Penseco Financial Services (PFNS) 10-Q 2013 Q2 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 June 30, 2013

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 August 1, 2013 was 3,276,079.

PENSECO FINANCIAL SERVICES CORPORATION

	Page
Part I - FINANCIAL INFORMATION
Item 1. Unaudited Financial Statements - Consolidated
Balance Sheets:
June 30, 2013		3
December 31, 2012		3
Statements of Income:
Three Months Ended June 30, 2013		4
Three Months Ended June 30, 2012		4
Six Months Ended June 30, 2013		5
Six Months Ended June 30, 2012		5
Statements of Comprehensive Income:
Three Months Ended June 30, 2013		6
Three Months Ended June 30, 2012		6
Six Months Ended June 30, 2013		6
Six Months Ended June 30, 2012		6
Statements of Changes in Stockholders’ Equity:
Three Months Ended June 30, 2013		7
Three Months Ended June 30, 2012		7
Six Months Ended June 30, 2013		8
Six Months Ended June 30, 2012		8
Statements of Cash Flows:
Six Months Ended June 30, 2013		9
Six Months Ended June 30, 2012		9
Notes to Unaudited Consolidated Financial Statements		10
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		33
Item 3. Quantitative and Qualitative Disclosures About Market Risk		53
Item 4. Controls and Procedures		54
Part II - OTHER INFORMATION
Item 1. Legal Proceedings		54
Item 1A. Risk Factors		54
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		55
Item 3. Defaults Upon Senior Securities		55
Item 4. Mine Safety Disclosures		55
Item 5. Other Information		55
Item 6. Exhibits		55
Signatures		56

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)

	June 30, 2013			December 31, 2012
ASSETS
Cash and due from banks	$	14,199		$	15,581
Interest bearing balances with banks		22,561			32,263
Federal funds sold		—			—
Cash and Cash Equivalents		36,760			47,844
Investment securities:
Available-for-sale, at fair value		152,511			161,391
Held-to-maturity (fair value of $19,537 and $16,774, respectively)		19,707			15,902
Total Investment Securities		172,218			177,293
Loans, net of unearned income		642,353			623,530
Less: Allowance for loan and lease losses		7,552			6,950
Loans, Net		634,801			616,580
Bank premises and equipment		14,960			15,137
Other real estate owned		949			656
Accrued interest receivable		3,004			2,862
Goodwill		26,398			26,398
Bank-owned life insurance		17,855			17,616
Federal Home Loan Bank stock		3,132			4,212
Other assets		9,592			9,444
Total Assets	$	919,669		$	918,042
LIABILITIES
Deposits:
Non-interest bearing	$	146,583		$	151,121
Interest bearing		586,551			570,827
Total Deposits		733,134			721,948
Other borrowed funds:
Securities sold under agreements to repurchase		8,188			8,019
Short-term borrowings		—			—
Long-term borrowings		35,633			45,397
Accrued interest payable		466			716
Other liabilities		9,363			9,516
Total Liabilities		786,784			785,596
STOCKHOLDERS’ EQUITY
Common stock; $.01 par value, 15,000,000 shares authorized, 3,276,079 shares issued and outstanding		33			33
Surplus		48,938			48,905
Retained earnings		86,412			83,798
Accumulated other comprehensive income		(2,498	)		(290	)
Total Stockholders’ Equity		132,885			132,446
Total Liabilities and Stockholders’ Equity	$	919,669		$	918,042

(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 June 30, 2013		Three Months Ended June 30, 2012
INTEREST INCOME
Interest and fees on loans and leases	$	7,633	$	8,179
Interest and dividends on investments:
U.S. Treasury securities and U.S. Agency obligations		414		615
States & political subdivisions		646		667
Other securities		16		13
Interest on Federal funds sold		—		—
Interest on balances with banks		28		6
Total Interest Income		8,737		9,480
INTEREST EXPENSE
Interest on time deposits of $100,000 or more		259		300
Interest on other deposits		391		614
Interest on other borrowed funds		311		493
Total Interest Expense		961		1,407
Net Interest Income		7,776		8,073
Provision for loan and lease losses		500		114
Net Interest Income After Provision for Loan and Lease Losses		7,276		7,959
NON-INTEREST INCOME
Trust department income		403		341
Service charges on deposit accounts		487		468
Merchant transaction income		918		891
Brokerage fee income		100		84
Other fee income		505		461
Bank-owned life insurance income		120		131
Other operating income		500		177
Impairment losses on investment securities		—		—
Realized gains (losses) on securities, net		24		69
Total Non-Interest Income		3,057		2,622
NON-INTEREST EXPENSES
Salaries and employee benefits		3,492		3,490
Premises and equipment		701		715
Merchant transaction expenses		582		596
FDIC insurance assessments		11		120
Other operating expenses		2,070		2,340
Total Non-Interest Expenses		6,856		7,261
Income before income taxes		3,477		3,320
Applicable income taxes		633		721
Net Income	$	2,844	$	2,599
Weighted average shares outstanding - Basic		3,276,079		3,276,079
Weighted average shares outstanding - Diluted		3,277,729		3,276,122
Earnings per Common Share - Basic	$	0.87	$	0.79
Earnings per Common Share - Diluted	$	0.87	$	0.79
Cash Dividends Declared Per Common Share	$	0.42	$	0.42

(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)

	Six Months Ended June 30, 2013		Six Months Ended June 30, 2012
INTEREST INCOME
Interest and fees on loans and leases	$	15,420	$	16,466
Interest and dividends on investments:
U.S. Treasury securities and U.S. Agency obligations		853		1,254
States & political subdivisions		1,269		1,382
Other securities		35		29
Interest on Federal funds sold		—		—
Interest on balances with banks		50		17
Total Interest Income		17,627		19,148
INTEREST EXPENSE
Interest on time deposits of $100,000 or more		524		612
Interest on other deposits		797		1,258
Interest on other borrowed funds		673		1,018
Total Interest Expense		1,994		2,888
Net Interest Income		15,633		16,260
Provision for loan and lease losses		800		306
Net Interest Income After Provision for Loan and Lease Losses		14,833		15,954
NON-INTEREST INCOME
Trust department income		794		703
Service charges on deposit accounts		954		927
Merchant transaction income		1,949		2,098
Brokerage fee income		190		141
Other fee income		906		864
Bank-owned life insurance income		239		249
Other operating income		726		418
Impairment losses on investment securities		—		—
Realized gains (losses) on securities, net		125		116
Total Non-Interest Income		5,883		5,516
NON-INTEREST EXPENSES
Salaries and employee benefits		7,075		7,204
Premises and equipment		1,502		1,552
Merchant transaction expenses		1,207		1,327
FDIC insurance assessments		129		230
Other operating expenses		4,068		4,288
Total Non-Interest Expenses		13,981		14,601
Income before income taxes		6,735		6,869
Applicable income taxes		1,370		1,540
Net Income	$	5,365	$	5,329
Weighted average shares outstanding - Basic		3,276,079		3,276,079
Weighted average shares outstanding - Diluted		3,277,516		3,276,100
Earnings per Common Share - Basic	$	1.64	$	1.63
Earnings per Common Share - Diluted	$	1.64	$	1.63
Cash Dividends Declared Per Common Share	$	0.84	$	0.84

(See accompanying Notes to Unaudited Consolidated Financial Statements)

5

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(unaudited)

(in thousands)

	Three Months Ended June 30, 2013			Three Months Ended June 30, 2012
Net Income	$	2,844		$	2,599
Other comprehensive income, net of tax:
Unrealized (losses) gains on securities:
Unrealized holding (losses) gains arising during the period		(1,811	)		415
Less: reclassification adjustment for gains (losses) included in net income		16			40
Other comprehensive income		(1,827	)		375
Comprehensive Income	$	1,017		$	2,974

	Six Months Ended   June 30, 2013			Six Months Ended   June 30, 2012
Net Income	$	5,365		$	5,329
Other comprehensive income, net of tax:
Unrealized (losses) gains on securities:
Unrealized holding (losses) gains arising during the period		(2,125	)		518
Less: reclassification adjustment for gains (losses) included in net income		83			71
Other comprehensive income		(2,208	)		447
Comprehensive Income	$	3,157		$	5,776

(See accompanying Notes to Unaudited Consolidated Financial Statements)

6

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

THREE MONTHS ENDED JUNE 30, 2013 AND 2012

(unaudited)

(in thousands, except per share amounts)

	Common Stock		Surplus		Retained Earnings			Accumulated Other Comprehensive Income			Total Stockholders’ Equity
Balance, March 31, 2012	$	33	$	48,865	$	80,067		$	(206	)	$	128,759
Stock-based compensation				10								10
Net income		—		—		2,599			—			2,599
Other comprehensive income									375			375
Cash dividends declared ($0.42 per share)		—		—		(1,376	)		—			(1,376	)
Balance, June 30, 2012	$	33	$	48,875	$	81,290		$	169		$	130,367
Balance, March 31, 2013	$	33	$	48,920	$	84,943		$	(671	)	$	133,225
Stock-based compensation				18								18
Net income		—		—		2,844			—			2,844
Other comprehensive income									(1,827	)		(1,827	)
Cash dividends declared ($0.42 per share)		—		—		(1,375	)		—			(1,375	)
Balance, June 30, 2013	$	33	$	48,938	$	86,412		$	(2,498	)	$	132,885

(See accompanying Notes to Unaudited Consolidated Financial Statements)

7

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

SIX MONTHS ENDED JUNE 30, 2013 AND 2012

(unaudited)

(in thousands, except per share amounts)

	Common Stock		Surplus		Retained Earnings			Accumulated Other Comprehensive Income			Total Stockholders’ Equity
Balance, December 31, 2011	$	33	$	48,865	$	78,713		$	(278	)	$	127,333
Stock-based compensation		—		10		—			—			10
Net income		—		—		5,329			—			5,329
Other comprehensive income		—		—		—			447			447
Cash dividends declared ($0.84 per share)		—		—		(2,752	)		—			(2,752	)
Balance, June 30, 2012	$	33	$	48,875	$	81,290		$	169		$	130,367
Balance, December 31, 2012	$	33	$	48,905	$	83,798		$	(290	)	$	132,446
Stock-based compensation		—		33		—			—			33
Net income		—		—		5,365			—			5,365
Other comprehensive income		—		—		—			(2,208	)		(2,208	)
Cash dividends declared ($0.84 per share)		—		—		(2,751	)		—			(2,751	)
Balance, June 30, 2013	$	33	$	48,938	$	86,412		$	(2,498	)	$	132,885

(See accompanying Notes to Unaudited Consolidated Financial Statements)

8

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)

	Six Months  Ended June 30, 2013			Six Months  Ended June 30, 2012
OPERATING ACTIVITIES
Net Income	$	5,365		$	5,329
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		409			455
Provision for loan and lease losses		800			306
Stock-based compensation		33			10
Deferred income tax provision (benefit)		61			72
Amortization of securities, (net of accretion)		226			134
Accretion of purchase accounting fair value adjustment (net of amortization)		(149	)		(224	)
Net realized (gains) losses on securities		(125	)		(116	)
(Gain) loss on other real estate		(46	)		(27	)
Gain on life insurance contract		(468	)		—
(Increase) decrease in interest receivable		(142	)		159
(Increase) decrease in cash surrender value of life insurance		(239	)		(249	)
Decrease (increase) in other assets		259			(343	)
Increase (decrease) in income taxes payable		1,276			1,510
(Decrease) increase in interest payable		(250	)		(254	)
Increase (decrease) in other liabilities		100			(1,059	)
Net cash provided (used) by operating activities		7,110			5,703
INVESTING ACTIVITIES
Purchase of investment securities available-for-sale		(6,031	)		(7,343	)
Purchase of investment securities to be held-to-maturity		(6,874	)		—
Proceeds from investment securities available-for-sale		9,154			7,368
Proceeds from repayments of investment securities available-for-sale		2,354			2,871
Proceeds from repayments of investment securities held-to-maturity		3,025			4,083
Loan (originations) collections, net		(20,154	)		(8,336	)
Proceeds from other real estate		644			1,346
Purchase of life insurance contract		—			(1,242	)
Investment in premises and equipment		(232	)		(1,783	)
Proceeds from Federal Home Loan Bank share buyback		1,080			525
Purchase of Federal Home Loan Bank restricted stock		—			(840	)
Net cash (used) provided by investing activities		(17,034	)		(3,351	)
FINANCING ACTIVITIES
Net increase (decrease) in demand and savings deposits		13,700			9,814
Net (payments) proceeds on time deposits		(2,514	)		(17,932	)
Increase (decrease) in securities sold under agreements to repurchase		169			507
Payments on long-term borrowings		(9,764	)		(6,428	)
Cash dividends paid		(2,751	)		(2,752	)
Net cash (used) provided by financing activities		(1,160	)		(16,791	)
Net (decrease) increase in cash and cash equivalents		(11,084	)		(14,439	)
Cash and cash equivalents at January 1		47,844			34,480
Cash and cash equivalents at June 30,	$	36,760		$	20,041
The Company paid interest and income taxes of $2,244 and $1,450 and $3,142 and $950 during the six months ended June 30, 2013 and 2012, respectively.

