Exhibit 13
Orrstown Financial Services, Inc.
2004 Annual Financial Report
C O N T E N T S
Page
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM 1
MANAGEMENT'S REPORT ON INTERNAL CONTROL 3
CONSOLIDATED FINANCIAL STATEMENTS
Balance sheets 4
Statements of income 5
Statements of changes in shareholders' equity 6
Statements of cash flows 7
Notes to consolidated financial statements 8 - 23
MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED
FINANCIAL CONDITION AND RESULTS OF OPERATIONS 24 - 33
SUMMARY OF QUARTERLY FINANCIAL DATA 33
SELECTED FIVE-YEAR FINANCIAL DATA 34
MARKET, DIVIDEND AND INVESTOR INFORMATION 35
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
Orrstown Financial Services, Inc.
We have audited the accompanying consolidated balance sheets of
Orrstown Financial Services, Inc. and its wholly-owned subsidiaries as of
December 31, 2004 and 2003, and the related statements of income, changes in
shareholders' equity, and cash flows for each of the years in the three-year
period ended December 31, 2004. We also have audited management's assessment,
included in the accompanying Management's Report on Internal Control, that
Orrstown Financial Services, Inc. and its wholly-owned subsidiaries maintained
effective internal control over financial reporting as of December 31, 2004,
based on criteria established in Internal Control - Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Orrstown Financial Services, Inc. and its wholly-owned subsidiaries management
is responsible for these financial statements, for maintaining effective
internal control over financial reporting, and for its assessment of the
effectiveness of internal control over financial reporting. Our responsibility
is to express an opinion on these financial statements, an opinion on
management's assessment, and an opinion on the effectiveness of the company's
internal control over financial reporting 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 audits to obtain reasonable assurance about whether the
financial statements are free of material misstatement and whether effective
internal control over financial reporting was maintained in all material
respects. Our audit of financial statements included examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
Our audit of internal control over financial reporting included obtaining an
understanding of internal control over financial reporting, evaluating
management's assessment, testing and evaluating the design and operating
effectiveness of internal control, and performing such other procedures as we
considered necessary in the circumstances. We believe that our audits provide a
reasonable basis for our opinions.
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 (1)
pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the company;
(2) 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 (3) 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, the financial statements referred to above present
fairly, in all material respects, the financial position of Orrstown Financial
Services, Inc. and its wholly-owned subsidiaries as of December 31, 2004 and
2003, and the results of their operations and their cash flows for each of the
years in the three-year period ended December 31, 2004 in conformity with
accounting principles generally accepted in the United States of America. Also,
in our opinion, management's assessment that Orrstown Financial Services, Inc.
and its wholly-owned subsidiaries maintained effective internal control over
financial reporting as of December 31, 2004 is fairly stated, in all material
respects, based on criteria established in Internal Control - Integrated
Framework issued by COSO. Furthermore, in our opinion, Orrstown Financial
Services, Inc. and its wholly-owned subsidiaries maintained, in all material
respects, effective internal control over financial reporting as of December 31,
2004, based on criteria established in Internal Control - Integrated Framework
issued by COSO.
/S/ Smith Elliott Kearns & Company, LLC
Smith Elliott Kearns & Company, LLC
Chambersburg, Pennsylvania
February 11, 2005
MANAGEMENT'S REPORT ON INTERNAL CONTROL
To our shareholders,
Orrstown Financial Services, Inc.
Shippensburg, Pennsylvania
The management of Orrstown Financial Services, Inc. and its wholly-owned
subsidiaries has the responsibility for establishing and maintaining an adequate
internal control structure and procedures for financial reporting. Management
maintains a comprehensive system of internal control to provide reasonable
assurance of the proper authorization of transactions, the safeguarding of
assets and the reliability of the financial records. The system of internal
control provides for appropriate division of responsibility and is documented by
written policies and procedures that are communicated to employees. Orrstown
Financial Services, Inc. and its wholly-owned subsidiaries maintains an internal
auditing program, under the supervision of the Audit Committee of the Board of
Directors, which independently assesses the effectiveness of the system of
internal control and recommends possible improvements.
Under the supervision and with the participation of the Corporation's
management, including its Chief Executive Officer and Chief Financial Officer,
the Corporation has evaluated the effectiveness of its internal control over
financial reporting as of December 31, 2004, using the Internal Control -
Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission. Based upon this evaluation, the Chief Executive Officer
and the Chief Financial Officer have concluded that the Corporation's disclosure
controls and procedures are adequate and effective to ensure that material
information relating to the Corporation and its consolidated subsidiaries is
made known to them by others within those entities. The Chief Executive Officer
and the Chief Financial Officer believe that at December 31, 2004, Orrstown
Financial Services, Inc. and its wholly-owned subsidiaries maintained an
effective system of internal control over financial reporting.
The accounting firm Smith Elliott Kearns & Company, LLC has issued an
attestation report on management's assessment of the Corporation's internal
control over financial reporting. The accounting firm's attestation report is
included in this financial report.
/S/ Kenneth R. Shoemaker /S/ Bradley S. Everly
Kenneth R. Shoemaker Bradley S. Everly
President and Chief Executive Officer Senior Vice President and Chief
Financial Officer
February 11, 2005
CONSOLIDATED BALANCE SHEETS
ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARIES
At December 31,
(Dollars in Thousands) 2004 2003
Assets
Cash and due from banks $ 11,456 $ 12,283
Federal funds sold 8,393 3,829
Interest bearing deposits with banks 1,124 1,001
Securities available for sale 79,829 89,074
Federal Home Loan Bank, Federal Reserve and
Atlantic Central Bankers Bank Stock, at cost
which approximates market value
2,972 2,912
----------------- ------------------
103,774 109,099
----------------- ------------------
Loans
Commercial, financial and agricultural 38,659 38,186
Real estate - Mortgages 324,703 277,985
Real estate - Construction and land development 18,744 21,016
Consumer 7,162 7,867
----------------- ------------------
389,268 345,054
Less: Allowance for loan losses (4,318) (4,161)
----------------- ------------------
Net Loans 384,950 340,893
----------------- ------------------
Premises and equipment, net 13,222 11,168
Accrued interest receivable 1,775 1,647
Cash surrender value of life insurance 7,516 7,234
Other assets 3,414 2,352
------------------ ------------------
Total assets $ 514,651 $ 472,393
----------------- ------------------
Liabilities and Shareholders' Equity
Deposits:
Non-interest bearing $ 66,784 $ 52,276
Interest bearing 338,579 306,367
----------------- ------------------
Total deposits 405,363 358,643
----------------- ------------------
Short-term borrowings 19,493 29,440
Long-term debt 35,569 37,193
Accrued interest and other liabilities 4,976 4,282
------------------ ------------------
Total liabilities 465,401 429,558
----------------- ------------------
Common stock, no par value - $ .05205 stated
value
per share 50,000,000 shares authorized with
5,126,205 shares issued at December 31, 2004
and $.1041 stated value per share 10,000,000
shares authorized with 2,537,011 shares
issued at December 31, 2003
267 264
Additional paid - in capital 34,434 32,928
Retained earnings 13,723 8,509
Accumulated other comprehensive income 826 1,134
------------------ ------------------
Total shareholders' equity 49,250 42,835
----------------- ------------------
Total liabilities and shareholders' equity $ 514,651 $ 472,393
------------------ ------------------
The Notes to Consolidated Financial Statements are an integral part of these
statements.
CONSOLIDATED STATEMENTS OF INCOME
ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED
SUBSIDIARIES
Years Ended December 31,
(Dollars in Thousands) 2004 2003 2002
Interest and dividend income
Interest and fees on loans $ 22,231 $ 19,610 $ 18,635
Interest and dividends on investment
securities
U.S. Government and agency 2,083 2,141 2,583
Tax exempt 1,206 1,335 1,370
Other investment income 372 398 585
------------- ------------ ------------
Total interest and dividend income 25,892 23,484 23,173
------------- ------------ ------------
Interest expense
Interest on deposits 5,201 5,015 6,069
Interest on borrowed money 1,785 1,742 1,916
------------- ------------ ------------
Total interest expense 6,986 6,757 7,985
------------- ------------ ------------
Net interest income 18,906 16,727 15,188
Provision for loan losses 210 491 720
------------- ------------ ------------
Net interest income after provision for loan 18,696 16,236 14,468
losses
------------- ------------ ------------
Other income
Service charges on deposit accounts 3,066 2,628 2,257
Other service charges, commissions and fees 1,016 1,238 914
Trust department income 1,863 1,463 1,386
Brokerage income 608 485 394
Investment securities gains 88 199 21
Other income 328 419 388
------------- ------------ ------------
Total other income 6,969 6,432 5,360
------------- ------------ ------------
Other expenses
Salaries 5,117 4,456 4,035
Employee benefits 2,792 2,331 1,958
Occupancy and equipment 2,398 2,109 1,800
Other operating expenses 4,411 4,114 3,895
------------- ------------ ------------
Total other expense 14,718 13,010 11,688
------------- ------------ ------------
Income before income tax 10,947 9,658 8,140
Income tax expenses 3,177 2,678 2,225
------------- ------------ ------------
Net income $ 7,770 $ 6,980 $ 5,915
------------- ------------ ------------
Earnings per share
Basic earnings per share $ 1.52 $ 1.38 $ 1
.18
Weighted average number of shares 5,106,683 5,054,370 5,020,288
outstanding
Diluted earnings per share $ 1.47 $ 1.34 $ 1.15
Weighted average number of shares 5,294,165 5,215,538 5,133,363
outstanding
Dividends per share $ 0.50 $ 0.42 $ 0.34
The Notes to Consolidated Financial Statements are an integral part of these
statements.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARIES
Years Ended December 31, 2004, 2003 and 2002
Accumulated
Additional Other Total
Common Paid-In Retained Comprehensive Shareholders'
(Dollars in thousands) Stock Capital Earnings Income Equity
Balance, December 31, 2001 $ 248 $ 25,077 $ 5,557 $ 280 $ 31,162
Comprehensive income
Net income 0 0 5,915 0 5,915
Change in unrealized gain on
investment securities available
for sale, net of tax of $ 911 0 0 0 1,769 1,769
----------
Total comprehensive income 7,684
----------
Cash dividends ($.34 per share) 0 0 ( 1,722) 0 ( 1,722)
Issuance of stock through
employee stock purchase plan/
stock option plan 0 71 0 0 71
Issuance of stock through
dividend reinvestment plan 2 765 0 0 767
---------- ---------- ---------- ---------- ----------
Balance, December 31, 2002 250 25,913 9,750 2,049 37,962
Comprehensive income
Net income 0 0 6,980 0 6,980
Change in unrealized loss on
investment securities available
for sale, net of tax of $ 471 0 0 0 ( 915) ( 915)
----------
Total comprehensive income 6,065
----------
Cash dividends ($.42 per share) 0 0 ( 2,126) 0 ( 2,126)
Stock dividends issued 12 6,061 ( 6,073) 0 0
Cash paid in lieu of fractional
stock dividends 0 0 ( 22) 0 ( 22)
Issuance of stock through
employee stock purchase plan/
stock option plan 1 205 0 0 206
Issuance of stock through
dividend reinvestment plan 1 749 0 0 750
---------- ---------- ---------- ---------- ----------
Balance, December 31, 2003 264 32,928 8,509 1,134 42,835
Comprehensive income
Net income 0 0 7,770 0 7,770
Change in unrealized loss on
investment securities available
for sale, net of tax of $ 159 0 0 0 ( 308) ( 308)
----------
Total comprehensive income 7,462
----------
Cash dividends ($.50 per share) 0 0 ( 2,556) 0 ( 2,556)
Issuance of stock through
employee stock purchase plan/
stock option plan 2 591 0 0 593
Issuance of stock through
dividend reinvestment plan 1 915 0 0 916
---------- ---------- ---------- ---------- ----------
Balance, December 31, 2004 $ 267 $ 34,434 $ 13,723 $ 826 $ 49,250
---------- ---------- ---------- ---------- ----------
The Notes to Consolidated Financial Statements are an integral part of these
statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARIES
Years Ended December 31,
(Dollars in Thousands) 2004 2003 2002
Cash flows from operating activities
Net income $ 7,770 $ 6,980 $ 5,915
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 1,197 1,013 874
Provision for loan losses 210 491 720
(Gain) loss on disposal of other real estate owned 45 (6) (3)
(Gain) loss on disposal of bank premises and (6) 0 2
equipment
Deferred income taxes 28 (110) (131)
Investment securities (gains) (88) (199) (21)
Increase in cash surrender value of life insurance (282) (318) (312)
(Increase) in accrued interest receivable (128) (41) (64)
Increase (decrease) in accrued interest payable 34 (6) (107)
Other, net 589 555 526
Net cash provided by operating activities 9,369 8,359 7,399
Cash flows from investing activities
Net (increase) decrease in interest bearing deposits (123) 94 (416)
with banks
Sales of available for sale securities 6,407 20,839 1,223
Maturities of available for sale securities 17,518 30,480 21,754
Purchases of available for sale securities (15,101) (51,475) (41,961)
Net (purchases) of FHLB Stock (60) (644) (565)
Net (increase) in loans (44,328) (63,811) (31,725)
Purchases of bank premises and equipment (3,182) (2,261) (1,641)
Purchases of intangible assets (1,155) 0 0
Proceeds from disposal of other real estate owned 228 89 64
Proceeds from disposal of bank premises and equipment 61 0 7
Investment in cash surrender value life insurance 0 0 (682)
Policies
Net cash (used) by investing activities (39,735) (66,689) (53,942)
Cash flows from financing activities
Net increase in deposits 46,720 39,475 38,000
Net increase (decrease) in short term purchased funds (9,947) 8,632 (10,723)
Proceeds from debt 0 10,000 5,026
Payments on debt (1,624) (1,346) (3,000)
Cash dividends paid (2,556) (2,126) (1,722)
Cash paid in lieu of fractional shares 0 (22) 0
Proceeds from sale of stock 1,510 956 838
Net cash provided by financing activities 34,103 55,569 28,419
Net increase (decrease) in cash and cash equivalents 3,737 (2,761) (18,124)
Cash and cash equivalents at beginning of period 16,112 18,873 36,997
Cash and cash equivalents at end of period $ 19,849 $ 16,112 $ 18,873
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest $ 6,952 $ 6,763 $ 8,092
Income Taxes 3,205 2,650 2,375
Supplemental schedule of noncash investing and financing activities:
Other real estate acquired in settlement of loans 61 83 61
Unrealized gain (loss) on investments securities (308) (915) 1,769
available for sale (net of tax effects)
The Notes to Consolidated Financial Statements are an integral part of these
statements.
