-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, T4ZfX8m7wKraJfwogC+fzTpMbKAeOODVfXjlBhuvABugu5VGLWP0Hl822Qevlj/6 5VkHzhrlIMsVrwnYl6uG5g== 0001168557-05-000013.txt : 20050315 0001168557-05-000013.hdr.sgml : 20050315 20050315151734 ACCESSION NUMBER: 0001168557-05-000013 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 20041231 FILED AS OF DATE: 20050315 DATE AS OF CHANGE: 20050315 FILER: COMPANY DATA: COMPANY CONFORMED NAME: ORRSTOWN FINANCIAL SERVICES INC CENTRAL INDEX KEY: 0000826154 STANDARD INDUSTRIAL CLASSIFICATION: STATE COMMERCIAL BANKS [6022] IRS NUMBER: 232530374 STATE OF INCORPORATION: PA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 033-18888 FILM NUMBER: 05681496 BUSINESS ADDRESS: STREET 1: 77 E KING STREET STREET 2: P O BOX 250 CITY: SHIPPENSBURG STATE: PA ZIP: 17257 BUSINESS PHONE: 7175326114 MAIL ADDRESS: STREET 1: 77 EAST KING STREET CITY: SHIPPANSBURG STATE: PA ZIP: 17257 10-K 1 orrstown10k.txt SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2004 Commission file number: 33-18888 ORRSTOWN FINANCIAL SERVICES, INC. (Exact name of registrant as specified in its charter) Pennsylvania 23-2530374 (State or other jurisdiction of incorporation (I.R.S. Employer or organization) Identification No.) 77 East King Street, P. O. Box 250, Shippensburg, Pennsylvania 17257 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (717) 532-6114 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, No Par Value Title of each class 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 (229.405 of this chapter) is not contained herein and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. X Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes X No As of December 31, 2004, 5,126,205 shares of the registrant's common stock were outstanding. The aggregate market value of such shares held by non-affiliates on that date was $ 222,766,785. DOCUMENTS INCORPORATED BY REFERENCE Portions of the annual shareholders report for the year ended December 31, 2004 are incorporated by reference into Parts I and II. Portions of the Proxy Statement for the 2005 Annual Meeting of Security Holders are incorporated by reference in Part III of this Form 10-K. ORRSTOWN FINANCIAL SERVICES, INC. FORM 10-K INDEX Page Part I Item 1. Business 3 Item 2. Properties 6 Item 3. LegalProceedings 6 Item 3a. Executive Officers of the Registrant 7 Item 4. Submission of Matters to a Vote of Security Holders 7 Part II Item 5. Market for Registrant's Common Equity and Related Security Holder Matters 8 Item 6. Selected Financial Data 8 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 8 Item 8. Financial Statements and Supplementary Data 8 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 16 Item 9a. Controls and Procedures 16 Item 9b. Other Information 16 Part III Item 10. Directors and Executive Officers of the Registrant 17 Item 11. Executive Compensation 17 Item 12. Security Ownership of Certain Beneficial Owners and Management 17 Item 13. Certain Relationships and Related Transactions 17 Item 14. Principal Accountant Fees and Services 17 Part IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K 18 Signatures 20 Part I Item 1. Business.History and Business Orrstown Financial Services, Inc. (the Corporation) is a financial holding company registered under the Gramm-Leach- Bliley Act. Orrstown Financial Services, Inc. was organized on November 17, 1987, under the laws of the Commonwealth of Pennsylvania for the purpose of acquiring Orrstown Bank (the Bank), Shippensburg, Pennsylvania, and such other banks and bank related activities as are permitted by law and desirable. On March 8, 1988, Orrstown Financial Services, Inc. acquired 100% ownership of Orrstown Bank, issuing 131,455 shares of Orrstown Financial Services, Inc.'s common stock to the former Bank shareholders. The Corporation files periodic reports with the Securities and Exchange Commission (SEC) in the form of 10-Q's - quarterly reports; 10-K - annual report; annual proxy statements and Form 8-K for any significant events that may arise during the year. Copies of the Corporation's filings may be obtained through the SEC's internet site at www.sec.gov or by accessing the Corporation's website at www.orrstown.com. Orrstown Financial Services, Inc.'s primary activity consists of owning and supervising its two subsidiaries, Orrstown Bank and Pennbanks Insurance Company Cell P1. Orrstown Bank is engaged in providing banking and bank related services in South Central Pennsylvania, principally Franklin and Cumberland Counties, where its fourteen branches are located in Shippensburg (2), Carlisle (4), Spring Run, Orrstown, Chambersburg (4), Greencastle and Mechanicsburg, Pennsylvania. The day-to-day management of Orrstown Bank is conducted by the subsidiary's officers. Pennbanks Insurance Company Cell P1 is a reinsurer of credit life, and disability insurance which services customers of Orrstown Bank. Orrstown Financial Services, Inc. derives a majority of its current income from Orrstown Bank. Orrstown Financial Services, Inc. has no employees other than its five officers who are also employees of the Bank, its subsidiary. On December 31, 2004, the Bank had 140 full-time and 30 part-time employees. Orrstown Bank was organized as a state-chartered bank in 1987 as part of an agreement and plan of merger between Orrstown Financial Services, Inc. and Orrstown Bank, the predecessor of Orrstown Bank, under which Orrstown Bank became a wholly-owned subsidiary of Orrstown Financial Services, Inc. As indicated, the Bank is the successor to Orrstown Bank which was originally organized in 1919. The Bank is engaged in commercial banking and trust business as authorized by the Pennsylvania Banking Code of 1965. This involves accepting demand, time and savings deposits, and granting loans. The Bank grants agribusiness, commercial and residential loans to customers in South Central Pennsylvania, principally Franklin and Cumberland Counties. The concentrations of credit by type of loan are set forth on the face of the balance sheet (page 4 of the annual report to shareholders). The Bank maintains a diversified loan portfolio and evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon the extension of credit, is based on management's credit evaluation of the customer and collateral standards established in the Bank's lending policies and procedures. All secured loans are supported with appraisals of collateral. Business equipment and machinery, inventories, accounts receivable, and farm equipment are considered appropriate security, provided they meet acceptable standards for liquidity and marketability. Loans secured by equipment and/or other non real estate collateral normally do not exceed 70% of appraised value or cost, whichever is lower. Loans secured by real estate generally do not exceed 80% of the appraised value of the property. Loan to collateral values are monitored as part of the loan review, and appraisals are updated as deemed appropriate in the circumstances. Administration and supervision over the lending process is provided by the Bank's Credit Administration Department. The loan review process is continuous, commencing with the approval of a loan. Each new loan is reviewed by the Loan Department for compliance with banking regulations and lending policy requirements for documentation, collateral standards, and approvals. The Bank employees a Loan Review Officer, who is independent from the Loan function and reports directly to the Chief Operating Officer and the Directors' Credit Administration Committee. The Loan Review Officer continually monitors and evaluates loan customers utilizing risk-rating criteria established in the lending policy in order to spot deteriorating trends and detect conditions which might indicate potential problem loans. The Loan Review Officer reports the results of the loan reviews quarterly to the Directors' Credit Administration Committee for approval and provides the basis for evaluating the adequacy of the allowance for loan losses. Through its trust department, the Bank renders services as trustee, executor, administrator, guardian, managing agent, custodian, investment advisor, and other fiduciary activities authorized by law. As of December 31, 2004, the Corporation had total assets of approximately $ 515 million, total shareholders' equity of approximately $ 49 million and total deposits of approximately $ 405 million. Regulation and Supervision Orrstown Financial Services, Inc. is a financial holding company, and is registered as such with the Board of Governors of the Federal Reserve System (the Federal Reserve Board). As a registered bank holding company and financial holding company, the Corporation is subject to regulation under the Bank Holding Company Act of 1956 and to inspection, examination, and supervision by the Federal Reserve Board. The operations of the Bank are subject to federal and state statutes applicable to banks chartered under the banking laws of the United States, and to banks whose deposits are insured by the Federal Deposit Insurance Corporation. Bank operations are also subject to regulations of the Pennsylvania Department of Banking, the Federal Reserve Board, and the Federal Deposit Insurance Corporation (FDIC). Several of the more significant regulatory provisions applicable to banks and financial holding companies to which the Corporation and its subsidiaries are subject are discussed below, along with certain regulatory matters concerning the Corporation and its subsidiaries. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory provisions. Any change in applicable law or regulation may have a material effect on the business and prospects of the Corporation and its subsidiaries. Financial and Bank Holding Company Activities "Financial in Nature" Requirement. As a financial holding company, the Corporation may engage in, and acquire companies engaged in, activities that are considered "financial in nature", as defined by the Gramm-Leach-Bliley Act and Federal Reserve Board interpretations. These activities include, among other things, securities underwriting, dealing and market-making, sponsoring mutual funds and investment companies, insurance underwriting and agency activities, and merchant banking. If any banking subsidiary of the Corporation ceases to be "well capitalized" or "well managed" under applicable regulatory standards, the Federal Reserve Board may, among other things, place limitations on the Corporation's ability to conduct the broader financial activities permissible for financial holding companies or, if the deficiencies persist, require the Corporation to divest the banking subsidiary. In addition, if any banking subsidiary of the Corporation receives a Community Reinvestment Act rating of less than satisfactory, the Corporation would be prohibited from engaging in any additional activities other than those permissible for bank holding companies that are not financial holding companies. The Corporation may engage directly or indirectly in activities considered financial in nature, either de novo or by acquisition, as long as it gives the Federal Reserve Board after-the-fact notice of the new activities. Interstate Banking and Branching. As a bank holding company, the Corporation is required to obtain prior Federal Reserve Board approval before acquiring more than 5% of the voting shares, or substantially all of the assets, of a bank holding company, bank, or savings association. Under the Riegle-Neal Interstate Banking and Branching Efficiency Act (Riegle-Neal), subject to certain concentration limits and other requirements, bank holding companies such as the Corporation may acquire banks and bank holding companies located in any state. Riegle-Neal also permits banks to acquire branch offices outside their home states by merging with out-of-state banks, purchasing branches in other states, and establishing de novo branch offices in other states. The ability of banks to acquire branch offices is contingent, however, on the host state having adopted legislation "opting in" to those provisions of Riegle-Neal. In addition, the ability of a bank to merge with a bank located in another state is contingent on the host state not having adopted legislation "opting out" of that provision of Riegle-Neal. Control Acquisitions. The Change in Bank Control Act prohibits a person or group of persons from acquiring "control" of a bank holding company, unless the Federal Reserve Board has been notified and has not objected to the transaction. Under a rebuttable presumption established by the Federal Reserve Board, the acquisition of 10% or more of a class of voting stock of a bank holding company with a class of securities registered under Section 12 of the Exchange Act, such as the Corporation, would, under the circumstances set forth in the presumption, constitute acquisition of control of the bank holding company. In addition, a company is required to obtain the approval of the Federal Reserve Board under the Bank Holding Company Act before acquiring 25% (5% in the case of an aquiror that is a bank holding company) or more of any class of outstanding voting stock of a bank holding company, or otherwise obtaining control or a "controlling influence" over that bank holding company. Liability for Banking Subsidiaries Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial and managerial strength to each of its subsidiary banks and to commit resources to their support. This support may be required at times when the bank holding company may not have the resources to provide it. Similarly, under the cross-guarantee provisions of the Federal Deposit Insurance Act, the FDIC can hold any FDIC-insured depository institution liable for any loss suffered or anticipated by the FDIC in connection with (1) the "default" of a commonly controlled FDIC-insured depository institution; or (2) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution "in danger of default". Capital Requirements Information concerning the Corporation and its subsidiaries with respect to capital requirements is incorporated by reference from Note 15, "Regulatory Matters", of the "Notes to Consolidated Financial Statements" included under Item 8 of this report, and from the "Capital Adequacy and Regulatory Matters" section of the "Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations", included under Item 7 of this report. FDICIA The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), and the regulations promulgated under FDICIA, among other things, established five capital categories for insured depository institutions - well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized - and requires federal bank regulatory agencies to implement systems for "prompt corrective action" for insured depository institutions that do not meet minimum capital requirements based on these categories. Unless a bank is well capitalized, it is subject to restrictions on its ability to offer brokered deposits and on certain other aspects of its operations. An undercapitalized bank must develop a capital restoration plan and its parent bank holding company must guarantee the bank's compliance with the plan up to the lesser of 5% of the bank's assets at the time it became undercapitalized and the amount needed to comply with the plan. As of December 31, 2004, the Bank was considered well capitalized based on the guidelines implemented by the bank regulatory agencies. Dividend Restrictions The Corporation's funds for cash distributions to its shareholders are derived from a variety of sources, including cash and temporary investments. One of the principal sources of those funds is dividends received from its subsidiary Orrstown Bank. Various federal laws limit the amount of dividends the Bank can pay to the Corporation without regulatory approval. In addition, federal bank regulatory agencies have authority to prohibit the Bank from engaging in an unsafe or unsound practice in conducting their business. The payment of dividends, depending upon the financial condition of the bank in question, could be deemed to constitute an unsafe or unsound practice. The ability of the Bank to pay dividends in the future is currently, and could be further, influenced by bank regulatory policies and capital guidelines. Additional information concerning the Corporation and its banking subsidiary with respect to dividends is incorporated by reference from Note 15, "Regulatory Matters", of the "Notes to Consolidated Financial Statements" included under Item 8 of this report, and the "Capital Adequacy and Regulatory Matters" sections of "Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations", included under Item 7 of this report. Depositor Preference Statute In the "liquidation or other resolution" of an institution by any receiver, U.S. federal legislation provides that deposits and certain claims for administrative expenses and employee compensation against the insured depository institution would be afforded a priority over the general unsecured claims against that institution, including federal funds and letters of credit. Other Federal Laws and Regulations Our operations are subject to additional federal laws and regulations applicable to financial institutions, including, without limitation: - Privacy provisions of the Gramm-Leach-Bliley Act and related regulations, which require us to maintain privacy policies intended to safeguard customer financial information, to disclose the policies to our customers and to allow customers to "opt out" of having their financial service providers disclose their confidential financial information to non-affiliated third parties, subject to certain exceptions; - Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records; - Consumer protection rules for the sale of insurance products by depository institutions, adopted pursuant to the requirements of the Gramm-Leach-Bliley Act; and - USA Patriot Act, which requires financial institutions to take certain actions to help prevent, detect and prosecute international money laundering and the financing of terrorism. Sarbanes-Oxley Act of 2002 On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act represents a comprehensive revision of laws affecting corporate governance, accounting obligations and corporate reporting. The Sarbanes-Oxley Act is applicable to all companies with equity securities registered or that file reports under the Securities Exchange Act of 1934. In particular, the Sarbanes-Oxley Act establishes: (i) new requirements for audit committees, including independence, expertise, and responsibilities; (ii) additional responsibilities regarding financial statements for the Chief Executive Officer and Chief Financial Officer of the reporting company; (iii) new standards for auditors and regulation of audits; (iv) increased disclosure and reporting obligations for the reporting company and its directors and executive officers; and (v) new and increased civil and criminal penalties for violations of the securities laws. Many of the provisions were effective immediately while other provisions become effective over a period of time and are subject to rulemaking by the SEC. Because the Corporation's common stock is registered with the SEC, it is currently subject to this Act. As an accelerated filer as defined in Rule 12b-2 of the Securities Exchange Act of 1934, the Corporation was subject to section 404 of the Sarbanes-Oxley Act for the year ended December 31, 2004. Future Legislation Changes to the laws and regulations in the state where the Corporation and the Bank do business can affect the operating environment of bank holding companies and their subsidiaries in substantial and unpredictable ways. The Corporation cannot accurately predict whether those changes in laws and regulations will occur, and, if those changes occur, the ultimate effect they would have upon the financial condition or results of operations of the Corporation. Forward Looking Statements Additional information concerning the Corporation and its banking subsidiary with respect to forward looking statements is incorporated by reference from the "Important Factors Relating to Forward Looking Statements" section of the "Management's Discussion and Analysis of Financial Condition and Results of Operations," included in this Report under Item 7. Competition The Bank's principal market area consists of Franklin County and Cumberland County, Pennsylvania. It services a substantial number of depositors in this market area, with the greatest concentration within a radius of Chambersburg, Shippensburg, and Carlisle, Pennsylvania. The Bank, like other depository institutions, has been subjected to competition from less heavily regulated entities such as credit unions, brokerage firms, money market funds, consumer finance and credit card companies, and other commercial banks, many of which are larger than the Bank. The principal methods of competing effectively in the financial services industry include improving customer service through the quality and range of services provided, improving efficiencies and pricing services competitively. Orrstown Bank is competitive with all competing financial institutions in its service area with respect to interest rates paid on time and savings deposits, service charges on deposit accounts and interest rates charged on loans. One outgrowth of the competitive environment discussed above has been significant consolidation within the financial services industry on a global, national, and regional level. We continue to implement strategic initiatives focused on expanding our core businesses and to explore, on an ongoing basis, acquisition, divestiture, and joint venture opportunities. We analyze each of our products and businesses in the context of customer demands, competitive advantages, industry dynamics, and growth potential. Item 2. Properties. Orrstown Bank owns buildings in Orrstown, Shippensburg (2), Carlisle (2), Spring Run, Chambersburg (3), and Mechanicsburg, Pennsylvania. Offices of the Bank are located in each of these buildings. It also leases space for offices located in Greencastle, Chambersburg, and Carlisle (2), Pennsylvania. Item 3. Legal Proceedings. Orrstown Financial Services, Inc. is an occasional party to legal actions arising in the ordinary course of its business. In the opinion of management, the Corporation has adequate legal defenses and/or insurance coverage respecting any and each of these actions and does not believe that they will materially affect the Corporation's operations or financial position. Item 3a. Executive Officers of Registrant The following table sets forth selected information about the principal officers of the holding company, each of whom is elected by the Board of Directors and each of whom holds office at the discretion of the Board. Name/Office Held Held Employee Age as of Since Since 3/10/05 Joel R. Zullinger, Chairman of the Board 1991 (1) 56 Jeffrey W. Coy, Vice Chairman of the Board 1988 (1) 53 Kenneth R. Shoemaker, President, CEO 1987 1986 57 Bradley S. Everly, Senior Vice President, Treasurer 1997 1997 53 Stephen C. Oldt, Executive Vice President, 1987 1987 62 Assistant Secretary Philip E. Fague, Executive Vice President, 2002 1988 45 Assistant Treasurer Denver L. Tuckey, Secretary 1999 (1) 71 Jeffrey W. Embly, Vice President 1999 1997 34
(1) These officers are not employees of the Corporation Senior Operating Officers of the Bank Name/Office Held Held Bank Age as of Since Employee 3/10/05 Since Kenneth R. Shoemaker, President, 1987 1986 57 Chief Executive Officer Stephen C. Oldt, Executive Vice 1987 1987 62 President, Chief Operations Officer Philip E. Fague, Executive Vice President, 1999/ 1988 45 Chief Sales and Service Officer 2000 Bradley S. Everly, Senior Vice 1997 1997 53 President, Chief Financial Officer Benjamin S. Stoops, Vice President, 1998 1998 53 Chief Technology Officer Jeffrey W. Embly, Vice President, 1999 1997 34 Senior Loan Officer Barbara E. Brobst, Vice President, 2002 1997 46 Senior Trust Officer Nathan A. Eifert, Vice President, 2003 2000 36 Director of Marketing Stephen C. Caldwell, Vice President, 2003 2002 56 Director of Human Resources
Item 4. Submission of Matters to Vote of Security Holders. None Part II Item 5. Market for Registrant's Common Stock and Related Security Holder Matters. Orrstown Financial Services, Inc.'s common stock is not traded on a national securities exchange, but is traded through the local and over the counter local markets under the symbol ORRF. At December 31, 2004, the approximate number of shareholders of record was approximately 2,555. The price ranges for Orrstown Financial Services, Inc. common stock set forth below are the approximate bid prices obtained from brokers who make a market in the stock. 2004 2003 Market Price Quarterly Market Price Quarterly Dividend (1) High Low Dividend High Low Dividend First quarter $50.00 $32.50 $0.120 $24.29 $22.38 $0.0955 Second quarter $44.00 $40.00 $0.120 $29.00 $23.10 $0.1050 Third quarter $47.00 $40.30 $0.130 $33.75 $30.00 $0.1050 Fourth quarter $45.25 $42.00 $0.130 $34.00 $31.88 $0.1150
(1)Note: All per share data has been restated after giving retroactive recognition to a 5% stock dividend effective May 30, 2004 and a 2-for-1 stock split effective February 10, 2004. See Note 15 to the financial statements contained in the annual shareholders' report for the year ended December 31, 2004 for restrictions on the payment of dividends. Item 6. Selected Financial Data. The selected five-year financial data on page 34 of the annual shareholders' report for the year ended December 31, 2004 is incorporated herein by reference. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Contractual obligation payments due by period of the Corporation as of December 31, 2004 are as follows: Less than 1 - 3 3 - 5 More than Total 1 year years years 5 years (Dollars in Thousands) Contractual obligations Long-term debt obligations $ 2,020 $ 6,392 $ 13,282 $ 13,875 $ 35,569 Operating lease obligations 127 213 177 0 517 ----------- ---------- --------- --------- --------- Total $ 2,147 $ 6,605 $ 13,459 $ 13,875 $ 36,086 =========== ========== ========= ========= =========
All other information required by Item 7 is included in "Management's Discussion and Analysis of Financial Condition and Results of Operations", on pages 24 through 33 of the annual shareholders' report which are incorporated herein by reference. Item 8. Financial Statements and Supplementary Data. The financial statements and supplementary data, some of which is required under Guide 3 (statistical disclosures by bank holding companies) are shown on pages 4 through 34 of the annual shareholders' report for the year ended December 31, 2004 and are incorporated herein by reference. Certain statistical information required in addition to those included in the annual shareholders' report are submitted herewith as follows. Description of Statistical Information Page Changes in net interest income tax equivalent yields 9 Investment portfolio 10 Loan portfolio 11 Summary of loan loss experience 12 Nonaccrual, delinquent and impaired loans 12 Allocation of allowances for loan losses 13 Deposits 14 Return on equity and assets 14 Consolidated summary of operations 15 ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARIES CHANGES IN NET INTEREST INCOME TAX EQUIVALENT YIELDS 2004 Versus 2003 2003 Versus 2002 Increase (Decrease) Increase (Decrease) Due to Change in Due to Change in (Dollars in Thousands) Average Average Total Average Average Total Volume Rate Increase Volume Rate Increase (Decrease) (Decrease) Interest Income Loans (net of unearned $ 3,493 ($ 850) $ 2,643 $ 3,507 ($ 2,529) $ 978 discounts) Taxable investment (115) 11 (104) 494 (1,004) (510) securities Nontaxable investment (122) (72) (194) (29) (25) (54) securities Other short-term (21) 41 20 (36) (83) (119) investments ----------- ---------- ---------- ---------- -------- ---------- Total interest income 3,235 (870) 2,365 3,936 (3,641) 295 ----------- ---------- ---------- ---------- -------- ---------- Interest Expense Interest bearing 153 (246) (93) 553 (720) (167) demand Savings deposits 17 (22) (5) 26 (87) (61) Time deposits 485 (201) 284 136 (962) (826) Short-term borrowings 10 51 61 (13) (142) (155) Long-term borrowings 83 (101) (18) 180 (199) (19) ----------- ---------- ---------- ---------- -------- ---------- Total interest expense 748 (519) 229 882 (2,110) (1,228) ----------- ---------- ---------- ---------- -------- ---------- Net interest income $ 2,136 $ 1,523 ---------- ----------
Changes which are attributed in part to volume and in part to rate are allocated in proportion to their relationships to the amounts of changes. ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARIES INVESTMENT PORTFOLIO The following table shows the maturities of investment securities at book value as of December 31, 2004, and weighted average yields of such securities. Yields are shown on a tax equivalent basis, assuming a 34% federal income tax rate. (Dollars in Thousands) Within 1 After 1 After 5 After 10 Total year year but years but years within 5 within 10 years years Bonds: U. S. Treasury Book value $ 28 $ 1,378 $ 0 $ 0 $ 1,406 Yield 5.75% 4.51% 0% 0% 4.53% U. S. Government agencies Book value 0 10,964 0 0 10,964 Yield 0% 3.23% 0% 0% 3.23% State and municipal Book value 1,364 0 2,018 20,503 23,885 Yield 8.70% 0% 7.36% 7.83% 7.84% Trust preferred Book value 0 0 0 1,000 1,000 Yield 0% 0% 0% 9.25% 9.25% ---------- ---------- ---------- --------- ---------- Total book value $ 1,392 $ 12,342 $ 2,018 $ 21,503 $ 37,255 Yield 8.64% 3.37% 7.36% 7.90% 6.40% ---------- ---------- ---------- --------- ---------- Mortgage-backed securities: Total book value $ 39,663 Yield 4.02% Equity Securities: Total book value $ 1,660 Yield 4.53% ---------- ---------- ---------- --------- ---------- Total Investment Securities $ 78,578 Yield 5.16% ---------- ---------- ---------- --------- ----------
ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARIES LOAN PORTFOLIO The following table presents the loan portfolio at the end of each of the last five years: (Dollars in Thousands) 2004 2003 2002 2001 2000 Commercial, financial and agricultural $ 38,659 $38,186 $33,806 $28,534 $23,938 Real estate - 18,744 21,016 22,048 20,480 17,425 Construction Real estate - Mortgage 324,703 277,985 217,791 192,192 157,722 Consumer (net of unearned 7,162 7,867 7,746 8,610 10,096 discount) --------- -------- -------- -------- -------- Total loans $389,268 $345,054 $281,391 $249,816 $209,181 --------- -------- -------- -------- ---------