9

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

For the Three and Six Months Ended June 30, 2013

(unaudited)

These Notes to Unaudited Consolidated Financial Statements reflect events subsequent to December 31, 2012, 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, 2012, which was filed with the Securities and Exchange Commission (SEC) on March 14, 2013.

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

The Statements are presented on the accrual basis of accounting.

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 information is presented in thousands of dollars, except as indicated and per share amounts are based on weighted average shares outstanding in each period. Net interest margin is stated on a tax equivalency yield.

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, 2012.

NOTE 3 — 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.

10

NOTE 4 — Earnings per Share

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

Three months ended June 30, 2013	Income (Numerator)		Shares (Denominator)		Per-share Amount
Basic EPS
Income available	$	2,844		3,276,079	$	0.87
Shares includable		—		1,650		—
Diluted EPS	$	2,844		3,277,729	$	0.87

Three months ended June 30, 2012	Income (Numerator)		Shares (Denominator)		Per-share Amount
Basic EPS
Income available	$	2,599		3,276,079	$	0.79
Shares includable		—		43		—
Diluted EPS	$	2,599		3,276,122	$	0.79

Six months ended June 30, 2013	Income (Numerator)		Shares (Denominator)		Per-share Amount
Basic EPS
Income available	$	5,365		3,276,079	$	1.64
Shares includable		—		1,437		—
Diluted EPS	$	5,365		3,277,516	$	1.64

Six months ended June 30, 2012	Income (Numerator)		Shares (Denominator)		Per-share Amount
Basic EPS
Income available	$	5,329		3,276,079	$	1.63
Shares includable		—		21		—
Diluted EPS	$	5,329		3,276,100	$	1.63

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.

11

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.

The amortized cost and fair value of investment securities at June 30, 2013 and December 31, 2012 are as follows:

Available-for-Sale

June 30, 2013	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
U.S. Agency securities	$	81,804	$	422	$	459	$	81,767
Mortgage-backed securities		13,572		587		—		14,159
States & political subdivisions		52,974		2,686		17		55,643
Total Debt Securities		148,350		3,695		476		151,569
Equity securities		651		291		—		942
Total Available-for-Sale	$	149,001	$	3,986	$	476	$	152,511

Available-for-Sale

December 31, 2012	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
U.S. Agency securities	$	83,927	$	757	$	2	$	84,682
Mortgage-backed securities		15,962		839		—		16,801
States & political subdivisions		53,846		4,991		—		58,837
Total Debt Securities		153,735		6,587		2		160,320
Equity securities		801		281		11		1,071
Total Available-for-Sale	$	154,536	$	6,868	$	13	$	161,391

Held-to-Maturity

June 30, 2013	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Mortgage-backed securities	$	11,965	$	525	$	—	$	12,490
States & political subdivisions		7,742		14		709		7,047
Total Held-to-Maturity	$	19,707	$	539	$	709	$	19,537

Held-to-Maturity

December 31, 2012	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Mortgage-backed securities	$	14,819	$	856	$	—	$	15,675
States & political subdivisions		1,083		16		—		1,099
Total Held-to-Maturity	$	15,902	$	872	$	—	$	16,774

12

Equity securities at June 30, 2013 and December 31, 2012 consisted primarily of common stock of companies in the financial services industry.

There were no proceeds involving available-for-sale debt securities for the six months ended June 30, 2013 and 2012.

The amortized cost and fair value of debt securities at June 30, 2013 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.

June 30, 2013	Available-for-Sale				Held-to-Maturity
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
Due in one year or less:
U.S. Agency securities	$	13,990	$	14,055	$	—	$	—
States & political subdivisions		10		11		—		—
After one year through five years:
U.S. Agency securities		67,814		67,712		—		—
States & political subdivisions		130		131		—		—
After five years through ten years:
States & political subdivisions		2,122		2,277		869		882
After ten years:
States & political subdivisions		50,712		53,224		6,873		6,165
Subtotal		134,778		137,410		7,742		7,047
Mortgage-backed securities		13,572		14,159		11,965		12,490
Total Debt Securities	$	148,350	$	151,569	$	19,707	$	19,537

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 June 30, 2013 and December 31, 2012 are as follows:

	Less than twelve months				Twelve months or more				Totals
June 30, 2013	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
U.S. Agency securities	$	41,214	$	439	$	3,125	$	20	$	44,339	$	459
States & political subdivisions		8,362		726		—		—		8,362		726
Equities		—		—		—		—		—		—
Total	$	49,576	$	1,165	$	3,125	$	20	$	52,701	$	1,185

	Less than twelve months				Twelve months or more				Totals
December 31, 2012	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
U.S. Agency securities	$	3,169	$	2	$	—	$	—	$	3,169	$	2
States & political subdivisions		—		—		—		—		—		—
Equities		141		9		48		2		189		11
Total	$	3,310	$	11	$	48	$	2	$	3,358	$	13

At June 30, 2013, twenty-four 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, 2012, four securities had unrealized losses for less than twelve months and one security 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 June 30, 2013.

13

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 June 30, 2013.

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 June 30, 2013.

NOTE 7 — Loans

Details regarding the Company’s loans are as follows:

As of:	June 30, 2013		December 31, 2012
Loans secured by real estate:
Construction and land development
Residential real estate	$	1,320	$	3,231
Commercial real estate		17,036		17,617
Secured by 1-4 family residential properties:
Revolving, open-end loans		28,718		29,947
Secured by first liens		200,899		194,324
Secured by junior liens		17,847		18,504
Secured by multi-family properties		17,456		15,906
Secured by non-farm, non-residential properties		208,996		199,879
Commercial and industrial loans to U.S. addressees		56,013		56,396
Loans to individuals for household, family and other personal expenditures:
Credit card and related plans		3,031		3,199
Other (installment and student loans, etc.)		49,732		49,199
Obligations of states & political subdivisions		28,616		22,586
All other loans		12,689		12,742
Gross Loans		642,353		623,530
Less: Unearned income on loans		—		—
Loans, net of unearned income	$	642,353	$	623,530

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.

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Age Analysis of Past Due Loans

As of June 30, 2013

	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	$	166	$	5	$	325	$	496	$	96,822	$	97,318	$	—
Commercial real estate:
Commercial real estate - construction		—		—		—		—		17,036		17,036		—
Commercial real estate - other		211		353		323		887		208,109		208,996		9
Consumer:
Consumer - credit card		13		3		16		32		2,999		3,031		16
Consumer - other		4		—		4		8		5,315		5,323		—
Consumer - auto		112		38		10		160		33,697		33,857		—
Student loans - TERI		33		13		38		84		5,680		5,764		—
Student loans - other		58		3		74		135		4,653		4,788		74
Residential:
Residential - prime		2,887		645		2,505		6,037		260,203		266,240		603
Total	$	3,484	$	1,060	$	3,295	$	7,839	$	634,514	$	642,353	$	702

Age Analysis of Past Due Loans

As of December 31, 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	$	23	$	49	$	304	$	376	$	91,348	$	91,724	$	—
Commercial real estate:
Commercial real estate construction		—		—		—		—		17,617		17,617		—
Commercial real estate - other		1,448		200		145		1,793		198,086		199,879		—
Consumer:
Consumer - credit card		16		1		25		42		3,157		3,199		25
Consumer - other		74		86		10		170		5,694		5,864		1
Consumer - auto		212		17		11		240		31,944		32,184		8
Student loans - TERI		77		43		19		139		5,749		5,888		—
Student loans - other		119		123		180		422		4,841		5,263		180
Residential:
Residential - prime		2,680		1,198		2,043		5,921		255,991		261,912		243
Total	$	4,649	$	1,717	$	2,737	$	9,103	$	614,427	$	623,530	$	457

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 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 – Cash equivalent or exceptional credit)

This classification includes loans which are fully secured by liquid collateral. Examples include: deposits, life insurance, certificates of deposit and securities.

15

The borrower demonstrates exceptional credit fundamentals, including stable and predictable profit margins and cash flows, strong liquidity and a conservative balance sheet with superior asset quality. Excellent cash flow coverage of existing and projected debt service. Historic and projected performance indicates borrower is able to meet obligations under almost any economic circumstances. The company has very good, professional management with an excellent track record and good depth in successor management.

Pass 2 (Average Risk)

This classification includes all 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 must be minimal and in the process of correction and not of a type that could subsequently introduce loan loss risk.

Borrower generates sufficient cash flow to fund debt service and some working assets and/or capital expansion needs. Profitability and key balance sheet ratios are at or slightly above peers. Current trends are positive or stable. Earnings are level or above the last two years.

Management has average to good experience with similar business activities and markets. The present venture appears to be well within management’s capacity. Management has depth, less formal but acceptable succession plan and limited turnover in key positions.

The industry is relatively established and the borrower is well established within the industry. Over-capacity and competitive forces are consistent with normal business cycles.

Pass 3 (Acceptable Risk)

This classification includes loans with terms and conditions that may deviate from the Bank’s loan policy. Collateral marketability and margins may exceed policy. Significant administration may be required.

Borrower generates sufficient cash flow to fund debt service, but most working asset and all capital expansion needs are provided from external sources. Borrower is able to meet payments. Profitability ratios and key balance sheet ratios are usually close to peers but one or more ratios e.g. leverage may be higher than peer. Earnings may be trending down over the last three years. Borrower may be able to obtain similar financing from other banks with comparable or less favorable terms.

Some management weakness may be evident, primarily in lack of depth. Management may come from unrelated industries or have more limited but acceptable experience. Key management succession may not be clear.

Borrower generally has limited capacity for additional debt. The Borrower has modest but sufficient debt coverage. Loans are protected by collateral. Business may be adversely affected by deteriorating industry conditions, internal operations problems, pending litigation or declining collateral quality. Potential adverse conditions are manageable.

