Penseco Financial Services (PFNS) 10-Q 2012 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2012

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number 000-23777

PENSECO FINANCIAL SERVICES CORPORATION

Incorporated pursuant to the laws of Pennsylvania

Internal Revenue Service — Employer Identification No. 23-2939222

150 North Washington Avenue, Scranton, Pennsylvania 18503-1848

(570) 346-7741

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer	¨	Accelerated filer	x
Non-accelerated filer	¨  (Do not check if a smaller reporting company)	Smaller reporting company	¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

The total number of shares of the registrant’s Common Stock, $0.01 par value, outstanding on November 1, 2012 was 3,276,079.

PENSECO FINANCIAL SERVICES CORPORATION

	Page
Part I — FINANCIAL INFORMATION
Item 1. Unaudited Financial Statements - Consolidated
Balance Sheets:
September 30, 2012		3
December 31, 2011		3
Statements of Income:
Three Months Ended September 30, 2012		4
Three Months Ended September 30, 2011		4
Nine Months Ended September 30, 2012		5
Nine Months Ended September 30, 2011		5
Statements of Comprehensive Income:
Three Months Ended September 30, 2012		6
Three Months Ended September 30, 2011		6
Nine Months Ended September 30, 2012		6
Nine Months Ended September 30, 2011		6
Statements of Changes in Stockholders’ Equity:
Three Months Ended September 30, 2012		7
Three Months Ended September 30, 2011		7
Nine Months Ended September 30, 2012		8
Nine Months Ended September 30, 2011		8
Statements of Cash Flows:
Nine Months Ended September 30, 2012		9
Nine Months Ended September 30, 2011		9
Notes to Unaudited Consolidated Financial Statements		10
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		34
Item 3. Quantitative and Qualitative Disclosures About Market Risk		56
Item 4. Controls and Procedures		56
Part II — OTHER INFORMATION
Item 1. Legal Proceedings		57
Item 1A. Risk Factors		57
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		57
Item 3. Defaults Upon Senior Securities		57
Item 4. Mine Safety Disclosures		57
Item 5. Other Information		57
Item 6. Exhibits		57
Signatures		58

2

PART I. FINANCIAL INFORMATION,Item 1 — Financial Statements

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED BALANCE SHEETS

(unaudited)

(in thousands, except share and per share amounts)

	September 30, 2012		December 31, 2011*
ASSETS
Cash and due from banks	$	11,901	$	13,184
Interest bearing balances with banks		6,414		21,296
Federal funds sold		—		—
Cash and Cash Equivalents		18,315		34,480
Investment securities:
Available-for-sale, at fair value		163,703		167,486
Held-to-maturity (fair value of $18,786 and $24,969, respectively)		17,690		23,722
Total Investment Securities		181,393		191,208
Loans, net of unearned income		639,060		631,522
Less: Allowance for loan and lease losses		6,966		6,711
Loans, Net		632,094		624,811
Bank premises and equipment		15,013		13,095
Other real estate owned		582		1,571
Accrued interest receivable		3,073		3,252
Goodwill		26,398		26,398
Bank owned life insurance		17,490		15,870
Federal Home Loan Bank stock		4,764		4,953
Other assets		9,072		9,894
Total Assets	$	908,194	$	925,532
LIABILITIES
Deposits:
Non-interest bearing	$	141,181	$	134,799
Interest bearing		563,951		585,719
Total Deposits		705,132		720,518
Other borrowed funds:
Securities sold under agreements to repurchase		11,873		9,981
Short-term borrowings		—		—
Long-term borrowings		49,576		58,220
Accrued interest payable		815		1,010
Other liabilities		8,688		8,470
Total Liabilities		776,084		798,199
STOCKHOLDERS’ EQUITY
Common stock; $ .01 par value, 15,000,000 shares authorized, 3,276,079 shares issued and outstanding		33		33
Surplus		48,890		48,865
Retained earnings		82,467		78,713
Accumulated other comprehensive income		720		(278	)
Total Stockholders’ Equity		132,110		127,333
Total Liabilities and Stockholders’ Equity	$	908,194	$	925,532

* - as restated see Note 18

(See accompanying Notes to Unaudited Consolidated Financial Statements)

3

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

(unaudited)

(in thousands, except share and per share amounts)

	Three Months Ended September 30, 2012		Three Months Ended September 30, 2011*
INTEREST INCOME
Interest and fees on loans and leases	$	8,059	$	8,463
Interest and dividends on investments:
U.S. Treasury securities and U.S. Agency obligations		544		597
States & political subdivisions		645		803
Other securities		14		16
Interest on Federal funds sold		—		2
Interest on balances with banks		3		3
Total Interest Income		9,265		9,884
INTEREST EXPENSE
Interest on time deposits of $100,000 or more		287		367
Interest on other deposits		500		833
Interest on other borrowed funds		475		585
Total Interest Expense		1,262		1,785
Net Interest Income		8,003		8,099
Provision for loan and lease losses		471		445
Net Interest Income After Provision for Loan and Lease Losses		7,532		7,654
NON-INTEREST INCOME
Trust department income		409		431
Service charges on deposit accounts		489		540
Merchant transaction income		1,357		1,680
Brokerage fee income		60		52
Other fee income		427		450
Bank-owned life insurance income		129		124
Other operating income		247		135
Impairment losses on investment securities		—		—
Realized gains (losses) on securities, net		3		159
Total Non-Interest Income		3,121		3,571
NON-INTEREST EXPENSES
Salaries and employee benefits		3,413		3,463
Premises and equipment		678		887
Merchant transaction expenses		866		1,110
FDIC insurance assessments		113		14
Other operating expenses		2,270		2,048
Total Non-Interest Expenses		7,340		7,522
Income before income taxes		3,313		3,703
Applicable income taxes		761		929
Net Income	$	2,552	$	2,774
Weighted average shares outstanding - Basic		3,276,079		3,276,079
Weighted average shares outstanding - Diluted		3,276,529		3,276,079
Earnings per Common Share - Basic	$	0.78	$	0.85
Earnings per Common Share - Diluted	$	0.78	$	0.85
Cash Dividends Declared Per Common Share	$	0.42	$	0.42

* - as restated see Note 18

(See accompanying Notes to Unaudited Consolidated Financial Statements)

4

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

(unaudited)

(in thousands, except share and per share amounts)

	Nine Months Ended September 30, 2012		Nine Months Ended September 30, 2011*
INTEREST INCOME
Interest and fees on loans and leases	$	24,525	$	25,133
Interest and dividends on investments:
U.S. Treasury securities and U.S. Agency obligations		1,798		2,157
States & political subdivisions		2,027		2,527
Other securities		43		45
Interest on Federal funds sold		—		2
Interest on balances with banks		7		9
Total Interest Income		28,400		29,873
INTEREST EXPENSE
Interest on time deposits of $100,000 or more		899		1,100
Interest on other deposits		1,758		2,680
Interest on other borrowed funds		1,493		1,824
Total Interest Expense		4,150		5,604
Net Interest Income		24,250		24,269
Provision for loan and lease losses		777		1,713
Net Interest Income After Provision for Loan and Lease Losses		23,473		22,556
NON-INTEREST INCOME
Trust department income		1,112		1,214
Service charges on deposit accounts		1,416		1,531
Merchant transaction income		3,455		3,853
Brokerage fee income		201		185
Other fee income		1,291		1,259
Bank-owned life insurance income		378		369
Other operating income		678		1,080
Impairment losses on investment securities		—		—
Realized gains (losses) on securities, net		119		439
Total Non-Interest Income		8,650		9,930
NON-INTEREST EXPENSES
Salaries and employee benefits		10,617		10,366
Premises and equipment		2,230		2,714
Merchant transaction expenses		2,193		2,609
FDIC insurance assessments		343		436
Other operating expenses		6,558		5,848
Total Non-Interest Expenses		21,941		21,973
Income before income taxes		10,182		10,513
Applicable income taxes		2,301		2,451
Net Income	$	7,881	$	8,062
Weighted average shares outstanding - Basic		3,276,079		3,276,079
Weighted average shares outstanding - Diluted		3,276,243		3,276,079
Earnings per Common Share - Basic	$	2.41	$	2.46
Earnings per Common Share - Diluted	$	2.41	$	2.46
Cash Dividends Declared Per Common Share	$	1.26	$	1.26

* - as restated see Note 18

(See accompanying Notes to Unaudited Consolidated Financial Statements)

5

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(unaudited)

(in thousands)

	Three Months Ended September 30, 2012			Three Months Ended September 30, 2011*
Net Income	$	2,552		$	2,774
Other comprehensive income, net of tax:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising during the period		550			1,199
Less: reclassification adjustment for (losses) gains included in net income		(1	)		88
Other comprehensive income (loss)		551			1,111
Comprehensive Income	$	3,103		$	3,885
	Nine Months Ended September 30, 2012			Nine Months Ended September 30, 2011*
Net Income	$	7,881		$	8,062
Other comprehensive income, net of tax:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising during the period		1,068			2,778
Less: reclassification adjustment for (losses) gains included in net income		70			269
Other comprehensive income (loss)		998			2,509
Comprehensive Income	$	8,879		$	10,571

* - as restated see Note 18

(See accompanying Notes to Unaudited Consolidated Financial Statements)

6

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

THREE MONTHS ENDED SEPTEMBER 30, 2012 AND 2011

(unaudited)

(in thousands, except per share amounts)

	Common Stock		Surplus		Retained Earnings			Accumulated Other Comprehensive Income			Total Stockholders’ Equity
Balance, June 30, 2011*	$	33	$	48,865	$	76,222		$	(720	)	$	124,400
Net income*		—		—		2,774			—			2,774
Other comprehensive income (loss)									1,111			1,111
Cash dividends declared ($0.42 per share)		—		—		(1,376	)		—			(1,376	)
Balance, September 30, 2011*	$	33	$	48,865	$	77,620		$	391		$	126,909
Balance, June 30, 2012	$	33	$	48,875	$	81,290		$	169		$	130,367
Stock-based compensation				15								15
Net income		—		—		2,552			—			2,552
Other comprehensive income (loss)									551			551
Cash dividends declared ($0.42 per share)		—		—		(1,375	)		—			(1,375	)
Balance, September 30, 2012	$	33	$	48,890	$	82,467		$	720		$	132,110

* - as restated see Note 18

(See accompanying Notes to Unaudited Consolidated Financial Statements)

7

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

NINE MONTHS ENDED SEPTEMBER 30, 2012 AND 2011

(unaudited)

(in thousands, except per share amounts)

	Common Stock		Surplus		Retained Earnings			Accumulated Other Comprehensive Income			Total Stockholders’ Equity
Balance, December 31, 2010*	$	33	$	48,865	$	73,686		$	(2,118	)	$	120,466
Net income*		—		—		8,062			—			8,062
Other comprehensive income									2,509			2,509
Cash dividends declared ($1.26 per share)		—		—		(4,128	)		—			(4,128	)
Balance, September 30, 2011*	$	33	$	48,865	$	77,620		$	391		$	126,909
Balance, December 31, 2011*	$	33	$	48,865	$	78,713		$	(278	)	$	127,333
Stock-based compensation				25								25
Net income		—		—		7,881			—			7,881
Other comprehensive income									998			998
Cash dividends declared ($1.26 per share)		—		—		(4,127	)		—			(4,127	)
Balance, September 30, 2012	$	33	$	48,890	$	82,467		$	720		$	132,110

* - as restated see Note 18

(See accompanying Notes to Unaudited Consolidated Financial Statements)

8

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)

	Nine Months Ended September 30, 2012			Nine Months Ended September 30, 2011*
OPERATING ACTIVITIES
Net Income	$	7,881		$	8,062
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		651			797
Provision for loan and lease losses		777			1,713
Stock-based compensation		25			—
Deferred income tax provision (benefit)		121			190
Amortization of securities, (net of accretion)		246			361
Net realized (gains) losses on securities		(119	)		(439	)
(Gain) loss on other real estate		(67	)		(245	)
Decrease (increase) in interest receivable		179			664
(Increase) decrease in bank owned life insurance		(378	)		(369	)
Decrease (increase) in other assets		701			(1,132	)
Increase (decrease) in income taxes payable		2,177			2,433
(Decrease) increase in interest payable		(195	)		(87	)
(Decrease) increase in other liabilities		(1,991	)		(3,837	)
Net cash provided (used) by operating activities		10,008			8,111
INVESTING ACTIVITIES
Purchase of investment securities available-for-sale		(15,675	)		(5,281	)
Purchase of investment securities to be held-to-maturity		—			—
Proceeds from investment securities available-for-sale		15,807			30,446
Proceeds from repayments of investment securities available-for-sale		5,084			2,916
Proceeds from repayments of investment securities held-to-maturity		5,983			15,478
Net loans (originated) repaid		(9,001	)		(26,536	)
Proceeds from other real estate		1,516			864
Investment in premises and equipment		(2,569	)		(583	)
Purchase of bank owned life insurance		(1,242	)		—
Purchase of Federal Home Loan Bank stock		(840	)		—
Proceeds from Federal Home Loan Bank share buyback		1,029			868
Net cash (used) provided by investing activities		92			18,172
FINANCING ACTIVITIES
Net increase (decrease) in demand and savings deposits		17,660			46,578
Net (payments) proceeds on time deposits		(33,046	)		(5,926	)
Increase (decrease) in securities sold under agreements to repurchase		1,892			3,246
Net (decrease) increase in short-term borrowings		—			(7,825	)
Increase in long-term borrowings		—			—
Payments on long-term borrowings		(8,644	)		(8,432	)
Cash dividends paid		(4,127	)		(4,128	)
Net cash (used) provided by financing activities		(26,265	)		23,513
Net (decrease) increase in cash and cash equivalents		(16,165	)		49,796
Cash and cash equivalents at January 1		34,480			14,219
Cash and cash equivalents at September 30	$	18,315		$	64,015
The Company paid interest and income taxes of $4,345 and $1,700 and $5,691 and $2,315 during the nine months ended September 30, 2012 and 2011, respectively.

* - as restated see Note 18

(See accompanying Notes to Unaudited Consolidated Financial Statements)

9

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

For the Three and Nine Months Ended September 30, 2012

(unaudited)

These Notes to Unaudited Consolidated Financial Statements reflect events subsequent to December 31, 2011, through the date of this Quarterly Report on Form 10-Q. These Notes to Unaudited Consolidated Financial Statements should be read in conjunction with Parts I and II of this Report and the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, which was filed with the Securities and Exchange Commission (SEC) on March 14, 2012.

NOTE 1 — Principles of Consolidation

Penseco Financial Services Corporation (Company) is a financial holding company incorporated under the laws of Pennsylvania. It is the parent company of Penn Security Bank and Trust Company (Bank), a Pennsylvania state chartered bank.

The Financial Statements of the Company have been consolidated with those of the Bank and its subsidiaries, eliminating all intercompany items and transactions.

The accounting policies of the Company conform with accounting principles generally accepted in the United States of America (GAAP) and with general practices within the banking industry.

NOTE 2 — Basis of Presentation

The unaudited consolidated financial statements have been prepared in accordance with applicable rules and regulations of the Securities and Exchange Commission (SEC), the instructions to SEC Form 10-Q and GAAP for interim financial information. In the opinion of management, all adjustments that are of a normal recurring nature and are considered necessary for a fair presentation have been included. The unaudited consolidated financial statements, as so adjusted, are not, however, necessarily indicative of the results of consolidated operations for a full year or any other period.

All dollar amounts are presented in thousands of dollars, except per share amounts.

For further information, refer to the audited consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

NOTE 3 — Earnings per Share

Basic earnings per share is computed on the weighted average number of common shares outstanding during each reporting period. Diluted earnings per share include restricted stock awards, issuable after a vesting period, calculated on the “Treasury Stock Method”. Restricted stock awards are issued subject to forfeiture during the vesting period.

Three months ended September 30, 2012	Income (Numerator)		Shares (Denominator)		Per-share Amount
Basic EPS
Income available	$	2,552		3,276,079	$	0.78
Shares includable		—		450		—
Diluted EPS	$	2,552		3,276,529	$	0.78
Three months ended September 30, 2011*	Income (Numerator)		Shares (Denominator)		Per-share Amount
Basic EPS
Income available	$	2,774		3,276,079	$	0.85
Shares includable		—		—		—
Diluted EPS	$	2,774		3,276,079	$	0.85

* - as restated see Note 18

10

Nine months ended September 30, 2012	Income (Numerator)		Shares (Denominator)		Per-share Amount
Basic EPS
Income available	$	7,881		3,276,079	$	2.41
Shares includable		—		164		—
Diluted EPS	$	7,881		3,276,243	$	2.41
Nine months ended September 30, 2011*	Income (Numerator)		Shares (Denominator)		Per-share Amount
Basic EPS
Income available	$	8,062		3,276,079	$	2.46
Shares includable		—		—		—
Diluted EPS	$	8,062		3,276,079	$	2.46

* - as restated see Note 18

NOTE 4 — Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan and lease losses and the valuation of property that is included in “other real estate owned” on our consolidated balance sheet and that was acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowances for loan and lease losses and valuation of other real estate owned, management obtains independent appraisals for significant properties.