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of operations
Orrstown Financial Services, Inc. (the Corporation) is a financial holding
company whose primary activity consists of supervising its wholly-owned
subsidiaries, Orrstown Bank and Pennbanks Insurance Company Cell P1. The
Corporation operates through its office in Shippensburg, Pennsylvania. Orrstown
Bank (the Bank) provides services through its network of offices in South
Central Pennsylvania, principally Franklin and Cumberland Counties. The Bank
engages in lending services for commercial loans, residential loans, commercial
mortgages and various forms of consumer lending. Deposit services include
checking, savings, time and money market deposits. The Bank also provides
investment and brokerage services through its Investment Services Department.
Its fourteen branches are located in Shippensburg (2), Carlisle (4), Spring Run,
Orrstown, Chambersburg (4), Mechanicsburg and Greencastle, Pennsylvania.
Pennbanks Insurance Company Cell P1 is a reinsurer of credit, life, and
disability insurance which services customers of Orrstown Bank. The Corporation
and its subsidiaries are subject to the regulation of certain Federal and state
agencies and undergo periodic examinations by such regulatory authorities.
Principles of consolidation
The consolidated financial statements include the accounts of the Corporation
and its wholly-owned subsidiaries, Orrstown Bank and Pennbanks Insurance Company
Cell P1. All significant intercompany transactions and accounts have been
eliminated.
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 allowance
for losses on loans and foreclosed real estate, management obtains independent
appraisals for significant properties.
While management uses available information to recognize losses on loans and
foreclosed real estate; future additions to the allowances may be necessary
based on changes in local economic conditions. In addition, regulatory
agencies, as an integral part of their examination process, periodically review
the Corporation's allowance for losses on loans and foreclosed real estate.
Such agencies may require the Corporation to recognize additions to the
allowance based on their judgments about information available to them at the
time of their examination. Because of these factors, management's estimate of
credit losses inherent in the loan portfolio and the related allowance may
change in the near term.
Investment securities
Under generally accepting accounting principles, the Corporation may segregate
their investment portfolio into three specific categories: "securities held to
maturity", "trading securities" and "securities available for sale". Securities
held to maturity are to be accounted for at their amortized cost; securities
classified as trading securities are to be accounted for at their current market
value with unrealized gains and losses on such securities included in current
period earnings; and securities classified as available for sale are to be
accounted for at their current market value with unrealized gains and losses on
such securities to be excluded from earnings and reported as a net amount in
other comprehensive income.
Management determines the appropriate classification of securities at the time
of purchase. If management has the intent and the Corporation has the ability
at the time of purchase to hold securities until maturity, they are classified
as securities held to maturity and carried at amortized historical cost.
Securities to be held for indefinite periods of time and not intended to be held
to maturity are classified as available for sale and carried at fair value.
Securities held for indefinite periods of time include securities that
management intends to use as part of its asset and liability management strategy
and that may be sold in response to changes in interest rates, resultant
prepayment risk and other factors related to interest rate and resultant
prepayment risk changes.
The Corporation has classified all of its investment securities as "available
for sale".
Realized gains and losses on dispositions are based on the net proceeds and
the adjusted book value of the securities sold, using the specific
identification method. Unrealized gains and losses on investment securities
available for sale are based on the difference between book value and fair value
of each security. These gains and losses are credited or charged to other
comprehensive income, whereas realized gains and losses flow through the
Corporation's results of operations.
Cash flows
For purposes of the Statements of Cash Flows, the Corporation has defined cash
and cash equivalents as those amounts included in the balance sheet captions
"Cash and due from banks" and "Federal funds sold". The Corporation has elected
to present the net increase or decrease in deposits with banks, loans, and
deposits in the Statements of Cash Flows.
Premises, equipment, furniture and fixtures and depreciation
Buildings, improvements, equipment, furniture and fixtures are carried at cost
less accumulated depreciation. Depreciation has been provided generally on the
straight-line method and is computed over the estimated useful lives of the
various assets as follows: building and improvements, 10 to 40 years,
equipment, furniture and fixtures 3 to 15 years, and computer software is
amortized over 3-5 years. Repairs and maintenance are charged to operations as
incurred, while major additions and improvements are capitalized. Gain or loss
on retirement or disposal of individual assets is recorded as income or expense
in the period of retirement or disposal.
Goodwill and identifiable intangible assets
The cost of acquired companies in excess of their fair value of the net asset
at the date of acquisition is recorded as goodwill. Identifiable intangible
assets relate to acquisitions of deposits from other banks and the purchase of
an investment management business. Goodwill is evaluated annually for
impairment and other intangible assets are amortized over the life of the asset
or 15 years.
Advertising
The Corporation follows the policy of charging costs of advertising to expense
as incurred. Advertising expense was $291,000, $267,000, and $218,000, for the
years ended December 31, 2004, 2003, and 2002, respectively.
Loans and allowance for loan losses
Loans are stated at the amount of unpaid principal, reduced by an allowance
for loan losses. Interest on loans is calculated by using the simple interest
method on daily balances of the principal amount outstanding. The allowance for
loan losses is established through a provision for loan losses charged to
expense. Loans are charged against the allowance when management believes that
the collectibility of the principal is unlikely. Subsequent recoveries, if any,
are credited to the allowance. The allowance is an amount that management
believes will be adequate to absorb possible losses on existing loans that may
become uncollectible. Evaluations of the allowance and collectibility of loans
are made on a quarterly basis by management and are guided by the Corporation's
policies. The evaluations take into consideration such factors as prior loan
loss experience, changes in the nature and volume of the loan portfolio, overall
portfolio quality, review of specific problem loans, and current economic
conditions that may affect the borrowers' ability to pay. This evaluation is
inherently subjective as it requires estimates that are susceptible to
significant revision as additional information becomes available. An
unallocated component is maintained in the allowance to cover uncertainties
inherent in management's underlying assumptions used to estimate probable
losses.
Nonaccrual / Impaired loans
The accrual of interest income on loans ceases when principal or interest is
past due 90 days or more and collateral is inadequate to cover principal and
interest or immediately if, in the opinion of management, full collection is
unlikely. Interest accrued but not collected as of the date of placement on
nonaccrual status is reversed and charged against current income unless fully
collateralized. Subsequent payments received either are applied to the
outstanding principal balance or recorded as interest income, depending upon
management's assessment of the ultimate collectibility of principal. Interest
income generally is not recognized on specific impaired loans unless the
likelihood of further loss is remote. Interest payments received on such loans
are applied as a reduction of loan principal balance. Interest income on
impaired loans is recognized only to the extent of interest payments received.
Foreclosed real estate
Real estate properties acquired through, or in lieu of, loan foreclosure are
to be sold and are initially recorded at the lower of carrying value or fair
value less estimated costs to sell the underlying collateral. After
foreclosure, valuations are periodically performed by management and the real
estate is carried at the lower of carrying amount or fair value less estimated
cost to sell.
Earnings per share of common stock
Earnings per share is calculated as net income divided by the weighted average
number of shares outstanding, after giving retroactive recognition to a 5% stock
dividend paid May 2003 and a two-for-one stock split effective February 2004.
For diluted net income per share, net income is divided by the weighted average
of shares outstanding plus the incremental number of shares added as a result of
converting common stock equivalents. The Corporation's common stock equivalents
consist of outstanding stock options.
A reconciliation of the weighted average shares outstanding used to calculate
basic net income per share and diluted net income per share follows. There is
no adjustment to net income to arrive at diluted net income per share.
2004 2003 2002
Weighted average shares outstanding (basic) 5,106,683 5,054,370 5,020,288
Impact of common stock equivalents 187,482 161,168 113,075
---------- ---------- ----------
Weighted average shares outstanding (diluted) 5,294,165 5,215,538 5,133,363
Stock-Based Compensation
The Corporation grants stock options for a fixed number of shares to directors
and employees with an exercise price equal to the fair value of the shares at
the date of grant. The Corporation accounts for stock option grants using the
intrinsic-value method in accordance with APB Opinion No. 25, "Accounting for
Stock Issued to Employees" and related Interpretations. Under the intrinsic-
value method, because the exercise price of the Corporation's employee stock
options is more than or equals the market price of the underlying stock on the
date of grant, no compensation expense is recognized. See Note 10 for the
proforma effect on net income and earnings per share as if the Corporation had
applied the fair value recognition provisions of FASB Statement 123, "Accounting
for Stock-Based Compensation" to stock-based employee compensation.
Federal income taxes
For financial reporting purposes the provision for loan losses charged to
operating expense is based on management's judgment, whereas for federal income
tax purposes, the amount allowable under present tax law is deducted. Deferred
compensation is charged to operating expense in the period the liability is
incurred for financial reporting purposes, whereas for federal income tax
purposes, these expenses are deducted when paid. Amortization of goodwill is
not deducted unless the asset is considered impaired for financial reporting
purposes and is deducted on a straight line basis over a fifteen year life for
federal income tax purposes. As a result of these and timing differences in
depreciation expense, deferred income taxes are provided for in the financial
statements. See Note 11 for further details.
Fair values of financial instruments
The Corporation meets the requirements for disclosure of fair value
information about financial instruments, whether or not recognized in the
balance sheet. In cases where quoted market prices are not available, fair
values are based on estimates using present value or other valuation techniques.
Those techniques are significantly affected by the assumptions used, including
the discount rate and estimates of future cash flows. In that regard, the
derived fair value estimates cannot be substantiated by comparison to
independent markets and, in many cases, could not be realized in immediate
settlement of the instruments. Certain financial instruments and all non-
financial instruments are excluded from disclosure requirements. Accordingly,
the aggregate fair value amounts presented do not represent the underlying value
of the Corporation.
The following methods and assumptions were used by the Corporation in
estimating fair values of financial instruments as disclosed herein:
Cash, Due from Banks, Short-Term Investments, and Federal Funds Sold. The
carrying amounts of cash, due from banks, short-term investments, and federal
funds sold approximate their fair value.
Securities Available for Sale. Fair values for investment securities are based
on quoted market prices.
Loans Receivable. For variable-rate loans that reprice frequently and have no
significant change in credit risk, fair values are based on carrying values.
Fair values for fixed rate loans are estimated using discounted cash flow
analyses, using interest rates currently being offered for loans with similar
terms to borrowers of similar credit quality. Fair values for impaired loans
are estimated using discounted cash flow analyses or underlying collateral
values, where applicable.
Deposit Liabilities. The fair values disclosed for demand deposits are, by
definition, equal to the amount payable on demand at the reporting date (that
is, their carrying amounts). The carrying amounts of variable-rate, fixed-term
money market accounts and certificates of deposit approximate their fair values
at the reporting date. Fair values for fixed-rate certificates of deposits and
IRA's are estimated using a discounted cash flow calculation that applies
interest rates currently being offered to a schedule of aggregated expected
maturities on time deposits.
Short-Term Borrowings. The carrying amounts of federal funds purchased,
borrowings under repurchase agreements, and other short-term borrowings maturing
within 90 days approximate their fair values. Fair values of other short-term
borrowings are estimated using discounted cash flow analyses based on the
Corporation's current incremental borrowing rates for similar types of borrowing
arrangements.
Long-Term Borrowings. The fair value of the Corporation's long-term debt is
estimated using a discounted cash flow analysis based on the Corporation's
current incremental borrowing rate for similar types of borrowing arrangements.
Accrued Interest. The carrying amounts of accrued interest approximate their
fair values.
Off-Balance-Sheet Instruments. The Corporation generally does not charge
commitment fees. Fees for standby letters of credit and other off-balance-sheet
instruments are not significant.
Comprehensive income
Under generally accepted accounting principles, comprehensive income is
defined as the change in equity from transactions and other events from non-
owner sources. It includes all changes in equity except those resulting from
investments by shareholders and distributions to shareholders. Comprehensive
income includes net income and certain elements of "other comprehensive income"
such as foreign currency transactions; accounting for futures contracts;
employers accounting for pensions; and accounting for certain investments in
debt and equity securities.
The Corporation has elected to report its comprehensive income in the
statement of changes in shareholders' equity. The only element of "other
comprehensive income" that the Corporation has is the unrealized gain or loss on
available for sale securities.