Industry may be transitional or historically volatile or may be trending down. Long-term outlook is acceptable. Firm may be established but not quite as strong or large as the average firm in the industry, or firm may be new in the industry.

Pass 4 (Watch)

This category can cover many different situations. A typical watch situation is one where a strong or moderately strong borrower suffers business reversals which are not long term but require attention.

The borrower has weaknesses resulting from performance trends or management concerns. 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. Cash flow may be weak but minimally acceptable.

Loans rated 4 are not considered criticized or classified assets. The rating is effective until the credit is strengthened or the relationship is moved out of the Bank. Therefore, the category does not include loans with undue or unwarranted credit risks that constitute identifiable weaknesses.

Criticized – Other Assets Especially Mentioned (Rated 5)

A “Criticized” (OAEM) classification includes loans which are fundamentally sound, but exhibit potential weaknesses which require corrective action to avoid any future credit risk. Close monitoring by the loan officer is warranted. Assets with this classification do not expose the Bank to sufficient risk to justify an adverse classification.

16

The following criteria are representative of a Criticized grade:

• An inadequate loan agreement or an inability to obtain the necessary loan documents or financial statements.

• Loans for which the loan agreement terms or covenants have been violated or waived.

• Adverse economic and market conditions which, in the future, may affect the borrower’s repayment ability.

• An adverse trend in the borrower’s financial condition that has not yet reached the point where the original payment terms are jeopardized.

• A payment schedule which delays principal amortization.

• Loans with collateral values where there is little margin between liquidation value and the amount of the loan commitment, or where the collateral has shown evidence of deterioration.

• Loan officers must work closely with the borrower and explore alternate means to diminish risk. Loans classified OAEM should be considered candidates for management by the Asset Recovery Officer.

Classified – Substandard (Rated 6)

Classified assets include loans with well-defined weaknesses which are inadequately protected by current net worth, repayment capacity, or pledged collateral of the borrower. Loans are classified 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.

A substandard loan may exhibit one or more of the following conditions:

• Borrower is unable to generate enough cash flow for debt reduction.

• Primary source of repayment is impaired or no longer available, and the Bank is relying upon the secondary source.

• Loss does not seem likely, but sufficient problems have arisen to cause the Bank to go to abnormal lengths to protect its position in order to maintain a high probability of repayment.

• Deterioration in the condition of the collateral or inadequate inspection or verification of value.

• Documentation flaws leaving the Bank in a subordinated or unsecured position.

• All substandard loans should be managed by the Asset Recovery Officer.

Doubtful (Rated 7)

An asset classified as Doubtful has all weaknesses inherent in the substandard category where collection or liquidation in full is highly questionable and improbable. The possibility of loss is extremely high, but because of certain important and reasonably specific pending factors that may work to the advantage and strengthening of the asset, its classification as an estimated loss is deferred until its more exact status may be determined. Pending factors include proposed merger, acquisition, liquidation proceedings, capital injection, perfecting liens on additional collateral, and business restructure plans.

The Bank considers Doubtful to be a temporary classification and will only classify an asset, or portion of an asset, as such when the information is not available to conclude as to classification or more clearly define the potential for loss. All loans classified as Doubtful are placed on non-accrual status and assigned to the Asset Recovery Officer for supervision.

Loss (Rated 8)

An asset classified as Loss is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future. All losses should be recognized in the quarter in which they are identified. These loans are to be managed by the Asset Recovery Officer.

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Credit Quality Indicators as of June 30, 2013

Commercial Credit Exposure

Credit Risk Profile by Creditworthiness Category

	Commercial		Commercial Real Estate - Construction		Commercial Real Estate - Other
Pass / Watch	$	95,321	$	17,036	$	194,904
Criticized		872		—		7,154
Substandard		1,125		—		6,938
Total	$	97,318	$	17,036	$	208,996

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	$	264,338	$	3,031	$	5,319	$	33,847	$	5,726	$	4,788
Non-performing		1,902		—		4		10		38		—
Total	$	266,240	$	3,031	$	5,323	$	33,857	$	5,764	$	4,788

Credit Quality Indicators as of December 31, 2012

Commercial Credit Exposure

Credit Risk Profile by Creditworthiness Category

		Commercial		Commercial Real Estate - Construction		Commercial Real Estate - Other
Pass / Watch		$	90,128	$	17,399	$	187,114
Criticized			876		218		6,222
Substandard			720		—		6,543
	��
Total		$	91,724	$	17,617	$	199,879

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	$	259,869	$	3,174	$	5,854	$	32,173	$	5,869	$	5,083
Non-performing		2,043		25		10		11		19		180
Total	$	261,912	$	3,199	$	5,864	$	32,184	$	5,888	$	5,263

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.

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Impaired Loans

June 30, 2013

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial real estate	$	314	$	314	$	—	$	287	$	—
Commercial		325		325		—		280		—
Consumer - TERI		38		38		—		61		—
Consumer - other		4		4		—		3		—
Consumer - auto		10		10		—		6		—
Residential real estate		1,437		1,437		—		1,047		—
With an allowance recorded:
Commercial real estate - construction		—		—		—		—		—
Commercial real estate - other		1,443		1,443		300		1,445		38
Commercial		612		612		612		532		12
Residential real estate		665		665		262		1,233		6
Total:	$	4,848	$	4,848	$	1,174	$	4,894	$	56
Commercial real estate	$	1,757	$	1,757	$	300	$	1,732	$	38
Commercial	$	937	$	937	$	612	$	812	$	12
Consumer	$	52	$	52	$	—	$	70	$	—
Residential real estate	$	2,102	$	2,102	$	262	$	2,280	$	6

Impaired Loans

December 31, 2012

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial real estate	$	145	$	145	$	—	$	201	$	—
Commercial		304		304		—		152		—
Consumer - TERI		19		19		—		48		—
Consumer - other		9		9		—		5		—
Consumer - auto		3		3		—		15		—
Residential - real estate		928		928		—		1,152		—
With an allowance recorded:
Commercial real estate construction		—		—		—		—		—
Commercial real estate - other		2,015		2,015		550		2,104		114
Commercial		351		351		351		351		17
Residential real estate		1,497		1,497		325		1,040		44
Total:	$	5,271	$	5,271	$	1,226	$	5,068	$	175
Commercial real estate	$	2,160	$	2,160	$	550	$	2,305	$	114
Commercial	$	655	$	655	$	351	$	503	$	17
Consumer	$	31	$	31	$	—	$	68	$	—
Residential real estate	$	2,425	$	2,425	$	325	$	2,192	$	44

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 at least a six month positive payment history.

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

	June 30, 2013		December 31, 2012
Commercial	$	325	$	304
Commercial real estate:
Commercial real estate - construction		—		—
Commercial real estate - other		314		145
Consumer:
Student loans - TERI		38		19
Student loans - other		—		—
Consumer - other		4		9
Consumer - auto		10		3
Residential:
Residential real estate		1,902		1,800
Total	$	2,593	$	2,280

The Allowance for Loan and Lease Losses and Recorded Investment in Loans for the six months ended June 30, 2013 is as follows:

	Commercial		Commercial Real Estate		Consumer			Residential			Credit Card			Unallocated		Total
Allowance for Loan and Lease Losses:
Beginning balance 12/31/12	$	799	$	2,304	$	540		$	2,981		$	326		$	—	$	6,950
Charge-offs		—		—		(72	)		(207	)		(45	)		—		(324	)
Recoveries		—		—		20			106			—			—		126
Provision		400		—		76			212			112			—		800
Ending balance 06/30/13	$	1,199	$	2,304	$	564		$	3,092		$	393		$	—	$	7,552
Ending balance: Individually evaluated for impairment		612		300		—			262			—			—		1,174
Ending balance: Collectively evaluated for impairment	$	587	$	2,004	$	564		$	2,830		$	393		$	—	$	6,378
Ending balance: Loans acquired with deteriorated credit quality	$	—	$	—	$	—		$	—		$	—		$	—	$	—
Loans:
Ending balance	$	97,318	$	226,032	$	49,732		$	266,240		$	3,031		$	—	$	642,353
Ending balance: Individually evaluated for impairment		937		1,757		52			2,102			—			—		4,848
Ending balance: Collectively evaluated for impairment	$	96,381	$	224,275	$	49,680		$	264,138		$	3,031		$	—	$	637,505
Ending balance: Loans acquired with deteriorated credit quality	$	—	$	—	$	—		$	—		$	—		$	—	$	—

20

The Allowance for Loan and Lease Losses and Recorded Investment in Loans for the year ended December 31, 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	)		(235	)		(431	)		(40	)		—		(817	)
Recoveries		1			6			57			67			1			—		132
Provision		83			37			268			490			46			—		924
Ending balance 12/31/12	$	799		$	2,304		$	540		$	2,981		$	326		$	—	$	6,950
Ending balance: Individually evaluated for impairment		351			550			—			325			—			—		1,226
Ending balance: Collectively evaluated for impairment	$	448		$	1,754		$	540		$	2,656		$	326		$	—	$	5,724
Ending balance: Loans acquired with deteriorated credit quality	$	—		$	—		$	—		$	—		$	—		$	—	$	—
Loans:
Ending balance	$	91,724		$	217,496		$	49,199		$	261,912		$	3,199		$	—	$	623,530
Ending balance: Individually evaluated for impairment		655			2,160			31			2,425			—			—		5,271
Ending balance: Collectively evaluated for impairment	$	91,069		$	215,336		$	49,168		$	259,487		$	3,199		$	—	$	618,259
Ending balance: Loans acquired with deteriorated credit quality	$	—		$	—		$	—		$	—		$	—		$	—	$	—

The Company had one commercial loan whose terms had been modified in a troubled debt restructuring as of June 30, 2013 and December 31, 2012; monthly payments were lowered to accommodate the borrower’s financial needs for a period of time.

Modification

June 30, 2013

	Number of Contracts	Pre-Modification Outstanding  Recorded Investment		Post-Modification Outstanding Recorded Investment
Troubled Debt Restructurings Commercial	1	$	808	$	346

There were no troubled debt restructurings that subsequently defaulted during the six months ended June 30, 2013.

Modification

December 31, 2012

	Number of Contracts	Pre-Modification Outstanding  Recorded Investment		Post-Modification Outstanding Recorded Investment
Troubled Debt Restructurings Commercial	1	$	808	$	351

The loan 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.

21

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

	Carrying Value		Credit Fair Value Adjustment		Net Amount
Commercial Loans:
Balance, December 31, 2012	$	—	$	—	$	—
Charge-offs		—		—		—
Loans transferred to other real estate owned		—		—		—
Payments		—		—		—
Balance, June 30, 2013	$	—	$	—	$	—
	Carrying Value		Credit Fair Value Adjustment		Net Amount
Commercial Loans:
Balance, December 31, 2011	$	211	$	211	$	—
Charge-offs		—		—		—
Loans transferred to other real estate owned		—		—		—
Payments		3		3		—
Balance, June 30, 2012	$	208	$	208	$	—

NOTE 8 — Loan Servicing

The Company generally retains the right to service mortgage loans sold to others. The cost allocated to the mortgage servicing rights retained has been recognized as a separate asset within other assets and is being 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.

