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 March 31, 1997 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from_____________________ to ___________________ Commission file number 0-13222 CITIZENS FINANCIAL SERVICES, INC. (Exact name of registrant as specified in its charter) PENNSYLVANIA 23-2265045 (State of other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 15 South Main Street, Mansfield, Pennsylvania 16933 (Address of principal executive offices ) (Zip Code) Registrant's telephone number, including area code: (717) 662-2121 Indicate by checkmark whether the registrant (1) has filed all reports 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_____ The number of shares outstanding of the Registrant's Common Stock, as of May 6, 1997 1,360,228 shares of Common Stock, par value $1.00. Citizens Financial Services, Inc. Form 10-Q INDEX Page Part I FINANCIAL INFORMATION (UNAUDITED) Item 1-Financial Statements Consolidated Balance Sheet as of March 31, 1997 and December 31, 1996 1 Consolidated Statement of Income for the Three Months Ended March 31, 1997 and 1996 2 Consolidated Statement of Cash Flows for the Three Months Ended March 31, 1997 and 1996 3 Notes to Consolidated Financial Statements 4-5 Item 2-Management's Discussion and Analysis of Financial Condition and Results of Operations 5-13 Part II OTHER INFORMATION AND SIGNATURES Item 1-Legal Proceedings 14 Item 2-Changes in Securities 14 Item 3-Defaults upon Senior Securities 14 Item 4-Submission of Matters to a Vote of Security Holders 14 Item 5-Other Information 14 Item 6-Exhibits and Reports on Form 8-K 14 Signatures 15 CITIZENS FINANCIAL SERVICES, INC. CONSOLIDATED BALANCE SHEET (UNAUDITED) March 31, December 31, 1997 1996 ASSETS: Cash and due from banks: Noninterest-bearing $ 8,039,159 $ 6,406,872 Interest-bearing 2,387,104 51,835 Total cash and cash equivalents 10,426,263 6,458,707 Available-for-sale securities 26,672,731 28,736,558 Held-to-maturity securities (estimated market value 1997,$57,747,000; December 31, 1996, $57,587,000) 55,428,587 57,320,754 Loans (net of allowance for possible loan losses 1997, $2,042,293; December 31, 1996, $1,995,028) 180,112,533 180,417,838 Foreclosed assets held for sale 153,958 164,223 Premises and equipment 4,767,209 4,344,977 Accrued interest receivable 2,937,580 2,930,283 Other assets 2,372,188 2,436,276 TOTAL ASSETS $282,871,049 $282,809,616 LIABILITIES: Deposits: Noninterest-bearing $ 18,824,408 $ 17,924,356 Interest-bearing 229,418,194 222,252,664 Total deposits 248,242,602 240,177,020 Borrowed funds 7,004,701 15,816,839 Accrued interest payable 1,768,923 2,292,742 Dividends payable 0 612,103 Other liabilities 1,954,939 1,007,099 TOTAL LIABILITIES 258,971,165 259,905,803 STOCKHOLDERS' EQUITY: Common Stock $1.00 par value; authorized 5,000,000 shares; issued and outstanding 1,360,228 shares in 1997 and 1996 1,360,228 1,360,228 Additional paid-in capital 6,828,301 6,828,301 Retained earnings 15,758,694 14,543,833 TOTAL 23,947,223 22,732,362 Unrealized holding (losses)gains on available-for-sale securities (47,339) 171,451 TOTAL STOCKHOLDERS' EQUITY 23,899,884 22,903,813 TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $282,871,049 $282,809,616 The accompanying notes are an integral part of these financial statements. 1 CITIZENS FINANCIAL SERVICES, INC. CONSOLIDATED STATEMENT OF INCOME (UNAUDITED) Three Months Ended March 31, 1997 1996 INTEREST INCOME: Interest and fees on loans $4,134,781 $3,791,274 Interest on interest-bearing deposits with banks 6,958 36,816 Interest and dividends on investments: Taxable 1,313,194 1,140,013 Nontaxable 12,561 19,442 Dividends 18,058 17,306 TOTAL INTEREST INCOME 5,485,552 5,004,851 INTEREST EXPENSE: Interest on deposits 2,641,453 2,414,438 Interest on borrowed funds 167,921 113,678 TOTAL INTEREST EXPENSE 2,809,374 2,528,116 NET INTEREST INCOME 2,676,178 2,476,735 Provision for possible loan losses 52,500 47,500 NET INTEREST INCOME AFTER PROVISION FOR POSSIBLE LOAN LOSSES 2,623,678 2,429,235 OTHER OPERATING INCOME: Service charge income 194,765 179,802 Trust income 94,364 68,268 Other income 56,579 53,494 Arbitration settlement 884,008 0 Realized securities gains, net 0 19,264 TOTAL OTHER OPERATING INCOME 1,229,716 320,828 OTHER OPERATING EXPENSES: Salaries and employee benefits 1,103,971 806,788 Occupancy expenses 137,755 113,955 Furniture and equipment expenses 149,729 136,209 Federal deposit insurance premiums 13,682 29,929 Other expenses 634,867 586,339 TOTAL OTHER OPERATING EXPENSES 2,040,004 1,673,220 Income before provision for income taxes 1,813,390 1,076,843 Provision for income taxes 598,529 351,789 NET INCOME $1,214,861 $ 725,054 Earnings per share $0.89 $0.53 Weighted average number of shares outstanding 1,360,228 1,360,228 The accompanying notes are an integral part of these financial statements. 