The components of the change in net unrealized gains (losses) on securities
were as follows:
(Dollars in thousands) 2004 2003 2002
Gross unrealized holding gains (losses) arising during the year ($ 379) ($ 1,187) $ 2,701
Reclassification adjustment for (gains) losses realized in net ( 88) ( 199) ( 21)
income
---------- ---------- ----------
Net unrealized holding gains (losses) before taxes ( 467) ( 1,386) 2,680
Tax effect 159 471 ( 911)
---------- ---------- ----------
Net change ($ 308) ($ 915) $ 1,769
---------- ---------- ----------
NOTE 2. INVESTMENTS
At December 31, 2004 and 2003 the investment securities portfolio was
comprised of securities classified as "available for sale", resulting in
investment securities being carried at fair value.
The amortized cost and fair values of investment securities available for sale
at December 31 were:
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
(Dollars in thousands) 2004
U. S. Treasury securities and obligations of U.S.
Government corporations and agencies $ 12,370 $ 38 $ 70 $ 12,338
Obligations of states and political subdivisions 23,885 1,001 56 24,830
Mortgage-backed securities 39,663 236 261 39,638
Equity securities 2,660 401 38 3,023
---------- ------------ ----------- -------------
Totals $ 78,578 $ 1,676 $ 425 $ 79,829
---------- ---------- ---------- ----------
2003
U. S. Treasury securities and obligations of U.S.
Government corporations and agencies $ 15,050 $ 51 $ 115 $ 14,986
Obligations of states and political subdivisions 22,022 1,185 3 23,204
Mortgage-backed securities 45,867 448 186 46,129
Corporate bonds 1,945 0 18 1,927
Equity securities 2,472 395 39 2,828
---------- ---------- ---------- ----------
Totals $ 87,356 $ 2,079 $ 361 $ 89,074
---------- ---------- ---------- ----------
NOTE 2. INVESTMENTS (Continued)
The following table shows gross unrealized losses and fair value, aggregated
by investment category and length of time that individual securities have been
in a continuous unrealized loss position, at December 31, 2004
Less Than 12 Months 12 Months or More Total
Fair Unrealized Fair Unrealized Fair Unrealized
(Dollars in thousands) Value Losses Value Losses Value Losses
U. S. Treasury securities and
obligations of U. S. Government
corporations and agencies $ 8,322 $ 68 $ 26 $ 2 $ 8,348 $ 70
Obligations of states and political 1,740 51 495 5 2,235 56
subdivisions
Mortgage-backed securities 15,531 94 8,392 167 23,923 261
---------- ---------- ---------- ---------- --------- ---------
Total debt securities 25,593 213 8,913 174 34,506 387
---------- ---------- ---------- ---------- --------- ---------
Equity securities 127 13 27 25 154 38
---------- ---------- ---------- ---------- --------- ---------
Total temporarily impaired securities $ 25,720 $ 226 $ 8,940 $ 199 $ 34,660 $ 425
---------- ---------- ---------- ---------- --------- ---------
The above table represents thirty-eight investment securities where the
current fair value is less than the related amortized cost. Management believes
the impairments to be temporary in all cases. Consideration is given to the
length of time and the extent to which the fair value has been less than cost,
the financial condition and near-term prospects of the issuer, and the intent
and ability of the Corporation to retain its investment in the issuer for a
period of time sufficient to allow for any anticipated recovery in fair value.
At December 31, 2004, sixteen issues of mortgage-backed securities have
unrealized losses. Of these, nine issues have been in a loss position for
twelve months or more. Five issues were purchased in the previous year in a
lower rate environment creating a lower current yield. Four issues are nearing
payoff which lowers their market value.
Three issues of state and political subdivision have unrealized losses with
one issue in a loss position for twelve months or more. Six issues of US
Treasury bonds have unrealized losses with one issue in a loss position for
twelve months or more. The one state and political bond and the one US Treasury
bond were purchased in a lower rate environment in the prior year. As
management has the ability to hold these securities until maturity, or for the
foreseeable future, no decline is deemed to be other than temporary.
At December 31, 2004, thirteen marketable equity securities have unrealized
losses with four issues in a loss position for twelve months or more. Although
their prices have fluctuated, the price has been higher in the past fifty-two
week period. Since the past two year chart has been generally up, there is
certainly the possibility of price appreciation in the stock moving forward.
These impairments are considered temporary due to the tremendous potential of
the technology sector and our belief that these investments could rebound.
The amortized cost and fair values of investment securities available for sale
at December 31, 2004, by contractual maturity are shown below. Contractual
maturities will differ from expected maturities because borrowers may have the
right to call or prepay obligations with or without call or prepayment
penalties.
Amortized Fair
(Dollars in thousands) Cost Value
Due in one year or less $ 902 $ 913
Due after one year through five years 12,343 12,312
Due after five years through ten years 2,018 2,117
Due after ten years 20,992 21,826
Mortgage-backed securities 39,663 39,638
Equity securities 2,660 3,023
------------ ------------
$ 78,578 $ 79,829
------------ ------------
Proceeds from sales of securities available for sale for the years ended
December 31, 2004, 2003, and 2002, were $6,407,000, $ 20,839,000 and
$ 1,223,000, respectively. Gross gains and losses on 2004 sales were $ 164,013
and $ 75,959 respectively. Gross gains and losses on 2003 sales were $ 525,612
and $ 326,485, respectively. Gross gains and losses on 2002 sales were $ 65,533
and $ 44,872, respectively.
The Corporation owned $ 2,728,900 of Federal Home Loan Bank stock, $ 54,000 of
Atlantic Central Bankers Bank stock and $ 189,000 of Federal Reserve Bank stock
at December 31, 2004. At December 31, 2003 the Corporation's stock ownership
was $ 2,668,800 of Federal Home Loan Bank stock, $ 54,000 of Atlantic Central
Bankers Bank stock and $189,000 of Federal Reserve Bank stock. Market value
approximates cost since none of the stocks are actively traded.
Securities with a market value of $ 62,201,000 and $ 70,143,000 at
December 31, 2004 and 2003, respectively, were pledged to secure public funds
and for other purposes as required or permitted by law.
NOTE 3. CONCENTRATION OF CREDIT RISK
The Corporation grants agribusiness, commercial, residential and consumer
loans to customers in South Central Pennsylvania, principally Franklin and
Cumberland Counties. Although the Corporation maintains a diversified loan
portfolio, a significant portion of its customers' ability to honor their
contracts is dependent upon economic sectors for construction contractors, non-
residential building operators, sales finance, sub-dividers and developers.
Management evaluates each customer's creditworthiness on a case-by-case basis.
The amount of collateral obtained, if deemed necessary by the Corporation upon
the extension of credit, is based on management's credit evaluation of the
customer. Collateral held varies but generally includes equipment and real
estate.
NOTE 4. ALLOWANCE FOR LOAN LOSSES
Activity in the allowance for loan losses is summarized as follows:
(Dollars in thousands) 2004 2003 2002
Balance at beginning of period $ 4,161 $ 3,734 $ 3,104
Recoveries 32 17 11
Provision for loan losses charged to income 210 491 720
------------ ------------ ------------
Total 4,403 4,242 3,835
Losses 85 81 101
------------ ------------ ------------
Balance at end of period $ 4,318 $ 4,161 $ 3,734
------------ ------------ ------------
NOTE 5. LOANS TO RELATED PARTIES
The Corporation has granted loans to the officers and directors of the
Corporation and its subsidiary and to their associates. Related party loans are
made on substantially the same terms, including interest rates and collateral,
as those prevailing at the time for comparable transactions with unrelated
persons and do not involve more than normal risk of collectibility. The
aggregate dollar amount of these loans was $ 2,637,000 at December 31, 2004, and
$ 2,630,000 at December 31, 2003. During 2004, $ 1,114,000 of new advances were
made and repayments totaled $ 1,107,000. Outstanding loans to employees totaled
$ 2,323,000 and $ 2,218,000 at December 31, 2004 and 2003, respectively.
NOTE 6. DELINQUENT AND NONACCRUAL LOANS
Loans 90 days or more past due (still accruing interest) were as follows at
December 31:
(Dollars in thousands) 2004 2003 2002
Commercial, financial and agricultural $ 0 $ 12 $ 190
Real estate 2,541 2,716 1,245
Consumer 9 15 11
----------- ----------- -----------
Total $ 2,550 $ 2,743 $ 1,446
----------- ----------- -----------
The following table shows the principal balances of nonaccrual loans as of
December 31:
(Dollars in thousands) 2004 2003 2002
Nonaccrual loans $ 314 $ 130 $ 85
----------- ----------- -----------
Interest income that would have been accrued
at original contract rates 31 12 9
Amount recognized as interest income 13 0 2
----------- ----------- -----------
Foregone revenue $ 18 $ 12 $ 7
----------- ----------- -----------
The Corporation had no impairment of loans as of December 31, 2004, 2003, and
2002.
During 2004, the Corporation foreclosed on loans secured by one real estate
property. This property was sold during 2004 at a gain of $ 6,166. A property
that was obtained through foreclosure during 2001 was sold in 2004 for a loss of
$51,517. Both of these amounts are included in other income on the statements
of income. Gains from sales of foreclosed property for the years ended December
31, 2003 and 2002 were $ 5,764 and $ 2,736, respectively. At December 31, 2004,
the Corporation was not holding any properties obtained through foreclosure on
the balance sheet.
NOTE 7. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK
The Corporation is a party to financial instruments with off-balance-sheet
risk in the normal course of business to meet the financial needs of its
customers and to reduce its own exposure to fluctuations in interest rates.
These financial instruments include commitments to extend credit and standby
letters of credit. Those instruments involve, to varying degrees, elements of
credit and interest rate risk in excess of the amount recognized in the balance
sheets. The contract amounts of those instruments reflect the extent of
involvement the Corporation has in particular classes of financial instruments.
The Corporation's exposure to credit loss in the event of nonperformance by
the other party to the financial instrument for commitments to extend credit and
standby letters of credit and financial guarantees written is represented by the
contractual amount of those instruments. The Corporation uses the same credit
policies in making commitments and conditional obligations as it does for on-
balance-sheet instruments.
Contract or
Notional Amount
(Dollars in thousands) 2004 2003
Financial instruments whose contract amounts
represent credit risk at December 31:
Commitments to extend credit $ 108,840 $ 86,481
Standby letters of credit and financial
guarantees written 10,610 9,469
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. Since many of the commitments are expected to expire
without being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements. The Corporation evaluates each customer's
credit-worthiness on a case-by-case basis. The amount of collateral obtained,
if deemed necessary by the Corporation upon extension of credit, is based on
management's credit evaluation of the customer. Collateral held varies but may
include accounts receivable, inventory, real estate, equipment, and income-
producing commercial properties.
Standby letters of credit and financial guarantees written are conditional
commitments issued by the Corporation to guarantee the performance of a customer
to a third party. Those guarantees are primarily issued to support public and
private borrowing arrangements. The credit risk involved in issuing letters of
credit is essentially the same as that involved in extending loans to customers.
The Corporation holds collateral supporting those commitments when deemed
necessary by management.
During 2004, the Corporation entered into purchase commitments of $ 1,208,068
related to the construction of a new branch office. At December 31, 2004,
$ 913,601 of these commitments had been paid.
NOTE 8. PREMISES AND EQUIPMENT
A summary of bank premises and equipment is as follows:
(Dollars in thousands) 2004 2003
Land $ 2,045 $ 1,358
Buildings and improvements 9,517 7,870
Leasehold improvements 199 199
Furniture and equipment 8,592 7,587
Construction in progress 48 334
------------ ------------
Total 20,401 17,348
Less accumulated depreciation and 7,179 6,180
amortization
------------ ------------
Bank premises and equipment, net $ 13,222 $ 11,168
------------ ------------
Depreciation expense amounted to $1,072,976, $ 943,484, and $ 803,123 for the
years ended December 31, 2004, 2003 and 2002, respectively.
NOTE 9. RETIREMENT PLANS
The Corporation maintains a 401(k) profit-sharing plan for those employees who
meet the eligibility requirements set forth in the plan. Employer contributions
to the plan are based on corporate performance and are at the discretion of the
Corporation's Board of Directors. In addition, there is a provision for an
employer match of 50 cents on the dollar for employee contributions up to 6% of
the employees' eligible compensation. Substantially all of the Corporation's
employees are covered by the plan and the contributions charged to operations
were $ 898,609, $ 754,498 and $ 650,065 for the years ended December 31, 2004,
2003, and 2002, respectively.
NOTE 9. RETIREMENT PLANS (Continued)
The Corporation has a deferred compensation arrangement with certain present
and former board directors whereby a director or his beneficiaries will receive
a monthly retirement benefit at age 65. The arrangement is funded by an amount
of life insurance on the participating director calculated to meet the
Corporation's obligations under the compensation agreement. The cash value of
the life insurance policies is an unrestricted asset of the Corporation. The
estimated present value of future benefits to be paid, which is included in
other liabilities, amounted to $ 121,009 and $ 122,029 at December 31, 2004 and
2003, respectively. Total annual expense for this deferred compensation plan was
$ 11,520, $ 12,325, and $ 12,456 for the years ended December 31, 2004, 2003 and
2002, respectively.
The Corporation also has a supplemental discretionary deferred compensation
plan for executive officers and directors. The plan is funded annually with
salary and fee reductions which are placed in a trust account invested by the
Corporation's trust department. Total amount contributed to the plan was $
77,200, $ 58,800 and $ 27,050, for the years ended December 31, 2004, 2003, and
2002, respectively.
The Corporation adopted three supplemental retirement and salary continuation
plans for directors and executive officers. These plans are funded with single
premium life insurance on the plan participants. The cash value of the life
insurance policies is an unrestricted asset of the Corporation. The Revenue
Neutral plan was paid out in March 2004 and there was no related expense for
this plan in 2004. The estimated present value of future benefits to be paid
totaled $ 1,134,986 and $ 952,296 at December 31, 2004 and 2003, respectively,
which is included in other liabilities. Total annual expense for these plans
amounted to $216,890, $ 245,460 and $ 257,468, for the years ended December 31,
2004, 2003, and 2002, respectively.
