10-K 1 l17962ae10vk.txt CITIZENS & NORTHERN CORPORATION 10-K/FYE 12-31-05 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K (MARK ONE) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2005 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _______________ TO _______________. Commission file number: 0-16084 CITIZENS & NORTHERN CORPORATION (Exact name of Registrant as specified in its charter) PENNSYLVANIA 23-2451943 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.)
90-92 MAIN STREET, WELLSBORO, PA 16901 (Address of principal executive offices) (Zip code) 570-724-3411 (Registrant's telephone number including area code) Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to section 12(g) of the Act: COMMON STOCK Par Value $1.00 Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [ ] No [X] Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [X] Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one:) Large accelerated filer [ ] Accelerated filer [X] Non-accelerated filer [ ] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] The aggregate market value of the registrant's common stock held by non-affiliates at June 30, 2005, the registrant's most recently completed second fiscal quarter, was $256,509,172. The number of shares of common stock outstanding at February 28, 2006 was 8,295,569. DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant's proxy statement for the annual meeting of its shareholders to be held April 18, 2006 are incorporated by reference into Parts III and IV of this report. 1 PART I ITEM 1. BUSINESS Citizens & Northern Corporation ("Corporation") is a holding company whose principal activity is community banking. The Corporation's principal office is located in Wellsboro, Pennsylvania. The largest subsidiary is Citizens & Northern Bank ("C&N Bank"). In the third quarter 2005, the Corporation completed the acquisition of Canisteo Valley Corporation and its subsidiary, First State Bank, a New York State chartered commercial bank with offices in Canisteo and South Hornell, NY. The acquisition of Canisteo Valley Corporation and First State Bank permits expansion of Citizens & Northern Corporation's banking operations into communities located in the southern tier of New York State, in close proximity to many of the northern Pennsylvania branch locations, and provides First State Bank with the administrative and credit management resources of a larger organization. The Corporation's other wholly-owned subsidiaries are Citizens & Northern Investment Corporation and Bucktail Life Insurance Company ("Bucktail"). Citizens & Northern Investment Corporation was formed in 1999 to engage in investment activities. Bucktail reinsures credit and mortgage life and accident and health insurance on behalf of the Bank. C&N Bank is a Pennsylvania banking institution that was formed by the consolidation of Northern National Bank of Wellsboro and Citizens National Bank of Towanda on October 1, 1971. Subsequent mergers included: First National Bank of Ralston in May 1972; Sullivan County National Bank in October 1977; Farmers National Bank of Athens in January 1984; and First National Bank of East Smithfield in May 1990. C&N Bank has held its current name since May 6, 1975, at which time C&N Bank changed its charter from a national bank to a Pennsylvania bank. C&N Bank and First State Bank (collectively, the "Banks") provide an extensive range of banking services, including deposit and loan products for personal and commercial customers. C&N Bank also maintains a trust division that provides a wide range of financial services, such as 401(k) plans, retirement planning, estate planning, estate settlements and asset management. In January 2000, C&N Bank formed a subsidiary, C&N Financial Services Corporation ("C&NFSC"). C&NFSC is a licensed insurance agency that provides insurance products to individuals and businesses. In 2001, C&NFSC added a broker-dealer division, which offers mutual funds, annuities, educational savings accounts and other investment products through registered agents. C&NFSC's operations are not significant in relation to the total operations of the Corporation. Management is currently exploring several options for offering Trust, insurance and brokerage services in New York State. All phases of the Banks' business are competitive. The Banks primarily compete in Tioga, Bradford, Sullivan and Lycoming counties in Pennsylvania, and Steuben and Allegany counties in New York. The Banks compete with local commercial banks headquartered in our market area as well as other commercial banks with branches in our market area. Some of the banks that have branches in the Banks' market area are larger in overall size than the Banks. With respect to lending activities and attracting deposits, the Banks also compete with savings banks, savings and loan associations, insurance companies, regulated small loan companies and credit unions. Also, the Banks compete with mutual funds for deposits. C&N Bank competes with insurance companies, investment counseling firms, mutual funds and other business firms and individuals for trust, investment management, brokerage and insurance services. The Banks are generally competitive with all financial institutions in our service area with respect to interest rates paid on time and savings deposits, service charges on deposit accounts and interest rates charged on loans. The Banks serve a diverse customer base, and are not economically dependent on any small group of customers or on any individual industry. Major initiatives over the last 5 years included the following: - expanded trust and financial services capabilities, including investment management, employee benefits and insurance services; - purchased and remodeled a former bank operations center in Williamsport, PA, and began offering trust and financial management, commercial lending, branch banking and other services, in 2004; - opened a branch office at a leased facility in South Williamsport, PA in 2004; - replaced the core banking computer system in 2004; - constructed and opened a branch facility in Jersey Shore, PA in 2005; - closed on the merger with Canisteo Valley Corporation in 2005; 2 - began construction on 2 new buildings, a branch facility in Old Lycoming Township, PA, and an administration building in Wellsboro, PA, both of which are expected to open in March 2006. At December 31, 2005, C&N Bank had total assets of $1,096,809,000, total deposits of $721,102,000, net loans outstanding of $623,474,000 and 334 full-time equivalent employees. At December 31, 2005, First State Bank had total assets of $44,476,000, total deposits of $37,093,000, net loans outstanding of $21,464,000 and 20 full-time equivalent employees. Most of the activities of the Corporation and its subsidiaries are regulated by federal or state agencies. The primary regulatory relationships are described as follows: - The Corporation is a bank holding company formed under the provisions of Section 3 of the Federal Reserve Act. The Corporation is under the direct supervision of the Federal Reserve and must comply with the reporting requirements of the Federal Bank Holding Company Act. - C&N Bank is a state-chartered, nonmember bank, supervised by the Federal Deposit Insurance Corporation and the Pennsylvania Department of Banking. - Canisteo Valley Corporation is the holding company for First State Bank. The Federal Reserve is the primary regulator for Canisteo Valley Corporation. - First State Bank is a state-chartered, nonmember bank, supervised by the Federal Deposit Insurance Corporation and the New York State Department of Banking. - C&NFSC is a Pennsylvania corporation. The Pennsylvania Department of Insurance regulates C&NFSC's insurance activities. Brokerage products are offered through a third party networking agreement between the Bank and UVEST Financial Services, Inc. - Bucktail is incorporated in the state of Arizona and supervised by the Arizona Department of Insurance. A copy of the Corporation's annual report on Form 10-K, quarterly reports on Form 10-Q, current events reports on Form 8-K, and amendments to these reports, will be furnished without charge upon written request to the Corporation's Treasurer at P.O. Box 58, Wellsboro, PA 16901. Copies of these reports will be furnished as soon as reasonably possible, after they are filed electronically with the Securities and Exchange Commission. The information is also available through the Corporation's web site at www.cnbankpa.com. ITEM 1A. RISK FACTORS The Corporation is subject to the many risks and uncertainties applicable to all banking companies, as well as risks specific to the Corporation's geographic locations. Although the Corporation seeks to effectively manage risks, and maintains a level of equity that exceeds the banking regulatory agencies' thresholds for being considered "well capitalized" (see Note 21 to the consolidated financial statements), management cannot predict the future and cannot eliminate the possibility of credit, operational or other losses. Accordingly, actual results may differ materially from management's expectations. Some of the Corporation's significant risks and uncertainties are discussed below. CREDIT RISK FROM LENDING ACTIVITIES - A significant source of risk is the possibility that losses will be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loan agreements. Most of the Corporation's loans are secured, but some loans are unsecured. With respect to secured loans, the collateral securing the repayment of these loans may be insufficient to cover the obligations owed under such loans. Collateral values may be adversely affected by changes in economic, environmental and other conditions, including declines in the value of real estate, changes in interest rates, changes in monetary and fiscal policies of the federal government, wide-spread disease, terrorist activity, environmental contamination and other external events. In addition, collateral appraisals that are out of date or that do not meet industry recognized standards may create the impression that a loan is adequately collateralized when it is not. The Corporation has adopted underwriting and credit monitoring procedures and policies, including regular reviews of appraisals and borrower financial statements, that management believes are appropriate to mitigate the risk of loss. Also, as discussed further in the "Provision and Allowance for Loan Losses" section of Management's Discussion and Analysis, the Corporation attempts to estimate the amount of losses that may be inherent in the portfolio through a quarterly evaluation process that includes several members of management and that addresses specifically identified problem loans, as well as other quantitative data and qualitative factors. Such risk management and accounting policies and procedures, however, may not prevent unexpected losses that could have a material adverse effect on the Corporation's financial condition, results of operations or liquidity. 3 INTEREST RATE RISK - Business risk arising from changes in interest rates is an inherent factor in operating a banking organization. The Corporation's assets are predominantly long-term, fixed rate loans and debt securities. Funding for these assets comes principally from shorter-term deposits and borrowed funds. Accordingly, there is an inherent risk of lower future earnings or decline in fair value of the Corporation's financial instruments when interest rates change. Significant fluctuations in interest rates could have a material adverse effect on the Corporation's financial condition, results of operations or liquidity. For additional information regarding interest rate risk, see Part II, Item 7A, "Quantitative and Qualitative Disclosures About Market Risk." EQUITY SECURITIES RISK - The Corporation's equity securities portfolio consists primarily of investments in stocks of banks and bank holding companies, mainly based in Pennsylvania. Investments in bank stocks are subject to the risk factors affecting the banking industry, and that could cause a general market decline in the value of bank stocks. Also, losses could occur in individual stocks held by the Corporation because of specific circumstances related to each bank. Further, because of the concentration of its holdings in Pennsylvania banks, these investments could decline in value if there were a downturn in the state's economy. These factors could have a material adverse effect on the Corporation's financial condition, results of operations or liquidity. For additional information regarding equity securities risk, see Part II, Item 7A, "Quantitative and Qualitative Disclosures About Market Risk." BREACH OF INFORMATION SECURITY AND TECHNOLOGY DEPENDENCE - The Corporation relies on software, communication, and information exchange on a variety of computing platforms and networks and over the Internet. Despite numerous safeguards, the Corporation cannot be certain that all of its systems are entirely free from vulnerability to attack or other technological difficulties or failures. The Corporation relies on the services of a variety of vendors to meet its data processing and communication needs. If information security is breached or other technology difficulties or failures occur, information may be lost or misappropriated, services and operations may be interrupted and the Corporation could be exposed to claims from customers. Any of these results could have a material adverse effect on the Corporation's financial condition, results of operations or liquidity. LIMITED GEOGRAPHIC DIVERSIFICATION - The Corporation grants commercial, residential and personal loans to customers primarily in the Pennsylvania Counties of Tioga, Bradford, Sullivan and Lycoming, and in Steuben and Allegany Counties in New York State. Although the Corporation has a diversified loan portfolio, a significant portion of its debtors' ability to honor their contracts is dependent on the local economic conditions within the region. Deterioration in economic conditions could adversely affect the quality of the Corporation's loan portfolio and the demand for its products and services, and accordingly, could have a material adverse effect on the Corporation's financial condition, results of operations or liquidity. GROWTH STRATEGY - In recent years, the Corporation has expanded its operations by adding new branches in Lycoming County, Pennsylvania, and by acquiring Canisteo Valley Corporation in the southern tier of New York State. The Corporation's future financial performance will depend on its ability to execute its strategic plan and manage its future growth. Failure to execute these plans could have a material adverse effect on the Corporation's financial condition, results of operations or liquidity. COMPETITION - All phases of the Corporation's business are competitive. Some competitors are much larger in total assets and capitalization than the Corporation, have greater access to capital markets and can offer a broader array of financial services. There can be no assurance that the Corporation will be able to compete effectively in its markets. Furthermore, developments increasing the nature or level of competition could have a material adverse effect on the Corporation's financial condition, results of operations or liquidity. GOVERNMENT REGULATION AND MONETARY POLICY - The Corporation and the banking industry are subject to extensive regulation and supervision under federal and state laws and regulations. The restrictions imposed by such laws and regulations limit the manner in which the Corporation conducts its business, undertakes new investments and activities and obtains financing. These regulations are designed primarily for the protection of the deposit insurance funds and consumers and not to benefit the Corporation's shareholders. Financial institution regulation has been the subject of significant legislation in recent years and may be the subject of further significant legislation in the future, none of which is in the control of the Corporation. Significant new laws or changes in, or repeals of, existing laws could have a material adverse effect on the Corporation's financial condition, results of operations or liquidity. Further, federal monetary policy, particularly as implemented through the Federal Reserve System, significantly affects short-term interest rates and credit conditions, and any unfavorable change in these conditions could have a material adverse effect on the Corporation's financial condition, results of operations or liquidity. 4 BANK SECRECY ACT AND RELATED LAWS AND REGULATIONS - These laws and regulations have significant implications for all financial institutions. They increase due diligence requirements and reporting obligations for financial institutions, create new crimes and penalties, and require the federal banking agencies, in reviewing merger and other acquisition transactions, to consider the effectiveness of the parties to such transactions in combating money laundering activities. Even innocent noncompliance and inconsequential failure to follow the regulations could result in significant fines or other penalties, which could have a material adverse impact on the Corporation's financial condition, results of operations or liquidity. ITEM 1B. UNRESOLVED STAFF COMMENTS Not applicable. ITEM 2. PROPERTIES The Banks owns each of their properties, except for the facilities located at 68 Main Street, Wellsboro, and 2 East Mountain Avenue, South Williamsport, which are leased. All of the properties are in good condition. None of the owned properties are subject to encumbrance. A listing of properties is as follows: Main administrative office: 90-92 Main Street Wellsboro, PA 16901 Branch offices - C&N Bank: 428 S. Main Street Athens, PA 18810 111 Main Street Dushore, PA 18614 Main Street East Smithfield, PA 18817 104 Main Street Elkland, PA 16920 230-232 Railroad Street Jersey Shore, PA 17740 102 E. Main Street Knoxville, PA 16928 Main Street Laporte, PA 18626 Main Street Liberty, PA 16930 1085 S. Main Street Mansfield, PA 16933 Route 220 Monroeton, PA 18832 3461 Route 405 Highway Muncy, PA 17756 Thompson Street Ralston, PA 17763 503 N. Elmira Street Sayre, PA 18840 2 East Mountain Avenue South Williamsport, PA 17702 41 Main Street Tioga, PA 16946 428 Main Street Towanda, PA 18848 Courthouse Square Troy, PA 16947 90-92 Main Street Wellsboro, PA 16901 130 Court Street Williamsport, PA 17701 Route 6 Wysox, PA 18854 Other C&N Bank offices: Bankcard Services 11822 Route 6 Wellsboro, PA 16901 C&N Financial Services Corp. 68 Main Street Wellsboro, PA 16901 Internal Audit Water Street Wellsboro, PA 16901 First State Bank offices: 3 Main Street Canisteo, NY 14823 111 Main Street Hornell, NY 14843 5 ITEM 3. LEGAL PROCEEDINGS The Corporation and the Banks are involved in various legal proceedings incidental to their business. Management believes the aggregate liability, if any, resulting from such pending and threatened legal proceedings will not have a material, adverse effect on the Corporation's financial condition or results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of 2005, no matters were submitted to a vote of security holders, through the solicitation of proxies or otherwise. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES QUARTERLY SHARE DATA Trades of the Corporation's stock are executed through various brokers who maintain a market in the Corporation's stock. Effective January 13, 2005, the Corporation's stock began to be listed on the NASDAQ SmallCap Market with the trading symbol CZNC. Previously, the Corporation's stock was available through the Over-The-Counter Bulletin Board. As of December 31, 2005, there were 2,425 shareholders of record of the Corporation's common stock. The following table sets forth the approximate high and low sales prices of the common stock during 2005 and 2004.
2005 2004 -------------------------- --------------------------------- Dividend Dividend Declared Declared per per High Low Quarter High Low Quarter ------ ------ -------- ------ ------ --------------- First quarter $32.25 $26.50 $0.23 $27.00 $25.00 $0.22 Second quarter 33.85 25.80 0.23 25.50 24.45 0.22 Third quarter 37.51 25.22 0.23 25.90 24.20 0.22 Fourth quarter 29.46 24.49 0.24 27.00 24.80 0.23 plus 1% plus 1% stock stock dividend dividend
While the Corporation expects to continue its policy of regular quarterly dividend payments, future dividend payments will depend upon maintenance of a strong financial condition, future earnings and capital and regulatory requirements. Also, the Corporation, C&N Bank and First State Bank are subject to restrictions on the amount of dividends that may be paid without approval of banking regulatory authorities. These restrictions are described in Note 21 to the consolidated financial statements. Known "market makers" who handle Citizens & Northern Corporation stock transactions are: Boenning & Scattergood, Inc. 4 Tower Bridge, Suite 300 200 Barr Harbor Drive West Conshohocken, PA 19428 Ferris, Baker, Watts, Inc. 100 Light Street - Eighth Floor Baltimore, MD 21201 Hill Thompson Magid, L.P. 15 Exchange Place Suite 800 Jersey City, NJ 07302 Monroe Securities, Inc. 343 West Erie Suite 410 Chicago, IL 60610 Knight Equity Markets, LP Newport Tower 525 Washington Blvd Jersey City, NJ 07310 Pershing Trading Company, LP 1 Pershing Plaza Jersey City, NJ 07399 RBC Capital Markets Corp. 60 South 6th St. P.O. Box 1160 Minneapolis, MN 55402 Ryan Beck & Co. 18 Columbia Turnpike Florham Park, NJ 07932 Sandler, O'Neill & Partners, LP 919 Third Avenue Sixth Floor New York, NY 10022 6 Janney Montgomery Scott, LLC 1801 Market Street Philadelphia, PA 19103 Schwab Capital Markets, LP 111 Pavonia Avenue East Jersey City, NJ 07310 EQUITY COMPENSATION PLAN INFORMATION The following table sets forth information concerning the Stock Incentive Plan and Independent Directors Stock Incentive Plan, both of which have been approved by the Corporation's shareholders. The figures shown in the table below are as of December 31, 2005.
