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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2008
COMMISSION FILE NUMBER 000-23777
PENSECO FINANCIAL SERVICES CORPORATION
SCRANTON, PENNSYLVANIA
COMMONWEALTH OF PENNSYLVANIA
I.R.S. EMPLOYER IDENTIFICATION NUMBER 23-2939222
150 NORTH WASHINGTON AVENUE
SCRANTON, PENNSYLVANIA 18503-1848
TELEPHONE NUMBER 570-346-7741
SECURITIES REGISTERED UNDER
SECTION 12(g) OF THE ACT
Common Stock, Par Value $ .01 per share
Indicate by check mark if the registrant is a well-known seasoned issuer, as
defined in Rule 405 of the Securities Act. Yes |_| No|X|
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. Yes |_| No|X|
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 if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K (ss. 229.405 of this chapter) is not contained herein, and
will not be contained, to the best of registrant's knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K. |_|
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer or a small reporting company. See the
definitions of "large accelerated filer", "accelerated filer" and "smaller
reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer |_| Accelerated filer |X|
Non-accelerated filer |_| (Do not check if a smaller reporting company)
Small reporting company |_|
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Act). Yes |_| No|X|
The aggregate market value of the Company's voting stock held by non-affiliates
of the registrant on June 30, 2008, based on the closing price of such stock on
that date, equals approximately $72,139,468.
The number of shares of common stock outstanding as of February 26, 2009 equals
2,148,000.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Corporation's definitive proxy statement relating to the 2009
Annual Meeting of Stockholders, to be held on May 5, 2009, are incorporated by
reference in Part III.
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PENSECO FINANCIAL SERVICES CORPORATION
PART I
ITEM 1 BUSINESS
GENERAL
PENSECO FINANCIAL SERVICES CORPORATION, (the "Company"), which is headquartered
in Scranton, Pennsylvania, was formed under the general corporation laws of the
State of Pennsylvania in 1997 and is registered as a financial holding company.
The Company became a holding company upon the acquisition of all of the
outstanding shares of Penn Security Bank and Trust Company (the "Bank"), a
state-chartered bank, on December 31, 1997. The Company is subject to
supervision by the Federal Reserve Board. The Bank, as a state-chartered
financial institution, is subject to supervision, regulation and examination by
the Federal Deposit Insurance Corporation and the Pennsylvania Department of
Banking.
The Company's principal banking office is located at 150 North Washington
Avenue, Scranton, Pennsylvania, containing trust, investor services, marketing,
audit, human resources, executive, data processing, central loan processing and
central bookkeeping offices. There are eight additional offices.
Through its banking subsidiary, the Company generates interest income from its
outstanding loans receivable and its investment portfolio. Other income is
generated primarily from merchant transaction fees, trust fees and service
charges on deposit accounts. The Company's primary costs are interest paid on
deposits and borrowings and general operating expenses. The Company provides a
variety of commercial and retail banking services to business and professional
customers, as well as retail customers, on a personalized basis. The Company's
primary lending products are real estate, commercial and consumer loans. The
Company also offers ATM access, credit cards, active investment accounts, trust
department services and other various lending, depository and related financial
services. The Company's primary deposit products are savings and demand deposit
accounts and certificates of deposit. The Company also offers collateralized
repurchase agreements that have a one day maturity, as an alternative deposit
option for its customers.
The Company has a third party marketing agreement with National Financial
Services that allows the Company to offer a full range of securities, brokerage
and annuity sales to its customers. The Investor Services division is located
in the headquarters building and the services are offered throughout the entire
branch system.
The Company is not dependent upon a single customer, or a few customers, the
loss of one or more of which would have a material adverse effect on its
operations. The operations and earnings of the Corporation are not materially
affected by seasonal changes or by Federal, state or local environmental laws or
regulations.
An Agreement and Plan of Merger (The Agreement) by and between Penseco Financial
Services Corporation, Penn Security Bank and Trust Company and Old Forge Bank,
dated December 5, 2008, provides for, among other things, Penseco to acquire Old
Forge Bank through a two-step merger transaction. Old Forge Bank will be merged
with and into Penn Security Bank and Trust Company. Following the merger, Penn
Security Bank and Trust Company will continue to operate as a banking subsidiary
of Penseco Financial Services Corporation.
Shareholders of Old Forge Bank will be entitled to receive the merger
consideration in either cash or shares of Penseco common stock, or any
combination thereof, subject to certain limitations and allocation procedures
set forth in the Agreement. The per share amount will be calculated from the
cash consideration and the value of the stock consideration based on the Penseco
closing price, as such term is defined in the Agreement. The per share amount
will be approximately $103.76, provided that the Penseco closing price per share
is between $35.99 and $39.77.
Penseco and Old Forge Bank have agreed to use reasonable best efforts to obtain
all regulatory approvals required to complete the transactions contemplated by
the merger agreement. These approvals include approval from the Federal Deposit
Insurance Corporation, under the Federal Bank Merger Act, and the Pennsylvania
Department of Banking under the Pennsylvania Banking Code of 1965, as well as
various other regulatory authorities. The transaction is also subject to the
non-objection of the Federal Reserve Bank of Philadelphia, because the merger
involves an acquisition by a bank holding company. Old Forge Bank and Penseco
have completed the filing of applications and notifications to obtain the
required regulatory approvals. The Company hopes to consummate the acquisition
of Old Forge Bank on or before April 1, 2009.
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FORWARD LOOKING INFORMATION
This Annual Report on Form 10-K contains forward-looking statements that are
based on assumptions and may describe future plans, strategies and expectations
of Penseco Financial Services Corporation. 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 of Penseco Financial Services Corporation and
its subsidiary 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. Treasury and the Federal Reserve Board, 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 real estate market values in Penseco
Financial Services Corporation's market area, changes in relevant accounting
principles and guidelines and inability of third party service providers to
perform. Additional factors that may affect our results are discussed in Item 1
A to this Annual Report on Form 10-K titled "Risk Factors" below.
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 Annual Report to
"Company," "we," "us" and "our" refer to Penseco Financial Services Corporation
and its subsidiary.
ITEM 1A RISK FACTORS
RISKS RELATED TO OUR BUSINESS
CREDIT RISK
CHANGES IN THE CREDIT QUALITY OF OUR LOAN PORTFOLIO MAY IMPACT THE LEVEL OF OUR
ALLOWANCE FOR LOAN LOSSES.
We make various judgments about the collectibility of our loans, including the
creditworthiness of our borrowers and the value of the real estate and other
assets serving as collateral for our loans. In determining the amount of the
allowance for loan losses, we review our loans and our loan loss and delinquency
experience, and we evaluate economic conditions. If our judgments are incorrect,
our allowance for loan losses may not be sufficient to cover future losses,
which will result in additions to our allowance through increased provisions
for loan losses. In addition, bank regulators periodically review our allowance
for loan losses and may require us to increase our provision for loan losses or
recognize further loan charge-offs. Increased provisions for loan losses would
increase our expenses and reduce our profits.
Nonetheless, to the best of management's knowledge, there are also no particular
risk elements in the local economy that put a group or category of loans at
increased risk. The Company does not engage in any sub-prime or Alt-A credit
lending. Therefore, the Company is not subject to any credit risks associated
with such loans.
Also, the Company is not dependent upon a single customer, or a few customers,
the loss of one or more of which would have a material adverse effect on its
operations. The operations and earnings of the Corporation are also not
materially affected by seasonal changes.
MARKET RISK
CHANGES IN INTEREST RATES COULD AFFECT OUR INVESTMENT VALUES AND NET INTEREST
INCOME WHICH COULD HURT OUR PROFITS.
At December 31, 2008, the Company owned approximately $95.0 million of
marketable securities available for sale. These securities are carried at fair
value on the consolidated balance sheets. Unrealized gains or losses on these
securities, that is, the difference between the fair value and the amortized
cost of these securities, is reflected in stockholders' equity, net of deferred
taxes. As of December 31, 2008, the Company's available for sale marketable
securities portfolio had a net unrealized gain, net of taxes, of $225 thousand.
The fair value of the Company's available for sale marketable securities is
subject to interest rate change, which would not affect recorded earnings, but
would increase or decrease comprehensive income and stockholders' equity.
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The principal component of the Company's earnings is net interest income, which
is the difference between interest and fees earned on interest-earning assets
and interest paid on deposits and other borrowings. 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 Company continually monitors the relationship of its interest rate sensitive
assets and liabilities through its Asset/Liability Committee.
STRONG COMPETITION WITHIN OUR MARKET COULD HURT OUR PROFITS AND INHIBIT GROWTH.
The Bank operates in a competitive environment in which it must share its market
with many local independent banks as well as several banks which are affiliates
or branches of very large regional holding companies. The Bank encounters
competition from diversified financial institutions, ranging in size from small
banks to the nationwide banks operating in its region. The competition includes
commercial banks, savings and loan associations, credit unions, other lending
institutions and mortgage originators.
The principal competitive factors among the Company's competitors can be grouped
into two categories: pricing and services. In the Company's primary service
area, interest rates on deposits, especially time deposits, and interest rates
and fees charged to customers on loans are very competitive. From a service
perspective, the Bank competes in areas such as convenience of location, types
of services, service costs and banking hours. Our profitability depends on our
continued ability to compete successfully in our market area.
COMPLIANCE RISK
WE OPERATE IN A HIGHLY REGULATED ENVIRONMENT AND MAY BE ADVERSELY AFFECTED BY
CHANGES IN LAWS AND REGULATIONS.
The Company is registered as a financial holding company under the Bank Holding
Company Act of 1956, as amended, and, as such, is subject to supervision and
regulation by the Board of Governors of the Federal Reserve System ("FRB"). The
Company is required to file annual and quarterly reports of its operations with
the FRB.
As a financial holding company, the Company is permitted to engage in
banking-related activities as authorized by the FRB, directly or through
subsidiaries or by acquiring companies already established in such activities
subject to the FRB regulations relating to those activities.
Our banking subsidiary, Penn Security Bank and Trust Company, as a Pennsylvania
state-chartered financial institution, is subject to supervision, regulation and
examination by the Commonwealth of Pennsylvania Department of Banking and by the
Federal Deposit Insurance Corporation (the "FDIC"), which insures the Bank's
deposits to the maximum extent permitted by law.
Any change in such regulation and oversight, whether in the form of regulatory
policy, regulations, legislation or supervisory actions, may have a material
impact on our operations.
OPERATIONAL RISK
THE COMPANY NEEDS TO CONTINUALLY ATTRACT AND RETAIN QUALIFIED PERSONNEL FOR ITS
OPERATIONS.
High quality customer service, as well as efficient and profitable operations,
are dependent on the Company's ability to attract and retain qualified
individuals for key positions within the organization. The Company has
successfully recruited several individuals for management positions in recent
years. As of December 31, 2008, the Company employed 172 full-time equivalent
employees. The employees of the Company are not represented by any collective
bargaining group. Management of the Company considers relations with its
employees to be good.
A CONTINUATION OF RECENT TURMOIL IN THE FINANCIAL MARKETS COULD HAVE AN ADVERSE
EFFECT ON THE FINANCIAL POSITION OR RESULTS OF OPERATIONS.
In recent periods, United States and global markets, as well as general economic
conditions, have been disrupted and volatile. Concerns regarding the financial
strength of financial institutions have led to distress in credit markets and
issues relating to liquidity among financial institutions. Some financial
institutions around the world have failed; others have been forced to seek
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acquisition partners. The United States and other governments have taken steps
to try to stabilize the financial system, including investing in financial
institutions. The Company has not applied for and is not participating in any
government sponsored Capital Purchase Programs. Our businesses, financial
conditions and results of operations could be adversely affected by (1)
continued disruption and volatility in financial markets, (2) continued capital
and liquidity concerns regarding financial institutions generally and our
counterparties specifically, including the Federal Home Loan Bank, (3)
limitations resulting from governmental action in an effort to stabilize or
provide additional regulation of the financial system, or (4) recessionary
conditions that are deeper or last longer than currently anticipated. Further,
there can be no assurance that action by federal and state legislatures, and
governmental agencies and regulators, including the enacted legislation
authorizing the U.S. government to invest in financial institutions, or changes
in tax policy, will help stabilize the U.S. financial system and any such
action, including changes to existing legislation or policy, could have an
adverse effect on the financial conditions or results of operations of the
Company.
OUR OPERATIONS COULD BE AFFECTED IF WE DO NOT HAVE ACCESS TO MODERN AND RELIABLE
TECHNOLOGY.
The Company operates in a highly-automated environment, wherein almost all
transactions are processed by computer software to produce results. To remain
competitive, the Company must continually evaluate the adequacy of its data
processing capabilities and make revisions as needed.
The Company regularly tests its ability to restore data capabilities in the
event of a natural disaster, sustained power failure or other inability to
utilize its primary systems.
LIQUIDITY RISK
INCREASED NEEDS FOR DISBURSEMENT OF FUNDS ON LOANS AND DEPOSITS CAN AFFECT OUR
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 an adequate level of readily
marketable assets and access to short-term funding sources. Management does not
foresee any adverse trends in liquidity.
OUR FUTURE PENSION PLAN COSTS AND CONTRIBUTIONS COULD BE UNFAVORABLY IMPACTED BY
THE FACTORS THAT ARE USED IN THE ACTUARIAL CALCULATIONS.
Our costs for the non-contributory defined benefit pension plans are dependent
upon a number of factors, such as the rates of return on plan assets, discount
rates, the level of interest rates used to measure the required minimum funding
levels of the plans, future government regulation and our required or voluntary
contributions made to the plans. Without sustained growth in the pension
investments over time to increase the value of our plan assets and depending
upon the other factors impacting our costs as listed above, we could be required
to fund our plans with higher amounts of cash than are anticipated by our
actuaries. Such increased funding obligations could have a material impact on
our liquidity by reducing our cash flows.
ITEM 1B UNRESOLVED STAFF COMMENTS
None
ITEM 2 PROPERTIES
There are nine offices positioned throughout the greater Northeastern
Pennsylvania region. They are located in the South Scranton, East Scranton,
Green Ridge, and Central City sections of Scranton, the Borough of Moscow, the
Town of Gouldsboro, South Abington Township, the Borough of Mount Pocono and the
Borough of East Stroudsburg at Eagle Valley Corners. Through these offices, the
Company provides a full range of banking and trust services primarily to
Lackawanna, Wayne, Monroe and the surrounding counties. All offices are owned by
the Bank or through a wholly owned subsidiary of the Bank, Penseco Realty, Inc.,
with the exception of the Mount Pocono Office, which is owned by the Bank but is
located on land occupied under a long-term lease. The Company also owns property
in the Borough of Dalton, Lackawanna County, to use for potential future
expansion.
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The principal office, located at the corner of North Washington Avenue and
Spruce Street in the "Central City" of Scranton's business district, houses the
operations, trust, investor services, marketing and audit departments as well as
the Company's executive offices. Several remote ATM locations are leased by the
Bank, which are located throughout Northeastern Pennsylvania. All branches and
ATM locations are equipped with closed circuit television monitoring.
ITEM 3 LEGAL PROCEEDINGS
There are no material pending legal proceedings, other than ordinary routine
litigation incidental to the business of the Company and its subsidiary, as to
which the Company or subsidiary is a party or of which any of their property is
subject.
ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted by the Company to its shareholders through the
solicitation of proxies or otherwise during the fourth quarter of the fiscal
year covered by this report.
PART II
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ITEM 5 MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES
This Form 10-K is the Company's annual disclosure statement as required under
Section 13 or 15(d) of the Securities Exchange Act of 1934. Questions may be
directed to any branch location of the Company or by contacting the Finance
Division Head's office at:
Patrick Scanlon, Senior Vice President, Finance Division Head
Penseco Financial Services Corporation
150 North Washington Avenue
Scranton, Pennsylvania 18503-1848
1-800-327-0394
Management of the Company is aware of the following securities dealers who make
a market in the Company stock:
Domestic Securities Janney Montgomery Scott, LLC
Freedman Billings Ramsey Knight Equity Markets, LP
Hill Thompson Magid & Company, Inc. Monroe Securities, Inc.
Hudson Securities, Inc. Stifel, Nicolaus & Company, Inc.
The Company's capital stock is traded on the "Over-the-Counter" (Bulletin
Board) under the symbol "PFNS". The following table sets forth the price range
together with dividends paid for each of the past two years. These quotations
do not necessarily reflect the value of actual transactions.
<Table>
<Caption>
Dividends Dividends
Paid Paid
2008 High Low Per Share 2007 High Low Per Share
- -------------------------------------------------- --------------------------------------------------
First Quarter $41 $35 $ .42 First Quarter $43 $38 $ .37
Second Quarter 42 37 .42 Second Quarter 40 37 .37
Third Quarter 41 38 .41 Third Quarter 38 36 .37
Fourth Quarter 40 36 .41 Fourth Quarter 40 34 .47
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$1.66 $1.58
</Table>
As of February 6, 2009 there were approximately 839 stockholders of the Company
based on the number of holders of record. Reference should be made to the
information about the Company's dividend policy and regulatory guidelines on
pages 19 and 48 of this Form 10-K.
TRANSFER AGENT
Registrar & Transfer Co., 10 Commerce Drive, Cranford, NJ 07016 serves as the
Company's transfer agent. Stockholders' questions should be directed to the
Registrar & Transfer Co. investor relations department at 800-368-5948.
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PENSECO FINANCIAL SERVICES CORPORATION
The following line graph sets forth comparative information regarding the
Company's cumulative shareholder return on its Common Stock over the last five
fiscal years. Total shareholder return is measured by dividing total dividends
(assuming dividend reinvestment) plus share price change for a period by the
share price at the beginning of the investment period. The Company's cumulative
shareholder return based on an investment of $100 at the beginning of the
five-year period beginning December 31, 2003 is compared to the cumulative total
return of the Russell 2000 Index ("Russell 2000") and the SNL Securities
Northeast Quadrant Pink Sheet Banks Index ("Pink Banks"), which more closely
reflects the Company's peer group. The yearly points marked on the horizontal
axis of the graph correspond to December 31st of that year.
[GRAPH APPEARS HERE]
<Table>
<Caption>
Period Ending
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Index 12/31/03 12/31/04 12/31/05 12/31/06 12/31/07 12/31/08
- --------------------------------------------------------------------------------------------------------------
Penseco Financial Services
Corporation $100.00 $106.10 $109.78 $115.71 $111.43 $108.24
Russell 2000 100.00 118.33 123.72 146.44 144.15 95.44
SNL Northeast OTC-BB and
Pink Banks 100.00 116.50 116.15 120.03 116.89 95.21
</Table>
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ITEM 6 SELECTED FINANCIAL DATA
(in thousands, except per share amounts)
RESULTS OF OPERATIONS:
<Table>
<Caption>
2008 2007 2006 2005 2004
- -------------------------------------------------------------------------------------------------------------------
Interest Income $ 33,898 $ 34,329 $ 31,922 $ 28,170 $ 25,385
Interest Expense 10,830 12,739 11,054 8,580 7,579
- -------------------------------------------------------------------------------------------------------------------
Net Interest Income 23,068 21,590 20,868 19,590 17,806
Provision for Loan Losses 861 657 433 263 144
- -------------------------------------------------------------------------------------------------------------------
Net Interest Income after Provision
for Loan Losses 22,207 20,933 20,435 19,327 17,662
Non-Interest Income 11,036 8,720 8,205 8,874 9,594
Non-Interest Expenses 22,172 21,331 21,037 20,719 20,584
Income Taxes 2,458 1,624 1,595 1,613 1,071
- -------------------------------------------------------------------------------------------------------------------
Net Income $ 8,613 $ 6,698 $ 6,008 $ 5,869 $ 5,601
- -------------------------------------------------------------------------------------------------------------------
BALANCE SHEET AMOUNTS:
Assets $ 628,967 $ 580,793 $ 569,821 $ 575,688 $ 563,708
Investment Securities $ 157,480 $ 145,448 $ 166,080 $ 229,957 $ 262,678
Net Loans $ 435,873 $ 399,939 $ 365,722 $ 317,562 $ 276,576
Deposits $ 424,725 $ 416,533 $ 413,800 $ 397,867 $ 395,301
Long-Term Borrowings $ 72,720 $ 55,966 $ 65,853 $ 75,401 $ 84,620
Stockholders' Equity $ 73,642 $ 69,715 $ 66,571 $ 63,799 $ 62,376
PER SHARE AMOUNTS:
Earnings per Share $ 4.01 $ 3.12 $ 2.80 $ 2.73 $ 2.61
Dividends per Share $ 1.66 $ 1.58 $ 1.50 $ 1.44 $ 1.35
Book Value per Share $ 34.28 $ 32.45 $ 30.99 $ 29.70 $ 29.04
Common Shares Outstanding 2,148,000 2,148,000 2,148,000 2,148,000 2,148,000
FINANCIAL RATIOS:
Net Interest Margin 3.93% 3.92% 3.89% 3.57% 3.18%
Return on Average Assets 1.40% 1.15% 1.07% 1.03% .96%
Return on Average Equity 11.89% 9.75% 9.15% 9.23% 9.11%
Average Equity to Average Asset 11.76% 11.81% 11.68% 11.19% 10.57%
Dividend Payout Ratio 41.40% 50.64% 53.57% 52.75% 51.72%
</Table>
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ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion is intended to provide information to facilitate the
understanding and assessment of significant changes and trends related to the
financial condition of the Company and the results of its operations. This
discussion and analysis should be read in conjunction with the Company's audited
consolidated financial statements and notes thereto. All information is
presented in thousands of dollars, except as indicated.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
Provision (allowance) for possible loan losses - The provision for loan losses
is based on past loan loss experience, management's evaluation of the potential
loss in the current loan portfolio under current economic conditions and such
other factors as, in management's best judgment, deserve current recognition in
estimating loan losses. The annual provision for loan losses charged to
operating expense is that amount which is sufficient to bring the balance of
the allowance for possible loan losses to an adequate level to absorb
anticipated 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.