Presented below are the approximate maturities of the loan portfolio (excluding real estate mortgages, installments, and credit cards) at December31, 2004: Under One to Over One Five Five (Dollars in Thousands) Year Years Years Total Commercial, financial and agricultural $ 1,568 $ 10,612 $ 26,479 $ 38,659 Real estate - Construction 3,835 2,349 12,560 18,744 ----------- ----------- --------- --------- Total loans $ 5,403 $ 12,961 $ 39,039 $ 57,403 ----------- ----------- --------- ---------
The following table presents the approximate amount of fixed rate loans and variable rate loans due as of December 31, 2004: Fixed Variable Rate (Dollars in Thousands) Loans Rate Loans Due within one year $ 1,332 $ 26,871 Due after one but within five years 19,475 16,298 Due after five years 76,418 248,874 ---------- ---------- Total loans $ 97,225 $ 292,043 ---------- ----------
ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARIES SUMMARY OF LOAN LOSS EXPERIENCE Years Ended December 31 (Dollars in Thousands) 2004 2003 2002 2001 2000 Average total loans outstanding $369,409 $313,833 $264,296 $233,103 $192,902 (net of unearned income) Allowance for loan losses, beginning of period 4,161 3,734 3,104 2,691 2,455 Additions to provision for loan losses 210 491 720 504 360 charged to operations Loans charged off during the year Mortgages 9 12 0 0 0 Commercial 21 4 48 67 99 Installment 39 33 36 2 19 Personal credit lines and credit cards 16 32 17 29 11 ---------- ---------- --------- --------- --------- Total charge-off's 85 81 101 98 129 ---------- ---------- --------- --------- --------- Recoveries of loans previously charged off: Mortgages 3 3 0 0 0 Commercial 0 0 3 6 1 Installment 25 8 8 1 2 Personal credit lines and credit cards 4 6 0 0 2 ---------- ---------- --------- --------- --------- Total recoveries 32 17 11 7 5 ---------- ---------- --------- --------- --------- Net loans charged off (recovered) 53 64 90 91 124 ---------- ---------- --------- --------- --------- Allowance for loan losses, end of period $ 4,318 $ 4,161 $ 3,734 $ 3,104 $ 2,691 Ratio of net loans charged off to 0.01% 0.02% 0.03% 0.04% 0.06% average loans outstanding
The provision is based on an evaluation of the adequacy of the allowance for possible loan losses. The evaluation includes, but is not limited to, review of net loan losses for the year, the present and prospective financial condition of the borrowers, and evaluation of current and projected economic conditions. ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARIES NONACCRUAL, DELINQUENT AND IMPAIRED LOANS The following table sets forth the outstanding balances of those loans on a nonaccrual status and those on accrual status which are contractually past due as to principal or interest payments for 30 days or more at December 31. (Dollars in Thousands) 2004 2003 2002 2001 2000 Nonaccrual loans $ 314 $ 130 $ 85 $ 56 $ 12 Accrual loans Restructured 0 1,410 1,428 0 0 30 through 89 days past due 1,643 1,440 1,419 2,244 865 90 days or more past due 2,550 2,743 1446 644 814 ---------- ---------- ---------- ---------- --------- Total accrual loans $ 4,193 $ 5,593 $ 4,293 $ 2,888 $ 1,679 ---------- ---------- ---------- ---------- ---------
See Note 6 of the notes to consolidated financial statements for details of income recognized and foregone revenue on nonaccrual loans for the past three years, and discussion concerning impaired loans at December 31, 2004. ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARIES ALLOCATION OF ALLOWANCE FOR LOAN LOSSES In retrospect the specific allocation in any particular category may prove excessive or inadequate and consequently may be reallocated in the future to reflect the then current conditions. Accordingly, the entire allowance is available to absorb losses in any category. The following is an allocation by loan categories of the allowance for loan losses for the last five years at December 31, 2004 2003 Percentage Percentage Allowance of Loans to Allowance of Loans to (Dollars in Thousands) Amount Total Amount Total Loans Loans Commercial, financial and $ 1,381 10% $ 928 11% agricultural Real estate - Commercial 617 39% 828 44% Real estate - Construction 0 5% 0 6% Real estate - Mortgage 330 44% 326 36% Consumer 105 2% 9 3% Unallocated 1,885 0% 2,070 0% ------------ -------- ----------- -------- Total $ 4,318 100% $ 4,161 100% ------------ -------- ----------- -------- 2002 2001 Percentage Percentage Allowance of Loans to Allowance of Loans to (Dollars in Thousands) Amount Total Amount Total Loans Loans Commercial, financial and $ 806 12% $ 466 11% agricultural 466 Real estate - Commercial 545 41% 563 46% Real estate - Construction 0 8% 0 8% Real estate - Mortgage 255 36% 350 31% Consumer 28 3% 33 4% Unallocated 2,100 0% 1,692 0% ------------ -------- ----------- -------- Total $ 3,734 100% $ 3,104 100% ------------ -------- ----------- -------- 2000 Percentage Allowance of Loans to (Dollars in Thousands) Amount Total Loans Commercial, financial and $ 43 12% agricultural 43 Real estate - Commercial 786 21% Real estate - Construction 0 8% Real estate - Mortgage 56 54% Consumer 34 5% Unallocated 1,772 0% ------------- -------- Total $ 2,691 100% ------------- --------
ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARIES DEPOSITS The average amounts of deposits are summarized below: Years Ended December 31, (Dollars in Thousands) 2004 2003 2002 Demand deposits $ 57,762 $ 47,416 $ 39,688 Interest bearing demand deposits 183,649 170,832 136,500 Savings deposits 29,752 26,602 23,558 Time deposits 114,181 97,539 94,043 -------------- ------------- ------------- Total deposits $ 385,344 $ 342,389 $ 293,789 -------------- ------------- -------------
The following is a breakdown of maturities of time deposits of $ 100,000 or more as of December 31, 2004: (Dollars in Thousands) Three months or less $ 16,962 Over three months through twelve 4,930 months over one year through three years 8,767 Over three years 3,027 -------------- Total $ 33,686 --------------
ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARIES RETURN ON EQUITY AND ASSETS The following table presents a summary of significant earnings and capital ratios applying daily average balances for the years ended December 31, (Dollars in Thousands) 2004 2003 2002 Average assets $ 495,919 $ 443,737 $ 385,765 Net income 7,770 6,980 5,915 Average equity 46,309 40,491 34,408 Cash dividends paid 2,556 2,126 1,722 Return on assets 1.57% 1.57% 1.53% Return on equity 16.78% 17.24% 17.19% Dividend payout ratio 32.89% 30.45% 29.12% Equity to asset ratio 9.34% 9.12% 8.92%
ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARIES CONSOLIDATED SUMMARY OF OPERATIONS Years Ended December 31, (Dollars in Thousands) 2004 2003 2002 2001 2000 Interest income $ 25,892 $ 23,484 $ 23,173 $ 23,978 $ 21,758 Interest expense 6,986 6,757 7,985 10,677 10,318 ----------- ----------- ---------- ---------- ----------- Net interest income 18,906 16,727 15,188 13,301 11,440 Provision for loan losses 210 491 720 504 360 ----------- ----------- ---------- ---------- ----------- Net interest income after provision for loan losses 18,696 16,236 14,468 12,797 11,080 ----------- ----------- ---------- ---------- ----------- Other income: Trust and brokerage services 2,471 1,948 1,780 1,480 1,466 Service charges on deposits, other service charges, collection and exchange charges, commissions and fees 4,082 3,866 3,171 2,634 1,818 Other operating income 416 618 409 366 458 ----------- ----------- ---------- ---------- ----------- Total other income 6,969 6,432 5,360 4,480 3,742 ----------- ----------- ---------- ---------- ----------- Income before operating expense 25,665 22,668 19,828 17,277 14,822 Operating expenses: Salaries and employees benefits 7,909 6,787 5,993 5,151 4,755 Occupancy and equipment expense 2,398 2,109 1,800 1,676 1,558 Other operating expenses 4,411 4,114 3,895 3,420 2,800 ----------- ----------- ---------- ---------- ----------- Total operating expenses 14,718 13,010 11,688 10,247 9,113 ----------- ----------- ---------- ---------- ----------- Income before income taxes 10,947 9,658 8,140 7,030 5,709 Income tax 3,177 2,678 2,225 1,938 1,537 ----------- ----------- ---------- ---------- ----------- Net income applicable to common stock $ 7,770 $ 6,980 $ 5,915 $ 5,092 $ 4,172 ----------- ----------- ---------- ---------- ----------- Per share data: (1) Basic earnings $ 1.52 $ 1.38 $ 1.18 $ 1.02 $ 0.85 Diluted earnings $ 1.47 $ 1.34 $ 1.15 $ 1.01 $ 0.84 Cash dividends $ 0.50 $ 0.42 $ 0.34 $ 0.28 $ 0.26 Weighted average shares: Basic 5,106,683 5,054,370 5,020,288 4,970,084 4,915,753 Diluted 5,294,165 5,215,538 5,133,363 5,036,082 4,939,464