NUMBER OF NUMBER OF WEIGHTED- SECURITIES SECURITIES TO BE AVERAGE REMAINING ISSUED UPON EXERCISE FOR FUTURE EXERCISE OF PRICE OF ISSUANCE UNDER OUTSTANDING OUTSTANDING EQUITY COMPEN- OPTIONS OPTIONS SATION PLANS ---------------- ----------- -------------- EQUITY COMPENSATION PLANS APPROVED BY SHAREHOLDERS 203,993 $21.51 161,882 EQUITY COMPENSATION PLANS NOT APPROVED BY SHAREHOLDERS 0 N/A 0
More details related to the Corporation's equity compensation plans are provided in Notes 1 and 15 to the consolidated financial statements. SALES OF UNREGISTERED SECURITIES During the year ended December 31, 2005, the Corporation issued 38,814 shares of common stock held in treasury upon the exercise of stock options by employees and directors under the Corporation's equity compensation plans. Exercise prices for the stock options ranged from $13.33 to $26.59 per share and resulted in aggregate cash proceeds to the Corporation of $726,732. Treasury shares were issued upon exercise of options by a small number of employees and directors in reliance upon the private placement exemption from registration under Section 4(2) of the Securities Act of 1933. 7 ITEM 6. SELECTED FINANCIAL DATA
2005 2004 2003 2002 2001 ----------- ----------- ----------- ----------- ----------- INCOME STATEMENT (IN THOUSANDS) Interest income $ 61,108 $ 57,922 $ 55,223 $ 57,285 $ 54,661 Interest expense 25,687 22,606 23,537 26,315 28,356 ----------- ----------- ----------- ----------- ----------- Interest margin 35,421 35,316 31,686 30,970 26,305 Provision for loan losses 2,026 1,400 1,100 940 600 ----------- ----------- ----------- ----------- ----------- Interest margin after provision for loan losses 33,395 33,916 30,586 30,030 25,705 Other income 7,636 6,922 6,595 6,624 6,120 Securities gains 1,802 2,877 4,799 2,888 1,920 Gain from sale of credit card loans 1,906 -- -- -- - Other expenses 28,962 26,001 22,114 20,849 18,671 ----------- ----------- ----------- ----------- ----------- Income before income tax provision 15,777 17,714 19,866 18,693 15,074 Income tax provision 2,793 2,851 3,609 3,734 3,022 ----------- ----------- ----------- ----------- ----------- Net income $ 12,984 $ 14,863 $ 16,257 $ 14,959 $ 12,052 =========== =========== =========== =========== =========== BALANCE SHEET AT YEAR END (IN THOUSANDS) Total securities (1) $ 433,244 $ 479,626 $ 484,825 $ 513,597 $ 437,398 Gross loans, excluding unearned discount 653,299 579,613 524,897 451,145 379,228 Total assets 1,162,954 1,123,002 1,066,901 1,018,768 866,999 Total deposits 757,065 676,545 658,065 640,304 576,274 Stockholders' equity, excluding accumulated other comprehensive income (3) 127,270 121,050 113,306 103,691 94,903 Total stockholders' equity 131,968 131,585 125,343 115,837 100,187 AVERAGE BALANCE SHEET (IN THOUSANDS) Total securities, at amortized cost (1) 446,845 485,183 474,406 470,764 412,654 Gross loans, excluding unearned discount 618,344 551,352 485,150 410,670 346,353 Earning assets 1,065,189 1,036,535 959,556 881,434 759,007 Total assets 1,144,619 1,114,041 1,034,720 943,001 805,229 Total assets, excluding unrealized gains/ losses (4) 1,133,422 1,097,859 1,014,424 930,539 798,590 Total deposits 702,404 669,307 651,026 613,392 544,579 Stockholders' equity, excluding accumulated other comprehensive income (4) 125,076 117,695 108,876 99,361 91,703 Stockholders' equity 132,465 128,374 122,271 107,595 96,021 COMMON STOCK AND PER SHARE DATA Net income per share - basic $ 1.57 $ 1.80 $ 1.97 $ 1.81 $ 1.46 Net income per share - diluted 1.55 1.79 1.96 1.81 1.45 Cash dividends declared per share 0.93 0.89 0.85 0.77 0.71 Stock dividend 1% 1% 1% 1% 1% Stockholders' equity per share (2) 15.89 15.92 15.18 14.04 12.14 Stockholders' equity per share, excluding accumulated other comprehensive income (loss) (2), (4) 15.33 14.65 13.72 12.57 11.50 Weighted average shares outstanding - basic 8,292,141 8,267,321 8,252,358 8,251,861 8,266,563 Weighted average shares outstanding - diluted 8,350,926 8,315,847 8,301,073 8,273,749 8,288,451 Number of shares outstanding at year-end 8,220,791 8,102,646 8,014,625 5,285,606 5,234,800 Number of shares authorized 20,000,000 20,000,000 10,000,000 10,000,000 10,000,000
8
2005 2004 2003 2002 2001 ----- ----- ----- ----- ----- FINANCIAL RATIOS Return on stockholders' equity, excluding accumulated other comprehensive income (3), (4) 10.38% 12.63% 14.93% 15.06% 13.14% Return on stockholders' equity (3) 9.80% 11.58% 13.30% 13.90% 12.55% Return on assets (3) 1.13% 1.33% 1.57% 1.59% 1.50% Stockholders' equity to assets, excluding accumulated other comprehensive income (3), (4) 11.04% 10.72% 10.73% 10.68% 11.48% Stockholders' equity to assets (3) 11.57% 11.52% 11.82% 11.41% 11.92% Stockholders' equity to loans (3) 21.42% 23.28% 25.20% 26.20% 27.72% Net income to: Total interest income 21.25% 25.66% 29.44% 26.11% 22.05% Interest margin 36.66% 42.09% 51.31% 48.30% 45.82% Dividends as a % of net income 58.85% 48.54% 41.96% 41.17% 46.08%
(1) Includes available-for-sale and held-to-maturity securities, and interest-bearing cash and due from banks. (2) For purposes of this computation, the number of outstanding shares has been increased for the effects of a 3-for-2 stock split issued in April 2003 and for 1% stock dividends issued in January following each year-end. (3) Ratios calculated using average balance sheet data. (4) Generally accepted accounting principles ("GAAP") require that available-for-sale securities be reported at fair value, with unrealized gains and losses excluded from earnings and reported separately through stockholders' equity, net of tax. Management believes there is an inherent mismatch between the income statement and balance sheet related to unrealized gains/losses that may create a material inconsistency in earnings-based ratios. Further, the amount of unrealized gains/losses may vary widely from period-to-period, depending on the financial markets as a whole and interest rate movements. Therefore, management has provided these "non-GAAP" amounts and ratios because we believe they provide meaningful information for evaluating the Corporation's financial position and results of operations. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain statements in this section and elsewhere in this Annual Report on Form 10-K are forward-looking statements. Citizens & Northern Corporation and its wholly-owned subsidiaries (collectively, the Corporation) intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995. Forward-looking statements, which are not historical facts, are based on certain assumptions and describe future plans, business objectives and expectations, and are generally identifiable by the use of words such as, "should", "likely", "expect", "plan", "anticipate", "target", "forecast", and "goal". These forward-looking statements are subject to risks and uncertainties that are difficult to predict, may be beyond management's control and could cause results to differ materially from those expressed or implied by such forward-looking statements. Factors which could have a material, adverse impact on the operations and future prospects of the Corporation include, but are not limited to, the following: - changes in monetary and fiscal policies of the Federal Reserve Board and the U.S. Government, particularly related to changes in interest rates - changes in general economic conditions - legislative or regulatory changes - downturn in demand for loan, deposit and other financial services in the Corporation's market area - increased competition from other banks and non-bank providers of financial services - technological changes and increased technology-related costs - changes in accounting principles, or the application of generally accepted accounting principles. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. 9 EARNINGS OVERVIEW 2005 VS. 2004 Net income in 2005 totaled $12,984,000, or $1.57 per share - basic, and $1.55 per share - diluted. Net income for 2005 was down 12.6% from 2004. The Corporation's lower 2005 earnings results reflected the impact of a flat yield curve, a significant increase in noninterest expense, and other factors. Despite substantial loan growth, the net interest margin increased only slightly in 2005 over 2004 (as noted in the "Net Interest Margin" section of Management's Discussion and Analysis, when calculated on a fully taxable equivalent basis, net interest income was lower by $651,000 in 2005 than in 2004). Increases in short-term interest rates contributed to a 13.6% increase in interest expense, while relatively flat (and at times, declining) long-term rates dampened the positive earnings effect of the growth in loans. The impact of rising interest costs became especially apparent in the fourth quarter, as the interest margin fell to $8,787,000 from $9,145,000 in the third quarter. Further, in light of the flat yield curve, the opportunities were very limited for earning a positive spread from maintaining borrowed funds and holding investment securities. Accordingly, the December 31, 2005 balance of available-for-sale securities was $47,787,000 lower than the year-end 2004 balance, and the December 31, 2005 balance of short-term and long-term borrowings was $38,066,000 lower than year-end 2004. Noninterest expense increased $2,961,000 (11.4%) in 2005 over 2004. Total salaries and benefit expenses increased $1,483,000, or 10.1% in 2005 over 2004, primarily due to new hires to accommodate expansion into new branches and for several support functions. Furniture and equipment expense increased $859,000, or 47.6%, mainly due to depreciation and maintenance costs associated with the new core banking software system, which was implemented in the fourth quarter 2004. The provision for loan losses increased $626,000 in 2005 over 2004, mainly due to estimates of possible future charge-offs on several large commercial loans, as well as volume-related increases in the portions of the provision determined based on historical net charge-off and subjective factors. In the fourth quarter 2005, the Corporation realized a gain from the sale of credit card receivables of $1,906,000. After the sale, the Corporation continues to offer credit cards through C&N Bank, but now as an agent for a national credit card issuer. Also in the fourth quarter 2005, the Corporation had net losses from sales of securities of $586,000, contributing to a $1,075,000 reduction in net securities gains in 2005 as compared to 2004. The fourth quarter 2005 losses were mainly from sales of securities that were purchased in 2003 and 2004, when market yields were lower than current conditions. Other (noninterest) income totaled $7,636,000 in 2005, an increase of $714,000, or 10.3%, over 2004. This category includes several sources of revenue. The sources of revenue with the largest increases in 2005 included the following: fees related to credit card operations of $175,000; dividends from Federal Home Loan Bank of Pittsburgh stock of $152,000; and debit card fees of $100,000. 2004 VS. 2003 Net income in 2004 was $14,863,000, or $1.80 per share - basic and $1.79 per share - diluted. Net income for 2004 was 8.6%, lower than the $16,257,000 ($1.97 per share - basic and $1.96 per share - diluted) recorded in 2003. Realized securities gains, net of realized losses, decreased $1,922,000 to $2,877,000 in 2004 from $4,799,000 in 2003. In both 2004 and 2003. the Corporation sold selected bank stocks that management believed to be fully valued, generating substantial realized gains. Assuming an income tax rate of 34%, the lower securities gains in 2004 reduced net income for 2004 by $1,269,000 from 2003. Excluding the effects of lower securities gains, net income for 2004 was approximately 1% lower than the amount recorded in 2003. The interest margin increased $3,630,000, or 11.5% in 2004 from $31,686,000 in 2003. Higher interest income, primarily from growth in loans, combined with lower interest expense, combined to drive the increase in the interest margin. Other (noninterest) operating expenses increased $1,363,000, or 25.9%, in 2004 over 2003. Overall, the increase in noninterest expenses resulted from start-up of the Williamsport and South Williamsport facilities, the implementation of the core computer system conversion and other activities that resulted in more expense incidental to additional personnel and technology costs. 10 OUTLOOK FOR 2006 Earnings for 2005 were impacted by 2 significant factors that will probably continue to have an effect in 2006: (1) continuation of a flat yield curve, for at least the first 3-4 months of 2006, and (2) start-up costs associated with our recent expansion and new facilities. Continuing tightening by the Federal Reserve (eight 1/4% increases in the Fed Funds target rate in 2005, and another in January 2006) have driven up interest costs on deposits and borrowings, and will continue to do so for at least the first few months of 2006. As the short end of the yield curve has been rising, the long end has fallen slightly. Accordingly, competitive rates for loans and debt securities have not increased commensurately with the increase in funding costs. Management expects the expansion and investments in new markets to provide future, continuing opportunities for earnings growth. In 2006, however, expenses associated with new facilities, personnel and other start-up costs, will affect earnings. The estimated increase in salaries and benefit expenses associated with having a full year of operations in Jersey Shore (which opened in August 2005), and an estimated 10 months of operations in the new facility in Old Lycoming Township, is $364,000. Further, depreciation and other occupancy expenses in 2006 from the new administration building in Wellsboro and the Old Lycoming Township facility, are estimated at approximately $400,000. Another major variable that affects the Corporation's earnings is securities gains and losses. Management's decisions regarding sales of securities are based on a variety of factors, with the overall goal of maximizing portfolio return over a long-term horizon. It is difficult to predict, with much precision, the amount of net securities gains and losses that will be realized in 2006. Total capital purchases for 2006 are estimated to total approximately $4.3 million, including approximately $1.7 million to complete the Wellsboro administration and Old Lycoming Township facilities. CRITICAL ACCOUNTING POLICIES The presentation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect many of the reported amounts and disclosures. Actual results could differ from these estimates. A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses. Management believes that the allowance for loan losses is adequate and reasonable. The Corporation's methodology for determining the allowance for loan losses is described in a separate section later in Management's Discussion and Analysis. Given the very subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make materially different assumptions, and could, therefore calculate a materially different allowance value. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation's allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination. Another material estimate is the calculation of fair values of the Corporation's debt securities. The Corporation receives estimated fair values of debt securities from an independent valuation service, or from brokers. In developing these fair values, the valuation service and the brokers use estimates of cash flows, based on historical performance of similar instruments in similar interest rate environments. Based on experience, management is aware that estimated fair values of debt securities tend to vary among brokers and other valuation services. Accordingly, when selling debt securities, management typically obtains price quotes from more than one source. As described in Note 1 to the consolidated financial statements, the large majority of the Corporation's securities are classified as available-for-sale. Accordingly, these securities are carried at fair value on the consolidated balance sheet, with unrealized gains and losses excluded from earnings and reported separately through accumulated other comprehensive income (included in stockholders' equity). 11 NET INTEREST MARGIN 2005/2004/2003 The Corporation's primary source of operating income is represented by the net interest margin. The net interest margin is equal to the difference between the amounts of interest income and interest expense. Tables I, II and III include information regarding the Corporation's net interest margin in 2005, 2004 and 2003. In each of these tables, the amounts of interest income earned on tax-exempt securities and loans have been adjusted to a fully taxable-equivalent basis. Accordingly, the net interest margin amounts presented in these tables exceed the amounts presented in the consolidated financial statements. The discussion that follows is based on amounts in the Tables. The net interest margin, on a tax-equivalent basis, was $38,567,000 in 2005, down $651,000, or 1.7%, from 2004. As reflected in Table III, interest rate changes had the effect of decreasing net interest income $2,310,000 in 2005 as compared to 2004, as rising short-term interest rates caused increases in the Corporation's interest expense on money market deposits, certificates of deposits and short-term borrowings. Table III also shows that increased interest income from higher volumes of earning assets (primarily loans) exceeded increases in interest expense attributable to higher volumes of interest-bearing liabilities by $1,659,000 in 2005 compared to 2004. As presented in Table II, the "Interest Rate Spread" (excess of average rate of return on interest-bearing assets over average cost of funds on interest-bearing liabilities) was 3.22% in 2005, compared to 3.43% in 2004. In 2004, the net interest margin was $39,218,000, an increase of $3,736,000 or 10.5%, over 2003. As reflected in Table III, increased interest income from higher volumes of earning assets exceeded increases in interest expense attributable to higher volumes of interest-bearing liabilities by $2,830,000 in 2004 compared to 2003. Table III also shows that interest rate changes had the effect of increasing net interest income $906,000 in 2004 compared to 2003. As shown in Table II, the Interest Rate Spread of 3.43% in 2004 was up from 3.31% in 2003. INTEREST INCOME AND EARNING ASSETS Interest income increased 3.9%, to $64,254,000 in 2005 from $61,824,000 in 2004. Interest and fees from loans increased $4,748,000, or 13.3%, while income from available-for-sale securities decreased $2,426,000, or 9.3%. Overall, the majority of the increase in interest income resulted from higher volumes of loans, which more than offset the effect of the lower average volume of available-for-sale securities. As indicated in Table II, average available-for-sale securities in 2005 amounted to $442,525,000, a decrease of 8.3% from 2004. Proceeds from sales and maturities of securities have been used, in part, to help fund the substantial growth in loans. Also, because short-term interest rates have been rising faster than long-term rates, there have been few opportunities to purchase mortgage-backed securities or other bonds at spreads sufficient to justify the applicable interest rate risk. The average rate of return on available-for-sale securities was 5.35% for 2005, slightly lower than the 5.41% rate of return for 2004. Tax-exempt securities (municipal bonds) were a smaller portion of the Corporation's earning assets in 2005 than in 2004. The average balance of municipal bonds shrunk to $123,295,000 in 2005 from $151,049,000 in 2004. Management decided to reduce the Corporation's investment in municipal bonds in order to reduce the potential for an alternative minimum tax liability that would otherwise have been expected for 2005. The average balance of gross loans increased 12.2% in 2005 over 2004, to $618,344,000 from $551,352,000. The acquisition of loans from First State Bank, which were added to the Corporation's balance sheet for the last 4 months of 2005 contributed $7,804,000 (1.4%) of the growth in average loans. The largest growth was in commercial loans, due in part to new personnel and relationships in Williamsport and throughout Lycoming County, as well as from growth in staffing and an increased emphasis on commercial lending throughout the Corporation's market area over the last few years. The average rate of return on loans was 6.53% in 2005, as compared to 6.47% in 2004. As reflected in Table II, the average balance of available-for-sale securities increased $11,043,000, or 2.3% in 2004 over 2003, while the average yield of 5.41% was comparable to the 2003 average yield of 5.43%. Average loans increased $66,202,000, or 13.6%, in 2004 over 2003, reflecting growth in commercial lending that continued into 2005. The average yield on loans was 6.47%, significantly lower than the average yield in 2003 of 6.88%. The lower average yield on loans in 2004 resulted from significant levels of mortgage refinancings that occurred in 2003, and by lower average yields on commercial loans with variable or adjustable rates. 12 INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES Interest expense rose $3,081,000, or 13.6%, to $25,687,000 in 2005 from $22,606,000 in 2004. Table II reflects the current trend in interest rates incurred on liabilities, as the overall cost of funds on interest-bearing liabilities rose to 2.81% in 2005, from 2.53% in 2004. In Table II, you can see the impact of rising short-term interest rates on some of the Corporation's largest sources of funds: (1) money market accounts, which increased to an average rate of 2.20% in 2005 from 1.31% in 2004, (2) certificates of deposit (CDs), which increased to an average rate of 3.26% from 2.85%, (3) short-term borrowings, which rose to an average rate of 2.80% from 1.37%, and (4) interest checking accounts, which increased to an average interest rate of 1.15% from 0.59%. Helping to offset some of the impact of rising short-term market rates were passbook Individual Retirement Accounts (IRAs), for which the average rate fell to 3.46% from 3.75%, and long-term borrowings, for which the average rate fell to 3.47% from 3.55%. In the first quarter 2004, the average rate paid on the majority of the Corporation's IRAs was 5%, which was the "floor" on 18-month passbook IRAs that existed prior to October 1, 2003. Effective April 1, 2004, the floor on those IRAs fell to 3%, and the Corporation's passbook IRA rate has ranged from 3.25% to 3.60% thereafter. The decrease in average rate incurred on long-term borrowings resulted from repayment of borrowings originated in earlier interest rate cycles at higher rates. As you can calculate from Table II, total average deposits (interest-bearing and noninterest-bearing) increased to $702,404,000 in 2005 from $669,307,000 in 2004, an increase of 4.9%. Fluctuations in deposits of nonprofit and municipal customers impacted average deposit balances significantly in 2005, as the Corporation has both lost and gained customers with average balances exceeding $10 million. The acquisition of deposits from First State Bank contributed $13,405,000, or 2.0%, of the increase in average deposits. Average total short-term and long-term borrowed funds amounted to $299,254,000 in 2005, down from $307,669,000 in 2004. In 2004, the Corporation utilized borrowings to fund security purchases and to help fund loan growth. In 2005, this trend has changed, as management has begun to use proceeds from the securities portfolio to help fund loan growth, and has either rolled over maturing long-term borrowings into short-term borrowing instruments at lower rates, or "shrunk the balance sheet" by paying off long-term borrowings as they mature, without replacement. This change in trend is reflected in the consolidated balance sheet, as total short-term borrowings increased slightly, to $34,734,000 at December 31, 2005 from $34,178,000 at December 31, 2004, and total long-term borrowings decreased to $232,205,000 at December 31, 2005 from $270,827,000 at December 31, 2004. Interest expense fell to $22,606,000 in 2004 from $23,537,000 in 2003. As reflected in Table III, lower average rates had the effect of lowering interest expense $3,161,000 in 2004. The impact of lower rates more than offset the effects on interest expense of higher average balances of interest-bearing liabilities in 2004 than in 2003. Because of eliminating the 5% floor on passbook IRAs, as noted above, the average rate incurred on IRAs fell to 3.75% in 2004 from 4.88% in 2003. Also, the average rate incurred on CDs was 2.85% in 2004, down from 3.14% in 2003. 13 TABLE I - ANALYSIS OF INTEREST INCOME AND EXPENSE
YEAR ENDED DECEMBER 31, INCREASE(DECREASE) --------------------------- ------------------ 2005 2004 2003 05/04 04/03 ------- ------- ------- ------- ------- (IN THOUSANDS) INTEREST INCOME Available-for-sale securities: Taxable $15,407 $15,415 $14,823 $ (8) $ 592 Tax-exempt 8,290 10,708 10,768 (2,418) (60) ------- ------- ------- ------- ------ Total available-for-sale securities 23,697 26,123 25,591 (2,426) 532 ------- ------- ------- ------- ------ Held-to-maturity securities, Taxable 25 27 31 (2) (4) Interest-bearing due from banks 34 11 10 23 1 Federal funds sold 97 10 8 87 2 Loans: Taxable 38,768 34,251 32,235 4,517 2,016 Tax-exempt 1,633 1,402 1,144 231 258 ------- ------- ------- ------- ------ Total loans 40,401 35,653 33,379 4,748 2,274 ------- ------- ------- ------- ------ Total Interest Income 64,254 61,824 59,019 2,430 2,805 ------- ------- ------- ------- ------ INTEREST EXPENSE Interest checking 535 232 266 303 (34) Money market 4,148 2,514 2,712 1,634 (198) Savings 303 283 425 20 (142) Certificates of deposit 6,428 5,135 5,959 1,293 (824) Individual Retirement Accounts 4,184 4,376 5,182 (192) (806) Other time deposits 6 5 17 1 (12) Short-term borrowings 1,239 542 487 697 55 Long-term borrowings 8,844 9,519 8,489 (675) 1,030 ------- ------- ------- ------- ------ Total Interest Expense 25,687 22,606 23,537 3,081 (931) ------- ------- ------- ------- ------ Net Interest Income $38,567 $39,218 $35,482 $ (651) $3,736 ======= ======= ======= ======= ======
(1) Interest income from tax-exempt securities and loans has been adjusted to a fully taxable-equivalent basis, using the Corporation's marginal federal income tax rate of 34%. (2) Fees on loans are included with interest on loans and amounted to $915,000 in 2005, $987,000 in 2004 and $1,323,000 in 2003. 14 TABLE II - ANALYSIS OF AVERAGE DAILY BALANCES AND RATES