2 CITIZENS FINANCIAL SERVICES, INC. CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED) Three months Ended March 31, CASH FLOWS FROM OPERATING ACTIVITIES: 1997 1996 Net income $ 1,214,861 $ 725,054 Adjustments to reconcile net income to net cash provided by operating activities: Provision for possible loan losses 52,500 47,500 Provision for depreciation and amortization 126,849 92,100 Amortization and accretion of investment securities 97,010 75,971 Deferred income taxes (16,786) 28,449 Realized gains on securities 0 (19,264) Realized gains on loans sold (2,396) (435) Originations of loans held for sale (195,200) (518,000) Proceeds from sales of loans held for sale 197,379 518,435 Loss (gain) on sale of foreclosed assets held for sale 2,432 (10,315) Increase in accrued interest receivable and other assets (90,904) (335,405) Increase (decrease) in accrued interest payable and other liabilities 424,020 (60,851) Net cash provided by operating activities 1,809,765 543,239 CASH FLOWS FROM INVESTING ACTIVITIES: Available-for-sale securities: Proceeds from sales of securities 0 16,047 Proceeds from maturity of securities 1,700,000 0 Purchase of securities 0 (1,080,625) Held-to-maturity securities: Proceeds from maturity and principal repayments of securities 1,980,683 2,316,040 Purchase of securities (153,200) (2,168,438) Net decrease (increase) in loans 240,856 (33,836) Capital expenditures (271,889) (49,163) Proceeds from sale of foreclosed assets held for sale 20,000 66,600 Net cash provided (used) by investing activities 3,516,450 (933,375) CASH FLOWS FROM FINANCING ACTIVITIES: Net increase in deposits 8,065,582 4,576,708 Proceeds from long-term borrowings 22,991 79,200 Repayments of long-term borrowings 0 (42,705) Net decrease in short-term borrowed funds (8,835,129) (1,742,782) Dividends paid (612,103) (579,349) Net (used) cash provided by financing activities (1,358,659) 2,291,072 Net increase in cash and cash equivalents 3,967,556 1,900,936 CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 6,458,707 5,572,661 CASH AND CASH EQUIVALENTS AT END OF PERIOD $10,426,263 $ 7,473,597 Supplemental Disclosures of Cash Flow Information: Interest paid $ 3,333,193 $ 3,042,218 Income taxes paid $ 0 $ 10,000 The accompanying notes are an integral part of these financial statements. 3 CITIZENS FINANCIAL SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Note 1 - Basis of Presentation The consolidated financial statements include the accounts of Citizens Financial Services, Inc. and its wholly-owned subsidiary, First Citizens National Bank (the "Bank"), (collectively, the "Company"). All material intercompany balances and transactions have been eliminated in consolidation. The accompanying interim financial statements have been prepared by the Company without audit and, in the opinion of management, reflect all adjustments (which include only normal recurring adjustments) necessary to present fairly the Company's financial position as of March 31, 1997, and the results of operations for the interim periods presented. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ significantly from those estimates. For further information refer to the consolidated financial statements and footnotes thereto incorporated by reference in the Company's Annual Report on Form 10-K for the year ended December 31, 1996. The results of operations for the three months ended March 31, 1997 and 1996 are not necessarily indicative of the results to be expected for the full year. The Bank currently engages in the general business of banking throughout its service area of Potter, Tioga and Bradford counties in North Central Pennsylvania and Allegany, Steuben, Chemung and Tioga counties in Southern New York. The Bank maintains its central office in Mansfield, Pennsylvania and presently operates banking facilities in Mansfield, Blossburg, Ulysses, Genesee, Wellsboro, Troy, Sayre, Canton, Gillett and the Wellsboro Weis Market store as well as automatic teller machines located in Soldiers and Sailors Memorial Hospital in Wellsboro, Mansfield Wal-Mart and at Mansfield University. The Bank's lending and deposit products are offered primarily within the vicinity of its service area. The Company faces strong competition in the communities it serves from other commercial banks, savings banks, and savings and loan associations, some of which are substantially larger institutions than the Company's subsidiary. In addition, personal and corporate trust services are offered by insurance companies, investment counseling firms, and other business firms and individuals. The Company also competes with credit unions, issuers of money market funds, securities brokerage firms, consumer finance companies, mortgage brokers and insurance companies. These entities are strong competitors for virtually all types of financial services. In