NOTE 5 — Reclassifications

Certain prior year amounts have been reclassified to conform to the current year presentation.

NOTE 6 — Investment Securities

Investments in securities are classified in two categories and accounted for as follows:

Securities Held-to-Maturity – Bonds, notes, debentures and mortgage-backed securities for which the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for amortization of premiums and accretion of discounts computed on the straight-line basis, which approximates the interest method, over the remaining period to maturity.

Securities Available-for-Sale – Bonds, notes, debentures, mortgage-backed securities not classified as securities to be held to maturity and certain equity securities are classified as available-for-sale and carried at fair value with unrealized holding gains and losses, net of tax, reported as a net amount in a separate component of stockholders’ equity until realized.

The amortization of premiums on mortgage-backed securities is done based on management’s estimate of the lives of the securities, adjusted, when necessary, for advanced prepayments in excess of those estimates.

Realized gains and losses on the sale of securities available-for-sale are determined using the specific identification method and are reported as a separate component of other income in the Statements of Income. Unrealized gains and losses are included as a separate item in computing comprehensive income.

Investment securities are evaluated periodically to determine whether a decline in their value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. The term “other than temporary” is not intended to indicate that the decline is permanent. It indicates that the prospects for a near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the security. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.

11

The amortized cost and fair value of investment securities at September 30, 2012 and December 31, 2011 are as follows:

Available-for-Sale

September 30, 2012	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
U.S. Agency securities	$	77,381	$	765	$	8	$	78,138
Mortgage-backed securities		23,336		1,114		—		24,450
States & political subdivisions		54,724		5,192		—		59,916
Corporate securities		—		—		—		—
Total Debt Securities		155,441		7,071		8		162,504
Equity securities		801		401		3		1,199
Total Available-for-Sale	$	156,242	$	7,472	$	11	$	163,703

Available-for-Sale

December 31, 2011	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
U.S. Agency securities	$	77,150	$	847	$	12	$	77,985
Mortgage-backed securities		21,270		896		—		22,166
States & political subdivisions		61,405		3,987		4		65,388
Corporate securities		1,002		2		—		1,004
Total Debt Securities		160,827		5,732		16		166,543
Equity securities		709		288		54		943
Total Available-for-Sale	$	161,536	$	6,020	$	70	$	167,486

Held-to-Maturity

September 30, 2012	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Mortgage-backed securities	$	16,608	$	1,077	$	—	$	17,685
States & political subdivisions		1,082		19		—		1,101
Total Held-to-Maturity	$	17,690	$	1,096	$	—	$	18,786

Held-to-Maturity

December 31, 2011	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Mortgage-backed securities	$	21,912	$	1,207	$	—	$	23,119
States & political subdivisions		1,810		40		—		1,850
Total Held-to-Maturity	$	23,722	$	1,247	$	—	$	24,969

Equity securities at September 30, 2012 and December 31, 2011 consisted primarily of common stock of companies in the financial services industry.

12

A summary of transactions involving available-for-sale debt securities for the nine months ended September 30, 2012 and 2011 are as follows:

	September 30, 2012		September 30, 2011
Proceeds from sales	$	—	$	15,318
Gross realized gains		—		145
Gross realized losses		—		—

The amortized cost and fair value of debt securities at September 30, 2012 by contractual maturity are shown in the following table. 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.

September 30, 2012	Available-for-Sale				Held-to-Maturity
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
Due in one year or less:
U.S. Agency securities	$	16,053	$	16,147	$	—	$	—
After one year through five years:
U.S. Agency securities		61,328		61,991		—		—
States & political subdivisions		170		171		—		—
After five years through ten years:
States & political subdivisions		2,486		2,723		1,082		1,101
After ten years:
States & political subdivisions		52,068		57,022		—		—
Subtotal		132,105		138,054		1,082		1,101
Mortgage-backed securities		23,336		24,450		16,608		17,685
Total Debt Securities	$	155,441	$	162,504	$	17,690	$	18,786

The gross fair value and unrealized losses of the Company’s investments aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2012 and December 31, 2011 are as follows:

	Less than twelve months				Twelve months or more				Totals
September 30, 2012	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
U.S. Agency securities	$	3,177	$	8	$	—	$	—	$	3,177	$	8
Mortgage-backed securities		—		—		—		—		—		—
States & political subdivisions		—		—		—		—		—		—
Equities		61		1		89		2		150		3
Total	$	3,238	$	9	$	89	$	2	$	3,327	$	11
	Less than twelve months				Twelve months or more				Totals
December 31, 2011	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
U.S. Agency securities	$	13,001	$	12	$	—	$	—	$	13,001	$	12
Mortgage-backed securities		—		—		—		—		—		—
States & political subdivisions		489		4		—		—		489		4
Corporate securities		—		—		—		—		—		—
Equities		136		29		100		25		236		54
Total	$	13,626	$	45	$	100	$	25	$	13,726	$	70

13

At September 30, 2012, three securities had unrealized losses for less than twelve months and one security had been in an unrealized loss position for twelve or more months. At December 31, 2011, ten securities had unrealized losses for less than twelve months and five securities had been in an unrealized loss position for twelve or more months.

U.S. Agency Securities

The unrealized losses on the Company’s investments in U.S. Agency securities were caused by interest rate fluctuations and not credit quality. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the par value of the investment. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at September 30, 2012.

Mortgage-backed Securities

The unrealized losses on the Company’s investments in mortgage-backed securities were caused by interest rate fluctuations and not credit quality. The contractual cash flows of these investments are guaranteed by an agency of the U.S. Government. Accordingly, it is expected that these securities would not be settled at a price less than the amortized cost of the Company’s investment. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at September 30, 2012.

States and Political Subdivisions

The unrealized losses on the Company’s investments in states and political subdivisions were caused by interest rate fluctuations and not credit quality. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the par value of the investment. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at September 30, 2012.

Marketable Equity Securities

The unrealized losses on the Company’s investments in marketable equity securities were caused by interest rate fluctuations and general market conditions. The Company’s investments in marketable equity securities consist primarily of investments in common stock of companies in the financial services industry. The Company has analyzed its equity portfolio and determined that the market value fluctuation in these equity securities is not a cause for recognition of a current loss. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their cost bases, the Company does not consider those investments to be other-than-temporarily impaired at September 30, 2012.

14

NOTE 7 — Loan Portfolio

Details regarding the Company’s loan portfolio during the periods indicated are as follows:

As of:	September 30, 2012		December 31, 2011
Loans secured by real estate:
Construction and land development
Residential real estate	$	5,020	$	5,064
Commercial real estate		17,989		20,541
Secured by 1-4 family residential properties:
Revolving, open-end loans		30,268		30,897
Secured by first liens		197,261		214,198
Secured by junior liens		19,301		21,858
Secured by multi-family properties		15,191		9,626
Secured by non-farm, non-residential properties		199,747		188,334
Commercial and industrial loans to U.S. addressees		58,276		55,482
Loans to individuals for household, family and other personal expenditures:
Credit card and related plans		3,040		3,242
Other (installment and student loans, etc.)		49,518		49,574
Obligations of states & political subdivisions		30,512		23,110
All other loans		12,937		9,596
Gross Loans		639,060		631,522
Less: Unearned income on loans		—		—
Loans, net of unearned income	$	639,060	$	631,522

The Company has not engaged in any sub-prime residential mortgage lending. Therefore, the Company is not subject to any credit risks associated with such loans. The Company’s loan portfolio consists of residential and commercial mortgage loans secured by properties primarily located in Northeastern Pennsylvania and subject to what the Company believes are conservative underwriting standards.

Age Analysis of Past Due Loans

As of September 30, 2012

	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans		Recorded Investment > 90 Days and Accruing
Commercial	$	330	$	—	$	388	$	718	$	101,007	$	101,725	$	—
Commercial real estate:
Commercial real estate - construction		—		—		—		—		17,989		17,989		—
Commercial real estate - other		358		9		133		500		199,247		199,747		—
Consumer:
Consumer - credit card		22		9		6		37		3,003		3,040		6
Consumer - other		41		11		1		53		5,665		5,718		—
Consumer - auto		62		39		32		133		32,036		32,169		5
Student loans - TERI		22		35		76		133		5,995		6,128		—
Student loans - other		145		48		200		393		5,110		5,503		200
Residential:
Residential - prime		1,739		1,063		3,327		6,129		260,912		267,041		1,369
Total	$	2,719	$	1,214	$	4,163	$	8,096	$	630,964	$	639,060	$	1,580

15

Age Analysis of Past Due Loans

As of December 31, 2011

	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans		Recorded Investment > 90 Days and Accruing
Commercial	$	23	$	—	$	477	$	500	$	87,688	$	88,188	$	—
Commercial real estate:
Commercial real estate construction		—		—		—		—		20,541		20,541		—
Commercial real estate - other		331		—		602		933		187,401		188,334		11
Consumer:
Consumer - credit card		34		11		6		51		3,191		3,242		6
Consumer - other		28		—		10		38		6,825		6,863		—
Consumer - auto		156		5		24		185		29,889		30,074		3
Student loans - TERI		14		62		61		137		6,117		6,254		—
Student loans - other		243		103		113		459		5,924		6,383		113
Residential:
Residential - prime		2,429		1,155		2,647		6,231		275,412		281,643		641
Total	$	3,258	$	1,336	$	3,940	$	8,534	$	622,988	$	631,522	$	774

Credit Quality Indicators. As part of the on-going monitoring of the credit quality of the Bank’s loan portfolio, management tracks certain credit quality indicators, including trends related to loan delinquency, the level of classified commercial loans, net charge-offs, non-performing loans (see details above) and the general economic conditions in the Company’s market area.

The Bank utilizes a risk grading matrix to assign a risk grade to each of its commercial loans. Loans are graded on a scale of 1 to 8. A description of the general characteristics of the 8 risk grades is as follows:

Pass 1 (Minimal Risk)

This classification includes loans which are fully secured by liquid collateral or loans to very high quality borrowers who demonstrate exceptional credit fundamentals, including stable and predictable profit margins and cash flows, strong liquidity, a conservative balance sheet, superior asset quality and good management with an excellent track record.

Pass 2 (Average Risk)

This classification includes loans which have no identifiable risk of collection and conform in all aspects to the Bank’s policies and procedures as well as federal and state regulations. Documentation exceptions are minimal, in the process of correction and not of a type that could subsequently introduce loan loss risk.

Pass 3 (Acceptable Risk)

This classification includes loans to borrowers of acceptable credit quality and risk. Such borrowers are differentiated from Pass 2 in terms of secondary sources of repayment or lesser stature in other key credit metrics in that they may be over-leveraged, undercapitalized, inconsistent in performance or in an industry that is known to have a higher level of risk, volatility, or susceptibility to weaknesses in the economy.

Pass 4 (Watch List)

This classification is intended to be utilized on a temporary basis for pass grade borrowers where a significant risk-modifying action is anticipated in the near term. It is assigned to loans where, for example, the financial condition of the company has taken a negative turn and may be temporarily strained; borrowers may exhibit excessive growth, declining earnings, strained cash flow, increasing leverage and/or weakening market position that indicate above-average risk. Interim losses and/or adverse trends may occur (but not to the level that would affect the Bank’s position) and cash flow may be weak but minimally acceptable.

Criticized 5 (Other Assets Especially Mentioned)

This classification is also intended to be temporary and includes loans to borrowers whose credit quality has clearly deteriorated and are at risk of further decline unless active measures are taken to correct the situation.

16

Classified 6 (Substandard)

This classification includes loans with well-defined weaknesses that are inadequately protected by current net worth, repayment capacity or pledged collateral of the borrower. Loans are substandard when they have one or more weaknesses that could jeopardize debt repayment and/or liquidation, primarily resulting in the possibility that the Bank may sustain some loss if the deficiencies are not corrected.

Classified 7 (Doubtful)

This classification includes loans that have all weaknesses inherent in the substandard category and where collection or liquidation in full is highly improbable. The possibility of loss is high, but because of certain important and reasonably specific pending factors, its classification as an estimated loss is deferred until its more exact status may be determined.

Classified 8 (Loss)

This classification includes loans considered uncollectible and of such little value that continuance as bankable assets is not warranted and, therefore, should be charged-off. This classification does not mean that the loans have absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off these assets even though partial recovery may occur in the future.

Credit Quality Indicators as of September 30, 2012

Commercial Credit Exposure

Credit Risk Profile by Creditworthiness Category

	Commercial		Commercial Real Estate - Construction		Commercial Real Estate - Other
Pass / Watch	$	99,964	$	17,771	$	188,722
Criticized		951		218		2,797
Substandard		810		—		8,228
Total	$	101,725	$	17,989	$	199,747

Consumer Credit Exposure

Credit Risk Profile by Payment Activity

	Residential Real Estate		Consumer - Credit Card		Consumer - Other		Consumer - Auto		Student Loans - TERI		Student Loans - Other
Performing	$	265,083	$	3,040	$	5,717	$	32,142	$	6,052	$	5,503
Non-performing		1,958		—		1		27		76		—
Total	$	267,041	$	3,040	$	5,718	$	32,169	$	6,128	$	5,503

Non-performing loans are those past due 90 days or more and not accruing.

Credit Quality Indicators as of December 31, 2011

Commercial Credit Exposure

Credit Risk Profile by Creditworthiness Category

	Commercial		Commercial Real Estate - Construction		Commercial Real Estate - Other
Pass / Watch	$	84,431	$	18,036	$	172,072
Criticized		2,790		2,505		7,811
Substandard		967		—		8,451
Total	$	88,188	$	20,541	$	188,334

17

Consumer Credit Exposure

Credit Risk Profile by Payment Activity

	Residential Real Estate		Consumer - Credit Card		Consumer - Other		Consumer - Auto		Student Loans - TERI		Student Loans - Other
Performing	$	278,996	$	3,236	$	6,853	$	30,050	$	6,193	$	6,270
Non-performing		2,647		6		10		24		61		113
Total	$	281,643	$	3,242	$	6,863	$	30,074	$	6,254	$	6,383

Impaired Loans. Loans are considered impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

Impaired Loans

September 30, 2012

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial real estate	$	133	$	133	$	—	$	201	$	—
Commercial		388		388		—		194		—
Consumer - TERI		76		76		—		52		—
Consumer - other		1		1		—		1		—
Consumer - auto		27		27		—		28		—
Residential real estate		1,376		1,376		—		1,071		—
With an allowance recorded:
Commercial real estate - construction		—		—		—		—		—
Commercial real estate - other		2,418		2,418		650		2,379		99
Commercial		354		354		354		552		14
Residential real estate		582		582		150		618		—
Total:	$	5,355	$	5,355	$	1,154	$	5,096	$	113
Commercial real estate	$	2,551	$	2,551	$	650	$	2,580	$	99
Commercial	$	742	$	742	$	354	$	746	$	14
Consumer	$	104	$	104	$	—	$	81	$	—
Residential real estate	$	1,958	$	1,958	$	150	$	1,689	$	—

18

Impaired Loans

December 31, 2011

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial real estate	$	591	$	591	$	—	$	390	$	—
Commercial		—		—		—		—		—
Consumer - TERI		61		61		—		65		—
Consumer - other		10		10		—		10		—
Consumer - auto		21		21		—		32		—
Residential real estate		806		806		—		1,081		—
With an allowance recorded:
Commercial real estate - construction		—		—		—		—		—
Commercial real estate - other		—		—		—		—		—
Commercial		845		845		443		1,000		28
Residential real estate		1,200		1,200		215		1,057		—
Total:	$	3,534	$	3,534	$	658	$	3,635	$	28
Commercial real estate	$	591	$	591	$	—	$	390	$	—
Commercial	$	845	$	845	$	443	$	1,000	$	28
Consumer	$	92	$	92	$	—	$	107	$	—
Residential real estate	$	2,006	$	2,006	$	215	$	2,138	$	—

Non-Accrual and Past Due Loans. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on non-accrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on non-accrual status regardless of whether or not such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest income is reversed. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured with the minimum of a six month positive payment history.