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:

June 30,
2014	$	212
2015		175
2016		138
2017		101
2018		65
Thereafter		28
Total	$	719

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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 June 30, 2013 is as follows:

Monthly Installment	Fixed Rate			Floating Rate			Maturity Date		Balance
Amortizing loans
$     18		2.66	%					08/28/14	$	246
67		3.44	%					03/02/15		1,302
13		3.48	%					03/31/15		273
10		3.83	%					04/02/18		531
186		4.69	%					03/13/23		17,481
Total amortizing										19,833
Non-amortizing loans
		2.36	%					09/22/17		6,500
					1.84	%		12/02/19		3,000
					1.48	%		12/19/19		6,300
Total non-amortizing										15,800
Total long-term debt									$	35,633

Aggregate maturities of long-term debt at June 30, 2013 are as follows:

June 30,	Principal
2014	$	2,687
2015		2,308
2016		1,701
2017		1,781
2018		8,345
Thereafter		18,811
Total	$	35,633

NOTE 12 — 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), a supplemental executive defined contribution plan, non-qualified supplemental executive retirement plans (SERP), 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
Six months ended June 30,	2013			2012			2013		2012
Service cost	$	—		$	—		$	21	$	24
Interest cost		323			336			67		70
Expected return on plan assets		(413	)		(404	)		—		—
Amortization of prior service cost		—			—			—		—
Amortization of net loss (gain)		90			68			58		55
Net periodic benefit cost	$	—		$	—		$	146	$	149

The Company previously disclosed in the financial statements included in its Annual Report on Form 10-K for the year ended December 31, 2012 that it expected to contribute $167 to its Employee’s Pension Plan and $295 to its Postretirement Life Insurance Plan in 2013. As of June 30, 2013, the Company expects to contribute $167 to its Employee’s Pension Plan and $291 to its Postretirement Life Insurance Plan during 2013. Readers should refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2012 for further details on the Company’s defined benefit pension plan.

23

The Company sponsors a Retirement Profit Sharing 401(k) Plan for all eligible employees. The Company’s profit sharing expense for the six months ended June 30, 2013 and 2012 was $280 and $300, 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.

There are 107,400 shares of the Company’s common stock available for grant as awards pursuant to the 2008 plan, including existing awards.

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

There were awards of restricted stock in the amount of $50 during the six months ended June 30, 2013.

	Restricted Stock
Nonvested shares	Number of Shares		Weighted- Average Grant-Date Fair Value
Nonvested, January 1, 2013		7,731	$	38.80
Granted		1,335		37.45
Vested		—		—
Forfeited		—		—
Nonvested, June 30, 2013		9,066	$	38.60

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

The Company began to expense the fair value of all share-based compensation over the requisite service periods commencing at grant date. 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 $33 of compensation expense for stock awards granted in the six months ended June 30, 2013. As of June 30, 2013, the Company had $277 of unrecognized compensation expense associated with restricted stock awards.

24

NOTE 14 — Accumulated Other Comprehensive Income

Changes in each component of accumulated other comprehensive income for the three months ended June 30, 2013 and 2012 were as follows:

	Unrealized Gains on Investment Securities			Defined Benefit Plans			Total
Balance, March 31, 2013	$	4,143		$	(4,814	)	$	(671	)
Current period change		(1,827	)		—			(1,827	)
Balance, June 30, 2013	$	2,316		$	(4,814	)	$	(2,498	)
Balance, March 31, 2012	$	3,998		$	(4,204	)	$	(206	)
Current period change		375			—			375
Balance, June 30, 2012	$	4,373		$	(4,204	)	$	169

Changes in each component of accumulated other comprehensive income for the six months ended June 30, 2013 and 2012 were as follows:

	Unrealized Gains on Investment Securities			Defined Benefit Plans			Total
Balance, December 31, 2012	$	4,524		$	(4,814	)	$	(290	)
Current period change		(2,208	)		—			(2,208	)
Balance, June 30, 2013	$	2,316		$	(4,814	)	$	(2,498	)
Balance, December 31, 2011	$	3,926		$	(4,204	)	$	(278	)
Current period change		447			—			447
Balance, June 30, 2012	$	4,373		$	(4,204	)	$	169

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 periods indicated is as follows:

Three Months Ended June 30, 2013	Pre-Tax Amount			Tax (Expense) Benefit			Net-of- Tax Amount
Unrealized losses on available-for-sale securities:
Unrealized losses arising during the period	$	(2,744	)	$	933		$	(1,811	)
Reclassification adjustment for gains recognized in net income		(24	)		8			(16	)
Net unrealized losses		(2,768	)		941			(1,827	)
Other comprehensive income	$	(2,768	)	$	941		$	(1,827	)
Three Months Ended June 30, 2012	Pre-Tax Amount			Tax (Expense) Benefit			Net-of- Tax Amount
Unrealized gains on available-for-sale securities:
Unrealized gains arising during the period	$	629		$	(214	)	$	415
Reclassification adjustment for gains recognized in net income		(61	)		21			(40	)
Net unrealized gains		568			(193	)		375
Other comprehensive income	$	568		$	(193	)	$	375

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Six Months Ended June 30, 2013	Pre-Tax Amount			Tax (Expense) Benefit			Net-of- Tax Amount
Unrealized losses on available-for-sale securities:
Unrealized losses arising during the period	$	(3,220	)	$	1,095		$	(2,125	)
Reclassification adjustment for gains recognized in net income		(125	)		42			(83	)
Net unrealized losses		(3,345	)		1,137			(2,208	)
Other comprehensive income	$	(3,345	)	$	1,137		$	(2,208	)
Six Months Ended June 30, 2012	Pre-Tax Amount			Tax (Expense) Benefit			Net-of- Tax Amount
Unrealized gains on available-for-sale securities:
Unrealized gains arising during the period	$	785		$	(267	)	$	518
Reclassification adjustment for gains recognized in net income		(108	)		37			(71	)
Net unrealized gains		677			(230	)		447
Other comprehensive income	$	677		$	(230	)	$	447

Note 15 — 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. The Company did not hold any instruments measured at fair value on a recurring basis using Level III inputs as of June 30, 2013. See Note 3 – Investment Securities for additional information.

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

	June 30, 2013
	Level I		Level II		Level III		Total
Assets:
Securities available-for-sale
U.S. Agency securities	$	—	$	81,767	$	—	$	81,767
Mortgage-backed securities:
Residential		—		14,159		—		14,159
States & political subdivisions:
Bank qualified tax exempt		—		55,643		—		55,643
Corporate securities:
Aaa credit rating		—		—		—		—
Equity securities:
Financial services industry		942		—		—		942
Total securities available-for-sale	$	942	$	151,569	$	—	$	152,511
	December 31, 2012
	Level I		Level II		Level III		Total
Assets:
Securities available-for-sale
U.S. Agency securities	$	—	$	84,682	$	—	$	84,682
Mortgage-backed securities:
Residential		—		16,801		—		16,801
States & political subdivisions:
Bank qualified tax exempt		—		58,837		—		58,837
Corporate securities:
Aaa credit rating		—		—		—		—
Equity securities:
Financial services industry		1,071		—		—		1,071
Total securities available-for-sale	$	1,071	$	160,320	$	—	$	161,391

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 valuation firm, 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, 2012. Goodwill and other identifiable intangibles were not evaluated during the six months ended June 30, 2013 as a result of management’s determination that no evidence of impairment was present during the period.

Impaired Loans

At June 30, 2013 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 $4,848 were reduced by a specific valuation allowance allocation totaling $1,174, to a total reported fair value of $3,674 based on collateral valuations utilizing Level III valuation inputs.

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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 a non-financial asset, 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.

Preferred Stock

Preferred stock consists of an investment in Senior Housing Crime Prevention Foundation Investment Corporation, an entity which supports Community Reinvestment Act initiatives.

Certain assets measured at fair value on a non-recurring basis as of June 30, 2013 are as follows:

	Fair Value Measurement Using
	Quoted Prices in Active Markets for Identical Assets/Liabilities Level I		Significant Other Observable Inputs Level II		Significant Unobservable Inputs Level III		Balance Total
Assets
Core deposit intangible	$	—	$	—	$	719	$	719
Goodwill		—		—		26,398		26,398
Impaired loans		—		—		3,674		3,674
Federal Home Loan Bank stock		—		—		3,132		3,132
Other real-estate owned		—		949		—		949
Preferred stock		—		—		660		660
Total non-financial assets	$	—	$	949	$	34,583	$	35,532

Certain assets measured at fair value on a non-recurring basis as of December 31, 2012 is as follows:

	Fair Value Measurement Using
	Quoted Prices in Active Markets for Identical Assets/Liabilities Level I		Significant Other Observable Inputs Level II		Significant Unobservable Inputs Level III		Balance Total
Assets
Core deposit intangible	$	—	$	—	$	838	$	838
Goodwill		—		—		26,398		26,398
Impaired loans		—		—		4,045		4,045
Federal Home Loan Bank stock		—		—		4,212		4,212
Other real-estate owned		—		656		—		656
Preferred stock		—		—		660		660
Total non-financial assets	$	—	$	656	$	36,153	$	36,809

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A reconciliation of items in Level III for the six month period ended June 30, 2013 is as follows:

	Core deposit intangible			Goodwill		Impaired Loans			Federal Home Loan Bank Stock			Preferred Stock		Total
Balance, December 31, 2012	$	838		$	26,398	$	4,045		$	4,212		$	660	$	36,153
Amortization of core deposit intangible		(119	)		—		—			—			—		(119	)
Increase in impaired loans		—			—		1,749			—			—		1,749
Decrease in impaired loans		—			—		(1,247	)		—			—		(1,247	)
Payments received		—			—		(873	)		(1,080	)		—		(1,953	)
Purchases		—			—		—			—			—		—
Balance, June 30, 2013	$	719		$	26,398	$	3,674		$	3,132		$	660	$	34,583

A reconciliation of items in Level III for the year ended December 31, 2012 is as follows:

	Core deposit intangible			Goodwill		Impaired Loans			Federal Home Loan Bank Stock			Preferred Stock		Total
Balance, December 31, 2011	$	1,106		$	26,398	$	2,876		$	4,953		$	—	$	35,333
Amortization of core deposit intangible		(268	)		—		—			—			—		(268	)
Increase in impaired loans		—			—		3,895			—			—		3,895
Decrease in impaired loans		—			—		(1,661	)		—			—		(1,661	)
Payments received		—			—		(1,065	)		(1,581	)		—		(2,646	)
Purchases		—			—		—			840			660		1,500
Balance, December 31, 2012	$	838		$	26,398	$	4,045		$	4,212		$	660	$	36,153

Disclosures about Fair Value of Financial Instruments

GAAP requires disclosure of the estimated fair value of an entity’s assets and liabilities considered to be financial instruments. As with most financial institutions, the majority of the Company’s 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. 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 June 30, 2013 and December 31, 2012 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.

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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 valuation firm 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.

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:

	June 30, 2013										Total Fair Value
	Carrying Value			Level 1		Level 2		Level 3
Cash and cash equivalents	$	36,760		$	36,760	$	—	$	—		$	36,760
Investment securities held-to-maturity		19,707			—		19,537		—			19,537
Loans, net		634,801			—		—		641,421			641,421
Bank-owned life insurance		17,855			—		17,855		—			17,855
Demand deposits		560,433			—		560,433		—			560,433
Time deposits		172,701			—		174,327		—			174,327
Short-term borrowings		8,188			—		8,188		—			8,188
Long-term borrowings		35,633			—		36,850		—			36,850
Standby Letters of Credit	$	(176	)	$	—	$	—	$	(176	)	$	(176	)

	December 31, 2012										Total Fair Value
	Carrying Value			Level 1		Level 2		Level 3
Cash and cash equivalents	$	47,844		$	47,844	$	—	$	—		$	47,844
Investment securities held-to-maturity		15,902			—		16,774		—			16,774
Loans, net		616,580			—		—		627,712			627,712
Bank-owned life insurance		17,616			—		17,616		—			17,616
Demand deposits		546,734			—		546,734		—			546,734
Time deposits		175,214			—		178,037		—			178,037
Short-term borrowings		8,019			—		8,019		—			8,019
Long-term borrowings		45,397			—		48,625		—			48,625
Standby Letters of Credit	$	(144	)	$	—	$	—	$	(144	)	$	(144	)

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NOTE 16 — 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 I and Total Capital to risk-weighted assets and of Tier I Capital to average assets (Leverage ratio). The table also presents the Company’s actual capital amounts and ratios. Management believes, as of June 30, 2013, that the Company and the Bank meet all capital adequacy requirements to which they are subject.