(1) Per share amounts have been restated to reflect:: The 2-for-1 stock split paid February 10, 2004 The 5% stock dividend paid May 30, 2003 The 5% stock dividend paid September 15, 2001 Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure Not applicable. Item 9a. Controls and Procedures The Corporation's Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the Corporation's disclosure controls and procedures (as such term is defined in Rules 13a-14(c) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of December 31, 2004. Based on such evaluation, such officers have concluded that the Corporation's disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to the Corporation (including its consolidated subsidiaries) required to be included in the Corporation's periodic filings under the Exchange Act. Management's report on internal control over financial reporting as of December 31, 2004 is shown on Page 3 of the annual shareholders' report for the year ended December 31, 2004 and is incorporated herein by reference. The attestation report of the registered public accounting firm on management's assessment of internal control over financial reporting is show non Pages 1 and 2 of the annual shareholders' report for the year ended December 31, 2004 and is incorporated herein by reference. There have not been any significant changes in the Corporation's internal control over financial reporting or in other factors that could significantly affect such control during the fourth quarter of 2004. Item 9b. Other Information The Corporation had no other events that should have been disclosed on form 8K that were not already disclosed on such form. PART III Item 10. Directors and Executive Officers of the Registrant The Corporation has adopted a code of ethics that applies to all senior financial officers (including its chief executive officer, chief financial officer, chief accounting officer, controller, and any person performing similar functions). The Corporation's Code of Ethics for Senior Financial Officers is available on Orrstown Bank's website at http://www.orrstown.com. All other information required by Item 10 is incorporated by reference from Orrstown Financial Services, Inc.'s definitive proxy statement for the 2005 Annual Meeting of Shareholders filed pursuant to Regulation 14A. Item 11. Executive Compensation The information required by Item 11 is incorporated by reference from Orrstown Financial Services, Inc.'s definitive proxy statement for the 2005 Annual Meeting of Shareholders filed pursuant to Regulation 14A. Item 12. Security Ownership of Certain Beneficial Owners and Management Equity Compensation Plan Information Plan Category Number of securities to Weighted-average Number of be issued upon exercise exercise price of securities of outstanding options outstanding options remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)) (a) (b) (c) Equity compensation 178,260 $ 26.42 234,854 plan approved by security holders Equity compensation 23,516 $ 21.65 42,094 plan not approved by security holders (1) --------- ------- --------- Total 201,776 $ 25.87 276,948 --------- ------- ---------
(3) Non-Employee Director Stock Option Plan of 2000. On January 27, 2000, the Board of Directors of the Corporation approved the Orrstown Financial Services, Inc. Non-Employee Director Stock Option Plan of 2000. The Directors' Option Plan is a formula plan under which options to purchase shares of the Corporation's Common Stock are granted each year to directors in office on April 1. The number of options granted each year is based on the Corporation's return on average equity for the most recent fiscal year. All options have a term of 10 years from the regular grant date, are fully exercisable from the regular grant date, and have an exercise price equal to the fair market value of the Corporation's Common Stock as of the date of the grant of the option based upon criteria as outlined in the plan. If a director "retires", whether as a result of reaching mandatory retirement age, or under any other circumstances, the Board of Directors, in its discretion, may determine to constitute retirement, the options previously granted to the director will expire at their scheduled expiration date. If a director's service as a director terminates for any other reason, the options previously granted to the director will expire six months after the date of termination of service unless scheduled to expire sooner. All other information required by Item 12 is incorporated by reference from Orrstown Financial Services, Inc.'s definitive proxy statement for the 2005 Annual Meeting of Shareholders filed pursuant to Regulation 14A. Item 13. Certain Relationships and Related Transactions The information required by Item 13 is incorporated by reference from Orrstown Financial Services, Inc.'s definitive proxy statement for the 2005 Annual Meeting of Shareholders filed pursuant to Regulation 14A. Item 14. Principal Accountant Fees and Services The information required by Item 14 is incorporated by reference from Orrstown Financial Services, Inc.'s definitive proxy statement for the 2005 Annual Meeting of Shareholders filed pursuant to Regulation 14A. PART IV Item 15. Exhibits, Financial Statement Schedules and Reports of Form 8-K. (a) The following documents are filed as part of this report: (1) - Financial Statements - The following consolidated financial statements of Orrstown Financial Services, Inc. and its subsidiaries, included in the annual report of the registrant to its shareholders for the year ended December 31, 2004, are incorporated by reference in Item 8: Consolidated balance sheets - December 31, 2004 and 2003 Consolidated statements of income - Years ended December 31, 2004, 2003, and 2002 Consolidated statements of shareholders' equity - Years ended December 31, 2004, 2003, and 2002 Consolidated statements of cash flows - Years ended December 31, 2004, 2003, and 2002 Notes to consolidated financial statements - December 31, 2004 (2) - Financial Statement Schedules - All financial statement schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted. (3) - Exhibits (3) (i) Articles of incorporation. Incorporated by reference to Exhibit 3(i) of the registrant's Form 10-K for the year ended December 31, 1998. (3)(ii) By-laws. Incorporated by reference to Exhibit 3.2 to the Registrant's Registration Statement on Form S-4, Registration No. 33-18888. (4) Instruments defining the rights of security holders including indentures. The rights of the holders of Registrant's common stock are contained in: (i) Articles of Incorporation of Orrstown Financial Services, Inc., incorporated by reference to Exhibit 3(i) of the registrant's Form 10-K for the year ended December 31, 1998. (ii) By-laws of Orrstown Financial Services, Inc., incorporated by reference to Exhibit 3.2 to the Registrant's Registration Statement on Form S-4 (Registration No. 33-18888). (10.1) Change in control agreement between Orrstown Financial Services, Inc. and its chief executive officer. Incorporated by reference to Exhibit 99 of the registrant's Form 10-K for the year ended December 31, 1996. (10.2) Salary continuation plan for selected officers - incorporated by reference to the registrant's Form 10-K for the year ended December 31, 1999 (10.3) Officer group term replacement plan for selected officers - incorporated by reference to the registrant's Form 10- K for the year ended December 31, 1999 (10.4) Director retirement plan - incorporated by reference to the registrant's Form 10-K for the year ended December 31, 1999 (10.5) Revenue neutral retirement plan - incorporated by reference to the registrant's Form 10-K for the year ended December 31, 1999 (10.6) Non-employee director stock option plan of 2000 - incorporated by reference to the registrant's registration statement on Form S-8 dated April 11, 2000 (10.7) Employee stock option plan of 2000 - incorporated by reference to the registrant's registration statement on Form S-8 dated March 31, 2000 (13) Annual report to security holders - filed herewith (14) Code of Ethics Policy for Senior Financial Officers - Incorporated by reference under Item 10 of this annual report (21) Subsidiaries of the registrant - filed herewith (23.1) Consent of independent auditors - filed herewith (31.1) Rule 13a - 14(a)/15d-14(a) Certification (Chief Executive Officer) - Filed herewith. (31.2) Rule 13a - 14(a)/15d-14(a) Certifications (Chief Financial Officer) - Filed herewith. (32.1) Section 1350 Certifications (Chief Executive Officer) - Filed herewith. (32.1) Section 1350 Certifications (Chief Financial Officer) - Filed herewith. All other exhibits for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted. (b) The registrant filed the following reports on Form 8-K during the calendar year ended December 31, 2004: Report filed January 2, 2004 Registrant announced a 2-for-1 Stock Split payable February 10, 2004. Report filed July 15, 2004 Registrant announced purchase of an investment management business. Report filed July 22, 2004 Registrant announced its earnings for the period ended June 30, 2004 Report filed October 25, 2004 Registrant announced its earnings for the period ended September 30, 2004 (c) Exhibits - The exhibits required to be filed as part of this report are submitted as a separate section of this report. (d) Financial statement schedules - None required. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ORRSTOWN FINANCIAL SERVICES, INC. (Registrant) By /s/ Kenneth R. Shoemaker Kenneth R. Shoemaker,President Dated: March 10, 2005 (Duly authorized officer) By /s/ Bradley S. Everly Bradley S. Everly, Chief Financial Officer (Principal Accounting Officer) Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date /s/ Kenneth R. Shoemaker President, CEO and March 10, 2005 Kenneth R. Shoemaker Director /s/ Anthony F. Ceddia Director March 10, 2005 Dr. Anthony F. Ceddia /s/ Glenn W. Snoke Director March 10, 2005 Glenn W. Snoke /s/ Gregory A. Rosenberry Director March 10, 2005 Gregory A. Rosenberry /s/ Joel R. Zullinger Chairman of the March 10, 2005 Joel R. Zullinger Board and Director /s/ Jeffrey W. Coy Vice Chairman March 10, 2005 Jeffrey W. Coy of the Board and Director /s/ John S. Ward Director March 10, 2005 John S. Ward /s/ Denver L. Tuckey Secretary and March 10, 2005 Denver L. Tuckey Director /s/ Andrea Pugh Director March 10, 2005 Andrea Pugh Exhibit 21 SUBSIDIARIES OF THE REGISTRANT 1. Orrstown Bank, Orrstown, Pennsylvania; a state-chartered bank organized under Pennsylvania Banking Code of 1965. 2. Pennbanks Insurance Company Cell P1 is a reinsurer of credit, life and disability insurance, which services customers of Orrstown Bank. Exhibit 23.1 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders of Orrstown Financial Services, Inc. We consent to the incorporation by reference in to previously filed Registration Statements (Form S-4 No. 33-18888, Form S-3 No. 333-53405, Form S-8 No. 333-33714, Form S-8 No. 333-34504, and Form S-8 No. 333-33712) of Orrstown Financial Services, Inc. of our report dated February 11, 2005, appearing in the 2004 annual report to shareholders incorporated by reference in this Form 10-K of Orrstown Financial Services, Inc. for the year ended December 31, 2004. /S/ SMITH ELLIOTT KEARNS & COMPANY, LLC -------------------------------------------------- SMITH ELLIOTT KEARNS & COMPANY, LLC Chambersburg, Pennsylvania March 10, 2005 Exhibit 31.1 CERTIFICATION I, Kenneth R. Shoemaker, President and CEO, certify, that: 1. I have reviewed this annual report on Form 10-K of Orrstown Financial Services, Inc. 2. Based on my knowledge, the annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report. 