Period-end non-accrual loans, segregated by class of loans, were as follows:

	September 30, 2012		December 31, 2011
Commercial	$	388	$	477
Commercial real estate:
Commercial real estate - construction		—		—
Commercial real estate - other		133		591
Consumer:
Student loans - TERI		76		61
Student loans - other		—		—
Consumer - other		1		10
Consumer - auto		27		21
Residential:
Residential real estate		1,958		2,006
Total	$	2,583	$	3,166

19

The Allowance for Loan and Lease Losses and Recorded Investment in Loans for the nine months ended September 30, 2012 is as follows:

	Commercial			Commercial Real Estate			Consumer			Residential			Credit Card			Unallocated		Total
Allowance for Loan and Lease Losses:
Beginning balance 12/31/11	$	793		$	2,294		$	450		$	2,855		$	319		$	—	$	6,711
Charge-offs		(78	)		(33	)		(113	)		(326	)		(36	)		—		(586	)
Recoveries		1			5			49			8			1			—		64
Provision		103			44			151			432			47			—		777
Ending balance 09/30/12	$	819		$	2,310		$	537		$	2,969		$	331		$	—	$	6,966
Ending balance: Individually evaluated for impairment		354			650			—			150			—			—		1,154
Ending balance: Collectively evaluated for impairment	$	465		$	1,660		$	537		$	2,819		$	331		$	—	$	5,812
Ending balance: Loans acquired with deteriorated credit quality	$	—		$	—		$	—		$	—		$	—		$	—	$	—
Loans:
Ending balance	$	101,725		$	217,736		$	49,518		$	267,041		$	3,040		$	—	$	639,060
Ending balance: Individually evaluated for impairment		742			2,551			104			1,958			—			—		5,355
Ending balance: Collectively evaluated for impairment	$	100,983		$	215,185		$	49,414		$	265,083		$	3,040		$	—	$	633,705
Ending balance: Loans acquired with deteriorated credit quality	$	—		$	—		$	—		$	—		$	—		$	—	$	—

The Allowance for Loan and Lease Losses and Recorded Investment in Loans for the year ended December 31, 2011 is as follows:

	Commercial			Commercial Real Estate			Consumer			Residential			Credit Card			Unallocated		Total
Allowance for Loan and Lease Losses:
Beginning balance 12/31/10	$	1,957		$	2,067		$	1,380		$	753		$	343		$	—	$	6,500
Charge-offs		(100	)		(663	)		(153	)		(1,275	)		(109	)		—		(2,300	)
Recoveries		3			18			45			58			6			—		130
Provision		(1,067	)		872			(822	)		3,319			79			—		2,381
Ending balance 12/31/11	$	793		$	2,294		$	450		$	2,855		$	319		$	—	$	6,711
Ending balance: Individually evaluated for impairment		443			—			—			215			—			—		658
Ending balance: Collectively evaluated for impairment	$	350		$	2,294		$	450		$	2,640		$	319		$	—	$	6,053
Ending balance: Loans acquired with deteriorated credit quality	$	—		$	—		$	—		$	—		$	—		$	—	$	—
Loans:
Ending balance	$	88,188		$	208,875		$	49,574		$	281,643		$	3,242		$	—	$	631,522
Ending balance: Individually evaluated for impairment		845			591			92			2,006			—			—		3,534
Ending balance: Collectively evaluated for impairment	$	87,343		$	208,284		$	49,482		$	279,637		$	3,242		$	—	$	627,988
Ending balance: Loans acquired with deteriorated credit quality	$	—		$	—		$	—		$	—		$	—		$	—	$	—

20

The Company had one commercial loan whose terms had been modified in a troubled debt restructuring as of September 30, 2012 and December 31, 2011; monthly payments were lowered to accommodate the borrower’s financial needs for a period of time.

Modification

September 30, 2012

	Number of Contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Troubled Debt Restructurings
Commercial		1	$	808	$	354

There were no troubled debt restructurings that subsequently defaulted during the nine months ended September 30, 2012.

Modification

December 31, 2011

	Number of Contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Troubled Debt Restructurings
Commercial		1	$	808	$	368

The loan above, classified as a Troubled Debt Restructuring (TDR), was charged down during 2010 to a balance of $401 and the entire pre-modification balance was split into two notes. The customer is currently paying principal and interest on one note and interest only on the other note. Nonetheless, the loan is fully reserved based on management’s evaluation of both the customer’s ability to maintain its cash flow and the value of the underlying collateral.

NOTE 8 — Loan Servicing

The Company generally retains the right to service mortgage loans sold to third parties. The cost allocated to the mortgage servicing rights retained has been recognized as a separate asset within other assets and is amortized in proportion to and over the period of estimated net servicing income.

Mortgage servicing rights are evaluated for impairment based on the fair value of those rights. Fair values are estimated using discounted cash flows based on current market rates of interest and expected future prepayment rates. For purposes of measuring impairment, the rights must be stratified by one or more predominant risk characteristics of the underlying loans. The Company stratifies its capitalized mortgage servicing rights based on the product type, interest rate and term of the underlying loans. The amount of impairment recognized is the amount, if any, by which the amortized cost of the rights for each stratum exceed the fair value.

NOTE 9 — Goodwill

Goodwill represents the excess of the purchase price over the underlying fair value of merged entities. Goodwill is assessed for impairment at least annually and as triggering events occur. In making this assessment, management considers a number of factors including, but not limited to, operating results, business plans, economic projections, anticipated future cash flows, and current market data. There are inherent uncertainties related to these factors and management’s judgment in applying them to the analysis of goodwill impairment. Changes in economic and operating conditions, as well as other factors, could result in goodwill impairment in future periods.

21

NOTE 10 — Other Intangible Assets

Intangible assets include the premium assigned to the core deposit relationships acquired in connection with our acquisition of Old Forge Bank in 2009. The core deposit intangible is being amortized over ten years from the date of acquisition on a sum-of-the-years-digits basis. Amortization expense is expected to be as follows:

September 30,
2013	$	239
2014		203
2015		166
2016		129
2017		92
Thereafter		74
Total	$	903

NOTE 11 — Long-Term Debt

The Company has established credit facilities with the Federal Home Loan Bank of Pittsburgh, which are secured by all of the Company’s assets. Additionally, in connection with the credit facilities, the Company has agreed to maintain sufficient qualifying collateral to fully secure the borrowings below.

A summary of long-term debt, including amortizing principal and interest payments, at September 30, 2012 is as follows:

Monthly Installment	Fixed Rate			Maturity Date		Balance
Amortizing loans
90		3.10	%		02/28/13		447
430		3.74	%		03/13/13		2,552
18		2.66	%		08/28/14		399
67		3.44	%		03/02/15		1,864
13		3.48	%		03/31/15		385
10		3.83	%		04/02/18		605
186		4.69	%		03/13/23		18,524
Total amortizing							24,776
Non-amortizing loans
		3.49	%		02/28/13		7,000
		2.89	%		11/28/14		2,000
		2.58	%		05/18/15		6,300
		3.32	%		11/27/15		3,000
		2.36	%		09/22/17		6,500
Total non-amortizing							24,800
Total long-term debt						$	49,576

Aggregate maturities of long-term debt at September 30, 2012 are as follows:

September 30,	Principal
2013	$	12,605
2014		2,696
2015		10,355
2016		4,720
2017		8,302
Thereafter		10,898
Total	$	49,576

22

NOTE 12 — Employee Benefit Plans

The Company provides an Employee Stock Ownership Plan (ESOP), a Retirement Profit Sharing 401(k) Plan, an Employees’ Pension Plan (currently frozen), an unfunded supplemental executive defined benefit plan (currently frozen) and a supplemental executive defined contribution plan, a Postretirement Life Insurance Plan, a Stock Appreciation Rights Plan (SAR), and a Long-Term Incentive Plan.

The components of the net periodic benefit cost are as follows:

	Pension Benefits						Other Benefits
Nine months ended September 30,	2012			2011			2012		2011*
Service cost	$	—		$	—		$	36	$	33
Interest cost		505			525			104		110
Expected return on plan assets		(607	)		(678	)		—		—
Amortization of prior service cost		—			—			—		6
Amortization of net loss (gain)		102			63			83		78
Net periodic benefit cost	$	—		$	(90	)	$	223	$	227

* - as restated see Note 18

The Company previously disclosed in the financial statements included in its Annual Report on Form 10-K for the year ended December 31, 2011 that it expected to contribute $350 to its pension plan in 2012. As of September 30, 2012, the Company expects to contribute $363 to its pension plan and $146 to its post-retirement plan during 2012 for retirees. Readers should refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 for further details on the Company’s defined benefit pension plan.

The Company sponsors a 401(k) profit sharing plan for all eligible employees. The Company’s profit sharing expense for the nine months ended September 30, 2012 and 2011 was $381 and $362, respectively.

The Company granted restricted stock awards during the nine months ended September 30, 2012 and 2011 valued at $300 and $56, respectively.

NOTE 13 — Stock Awards

Under the 2008 Long-Term Incentive Plan (the “2008 plan”), the Compensation Committee of the board of directors has broad authority with respect to awards granted under the 2008 plan, including, without limitation, the authority to:

• Designate the individuals eligible to receive awards under the 2008 plan.

• Determine the size, type and date of grant for individual awards, provided that awards approved by the Committee are not effective unless and until ratified by the board of directors.

• Interpret the 2008 plan and award agreements issued with respect to individual participants.

Persons eligible to receive awards under the 2008 Plan include directors, officers, employees, consultants and other service providers of the Company and its subsidiaries, except that incentive stock option may be granted only to individuals who are employees on the date of grant.

The total number of shares of the Company’s common stock available for grant awards under the 2008 plan shall not exceed in the aggregate five percent of the outstanding shares of the Company’s common stock as of February 15, 2008, or 107,400 shares of the Company’s common stock.

The 2008 plan authorizes grants of stock options, stock appreciation rights, dividend equivalents, performance awards, restricted stock and restricted stock units.

23

	Restricted Stock
Nonvested shares	Number of Shares		Weighted- Average Grant-Date Fair Value
Nonvested, January 1, 2012		—	$	—
Granted		7,731		38.80
Vested		—		—
Forfeited		—		—
Nonvested, September 30, 2012		7,731	$	38.80

Restricted stock granted to officers vest after five years. The weighted average period over which these expenses will be recognized is approximately five years.

In accordance with GAAP, the Company began to expense the fair value of all-share based compensation over the requisite service periods. The fair value of restricted stock is expensed on a straight-line basis. The Company classifies share-based compensation for employees within “salaries and employee benefits” on the Consolidated Statements of Income.

The Company recognized $25 of compensation expense for stock awards granted in the nine months ended September 30, 2012.

As of September 30, 2012, the Company had $275 of unrecognized compensation expense associated with restricted stock grants.

NOTE 14 — Comprehensive Income

Changes in each component of accumulated other comprehensive income for the three months ended September 30, 2012 and 2011 were as follows:

	Unrealized Gains on Investment Securities		Defined Benefit Plans			Total
Balance, June 30, 2012	$	4,374	$	(4,205	)	$	169
Current period change		551		—			551
Balance, September 30, 2012	$	4,925	$	(4,205	)	$	720
Balance, June 30, 2011	$	2,498	$	(3,218	)*	$	(720	)
Current period change		1,111		—			1,111
Balance, September 30, 2011	$	3,609	$	(3,218	)	$	391

* - as restated see Note 18

Changes in each component of accumulated other comprehensive income for the nine months ended September 30, 2012 and 2011 were as follows:

	Unrealized Gains on Investment Securities		Defined Benefit Plans*			Total
Balance, December 31, 2011	$	3,927	$	(4,205	)	$	(278	)
Current period change		998		—			998
Balance, September 30, 2012	$	4,925	$	(4,205	)	$	720
Balance, December 31, 2010	$	1,100	$	(3,218	)	$	(2,118	)
Current period change		2,509		—			2,509
Balance, September 30, 2011	$	3,609	$	(3,218	)	$	391

* - as restated see Note 18

24

Other Comprehensive Income

The components of other comprehensive income are reported net of related tax effects in the Consolidated Statements of Comprehensive Income.

A reconciliation of other comprehensive income for the three months ended September 30, 2012 and 2011 is as follows:

Three Months Ended September 30, 2012	Pre-Tax Amount			Tax (Expense) Benefit			Net-of- Tax Amount
Unrealized gains on available-for-sale securities:
Unrealized holding gains arising during the period	$	833		$	(283	)	$	550
Reclassification adjustment for losses recognized in net income		2			(1	)		1
Net unrealized gains		835			(284	)		551
Other comprehensive income	$	835		$	(284	)	$	551
Three Months Ended September 30, 2011	Pre-Tax Amount			Tax (Expense) Benefit			Net-of- Tax Amount
Unrealized gains on available-for-sale securities:
Unrealized holding gains arising during the period	$	1,816		$	(617	)	$	1,199
Reclassification adjustment for gains recognized in net income		(133	)		45			(88	)
Net unrealized gains		1,683			(572	)		1,111
Other comprehensive income	$	1,683		$	(572	)	$	1,111

A reconciliation of other comprehensive income for the nine months ended September 30, 2012 and 2011 is as follows:

Nine Months Ended September 30, 2012	Pre-Tax Amount			Tax (Expense) Benefit			Net-of- Tax Amount
Unrealized gains on available-for-sale securities:
Unrealized holding gains arising during the period	$	1,618		$	(550	)	$	1,068
Reclassification adjustment for gains recognized in net income		(106	)		36			(70	)
Net unrealized gains		1,512			(514	)		998
Other comprehensive income	$	1,512		$	(514	)	$	998
Nine Months Ended September 30, 2011	Pre-Tax Amount			Tax (Expense) Benefit			Net-of- Tax Amount
Unrealized gains on available-for-sale securities:
Unrealized holding gains arising during the period	$	4,210		$	(1,432	)	$	2,778
Reclassification adjustment for gains recognized in net income		(408	)		139			(269	)
Net unrealized gains		3,802			(1,293	)		2,509
Other comprehensive income	$	3,802		$	(1,293	)	$	2,509

25

NOTE 15 — Regulatory Matters

The Company and the Bank are subject to various regulatory capital requirements administered by the Federal Deposit Insurance Corporation (FDIC) and the Board of Governors of the Federal Reserve System (Federal Reserve Board). Failure to meet minimum capital requirements can initiate certain mandatory–and possibly additional discretionary–actions by regulators that, if undertaken, could have a direct material effect on the Company and the Bank’s Consolidated Financial Statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company and the Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following Capital Adequacy table) of Tier 1 and Total Capital to risk-weighted assets and of Tier 1 Capital to average assets (Leverage ratio). The table also presents the Company’s actual capital amounts and ratios. Management believes, as of September 30, 2012, that the Company and the Bank meet all capital adequacy requirements to which they are subject.

As of September 30, 2012, the most recent regulatory notifications categorized the Bank as “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as “well capitalized”, the Bank must maintain minimum Tier 1 Capital, Total Capital and Leverage ratios as set forth in the Capital Adequacy table. There are no conditions or events since that notification that management believes have changed the Company’s categorization by the FDIC.

The Company and Bank are also subject to minimum capital levels, which could limit the payment of dividends. As of September 30, 2012, the Company and Bank have capital levels that are in excess of the minimum capital level ratios required.

The Pennsylvania Banking Code restricts capital funds available for payment of dividends to the retained earnings of the Bank. The balances in the capital stock and surplus accounts are unavailable for dividends. Dividends from the Bank are the Company’s primary source of funds.

In addition, the Bank is subject to restrictions imposed by Federal law on certain transactions with the Company’s affiliates. These transactions include extensions of credit, purchases of or investments in stock issued by an affiliate, purchases of assets subject to certain exceptions, acceptance of securities issued by an affiliate as collateral for loans, and the issuance of guarantees, acceptances, and letters of credit on behalf of affiliates. These restrictions prevent the Company’s affiliates from borrowing from the Bank unless the loans are secured by obligations of designated amounts. Further, the aggregate value of such transactions between the Bank and a single affiliate is limited in amount to 10 percent of the Bank’s capital stock and surplus, and the aggregate value of such transactions with all affiliates is limited to 20 percent of the Bank’s capital stock and surplus. The Federal Reserve System has interpreted “capital stock and surplus” to include undivided profits.