As of June 30, 2013, 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 I 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 June 30, 2013, the Company and Bank had capital levels that were in excess of the minimum capital level ratios required to pay dividends.

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							To Be
							Adequacy Purposes							“Well Capitalized”
As of June 30, 2013	Amount		Ratio				Amount			Ratio				Amount			Ratio
Total Capital (to Risk Weighted Assets)
PFSC (Company)	$	111,959		17.78	%	³	$	50,376	³		8.0	%	³		N/A	³		N/A
PSB (Bank)	$	108,035		17.17	%	³	$	50,330	³		8.0	%	³	$	62,913	³		10.0	%
Tier 1 Capital (to Risk Weighted Assets)
PFSC (Company)	$	104,276		16.56	%	³	$	25,188	³		4.0	%	³		N/A	³		N/A
PSB (Bank)	$	100,483		15.97	%	³	$	25,165	³		4.0	%	³	$	37,748	³		6.0	%
Tier 1 Capital (to Average Assets)
PFSC (Company)	$	104,276		11.66	%	³	$	*	³		*		³		N/A	³		N/A
PSB (Bank)	$	100,483		11.29	%	³	$	*	³		*		³	$	44,487	³		5.0	%

PFSC – *3.0% ($26,829), 4.0% ($35,772) or 5.0% ($44,715) depending on the bank’s CAMELS Rating and other regulatory risk factors.

PSB – *3.0% ($26,692), 4.0% ($35,590) or 5.0% ($44,487) depending on the bank’s CAMELS Rating and other regulatory risk factors.

Actual							Regulatory Requirements
							For Capital							To Be
							Adequacy Purposes							“Well Capitalized”
As of December 31, 2012	Amount		Ratio				Amount			Ratio				Amount			Ratio
Total Capital (to Risk Weighted Assets)
PFSC (Company)	$	109,978		17.96	%	³	$	48,994	³		8.0	%	³		N/A	³		N/A
PSB (Bank)	$	106,135		17.35	%	³	$	48,934	³		8.0	%	³	$	61,167	³		10.0	%
Tier 1 Capital (to Risk Weighted Assets)
PFSC (Company)	$	102,906		16.80	%	³	$	24,497	³		4.0	%	³		N/A	³		N/A
PSB (Bank)	$	99,185		16.22	%	³	$	24,467	³		4.0	%	³	$	36,700	³		6.0	%
Tier 1 Capital (to Average Assets)
PFSC (Company)	$	102,906		11.50	%	³	$	*	³		*		³		N/A	³		N/A
PSB (Bank)	$	99,185		11.14	%	³	$	*	³		*		³	$	44,526	³		5.0	%

PFSC – *3.0% ($26,850), 4.0% ($35,799) or 5.0% ($44,749) depending on the bank’s CAMELS Rating and other regulatory risk factors.

PSB – *3.0% ($26,716), 4.0% ($35,621) or 5.0% ($44,526) depending on the bank’s CAMELS Rating and other regulatory risk factors.

Note 17 — Post-retirement Life Insurance Benefit

In 1995, the Company established a post-retirement life insurance benefit equal to three times the employees’ salary at retirement for all employees employed with the Company at July 1, 1995. Employees hired by the Company after July 1, 1995, received a post-retirement life insurance benefit equal to $50,000 at retirement, which decreases by $5,000 annually to a minimum benefit of $5,000 by the time the recipient reaches age 75. In June of 2012, the Company amended the post-retirement life insurance benefit for all active employees, regardless of hire date, to a benefit of $50,000 at retirement, then decreasing by $5,000 a year to $5,000 at age 75. Because the product offered is term life insurance, the Company is exposed to increasing costs in future years.

The Company is evaluating various options to reduce or settle its obligation for benefits, to the current retiree group only. One option under consideration is a plan offered by an insurance company, as to this current retiree group, whereby the Company would enter into an agreement with the insurance company to transfer all risk and obligation for the benefits payable as to the current retiree group in exchange for a one-time fixed payment by the Company.

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The agreement would require a one-time payment to the insurance company, estimated to be approximately $4.1 million. There would be no further cost to the Company as to the current retirees, after this payment. The Company would recognize a settlement charge, net of tax, of approximately $1.6 million in the period in which it occurs.

Note 18 — Agreement and Plan of Merger

On June 28, 2013, the Company announced it had entered into a merger agreement with Peoples Financial Services Corp (“Peoples”), pursuant to which the Company will merge with and into Peoples. The merger agreement provides that shareholders of the Company will receive a fixed ratio of 1.3636 shares of Peoples common stock for each outstanding share of the Company’s common stock, subject to adjustment upon the occurrence of certain events described in the merger agreement. The transaction has been unanimously approved by the boards of directors of each of the Company and Peoples. The transaction is subject to the receipt of shareholder approval from the shareholders of both the Company and Peoples, regulatory approvals and other customary closing conditions.

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.

In addition to these risks, acquisitions and business combinations – such as the business combination currently proposed between Penseco Financial Services Corporation and Peoples Financial Services Corp. – present risks other than those presented by the nature of the business acquired. Acquisitions and business combinations may be substantially more expensive to complete than originally anticipated, and the anticipated benefits may be significantly harder – or take longer – to achieve than expected. As regulated financial institutions, our pursuit of attractive acquisition and business combination opportunities could be negatively impacted by regulatory delays or other regulatory issues. Regulatory and/or legal issues related to the pre-acquisition operations of an acquired or combined business may cause reputational harm to the Company or Peoples following the acquisition or combination, and integration of the acquired or combined business with ours may result in additional future costs arising as a result of those issues.

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 June 30, 2013, including any significant changes from December 31, 2012, and significant changes in the results of our operations for the three and six month periods ended June 30, 2013 and June 30, 2012.

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Agreement and Plan of Merger

On June 28, 2013, the Company announced it had entered into a merger agreement with Peoples, pursuant to which the Company will merge with and into Peoples. The merger agreement provides that shareholders of the Company will receive a fixed ratio of 1.3636 shares of Peoples common stock for each outstanding share of the Company’s common stock, subject to adjustment upon the occurrence of certain events described in the merger agreement. Upon closing of the transaction, the Company’s shareholders are expected to own approximately 59% of the common stock in the combined company and Peoples shareholders are expected to own approximately 41%. As of June 30, 2013, Peoples had consolidated total assets, net loans, total deposits, and total shareholders’ equity of $689.0 million, $492.2 million, $596.9 million, and $67.6 million, respectively. Upon completion of the merger, the combined company is expected to have approximately $1.6 billion in assets. The transaction has been unanimously approved by the board of directors of both the Company and Peoples. The transaction is subject to the receipt of shareholder approval from the shareholders of both the Company and Peoples, regulatory approvals and other customary closing conditions, and is expected to be completed in the fourth quarter of 2013.

The Company believes that the successful completion of the merger will present an opportunity to generate greater earnings per share for Penseco shareholders and will better position the company for future growth than the Company could achieve by remaining independent. We expect the merger will create a larger, more profitable company that can better serve the consumer and business segments that we target in our footprint.

Critical Accounting Policies

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 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 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 19 of the “General Notes to Financial Statements” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

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 2009.

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.

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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 assumed in connection with the Company’s 2009 acquisition of Old Forge Bank in a cash and stock transaction valued at approximately $55.5 million (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.

Securities sold under agreements to repurchase – The Company 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 secured 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 calculate the present value of 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.

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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 Step One Test, a professional evaluation of the Company as of December 31, 2012. The Company practice is currently to perform a Step One Test every other year and a Qualitative Test in the alternate years. The 2012 test was performed on this basis and not as a result of any qualitative factor indicating potential impairment. The evaluation considered both income and market approaches. Market conditions that could negatively impact the value of goodwill in the future are those set forth in the Risk Factors discussed in Part I, Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2012. Management has determined that the carrying value of goodwill was not impaired at December 31, 2012. Goodwill and other identifiable intangibles were not evaluated during the six months ended June 30, 2013 as a result of management’s determination that no evidence of impairment was present.

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 June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
Interest Income	$	8,737		$	9,480		$	17,627		$	19,148
Interest Expense		961			1,407			1,994			2,888
Net Interest Income		7,776			8,073			15,633			16,260
Provision for loan and lease losses		500			114			800			306
Non-Interest Income		3,057			2,622			5,883			5,516
Non-Interest Expenses		6,856			7,261			13,981			14,601
Net Income	$	2,844		$	2,599		$	5,365		$	5,329
Total Revenue (1)	$	11,794		$	12,102		$	23,510		$	24,664
Net Interest Margin (2)		3.87	%		4.08	%		3.92	%		4.09	%
Return on Assets (ROA)		1.22	%		1.13	%		1.16	%		1.15	%
Return on Equity (ROE)		8.48	%		8.01	%		8.01	%		8.24	%

(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 June 30, 2013 of $2,844, an increase of $245, or 9.4%, to $0.87 per basic and diluted weighted average share, compared with $2,599, or $0.79 per basic and diluted weighted average share, from the year ago period. Net interest income decreased $297, or 3.7%. Net interest income, after provision for loan and lease losses, decreased $683, or 8.6%, during the 2013 period, due to a decrease in interest income of $743, or 7.8%, and an increase in the provision for loan and lease losses of $386, offset by a decrease in interest expense of $446, or 31.7%, from lower funding costs. Non-interest income increased $435, or 16.6%, largely due to increased other operating income from a one-time bank-owned life insurance death benefit of $468. Non-interest expenses decreased $405, or 5.6%.

The Company reported net income for the six months ended June 30, 2013 of $5,365, an increase of $36, or 0.7%, to $1.64 per basic and diluted weighted average share, compared with $5,329, or $1.63 per basic and diluted weighted average share, from the year ago period. Net interest income decreased $627, or 3.9%. Net interest income, after provision for loan and lease losses, decreased $1,121, or 7.0%, during the 2013 period, due to a decrease in interest income of $1,521, or 7.9%, and an increase in the provision for loan and lease losses of $494, offset by a decrease in interest expense of $894, or 31.0%, from lower funding costs. The decrease in interest income for the three and six months ended June 30, 2013 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 increased $367, or 6.7%, largely due to increased other operating income from a one-time bank-owned life insurance death benefit of $468. Non-interest expenses decreased $620, or 4.2%.

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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.

	Three Months Ended
	June 30, 2013			June 30, 2012
Homogeneous loan pools (interest income)	$	78		$	98
Time deposits (interest expense)		1			7
Core deposit intangible expense (other operating expense)		(37	)		(42	)
Net income from acquisition fair value adjustment	$	42		$	63

	Six Months Ended
	June 30, 2013			June 30, 2012
Homogeneous loan pools (interest income)	$	174		$	219
Time deposits (interest expense)		4			18
Core deposit intangible expense (other operating expense)		(79	)		(91	)
Net income from acquisition fair value adjustment	$	99		$	146

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 is being amortized over ten years on a sum-of-the-years-digits basis.