Provision for income taxes - Management believes that the assumptions and
judgments used to record tax related assets or liabilities have been
appropriate.
Fair value of certain investment securities - Fair value of investment
securities are based on quoted market prices.
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 current
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.
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.
SUMMARY
Net income for 2008 increased $1,915 or 28.6%, to $8,613 or $4.01 per share
compared with the year ago period of $6,698 or $3.12 per share. The increase in
net income was primarily attributable to a one time after tax increase in income
of $1,129 ($.53 per share) related to VISA, Inc.'s Initial Public Offering,
which consisted of a gain from the mandatory partial share redemption by VISA
and the reversal of a litigation liability accrual that had been recorded by the
Company in the fourth quarter of 2007. Excluding the impact of the VISA
transaction, net income increased $458 or 6.5% from the twelve months of
2007(1). Net interest income increased $1,478 or 6.8% to $23,068 for the twelve
months ended December 31, 2008 compared to $21,590 for the same period of 2007.
The increase resulted from higher interest on investments of $504 or 7.1% due to
increased volume of securities of states & political subdivisions and U.S.
Agencies. Total interest expense declined $1,909 or 15.0% mainly due to lower
deposit costs. Net interest income after provision for loan losses increased
$1,274 or 6.1%. The provision for loan losses increased $204 to $861 during 2008
compared with $657 for the same period of 2007.
- ------------------------
1 See pages 20 and 21 for a reconciliation of GAAP net income to net income
excluding the gain related to the VISA, Inc. initial public offering during the
years ended December 31, 2008.
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Earnings for 2007 were impacted by a fourth quarter charge, related to lawsuits
against VISA, Inc., which VISA member banks were required to recognize as a
contingent liability to indemnify VISA, Inc. as described further herein. The
Company recorded a total expense of $497, which is $328 net of tax, or $0.15 per
share. Net earnings for 2007 increased from 2006 mainly due to higher interest
income from strong loan demand experienced during 2007. This was offset by a
higher provision for loan losses, as well as, increased operating expenses.
Income taxes were slightly higher than year ago levels.
The Company's return on average assets was 1.40% in 2008 compared to 1.15% in
2007 and 1.07% in 2006. Return on average equity was 11.89%, 9.75% and 9.15% in
2008, 2007 and 2006, respectively.
RESULTS OF OPERATIONS
NET INTEREST INCOME
The principal component of the Company's earnings is net interest income, which
is the difference between interest and fees earned on interest-earning assets
and interest paid on deposits and other borrowings.
Net interest income increased $1.5 million or 6.9% to $23.1 million for 2008
compared to $21.6 million for 2007. Loan interest income was slightly lower for
2008. Investment income increased due to increased volume of securities of
states & political subdivisions and U.S. Agency securities. Interest expense for
2008 decreased $1.9 million or 15.0% to $10.8 million for 2008 compared to $12.7
million in 2007, mainly due to lower deposit costs.
Net interest income increased $.7 million or 3.3% to $21.6 million for 2007
compared to $20.9 million for 2006. Loan interest income was higher overall for
2007 due to increases in the volume of new loans. Investment income decreased
due in part to the return of principal on the Mortgage-Backed Securities
portfolio and maturities of U.S. Agency Securities. The proceeds were used to
fund loan demand. Interest expense for 2007 increased $1.6 million or 14.4% to
$12.7 million for 2007 compared to $11.1 million in 2006. The increase is
primarily due to competitive market pressures to pay higher rates.
Net interest income, when expressed as a percentage of average interest-earning
assets, is referred to as net interest margin. The Company's net interest margin
for the year ended December 31, 2008 was 3.93% compared with 3.92% for the year
ended December 31, 2007 and 3.89% for the year ended December 31, 2006.
Interest income in 2008 totaled $33.9 million, compared to $34.3 million in
2007, a decrease of $.4 million or 1.2%. The tax equivalent yield on average
interest-earning assets decreased to 6.07% in 2008, compared to 6.50% in 2007.
Average interest-earning assets increased in 2008 to $586.7 million from $551.3
million in 2007. Average loans, which are typically the Company's highest
yielding earning assets, increased $35.2 million or 9.1% in 2008. Average loans
represented 71.8% of 2008 average interest-earning assets, compared to 70.0% in
2007. Income on loans decreased $.2 million or .8% in 2008, compared to an
increase in loan income of $3.0 million or 12.8% during 2007. Investment
securities increased on average by $10.7 million or 7.2% to $160.1 million in
2008 compared to $149.4 million in 2007. Income on investments increased $.5
million or 7.0% to $7.6 million in 2008, from $7.1 million in 2007. Average
earning assets, including BOLI, increased to 96.4% of average total assets for
2008 compared to 96.0% for the year ago period.
The average rate paid on interest-bearing liabilities decreased during 2008 to
2.32%, compared to 2.94% in 2007.
Interest income in 2007 totaled $34.3 million, compared to $31.9 million in
2006, an increase of $2.4 million or 7.5%. The tax equivalent yield on average
interest-earning assets increased to 6.50% in 2007, compared to 6.20% in 2006.
Average interest-earning assets increased in 2007 to $551.3 million from $536.9
million in 2006. Average loans, which are typically the Company's highest
yielding earning assets, increased $46.0 million or 13.5% in 2007. Average loans
represented 70.0% of 2007 average interest-earning assets, compared to 63.3% in
2006. Income on loans increased $3.0 million or 12.8% in 2007, compared to an
increase in loan income of $4.8 million or 25.8% during 2006. Investment
securities decreased on average by $44.7 million or 23.0% to $149.4 million
compared to $194.1 million in 2006. Income on investments declined $1.3 million
or 15.5% to $7.1 million in 2007, from $8.4 million in 2006. Average earning
assets, including BOLI, increased to 96.0% of average total assets for 2007
compared to 95.7% for the year ago period.
The average rate paid on interest-bearing liabilities increased during 2007 to
2.94%, compared to 2.63% in 2006.
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.
10
<Page>11
DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS' EQUITY/INTEREST RATES AND
INTEREST DIFFERENTIAL
The table below presents average weekly balances, interest income on a fully
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 years ended
December 31, 2008, 2007 and 2006.
<Table>
<Caption>
- -----------------------------------------------------------------------------------------------------------------------------------
2008 2007 2006
ASSETS AVERAGE REVENUE YIELD/ AVERAGE REVENUE YIELD/ AVERAGE REVENUE YIELD/
BALANCE EXPENSE RATE BALANCE EXPENSE RATE BALANCE EXPENSE RATE
- -----------------------------------------------------------------------------------------------------------------------------------
Investment Securities:
Available-for-Sale
U.S. Agency obligations $ 47,530 $ 2,270 4.78% $ 38,992 $ 1,824 4.68% $ 83,355 $ 3,186 3.82%
States & political subdivision 40,127 1,818 6.86 31,098 1,385 6.75 24,851 1,114 6.79
Federal Home Loan Bank stock 4,911 164 3.34 3,948 248 6.28 4,738 232 4.90
Other 2,497 92 3.68 4,208 156 3.71 3,119 108 3.46
Held to Maturity:
U.S. Agency obligations 35,775 1,677 4.69 41,866 1,907 4.56 48,801 2,174 4.45
States & political subdivisions 29,235 1,562 8.10 29,246 1,559 8.08 29,221 1,574 8.16
Loans, net of unearned income:
Real estate mortgages 270,368 16,376 6.06 246,504 15,825 6.42 202,709 13,578 6.70
Commercial real estate 90,544 5,734 6.33 76,132 5,637 7.40 67,736 4,881 7.21
Commercial 24,286 1,612 6.64 23,036 1,928 8.37 31,690 2,131 6.72
Consumer & other 35,794 2,496 6.97 40,141 3,039 7.57 37,679 2,784 7.39
Federal funds sold 1,739 29 1.67 8,795 456 5.18 - - -
Interest on balances with banks 3,883 68 1.75 7,288 365 5.01 3,047 160 5.25
- -----------------------------------------------------------------------------------------------------------------------------------
Total Interest Earning Assets/
Total Interest Income 586,689 $33,898 6.07% 551,254 $34,329 6.50% 536,946 $31,922 6.20%
- -----------------------------------------------------------------------------------------------------------------------------------
Cash and due from banks 9,687 10,575 10,534
Bank premises and equipment 9,362 9,609 9,427
Accrued interest receivable 3,350 3,338 3,035
Cash surrender value life insurance 7,515 7,199 1,125
Other assets 4,693 4,067 5,118
Less: Allowance for loan losses 4,986 4,328 3,895
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $616,310 $581,714 $562,290
- -----------------------------------------------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Demand-Interest Bearing $ 53,915 $ 377 .70% $ 55,803 $ 570 1.02% $ 49,753 $ 347 .70%
Savings 76,326 412 .54 81,096 880 1.09 82,687 767 .93
Money markets 114,521 2,131 1.86 93,089 2,851 3.06 83,349 2,225 2.67
Time-Over $100 37,745 1,451 3.84 41,146 2,010 4.89 32,692 1,408 4.31
Time-Other 70,436 2,602 3.69 74,923 3,064 4.09 77,551 2,865 3.69
Repurchase agreements 34,204 848 2.48 25,842 839 3.25 19,457 455 2.34
Short-term borrowings 7,069 175 2.48 1,254 62 4.94 3,466 189 5.45
Long-term borrowings 73,252 2,834 3.87 60,867 2,463 4.05 70,592 2,798 3.96
- -----------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities/
Total Interest Expense 467,468 $10,830 2.32% 434,020 $12,739 2.94% 419,547 $11,054 2.63%
- -----------------------------------------------------------------------------------------------------------------------------------
Demand-Non-interest bearing 72,015 74,195 72,950
All other liabilities 4,366 4,818 4,141
Stockholders' equity 72,461 68,681 65,652
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES
STOCKHOLDERS' EQUITY $616,310 $581,714 $562,290
- -----------------------------------------------------------------------------------------------------------------------------------
Interest Spread 3.75% 3.56% 3.57%
- -----------------------------------------------------------------------------------------------------------------------------------
Net Interest Income $23,068 $21,590 $20,868
- -----------------------------------------------------------------------------------------------------------------------------------
FINANCIAL RATIOS
Net interest margin 3.93% 3.92% 3.89%
Return on average assets 1.40% 1.15% 1.07%
Return on average equity 11.89% 9.75% 9.15%
Average equity to average assets 11.76% 11.81% 11.68%
Dividend payout ratio 41.40% 50.64% 53.57%
</Table>
11
<Page>12
<Table>
<Caption>
DOLLAR AMOUNT OF CHANGE IN INTEREST INCOME
DOLLAR AMOUNT CHANGE IN CHANGE IN CHANGE IN
2008 COMPARED TO 2007 OF CHANGE VOLUME RATE RATE-VOLUME
-----------------------------------------------------------------------------------------------------------
EARNING Investment Securities:
ASSETS Available-for-Sale
U.S. Agency obligations $ 446 $ 400 $ 39 $ 7
States & political subdivision 433 402 25 6
Equity securities (148) (3) (117) (28)
Held to Maturity:
U.S. Agency obligations (230) (278) 54 (6)
States & political subdivisions 3 (1) 4 -
Loans, net of unearned income:
Real estate mortgages 648 2,645 (2,291) 294
Commercial (316) 105 (399) (22)
Consumer and other (543) (329) (241) 27
Federal funds sold (427) (366) (309) 248
Interest bearing balances with banks (297) (171) (238) 112
-----------------------------------------------------------------------------------------------------------
Total Interest Income (431) 2,404 (3,473) 638
-----------------------------------------------------------------------------------------------------------
INTEREST Deposits:
BEARING Demand-Interest Bearing (193) (19) (179) 5
LIABILITIES Savings (468) (52) (446) 30
Money markets (720) 656 (1,117) (259)
Time-Over $100 (559) (166) (432) 39
Time-Other (462) (184) (300) 22
Repurchase agreements 9 272 (199) (64)
Short-term borrowings 113 287 (31) (143)
Long-term borrowings 371 502 (110) (21)
-----------------------------------------------------------------------------------------------------------
Total Interest Expense (1,909) 1,296 (2,814) (391)
-----------------------------------------------------------------------------------------------------------
NET INTEREST INCOME $ 1,478 $ 1,108 $ (659) $ 1,029
===========================================================================================================
- -------------------------------------------------------------------------------------------------------------------------------
2007 COMPARED TO 2006
-----------------------------------------------------------------------------------------------------------
EARNING Investment Securities:
ASSETS Available-for-Sale
U.S. Agency obligations $(1,362) $(1,695) $ 717 $ 384
States & political subdivision 271 280 (7) (2)
Equity securities 64 (1) 73 (8)
Held to Maturity:
U.S. Agency obligations (267) (309) 54 (12)
States & political subdivisions (15) 2 (17) -
Loans, net of unearned income:
Real estate mortgages 3,003 3,565 (487) (75)
Commercial (203) (582) 523 (144)
Consumer and other 255 182 68 5
Federal funds sold 456 - - 456
Interest bearing balances with banks 205 223 (7) (11)
-----------------------------------------------------------------------------------------------------------
Total Interest Income 2,407 1,665 917 (175)
-----------------------------------------------------------------------------------------------------------
Deposits:
INTEREST Demand-Interest Bearing 223 42 159 22
BEARING Savings 632 33 530 69
LIABILITIES Money markets 626 260 325 41
Time-Over $100 602 364 190 48
Time-Other (320) (523) 239 (36)
Repurchase agreements 384 149 177 58
Short-term borrowings (127) (121) 18 (24)
Long-term borrowings (335) (385) 64 (14)
-----------------------------------------------------------------------------------------------------------
Total Interest Expense 1,685 (181) 1,702 164
-----------------------------------------------------------------------------------------------------------
NET INTEREST INCOME $ 722 $ 1,846 $ (785) $ (339)
-----------------------------------------------------------------------------------------------------------
</Table>
12
<Page>13
PROVISION FOR LOAN LOSSES
The provision for loan losses represents management's determination of the
amount necessary to bring the allowance for loan losses to a level that
management considers adequate to reflect the risk of future losses inherent in
the Company's loan portfolio.
The provision for loan losses was $861 in 2008, an increase of 31.1% compared to
$657 for 2007. The increase in the provision was due to the Company's increased
loan portfolio, as well as management's viewpoint in valuing the loan portfolio
for loan losses as the economy has slowed down. The allowance for loan losses at
December 31, 2008 was $5,275 or 1.20% of total loans compared to $4,700 or 1.16%
of total loans at December 31, 2007.
The Company believes that the judgments used in establishing the allowance for
loan losses are based on reliable information. In assessing the sufficiency of
the allowance for loan 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 establishing the allowance on
a periodic basis. Based on its assessment, the Company has not found it
necessary to change the allowance by material amounts.
There are also 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 loans, which typically bear a higher risk. These loans
are typically secured by real estate to minimize this risk.
The process of determining the adequacy of the allowance is necessarily
judgmental and subject to changes in external conditions. Accordingly, there can
be no assurance that existing levels of the allowance will ultimately prove
adequate to cover actual loan losses.
NON-INTEREST INCOME
The following table sets forth information by category of non-interest income
for the Company for the past three years:
<Table>
<Caption>
Years Ended December 31, 2008 2007 2006
- ----------------------------------------------------------------------------------
Trust department income $ 1,474 $ 1,535 $ 1,483
Service charges on deposit accounts 1,477 1,014 860
Merchant transaction income 4,502 4,256 3,947
Brokerage fee income 596 261 271
Other fee income 1,279 1,211 1,152
Bank owned life insurance 316 314 54
Other operating income 167 80 119
VISA mandatory share redemption 1,213 - -
Realized gains on securities, net 12 49 319
- ----------------------------------------------------------------------------------
Total Non-Interest Income $ 11,036 $ 8,720 $ 8,205
- ----------------------------------------------------------------------------------
</Table>
Total non-interest income increased $2,316 or 26.6% to $11,036 during 2008, from
$8,720 for the same period of 2007. Trust department income decreased $61 due to
the decrease in market value of trust assets. Service charges on deposit
accounts increased $463 or 45.7% primarily due to the increased number of
accounts and increased service charge activity. Merchant transaction income
increased $246 or 5.8%, mainly due to higher transaction volume and new
business. Brokerage fee income increased $335 or 128.4% due to new and increased
business in the wealth management area. Other operating income increased $87 or
108.7% due to a gain on the sale of other real estate owned of $69, along with
an increase in general operating income. The Company realized a gain of $1,213
related to VISA, Inc.'s Initial Public Offering, which consisted of a mandatory
partial share redemption, during the first quarter of 2008, discussed earlier.
Realized gains on securities decreased $37 to $12 during 2008 from $49 for 2007.
Total non-interest income increased $515 or 6.3% to $8,720 during 2007, from
$8,205 for the same period of 2006. Service charges on deposit accounts
increased $154 or 17.9%, primarily due to increased service charge collections
during 2007. Merchant transaction income increased $309 or 7.8%, mainly due to
increased transaction volume and new business. Brokerage fee income decreased
$10 or 3.7%. Income from Bank owned life insurance, which was purchased in the
fourth quarter of 2006, increased $260 to $314 in 2007 from $54 in 2006.
13
<Page>14
NON-INTEREST EXPENSES
VISA CONTINGENCY
In October 2007, Penn Security Bank & Trust Company, as a member of VISA U.S.A.
Inc. received shares of restricted stock in VISA, Inc. (VISA) as a result of a
global restructuring of VISA in preparation for an initial public offering in
2008.
In connection with this, VISA member banks were required to recognize a
contingent obligation to indemnify VISA under its revised bylaws for potential
losses arising from certain antitrust litigation, at the estimated fair value of
such obligation, in accordance with FASB Interpretation No. 45. The Company,
accordingly, recorded a $497 charge or $328, net of tax, in the fourth quarter
of 2007. Upon successful completion of the public offering in 2008, VISA
established an escrow account for the litigation, funded by a partial redemption
of member shares allowing the Company to reverse the $497 litigation accrual
during the first quarter of 2008.
The following table sets forth information by category of non-interest expenses
for the Company for the past three years:
<Table>
<Caption>
Years Ended December 31, 2008 2007 2006
- ----------------------------------------------------------------------------------
Salaries and employee benefits $10,157 $ 9,118 $10,315
Expense of premises and equipment, net 2,703 2,586 2,397
Merchant transaction expenses 3,403 3,358 3,141
Other operating expenses 5,909 6,269 5,184
- ----------------------------------------------------------------------------------
Total Non-Interest Expenses $22,172 $21,331 $21,037
- ----------------------------------------------------------------------------------
</Table>
Total non-interest expenses increased $841 or 3.9% to $22,172 during 2008
compared with $21,331 for the same period of 2007. Salaries and employee
benefits expense increased $1,039 or 11.4% largely due to a $356 retirement
contribution to fifty employees negatively impacted by the Company's pension
freeze during the second quarter of 2008, and an additional $70 contribution to
the 401(k) plan benefiting all employees, and increased salaries resulting from
additional employee hires and increased commissions related to our wealth
management division. Premises and fixed assets expense increased $117 or 4.5%
due to computer system upgrades and increased occupancy expense. Merchant
transaction expenses increased $45 or 1.3% due to higher transaction volume.