NOTE 10. STOCK COMPENSATION PLANS
During 2000 the Corporation implemented two stock option plans (one for
employees and one for nonemployee directors). Under the Corporation's stock
option plans the Corporation may grant options to its directors, officers, and
employees for up to 507,150 shares of common stock. Both incentive stock
options and nonqualified stock options may be granted under the plans. The
exercise price of each option equals the market price of the Corporation's stock
on the date of grant and an option's maximum term is ten years.
A summary of the status of the Corporation's stock option plans at December
31, 2004, 2003, and 2002 is presented below:
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
2004 2003 2002
Outstanding at beginning of year 181,550 $20.98 134,726 $18.78 86,184 $17.65
Granted 45,908 40.83 49,028 26.85 49,644 20.70
Exercised (25,682) 18.08 (2,204) 17.01 0 0
Forfeited 0 0.00 0 0.00 (1,102) 17.01
---------- ---------- ---------- --------- ---------- ----------
Options exercisable at year end 201,776 $25.87 181,550 $20.98 134,726 $18.78
---------- ---------- ---------- --------- ---------- ----------
Information pertaining to options outstanding at December 31, 2004 is as
follows:
Options Outstanding Options Exercisable
Weighted
Average
Range of Number Remaining Weighted Number Weighted Average
Contractual Average
Exercise Prices Outstanding Life Exercise Exercisable Exercise Price
(Years) Price
$17.01 - $17.91 21,802 5.44 $17.23 21,802 $17.23
$17.97 - $18.19 40,618 6.46 18.16 40,618 18.16
$18.69 - $20.95 44,820 7.47 20.67 44,820 20.67
$22.99 - $27.26 48,628 8.48 26.85 48,628 26.85
$40.70 - $43.13 45,908 9.49 40.83 45,908 40.83
---------- ------ ------ -------- -------
$17.01 - $43.13 201,776 7.75 $25.87 201,776 $25.87
---------- ------ ------ -------- -------
NOTE 10. STOCK COMPENSATION PLANS (Continued)
The fair value of each option granted is estimated on the date of grant using
the Black-Scholes option-pricing model with the following weighted-average
assumptions:
Grant-Date Dividend Expected Risk Free Life
Fair Value Yield Volatility Interest (Years)
Rate
Nonemployee director stock option plan
2004 $14.75 1.11% 32.80% 3.38% 7
2003 7.59 1.40 25.36 3.40 10
2002 3.45 1.61 26.68 3.50 6
Employee stock option plan
2004 $12.60 1.18% 32.18% 3.85% 5
2003 6.83 1.40 16.32 3.40 10
2002 4.39 1.48 30.04 3.50 6
The Corporation accounts for the plans under the recognition and measurement
principles of APB Opinion No. 25 and related Interpretations. No stock-based
employee compensation cost is reflected in net income for options granted since
all options granted under the plan had an exercise price equal to the market
value of the underlying common stock on the date of grant. The following table
illustrates the effect on net income and earnings per share if the Corporation
had applied the fair value recognition provisions of FASB Statement No.123 to
stock-based employee compensation.
In thousands, except per share data) 2004 2003 2002
Net income As reported $ 7,770 $ 6,980 $ 5,915
Pro forma 7,385 6,757 5,712
Basic earnings per share As reported $ 1.52 $ 1.38 $ 1.18
Pro forma 1.45 1.34 1.14
Diluted earnings per share As reported $ 1.47 $ 1.34 $ 1.15
Pro forma 1.39 1.30 1.11
During 2000 the Corporation implemented an employee stock purchase plan under
which 165,375 shares of common stock have been reserved for issuance to
employees. The number of shares which may be issued to each participant is
determined annually, based on individual earnings, and their cost is equal to
85% of the fair market value as established by the average of the average of the
daily high bid and daily low offer quotations for the shares reported in the OTC
Bulletin Board service, during the ten trading days immediately preceding the
date of purchase. If no bid or offer quotation for the shares is reported
through the OTC Bulletin Board service during the ten business day period, the
fair market value is the price of the last trade reported through the OTC
Bulletin Board service prior to the purchase date. A total of 142,564 shares of
common stock remained reserved at December 31, 2004 for future grants under the
plan. Employees purchased 3,916, 8,561, and 4,152 shares at a weighted average
price of $ 32.74, $ 19.71, and $ 17.30 per share in 2004, 2003, and 2002,
respectively.
Shares of common stock registered and available for issuance through approved
plans at December 31, 2004 are as follows:
Number
of Shares
Stock option plans 276,948
Employee stock purchase plan 142,564
Dividend reinvestment plan 729,095
----------
Total registered shares 1,148,607
----------
NOTE 11. INCOME TAXES
The components of federal income tax expense are summarized as follows:
(Dollars in thousands) 2004 2003 2002
Current year provision $ 3,149 $ 2,788 $ 2,356
Deferred income taxes (benefits) 28 (110) (131)
--------------- --------------- ---------------
Net federal income tax expense $ 3,177 $ 2,678 $ 2,225
--------------- --------------- ---------------
Federal income taxes were computed after reducing pretax accounting income
for non-taxable income in the amount of $ 1,713,461, $ 1,835,294, and
$ 1,857,654 for 2004, 2003, and 2002, respectively. A reconciliation of the
effective applicable income tax rate to the federal statutory rate is as
follows:
2004 2003 2002
Federal income tax rate 34.0% 34.0% 34.0%
Reduction resulting from 5.0% 6.3% 6.7%
nontaxable income
------ ------ ------
Effective income tax rate 29.0% 27.7% 27.3%
------ ------ ------
Deferred tax liabilities have been provided for taxable temporary differences
related to accumulated depreciation, unrealized gains on available for sale
securities and deductible amortization expense of goodwill and intangibles.
Deferred tax assets have been provided for deductible temporary differences
related to the allowance for loan losses, asset impairment, and directors'
deferred compensation and retirement plans. The Corporation has not recorded a
valuation allowance for deferred tax assets as they feel that it is more likely
than not that they will be ultimately realized. The net deferred tax assets
(liabilities) included in the accompanying consolidated balance sheets includes
the following significant components:
(Dollars in thousands) 2004 2003
Deferred tax assets
Allowance for loan losses $ 1,409 $ 1,373
Asset impairment 13 0
Deferred compensation 232 205
Retirement plans and salary continuation 386 324
-------------- --------------
Total deferred tax assets 2,040 1,902
-------------- --------------
Deferred tax liabilities
Net unrealized (gains) on securities available for sale (425) (584)
Depreciation (1,024) (866)
Goodwill and intangibles (8) 0
--------------- ---------------
Total deferred tax liabilities (1,457) (1,450)
-------------- --------------
Net deferred tax asset $ 583 $ 452
-------------- --------------
NOTE 12. DEPOSITS
Included in interest bearing deposits at December 31 are NOW account products
with balances totaling $ 142,583,000 and $ 146,627,000 for 2004 and 2003,
respectively. Also included in interest bearing deposits at December 31, 2004
and 2003 are money market account products with balances totaling $ 43,284,000
and $ 29,641,000, respectively. At December 31, 2004 and 2003 time deposits of
$ 100,000 and over aggregated $ 33,686,000 and $ 18,845,000, respectively.
Interest expense on time deposits of $ 100,000 and over was $ 788,000, $ 546,000
and $ 710,000 for the years ended December 31, 2004, 2003, and 2002,
respectively. At December 31, 2004 the scheduled maturities of certificates of
deposit are as follows:
(Dollars in thousands)
2005 $ 52,011
2006 35,115
2007 16,938
2008 3,643
2009 and thereafter 9,891
-------------
$ 117,598
-------------
NOTE 12. DEPOSITS (Continued)
The Corporation accepts deposits of the officers and directors of the
Corporation and its subsidiary on the same terms, including interest rates, as
those prevailing at the time for comparable transactions with unrelated persons.
The aggregate dollar amount of deposits of officers and directors totaled
$ 614,000 and $ 992,000 at December 31, 2004 and 2003, respectively.
Total overdrafts of the Bank of $ 866,000 and $ 343,000 at December 31, 2004
and 2003, respectively, were reclassified as loans for financial reporting
purposes.
NOTE 13. LIABILITIES FOR BORROWED MONEY
Federal funds purchased and securities sold under agreements to repurchase
generally mature within one day from the transaction date. Information
concerning securities sold under agreements to repurchase is summarized as
follows:
(Dollars in Thousands) 2004 2003
Average balance during the year $ 22,708 $ 23,014
Average interest rate during the year 1.22% 1.04%
Maximum month-end balance during the year $ 35,373 $ 29,440
Securities underlying the agreements at year-end:
Carrying value 37,532 39,152
Estimated fair value 37,868 39,640
At December 31, the Corporation had notes outstanding with the Federal Home
Loan Bank of Pittsburgh as follows:
(Dollars in Thousands) Convertible Frequency & Basis
Amount Maturity Interest to Adjustable for Adjustable
2004 2003 Date Rate Rate Rate
$ 0 $ 1,000 01/04 6.42% Fixed Rate
350 350 04/05 7.35 Fixed Rate
1,000 1,000 05/05 1.67 Fixed Rate
5,000 5,000 05/06 2.08 Fixed Rate
1,393 1,779 05/08 2.43 Fixed Rate
7,500 7,500 09/08 5.06 09/15/03 (1) Quarterly based on 3 months
LIBOR plus .15%
5,000 5,000 10/08 4.66 10/07/03 (1) Quarterly based on 3 months
LIBOR plus .15%
1,582 1,848 05/10 2.85 Fixed Rate
5,000 5,000 02/11 4.50 02/07/02 (1) Quarterly based on 3 months
LIBOR plus .19%
3,000 3,000 03/11 3.94 03/25/02 (1) Quarterly based on 3 months
LIBOR plus .13%
5,000 5,000 02/12 4.70 (2)
350 350 04/20 7.40 Fixed Rate
----------- ----------
$ 35,175 $ 36,827
----------- ----------
(1) The rate can adjust to an adjustable rate based on market rates.
(2) The 3 month LIBOR is evaluated quarterly and the loan converts to an
adjustable rate if the 3 month LIBOR is greater than 8%. The rate would then
adjust quarterly based on 3 month LIBOR plus .20%.
Interest rates are fixed, but, as indicated above, some of the notes can
convert to adjustable rates. Interest only is paid on a monthly basis. The
notes contain prepayment penalty charges, but management has no intention to pay
off early.
Two of the above borrowings are term notes that require monthly principal
reductions of the note balance. The aggregate amount of future principal
payments required on these two notes at December 31, 2004 is as follows:
NOTE 13. LIABILITIES FOR BORROWED MONEY (Continued)
(Dollars in Thousands)
2005 $ 670
2006 687
2007 705
2008 475
2009 307
Thereafter 131
------------
$ 2,975
------------
The Corporation also has available a $ 15 million line of credit with the
Federal Home Loan Bank of Pittsburgh (FHLB). The interest rate is variable and
can change daily based on FHLB's cost of borrowing. Collateral for all
outstanding advances and the line consists of certain securities and the
Corporation's 1-4 family mortgage loans totaling $ 212,998,000 and $ 188,944,000
at December 31, 2004 and 2003, respectively. The Corporation also has available
a line of credit with Atlantic Central Bankers Bank of $8.5 million at December
31, 2004 and $ 6 million at December 31, 2003 and a $5 million available line of
credit with the Bank of Lancaster County at December 31, 2004. The ACBB and
Bank of Lancaster County lines of credit are unsecured and the rates are based
on the daily Federal Funds rate. There were no borrowings under these lines of
credit at December 31, 2004 or 2003.
Also included in other borrowed funds are borrowings against certain life
insurance policies that are used to fund deferred compensation benefits for
certain directors. Interest rates are fixed at 8%. Collateral is the cash
surrender value of the policies as disclosed in Note 9. The total balance of
these loans was $ 394,000 and $ 366,000 at December 31, 2004 and 2003,
respectively.
Total interest expense on borrowed funds charged to operations was $
1,502,425, $ 1,498,734 and $ 1,517,619 for the years ended December 31, 2004,
2003, and 2002, respectively.