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. Interest-earning assets are composed primarily of loans and investment securities while deposits, 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 decreased $297, or 3.7%, to $7,776 for the three months ended June 30, 2013, compared to $8,073 for the three months ended June 30, 2012. The average yield on interest-earning assets decreased 43 basis points, or 9.1%, to 4.32%, on a tax-equivalent basis.

The net interest margin represents the Company’s net yield on its average interest-earning assets and is calculated as net interest income, as adjusted to account for tax-exempt investments and loans, divided by average interest-earning assets. For the three months ended June 30, 2013, net interest margin decreased 21 basis points, to 3.87%, from 4.08% in the corresponding period of 2012.

Average interest-earning assets increased $11.3 million, or 1.3%, from $848.0 million for the three months ended June 30, 2012 to $859.3 million for the corresponding period in 2013. Average interest-bearing liabilities decreased $4.2 million, or 0.7%, from $643.1 million for the three months ended June 30, 2012, to $638.9 million over the corresponding 2013 period. As a percentage of average assets, average interest-earning assets, including bank-owned life insurance (BOLI), increased for the three months ended June 30, 2013 and 2012, respectively, to 94.0% from 93.7%.

Changes in the mix of both interest-earning assets and funding sources also impacted net interest income in the three months ended June 30, 2013 and 2012. Average loans as a percentage of average interest-earning assets decreased from 75.3% for the three months ended June 30, 2012 to 74.6% for the corresponding period in 2013. Average investment securities decreased $14.4 million, or 7.7%, period over period, and as a percentage of interest-earning assets, decreased to 20.2% for the three months ended June 30, 2013 from 22.1% for the three months ended June 30, 2012. Average short-term investments, federal funds sold, FHLB stock and interest-bearing balances with banks, increased as a percentage of average interest-earning assets to 5.2% for the three months ended June 30, 2013 from 2.5% for the three months ended June 30, 2012. Average savings deposits increased $5.4 million, or 4.3%. Average

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time deposits decreased $27.6 million, or 13.7%, from $201.7 million, or 31.4%, of interest-bearing liabilities for the three months ended June 30, 2012 to $174.1 million, or 27.3%, of interest-bearing liabilities for the corresponding period of 2013, due primarily to the redemption of brokered certificates of deposit. Also, during the three months ended June 30, 2013, average securities sold under agreements to repurchase decreased $1.3 million, or 13.3%, and average long-term borrowings decreased $16.9 million, or 31.9%. Average demand non-interest bearing deposits increased $9.7 million, or 7.1%.

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 24 basis points from 3.49% for the three months ended June 30, 2012 to 3.25% for the three months ended June 30, 2013. Also, average loan yields decreased 38 basis points from 5.27% for the three months ended June 30, 2012 to 4.89% for the three months ended June 30, 2013.

Interest expense for the three months ended June 30, 2013 totaled $961, compared to $1,407 in the corresponding 2012 period, a decrease of $446 or 31.7%. The average rate paid on interest-bearing liabilities for the three months ended June 30, 2013 decreased to 0.60%, compared to 0.88% in 2012.

The average time deposit costs decreased 25 basis points from 1.34% for the three months ended June 30, 2012 to 1.09% for the three months ended June 30, 2013. In addition, the average cost of money market accounts decreased 11 basis points from 0.34% for the three months ended June 30, 2012 to 0.23% for the three months ended June 30, 2013.

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.

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 June 30, 2013 and June 30, 2012.

	June 30, 2013							June 30, 2012
	Average Balance		Revenue/ Expense		Yield/ Rate			Average Balance		Revenue/ Expense		Yield/ Rate
ASSETS
Investment Securities
Available-for-sale:
U.S. Agency obligations	$	97,385	$	296		1.22	%	$	105,169	$	430		1.64	%
States & political subdivisions		57,841		606		6.35	%		60,941		650		6.47	%
Other		875		13		5.94	%		1,061		12		4.52	%
Held-to-maturity:
U.S. Agency obligations		12,713		118		3.71	%		19,192		185		3.86	%
States & political subdivisions		4,463		40		5.47	%		1,339		17		7.77	%
Loans, net of unearned income:(2)
Real estate mortgages		281,404		3,268		4.65	%		290,395		3,379		4.65	%
Commercial real estate		205,374		2,119		4.13	%		189,955		2,304		4.85	%
Commercial		58,295		761		5.22	%		56,922		765		5.38	%
Consumer and other		96,079		1,485		7.05	%		101,461		1,731		7.75	%
Federal funds sold		—		—		—			—		—		—
Federal Home Loan Bank stock		3,279		3		0.37	%		5,356		1		0.07	%
Interest on balances with banks		41,604		28		0.27	%		16,162		6		0.15	%
Total Interest-Earning Assets/
Total Interest Income		859,312	$	8,737		4.32	%		847,953	$	9,480		4.75	%
Cash and due from banks		5,335							5,261
Bank premises and equipment		14,992							14,231
Accrued interest receivable		2,723							3,026
Goodwill		26,398							26,398
Bank-owned life insurance		17,783							17,284
Other assets		13,406							16,057
Less: Allowance for loan and lease losses		7,077							6,819
Total Assets	$	932,872						$	923,391
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits:
Demand-Interest bearing	$	108,860	$	53		0.19	%	$	93,548	$	57		0.24	%
Savings		130,229		19		0.06	%		124,783		44		0.14	%
Money markets		181,255		105		0.23	%		159,329		135		0.34	%
Time - Over $100		83,492		259		1.24	%		82,132		300		1.46	%
Time - Other		90,635		214		0.94	%		119,602		378		1.26	%
Federal funds purchased		—		—		—			—		—		—
Securities sold under agreements to repurchase		8,490		6		0.28	%		9,775		8		0.33	%
Short-term borrowings		—		—		—			960		1		0.42	%
Long-term borrowings		35,985		305		3.39	%		52,941		484		3.66	%
Total Interest Bearing Liabilities/
Total Interest Expense		638,946	$	961		0.60	%		643,070	$	1,407		0.88	%
Demand - Non-interest bearing		145,757							136,102
All other liabilities		14,061							14,505
Stockholders’ equity		134,108							129,714
Total Liabilities and Stockholders’ Equity	$	932,872						$	923,391
Interest Spread						3.72	%						3.87	%
Net Interest Income			$	7,776						$	8,073
FINANCIAL RATIOS
Net interest margin (1)						3.87	%						4.08	%
Return on average assets						1.22	%						1.13	%
Return on average equity						8.48	%						8.01	%
Average equity to average assets						14.38	%						14.05	%
Dividend payout ratio						48.28	%						53.16	%

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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, based on a 34% tax rate, is made to interest income. This adjustment increased interest income by $541 and $579 for the three months ended June 30, 2013 and 2012, 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.

(2) Non-accrual loan balances are included in their respective loan categories.

Net interest income decreased $627, or 3.9%, to $15,633 for the six months ended June 30, 2013, compared to $16,260 for the six months ended June 30, 2012. The average yield on interest-earning assets decreased 38 basis points, or 8.0%, to 4.39%, on a tax-equivalent basis.

For the six months ended June 30, 2013, net interest margin decreased 17 basis points, to 3.92%, from 4.09% in the corresponding period of 2012.

Average interest-earning assets remained unchanged from $851.9 million for the six months ended June 30, 2013 and 2012, respectively and average interest-bearing liabilities decreased $13.1 million, or 2.0%, from $645.2 million for the six months ended June 30, 2012, to $632.1 million over the corresponding 2013 period. As a percentage of average assets, average interest-earning assets, including bank-owned life insurance (BOLI), increased slightly for the six months ended June 30, 2013 and 2012, respectively, to 94.0% from 93.9%.

Changes in the mix of both interest-earning assets and funding sources also impacted net interest income in the six months ended June 30, 2013 and 2012. Average loans as a percentage of average interest-earning assets remained relatively unchanged from 74.8% for the six months ended June 30, 2012 to 74.7% for the corresponding period in 2013. Average investment securities decreased $15.4 million, or 8.1%, period over period, and as a percentage of interest-earning assets, decreased to 20.5% for the six months ended June 30, 2013 from 22.3% for the six months ended June 30, 2012. Average short-term investments, federal funds sold, FHLB stock and interest-bearing balances with banks, increased as a percentage of average interest-earning assets to 4.9% for the six months ended June 30, 2013 from 2.9% for the six months ended June 30, 2012. Average savings deposits increased $5.5 million, or 4.5%. Average time deposits decreased $32.0 million, or 15.5%, from $206.3 million, or 32.0%, of interest-bearing liabilities for the six months ended June 30, 2012 to $174.3 million, or 27.6%, of interest-bearing liabilities for the corresponding period of 2013, due primarily to the redemption of brokered certificates of deposit. Also, during the six months ended June 30, 2013, average securities sold under agreements to repurchase decreased $2.1 million, or 21.4%, and average long-term borrowings decreased $15.8 million, or 28.9%. Average demand non-interest bearing deposits increased $7.5 million, or 5.4%.

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 34 basis points from 3.56% for the six months ended June 30, 2012 to 3.22% for the six months ended June 30, 2013. Also, average loan yields decreased 33 basis points from 5.31% for the six months ended June 30, 2012 to 4.98% for the six months ended June 30, 2013.

Interest expense for the six months ended June 30, 2013 totaled $1,994, compared to $2,888 in the corresponding 2012 period, a decrease of $894 or 31.0%. The average rate paid on interest-bearing liabilities for the six months ended June 30, 2013 decreased to 0.63%, compared to 0.90% in 2012.

The average time deposit costs decreased 20 basis points from 1.32% for the six months ended June 30, 2012 to 1.12% for the six months ended June 30, 2013. In addition, the average cost of money market accounts decreased 12 basis points from 0.35% for the six months ended June 30, 2012 to 0.23% for the six months ended June 30, 2013.

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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 six months ended June 30, 2013 and June 30, 2012.