recent years, the financial services industry has experienced tremendous change to competitive barriers between bank and non-bank institutions. The Company not only must compete with traditional financial institutions, but also with other business corporations that have begun to deliver competing financial services. Competition for banking services is based on price, nature of product, quality of service, and in the case of certain activities, convenience of location. LOANS Historically loans have been originated by the Bank to customers in North Central Pennsylvania and the Southern Tier of New York. Loans have been originated primarily through direct loans to our existing customer base with new customers generated by referrals from real estate brokers, building contractors, attorneys, accountants and existing customers. The Bank also does a limited amount of indirect loans though new and used car dealers in the primary lending area. 4 All lending is governed by a lending policy which is developed and maintained by management and approved by the board of directors. The Bank's lending policy regarding real estate loans is that the maximum mortgage granted on owner occupied residential property is 80% of the appraised value or purchase price (whichever is lower) when secured by the first mortgage on the property. Home equity lines of credit or second mortgage loans are originated subject to maximum mortgage liens against the property of 80% of the current appraised value. The maximum term for mortgage loans is 25 years for one-to four- family residential property and 15 years for commercial and vacation property. DEPOSITS Over the last few years the Company, responding to the demand for new competitive products in the market area, began to tier interest-bearing transaction and savings accounts by deposit size (larger balances receive higher rates). The Company has been offering a wide variety of deposit instruments, as have its competitors. Limited transaction deposit accounts with interest rates that vary as often as daily, unlimited transaction interest-bearing accounts, Premier 55 Club, Premier 55 Plus Club, Gold Club, individual retirement accounts, longer-term certificates of deposit (generally of five-year maturity), promotional 30-month, 66-month and Roll-Up certificates of deposit (allows the customer to increase the interest rate by a maximum of 100 basis points once during the term were some of the deposit product variations. TRUST SERVICES Traditional trust and investment management and estate settlements are offered by the Bank. Note 2 - Earnings per Share Earnings per share calculations give retroactive effect to stock dividends Declared by the Company. The number of shares used in the earnings per share and dividends per share calculation was 1,360,228 for 1997 and 1996. Item 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is management's discussion and analysis of certain significant factors that have affected the Company's financial position and operating results during the periods indicated in the accompanying consolidated financial statements. The results of operations for the three months ended March 31, 1997 and 1996 are not necessarily indicative of the results to be expected for the full year. In addition to historical information, this quarterly report contains forward-looking statements. The forward-looking statements contained herein are subject to certain risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Important factors that might cause such a material difference include, but are not limited to, those discussed in the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations". Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management's analysis only as of the date thereof. The Company undertakes no obligation to publicly revise or update these forward-looking statements to reflect events or circumstances that arise after the date hereof. Readers should carefully review the risk factors described in other documents the Company files from time to time with the Securities and Exchange Commission, including the quarterly reports on Form 10-Q to be filed by the Company and any current reports on Form 8-K filed by the Company. Financial Condition For the three month period ended March 31, 1997, the assets of the Company had a slight decrease of $.9 million compared with an increase of $2.7 million for the same period in 1996. The lack of growth in net assets was the increase in deposits being offset by principal reduction of short-term debt along with the maturity of investments. 