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Actual							Regulatory Requirements
							For Capital Adequacy Purposes								To Be “Well Capitalized”
As of September 30, 2012	Amount		Ratio				Amount				Ratio				Amount			Ratio
Total Capital (to Risk Weighted Assets)
PFSC (Company)	$	109,078		17.38	%	>	$	50,198		>		8.0	%	>		N/A	>		N/A
PSB (Bank)	$	105,288		16.80	%	>	$	50,142		>		8.0	%	>	$	62,677	>		10.0	%
Tier 1 Capital (to Risk Weighted Assets)
PFSC (Company)	$	101,933		16.24	%	>	$	25,099		>		4.0	%	>		N/A	>		N/A
PSB (Bank)	$	98,322		15.69	%	>	$	25,071		>		4.0	%	>	$	37,606	>		6.0	%
Tier 1 Capital (to Average Assets)
PFSC (Company)	$	101,933		11.40	%	>	$		*	>		*		>		N/A	>		N/A
PSB (Bank)	$	98,322		11.06	%	>	$		*	>		*		>	$	44,469	>		5.0	%

PFSC - *3.0% ($26,815), 4.0% ($35,753) or 5.0% ($44,691) depending on the bank’s CAMELS Rating and other regulatory risk factors.

PSB - *3.0% ($26,681), 4.0% ($35,575) or 5.0% ($44,469) depending on the bank’s CAMELS Rating and other regulatory risk factors.

Actual							Regulatory Requirements
							For Capital Adequacy Purposes								To Be “Well Capitalized”
As of December 31, 2011*	Amount		Ratio				Amount				Ratio				Amount			Ratio
Total Capital (to Risk Weighted Assets)
PFSC (Company)	$	104,401		16.87	%	>	$	49,502		>		8.0	%	>		N/A	>		N/A
PSB (Bank)	$	100,745		16.30	%	>	$	49,456		>		8.0	%	>	$	61,820	>		10.0	%
Tier 1 Capital (to Risk Weighted Assets)
PFSC (Company)	$	97,585		15.77	%	>	$	24,751		>		4.0	%	>		N/A	>		N/A
PSB (Bank)	$	94,034		15.21	%	>	$	24,728		>		4.0	%	>	$	37,092	>		6.0	%
Tier 1 Capital (to Average Assets)
PFSC (Company)	$	97,585		10.82	%	>	$		*	>		*		>		N/A	>		N/A
PSB (Bank)	$	94,034		10.48	%	>	$		*	>		*		>	$	44,872	>		5.0	%

PFSC - *3.0% ($27,051), 4.0% ($36,068) or 5.0% ($45,085) depending on the bank’s CAMELS Rating and other regulatory risk factors.

PSB - *3.0% ($26,923), 4.0% ($35,898) or 5.0% ($44,872) depending on the bank’s CAMELS Rating and other regulatory risk factors.

* - as restated see Note 18

NOTE 16 — Merger

An Agreement and Plan of Merger (the “Agreement”) by and between the Company, the Bank and Old Forge Bank, was entered into on December 5, 2008. The Agreement provided for, among other things, the Company to acquire 100% of the outstanding common shares of Old Forge Bank through a two-step merger transaction. The Company consummated the acquisition of Old Forge Bank on April 1, 2009, at which time Old Forge Bank was merged with and into the Bank (the “Merger”). Following the Merger, the Bank continues to operate as a banking subsidiary of the Company.

In connection with its acquisition of Old Forge Bank, the Company acquired loans with evidence of credit deterioration that have been accounted for under ASC 310-30. As of September 30, 2012, there were two such loans remaining with a carrying value of $168 and a credit fair value adjustment of $168. As of December 31, 2011, these same loans had a carrying value of $211 and a credit fair value adjustment of $211. As of September 30, 2011, these loans had a carrying value of $217 with a credit fair value adjustment of $217. There is no accretable yield for the

27

specific loans accounted for under Accounting Standard Codification 310-30-30. There were no significant prepayment estimates by management in the determination of contractual cash flows and cash flows expected to be collected.

Changes in the credit fair value adjustment on specific loans purchased are as follows:

Nine Months Ended September 30, 2012
	Carrying Value			Credit Fair Value Adjustment			Net Amount
Balance, December 31, 2011
Residential Mortgages	$	—		$	—		$	—
Commercial		211			211			—
Consumer / Other		—			—			—
		211			211			—
Charge-offs
Residential Mortgages		—			—			—
Commercial		—			—			—
Consumer / Other		—			—			—
Total Charge-offs		—			—			—
Loans transferred to other real estate owned
Residential Mortgages		—			—			—
Commercial		—			—			—
Consumer / Other		—			—			—
Total loans transferred to other real estate owned		—			—			—
Payments
Residential Mortgages		—			—			—
Commercial		(43	)		(43	)		—
Consumer / Other		—			—			—
Total Payments		(43	)		(43	)		—
Balance, September 30, 2012	$	168		$	168		$	—

Nine Months Ended September 30, 2011
	Carrying Value			Credit Fair Value Adjustment			Net Amount
Balance, December 31, 2010
Residential Mortgages	$	—		$	—		$	—
Commercial		229			229			—
Consumer / Other		—			—			—
		229			229			—
Charge-offs
Residential Mortgages		—			—			—
Commercial		—			—			—
Consumer / Other		—			—			—
Total Charge-offs		—			—			—
Loans transferred to other real estate owned
Residential Mortgages		—			—			—
Commercial		—			—			—
Consumer / Other		—			—			—
Total loans transferred to other real estate owned		—			—			—
Payments
Residential Mortgages		—			—			—
Commercial		(12	)		(12	)		—
Consumer / Other		—			—			—
Total Payments		(12	)		(12	)		—
Balance, September 30, 2011	$	217		$	217		$	—

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Note 17 – Fair Value Measurements

The following table sets forth the Company’s financial assets that were accounted for at fair value and are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

Level I–Quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date.

Level II–Observable inputs other than Level I prices, such as quoted prices for similar assets or liabilities in active markets; quoted prices in markets that are not active for identical or similar assets or liabilities; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level III–Unobservable inputs that are supported by little or no market activity and significant to the fair value of the assets or liabilities that are developed using the reporting entities’ estimates and assumptions, which reflect those that market participants would use.

Assets Measured at Fair Value on a Recurring Basis

A description of the valuation methodologies used for financial assets measured at fair value on a recurring basis, as well as the classification of the assets pursuant to the valuation hierarchy, are as follows:

Securities Available-for-Sale

Securities classified as available-for-sale are reported using Level I, Level II and Level III inputs. Level I instruments generally include equity securities valued in accordance with quoted market prices in active markets. Level II instruments include U.S. government agency obligations, state and municipal bonds, mortgage-backed securities and corporate bonds. For these securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. Level III instruments include certain non-public equity securities and real estate sold under contract. See Note 6 – Investment Securities for additional information.

Assets and liabilities measured at fair value on a recurring basis are summarized as follows:

	September 30, 2012
	Level I		Level II		Level III		Total
Assets:
Securities available-for-sale
U.S. Agency securities	$	—	$	78,138	$	—	$	78,138
Mortgage-backed securities:
Residential		—		24,450		—		24,450
States & political subdivisions:
Bank qualified tax exempt		—		59,916		—		59,916
Corporate securities:
Aaa credit rating		—		—		—		—
Equity securities:
Financial services industry		1,199		—		—		1,199
Total securities available-for-sale	$	1,199	$	162,504	$	—	$	163,703

29

	December 31, 2011
	Level I		Level II		Level III		Total
Assets:
Securities available-for-sale
U.S. Agency securities	$	—	$	77,985	$	—	$	77,985
Mortgage-backed securities:
Residential		—		22,166		—		22,166
States & political subdivisions:
Bank qualified tax exempt		—		65,388		—		65,388
Corporate securities:
Aaa credit rating		—		1,004		—		1,004
Equity securities:
Financial services industry		943		—		—		943
Total securities available-for-sale	$	943	$	166,543	$	—	$	167,486

Assets Measured at Fair Value on a Nonrecurring Basis

Certain non-financial assets and non-financial liabilities, measured at fair value on a non-recurring basis, include foreclosed and non-performing assets, goodwill and intangible assets.

A description of the valuation methodologies and classification levels used for non-financial assets and non-financial liabilities measured at fair value on a nonrecurring basis are listed as follows:

Goodwill and Other Identifiable Intangibles

The Company employs general industry practices in evaluating the fair value of its goodwill and other identifiable intangibles. The Company calculates the fair value, with the assistance of a third party specialist, using a combination of the following valuation methods: dividend discount analysis under the income approach, which calculates the present value of all excess cash flows plus the present value of a terminal value and market multiples (pricing ratios) under the market approach. Management performed a review of goodwill and other identifiable intangibles as of December 31, 2011. Goodwill and other identifiable intangibles were not evaluated during the nine months ended September 30, 2012 as a result of management’s determination that no evidence of impairment was present during the period.

Impaired Loans

At September 30, 2012 certain impaired loans were re-measured and reported at fair value through a specific valuation allowance allocation of the allowance for loan and lease losses based upon the fair value of the underlying collateral and the evaluation of expected future cash flows. Impaired loans with a carrying value of $5,355 were reduced by a specific valuation allowance allocation totaling $1,154, to a total reported fair value of $4,201 based on collateral valuations utilizing Level III valuation inputs.

Federal Home Loan Bank Stock

Federal Home Loan Bank of Pittsburgh (FHLB) stock is a required investment in order for the Company to participate in a FHLB line of credit program. The FHLB stock is stated at par value as it is restricted to purchases and sales with the FHLB.

Other Real Estate Owned

Foreclosed real estate, which is considered to be non-financial assets, has been valued using a market approach. The values were determined using market prices of similar real estate assets, which the Company considered to be Level II inputs.

30

Certain assets measured at fair value on a non-recurring basis as of September 30, 2012 is as follows:

	Fair Value Measurement Using
	Quoted Prices in Active Markets for Identical Assets/Liabilities		Significant Other Observable Inputs		Significant Unobservable Inputs		Balance September 30, 2012
	Level I		Level II		Level III		Total
Assets
Core deposit intangible	$	—	$	—	$	903	$	903
Goodwill		—		—		26,398		26,398
Impaired loans		—		—		4,201		4,201
Federal Home Loan Bank stock		—		—		4,764		4,764
Other real-estate owned		—		582		—		582
Total non-financial assets	$	—	$	582	$	36,266	$	36,848

Certain assets measured at fair value on a non-recurring basis as of December 31, 2011 is as follows:

	Fair Value Measurement Using
	Quoted Prices in Active Markets for Identical Assets/Liabilities		Significant Other Observable Inputs		Significant Unobservable Inputs		Balance December 31, 2011
	Level I		Level II		Level III		Total
Assets
Core deposit intangible	$	—	$	—	$	1,106	$	1,106
Goodwill		—		—		26,398		26,398
Impaired loans		—		—		2,876		2,876
Federal Home Loan Bank stock		—		—		4,953		4,953
Other real-estate owned		—		1,571		—		1,571
Total non-financial assets	$	—	$	1,571	$	35,333	$	36,904

A reconciliation of items in Level III for the nine month period ended September 30, 2012 is as follows:

	Core deposit intangible			Goodwill		Impaired Loans			Federal Home Loan Bank Stock			Total
Balance, December 31, 2011	$	1,106		$	26,398	$	2,876		$	4,953		$	35,333
Amortization of core deposit intangible		(203	)		—		—			—			(203	)
Increase in impaired loans		—			—		3,236			—			3,236
Decrease in impaired loans		—			—		(1,114	)		—			(1,114	)
Purchase of FHLB stock		—			—		—			840			840
Payments received		—			—		(797	)		(1,029	)		(1,826	)
Balance, September 30, 2012	$	903		$	26,398	$	4,201		$	4,764		$	36,266

31

A reconciliation of items in Level III for the year ended December 31, 2011 is as follows:

	Core deposit intangible			Goodwill		Impaired Loans			Federal Home Loan Bank Stock			Total
Balance, December 31, 2010	$	1,410		$	26,398	$	3,078		$	6,082		$	36,968
Amortization of core deposit intangible		(304	)		—		—			—			(304	)
Increase in impaired loans		—			—		2,586			—			2,586
Decrease in impaired loans		—			—		(2,178	)		—			(2,178	)
Payments received		—			—		(610	)		(1,129	)		(1,739	)
Balance, December 31, 2011	$	1,106		$	26,398	$	2,876		$	4,953		$	35,333

Disclosures about Fair Value of Financial Instruments

General Accepted Accounting Principles require disclosure of the estimated fair value of an entity’s assets and liabilities considered to be financial instruments. For the Company, as for most financial institutions, the majority of its assets and liabilities are considered financial instruments. However, many such instruments lack an available trading market, as characterized by a willing buyer and seller engaging in an exchange transaction. Also, it is the Company’s general practice and intent to hold its financial instruments to maturity and not to engage in trading or sales activities, except for certain loans and investments. Therefore, the Company had to use significant estimates and present value calculations to prepare this disclosure.

Changes in the assumptions or methodologies used to estimate fair values may materially affect the estimated amounts. Also, management is concerned that there may not be reasonable comparability between institutions due to the wide range of permitted assumptions and methodologies in the absence of active markets. This lack of uniformity gives rise to a high degree of subjectivity in estimating financial instrument fair values.

Estimated fair values have been determined by the Company using the best available data and an estimation methodology suitable for each category of financial instruments. The estimation methodologies used at September 30, 2012 and December 31, 2011 are outlined below. The methodologies for estimating the fair value of financial assets and financial liabilities that are measured at fair value on a recurring or non-recurring basis are discussed in the fair value measurements section above. The estimated fair value approximates carrying value for cash and cash equivalents, accrued interest and the bank owned life insurance policies. The methodologies for other financial assets and financial liabilities are discussed below:

Short-term financial instruments

The carrying value of short-term financial instruments including cash and due from banks, federal funds sold, interest-bearing deposits in banks and other short-term investments and borrowings, approximates the fair value of these instruments. These financial instruments generally expose the Company to limited credit risk and have no stated maturities or have short-term maturities with interest rates that approximate market rates.

Investment securities held-to-maturity

The estimated fair values of investment securities held to maturity are based on quoted market prices provided by independent third parties that specialize in those investment sectors. If quoted market prices are not available, estimated fair values are based on quoted market prices of comparable instruments.

Loans

The loan portfolio, net of unearned income, has been valued by a third party specialist using quoted market prices, if available. When market prices were not available, a credit risk-based discounted cash flow analysis was utilized. The primary assumptions utilized in this analysis are the discount rate based on the LIBOR curve, adjusted for credit risk, and prepayment estimates based on factors such as refinancing incentives, age of the loan and seasonality. These assumptions were applied by loan category and different spreads were applied based upon prevailing market rates by category.

32

Deposits

The estimated fair values of demand deposits (interest and non-interest bearing checking accounts, savings and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (their carrying amounts). The fair value for certificates of deposit was calculated by an independent third party by discounting contractual cash flows using current market rates for instruments with similar maturities, using a credit based risk model. The carrying amount of accrued interest receivable and payable approximates fair value.

Long-term borrowings

The amounts assigned to long-term borrowings were based on quoted market prices, when available, or based on discounted cash flow calculations using prevailing market interest rates for debt of similar terms.

The carrying and fair values of certain financial instruments are as follows:

	September 30, 2012						December 31, 2011
	Carrying Amount			Fair Value			Carrying Amount			Fair Value
Cash and cash equivalents	$	18,315		$	18,315		$	34,480		$	34,480
Investment securities held-to-maturity		17,690			18,786			23,722			24,969
Loans, net		632,094			647,432			624,811			637,976
Bank owned life insurance		17,490			17,490			15,870			15,870
Demand deposits		523,450			523,450			505,790			505,790
Time deposits		181,682			184,793			214,728			218,163
Short-term borrowings		11,873			11,873			9,981			9,981
Long-term borrowings		49,576			54,057			58,220			62,125
Standby Letters of Credit	$	(153	)	$	(153	)	$	(191	)	$	(191	)

Note 18 – Restatement

During the quarter ended June 30, 2012, the Company became aware that the actuarially computed value of its postretirement benefit liability was inaccurate. The postretirement benefit plan provides employees with life insurance coverage that continues at various levels after retirement. Due to a change in the assumptions provided by the Company to its actuary as to the cost of future premiums, the actuarially computed unfunded liability was understated.

The restatement resulted in the following changes to numbers previously reported:

As of December 31, 2010, an increase in other liabilities (postretirement liability) of $2,206 and an increase in other assets (deferred taxes) of $750 resulted in a net decrease to Stockholders’ Equity of $1,456, from $121,922 to $120,466.

As of June 30, 2011, an increase in other liabilities of $2,338 and an increase in other assets of $795 resulted in a net decrease to Stockholders’ Equity of $1,543, from $125,943 to $124,400.