2005 2004 2003 -------------------- -------------------- -------------------- RATE OF RATE OF RATE OF RETURN/ RETURN/ RETURN/ COST OF COST OF COST OF AVERAGE FUNDS AVERAGE FUNDS AVERAGE FUNDS BALANCE % BALANCE % BALANCE % ---------- ------- ---------- ------- ---------- ------- (DOLLARS IN THOUSANDS) EARNING ASSETS Available-for-sale securities, at amortized cost: Taxable $ 319,230 4.83% $ 331,447 4.65% $ 325,082 4.56% Tax-exempt 123,295 6.72% 151,049 7.09% 146,371 7.36% ---------- ---- ---------- ---- ---------- ---- Total available-for-sale securities 442,525 5.35% 482,496 5.41% 471,453 5.43% ---------- ---- ---------- ---- ---------- ---- Held-to-maturity securities, Taxable 427 5.85% 460 5.87% 604 5.13% Interest-bearing due from banks 1,293 2.63% 1,449 0.76% 1,669 0.60% Federal funds sold 2,600 3.73% 778 1.29% 680 1.18% Loans: Taxable 592,227 6.55% 530,045 6.46% 468,501 6.88% Tax-exempt 26,117 6.25% 21,307 6.58% 16,649 6.87% ---------- ---- ---------- ---- ---------- ---- Total loans 618,344 6.53% 551,352 6.47% 485,150 6.88% ---------- ---- ---------- ---- ---------- ---- Total Earning Assets 1,065,189 6.03% 1,036,535 5.96% 959,556 6.15% Cash 9,014 14,273 13,583 Unrealized gain/loss on securities 11,197 16,182 20,296 Allowance for loan losses (7,297) (6,523) (5,908) Bank premises and equipment 19,247 14,953 11,090 Intangible Asset - Core Deposit Intangible 169 -- -- Intangible Asset - Goodwill 983 -- -- Other assets 46,117 38,621 36,103 ---------- ---------- ---------- Total Assets $1,144,619 $1,114,041 $1,034,720 ========== ========== ========== INTEREST-BEARING LIABILITIES Interest checking $ 46,408 1.15% $ 39,188 0.59% $ 37,647 0.71% Money market 188,507 2.20% 192,450 1.31% 190,161 1.43% Savings 60,203 0.50% 57,439 0.49% 54,789 0.78% Certificates of deposit 197,165 3.26% 180,332 2.85% 190,019 3.14% Individual Retirement Accounts 121,013 3.46% 116,622 3.75% 106,216 4.88% Other time deposits 1,152 0.52% 1,275 0.39% 1,666 1.02% Short-term borrowings 44,267 2.80% 39,458 1.37% 7,033 1.29% Long-term borrowings 254,987 3.47% 268,211 3.55% 242,358 3.67% ---------- ---- ---------- ---- ---------- ---- Total Interest-bearing Liabilities 913,702 2.81% 894,975 2.53% 829,889 2.84% Demand deposits 87,956 82,001 70,528 Other liabilities 10,496 8,691 12,032 ---------- ---------- ---------- Total Liabilities 1,012,154 985,667 912,449 ---------- ---------- ---------- Stockholders' equity, excluding other comprehensive income/loss 125,076 117,695 108,876 Other comprehensive income/loss 7,389 10,679 13,395 Total Stockholders' Equity 132,465 128,374 122,271 ---------- ---------- ---------- Total Liabilities and Stockholders' Equity $1,144,619 $1,114,041 $1,034,720 ========== ========== ========== Interest Rate Spread 3.22% 3.43% 3.31% Net Interest Income/Earning Assets 3.62% 3.78% 3.70%
(1) Rates of return on tax-exempt securities and loans are calculated on a fully-taxable equivalent basis, using the Corporation's marginal federal income tax rate of 34%. (2) Nonaccrual loans are included in the loan balances above. 15 TABLE III - THE EFFECT OF VOLUME AND RATE CHANGES ON INTEREST INCOME AND INTEREST EXPENSE
YEAR ENDED 12/31/05 VS. 04 YEARS ENDED 12/31/04 VS. 03 --------------------------- --------------------------- CHANGE CHANGE CHANGE CHANGE IN IN TOTAL IN IN TOTAL VOLUME RATE CHANGE VOLUME RATE CHANGE ------- ------- ------- ------ ------- ------- (IN THOUSANDS) EARNING ASSETS Available-for-sale securities: Taxable $ (579) $ 571 $ (8) $ 426 $ 166 $ 592 Tax-exempt (1,888) (530) (2,418) 338 (398) (60) ------- ------- ------- ------ ------- ------- Total available-for-sale securities (2,467) 41 (2,426) 764 (232) 532 ------- ------- ------- ------ ------- ------- Held-to-maturity securities, Taxable (2) -- (2) (8) 4 (4) Interest-bearing due from banks (1) 24 23 (1) 2 1 Federal funds sold 48 39 87 1 1 2 Loans: Taxable 4,066 451 4,517 3,996 (1,980) 2,016 Tax-exempt 304 (73) 231 308 (50) 258 ------- ------- ------- ------ ------- ------- Total loans 4,370 378 4,748 4,304 (2,030) 2,274 ------- ------- ------- ------ ------- ------- Total Interest Income 1,948 2,430 5,060 2,805 482 (2,255) ------- ------- ------- ------ ------- ------- INTEREST-BEARING LIABILITIES Interest checking 50 253 303 11 (45) (34) Money market (53) 1,687 1,634 33 (231) (198) Savings 14 6 20 20 (162) (142) Certificates of deposit 506 787 1,293 (294) (530) (824) Individual Retirement Accounts 161 (353) (192) 473 (1,279) (806) Other time deposits -- 1 1 (3) (9) (12) Short-term borrowings 73 624 697 1 8 9 Long-term borrowings (462) (213) (675) 1,989 (913) 1,076 ------- ------- ------- ------ ------- ------- Total Interest Expense 289 2,792 3,081 2,230 (3,161) (931) ------- ------- ------- ------ ------- ------- Net Interest Income $ 1,659 $(2,310) $ (651) $2,830 $ 906 $ 3,736 ======= ======= ======= ====== ======= =======
(1) Changes in interest income on tax-exempt securities and loans are presented on a fully taxable-equivalent basis, using the Corporation's marginal federal income tax rate of 34%. (2) The change in interest due to both volume and rates has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. 16 NONINTEREST INCOME 2005/2004/2003 Total noninterest income increased $1,545,000, or 15.8%, in 2005 as compared to 2004. In 2004, total noninterest income decreased $1,595,000, or 14.0%, compared to 2003. The gain from sale of credit card loans, and fluctuations in amounts of net realized security gains in 2005, 2004 and 2003 are discussed in the "Earnings Overview" section of Management's Discussion and Analysis. Excluding the effect of the credit card sale and net securities gains, noninterest income increased $714,000, or 10.3%, in 2005 over 2004, and $327,000, or 5.0%, in 2004 over 2003. Items of significance related to changes in other income are as follows: 2005 VS. 2004 - Service charges on deposit accounts fell slightly, to $1,689,000 in 2005 from $1,717,000 in 2004. Throughout much of the first half of 2005, changes in deposit account processing resulting from the new core banking system resulted in overdraft and other charges not being assessed for some transactions that would have generated charges with the former system. Management worked with the core system vendor, and during the third quarter 2005 was able to reestablish virtually all of the remaining, significant overdraft and service charge routines. Those changes, along with fee increases in overdraft and other services, helped restore service charge revenue for 2005, on an annual basis, to a level almost as high as in 2004. - Other service charges and fees increased $59,000, or 19.2%, in 2005 over 2004, primarily from higher volumes of transactions, including letters of credit, ATM surcharges and other transactions. - Trust and financial management revenue decreased 0.8%, to $2,088,000 in 2005 from $2,105,000 in 2004. The small decrease in revenue for 2005 occurred mainly because revenue for 2004 included more fees collected from settlements of estates. Much of the trust fees are determined based on the amount of assets under management, which have increased 9.2% as of December 31, 2005 as compared to one year earlier, to $418,259,000. - Insurance commissions, fees and premiums increased $52,000, or 11.8%, in 2005 over 2004. In the third quarter 2005, Bucktail recorded a "catch-up" adjustment to recognize revenue for insurance premiums associated with policies issued related to collateral mortgage transactions. Overall, Bucktail's operations are not a significant component of the Corporation's operations. - The increase in cash surrender value of insurance fell $50,000, or 8.2%, in 2005 as compared to 2004. The Corporation's policy return is determined, in part, by the amount of earnings generated from a pooled separate investment trust held by the life insurance company. In 2005, earnings from that pooled separate trust fund were lower than in 2004, which is reflective of lower market yields on debt securities. - Fees related to the Corporation's credit card operation increased $175,000, or 22.4%, in 2005 over 2004, primarily because of higher volumes and rates on merchant processing and interchange transactions. Within this category, the largest increase was in interchange fees, which increased $123,000 in 2005, to $758,000. This source of revenue will not recur after 2005, due to the sale of the credit card portfolio. The second largest source of revenue within this category, merchant processing fees, increased $57,000 in 2005, to $141,000. The Corporation did not sell its merchant services as part of the credit card portfolio sale, and will continue to provide merchant processing services in 2006. - Other operating income increased $523,000, or 53.9%, in 2005 over 2004. Within this line item, the largest changes in 2005 were increases in the following categories: - dividends from Federal Home Loan Bank of Pittsburgh stock, which increased $152,000 to $325,000 - debit card fees, which increased $100,000 to $358,000 - broker dealer revenues, which increased $87,000 to $297,000, and - training grant revenue of $65,000, with none received in 2004. 2004 VS. 2003 - Trust and financial management revenue rose $372,000, or 21.5% for 2004 compared to 2003. Trust and financial management revenue for 2004 included the effects of some large estate settlements, and also reflected 16.2% growth in assets under management at December 31, 2004, as compared to December 31, 2003. 17 - The increase in cash surrender value of life insurance fell $105,000 to $610,000 in 2004 from $715,000 in 2003. As in 2005, lower earnings on the policy were reflective of lower earnings from the pooled separate trust fund's holdings of debt securities. TABLE IV - COMPARISON OF NONINTEREST INCOME
2005 % CHANGE 2004 % CHANGE 2003 ------- -------- ------ -------- ------- (IN THOUSANDS) Service charges on deposit accounts $ 1,689 (1.6) $1,717 (1.7) $ 1,746 Service charges and fees 367 19.2 308 7.3 287 Trust and financial management revenue 2,088 (0.8) 2,105 21.5 1,733 Insurance commissions, fees and premiums 491 11.8 439 12.3 391 Increase in cash surrender value of life insurance 560 (8.2) 610 (14.7) 715 Fees related to credit card operation 948 22.6 773 (1.4) 784 Other operating income 1,493 53.9 970 3.3 939 ------- ---- ------ ----- ------- Total other income before gain on sale of credit card loans and realized gains on securities, net 7,636 10.3 6,922 5.0 6,595 Gain on sale of credit card loans 1,906 -- -- Realized gains on securities, net 1,802 (37.4) 2,877 (40.1) 4,799 ------- ---- ------ ----- ------- Total Other Income $11,344 15.8 $9,799 (14.0) $11,394 ======= ==== ====== ===== =======
OTHER NONINTEREST EXPENSE 2005/2004/2003 Total noninterest expense increased $2,961,000, or 11.4%, in 2005 over 2004, to $28,962,000. Noninterest expense from Canisteo Valley Corporation and First State Bank totaled $577,000, or 2.2%, of the 2005 increase. In 2004, total noninterest expense increased $3,887,000, or 17.6%, over 2003. 2005 VS. 2004 Salaries and wages increased $1,135,000, or 10.1%, in 2005 over 2004. The increase in salaries expense is primarily a reflection of a greater number of employees, resulting from expansion into new branches and the addition of new employees for support functions. The number of full-time equivalent employees was 354 as of December 31, 2005, up 9.3% from one year earlier. Pensions and other employee benefit expenses increased $348,000, or 10.2%, in 2005 over 2004. In the aggregate, total pensions and other employee benefits expense, as a percentage of salaries and wages, was 30.3%, the same as in 2004. Increases in numbers of employees drove up expenses for health insurance, contributions to the savings and retirement (401(k)) plan and payroll taxes. Helping to mitigate some of the expense increases within this category were reductions in expense associated with the defined benefit plan and professional fees related to employee benefit plan matters. More detail concerning the Corporation's retirement plans is provided in Note 15 to the consolidated financial statements. Occupancy expense increased $178,000, or 10.7%, in 2005 over 2004, primarily as a result of higher depreciation and maintenance costs associated with new facilities. Furniture and equipment expense increased $859,000, or 47.6%, in 2005 over 2004. Depreciation expense within this category increased $586,000, to $1,601,000 in 2005 from $1,015,000 in 2004, including an increase of $468,000 in 2005 from the new core banking software system that was placed in service during the fourth quarter 2004. Similarly, maintenance and repair expense within this category increased $241,000 in 2005 over 2004, primarily because of inclusion of a full year of maintenance costs associated with the new core banking software system of approximately $377,000 in 2005, up from 2 months' of costs totaling $60,000 in 2004. 18 Other operating expense increased $435,000, or 6.6%, in 2005 over 2004. Most of the line items within this category increased in 2005, in part due to expansion into more locations and the resulting higher volume of transactions and costs. Total other operating expense incurred by Canisteo Valley Corporation and First State Bank in the final 4 months of 2005 totaled $281,000, or 4.2% of the total increase. The most significant increases within this category were: (1) expenses associated with maintaining and preparing other real estate properties for sale, which increased $210,000 in 2005 to $304,000; (2) attorney fees, which increased $164,000 in 2005 to $203,000, mainly because of collection activities on a large commercial credit, and (3) Bucktail expenses, which increased $117,000 to $323,000, due to a larger volume of claims. Helping to reduce the overall increase in this category was a decrease in professional fees of $530,000, to $215,000 in 2005. In 2004, the Corporation incurred a significant amount of professional fees expense associated with the core banking system conversion. 2004 VS. 2003 Salaries and wages increased $1,552,000, or 16.0%, for 2004 compared to 2003. The number of full-time equivalent employees (FTEs) increased 10.6%, to 324 at December 31, 2004 from 293 at December 31, 2003. The increased number of employees included personnel for the new Willamsport and South Williamsport branches opened in 2004, as well as new positions added in 2004 for Trust, Commercial Lending, Loan Administration, Accounting and Employee Training functions, as well as 5 Management Trainees who worked primarily on the core computer system conversion. In addition, paid overtime increased approximately $90,000 in 2004 over 2003, mainly due to core system conversion efforts. Pensions and other employee benefits increased $87,000, or 2.6%, in 2004 over 2003. As a percentage of salaries and wages, pensions and other employee benefits fell to 30.3% in 2004 from 34.2% in 2003. In 2004, employer contributions to the 401(k) profit sharing plan totaled 6.7% of salaries and wages, down from 7.8% in 2003. The lower percentage of profit sharing contributions in 2004 reflected a higher proportion of new employees hired in 2004, as the new hires began to qualify for contributions in 2005. Other expense reductions in 2004 included professional fees related to employee benefit matters, which decreased $89,000 to $167,000, defined benefit pension plan expense, which decreased $45,000 to $388,000 and supplemental executive retirement plan expense, which fell $41,000 to $4,000. Occupancy expense increased $369,000, or 28.5%, in 2004 over 2003. The greatest portion of the increase in occupancy expense was attributable to increased costs of $112,000 for building maintenance and repairs. Depreciation expense also rose $93,000 from 2003's level, as the Corporation recorded depreciation on the new Williamsport facility and on building renovation costs for several locations. Total energy costs increased $68,000, primarily due to higher utility rates in several locations, as well as the initial expenses associated with the Williamsport and South Williamsport facilities during 2004. Furniture and equipment expense increased $433,000, or 31.6%, in 2004 compared to 2003. The largest increase within this category was in depreciation expense, which increased $283,000. The depreciation expense related to the Corporation's Management Information Systems function increased $180,000 in 2004, including $143,000 related to software and hardware for the new core system that was placed in service in October 2004. Depreciation expense also increased due to the addition of computer equipment and furniture for the Williamsport and South Williamsport locations. In addition to the increase in depreciation, maintenance and repairs expense increased $121,000 in 2004, mainly due to maintenance contracts associated with the new software and hardware. In total, other operating expense increased $1,363,000, or 25.9%, in 2004 over 2003. This category includes many different types of expenses. The most significant changes within this category are as follows: - Bank professional fees increased $374,000, to $745,000. Included in this category was approximately $347,000 in expenses for training and other professional services related to the core banking software implementation. - Supplies expense increased $204,000, to $645,000 in 2004. This increase included costs associated with new locations and an increased number of employees as well as supplies used in the new core system training. - Travel, lodging and meal expenses increased $171,000 to $284,000 mainly from costs related to teams of employees who traveled to the vendor's headquarters for training on the new core system. - Fees paid to Corporation, Bank and Advisory Board Directors increased $106,000 in 2004, to $406,000. This reflected increases in rates paid for meeting fees, and retainers, based on recommendations from a competitive survey completed by a consultant early in 2004. Prior to 2004, no Director fee rates had increased since 1999. - Software-related expense increased $101,000 in 2004, to $250,000. This increase was mainly attributable to costs associated with a new Human Resources Information System that was installed in 2004. 19 - Advertising expense increased $90,000 in 2004, to $464,000, mainly due to advertising programs in the Williamsport marketplace. TABLE V - COMPARISON OF NONINTEREST EXPENSE
2005 % CHANGE 2004 % CHANGE 2003 ------- -------- ------- -------- ------- (IN THOUSANDS) Salaries and wages $12,383 10.1 $11,248 16.0 $ 9,696 Pensions and other employee benefits 3,752 10.2 3,404 2.6 3,317 Occupancy expense, net 1,842 10.7 1,664 28.5 1,295 Furniture and equipment expense 2,664 47.6 1,805 31.6 1,372 Expenses related to credit card operation 462 11.6 414 7.5 385 Pennsylvania shares tax 804 (5.0) 846 6.8 792 Other operating expense 7,055 6.6 6,620 25.9 5,257 ------- ---- ------- ---- ------- Total Other Expense $28,962 11.4 $26,001 17.6 $22,114 ======= ==== ======= ==== =======
INCOME TAXES The income tax provision was $2,793,000, or 17.70% of pre-tax income, in 2005, as compared to 16.09% in 2004 and 18.17% in 2003. The increase in the tax provision/pre-tax income rate in 2005 over 2004 reflected lower average holdings of tax-exempt securities. Management decided to reduce the Corporation's investment in municipal bonds in order to reduce the potential for an alternative minimum tax liability that would otherwise have been expected for 2005. In contrast, the lower income tax expense rate in 2004 than in 2003 resulted from lower pre-tax income in 2004, as well as higher average holdings of tax-exempt securities and loans. These factors contributed to the Corporation incurring an alternative minimum tax liability of $352,000 in 2004. A more complete analysis of income taxes is presented in Note 16 to the consolidated financial statements. FINANCIAL CONDITION Significant changes in the average balances of the Corporation's earning assets and interest-bearing liabilities are described in the Net Interest Margin section of Management's Discussion and Analysis. That discussion provides useful information regarding changes in the Corporation's balance sheet over the 2-year period ended December 31, 2005, including discussions of available-for-sale securities, loans, deposits and borrowings. The acquisition of Canisteo Valley Corporation was effective at the end of August 2005. That transaction was an all-cash acquisition, which had the effect of increasing the Corporation's assets and liabilities. At December 31, 2005, total consolidated assets of Canisteo Valley Corporation amounted to $44,476,000, including net loans of $21,464,000, while deposits totaled $37,015,000. Other significant balance sheet items - the allowance for loan losses and stockholders' equity - are discussed in separate sections of Management's Discussion and Analysis. Table VI shows the composition of the investment portfolio at December 31, 2005, 2004 and 2003. Comparison of the amortized cost totals of available-for-sale securities at each year-end presented reflects a reduction from $464,793,000 at December 31, 2003 to $459,123,000 at December 31, 2004, and then a further reduction to $420,185,000 at December 31, 2005. Management's decision to reduce the size of the securities portfolio was attributable to 2 primary factors: (1) substantial loan growth, and (2) the need to manage interest rate risk within acceptable parameters. Specifically, in light of the flat yield curve, the opportunities have been very limited for earning a positive spread from maintaining borrowed funds and holding investment securities, and because there is almost no difference between short-term and long-term rates, the Corporation faces the risk that excessive holdings of long-term, fixed rate securities could result in future losses or diminished net interest margin results when the yield curve "normalizes." Accordingly, management has utilized proceeds from principal repayments and sales of securities to help fund loan growth. The Corporation's liquidity position is discussed in a separate section of Management's Discussion and Analysis, and interest rate risk is discussed in more detail in Part II, Item 7A. As described in the Net Interest Margin section of Management's Discussion and Analysis, loans outstanding grew substantially in both 2005 and 2004. In fact, as reflected in Table VII, the year-end balance of loans, net of the allowance for loan losses, has grown more than 10% compared to the previous year-end, for each of the last 4 years. Table VIII presents a table of loan maturities. Fixed rate loans are included in Table VIII based on their contractually scheduled principal repayments, while variable rate loans are included based on contractual principal repayments, with the remaining balance reflected in the Table as of the date of the next change in rate. Table VIII shows that the majority ($464,962,000 20 or 71%) of the loan portfolio is fixed rate, including $178,818,000 or 27% fixed rate beyond 5 years. This substantial investment in long-term, fixed rate loans is one of the major concerns management attempts to address through interest rate risk management practices. See Part II, Item 7A for a more detailed discussion of the Corporation's interest rate risk. Premises and equipment, net of accumulated depreciation, increased to $22,605,000 at December 31, 2005 from $16,725,000 at December 31, 2004 and $12,482,000 at December 31, 2003. A portion of the increase in premises in equipment in 2005 was related to the acquisition of Canisteo Valley Corporation, which had a balance of $1,429,000 at December 31, 2005. The total cost of premises and equipment purchases (excluding the Canisteo acquisition) was $6,712,000 in 2005, $5,830,000 in 2004 and $3,360,000 in 2003. The major capital purchases in 2005 were building-related. The total cost for land, building construction and furnishings for the Jersey Shore branch, which opened in August 2005, was just over $2 million, including approximately $1.6 million of expenditures in 2005. Construction in progress at December 31, 2005 had a balance of $4,237,000, including $3,768,000 related to the Wellsboro administration and Old Lycoming Township building projects. In 2004, capital purchases for Management Information System purposes totaled $2,624,000, including the new core banking software, as well as related software, network servers and other equipment. Also in 2004, the Corporation completed the renovation of the Williamsport facility, and opened the branch in early June (Trust and Commercial Lending staff moved in a few months prior to the opening of the branch). Total cost allocated to the Williamsport land and building amounted to $2,428,000, of which approximately $1,800,000 was incurred in 2003 with the remainder in 2004. Capital purchases for furniture and equipment for operations in the Williamsport facility amounted to $461,000 in 2004. In 2003, the most significant projects included remodeling and addition to the Sayre facility, remodeling of the Elkland facility, and purchases of an additional 80 thin client computer stations for teller lines throughout the branch network. Depreciation expense increased to $2,301,000 in 2005, from $1,587,000 in 2004 and $1,211,000 in 2003. Total capital purchases for 2006 are estimated at approximately $4.3 million. In light of the Corporation's strong capital position and ample sources of liquidity, management does not expect capital expenditures to have a material, detrimental effect on the Corporation's financial condition in 2006. As discussed in the "Outlook for 2006" section of Management's Discussion and Analysis, depreciation and other occupancy expenses in 2006 from the new administration building in Wellsboro and the Old Lycoming Township facility, are estimated at approximately $400,000, and the Corporation will incur payroll and other start-up costs associated with its new branch locations. The overall impact on the Corporation's earnings in 2006 and thereafter will depend on the Corporation's ability to build market share and produce profitable results from those locations, and how long that will take. TABLE VI - INVESTMENT SECURITIES
AS OF DECEMBER 31, ------------------------------------------------------------------ 2005 2004 2003 -------------------- -------------------- -------------------- AMORTIZED FAIR AMORTIZED FAIR AMORTIZED FAIR COST VALUE COST VALUE COST VALUE --------- -------- --------- -------- --------- -------- AVAILABLE-FOR-SALE SECURITIES: Obligations of the U.S. Treasury $ 501 $ 500 $ -- $ -- $ -- $ -- Obligations of other U.S. Government agencies 43,999 43,339 37,009 36,312 61,437 61,070 Obligations of states and political subdivisions 116,241 117,709 125,809 129,370 159,128 162,418 Other securities 94,849 95,157 100,871 103,107 45,992 47,648 Mortgage-backed securities 140,562 137,327 169,046 168,033 168,285 169,208 -------- -------- -------- -------- -------- -------- Total debt securities 396,152 394,032 432,735 436,822 434,842 440,344 Marketable equity securities 24,033 33,266 26,388 38,263 29,951 42,688 -------- -------- -------- -------- -------- -------- Total $420,185 $427,298 $459,123 $475,085 $464,793 $483,032 ======== ======== ======== ======== ======== ======== HELD-TO-MATURITY SECURITIES: Obligations of the U.S. Treasury $ 313 $ 324 $ 316 $ 339 $ 319 $ 349 Obligations of other U.S. Government agencies 98 106 98 112 199 216 Mortgage-backed securities 11 11 19 20 42 44 -------- -------- -------- -------- -------- -------- Total $ 422 $ 441 $ 433 $ 471 $ 560 $ 609 ======== ======== ======== ======== ======== ========
21 TABLE VII - FIVE-YEAR SUMMARY OF LOANS BY TYPE
2005 % 2004 % 2003 % 2002 % 2001 % -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ (IN THOUSANDS) Real estate - construction $ 5,552 0.85 $ 4,178 0.72 $ 2,856 0.54 $ 103 0.02 $ 1,814 0.48 Real estate - residential mortgage 361,857 55.39 347,705 59.98 330,807 63.03 292,136 64.76 245,997 64.87 Real estate - commercial mortgage 153,661 23.52 128,073 22.10 100,240 19.10 78,317 17.36 60,267 15.89 Consumer 31,559 4.83 31,702 5.47 33,977 6.47 31,532 6.99 29,284 7.72 Agricultural 2,340 0.36 2,872 0.50 2,948 0.56 3,024 0.67 2,344 0.62 Commercial 69,396 10.62 43,566 7.52 34,967 6.66 30,874 6.84 24,696 6.51 Other 1,871 0.29 1,804 0.31 1,183 0.23 2,001 0.44 1,195 0.32 Political subdivisions 27,063 4.14 19,713 3.40 17,854 3.40 13,062 2.90 13,479 3.55 Lease receivables -- 0.00 -- 0.00 65 0.01 96 0.02 152 0.04 -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ Total 653,299 100.00 579,613 100.00 524,897 100.00 451,145 100.00 379,228 100.00 Less: allowance for loan losses (8,361) (6,787) (6,097) (5,789) (5,265) -------- -------- -------- -------- -------- Loans, net $644,938 $572,826 $518,800 $445,356 $373,963 ======== ======== ======== ======== ========