NOTE 14. ORRSTOWN FINANCIAL SERVICES, INC. (PARENT COMPANY ONLY) FINANCIAL
INFORMATION
The following are the condensed balance sheets, income statements and
statements of cash flows for the parent company:
BALANCE SHEETS At December 31,
(Dollars in Thousands) 2004 2003
Assets
Cash $ 2,667 $ 1,385
Securities available for sale 2,964 2,794
Investment in wholly-owned subsidiaries 45,074 40,043
Other assets 49 32
-------- --------
Total assets $ 50,754 $ 44,254
-------- --------
Liabilities
Accrued expenses $ 681 $ 593
Deferred taxes 123 126
Notes payable 700 700
-------- --------
Total liabilities 1,504 1,419
-------- --------
Shareholders' Equity
Common stock, no par value - $ .05205 stated value per share
50,000,000 shares authorized with 5,126,205 shares issued
at December 31, 2004 and $.1041 stated value per share
10,000,000 shares authorized with 2,537,011 shares
issued at December 31, 2003 267 264
Additional paid-in capital 34,434 32,928
Retained earnings 13,723 8,509
Accumulated other comprehensive income 826 1,134
--------- ---------
Total shareholders' equity 49,250 42,835
--------- ---------
Total liabilities and shareholders' equity $ 50,754 $ 44,254
--------- ---------
NOTE 14. ORRSTOWN FINANCIAL SERVICES, INC. (PARENT COMPANY ONLY) FINANCIAL
INFORMATION (Continued)
INCOME STATEMENTS Years Ended December 31,
(Dollars in Thousands) 2004 2003 2002
Income
Dividends from wholly-owned subsidiary $ 2,475 $ 1,415 $ 1,010
Other interest and dividend income 145 134 130
Other income 44 92 29
Gain on sale of investment securities 51 128 6
---------- ---------- ----------
Total income 2,715 1,769 1,175
---------- ---------- ----------
Expenses
Interest on borrowings 52 52 52
Other expenses 238 190 179
---------- ---------- ----------
Total expenses 290 242 231
---------- ---------- ----------
Income before income taxes and equity in
undistributed income of subsidiaries 2,425 1,527 944
Income tax expense (benefit) (12) 30 (29)
---------- ---------- ----------
Income before equity in undistributed income
of subsidiaries 2,437 1,497 973
---------- ---------- ----------
Equity in undistributed income of subsidiaries
Net income of subsidiaries 7,808 6,898 5,952
Less: dividends (2,475) (1,415) (1,010)
---------- ---------- ----------
Equity in undistributed income of subsidiaries 5,333 5,483 4,942
---------- ---------- ----------
Net income $ 7,770 $ 6,980 $ 5,915
---------- ---------- ----------
STATEMENTS OF CASH FLOWS Years Ended December 31,
(Dollars in Thousands) 2004 2003 2002
Cash flows from operating activities:
Net income $ 7,770 $ 6,980 $ 5,915
Adjustments to reconcile net income to cash provided
by operating activities:
Security (gains) (51) (128) (6)
Equity in undistributed income of subsidiary (5,333) (5,483) (4,942)
Increase (decrease) in other liabilities 88 104 95
(Increase) decrease in other assets (17) 40 (14)
-------- -------- --------
Net cash provided by operating activities 2,457 1,513 1,048
-------- -------- --------
Cash flows from investing activities:
Purchase of available for sale securities (522) (791) (329)
Sales of available for sale securities 393 543 208
Sales of property and equipment 0 0 5
-------- -------- --------
Net cash provided (used) by investing activities (129) (248) (116)
-------- -------- --------
Cash flows from financing activities:
Cash dividends paid (2,556) (2,126) (1,722)
Cash paid in lieu of fractional stock dividends 0 (22) 0
Proceeds from sale of stock 1,510 956 838
-------- -------- --------
Net cash provided (used) by financing activities (1,046) (1,192) (884)
-------- -------- --------
Net increase (decrease) in cash 1,282 73 48
Cash, beginning balance 1,385 1,312 1,264
-------- -------- --------
Cash, ending balance $ 2,667 $ 1,385 $ 1,312
-------- -------- --------
NOTE 15. REGULATORY MATTERS
Dividends paid by Orrstown Financial Services, Inc. are generally provided
from the subsidiary bank's dividends to the parent company. Under provisions of
the Pennsylvania Banking Code, cash dividends may be paid from accumulated net
earnings (retained earnings) as long as minimum capital requirements are met.
The minimum capital requirements stipulate that the bank's surplus or additional
paid-in capital be equal to the amount of capital. Orrstown Bank is well above
these requirements and the balance of $ 38,066,000 in its retained earnings at
December 31, 2004 is fully available for cash dividends. Orrstown Financial
Services' balance of retained earnings at December 31, 2004 is $ 13,723,000 and
would be available for cash dividends, although payment of dividends to such
extent would not be prudent or likely. The Federal Reserve Board, which
regulates bank holding companies, establishes guidelines which indicate that
cash dividends should be covered by current period earnings.
The Corporation is also subject to various regulatory capital requirements
administered by 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 Corporation's financial statements. Under capital
adequacy guidelines, the Corporation is required to maintain minimum capital
ratios. The leverage ratio compares capital to total adjusted balance sheet
assets, while the risk-based ratios compare capital to risk-weighted assets and
off-balance-sheet activity in order to make capital levels more sensitive to
risk profiles of individual banks. A comparison of Orrstown Financial Services'
capital ratios to regulatory minimums at December 31 is as follows:
Orrstown Financial Regulatory
Services
Minimum
2004 2003 Requirement
s
Leverage ratio 9.25% 8.92% 4%
Risk-based capital ratios:
Tier I (core capital) 12.19% 12.15% 4%
Combined Tier I and Tier II (core capital
plus allowance for loan losses) 13.35% 13.38% 8%
As of December 31, 2004 the most recent notification, from the Federal Reserve
Board, categorized the Corporation as well capitalized under the regulatory
framework for prompt corrective action. There are no conditions or events since
that notification that management believes have changed the Corporation's
category.
NOTE 16. LEASES
The Corporation leases land and building space associated with certain branch
offices, remote automated teller machines, and certain data processing equipment
under agreements which expire at various times from 2005 through 2022. Total
rent expense charged to operations in connection with these leases was $
243,990, $ 218,769 and $ 180,766 for the years ended December 31, 2004, 2003,
and 2002, respectively.
The total minimum rental commitments under operating leases at December 31,
2004 are as follows:
(Dollars in Thousands) Due in the Year Ending December 31,
2005 $ 127
2006 108
2007 105
2008 98
2009 79
----------------
$ 517
----------------
NOTE 17. COMPENSATING BALANCE ARRANGEMENTS
The Corporation maintains deposit balances at several correspondent banks
which provide check collection and item processing services to the Corporation.
The balances with these correspondent banks, at times, exceed federally insured
limits; management considers this to be a normal business risk.
Required deposit balances at the Federal Reserve were $ 65,000 at both
December 31, 2004 and 2003. Required deposit balances at Atlantic Central
Bankers Bank were $ 540,000 at both December 31, 2004 and 2003.
NOTE 18. FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair values of the Corporation's financial instruments were as
follows at December 31:
- - - - - - - 2004 - - - - - - - - - - - - - 2003 - - - - - -
Carrying Fair Carrying Fair
(Dollars in Thousands) Amount Value Amount Value
Financial Assets
Cash, due from banks, and short-term
investments $ 12,580 $ 12,580 $ 13,284 $ 13,284
Federal funds sold 8,393 8,393 3,829 3,829
Securities available for sale 79,829 79,829 89,074 89,074
Restricted bank stocks 2,972 2,972 2,912 2,912
Loans 389,268 345,054
Allowance for loan losses (4,318) (4,161)
----------- ----------- ----------- -----------
Net loans 384,950 378,670 340,893 344,897
Accrued interest receivable 1,775 1,775 1,647 1,647
----------- ----------- ----------- -----------
Total financial assets $ 490,499 $ 484,219 $ 451,639 $ 455,643
----------- ----------- ----------- -----------
Financial Liabilities
Deposits $ 405,363 $ 405,278 $ 358,643 $ 360,997
Short-term borrowed funds 19,493 19,493 29,440 29,440
Long-term borrowed funds 35,569 36,478 37,193 38,497
Accrued interest payable 431 431 397 397
----------- ----------- ----------- -----------
Total financial liabilities $ 460,856 $ 461,680 $ 425,673 $ 29,331
----------- ----------- ----------- -----------
NOTE 19. GOODWILL AND INTANGIBLE ASSETS
On July 14, 2004 Orrstown Bank purchased an investment management business and
the related registered trademark. The following intangible assets were recorded
as part of this transaction:
Gross
(Dollars in Thousands) Amount Amortization Period
Goodwill $ 748 Subject to impairment evaluation
--------
Intangible assets:
Restrictive covenant 5 18 months
Customer list 402 15 years
--------
Total intangible assets $ 407
--------
The identifiable intangible assets that are related to acquisitions of
deposits and other intangibles are amortized on a straight-line basis over
fifteen years. The following table shows the amount of good will and intangible
assets included in other assets on the balance sheet at December 31:
Gross Accumulated Net
Amount Amortization Amount
(Dollars in thousands) 2004
Goodwill $ 748 $ 0 $ 748
------------ ----------- ------------
Intangible assets:
Deposit premiums 683 407 276
Customer list 402 13 389
Other 61 56 5
------------ ----------- ------------
Total intangible assets $ 1,146 $ 476 $ 670
------------ ----------- ------------
2003
Intangible assets:
Deposit premiums $ 683 $ 361 $ 322
Other 56 49 7
------------ ----------- ------------
Total intangible assets $ 739 $ 410 $ 329
------------ ----------- ------------
Amortization expense was $66,000, $54,000, and $57,000 for the years ended
December 31, 2004, 2003 and 2002, respectively. The estimated aggregate
amortization expense for the next five years is as follows:
(Dollars in Thousands)
2005 $ 77
2006 72
2007 72
2008 72
2009 72
--------
$ 365
--------
Item 7. Management's Discussion and Analysis of Consolidated Financial Condition
and Results of Operations
The following is a discussion of our consolidated financial condition and
results of operations for each of the three years ended December 31, 2004, 2003
and 2002. Some statements and information contained in this "Management's
Discussion and Analysis of Financial Condition and Results of Operations" are
not historical facts but are forward-looking statements. For a discussion of
these forward-looking statements and important factors that could cause results
to differ materially from the forward-looking statements contained in this
Annual Report, see "Important Factors Relating to Forward Looking Statements".
The following discussion and analysis should be read in conjunction with our
Consolidated Financial Statements and Notes to Consolidated Financial Statements
presented in this report. Certain prior period amounts presented in this
discussion and analysis, have been reclassified to conform to current period
classifications.
Overview
Orrstown Financial Services, Inc. (the Corporation) is a financial holding
company maintaining two wholly-owned subsidiaries, Orrstown Bank (the Bank) and
Pennbanks Insurance Company Cell P1, a provider of credit life and disability
insurance. The Bank is dedicated to maintaining its strong community roots and
providing a wide array of services to the customers in the markets we serve.
Deposit services include a variety of checking, savings, time and money market
deposits along with related debit card services. The Branch Executive Officers,
Customer Service Officers and tellers are trained to provide the best personal,
professional service in our market areas. Lending services include commercial
loans, residential loans, commercial mortgages and various forms of consumer
lending. Business Development Officers are assigned in each of the communities
we serve and they are a vital part of our continued strong loan growth. The
Bank completed another record year for the production of net income and earnings
per share. We have grown consistently throughout the past five years, as
evidenced by the following financial data, while maintaining excellent loan
quality. The Corporation is committed to providing both shareholder value and
unparalleled customer service.
The Corporation reached a milestone in July 2004 by increasing asset size to
more than $ 500 million. Assets exceeded $ 500 million through year end. This
will entail changes in reporting requirements for 2005 for the Bank and the
Corporation. Also in July of 2004, the Bank purchased a Chambersburg,
Pennsylvania-based investment management business and the related "Integrity
Financial" Pennsylvania registered trademark. Orrstown Bank operates the
Integrity Financial business as part of the Bank's Investment Management
Division. The addition of this business contributed to noninterest income
during the second half of 2004. The Bank's Investment Management Division has
increased its assets under management consistently even through down markets,
but realizes that great opportunities exist to continue this expansion as
customers get to know our growing Bank. The Corporation will strive to continue
the pattern of growth shown in the past by increasing the customer base with
loan and deposit growth within our existing branches and markets, through select
branch expansion into neighboring markets, and by watching for compatible
acquisitions or opportunities as they arise.
For the year ended December 31, 2004, the Corporation recorded net income of
$ 7,770,000, an increase of 11.3% over 2003 earnings of $ 6,980,000, which was
an 18.0% increase over net income of $ 5,915,000 in 2002. Basic earnings per
share have increased over this time period from $1.18 in 2002 to $ 1.38 in 2003
and $ 1.52 in 2004. The per share amounts have been restated to reflect the 5%
stock dividend paid to shareholders on May 30, 2003 and the 2-for-1 stock split
effective February 10, 2004. In April 2004 the shareholders of the Corporation
voted to increase the number of authorized shares of common stock from 10
million shares to 50 million shares thus allowing for future splits or stock
dividends.
The Corporation's earnings performance continues to be well above peer group
averages as measured by various ratio analyses. Two widely recognized
performance indicators are the return on average assets (ROA) and the return on
average equity (ROE). The return on average assets was 1.57% in 2004, 1.57% in
2003, and 1.53% in 2002. The return on average equity was 17.19% in 2002,
17.24% in 2003, and 16.78% in 2004. Peer averages for publicly traded community
banks with $500 million in assets or less, have been less than 1% for ROA and
under 10% for ROE during the past few years.
Economic Climate
The historically low, flat interest rate environment of 2003 continued midway
through 2004 before interest rates started to rise. In July 2004, the Federal
Reserve Board raised the federal funds rate for the first time in four years.
The prime lending rate followed the federal funds rate. From June 2004, both
rates increased 125 basis points within seven months in 25 basis point
increments. The prime lending rate stood at 5.25 at December 31, 2004. The
economy continued to grow slowly but steadily and the Federal Reserve is closely
monitoring the expansion with a long term eye on inflation. This view leads to
the expectation of additional prime lending rate increases during 2005. The
anticipated rate increases should bode well for the Corporation's earnings
stream since the balance sheet is positioned to prosper in a rising rate
environment.
Net Interest Income
Net interest income is the amount by which interest income on earning assets
exceeds interest paid on interest bearing liabilities. The amount of net
interest income is affected by changes in interest rates, account balances or
volume and the mix of earning assets and interest bearing liabilities. Net
interest income is still the primary source of commercial bank profits despite
the continued industry wide push to build noninterest income streams. This is
particularly true for community banks.