5 Cash and cash equivalents increased $4 million in 1997 compared with an increase of $1.9 million for the same period in 1996. Surplus funds from deposit growth in 1997 were placed in short-term interest bearing investments. Total investment securities decreased $4 million or 10.5% during the first three months of 1997 compared with an increase of $.5 million for the same period in 1996. The decrease reflects normal maturities. Net loan balances had virtually the same change for both periods with a slight decrease of $.3 million for the first three months of 1996 and 1997, respectively. This represents a normal seasonal slow down and is not expected to continue as the normal home building season in spring and summer. During the remainder of 1997, management expects that loan demand will continue as a result of the attractive interest rates currently promoted and while we are experiencing a generally healthy local economy. The major concentrations of loans continue to be in residential real estate-consisting of loans to purchase and improve real estate, debt consolidation and home equity lines of credit. The Bank also expects to be successful in lending to local state and political subdivisions during the remainder of 1997. The loan portfolio consists of the following (in thousands): March 31, December 31, March 31, 1997 1996 1996 Real estate loans - residential $112,470 $112,678 $ 97,177 Real estate loans - commercial 28,174 27,670 24,607 Real estate loans - agricultural 5,848 6,134 7,525 Loans to individuals for household, family and other purchases 14,835 14,465 13,425 Commercial and other loans 11,103 11,529 10,804 State and political subdivision loans 9,879 10,105 8,122 Total 182,309 182,581 161,660 Less: unearned income on loans 154 168 220 Loans, net of unearned income $182,155 $182,413 $161,440 Deposit growth continues to be strong, increasing by $8.1 million or 3.4%, because of the three additional offices in addition to the competitive pricing of certificates of deposit. The first three months of 1996 saw an increase of $4.6 million. Borrowed funds decreased by $8.8 million during the first three months of 1997 compared with a decrease of $1.7 million in 1996. This decrease resulted from repayments of short-term borrowing to the Federal Home Loan Bank. The Company's daily cash requirements or short-term investments are met by using the financial instruments available through the Federal Home Loan Bank. The strong increase in deposits coupled with investments maturing enabled a decrease in short-term borrowing during the first quarter of 1997. 6 Capital The Company has computed its risk-based capital ratios as follows (dollars in thousands): March 31, December 31, 1997 1996 Tier I - Total stockholders' equity $ 23,900 $ 22,904 Less: Unrealized holding gains (losses) on available-for-sale securities (47) 172 Goodwill and core deposit intangible 918 945 Tier I, net 23,029 21,787 Tier II - Allowance for loan losses(1) 2,015 1,977 Total qualifying capital $ 25,044 $ 23,764 Risk-adjusted on-balance sheet assets $153,673 $131,111 Risk-adjusted off-balance sheet exposure (2) 7,472 6,129 Total risk-adjusted assets $161,145 $137,240 March 31, December 31, Ratios: 1997 1996 Tier I risk-based capital ratio 14.3% 13.8% Federal minimum required 4.0 4.0 Total risk-based capital ratio 15.5% 15.0% Federal minimum required 8.0 8.0 Leverage ratio (3) 8.2% 7.8% Federal minimum required 4.0 4.0 (1) Allowance for loan losses is limited to 1.25% of total risk-adjusted assets. (2) Off-balance sheet exposure is caused primarily by standby letters of credit and loan commitments with a remaining maturity exceeding one year. These obligations have been converted to on-balance sheet credit equivalent amounts and adjusted for risk. (3) Tier I capital divided by average total assets. See the discussion of liquidity below for details regarding future expansion plans and the impact on capital. Results of Operations Net income for the three month period ending March 31, 1997 was $1,215,000 an increase of $490,000 or 67.6% over the 1996 related period. Earnings per share was $.89 during the first quarter of 1996 compared with $.53 during the comparable 1996 period. The large increase was the result of an arbitration settlement discussed below. Net interest income, the most significant component of earnings, is the amount by which interest generated from earning assets exceeds interest expense on liabilities. Net interest income for the current three month period, after provision for possible loan losses, was $2,624,000, an increase of $194,000 or 8% compared with an increase of $165,000 or 7.3% during the same period in 1996. 