TABLE VIII - LOAN MATURITY DISTRIBUTION
AS OF DECEMBER 31, 2005 ----------------------------------------------------------------------------------------- FIXED RATE LOANS: VARIABLE OR ADJUSTABLE RATE LOANS: ------------------------------------------- ------------------------------------------- GREATER GREATER 1 YEAR OR THAN 1 YEAR OR THAN LESS 1-5 YEARS >5 YEARS TOTAL LESS 1-5 YEARS 5 YEARS TOTAL --------- --------- -------- -------- --------- --------- -------- -------- (IN THOUSANDS) Real Estate $63,036 $137,364 $ 92,164 $292,564 $ 68,488 $51,993 $3,009 $123,490 Commercial 11,571 40,902 82,557 135,030 59,387 682 456 60,525 Consumer 14,231 19,040 4,097 37,368 4,256 66 -- 4,322 ------- -------- -------- -------- -------- ------- ------ -------- $88,838 $197,306 $178,818 $464,962 $132,131 $52,741 $3,465 $188,337 ======= ======== ======== ======== ======== ======= ====== ========
PROVISION AND ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is maintained at a level which, in management's judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management's evaluation of the collectibility of the loan portfolio. In evaluating collectibility, management considers a number of factors, including the status of specific impaired loans, trends in historical loss experience, delinquency trends, credit concentrations, comparison of historical loan loss data to that of other financial institutions and economic conditions within the Corporation's market area. Allowances for impaired loans are determined based on collateral values or the present value of estimated cash flows. The allowance is increased by a provision for loan losses, which is charged to expense, and reduced by charge-offs, net of recoveries. Each quarter, management performs a detailed assessment of the allowance and provision for loan losses. For C&N Bank, this assessment is conducted under the direction of the Chief Financial Officer and Executive Vice President in charge of Commercial Lending, with input from the Credit Administration Department, other Branch and Lending Staff, and the Chief Executive Officer. The assessment process includes review of identified risk elements in the loan portfolio, including the "Watch List", past due reports and other information. The "Watch List" is a collection of loans that have a history of delinquency, collateral deficiency, cash flow problems, or other factors that have come to management's attention to create the need for special monitoring. One of the key aspects of the quarterly assessment is the evaluation of each Watch List relationship with an outstanding balance of $200,000 or more. This evaluation includes an updated assessment of collection activities and planning for each such relationship, as well as evaluation of the probable loss (if any). For First State Bank, the fourth quarter 2005 assessment was performed for all Watch List relationships of $50,000 or more. Both C&N Bank and First State Bank also engage consulting firms, at least annually, to perform independent credit reviews of large credit relationships. Management gives substantial consideration to the classifications and recommendations of the independent credit reviewers in determining the allowance for loan losses. The allowance for loan losses reflects probable losses resulting from the analysis of individual loans and historical loss experience, as modified for identified trends and concerns, for each loan category. The historical loan loss experience 22 element is determined based on the ratio of net charge-offs to average loan balances over a three-year period, for each significant type of loan, modified for qualitative risk adjustment factors identified by management for each type of loan. The charge-off ratio and qualitative factors are then applied to the current outstanding loan balance for each type of loan (net of other loans that are individually evaluated). Prior to the fourth quarter 2005, C&N Bank had utilized the ratio of net charge-offs to average balances over a five-year period in calculating the historical loan loss experience portion of the allowance portfolio. Management made the change to the three-year assumption, which had very little effect on the allowance valuation as of December 31, 2005, mainly because management believes net charge-off experience over a 3-year period may be more representative of losses existing in the portfolio as of the balance sheet date. In the second quarter 2005, management changed its process for determining and disclosing the components of the allowance for loan losses. A management committee evaluated several qualitative factors, including economic conditions, lending policies, changes in the portfolio, risk profile of the portfolio, competition and regulatory requirements, and other factors. This analysis was performed separately for the following categories of lending activity: commercial, mortgage, consumer and credit card. The management committee met again in the third and fourth quarters and updated its analysis (excluding credit card, for which substantially all of the loans were sold in the fourth quarter 2005). Based on the results of these evaluations, allocations were made to the components of the allowance shown in Table X. In periods prior to June 30, 2005, the portion of the allowance determined by management's subjective assessment of economic conditions and other factors was reflected completely in the unallocated component of the allowance. Primarily as a result of this change in process, Table X shows the amounts allocated to the allowance for commercial, consumer mortgage and consumer loans at December 31, 2005 have increased in comparison to the corresponding amounts at December 31, 2004, while the unallocated portion of the allowance decreased to $0 at December 31, 2005 from $2,578,000 at December 31, 2004. As indicated in Table XI, total impaired loans amounted to $8,216,000 at December 31, 2005, as compared to $8,261,000 at December 31, 2004 and $4,621,000 at December 31, 2003. In total, the valuation allowance related to impaired loans amounted to $2,374,000 at December 31, 2005, up from $1,378,000 at December 31, 2004 and $1,542,000 at December 31, 2003. Table XI also shows that the amount of loans classified as nonaccrual amounted to $6,365,000 at December 31, 2005, as compared to $7,796,000 at December 31, 2004 and $1,145,000 at December 31, 2003. The growth in 2004 in past due and nonaccrual loans resulted mainly from certain large commercial loan relationships, including one commercial loan relationship with total outstanding loan balances of approximately $2.8 million at December 31, 2005, and $3.7 million as of December 31, 2004. In 2004, management moved most of the loans outstanding related to this large relationship to nonaccrual status. Also, in 2005, a large ($600,000) residential mortgage loan to the principal owner of this relationship was moved to nonaccrual. As of December 31, 2005, the valuation allowances related to these loans totaled $689,000, up from $173,000 at December 31, 2004. There is another commercial loan relationship with total outstanding balances of approximately $1.6 million that was classified as impaired and nonaccrual throughout most of 2004 and all of 2005, and for which the valuation allowance was increased to $400,000 as of December 31, 2005 from $200,000 as of December 31, 2004. Management believes it has been conservative in its decisions concerning identification of impaired loans, estimates of loss and nonaccrual status. However, the actual losses realized from these relationships could vary materially from the allowances estimated as of December 31, 2005. Management continues to closely monitor these commercial loan relationships, and will adjust its estimates of loss and decisions concerning nonaccrual status, if appropriate. The allowance for loan losses was $8,361,000 at December 31, 2005, an increase of $1,574,000 from the balance of $6,787,000 at December 31, 2004. Table IX shows that gross charge-offs totaled $984,000, and net charge-offs totaled $829,000, in 2005. These amounts were higher than the corresponding totals for 2004 of $786,000 (gross charge-offs) and $710,000 (net charge-offs). Table IX also shows that the allowance for loan losses recorded as part of the Canisteo Valley Corporation (First State Bank) acquisition amounted to $377,000. Although there were loans included on First State Bank's Watch List as of the acquisition date that management was monitoring, substantially all of these loans were commercial loans with low balances, or consumer or residential mortgage loans that can be collectively evaluated for impairment. Accordingly, there were no acquired loans that were classified individually as impaired. The provision for loan losses amounted to $2,026,000 in 2005, $1,400,000 in 2004 and $1,100,000 in 2003. The amount of the provision in each year is determined based on the amount required to maintain an appropriate allowance in light of the factors described above. Tables IX through XII present historical data related to the allowance for loan losses. 23 TABLE IX - ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES
YEARS ENDED DECEMBER 31, ------------------------------------------ 2005 2004 2003 2002 2001 ------ ------ ------ ------ ------ (IN THOUSANDS) Balance, beginning of year $6,787 $6,097 $5,789 $5,265 $5,291 ------ ------ ------ ------ ------ Charge-offs: Real estate loans 264 375 168 123 144 Installment loans 224 217 326 116 138 Credit cards and related plans 198 178 171 190 200 Commercial and other loans 298 16 303 123 231 ------ ------ ------ ------ ------ Total charge-offs 984 786 968 552 713 ------ ------ ------ ------ ------ Recoveries: Real estate loans 14 3 75 30 6 Installment loans 61 32 52 30 27 Credit cards and related plans 30 23 17 18 20 Commercial and other loans 50 18 32 58 34 ------ ------ ------ ------ ------ Total recoveries 155 76 176 136 87 ------ ------ ------ ------ ------ Net charge-offs 829 710 792 416 626 Allowance for loan losses recorded in acquisition 377 -- -- -- -- Provision for loan losses 2,026 1,400 1,100 940 600 ------ ------ ------ ------ ------ Balance, end of year $8,361 $6,787 $6,097 $5,789 $5,265 ====== ====== ====== ====== ======
TABLE X - ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES BY TYPE
2005 2004 2003 2002 2001 ------ ------ ------ ------ ------ (IN THOUSANDS) Commercial $2,705 $1,909 $1,578 $1,315 $1,837 Consumer mortgage 2,806 513 456 460 674 Impaired loans 2,374 1,378 1,542 1,877 73 Consumer 476 409 404 378 494 Unallocated -- 2,578 2,117 1,759 2,187 ------ ------ ------ ------ ------ Total Allowance $8,361 $6,787 $6,097 $5,789 $5,265 ====== ====== ====== ====== ======
The above allocation is based on estimates and subjective judgments and is not necessarily indicative of the specific amounts or loan categories in which losses may occur. TABLE XI - PAST DUE AND IMPAIRED LOANS
2005 2004 2003 ------ ------ ------ (IN THOUSANDS) Impaired loans without a valuation allowance $ 910 $3,552 $ 114 Impaired loans with a valuation allowance 7,306 4,709 4,507 ------ ------ ------ Total impaired loans $8,216 $8,261 $4,621 ====== ====== ====== Valuation allowance related to impaired loans $2,374 $1,378 $1,542 Total nonaccrual loans $6,365 $7,796 $1,145 Total loans past due 90 days or more and still accruing $1,369 $1,307 $2,546
24 TABLE XII - FIVE-YEAR HISTORY OF LOAN LOSSES
2005 2004 2003 2002 2001 AVERAGE -------- -------- -------- -------- -------- -------- (IN THOUSANDS) Average gross loans $618,344 $551,352 $485,150 $410,670 $346,353 $482,374 Year-end gross loans 653,299 579,613 524,897 451,145 379,228 517,636 Year-end allowance for loan losses 8,361 6,787 6,097 5,789 5,265 6,460 Year-end nonaccrual loans 6,365 7,796 1,145 1,252 1,050 3,522 Year-end loans 90 days or more past due and still accruing 1,369 1,307 2,546 2,318 2,067 1,921 Net charge-offs 829 710 792 416 626 675 Provision for loan losses 2,026 1,400 1,100 940 600 1,213 Earnings coverage of charge-offs 15.7 20.9 20.5 36.0 19.3 21.1 Allowance coverage of charge-offs 10.1 9.6 7.7 13.9 8.4 9.6 Net charge-offs as a % of provision for loan losses 40.92% 50.71% 72.00% 44.26% 104.33% 55.65% Net charge-offs as a % of average gross loans 0.13% 0.13% 0.16% 0.10% 0.18% 0.14%
CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS Table XIII presents the Corporation's significant fixed and determinable contractual obligations as of December 31, 2005, by payment date. The payment amounts represent the principal amounts of time deposits and borrowings, and do not include interest. Operating leases and software maintenance commitments are presented at the amounts due to the recipients, and are not discounted to present value. TABLE XIII - CONTRACTUAL OBLIGATIONS
1 YEAR 1-3 3-5 OVER 5 CONTRACTUAL OBLIGATIONS OR LESS YEARS YEARS YEARS TOTAL ----------------------- -------- -------- ------- ------- -------- (IN THOUSANDS) Time deposits $194,779 $118,729 $24,584 $ 36 $338,128 Short-term borrowings, Federal Home Loan Bank of Pittsburgh 7,000 -- -- -- 7,000 Long-term borrowings: Federal Home Loan Bank of Pittsburgh 57,700 102,567 5,432 19,786 185,485 Repurchase agreements 20,220 26,500 -- -- 46,720 Operating leases 171 101 13 -- 285 Software maintenance 360 720 300 -- 1,380 -------- -------- ------- ------- -------- Total $280,230 $248,617 $30,329 $19,822 $578,998 ======== ======== ======= ======= ========
In addition to the amounts described in Table XIII, the Corporation has obligations related to deposits without a stated maturity with outstanding principal balances totaling $418,937,000 at December 31, 2005. The Corporation also has obligations related to overnight customer repurchase agreements with principal balances totaling $27,734,000 at December 31, 2005. As described more fully in Note 19 to the consolidated financial statements, the Corporation has a contingent obligation to pay additional licensing fees, based on the Bank's asset size, through October 2009. The Corporation's significant off-balance sheet arrangements consist of commitments to extend credit and standby letters of credit. Off-balance sheet arrangements are described in Note 18 to the consolidated financial statements. 25 LIQUIDITY Liquidity is the ability to quickly raise cash at a reasonable cost. An adequate liquidity position permits the Corporation to pay creditors, compensate for unforeseen deposit fluctuations and fund unexpected loan demand. The Corporation maintains overnight borrowing facilities with several correspondent banks that provide a source of day-to-day liquidity. Also, the Corporation maintains borrowing facilities with FHLB - Pittsburgh, secured by various securities and mortgage loans. At December 31, 2005, the Corporation had unused borrowing availability with correspondent banks and FHLB - Pittsburgh totaling approximately $150,000,000. Additionally, the Corporation uses repurchase agreements placed with brokers to borrow funds secured by investment assets, and uses "RepoSweep" arrangements to borrow funds from commercial banking customers on an overnight basis. Historically, one of the tools used to monitor a bank's longer-term liquidity situation has been the loan-to-deposit ratio. As of December 31, 2005 and 2004, this ratio was 85%, which is an average ratio by banking industry standards, but higher than the Corporation's position had been in many years. The higher than historical level of loans-to-deposits reflects the Corporation's very strong loan growth over the past few years. The loan-to-deposit ratio was 79% at December 31, 2003, 70% at December 31, 2002 and 65% at December 31, 2001. Management believes the current, higher loan-to-deposit ratio provides opportunities for a higher average yield on earning assets, but is an indicator that some of the Corporation's historical liquidity "cushion" has been reduced; however, the current position continues to provide sufficient funds for maintenance of a substantial investment securities portfolio. If required to raise cash in an emergency situation, the Corporation could sell non-pledged investment securities to meet its obligations. At December 31, 2005, the carrying value of non-pledged securities was $210,119,000. Management believes the combination of its strong capital position (discussed in the next section), ample available borrowing facilities and moderate loan to deposit ratio have placed the Corporation in a position of minimal short-term and long-term liquidity risk. STOCKHOLDERS' EQUITY AND CAPITAL ADEQUACY The Corporation and the Banks are subject to various regulatory capital requirements administered by the federal banking agencies. For many years, the Corporation and C&N Bank have maintained extremely strong capital positions, and First State Bank is also well capitalized. Details concerning the Corporation's and the Banks' regulatory capital amounts and ratios are presented in Note 21 to the consolidated financial statements. As reflected in Note 21, at December 31, 2005 and 2004, the ratios of total capital to risk-weighted assets, tier 1 capital to risk-weighted assets and tier 1 capital to average total assets are well in excess of regulatory capital requirements. The Corporation's total stockholders' equity is affected by fluctuations in the fair values of available-for-sale securities. The difference between amortized cost and fair value of available-for-sale securities, net of deferred income tax, is classified as "Accumulated Other Comprehensive Income" within stockholders' equity. Changes in accumulated other comprehensive income are excluded from earnings and directly increase or decrease stockholders' equity. COMPREHENSIVE INCOME Comprehensive income is a measure of all changes in the equity of a corporation, excluding transactions with owners in their capacity as owners (such as proceeds from issuances of stock and dividends). The difference between net income and comprehensive income is termed "Other Comprehensive Income". For the Corporation, other comprehensive income consists of unrealized gains and losses on available-for-sale securities, net of deferred income tax. Comprehensive income should not be construed to be a measure of net income. The amount of unrealized gains or losses reflected in comprehensive income may vary widely from period-to-period, depending on the financial markets as a whole and how the portfolio of available-for-sale securities is affected by interest rate movements. Total comprehensive income was $7,147,000 in 2005, $13,361,000 in 2004 and $16,148,000 in 2003. Other comprehensive (loss) amounted to ($5,837,000) in 2005, ($1,502,000) in 2004 and ($109,000) in 2003. INFLATION The Corporation is significantly affected by the Federal Reserve Board's efforts to control inflation through changes in interest rates. As discussed in the "Earnings Overview" section of Management's Discussion and Analysis, rising short-term interest rates, which were triggered by the Federal Reserve's actions to increase the fed funds target rate several times, hurt the Corporation's operating results for 2005. Further concerns over the possibility of inflation could lead to further increases in the fed funds target rate, which management believes would continue to "squeeze" the net interest margin. Although management cannot predict future changes in the rates of inflation, management monitors the impact of economic trends, including any indicators of inflationary pressures, in managing interest rate and other financial risks. 26 RECENT ACCOUNTING PRONOUNCEMENTS In March 2004, the FASB issued Emerging Issues Task Force (EITF) Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. This statement provides guidance for evaluating whether an investment is other-than-temporarily impaired and was effective for the other-than-temporary impairment evaluations made in the reporting periods beginning after June 15, 2004. The FASB staff had issued a proposed Board-directed FASB Staff Position, FSP EITF Issue 03-1-a, Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1. The proposed FSP would have provided implementation guidance with respect to debt securities that are impaired solely due to interest rates and/or sector spreads and analyzed for other-than-temporary impairment under paragraph 16 of Issue 03-1. In September 2004, based on comment letters received by constituents, the Board decided to further consider whether application guidance was necessary for all securities analyzed for impairment under paragraphs 10-20 of Issue 03-1. In November 2005, the FASB issued FSP 115-1 and FAS 124-1, which nullified much of the detailed implementation guidance that had been included in FSP EITF Issue 03-1-a, and carried forward the rest of the existing requirements for evaluating securities for impairment and providing disclosures related to impaired securities. In December 2004, the FASB issued SFAS 123R, which replaces SFAS 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion 25, Accounting for Stock Issued to Employees. SFAS 123R will require the Corporation to record stock option expense based on estimated fair value determined using an option valuation model. SFAS No. 123R will require the Corporation to record stock option expense based on estimated fair value calculated using an option valuation model. Since all of the Corporation's stock options are exercisable at December 31, 2005, SFAS No. 123R will only apply to new awards, starting in 2006. In recent years, stock options have been awarded to directors and selected officers in January, based on performance in the previous year. In January 2006, it was determined that no awards were to be made based on 2005's results; accordingly, SFAS No. 123R is not expected to have an impact on the Corporation's results of operations in 2006, but to the extent future awards are made, will impact future years. In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections that changes the requirements for the accounting for and reporting of a change in accounting principle. SFAS No. 154 replaces APB Opinion No. 20, Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. APB Opinion No. 20 previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. SFAS No. 154 requires retrospective application to prior periods' financial statements of changes in accounting principle, unless impracticable to determine either the period-specific effects or the cumulative effect of the change. This statement also redefines "restatement" to include the revision of previously issued financial statements to reflect the correction of an error. This statement is effective for accounting changes and error corrections made in fiscal years beginning after December 15, 2005. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK MARKET RISK The Corporation's two major categories of market risk, interest rate risk and equity securities risk, are discussed in the following sections. INTEREST RATE RISK Business risk arising from changes in interest rates is an inherent factor in operating a bank. The Corporation's assets are predominantly long-term, fixed rate loans and debt securities. Funding for these assets comes principally from shorter-term deposits and borrowed funds. Accordingly, there is an inherent risk of lower future earnings or decline in fair value of the Corporation's financial instruments when interest rates change. C&N Bank uses a simulation model to calculate the potential effects of interest rate fluctuations on net interest income and the market value of portfolio equity. Only assets and liabilities of C&N Bank are included in management's monthly simulation model calculations. Since C&N Bank makes up more than 90% of the Corporation's total assets and liabilities, and because C&N Bank is the source of the most volatile interest rate risk, presently management does not consider it necessary to run the model for the remaining entities within the consolidated group. (Management intends to add First State Bank's data to the model, beginning sometime in 2006.) For purposes of these calculations, the market value of portfolio equity includes the fair values of financial instruments, such as securities, loans, deposits and borrowed funds, and the book values of nonfinancial assets and liabilities, such as premises and equipment and accrued expenses. The model measures and projects potential changes in net interest income, and calculates the discounted present value of 27 anticipated cash flows of financial instruments, assuming an immediate increase or decrease in interest rates. Management ordinarily runs a variety of scenarios within a range of plus or minus 50-300 basis points of current rates. C&N Bank's Board of Directors has established policy guidelines for acceptable levels of interest rate risk, based on an immediate increase or decrease in interest rates. C&N Bank's policy provides limits at +/- 100, 200 and 300 basis points from current rates for fluctuations in net interest income from the baseline (flat rates) one-year scenario. The policy also limits acceptable market value variances from the baseline values based on current rates. As the table shows, as of December 31, 2005, the decline in net interest income and market value exceed the policy threshold marks if interest rates were to immediately rise 200 or 300 basis points. The table also shows that, at December 31, 2004, the changes in net interest income and market value were within the policy threshold for all calculations except that the market value decline exceeded the limit in the +300 basis point scenario. These "out of policy" positions are a reflection of the Corporation's liability sensitive position (on average, deposits and borrowings reprice more quickly than loans and debt securities). Management has reviewed these positions with the Board of Directors monthly throughout 2004 and 2005, and management will continue to evaluate whether to make changes to asset and liability holdings in an effort to reduce exposure to rising interest rates. The table that follows was prepared using the simulation model described above. The model makes estimates, at each level of interest rate change, regarding cash flows from principal repayments on loans and mortgage-backed securities and call activity on other investment securities. Actual results could vary significantly from these estimates, which could result in significant differences in the calculations of projected changes in net interest margin and market value of portfolio equity. Also, the model does not make estimates related to changes in the composition of the deposit portfolio that could occur due to rate competition and the table does not necessarily reflect changes that management would make to realign the portfolio as a result of changes in interest rates. 28 TABLE XIV - THE EFFECT OF HYPOTHETICAL CHANGES IN INTEREST RATES DECEMBER 31, 2005 DATA