For the year ended December 31, 2004, net interest income totaled
$ 18,906,000, an increase of $ 2,179,000, or 13.0%, over 2003. The 2003 total
was $ 16,727,000, or 10.1%, over 2002 results. On a taxable equivalent basis,
net interest income increased by 12.2% in 2004 and 9.5% in 2003. Marginal tax
rates used in the taxable equivalent equation were 34% for all three years
presented.
The Corporation's taxable equivalent net interest spread was 4.06% in 2002,
3.90% in 2003, and 3.91% in 2004. The net interest margin, which factors in
noninterest bearing funds sources, has moved from 4.43% to 4.20% to 4.21%,
respectively. Average earning assets represented 94.0% of total average assets
in 2004, 94.0% in 2003, and 93.5% in 2002 as growth in interest bearing assets
has consistently outstripped growth in nonearning assets.
Even though rates increased in the second half of 2004, volume factors were
still primarily responsible for the increase in interest income. The variable
commercial loan portfolio was the only portfolio with an increase in interest
income partially due to an increase in interest rate environment in the second
half of 2004. The Bank is positioned to increase net interest income if
expected interest rate increases materialize during 2005. This will make the
rate variance a more material contributor to net interest income gains in 2005.
Interest earning assets grew 11.8%, or $ 49,102,000, during 2004 on an average
daily basis, with the commercial loan portfolio responsible for $38,763,000 of
the total growth. Commercial loans secured by real estate, continue to be the
fastest growing segment of the loan portfolio. Interest income increased
$2,365,000 or 9.7%, on a fully taxable basis, for the same period.
Interest bearing liabilities grew 10.1%, or $ 35,483,000, on an average daily
basis, split fairly evenly between interest bearing transaction accounts and
growth in time deposits. Our deposit mix, which is heavily laden with variable
rate transaction accounts that are discretionarily priced, enables us great
flexibility in pricing. Free funds were up by $ 13,619,000, while net interest
margin remained almost flat at 4.21% verses the 4.20% realized during 2003. The
net interest margin increased as 2004 progressed, however, with prime rate
increases widening the net interest margin.
The Corporation's balance sheet is positioned to hold spreads in a flat or
slightly falling interest rate environment but is well positioned for spread
increases as rates rise as is evident from the fourth quarter's performance.
2004 2003 2002
Tax Tax Tax Tax Tax Tax
Average Equivalent Average Equivalent Average Equivalent
Equivalent Equivalent Equivalent
(Dollars in thousands) Balance Interest Rate Balance Interest Rate Balance Interest Rate
Assets
Interest Earning Assets:
Federal funds sold
& interest bearing
bank balances $12,764 $ 178 1.39% $ 14,678 $ 158 1.08% $ 16,830 $ 277 1.65%
------- -------- ------ -------- --------- ------ --------- --------- ------
Taxable investment
Securities 60,888 2,277 3.74 63,972 2,381 3.72 54,643 2,891 5.29
Tax-exempt investment
Securities 23,033 1,828 7.94 24,509 2,022 8.25 24,853 2,076 8.35
------- -------- ------ -------- --------- ------ --------- --------- ------
Total investment
Securities 83,921 4,105 4.89 88,481 4,403 4.98 79,496 4,967 6.25
------- -------- ------ -------- --------- ------ --------- --------- ------
Taxable loans 364,678 22,021 6.04 310,311 19,444 6.27 261,114 18,473 7.07
Tax-exempt loans 4,731 318 6.72 3,522 252 7.16 3,182 245 7.70
------- -------- ------ -------- --------- ------ --------- --------- ------
Total Loans 369,409 22,339 6.05 313,833 19,696 6.28 264,296 18,718 7.08
------- -------- ------ -------- --------- ------ --------- --------- ------
Total interest-earning
assets 466,094 26,622 5.71 416,992 24,257 5.82 360,622 23,962 6.64
Non-Interest Earning Assets:
Cash and due
from banks 10,687 9,580 8,853
Bank premises and
equipment 11,852 10,505 9,427
Other assets 11,602 10,604 10,229
Less allowance for
loan losses (4,316) (3,944) (3,366)
------- -------- ------ -------- --------- ------ --------- --------- ------
Total $495,919 $443,737 385,765
------- -------- ------ -------- --------- ------ --------- --------- ------
Liabilities and Shareholders' Equity
Interest Bearing Liabilities:
Interest bearing
demand deposits $183,649 $ 1,942 1.06 $170,832 $ 2,035 1.19 $136,500 $ 2,202 1.61
Savings deposits 29,752 135 0.45 26,602 140 0.53 23,558 201 0.85
Time deposits 114,181 3,124 2.74 97,539 2,840 2.91 94,043 3,666 3.90
Short term borrowings 24,296 304 1.25 23,294 243 1.04 24,057 398 1.65
Long term borrowings 35,885 1,481 4.13 34,013 1,499 4.41 30,400 1,518 4.99
------- -------- ------ -------- --------- ------ --------- --------- ------
Total interest bearing
liabilities 387,763 6,986 1.80 352,280 6,757 1.92 308,558 7,985 2.59
Non-Interest Bearing Liabilities:
Demand deposits 57,762 47,416 39,688
Other 4,085 3,550 3,111
------- -------- ------ -------- --------- ------ --------- --------- ------
Total Liabilities 449,610 403,246 351,357
Shareholders' Equity 46,309 40,491 34,408
------- -------- ------ -------- --------- ------ --------- --------- ------
Total $495,919 1.50 $443,737 1.62 $385,765 2.21
------- -------- ------ -------- --------- ------ --------- --------- ------
Net interest income / net
interest spread $ 19,636 3.91% $ 17,500 3.90% $ 15,977 4.06%
------- -------- ------ -------- --------- ------ --------- --------- ------
Net interest margin 4.21% 4.20% 4.43%
------- -------- ------ -------- --------- ------ --------- --------- ------
Noninterest Income and Expenses
Other income, excluding securities gains, increased $ 648,000, or 10.4% in
2004. $ 438,000 of the growth was in service charges on deposit accounts which
included a $ 154,000 increase in bounce protection fees due to continued growth
of the deposit base. In addition, there was a $ 90,000 increase in merchant
account fees as growth in business accounts remains very good. Loan fees
decreased from 2003 levels, due primarily to a decline in residential mortgage
lending following the robust growth of 2003, which had been fueled by
refinancing activity. Trust department income increased $400,000 over last year
due to an increase in trust assets under management of $55,000,000. Brokerage
income also increased by $123,000 over 2003 due in part growth from the
investment management acquisition previously mentioned. Securities gains were
down from the prior year and included a $38,000 permanent impairment of an
equity investment that was recorded during the fourth quarter.
Average daily assets increased by 11.8% during 2004 and generally contributed
to the 13.1% increase in operating expenses. The growth of the Corporation
required additional hiring throughout the year and loan growth contributed to an
increase in incentive compensation, both increasing salary expense by $ 661,000
over 2003. Employee benefits followed suit, increasing $461,000 over 2003 due
to the addition of employees and included a 20% increase in health care rates,
which resulted in a 38% increase in 2004 health care costs. Occupancy and
equipment increased $ 289,000 over the prior year due to improvements in
technology and the opening of the Bank's thirteenth full service branch during
May 2004 in Carlisle, Pennsylvania and the fourteenth full service branch in
December 2004 in Chambersburg, Pennsylvania. The new Chambersburg branch will
replace the in store Wal-Mart branch, which will close in March 2005, thus
reducing lease expense. Professional fees expense included in other expenses,
increased $ 72,000 over 2003 due in part to compliance with the Sarbanes-Oxley
Act section 404. Despite the growth in noninterest expenses, the Corporation
was able to generate an efficiency ratio for the year of 55.2% for 2004,
following 54.6% for 2003 and 54.5% during 2002.
The table that follows provides additional information regarding noninterest
income and noninterest expense changes over the past three years:
ANALYSES OF NONINTEREST INCOME AND EXPENSES
Year Ended December 31, % Change
(Dollars in thousands) 2004 2003 2002 2004-2003 2003-2002
Other Income
Service charges on deposit accounts $ 3,066 $ 2,628 $ 2,257 16.7% 16.4%
Loan service charges and fees 688 848 485 -18.9% 74.8%
ATM fees 227 167 177 35.9% -5.6%
Other service charges, commissions and 101 223 252 -54.7% -11.5%
fees
Trust department income 1,863 1,463 1,386 27.3% 5.6%
Brokerage income 608 485 394 25.4% 23.1%
Cash surrender value increases 298 335 327 -11.0% 2.4%
Other operating income 30 84 61 -64.3% 37.7%
--------- ---------- ---------- ------ -------
Subtotal before securities transactions 6,881 6,233 5,339 10.4% 16.7%
Securities gains (losses) 88 199 21 -55.8% 847.6%
--------- ---------- ---------- ------ -------
Total other income $ 6,969 $ 6,432 $ 5,360 8.3% 20.0%
--------- ---------- ---------- ------ -------
Other Expenses
Salaries 5,117 4,456 4,035 14.8% 10.4%
Employee benefits 2,792 2,331 1,958 19.8% 19.1%
Occupancy and equipment 2,398 2,109 1,800 13.7% 17.2%
Data processing 582 535 493 8.8% 8.5%
ATM expense 142 203 176 -30.0% 15.3%
Telephone 259 230 265 12.6% -13.2%
Printing and supplies 239 268 246 -10.8% 8.9%
Postage 187 191 189 -2.1% 1.1%
Directors fees 326 308 253 5.8% 21.7%
Advertising 291 267 218 9.0% 22.5%
Pennsylvania shares tax 306 287 245 6.6% 17.1%
Contributions 163 194 251 -16.0% -22.7%
Other operating expenses 1,916 1,631 1,559 17.5% 4.6%
--------- ---------- ---------- ------ -------
Total operating expenses $ 14,718 $ 13,010 $ 11,688 13.1% 11.3%
--------- ---------- ---------- ------ -------
noninterest income as a % of
noninterest expense 47.4% 49.4% 45.9%
Federal Income Taxes
The Corporation's effective federal income tax rate for the year ended
December 31, 2004 was 29.0% as compared to 27.7% in 2003 and 27.3% in 2002.
Corporate income tax rates for 2005 are forecast to be similar but slightly
above 2004 levels due to maturing tax free debt securities. The Corporation is
firmly entrenched in the 34% bracket so all taxable income will be taxed at 34%
in 2005.
Asset Quality
The quality of the Corporation's asset structure continues to be strong. A
substantial amount of time is devoted by management to overseeing the investment
of funds in loans and securities and the formulation of policies directed toward
the profitability and minimization of risk associated with the investments.
Credit Risk Analysis
The Bank follows generally conservative lending practices and continues to
carry a high quality loan portfolio with no unusual or undue concentrations of
credit. No loans are extended to non domestic borrowers or governments,
consistent with past practice and policy. Net charge-offs historically have
been quite low, when compared to industry standards, and represented only .01%
of average outstanding loans during 2004 and .02% of average 2003 loans.
Nonperforming loans, as represented by nonaccrual and restructured items, were
..08% and .45% of outstanding loans at December 31, 2004 and 2003, respectively.
Loans 90 days or more past due and still accruing represented .66% and .79% of
outstanding loans at December 31, 2004 and 2003, respectively.
Allowance for Loan Losses
Historically, the Corporation has had an enviable record regarding its
control of loan losses, but lending is a banking service that inherently
contains elements of risk. The Bank policy related to the allowance for loan
losses is considered to be a critical accounting policy because the allowance
for loan losses represents a particularly sensitive accounting estimate. The
amount of the allowance is based on management's evaluation of the
collectibility of the loan portfolio, including the nature of the loan
portfolio, credit concentrations, trends in historical loss experience, specific
impaired loans, and economic conditions. The allowance for loan losses is
established through a provision for loan losses charged to expense. Loans are
charged against the allowance for loan losses when management believes that the
collectibility of the principal is unlikely. The allowance 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
loans and prior loan loss experience. The evaluations take into consideration
such factors as changes in the nature and volume of the loan portfolio, overall
portfolio quality, review of specific problem loans, and current economic
conditions that may affect the borrowers' ability to pay.
Through this review and evaluation process, an amount deemed adequate to meet
current growth and future loss expectations is charged to operations. The
provision for loan losses amounted to $ 210,000, $ 491,000, and $ 720,000 for
2004, 2003 and 2002, respectively. These provisions compared to net charge-offs
of $ 53,000, $ 64,000 and $ 90,000 for 2004, 2003 and 2002, respectively. The
provision for loan losses was decreased 57.2% during 2004 while loans increased
12.8%. This served to reduce the unallocated portion of the reserve, under
internal evaluation procedures, to approximately 44%. The reserve at December
31, 2004 represented 1.11% of loans outstanding. Net charge-offs for 2004
represented only .01% of average loans outstanding.
