000 and $53,301,000 for 2002, 2001 and 2000, respectively. The following table represents gross realized gains and gross realized losses on those transactions (in thousands): 2002 2001 2000 ------ ------ ------ Gross realized gains: U.S. Government and agency securities $ 204 $ 133 $ 36 State and political securities 2,234 20 170 Other Debt Securities 6 - - Equity securities 1,803 1,226 1,577 ------ ------ ------ $4,247 $1,379 $1,783 ====== ====== ====== Gross realized losses: U.S. Government and agency securities $ 125 $ 13 $ 731 State and political securities 67 149 30 Equity securities 3,822 184 753 ------ ------ ------ $4,014 $ 346 $1,514 ====== ====== ====== In 2002, the Company recorded an investment security gain of $69,000 resulting from a business combination where the Company received the common stock of the acquirer in a non- monetary exchange. This gain is included in the above table. 72 A charge of $270,000 was recorded in 2002 to recognize other than temporary declines in the value of marketable equity securities. This loss is included in the above table. Investment securities with a carrying value of approximately $34,914,000 and $36,539,000 at December 31, 2002 and 2001, respectively, were pledged to secure certain deposits, security repurchase agreements, and for other purposes as required by law. There is no concentration of investments that exceed ten percent of shareholders' equity for any individual issuer, excluding those guaranteed by the U.S. Government. NOTE D - LOANS Major loan classifications loans are summarized as follows (in thousands): <table> <caption> 2002 --------------------------------------------------- Past Due Past Due 30 to 90 90 Days Non- Current Days or More Accrual Total -------- -------- -------- ------- -------- <s> <c> <c> <c> <c> <c> Commercial and agricultural $ 22,652 $ 769 $ 7 $280 $ 23,708 Real estate mortgage: Residential 136,819 2,752 175 526 140,272 Commercial 73,988 504 1,006 65 75,563 Construction 3,335 21 - - 3,356 Installment loans to individuals 14,593 316 37 - 14,946 -------- ------ ------ ---- -------- 251,387 $4,362 $1,225 $871 257,845 ====== ====== ==== Less: Allowance for loan losses 2,953 2,953 -------- -------- Loans, net $248,434 $254,892 ======== ======== <caption> 2001 --------------------------------------------------- Past Due Past Due 30 to 90 90 Days Non- Current Days or More Accrual Total -------- -------- -------- ------- -------- <s> <c> <c> <c> <c> <c> Commercial and agricultural $ 22,233 $ 334 $ 36 $ 26 $ 22,629 Real estate mortgage: Residential 136,361 3,311 296 255 140,223 Commercial 64,051 2,712 - - 66,763 Construction 4,042 35 - - 4,077 Installment loans to individuals 17,583 342 6 - 17,931 -------- ------ ------ ---- -------- 244,270 $6,734 $ 338 $281 251,623 ====== ====== ==== Less: Allowance for loan losses 2,927 2,927 -------- -------- Loans, net $241,343 $248,696 ======== ======== </table> 73 Loans on which the accrual of interest has been discontinued or reduced amounted to approximately $871,000 and $281,000 at December 31, 2002 and 2001, respectively. If interest had been recorded at the original rate on those loans, such income would have approximated $24,000, $28,000, and $86,000 for the years ended December 31, 2002, 2001 and 2000, respectively. Interest income on such loans, which is recorded as received, amounted to approximately $17,000, $19,000, and $45,000 for the years ended December 31, 2002, 2001 and 2000, respectively. Changes in the allowance for loan losses for the years ended December 31, are as follows (in thousands): 2002 2001 2000 ------- ------- ------- Balance, beginning of year $2,927 $2,879 $2,823 Provision charged to operations 365 372 286 Loans charged off (402) (358) (269) Recoveries 63 34 39 ------ ------ ------ Balance, end of year $2,953 $2,927 $2,879 The Company had no concentration of loans to borrowers engaged in similar businesses or activities which exceed five percent of total assets at December 31, 2002 or December 31, 2001. The Company grants commercial, industrial, residential, and installment loans to customers throughout North-central Pennsylvania. Although the Company has a diversified loan portfolio at December 31, 2002 and 2001, a substantial portion of its debtors' ability to honor their contracts is dependent on the economic conditions within this region. NOTE E - BANK PREMISES AND EQUIPMENT Major classifications of Bank premises and equipment are summarized as follows at December 31, (in thousands): 74 2002 2001 ------- ------- Land $ 566 $ 566 Bank premises 4,855 4,668 Furniture and equipment 6,001 5,292 Leasehold improvements 842 834 ------- ------- Total 12,264 11,360 Less accumulated depreciation 7,408 6,882 ------- ------- Net $ 4,856 $ 4,478 ======= ======= Depreciation charges to operations for the years ended 2002, 2001 and 2000 was $526,000, $489,000 and $551,000, respectively. NOTE F - GOODWILL A summary of goodwill is as follows: 2002 2001 ------- ------- Gross carrying amount $3,308 $3,308 Less accumulated amortization (276) (276) ------ ------ Net carrying amount $3,032 $3,032 Amortization expense amounted to $221,000 for 2001. The gross carrying amount of goodwill was tested for impairment in the second quarter. The Company performed its initial impairment analysis of goodwill noting that the estimated fair value exceeded the carrying amount. The following tables sets forth a comparison of net income and basic and diluted earnings per share adjusted for the adoption of FAS No. 142, Goodwill and Other Intangible Asset:. 