Other operating expenses decreased $360 or 5.7% largely due to the $497 VISA
litigation charge accrual recorded by the Company during the fourth quarter of
2007(2). Excluding this VISA litigation accrual, other operating expense
increased year over year $634 mostly related to the Company's new brand and logo
expenses of $120, legal fees related to loan collection efforts of $128, and
professional expenses of $134 related to the pension freeze, $82 related to
outsourced audit and compliance services, and $78 related to computer system
updates.
Total non-interest expenses increased $294 or 1.4% to $21,331 during 2007
compared with $21,037 for the same period of 2006. Salaries and employee
benefits decreased $1,197 or 11.6%, primarily due to a one time charge of $1,119
recorded in the fourth quarter of 2006 in connection with the Voluntary Early
Retirement Initiative (VERI) program. Merchant transaction expenses increased
$217 or 6.9%, due to increased transaction volume. Other operating expenses
increased $1,085 or 20.9%, largely due to increases in advertising expense of
$233 and contributions of $100, in addition to the $497 liability recorded for
the VISA lawsuits discussed above, which is expected to be a one time charge.
INCOME TAXES
Federal income tax expense increased $834 or 51.4% to $2,458 in 2008 compared to
$1,624 in 2007, primarily due to the VISA initial public offering and overall
higher income.
Federal income tax expense increased $29 or 1.8% to $1,624 in 2007 compared to
$1,595 in 2006, due to increased operating income partly offset by higher
tax-free income.
The Company's effective income tax rate for 2008, 2007 and 2006 was 22.2%,
19.5% and 21.0%, respectively.
- --------------------
2 See pages 20 and 21 for a reconciliation of GAAP net income to net
income excluding the gain related to the VISA, Inc. initial public offering
during the years ended December 31, 2008.
14
<Page>15
The Company uses the asset and liability method of accounting for deferred
income taxes. If current available information raises doubt as to the
realization of deferred tax assets, a valuation allowance is established. The
Company evaluates the recoverability of deferred tax assets based on its ability
to generate future profits. The Company employs budgeting and periodic reporting
processes to continually monitor its progress. Historically, the Company has had
sufficient profits for recovery of deferred tax benefits.
For further discussion pertaining to Federal income taxes, see Note 15 to the
Consolidated Financial Statements.
FINANCIAL CONDITION
Total assets increased $48.2 million or 8.3% during 2008 to $629.0 million at
December 31, 2008 compared to $580.8 million at December 31, 2007. Total assets
increased $11.0 million or 1.9% during 2007 to $580.8 million at December 31,
2007 compared to $569.8 million at December 31, 2006.
INVESTMENT PORTFOLIO
The Company maintains a portfolio of investment securities to provide income and
serve as a source of liquidity for its ongoing operations.
The following table presents the carrying value, by security type, for the
Company's investment portfolio:
<Table>
<Caption>
December 31, 2008 2007 2006
- -----------------------------------------------------------------------------
U.S. Agency obligations $ 80,643 $ 69,516 $ 99,247
States & political subdivisions 70,010 68,714 59,471
Equity securities 6,827 7,218 7,362
- -----------------------------------------------------------------------------
Total Investment Securities $157,480 $145,448 $166,080
- -----------------------------------------------------------------------------
</Table>
Equity securities at December 31, 2008 and 2007 consisted primarily of other
financial institutions' stock and Federal Home Loan Bank of Pittsburgh (FHLB)
stock, which is a required investment in order to participate in an available
line of credit program. The FHLB stock is stated at par value as it is
restricted to purchases and sales with the FHLB. The FHLB suspended its stock
repurchase and dividend payments during December 2008. Based on current
financial information available, management does not believe the FHLB stock
value is impaired as of December 31, 2008.
In recent periods, United States and global markets, as well as general economic
conditions, have been disrupted and volatile. Concerns regarding the financial
strength of financial institutions have led to distress in credit markets and
issues relating to liquidity among financial institutions. The United States and
other governments have taken steps to try to stabilize the financial system,
including investing in financial institutions. The Company has not applied for
and is not participating in any government sponsored Capital Purchase Programs.
Our businesses, financial conditions and results of operations could be
adversely affected by (1) continued disruption and volatility in financial
markets, (2) continued capital and liquidity concerns regarding financial
institutions generally and our counterparties specifically, including the
Federal Home Loan Bank, (3) limitations resulting from governmental action in an
effort to stabilize or provide additional regulation of the financial system, or
(4) recessionary conditions that are deeper or last longer than currently
anticipated.
The Company does not hold any Federal National Mortgage Association (Fannie Mae)
or Federal Home Loan Mortgage Corporation (Freddie Mac) preferred or common
equity securities and does not hold any trust preferred securities.
A summary of transactions involving available-for-sale debt securities in 2008,
2007 and 2006 are as follows:
<Table>
<Caption>
December 31, 2008 2007 2006
- ---------------------------------------------------------------------
Proceeds from sales $ 11,798 $ - $ -
Gross realized gains 11 - -
Gross realized losses - - -
</Table>
15
<Page>16
LOAN PORTFOLIO
Details regarding the Company's loan portfolio for the past five years are as
follows:
<Table>
<Caption>
December 31, 2008 2007 2006 2005 2004
- ------------------------------------------------------------------------------------------------------------------
Real estate - construction and land development $ 21,949 $ 25,858 $ 23,714 $ 13,132 $ 6,805
Real estate mortgages 355,528 318,437 284,323 227,853 196,149
Commercial 27,793 24,505 26,265 42,894 41,560
Credit card and related plans 3,272 3,324 3,282 3,152 2,872
Installment 28,135 26,542 25,532 26,293 25,679
Obligations of states & political subdivisions 4,471 5,973 6,806 8,038 7,111
- ------------------------------------------------------------------------------------------------------------------
Loans, net of unearned income 441,148 404,639 369,922 321,362 280,176
Less: Allowance for loan losses 5,275 4,700 4,200 3,800 3,600
- ------------------------------------------------------------------------------------------------------------------
Loans, net $435,873 $399,939 $365,722 $317,562 $276,576
- ------------------------------------------------------------------------------------------------------------------
</Table>
LOANS
Total net loans increased $36.0 million or 9.0% to $435.9 million at December
31, 2008 from $399.9 million at December 31, 2007. This increase is mainly due
to strong loan demand with a mix of fixed and variable rate loans backed by real
estate.
Total net loans increased $34.2 million or 9.4% to $399.9 million at December
31, 2007 from $365.7 million at December 31, 2006. This increase is mainly due
to strong loan demand with a mix of fixed and variable rate loans backed by real
estate.
LOAN QUALITY
The lending activities of the Company are guided by the comprehensive lending
policy established by the Board of Directors. Loans must meet criteria which
include consideration of the character, capacity and capital of the borrower,
collateral provided for the loan, and prevailing economic conditions. Due to the
consistent application of conservative underwriting standards, the Company's
loan quality has remained strong during the current general economic downturn.
The Company has not engaged in any sub-prime credit lending and is therefore,
not subject to the credit risks associated with such loans.
Regardless of credit standards, there is risk of loss inherent in every loan
portfolio. The allowance for loan losses is an amount that management believes
will be adequate to absorb possible losses on existing loans that may become
uncollectible, based on evaluations of the collectibility of the 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 losses is adequate. While management uses available
information to recognize losses on loans, future additions to the allowance may
be necessary based on changes in economic conditions. In addition, various
regulatory agencies, as an integral part of their examination process,
periodically review the Company's allowance for loan losses. Such agencies may
require the Company to recognize additions to the allowance based on their
judgment of information available to them at the time of their examination.
The allowance for loan losses is increased by periodic charges against earnings
as a provision for loan 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.
16
<Page>17
NON-PERFORMING ASSETS
Non-performing assets consist of non-accrual loans, loans past due 90 days or
more and still accruing interest and other real estate owned. The following
table sets forth information regarding non-performing assets as of the dates
indicated:
<Table>
<Caption>
As of 2008 2007 2006 2005 2004
- ------------------------------------------------------------------------------------------------------------------
Non-accrual loans $1,454 $1,610 $3,180 $1,627 $1,991
Other real estate owned - - - 91 176
- ------------------------------------------------------------------------------------------------------------------
Total non-performing assets $1,454 $1,610 $3,180 $1,718 $2,167
- ------------------------------------------------------------------------------------------------------------------
Loans past due 90 days or more and accruing:
Secured by real estate $ 810 $ 57 $ 177 $ - $ -
Guaranteed student loans 203 408 251 152 253
Credit card loans 17 2 6 21 13
Commercial loans 119 - - - -
Consumer loans 4 12 - - -
- ------------------------------------------------------------------------------------------------------------------
Total loans past due 90 days or
more and accruing $1,153 $ 479 $ 434 $ 173 $ 266
- ------------------------------------------------------------------------------------------------------------------
</Table>
Loans are generally placed on a non-accrual status when principal or interest is
past due 90 days or when payment in full is not anticipated. 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
past due interest is collected and the collection of future principal and
interest is probable.
Loans on which the accrual of interest has been discontinued or reduced amounted
to $1,454, $1,610 and $3,180 at December 31, 2008, 2007 and 2006, respectively.
The decrease in 2007 was primarily due to the resoulution of a single borrower
relationship outstanding in 2006. If interest on those loans had been accrued,
such income would have been $192, $153 and $209 for 2008, 2007 and 2006,
respectively. Interest income on those loans, which is recorded only when
received, amounted to $29, $17 and $10 for 2008, 2007 and 2006, respectively.
There are no commitments to lend additional funds to individuals whose loans are
in non-accrual status.
Real estate loans of $810 that are past due 90 days or more and still accruing
are primarily 1-4 family residential loans with a favorable loan to value ratio.
Management's process for evaluating the adequacy of the allowance for loan
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, economic conditions and overall credit risk.
These reports also address the current status and actions in process on each
listed loan. From this information, adjustments are made to the allowance for
loan 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.
As of December 31, 2008 there are no significant loans as to which management
has serious doubt about their collectibility.
During the second quarter of 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 Federal
Bankruptcy Code. Currently, the Company holds $8.4 million of TERI loans. 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. At December 31, 2008 there
was $144 in such loans placed on non-accrual status.
At December 31, 2008, 2007 and 2006, the Company did not have any loans
specifically classified as impaired.
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.
The Company does not engage in any sub-prime or ALT-A credit lending. Therefore,
the Company is not subject to any credit risks associated with such loans.
17
<Page>18
LOAN LOSS EXPERIENCE
The following table presents the Company's loan loss experience during the
periods indicated:
<Table>
<Caption>
Years Ended December 31, 2008 2007 2006 2005 2004
- ------------------------------------------------------------------------------------------------------
Balance at beginning of year $4,700 $4,200 $3,800 $3,600 $3,500
- ------------------------------------------------------------------------------------------------------
Charge-offs:
Real estate mortgages 83 84 74 31 -
Commercial and all others - 10 18 - 12
Credit card and related plans 55 66 49 68 34
Installment loans 179 5 26 14 7
- ------------------------------------------------------------------------------------------------------
Total charge-offs 317 165 167 113 53
- ------------------------------------------------------------------------------------------------------
Recoveries:
Real estate mortgages - 5 - 46 3
Commercial and all others 14 1 131 - -
Credit card and related plans 16 1 3 3 2
Installment loans 1 1 - 1 4
- ------------------------------------------------------------------------------------------------------
Total recoveries 31 8 134 50 9
- ------------------------------------------------------------------------------------------------------
Net charge-offs 286 157 33 63 44
- ------------------------------------------------------------------------------------------------------
Provision charged to operations 861 657 433 263 144
- ------------------------------------------------------------------------------------------------------
Balance at End of Year $5,275 $4,700 $4,200 $3,800 $3,600
- ------------------------------------------------------------------------------------------------------
Ratio of net charge-offs
to average loans outstanding 0.07% 0.04% 0.01% 0.02% 0.02%
- ------------------------------------------------------------------------------------------------------
</Table>
The allowance for loan losses at December 31, 2008 was $5,275 or 1.20% of total
loans compared to $4,700 or 1.16% of total loans at December 31, 2007.
The allowance for loan losses is allocated as follows:
<Table>
<Caption>
December 31, 2008 2007 2006 2005 2004
- ----------------------------------------------------------------------------------------------------------------------
Amount %(1) Amount %(1) Amount %(1) Amount %(1) Amount %(1)
- ----------------------------------------------------------------------------------------------------------------------
Real estate mortgages $1,200 86% $1,200 85% $1,200 83% $1,200 75% $1,100 72%
Commercial and all others 3,275 6 2,900 7 2,500 9 2,190 16 2,070 18
Credit card and related plans 300 1 300 1 250 1 185 1 180 1
Personal installment loans 500 7 300 7 250 7 225 8 250 9
- ----------------------------------------------------------------------------------------------------------------------
Total $5,275 100% $4,700 100% $4,200 100% $3,800 100% $3,600 100%
- ----------------------------------------------------------------------------------------------------------------------
</Table>
(1) - Percent of loans in each category to total loans
DEPOSITS
The primary source of funds to support the Company's operations is its deposit
base. Company deposits increased $8.2 million to $424.7 million at December 31,
2008 from $416.5 million at December 31, 2007. Largely, the Company experienced
growth in transaction accounts and time deposits due to increased marketing
efforts. Company deposits increased $2.7 million to $416.5 million at December
31, 2007 from $413.8 million at December 31, 2006. The Company experienced
growth in transaction accounts due to increased marketing efforts along with
higher interest rates, offset by a decline in time deposits.
The maturities of time deposits of $100,000 or more at December 31, 2008 are as
follows:
<Table>
<Caption>
Three months or less $ 17,998
Over three months through six months 7,956
Over six months through twelve months 8,271
Over twelve months 3,735
--------
Total $ 37,960
========
</Table>
18
<Page>19
DIVIDEND POLICY
Payment of future dividends will be subject to the discretion of the Board of
Directors and will depend upon the earnings of the Company, its financial
condition, its capital requirements, its need for funds and other matters as the
Board deems appropriate.
Dividends on the Company common stock, if approved by the Board of Directors,
are customarily paid on or about March 15, June 15, September 15 and December
15.
ASSET/LIABILITY MANAGEMENT
The Company's policy is to match its level of rate-sensitive assets and
rate-sensitive liabilities within a limited range, thereby reducing its exposure
to interest rate fluctuations. While no single measure can completely identify
the impact of changes in interest rates on net interest income, one gauge of
interest rate-sensitivity is to measure, over a variety of time periods, the
differences in the amounts of the Company's rate-sensitive assets and
rate-sensitive liabilities. These differences, or "gaps", provide an indication
of the extent to which net interest income may be affected by future changes in
interest rates. A positive gap exists when rate-sensitive assets exceed
rate-sensitive liabilities and indicates that a greater volume of assets than
liabilities will reprise during a given period. This mismatch may enhance
earnings in a rising interest rate environment and may inhibit earnings when
interest rates decline. Conversely, when rate-sensitive liabilities exceed
rate-sensitive assets, referred to as a negative gap, it indicates that a
greater volume of liabilities than assets may reprise during the period. In this
case, a rising interest rate environment may inhibit earnings and declining
interest rates may enhance earnings. However, because interest rates for
different asset and liability products offered by financial institutions respond
differently, the gap is only a general indicator of interest rate sensitivity.
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 an adequate level of readily
marketable assets and access to short-term funding sources. Management does not
foresee any adverse trends in liquidity.
The Company remains in a highly liquid condition both in the short and long
term. 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.
In connection with the Agreement and Plan of Merger dated December 5, 2008,
between the Company and Old Forge Bank, the Company expects to complete the
merger with Old Forge Bank in the first quarter of 2009 requiring the payment of
$17.4 million cash consideration and the issuance of approximately $40.6 million
of Company stock. The Company will also incur approximately $1.2 million, in
after tax merger related costs. For further discussion see Note 23 to the
Consolidated Financial Statements.
The Company offers collateralized repurchase agreements, which have a one day
maturity, as an alternative deposit option for its customers. The Company also
has long-term debt outstanding to the FHLB, which was used to purchase a Freddie
Mac pool of residential mortgages, as described earlier in this report. At
December 31, 2008, the Company had $148,975 of available borrowing capacity with
the FHLB.
COMMITMENTS AND CONTINGENT LIABILITIES
In the normal course of business, there are outstanding commitments and
contingent liabilities, created under prevailing terms and collateral
requirements such as commitments to extend credit, financial guarantees and
letters of credit, which are not reflected in the accompanying Financial
Statements. The Company does not anticipate any losses as a result of these
transactions. These instruments involve, to varying degrees, elements of credit
and interest rate risk in excess of the amount recognized in the Balance Sheets.
The contract or notional amounts of those instruments reflect the extent of
involvement the Company has in particular classes of financial instruments.
19
<Page>20
Financial instruments whose contract amounts represent credit risk at December
31, 2008 and 2007 are as follows:
<Table>
<Caption>
2008 2007
- -----------------------------------------------------------------
Commitments to extend credit:
Fixed rate $26,396 $40,105
Variable rate $92,935 $78,868
Standby letters of credit $11,173 $13,104
</Table>
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of any condition established in the contract. Commitments
generally have expiration dates of one year or less or other termination clauses
and may require payment of a fee. Since many of the commitments are expected to
expire without being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements.
Standby letters of credit are conditional commitments issued to guarantee the
performance of a customer to a third party. The credit risk involved in issuing
letters of credit is essentially the same as that involved in extending loan
facilities to customers.
At December 31, 2008 the Bank has entered into contracts for the renovation of
a branch, in the amount of $1,909, approximately $113 of which had been
disbursed as of December 31, 2008.
RELATED PARTIES
The Company does not have any material transactions involving related persons or
entities, other than traditional banking transactions, which are made on the
same terms and conditions as those prevailing at the time for comparable
transactions with unrelated parties. At December 31, 2008, the Bank has issued
standby letters of credit for the accounts of related parties in the amount of
$7,990.
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 would come from retained earnings from the
operations of the Company and 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's total risk-based capital ratio was 19.81% at December 31, 2008.
The Company's risk-based capital ratio is more than the 10.00% ratio that
Federal regulators use as the "well capitalized" threshold. This is the current
criteria which the FDIC uses in determining the lowest insurance rate for
deposit insurance. The Company's risk-based capital ratio is more than double
the 8.00% limit which determines whether a company is "adequately capitalized".
Under these rules, the Company could significantly increase its assets and still
comply with these capital requirements without the necessity of increasing its
equity capital.
The following table presents Stockholders' Equity of the Company for the past
two years:
<Table>
<Caption>
Year Ended December 31, 2008 2007
- -------------------------------------------------------------
Balance at beginning of year $69,715 $66,571
Net income 8,613 6,698
Other comprehensive income (1,121) (160)
Cash dividends declared (3,565) (3,394)
- -------------------------------------------------------------
Total Stockholders' Equity 73,642 69,715
- -------------------------------------------------------------
</Table>
NON-GAAP FINANCIAL MEASURES: (VISA TRANSACTION)
Certain financial measures contained in this 10-K exclude the decrease of the
liability accrual related to VISA's covered litigation provision as well as the
gain from the mandatory redemption of a portion of the Company's class B shares
in VISA. Financial measures which exclude the above-referenced items have not
been determined in accordance with generally accepted accounting principles
(GAAP) and are therefore non-GAAP financial measures. Management of the Company
believes that investors' understanding of the Company's performance is enhanced
by disclosing these non-GAAP financial measures as a reasonable basis for
20
<Page>21
comparison of the Company's ongoing results of operations. These non-GAAP
measures should not be considered a substitute for GAAP-basis measures and
results. Our non-GAAP measures may not be comparable to non-GAAP measures of
other companies. The attached Non-GAAP Reconciliation Schedule provides a
reconciliation of these non-GAAP financial measures to the most closely
analogous measure determined in accordance with GAAP.
In March 2008, VISA, Inc. (VISA) completed its initial public offering. Penn
Security Bank & Trust Company and certain other VISA member banks are
shareholders in VISA. Following the initial public offering, the Company
received $1.2 million in proceeds from the offering, as a mandatory partial
redemption of 28,351 shares, reducing the Company's holdings from 73,333 to
44,982 shares of Class B common stock. Using proceeds from this offering, VISA
established a $3.0 billion escrow account to cover the resolution of pending
litigation and related claims. The partial redemption proceeds of $1.2 million
are reflected in other non-interest income in 2008.