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report. 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act rules 13a-15(f) and 15d-15(f)) for the registrant and we have: (a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; (c) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this annual report based on such evaluation; and (d) disclosed in this annual report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting. 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies and material weaknesses in the design or operation of the internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. By: /s/ Kenneth R. Shoemaker Kenneth R. Shoemaker President and CEO (Principal Executive Officer) March 10, 2005 Exhibit 31.2 CERTIFICATION I, Bradley S. Everly, Sr. Vice President and CFO, certify, that: 1. I have reviewed this annual report on Form 10-K of Orrstown Financial Services, Inc. 2. Based on my knowledge, the annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report. 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report. 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act rules 13a-15(f) and 15d-15(f)) for the registrant and we have: (a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; (c) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this annual report based on such evaluation; and (d) disclosed in this annual report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting. 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies and material weaknesses in the design or operation of the internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. By: /s/ Bradley S. Everly Bradley S. Everly Sr. Vice President and CFO (Principal Financial Officer) March 10, 2005 Exhibit 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Orrstown Financial Services, Inc. (the Corporation) on Form 10-K for the period ending December 31, 2004 as filed with the Securities and Exchange Commission on the date therein specified (the "Report"), I, Kenneth R. Shoemaker, President and Chief Executive Officer of the Corporation, certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Corporation as of and for the period covered by the report. /s/ Kenneth R. Shoemaker Kenneth R. Shoemaker President and Chief Executive Officer Dated: March 10, 2005 Exhibit 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Orrstown Financial Services, Inc. (the Corporation) on Form 10-K for the period ending December 31, 2004 as filed with the Securities and Exchange Commission on the date therein specified (the "Report"), I, Bradley S. Everly, Senior Vice President and Chief Financial Officer of the Corporation, certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Corporation as of and for the period covered by the report. /s/ Bradley S. Everly Bradley S. Everly Senor Vice President and Chief Financial Officer Dated: March 10, 2005 EX-13 2 exhibit13.txt ANNUAL REPORT Exhibit 13 Orrstown Financial Services, Inc. 2004 Annual Financial Report C O N T E N T S Page REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM 1 MANAGEMENT'S REPORT ON INTERNAL CONTROL 3 CONSOLIDATED FINANCIAL STATEMENTS Balance sheets 4 Statements of income 5 Statements of changes in shareholders' equity 6 Statements of cash flows 7 Notes to consolidated financial statements 8 - 23 MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS 24 - 33 SUMMARY OF QUARTERLY FINANCIAL DATA 33 SELECTED FIVE-YEAR FINANCIAL DATA 34 MARKET, DIVIDEND AND INVESTOR INFORMATION 35 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders of Orrstown Financial Services, Inc. We have audited the accompanying consolidated balance sheets of Orrstown Financial Services, Inc. and its wholly-owned subsidiaries as of December 31, 2004 and 2003, and the related statements of income, changes in shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2004. We also have audited management's assessment, included in the accompanying Management's Report on Internal Control, that Orrstown Financial Services, Inc. and its wholly-owned subsidiaries maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Orrstown Financial Services, Inc. and its wholly-owned subsidiaries management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements, an opinion on management's assessment, and an opinion on the effectiveness of the company's internal control over financial reporting based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Orrstown Financial Services, Inc. and its wholly-owned subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, management's assessment that Orrstown Financial Services, Inc. and its wholly-owned subsidiaries maintained effective internal control over financial reporting as of December 31, 2004 is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by COSO. Furthermore, in our opinion, Orrstown Financial Services, Inc. and its wholly-owned subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by COSO. /S/ Smith Elliott Kearns & Company, LLC Smith Elliott Kearns & Company, LLC Chambersburg, Pennsylvania February 11, 2005 MANAGEMENT'S REPORT ON INTERNAL CONTROL To our shareholders, Orrstown Financial Services, Inc. Shippensburg, Pennsylvania The management of Orrstown Financial Services, Inc. and its wholly-owned subsidiaries has the responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting. Management maintains a comprehensive system of internal control to provide reasonable assurance of the proper authorization of transactions, the safeguarding of assets and the reliability of the financial records. The system of internal control provides for appropriate division of responsibility and is documented by written policies and procedures that are communicated to employees. Orrstown Financial Services, Inc. and its wholly-owned subsidiaries maintains an internal auditing program, under the supervision of the Audit Committee of the Board of Directors, which independently assesses the effectiveness of the system of internal control and recommends possible improvements. Under the supervision and with the participation of the Corporation's management, including its Chief Executive Officer and Chief Financial Officer, the Corporation has evaluated the effectiveness of its internal control over financial reporting as of December 31, 2004, using the Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based upon this evaluation, the Chief Executive Officer and the Chief Financial Officer have concluded that the Corporation's disclosure controls and procedures are adequate and effective to ensure that material information relating to the Corporation and its consolidated subsidiaries is made known to them by others within those entities. The Chief Executive Officer and the Chief Financial Officer believe that at December 31, 2004, Orrstown Financial Services, Inc. and its wholly-owned subsidiaries maintained an effective system of internal control over financial reporting. The accounting firm Smith Elliott Kearns & Company, LLC has issued an attestation report on management's assessment of the Corporation's internal control over financial reporting. The accounting firm's attestation report is included in this financial report. /S/ Kenneth R. Shoemaker /S/ Bradley S. Everly Kenneth R. Shoemaker Bradley S. Everly President and Chief Executive Officer Senior Vice President and Chief Financial Officer February 11, 2005 CONSOLIDATED BALANCE SHEETS ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARIES At December 31, (Dollars in Thousands) 2004 2003 Assets Cash and due from banks $ 11,456 $ 12,283 Federal funds sold 8,393 3,829 Interest bearing deposits with banks 1,124 1,001 Securities available for sale 79,829 89,074 Federal Home Loan Bank, Federal Reserve and Atlantic Central Bankers Bank Stock, at cost which approximates market value 2,972 2,912 ----------------- ------------------ 103,774 109,099 ----------------- ------------------ Loans Commercial, financial and agricultural 38,659 38,186 Real estate - Mortgages 324,703 277,985 Real estate - Construction and land development 18,744 21,016 Consumer 7,162 7,867 ----------------- ------------------ 389,268 345,054 Less: Allowance for loan losses (4,318) (4,161) ----------------- ------------------ Net Loans 384,950 340,893 ----------------- ------------------ Premises and equipment, net 13,222 11,168 Accrued interest receivable 1,775 1,647 Cash surrender value of life insurance 7,516 7,234 Other assets 3,414 2,352 ------------------ ------------------ Total assets $ 514,651 $ 472,393 ----------------- ------------------ Liabilities and Shareholders' Equity Deposits: Non-interest bearing $ 66,784 $ 52,276 Interest bearing 338,579 306,367 ----------------- ------------------ Total deposits 405,363 358,643 ----------------- ------------------ Short-term borrowings 19,493 29,440 Long-term debt 35,569 37,193 Accrued interest and other liabilities 4,976 4,282 ------------------ ------------------ Total liabilities 465,401 429,558 ----------------- ------------------ Common stock, no par value - $ .05205 stated value per share 50,000,000 shares authorized with 5,126,205 shares issued at December 31, 2004 and $.1041 stated value per share 10,000,000 shares authorized with 2,537,011 shares issued at December 31, 2003 267 264 Additional paid - in capital 34,434 32,928 Retained earnings 13,723 8,509 Accumulated other comprehensive income 826 1,134 ------------------ ------------------ Total shareholders' equity 49,250 42,835 ----------------- ------------------ Total liabilities and shareholders' equity $ 514,651 $ 472,393 ------------------ ------------------ The Notes to Consolidated Financial Statements are an integral part of these statements.