75 2002 2001 2000 ------ ------ ------ (Dollars in thousands, except per share amounts) Goodwill amortization $ - $ 221 $ 55 Net income $8,886 $7,742 $6,566 Addback: Goodwill amortization (net of tax) - 146 36 ------ ------ ------ Adjusted net income $8,886 $7,888 $6,602 ====== ====== ====== Basic earnings per share: Net income $ 2.93 $ 2.53 $ 2.10 Goodwill amortization - 0.04 0.01 ------ ------ ------ Adjusted basic earnings per share $ 2.93 $ 2.57 $ 2.11 ====== ====== ====== Diluted earnings per share: Net income $ 2.93 $ 2.53 $ 2.10 Goodwill amortization - 0.04 0.01 ------ ------ ------ Adjusted diluted earnings per share $ 2.93 $ 2.57 $ 2.11 ====== ====== ====== NOTE G - DEPOSITS Time deposits of $100,000 or more totaled approximately $29,126,000 on December 31, 2002 and $32,646,000 on December 31, 2001. Interest expense related to such deposits was approximately $1,098,000, $1,913,000, and $1,571,000 for the years ended December 31, 2002, 2001 and 2000, respectively. Maturities on time deposits of $100,000 or more are as follows: 2002 ------- Three months or less $ 6,770 Three months to six months 7,436 Six months to twelve months 6,093 Over twelve months 8,827 ------- Total $29,126 ======= 76 Time deposits at December 31, 2002 mature as follows: 2003 - - $85,397,000; 2004 - $20,365,000; 2005 - $15,168,000; 2006 - $10,627,000; 2007 - $1,169,000; thereafter - $1,054,000. 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): 2002 2001 -------- -------- Open Repo Plus: Balance at year end $ 1,840 $ 8,830 Maximum amount outstanding at any month end 8,510 16,861 Average balance outstanding during the year 1,646 4,425 Weighted-average interest rate: At year end 1.31% 1.20% Paid during the year 1.96% 3.48% Repurchase Agreements: Balance at year end $11,723 $10,275 Maximum amount outstanding at any month end 20,870 18,825 Average balance outstanding during the year 14,819 15,697 Weighted-average interest rate: At year end 2.68% 3.76% Paid during the year 3.17% 4.77% NOTE I - OTHER BORROWINGS Other borrowings are comprised of advances from the FHLB. A schedule of other borrowings by maturity as of December 31, 2002 and 2001 is summarized as follows (in thousands): 77 <table> <caption> Interest Description Maturity Rate 2002 2001 - -------------------------- ----------------- --------- ------- ------- <s> <c> <c> <c> <c> FHLB Borrowing April 30, 2007 (7) 4.49% $ 5,000 $ - Convertible Select Advance April 7, 2008 (1) 5.54% 10,000 10,000 Convertible Select Advance June 16, 2008 (2) 5.56% 10,000 10,000 Convertible Select Advance February 26, 2009 (3) 5.06% 5,000 5,000 Convertible Select Advance August 10, 2010 (4) 6.65% 5,000 5,000 Convertible Select Advance October 15, 2011 (5) 4.72% 5,000 5,000 FHLB Borrowing October 17, 2011 6.92% 500 500 Convertible Select Advance November 5, 2011 (6) 4.25% 5,000 5,000 FHLB Borrowing October 10, 2012 (8) 3.68% 5,000 - FHLB Borrowing June 24, 2013 5.87% 528 528 FHLB Borrowing May 25, 2015 6.92% 750 750 ------- ------- Total $51,778 $41,778 ======= ======= </table> The Bank maintains a credit arrangement, which includes a revolving line of credit with FHLB. Under this credit arrangement, the Bank has a remaining borrowing capacity of approximately $153,147,000 at December 31, 2002, is subject to annual renewal, and typically incurs no service charges. Under terms of a blanket agreement, collateral for the FHLB borrowings must be secured by certain qualifying assets of the Bank which consist principally of first mortgage loans. (1) The FHLB has the option to convert this interest rate to an adjustable rate based on the three-month LIBOR at the five- year anniversary date of the borrowings origination, which will occur in the third quarter of 2003. (2) The FHLB has the option to convert this interest rate to an adjustable rate based on the three-month LIBOR at the five- year anniversary date of the borrowings origination, which will occur in the second quarter of 2003. (3) The FHLB has the option to convert this interest rate to an adjustable rate based on the three-month LIBOR at the five- year anniversary date of the borrowings origination, which will occur in the first quarter of 2004. (4) The FHLB has the option to convert this interest rate to an adjustable rate based on the three-month LIBOR at the five- year anniversary date of the borrowings origination, which will occur in the third quarter of 2005. 