7 Analysis of Average Balances and Interest Rates (1) March 31, 1997 March 31, 1996 March 31, 1995 Average Average Average Average Average Average Balance Interest Rate Balance Interest Rate Balance Interest Rate $ $ % $ $ % $ $ % ASSETS Short-term investments: Interest-bearing deposits at banks 525 7 5.41 2,743 37 5.43 36 1 5.59 Investment securities: Taxable 83,799 1,331 6.44 71,192 1,157 6.54 61,644 1,023 6.73 Tax-exempt(3) 606 19 12.72 931 29 12.53 2,533 79 12.65 Total investment securities 84,405 1,350 6.49 72,123 1,186 6.61 64,177 1,102 6.96 Loans: Residential mortgage loans 112,919 2,565 9.21 97,206 2,267 9.38 97,275 2,193 9.14 Commercial & farm loans 43,247 1,031 9.67 41,017 1,012 9.92 38,055 911 9.71 Loans to state & political subdivisions 9,963 209 8.51 8,267 181 8.81 7,368 155 8.53 Other loans 15,312 399 10.57 14,161 379 10.76 14,066 339 9.77 Loans, net of discount (2)(3)(4) 181,441 4,204 9.40 160,651 3,839 9.61 156,764 3,598 9.31 Total interest-earning assets 266,371 5,561 8.47 235,517 5,062 8.64 220,977 4,701 8.63 Cash and due from banks 6,320 4,991 4,825 Bank premises and equipment 4,570 4,162 4,115 FASB 115 adjustment 218 482 (370) Other assets 4,459 3,312 2,875 Total noninterest-bearing assets 15,567 12,947 11,445 Total assets 281,938 248,464 232,422 LIABILITIES AND STOCKHOLDERS' EQUITY Interest-bearing deposits: NOW accounts 31,125 184 2.40 24,255 126 2.09 23,788 148 2.52 Savings accounts 27,444 150 2.22 25,919 144 2.23 25,957 170 2.66 Money market accounts 26,187 285 4.41 24,288 267 4.42 21,302 248 4.72 Certificates of deposit 140,825 2,023 5.83 126,476 1,877 5.97 111,982 1,545 5.60 Total interest-bearing deposits 225,581 2,642 4.75 200,938 2,414 4.83 183,029 2,111 4.68 Other borrowed funds 11,129 168 6.12 7,284 114 6.29 13,422 203 6.13 Total interest-bearing liabilities 236,710 2,810 4.81 208,222 2,528 4.88 196,451 2,314 4.78 Demand deposits 18,104 15,178 14,150 Other liabilities 3,666 3,513 2,489 Total noninterest-bearing liabilities 21,770 18,691 16,639 Stockholders' equity 23,458 21,551 19,332 Total liabilities & stockholders' equity 281,938 248,464 232,422 Net interest income 2,751 2,534 2,387 Net interest spread (5) 3.65% 3.76% 3.85% Net interest income as a percentage of average interest-earning assets 4.19% 4.33% 4.38% Ratio of interest-earning assets to interest-bearing liabilities 1.13 1.13 1.12 (1) Averages are based on daily balances. (2) Includes loan origination and commitment fees. (3) Tax exempt interest revenue is shown on a tax equivalent basis for proper comparison using a statutory federal income tax rate of 34%. (4) Income on non-accrual loans is accounted for on a cash basis, and the loan balances are included in interest-earning assets. (5) Interest rate spread represents the difference between the average rate earned on interest-earning assets and the average rate paid on interest-bearing liabilities. 8 As described in the table above, the yield on earning assets, on a tax-equivalent basis, was 8.47% and 8.64% during the first three months of 1997 and 1996, respectively (a decline of 17 basis points). The cost of funds was 4.81% and 4.88% during the same three month period (a decrease of 7 basis points). In comparing the average interest cost of 1997 versus 1996, NOW accounts increased 31 basis points (the result of a new higher rate tiered product targeted to State and Political Accounts), savings accounts and money market accounts each decreased by 1 basis point. The interest rate on certificates of deposit decreased by 14 basis points. As described above, the Company has continued to experience a slight narrowing of its margin percentage during the three months of 1997. The Company continues to review various pricing strategies to enhance deposit growth while maintaining or expanding the current interest margin. Analysis of Changes in Net Interest Income of a Tax Equivalent Basis (in thousands) 1997 vs. 1996 (1) 1996 vs. 1995 (1) Change in Change Total Change in Change Total Volume in Rate Change Volume in Rate Change Interest income: Short-term investments: Interest-bearing deposits at banks $ (30) $ 0 $ (30) $ 37 $ (1) $ 36 Investment securities: Taxable 200 (26) 174 155 (21) 134 Tax-exempt (10) 0 (10) (50) 0 (50) Total investments 190 (26) 164 105 (21) 84 Loans: Residential mortgage loans 356 (58) 298 (2) 76 74 Commercial and farm loans 51 (32) 19 73 28 101 Loans to state & political subdivisions 35 (7) 28 20 6 26 Other loans 30 (10) 20 2 38 40 Total loans - net of discount (2)(3)(4) 472 (107) 365 93 148 241 Total interest income 632 (133) 499 235 126 361 Interest expense: Interest bearing deposits: NOW accounts 39 19 58 3 (25) (22) Savings accounts 8 (2) 6 0 (26) (26) Money market accounts 21 (3) 18 31 (12) 19 Certificates of deposit 204 (58) 146 210 122 332 Total interest-bearing deposits 272 (44) 228 244 59 303 Other borrowed funds 58 (4) 54 (94) 5 (89) Total interest expense 330 (48) 282 150 64 214 Net interest income $ 302 $ (85) $ 217 $ 85 $ 62 $ 147 (1)The portion of the total change attributable to both volume and rate changes during the year has been allocated to volume and rate components based upon the absolute dollar amount of the change in each component prior to allocation. 