The remaining unredeemed shares of VISA Class B common stock are restricted and
may not be transferred until the later of (1) three years from the date of the
initial public offering or (2) the period of time necessary to resolve the
covered litigation. A conversion ratio of 0.71429 was established for the
conversion rate of Class B shares into Class A shares. If the funds in the
escrow account are insufficient to settle all the covered litigation, VISA may
sell additional Class A shares, use the proceeds to settle litigation, and
further reduce the conversion ratio. If funds remain in the escrow account after
all litigation is settled, the Class B conversion ratio will be increased to
reflect that surplus. As of December 31, 2008, the value of the Class A shares
was $52.45 per share. The value of unredeemed Class A equivalent shares owned by
the Company was $1.7 million as of December 31, 2008, and has not yet been
reflected in the accompanying financial statements.
In connection with VISA's establishment of the litigation escrow account, the
Company reversed a $497 thousand reserve in the first quarter of 2008, reflected
as a reduction of other non-interest expense. This reserve was created in the
fourth quarter of 2007, pending completion of the VISA, Inc. initial public
offering as a charge to other non-interest expense.
NON-GAAP RECONCILIATION SCHEDULE
PENSECO FINANCIAL SERVICES CORPORATION
(UNAUDITED)
(IN THOUSANDS)
The following tables present the reconciliation of non-GAAP financial measures
to reported GAAP financial measures.
<Table>
<Caption>
Years Ended December 31,
------------------------
2008 2007 Change
------------------------------------
Net interest income after provision for loan losses $22,207 $20,933 $ 1,274
Non-interest income 11,036 8,720 2,316
Non-interest expense (22,172) (21,331) (841)
Income tax provision (2,458) (1,624) (834)
-------- -------- --------
Net income 8,613 6,698 1,915
ADJUSTMENTS
- -----------
Non-interest income
Gain on mandatory redemption of VISA, Inc.
class B common stock (1,213) - (1,213)
Non-interest expense
Covered litigation provision (497) 497 (994)
-------- -------- --------
Total Adjustments pre-tax (1,710) 497 (2,207)
Income tax provision 581 (169) 750
-------- -------- --------
After tax adjustments to GAAP (1,129) 328 (1,457)
-------- -------- --------
Adjusted net income $ 7,484 $ 7,026 $ 458
======== ======== ========
Return on Average Assets 1.21% 1.21%
Return on Average Equity 10.33% 10.23%
</Table>
Return on average equity (ROE) and return on average assets (ROA) for the year
ended December 31, 2008 was 11.89% (10.33% excluding the VISA IPO impact) and
1.40% (1.21% excluding the VISA IPO impact), respectively. ROE was 9.75% (10.23%
excluding the VISA IPO impact) and ROA was 1.15% (1.21% excluding the VISA IPO
impact) for the same period last year.
21
<Page>22
ITEM 7A 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
Asset/Liability Committee. Interest rate risk is the potential of economic
losses due to future interest rate changes. These economic losses can be
reflected as a loss of future net interest income and/or a loss of current fair
market values. The objective is to measure the effect on net interest income and
to adjust the balance sheet to minimize the inherent risk while at the same time
maximizing income. Management realizes certain risks are inherent and that the
goal is to identify and minimize the risks. Tools used by management include the
standard GAP report and an interest rate shock simulation report. The Company
has no market risk sensitive instruments held for trading purposes. It appears
the Company's market risk is reasonable at this time.
The following table provides information about the Company's market rate
sensitive instruments used for purposes other than trading that are sensitive to
changes in interest rates. For loans, securities, and liabilities with
contractual maturities, the table presents principal cash flows and related
weighted-average interest rates by contractual maturities as well as the
Company's historical experience of the impact of interest rate fluctuations on
the prepayment of residential and home equity loans and mortgage-backed
securities. For core deposits (e.g., DDA, interest checking, savings and money
market deposits) that have no contractual maturity, the table presents principal
cash flows and, as applicable, related weighted-average interest rates based on
the Company's historical experience, management's judgment, and statistical
analysis, as applicable, concerning their most likely withdrawal behaviors.
22
<Page>23
MATURITIES AND SENSITIVITY OF MARKET RISK AS OF DECEMBER 31, 2008
The table below presents States and political subdivisions securities on a
fully taxable equivalent basis.
<Table>
<Caption>
NON-RATE FAIR
2009 2010 2011 2012 2013 THEREAFTER SENSITIVE TOTAL VALUE
- -----------------------------------------------------------------------------------------------------------------------------------
ASSETS
Fixed interest rate securities:
U.S. Agency obligations $ 25,247 $ 17,503 $ 14,076 $ 3,379 $ 2,409 $ 8,429 $ - $ 71,043 $ 71,705
YIELD 4.96% 4.10% 3.97% 5.15% 5.15% 5.15% - 4.58% -
State & political subdivisions 6,131 8,966 14,030 7,797 6,560 26,526 - 70,010 71,545
YIELD 8.51% 8.53% 7.62% 7.61% 6.65% 6.75% - 7.54% -
Variable interest rate securities:
U.S. Agency obligations 9,600 - - - - - - 9,600 9,597
YIELD 3.42% - - - - - - 3.42% -
Federal Home Loan Bank stock - - - - - - 5,568 5,568 5,568
YIELD - - - - - - - - -
Other - - - - - 1,259 - 1,259 1,259
YIELD - - - - - 1.78% - 1.78% -
Fixed interest rate loans:
Real estate mortgages 115,321 40,502 22,096 7,760 2,231 6,522 - 194,432 196,185
YIELD 6.25% 6.29% 6.34% 6.53% 6.81% 6.39% - 6.29% -
Commercial 2,453 612 461 1,045 224 733 - 5,528 5,405
YIELD 6.10% 6.40% 6.84% 6.31% 6.94% 6.94% - 6.38% -
Consumer and other 6,791 1,601 1,038 766 654 6,867 - 17,717 16,903
YIELD 5.91% 7.41% 7.24% 7.08% 6.97% 6.30% - 6.36% -
Variable interest rate loans:
Real estate mortgages 113,361 21,169 21,262 8,055 14,004 5,194 - 183,045 184,696
YIELD 4.43% 6.18% 6.69% 6.74% 6.25% 6.75% - 5.18% -
Commercial 18,572 1,413 975 457 591 257 - 22,265 20,854
YIELD 3.96% 6.43% 6.68% 7.10% 6.12% 6.74% - 4.39% -
Consumer and other 14,796 114 240 2,601 159 251 - 18,161 17,326
YIELD 5.91% 7.86% 6.43% 8.02% 6.86% 6.29% - 6.19% -
Less: Allowance for loan losses - - - - - 5,275 - 5,275 -
Interest bearing balances with banks 2,109 - - - - - - 2,109 2,109
YIELD .50% - - - - - - .50% -
Cash surrender life insurance 7,684 - - - - - - 7,684 7,684
YIELD 4.15% - - - - - - 4.15% -
Cash and due from banks - - - - - - 7,246 7,246 7,246
Other assets - - - - - - 18,575 18,575 -
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $322,065 $ 91,880 $ 74,178 $31,860 $26,832 $ 50,763 $ 31,389 $628,967 $618,082
- -----------------------------------------------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Variable interest rate deposits:
Demand-Interest bearing $ 6,352 $ - $ - $ - $ - $ 45,623 $ - $ 51,975 $ 51,975
YIELD 1.19% - - - - .31% - .42% -
Savings 10,398 - - - - 64,509 - 74,907 74,907
YIELD .75% - - - - .35% - .41% -
Money markets 115,811 - - - - - - 115,811 115,811
YIELD 1.13% - - - - - - 1.13% -
Fixed interest rate deposits:
Time-Over $100,000 34,225 1,555 1,220 549 411 - - 37,960 38,336
YIELD 2.99% 3.19% 4.40% 4.22% 4.64% - - 3.08% -
Time-Other 50,860 11,141 4,989 1,868 2,514 244 - 71,616 72,325
YIELD 2.88% 3.39% 4.04% 4.69% 4.13% 4.09% - 3.14% -
Demand-Non interest bearing - - - - - - 72,456 72,456 72,456
Repurchase agreements 29,155 - - - - - - 29,155 29,164
YIELD 1.35% - - - - - - 1.35% -
Short-term borrowings 24,204 - - - - - - 24,204 24,197
YIELD .66% - - - - - - .66% -
Long-term borrowings 13,340 11,108 10,368 10,368 10,867 16,669 - 72,720 75,415
YIELD 3.50% 3.56% 3.64% 3.71% 3.69% 4.59% - 3.84% -
Other liabilities - - - - - - 4,521 4,521 -
Stockholders' equity - - - - - - 73,642 73,642 -
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY $284,345 $ 23,804 $ 16,577 $12,785 $13,792 $127,045 $ 150,619 $628,967 $554,586
- -----------------------------------------------------------------------------------------------------------------------------------
EXCESS OF ASSETS (LIABILITIES)
SUBJECT TO INTEREST RATE CHANGE $ 37,720 $ 68,076 $ 57,601 $19,075 $13,040 $(76,282) $(119,230) $ -
- -----------------------------------------------------------------------------------------------------------------------------------
</Table>
23
<Page>24
ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
CONSOLIDATED BALANCE SHEETS
<Table>
<Caption>
DECEMBER 31, 2008 2007
- --------------------------------------------------------------------------------------------
Cash and due from banks $ 7,246 $ 10,677
Interest bearing balances with banks 2,109 967
- --------------------------------------------------------------------------------------------
Cash and Cash Equivalents 9,355 11,644
Investment securities:
Available-for-sale, at fair value 94,996 77,328
Held-to-maturity (fair value of $64,678
and $69,491, respectively) 62,484 68,120
- --------------------------------------------------------------------------------------------
Total Investment Securities 157,480 145,448
Loans, net of unearned income 441,148 404,639
Less: Allowance for loan losses 5,275 4,700
- --------------------------------------------------------------------------------------------
Loans, Net 435,873 399,939
Bank premises and equipment 10,391 9,323
Other real estate owned - -
Accrued interest receivable 3,518 3,558
Cash surrender value of life insurance 7,684 7,368
Other assets 4,666 3,513
- --------------------------------------------------------------------------------------------
TOTAL ASSETS $ 628,967 $ 580,793
- --------------------------------------------------------------------------------------------
Deposits:
Non-interest bearing $ 72,456 $ 73,926
Interest bearing 352,269 342,607
- --------------------------------------------------------------------------------------------
Total Deposits 424,725 416,533
Other borrowed funds:
Repurchase agreements 29,155 20,492
Short-term borrowings 24,204 13,201
Long-term borrowings 72,720 55,966
Accrued interest payable 1,118 1,498
Other liabilities 3,403 3,388
- --------------------------------------------------------------------------------------------
TOTAL LIABILITIES 555,325 511,078
- --------------------------------------------------------------------------------------------
Common stock, $.01 par value, 15,000,000 shares
authorized, 2,148,000 shares issued and outstanding 21 21
Surplus 10,819 10,819
Retained earnings 64,745 59,697
Accumulated other comprehensive income (1,943) (822)
- --------------------------------------------------------------------------------------------
TOTAL STOCKHOLDERS' EQUITY 73,642 69,715
- --------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 628,967 $ 580,793
- --------------------------------------------------------------------------------------------
</Table>
The accompanying Notes are an integral part of these Consolidated Financial
Statements.
24
<Page>25
CONSOLIDATED STATEMENTS OF INCOME
<Table>
<Caption>
YEARS ENDED DECEMBER 31, 2008 2007 2006
- ------------------------------------------------------------------------------------------------------------
Interest and fees on loans $ 26,218 $ 26,429 $ 23,374
Interest and dividends on investments:
U.S. Treasury securities and U.S. Agency obligations 3,947 3,731 5,360
States & political subdivisions 3,380 2,944 2,688
Other securities 256 404 340
Interest on Federal funds sold 29 456 -
Interest on balances with banks 68 365 160
- ------------------------------------------------------------------------------------------------------------
TOTAL INTEREST INCOME 33,898 34,329 31,922
- ------------------------------------------------------------------------------------------------------------
Interest on time deposits of $100,000 or more 1,451 2,010 1,408
Interest on other deposits 5,522 7,365 6,204
Interest on other borrowed funds 3,857 3,364 3,442
- ------------------------------------------------------------------------------------------------------------
TOTAL INTEREST EXPENSE 10,830 12,739 11,054
- ------------------------------------------------------------------------------------------------------------
NET INTEREST INCOME 23,068 21,590 20,868
Provision for loan losses 861 657 433
- ------------------------------------------------------------------------------------------------------------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 22,207 20,933 20,435
- ------------------------------------------------------------------------------------------------------------
Trust department income 1,474 1,535 1,483
Service charges on deposit accounts 1,477 1,014 860
Merchant transaction income 4,502 4,256 3,947
Brokerage fee income 596 261 271
Other fee income 1,279 1,211 1,152
Bank-owned life insurance 316 314 54
Other operating income 167 80 119
VISA mandatory share redemption 1,213 - -
Realized gains on securities, net 12 49 319
- ------------------------------------------------------------------------------------------------------------
TOTAL NON-INTEREST INCOME 11,036 8,720 8,205
- ------------------------------------------------------------------------------------------------------------
Salaries and employee benefits 10,157 9,118 10,315
Expense of premises and equipment, net 2,703 2,586 2,397
Merchant transaction expenses 3,403 3,358 3,141
Other operating expenses 5,909 6,269 5,184
- ------------------------------------------------------------------------------------------------------------
TOTAL NON-INTEREST EXPENSES 22,172 21,331 21,037
- ------------------------------------------------------------------------------------------------------------
Income before income taxes 11,071 8,322 7,603
Applicable income taxes 2,458 1,624 1,595
- ------------------------------------------------------------------------------------------------------------
NET INCOME $ 8,613 $ 6,698 $ 6,008
- ------------------------------------------------------------------------------------------------------------
EARNINGS PER SHARE $ 4.01 $ 3.12 $ 2.80
- ------------------------------------------------------------------------------------------------------------
</Table>
The accompanying Notes are an integral part of these Consolidated Financial
Statements.
25
<Page>26
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<Table>
<Caption>
YEARS ENDED DECEMBER 31, 2008, 2007 AND 2006
- --------------------------------------------
ACCUMULATED
OTHER TOTAL
COMMON RETAINED COMPREHENSIVE STOCKHOLDERS'
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) STOCK SURPLUS EARNINGS INCOME EQUITY
- ---------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2005 $ 21 $ 10,819 $ 53,607 $ (648) $ 63,799
Comprehensive income:
Net income, 2006 - - 6,008 - 6,008
Other comprehensive income, net of tax
Unrealized gains on securities, net of
reclassification adjustment - - - 648 648
Minimum pension liability adjustment - - - 1,011 1,011
-------- --------
Other comprehensive income 1,659 1,659
--------
Comprehensive income 7,667
Cash dividends declared ($1.50 per share) - - (3,222) - (3,222)
Adjustment to initially apply FASB Statement
No. 158, net of tax - - - (1,673) (1,673)
- ---------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2006 21 10,819 56,393 (662) 66,571
Comprehensive income:
Net income, 2007 - - 6,698 - 6,698
Other comprehensive income, net of tax
Unrealized losses on securities, net of
reclassification adjustment - - - (57) (57)
Unrealized losses on employee benefit plans, net - - - (103) (103)
-------- --------
Other comprehensive income (160) (160)
---------
Comprehensive income 6,538
Cash dividends declared ($1.58 per share) - - (3,394) - (3,394)
- ---------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2007 21 10,819 59,697 (822) 69,715
Comprehensive income:
Net income, 2008 - - 8,613 - 8,613
Other comprehensive income, net of tax
Unrealized losses on securities, net of
reclassification adjustment - - - (728) (728)
Unrealized losses on employee benefit plans, net- - - - (393) (393)
-------- --------
Other comprehensive income (1,121) (1,121)
--------
Comprehensive income 7,492
Cash dividends declared ($1.66 per share) - - (3,565) - (3,565)
- ---------------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2008 $ 21 $ 10,819 $ 64,745 $ (1,943) $ 73,642
- ---------------------------------------------------------------------------------------------------------------------------------
</Table>
The accompanying Notes are an integral part of these Consolidated Financial
Statements.
26
<Page>27
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<Table>
<Caption>
YEARS ENDED DECEMBER 31, 2008 2007 2006
- -----------------------------------------------------------------------------------------------------------
Net Income $ 8,613 $ 6,698 $ 6,008
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation 795 861 723
Provision for loan losses 861 657 433
Deferred income tax provision (benefit) 244 (344) (254)
Amortization of securities (net of accretion) 317 366 419
Gain on VISA mandatory share redemption (1,213) - -
Increase in cash surrender value of life insurance (316) (314) (54)
Net realized (gains) losses on securities (12) (49) (319)
(Gain) loss on other real estate (69) (19) 10
Decrease (increase) in interest receivable 40 74 (159)
Increase in other assets (350) (36) (304)
Decrease in income taxes payable (565) (14) (4)
(Decrease) increase in interest payable (380) 26 211
(Decrease) increase in other liabilities (484) 82 940
- -----------------------------------------------------------------------------------------------------------
NET CASH PROVIDED BY OPERATING ACTIVITIES 7,481 7,988 7,650
- -----------------------------------------------------------------------------------------------------------
Purchase of investment securities available-for-sale (51,389) (21,412) (25,770)
Proceeds from sales and maturities of investment
securities available-for-sale 24,976 21,962 68,287
Proceeds from repayments of investment
securities available-for-sale 7,603 13,779 15,028
Proceeds from repayments of investment
securities to be held-to-maturity 5,369 5,899 7,213
Proceeds from VISA mandatory share redemption 1,213 - -
Net loans originated (36,817) (34,950) (48,676)
Proceeds from other real estate 91 95 164
Investment in premises and equipment (1,863) (713) (741)
Purchase of life insurance policies - - (7,000)
- -----------------------------------------------------------------------------------------------------------
NET (USED) CASH PROVIDED BY INVESTING ACTIVITIES (50,817) (15,340) 8,505
- -----------------------------------------------------------------------------------------------------------
Net increase (decrease) in demand and savings deposits 2,426 17,781 (1,374)
Net proceeds (payments) on time deposits 5,766 (15,048) 17,307
Increase (decrease) in repurchase agreements 8,663 7,051 (16,973)
Net increase in short-term borrowings 11,003 7,715 860
Increase in long-term borrowings 27,000 - -
Payments on long-term borrowings (10,246) (9,887) (9,548)
Cash dividends paid (3,565) (3,394) (3,222)
- -----------------------------------------------------------------------------------------------------------
NET CASH PROVIDED (USED) BY FINANCING ACTIVITIES 41,047 4,218 (12,950)
- -----------------------------------------------------------------------------------------------------------
Net (decrease) increase in cash and cash equivalents (2,289) (3,134) 3,205
Cash and cash equivalents at January 1 11,644 14,778 11,573
- -----------------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS AT DECEMBER 31 $ 9,355 $ 11,644 $ 14,778
- -----------------------------------------------------------------------------------------------------------
</Table>
The accompanying Notes are an integral part of these Consolidated Financial
Statements.
27
<Page>28
GENERAL NOTES TO FINANCIAL STATEMENTS
NOTE 1 -- NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Penseco Financial Services Corporation (Company) is a financial holding company,
incorporated in 1997 under the laws of Pennsylvania. It is the parent company of
Penn Security Bank and Trust Company (Bank), a state chartered bank.
The Company operates nine banking offices under a state bank charter and
provides full banking services, including trust services, to individual and
corporate customers primarily in Northeastern Pennsylvania. The Company's
primary deposit products are savings and demand deposit accounts and
certificates of deposit. Its primary lending products are real estate,
commercial and consumer loans.
The Company's revenues are attributable to a single reportable segment,
therefore segment information is not presented.
The accounting policies of the Company conform with accounting principles
generally accepted in the United States of America and with general practices
within the banking industry.
BASIS OF PRESENTATION
The Financial Statements of the Company have been consolidated with those of its
wholly-owned subsidiary, Penn Security Bank and Trust Company, eliminating all
intercompany items and transactions.
The Statements are presented on the accrual basis of accounting.
All information is presented in thousands of dollars, except per share amounts.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change
relate to the determination of the allowance for losses on loans and the
valuation of real estate acquired in connection with foreclosures or in
satisfaction of loans. In connection with the determination of the allowances
for losses on loans and foreclosed real estate, management obtains independent
appraisals for significant properties.