For the three months ended September 30, 2011, an increase of $66 in salaries and employee benefits expense and a decrease of $22 in applicable income taxes, or a net reduction in net income of $44 from $2,818 to $2,774 or approximately $0.01 per share. Comprehensive income also was reduced by $44, from $3,929 to $3,885.

For the nine months ended September 30, 2011, an increase of $198 in salaries and employee benefits expense and a decrease of $67 in applicable income taxes, or a net reduction in net income of $131 from $8,193 to $8,062 or approximately $0.04 per share. Comprehensive income also was reduced by $131, from $10,702 to $10,571.

As of September 30, 2011, an increase in other liabilities (postretirement liability) of $2,404 and an increase in other assets (deferred taxes) of $817 resulted in a net decrease to Stockholders’ Equity of $1,587, from $128,496 to $126,909.

As of December 31, 2011, an increase in other liabilities (postretirement liability) of $2,525 and an increase in other assets (deferred taxes) of $858 resulted in a net decrease to Stockholders’ Equity of $1,667, from $129,000 to $127,333.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

FORWARD LOOKING INFORMATION

This Quarterly Report on Form 10-Q contains forward-looking statements that are based on assumptions and may describe future plans, strategies and expectations of Penseco Financial Services Corporation and its direct and indirect subsidiaries. These forward-looking statements are generally identified by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project” or similar expressions. Penseco Financial Services Corporation’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations include, but are not limited to, changes in interest rates, national and regional economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. government, including policies of the U.S. Department of Treasury and the Federal Reserve System, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in Penseco Financial Services Corporation’s market area, changes in the values of real estate and other collateral, particularly in our market area, changes in relevant accounting principles and guidelines and inability of third party service providers to perform.

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, Penseco Financial Services Corporation does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events.

Unless the context indicates otherwise, all references in this Quarterly Report to “Company,” “we,” “us” and “our” refer to Penseco Financial Services Corporation and its direct and indirect subsidiaries.

The following commentary provides an overview of the financial condition at September 30, 2012, including any significant changes from December 31, 2011, and significant changes in the results of our operations for the three and nine month periods ended September 30, 2012 and September 30, 2011.

Critical Accounting Policies

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Provision and Allowance for loan and lease losses–The provision for loan and lease losses charged to operating expense represents the adjustment that, in management’s judgment, is necessary to maintain the allowance for loan and lease losses at a level that is adequate to absorb probable losses inherent in the Company’s loan portfolio. The allowance for loan and lease losses is determined based on a documented and consistently applied methodology. This methodology considers all significant factors that affect the collectability of the loans within our portfolio, including past loan loss experience, management’s evaluation of the probable loss in the current loan portfolio under current economic conditions and such other factors as, in management’s best judgment, merit recognition in estimating loan and lease losses.

Actuarial assumptions associated with pension, post-retirement and other employee benefit plans–These assumptions include discount rate, rate of future compensation increases and expected return on plan assets.

Income taxes–The calculation of the provision for federal income taxes is complex and requires the use of estimates and judgments. Deferred federal income tax assets or liabilities represent the estimated impact of temporary differences between the recognition of assets and liabilities under GAAP, and how such assets and liabilities are recognized under the federal tax code. The Company uses an estimate of future earnings to support management’s position that the benefit of the deferred tax assets will be realized. If projected income is not recognized, at all or in the amounts predicted, the asset may not be realized and net income will be reduced. Deferred tax assets are described further in Note 18 of the “Notes to Consolidated Financial Statements” in the Company’s most recent Annual Report on Form 10-K.

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The Company and its subsidiary file income tax and other returns in the U.S. Federal jurisdiction, Pennsylvania state jurisdiction and certain local jurisdictions.

Management evaluated the Company’s tax positions and concluded that the aggregate liabilities related to taxes are appropriately reflected in the consolidated financial statements. With few exceptions, the Company is no longer subject to income tax examinations by the U.S. Federal, state or local tax authorities for years before 2008.

Fair Value Measurements–Fair values of financial instruments are estimated using relevant market information and other assumptions. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayment speeds and other factors. Changes in assumptions or in market conditions could significantly affect the estimates. Fair value measurements are classified within one of three levels within a valuation hierarchy based on the transparency of inputs to each valuation as of the fair value measurement date. The three levels are defined as follows:

Level I–quoted prices (unadjusted) for identical assets or liabilities in active markets.

Level II–inputs include quoted prices for similar assets and liabilities in active markets, quoted prices of identical or similar assets or liabilities in markets that are not active, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

Level III–inputs that are unobservable and significant to the fair value measurement. Financial instruments are considered Level III when values are determined using pricing models, discounted cash flow methodologies, or similar techniques, and at least one significant model assumption or input is unobservable.

Other-than-temporary impairment of investments–Investments are evaluated periodically to determine whether a decline in their value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. The term “other-than-temporary” is not intended to indicate that the decline is permanent. It indicates that the prospects for a near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the investment. Once a decline in value is determined to be other-than-temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.

Premium amortization–The amortization of premiums on mortgage-backed securities is done based on management’s estimate of the lives of the securities, adjusted, when necessary, for advanced prepayments in excess of those estimates.

Loans purchased–Loans purchased as a result of the Merger were recorded at the acquisition date fair value. Management made three different types of fair value adjustments in order to record the loans at fair value. An interest rate fair value adjustment was made comparing current weighted average rates of the acquired loans to stated market rates of similar loan types. A general credit fair value adjustment was made on similar loan types based on historical loss projections plus a discount for the weak economic environment. A specific credit fair value adjustment was made to loans identified by management as being problematic. The specific loans have been discounted by management based on collateral values and expected cash flows. The interest rate and general credit fair value adjustments are being accreted over an eight year period based on a sum-of-the-years-digits basis. The specific credit fair value adjustment is reduced only when cash flows are received or loans are charged-off or transferred to other real estate owned.

Loan servicing rights–Mortgage servicing rights are evaluated for impairment based on the fair value of those rights. Fair values are estimated using discounted cash flows based on current market rates of interest and expected future prepayment rates. For purposes of measuring impairment, the rights must be stratified by one or more predominant risk characteristics of the underlying loans. The Company stratifies its capitalized mortgage servicing rights based on the product type, interest rate and term of the underlying loans. The amount of impairment recognized is the amount, if any, by which the amortized cost of the rights for each stratum exceed the fair value.

Time deposits–Time deposits acquired through the Merger have been recorded at their acquisition date fair value. The fair value of time deposits represents the present value of the time deposits’ expected contractual payments discounted by market rates for similar deposits. The fair value adjustment is amortized monthly based on a level yield methodology.

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Securities sold under agreements to repurchase–The Company also offers securities sold under agreements to repurchase as an alternative to conventional savings deposits for its customers. The securities sold under agreements to repurchase are accounted for as a collateralized borrowing with a one day maturity and are collateralized by U.S. Agency securities.

Core deposit intangible–The fair value assigned to the core deposit intangible asset represents the future economic benefit of the potential cost savings from acquiring core deposits in the Merger compared to the cost of obtaining alternative funding, such as brokered deposits, from market sources. Management utilized an income approach to present value the expected after tax cash flow benefits of the acquired core deposits. The core deposit intangible is being amortized over ten years on a sum-of-the-years-digits basis.

Goodwill–Goodwill is reviewed by management for possible impairment at least annually or more frequently upon the occurrence of an event or when circumstances indicate that its carrying amount exceeds fair value. Management has obtained a professionally prepared qualitative test for goodwill impairment as of December 31, 2011. Market conditions that could negatively impact the value of goodwill in the future are essentially those Risk Factors discussed in Part I, Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, in particular Credit Risk, Interest Rate Risk and Compliance Risk. As a result of such qualitative impairment test, management has determined that goodwill was not impaired at December 31, 2011. Goodwill and other identifiable intangibles were not evaluated during the nine months ended September 30, 2012 as a result of management’s determination that no evidence of impairment was present during the period.

Depreciation–Provision for depreciation and amortization, computed principally on the straight-line method, is charged to operating expenses over the estimated useful lives of the assets.

Comparison of Operating Results

	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011*			2012			2011*
Interest Income	$	9,265		$	9,884		$	28,400		$	29,873
Interest Expense		1,262			1,785			4,150			5,604
Net Interest Income		8,003			8,099			24,250			24,269
Provision for loan and lease losses		471			445			777			1,713
Non-Interest Income		3,121			3,571			8,650			9,930
Non-Interest Expenses		7,340			7,522			21,941			21,973
Net Income	$	2,552		$	2,774		$	7,881		$	8,062
Total Revenue (1)	$	12,386		$	13,455		$	37,050		$	39,803
Net Interest Margin (2)		4.12	%		4.15	%		4.15	%		4.12	%
Return on Assets (ROA)		1.11	%		1.18	%		1.14	%		1.16	%
Return on Equity (ROE)		7.69	%		8.83	%		8.05	%		8.70	%

* - as restated see Note 18

(1) Total revenue is the sum of interest income and non-interest income.

(2) The net interest margin is equal to tax equivalent net interest income divided by average interest-earning assets.

The Company reported net income for the three months ended September 30, 2012 of $2,552, or $0.78 per basic and diluted weighted average share, compared with $2,774, or $0.85 per basic and diluted weighted average share, from the year ago period, a decrease of $222, or 8.0%. Pre-provision net interest income decreased $96, or 1.2%. Net interest income, after provision for loan and lease losses, decreased $122, or 1.6%, during the 2012 period, due to a decrease in interest income of $619, or 6.3%, an increased provision for loan and lease losses of $26, or 5.8%, offset by reduced interest expense of $523, or 29.3%, from lower funding costs. The decrease in interest income was primarily attributable to investment and loan cash flows being reinvested at historically low yields, including excess

36

reserve deposits held at the Federal Reserve Bank of Philadelphia. Non-interest income decreased $450, or 12.6%, largely due to decreased merchant transaction income due to lower volume and decreased net realized gains on securities, offset by higher net gains on the sale of other real estate owned property. Non-interest expenses decreased $182, or 2.4%, due mostly to lower merchant transaction expenses and premises and equipment expenses, offset by higher Pennsylvania shares tax expenses and FDIC insurance expenses.

The Company reported net income for the nine months ended September 30, 2012 of $7,881, or $2.41 per basic and diluted weighted average share, compared with $8,062, or $2.46 per basic and diluted weighted average share from the year ago period, a decrease of $181, or 2.2%. Pre-provision net interest income decreased $19, or 0.1%. Net interest income, after provision for loan and lease losses, increased $917, or 4.1%, during the 2012 period, due to a reduction in interest expense of $1,454, or 25.9%, from lower funding costs and a $936, or 54.6%, decrease in the provision for loan and lease losses, offset by a decrease in interest income of $1,473, or 4.9%. The decrease in interest income was primarily attributable to investment and loan cash flows being reinvested at historically low yields, including excess reserve deposits held at the Federal Reserve Bank of Philadelphia. Non-interest income decreased $1,280, or 12.9%, largely due to income recorded on the reversal of a contingent liability of $500 during the quarter ended March 31, 2011, along with decreased merchant transaction income and net realized gains on securities. Non-interest expenses decreased $32, or 0.1%, due mostly to lower merchant transaction expenses and premises and equipment expenses, offset by higher Pennsylvania shares tax expenses, other real estate owned expenses and salary and employee benefits.

The Dodd-Frank Act, which was enacted in July 2010, and the regulations that have been and will be promulgated under the Act, are reducing our non-interest income, such as overdraft fees by $115 for the nine months ended September 30, 2012 compared to the same period in 2011, and increasing compliance and regulatory costs.

We have defined our “core operations” to exclude the reversal, in the three months ended March 31, 2011, of a contingent liability recorded in connection with the acquisition of Old Forge Bank in the amount of $330, net of tax. Net income from core operations increased $149, or 1.9%, for the nine months ended September 30, 2012 to $7,881, compared to $7,732 for the same period in 2011. Net income from core operations is a non-GAAP measure of net income. A reconciliation of the net income from core operations and disclosure of the non-GAAP return on assets, return on equity and dividend payout ratio derived from that measure are described in the non-GAAP reconciliation included in this Quarterly Report on Form 10-Q on pages 54-55.

The following table reflects net income from accretion and amortization, net of taxes, of acquisition date fair value adjustments relating to the Merger included in the Company’s financial results during the periods indicated.

Accretion of the loan pools credit fair value adjustment and market rate fair value adjustment is calculated on a sum-of-the-years-digits basis over an eight year period. The fair value market rate adjustment of the time deposits is amortized monthly based on a level yield methodology over five years. The core deposit intangible established in connection with the 2009 acquisition of Old Forge Bank is being amortized over ten years from the date of acquisition on a sum-of-the-years-digits basis.

	Three Months Ended
	September 30, 2012			September 30, 2011
Homogeneous loan pools (interest income)	$	97		$	124
Time deposits (interest expense)		5			22
Core deposit intangible expense (other operating expense)		(43	)		(48	)
Net income from acquisition fair value adjustment	$	59		$	98
	Nine Months Ended
	September 30, 2012			September 30, 2011
Homogeneous loan pools (interest income)	$	316		$	403
Time deposits (interest expense)		23			77
Core deposit intangible expense (other operating expense)		(134	)		(152	)
Net income from acquisition fair value adjustment	$	205		$	328

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Net Interest Income and Net Interest Margin

Net interest income, the principal component of the Company’s earnings, is defined as the difference between interest and fees earned on interest-earning assets and interest paid on deposits and other borrowings. Average interest-earning assets are composed primarily of loans and investments while deposits and short-term and long-term borrowings represent interest-bearing liabilities. Variations in the volume and mix of these assets and liabilities, as well as changes in the yields earned and rates paid, are determinants of changes in net interest income.

Net interest income (before the provision for loan and lease losses) decreased $96, or 1.2%, to $8,003 for the three months ended September 30, 2012 compared to $8,099 for the three months ended September 30, 2011. The average yield on interest-earning assets decreased 28 basis points, or 5.6%.

The net interest margin represents the Company’s net yield on its average interest-earning assets and is calculated as net interest income divided by average interest-earning assets. For the three months ended September 30, 2012, net interest margin (tax equivalent basis) decreased 3 basis points, to 4.12%, from 4.15% in the same period of 2011.

The most significant impact on net interest income between periods is derived from the interaction of changes in the volume of, and rates earned or paid on, interest-earning assets and interest-bearing liabilities. The volume of earning dollars in loans and investments, compared to the volume of interest-bearing liabilities represented by deposits and borrowings, combined with the spread, produces the changes in net interest income between periods.

Total average interest-earning assets and average interest-bearing liabilities decreased from the three months ended September 30, 2011. Due to current low interest rates, the Bank is reluctant to maintain long-term, thirty year, mortgage loans and commit to long-term investment securities and has decided to allow these assets to runoff or refinance out of the Bank’s portfolio. Average interest-earning assets decreased $6.7 million, or 0.8%, from $835.2 million for the three months ended September 30, 2011 to $828.5 million for the corresponding period in 2012 and average interest-bearing liabilities decreased $48.2 million, or 7.1%, from $683.2 million to $635.0 million over the same periods. As a percentage of average assets, average interest-earning assets, including bank-owned life insurance (BOLI), increased for the three months ended September 30, 2012 and 2011, respectively, to 91.9% from 90.3%.

Changes in the mix of both interest-earning assets and funding sources also impacted net interest income in the three months ended September 30, 2012 and 2011. Average loans as a percentage of average interest-earning assets increased from 75.0% for the three months ended September 30, 2011 to 76.8% for the corresponding period in 2012. Average investment securities increased $3.6 million, or 2.0%, period over period, and as a percentage of interest-earning assets, increased to 22.1% for the three months ended September 30, 2012 from 21.5% for the three months ended September 30, 2011. Average short-term investments, federal funds sold, FHLB stock and interest-bearing balances with banks, decreased as a percentage of average assets to 1.0% for the three months ended September 30, 2012 from 3.1% for the three months ended September 30, 2011. Average time deposits decreased $56.6 million, or 22.9%, from $247.3 million, or 36.2%, of interest-bearing liabilities for the three months ended September 30, 2011 to $190.7 million, or 30.0%, of interest-bearing liabilities for the corresponding period of 2012. Also, during the three months ended September 30, 2012, average securities sold under agreements to repurchase decreased $11.9 million, or 51.7%, and average long-term borrowings decreased $10.8 million, or 17.6%.

Shifts in the interest rate environment to lower rates and local competition for loans and deposits affected the rates paid for funds as well as the yields earned on assets. The investment securities tax equivalent yield decreased 72 basis points from 4.08% for the three months ended September 30, 2011 to 3.36% for the three months ended September 30, 2012. Also, average loan yields decreased 31 basis points from 5.51% for the three months ended September 30, 2011 to 5.20% for the three months ended September 30, 2012.