9 The above table detailing the change in net interest income clearly shows the $632,000 resulting from volume increases in investments and loans. The volume of interest expense increased the cost of interest-bearing deposits by $330,000. The positive gain in volume of $302,000 combined with a decrease due to rate of $85,000 resulted in a net increase of $217,000. The provision for possible loan losses increased $5,000 to $52,500 in the three month period of 1997, compared with a provision of $47,500 in the same period of 1996. This increase was appropriate given management's quarterly review of the allowance for loan losses that is based on the following information; migration analysis of delinquent and non accrual loans, estimated future losses on loans, recent review of large problem credits, local and national economic conditions, historical loss experience, OCC qualitative adjustments, purchase of loans through acquisitions and peer comparisons. Total other operating income increased $909,000 compared with the same period in 1996. Trust income increased $26,000, service charge income increased $15,000, and other income increased $3,000. Net realized securities gains decreased by $19,000, during the current three month period compared to 1996, as there were not sales during the current period. On February 27, 1997 the Bank reached an arbitration settlement with a vendor. The settlement was for legal remedies associated with relationships with this vendor. The Bank received $884,000 in cash and $250,000 in credits to be applied to future expenditures, which if unused will expire within two years. The amount received by the Bank is net of fees associated with the arbitration. Total other operating expense was $2,040,000 in the first three months of 1997 reflecting an increase of $367,000 over the 1996 period. Salaries and benefit's expense increased by $297,000 for the current three month period reflecting normal merit increases, the addition of employees for the three additional offices and an accrual of $154,000 for profit sharing reflecting the additional income. Occupancy expense increased by $24,000 or 21% while furniture and equipment expenses increased by $14,000 or 9.9%, both reflecting the addition of 3 branches. Federal deposit insurance premium expense decreased $16,000 or 54.3%. Based on estimated deposit levels projected for 1997, Management expects that the FDIC assessment will be approximately $67,000 or $305,000 less than the premium in 1996. This reduction is because the SAIF assessment of $274,000 during the third quarter of 1996 will not reoccur. On September 30,1996, the President signed into law the Deposit Insurance Funds Act of 1996 to recapitalize the SAIF administered by the FDIC and to provide repayment of Financial Institution Collateral Obligation ("FICO") Bonds issued by the United State Treasury Department. During 1997, 1998 and 1999, the average regular annual deposit insurance assessment is estimated to be about 1.29 cents per $100 of deposits for BIF deposits and 6.44 cents per $100 of deposits for SAIF deposits. Individual institutions assessments will continue to vary according to their capital and management ratings. As always, the FDIC will be able to raise the assessments as necessary to maintain the funds at their target capital ratios provided by law. After 1999, BIF and SAIF will share the FICO costs equally. Under current estimates, BIF and SAIF assessment bases would each be assessed at the rate of approximately 2.43 cents per $100 of deposits. The FICO bonds will mature in 2018-2019, ending the interest payment obligation. Other expenses increased $48,000 or 8.3% in the first three months of 1997 over the 1996 related period reflecting the expenses resulting from the additional three branches. The provision for income taxes was $599,000 during the first three months of 1997 compared with $352,000 during the 1996 related period. Income before taxes increased $737,000 in the 1997 period over the same period in 1996. 10 Liquidity Liquidity is a measure of the Company's ability to efficiently meet normal cash flow requirements of both borrowers and depositors. To maintain proper liquidity, the Company uses funds management policies along with its investment policies to assure it can meet its financial obligations to depositors, credit customers and shareholders. Liquidity is needed to meet depositors' withdrawal demands, extend credit to meet borrowers' needs, provide funds for normal operating expenses and cash dividends, and fund other capital expenditures. During the first three months of 1997 there was $272,000 of capital expenditures, $223,000 more than the capital acquisitions during the same period in 1996. The major expenditure of $203,000 was to purchase and renovate the Canton office. Management projects that capital expenditures for the remainder of 1997 will be approximately $900,000. During the