PERIOD ENDING DECEMBER 31, 2006 ---------------------------------------------------------- INTEREST INTEREST NET INTEREST NII NII BASIS POINT CHANGE IN RATES INCOME EXPENSE INCOME (NII) % CHANGE RISK LIMIT --------------------------- -------- -------- ------------ -------- ---------- (IN THOUSANDS) +300 $66,381 $43,764 $22,617 -24.8% 20.0% +200 64,649 39,466 25,183 -16.3% 15.0% +100 62,850 35,168 27,682 -7.9% 10.0% 0 60,942 30,871 30,071 0.0% 0.0% -100 58,178 26,573 31,605 5.1% 10.0% -200 55,000 23,098 31,902 6.1% 15.0% -300 51,805 19,877 31,928 6.2% 20.0%
MARKET VALUE OF PORTFOLIO EQUITY AT DECEMBER 31, 2005 -------------------------------- PRESENT PRESENT PRESENT VALUE VALUE VALUE BASIS POINT CHANGE IN RATES EQUITY % CHANGE RISK LIMIT --------------------------- -------- -------- ---------- +300 $ 54,493 -56.8% 45.0% +200 77,762 -38.3% 35.0% +100 102,136 -19.0% 25.0% 0 126,029 0.0% 0.0% -100 142,377 13.0% 25.0% -200 151,148 19.9% 35.0% -300 160,867 27.6% 45.0%
DECEMBER 31, 2004 DATA
PERIOD ENDING DECEMBER 31, 2005 ---------------------------------------------------------- INTEREST INTEREST NET INTEREST NII NII BASIS POINT CHANGE IN RATES INCOME EXPENSE INCOME (NII) % CHANGE RISK LIMIT --------------------------- -------- -------- ------------ -------- ---------- (IN THOUSANDS) +300 $62,724 $34,583 $28,141 -16.8% 20.0% +200 61,066 30,840 30,226 -10.7% 15.0% +100 59,327 27,098 32,229 -4.7% 10.0% 0 57,343 23,510 33,833 0.0% 0.0% -100 54,581 20,676 33,905 0.2% 10.0% -200 51,800 17,924 33,876 0.1% 15.0% -300 49,090 16,850 32,240 -4.7% 20.0%
MARKET VALUE OF PORTFOLIO EQUITY AT DECEMBER 31, 2004 -------------------------------- PRESENT PRESENT PRESENT VALUE VALUE VALUE BASIS POINT CHANGE IN RATES EQUITY % CHANGE RISK LIMIT --------------------------- -------- -------- ---------- +300 $ 71,244 -49.2% 45.0% +200 94,088 -32.9% 35.0% +100 117,491 -16.2% 25.0% 0 140,168 0.0% 0.0% -100 153,026 9.2% 25.0% -200 162,400 15.9% 35.0% -300 171,463 22.3% 45.0%
29 EQUITY SECURITIES RISK The Corporation's equity securities portfolio consists primarily of investments in stocks of banks and bank holding companies, mainly based in Pennsylvania. The Corporation also owns some other stocks and mutual funds. Included in "Other equity securities" in the table that follows are preferred stocks issued by U.S. Government agencies with a fair value of $1,997,000 at December 31, 2005 and $6,130,000 at December 31, 2004. Investments in bank stocks are subject to the risk factors affecting the banking industry generally, including competition from non-bank entities, credit risk, interest rate risk and other factors that could result in a decline in market prices. Also, losses could occur in individual stocks held by the Corporation because of specific circumstances related to each bank. Further, because of the concentration of its holdings in Pennsylvania banks, these investments could decline in value if there were a downturn in the state's economy. The Corporation's management monitors its risk associated with its equity securities holdings by reviewing its holdings on a detailed, individual security basis, at least monthly, considering all of the factors described above. Equity securities held as of December 31, 2005 and 2004 are as follows:
HYPOTHETICAL HYPOTHETICAL 10% 20% DECLINE IN DECLINE IN FAIR MARKET MARKET AT DECEMBER 31, 2005 COST VALUE VALUE VALUE -------------------- ------- ------- ------------ ------------ (IN THOUSANDS) Banks and bank holding companies $20,010 $28,879 $(2,888) $(5,776) Other equity securities 4,023 4,387 (439) (877) ------- ------- ------- ------- Total $24,033 $33,266 $(3,327) $(6,653) ======= ======= ======= =======
HYPOTHETICAL HYPOTHETICAL 10% 20% DECLINE IN DECLINE IN FAIR MARKET MARKET AT DECEMBER 31, 2005 COST VALUE VALUE VALUE -------------------- ------- ------- ------------ ------------ Banks and bank holding companies $17,426 $29,880 $(2,988) $(5,976) Other equity securities 8,962 8,383 (838) (1,677) ------- ------- ------- ------- Total $26,388 $38,263 $(3,826) $(7,653) ======= ======= ======= =======
30 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CONSOLIDATED BALANCE SHEET
DECEMBER 31, DECEMBER 31, 2005 2004 ------------ ------------ (In Thousands Except Share Data) ASSETS Cash and due from banks: Noninterest-bearing $ 20,922 $ 14,845 Interest-bearing 5,524 4,108 ---------- ---------- Total cash and cash equivalents 26,446 18,953 Available-for-sale securities 427,298 475,085 Held-to-maturity securities 422 433 Loans, net 644,938 572,826 Bank-owned life insurance 18,643 18,083 Accrued interest receivable 5,500 5,094 Bank premises and equipment, net 22,605 16,725 Foreclosed assets held for sale 194 497 Intangible Asset - Core deposit intangible 464 -- Intangible Asset - Goodwill 2,919 -- Other assets 13,525 15,306 ---------- ---------- TOTAL ASSETS $1,162,954 $1,123,002 ========== ========== LIABILITIES Deposits: Noninterest-bearing $ 96,644 $ 80,378 Interest-bearing 660,421 596,167 ---------- ---------- Total deposits 757,065 676,545 Dividends payable 1,973 1,864 Short-term borrowings 34,734 34,178 Long-term borrowings 232,205 270,827 Accrued interest and other liabilities 5,009 8,003 ---------- ---------- TOTAL LIABILITIES 1,030,986 991,417 ---------- ---------- STOCKHOLDERS' EQUITY Common stock, par value $1.00 per share; authorized 20,000,000 shares in 2005 and 2004; issued 8,389,418 in 2005 and 8,307,305 in 2004 8,389 8,307 Stock dividend distributable 2,183 2,188 Paid-in capital 24,964 22,456 Retained earnings 93,728 90,484 ---------- ---------- Total 129,264 123,435 Accumulated other comprehensive income 4,698 10,535 Unamortized stock compensation (50) (46) Treasury stock, at cost: 168,627 shares at December 31, 2005 (1,944) 204,659 shares at December 31, 2004 (2,339) ---------- ---------- TOTAL STOCKHOLDERS' EQUITY 131,968 131,585 ---------- ---------- TOTAL LIABILITIES & STOCKHOLDERS' EQUITY $1,162,954 $1,123,002 ========== ==========
The accompanying notes are an integral part of the consolidated financial statements. 31 CONSOLIDATED STATEMENT OF INCOME
YEARS ENDED DECEMBER 31, --------------------------- 2005 2004 2003 ------- ------- ------- (IN THOUSANDS EXCEPT PER SHARE DATA) INTEREST INCOME Interest and fees on loans $38,768 $34,251 $32,235 Interest on balances with depository institutions 34 11 10 Interest on loans to political subdivisions 1,118 952 781 Interest on federal funds sold 97 10 8 Income from available-for-sale and held-to-maturity securities: Taxable 14,351 13,999 13,686 Tax-exempt 5,659 7,256 7,335 Dividends 1,081 1,443 1,168 ------- ------- ------- Total interest and dividend income 61,108 57,922 55,223 ------- ------- ------- INTEREST EXPENSE Interest on deposits 15,604 12,545 14,561 Interest on short-term borrowings 1,239 542 487 Interest on long-term borrowings 8,844 9,519 8,489 ------- ------- ------- Total interest expense 25,687 22,606 23,537 ------- ------- ------- Interest margin 35,421 35,316 31,686 Provision for loan losses 2,026 1,400 1,100 ------- ------- ------- Interest margin after provision for loan losses 33,395 33,916 30,586 ------- ------- ------- OTHER INCOME Service charges on deposit accounts 1,689 1,717 1,746 Service charges and fees 367 308 287 Trust and financial management revenue 2,088 2,105 1,733 Insurance commissions, fees and premiums 491 439 391 Increase in cash surrender value of life insurance 560 610 715 Fees related to credit card operation 948 773 784 Gain from sale of credit card loans 1,906 -- -- Other operating income 1,493 970 939 ------- ------- ------- Total other income before realized gains on securities, net 9,542 6,922 6,595 Realized gains on securities, net 1,802 2,877 4,799 ------- ------- ------- Total other income 11,344 9,799 11,394 ------- ------- ------- OTHER EXPENSES Salaries and wages 12,383 11,248 9,696 Pensions and other employee benefits 3,752 3,404 3,317 Occupancy expense, net 1,842 1,664 1,295 Furniture and equipment expense 2,664 1,805 1,372 Expenses related to credit card operation 462 414 385 Pennsylvania shares tax 804 846 792 Other operating expense 7,055 6,620 5,257 ------- ------- ------- Total other expenses 28,962 26,001 22,114 ------- ------- ------- Income before income tax provision 15,777 17,714 19,866 Income tax provision 2,793 2,851 3,609 ------- ------- ------- NET INCOME $12,984 $14,863 $16,257 ======= ======= ======= NET INCOME PER SHARE - BASIC $ 1.57 $ 1.80 $ 1.97 ======= ======= ======= NET INCOME PER SHARE - DILUTED $ 1.55 $ 1.79 $ 1.96 ======= ======= =======
The accompanying notes are an integral part of the consolidated financial statements 32 CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
ACCUMULATED OTHER STOCK COMPRE- UNAMORTIZED COMMON DIVIDEND PAID-IN RETAINED HENSIVE STOCK TREASURY STOCK DISTRIBUTABLE CAPITAL EARNINGS INCOME COMPENSATION STOCK TOTAL ------ ------------- ------- -------- ----------- ------------ -------- -------- (IN THOUSANDS EXCEPT PER SHARE DATA) BALANCE, DECEMBER 31, 2002 $5,431 $ 1,639 $21,153 $77,584 $12,146 $(49) $(2,067) $115,837 Comprehensive income: Net income 16,257 16,257 Unrealized loss on securities, net of reclassification adjustment and tax effects (109) (109) ------- -------- Total comprehensive income 16,148 -------- Cash dividends declared, $0.85 per share (6,821) (6,821) Treasury stock purchased (174) (174) Amortization of restricted stock 102 102 Shares issued from treasury related to exercise of stock options 78 119 197 Tax benefit from employee benefit plan 84 84 Stock dividend issued 53 (1,639) 1,556 (30) 3-for-2 stock split, April 2003 2,742 (2,742) -- Stock dividend declared, 1% 2,164 (2,164) -- Restricted stock granted 59 (107) 48 -- ------ ------- ------- ------- ------- ----- ------- -------- BALANCE, DECEMBER 31, 2003 8,226 2,164 20,104 84,940 12,037 (54) (2,074) 125,343 Comprehensive income: Net income 14,863 14,863 Unrealized loss on securities, net of reclassification adjustment and tax effects (1,502) (1,502) ------- -------- Total comprehensive income 13,361 -------- Cash dividends declared, $.89 per share (7,214) (7,214) Treasury stock purchased (575) (575) Shares issued from treasury related to exercise of stock options 245 283 528 Amortization of restricted stock 85 85 Tax benefit from employee benefit plan 83 83 Stock dividend issued 81 (2,164) 2,057 (26) Stock dividend declared, 1% 2,188 (2,188) -- Restricted stock granted 62 (99) 37 -- Forfeiture of restricted stock (12) 22 (10) -- ------ ------- ------- ------- ------- ----- ------- -------- BALANCE, DECEMBER 31, 2004 8,307 2,188 22,456 90,484 10,535 (46) (2,339) 131,585 Comprehensive income: Net income 12,984 12,984 Unrealized loss on securities, net of reclassification adjustment and tax effects (5,837) (5,837) ------- -------- Total comprehensive income 7,147 -------- Cash dividends declared, $.93 per share (7,641) (7,641) Treasury stock purchased (59) (59) Shares issued from treasury related to exercise of stock options 244 412 656 Amortization of restricted stock 93 93 Tax benefit from employee benefit plan 84 84 Tax benefit from stock options 129 129 Stock dividend issued 82 (2,188) 2,080 (26) Stock dividend declared, 1% 2,183 (2,183) -- Restricted stock granted 64 (111) 47 -- Forfeiture of restricted stock (9) 14 (5) -- ------ ------- ------- ------- ------- ----- ------- -------- BALANCE, DECEMBER 31, 2005 $8,389 $ 2,183 $24,964 $93,728 $ 4,698 $ (50) $(1,944) $131,968 ====== ======= ======= ======= ======= ===== ======= ========
The accompanying notes are an integral part of the consolidated financial statements. 33 CONSOLIDATED STATEMENT OF CASH FLOWS
YEARS ENDED DECEMBER 31, --------------------------------- 2005 2004 2003 --------- --------- --------- (IN THOUSANDS) CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 12,984 14,863 16,257 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 2,026 1,400 1,100 Realized gains on securities, net (1,802) (2,877) (4,799) Gain on sale of foreclosed assets, net (126) (9) (105) Depreciation expense 2,301 1,587 1,211 Accretion and amortization of securities, net 417 718 1,241 Increase in cash surrender value of life insurance (560) (610) (715) Amortization of restricted stock 93 85 102 Amortization of core deposit intangible 83 -- -- Deferred income taxes (640) 96 (25) (Increase) decrease in accrued interest receivable and other assets (971) (424) 487 Increase (decrease) in accrued interest payable and other liabilities 310 78 (164) --------- --------- --------- Net Cash Provided by Operating Activities 14,115 14,907 14,590 --------- --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from maturity of held-to-maturity securities 8 122 145 Proceeds from sales of available-for-sale securities 187,029 111,585 53,562 Proceeds from calls and maturities of available-for-sale securities 56,909 96,265 178,682 Purchase of available-for-sale securities (194,332) (200,015) (199,705) Purchase of Federal Home Loan Bank of Pittsburgh stock (4,672) (3,299) (1,855) Redemption of Federal Home Loan Bank of Pittsburgh stock 7,369 2,514 482 Net increase in loans (50,943) (56,015) (74,824) Purchase of premises and equipment (6,712) (5,830) (3,360) Proceeds from sale of foreclosed assets 822 202 340 Proceeds from acquisition of Canisteo Valley Corporation, net 202 -- -- --------- --------- --------- Net Cash Used in Investing Activities (4,320) (54,471) (46,533) --------- --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Net increase in deposits 42,512 18,480 17,761 Net increase (decrease) in short-term borrowings 556 (3,585) (5,872) Proceeds from long-term borrowings 18,163 84,112 64,500 Repayments of long-term borrowings (56,785) (48,475) (37,524) Purchase of treasury stock (59) (575) (174) Sale of treasury stock 656 528 197 Tax benefit from compensation plans 213 -- -- Dividends paid (7,558) (7,139) (6,674) --------- --------- --------- Net Cash (Used In) Provided by Financing Activities (2,302) 43,346 32,214 --------- --------- --------- INCREASE IN CASH AND CASH EQUIVALENTS 7,493 3,782 271 CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 18,953 15,171 14,900 --------- --------- --------- CASH AND CASH EQUIVALENTS, END OF YEAR $ 26,446 $ 18,953 $ 15,171 ========= ========= =========
34 CONSOLIDATED STATEMENT OF CASH FLOWS
YEARS ENDED DECEMBER 31, --------------------------- 2005 2004 2003 ------- ------- ------- (IN THOUSANDS) (CONTINUED) SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Assets acquired through foreclosure of real estate loans $ 347 $ 589 $ 280 Interest paid $26,260 $22,070 $23,736 Income taxes paid $ 2,959 $ 2,999 $ 3,195 ACQUISITION OF CANISTEO VALLEY CORPORATION: Cash and cash equivalents received $ 7,136 Cash paid for acquisition (6,934) ------- Net cash received on acquisition $ 202 ======= NONCASH ASSETS RECEIVED AND LIABILITIES ASSUMED FROM ACQUISITION OF CANISTEO VALLEY CORPORATION: Assets received: Available for sale securities $ 9,439 Loans 23,542 Premises and equipment 1,469 Foreclosed assets 46 Intangible asset - core deposit intangible 547 Intangible asset - goodwill 2,944 Other assets 446 ------- Total noncash assets received $38,433 ======= Liabilities assumed: Deposits $38,008 Other liabilities 627 ------- Total noncash liabilities assumed $38,635 =======
The accompanying notes are an integral part of the consolidated financial statements. 35 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF CONSOLIDATION - The consolidated financial statements include the accounts of Citizens & Northern Corporation ("Corporation"), and its subsidiaries, Citizens & Northern Bank ("C&N Bank"), Canisteo Valley Corporation (acquired in 2005 - see Note 4), Bucktail Life Insurance Company and Citizens & Northern Investment Corporation. The consolidated financial statements also include the accounts of Canisteo Valley Corporation's wholly-owned subsidiary, First State Bank, and C&N Bank's wholly-owned subsidiary, C&N Financial Services Corporation. All material intercompany balances and transactions have been eliminated in consolidation. NATURE OF OPERATIONS - The Corporation is primarily engaged in providing a full range of banking and mortgage services to individual and corporate customers in Northcentral Pennsylvania and Southern New York State. Lending products include mortgage loans, commercial loans, consumer loans and credit cards, as well as specialized instruments such as commercial letters-of-credit. Deposit products include various types of checking accounts, passbook and statement savings, money market accounts, interest checking accounts, individual retirement accounts and certificates of deposit. The Corporation also offers non-insured "Repo Sweep" accounts. The Corporation provides Trust and Financial Management services, including administration of trusts and estates, retirement plans, and other employee benefit plans, and investment management services. The Corporation offers a variety of personal and commercial insurance products through C&N Financial Services Corporation. C&N Financial Services Corporation also has a broker-dealer division, which offers mutual funds, annuities, educational savings accounts and other investment products through registered agents. The Corporation is subject to competition from other financial institutions. It is also subject to regulation by certain federal and state agencies and undergoes periodic examination by those regulatory authorities. USE OF ESTIMATES - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect reported amounts and disclosures. Actual results could differ from these estimates. A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses. Management believes that the allowance for loan losses is adequate and reasonable. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation's allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination. INVESTMENT SECURITIES - Investment securities are accounted for as follows: HELD-TO-MATURITY SECURITIES - includes debt securities that the Corporation has the positive intent and ability to hold to maturity. These securities are reported at cost adjusted for amortization of premiums and accretion of discounts, computed using the level-yield method. AVAILABLE-FOR-SALE SECURITIES - includes debt securities not classified as held-to-maturity and unrestricted equity securities. Such securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported separately through accumulated other comprehensive income, net of tax. Amortization of premiums and accretion of discounts on available-for-sale securities are recorded using the level yield method over the remaining contractual life of the securities, adjusted for actual prepayments. Realized gains and losses on sales of available-for-sale securities are computed on the basis of specific identification of the adjusted cost of each security. RESTRICTED EQUITY SECURITIES - Restricted equity securities consist primarily of Federal Home Loan Bank of Pittsburgh stock, and are carried at cost and evaluated for impairment. Holdings of restricted equity securities are included in Other Assets in the Consolidated Balance Sheet, and dividends received on restricted securities are included in Other Income in the Consolidated Statement of Income. LOANS - Loans are stated at unpaid principal balances, less the allowance for loan losses and net deferred loan fees. Loan origination and commitment fees, as well as certain direct origination costs, are deferred and amortized as a yield adjustment over the lives of the related loans using the interest method. Amortization of deferred loan fees is discontinued when a loan is placed on nonaccrual status. 36 Loans are placed on nonaccrual status when, in the opinion of management, collection of interest is doubtful. Any unpaid interest previously accrued on those loans is reversed from income. Interest income is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on loans for which the risk of further loss is greater than remote are applied as a reduction of the loan principal balance. Interest income on other nonaccrual loans is recognized only to the extent of interest payments received. The allowance for loan losses is maintained at a level which, in management's judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management's evaluation of the collectibility of the loan portfolio, based on factors such as credit concentrations, past due or delinquency status, trends in historical loss experience, specific impaired loans, and economic conditions. Past due or delinquency status of loans is computed based on the contractual terms of the loans. Allowances for impaired loans are determined based on collateral values or the present value of estimated cash flows. The allowance is increased by a provision for loan losses, which is charged to expense, and reduced by charge-offs, net of recoveries. Loan balances are charged off when it becomes evident that such balances are not fully collectible. BANK PREMISES AND EQUIPMENT - Bank premises and equipment are stated at cost less accumulated depreciation. Repair and maintenance expenditures which extend the useful lives of assets are capitalized, and other repair and maintenance expenditures are expensed as incurred. Depreciation expense is computed using the straight-line method. INTEREST COSTS - The Corporation capitalizes interest as a component of the cost of premises and equipment constructed or acquired for its own use. In 2005, total interest incurred was $25,755,000, of which $25,687,000 was charged to expense and $68,000 was capitalized. In 2004, total interest incurred was $22,649,000, of which $22,606,000 was charged to expense and $43,000 was capitalized. Total interest incurred amounted to $23,537,000 in 2003, all of which was charged to expense. FORECLOSED ASSETS HELD FOR SALE - Foreclosed assets held for sale consist of real estate acquired by foreclosure and are carried at estimated fair value, less selling cost. GOODWILL AND CORE DEPOSIT INTANGIBLE ASSETS - Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. Goodwill will be tested at least annually for impairment. The core deposit intangible is being amortized over a period of time that represents its expected life using a method of amortization that reflects the pattern of economic benefit. The core deposit intangible is subject to impairment testing whenever events or changes in circumstances indicate its carrying amount may not be recoverable. INCOME TAXES - Provisions for deferred income taxes are made as a result of temporary differences in financial and income tax methods of accounting. These differences relate principally to loan losses, securities gains or losses, depreciation, pension and other postretirement benefits, alternative minimum tax, investments in limited partnerships, loan origination fees and costs and differences arising from an acquisition. STOCK COMPENSATION PLANS - The Corporation uses the intrinsic value method of accounting for stock compensation plans, under Accounting Principles Board Opinion 25 (APB Opinion 25), and as permitted by Statement of Financial Accounting Standards (SFAS) No. 123. Utilizing the intrinsic value method, compensation cost is measured by the excess of the quoted market price of the stock as of the grant date (or other measurement date) over the amount an employee or director must pay to acquire the stock. Stock options issued under the Corporation's stock option plans have no intrinsic value, and accordingly, no compensation cost is recorded for them. The Corporation has also made awards of restricted stock. Compensation cost related to restricted stock is recognized based on the market price of the stock at the grant date over the vesting period. The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value provisions of SFAS No. 123 to stock options. 37
2005 2004 2003 ------- ------- ------- (NET INCOME IN THOUSANDS) Net income, as reported $12,984 $14,863 $16,257 Deduct: Total stock option compensation expense determined under fair value method for all awards, net of tax effects (69) (90) (124) ------- ------- ------- Pro forma net income $12,915 $14,773 $16,133 ======= ======= ======= Earnings per share-basic As reported $ 1.57 $ 1.80 $ 1.97 Pro forma $ 1.56 $ 1.79 $ 1.95 Earnings per share-diluted As reported $ 1.55 $ 1.79 $ 1.96 Pro forma $ 1.55 $ 1.78 $ 1.94
In December 2004, the Financial Accounting Standards Board issued SFAS No. 123R, which replaces SFAS No. 123 and supersedes APB Opinion 25. SFAS No. 123R will require the Corporation to record stock option expense based on estimated fair value calculated using an option valuation model. Since all of the Corporation's stock options are exercisable at December 31, 2005, SFAS No. 123R will only apply to new awards, starting in 2006. OFF-BALANCE SHEET FINANCIAL INSTRUMENTS - In the ordinary course of business, the Corporation has entered into off-balance sheet financial instruments consisting of commitments to extend credit and standby letters of credit. Such financial instruments are recorded in the financial statements when they become payable. CASH FLOWS - The Corporation utilizes the net reporting of cash receipts and cash payments for certain deposit and lending activities. The Corporation considers all cash and amounts due from depository institutions, interest-bearing deposits in other banks, and federal funds sold to be cash equivalents. TRUST ASSETS AND INCOME - Assets held by the Corporation in a fiduciary or agency capacity for its customers are not included in the financial statements since such items are not assets of the Corporation. Trust income is recorded on a cash basis, which is not materially different from the accrual basis. 2. COMPREHENSIVE INCOME U.S. generally accepted accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although unrealized gains and losses on available-for-sale securities are reported as a separate component of the equity section of the balance sheet, changes in unrealized gains and losses on available-for-sale securities, along with net income, are components of comprehensive income. The components of other comprehensive income, and the related tax effects, are as follows:
YEARS ENDED DECEMBER 31, --------------------------- 2005 2004 2003 ------- ------- ------- (IN THOUSANDS) Net income $12,984 $14,863 $16,257 Unrealized holding (losses) gains on available-for-sale securities (7,042) 600 4,636 Reclassification adjustment for gains realized in income (1,802) (2,877) (4,799) ------- ------- ------- Other comprehensive loss before income tax (8,844) (2,277) (163) Income tax related to other comprehensive loss 3,007 775 54 ------- ------- ------- Other comprehensive loss (5,837) (1,502) (109) ------- ------- ------- Comprehensive income $ 7,147 $13,361 $16,148 ======= ======= =======
38 3. PER SHARE DATA Net income per share is based on the weighted-average number of shares of common stock outstanding. The number of shares used in calculating net income and cash dividends per share reflect the retroactive effect of a 3-for-2 stock split issued in April 2003, as well as 1% stock dividends declared in the fourth quarter of each year presented, payable in the first quarter of the following year. The following data show the amounts used in computing basic and diluted net income per share. As shown in the table that follows, diluted earnings per share is computed using weighted average common shares outstanding, plus weighted-average common shares available from the exercise of all dilutive stock options, less the number of shares that could be repurchased with the proceeds of stock option exercises based on the average share price of the Corporation's common stock during the period.