EMERGING ACCOUNTING STANDARDS
In September 2006, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 157, Fair Value Measurements
(SFAS No. 157). SFAS No. 157 defines fair value, establishes a framework for
measuring fair value and expands disclosures about fair value measurement. The
Statement also emphasizes that fair value is a market-based measurement, not an
entity-specific measurement and sets out a fair value hierarchy with the highest
priority being quoted prices in active markets. Under the Statement, fair value
measurements are disclosed by level within that hierarchy. In February 2008, the
FASB issued FASB Staff Position No. 157-2, Effective Date of FASB Statement No.
157, which permits a one-year deferral for the implementation of SFAS No. 157
with regard to nonfinancial assets and liabilities that are not recognized or
disclosed at fair value in the financial statements on a recurring basis. The
Company adopted SFAS No. 157 for the fiscal year beginning January 1, 2008,
except for nonfinancial assets and nonfinancial liabilities that are not
recognized or disclosed at fair value in the financial statements on a recurring
basis for which delayed application is permitted until the Company's year
beginning January 1, 2009.
The adoption of the remaining provisions of SFAS No. 157 is not expected to have
a material impact on the Company's financial position, results of operations or
cash flows.
In September 2006, the FASB ratified Emerging Issues Task Force (EITF) issue No.
06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of
Endorsement Split-Dollar Life Insurance Arrangements (EITF 06-4), and in March
2007, the FASB ratified EITF Issue No. 06-10, Accounting for Collateral
Assignment Split-Dollar Life Insurance Arrangements (EITF 06-10). EITF 06-4
requires deferred compensation or postretirement benefit aspects of an
endorsement-type split-dollar life insurance arrangement to be recognized as a
liability by the employer and states the obligation is not effectively settled
by the purchase of a life insurance policy. The liability for future benefits
should be recognized based on the substantive agreement with the employee, which
may be either to provide a future death benefit or to pay for the future cost of
the life insurance. EITF 06-10 provides recognition guidance for postretirement
benefit liabilities related to collateral assignment split-dollar life insurance
arrangements, as well as recognition and measurement of the associated asset on
the basis of the terms of the collateral assignment split-dollar life insurance
arrangement. EITF 06-4 and EITF 06-10 are effective for fiscal years beginning
after December 15, 2007.
28
<Page>29
The adoption of this statement did not have a material impact on the Company's
financial position, results of operations or cash flows.
In December 2007, the FASB issued Statement of Financial Accounting Standards
No. 141R, Business Combinations (SFAS No. 141 (R)) and Statement of Financial
Accounting Standards No. 160, Noncontrolling Interests in Consolidated Financial
Statements, and Amendment of ARB No. 51 (SFAS No. 160). These new standards
significantly change the accounting for and reporting of business combination
transactions and noncontrolling interests (previously referred to as minority
interests) in consolidated financial statements. Both standards are effective
for fiscal years beginning on or after December 15, 2008, with early adoption
prohibited.
The effects of SFAS No. 141 (R) on the Company's financial statements will
depend on the nature and significance of any acquisitions subject to SFAS No.
141 (R). The adoption of SFAS No. 160 is not expected to have a material impact
on the Company's financial position, results of operations or cash flows.
In March 2008, the FASB issued Statement of Financial Accounting Standards No.
161, Disclosures about Derivative Instruments and Hedging Activities - an
amendment of FASB Statement No. 133 (SFAS No. 161). SFAS No. 161 requires
additional disclosures about the objectives of using derivative instruments, the
method by which the derivative instruments and related hedged items are
accounted for under Statement No. 133 and its related interpretations, and the
effect of derivative instruments and related hedged items on financial position,
financial performance and cash flows. SFAS No. 161 also requires disclosure of
the fair values of derivative instruments and their gains and losses in a
tabular format. SFAS No. 161 is effective for fiscal years and interim periods
beginning after November 15, 2008, or the Company's quarter ending March 31,
2009. As this pronouncement is only disclosure-related, the Company does not
anticipate that SFAS No. 161 will have an impact on its financial position and
results of operations.
In April 2008, the FASB issued Staff Position (FSP) No. 142-3, Determination of
the Useful Life of Intangible Assets (FSP FAS 142-3). FSP FAS 142-3 amends the
factors that should be considered in developing renewal or extension assumptions
used to determine the useful life of a recognized intangible asset under SFAS
No. 142, Goodwill and Other Intangible Assets. It is effective for financial
statements issued for fiscal years beginning after December 15, 2008, and
interim periods within those fiscal years and should be applied prospectively to
intangible assets acquired after the effective date. Early adoption is not
permitted. FSP FAS 142-3 also requires expanded disclosure related to the
determination of intangible asset useful lives and should be applied to all
intangible assets recognized as of, and subsequent to the effective date. The
impact of FSP FAS 142-3 on the Company will depend on the size and nature of
acquisitions on or after January 1, 2009.
In December 2008, the FASB issued Staff Position No. 132(R)-1, Employers'
Disclosures about Postretirement Benefit Plan Assets (FSP FAS 132(R)-1). FSP FAS
132(R)-1 requires more detailed disclosures about employers' plan assets in a
defined benefit pension or other postretirement plan, including employers'
investment strategies, major categories of plan assets, concentrations of risk
within plan assets, and inputs and valuation techniques used to measure the fair
value of plan assets. FSP FAS 132(R)-1 also requires, for fair value
measurements using significant unobservable inputs (Level 3), disclosure of the
effect of the measurement on changes in plan assets for the period. The
disclosures about plan assets required by FSP FAS 132(R)-1 must be provided for
fiscal years ending after December 15, 2009. As this pronouncement is only
disclosure-related, the Company does not anticipate that FAS 132 (R)-1 will have
an impact on its financial position and results of operations.
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 and certain equity securities not classified as securities to be held
to maturity are carried at fair value with unrealized holding gains and losses,
net of tax, reported as a net amount in a separate component of stockholders'
equity until realized.
The amortization of premiums on mortgage-backed securities is done based on
management's estimate of the lives of the securities, adjusted, when necessary,
for advanced prepayments in excess of those estimates.
Realized gains and losses on the sale of securities available-for-sale are
determined using the specific identification method and are reported as a
separate component of other income in the Statements of Income. Unrealized gains
and losses are included as a separate item in computing comprehensive income.
29
<Page>30
LOANS AND PROVISION (ALLOWANCE) FOR POSSIBLE LOAN LOSSES
Loans are stated at the principal amount outstanding, net of any unearned
income, deferred loan fees and the allowance for loan losses. Interest is
accrued daily on the outstanding balances.
Loans are generally placed on a non-accrual status when principal or interest is
past due 90 days or when payment in full is not anticipated. 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
past due interest is collected and the collection of principal is probable.
The provision for loan losses is based on past loan loss experience,
management's evaluation of the potential loss in the current loan portfolio
under current economic conditions and such other factors as, in management's
best judgement, deserve current recognition in estimating loan losses. The
annual provision for loan losses charged to operating expense is that amount
which is sufficient to bring the balance of the allowance for possible loan
losses to an adequate level to absorb anticipated losses.
PREMISES AND EQUIPMENT
Premises and equipment are stated at cost less accumulated 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. Maintenance and repairs are charged to current expense as
incurred.
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 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 current 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.
ADVERTISING EXPENSES
Advertising costs are expensed as incurred. Advertising expenses for the years
ended December 31, 2008, 2007 and 2006, amounted to $603, $612 and $379,
respectively.
INCOME TAXES
Provisions for income taxes are based on taxes payable or refundable for the
current year (after exclusion of non-taxable income such as interest on state
and municipal securities) as well as deferred taxes on temporary differences,
between the amount of taxable income and pre-tax financial income and between
the tax bases of assets and liabilities and their reported amounts in the
Financial Statements. Deferred tax assets and liabilities are included in the
Financial Statements at currently enacted income tax rates applicable to the
period in which the deferred tax assets and liabilities are expected to be
realized or settled as prescribed in Statement of Financial Accounting Standards
No. 109, Accounting for Income Taxes (SFAS 109). As changes in tax laws or rates
are enacted, deferred tax assets and liabilities are adjusted through the
provision for income taxes.
PENSION EXPENSE
Pension expense has been determined in accordance with Statement of Financial
Accounting Standards No. 87, Employers Accounting for Pensions (SFAS 87).
STOCK APPRECIATION RIGHTS EXPENSE
The Company records its obligation under its stock appreciation rights plan in
accordance with Statement of Financial Accounting Standards No. 123R, Accounting
For Stock Based Compensation (SFAS 123R).
30
<Page>31
POSTRETIREMENT BENEFITS EXPENSE
Postretirement benefits expense has been determined in accordance with Statement
of Financial Accounting Standards No. 106, Employers Accounting for
Postretirement Benefits Other Than Pensions (SFAS 106).
CASH FLOWS
For purposes of the Statements of Cash Flows, cash and cash equivalents include
cash on hand, due from banks, interest bearing balances with banks and Federal
funds sold for a one-day period.
The Company paid interest and income taxes during the years ended December 31,
2008, 2007 and 2006 as follows:
<Table>
<Caption>
2008 2007 2006
- ----------------------------------------------------------------------------
Income taxes paid $ 2,836 $ 1,730 $ 1,752
Interest paid $11,210 $12,713 $10,843
</Table>
Non-cash transactions during the years ended December 31, 2008, 2007 and 2006,
comprised entirely of the net acquisition of real estate in the settlement of
loans, amounted to $22, $76 and $83, respectively.
LONG-LIVED ASSETS
The Company reviews the carrying value of long-lived assets for impairment
whenever events or changes in circumstances indicate that carrying amounts of
the assets might not be recoverable, as prescribed in Statement of Financial
Accounting Standards No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets (SFAS 144).
TRUST ASSETS AND INCOME
Assets held by the Company in a fiduciary or agency capacity for its customers
are not included in the Financial Statements since such items are not assets of
the Company. Trust income is reported on the accrual basis of accounting.
EARNINGS PER SHARE
Basic earnings per share is computed on the weighted average number of common
shares outstanding during each year (2,148,000) as prescribed in Statement of
Financial Accounting Standards No. 128, Earnings Per Share (SFAS 128). A
calculation of diluted earnings per share is not applicable to the Company.
RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform to the current year
presentation.
NOTE 2 -- CASH AND DUE FROM BANKS
Cash and due from banks are summarized as follows:
<Table>
<Caption>
December 31, 2008 2007
- ------------------------------------------------------------
Cash items in process of collection $ 3,026 $ 4,781
Non-interest bearing balances 735 1,830
Cash on hand 3,485 4,066
- ------------------------------------------------------------
Total $ 7,246 $10,677
- ------------------------------------------------------------
</Table>
The Company may, from time to time, maintain bank balances with other financial
institutions in excess of FDIC limitations. Management is not aware of any
evidence that would indicate that such deposits are at risk.
31
<Page>32
NOTE 3 -- INVESTMENT SECURITIES
The amortized cost and fair value of investment securities at December 31, 2008
and 2007 are as follows:
<Table>
<Caption>
AVAILABLE-FOR-SALE
Gross Gross
Amortized Unrealized Unrealized Fair
2008 Cost Gains Losses Value
- -----------------------------------------------------------------------------------------
U.S. Agency securities $ 25,221 $ 919 $ - $ 26,140
Mortgage-backed securities 20,873 392 16 21,249
States & political subdivisions 41,726 514 1,460 40,780
- -----------------------------------------------------------------------------------------
Total Debt Securities 87,820 1,825 1,476 88,169
Equity securities 6,835 623 631 6,827
- -----------------------------------------------------------------------------------------
Total Available-for-Sale $ 94,655 $ 2,448 $ 2,107 $ 94,996
- -----------------------------------------------------------------------------------------
</Table>
<Table>
<Caption>
Gross Gross
Amortized Unrealized Unrealized Fair
2007 Cost Gains Losses Value
- -----------------------------------------------------------------------------------------
U.S. Agency securities $ 14,929 $ 144 $ - $ 15,073
Mortgage-backed securities 15,402 161 - 15,563
States & political subdivisions 38,740 830 96 39,474
- -----------------------------------------------------------------------------------------
Total Debt Securities 69,071 1,135 96 70,110
Equity securities 6,812 921 515 7,218
- -----------------------------------------------------------------------------------------
Total Available-for-Sale $ 75,883 $ 2,056 $ 611 $ 77,328
- -----------------------------------------------------------------------------------------
</Table>
<Table>
<Caption>
HELD-TO-MATURITY
Gross Gross
Amortized Unrealized Unrealized Fair
2008 Cost Gains Losses Value
- -----------------------------------------------------------------------------------------
Mortgage-backed securities $ 33,254 $ 661 $ 2 $ 33,913
States & political subdivisions 29,230 1,558 23 30,765
- -----------------------------------------------------------------------------------------
Total Held-to-Maturity $ 62,484 $ 2,219 $ 25 $ 64,678
- -----------------------------------------------------------------------------------------
</Table>
<Table>
<Caption>
Gross Gross
Amortized Unrealized Unrealized Fair
2007 Cost Gains Losses Value
- -----------------------------------------------------------------------------------------
Mortgage-backed securities $ 38,880 $ 3 $ 341 $ 38,542
States & political subdivisions 29,240 1,709 - 30,949
- -----------------------------------------------------------------------------------------
Total Held-to-Maturity $ 68,120 $ 1,712 $ 341 $ 69,491
- -----------------------------------------------------------------------------------------
</Table>
Equity securities at December 31, 2008 and 2007 consisted primarily of other
financial institutions' stock and Federal Home Loan Bank of Pittsburgh (FHLB)
stock, which is a required investment in order to participate in an available
line of credit program. The FHLB stock is stated at par value as it is
restricted to purchases and sales with the FHLB. The FHLB suspended its stock
repurchase and dividend payments during December 2008. Based on current
financial information available, management does not believe the FHLB stock
value is impaired as of December 31, 2008.
The Company does not hold any Federal National Mortgage Association (Fannie Mae)
or Federal Home Loan Mortgage Corporation (Freddie Mac) preferred or common
equity securities and does not hold any trust preferred securities.
A summary of transactions involving available-for-sale debt securities in 2008,
2007 and 2006 are as follows:
<Table>
<Caption>
December 31, 2008 2007 2006
- ----------------------------------------------------------------------
Proceeds from sales $11,798 $ - $ -
Gross realized gains 11 - -
Gross realized losses - - -
</Table>
32
<Page>33
Investment securities with amortized costs and fair values of $125,804 and
$128,573, respectively, at December 31, 2008 and $128,682 and $131,134,
respectively, at December 31, 2007, were pledged to secure trust funds, public
deposits and for other purposes as required by law.
The amortized cost and fair value of debt securities at December 31, 2008 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.
<Table>
<Caption>
Available-for-Sale Held-to-Maturity
- ------------------------------------------------------------------------------------------------
Amortized Fair Amortized Fair
Cost Value Cost Value
- ------------------------------------------------------------------------------------------------
Due in one year or less:
U.S. Agency securities $ 7,022 $ 7,216 $ - $ -
After one year through five years:
U.S. Agency securities 18,199 18,924 - -
After five years through ten years:
States & political subdivisions 1,241 1,334 5,173 5,433
After ten years:
States & political subdivisions 40,485 39,446 24,057 25,332
- ------------------------------------------------------------------------------------------------
Subtotal 66,947 66,920 29,230 30,765
Mortgage-backed securities 20,873 21,249 33,254 33,913
- ------------------------------------------------------------------------------------------------
Total Debt Securities $ 87,820 $ 88,169 $ 62,484 $ 64,678
- ------------------------------------------------------------------------------------------------
</Table>
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 December 31, 2008 and
2007 are as follows:
<Table>
<Caption>
Less than twelve months Twelve months or more Totals
----------------------------------------------------------------------------------
Fair Unrealized Fair Unrealized Fair Unrealized
December 31, 2008 Value Losses Value Losses Value Losses
- ----------------------------------------------------------------------------------------------------------------------------
Mortgage-backed securities $ - $ - $ 5,351 $ 18 $ 5,351 $ 18
States & political subdivisions 21,569 1,247 1,409 236 22,978 1,483
Equities 37 15 395 616 432 631
- ----------------------------------------------------------------------------------------------------------------------------
Total $21,606 $1,262 $ 7,155 $ 870 $28,761 $ 2,132
- ----------------------------------------------------------------------------------------------------------------------------
</Table>
<Table>
<Caption>
Less than twelve months Twelve months or more Totals
----------------------------------------------------------------------------------
Fair Unrealized Fair Unrealized Fair Unrealized
December 31, 2007 Value Losses Value Losses Value Losses
- ----------------------------------------------------------------------------------------------------------------------------
Mortgage-backed securities $ - $ - $38,285 $ 341 $38,285 $ 341
States & political subdivisions 8,817 96 - - 8,817 96
Equities 1,075 285 464 230 1,539 515
- ----------------------------------------------------------------------------------------------------------------------------
Total $ 9,892 $ 381 $38,749 $ 571 $48,641 $ 952
- ----------------------------------------------------------------------------------------------------------------------------
</Table>
The table at December 31, 2008, includes forty-two (42) securities that have
unrealized losses for less than twelve months and twenty (20) securities that
have been in an unrealized loss position for twelve or more months. The table at
December 31, 2007, includes twenty-five (25) securities that have unrealized
losses for less than twelve months and seven (7) securities that have been in an
unrealized loss position for twelve or more months. The Company has analyzed its
investment portfolio and determined that the market value fluctuation in these
securities is consistent with the broader market and not a cause for recognition
of a current loss.
MORTGAGE-BACKED SECURITIES
The unrealized losses on the Company's investments in mortgage-backed securities
were caused by interest rate fluctuations. The contractual cash flows of these
investments are guaranteed by an agency of the U.S. government. Accordingly, it
is expected that these
33
<Page>34
securities would not be settled at a price less than the amortized cost of the
Company's investment. Because the decline in market value is attributable to
changes in interest rates and not credit quality, and because the Company has
the ability to hold these investments until a recovery of fair value, which may
be maturity, the Company does not consider these investments to be other-than-
temporarily impaired at December 31, 2008.
STATES AND POLITICAL SUBDIVISIONS
The unrealized losses on the Company's investments in states and political
subdivisions were caused by interest rate fluctuations. 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 has the ability
to hold these investments until a recovery of fair value, which may be maturity,
the Company does not consider these investments to be other-than-temporarily
impaired at December 31, 2008.
MARKETABLE EQUITY SECURITIES
The unrealized losses on the Company's investments in marketable equity
securities were caused primarily by interest rate fluctuations and other 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 equities is consistent with the broader market
and not a cause for recognition of a current loss. Because the Company has the
ability and intent to hold these investments for a reasonable period of time
sufficient for a forecasted recovery of fair value, the Company does not
consider these investments to be other-than-temporarily impaired at December 31,
2008.
NOTE 4 -- LOANS
Major classifications of loans are as follows:
<Table>
<Caption>
December 31, 2008 2007
- ---------------------------------------------------------------------------
Loans secured by real estate:
Construction and land development $ 21,949 $ 25,858
Secured by 1-4 family residential properties:
Revolving, open-end loans 28,738 22,432
Secured by first liens 200,920 184,193
Secured by junior liens 23,107 27,877
Secured by multi-family properties 3,795 3,092
Secured by non-farm, non-residential properties 98,968 80,843
Commercial and industrial loans to U.S. addressees 27,793 24,505
Loans to individuals for household, family
and other personal expenditures:
Credit card and related plans 3,272 3,324
Other (installment and student loans, etc.) 25,009 25,482
Obligations of states & political subdivisions 4,471 5,973
All other loans 3,126 1,060
- ----------------------------------------------------------------------------
Gross Loans 441,148 404,639
Less: Unearned income on loans - -
- ----------------------------------------------------------------------------
Loans, Net of Unearned Income $441,148 $404,639
- ----------------------------------------------------------------------------
</Table>
Loans on which the accrual of interest has been discontinued or reduced amounted
to $1,454, $1,610 and $3,180 at December 31, 2008, 2007 and 2006, respectively.
The decrease in 2007 was primarily due to the resolution of a single borrower
relationship outstanding in 2006. If interest on those loans had been accrued,
such income would have been $192, $153 and $209 for 2008, 2007 and 2006,
respectively. Interest income on those loans, which is recorded only when
received, amounted to $29, $17 and $10 for 2008, 2007 and 2006, respectively.