78 (5) The FHLB has the option to convert this interest rate to an adjustable rate based on the three-month LIBOR at the two- year anniversary date of the borrowings origination, which will occur in the fourth quarter of 2003. (6) The FHLB has the option to convert this interest rate to an adjustable rate based on the three-month LIBOR at the three-year anniversary date of the borrowings origination, which will occur in the fourth quarter of 2004. (7) The FHLB has the option to convert this interest rate to an adjustable rate based on the three-month LIBOR at the one- year anniversary date of the borrowings origination, which will occur in the second quarter of 2003. (8) The FHLB has the option to convert this interest rate to an adjustable rate based on the three-month LIBOR at the two- year anniversary date of the borrowings origination, which will occur in the fourth quarter of 2004. NOTE J - INCOME TAXES The following temporary differences gave rise to the net deferred tax asset at December 31, 2002 and 2001 (in thousands): 2002 2001 -------- ------ Deferred tax asset: Allowance for loan losses $ 693 $ 668 Deferred compensation 337 303 Contingencies 20 55 Pension 371 348 Loan fees and costs 261 215 Investment securities allowance 92 - ------- ------ Total 1,774 1,589 ------- ------ Deferred tax liability: Bond accretion 31 25 Depreciation 192 129 Unrealized gains on available for sale securities 2,650 891 ------- ------ Total 2,873 1,045 ------- ------ Deferred tax asset (liability), net $(1,099) $ 544 ======= ====== 79 No valuation allowance was established at December 31, 2002 and 2001, in the view of the Company's ability to carry back taxes paid in previous years and certain tax strategies, coupled with the anticipated future taxable income as evidenced by the Company's earning potential. The provision for income taxes is comprised of the following (in thousands): Year Ended December 31, --------------------------- 2002 2001 2000 ------- ------- ------- Currently payable $2,363 $2,117 $1,730 Deferred benefit (116) (139) (111) ------ ------ ------ Total provision $2,247 $1,978 $1,619 ====== ====== ====== The effective federal income tax rate for the years ended December 31, 2002, 2001, and 2000 was 20.2 percent, 20.3 percent, and 19.8 percent, respectively. A reconciliation between the expected income tax and rate and the effective income tax and rate on income before income tax provision follows (in thousands): <table> <caption> 2002 2001 2000 ------------------ ------------------ ----------------- Amount % Amount % Amount % -------- ------- -------- ------- ------- ------- <s> <c> <c> <c> <c> <c> <c> Provision at expected rate $ 3,785 34.0 % $ 3,305 34.0 % $2,783 34.0 % Decrease in tax resulting from: Tax-exempt income (1,367) (12.3) (1,103) (11.4) (837) (10.2) Other, net (171) (1.5) (224) (2.3) (327) (4.0) ------- ----- ------- ----- ------ ----- Effective income tax and rates $ 2,247 20.2 % $ 1,978 20.3 % $1,619 19.8 % ======= ===== ======= ===== ====== ===== </table> 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 80 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): 2002 2001 ------- ------- Change in benefit obligation: Benefit obligation at beginning of year $ 4,976 $ 3,935 Service cost 381 298 Interest cost 342 271 Amendments 97 - Actuarial adjustment 753 524 Benefits paid (76) (52) ------- ------- Benefit obligation at end of year 6,473 4,976 ------- ------- Change in plan assets: Fair value of plan assets at beginning of year 3,115 3,597 Actual loss on plan assets (407) (430) Employer contribution 499 - Benefits paid (76) (52) ------- ------- Fair value of plan assets at end of year 3,131 3,115 ------- ------- Funded status (3,342) (1,861) ------- ------- Unrecognized net actuarial loss 1,996 609 Unrecognized transition asset (24) (27) Unrecognized prior service cost 280 209 ------- ------- Accrued benefit payable $(1,090) $(1,070) ======= ======= Weighted-average assumptions as of December 31: Discount rate 6.00% 6.50% Expected return on plan assets 8.00% 8.00% Rate of compensation increase 5.00% 5.00% 81 2002 2001 2000 ------ ------ ------ Components of net periodic benefit cost: Service cost $ 381 $ 298 $ 256 Interest cost 342 271 242 Expected return on plan assets (246) (286) (291) Amortization of transition asset (3) (3) (3) Amortization of prior service cost 26 20 20 Recognized net actuarial (gain) loss 19 (15) (33) ----- ----- ----- Net periodic benefit cost $ 519 $ 285 $ 191 ===== ===== ===== The plan assets are invested primarily in bonds, stocks, equity funds, and mortgages under the control of the plan's trustees as of December 31, 2002. 401(k) Savings Plan The Company also offers a 401(k) savings plan in which eligible participating employees may elect to contribute up to a maximum percentage allowable not to exceed the limits of Code Sections 401(k), 404, and 415. The Company may make matching contributions equal to a discretionary percentage to be determined by the Company. Participants are at all times fully vested in their contributions and vest over a period of five years in the employer contribution. Contribution expense was approximately $80,000, $65,000, and $67,000 for the years ended December 31, 2002, 2001, and 2000, respectively. Deferred Compensation Plan The Company has a deferred compensation plan whereby participating directors elected to forego directors' fees for a period of five years. Under this plan, the Company will make payments for a ten-year period beginning at age 65 in most cases or at death, if earlier, at which time payments would be made to their designated beneficiaries. To fund benefits under the deferred compensation plan, the Company has acquired corporate-owned life insurance policies on the lives of the participating directors for which insurance 82 benefits are payable to the Company. The total expense charged to other expenses was $98,000, $67,000 and $66,000 for the years ended December 31, 2002, 2001 and 2000, respectively. Benefits paid under the plan were approximately $51,000 in 2002 and $51,000 in 2001 and $53,000 in 2000. 