SUMMARY OF LOAN LOSS EXPERIENCE
Year Ended December 31,
(Dollars in thousands) 2004 2003 2002 2001 2000
Amount of loans outstanding at end of period $ 389,268 $ 345,054 $ 281,391 $ 249,816 $ 209,181
---------- ---------- ---------- ---------- ----------
Daily average loans outstanding $ 369,409 $ 313,833 $ 264,296 $ 233,103 $ 192,902
---------- ---------- ---------- ---------- ----------
Balance of allowance for possible loan
losses
at beginning of period $ 4,161 $ 3,734 $ 3,104 $ 2,691 $ 2,455
Loans charged off
Commercial, financial and agricultural 21 4 0 0 90
Real estate 9 13 48 67 9
Consumer 55 64 53 31 30
---------- ---------- ---------- ---------- ----------
Total loans charged off 85 81 101 98 129
---------- ---------- ---------- ---------- ----------
Recoveries of loans previously charged off
Commercial, financial and agricultural 0 0 0 0 1
Real estate 3 3 3 3 0
Consumer 29 14 8 4 4
---------- ---------- ---------- ---------- ----------
Total recoveries 32 17 11 7 5
---------- ---------- ---------- ---------- ----------
Net loans charged off (recovered) 53 64 90 91 124
Additions to allowance charged to expense 210 491 720 504 360
---------- ---------- ---------- ---------- ----------
Balance at end of period $ 4,318 $ 4,161 $ 3,734 $ 3,104 $ 2,691
---------- ---------- ---------- ---------- ----------
Ratio of net charge-offs to
average loans outstanding 0.01% 0.02% 0.03% 0.04% 0.06%
---------- ---------- ---------- ---------- ----------
Ratio of reserve to gross loans
outstanding at December 31 1.11% 1.21% 1.33% 1.24% 1.29%
---------- ---------- ---------- ---------- ----------
Risk Elements
Nonperforming assets are comprised of nonaccrual and restructured loans and
other real estate owned (OREO) not including bank premises. OREO represents
property acquired through foreclosure or settlements of loans and is carried at
the lower of the principal amount of the loan outstanding at the time acquired
or the estimated fair value of the property. The excess, if any, of the
principal balance at the time acquired over the carrying amount is charged
against the reserve for loan losses. The Bank's loan loss history has been much
better than peer standards and analysis of the current credit risk position is
favorable. The allowance for loan losses is ample given the current composition
of the loan portfolio and adequately covers the credit risk management sees
under present economic conditions. Management is prepared to make any reserve
adjustments that may become necessary as economic conditions change.
NONPERFORMING ASSETS
December 31,
(Dollars in thousands) 2004 2003 2002 2001 2000
Loans on nonaccrual (cash) basis $ 314 $ 130 $ 85 $ 56 $ 12
Loans whose terms have been renegotiated to provide a
reduction or deferral of interest or principal because
of a
deterioration in the financial position of the borrower 0 1,410 1,428 0 0
OREO 0 211 211 211 0
----------- --------- --------- --------- ----------
Total nonperforming loans and OREO $ 314 $ 1,751 $ 1,724 $ 267 $ 12
----------- --------- --------- --------- ----------
Ratio of nonperforming assets to total loans
and OREO 0.08% 0.51% 0.61% 0.11% 0.01%
----------- --------- --------- --------- ----------
Ratio of nonperforming assets to total assets 0.06% 0.37% 0.42% 0.07% 0.00%
----------- --------- --------- --------- ----------
OTHER CREDIT RISK ELEMENTS:
Loans past due 90 or more days and still accruing $ 2,550 $ 2,743 $ 1,446 $ 644 $ 814
----------- --------- --------- --------- ----------
Ratio of other credit risk elements to total
loans and OREO 0.66% 0.79% 0.51% 0.26% 0.39%
----------- --------- --------- --------- ----------
Ratio of other credit risk elements to total assets 0.50% 0.58% 0.35% 0.17% 0.26%
----------- --------- --------- --------- ----------
Total nonperforming and other risk assets $ 2,864 $ 4,494 $ 3,170 $ 911 $ 826
----------- --------- --------- --------- ----------
Ratio of total risk assets to total loans and OREO 0.74% 1.30% 1.13% 0.36% 0.39%
----------- --------- --------- --------- ----------
Ratio of total risk assets to total assets 0.56% 0.95% 0.77% 0.24% 0.26%
----------- --------- --------- --------- ----------
Critical Accounting Estimates
The Bank policy related to the allowance for loan losses is considered to be
a critical accounting policy because the allowance for loan losses represents a
particularly sensitive accounting estimate. The amount of the allowance is
based on management's evaluation of the collectibility of the loan portfolio,
including the nature of the loan portfolio, credit concentrations, trends in
historical loss experience, specific impaired loans, and economic conditions.
The allowance for loan losses is established through a provision for loan
losses charged to expense. Loans are charged against the allowance for loan
losses when management believes that the collectibility of the principal is
unlikely. The allowance 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 loans and prior loan loss experience.
The evaluations take into consideration such factors as changes in the nature
and volume of the loan portfolio, overall portfolio quality, grouping of like
loans, grading of individual loan quality, review of specific problem loans, the
examination of underlying collateral and current economic conditions that may
affect the borrowers' ability to pay.
Liquidity, Rate Sensitivity and Interest Rate Risk Analysis
The primary function of asset/liability management is to assure adequate
liquidity and rate sensitivity. Liquidity management involves the ability to
meet the cash flow requirements of customers who may be either depositors
wanting to withdraw funds or borrowers needing assurance that sufficient funds
will be available to meet their credit needs. Interest rate sensitivity
management requires the maintenance of an appropriate balance between interest
sensitive assets and liabilities. Interest bearing assets and liabilities that
are maturing or repricing should be adequately balanced to avoid fluctuating net
interest margins and to enhance consistent growth of net interest income through
periods of changing interest rates.
The Corporation has consistently followed a strategy of pricing assets and
liabilities according to prevailing market rates while largely matching
maturities, within the guidelines of sound marketing and competitive practices.
The goal is to maintain a predominantly matched position with very few planned
mismatches. Rate spreads will be sacrificed at times in order to enable the
overall rate sensitivity position to stay within the guidelines called for by
asset/liability management policy. Rate sensitivity is measured by monthly gap
analysis, quarterly rate shocks, and periodic simulation. Investment and
pricing decisions are made using both liquidity and sensitivity analyses as
tools. The schedule that follows reflects the degree to which the Corporation
can adjust its various portfolios to meet interest rate changes. Additionally,
the Bank is a Federal Home Loan Bank (FHLB) member, and standard credit
arrangements available to FHLB members provide increased liquidity.
RATE SENSITIVITY ANALYSIS AT DECEMBER 31, 2004
Interest Sensitivity Period
After 3 After 6
Within 3 Within 6 Within 12 After
(Dollars in thousands) Months Months Months 1 Year Total
Rate Sensitive Assets (RSA)
Loans 181,434 10,973 17,912 178,949 389,268
Investment securities 11,415 7,725 9,666 53,995 82,801
Other earning assets 9,517 0 0 0 9,517
-------- -------- -------- -------- --------
Total RSA 202,366 18,698 27,578 232,944 481,586
-------- -------- -------- -------- --------
Rate Sensitive Liabilities (RSL)
Interest bearing deposits 83,080 8,016 21,531 225,952 338,579
Short term borrowed funds 19,493 0 0 0 19,493
Long term borrowed funds 0 1,350 0 34,219 35,569
-------- -------- -------- -------- --------
Total RSL 102,573 9,366 21,531 260,171 393,641
-------- -------- -------- -------- --------
Rate Sensitive GAP
Period 99,793 9,332 6,047 (27,227) 87,945
Cumulative 99,793 109,125 115,172 87,945
GAP as a Percent of Total Assets
Period 19.39% 1.81% 1.17% -5.29%
Cumulative 19.39% 21.20% 22.38% 17.09%
RSA/RSL cumulative 1.97 1.97 1.86 1.22
The asset biased, or positive, gap position indicates that earnings are
naturally enhanced, or more easily maintained, in a rising rate environment.
This indicates that the balance sheet is well positioned to react to anticipated
rate increases during 2005 and positioned adequately to avoid material earnings
damage if rates do not rise.
Capital Adequacy and Regulatory Matters
The Corporation maintains a strong capital base which provides adequate
resources to absorb both normal and unusual risks inherent to the banking
business. Internal capital generation has been supported by net income retained
after the declaration of dividends, dividend reinvestment participation and
through the exercise of ESOP shares. Total shareholders' equity rose
$ 6,415,000 during 2004, or an increase of 15.0% over 2003. This followed
growth of 12.8% and 21.8% during 2003 and 2002, respectively. Unrealized gain
on securities decreased $308,000 from the year ended 2003 to 2004. The
increasing earnings stream during this period has allowed the Corporation to
steadily increase cash dividends paid to shareholders. In 2004 cash dividends
rose $ 430,000, or 20.2% over 2003 levels while net income rose 11.3% during the
period. This followed a 23.4% increase in dividend payout for 2003 versus 2002.
Dividends per share have moved from $ 0.343 to $ 0.421 to $ 0.50 for 2002
through 2004, respectively.
(Dollars in thousands) 2004 2003 2002
At December 31:
Shareholders' equity $ 49,250 $ 42,835 $ 37,962
Equity / assets 9.57% 9.07% 9.25%
For the Year:
Average equity / average assets 9.34% 9.13% 8.92%
Dividend payout 32.89% 30.45% 29.12%
Return on average equity 16.78% 17.24% 17.19%
Dividends paid $ 2,556 $ 2,126 $ 1,722
Regulatory
Regulatory Capital Measures: Minimums
Tier I capital ratio 12.2% 12.2% 12.7% 4.0%
Total (Tier I and Tier II) capital 13.4% 13.4% 13.9% 8.0%
ratio
Leverage ratio 9.3% 8.9% 8.8% 4.0%
The maintenance of a strong capital base, above regulatory risk based
minimums and industry averages, has been an integral part of the Corporation's
operating philosophy. Management foresees no problem in maintaining capital
ratios well in excess of regulatory requirements.
The Corporation and its banking subsidiary are subject to periodic
examinations by the Federal Reserve Bank and the Pennsylvania Department of
Banking. During 2004, three examinations were conducted at the Bank level
including, but not limited to, capital adequacy, asset quality, earnings,
liquidity provisions, sensitivity to market risk, asset/liability management;
evaluation of lending, investment and service; and adherence to civil rights
laws, banking laws and regulations. An exam of risk assessment and management
practices of the Holding Company was also completed in 2004. No comments were
received from regulatory agencies which, if implemented, would have a material
effect on Orrstown Financial Services, Inc.'s liquidity, capital resources, or
operations.
Future Impact of Recently Issued Accounting Standards
In December 2003, the Accounting Standards Executive Committee ("AcSEC") of
the American Institute of Certified Public Accountants issued Statement of
Position ("SOP") 03-3, "Accounting for Certain Loans or Debt Securities Acquired
in a Transfer." The SOP is effective for loans acquired in fiscal years
beginning after December 15, 2004. The scope of the SOP applies to unhealthy
"problem" loans that have been acquired, either individually in a portfolio, or
in a business acquisition. The SOP addresses accounting for differences between
contractual cash flows and cash flows expected to be collected from an
investor's initial investment in loans or debt securities (loans) acquired in a
transfer if those differences are attributable, at least in part, to credit
quality. The SOP does not apply to loans originated by the Company. The
Company intends to adopt the provisions of SOP 03-3 effective January 1, 2005,
and does not expect the initial implementation to have a significant effect on
the Company's consolidated financial position or consolidated results of
operations.
On March 9, 2004, the SEC Staff issued Staff Accounting Bulletin No. 105,
"Application of Accounting Principles to Loan Commitments" ("SAB 105"). SAB 105
clarifies existing accounting practices relating to the valuation of issued loan
commitments, including interest rate lock commitments ("IRLC"), subject to SFAS
No. 149 and Derivative Implementation Group Issue C13, "Scope Exceptions: When a
Loan Commitment is included in the Scope of Statement 133." Furthermore, SAB 105
disallows the inclusion of the values of a servicing component and other
internally developed intangible assets in the initial and subsequent IRLC
valuation. The provisions of SAB 105 were effective for loan commitments entered
into after March 31, 2004. The Company has adopted the provisions of SAB 105.
Since the provisions of SAB 105 affect only the timing of the recognition of
mortgage banking income, management does not anticipate that this guidance will
have a material adverse effect on either the Company's consolidated financial
position or consolidated results of operations.
Emerging Issues Task Force Issue No. (EITF) 03-1 "The Meaning of Other-Than-
Temporary Impairment and Its Application to Certain Investments" was issued and
is effective March 31, 2004. The EITF 03-1 provides guidance for determining
the meaning of "other -than-temporarily impaired" and its application to certain
debt and equity securities within the scope of Statement of Financial Accounting
Standards No. 115 "Accounting for Certain Investments in Debt and Equity
Securities" ("SFAS No. 115") and investments accounted for under the cost
method. The guidance requires that investments which have declined in value due
to credit concerns or solely due to changes in interest rates must be recorded
as other-than-temporarily impaired unless the Company can assert and demonstrate
its intention to hold the security for a period of time sufficient to allow for
a recovery of fair value up to or beyond the cost of the investment which might
mean maturity. This issue also requires disclosures assessing the ability and
intent to hold investments in instances in which an investor determines that an
investment with a fair value less than cost is not other-than-temporarily
impaired. On September 30, 2004, the Financial Accounting Standards Board
decided to delay the effective date for the measurement and recognition guidance
contained in Issue 03-1. This delay does not suspend the requirement to
recognize other-than-temporary impairments as required by existing authoritative
literature. The disclosure guidance in Issue 03-1 was not delayed.