Also, at December 31, 2008 and 2007, the Bank had loans totaling $1,153 and
$479, respectively, which were past due 90 days or more and still accruing
interest.
The Company does not engage in any sub-prime or Alt-A credit lending. Therefore,
the Company is not subject to any credit risks associated with such loans. The
Company's lending is primarily residential and commercial secured mortgage
loans, in Northeastern Pennsylvania, based upon conservative underwriting
standards.
34
<Page>35
NOTE 5 -- ALLOWANCE FOR LOAN LOSSES
Changes in the allowance for loan losses are as follows:
<Table>
<Caption>
Years Ended December 31, 2008 2007 2006
- -------------------------------------------------------------------------
Balance at beginning of year $ 4,700 $ 4,200 $ 3,800
Provision charged to operations 861 657 433
Recoveries credited to allowance 31 8 134
- -------------------------------------------------------------------------
5,592 4,865 4,367
Losses charged to allowance (317) (165) (167)
- -------------------------------------------------------------------------
Balance at End of Year $ 5,275 $ 4,700 $ 4,200
- -------------------------------------------------------------------------
</Table>
A comparison of the provision for loan losses for Financial Statement purposes
with the allowable bad debt deduction for tax purposes is as follows:
<Table>
<Caption>
Years Ended December 31, Book Provision Tax Deduction
- ------------------------ -------------- -------------
2008 $ 861 $ 286
2007 $ 657 $ 157
2006 $ 433 $ 33
</Table>
The balance of the Reserve for Bad Debts as reported for Federal income tax
purposes was $0 at December 31, 2008, 2007 and 2006.
NOTE 6 --LOAN SERVICING
The Company services $38,828 in mortgage loans for Freddie Mac which are not
included in the accompanying Consolidated Balance Sheets.
Custodial escrow balances maintained in connection with the foregoing loan
servicing, and included in deposits, were approximately $586 and $604, at
December 31, 2008 and 2007, respectively. The balance of the servicing rights
was $41 and $91 at December 31, 2008 and 2007, respectively, net of
amortization.
The Company has recorded new mortgage servicing rights of $9 and $0 at December
31, 2008 and 2007, respectively. Amortization expense of $59 and $106 was
recorded for the years ended December 31, 2008 and 2007, respectively.
There was no allowance for impairment recorded at December 31, 2008 or 2007.
NOTE 7 -- BANK PREMISES AND EQUIPMENT
<Table>
<Caption>
December 31, 2008 2007
- ---------------------------------------------------------
Land $ 3,117 $ 3,117
Buildings and improvements 15,970 14,787
Furniture and equipment 15,350 14,670
- ---------------------------------------------------------
34,437 32,574
Less: Accumulated depreciation 24,046 23,251
- ---------------------------------------------------------
Net Bank Premises and Equipment $10,391 $ 9,323
- ---------------------------------------------------------
</Table>
Buildings and improvements are being depreciated over 10 to 39.5 year periods
and equipment over 3 to 10 year periods. Depreciation expense amounted to $795
in 2008, $861 in 2007 and $723 in 2006.
Occupancy expenses were reduced by rental income received in the amount of $154,
$64 and $64 in the years ended December 31, 2008, 2007 and 2006, respectively.
NOTE 8 -- OTHER REAL ESTATE OWNED
Real estate acquired through foreclosure is recorded at the lower of cost or
market at the time of acquisition. Any subsequent write-downs are charged
against operating expenses. The other real estate owned was $0 as of December
31, 2008 and 2007.
35
<Page>36
NOTE 9 -- INVESTMENT IN AND LOAN TO, INCOME FROM DIVIDENDS AND EQUITY IN
EARNINGS OR LOSSES OF SUBSIDIARY
Penseco Realty, Inc. is a wholly-owned subsidiary of the Bank which owns
certain banking premises. Selected financial information is presented below:
<Table>
<Caption>
Equity in
Percent underlying Bank's
of voting Total net assets at Amount proportionate
stock investment balance of part of loss for
Year owned and loan sheet date dividends the period
- -----------------------------------------------------------------------------------------------------
2008 100% $ 3,250 $ 3,235 None $ -
2007 100% $ 3,250 $ 3,235 None $ -
2006 100% $ 3,250 $ 3,235 None $ -
</Table>
NOTE 10 -- CASH SURRENDER VALUE OF LIFE INSURANCE
The Company has purchased Bank Owned Life Insurance (BOLI) policies on certain
officers.
The policies are split-dollar life insurance policies which provide for the
Company to receive the cash value of the policy and to split the residual
proceeds with the officer's designated beneficiary upon the death of the
insured, while the officer is employed at the Company. The majority of the
residual proceeds are retained by the Company per the individual agreements with
the insured officers.
NOTE 11 -- DEPOSITS
<Table>
<Caption>
December 31, 2008 2007
- ------------------------------------------------------------
Demand - Non-interest bearing $ 72,456 $ 73,926
Demand - Interest bearing 51,975 54,819
Savings 74,907 80,054
Money markets 115,811 103,924
Time - Over $100,000 37,960 40,395
Time - Other 71,616 63,415
- ------------------------------------------------------------
Total $424,725 $ 416,533
- ------------------------------------------------------------
</Table>
<Table>
<Caption>
Scheduled maturities of time deposits are as follows:
2009 $ 85,085
2010 12,696
2011 6,209
2012 2,417
2013 2,925
2014 and thereafter 244
- ---------------------------------
Total $109,576
- ---------------------------------
</Table>
36
<Page>37
NOTE 12 -- OTHER BORROWED FUNDS
At December 31, 2008 and 2007, other borrowed funds consisted of demand notes to
the U.S. Treasury, Federal Home Loan Bank overnight borrowings and repurchase
agreements.
Short-term borrowings generally have original maturity dates of thirty days or
less.
Investment securities with amortized costs and fair values of $49,599 and
$50,869, respectively, at December 31, 2008 and $49,990 and $50,009,
respectively, at December 31, 2007, were pledged to secure repurchase
agreements.
<Table>
<Caption>
Year Ended December 31, 2008 2007
- ----------------------------------------------------------------------------
Amount outstanding at year end $53,359 $33,693
Average interest rate at year end .68% 3.27%
Maximum amount outstanding at any month end $53,359 $33,920
Average amount outstanding $43,421 $27,096
Weighted average interest rate during the year
Federal funds purchased 2.47% 4.94%
Repurchase agreements 2.48% 3.25%
Demand notes to U.S. Treasury 2.60% 5.76%
</Table>
The Company has an available credit facility with the Federal Reserve Bank of
Philadelphia in the amount of $10,000, secured by pledged securities with
amortized costs and fair values of $10,088 and $10,290, respectively, at
December 31, 2008 and $10,143 and $10,053, respectively, at December 31, 2007
and with interest rates of .50% at December 31, 2008 and 4.25% at December 31,
2007. There is no stated expiration date for the credit facility as long as the
Company maintains the pledged securities at the Federal Reserve Bank. There was
no outstanding balance as of December 31, 2008 and 2007.
The Company has a $15.9 million Borrower In Custody (BIC) line of credit, with
the Federal Reserve Bank of Philadelphia, secured by pledged securities with
amortized costs and fair values of $15,869 and $15,868, respectively, at
December 31, 2008. There was no outstanding balance as of December 31, 2008.
The Company has the availability of a $5,000 overnight Federal funds line of
credit with Wells Fargo. Also, the Company has a $19,000 overnight Federal Funds
line with PNC Bank. There was no balance outstanding as of December 31, 2008 and
2007.
The Company maintains a collateralized maximum borrowing capacity of $148,975
with the Federal Home Loan Bank of Pittsburgh. There was a balance of $23,650
outstanding as of December 31, 2008.
37
<Page>38
NOTE 13 -- LONG-TERM DEBT
The loans from the Federal Home Loan Bank of Pittsburgh, which were borrowed to
purchase mortgage-backed securities, are secured by a general collateral pledge
of the Company's assets.
<Table>
<Caption>
A summary of long-term debt, including amortizing principal Aggregate maturities of long-term debt at
and interest payments, at December 31, 2008 is as follows: December 31, 2008 are as follows:
Monthly
Installment Fixed Rate Maturity Date Balance December 31, Principal
- -------------------------------------------------------------- ----------------------------------------
Amortizing Loans
$ 253 3.22% 03/15/10 $ 3,714 2009 $ 12,455
90 3.10% 02/28/13 4,219 2010 10,539
430 3.74% 03/13/13 20,250 2011 10,083
67 3.44% 03/02/15 4,466 2012 10,394
13 3.48% 03/31/15 904 2013 10,887
10 3.83% 04/02/18 945 Thereafter 18,362
186 4.69% 03/13/23 23,222 ---------
- -------------------------------------------------------------- $ 72,720
Total amortizing 57,720 =========
- --------------------------------------------------------------
Non-amortizing loans
2.61% 03/02/09 1,000
2.62% 08/31/09 1,000
2.61% 03/01/10 1,000
2.61% 08/30/10 1,000
2.88% 02/28/11 2,000
3.27% 02/29/12 2,000
3.49% 02/28/13 7,000
- --------------------------------------------------------------
Total non-amortizing 15,000
- --------------------------------------------------------------
Total long term-debt $ 72,720
- --------------------------------------------------------------
</Table>
The Company has agreed to maintain sufficient qualifying collateral to fully
secure the above borrowings.
NOTE 14 --BENEFIT PLANS
The Company provides an Employee Stock Ownership Plan (ESOP), a Retirement
Profit Sharing 401(k) Plan, an Employees' Pension Plan, unfunded supplemental
executive defined benefit and defined contribution plans, a Postretirement Life
Insurance Plan, a Stock Appreciation Rights Plan (SAR), and a Long-Term
Incentive Plan.
Under the ESOP, amounts voted by the Board of Directors are paid into the ESOP
and each employee is credited with a share in proportion to their annual
compensation. All contributions to the ESOP are invested in or will be invested
primarily in Company stock. Distribution of a participant's ESOP account occurs
upon retirement, death or termination in accordance with the plan provisions.
At December 31, 2008 and 2007, the ESOP held 67,754 and 67,101 shares,
respectively, of the Company's stock, all of which were acquired as described
above and allocated to specific participant accounts. These shares are treated
the same for dividend purposes and earnings per share calculations as are any
other outstanding shares of the Company's stock. The Company contributed $0, $70
and $70 to the ESOP plan during the years ended December 31, 2008, 2007 and
2006, respectively.
Under the Retirement Profit Sharing Plan, amounts approved by the Board of
Directors have been paid into a fund and each employee was credited with a share
in proportion to their annual compensation. Upon retirement, death or
termination, each employee is paid the total amount of their credits in the fund
in one of a number of optional ways in accordance with the plan provisions. The
Company contributed $70 and $70 to the plan during the years ended December 31,
2007 and 2006, respectively. Effective July 1, 2008, the Retirement Profit
Sharing Plan became a 401(k) Deferred Compensation and Profit Sharing Plan for
eligible employees. Eligible employees may elect deferrals of up to the maximum
amounts permitted by law. The Bank's contributions to the plan in 2008 included
a Safe Harbor contribution of $202, and a discretionary match of $119 equal to
one-half of employee deferrals, up to a maximum match of 3%. The Company also
provided a benefit of $356, allocated to fifty employees who were negatively
impacted by the Employees' Pension Plan freeze in the second quarter of 2008. A
portion of this benefit was rolled into the 401(k) plan and the balance used to
fund individual Supplemental Employee Retirement Plans (SERP) for the impacted
employees.
38
<Page>39
Under the Employees' Pension Plan (currently under curtailment), amounts
computed on an actuarial basis were being paid by the Company into a trust fund.
The plan provided for fixed benefits payable for life upon retirement at the age
of 65, based on length of service and compensation levels as defined in the
plan. As of June 22, 2008 no further benefits are being accrued in this plan.
Plan assets of the trust fund are invested and administered by the Trust
Department of Penn Security Bank and Trust Company.
The Unfunded Supplemental Executive Pension Plan (currently under curtailment)
provided certain officers with additional retirement benefits to replace
benefits lost due to limits imposed on qualified plans by Federal tax law.
Benefits under this plan were actuarially computed and recorded as a liability.
As of June 22, 2008 no further benefits are being accrued in this plan.
Effective July 1, 2008, the Company established an Unfunded Supplemental
Executive Defined Contribution Plan to replace 401(k) plan benefits lost due to
compensation limits imposed on qualified plans by Federal tax law. The annual
benefit is a maximum of 6% of the executive compensation in excess of Federal
limits.
The Postretirement Life Insurance Plan is an unfunded, non-vesting defined
benefit plan. The plan is non-contributory and provides for a reducing level of
term life insurance coverage following retirement. Annual expense amounts are
calculated on an actuarial basis and are recorded as a liability.
The Company granted 10,000 SAR's to an executive on January 3, 2006 at a strike
price of $43.00 per share. The Company also granted 8,500 SAR's to an executive
on February 29, 2008 at a strike price of $37.50 per share. All rights vest on a
straight-line basis over a five year period and are expected to be settled in
cash when exercised. The Company calculates the value of the vested rights using
the Black-Scholes method and has recorded an expense of $14 in 2008 and $19 in
2007.
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:
|0| Designate the individuals eligible to receive awards under the 2008
plan.
|0| 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.
|0| Interpret the 2008 plan and award agreements issued with respect to
individual participants.
Persons eligible to receive awards under the 2008 Plan include directors,
officers, employees, consultants and other service providers of the Company and
its subsidiaries, except that incentive stock option may be granted only to
individuals who are employees on the date of grant.
The total number of shares of the company's common stock available for grant as
wards under the 2008 plan shall not exceed in the aggregate five percent of the
outstanding shares of the Company's common stock as of February 15, 2008, or
107,400 shares of the Company's common stock.
The 2008 plan authorizes grants of stock options, stock appreciation rights,
dividend equivalents, performance awards, restricted stock and restricted stock
units. There were no awards made under the 2008 plan.
39
<Page>40
<Table>
<Caption>
Obligations and funded status of the plans:
Pension Benefits Other Benefits
---------------- --------------
December 31, 2008 2007 2008 2007
- ----------------------------------------------------------------------------- ---------------------
Change in benefit obligation:
Benefit obligation, beginning $ 13,558 $ 12,600 $ 292 $ 299
Service cost 209 438 5 5
Interest cost 752 738 18 18
Amendments (1,969) - - -
Change in assumptions (159) (154) 30 (17)
Actuarial (gain) loss - 559 - 3
Benefit paid (609) (623) (18) (16)
- ----------------------------------------------------------------------------- ---------------------
Benefit obligation, ending 11,782 13,558 327 292
- ----------------------------------------------------------------------------- ---------------------
Change in plan assets:
Fair value of plan assets, beginning 12,255 11,548 - -
Actual return on plan assets (1,775) 1,051 - -
Employer contribution 100 279 - -
Benefits paid (609) (623) - -
- ----------------------------------------------------------------------------- ---------------------
Fair value of plan assets, ending 9,971 12,255 - -
- ----------------------------------------------------------------------------- ---------------------
Funded status at end of year $ (1,811) $ (1,303) $ (327) $ (292)
- ----------------------------------------------------------------------------- ---------------------
</Table>
<Table>
<Caption>
Amounts recognized in the balance sheet consist of:
Pension Benefits Other Benefits
---------------- --------------
December 31, 2008 2007 2008 2007
- ----------------------------------------------------------------------------- ---------------------
Non Current Assets $ 616 $ 443 $ - $ -
Non Current Liabilities $ 1,811 $ 1,303 $ 327 $ 292
</Table>
<Table>
<Caption>
Amounts recognized in the accumulated other comprehensive income consist of:
Pension Benefits Other Benefits
---------------- --------------
December 31, 2008 2007 2008 2007
- ----------------------------------------------------------------------------- ---------------------
Prior service costs $ - $ 52 $ 20 $ 27
Net actuarial loss (gain) 3,280 2,656 (16) (45)
Deferred taxes (1,115) (921) (1) 6
- ----------------------------------------------------------------------------- ---------------------
Net amount recognized $ 2,165 $ 1,787 $ 3 $(12)
- ----------------------------------------------------------------------------- ---------------------
</Table>
The accumulated benefit obligation for all defined benefit pension plans was
$11,783 and $11,531 at December 31, 2008 and 2007, respectively.
Information for pension plans with an accumulated benefit obligation in excess
of plan assets is as follows:
<Table>
<Caption>
Pension Benefits
----------------
2008 2007
- -------------------------------------------------------------------
Projected benefit obligation $ 4 $ 14
Accumulated benefit obligation 4 4
Fair value of plan assets - -
</Table>
40
<Page>41
Components of net periodic pension cost and other amounts recognized in other
comprehensive income:
<Table>
<Caption>
Pension Benefits
----------------
Years Ended December 31, 2008 2007 2006
- -----------------------------------------------------------------------------------------
Components of net periodic pension cost:
Service cost $ 209 $ 438 $ 436
Interest cost 752 738 673
Expected return on plan assets (985) (962) (890)
Amortization of prior service cost - 1 -
Amortization of unrecognized net loss 86 141 166
Curtailment loss 30 - -
- -----------------------------------------------------------------------------------------
Net periodic pension cost $ 92 $ 356 $ 385
- -----------------------------------------------------------------------------------------
Other changes in plan assets and benefit obligations recognized in other
comprehensive income:
Net loss 624 175 -
Prior service cost (52) - -
Deferred tax (194) (60) -
FASB 158 recognition of deferred cost, net - - 1,673
Reverse effect of additional minimum labiality - - (1,011)
- -----------------------------------------------------------------------------------------
Total recognized in other comprehensive income 378 115 662
- -----------------------------------------------------------------------------------------
Total recognized in net period pension
Cost and other comprehensive income $ 470 $ 471 $ 1,047
- -----------------------------------------------------------------------------------------
</Table>
<Table>
<Caption>
Other Benefits
--------------
Years Ended December 31, 2008 2007 2006
- -----------------------------------------------------------------------------------------
Components of net periodic pension cost:
Service Cost $ 5 $ 5 $ 6
Interest Cost 18 18 17
Amortization of prior service cost 7 7 7
Amortization of unrecognized net gain - - -
- -----------------------------------------------------------------------------------------
Net periodic other benefit cost 30 30 30
- -----------------------------------------------------------------------------------------
Other changes in plan assets and benefit obligations recognized in other
comprehensive income:
Net loss 29 (11) -
Prior service cost (7) (7) -
Deferred tax (7) 6 -
- -----------------------------------------------------------------------------------------
Total recognized in other comprehensive income 15 (12) -
- -----------------------------------------------------------------------------------------
Total recognized in net period pension
Cost and other comprehensive income $ 45 $ 18 $ 30
- -----------------------------------------------------------------------------------------
</Table>
The estimated net loss for the defined benefit pension plans that will be
amortized from accumulated other comprehensive income into net periodic benefit
cost over the next fiscal year is $175. There is no estimated amortization of
net loss for the defined benefit postretirement plan that will be amortized from
accumulated other comprehensive income over the next fiscal year.
41
<Page>42
Weighted-average assumptions used to determine benefit obligations were as
follows:
<Table>
<Caption>
Pension Benefits Other Benefits
---------------- ----------------
December 31, 2008 2007 2008 2007
- ---------------------------------------------------------------------------------------
Discount rate 6.00% 6.00% 6.00% 6.00%
Expected long-term return on plan assets 8.50% 8.50% - -
Rate of compensation increase 3.50% 3.50% 3.50% 3.50%
</Table>
The expected long-term return on plan assets was determined using average
historical returns of the Company's plan assets.
The Company's pension plan weighted-average asset allocations at December 31,
2008 and 2007, by asset category are as follows:
<Table>
<Caption>
Plan Assets at December 31,
- ---------------------------
2008 2007
- ---------------------------------------------------------
Asset Category
- --------------
Equity securities 45.3% 56.7%
Corporate bonds 30.8 21.3
U.S. Government securities 21.6 21.1
Cash and cash equivalents 2.3 .9
- ---------------------------------------------------------
100.0% 100.0%
- ---------------------------------------------------------
</Table>
The Company investment policies and strategies include:
1.) The Trust and Investment Division's equity philosophy is Large-Cap Core with
a value bias. We invest in individual high-grade common stocks that are selected
from our approved list.
2.) Diversification is maintained by having no more than 20% in any industry
sector and no individual equity representing more than 10% of the portfolio.
3.) The fixed income style is conservative but also responsive to the various
needs of our individual clients. For our "Fixed Income" securities, we buy U.S.