CONSOLIDATED STATEMENTS OF INCOME ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARIES Years Ended December 31, (Dollars in Thousands) 2004 2003 2002 Interest and dividend income Interest and fees on loans $ 22,231 $ 19,610 $ 18,635 Interest and dividends on investment securities U.S. Government and agency 2,083 2,141 2,583 Tax exempt 1,206 1,335 1,370 Other investment income 372 398 585 ------------- ------------ ------------ Total interest and dividend income 25,892 23,484 23,173 ------------- ------------ ------------ Interest expense Interest on deposits 5,201 5,015 6,069 Interest on borrowed money 1,785 1,742 1,916 ------------- ------------ ------------ Total interest expense 6,986 6,757 7,985 ------------- ------------ ------------ Net interest income 18,906 16,727 15,188 Provision for loan losses 210 491 720 ------------- ------------ ------------ Net interest income after provision for loan 18,696 16,236 14,468 losses ------------- ------------ ------------ Other income Service charges on deposit accounts 3,066 2,628 2,257 Other service charges, commissions and fees 1,016 1,238 914 Trust department income 1,863 1,463 1,386 Brokerage income 608 485 394 Investment securities gains 88 199 21 Other income 328 419 388 ------------- ------------ ------------ Total other income 6,969 6,432 5,360 ------------- ------------ ------------ Other expenses Salaries 5,117 4,456 4,035 Employee benefits 2,792 2,331 1,958 Occupancy and equipment 2,398 2,109 1,800 Other operating expenses 4,411 4,114 3,895 ------------- ------------ ------------ Total other expense 14,718 13,010 11,688 ------------- ------------ ------------ Income before income tax 10,947 9,658 8,140 Income tax expenses 3,177 2,678 2,225 ------------- ------------ ------------ Net income $ 7,770 $ 6,980 $ 5,915 ------------- ------------ ------------ Earnings per share Basic earnings per share $ 1.52 $ 1.38 $ 1 .18 Weighted average number of shares 5,106,683 5,054,370 5,020,288 outstanding Diluted earnings per share $ 1.47 $ 1.34 $ 1.15 Weighted average number of shares 5,294,165 5,215,538 5,133,363 outstanding Dividends per share $ 0.50 $ 0.42 $ 0.34 The Notes to Consolidated Financial Statements are an integral part of these statements.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARIES Years Ended December 31, 2004, 2003 and 2002 Accumulated Additional Other Total Common Paid-In Retained Comprehensive Shareholders' (Dollars in thousands) Stock Capital Earnings Income Equity Balance, December 31, 2001 $ 248 $ 25,077 $ 5,557 $ 280 $ 31,162 Comprehensive income Net income 0 0 5,915 0 5,915 Change in unrealized gain on investment securities available for sale, net of tax of $ 911 0 0 0 1,769 1,769 ---------- Total comprehensive income 7,684 ---------- Cash dividends ($.34 per share) 0 0 ( 1,722) 0 ( 1,722) Issuance of stock through employee stock purchase plan/ stock option plan 0 71 0 0 71 Issuance of stock through dividend reinvestment plan 2 765 0 0 767 ---------- ---------- ---------- ---------- ---------- Balance, December 31, 2002 250 25,913 9,750 2,049 37,962 Comprehensive income Net income 0 0 6,980 0 6,980 Change in unrealized loss on investment securities available for sale, net of tax of $ 471 0 0 0 ( 915) ( 915) ---------- Total comprehensive income 6,065 ---------- Cash dividends ($.42 per share) 0 0 ( 2,126) 0 ( 2,126) Stock dividends issued 12 6,061 ( 6,073) 0 0 Cash paid in lieu of fractional stock dividends 0 0 ( 22) 0 ( 22) Issuance of stock through employee stock purchase plan/ stock option plan 1 205 0 0 206 Issuance of stock through dividend reinvestment plan 1 749 0 0 750 ---------- ---------- ---------- ---------- ---------- Balance, December 31, 2003 264 32,928 8,509 1,134 42,835 Comprehensive income Net income 0 0 7,770 0 7,770 Change in unrealized loss on investment securities available for sale, net of tax of $ 159 0 0 0 ( 308) ( 308) ---------- Total comprehensive income 7,462 ---------- Cash dividends ($.50 per share) 0 0 ( 2,556) 0 ( 2,556) Issuance of stock through employee stock purchase plan/ stock option plan 2 591 0 0 593 Issuance of stock through dividend reinvestment plan 1 915 0 0 916 ---------- ---------- ---------- ---------- ---------- Balance, December 31, 2004 $ 267 $ 34,434 $ 13,723 $ 826 $ 49,250 ---------- ---------- ---------- ---------- ---------- The Notes to Consolidated Financial Statements are an integral part of these statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARIES Years Ended December 31, (Dollars in Thousands) 2004 2003 2002 Cash flows from operating activities Net income $ 7,770 $ 6,980 $ 5,915 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 1,197 1,013 874 Provision for loan losses 210 491 720 (Gain) loss on disposal of other real estate owned 45 (6) (3) (Gain) loss on disposal of bank premises and (6) 0 2 equipment Deferred income taxes 28 (110) (131) Investment securities (gains) (88) (199) (21) Increase in cash surrender value of life insurance (282) (318) (312) (Increase) in accrued interest receivable (128) (41) (64) Increase (decrease) in accrued interest payable 34 (6) (107) Other, net 589 555 526 Net cash provided by operating activities 9,369 8,359 7,399 Cash flows from investing activities Net (increase) decrease in interest bearing deposits (123) 94 (416) with banks Sales of available for sale securities 6,407 20,839 1,223 Maturities of available for sale securities 17,518 30,480 21,754 Purchases of available for sale securities (15,101) (51,475) (41,961) Net (purchases) of FHLB Stock (60) (644) (565) Net (increase) in loans (44,328) (63,811) (31,725) Purchases of bank premises and equipment (3,182) (2,261) (1,641) Purchases of intangible assets (1,155) 0 0 Proceeds from disposal of other real estate owned 228 89 64 Proceeds from disposal of bank premises and equipment 61 0 7 Investment in cash surrender value life insurance 0 0 (682) Policies Net cash (used) by investing activities (39,735) (66,689) (53,942) Cash flows from financing activities Net increase in deposits 46,720 39,475 38,000 Net increase (decrease) in short term purchased funds (9,947) 8,632 (10,723) Proceeds from debt 0 10,000 5,026 Payments on debt (1,624) (1,346) (3,000) Cash dividends paid (2,556) (2,126) (1,722) Cash paid in lieu of fractional shares 0 (22) 0 Proceeds from sale of stock 1,510 956 838 Net cash provided by financing activities 34,103 55,569 28,419 Net increase (decrease) in cash and cash equivalents 3,737 (2,761) (18,124) Cash and cash equivalents at beginning of period 16,112 18,873 36,997 Cash and cash equivalents at end of period $ 19,849 $ 16,112 $ 18,873 Supplemental disclosure of cash flow information: Cash paid during the period for: Interest $ 6,952 $ 6,763 $ 8,092 Income Taxes 3,205 2,650 2,375 Supplemental schedule of noncash investing and financing activities: Other real estate acquired in settlement of loans 61 83 61 Unrealized gain (loss) on investments securities (308) (915) 1,769 available for sale (net of tax effects) The Notes to Consolidated Financial Statements are an integral part of these statements.