The average time deposit costs decreased 24 basis points from 1.43% for the three months ended September 30, 2011 to 1.19% for the three months ended September 30, 2012. In addition, the average cost of money market accounts decreased 14 basis points from 0.48% for the three months ended September 30, 2011 to 0.34% for the three months ended September 30, 2012.

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Interest expense for the three months ended September 30, 2012 totaled $1,262, compared to $1,785 in 2011, a decrease of $523 or 29.3%. The average rate paid on interest-bearing liabilities for the three months ended September 30, 2012 decreased to 0.79%, compared to 1.08% in 2011. Average savings deposits increased $8.0, or 6.7%. Average time deposits decreased $56.6, or 22.9%, for the three months ended September 30, 2012 due primarily to the redemption of brokered certificates of deposit. Average demand non-interest bearing deposits increased $14.3, or 11.5%.

The historically low interest rates continue to stress our margin as funding costs have reached a low point and asset yields for the most part continue to price downward.

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Distribution of Assets, Liabilities and Stockholders’ Equity / Interest Rates and Interest Differential

The table below presents average balances, interest income on a taxable equivalent basis and interest expense, as well as average rates earned and paid on the Company’s major asset and liability items for the three months ended September 30, 2012 and September 30, 2011.

	September 30, 2012							September 30, 2011*
	Average Balance		Revenue/ Expense		Yield/ Rate			Average Balance		Revenue/ Expense		Yield/ Rate
ASSETS
Investment Securities
Available-for-sale:
U.S. Agency obligations	$	103,565	$	378		1.46	%	$	78,800	$	361		1.80	%
States & political subdivisions		59,444		629		6.41	%		64,144		721		6.81	%
Other		1,103		13		4.71	%		5,253		16		1.20	%
Held-to-maturity:
U.S. Agency obligations		17,580		166		3.78	%		24,713		236		3.84	%
States & political subdivisions		1,200		16		8.00	%		6,399		82		7.75	%
Loans, net of unearned income:
Real estate mortgages		288,186		3,400		4.72	%		315,109		4,040		5.16	%
Commercial real estate		190,472		2,243		4.71	%		185,664		2,292		4.92	%
Commercial		61,423		855		5.57	%		41,198		610		5.88	%
Consumer and other		96,072		1,561		7.37	%		84,493		1,521		7.95	%
Federal funds sold		—		—		—			10,109		2		0.12	%
Federal Home Loan Bank stock		4,928		1		0.08	%		5,298		—		—
Interest on balances with banks		4,546		3		0.26	%		14,010		3		0.12	%
Total Interest-Earning Assets/
Total Interest Income		828,519	$	9,265		4.73	%		835,190	$	9,884		5.01	%
Cash and due from banks		21,740							42,669
Bank premises and equipment		14,790							13,214
Accrued interest receivable		2,864							3,128
Goodwill		26,398							26,398
Bank owned life insurance		17,415							15,676
Other assets		15,283							12,952
Less: Allowance for loan and lease losses		6,728							6,553
Total Assets	$	920,281						$	942,674
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits:
Demand-Interest bearing	$	90,932	$	49		0.22	%	$	68,680	$	51		0.24	%
Savings		126,853		34		0.11	%		118,937		78		0.24	%
Money markets		164,461		138		0.34	%		163,339		186		0.48	%
Time - Over $100		81,431		287		1.41	%		84,542		367		1.68	%
Time - Other		109,241		279		1.02	%		162,767		518		1.32	%
Federal funds purchased		—		—		—			—		—		—
Securities sold under agreements to repurchase		11,081		9		0.32	%		23,027		21		0.36	%
Short-term borrowings		269		—		0.00	%		385		—		—
Long-term borrowings		50,703		466		3.68	%		61,527		564		3.72	%
Total Interest Bearing Liabilities/
Total Interest Expense		634,971	$	1,262		0.79	%		683,204	$	1,785		1.08	%
Demand - Non-interest bearing		139,105							124,831
All other liabilities		13,489							9,045
Stockholders’ equity		132,716							125,594
Total Liabilities and Stockholders’ Equity	$	920,281						$	942,674
Interest Spread						3.94	%						3.93	%
Net Interest Income			$	8,003						$	8,099
FINANCIAL RATIOS
Net interest margin (1)						4.12	%						4.15	%
Return on average assets						1.11	%						1.18	%
Return on average equity						7.69	%						8.83	%
Average equity to average assets						14.42	%						13.32	%
Dividend payout ratio						53.85	%						49.41	%

* - as restated see Note 18

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(1) The net interest margin is equal to tax equivalent net interest income divided by average interest-earning assets. In order to make pre-tax income on tax-exempt investments and loans comparable to taxable investments and loans, a tax equivalent adjustment is made to interest income. This adjustment increased interest income by $541 and $572 for the three months ended September 30, 2012 and 2011, respectively. The Company believes that the tax equivalent presentation is consistent with industry practice. Although the Company believes that these financial measures enhance investors’ understanding of our business and performance, these measures should not be considered an alternative to GAAP.

Net interest income (before the provision for loan and lease losses) decreased $19, or 0.1%, to $24,250 for the nine months ended September 30, 2012 compared to $24,269 for the nine months ended September 30, 2011. The average yield on interest-earning assets decreased 18 basis points, or 3.6%.

For the nine months ended September 30, 2012, net interest margin increased 3 basis points to 4.15% from 4.12% in the same period of 2011.

Total average interest-earning assets and average interest-bearing liabilities decreased from the nine months ended September 30, 2012. Average interest-earning assets decreased $9.1 million, or 1.1%, from $842.5 million for the nine months ended September 30, 2011 to $833.4 million for the corresponding period in 2012 and average interest-bearing liabilities decreased $34.7 million, or 5.1%, from $676.5 million to $641.8 million over the same periods. As a percentage of average assets, average interest-earning assets, including bank-owned life insurance (BOLI), decreased for the nine months ended September 30, 2012 and 2011, respectively, to 92.1% from 92.5%.

Changes in the mix of both interest-earning assets and funding sources also impacted net interest income in the nine months ended September 30, 2012 and 2011. Average loans as a percentage of average interest-earning assets increased from 73.5% for the nine months ended September 30, 2011 to 76.4% for the corresponding period in 2012. Average investment securities decreased $11.5 million, or 5.8%, period over period, and as a percentage of interest-earning assets, decreased to 22.5% for the nine months ended September 30, 2012 from 23.6% for the nine months ended September 30, 2011. Average short-term investments, federal funds sold, FHLB stock and interest-bearing balances with banks, decreased as a percentage of average assets to 1.0% for the nine months ended September 30, 2012 from 2.6% for the nine months ended September 30, 2011. Average time deposits decreased $46.9 million, or 18.9%, from $248.0 million, or 36.7%, of interest-bearing liabilities for the nine months ended September 30, 2011 to $201.1 million, or 31.3%, of interest-bearing liabilities for the corresponding period in 2012. Also, during the nine months ended September 30, 2012, average securities sold under agreements to repurchase decreased $11.1 million, or 52.1%, and average long-term borrowings decreased $10.7 million, or 16.7%.

Shifts in the interest rate environment to lower rates and local competition for loans and deposits affected the rates paid for funds as well as the yields earned on assets. The investment securities tax equivalent yield decreased 55 basis points from 4.04% for the nine months ended September 30, 2011 to 3.49% for the nine months ended September 30, 2012. Also, average loan yields decreased 24 basis points from 5.51% for the nine months ended September 30, 2011 to 5.27% for the nine months ended September 30, 2012.

The average time deposit costs decreased 23 basis points from 1.51% for the nine months ended September 30, 2011 to 1.28% for the nine months ended September 30, 2012. In addition, the average cost of money market accounts decreased 13 basis points from 0.48% for the nine months ended September 30, 2011 to 0.35% for the nine months ended September 30, 2012.

Interest expense for the nine months ended September 30, 2012 totaled $4,150, compared to $5,604 in 2011, a decrease of $1,454 or 25.9%. The average rate paid on interest-bearing liabilities for the nine months ended September 30, 2012 decreased to 0.86%, compared to 1.08% in 2011. Average savings deposits increased $7.1, or 6.1%. Average time deposits decreased $46.9, or 18.9%, for the nine months ended September 30, 2012 due primarily to the redemption of brokered certificates of deposit. Average demand non-interest bearing deposits increased $19.1, or 16.0%.

41

Distribution of Assets, Liabilities and Stockholders’ Equity / Interest Rates and Interest Differential

The table below presents average balances, interest income on a taxable equivalent basis and interest expense, as well as average rates earned and paid on the Company’s major asset and liability items for the nine months ended September 30, 2012 and September 30, 2011.

	September 30, 2012							September 30, 2011*
	Average Balance		Revenue/ Expense		Yield/ Rate			Average Balance		Revenue/ Expense		Yield/ Rate
ASSETS
Investment Securities
Available-for-sale:
U.S. Agency obligations	$	103,935	$	1,233		1.58	%	$	94,345	$	1,377		1.92	%
States & political subdivisions		61,513		1,970		6.47	%		63,195		2,153		6.88	%
Other		1,290		39		4.03	%		5,219		45		1.20	%
Held-to-maturity:
U.S. Agency obligations		19,258		565		3.91	%		26,197		780		3.96	%
States & political subdivisions		1,450		57		7.91	%		9,903		374		7.63	%
Loans, net of unearned income:
Real estate mortgages		291,846		10,631		4.86	%		317,262		12,205		5.16	%
Commercial real estate		188,716		6,670		4.71	%		179,380		6,642		4.92	%
Commercial		57,582		2,341		5.42	%		39,782		1,735		5.76	%
Consumer and other		98,865		4,883		7.48	%		82,707		4,551		8.05	%
Federal funds sold		—		—		—			3,992		2		0.12	%
Federal Home Loan Bank stock		5,162		4		0.10	%		5,611		—		—
Interest on balances with banks		3,758		7		0.25	%		14,873		9		0.12	%
Total Interest-Earning Assets/
Total Interest Income		833,375	$	28,400		4.82	%		842,466	$	29,873		5.00	%
Cash and due from banks		21,575							21,148
Bank premises and equipment		14,242							13,336
Accrued interest receivable		2,975							3,291
Goodwill		26,398							26,398
Bank owned life insurance		17,017							15,551
Other assets		14,439							12,421
Less: Allowance for loan and lease losses		6,744							6,566
Total Assets	$	923,277						$	928,045
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits:
Demand-Interest bearing	$	90,956	$	172		0.25	%	$	69,653	$	185		0.36	%
Savings		124,257		132		0.14	%		117,185		235		0.24	%
Money markets		161,136		421		0.35	%		155,223		555		0.48	%
Time - Over $100		82,500		899		1.45	%		83,907		1,100		1.80	%
Time - Other		118,601		1,033		1.16	%		164,139		1,705		1.44	%
Federal funds purchased		33		—		—			—		—		—
Securities sold under agreements to repurchase		10,210		25		0.33	%		21,288		67		0.36	%
Short-term borrowings		742		2		0.36	%		1,039		3		0.36	%
Long-term borrowings		53,362		1,466		3.66	%		64,099		1,754		3.60	%
Total Interest Bearing Liabilities/
Total Interest Expense		641,797	$	4,150		0.86	%		676,533	$	5,604		1.08	%
Demand - Non-interest bearing		138,334							119,191
All other liabilities		12,643							8,787
Stockholders’ equity		130,503							123,534
Total Liabilities and Stockholders’ Equity	$	923,277						$	928,045
Interest Spread						3.96	%						3.92	%
Net Interest Income			$	24,250						$	24,269
FINANCIAL RATIOS
Net interest margin (1)						4.15	%						4.12	%
Return on average assets						1.14	%						1.16	%
Return on average equity						8.05	%						8.70	%
Average equity to average assets						14.13	%						13.31	%
Dividend payout ratio						52.28	%						51.22	%

* - as restated see Note 18

42

(1) The net interest margin is equal to tax equivalent net interest income divided by average interest-earning assets. In order to make pre-tax income on tax-exempt investments and loans comparable to taxable investments and loans, a tax equivalent adjustment is made to interest income. This adjustment increased interest income by $1,711 and $1,742 for the nine months ended September 30, 2012 and 2011, respectively. The Company believes that the tax equivalent presentation is consistent with industry practice. Although the Company believes that these financial measures enhance investors’ understanding of our business and performance, these measures should not be considered an alternative to GAAP.

Provision for Loan and Lease Losses

The provision for loan and lease losses represents the charge to operating expense necessary to maintain the allowance for loan and lease losses at a level which management determines is adequate to absorb probable losses inherent in the Company’s loan portfolio.

During the three and nine months ended September 30, 2012, the local economy continued to struggle. The local housing market remained weak and the unemployment rate in Northeastern Pennsylvania was 9.4% at August 31, 2012. The Company continues to proactively evaluate probable loan and lease losses and address delinquent loans by, among other things, obtaining current appraisals of collateral, increasing communication with clients and placing loans on non-accrual status when collection is in doubt and the loan is moving toward foreclosure.

The Bank’s methodology for determining the allowance for loan and lease losses (ALLL) is based on a documented and consistently applied analysis of its loan portfolio. This analysis considers all significant factors that affect the collectability of the loans within our portfolio and supports the credit losses estimated by this process. Our ALLL methodology includes procedures for a review by a party who is independent of the Bank’s credit approval and ALLL estimation processes.

The Bank applies its allowance methodology in accordance with the Federal Financial Institutions Examination Council (“FFIEC”) Interagency Policy Statements, as amended, and GAAP to assess the adequacy of its allowance for loan and lease losses. Under GAAP, the adequacy of the allowance for loan and lease losses is determined based on the provisions of FASB ASC 310 for loans specifically identified to be individually evaluated for impairment and the requirements of FASB ASC 450 for large groups of smaller balance homogeneous loans to be collectively evaluated for impairment. Loans are identified by the Bank’s rating system, past due reports, watch list and sensitivity to economic factors and are then collectively evaluated for impairment compared to other loans utilizing standard criteria. Consideration is given to current local economic conditions which the Company continues to classify as recessionary.

The Bank’s historical analysis of loss factors, utilizes a rolling twenty quarters, but assigns greater weight to the four quarters of the previous five years that reflected the greatest loan loss allowances calculated by dollar amount. This methodology is designed to better address deterioration in local economic conditions. In addition, and in view of the concentration of the Bank’s loan portfolio in real estate – approximately 80% of the portfolio is secured by real estate mainly in the counties in which the Bank operates – the Bank also took into account the decline in real estate sales and new construction in our market area and drop in real estate values within the market area. The Bank’s provision for loan and lease losses for the quarter ended September 30, 2012 was allocated primarily to commercial portfolios. Reference should be made to the information about the Company’s provision for loan and lease losses under the heading “General Notes to Financial Statements – Note 7 – Loan Portfolio”.

There were no changes in the methodology of determining the allowance for loan losses during the three and nine months ended September 30, 2012. Management continues to focus on trends in real estate delinquencies related to the poor labor and housing markets locally, in determining the allowance for loan losses. Management also continually compares the probable losses estimated in accordance with our allowance for loan loss methodology with actual losses.

Based on this methodology, management made a provision for loan and lease losses of $777 for the nine month period ended September 30, 2012, compared to a $1,713 provision for the comparable prior year period, resulting in an allowance for loan and lease losses of $6,966 at September 30, 2012 compared to $6,711 at September 30, 2011. We believe that the decrease in the provision for loan and lease losses for the nine months ended September 30, 2012 reflects management’s proactive efforts to resolve credit issues through closer interaction with the affected customers, active collection efforts and foreclosure.

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The amount and number of charge-offs and foreclosures during the periods indicated are as follows:

At:	At and For The Nine Months Ended September 30, 2012			At and For The Twelve Months Ended December 31, 2011			At and For The Nine Months Ended September 30, 2011
Provision for loan and lease losses	$	777		$	2,381		$	1,713
Allowance for loan and lease losses to non-performing loans		269.69	%		211.97	%		194.35	%
Non-performing loans to period end loans		0.40	%		0.50	%		0.54	%
Ratio of charged-off loans to average loans		0.09	%		0.37	%		0.25	%
Ratio of foreclosed loans to average loans		0.13	%		0.38	%		0.38	%
Allowance for loan and lease losses to period end loans		1.09	%		1.06	%		1.05	%

At:	At and For The Nine Months Ended September 30, 2012				At and For The Twelve Months Ended December 31, 2011				At and For The Nine Months Ended September 30, 2011
	Amount		(#)		Amount		(#)		Amount		(#)
Charge-offs	$	586		48	$	2,300		90	$	1,576		66
Foreclosures completed		835		9		2,370		14		2,370		14
Non-performing loans		2,583		75		3,166		77		3,453		82

The Company had one commercial loan whose terms had been modified in a troubled debt restructuring (TDR) as of September 30, 2012 and December 31, 2011; monthly payments were lowered to accommodate the borrower’s financial needs for a period of time.