Government bonds and Agencies or high-grade Corporate rated "A" or better. The
Company targets the following allocation percentages: cash equivalents 10%,
fixed income 40% and equities 50%.
There is no Company stock included in equity securities at December 31, 2008 or
2007.
Contributions
- -------------
The Company does not expect to contribute to the Employees' Pension Plan in 2009
due to the curtailment of the Plan in June 2008. The Company expects to
contribute $18 to its Postretirement Life Insurance Plan in 2009.
42
<Page>43
Estimated Future Benefit Payments
- ---------------------------------
The following benefit payments, which reflect expected future service, as
appropriate, are expected to be paid in the next five years and in the aggregate
for the five years thereafter:
<Table>
<Caption>
Pension Benefits Other Benefits
---------------- --------------
2009 $ 600 $ 18
2010 595 18
2011 602 18
2012 645 18
2013 739 19
2014-2018 4,666 106
</Table>
NOTE 15 -- INCOME TAXES
The total income taxes in the Statements of Income are as follows:
<Table>
<Caption>
Years Ended December 31, 2008 2007 2006
- ----------------------------------------------------------------------------------
Currently payable $ 2,214 $ 1,968 $ 1,849
Deferred provision (benefit) 244 (344) (254)
- ----------------------------------------------------------------------------------
Total $ 2,458 $ 1,624 $ 1,595
- ----------------------------------------------------------------------------------
</Table>
A reconciliation of income taxes at statutory rates to applicable income taxes
reported in the Statements of Income is as follows:
<Table>
<Caption>
Years Ended December 31, 2008 2007 2006
- ----------------------------------------------------------------------------------
Tax at statutory rate $ 3,764 $ 2,829 $ 2,585
Reduction for non-taxable interest (1,409) (1,301) (1,052)
Other additions 103 96 62
- ----------------------------------------------------------------------------------
Applicable Income Taxes $ 2,458 $ 1,624 $ 1,595
- ----------------------------------------------------------------------------------
</Table>
The components of the deferred income tax (benefit) provision, which result from
temporary differences, are as follows:
<Table>
<Caption>
Years Ended December 31, 2008 2007 2006
- --------------------------------------------------------------------------------
Accretion of discount on bonds $ (6) $ 18 $ (29)
Accelerated depreciation 316 21 13
Supplemental benefit plans (46) - 51
Allowance for loan losses (196) (192) (243)
Prepaid pension cost 7 (22) (46)
Accrued liabilities 169 (169) -
- --------------------------------------------------------------------------------
Total $ 244 $ (344) $ (254)
- --------------------------------------------------------------------------------
</Table>
43
<Page>44
The significant components of deferred tax assets and liabilities are as
follows:
<Table>
<Caption>
December 31, 2008 2007
- --------------------------------------------------------------
Deferred tax assets:
Allowance for loan losses $ 1,794 $ 1,598
Accrued pension costs 616 443
Accrued supplemental benefit plans 46 -
Accumulated depreciation - 288
Accrued liabilities - 169
Post retirement losses 1 -
- --------------------------------------------------------------
Total Deferred Tax Assets 2,457 2,498
- --------------------------------------------------------------
Deferred tax liabilities:
Unrealized securities gains 116 492
Accumulated accretion 52 58
Accumulated depreciation 28 -
Post retirement gains - 6
- --------------------------------------------------------------
Total Deferred Tax Liabilities 196 556
- --------------------------------------------------------------
Net Deferred Tax Assets $ 2,261 $ 1,942
- --------------------------------------------------------------
</Table>
In management's opinion, the deferred tax assets are realizable in as much as
there is a history of strong earnings and a carryback potential greater than the
deferred tax assets. Management is not aware of any evidence that would preclude
the realization of the benefit in the future and, accordingly, has not
established a valuation allowance against the deferred tax assets.
NOTE 16 -- ACCUMULATED OTHER COMPREHENSIVE INCOME
Accumulated other comprehensive income was ($1,943), ($822) and ($662) at
December 31, 2008, 2007 and 2006, respectively.
OTHER COMPREHENSIVE INCOME
Other comprehensive income (comprehensive income, excluding net income),
beginning with the 2006 period, includes two components, the change in
unrealized holding gains and losses on available for sale securities and the
change in the unfunded pension liability. The components of other comprehensive
income are reported net of related tax effects in the Consolidated Statements of
Changes in Stockholders' Equity.
In 2006, accumulated other comprehensive income includes the initial application
of FASB No. 158 to record the unrecognized components of net periodic pension
cost. As of 2007, changes in these components are shown in other comprehensive
income.
A reconciliation of other comprehensive income for the years ended December 31,
2008, 2007 and 2006 is as follows:
<Table>
<Caption>
Tax
Before-Tax Benefit Net-of-Tax
2008 Amount (Expense) Amount
- -------------------------------------------------------------------------------------------------------------
Unrealized losses on available-for-sale securities:
Unrealized losses arising during the year $ (1,092) $ 371 $ (721)
Less: Reclassification adjustment for gains realized in income 12 (5) 7
-------------------------------------
Net unrealized losses (1,104) 376 (728)
Change in funded status of employee benefit plans (595) 202 (393)
- -------------------------------------------------------------------------------------------------------------
Other Comprehensive Income $ (1,699) $ 578 $(1,121)
- -------------------------------------------------------------------------------------------------------------
</Table>
44
<Page>45
<Table>
<Caption>
Tax
Before-Tax Benefit Net-of-Tax
2007 Amount (Expense) Amount
- -------------------------------------------------------------------------------------------------------------
Unrealized losses on available-for-sale securities:
Unrealized losses arising during the year $ (38) $ 13 $ (25)
Less: Reclassification adjustment for gains realized in income 49 (17) 32
-------------------------------------
Net unrealized losses (87) 30 (57)
Change in funded status of employee benefit plans (157) 54 (103)
- -------------------------------------------------------------------------------------------------------------
Other Comprehensive Income (244) 84 (160)
- -------------------------------------------------------------------------------------------------------------
</Table>
<Table>
<Caption>
Tax
Before-Tax Benefit Net-of-Tax
2006 Amount (Expense) Amount
- -------------------------------------------------------------------------------------------------------------
Unrealized gains on available-for-sale securities:
Unrealized gains arising during the year $ 1,302 $ (443) $ 859
Less: Reclassification adjustment for gains realized in income 319 (108) 211
-------------------------------------
Net unrealized gains 983 (335) 648
Change in minimum pension liability 1,531 (520) 1,011
- -------------------------------------------------------------------------------------------------------------
Other Comprehensive Income $ 2,514 $ (855) $ 1,659
- -------------------------------------------------------------------------------------------------------------
</Table>
NOTE 17 --COMMITMENTS AND CONTINGENT LIABILITIES
In the normal course of business, there are outstanding commitments and
contingent liabilities, created under prevailing terms and collateral
requirements such as commitments to extend credit, financial guarantees and
letters of credit, which are not reflected in the accompanying Financial
Statements. The Company does not anticipate any losses as a result of these
transactions. These instruments involve, to varying degrees, elements of credit
and interest rate risk in excess of the amount recognized in the Balance Sheets.
The contract or notional amounts of those instruments reflect the extent of
involvement the Company has in particular classes of financial instruments.
Financial instruments whose contract amounts represent credit risk at December
31, 2008 and 2007 are as follows:
<Table>
<Caption>
2008 2007
- ------------------------------------------------------------------------
Commitments to extend credit:
Fixed rate $ 26,396 $ 40,105
Variable rate $ 92,935 $ 78,868
Standby letters of credit $ 11,173 $ 13,104
</Table>
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of any condition established in the contract. Commitments
generally have expiration dates of one year or less or other termination clauses
and may require payment of a fee. Since many of the commitments are expected to
expire without being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements.
Standby letters of credit are conditional commitments issued to guarantee the
performance of a customer to a third party. The credit risk involved in issuing
letters of credit is essentially the same as that involved in extending loan
facilities to customers.
Various actions and proceedings are presently pending to which the Company is a
party. Management is of the opinion that the aggregate liabilities, if any,
arising from such actions would not have a material adverse effect on the
financial position of the Company.
45
<Page>46
NOTE 18 -- FAIR VALUE DISCLOSURE
GENERAL
Statement of Financial Accounting Standards No.107, "Disclosures about Fair
Value of Financial Instruments" (SFAS 107), requires the disclosure of the
estimated fair value of on and off-balance sheet financial instruments.
VALUATION METHODS AND ASSUMPTIONS
Estimated fair values have been determined using the best available data, an
estimation methodology suitable for each category of financial instruments. For
those loans and deposits with floating interest rates it is presumed that
estimated fair values generally approximate the carrying amount balances.
Financial instruments actively traded in a secondary market have been valued
using quoted available market prices. Those with stated maturities have been
valued using a present value discounted cash flow with a discount rate
approximating current market for similar assets and liabilities. Those
liabilities with no stated maturities have an estimated fair value equal to both
the amount payable on demand and the carrying amount balance. The net loan
portfolio has been valued using a present value discounted cash flow. The
discount rate used in these calculations is the current loan rate adjusted for
non-interest operating costs, credit loss and assumed prepayment risk. Off
balance sheet carrying amounts and fair value of letters of credit represent the
deferred income fees arising from those unrecognized financial instruments.
Changes in assumptions or estimation methodologies may have a material effect on
these estimated fair values.
All assets and liabilities which are not considered financial instruments have
not been valued differently than has been customary with historical cost
accounting.
46
<Page>47
<Table>
<Caption>
December 31, 2008 December 31, 2007
- ------------------------------------------------------------------------------------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
- ------------------------------------------------------------------------------------------------------
Financial Assets:
Cash and due from banks $ 7,246 $ 7,246 $ 10,677 $ 10,677
Interest bearing balances with banks 2,109 2,109 967 967
- ------------------------------------------------------------------------------------------------------
Cash and cash equivalents 9,355 9,355 11,644 11,644
Investment Securities:
Available-for-sale:
U.S. Agency obligations 47,389 47,389 30,636 30,636
States & political subdivisions 40,780 40,780 39,474 39,474
Federal Home Loan Bank stock 5,568 5,568 4,389 4,389
Other securities 1,259 1,259 2,829 2,829
Held-to-maturity:
U.S. Agency obligations 33,254 33,913 38,880 38,542
States & political subdivisions 29,230 30,765 29,240 30,949
- ------------------------------------------------------------------------------------------------------
Total investment securities 157,480 159,674 145,448 146,819
Loans, net of unearned income:
Real estate mortgages 377,477 380,881 344,295 346,052
Commercial 27,793 26,259 24,505 24,409
Consumer and other 35,878 34,229 35,839 35,758
Less: Allowance for loan losses 5,275 4,700
- ------------------------------------------------------------------------------------------------------
Loans, net 435,873 441,369 399,939 406,219
Cash surrender value of life insurance 7,684 7,684 7,368 7,368
- ------------------------------------------------------------------------------------------------------
Total Financial Assets 610,392 $618,082 564,399 $572,050
======== ========
Other assets 18,575 16,394
- ------------------------------------------------------------------------------------------------------
Total Assets $628,967 $580,793
- ------------------------------------------------------------------------------------------------------
Financial Liabilities:
Demand - Non-interest bearing $ 72,456 $ 72,456 $ 73,926 $ 73,926
Demand - Interest bearing 51,975 51,975 54,819 54,819
Savings 74,907 74,907 80,054 80,054
Money markets 115,811 115,811 103,924 103,924
Time 109,576 110,661 103,810 104,153
- ------------------------------------------------------------------------------------------------------
Total Deposits 424,725 425,810 416,533 416,876
Repurchase agreements 29,155 29,164 20,492 20,453
Short-term borrowings 24,204 24,197 13,201 13,201
Long-term borrowings 72,720 75,415 55,966 56,028
- ------------------------------------------------------------------------------------------------------
Total Financial Liabilities 550,804 $554,586 506,192 $506,558
======== =========
Other Liabilities 4,521 4,886
Stockholders' Equity 73,642 69,715
- ------------------------------------------------------------------------------------------------------
Total Liabilities and Stockholders' Equity $628,967 $580,793
- ------------------------------------------------------------------------------------------------------
Standby Letters of Credit $ (112) $ (112) $ (131) $ (131)
</Table>
47
<Page>48
NOTE 19 -- OPERATING LEASES
The Company leases the land upon which the Mount Pocono Office was built and the
land upon which a drive-up ATM was built on Meadow Avenue, Scranton. The Company
also leases space at several locations which are being used as remote banking
facilities. Rental expense was $85 in 2008, $83 in 2007 and $90 in 2006. All
leases contain renewal options. The Mount Pocono and the Meadow Avenue leases
contain the right of first refusal for the purchase of the properties and
provisions for annual rent adjustments based upon the Consumer Price Index.
Future minimum rental commitments under these leases at December 31, 2008 are as
follows:
<Table>
<Caption>
Mount Meadow ATM
Pocono Avenue Sites Total
- ---------------------------------------------------------------------------
2009 $ 58 $ 23 $ 8 $ 89
2010 58 23 6 87
2011 25 8 6 39
2012 - - - -
2013 and beyond - - - -
- ---------------------------------------------------------------------------
Total minimum payments required $141 $ 54 $ 20 $215
- ---------------------------------------------------------------------------
</Table>
NOTE 20 -- LOANS TO DIRECTORS, PRINCIPAL OFFICERS AND RELATED PARTIES
The Company has had, and may be expected to have in the future, banking
transactions in the ordinary course of business with directors, principal
officers, their immediate families and affiliated companies in which they are
principal stockholders (commonly referred to as related parties), on the same
terms, including interest rates and collateral, as those prevailing at the time
for comparable transactions with others. A summary of loans to directors,
principal officers and related parties is as follows:
<Table>
<Caption>
Years Ended December 31, 2008 2007
- -----------------------------------------------------------
Beginning Balance $ 9,703 $ 9,058
Additions 3,584 3,694
Reclassifications - (251)
Collections (3,271) (2,798)
- -----------------------------------------------------------
Ending Balance $10,016 $ 9,703
- -----------------------------------------------------------
</Table>
In addition to the loan amounts shown above, the Bank has issued standby letters
of credit for the accounts of related parties in the amount of $7,990.
NOTE 21 -- REGULATORY MATTERS
The Company and the Bank are subject to various regulatory capital requirements
administered by the Federal banking agencies. 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 Capital Adequacy table on the following page) 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 December 31, 2008, that the Company and
the Bank meet all capital adequacy requirements to which they are subject.
As of December 31, 2008, the most recent notification from the Federal Deposit
Insurance Corporation (FDIC) categorized the Company as "well capitalized" under
the regulatory framework for prompt corrective action. To be categorized as
"well capitalized", the Company 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.
48
<Page>49
The Company and Bank are also subject to minimum capital levels, which could
limit the payment of dividends, although the Company and Bank currently have
capital levels which are in excess of minimum capital level ratios required.
The Pennsylvania Banking Code restricts capital funds available for payment of
dividends to the retained earnings of the Bank. Accordingly, at December 31,
2008, the balances in the capital stock and surplus accounts totaling $10,840
are unavailable for dividends.
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 the
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 of such transactions by the Bank with a single affiliate is limited in
amount to 10 percent of the Bank's Capital Stock and Surplus, and the aggregate
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.
<Table>
<Caption>
Actual Regulatory Requirements
- ------------------------------------------------------------------- -------------------------------------------
For Capital To Be
Adequacy Purposes "Well Capitalized"
----------------- ------------------
As of December 31, 2008 Amount Ratio Amount Ratio Amount Ratio
- ------------------------------------------------------------------------------------------------------------------
Total Capital (to Risk Weighted Assets)
PFSC (Company) $80,630 19.81% > $32,570 > 8.0% > $40,712 > 10.0%
- - - -
PSB (Bank) $77,275 19.03% > $32,486 > 8.0% > $40,607 > 10.0%
- - - -
Tier 1 Capital (to Risk Weighted Assets)
PFSC (Company) $75,544 18.56% > $16,285 > 4.0% > $24,427 > 6.0%
- - - -
PSB (Bank) $72,197 17.78% > $16,243 > 4.0% > $24,364 > 6.0%
- - - -
Tier 1 Capital (to Average Assets)
PFSC (Company) $75,544 12.26% > * > * > $30,813 > 5.0%
- - - -
PSB (Bank) $72,197 11.73% > * > * > $30,765 > 5.0%
- - - -
</Table>
PFSC - *3.0% ($18,488), 4.0% ($24,651) or 5.0% ($30,813) depending on the bank's
CAMELS Rating and other regulatory risk factors.
PSB - *3.0% ($18,459), 4.0% ($24,612) or 5.0% ($30,765) depending on the bank's
CAMELS Rating and other regulatory risk factors.
<Table>
<Caption>
For Capital To Be
Adequacy Purposes "Well Capitalized"
----------------- ------------------
As of December 31, 2007 Amount Ratio Amount Ratio Amount Ratio
- ------------------------------------------------------------------------------------------------------------------
Total Capital (to Risk Weighted Assets)
PFSC (Company) $75,145 19.89% > $30,222 > 8.0% > $37,777 > 10.0%
- - - -
PSB (Bank) $71,840 19.11% > $30,080 > 8.0% > $37,601 > 10.0%
- - - -
Tier 1 Capital (to Risk Weighted Assets)
PFSC (Company) $70,445 18.65% > $15,111 > 4.0% > $22,666 > 6.0%
- - - -
PSB (Bank) $67,140 17.86% > $15,040 > 4.0% > $22,561 > 6.0%
- - - -
Tier 1 Capital (to Average Assets)
PFSC (Company) $70,445 12.11% > * > * > $29,081 > 5.0%
- - - -
PSB (Bank) $67,140 11.62% > * > * > $28,900 > 5.0%
- - - -
</Table>
PFSC - *3.0% ($17,449), 4.0% ($23,265) or 5.0% ($29,081) depending on the bank's
CAMELS Rating and other regulatory risk factors.
PSB - *3.0% ($17,340), 4.0% ($23,120) or 5.0% ($28,900) depending on the bank's
CAMELS Rating and other regulatory risk factors.
49
<Page>50
NOTE 22 -- PENSECO FINANCIAL SERVICES CORPORATION (PARENT CORPORATION) The
condensed Company-only information follows:
BALANCE SHEETS
<Table>
<Caption>
DECEMBER 31, 2008 2007
- ----------------------------------------------------------------------------------
Cash $ 16 $ 5
Interest bearing balances with banks 2,085 920
- ----------------------------------------------------------------------------------
Cash and Cash Equivalents 2,101 925
Investment in bank subsidiary 70,300 66,141
Equity investments 1,239 2,809
Other Assets 2 -
- ----------------------------------------------------------------------------------
TOTAL ASSETS $73,642 $69,875
- ----------------------------------------------------------------------------------
TOTAL LIABILITIES $ - $ 160
TOTAL STOCKHOLDERS' EQUITY 73,642 69,715
- ----------------------------------------------------------------------------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $73,642 $69,875
- ----------------------------------------------------------------------------------
</Table>
<Table>
<Caption>
STATEMENTS OF INCOME
YEARS ENDED DECEMBER 31, 2008 2007 2006
- ---------------------------------------------------------------------------------------------------------
Dividends from bank subsidiary $ 3,565 $ 3,394 $ 3,222
Dividends on investment securities 91 99 106
Interest on balances with banks 19 40 5
Gain on sale of equities 1 49 319
- ---------------------------------------------------------------------------------------------------------
Total income 3,676 3,582 3,652
Other non-interest expense 69 88 21
- ---------------------------------------------------------------------------------------------------------
Net income before undistributed earnings of bank subsidiary $ 3,607 3,494 3,631
Undistributed earnings of bank subsidiary 5,006 3,204 2,377
- ---------------------------------------------------------------------------------------------------------
Net Income $ 8,613 $ 6,698 $ 6,008
- ---------------------------------------------------------------------------------------------------------
</Table>
<Table>
<Caption>
STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2008 2007 2006
- ---------------------------------------------------------------------------------------------------------
Operating Activities:
Net income $ 8,613 $ 6,698 $ 6,008
Adjustments to reconcile net income to net cash
provided by operating activities:
Gain on sale of equities (1) (49) (319)
Equity in undistributed net income of bank subsidiary (5,006) (3,204) (2,377)
(Decrease) increase in other liabilities (23) 23 -
- ---------------------------------------------------------------------------------------------------------
NET CASH PROVIDED BY OPERATING ACTIVITIES 3,583 3,468 3,312
- ---------------------------------------------------------------------------------------------------------
Investing Activities:
Purchase of equity investments - (1,055) (160)
Proceeds from sales of equity securities 1,158 351 1,544
- ---------------------------------------------------------------------------------------------------------
NET CASH (USED) PROVIDED BY INVESTING ACTIVITIES 1,158 (704) 1,384
- ---------------------------------------------------------------------------------------------------------
Financing Activities:
Cash dividends paid (3,565) (3,394) (3,222)
- ---------------------------------------------------------------------------------------------------------
NET CASH USED BY FINANCING ACTIVITIES (3,565) (3,394) (3,222)
- ---------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents 1,176 (630) 1,474
Cash and cash equivalents at January 1 925 1,555 81
- ---------------------------------------------------------------------------------------------------------
Cash and cash equivalents at December 31 $ 2,101 $ 925 $ 1,555
- ---------------------------------------------------------------------------------------------------------
</Table>
50
<Page>51
NOTE 23 -- AGREEMENT AND PLAN OF MERGER
An Agreement and Plan of Merger (The Agreement) by and between Penseco Financial
Services Corporation, Penn Security Bank and Trust Company and Old Forge Bank,
dated December 5, 2008, provides for, among other things, Penseco to acquire Old
Forge Bank through a two-step merger transaction. Old Forge Bank will be merged
with and into Penn Security Bank and Trust Company. Following the merger, Penn
Security Bank and Trust Company will continue to operate as a banking subsidiary
of Penseco Financial Services Corporation.