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: 2002 2001 ----------------- ------------------- Weighted- Weighted- average average Exercise Exercise Shares Price Shares Price ------ -------- ------- --------- Outstanding, beginning of year 41,501 $38.60 42,301 $37.87 Granted - - - - Exercised 5,188 25.98 800 25.98 Forfeited 5,963 25.98 - - ------ ------ ------ ------ Outstanding, end of year 30,350 $42.56 41,501 $38.10 ====== ====== Options exercisable at year-end 30,350 $42.56 41,501 $38.10 ====== ====== 83 The following table summarizes information about nonqualified and incentive stock options outstanding at December 31, 2002: Outstanding Exercisable ----------------------------- ------------------- Average Average Exercise Average Exercise Exercise Price Shares Life Price Shares Price - -------- ------ ------- -------- ------ -------- $53.18 9,900 6 $53.18 9,900 $53.18 $42.00 10,450 7 $42.00 10,450 $42.00 $32.63 10,000 8 $32.63 10,000 $32.63 NOTE M - RELATED PARTY TRANSACTIONS Certain directors and executive officers of the Company and the Bank, including their immediate families and companies in which they are principal owners (more than ten percent), are indebted to the Company. Such indebtedness was incurred in the ordinary course of business on the same terms and at those rates prevailing at the time for comparable transactions with others. A summary of loan activity with executive officers, directors, principal shareholders, and associates of such persons is listed below (in thousands): Beginning Ending Year Balance Additions Payments Balance - ---- --------- --------- -------- ------- 2002 $5,192 $3,234 $1,641 $6,785 NOTE N - COMMITMENTS AND CONTINGENT LIABILITIES The following schedule of future minimum rental payments under operating leases with noncancellable terms in excess of one year as of December 31, 2002 (in thousands): 84 Year Ending December 31, ------------------------ 2003 $ 237 2004 218 2005 205 2006 179 2007 149 Thereafter 76 ------ Total $1,064 ====== Total rental expense for all operating leases for the years ended December 31, 2002, 2001 and 2000 approximated $258,000, $270,000 and $213,000, respectively. The Company is subject to lawsuits and claims arising out of its business. In the opinion of management, after review and consultation with counsel, any proceedings that may be assessed will not have a material adverse effect on the consolidated financial position of the Company. 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. 85 Financial instruments whose contract amounts represent credit risk are as follows at December 31 (in thousands): 2002 2001 ------- ------- Commitments to extend credit $29,497 $29,490 Standby letters of credit $ 741 $ 348 Commitments to extend credit are legally binding agreements to lend to customers. Commitments generally have fixed expiration dates or other termination clauses and may require payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future liquidity requirements. The Company evaluates each customer's credit worthiness on a case- by-case basis. The amount of collateral obtained, if deemed necessary by the Company, on extension of credit is based on management's credit assessment of the counterparty. Standby letters of credit represent conditional commitments issued by the Company to guarantee the performance of a customer to a third party. These instruments are issued primarily to support bid or performance related contracts. The coverage period for these instruments is typically a one year period with an annual renewal option subject to prior approval by management. Fees earned from the issuance of these letters are recognized over the coverage period. For secured letters of credit, the collateral is typically Bank deposit instruments or customer business assets. NOTE P - CAPITAL REQUIREMENTS Federal regulations require the Company and the Bank to maintain minimum amounts of capital. Specifically, each is required to maintain certain minimum dollar amounts and ratios of Total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average total assets. In addition to the capital requirements, the Federal Deposit Insurance Corporation Improvement Act ("FDICIA") established five capital categories ranging from "well capitalized" to "critically undercapitalized." Should any institution fail to meet the requirements to be considered "adequately capitalized," it would become subject to a series of increasingly restrictive regulatory actions. 86 As of December 31, 2002 and 2001, the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be classified as a well capitalized financial institution, Total risk-based, Tier 1 risk-based and Tier 1 leverage capital ratios must be at least 10%, 6%, and 5%, respectively. 