The following table presents loans whose terms were modified in a TDR at the dates indicated below:

	September 30, 2012		December 31, 2011
Restructured Loans on Accrual Status and Not Past Due 90 Days or More	$	354	$	368
Restructured Loans Included in Non-Accrual Loans or Accruing Loans Past Due 90 Days or More		—		—
Total Restructured Loans	$	354	$	368

The Company believes that the judgments used in determining the allowance for loan and lease losses are based on reliable information. In assessing the adequacy of the allowance for loan and lease losses, management considers how well prior estimates have related to actual experience. The Company continually monitors the risk elements, historical rates and other data used in determining the allowance on a periodic basis. Based on this ongoing evaluation, a provision for loan and lease losses is made in the amount necessary to maintain an appropriate allowance.

The methodology for determining the adequacy of the allowance is necessarily judgmental and subject to changes in external conditions. Although management uses available information to establish the appropriate level of the allowance for loan and lease losses, future additions or reductions to the allowance may be necessary as a result of changes in economic conditions and other factors. As a result, our allowance for loan and lease losses may not be sufficient to cover actual loan and lease losses, and future provisions for loan and lease losses could materially adversely affect the Company’s operating results. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan and lease losses. Discussions with these regulatory agencies may result in adjustments to the Company’s allowance based on judgments about information available to the agencies at the time of their examination.

44

Other than the risks associated with the geographic concentration of our customers, facilities and the collateral securing some of our loans, there are no particular risk elements in the local economy that put a group or category of loans at increased risk. However, the Company has increased its portfolio of commercial and commercial real estate loans in past the five years, which typically bear a higher risk. These loans are typically secured by real estate to minimize this risk. At September 30, 2012, management believes the allowance for loan and lease losses is adequate to absorb probable loan and lease losses inherent in the loan portfolio.

Non-Interest Income

The following table sets forth information by category of non-interest income for the Company for the three months ended September 30, 2012 and September 30, 2011, respectively:

Three Months Ended	September 30, 2012		September 30, 2011
Trust department income	$	409	$	431
Service charges on deposit accounts		489		540
Merchant transaction income		1,357		1,680
Brokerage fee income		60		52
Other fee income		427		450
Bank-owned life insurance income		129		124
Other operating income		247		135
Realized gains (losses) on securities, net		3		159
Total Non-Interest Income	$	3,121	$	3,571

Total non-interest income decreased $450, or 12.6%, to $3,121 for the three months ended September 30, 2012, compared with $3,571 for the same period in 2011. This decrease was primarily attributable to a decrease of $323 in merchant transaction income due to lower volume and a decrease of $156 in net realized gains on securities. These decreases were offset by a $112 increase in other operating income resulting from increases in the gains on the sale of mortgage loans and, to a lesser extent, increases in brokerage fee income and bank-owned life insurance income.

The following table sets forth information by category of non-interest income for the Company for the nine months ended September 30, 2012 and September 30, 2011, respectively:

Nine Months Ended:	September 30, 2012		September 30, 2011
Trust department income	$	1,112	$	1,214
Service charges on deposit accounts		1,416		1,531
Merchant transaction income		3,455		3,853
Brokerage fee income		201		185
Other fee income		1,291		1,259
Bank-owned life insurance income		378		369
Other operating income		678		1,080
Realized gains (losses) on securities, net		119		439
Total Non-Interest Income	$	8,650	$	9,930

Total non-interest income decreased $1,280, or 12.9%, to $8,650 for the nine months ended September 30, 2012, compared with $9,930 for the same period in 2011. This decrease was attributable to a decrease of $402 in other operating income due to income recorded in connection with the reversal of a contingent liability of $500 during the quarter ended March 31, 2011, as well as a $398 decrease in merchant transaction income due to lower volume, a $320 decrease in net realized gains on securities, a $115 decrease in service charges on deposit accounts due to decreased overdraft activity and a $102 decrease in trust department income due to lower estate fees.

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Non-Interest Expenses

The following table sets forth information by category of non-interest expense for the Company for the three months ended September 30, 2012 and September 30, 2011, respectively:

Three Months Ended:	September 30, 2012		September 30, 2011*
Salaries and employee benefits	$	3,413	$	3,463
Expense of premises and equipment, net		678		887
Merchant transaction expenses		866		1,110
FDIC insurance assessments		113		14
Other operating expenses		2,270		2,048
Total Non-Interest Expenses	$	7,340	$	7,522

* - as restated see Note 18

Total non-interest expenses decreased $182, or 2.4%, to $7,340 for the three months ended September 30, 2012 compared with $7,522 for the same period in 2011. Expense of premises and equipment decreased $209, due primarily to lower occupancy and depreciation expense. Merchant transaction expenses decreased $244, due to lower volume. These decreases in total non-interest expenses were partially offset by an increase in other operating expenses of $222, resulting from increased Pennsylvania shares tax expense and other real estate owned expenses and increased FDIC insurance assessments of $99.

The following table sets forth information by category of non-interest expense for the Company for the nine months ended September 30, 2012 and September 30, 2011, respectively:

Nine Months Ended:	September 30, 2012		September 30, 2011*
Salaries and employee benefits	$	10,617	$	10,366
Expense of premises and equipment, net		2,230		2,714
Merchant transaction expenses		2,193		2,609
FDIC insurance assessments		343		436
Other operating expenses		6,558		5,848
Total Non-Interest Expenses	$	21,941	$	21,973

* - as restated see Note 18

Total non-interest expenses decreased $32, or 0.1%, to $21,941 for the nine months ended September 30, 2012 compared with $21,973 for the same period in 2011. Expense of premises and equipment decreased $484, due primarily to lower occupancy and depreciation expense. Merchant transaction expenses decreased $416, due to lower volume. FDIC insurance assessments decreased $93. These decreases in total non-interest expenses were offset by an increase in other operating expenses of $710, resulting from increased Pennsylvania shares tax expense and other real estate owned expenses and an increase in salaries and employee benefits of $251, primarily attributable to merit-based increases, mortgage banking commissions and supplemental retirement plan expenses.

Income Taxes

Applicable income taxes decreased $168, or 18.1%, and $150, or 6.1%, primarily due to lower taxable income for the three months and nine months ended September 30, 2012, respectively.

Cash Equivalents and Investments

The Company’s investment portfolio has two primary functions: to provide liquidity and to contribute to earnings. To provide liquidity, the Company may invest in short-term securities such as Federal funds sold and interest-bearing deposits with banks, which are classified as cash equivalents, as well as U.S. Treasury securities and U.S. Agency securities with maturities of one year or less. These funds are invested on a short-term basis to ensure the availability of funds to meet customer demand for credit needs.

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The Company enhances interest income by securing long-term investments within its investment portfolio by means of U.S. Treasury securities, U.S. Agency securities, municipal securities and mortgage-backed securities, generally with maturities greater than one year. The Company’s mortgage-backed securities portfolio does not contain any sub-prime or Alt-A credits. The Company is considering replacing investment proceeds with loans and the remainder of the excess cash flows being redeployed into AAA-rated securities with three to four year durations.

The Company remains highly liquid despite the use of investment and loan cash flows to fund the reduction of higher cost borrowings and time deposits.

The following table presents the carrying value, by security type and by maturity, for the Company’s investment portfolio:

	September 30, 2012		December 31, 2011
U.S. Agency obligations	$	78,138	$	77,985
Mortgage-backed securities		41,058	$	44,078
States & political subdivisions		60,998		67,198
Corporate securities		—		1,004
Total Debt Securities		180,194		190,265
Equity Securities		1,199		943
Total Investment Securities	$	181,393	$	191,208

Loan Portfolio

Details regarding the Company’s loan portfolio are as follows:

As of:	September 30, 2012		December 31, 2011
Construction and land development
Residential real estate	$	5,020	$	5,064
Commercial real estate		17,989		20,541
Residential real estate		262,021		276,579
Commercial secured by real estate		199,747		188,334
Commercial loans		58,276		55,482
Credit card and related plans		3,040		3,242
Installment and other		62,455		59,170
Obligations of states & political subdivisions		30,512		23,110
Loans, net of unearned income		639,060		631,522
Less: Allowance for loan and lease losses		6,966		6,711
Loans, net	$	632,094	$	624,811

There were no purchased loans during the three and nine months ended September 30, 2012, other than loan participations with local banks in the Bank’s primary market area. Originations of new loans in 2012 were primarily commercial and municipal loans.

The Company has not engaged in any sub-prime residential mortgage lending. Therefore, the Company is not subject to any credit risks associated with such loans. The Company’s loan portfolio consists primarily of residential and commercial mortgage loans secured by properties located in Northeastern Pennsylvania and subject to what we believe are conservative underwriting standards.

Loans secured by real estate continue to be the largest component of the loan portfolio, representing 76% and 78% of total loans at September 30, 2012 and December 31, 2011, respectively. Economic conditions and recessionary concerns over the past several years have resulted in lower levels of loan demand. The decline ratio on loan applications has remained consistent with our historical experience. As we expect these conditions and concerns to continue for the near term, we expect that loan growth may be slower than historically expected.

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Loan Quality

Our lending activities are guided by a comprehensive lending policy approved by our board of directors. Loans must meet certain criteria relating to the character, capacity and capital of the borrower, collateral provided for the loan, and prevailing economic conditions. Our non-performing assets and charge-offs are well below industry levels, which we believe reflects the consistent application of our conservative underwriting standards.

Regardless of credit standards, there is risk of loss inherent in every loan portfolio. The allowance for loan and lease losses is an amount that management believes will be adequate to absorb probable losses on existing loans. The evaluations take into consideration such factors as change in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, industry experience, collateral value and current economic conditions that may affect the borrower’s ability to pay. Management believes that the allowance for loan and lease losses was adequate at September 30, 2012. Management uses available information to estimate probable losses on loans; however, future additions to the allowance may be necessary based on changes in economic conditions and other factors. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan and lease losses. Such agencies may require the Company to recognize additions to the allowance, or take other actions that would impact the allowance, based on their judgment of information available to them at the time of their examination.

The allowance for loan and lease losses is increased by periodic charges against earnings as a provision for loan and lease losses, and decreased periodically by charge-offs of loans (or parts of loans) that management has determined to be uncollectible, net of actual recoveries on loans previously charged-off. (See also, “Provision for Loan and Leases Losses.”)

The allowance for loan and lease losses as a percentage of loans was 1.09% at September 30, 2012, compared to 1.06% at December 31, 2011 and 1.05% at September 30, 2011.

Market Area

The Northeastern Pennsylvania economy in which we operate has been affected by the economic decline that has affected the U.S. economy as a whole. The national unemployment rate and the statewide unemployment rate stood at 8.1% and the Scranton/Wilkes-Barre metropolitan area unemployment rate was 9.4% at August 31, 2012. The region still leads the state’s 14 metro areas with the highest unemployment rate for more than two years, according to the data released recently by the State Department of Labor and Industry. The high unemployment rate can be attributed to a gradual decline in manufacturing in Northeastern Pennsylvania, and much like the rest of the country, a slowdown in construction of residential and commercial property.

High unemployment in Northeastern Pennsylvania will continue to put pressure on the local economy and on our loan portfolio. Average home prices only increased by 1.2% in July over the year-earlier period, according to the latest Case-Shiller House Price Index, which is a leading measure for the U.S. residential housing market. We believe that our focus on identifying borrowers who are facing cash flow problems before they are unable to make their payments will significantly improve our ability to help these borrowers maintain their debt service through difficult times.

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Non-Performing Assets

Non-performing assets consist of non-accrual loans and other real estate owned. The following table sets forth information regarding non-performing assets and loans past due 90 days or more and still accruing interest as of the dates indicated:

As of:	September 30, 2012			December 31, 2011			September 30, 2011
Non-accrual loans
Residential real estate	$	1,958		$	2,006		$	2,332
Commercial real estate		133			591			608
Commercial loans		388			477			443
Consumer loans		104			92			70
Total non-performing loans	$	2,583		$	3,166		$	3,453
Other real estate owned		582			1,571			2,109
Total non-performing assets	$	3,165		$	4,737		$	5,562
Loans past due 90 days or more and accruing:
Residential real estate	$	1,369		$	641		$	496
Commercial real estate		—			11			—
Guaranteed student loans		200			113			240
Credit card loans		6			6			24
Commercial loans		—			—			—
Consumer loans		5			3			5
Total loans past due 90 days or more and accruing	$	1,580		$	774		$	765
Non-performing loans to period end loans		0.40	%		0.50	%		0.54	%
Total loans past due 90 days or more and accruing to period end loans		0.25	%		0.12	%		0.12	%
Non-performing assets to period end assets		0.35	%		0.51	%		0.59	%

Loans are generally placed on non-accrual status when principal or interest is past due 90 days and when payment in full is not anticipated. For commercial loans, an appraisal is obtained if the loan has been downgraded and the appraisal on file is at least one year old. When a loan is placed on non-accrual status, all interest previously accrued but not collected is charged against current income. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured after a minimum of a six month positive payment history.

In 2008, the Company was notified that The Education Resources Institute, Inc. (TERI), a guarantor of a portion of our student loan portfolio, had filed for reorganization under Chapter 11 of the United States Bankruptcy Code. As of September 30, 2012, the Company had $6,489 of TERI-guaranteed loans out of a total student loan portfolio of $12,905. The Company does not anticipate that TERI’s bankruptcy filing will significantly impact the Company’s financial statements. These loans are placed on non-accrual status when they become more than 90 days past due. As of September 30, 2012, $75 of such loans were on non-accrual status.

Loans on which the accrual of interest has been discontinued or reduced amounted to $2,583 and $3,453 at September 30, 2012 and 2011, respectively. We believe that the decrease in non-accrual loans reflects management’s focused efforts to proactively address delinquent accounts. Real estate loans of $1,369 that are past due 90 days or more and still accruing are primarily 1-4 family residential loans with favorable loan-to-value ratios and that are in the process of collection. One large loan in the amount of $517 accounted for the majority of the increase.

If interest on non-accrual loans had been accrued, such income would have been $104 and $192 for the nine months ended September 30, 2012 and September 30, 2011, respectively. Interest income on non-accrual loans, which is recorded only when received, amounted to $0 for each of the nine months ended September 30, 2012 and September 30, 2011, respectively. There are no commitments to lend additional funds to borrowers whose loans are in non-accrual status.

49

Management’s process for evaluating the adequacy of the allowance for loan and lease losses includes reviewing each month’s loan committee reports which list all loans that do not meet certain internally developed criteria as to collateral adequacy, payment performance and overall credit risk. These reports also address the current status and actions in process on each listed loan. This information is used in our ALLL methodology and resulting adjustments are made to the allowance for loan and lease losses. Such adjustments include both specific loss allocation amounts and general provisions by loan category based on present and past collection experience, nature and volume of the loan portfolio, overall portfolio quality, and current economic conditions that may affect the borrower’s ability to pay.

Estimated “low” and “high” allowances for loan and lease loss amounts are derived by accumulating the loss estimates for specific loans and general pools. The actual allowance for loan and lease losses, situated within the estimated low-to-high range, is approved on a quarterly basis by our board of directors.

As of September 30, 2012, the Company had total impaired loans of $5,355. Of the total allowance for loan and lease losses, $1,154 was specifically related to these impaired loans at September 30, 2012.

Most of the Company’s lending activity is with customers located in the Company’s geographic market area and repayment thereof is affected by economic conditions in this market area.