EITF No. 03-16, "Accounting for Investments in Limited Liability Companies
was ratified by the Board and is effective for reporting periods beginning after
June 15, 2004." APB Opinion No. 18, "The Equity Method of Accounting
Investments in Common Stock," prescribes the accounting for investments in
common stock of corporations that are not consolidated. AICPA Accounting
Interpretation 2, "Investments in Partnerships Ventures," of Opinion 18,
indicates that "many of the provisions of the Opinion would be appropriate in
accounting" for partnerships. In EITF Abstracts, Topic No. D-46, "Accounting for
Limited Partnership Investments," the SEC staff clarified its view that
investments of more than 3 to 5 percent are considered to be more than minor
and, therefore, should be accounted for using the equity method. Limited
liability companies (LLCs) have characteristics of both corporations and
partnerships, but are dissimilar from both in certain respects. Due to those
similarities and differences, diversity in practice exists with respect to
accounting for non-controlling investments in LLCs. The consensus reached was
that an LLC should be viewed as similar to a corporation or similar to a
partnership for purposes of determining whether a non-controlling investment
should be accounted for using the cost method or the equity method of
accounting.
In December 2004, the FASB issued Statement of Financial Accounting Standards
No. 123 (revised 2004), "Share-Based Payment." This Statement establishes
standards for the accounting for transactions in which an entity exchanges its
equity instruments for goods or services. It also addresses transactions in
which an entity incurs liabilities in exchange for goods or services that are
based on the fair value of the entity's equity instruments or that may be
settled by the issuance of those equity instruments. The Statement focuses
primarily on accounting for transactions in which an entity obtains employee
services in share-based payment transactions. The Statement requires a public
entity to measure the cost of employee services received in exchange for an
award of equity instruments based on the grant-date fair value of the award
(with limited exceptions). That cost will be recognized over the period during
which an employee is required to provide service in exchange for the award - the
requisite service period (usually the vesting period). The entity will initially
measure the cost of employee services received in exchange for an award of
liability instruments based on its current fair value; the fair value of that
award will be re-measured subsequently at each reporting date through the
settlement date. Changes in fair value during the requisite service period
will be recognized as compensation cost over that period. The grant-date fair
value of employee share options and similar instruments will be estimated using
option-pricing models adjusted for the unique characteristics of those
instruments (unless observable market prices for the same or similar instruments
are available). If an equity award is modified after the grant date,
incremental compensation cost will be recognized in an amount equal to the
excess of the fair value of the modified award over the fair value of the
original award immediately before the modification. This Statement is effective
for public entities that do not file as small business issuers-as of the
beginning of the first interim or annual reporting period that begins after June
15, 2005. For public companies that file as small business issuers - as of the
beginning of the first interim or annual reporting period that begins after
December 15, 2005. Under the transition method, compensation cost is recognized
on or after the required effective date for the portion of outstanding awards
for which the requisite service has not yet been rendered, based on the grant-
date fair value of those awards calculated under Statement 123 for either
recognition or pro forma disclosures. For periods before the required
effective date, entities may elect to apply a modified version of retrospective
application under which financial statements for prior periods are adjusted on a
basis consistent with the pro forma disclosures required for those periods by
Statement 123.
Important Factors Relating to Forward Looking Statements
This Report contains statements that are considered "forward-looking
statements" as defined in the Private Securities Litigation Reform Act of 1995.
In addition, the Corporation may make other written and oral communications from
time to time that contain such statements. Forward-looking statements,
including statements as to industry trends, future expectations and other
matters that do not relate strictly to historical facts, are based on certain
assumptions by management, and are often identified by words or phrases such as
"anticipated", "believe", "expect", "intend", "seek", "plan", "objective",
"trend", and "goal". Forward-looking statements are subject to various
assumptions, risks, and uncertainties, which change over time, and speak only as
of the date they are made.
The Corporation undertakes no obligation to update any forward-looking
statements. Actual results could differ materially from those anticipated in
forward-looking statements and future results could differ materially from
historical performance. In addition to factors mentioned elsewhere in this
Report or previously disclosed in our SEC reports (accessible on the SEC's
website at www.sec.gov or on our website at www.orrstown.com), the following
factors, among others, could cause actual results to differ materially from
forward-looking statements and future results could differ materially from
historical performance:
- - general political and economic conditions may be less favorable than
expected;
- - developments concerning credit quality in various corporate lending
industry sectors as well as consumer and other types of credit, may result in an
increase in the level of our provision for credit losses, nonperforming assets,
net charge-offs and reserve for credit losses;
- - customer borrowing, repayment, investment, and deposit practices generally
may be less favorable than anticipated; and interest rate and currency
fluctuations, equity and bond market fluctuations, and inflation may be grater
than expected;
- - the mix of interest rates and maturities of our interest earning assets and
interest bearing liabilities (primarily loans and deposits) may be less
favorable than expected;
- - competitive product and pricing pressures among financial institutions
within our markets may increase;
- - legislative or regulatory developments, including changes in laws or
regulations concerning taxes, banking, securities, capital requirements and
risk-based capital guidelines, reserve methodologies, deposit insurance and
other aspects of the financial services industry, may adversely affect the
businesses in which we are engaged or our financial results;
- - legal and regulatory proceedings and related matters with respect to the
financial services industry, including those directly involving the Corporation
and its subsidiaries, could adversely affect the Corporation or the financial
services industry generally;
- - pending and proposed changes in accounting rules, policies, practices, and
procedures could adversely affect our financial results;
- - instruments and strategies used to manage exposure to various types of
market and credit risk could be less effective than anticipated, and we may not
be able to effectively mitigate our risk exposures in particular market
environments or against particular types of risk;
- - terrorist activities or other hostilities, including the situation
surrounding Iraq, may adversely affect the general economy, financial and
capital markets, specific industries, and the Corporation; and
" technological changes, including the impact of the Internet on our
businesses, may be more difficult or expensive than anticipated.
SUMMARY OF QUARTERLY FINANCIAL DATA
The unaudited quarterly results of operations for the years ended December 31, are as follows:
2004 2003
Quarter Ended Quarter Ended
(Dollars in thousands) March June September December March June September December
Interest income $ 6,127 $ 6,282 $ 6,606 $ 6,877 $ 5,700 $ 5,884 $ 5,843 $ 6,057
Interest expense 1,661 1,683 1,802 1,840 1,702 1,716 1,667 1,672
Net interest income 4,466 4,599 4,804 5,037 3,998 4,168 4,176 4,385
Provision for loan 150 30 30 0 252 24 24 191
losses
Net interest income after
provision for loan 4,316 4,569 4,774 5,037 3,746 4,144 4,152 4,194
losses
Securities gains (losses) 67 48 0 (27) 178 (7) 23 5
Other income 1,550 1,696 1,818 1,817 1,395 1,591 1,679 1,568
Other expense 3,397 3,696 3,770 3,855 3,119 3,218 3,228 3,445
Income before income 2,536 2,617 2,822 2,972 2,200 2,510 2,626 2,322
taxes
Applicable income taxes 730 726 856 865 656 693 891 438
Net income $ 1,806 $ 1,891 $ 1,966 $ 2,107 $ 1,544 $ 1,817 $ 1,735 $ 1,884
Per Common Share Data
Net income $ $ 0.37 $ 0.39 $ 0.41 $ 0.31 $ 0.36 $ 0.34 $ 0.37
0.35
Diluted net income $ $ 0.36 $ 0.37 $ 0.40 $ 0.30 $ 0.35 $ 0.33 $ 0.36
0.34
Dividends 0.12 0.12 0.13 0.13 0.0955 0.105 0.105 0.115
Performance Statistics
Return on average assets 1.54% 1.55% 1.53% 1.64% 1.52% 1.67% 1.50% 1.60%
Return on average equity 16.47% 16.62% 16.77% 17.22% 16.15% 18.38% 16.70% 17.68%
Average equity / avg. 9.37% 9.33% 9.12% 9.53% 9.41% 9.08% 8.96% 9.07%
assets
All per share amounts have been adjusted to give retroactive recognition to a 5%
stock dividend effective May 30, 2003 and a 2-for-1 stock split paid February
10, 2004.
SELECTED FIVE -YEAR FINANCIAL DATA
ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARIES
Year Ended December 31,
(Dollars in thousands) 2004 2003 2002 2001 2000
Summary of Operations
Interest income $ 25,892 $ 23,484 $ 23,173 $ 23,978 $ 21,758
Interest expense 6,986 6,757 7,985 10,677 10,318
-------- -------- -------- -------- --------
Net interest income 18,906 16,727 15,188 13,301 11,440
Provision for loan losses 210 491 720 504 360
-------- -------- -------- -------- --------
Net interest income after provision for
loan losses 18,696 16,236 14,468 12,797 11,080
Securities gains (losses) 88 199 21 11 114
Other operating income 6,881 6,233 5,339 4,469 3,628
Other operating expenses 14,718 13,010 11,688 10,247 9,113
-------- -------- -------- -------- --------
Income before income taxes 10,947 9,658 8,140 7,030 5,709
Applicable income tax 3,177 2,678 2,225 1,938 1,537
-------- -------- -------- -------- --------
Net income $ 7,770 $ 6,980 $ 5,915 $ 5,092 $ 4,172
-------- -------- -------- -------- --------
Per Common Share Data*
Income before taxes $ 2.14 $ 1.91 $ 1.62 $ 1.41 $ 1.16
Applicable income taxes 0.62 0.53 0.44 0.39 0.31
Net income 1.52 1.38 1.18 1.02 0.85
Diluted net income 1.47 1.34 1.15 1.01 0.84
Cash dividend paid 0.500 0.421 0.343 0.284 0.259
Book value at December 31 9.61 8.44 7.54 6.24 5.40
Average shares outstanding - basic 5,106,683 5,054,370 5,020,288 4,970,084 4,915,753
Average shares outstanding - diluted 5,294,165 5,215,538 5,133,363 5,036,082 4,939,464
Stock Price Statistics*
Close $ 45.00 $ 33.50 $ 22.38 $ 18.57 $ 18.14
High 50.00 34.00 23.81 21.32 19.95
Low 32.50 22.38 18.36 16.67 16.89
Price earnings ratio at close 29.6 24.3 19.0 18.1 21.4
Price to book at close 4.7 4.0 3.0 3.0 3.4
Year-End Balance Sheet Data
Total assets $ 514,651 $ 472,393 $ 410,298 $ 373,728 $ 311,903
Total loans 389,268 345,054 281,391 249,816 209,181
Total investment securities 82,801 92,374 70,125 72,053
91,986
Deposits - noninterest bearing 66,784 42,704 39,881 31,716
52,276
Deposits - interest bearing 338,579 306,367 276,464 241,287 210,292
Total deposits 405,363 358,643 319,168 281,168 242,008
Liabilities for borrowed money 55,062 49,347 58,043 40,228
66,633
Total shareholders' equity 49,250 37,962 31,162 26,674
42,835
Trust assets under management -
market value 349,000 294,000 231,000 221,000 206,000
Performance Statistics
Average equity / average assets 9.34% 9.13% 8.92% 8.70% 8.38%
Return on average equity 16.78% 17.24% 17.19% 17.20% 17.42%
Return on average assets 1.57% 1.57% 1.53% 1.50% 1.46%
* Per share amounts have been restated to reflect:
The 2-for-1 stock split paid February 10, 2004
The 5% stock dividend paid May 30, 2003
The 5% stock dividend paid September 15, 2001
Market, Dividend & Investor Information
Market and Dividend Information
The common stock of Orrstown Financial Services, Inc. is traded in the over-the-
counter market under the symbol ORRF. At the close of business December 31,
2004, there were approximately 2,555 shareholders of record, with a total of
5,126,205 shares outstanding. The table below sets forth the range of high and
low quarterly sales prices and dividends declared per common share.
2004 2003
Market Price Market Price
Quarterly Quarterly
High Low Dividend High Low Dividend
First quarter $50.00 $32.50 $0.12 $24.29 $22.38 $0.0955
Second quarter $44.00 $40.00 $0.12 $29.00 $23.10 $0.1050
Third quarter $47.00 $40.30 $0.13 $33.75 $30.00 $0.1050
Fourth quarter $45.25 $42.00 $0.13 $34.00 $31.88 $0.1150
$0.50 $0.4205
Investor Information
Annual Meeting
The annual meeting of Orrstown Financial Services, Inc. stockholders is
scheduled for May 3, 2005 at 9:00 a.m. at Shippensburg University Conference
Center, 500 Newburg Road, Shippensburg, PA 17257. All stockholders are
cordially invited to attend.
Annual and Quarterly Reports
Copies of the annual and quarterly reports may be obtained at any office of
Orrstown Bank, or by writing to Registrar and Transfer Company or by contacting
Charlene Feuchtenberger, Orrstown Bank, P.O. Box 250, Shippensburg, PA 17257.
Form 10-K
A copy of the corporation's Form 10-K, as filed with the Securities and Exchange
Commission, may be obtained by writing to Orrstown Bank, P.O. Box 250,
Shippensburg, PA 17257.
Transfer Agent
The transfer agent for Orrstown Financial Services, Inc. is Registrar and
Transfer Company, 10 Commerce Drive, Cranford, New Jersey 07016-3572. E-mail:
info@rtco.com. Internet address: www.rtco.com. Phone (800) 368-5948.
Market Makers
Arthurs Lestrange & Co., Inc. Ryan, Beck & Co., Inc. Boenning & Scattergood, Inc.
1405 McFarland Road 220 South Orange Avenue Four Tower Bridge
Pittsburgh, PA 15216 Livingston, NJ 07039 200 Barr Harbor Drive, Suite 300
(877) 282-1941 (800) 342-2325 West Conshohocken, PA 19428
(800) 883-1212
Ferris, Baker Watts, Inc. Janney Montgomery Scott, LLC
100 Light Street 1801 Market Street
Baltimore, MD 21202 10th Floor
(800) 436-2000 Philadelphia, PA 19103
(800) 526-6397