	June 30, 2013							June 30, 2012
	Average Balance		Revenue/ Expense		Yield/ Rate			Average Balance		Revenue/ Expense		Yield/ Rate
ASSETS
Investment Securities
Available-for-sale:
U.S. Agency obligations	$	98,683	$	607		1.23	%	$	104,120	$	855		1.64	%
States & political subdivisions		58,208		1,210		6.30	%		62,548		1,340		6.49	%
Other		963		29		6.02	%		1,384		26		3.76	%
Held-to-maturity:
U.S. Agency obligations		13,405		246		3.67	%		20,097		399		3.97	%
States & political subdivisions		3,052		59		5.83	%		1,575		42		8.13	%
Loans, net of unearned income:(2)
Real estate mortgages		280,112		6,629		4.73	%		293,676		7,231		4.92	%
Commercial real estate		202,594		4,168		4.11	%		187,837		4,427		4.71	%
Commercial		57,510		1,683		5.85	%		55,661		1,486		5.34	%
Consumer and other		95,772		2,940		7.01	%		100,262		3,322		7.54	%
Federal funds sold		—		—		—			—		—		—
Federal Home Loan Bank stock		3,614		6		0.33	%		5,278		3		0.11	%
Interest on balances with banks		38,009		50		0.26	%		19,462		17		0.17	%
Total Interest-Earning Assets/
Total Interest Income		851,922	$	17,627		4.39	%		851,900	$	19,148		4.77	%
Cash and due from banks		5,469							5,395
Bank premises and equipment		15,036							13,968
Accrued interest receivable		2,705							3,030
Goodwill		26,398							26,398
Bank-owned life insurance		17,724							16,818
Other assets		13,143							14,017
Less: Allowance for loan and lease losses		6,985							6,752
Total Assets	$	925,412						$	924,774
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits:
Demand-Interest bearing	$	107,436	$	109		0.20	%	$	90,968	$	122		0.27	%
Savings		128,456		37		0.06	%		122,959		99		0.16	%
Money markets		175,271		200		0.23	%		159,474		283		0.35	%
Time - Over $100		82,603		524		1.27	%		83,035		612		1.47	%
Time - Other		91,701		451		0.98	%		123,280		754		1.22	%
Federal funds purchased		—		—		—			50		—		—
Securities sold under agreements to repurchase		7,717		10		0.26	%		9,775		16		0.33	%
Short-term borrowings		—		—		—			978		2		0.41	%
Long-term borrowings		38,910		663		3.41	%		54,692		1,000		3.66	%
Total Interest Bearing Liabilities/
Total Interest Expense		632,094	$	1,994		0.63	%		645,211	$	2,888		0.90	%
Demand - Non-interest bearing		145,375							137,948
All other liabilities		14,040							12,219
Stockholders’ equity		133,903							129,396
Total Liabilities and Stockholders’ Equity	$	925,412						$	924,774
Interest Spread						3.76	%						3.87	%
Net Interest Income			$	15,633						$	16,260
FINANCIAL RATIOS
Net interest margin (1)						3.92	%						4.09	%
Return on average assets						1.16	%						1.15	%
Return on average equity						8.01	%						8.24	%
Average equity to average assets						14.47	%						13.99	%
Dividend payout ratio						51.22	%						51.53	%

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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, based on a 34% tax rate, is made to interest income. This adjustment increased interest income by $1,072 and $1,169 for the six months ended June 30, 2013 and 2012, 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.

(2) Non-accrual loan balances are included in their respective loan categories.

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 six months ended June 30, 2013, the local economy continued to struggle. The local housing market remained weak and the unemployment rate in Northeastern Pennsylvania was 9.3% in May 2013. 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 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 follows its allowance methodology in accordance with the Federal Financial Institutions Examination Council (“FFIEC”) Interagency Policy Statements, as amended, and GAAP in assessing 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 considers the current trends in local economic conditions affecting the Bank. This methodology is designed to address deterioration in local economic conditions and to provide the Bank with the most current information available for estimating the allowance for loan and lease losses. In addition, and in view of the concentration of the Bank’s loan portfolio in real estate – approximately 77% 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, over the past three years. The Bank’s provision for loan and lease losses for the quarter ended June 30, 2013 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 “Notes to Unaudited Financial Statements – Note 7”.

Management continues to focus on trends in real estate delinquencies related to the poor local labor and housing markets in determining the allowance for loan and lease losses. Management also continually compares the probable losses estimated in accordance with our allowance for loan and lease loss methodology with actual losses incurred.

Based on this methodology, management made a provision for loan and lease losses of $800 for the six month period ended June 30, 2013, compared to a $306 provision for the comparable prior year period, resulting in an allowance for loan and lease losses of $7,552 at June 30, 2013 compared to $6,938 at June 30, 2012. For the twelve months ended December 31, 2012, the provision for loan and lease losses was $924, resulting in an allowance for loan and lease losses of $6,950 at December 31, 2012.

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The provision for loan and lease losses and certain ratios at the dates or for the periods indicated are as follows:

	At and For The Six Months Ended June 30, 2013			At and For The Twelve Months Ended December 31, 2012			At and For The Six Months Ended June 30, 2012
Provision for loan and lease losses	$	800		$	924		$	306
Period end allowance for loan and lease losses to non-performing loans		291.25	%		304.82	%		344.83	%
Non-performing loans to period end loans		0.40	%		0.37	%		0.31	%
Ratio of charged-off loans to average outstanding loans		0.05	%		0.13	%		0.02	%
Ratio of foreclosed loans to average outstanding loans		0.16	%		0.18	%		0.11	%

	At and For The Six Months Ended June 30, 2013				At and For The Twelve Months Ended December 31, 2012				At and For The Six Months Ended June 30, 2012
	Amount		(#)		Amount		(#)		Amount		(#)
Charge-offs	$	324		45	$	817		65	$	131		24
Foreclosures completed		1,007		8		1,138		12		715		8
Non-performing loans		2,593		45		2,280		68		2,012		72

The Company had one commercial loan whose terms had been modified in a troubled debt restructuring (TDR) as of June 30, 2013 and December 31, 2012; 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:

	June 30, 2013		December 31, 2012
Restructured Loans on Accrual Status and Not Past Due 90 Days or More	$	346	$	351
Restructured Loans Included in Non-Accrual Loans or Accruing Loans
Past Due 90 Days or More		—		—
Total Restructured Loans	$	346	$	351

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 judgment-based 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.

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, commercial real estate and

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municipal loans in the last five years, which typically bear a higher risk. These loans are typically secured by real estate to minimize this risk. At June 30, 2013, management believes the allowance for loan and lease losses was 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 June 30, 2013 and June 30, 2012, respectively:

Three Months Ended:	June 30, 2013		June 30, 2012
Trust department income	$	403	$	341
Service charges on deposit accounts		487		468
Merchant transaction income		918		891
Brokerage fee income		100		84
Other fee income		505		461
Bank-owned life insurance income		120		131
Other operating income		500		177
Realized gains (losses) on securities, net		24		69
Total Non-Interest Income	$	3,057	$	2,622

Total non-interest income increased $435, or 16.6%, to $3,057 for the three months ended June 30, 2013, compared with $2,622 for the corresponding period in 2012. This increase was primarily attributable to an increase of $323 in other operating income due mostly to a one-time bank-owned life insurance death benefit of $468, an increase of $62 in trust department income, and an increase of $44 in other fee income, offset by a $45 decrease in net realized gains on securities.

The following table sets forth information by category of non-interest income for the Company for the six months ended June 30, 2013 and June 30, 2012, respectively:

Six Months Ended:	June 30, 2013		June 30, 2012
Trust department income	$	794	$	703
Service charges on deposit accounts		954		927
Merchant transaction income		1,949		2,098
Brokerage fee income		190		141
Other fee income		906		864
Bank-owned life insurance income		239		249
Other operating income		726		418
Realized gains (losses) on securities, net		125		116
Total Non-Interest Income	$	5,883	$	5,516

Total non-interest income increased $367, or 6.7%, to $5,883 for the six months ended June 30, 2013, compared with $5,516 for the corresponding period in 2012. This increase was primarily attributable to an increase of $308 in other operating income due mostly to a one-time bank-owned life insurance death benefit of $468, an increase of $91 in trust department income and a $49 increase in brokerage fee income, offset by a $149 decrease in merchant transaction income.

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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 June 30, 2013 and June 30, 2012, respectively:

Three Months Ended:	June 30, 2013		June 30, 2012
Salaries and employee benefits	$	3,492	$	3,490
Premises and equipment		701		715
Merchant transaction expenses		582		596
FDIC insurance assessments		11		120
Other operating expenses		2,070		2,340
Total Non-Interest Expenses	$	6,856	$	7,261

Total non-interest expenses decreased $405, or 5.6%, to $6,856 for the three months ended June 30, 2013 compared with $7,261 for the corresponding period in 2012. This decrease was attributable to a $270 decrease in other operating expenses resulting from a $55 reduction in Pennsylvania shares tax expense, in addition to a $109 decrease in FDIC insurance assessments from the refund of the pre-paid FDIC insurance assessment.

The following table sets forth information by category of non-interest expense for the Company for the six months ended June 30, 2013 and June 30, 2012, respectively:

Six Months Ended:	June 30, 2013		June 30, 2012
Salaries and employee benefits	$	7,075	$	7,204
Premises and equipment		1,502		1,552
Merchant transaction expenses		1,207		1,327
FDIC insurance assessments		129		230
Other operating expenses		4,068		4,288
Total Non-Interest Expenses	$	13,981	$	14,601

Total non-interest expenses decreased $620, or 4.2%, to $13,981 for the six months ended June 30, 2013 compared with $14,601 for the corresponding period in 2012. This decrease was attributable to a $129 decrease in salaries and employee benefits due to lower compensation expenses. Merchant transaction expenses decreased $120, due to lower volume. FDIC insurance assessments decreased $101 from the refund of the pre-paid FDIC insurance assessment. Also, other operating expenses decreased $220, resulting mostly from a $167 reduction in Pennsylvania shares tax expense and reduced legal and professional fees.

Income Taxes

Applicable income taxes decreased $88, or 12.2%, and $170, or 11.0%, primarily due to lower taxable income for the three months and six months ended June 30, 2013, 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. The Company is considering replacing investment proceeds with loans and the remainder of the excess cash flows being redeployed into AAA-rated securities with mid to long-term durations in order to increase investment yields.

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.

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

	June 30, 2013		December 31, 2012
U.S. Agency obligations	$	81,767	$	84,682
Mortgage-backed securities		26,124		31,620
States & political subdivisions		63,385		59,920
Total Debt Securities		171,276		176,222
Equity Securities		942		1,071
Total Investment Securities	$	172,218	$	177,293

Loan Portfolio

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

As of:	June 30, 2013		December 31, 2012
Construction and land development
Residential real estate	$	1,320	$	3,231
Commercial real estate		17,036		17,617
Residential real estate		264,920		258,681
Commercial real estate		208,996		199,879
Commercial loans		56,013		56,396
Credit card and related plans		3,031		3,199
Other (installment and student loans, etc.)		49,732		49,199
Obligations of states & political subdivisions		28,616		22,586
All other loans		12,689		12,742
Loans, net of unearned income		642,353		623,530
Less: Allowance for loan and lease losses		7,552		6,950
Loans, net	$	634,801	$	616,580

The Company did not purchase any loans during the six months ended June 30, 2013, other than loan participations with local banks in the Bank’s primary market area. Originations of new loans in 2013 were primarily residential real estate and commercial real estate.

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 77% of total loans at June 30, 2013 and December 31, 2012. Economic conditions and recessionary concerns over the past several years have resulted in lower levels of loan demand. The decline in 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.

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 maintained at an amount that management believes is 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 June 30, 2013. Management uses available information to estimate probable losses on loans;

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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) management has determined to be uncollectible, net of actual recoveries on loans previously charged-off.

The allowance for loan and lease losses as a percentage of loans was 1.18% at June 30, 2013, compared to 1.11% at December 31, 2012 and 1.09% at June 30, 2012.

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 was 7.6% while the statewide unemployment rate stood at 7.5% and the Scranton/Wilkes-Barre metropolitan area unemployment rate was 9.3% for May 2013. The region still leads the state’s 14 metro areas with the highest unemployment rate for the thirty-eighth consecutive month, 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.