second and third quarters approximately $700,000 is anticipated for the purchase of new hardware and software to be fully installed during August 1997. Additional renovations are planned for the Canton and Gillett offices during 1997. Management is currently renting two properties as a temporary solution to the space limitations it has experienced at the main office. On July 17, 1996, the Bank purchased a building and lot adjoining the Mansfield branch location for $255,000. The Company plans to use this area for the new operations/administration center that has been in the early planning stages for more than six years. Management anticipates that the construction will take place in 1997 or early 1998 with a total estimated cost of approximately $2 million. Management believes that it has sufficient resources to complete these projects from its normal operations and that they will have a long term positive effect on revenues, efficiency and the capacity for future growth. Liquidity is achieved primarily from temporary or short-term investments in the Federal Home Loan Bank of Pittsburgh, PA ("FHLB"), and investments that mature less than one year. The Company also has a maximum borrowing capacity at the FHLB of approximately $85 million as an additional source of liquidity. There are no short-term borrowings from the FHLB as of March 31, 1997. Apart from those matters described above, management does not currently believe that there are any current trends, events or uncertainties that would have a material impact on capital. Asset / Liability Management The objective of interest rate sensitivity management is to maintain an appropriate balance between the stable growth of income and the risks associated with maximizing income through interest sensitivity imbalances. The primary components of interest-sensitive assets include adjustable rate loans and investments, loan repayments, investment maturities and money market investments. The primary components of interest-sensitive liabilities include maturing certificates of deposit, IRA certificates of deposit (individuals over 59 1/2 have the option of changing), money market deposits, savings deposits, NOW accounts and short-term borrowing. Gap analysis, one of the methods used by the Company to analyze interest rate risk, does not necessarily show the precise impact of specific interest rate movements on the Company's net interest income because the repricing of certain assets and liabilities is discretionary and is subject to competitive and other pressures. In addition, assets and liabilities within the same period may, in fact, reprice at different times and at different rate levels. Management has procedures to manage the one year cumulative gap position to be within the Asset/Liability policy guidelines of .75 to 1.25. The Company has not experienced the kind of earnings volatility that might be indicated from gap analysis. The Company currently uses a computer simulation model to better measure the impact of interest rate changes on net interest income to simulate the potential effects of changing interest rates. Management uses the model as part of its risk management process to effectively identify, measure, and monitor the bank's risk exposure. 11 Credit Quality Risk The following table identifies amounts of loan losses and nonperforming loans. Past due loans are those that were contractually past due 90 days or more as to interest or principal payments (dollars in thousands). March 31, December 31, 1997 1996 1995 1994 1993 Non accruing loans $ 1,401 $ 844 $ 762 $ 1,557 $ 1,566 Impaired loans 414 414 697 Accrual loans - 90 days or more past due 242 723 689 267 418 Total nonperforming loans $ 2,057 $ 1,981 $ 2,148 $ 1,824 $ 1,984 Other real estate owned $ 154 $ 164 $ 208 $ 168 $ 231 Loans outstanding at end of period $182,309 $182,581 $161,886 $157,144 $143,218 Unearned income 154 168 259 575 1,311 Loans, net of unearned income $182,155 $182,413 $161,627 $156,569 $141,907 Nonperforming loans as percent of loans, net of unearned income 1.13% 1.09% 1.33% 1.17% 1.40% Total nonperforming assets as a percent loans of net unearned income 1.21% 1.18% 1.46% 1.27% 1.56% Transactions in the allowance for possible loan losses were as follows (in thousands): At March 31, Years Ended December 31, 1997 1996 1995 1994 1993 Balance, beginning of period $1,995 $1,833 $1,721 $1,516 $1,201 Charge-offs (8) (64) (69) (68) (71) Recoveries 3 21 18 18 71 Provision for loan losses 52 205 163 255 315 Balance, end of period $2,042 $1,995 $1,833 $1,721 $1,516 The allowance is maintained at a level to absorb potential future loan losses. The allowance is increased by provisions charged to operating expense and reduced by net charge-offs. Management establishes the level of the allowance and the quarterly provision based on its evaluation of the