WEIGHTED- AVERAGE COMMON EARNINGS NET INCOME SHARES PER SHARE ----------- --------- --------- 2005 Earnings per share - basic $12,984,000 8,292,141 $1.57 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 212,323 Hypothetical share repurchase at $29.62 (153,538) ----------- --------- ----- Earnings per share - diluted $12,984,000 8,350,926 $1.55 =========== ========= ===== 2004 Earnings per share - basic $14,863,000 8,267,321 $1.80 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 188,514 Hypothetical share repurchase at $25.39 (139,988) ----------- --------- ----- Earnings per share - diluted $14,863,000 8,315,847 $1.79 =========== ========= ===== 2003 Earnings per share - basic $16,257,000 8,252,358 $1.97 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 195,624 Hypothetical share repurchase at $24.27 (146,909) ----------- --------- ----- Earnings per share - diluted $16,257,000 8,301,073 $1.96 =========== ========= =====
4. ACQUISITION Effective at 11:59 p.m. on August 31, 2005, Citizens & Northern Corporation acquired 100% of Canisteo Valley Corporation in an all-cash merger transaction. Accordingly, the results of operations for Canisteo Valley Corporation have been included in the accompanying consolidated financial statements from that date forward. Canisteo Valley Corporation is the parent company of First State Bank, a New York State chartered commercial bank with offices in Canisteo and South Hornell, NY. The acquisition of Canisteo Valley Corporation and First State Bank permits expansion of Citizens & Northern Corporation's banking operations into communities located in the southern tier of New York State, in close proximity to many of the northern Pennsylvania branch locations, and provides First State Bank with the administrative and credit management resources of a larger organization. 39 Following is a condensed balance sheet showing the fair values of the assets acquired and the liabilities assumed as of the date of acquisition: (IN THOUSANDS) Assets received: Cash and cash equivalents $ 7,136 Available for sale securities 9,439 Loans 23,542 Premises and equipment 1,469 Foreclosed assets 46 Intangible asset - core deposit intangible 547 Intangible asset - goodwill 2,944 Other assets 446 ------- Total assets received 45,569 ------- Liabilities assumed: Deposits 38,008 Other liabilities 627 ------- Total liabilities assumed 38,635 ------- Net assets acquired $ 6,934 =======
The core deposit intangible is being amortized over the weighted-average useful life of 3.7 years, with no estimated residual value. None of the goodwill arising from the acquisition is deductible for income tax purposes. The pro forma effect of Canisteo Valley Corporation's (including First State Bank's) revenues and operating results on the Corporation's financial statements for 2005 and 2004 would not be significant. 5. SALE OF CREDIT CARD LOANS On November 30, 2005, the Corporation sold substantially all of its credit card portfolio, with a total book value of $8.3 million, to a third party and recognized a gain of $1.9 million. As part of the sale, the Corporation agreed to continue to provide servicing for these credit cards through May 2006. The Corporation recorded a $280,000 liability for the estimated direct costs of providing these services net of a servicing fee to be received from the buyer. The $1.9 million gain is net of the $280,000 liability. The liability was reduced by $44,000 during December 2005 with offsetting reductions to salaries and wages expense of $21,000 and other expenses of $23,000. The liability, which is included in accrued interest and other liabilities, was $236,000 at December 31, 2005. 6. CASH AND DUE FROM BANKS Banks are required to maintain reserves consisting of vault cash and deposit balances with the Federal Reserve Bank in their district. The reserves are based on deposit levels during the year and account activity and other services provided by the Federal Reserve Bank. Average daily currency, coin, and cash balances with the Federal Reserve Bank needed to cover reserves against deposits for 2005 ranged from $1,775,000 to $6,616,000. For 2004, theses balances ranged from $2,984,000 to $4,541,000. Average daily cash balances with the Federal Reserve Bank required for services provided to the Bank were $2,600,000 in 2005 and $2,500,000 in 2004. Total balances restricted amounted to $6,616,000 at December 31, 2005 and $6,248,000 at December 31, 2004. Deposits with one financial institution are insured up to $100,000. The Corporation maintains cash and cash equivalents with certain financial institutions in excess of the insured amount. 40 7. SECURITIES Amortized cost and fair value of securities at December 31, 2005 and 2004 are summarized as follows:
DECEMBER 31, 2005 ---------------------------------------------- GROSS GROSS UNREALIZED UNREALIZED AMORTIZED HOLDING HOLDING FAIR COST GAINS LOSSES VALUE --------- ---------- ---------- -------- (IN THOUSANDS) AVAILABLE-FOR-SALE SECURITIES: Obligations of the U.S. Treasury $ 501 $ -- $ (1) $ 500 Obligations of other U.S. Government agencies 43,999 43 (703) 43,339 Obligations of states and political subdivisions 116,241 2,598 (1,130) 117,709 Other securities 94,849 1,428 (1,120) 95,157 Mortgage-backed securities 140,562 165 (3,400) 137,327 -------- ------- ------- -------- Total debt securities 396,152 4,234 (6,354) 394,032 Marketable equity securities 24,033 9,494 (261) 33,266 -------- ------- ------- -------- Total $420,185 $13,728 $(6,615) $427,298 ======== ======= ======= ======== HELD-TO-MATURITY SECURITIES: Obligations of the U.S. Treasury $ 313 $ 11 $ -- $ 324 Obligations of other U.S. Government agencies 98 8 -- 106 Mortgage-backed securities 11 -- -- 11 -------- ------- ------- -------- Total $ 422 $ 19 $ -- $ 441 ======== ======= ======= ========
DECEMBER 31, 2004 ---------------------------------------------- GROSS GROSS UNREALIZED UNREALIZED AMORTIZED HOLDING HOLDING FAIR COST GAINS LOSSES VALUE --------- ---------- ---------- -------- (IN THOUSANDS) AVAILABLE-FOR-SALE SECURITIES: Obligations of the U.S. Treasury $ -- $ -- $ -- $ -- Obligations of other U.S. Government agencies 37,009 67 (764) 36,312 Obligations of states and political subdivisions 125,809 4,147 (586) 129,370 Other securities 100,871 2,675 (439) 103,107 Mortgage-backed securities 169,046 1,002 (2,015) 168,033 -------- ------- ------- -------- Total debt securities 432,735 7,891 (3,804) 436,822 Marketable equity securities 26,388 12,874 (999) 38,263 -------- ------- ------- -------- Total $459,123 $20,765 $(4,803) $475,085 ======== ======= ======= ======== HELD-TO-MATURITY SECURITIES: Obligations of the U.S. Treasury $ 316 $ 23 $ -- $ 339 Obligations of other U.S. Government agencies 98 14 -- 112 Mortgage-backed securities 19 1 -- 20 -------- ------- ------- -------- Total $ 433 $ 38 $ -- $ 471 ======== ======= ======= ========
The following table presents gross unrealized losses and fair value of investments with unrealized loss positions that are not deemed to be other-than-temporarily impaired, aggregated by length of time that individual securities have been in a continuous unrealized loss position at December 31, 2005 and 2004: 41
LESS THAN 12 MONTHS 12 MONTHS OR MORE TOTAL --------------------- -------------------- --------------------- FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED DECEMBER 31, 2005 VALUE LOSSES VALUE LOSSES VALUE LOSSES ----------------- -------- ---------- ------- ---------- -------- ---------- (IN THOUSANDS) AVAILABLE-FOR-SALE SECURITIES: Obligations of the U.S. Treasury $ 501 $ (1) $ -- $ -- $ 501 $ (1) Obligations of other U.S. Government agencies 35,752 (598) 4,895 (105) 40,647 (703) Obligations of states and political subdivisions 37,213 (625) 6,737 (505) 43,950 (1,130) Other securities 42,480 (328) 24,997 (792) 67,477 (1,120) Mortgage-backed securities 66,147 (1,219) 60,899 (2,181) 127,046 (3,400) -------- ------- ------- ------- -------- ------- Total debt securities 182,093 (2,771) 97,528 (3,583) 279,621 (6,354) Marketable equity securities 3,598 (112) 1,132 (149) 4,730 (261) -------- ------- ------- ------- -------- ------- Total temporarily impaired available-for-sale Securities $185,691 $(2,883) $98,660 $(3,732) $284,351 $(6,615) ======== ======= ======= ======= ======== =======
LESS THAN 12 MONTHS 12 MONTHS OR MORE TOTAL --------------------- -------------------- --------------------- FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED DECEMBER 31, 2004 VALUE LOSSES VALUE LOSSES VALUE LOSSES ----------------- -------- ---------- ------- ---------- -------- ---------- (IN THOUSANDS) AVAILABLE-FOR-SALE SECURITIES: Obligations of the U.S. Treasury $ -- $ -- $ -- $ -- $ -- $ -- Obligations of other U.S. Government agencies 19,675 (325) 9,550 (439) 29,225 (764) Obligations of states and political subdivisions 15,497 (260) 12,265 (326) 27,762 (586) Other securities 41,837 (316) 4,975 (123) 46,812 (439) Mortgage-backed securities 94,435 (1,440) 25,646 (575) 120,081 (2,015) -------- ------- ------- ------- -------- ------- Total debt securities 171,444 (2,341) 52,436 (1,463) 223,880 (3,804) Marketable equity securities 1,366 (52) 4,958 (947) 6,324 (999) -------- ------- ------- ------- -------- ------- Total temporarily impaired available-for-sale securities $172,810 $(2,393) $57,394 $(2,410) $230,204 $(4,803) ======== ======= ======= ======= ======== =======
Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) 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. The unrealized losses on debt securities are primarily the result of volatility in interest rates. Based on the credit worthiness of the issuers, which are almost exclusively U.S. Government-sponsored agencies or state and political subdivisions, management believes the Corporation's debt securities at December 31, 2005 were not other-than-temporarily impaired. The amortized cost and fair value of investment debt securities at December 31, 2005 follow. Maturities of debt securities (including mortgage-backed securities) are presented based on contractual maturities. Expected maturities differ from contractual maturities because monthly principal payments are received from mortgage-backed securities, and because borrowers may have the right to prepay obligations with or without prepayment penalties. 42
DECEMBER 31, 2005 -------------------- AMORTIZED FAIR COST VALUE --------- -------- (IN THOUSANDS) AVAILABLE-FOR-SALE SECURITIES: Due in one year or less $ 3,236 $ 3,226 Due after one year through five years 5,291 4,980 Due after five years through ten years 33,500 33,514 Due after ten years 354,125 352,312 -------- -------- Total $396,152 $394,032 ======== ======== HELD-TO-MATURITY SECURITIES: Due in one year or less $ -- $ -- Due after one year through five years 417 436 Due after five years through ten years -- -- Due after ten years 5 5 -------- -------- Total $ 422 $ 441 ======== ========
The following table shows the amortized cost and maturity distribution of the debt securities portfolio at December 31, 2005:
WITHIN ONE - FIVE - AFTER ONE FIVE TEN TEN YEAR YIELD YEARS YIELD YEARS YIELD YEARS YIELD TOTAL YIELD ------ ----- ------ ----- ------- ----- -------- ----- -------- ----- (IN THOUSANDS, EXCEPT FOR PERCENTAGES) AVAILABLE-FOR-SALE SECURITIES: Obligations of other U.S. Treasury $ 501 4.34% $ -- -- $ -- -- $ -- -- $ 501 4.34% Obligations of other U.S. Government agencies 999 4.64% 1,500 4.85% 20,500 5.18% 21,000 5.12% 43,999 5.13% Obligations of states and political subdivisions 1,736 3.99% 2,876 3.75% 1,690 4.67% 109,939 4.58% 116,241 4.55% Other securities -- -- 915 4.80% 6,343 6.86% 87,591 5.60% 94,849 5.68% Mortgage-backed securities -- -- -- -- 4,967 5.08% 135,595 4.51% 140,562 4.53% ------ ---- ------ ---- ------- ---- -------- ---- -------- ---- Total $3,236 4.24% $5,291 4.24% $33,500 5.46% $354,125 4.53% $396,152 4.88% ====== ==== ====== ==== ======= ==== ======== ==== ======== ==== HELD-TO-MATURITY SECURITIES: Obligations of the U.S. Treasury $ -- -- $ 313 5.30% $ -- -- $ -- -- $ 313 5.30% Obligations of other U.S. Government agencies -- -- 98 7.16% -- -- -- -- 98 7.16% Mortgage-backed securities -- -- 6 6.22% -- -- 5 6.35% 11 6.28% ------ ---- ------ ---- ------- ---- -------- ---- -------- ---- Total $ -- -- $ 417 5.75% $ -- -- $ 5 6.35% $ 422 5.76% ====== ==== ====== ==== ======= ==== ======== ==== ======== ====
Investment securities carried at $129,692,000 at December 31, 2005 and $89,158,000 at December 31, 2004, were pledged as collateral for public deposits, trusts and certain other deposits as provided by law. Also, see Note 12 for information concerning securities pledged to secure borrowing arrangements. Gross realized gains and losses from the sales of available-for-sale securities, and the income tax provision related to net realized gains, for 2005, 2004 and 2003 were as follows:
2005 2004 2003 ------- ------- ------ (IN THOUSANDS) Gross realized gains $ 4,683 $ 3,880 $4,860 Gross realized losses (2,881) (1,003) (61) ------- ------- ------ Net realized gains $ 1,802 $ 2,877 $4,799 ======= ======= ====== Income tax provision related to net realized gains $ 613 $ 978 $1,632 ======= ======= ======
43 8. LOANS Major categories of loans and leases included in the loan portfolio are as follows:
DECEMBER 31, % OF DECEMBER 31, % OF 2005 TOTAL 2004 TOTAL ------------ ------ ------------ ------ (IN THOUSANDS) Real estate - construction $ 5,552 0.85% $ 4,178 0.72% Real estate - residential mortgage 361,857 55.39% 347,705 59.98% Real estate - commercial mortgage 153,661 23.52% 128,073 22.10% Consumer 31,559 4.83% 31,702 5.47% Agricultural 2,340 0.36% 2,872 0.50% Commercial 69,396 10.62% 43,566 7.52% Other 1,871 0.29% 1,804 0.31% Political subdivisions 27,063 4.14% 19,713 3.40% -------- ------ -------- ------ Total 653,299 100.00% 579,613 100.00% Less: allowance for loan losses (8,361) (6,787) -------- -------- Loans, net $644,938 $572,826 ======== ========
Net unamortized loan fees of $1,508,000 at December 31, 2005 and $1,704,000 at December 31, 2004 have been offset against the carrying value of loans. There is no concentration of loans to borrowers engaged in similar businesses or activities that exceed 10% of total loans at December 31, 2005. The Corporation grants commercial, residential and personal loans to customers primarily in the Pennsylvania Counties of Tioga, Bradford, Sullivan and Lycoming, and in Steuben and Allegany Counties in New York State. Although the Corporation has a diversified loan portfolio, a significant portion of its debtors' ability to honor their contracts is dependent on the local economic conditions within the region. Transactions in the allowance for loan losses were as follows:
2005 2004 2003 ------ ------ ------ (IN THOUSANDS) Balance at beginning of year $6,787 $6,097 $5,789 Allowance for loan losses recorded in acquisition 377 -- -- Provision charged to operations 2,026 1,400 1,100 Loans charged off (984) (786) (968) Recoveries 155 76 176 ------ ------ ------ Balance at end of year $8,361 $6,787 $6,097 ====== ====== ======
Information related to impaired and nonaccrual loans, and loans past due 90 days or more, as of December 31, 2005 and 2004 is as follows:
2005 2004 2003 ------ ------ ------ (IN THOUSANDS) Impaired loans without a valuation allowance $ 910 $3,552 $ 114 Impaired loans with a valuation allowance 7,306 4,709 4,507 ------ ------ ------ Total impaired loans $8,216 $8,261 $4,621 ====== ====== ====== Valuation allowance related to impaired loans $2,374 $1,378 $1,542 Total nonaccrual loans $6,365 $7,796 $1,145 Total loans past due 90 days or more and still accruing $1,369 $1,307 $2,546
44 The following is a summary of information related to impaired loans for 2005, 2004 and 2003:
2005 2004 2003 ------ ------ ------ (IN THOUSANDS) Average investment in impaired loans $8,282 $7,458 $3,425 ====== ====== ====== Interest income recognized on impaired loans $ 291 $ 352 $ 313 ====== ====== ====== Interest income recognized on a cash basis on impaired loans $ 291 $ 352 $ 313 ====== ====== ======
No additional funds are committed to be advanced in connection with impaired loans. 9. BANK PREMISES AND EQUIPMENT Bank premises and equipment are summarized as follows:
DECEMBER 31, ------------------- 2005 2004 -------- -------- (IN THOUSANDS) Land $ 2,118 $ 1,449 Buildings and improvements 19,296 15,734 Furniture and equipment 15,725 13,539 Construction in progress 4,237 874 -------- -------- Total 41,376 31,596 Less: accumulated depreciation (18,771) (14,871) -------- -------- Net $ 22,605 $ 16,725 ======== ========
Depreciation expense included in occupancy expense and furniture and equipment expense was as follows:
2005 2004 2003 ------ ------ ------ (IN THOUSANDS) Occupancy expense $ 700 $ 572 $ 479 Furniture and equipment expense 1,601 1,015 732 ------ ------ ------ Total $2,301 $1,587 $1,211 ====== ====== ======
45 10. INTANGIBLE ASSETS Information related to the core deposit intangible asset as of December 31, 2005 was as follows: (IN THOUSANDS) Gross amount $547 Less: accumulated amortization (83) ---- Net $464 ====
Amortization expense for 2005 was $83,000. Estimated amortization expense for each of the ensuing five years is as follows: (IN THOUSANDS) 2006 $128 2007 85 2008 64 2009 48 2010 36
Changes in the carrying amount of goodwill in 2005 are summarized in the following table: (IN THOUSANDS) Balance, beginning of year $ -- Goodwill arising in business combination (see Note 4) 2,944 Reduction in valuation allowance on deferred tax asset related to net operating loss (25) ------ Balance, end of year $2,919 ======
11. DEPOSITS At December 31, 2005, the scheduled maturities of time deposits are as follows: (IN THOUSANDS) 2006 $194,779 2007 98,149 2008 20,580 2009 13,958 2010 10,626 THEREAFTER 36 -------- $338,128 ========
Included in interest-bearing deposits are time deposits in the amount of $100,000 or more. As of December 31, 2005, the remaining maturities or repricing frequency of time deposits of $100,000 or more are as follows: (IN THOUSANDS) Three months or less $37,575 Over 3 months through 12 months 30,203 Over 1year through 3 years 23,055 Over 3 years 5,374 ------- Total $96,207 =======
Interest expense from deposits of $100,000 or more amounted to $2,975,000 in 2005, $2,214,000 in 2004 and $2,693,000 in 2003. 46 12. BORROWED FUNDS SHORT-TERM BORROWINGS Short-term borrowings include the following:
AT DECEMBER 31, ----------------- 2005 2004 ------- ------- (IN THOUSANDS) Federal Home Loan Bank of Pittsburgh borrowings (a) $ 7,000 $ 8,000 Customer repurchase agreements (b) 27,734 21,178 Other repurchase agreements (c) -- 5,000 ------- ------- Total short-term borrowings $34,734 $34,178 ======= =======
The weighted average interest rate on total short-term borrowings outstanding was 2.80% at December 31, 2005 and 1.37% at December 31, 2004. The maximum amount of total short-term borrowings outstanding at any month-end was $60,037,000 in 2005 and $55,278,000 in 2004. (a) Short-term FHLB - Pittsburgh loans are as follows:
AT DECEMBER 31, --------------- 2005 2004 ------ ------ (IN THOUSANDS) Fixed Rate 3.76% maturing April 26, 2006 $7,000 $ -- Fixed Rate 1.47% maturing February 23, 2005 3,000 Fixed Rate 2.67% maturing March 17, 2005 5,000 ------ ------ Total short-term FHLB - Pittsburgh borrowings $7,000 $8,000 ====== ======
Collateral for FHLB - Pittsburgh loans is described under the "Long-term Borrowings" section of this note. (b) Customer repurchase agreements mature overnight, and are collateralized by securities with a carrying value of $34,521,000 at December 31, 2005 and $26,336,000 at December 31, 2004. (c) Other repurchase agreements included in short-term borrowings are as follows:
AT DECEMBER 31, --------------- 2005 2004 ------ ------ (IN THOUSANDS) Fixed Rate 1.45% matures April 26, 2005 $-- $5,000 --- ------ Total other repurchase agreements $-- $5,000 === ======
The terms and collateral related to repurchase agreements are described under the "Long-term Borrowings" section of this note. LONG-TERM BORROWINGS Long-term borrowings are as follows:
AT DECEMBER 31, ------------------- 2005 2004 -------- -------- (IN THOUSANDS) FHLB - Pittsburgh borrowings (d) $185,485 $208,441 Repurchase agreements (e) 46,720 62,386 -------- -------- Total long-term borrowings $232,205 $270,827 ======== ========
47 (d) Long-term borrowings from FHLB - Pittsburgh are as follows:
AT DECEMBER 31, ------------------- 2005 2004 -------- -------- (IN THOUSANDS) Loans maturing in 2006 with rates ranging from 2.07% to 4.83% $ 57,700 $ 50,700 Loans maturing in 2007 with rates ranging from 2.33% to 4.58% 79,067 74,067 Loans maturing in 2008 with rates ranging from 2.97% to 4.33% 23,500 19,500 Loans maturing in 2009 with rates ranging from 3.60% to 3.62% 5,432 6,384 Loan maturing in 2011 with a rate of 4.98% 5,000 5,000 Loan maturing in 2012 with a rate of 4.54% 10,000 10,000 Loan maturing in 2016 with a rate of 6.86% 428 453 Loan maturing in 2017 with a rate of 6.83% 55 58 Loan maturing in 2020 with rates ranging from 4.67% to 4.79% 2,850 2,279 Loan maturing in 2025 with a rate of 4.91% 1,453 -------- -------- Total long-term FHLB - Pittsburgh borrowings $185,485 $168,441 ======== ========
The FHLB - Pittsburgh loan facilities are collateralized by qualifying securities and mortgage loans with a book value totaling $299,353,000 at December 31, 2005. Also, the FHLB - Pittsburgh loan facilities require the Corporation to invest in established amounts of FHLB - Pittsburgh stock. The carrying values of the Corporation's holdings of FHLB - Pittsburgh stock were $10,128,000 at December 31, 2005 and $12,360,000 at December 31, 2004. (e) Repurchase agreements included in long-term borrowings are as follows:
AT DECEMBER 31, ----------------- 2005 2004 ------- ------- (IN THOUSANDS) Agreements maturing in 2005 with rates ranging from 2.01% to 4.63% $ -- $15,666 Agreements maturing in 2006 with rates ranging from 2.02% to 4.63% 20,220 20,220 Agreements maturing in 2007 with rates ranging from 2.53% to 3.23% 14,500 14,500 Agreements maturing in 2008 with rates ranging from 3.00% to 3.60% 12,000 12,000 ------- ------- Total long-term repurchase agreements $46,720 $62,386 ======= =======
Securities sold under repurchase agreements were delivered to the broker-dealers who arranged the transactions. The broker-dealers may have sold, loaned or otherwise disposed of such securities to other parties in the normal course of their operations, and have agreed to resell to the Corporation substantially identical securities at the maturities of the agreements. The carrying value of the underlying securities was $54,966,000 at December 31, 2005 and $70,528,000 at December 31, 2004. Average daily repurchase agreement borrowings amounted to $51,022,000 in 2005, $58,663,000 in 2004 and $40,333,000 in 2003. During 2005, 2004 and 2003, the maximum amounts of outstanding borrowings under repurchase agreements with broker-dealers were $67,386,000, $67,386,000 and $50,153,000. The weighted average interest rate on repurchase agreements was 2.92% in 2005, 3.20% in 2004 and 3.68% in 2003. 13. DERIVATIVE FINANCIAL INSTRUMENTS The Corporation has utilized derivative financial instruments related to a certificate of deposit product called the "Index Powered Certificate of Deposit" (IPCD). IPCDs have a term of 5 years, with interest paid at maturity based on 90% of the appreciation (as defined) in the S&P 500 index. There is no guaranteed interest payable to a depositor of an IPCD - however, assuming an IPCD is held to maturity, a depositor is guaranteed the return of his or her principal, at a minimum. In 2004, the Corporation stopped originating new IPCDs, but continues to maintain and account for IPCDs and the related derivative contracts entered into between 2001 and 2004. Statement of Financial Accounting Standards No. 133 requires the Corporation to separate the amount received from each IPCD issued into 2 components: (1) an embedded derivative, and (2) the principal amount of each deposit. Embedded derivatives are derived from the Corporation's obligation to pay each IPCD depositor a return based on appreciation in the S&P 500 index. Embedded derivatives are carried at fair value, and are included in other liabilities in the consolidated balance sheet. Changes in fair value of the embedded derivative are included in other expense in the consolidated income statement. The difference between the contractual amount of each IPCD issued, and the amount of 48 the embedded derivative, is recorded as the initial deposit (included in interest-bearing deposits in the consolidated balance sheet). Interest expense is added to principal ratably over the term of each IPCD at an effective interest rate that will increase the principal balance to equal the contractual IPCD amount at maturity. In connection with IPCD transactions, the Corporation has entered into Equity Indexed Call Option (Swap) contracts with FHLB-Pittsburgh. Under the terms of the Swap contracts, the Corporation must pay FHLB-Pittsburgh quarterly amounts calculated based on the contractual amount of IPCDs issued times a negotiated rate. In return, FHLB-Pittsburgh is obligated to pay the Corporation, at the time of maturity of the IPCDs, an amount equal to 90% of the appreciation (as defined) in the S&P 500 index. If the S&P 500 index does not appreciate over the term of the related IPCDs, the FHLB-Pittsburgh would make no payment to the Corporation. The effect of the Swap contracts is to limit the Corporation's cost of IPCD funds to the market rate of interest paid to FHLB-Pittsburgh. (In addition, the Corporation paid a fee of 0.75% to a consulting firm at inception of each deposit. This fee is amortized to interest expense over the term of the IPCDs.) Swap liabilities are carried at fair value, and included in other liabilities in the consolidated balance sheet. Changes in fair value of swap liabilities are included in other expense in the consolidated income statement. Amounts recorded related to IPCDs are as follows (in thousands):