The high unemployment in Northeastern Pennsylvania will continue to put pressure on the local economy and on our loan portfolio, even as average home prices increased 11.6% for the twelve months ending in April 2013, 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:	June 30, 2013			December 31, 2012			June 30, 2012
Non-accrual loans
Residential real estate	$	1,902		$	1,800		$	1,386
Commercial real estate		314			145			145
Commercial loans		325			304			423
Consumer loans		52			31			58
Total non-performing loans	$	2,593		$	2,280		$	2,012
Other real estate owned		949			656			726
Total non-performing assets	$	3,542		$	2,936		$	2,738
Loans past due 90 days or more and accruing:
Residential real estate	$	603		$	243		$	1,447
Commercial real estate		9			—			—
Guaranteed student loans		74			180			96
Credit card loans		16			25			12
Commercial loans		—			—			—
Consumer loans		—			9			1
Total loans past due 90 days or more and accruing	$	702		$	457		$	1,556
Non-performing loans to period end loans		0.40	%		0.37	%		0.31	%
Non-performing assets to period end assets		0.39	%		0.32	%		0.30	%
Total loans past due 90 days or more and accruing to period end loans		0.11	%		0.07	%		0.24	%

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 June 30, 2013, the Company had $6,036 of TERI-guaranteed loans out of a total student loan portfolio of $11,565. 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 June 30, 2013, $38 of such loans were on non-accrual status.

Loans on which the accrual of interest has been discontinued or reduced amounted to $2,593 and $2,012 at June 30, 2013 and 2012, respectively. If interest on non-accrual loans had been accrued, such income would have been $100 and $72 for the six months ended June 30, 2013 and June 30, 2012, respectively. No interest income on non-accrual loans was received in the six months ended June 30, 2013 and June 30, 2012. There are no commitments to lend additional funds to borrowers whose loans are in non-accrual status.

As of June 30, 2013, our non-performing loans were comprised of forty-four loans of which nine loans were in excess of one hundred thousand dollars in size and the remainder of which were less than one hundred thousand dollars each.

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

48

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 June 30, 2013, the Company had total impaired loans of $4,848. Of the total allowance for loan and lease losses, $1,174 was specifically related to these impaired loans at June 30, 2013.

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:	June 30, 2013			June 30, 2012
Balance at beginning of period	$	7,110		$	6,811
Charge-offs:
Residential real estate mortgages		51			—
Commercial real estate		—			—
Commercial loans		—			—
Credit card and related plans		18			10
Installment loans		33			20
Total charge-offs		102			30
Recoveries:
Residential real estate mortgages		41			—
Commercial real estate		—			—
Commercial loans		—			—
Credit card and related plans		—			—
Installment loans		3			43
Total recoveries		44			43
Net charge-offs (recoveries)		58			(13	)
Provision charged to operations		500			114
Balance at End of Period	$	7,552		$	6,938
Ratio of net charge-offs (recoveries) to average outstanding loans		0.01	%		0.00	%

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Six Months Ended:	June 30, 2013			June 30, 2012
Balance at beginning of period	$	6,950		$	6,711
Charge-offs:
Residential real estate mortgages		207			—
Commercial real estate		—			33
Commercial loans		—			5
Credit card and related plans		45			18
Installment loans		72			75
Total charge-offs		324			131
Recoveries:
Residential real estate mortgages		106			1
Commercial real estate		—			5
Commercial loans		—			—
Credit card and related plans		—			—
Installment loans		20			46
Total recoveries		126			52
Net charge-offs (recoveries)		198			79
Provision charged to operations		800			306
Balance at End of Period	$	7,552		$	6,938
Ratio of net charge-offs (recoveries) to average outstanding loans		0.03	%		0.01	%

The allowance for loan and lease losses at June 30, 2013 was $7,552, or 1.18%, of total loans compared to $6,938 or 1.09% of total loans at June 30, 2012.

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

As of:	June 30, 2013					December 31, 2012					June 30, 2012
	Amount		% *			Amount		% *			Amount		% *
Residential real estate	$	3,092		41	%	$	2,981		42	%	$	2,856		42	%
Commercial real estate and all others		3,503		50	%		3,103		49	%		3,148		49	%
Credit card and related plans		393		1	%		326		1	%		340		1	%
Personal installment loans		564		8	%		540		8	%		594		8	%
Total	$	7,552		100	%	$	6,950		100	%	$	6,938		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.

As of June 30, 2013, the total of the allowance for loan and lease losses was $7,552. 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.

Other Real Estate Owned

The Bank has six properties in other real estate owned as of June 30, 2013 with a value of $949 compared to $656 at December 31, 2012 and $726 at June 30, 2012. Of the six properties two are commercial with a carrying value of $756 and the remaining four properties are residential. The Bank had seven residential properties in other real estate owned on December 31, 2012. As of June 30, 2012, the Bank had eight properties in other real estate owned. Of the eight properties, one was commercial with a carrying value of $100; the remaining seven properties were residential.

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Deposits

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

	June 30, 2013		December 31, 2012
Demand - Non-interest bearing	$	146,583	$	151,121
Demand - Interest bearing		105,467		102,722
Savings		132,487		126,618
Money markets		175,897		166,273
Time - Over $100,000		83,063		81,855
Time - Other		89,637		93,359
Total Deposits	$	733,134	$	721,948

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 June 30 2013, the Company had Certificate of Deposit Account Registry Service (“CDARS”) reciprocal deposits in the amount of $25.2 million. The Bank also currently issues brokered certificates of deposit as an alternative to wholesale funding due to their favorable terms. There was no balance outstanding as of June 30, 2013 and December 31, 2012, respectively. The brokered certificates of deposit issued are generally a low cost alternative to wholesale funding with the majority offered having a call feature optionality not provided by wholesale funding.

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.

The Bank 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 Bank also has long-term debt outstanding to the FHLB, originated in prior years. At June 30, 2013, the Bank had $201,535 of available borrowing capacity with the FHLB, a borrower-in-custody (BIC) line of credit of $32,650 with the Federal Reserve Bank of Philadelphia, available borrowing capacity at the Federal Reserve discount window of $11,234, an overnight Federal funds line of credit of $19,000 with PNC Bank 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.

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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 presented.

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. Because 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.

Legal Proceedings

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.

Regulatory Matters

The new Basel III capital rules for community banks will begin transitioning on January 1, 2015. The new minimum capital requirements are effective on January 1, 2015, whereas the capital conversion buffer and the deductions from common equity tier 1 capital phase in over time.

The new rule takes important steps toward improving the quality and increasing the quantity of capital for all banking organizations as well as setting higher standards for large, internationally active banking organizations. The new Basel III rule will result in capital requirements that better reflect banking organizations’ risk profiles, thereby improving the overall resilience of the banking system. The federal banking agencies have carefully considered the potential impacts on all banking organizations, including community banking organizations, and sought to minimize the potential burden of these changes where consistent with applicable law and the agencies’ goals of establishing a robust and comprehensive capital framework.

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.

The Company’s total risk-based capital ratio was 17.78% at June 30, 2013. The Bank’s total risk-based capital ratio was 17.17% at June 30, 2013; this is more than the 10.00% ratio that Federal regulators use as the “well capitalized”

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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

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:

	June 30, 2013		December 31, 2012		June 30, 2012
Loans, net of unearned income	$	642,353	$	623,530	$	638,970
Credit fair value adjustment on purchased loans		900		1,209		1,797
Total adjusted loans	$	643,253	$	624,739	$	640,767

	June 30, 2013			December 31, 2012			June 30, 2012
Allowance for loan and lease losses	$	7,552		$	6,950		$	6,938
Credit fair value adjustment on purchased loans		900			1,209			1,797
Total adjusted allowance	$	8,452		$	8,159		$	8,735
Total adjusted allowance to adjusted loans		1.31	%		1.31	%		1.36	%

Item 3. Quantitative and Qualitative Disclosures 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 Bank’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 manage the inherent risk while at the same time maximizing income. Management realizes certain risks are inherent and that the goal is to identify and manage 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, 2012. Management, as part of its regular practices, performs

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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, 2012.

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 June 30, 2013, that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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, 2012, which was filed with the Securities and Exchange Commission (SEC) on March 14, 2013, except for the following risk factors which have been amended or added since December 31, 2012.

We will be subject to business uncertainties and contractual restrictions while the merger with Peoples is pending.

Uncertainties about the effect of our pending merger with Peoples on our business may have an adverse effect on us. These uncertainties may also impair our ability to attract, retain and motivate strategic personnel until the merger is consummated, and could cause our customers and others that deal with us to seek to change their existing business relationship, which could negatively impact the combined bank upon consummation of the merger. In addition, the merger agreement restricts us from taking certain specified actions without Peoples’ consent until the merger is consummated. These restrictions may prevent us from pursuing or taking advantage of attractive business opportunities that may arise prior to the completion of the merger.

The merger agreement limits our ability to pursue alternatives to the merger with Peoples.

The merger agreement contains terms and conditions that make it more difficult for us to engage in a business combination with a party other than Peoples. Subject to limited exceptions, we are required to convene a special meeting of shareholders and our board of directors is required to recommend approval of the merger agreement. If our board of directors determines to accept a superior acquisition proposal from a competing third party, we will be obligated to pay a $3.7 million termination fee to Peoples. A competing third party may be discouraged from considering or proposing a business combination with us, including an acquisition on better terms than those reflected in the merger agreement with Peoples, due to the termination fee and our obligations under the merger agreement.

Penseco shareholders cannot be sure of the market value of the Peoples common stock that they will receive in the merger.

The merger agreement provides that Penseco shareholders will receive in exchange for each share of Penseco common stock they own immediately prior to completion of the merger 1.3636 shares of Peoples common stock, subject to adjustment upon the occurrence of certain events described in the merger agreement (the “Exchange Ratio”). At the time the merger agreement was signed, the closing price of Peoples common stock on the OTCQB was $35.25. Except under limited circumstances, if Peoples’ stock price declines prior to the completion of the merger, Peoples will not be required to adjust the Exchange Ratio. As a result, the market price of shares of Peoples common stock that a Penseco shareholder receives in the merger may decline from the date when the merger agreement was signed to the closing of the merger.

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In addition, relative prices of Peoples common stock and Penseco common stock are likely to change between the dates of the joint proxy statement/prospectus to be mailed to Penseco shareholders in connection with the special meeting at which Penseco shareholders will be asked to approve the merger. The market prices of Peoples and Penseco common stock may change as a result of a variety of factors, including general market and economic conditions, changes in business, operations and prospects, and regulatory considerations. Many of these factors are beyond the control of Peoples and Penseco. As Peoples and Penseco market share prices fluctuate, the value of the shares of Peoples common stock that a Penseco shareholder will receive will correspondingly fluctuate. It is impossible to predict accurately the market price of Peoples common stock upon, or after completion of, the merger. Accordingly, it is also impossible to predict accurately the market value of the consideration to be received by shareholders of Penseco in the merger upon their exchange of shares of Penseco common stock for shares of Peoples common stock.

Failure to complete the merger could negatively affect the market price of our common stock.

If the merger is not completed for any reason, we will be subject to a number of material risks, including the following:

• the market price of our common stock may decline to the extent that the current market price of our shares reflects a market assumption that the merger will be completed;

• costs relating to the merger, such as legal, accounting and financial advisory fees, and, in specified circumstances, termination fees, must be paid even if the merger is not completed; and

• the diversion of management’s attention from the day-to-day business operations and the potential disruption to our employees and business relationships during the period before the completion of the merger may make it difficult to regain financial and market positions if the merger does not occur.

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.

2.1	Agreement and Plan of Merger, dated as of June 28, 2013, between Penseco Financial Services Corporation and Peoples Financial Services Corp. (incorporated by reference to Exhibit 2.1 to the Registrant’s current report on Form 8-K filed with the SEC on June 28, 2013).
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

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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:	August 8, 2013
By	/s/    PATRICK SCANLON
	Patrick Scanlon
	Senior Vice President, Finance Division Head
	(Principal Financial Officer)
Dated:	August 8, 2013

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