Loan Loss Experience

The following table presents the Company’s allowance for loan and lease losses during the periods indicated:

Three Months Ended:	September 30, 2012			September 30, 2011
Balance at beginning of period	$	6,938		$	6,711
Charge-offs:
Residential real estate mortgages		326			307
Commercial real estate		—			16
Commercial loans		73			50
Credit card and related plans		18			29
Installment loans		38			67
Total charge-offs		455			469
Recoveries:
Residential real estate mortgages		7			8
Commercial real estate		—			—
Commercial loans		1			—
Credit card and related plans		1			5
Installment loans		3			11
Total recoveries		12			24
Net charge-offs (recoveries)		443			445
Provision charged to operations		471			445
Balance at End of Period	$	6,966		$	6,711
Ratio of net charge-offs (recoveries) to average loans outstanding		0.07	%		0.07	%

50

Nine Months Ended:	September 30, 2012			September 30, 2011
Balance at beginning of period	$	6,711		$	6,500
Charge-offs:
Residential real estate mortgages		326			1,032
Commercial real estate		33			274
Commercial loans		78			62
Credit card and related plans		36			81
Installment loans		113			127
Total charge-offs		586			1,576
Recoveries:
Residential real estate mortgages		8			26
Commercial real estate		5			—
Commercial loans		1			3
Credit card and related plans		1			6
Installment loans		49			39
Total recoveries		64			74
Net charge-offs (recoveries)		522			1,502
Provision charged to operations		777			1,713
Balance at End of Period	$	6,966		$	6,711
Ratio of net charge-offs (recoveries) to average loans outstanding		0.08	%		0.24	%

The allowance for loan and lease losses at September 30, 2012 was $6,966, or 1.09%, of total loans compared to $6,711 or 1.05% of total loans at September 30, 2011.

The allowance for loan and lease losses was allocated as follows:

As of:	September 30, 2012					December 31, 2011					September 30, 2011
	Amount		% *			Amount		% *			Amount		% *
Residential real estate	$	2,969		41	%	$	2,855		44	%	$	2,368		46	%
Commercial real estate and all others		3,129		50	%		3,087		47	%		3,458		45	%
Credit card and related plans		331		1	%		319		1	%		345		1	%
Personal installment loans		537		8	%		450		8	%		540		8	%
Total	$	6,966		100	%	$	6,711		100	%	$	6,711		100	%

* Percent of loans in each category to total loans

The entire ALLL is available for losses in any loan category, notwithstanding the allocation above.

Our non-performing loans decreased from $3,453, at September 30, 2011, to $3,166 at December 31, 2011, and to $2,583 at September 30, 2012. As of September 30, 2012, our non-performing loans were comprised of thirty-three loans of which twelve loans were in excess of one hundred thousand dollars in size and the remainder of which were less than one hundred thousand dollars each. The decrease in non-performing loans is attributed to payments and pay-offs in the amount of $1,387, properties moving to OREO in the amount of $831 and charge-offs in the amount of $780, with new additions to non-accrual in the amount of $2,687 for the period.

As of September 30, 2012, the total of the allowance for loan and lease losses was $6,966. Through the application of our ALLL methodology, the allowance reflects management’s conservative view of the local economic conditions.

As a result of the local and national weakness in the residential real estate industry, and to evaluate a potential loan loss, the Bank orders a current appraisal of the collateral securing such loan after it is 90 days delinquent to assess the current loan to value ratio. An appraisal is ordered in the case of commercial loans, if a loan has been downgraded and the current appraisal on file is at least one year old. Both residential and commercial appraisals continue to be discounted appropriately for purposes of applying loan to value requirements in the Bank’s loan policy, in view of the weak real estate market.

51

Other Real Estate Owned

The Bank has seven properties in other real estate owned as of September 30, 2012 with a value of $582 compared to $1,571 at December 31, 2011 and $2,109 at September 30, 2011. Of the seven properties, one is commercial with a carrying value of $100; the remaining six properties are residential. The Bank had eight properties in other real estate owned as of December 31, 2011. Of the eight properties, two were commercial with a carrying value of $1,000; the remaining six properties were residential. As of September 30, 2011, the Bank had 11 properties in other real estate owned, which represented ten relationships. Two of the properties were commercial and nine were residential.

The largest property in other real estate owned at December 31, 2011, with a carrying value of $792, was sold on April 24, 2012 with a total consideration of $900.

Presently, there are nine properties in the process of loan foreclosure. Eight of these properties are residential with the largest having a balance of $206. The commercial property has a balance of $143.

Deposits

Details regarding the Company’s deposit portfolio at the dates indicated are as follows:

	September 30, 2012		December 31, 2011
Demand - Non-interest bearing	$	141,181	$	134,799
Demand - Interest bearing		91,609		85,111
Savings		125,582		120,269
Money markets		165,078		165,611
Time - Over $100,000		79,791		84,828
Time - Other		101,891		129,900
Total Deposits	$	705,132	$	720,518

The Company largely relies on its core deposit base of checking and savings accounts to fund operations. Management has competitively priced its deposit products in checking, savings, money market and time deposits to provide a stable source of funding.

In general, as interest rates in the economy change, some deposits migrate towards investments with higher anticipated yields. Historically, the Bank’s core deposits have been stable and not significantly impacted by such trends.

As of September 30, 2012, the Company had Certificate of Deposit Account Registry Service (“CDARS”) reciprocal deposits in the amount of $22.3 million. The Bank also currently issues brokered certificates of deposit as an alternative to wholesale funding due to their favorable terms. The balance of this funding as of September 30, 2012 and December 31, 2011 was $6.2 million and $23.2 million, respectively. The brokered certificates of deposit issued were generally a low cost alternative to wholesale funding with the majority offered having a call feature optionality not provided by wholesale funding. As of September 30, 2012, the dollar amount of brokered deposits, exclusive of CDARS reciprocal deposits, was $6.2 million, or 0.9%, of total deposits, compared to $23.2 million, or 3.2%, at December 31, 2011.

Liquidity

The objective of liquidity management is to maintain a balance between sources and uses of funds in such a way that the cash requirements of customers for loans and deposit withdrawals are met in the most economical manner. Management monitors its liquidity position continuously in relation to trends of loans and deposits for short-term as well as long-term requirements. Liquid assets are monitored on a daily basis to assure maximum utilization. Management also manages its liquidity requirements by maintaining readily marketable assets and access to short-term funding sources.

The Company remains in a highly liquid condition both in the short and long term and does not foresee any adverse trends in liquidity. Sources of liquidity include the Company’s U.S. Agency bond portfolios, additional deposits, earnings, overnight loans to and from other companies (Federal Funds) and lines of credit at the Federal Reserve Bank and the Federal Home Loan Bank (FHLB). The Company is not a party to any commitments, guarantees or obligations that could materially affect its liquidity.

52

The Company offers collateralized securities sold under agreements to repurchase, which have a one day maturity, as an alternative deposit option for its customers. The securities sold under agreements to repurchase are accounted for as a collateralized borrowing with a one day maturity and are collateralized by U.S. Agency securities. The Company also has long-term debt outstanding to the FHLB, which was used to purchase a Freddie Mac pool of residential mortgages. At September 30, 2012, the Company had $204,896 of available borrowing capacity with the FHLB, a Borrower-In-Custody (BIC) line of credit of $33,450 with the Federal Reserve Bank of Philadelphia, available borrowing capacity at the Discount Window of $15,460, an overnight Federal funds line of credit of $19,000 with PNC Bank, an overnight Federal funds line of credit of $5,000 with Wells Fargo and an overnight Federal funds line of credit of $5,000 with Atlantic Central Bankers Bank.

The Company is a separate legal entity from the Bank and must provide for its own liquidity. In addition to its operating expenses, the Company is responsible for paying any dividends declared to its shareholders. The Company’s primary source of funds is dividends received from the Bank. The amount of dividends that the Bank may declare and pay to the Company is generally restricted under Pennsylvania law to the retained earnings of the Bank.

Commitments and Contingent Liabilities

In the normal course of business, there are outstanding commitments and contingent liabilities, created under prevailing terms and collateral requirements such as commitments to extend credit, financial guarantees and letters of credit, which are not reflected in the accompanying Financial Statements. The Company does not anticipate any losses as a result of these transactions. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Balance Sheets.

The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have expiration dates of one year or less or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

Various actions and proceedings are presently pending to which the Company is a party. Management is of the opinion that the aggregate liabilities, if any, arising from such actions would not have a material adverse effect on the financial position of the Company.

Capital Resources

A strong capital position is important to the continued profitability of the Company and promotes depositor and investor confidence. The Company’s capital provides a basis for future growth and expansion and also provides additional protection against unexpected losses.

Additional sources of capital are retained earnings from the operations of the Company and proceeds from the sale of additional shares of common stock. Management has no plans to offer additional shares of common stock at this time.

The Company and the Bank are subject to various regulatory capital requirements administered by the Federal Deposit Insurance Corporation (FDIC) and the Board of Governors of the Federal Reserve System (Federal Reserve Board). Failure to meet minimum capital requirements can initiate certain mandatory–and possibly additional discretionary–actions by regulators that, if undertaken, could have a direct material effect on the Company and the Bank’s Consolidated Financial Statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company and the Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

53

The Company’s total risk-based capital ratio was 17.38% at September 30, 2012. The Bank’s total risk-based capital ratio was 16.80% at September 30, 2012, which is more than the 10.00% ratio that Federal regulators use as the “well capitalized” threshold under the Federal prompt corrective action regulations. This is the current criteria which the FDIC uses in determining the lowest insurance rate for deposit insurance. The Bank’s risk-based capital ratio is more than double the 8.00% minimum threshold, which determines whether a company is “adequately capitalized”. Under these rules, the Bank could significantly increase its assets and still comply with these capital requirements without the necessity of increasing its equity capital.

Non-GAAP Financial Measures

Core Earnings Calculation

Certain financial measures for the three and nine months ended September 30, 2011 reported herein exclude the effect of the reversal of a contingent liability recorded in connection with the 2009 acquisition of Old Forge Bank. Management of the Company believes that investors’ understanding of the Company’s performance is enhanced by disclosing these non-GAAP financial measures as a reasonable basis for comparison of the Company’s ongoing results of operations. These non-GAAP measures should not be considered a substitute for GAAP-basis measures and results. Our non-GAAP measures may not be comparable to non-GAAP measures of other companies.

The following tables present the reconciliation of these non-GAAP financial measures to reported GAAP financial measures:

	Three Months Ended September 30,
	2012			2011*			Change
Unadjusted (GAAP)
Net interest income after provision for loan and lease losses	$	7,532		$	7,654		$	(122	)
Non-interest income		3,121			3,571			(450	)
Non-interest expense		(7,340	)		(7,522	)		182
Income tax (provision) benefit		(761	)		(929	)		168
Net income		2,552			2,774			(222	)
Adjustments
Non-interest income
Reversal of a contingent liability recorded in the Merger		—			—			—
Total adjustments pre-tax		—			—			—
Income tax provision (benefit)		—			—			—
After tax adjustments to GAAP		—			—			—
Adjusted “net income from core operations”	$	2,552		$	2,774		$	(222	)
Adjusted Return on Average Assets		1.11	%		1.18	%
Adjusted Return on Average Equity		7.69	%		8.83	%
Adjusted Dividend Payout Ratio		53.85	%		49.41	%

* - as restated see Note 18

Return on average equity (ROE) and return on average assets (ROA) for the three months ended September 30, 2012 was 7.69% and 1.11%, respectively. ROE was 8.83% and ROA was 1.18% for the same period last year. The dividend payout ratio was 53.85% for the three months ended September 30, 2012 and 49.41% for the same period last year.

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	Nine Months Ended September 30,
	2012			2011*			Change
Unadjusted (GAAP)
Net interest income after provision for loan and lease losses	$	23,473		$	22,556		$	917
Non-interest income		8,650			9,930			(1,280	)
Non-interest expense		(21,941	)		(21,973	)		32
Income tax (provision) benefit		(2,301	)		(2,451	)		150
Net income		7,881			8,062			(181	)
Adjustments
Non-interest income
Reversal of a contingent liability recorded in the Merger		—			(500	)		500
Total adjustments pre-tax		—			(500	)		500
Income tax provision (benefit)		—			170			(170	)
After tax adjustments to GAAP		—			(330	)		330
Adjusted “net income from core operations”	$	7,881		$	7,732		$	149
Adjusted Return on Average Assets		1.14	%		1.11	%
Adjusted Return on Average Equity		8.05	%		8.35	%
Adjusted Dividend Payout Ratio		52.28	%		53.39	%

* - as restated see Note 18

Return on average equity (ROE) and return on average assets (ROA) for the nine months ended September 30, 2012 was 8.05% and 1.14%, respectively. ROE was 8.70% (8.35% excluding the reversal of a contingent liability) and ROA was 1.16% (1.11% excluding the reversal of a contingent liability) for the same period last year. The dividend payout ratio was 52.28% for the nine months ended September 30, 2012 and 51.22% (53.39% excluding the reversal of a contingent liability) for the same period last year.

Allowance for Loan and Lease Losses and Credit Fair Value Adjustment

Management believes that the following information, as to the Company’s evaluation of probable credit losses and its effect on results of operations and financial condition, is useful to investors. The Company has provided for anticipated loan losses through the allowance for loan and lease losses and a credit fair value adjustment on loans acquired, as shown below:

	September 30, 2012			December 31, 2011			September 30, 2011
Loans, net of unearned income	$	639,060		$	631,522		$	637,841
Credit fair value adjustment on purchased loans		1,567			2,343			2,623
Total adjusted loans	$	640,627		$	633,865		$	640,464
	September 30, 2012			December 31, 2011			September 30, 2011
Allowance for loan and lease losses	$	6,966		$	6,711		$	6,711
Credit fair value adjustment on purchased loans		1,567			2,343			2,623
Total adjusted allowance	$	8,533		$	9,054		$	9,334
Total adjusted allowance to adjusted loans		1.33	%		1.43	%		1.46	%

55

Item 3. Quantitative and Qualitative Disclosure About Market Risk

The Company currently does not enter into derivative financial instruments, which include futures, forwards, interest rate swaps, option contracts and other financial instruments with similar characteristics. However, the Company is party to traditional 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, financial guarantees and letters of credit. These traditional instruments involve to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Consolidated Balance Sheets.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party up to a stipulated amount and with specified terms and conditions.

Commitments to extend credit and standby letters of credit are not recorded as an asset or liability by the Company until the instrument is exercised.

The Company’s exposure to market risk is reviewed on a regular basis by the Company’s board of directors. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. Management realizes certain risks are inherent and that the goal is to identify and minimize the risks. Tools used by management include the standard GAP report and an interest rate shock simulation report. The Company has no market risk sensitive instruments held for trading purposes. Management believes the Company’s market risk is reasonable at this time.

For a discussion of the Company’s asset and liability management policies, as well as the potential impact of interest rate changes upon the market value of the Company’s financial instruments, see Item 7A in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. Management, as part of its regular practices, performs periodic reviews of the impact of interest rate changes upon net interest income and market value of the Company’s portfolio equity. Based on, among other factors, such reviews, management believes that there have been no material changes in the market risk of the Company’s asset and liability position since December 31, 2011.

Item 4. Controls and Procedures

Under the supervision and with the participation of the Company’s management, including our Chief Executive Officer (our principal executive officer) and Finance Division Head (our principal financial officer), we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) under the Securities Exchange Act of 1934. Based upon this evaluation, the Company’s Chief Executive Officer and the Company’s Finance Division Head concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.

No changes in our internal control over financial reporting occurred during the quarter ended September 30, 2012 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. During the quarter ended September 30, 2012, the Company instituted a dual control verification process as to data submitted to its actuary.

56

PART II. OTHER INFORMATION

Item 1 — Legal Proceedings

None.

Item 1A — Risk Factors

There are no material changes to the risk factors set forth in Part I, Item 1A, “Risk Factors,” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, which was filed with the Securities and Exchange Commission (SEC) on March 14, 2012. Please refer to that section for disclosures regarding the risks and uncertainties related to the company’s business.

Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3 — Defaults Upon Senior Securities

None.

Item 4 — Mine Safety Disclosures

None.

Item 5 — Other Information

None.

Item 6 — Exhibits

31.1	Rule 13a-14(a) / 15-d-4(a) Certifications of the Principal Executive Officer
31.2	Rule 13a-14(a) / 15-d-4(a) Certifications of the Principal Financial Officer
32	Section 1350 Certifications
101.INS	XBRL Instance Document
101.SCH	XBRL Taxonomy Extension Schema
101.CAL	XBRL Taxonomy Extension Calculation Linkbase
101.DEF	XBRL Taxonomy Extension Definition Linkbase
101.LAB	XBRL Taxonomy Extension Label Linkbase
101.PRE	XBRL Taxonomy Extension Presentation Linkbase

57

SIGNATURES

Pursuant to the requirements 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.

PENSECO FINANCIAL SERVICES CORPORATION

By	/s/ CRAIG W. BEST
	Craig W. Best
	President and CEO
	(Principal Executive Officer)

Dated: November 6, 2012

By	/s/ PATRICK SCANLON
	Patrick Scanlon
	Senior Vice President, Finance Division Head
	(Principal Financial Officer)

Dated: November 6, 2012

58