loan portfolio, current and projected economic conditions, the historical loan loss experience, present and prospective financial condition of borrowers, the level of nonperforming assets, and other relevant factors. While management evaluates all of this information quarterly, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the evaluation. In addition, various regulatory agencies, as an integral part of their examination process, review the Company's allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance based on their evaluation of information available to them at the time of their examination. Based on this process, management currently believes that the allowance is adequate to offset any exposure that may exist for under-collateralized or uncollectible loans. The Company has one loan as of March 31, 1997 that it considers impaired. Management believes that the liquidation of the collateral would equal or exceed principal based on the current or last appraisal. Thus, no allowance reserve is required. Management continues to monitor the impaired loans and will liquidate the collateral as soon as legal constraints are satisfied. The Company does not accrue interest income on impaired loans. Subsequent cash payments received are applied to the outstanding principal balance or recorded as interest income, depending upon management's assessment of its ultimate ability to collect principal and interest. 12 General Various congressional bills have been passed and other proposals have been made for significant changes to the banking system, including provisions for: recapitalization by the FDIC of the SAIF as discussed previously; limitations on deposit insurance coverage; changing the timing and method financial institutions use to pay for deposit insurance; expanding the power of banks by removing restrictions on bank underwriting activities; tightening the regulation of bank derivatives activities; allowing commercial enterprises to own banks; and permitting bank holding companies or the bank to own or control affiliates that engage in securities, mutual funds and insurance activities. Apart from those matters described above, management does not currently believe that there are any current trends, events or uncertainties that would have a material impact on future operating results, liquidity or capital resources nor is it aware of any current recommendations by the regulatory authorities that if they were to be carried out would have such an effect, although the general cost of compliance with numerous and multiple federal and state laws and regulations does have and in the future may have a negative impact on the company's results of operations. Except as previously discussed in the section on the result of operations, management believes that the effect of the provisions of future legislation on liquidity, capital resources, and the results of operations of the company will not be material. 13 PART II - OTHER INFORMATION AND SIGNATURES Item 1 - Legal Proceedings Management is not aware of any litigation that would have a material adverse effect on the consolidated financial position of the Company. Any pending proceedings are ordinary, routine litigation incidental to the business of the Company and its subsidiary. In addition, no material proceedings are pending or are known to be threatened or contemplated against the Company and its subsidiary by government authorities. Item 2 - Changes in Securities - Nothing to report. Item 3 - Defaults Upon Senior Securities - Nothing to report. Item 4 - Submission of Matters to a Vote of Security Holders: Results of the voting at the Annual Meeting of Shareholders April 15, 1997 held at 12:00 p.m. at the Tioga County Fairgrounds Youth Building, Whitneyville, Pennsylvania, 16901 1. Election of Class 3 Directors whose term will expire in 2000 For Withhold Authority Bruce L. Adams 1,010,039 27,790 William D. Van Etten 1,009,937 27,892 Continuing Directors: Robert E. Dalton Class 2 Term Expires 1998 John E. Novak Class 2 Term Expires 1998 Rudolph J. van der Heil Class 2 Term Expires 1998 Carol J. Tama Class 1 Term Expires 1999 R. Lowell Coolidge Class 1 Term Expires 1999 Richard E. Wilber Class 1 Term Expires 1999 John M. Thomas, M.D. Class 1 Term Expires 1999 Larry J. Croft Class 1 Term Expires 1999 Item 5 - Other Information - Nothing to report. Item 6 - Exhibits and reports on Form 8-K. (a) Exhibits - None. (b) Reports - None. 14 Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the undersigned Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized. Citizens Financial Services, Inc. (Registrant) May 7, 1997 /s/ Richard E. Wilber By: Richard E. Wilber President and Chief Financial Officer (Principal Executive Officer) May 7, 1997 /s/ Thomas C. Lyman By: Thomas C. Lyman Treasurer (Principal Financial & Accounting Officer 15