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): 2002 2001 --------------- --------------- Amount Ratio Amount Ratio ------- ----- ------- ----- Total Capital (to Risk-weighted Assets) Actual $58,953 22.2% $53,281 20.1% For Capital Adequacy Purposes 21,236 8.0 21,208 8.0 To Be Well Capitalized 26,545 10.0 26,510 10.0 Tier I Capital (to Risk-weighted Assets) Actual $54,915 20.7% $49,936 18.8% For Capital Adequacy Purposes 10,618 4.0 10,604 4.0 To Be Well Capitalized 15,927 6.0 15,906 6.0 Tier I Capital (to Average Assets) Actual $54,915 12.0% $49,936 12.6% For Capital Adequacy Purposes 18,310 4.0 15,880 4.0 To Be Well Capitalized 22,888 5.0 19,805 5.0 The Bank's actual capital amounts and ratios are presented in the following table (in thousands): 87 2002 2001 --------------- --------------- Amount Ratio Amount Ratio ------- ----- ------- ----- Total Capital (to Risk-weighted Assets) Actual $47,232 18.3% $41,409 16.3% For Capital Adequacy Purposes 20,616 8.0 20,390 8.0 To Be Well Capitalized 25,770 10.0 25,488 10.0 Tier I Capital (to Risk-weighted Assets) Actual $43,723 17.0% $38,100 15.0% For Capital Adequacy Purposes 10,308 4.0 10,195 4.0 To Be Well Capitalized 15,462 6.0 15,293 6.0 Tier I Capital (to Average Assets) Actual $43,723 9.7% $38,100 9.7% For Capital Adequacy Purposes 17,970 4.0 15,727 4.0 To Be Well Capitalized 22,462 5.0 19,659 5.0 NOTE Q - REGULATORY RESTRICTIONS The Pennsylvania Banking Code restricts the availability of capital funds for payment of dividend by all state-chartered banks to the additional paid in capital of the Bank. Accordingly, at December 31, 2002, the balance in the additional paid in capital account totaling approximately $11,700,000 is unavailable for dividends. The Bank is subject to regulatory restrictions, which limit its ability to loan funds to Penns Woods Bancorp, Inc. At December 31, 2002, the regulatory lending limit amounted to approximately $4,676,000. Cash and Due from Banks Included in cash and due from banks are reserves required by the district Federal Reserve Bank of $1,152,000 and $1,523,000 at December 31, 2002 and 2001. The required reserves are computed by applying prescribed ratios to the classes of 88 average deposit balances. These are held in the form of cash on hand and a balance maintained directly with the Federal Reserve Bank. NOTE R - ACQUISITION On October 1, 2000, the Bank acquired The M Group in a business acquisition accounted for as a purchase. The M Group is engaged in the insurance business. The results of operations of The M Group are included in the accompanying consolidated financial statements since the date of acquisition. The total cost of the acquisition was $3,321,000, which exceeds the fair value of the net assets of The M Group by $3,308,000 which was allocated to goodwill. NOTE S - ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS The Company is required to disclose estimated fair values for its financial instruments. Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. Also, it is the Company's general practice and intention to hold most of its financial instruments to maturity and not to engage in trading or sales activities. Because no market exists for a significant portion of the Company's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions can significantly affect the estimates. Estimated fair values have been determined by the Company using historical data and an estimation methodology suitable for each category of financial instruments. The estimated fair value of the Company's investment securities is described in Note A. The Company's fair value estimates, methods, and assumptions are set forth below for the Company's other financial instruments. As certain assets and liabilities, such as deferred tax assets, premises and equipment, and many other operational 89 elements of the Company, are not considered financial instruments but have value, this estimated fair value of financial instruments would not represent the full market value of the Company. The estimated fair values of the Company's financial instruments are as follows: 2002 2001 ------------------- ------------------- Carrying Fair Carrying Fair Value Value Value Value -------- -------- -------- -------- Financial assets: Cash and due from banks $ 11,731 $ 11,731 $ 14,844 $ 14,844 Investment securities: Available for sale 176,436 176,436 131,985 131,985 Held to maturity 1,181 1,289 1,302 1,312 Loans held for sale 2,651 2,651 3,993 3,993 Loans, net 254,892 267,563 248,696 257,062 Bank-owned life insurance 8,537 8,537 8,126 8,126 Regulatory stock 3,963 3,963 2,875 2,875 Accrued interest receivable 2,460 2,460 2,685 2,685 -------- -------- -------- -------- Total $461,851 $474,630 $414,506 $422,882 ======== ======== ======== ======== Financial liabilities: Interest-bearing deposits $272,787 $276,881 $249,873 $251,955 Noninterest-bearing deposits 67,061 67,061 55,277 55,277 Short-term borrowings 13,563 13,563 19,105 19,105 Other borrowings 51,778 56,384 41,778 42,369 Accrued interest payable 1,092 1,092 1,190 1,190 -------- -------- -------- -------- Total $406,281 $414,981 $367,223 $369,896 ======== ======== ======== ======== Cash and due from banks, loans held for sale, regulatory stock, accrued interest receivable, short-term borrowings, and accrued interest payable: The fair value is equal to the carrying value. Investment securities: The fair value of investment securities available for sale and held to maturity is equal to the available quoted market price. If no quoted market price is available, fair value is estimated using the quoted market price for similar securities. 90 Loans: Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, commercial real estate, residential mortgage, credit card, and other consumer. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories. The fair value of performing loans, except residential mortgage and credit card loans, is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The estimate of maturity is based on the Company's historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions. For performing residential mortgage loans, fair value is estimated by discounting contractual cash flows adjusted for prepayment estimates using discounted rates based on secondary market sources adjusted to reflect differences in servicing and credit costs. For credit card loans, cash flows and maturities are estimated based on contractual interest rates and historical experience and are discounted using secondary market rates adjusted for differences in servicing and credit costs. Fair value for significant nonperforming loans is based on recent external appraisals. If appraisals are not available, estimated cash flows are discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows, and discounted rates are judgmentally determined using available market information and specific borrower information. Bank-Owned Life Insurance: The fair value is equal to the Cash Surrender Value of life insurance policies. 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 91 payable on demand as of December 31, 2002 and 2001. The fair value of certificates of deposit is based on the discounted value of contractual cash flows. The fair value estimates above do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market, commonly referred to as the core deposit intangible. Other Borrowings: The fair value of other borrowings is based on the discounted value of contractual cash flows. Commitments to Extend Credit, Standby Letters of Credit, and Financial Guarantees Written: There is no material difference between the notional amount and the estimated fair value of off-balance sheet items at December 31, 2002 and 2001 respectively. The contractual amounts of unfunded commitments and letters of credit are presented in Note O. NOTE T - PARENT COMPANY ONLY FINANCIAL STATEMENTS Condensed financial information for Penns Woods Bancorp, Inc. follows: CONDENSED BALANCE SHEET, DECEMBER 31, 2002 2001 ------- ------- (in thousands) ASSETS Cash $ 481 $ 151 Investment in subsidiaries: Bank 51,019 43,371 Nonbank 11,760 11,938 Other assets 20 29 ------- ------- Total Assets $63,280 $55,489 ======= ======= 92 LIABILITIES AND SHAREHOLDERS' EQUITY Other liabilities $ 138 $ 237 Shareholders' equity 63,142 55,252 ------- ------- Total Liabilities and Shareholders' Equity $63,280 $55,489 ======= ======= CONDENSED STATEMENT OF INCOME, FOR THE YEARS ENDED DECEMBER 31, 2002 2001 2000 ------- ------- ------- (in thousands) OPERATING INCOME Dividends from subsidiaries $4,878 $5,984 $6,220 Equity in undistributed net income of subsidiaries 4,121 1,899 443 Other income - - 2 OPERATING EXPENSES (113) (141) (99) ------ ------ ------ NET INCOME $8,886 $7,742 $6,566 ====== ====== ====== CONDENSED STATEMENT OF CASH FLOWS, FOR THE YEARS ENDED DECEMBER 31, <table> <caption> 2002 2001 2000 -------- -------- -------- (in thousands) <s> <c> <c> <c> OPERATING ACTIVITIES Net income $ 8,886 $ 7,742 $ 6,566 Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed net income of subsidiaries (4,121) (1,899) (443) Other, net (23) (26) 21 ------- ------- ------- Net cash provided by operating activities 4,742 5,817 6,144 ------- ------- ------- INVESTING ACTIVITIES Additional investment in subsidiaries - (276) (1,752) ------- ------- ------- FINANCING ACTIVITIES Dividends paid (4,124) (3,729) (3,426) Proceeds from exercise of stock options 113 21 65 Purchase of treasury stock (401) (1,838) (902) ------- ------- ------- Net cash used in financing activities (4,412) (5,546) (4,263) ------- ------- ------- NET INCREASE (DECREASE) IN CASH 330 (5) 129 CASH, BEGINNING OF YEAR 151 156 27 ------- ------- ------- CASH, END OF YEAR $ 481 $ 151 $ 156 ======= ======= ======= </table> 93 NOTE U - CONSOLIDATED QUARTERLY FINANCIAL DATA (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE DATA) <table> <caption> FOR THE THREE MONTHS ENDED ---------------------------------------- March June September December 2002 31 30 30 31 - ---------------------------------- ------- ------- --------- -------- <s> <c> <c> <c> <c> Interest income $7,076 $7,199 $7,399 $7,430 Interest expense 2,719 2,740 2,715 2,672 ------ ------ ------ ------ Net interest income 4,357 4,459 4,684 4,758 Provision for loan losses 105 80 90 90 Other income 1,401 1,317 1,231 1,271 Securities gains (losses), net (119) (72) 281 143 Other expenses 2,952 3,056 3,070 3,135 ------ ------ ------ ------ Income before income tax provision 2,582 2,568 3,036 2,947 Income tax provision 485 528 660 574 ------ ------ ------ ------ Net income $2,097 $2,040 $2,376 $2,373 ====== ====== ====== ====== Earnings per share - basic $ 0.69 $ 0.67 $ 0.78 $ 0.79 Earnings per share - diluted $ 0.69 $ 0.67 $ 0.78 $ 0.79 <caption> FOR THE THREE MONTHS ENDED ---------------------------------------- March June September December 2001 31 30 30 31 - ---------------------------------- ------- ------- --------- -------- <s> <c> <c> <c> <c> Interest income $7,103 $7,150 $7,229 $7,254 Interest expense 3,293 3,197 3,055 2,936 ------ ------ ------ ------ Net interest income 3,810 3,953 4,174 4,318 Provision for loan losses 93 93 93 93 Other income 907 906 1,058 1,205 Securities gains, net 135 211 369 318 Other expenses 2,684 2,739 2,796 3,053 ------ ------ ------ ------ Income before income tax provision 2,075 2,238 2,712 2,695 Income tax provision 391 432 586 569 ------ ------ ------ ------- Net income $1,684 $1,806 $2,126 $2,126 ====== ====== ====== ======= Earnings per share - basic $ 0.55 $ 0.58 $ 0.70 $ 0.70 Earnings per share - diluted $ 0.55 $ 0.58 $ 0.70 $ 0.70 </table> 94 ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None 95 PART III ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information appearing in the Proxy Statement under the caption "Election of Directors" is incorporated herein by reference. (a) Identification of directors. The information appearing under the caption "Election of Directors" in the Company's Proxy Statement dated March 21, 2003 (at page 4 thereto) is incorporated herein by reference. ITEM 11 EXECUTIVE COMPENSATION Information appearing under the caption "Executive Compensation" in the Company's Proxy Statement (at page 5 thereto) is incorporated herein by reference. ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS The information appearing under the caption "Principal Beneficial Owners of the Corporation's Common Stock" in the Company's Proxy Statement (at page 2 thereto) is incorporated herein by reference. 96 Equity Compensation Plan Information <table> <caption> Number of securities remaining Number of available for future securities to be Weighted- issuance under issued upon average equity compensation exercise of exercise of plans (excluding outstanding options, outstanding options, securities reflected warrants and rights warrants and rights in column (a)) Plan Category (a) (b) (c) - ------------- -------------------- -------------------- --------------------- <s> <c> <c> <c> Equity compensation plans approved by security holders 30,350 $ 42.56 79,650 Equity compensation plans not approved by security holders - - - ------- ------- ------- Total 30,350 $ 42.56 79,650 </table> ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There have been no material transactions between the Company and the Bank, nor any material transactions proposed, with any Director or Executive Officer of the Company and the Bank, or any associate of the foregoing persons. The Company and the Bank have had, and intend to continue to have, banking and financial transactions in the ordinary course of business with Directors and Officers of the Company and the Bank and their associates on comparable terms and with similar interest rates as those prevailing from time to time for other customers of the Company and the Bank. Total loans outstanding from the Bank at December 31, 2002 to the Company's and the Bank's Officers and Directors as a group and members of their immediate families and companies in which they had an ownership interest of 10% or more was $6,785,000 or approximately 10.7% of the total equity capital of the Company. Loans to such persons were made in the ordinary course of business, were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons, and did not involve more than the normal risk of collectability or present other unfavorable features. See also the information appearing in footnote L to the Consolidated Financial Statements included elsewhere in the Annual Report. 97 ITEM 14 CONTROLS AND PROCEDURES Within the 90 days prior to the date of this Form 10-K, the Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's President and Chief Executive Officer along with the Company's Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Company's President and Chief Executive Officer along with the Company's Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's periodic SEC filings. There have been no significant changes in the Company's internal controls or in other factors which could significantly affect internal controls subsequent to the date the Company carried out its evaluation. 98 PART IV ITEM 15 EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Financial Statements 1. The following consolidated financial statements and reports are set forth in Item 8: Report of Independent Auditors Consolidated Balance Sheet Consolidated Statement of Income Consolidated Statement of Changes in Shareholders' Equity Consolidated Statement of Cash Flows Notes to the Consolidated Financial Statements 2. The following schedule is submitted herewith: I. Indebtedness of Related Parties The schedules not included are omitted because the required matter or conditions are not present, the data is insignificant or the required information is submitted as part of the consolidated financial statements and notes thereto. (b) Reports on Form 8-K None. (c) Exhibits: (3)(i) Articles of Incorporation of the Registrant, as presently in effect (incorporated by reference to Exhibit 3.1 of the Registrant's Registration Statement on Form S-4, No. 333-65821). (3)(ii) Bylaws of the Registrant as presently in effect (incorporated by reference to Exhibit 3.2 of the Registrant's Registration Statement on Form S-4, No. 333-65821). 99 (10)(i) Employment Agreement, dated August 29, 1991, between Jersey Shore State Bank and Ronald A. Walko incorporated by reference to Exhibit 10.3 of the Registrant's Registration Statement on Form S-4, No. 333-65821).