Shareholders of Old Forge Bank will be entitled to receive the merger
consideration in either cash or shares of Penseco common stock, or any
combination thereof, subject to certain limitations and allocation procedures
set forth in the Agreement. The per share amount will be calculated from the
cash consideration and the value of the stock consideration based on the Penseco
closing price, as such term is defined in the Agreement. The per share amount
will be approximately $103.76, provided that the Penseco closing price is
between $35.99 and $39.77 per share.
Penseco and Old Forge Bank have agreed to use reasonable best efforts to obtain
all regulatory approvals required to complete the transactions contemplated by
the merger agreement. These approvals include approval from the Federal Deposit
Insurance Corporation, under the Federal Bank Merger Act, and the Pennsylvania
Department of Banking under the Pennsylvania Banking Code of 1965, as well as
various other regulatory authorities. The transaction is also subject to the
non-objection of the Federal Reserve Bank of Philadelphia, because the merger
involves an acquisition by a bank holding company. Old Forge Bank and Penseco
have completed the filing of applications and notifications to obtain the
required regulatory approvals. The Company hopes to consummate the acquisition
of Old Forge Bank on or before April 1, 2009.
NOTE 24 -- SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
<Table>
<Caption>
First Second Third Fourth
2008 Quarter Quarter Quarter Quarter
- ----------------------------------------------------------------------------------------
Net Interest Income $ 5,577 $ 5,667 $ 5,828 $ 5,996
Provision for Loan Losses 235 216 167 243
Other Income 3,618 2,364 2,986 2,068
Other Expenses and Taxes 6,003 5,887 6,405 6,335
Net Income 2,957 1,928 2,242 1,486
Earnings Per Share $ 1.38 $ .90 $ 1.04 $ .69
</Table>
<Table>
<Caption>
First Second Third Fourth
2007 Quarter Quarter Quarter Quarter
- ----------------------------------------------------------------------------------------
Net Interest Income $ 5,245 $ 5,342 $ 5,530 $ 5,473
Provision for Loan Losses 96 124 308 129
Other Income 2,096 1,980 2,663 1,981
Other Expenses and Taxes 5,575 5,498 5,704 6,178
Net Income 1,670 1,700 2,181 1,147
Earnings Per Share $ .78 $ .79 $ 1.01 $ .54
</Table>
NOTE 25 -- FAIR VALUE MEASUREMENTS (SFAS NO. 157)
Effective January 1, 2008, the Company adopted SFAS No. 157, which, among other
things, requires enhanced disclosures about assets and liabilities carried at
fair value. SFAS No. 157 establishes a hierarchal disclosure framework
associated with the level of pricing observability utilized in measuring assets
and liabilities at fair value. The three broad levels defined by SFAS No. 157
hierarchy are as follows:
Level I: Quoted prices are available in active markets for identical assets or
liabilities as of the record date.
Level II: Pricing inputs are other than quoted prices in active markets, which
are either directly or indirectly observable as of the reported date.
The nature of these assets and liabilities include items for which
quoted prices are available but traded less frequently, and items that
are fair valued using other financial instruments, the parameters of
which can be directly observed.
51
<Page>52
Level III: Assets and liabilities that have little to no pricing observability
as of the reported date. These items do not have two-way markets and
are measured using management's best estimate of fair value, where
the inputs into the determination of fair value require significant
management judgment or estimation.
The following table presents the assets reported on the consolidated statements
of financial condition at their fair value as of December 31, 2008 by level
within the fair value hierarchy. As required by SFAS No. 157, financial assets
and liabilities are classified in their entirety based on the lowest level of
input that is significant to the fair value measurement.
<Table>
<Caption>
December 31, 2008
-----------------------------------------------
Level I Level II Level III Total
------- -------- --------- --------
Assets:
Securities available-for-sale $6,777 $88,169 $ 50 $94,996
</Table>
The Company has no other assets or liabilities measured at fair value on a
non-recurring basis as of December 31, 2008.
52
<Page>53
MMQ
Francis J. Merkel, CPA
Joseph J. Quinn, CPA/ABV, CVA
Daniel J. Gerrity, CPA
Mary Ann E. Novak, CPA
McGrail Merkel Quinn & Associates
CERTIFIED PUBLIC ACCOUNTANTS & CONSULTANTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
Penseco Financial Services Corporation
We have audited the accompanying consolidated balance sheets of Penseco
Financial Services Corporation and subsidiary as of December 31, 2008 and
2007, and the related consolidated statements of income, stockholders'
equity, and cash flows for each of the three years in the period ended
December 31, 2008. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require
that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation. We believe
that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Penseco
Financial Services Corporation and subsidiary as of December 31, 2008 and
2007, and the results of their operations and their cash flows for each of
the three years in the period ended December 31, 2008, in conformity with
U.S. generally accepted accounting principles.
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), Penseco Financial Services
Corporation and subsidiaries' internal control over financial reporting as of
December 31, 2008, based on criteria established in Internal Control --
Integrated Framework issued by the Committee of Sponsoring Organizations of
the Treadway Commission, and our report dated February 26, 2009 expressed an
unqualified opinion on the effectiveness of Penseco Financial Services
Corporation's internal control over financial reporting.
/S/ McGrail Merkel Quinn & Associates
Scranton, Pennsylvania
February 26, 2009
RSM McGladrey Network
An Independently Owned Member
Clay Avenue Professional Plaza, 1173 Clay Avenue, Scranton, PA 18510
570 961-0345 Fax: 570 961-8650
www.mmq.com
53
<Page>54
MMQ
Francis J. Merkel, CPA
Joseph J. Quinn, CPA/ABV, CVA
Daniel J. Gerrity, CPA
Mary Ann E. Novak, CPA
McGrail Merkel Quinn & Associates
CERTIFIED PUBLIC ACCOUNTANTS & CONSULTANTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
Penseco Financial Services Corporation
We have audited Penseco Financial Services Corporation and subsidiary's internal
control over financial reporting as of December 31, 2008, based on criteria
established in Internal Control -- Integrated Framework issued by the Committee
of Sponsoring Organizations of the Treadway Commission. Penseco Financial
Services Corporation and subsidiary's management is responsible for maintaining
effective internal control over financial reporting and for its assessment of
the effectiveness of internal control over financial reporting included in the
accompanying Management's Report on Internal Control Over Financial Reporting.
Our responsibility is to express an opinion on the Company's internal control
over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, assessing the risk that a material weakness exists, and
testing and evaluating the design and operating effectiveness of internal
control based on the assessed risk. Our audit also included performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (a) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (b)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (c) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
In our opinion, Penseco Financial Services Corporation and subsidiary
maintained, in all material respects, effective internal control over financial
reporting as of December 31, 2008, based on criteria established in Internal
Control -- Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated financial
statements of Penseco Financial Services Corporation and subsidiary and our
report dated February 26, 2009 expressed an unqualified opinion.
/S/ McGrail Merkel Quinn & Associates
Scranton, Pennsylvania
February 26, 2009
RSM McGladrey Network
An Independently Owned Member
Clay Avenue Professional Plaza, 1173 Clay Avenue, Scranton, PA 18510
570 961-0345 Fax: 570 961-8650
www.mmq.com
54
<Page>55
ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE
There were no changes in or disagreements with accountants on matters of
accounting principles or practices or financial statement disclosures in 2008 or
2007.
ITEM 9A CONTROLS AND PROCEDURES
Under the supervision and with the participation of our management, including
our Chief Executive Officer and Finance Division Head, 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, our Chief Executive Officer and our Finance Division Head concluded
that our disclosure controls and procedures were effective as of the end of the
period covered by this annual report. Management's annual report on internal
control over financial reporting is included below.
The Company continually assesses the adequacy of its internal control over
financial reporting and enhances its controls in response to internal control
assessments, and internal and external audit and regulatory recommendations. No
change in internal control over financial reporting during the quarter ended
December 31, 2008, or through the date of this Annual Report on Form 10-K, have
materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.
Management maintains a comprehensive system of controls intended to ensure that
transactions are executed in accordance with management's authorization, assets
are safeguarded, and financial records are reliable. Management also takes steps
to see that information and communication flows are effective and to monitor
performance, including performance of internal control procedures.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate due to changes in conditions, or that the degree of compliance with
the policies or procedures may deteriorate.
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of Penseco Financial Services Corporation is responsible for
establishing and maintaining adequate internal control over financial reporting.
Penseco Financial Services Corporation's internal control system over financial
reporting was designed to provide reasonable assurance to the Company's
management and Board of Directors regarding the preparation and fair
presentation of published financial statements in accordance with U.S. generally
accepted accounting principles. All internal control systems, no matter how well
designed, have inherent limitations. Therefore, even those systems determined to
be effective can provide only reasonable assurance with respect to financial
statement preparation and presentation.
The Company's management, under the supervision and with the participation of
the Company's Chief Executive Officer and Finance Division Head, has evaluated
the effectiveness of the Company's internal control over financial reporting as
of December 31, 2008 based on the criteria set forth by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO) in Internal
Controls-Integrated Framework. Based on this assessment, management believes
that, as of December 31, 2008, the Company's internal control over financial
reporting is effective.
The effectiveness of the Company's internal control over financial reporting as
of December 31, 2008 has been audited by McGrail, Merkel, Quinn & Associates, an
independent registered public accounting firm, as stated in their report
appearing on page 54.
ITEM 9B OTHER INFORMATION
None
55
<Page>56
PART III
ITEM 10 DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Code of Ethical Conduct
-----------------------
The Company has a Code of Ethical Conduct applicable to all employees including
the Company's Principal Executive Officer and Principal Financial Officer
(Finance Division Head). The purpose of the Code is to promote honest and
ethical conduct, full and fair disclosures of financial information, compliance
with laws and regulations and accountability for actions.
A copy of the Code of Ethics may be obtained, without charge, on our website
(www.pennsecurity.com) or by contacting:
Patrick Scanlon, Senior Vice President, Finance Division Head
Penseco Financial Services Corporation
150 North Washington Avenue
Scranton, PA 18503-1848
1-800-327-0394
AUDIT COMMITTEE FINANCIAL EXPERT
--------------------------------
The information required by this Item as to Directors of the Company contained
under the headings "Stock Ownership", Item 1 "Election of Directors", "Corporate
Governance" and "Certain Relationships and Related Transactions" within the
Proxy Statement relating to the Company's Annual Meeting of Shareholders, to be
held May 5, 2009, ("The Proxy Statement") is incorporated herein by reference.
The information required by this item as to the Audit Committee's financial
expert (or lack thereof) is incorporated herein by reference to the section
entitled "Corporate Governance-Committees of the Board of Directors" in the
Proxy Statement.
ITEM 11 EXECUTIVE COMPENSATION
The information contained under the headings "Executive Compensation", "Director
Compensation", "Compensation Discussion and Analysis", "Compensation and
Benefits Committee Report" and "Compensation Committee Interlocks and Insider
Participation" in the Proxy Statement is incorporated herein by reference.
ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The information contained under the heading "Stock Ownership" in the Proxy
Statement is incorporated herein by reference.
ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
INDEPENDENCE
The information contained under the headings "Certain Relationships and Related
Transactions" and "Corporate Governance" and "Item 1- Election of Directors" in
the Proxy Statement is incorporated herein by reference.
ITEM 14 PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information contained under the heading "Item 2- Ratification of Independent
Registered Public Accounting Firm" in the Proxy Statement is incorporated herein
by reference.
56
<Page>57
PART IV
ITEM 15 EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) (1) Financial Statements - The following financial statements are
incorporated by reference in Part II, Item 8 hereof:
Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Stockholders' Equity
Consolidated Statements of Cash Flows
General Notes to Financial Statements
Report of Independent Registered Public Accounting Firm
(2) Financial Statement Schedules - The Financial Statement Schedules are
incorporated by reference in Part II, Item 8 hereof.
(3) Exhibits
The following exhibits are filed herewith or incorporated by reference
as part of this Annual Report.
3(i) Articles of Incorporation (Incorporated herein by reference to
Exhibit 3(i) of Registrant's report on Form 10-K filed with the
SEC on March 30, 1998.)
3(ii) By-Laws (Incorporated herein by reference to Exhibit 3(ii) of
Registrant's report on Form 10-K filed with the SEC on March
16, 2006.)
10 Material contracts (Incorporated herein by reference to Exhibit
10 of Registrant's report on Form 10-K filed with the SEC on
March 16, 2006.)
14 Code of Ethics (Incorporated herein by reference to Exhibit 10 of
Registrant's report on Form 10-K filed with the SEC on March
16, 2006.)
21 Subsidiaries of the registrant (Incorporated herein by reference
to Exhibit 21 of Registrant's report on Form 10-K filed with the
SEC on March 30, 1998.)
31 Certifications required under Section 302 of the Sarbanes-Oxley
Act 2002
32 Certifications required under Section 906 of the Sarbanes-Oxley
Act of 2002
(b) The exhibits required to be filed by this Item are listed under
Item 15(a)(3), above.
(c) There are no financial statement schedules required to be filed under this
item.
57
<Page>58
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Bank has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized on February 27, 2009.
By: /s/ Craig W. Best
------------------------------------
Craig W. Best
President and CEO
By: /s/ Patrick Scanlon
------------------------------------
Patrick Scanlon
Senior Vice President, Finance Division Head
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities indicated on February 27, 2009.
By: /s/ Craig W. Best By: /s/ Robert W. Naismith, Ph. D.
----------------------------- --------------------------------------
Craig W. Best Robert W. Naismith, Ph. D.
President and CEO Director
By: /s/ Edwin J. Butler By: /s/ James B. Nicholas
----------------------------- --------------------------------------
Edwin J. Butler James B. Nicholas
Director Director
By: /s/ Richard E. Grimm By: /s/ Emily S. Perry
----------------------------- --------------------------------------
Richard E. Grimm Emily S. Perry
Director Director
By: /s/ Russell C. Hazelton By: /s/ Sandra C. Phillips
----------------------------- --------------------------------------
Russell C. Hazelton Sandra C. Phillips
Director Director
By: /s/ D. William Hume By: /s/ Otto P. Robinson, Jr.
----------------------------- --------------------------------------
D. William Hume Otto P. Robinson, Jr.
Director, Chairman of The Board Director
By: /s/ James G. Keisling By: /s/ Steven L. Weinberger
----------------------------- --------------------------------------
James G. Keisling Steven L. Weinberger
Director Director
By: /s/ P. Frank Kozik
-----------------------------
P. Frank Kozik
Director
58
<Page>59
CERTIFICATIONS
I, Craig W. Best, certify that:
1. I have reviewed this annual report on Form 10-K of Penseco Financial Services
Corporation;
2. Based on my knowledge, this report does not contain any untrue statement of a
material fact or omit to state a material fact necessary to make the statements
made, in light of the circumstances under which such statements were made, not
misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as
of, and for, the periods presented in this report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial
reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f))for the
registrant and have:
a) Designed such disclosure controls and procedures, or caused such disclosure
controls and procedures to be designed under our supervision, to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this report is being prepared;
b) Designed such internal control over financial reporting, or caused such
internal control over financial reporting to be designed under our supervision,
to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles;
c) Evaluated the effectiveness of the registrant's disclosure controls and
procedures and presented in this report our conclusions about the effectiveness
of the disclosure controls and procedures, as of the end of the period covered
by this report based on such evaluation; and
d) Disclosed in this report any change in the registrant's internal control over
financial reporting that occurred during the registrant's most recent fiscal
quarter (the registrant's fourth fiscal quarter in the case of an annual report)
that has materially affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation of internal control over financial reporting, to the
registrant's auditors and the audit committee of the registrant's board of
directors:
a) All significant deficiencies and material weaknesses in the design or
operation of internal control over financial reporting which are reasonably
likely to adversely affect the registrant's ability to record, process,
summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal control over
financial reporting.
Date: February 26, 2009
/s/ Craig W. Best
- -------------------
Craig W. Best
President and CEO
59
<Page>60
I, Patrick Scanlon, certify that:
1. I have reviewed this annual report on Form 10-K of Penseco Financial Services
Corporation;
2. Based on my knowledge, this report does not contain any untrue statement of
a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements were
made, not misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as
of, and for, the periods presented in this report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial
reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f))for the
registrant and have:
a) Designed such disclosure controls and procedures, or caused such disclosure
controls and procedures to be designed under our supervision, to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this report is being prepared;
b) Designed such internal control over financial reporting, or caused such
internal control over financial reporting to be designed under our supervision,
to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles;
c) Evaluated the effectiveness of the registrant's disclosure controls and
procedures and presented in this report our conclusions about the effectiveness
of the disclosure controls and procedures, as of the end of the period covered
by this report based on such evaluation; and
d) Disclosed in this report any change in the registrant's internal control over
financial reporting that occurred during the registrant's most recent fiscal
quarter (the registrant's fourth fiscal quarter in the case of an annual report)
that has materially affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation of internal control over financial reporting, to the
registrant's auditors and the audit committee of the registrant's board of
directors:
a) All significant deficiencies and material weaknesses in the design or
operation of internal control over financial reporting which are reasonably
likely to adversely affect the registrant's ability to record, process,
summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal control over
financial reporting.
Date: February 26, 2009
/s/ Patrick Scanlon
- -------------------
Patrick Scanlon
Senior Vice President, Finance Division Head
60
<Page>61
CERTIFICATION OF PERIODIC FINANCIAL REPORT PURSUANT TO SECTION 906
OF THE SARBANES-OXLEY ACT OF 2002
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (subsection (a) and
(b) of Section 1350, Chapter 63 of Title 18, United States Code), the
undersigned officer of Penseco Financial Services Corporation (the "Company")
certifies to his knowledge that:
(1) The Annual Report on Form 10-K of the Company for the year ended December
31, 2008 (the "Form 10-K") fully complies with the requirements of Section 13(a)
or 15(d) of the Securities Exchange Act of 1934 (the "Act"); and
(2) The information contained in the Form 10-K fairly presents, in all material
respects, the financial conditions and results of operations of the Company as
for the dates and for the periods referred to in the Form 10-K.
/s/ Craig W. Best
- -------------------
Craig W. Best
President and CEO
February 26, 2009
CERTIFICATION OF PERIODIC FINANCIAL REPORT PURSUANT TO SECTION 906
OF THE SARBANES-OXLEY ACT OF 2002
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (subsection (a) and
(b) of Section 1350, Chapter 63 of Title 18, United States Code), the
undersigned officer of Penseco Financial Services Corporation (the "Company")
certifies to his knowledge that:
(1) The Annual Report on Form 10-K of the Company for the year ended December
31, 2008 (the "Form 10-K") fully complies with the requirements of Section 13(a)
or 15(d) of the Securities Exchange Act of 1934 (the "Act"); and
(2) The information contained in the Form 10-K fairly presents, in all material
respects, the financial conditions and results of operations of the Company as
for the dates and for the periods referred to in the Form 10-K.
/s/ Patrick Scanlon
- -------------------
Patrick Scanlon
Senior Vice President, Finance Division Head
February 26, 2009
61