AT DECEMBER 31, --------------- 2005 2004 ------ ------ Contractual amount of IPCDs (equal to notional amount of Swap contracts) $3,952 $4,045 Carrying value of IPCDs 3,733 3,695 Carrying value of embedded derivative liabilities 558 297 Carrying value of Swap contract liabilities (346) 42
FOR THE YEARS ENDED DECEMBER 31, -------------------------------- 2005 2004 2003 ---- ---- ---- Interest expense $156 $143 $112 Other expense 13 9 10
14. FAIR VALUE OF FINANCIAL INSTRUMENTS The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Corporation's financial instruments. 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. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. SFAS No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Therefore, the aggregate fair value amounts presented may not represent the underlying fair value of the Corporation. The Corporation used the following methods and assumptions in estimating fair value disclosures for financial instruments: CASH AND CASH EQUIVALENTS - The carrying amounts of cash and short-term instruments approximate fair values. SECURITIES - Fair values for securities, excluding restricted equity securities, are based on quoted market prices. The carrying value of restricted equity securities approximates fair value based on applicable redemption provisions. LOANS - Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, commercial real estate, residential mortgage, credit card and other consumer. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories. The fair value of performing loans, except residential mortgage and credit card loans, is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the 49 credit and interest rate risk inherent in the loans. The estimate of maturity is based on the Corporation's historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions. For performing residential mortgage loans, fair value is estimated by discounting contractual cash flows adjusted for prepayment estimates based on historical experience. For credit card loans, cash flows and maturities are estimated based on contractual interest rates and historical experience. Fair value of nonperforming loans is based on recent appraisals or estimates prepared by the Corporation's lending officers. DEPOSITS - The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, savings, money market and interest checking accounts, is (by definition) equal to the amount payable on demand at December 31, 2005 and 2004. The fair value of all other deposit categories is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities. The fair value estimates of deposits do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market, commonly referred to as the core deposit intangible. BORROWED FUNDS - The fair value of borrowings is estimated using discounted cash flow analyses based on rates currently available to the Corporation for similar types of borrowing arrangements. ACCRUED INTEREST - The carrying amounts of accrued interest receivable and payable approximate fair values. EMBEDDED DERIVATIVE LIABILITIES - IPCDS - The fair values of embedded derivatives are calculated by a third party. Factors that affect the fair value of embedded derivatives include term to maturity, market interest rates and other market factors that affect the present value of the Corporation's obligation to pay each IPCD depositor a return based on appreciation in the S&P 500 index. EMBEDDED DERIVATIVE LIABILITIES - EQUITY OPTION SWAP CONTRACTS - The fair values of equity option Swap contracts are calculated by a third party. Factors that affect the fair value of equity option Swap contracts include: (1) the negotiated rate associated with the Corporation's obligation to make quarterly payments to the FHLB-Pittsburgh over the term of each IPCD; and (2) term to maturity, market interest rates and other market factors that affect the present value of the FHLB-Pittsburgh's obligation to pay the Corporation a return based on appreciation in the S&P 500 index. The estimated fair values, and related carrying amounts, of the Corporation's financial instruments are as follows:
DECEMBER 31, 2005 DECEMBER 31, 2004 ------------------- ------------------- CARRYING FAIR CARRYING FAIR AMOUNT VALUE AMOUNT VALUE -------- -------- -------- -------- (IN THOUSANDS) Financial assets: Cash and cash equivalents $ 26,446 $ 26,446 $ 18,953 $ 18,953 Available-for-sale securities 427,298 427,298 475,085 475,085 Held-to-maturity securities 422 441 433 471 Restricted equity securities 10,128 10,128 12,360 12,360 Loans, net 644,938 637,093 572,826 578,720 Accrued interest receivable 5,500 5,500 5,094 5,094 Equity option Swap contracts - IPCDs 346 346 -- -- Financial liabilities: Deposits 757,065 757,566 676,545 677,182 Short-term borrowings 34,734 33,930 34,178 34,133 Long-term borrowings 232,205 227,993 270,827 270,015 Accrued interest payable 1,128 1,128 1,639 1,639 Embedded derivative liabilities - IPCDs 558 558 297 297 Equity option Swap contracts - IPCDs -- -- 42 42
50 15. EMPLOYEE AND POSTRETIREMENT BENEFIT PLANS DEFINED BENEFIT PLANS The Corporation has a noncontributory defined benefit pension plan for all employees meeting certain age and length of service requirements. Benefits are based primarily on years of service and the average annual compensation during the highest five consecutive years within the final ten years of employment. Also, the Corporation sponsors a defined benefit health care plan that provides postretirement medical benefits and life insurance to employees who meet certain age and length of service requirements. This plan contains a cost-sharing feature, which causes participants to pay for all future increases in costs related to benefit coverage. Accordingly, actuarial assumptions related to health care cost trend rates do not affect the liability balance at December 31, 2005 and 2004, and will not affect the Corporation's future expenses. The Corporation uses a December 31 measurement date for its plans. The following tables show the funded status and amounts recognized in the consolidated balance sheet from these defined benefit plans:
PENSION POSTRETIREMENT BENEFITS BENEFITS ----------------- --------------- 2005 2004 2005 2004 ------- ------- ------ ------ (IN THOUSANDS) CHANGE IN BENEFIT OBLIGATION: Benefit obligation at beginning of year $11,195 $10,086 $1,129 $1,029 Service cost 475 474 43 43 Interest cost 618 620 63 63 Plan participants' contributions -- -- 190 164 Actuarial loss (gain) (139) 478 18 46 Benefits paid (481) (463) (241) (216) ------- ------- ------ ------ Benefit obligation at end of year $11,668 $11,195 $1,202 $1,129 ======= ======= ====== ======
2005 2004 2005 2004 ------- ------- ------- ------- CHANGE IN PLAN ASSETS: Fair value of plan assets at beginning of year $ 9,313 $ 8,654 $ -- $ -- Actual return on plan assets 745 794 -- -- Employer contribution 178 328 51 52 Plan participants' contributions -- -- 190 164 Benefits paid (481) (463) (241) (216) ------- ------- ------- ------- Fair value of plan assets at end of year $ 9,755 $ 9,313 $ -- $ -- ======= ======= ======= ======= Funded status $(1,913) $(1,882) $(1,202) $(1,129) Unrecognized net actuarial loss (gain) 2,235 2,364 121 105 Unrecognized transition (asset) obligation (114) (137) 256 292 ------- ------- ------- ------- Prepaid (accrued) benefit cost $ 208 $ 345 $ (825) $ (732) ======= ======= ======= =======
The accumulated benefit obligation for the defined benefit pension plan was $9,442,000 at December 31, 2005 and $8,380,000 at December 31, 2004. 51 The components of net periodic benefit costs from these defined benefit plans are as follows:
PENSION BENEFITS POSTRETIREMENT BENEFITS --------------------- ----------------------- 2005 2004 2003 2005 2004 2003 ----- ----- ----- ---- ---- ---- (IN THOUSANDS) Service cost $ 475 $ 474 $ 394 $ 43 $ 43 $ 32 Interest cost 618 620 590 63 63 60 Expected return on plan assets (793) (748) (615) -- -- -- Amortization of transition (asset) obligation (23) (23) (22) 36 36 37 Recognized net actuarial loss (gain) 38 65 86 2 2 1 ----- ----- ----- ---- ---- ---- Net periodic benefit cost $ 315 $ 388 $ 433 $144 $144 $130 ===== ===== ===== ==== ==== ====
The weighted-average assumptions used to determine benefit obligations as of December 31, 2005 and 2004 are as follows:
PENSION POSTRETIREMENT BENEFITS BENEFITS ----------- -------------- Discount rate 5.50% 6.00% 5.50% 6.00% Expected return on plan assets 8.50% 8.50% N/A N/A Rate of compensation increase 4.00% 4.50% N/A N/A
The expected return on pension plan assets is a significant assumption used in the calculation of net periodic benefit cost. This assumption reflects the average long-term rate of earnings expected on the funds invested or to be invested to provide for the benefits included in the projected benefit obligation. The selected rate considers the historical and expected future investment trends of the present and expected future assets in the plan. Management believes the assumed 8.50% return on plan assets, which was used for net periodic benefit cost calculations in 2003, 2004 and 2005, is reasonable. Management has calculated the average annual return on pension plan assets over the period 1991-2005 to be 9.26%, with annual returns ranging from a low of -7.23% to a high of +19.87% over that period. The Corporation's pension plan weighted-average asset allocations at December 31, 2005 and 2004 are as follows:
2005 2004 ---- ---- Cash and cash equivalents 4% 5% Debt securities 33% 34% Equity securities 63% 61% --- --- Total 100% 100% === ===
The Bank's Trust and Financial Management Department manages the investment of pension plan assets. The targeted asset allocation for the pension plan is 60% equity securities, 35% debt securities and 5% cash. This targeted asset allocation reflects a balanced approach, considering the need for growth of plan assets to meet future demand, as well as the need for ongoing liquidity to fund benefit payments. Specifically, the Trust Department attempts to match the maturities of zero-coupon bonds with the estimated amounts of benefit payments over the ensuing 10-year period. Within the equity portion of pension plan investments, the Trust Department employs a strategy of diversification. Holdings include large capitalization stocks from many different industries, as well as mid-cap and foreign mutual funds. The pension plan's assets do not include any shares of the Corporation's common stock. The Corporation expects to contribute $380,000 to the defined benefit pension plan, and $62,000 to the postretirement benefit plan, in 2005. 52 Estimated future benefit payments (including, for the postretirement plan, only the estimated employer contributions), which reflect expected future service, are as follows:
PENSION POSTRETIREMENT BENEFITS BENEFITS -------- -------------- (IN THOUSANDS) 2006 $ 430 $ 62 2007 437 62 2008 443 67 2009 485 69 2010 508 73 2011-2015 3,130 424
In December 2003, the Medicare Prescription Drug, Improvement and Modernization Act (the "Act") was signed into law. The Act introduces a prescription drug benefit under Medicare (Medicare Part D) as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least "actuarially equivalent" to Medicare Part D. The Corporation has been informed that the Medicare program has determined that benefits provided under the Corporation's postretirement plan for the plan year ending June 30, 2006 are considered to be actuarially equivalent to benefits available under Medicare Part D. However, it is uncertain whether plan benefits will be considered actuarially equivalent after June 30, 2006, and therefore, the calculation of the benefit obligation at December 31, 2005 has not been reduced for any future reimbursements from the Medicare program. PROFIT SHARING AND DEFERRED COMPENSATION PLANS The Corporation has a profit sharing plan that incorporates the deferred salary savings provisions of Section 401(k) of the Internal Revenue Code. The Corporation's matching contributions to the Plan depend upon the tax deferred contributions of employees. The Corporation's total basic and matching contributions were $834,000 in 2005, $727,000 in 2004 and $728,000 in 2003. The profit sharing/401(k) Plan includes an Employee Stock Ownership Plan (ESOP). A portion of the Corporation's basic contributions to the Plan are made to the ESOP, and the Plan uses these funds to purchase Corporation stock for the accounts of Plan participants. These purchases are made on the market (not directly from the Corporation), and employees are not permitted to purchase Corporation stock under the Plan. The Plan includes a diversification feature which permits Plan participants, upon reaching age 55 and 10 years of service (as defined), to sell up to 50% of their Corporation shares back to the Plan over a period of 6 years. As of December 31, 2005 and 2004, there were no shares allocated for repurchase by the Plan. Dividends paid on shares held by the ESOP are charged to retained earnings. All Corporation shares owned through the ESOP are included in the calculation of weighted-average shares outstanding for purposes of calculating earnings per share - basic and diluted. The ESOP held 257,873 shares of Corporation stock at December 31, 2005 and 275,064 shares at December 31, 2004, all of which had been allocated to Plan participants. The Corporation's contributions to the ESOP portion of the Plan (included in total contributions reported above) totaled $433,000 in 2005, $385,000 in 2004 and $377,000 in 2003. The Corporation also has a nonqualified supplemental deferred compensation arrangement with its key officers. Charges to expense for officers' supplemental deferred compensation were $32,000 in 2005, $4,000 in 2004 and $45,000 in 2003. STOCK-BASED COMPENSATION PLANS The Corporation has a Stock Incentive Plan for a selected group of senior officers. A total of 400,000 shares of common stock may be issued under the Stock Incentive Plan. Awards may be made under the Stock Incentive Plan in the form of qualified options ("Incentive Stock Options," as defined in the Internal Revenue Code), nonqualified options, stock appreciation rights or restricted stock. Through 1999, all awards under the Stock Incentive Plan were Incentive Stock Options, with exercise prices equal to the market price of the stock at the date of grant, ratable vesting over 5 years and a contractual expiration of 10 years. In 2000, 2002, 2003, 2004 and 2005, there were awards of Incentive Stock Options and restricted stock. The Incentive Stock Options granted in 2000, 2002, 2003, 2004 and 2005 have an exercise price equal to the market value of the stock at the date of grant, vest after 6 months and expire after 10 years. The restricted stock awards vest ratably over 3 years. Also, the Corporation has an Independent Directors Stock Incentive Plan. This plan permits awards of nonqualified stock options and/or restricted stock to non-employee directors. A total of 75,000 shares of common stock may be issued under 53 the Independent Directors Stock Incentive Plan. The recipients' rights to exercise stock options under this plan expire 10 years from the date of grant. The exercise prices of all stock options awarded under the Independent Directors Stock Incentive Plan are equal to market value as of the dates of grant. The restricted stock awards vest ratably over 3 years. As described in Note 1, the Corporation applies Accounting Principles Board Opinion 25 and related interpretations in accounting for stock options. Accordingly, no compensation expense has been recognized for the stock options. Had compensation cost for the stock options been determined based on the fair value at the grant dates for awards consistent with the method of SFAS No. 123, the effect on the Corporation's net income and earnings per share would have been adjusted to the pro forma amounts indicated in the following table.
2005 2004 2003 ------- ------- ------- (NET INCOME IN THOUSANDS) Net income As reported $12,984 $14,863 $16,257 Pro forma $12,915 $14,773 $16,133 Earnings per share-basic As reported $ 1.57 $ 1.80 $ 1.97 Pro forma $ 1.56 $ 1.79 $ 1.95 Earnings per share-diluted As reported $ 1.55 $ 1.79 $ 1.96 Pro forma $ 1.55 $ 1.78 $ 1.94
For purposes of the calculations of SFAS No. 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:
2005 2004 2003 ------- ------- ------- Volatility 15% 15% 15% Expected option lives 6 Years 6 Years 6 Years Risk-free interest rate 3.93% 3.87% 3.55% Dividend yield 4.73% 4.46% 4.30%
A summary of the status of the Corporation's stock option plans is presented below:
2005 2004 2003 ------------------ ------------------ ------------------ WEIGHTED WEIGHTED WEIGHTED AVERAGE AVERAGE AVERAGE EXERCISE EXERCISE EXERCISE SHARES PRICE SHARES PRICE SHARES PRICE ------- -------- ------- -------- ------- -------- Outstanding, beginning of year 212,463 $20.03 213,058 $18.81 180,722 $18.11 Granted 37,176 $27.00 33,249 $26.59 46,411 $20.73 Exercised (38,814) $18.72 (29,795) $18.32 (12,066) $16.28 Forfeited (6,832) $21.85 (4,049) $21.80 (2,009) $16.19 ------- ------ ------- ------ ------- ------ Outstanding, end of year 203,993 $21.51 212,463 $20.03 213,058 $18.11 ======= ====== ======= ====== ======= ====== Options exercisable at year-end 203,993 $21.51 212,463 $20.03 207,898 $18.82 Fair value of options granted $ 2.45 $ 2.57 $ 2.11
54 The following table summarizes information about stock options outstanding as of December 31, 2005:
OUTSTANDING EXERCISABLE AT REMAINING AT DECEMBER 31, CONTRACTUAL DECEMBER 31, EXERCISE PRICES 2005 LIFE IN YEARS 2005 --------------- ------------ ------------- ------------- $17.00 2,550 1 2,550 $18.03-$22.17 12,540 2 12,540 $24.25-$24.33 18,225 3 18,225 $18.00-$22.08 21,150 4 21,150 $13.50-$16.67 14,310 5 14,310 $17.00 37,909 6 37,909 $20.73 35,329 7 35,329 $26.59 27,289 8 27,289 $27.00 34,691 9 34,691 ------- ------- 203,993 203,993 ======= =======
The following table summarizes restricted stock awards in 2005, 2004 and 2003:
2005 2004 2003 ------- ------- ------- Number of shares awarded 4,128 3,714 5,166 Market price of stock at date of grant $ 27.00 $ 26.59 $ 20.73
Compensation expense related to restricted stock was $93,000 in 2005, $85,000 in 2004 and $102,000 in 2003. 55 16. INCOME TAXES The following temporary differences gave rise to the net deferred tax liability at December 31, 2005 and 2004:
2005 2004 ---- ---- (IN THOUSANDS) Deferred tax liabilities: Unrealized holding gains on securities $ 2,411 $ 5,427 Bank premises and equipment 1,445 1,151 Core deposit intangible 193 -- Realized gains on securities 136 75 Prepaid pension 72 120 Other deferred tax liabilities 75 24 ------- ------- Total 4,332 6,797 ------- ------- Deferred tax assets: Allowance for loan losses (2,896) (2,375) Credit for alternative minimum tax paid (352) (300) Postretirement and sick benefits (308) (276) Supplemental executive retirement plan (185) (178) Net operating loss carryforward (138) -- Valuation allowance on net operating loss carryforward 138 -- Investments in limited partnerships (131) (125) Fair value discount on purchased loans (95) -- Loan fees and costs (80) (60) Other deferred tax assets (151) (48) ------- ------- Total (4,198) (3,362) ------- ------- Deferred tax liability, net $ 134 $ 3,435 ======= =======
2005 2004 2003 ---- ---- ---- Currently payable $ 3,433 $ 2,755 $ 3,634 Deferred (640) 96 (25) ------- ------- ------- Total provision $ 2,793 $ 2,851 $ 3,609 ======= ======= =======
2005 2004 2003 ---------------- ---------------- ---------------- AMOUNT % AMOUNT % AMOUNT % ------- ------ ------- ------ ------- ------ Expected provision $ 5,522 35.00% $ 6,200 35.00% $ 6,953 35.00% Tax-exempt interest income (2,301) (14.58) (2,790) (15.75) (2,766) (13.92) Nondeductible interest expense 223 1.41 238 1.34 242 1.22 Dividends received deduction (254) (1.61) (347) (1.96) (284) (1.43) Increase in cash surrender value of life insurance (196) (1.24) (214) (1.21) (250) (1.26) Surtax exemption (83) (0.53) (84) (0.47) (185) (0.93) Other, net (118) (0.75) (152) (0.86) (101) (0.51) ------- ----- ------- ----- ------- ----- Effective income tax provision $ 2,793 17.70% $ 2,851 16.09% $ 3,609 18.17% ======= ===== ======= ===== ======= =====
The Corporation has available at December 31, 2005, an unused operating loss carryforward of approximately $348,000 that was assumed in the acquisition of Canisteo Valley Corporation. This operating loss carryforward may be applied against future taxable income through its expiration in 2024; however, the amount that may be utilized in any year is limited to the amount of taxable income generated by Canisteo Valley Corporation. If in the future the deferred tax asset related to the operating loss is realized, all of the associated valuation allowance will be allocated to reduce goodwill. 56 17. RELATED PARTY TRANSACTIONS Loans to executive officers, directors of the Corporation and its subsidiaries and any associates of the foregoing persons are as follows:
BEGINNING NEW OTHER ENDING BALANCE LOANS REPAYMENTS CHANGES BALANCE --------- ------ ---------- ------- ------- (IN THOUSANDS) 13 directors, 5 executive officers 2005 $7,695 $3,220 $(2,513) $ 833 $9,235 13 directors, 5 executive officers 2004 7,193 1,501 (2,054) 1,055 7,695 13 directors, 5 executive officers 2003 6,623 612 (956) 914 7,193
The above transactions were made in the ordinary course of business on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and do not involve more than normal risks of collectibility. Other changes represent net increases in existing lines of credit and transfers in and out of the related party category. Deposits from related parties held by the Corporation amounted to $2,900,000 at December 31, 2005 and $1,887,000 at December 31, 2004. 18. 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. These financial instruments include commitments to extend credit and financial standby letters of credit. These instruments involve, to varying degrees, elements of credit, interest rate or liquidity risk in excess of the amount recognized in the consolidated balance sheet. The contract amounts of these instruments express the extent of involvement the Corporation has in particular classes of financial instruments. The Corporation's exposure to credit loss from nonperformance by the other party to the financial instruments for commitments to extend credit and financial standby letters of credit is represented by the contractual amount of these instruments. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Financial instruments whose contract amounts represent credit risk at December 31, 2005 and 2004 are as follows:
2005 2004 -------- -------- (IN THOUSANDS) Commitments to extend credit $123,463 $226,121 Standby letters of credit 19,582 17,049
Commitments to extend credit are legally binding agreements to lend to customers. Commitments generally have fixed expiration dates or other termination clauses and may require payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future liquidity requirements. The Corporation evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation, for extensions of credit is based on management's credit assessment of the counterparty. Financial standby letters of credit are conditional commitments issued by the Corporation guaranteeing performance by a customer to a third party. Those guarantees are issued primarily to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Some of the financial standby letters of credit are collateralized by real estate or other assets, while others are unsecured. The extent to which proceeds from liquidation of collateral would be expected to cover the maximum potential amount of future payments related to financial standby letters of credit is not estimable. The Corporation has recorded no liability associated with financial standby letters of credit as of December 31, 2005 and 2004. Financial standby letters of credit as of December 31, 2005 expire as follows: 57
Year of Expiration Amount ------------------ ------ (IN THOUSANDS) 2006 $17,701 2007 1,403 2008 424 2009 35 2010 19 ------- Total $19,582 =======
19. OPERATING LEASES AND OTHER PURCHASE COMMITMENTS The Corporation leases facilities and office equipment under operating leases expiring through 2009. Rental expense under operating leases totaled approximately $213,000 in 2005 and $89,000in 2004. Minimum future rental payments under non-cancelable operating leases having remaining terms in excess of 1 year as of December 31, 2005 are as follows: (IN THOUSANDS) 2006 $171 2007 73 2008 28 2009 13 2010 THEREAFTER