* (10)(ii) Employment Agreement, dated November 5, 1984, between Jersey Shore State Bank and Hubert A. Valencik (incorporated by reference to Exhibit (10)(iii) of the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 2000).* (10)(iii) Employee Severance Benefit Plan, dated May 30, 1996, for Ronald A. Walko (incorporated by reference to Exhibit 10.4 of the Registrant's Registration Statement on Form S-4, No. 333- 65821).* (10)(iv) Employee Severance Benefit Plan, dated May 30, 1996, for Hubert A. Valencik (incorporated by reference to Exhibit (10)(v) of the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 2000).* (10)(v) Penns Woods Bancorp, Inc. 1998 Stock Option Plan (incorporated by reference to Exhibit 10.1 of the Registrant's Registration Statement on Form S-4, No. 333-65821). (21) Subsidiaries of the Registrant. (23) Consent of Independent Certified Public Accountants. (99)(i) Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (99)(ii) Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. * Denotes compensatory plan or arrangement. 100 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. March 11, 2003 PENNS WOODS BANCORP, INC. BY: /s/ Ronald A. Walko ------------------------------- Ronald A. Walko, President and Chief Executive Officer Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: /s/ Ronald A. Walko - ----------------------------- Ronald A. Walko President, Chief March 11, 2003 Executive Officer and Director /s/ Sonya E. Scott - ----------------------------- Sonya E. Scott Principal March 11, 2003 Accounting Officer and Principal Financial Officer /s/ Phillip H. Bower - ----------------------------- Phillip H. Bower Director March 11, 2003 /s/ Lynn S. Bowes - ----------------------------- Lynn S. Bowes Director March 11, 2003 /s/ Michael J. Casale, Jr. - ----------------------------- Michael J. Casale, Jr. Director March 11, 2003 101 /s/ H. Thomas Davis, Jr. - ----------------------------- H. Thomas Davis, Jr. Director March 11, 2003 /s/ James M. Furey II - ----------------------------- James M. Furey II Director March 11, 2003 /s/ Jay H. McCormick - ----------------------------- Jay H. McCormick Director March 11, 2003 /s/ R. Edward Nestlerode, Jr. - ----------------------------- R. Edward Nestlerode, Jr. Director March 11, 2003 /s/ James E. Plummer - ----------------------------- James E. Plummer Director March 11, 2003 /s/ William H. Rockey - ----------------------------- William H. Rockey Senior Vice March 11, 2003 President and Director 102 CERTIFICATIONS I, Ronald A. Walko, Chief Executive Officer of Penns Woods Bancorp, Inc. (the "Company"), certify that: 1. I have reviewed this annual report on Form 10-K of Penns Woods Bancorp, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The Company's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d- 14) for the Company and have: (a) designed such disclosure controls and procedures to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) evaluated the effectiveness of the Company's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and (c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The Company's other certifying officer and I have disclosed, based on our most recent evaluation, to the Company's auditors and the audit committee of Company's Board of Directors: 103 (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the Company's ability to record, process, summarize and report financial data and have identified for the Company's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Company's internal controls; and 6. The Company's other certifying officer and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 11, 2003 /s/ Ronald A. Walko ---------------------------------- Ronald A. Walko Chief Executive Officer 104 I, Sonya E. Scott, Chief Financial Officer of Penns Woods Bancorp, Inc. (the "Company"), certify that: 1. I have reviewed this annual report on Form 10-K of Penns Woods Bancorp, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The Company's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d- 14) for the Company and have: (a) designed such disclosure controls and procedures to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) evaluated the effectiveness of the Company's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and (c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 4. The Company's other certifying officer and I have disclosed, based on our most recent evaluation, to the Company's auditors and the audit committee of Company's Board of Directors: (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the 105 Company's ability to record, process, summarize and report financial data and have identified for the Company's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Company's internal controls; and 6. The Company's other certifying officer and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 11, 2003 /s/ Sonya E. Scott ---------------------------------- Sonya E. Scott Chief Financial Officer 106 EXHIBIT INDEX (21) Subsidiaries of the Registrant. (23) Consent of Independent Certified Public Accountants. (99)(i) Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (99)(ii) Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 107