The facility leases contain renewal options for an additional 5-15 years at rental amounts established in the leases. In 2004, the Corporation purchased the license to utilize banking software, and entered into contractual commitments to pay annual maintenance fees associated with the software. Maintenance expense amounted to $360,000 in 2005 and $60,000 in 2004, and maintenance fees payable will be approximately $360,000 per year through 2008 and $300,000 in 2009. Through October 2009, the Corporation would also be required to pay additional software license fees, based on the Bank's asset size, determined based on the following schedule (additional licensing fees in thousands):
ASSET SIZE ADDITIONAL LICENSING FEE ---------- ------------------------ $1.75 BILLION TO $2 BILLION $250 $2 BILLION TO $2.25 BILLION 150 in addition to the $250 noted above $2.25 BILLION TO $2.5 BILLION 250 in addition to the $400 noted above ABOVE $2.5 BILLION Based on the vendor's then-current fee schedule
Effective in October 2007, the Corporation has the right to terminate its contractual commitment to the software vendor, subject to payment of 25% of any remaining annual maintenance fees. The agreement between the software vendor and the Corporation contains options for an unlimited number of additional 5-year renewals. The agreement includes formulas to determine the amounts of maintenance fees and additional licensing fees, if the Corporation exercises the renewal options. 20. CONTINGENCIES In the normal course of business, the Corporation is subject to pending and threatened litigation in which claims for monetary damages are asserted. In management's opinion, the Corporation's financial position and results of operations would not be materially affected by the outcome of these legal proceedings. 58 21. REGULATORY MATTERS The Corporation (on a consolidated basis) and the subsidiary Banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Corporation's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation and the Banks must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies. Quantitative measures established by regulation to ensure capital adequacy require the Corporation and the Banks to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2005 and 2004, that the Corporation and the Banks meet all capital adequacy requirements to which they are subject. To be categorized as well capitalized, an institution must maintain minimum total risk based, Tier I risk based and Tier I leverage ratios as set forth in the following table. The Corporation's and the Banks' actual capital amounts and ratios are also presented in the following table. (DOLLARS IN THOUSANDS)
MINIMUM TO BE WELL MINIMUM CAPITALIZED UNDER CAPITAL PROMPT CORRECTIVE ACTUAL REQUIREMENT ACTION PROVISIONS ---------------- ------------------- ------------------- AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO -------- ----- ------- --------- ------- --------- DECEMBER 31, 2005: Total capital to risk- weighted assets: Consolidated $136,403 18.19% $59,994 > or = 8% n/a N/a C&N Bank 106,300 15.00% 56,708 > or = 8% $70,885 > or = 10% First State Bank 3,940 16.05% 1,964 > or = 8% 2,455 > or = 10% Tier 1 capital to risk- weighted assets: Consolidated 123,887 16.52% 29,997 > or = 4% n/a N/a C&N Bank 96,128 13.56% 28,354 > or = 4% 42,531 > or = 6% First State Bank 3,632 14.80% 982 > or = 4% 1,473 > or = 6% Tier 1 capital to average assets: Consolidated 123,887 10.62% 46,665 > or = 4% n/a N/a C&N Bank 96,128 8.72% 44,116 > or = 4% 55,145 > or = 5% First State Bank 3,632 8.78% 1,655 > or = 4% 2,068 > or = 5% DECEMBER 31, 2004: Total capital to risk- weighted assets: Consolidated $133,181 18.89% $56,399 > or = 8% n/a n/a C&N Bank 107,974 15.66% 55,172 > or = 8% $68,965 > or = 10% Tier 1 capital to risk- weighted assets: Consolidated 121,050 17.17% 28,200 > or = 4% n/a n/a C&N Bank 98,637 14.30% 27,586 > or = 4% 41,379 > or = 6% Tier 1 capital to average assets: Consolidated 121,050 10.69% 45,276 > or = 4% n/a n/a C&N Bank 98,637 8.95% 44,103 > or = 4% 55,129 > or = 5%
59 Restrictions imposed by Federal Reserve Regulation H limit dividend payments in any year to the current year's net income plus the retained net income of the prior two years without approval of the Federal Reserve Board. Accordingly, the Corporation's dividends in 2006 may not exceed $12,992,000, plus consolidated net income for 2006. Additionally, banking regulators limit the amount of dividends that may be paid by the Banks to the Corporation. Retained earnings against which dividends may be paid without prior approval of the banking regulators amounted to approximately $86,145,000 at December 31, 2005, subject to the minimum capital ratio requirements noted above. Restrictions imposed by federal law prohibit the Corporation from borrowing from the Banks unless the loans are secured in specific amounts. Such secured loans to the Corporation are generally limited to 10% of the Banks' tangible stockholder's equity (excluding accumulated other comprehensive income) or $9,976,000 at December 31, 2005. 22. PARENT COMPANY ONLY The following is condensed financial information for Citizens & Northern Corporation. CONDENSED BALANCE SHEET
DECEMBER 31, ------------------- 2005 2004 -------- -------- (IN THOUSANDS) ASSETS Cash $ 729 $ 725 Investment in subsidiaries: Citizens & Northern Bank 98,007 104,989 Citizens & Northern Investment Corporation 25,682 25,270 Canisteo Valley Corporation 6,958 -- Bucktail Life Insurance Company 2,485 2,373 Other assets 81 99 -------- -------- TOTAL ASSETS $133,942 $133,456 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Dividends payable $ 1,973 $ 1,864 Other liabilities 1 7 Stockholders' equity 131,968 131,585 -------- -------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $133,942 $133,456 ======== ========
CONDENSED INCOME STATEMENT
YEARS ENDED DECEMBER 31, --------------------------- 2005 2004 2003 ------- ------- ------- (IN THOUSANDS) Dividends from Citizens & Northern Bank $13,805 $ 7,582 $ 6,870 Other dividend income and security gains 6 5 -- Expenses (162) (123) (183) ------- ------- ------- Income before equity in undistributed income of subsidiaries 13,649 7,464 6,687 Equity in undistributed income of subsidiaries (665) 7,399 9,570 ------- ------- ------- NET INCOME $12,984 $14,863 $16,257 ======= ======= =======
60 CONDENSED STATEMENT OF CASH FLOWS
YEARS ENDED DECEMBER 31, --------------------------- 2005 2004 2003 ------- ------- ------- (IN THOUSANDS) CASH FLOWS FROM OPERATING ACTIVITIES: Net income $12,984 $14,863 $16,257 Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed net income of subsidiaries 665 (7,399) (9,570) Amortization of restricted stock 93 85 102 Decrease (increase) in other assets 18 (45) (9) (Decrease) increase in other liabilities (6) 78 68 ------- ------- ------- Net Cash Provided by Operating Activities 13,754 7,582 6,848 ------- ------- ------- CASH FLOWS FROM INVESTING ACTIVITIES, Investment in subsidiary (7,002) -- (460) ------- ------- ------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from sale of treasury stock 656 528 197 Tax benefit from compensation plans 213 -- -- Purchase of treasury stock (59) (575) (174) Dividends paid (7,558) (7,139) (6,674) ------- ------- ------- Net Cash Used in Financing Activities (6,748) (7,186) (6,651) ------- ------- ------- INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 4 396 (263) CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 725 329 592 ------- ------- ------- CASH AND CASH EQUIVALENTS, END OF YEAR $ 729 $ 725 $ 329 ======= ======= =======
23. SUMMARY OF QUARTERLY CONSOLIDATED FINANCIAL DATA (UNAUDITED) The following table presents summarized quarterly financial data for 2005 and 2004:
2005 QUARTER ENDED ------------------------------------------ MAR. 31, JUNE 30, SEPT. 30, DEC. 31, -------- -------- --------- -------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Interest income $14,693 $14,908 $15,571 $15,936 Interest expense 5,957 6,155 6,426 7,149 ------- ------- ------- ------- Interest margin 8,736 8,753 9,145 8,787 Provision for loan losses 375 375 375 901 ------- ------- ------- ------- Interest margin after provision for loan losses 8,361 8,378 8,770 7,886 Other income 1,703 1,889 2,149 1,895 Gain from sale of credit card loans -- -- -- 1,906 Securities gains (losses) 1,066 929 393 (586) Other expenses 7,128 7,173 7,303 7,358 ------- ------- ------- ------- Income before income tax provision 4,002 4,023 4,009 3,743 Income tax provision 707 725 722 639 ------- ------- ------- ------- Net income $ 3,295 $ 3,298 $ 3,287 $ 3,104 ------- ------- ------- ------- Net income per share - basic $ 0.40 $ 0.40 $ 0.40 $ 0.37 ======= ======= ======= ======= Net income per share - diluted $ 0.39 $ 0.39 $ 0.39 $ 0.37 ======= ======= ======= =======
61
2005 QUARTER ENDED ------------------------------------------ MAR. 31, JUNE 30, SEPT. 30, DEC. 31, -------- -------- --------- -------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Interest income $14,015 $14,343 $14,573 $14,991 Interest expense 5,703 5,493 5,665 5,745 ------- ------- ------- ------- Interest margin 8,312 8,850 8,908 9,246 Provision for loan losses 350 350 350 350 ------- ------- ------- ------- Interest margin after provision for loan losses 7,962 8,500 8,558 8,896 Other income 1,625 1,855 1,627 1,815 Securities gains (losses) 964 321 459 1,133 Other expenses 6,228 6,289 6,738 6,746 ------- ------- ------- ------- Income before income tax provision 4,323 4,387 3,906 5,098 Income tax provision 617 698 501 1,035 ------- ------- ------- ------- Net income $ 3,706 $ 3,689 $ 3,405 $ 4,063 ======= ======= ======= ======= Net income per share - basic $ 0.45 $ 0.45 $ 0.41 $ 0.49 ======= ======= ======= ======= Net income per share - diluted $ 0.44 $ 0.44 $ 0.41 $ 0.49 ======= ======= ======= =======
62 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and Board of Directors of Citizens & Northern Corporation: We have audited the accompanying consolidated balance sheet of Citizens & Northern Corporation and subsidiaries (collectively, the "Corporation") as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Citizens & Northern Corporation and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Corporation's internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee on Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 24, 2006 expressed an unqualified opinion on management's assessment of internal control over financial reporting and an unqualified opinion on the effectiveness of internal control over financial reporting. Parente Randolph, LLC /s/ Williamsport, Pennsylvania February 24, 2006 63 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None ITEM 9A. CONTROLS AND PROCEDURES EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES The Corporation's management, under the supervision of and with the participation of the Corporation's Chief Executive Officer and Chief Financial Officer, has carried out an evaluation of the design and effectiveness of the Corporation's disclosure controls and procedures as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Securities Exchange Act of 1934 as of the end of period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Corporation's disclosure controls and procedures are effective to ensure that all material information required to be disclosed in reports the Corporation files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms. There were no significant changes in the Corporation's internal control over financial reporting that occurred during the period covered by this report that has materially affected, or that is reasonably likely to affect, our internal control over financial reporting. MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING The Corporation's management is responsible for establishing and maintaining adequate internal control over financial reporting, as that term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). The Corporation's system of internal control over financial reporting has been designed to provide reasonable assurance to the Corporation's management and board of directors regarding the reliability of financial reporting and the preparation and fair presentation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. Any system of internal control over financial reporting, no matter how well designed, has inherent limitations, including the possibility that a control can be circumvented or overridden and misstatements due to error or fraud may occur and not be detected. Also, because of changes in conditions, internal control effectiveness may vary over time. Accordingly, even an effective system of internal control will provide only reasonable assurance with respect to financial statement preparation and presentation. The Corporation's management has assessed the effectiveness of the Corporation's internal control over financial reporting as of December 31, 2005. To make this assessment, we used the criteria for effective internal control over financial reporting described in Internal Control - Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our assessment and based on such criteria, we believe that, as of December 31, 2005, the Corporation's internal control over financial reporting was effective. Parente Randolph, LLC, the independent registered public accounting firm that audited the Corporation's consolidated financial statements, has issued an audit report on management's assessment of internal control over financial reporting as of December 31, 2005. That report appears below. FEBRUARY 8, 2006 BY: CRAIG G. LITCHFIELD /S/ DATE ------------------------------------ CHAIRMAN, PRESIDENT AND CHIEF EXECUTIVE OFFICER FEBRUARY 8, 2006 BY: MARK A. HUGHES /S/ DATE ------------------------------------ TREASURER AND CHIEF FINANCIAL OFFICER 64 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and Board of Directors of Citizens & Northern Corporation: We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that Citizens & Northern Corporation and subsidiaries maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Citizens & Northern Corporation's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, 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 audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (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. 65 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, management's assessment that Citizens & Northern Corporation and subsidiaries maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Citizens & Northern Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Citizens & Northern Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2005, and our report dated February 24, 2006 expressed an unqualified opinion. Parente Randolph, LLC /s/ Williamsport, Pennsylvania February 24, 2006 66 ITEM 9B. OTHER INFORMATION There was no information the Corporation was required to disclose in a report on Form 8-K during the fourth quarter 2005 that was not disclosed. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information concerning Directors and Executive Officers is incorporated herein by reference to disclosure under the captions "Proposal 1 - Election of Directors," "Corporation's and Bank's Executive Officers," "Section 16(a) Beneficial Ownership Reporting Compliance," "Board of Director Committees, Attendance at Meetings and Compensation of Directors" and "Stockholder Proposals" of the Corporation's proxy statement dated March 21, 2006 for the annual meeting of stockholders to be held on April 18, 2006. The Corporation's Board of Directors has adopted a Code of Ethics, available on the Corporation's web site at www.cnbankpa.com for the Corporation's employees, officers and directors. (The provisions of the Code of Ethics are also included in the Corporation's employee handbook.) ITEM 11. EXECUTIVE COMPENSATION Information concerning executive compensation is incorporated herein by reference to disclosure under the captions "Executive Compensation," "Stock Incentive plan," "Option Grants," "Aggregated Stock Options Exercised During 2005 and Year-end Option Values," "Pension Plan," "Savings Plan," "Incentive Award Plan" and "Change in Control Agreements" of the Corporation's proxy statement dated March 21, 2006 for the annual meeting of stockholders to be held on April 18, 2006. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED MATTERS Information concerning security ownership of certain beneficial owners and management is incorporated herein by reference to disclosure under the caption "Security Ownership of Management" of the Corporation's proxy statement dated March 21, 2006 for the annual meeting of stockholders to be held on April 18, 2006. "Equity Compensation Plan Information" as required by Item 201(d) of Regulation S-K is incorporated by reference herein from Item 5 (Market for Registrant's Common Equity and Related Stockholder Matters) of this Form 10-K. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information concerning loans and deposits with Directors and Executive Officers is provided in Note 17 to the Consolidated Financial Statements, which is included in Part II, Item 8 of this Annual Report on Form 10-K. Additional information is incorporated herein by reference to disclosure appearing under the caption "Certain Transactions" of the Corporation's proxy statement dated March 21, 2006 for the annual meeting of stockholders to be held on April 18, 2006. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES Information concerning services provided by the Corporation's independent auditors, Parente Randolph, LLC, the audit committee's pre-approval policies and procedures for such services, and fees paid by the Corporation to that firm, is incorporated herein by reference to disclosure under the caption "Audit Committee" of the Corporation's proxy statement dated March 21, 2006 for the annual meeting of stockholders to be held on April 18, 2006. 67 PART IV ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) (1). The following consolidated financial statements are set forth in Part II, Item 8:
Page -------- Report of Independent Registered Public Accounting Firm 63 Financial Statements: Consolidated Balance Sheet - December 31, 2005 and 2004 31 Consolidated Statement of Income - Years Ended December 31, 2005, 2004 and 2003 32 Consolidated Statement of Changes in Stockholders' Equity - Years Ended December 31, 2005, 2004 and 2003 33 Consolidated Statement of Cash Flows - Years Ended December 31, 2005, 2004 and 2003 34 - 35 Notes to Consolidated Financial Statements 36 - 62
(a)(2) Financial statement schedules are not applicable or included in the financial statements or related notes. (a)(3) Exhibits (numbered as in Item 601 of Regulation S-K): 2. Plan of acquisition, Not applicable reorganization, arrangement, liquidation or succession 3. (i) Articles of Incorporation Incorporated by reference to the exhibits filed with the Corporation's registration statement on Form S-4 on March 27, 1987. 3. (ii) By-laws Incorporated by reference to Exhibit 3.1 of the Corporation's Form 8-K filed August 25, 2004 4. Instruments defining the rights of Not applicable security holders, including indentures 9. Voting trust agreement Not applicable 10. Material contracts: 10.1 Change in Control Agreement Filed herewith dated July 21, 2005 between the Corporation and Harold F. Hoose, III 10.2 Form of Stock Option and Filed herewith Restricted Stock Agreements dated January 3, 2005 between the Corporation and certain officers pursuant to the Citizens & Northern Corporation Stock Incentive Plan 10.3 Form of Stock Option and Filed herewith Restricted Stock Agreements dated January 3, 2005 between the Corporation and the Directors pursuant to the Citizens & Northern Corporation Independent Directors Stock Incentive Plan
68 10.4 Form of Indemnification Incorporated by reference to Exhibit Agreements dated May 2004 between 10.1 filed with the Corporation's Form the Corporation and the Directors 10-K on March 11, 2005 and certain officers 10.5 Change in Control Agreement Incorporated by reference to Exhibit dated December 31, 2003 between 10.2 filed with the Corporation's Form the Corporation and Thomas L. 10-K on March 11, 2005 Rudy, Jr. 10.6 Change in Control Agreement Incorporated by reference to Exhibit dated December 31, 2003 between 10.1 filed with the Corporation's Form the Corporation and Craig G. 10-K on March 10, 2004 Litchfield 10.7 Change in Control Agreement Incorporated by reference to Exhibit dated December 31, 2003 between 10.2 filed with the Corporation's Form the Corporation and Mark A. Hughes 10-K on March 10, 2004 10.8 Change in Control Agreement Incorporated by reference to Exhibit dated December 31, 2003 between 10.4 filed with the Corporation's Form the Corporation and Deborah E. 10-K on March 10, 2004 Scott 10.9 Second Amendment to Citizens Incorporated by reference to Exhibit & Northern Corporation Stock 10.5 filed with the Corporation's Form Incentive Plan 10-K on March 10, 2004 10.10 First Amendment to Citizens Incorporated by reference to Exhibit & Northern Corporation Stock 10.6 filed with the Corporation's Form Incentive Plan 10-K on March 10, 2004 10.11 Citizens & Northern Incorporated by reference to Exhibit Corporation Stock Incentive Plan 10.7 filed with the Corporation's Form 10-K on March 10, 2004 10.12 Citizens & Northern Incorporated by reference to Exhibit A Corporation Independent Directors to the Corporation's proxy statement Stock Incentive Plan dated March 19, 2001 for the annual meeting of stockholders held on April 17, 2001. 10.13 Amendment #1 to Citizens & Incorporated by reference to Exhibit Northern Bank Supplemental 10.2(b) filed with the Corporation's Executive Retirement Plan Form 10-K on March 19, 2001 10.14 Amendment #2 to Citizens & Incorporated by reference to Exhibit Northern Bank Supplemental 10.2(a) filed with the Corporation's Executive Retirement Plan Form 10-K on March 19, 2001 10.15 Citizens & Northern Bank Incorporated by reference to Exhibit Supplemental Executive Retirement 10.2 filed with the Corporation's Form Plan 10-K on March 19, 2001
69 11. Statement re: computation of per Information concerning the computation share earnings of earnings per share is provided in Note 3 to the Consolidated Financial Statements, which is included in Part II, Item 8 of Form 10-K. 12. Statements re: computation of Not applicable ratios 13. Annual report to security Not applicable holders, Form 10-Q or quarterly report to security holders 14. Code of ethics The Code of Ethics is available through the Corporation's website at www.cnbankpa.com. To access the Code of Ethics, click on "Shareholder News & Info.," followed by "Corporate Governance" and "Code of Ethics." 16. Letter re: change in certifying Not applicable accountant 18. Letter re: change in accounting Not applicable principles 21. Subsidiaries of the registrant Filed herewith 22. Published report regarding Not applicable matters submitted to vote of security holders 23. Consents of experts and counsel Not applicable 24. Power of attorney Not applicable 31. Rule 13a-14(a)/15d-14(a) certifications: 31.1 Certification of Chief Filed herewith Executive Officer 31.2 Certification of Chief Filed herewith Financial Officer 32. Section 1350 certifications Filed herewith 33. Report on assessment of Not applicable compliance with servicing criteria for asset-backed securities 34. Attestation report on assessment Not applicable of compliance with servicing criteria for asset-backed securities 99. Additional exhibits: 99.1 Additional information mailed Filed herewith to stockholders with proxy statement and Form 10-K on March 21, 2006
(b) Exhibits - The required exhibits are listed under Part IV, Item 15(a)(3) of Form 10-K. (c) Financial statement schedules are omitted because the required information is not applicable or is included elsewhere in Form 10-K. 70 SIGNATURES PURSUANT to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Citizens & Northern Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized: By: Craig G. Litchfield /s/ --------------------------------- Craig G. Litchfield Chairman, President and Chief Executive Officer Date: March 3, 2006 By: Mark A. Hughes /s/ --------------------------------- Treasurer and Principal Accounting Officer Date: March 3, 2006 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. BOARD OF DIRECTORS /s/ Dennis F. Beardslee /s/ Edward L. Learn ------------------------------------- ---------------------------------------- Dennis F. Beardslee Edward L. Learn Date: March 3, 2006 Date: March 3, 2006 /s/ R. Robert DeCamp /s/ Craig G. Litchfield ------------------------------------- ---------------------------------------- R. Robert DeCamp Craig G. Litchfield Date: March 3, 2006 Date: March 3, 2006 /s/ Jan E. Fisher /s/ Edward H. Owlett, III ------------------------------------- ---------------------------------------- Jan E. Fisher Edward H. Owlett, III Date: March 3, 2006 Date: March 3, 2006 /s/ R. Bruce Haner /s/ Leonard Simpson ------------------------------------- ---------------------------------------- R. Bruce Haner Leonard Simpson Date: March 3, 2006 Date: March 3, 2006 /s/ Susan E. Hartley /s/ James E. Towner ------------------------------------- ---------------------------------------- Susan E. Hartley James E. Towner Date: March 3, 2006 Date: March 3, 2006 /s/ Karl W. Kroeck /s/ Ann M. Tyler ------------------------------------- ---------------------------------------- Karl W. Kroeck Ann M. Tyler Date: March 3, 2006 Date: March 3, 2006 /s/ Leo F. Lambert ------------------------------------- Leo F. Lambert Date: March 3, 2006 71