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of operations Orrstown Financial Services, Inc. (the Corporation) is a financial holding company whose primary activity consists of supervising its wholly-owned subsidiaries, Orrstown Bank and Pennbanks Insurance Company Cell P1. The Corporation operates through its office in Shippensburg, Pennsylvania. Orrstown Bank (the Bank) provides services through its network of offices in South Central Pennsylvania, principally Franklin and Cumberland Counties. The Bank engages in lending services for commercial loans, residential loans, commercial mortgages and various forms of consumer lending. Deposit services include checking, savings, time and money market deposits. The Bank also provides investment and brokerage services through its Investment Services Department. Its fourteen branches are located in Shippensburg (2), Carlisle (4), Spring Run, Orrstown, Chambersburg (4), Mechanicsburg and Greencastle, Pennsylvania. Pennbanks Insurance Company Cell P1 is a reinsurer of credit, life, and disability insurance which services customers of Orrstown Bank. The Corporation and its subsidiaries are subject to the regulation of certain Federal and state agencies and undergo periodic examinations by such regulatory authorities. Principles of consolidation The consolidated financial statements include the accounts of the Corporation and its wholly-owned subsidiaries, Orrstown Bank and Pennbanks Insurance Company Cell P1. All significant intercompany transactions and accounts have been eliminated. Use of estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for losses on loans and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowance for losses on loans and foreclosed real estate, management obtains independent appraisals for significant properties. While management uses available information to recognize losses on loans and foreclosed real estate; future additions to the allowances may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Corporation's allowance for losses on loans and foreclosed real estate. Such agencies may require the Corporation to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. Because of these factors, management's estimate of credit losses inherent in the loan portfolio and the related allowance may change in the near term. Investment securities Under generally accepting accounting principles, the Corporation may segregate their investment portfolio into three specific categories: "securities held to maturity", "trading securities" and "securities available for sale". Securities held to maturity are to be accounted for at their amortized cost; securities classified as trading securities are to be accounted for at their current market value with unrealized gains and losses on such securities included in current period earnings; and securities classified as available for sale are to be accounted for at their current market value with unrealized gains and losses on such securities to be excluded from earnings and reported as a net amount in other comprehensive income. Management determines the appropriate classification of securities at the time of purchase. If management has the intent and the Corporation has the ability at the time of purchase to hold securities until maturity, they are classified as securities held to maturity and carried at amortized historical cost. Securities to be held for indefinite periods of time and not intended to be held to maturity are classified as available for sale and carried at fair value. Securities held for indefinite periods of time include securities that management intends to use as part of its asset and liability management strategy and that may be sold in response to changes in interest rates, resultant prepayment risk and other factors related to interest rate and resultant prepayment risk changes. The Corporation has classified all of its investment securities as "available for sale". Realized gains and losses on dispositions are based on the net proceeds and the adjusted book value of the securities sold, using the specific identification method. Unrealized gains and losses on investment securities available for sale are based on the difference between book value and fair value of each security. These gains and losses are credited or charged to other comprehensive income, whereas realized gains and losses flow through the Corporation's results of operations. Cash flows For purposes of the Statements of Cash Flows, the Corporation has defined cash and cash equivalents as those amounts included in the balance sheet captions "Cash and due from banks" and "Federal funds sold". The Corporation has elected to present the net increase or decrease in deposits with banks, loans, and deposits in the Statements of Cash Flows. Premises, equipment, furniture and fixtures and depreciation Buildings, improvements, equipment, furniture and fixtures are carried at cost less accumulated depreciation. Depreciation has been provided generally on the straight-line method and is computed over the estimated useful lives of the various assets as follows: building and improvements, 10 to 40 years, equipment, furniture and fixtures 3 to 15 years, and computer software is amortized over 3-5 years. Repairs and maintenance are charged to operations as incurred, while major additions and improvements are capitalized. Gain or loss on retirement or disposal of individual assets is recorded as income or expense in the period of retirement or disposal. Goodwill and identifiable intangible assets The cost of acquired companies in excess of their fair value of the net asset at the date of acquisition is recorded as goodwill. Identifiable intangible assets relate to acquisitions of deposits from other banks and the purchase of an investment management business. Goodwill is evaluated annually for impairment and other intangible assets are amortized over the life of the asset or 15 years. Advertising The Corporation follows the policy of charging costs of advertising to expense as incurred. Advertising expense was $291,000, $267,000, and $218,000, for the years ended December 31, 2004, 2003, and 2002, respectively. Loans and allowance for loan losses Loans are stated at the amount of unpaid principal, reduced by an allowance for loan losses. Interest on loans is calculated by using the simple interest method on daily balances of the principal amount outstanding. The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance when management believes that the collectibility of the principal is unlikely. Subsequent recoveries, if any, are credited to the allowance. The allowance is an amount that management believes will be adequate to absorb possible losses on existing loans that may become uncollectible. Evaluations of the allowance and collectibility of loans are made on a quarterly basis by management and are guided by the Corporation's policies. The evaluations take into consideration such factors as prior loan loss experience, changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current economic conditions that may affect the borrowers' ability to pay. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as additional information becomes available. An unallocated component is maintained in the allowance to cover uncertainties inherent in management's underlying assumptions used to estimate probable losses. Nonaccrual / Impaired loans The accrual of interest income on loans ceases when principal or interest is past due 90 days or more and collateral is inadequate to cover principal and interest or immediately if, in the opinion of management, full collection is unlikely. Interest accrued but not collected as of the date of placement on nonaccrual status is reversed and charged against current income unless fully collateralized. Subsequent payments received either are applied to the outstanding principal balance or recorded as interest income, depending upon management's assessment of the ultimate collectibility of principal. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on such loans are applied as a reduction of loan principal balance. Interest income on impaired loans is recognized only to the extent of interest payments received. Foreclosed real estate Real estate properties acquired through, or in lieu of, loan foreclosure are to be sold and are initially recorded at the lower of carrying value or fair value less estimated costs to sell the underlying collateral. After foreclosure, valuations are periodically performed by management and the real estate is carried at the lower of carrying amount or fair value less estimated cost to sell. Earnings per share of common stock Earnings per share is calculated as net income divided by the weighted average number of shares outstanding, after giving retroactive recognition to a 5% stock dividend paid May 2003 and a two-for-one stock split effective February 2004. For diluted net income per share, net income is divided by the weighted average of shares outstanding plus the incremental number of shares added as a result of converting common stock equivalents. The Corporation's common stock equivalents consist of outstanding stock options. A reconciliation of the weighted average shares outstanding used to calculate basic net income per share and diluted net income per share follows. There is no adjustment to net income to arrive at diluted net income per share. 2004 2003 2002 Weighted average shares outstanding (basic) 5,106,683 5,054,370 5,020,288 Impact of common stock equivalents 187,482 161,168 113,075 ---------- ---------- ---------- Weighted average shares outstanding (diluted) 5,294,165 5,215,538 5,133,363
Stock-Based Compensation The Corporation grants stock options for a fixed number of shares to directors and employees with an exercise price equal to the fair value of the shares at the date of grant. The Corporation accounts for stock option grants using the intrinsic-value method in accordance with APB Opinion No. 25, "Accounting for Stock Issued to Employees" and related Interpretations. Under the intrinsic- value method, because the exercise price of the Corporation's employee stock options is more than or equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. See Note 10 for the proforma effect on net income and earnings per share as if the Corporation had applied the fair value recognition provisions of FASB Statement 123, "Accounting for Stock-Based Compensation" to stock-based employee compensation. Federal income taxes For financial reporting purposes the provision for loan losses charged to operating expense is based on management's judgment, whereas for federal income tax purposes, the amount allowable under present tax law is deducted. Deferred compensation is charged to operating expense in the period the liability is incurred for financial reporting purposes, whereas for federal income tax purposes, these expenses are deducted when paid. Amortization of goodwill is not deducted unless the asset is considered impaired for financial reporting purposes and is deducted on a straight line basis over a fifteen year life for federal income tax purposes. As a result of these and timing differences in depreciation expense, deferred income taxes are provided for in the financial statements. See Note 11 for further details. Fair values of financial instruments The Corporation meets the requirements for disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Certain financial instruments and all non- financial instruments are excluded from disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Corporation. The following methods and assumptions were used by the Corporation in estimating fair values of financial instruments as disclosed herein: Cash, Due from Banks, Short-Term Investments, and Federal Funds Sold. The carrying amounts of cash, due from banks, short-term investments, and federal funds sold approximate their fair value. Securities Available for Sale. Fair values for investment securities are based on quoted market prices. Loans Receivable. For variable-rate loans that reprice frequently and have no significant change in credit risk, fair values are based on carrying values. Fair values for fixed rate loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Fair values for impaired loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable. Deposit Liabilities. The fair values disclosed for demand deposits are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts). The carrying amounts of variable-rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date. Fair values for fixed-rate certificates of deposits and IRA's are estimated using a discounted cash flow calculation that applies interest rates currently being offered to a schedule of aggregated expected maturities on time deposits. Short-Term Borrowings. The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings maturing within 90 days approximate their fair values. Fair values of other short-term borrowings are estimated using discounted cash flow analyses based on the Corporation's current incremental borrowing rates for similar types of borrowing arrangements. Long-Term Borrowings. The fair value of the Corporation's long-term debt is estimated using a discounted cash flow analysis based on the Corporation's current incremental borrowing rate for similar types of borrowing arrangements. Accrued Interest. The carrying amounts of accrued interest approximate their fair values. Off-Balance-Sheet Instruments. The Corporation generally does not charge commitment fees. Fees for standby letters of credit and other off-balance-sheet instruments are not significant. Comprehensive income Under generally accepted accounting principles, comprehensive income is defined as the change in equity from transactions and other events from non- owner sources. It includes all changes in equity except those resulting from investments by shareholders and distributions to shareholders. Comprehensive income includes net income and certain elements of "other comprehensive income" such as foreign currency transactions; accounting for futures contracts; employers accounting for pensions; and accounting for certain investments in debt and equity securities. The Corporation has elected to report its comprehensive income in the statement of changes in shareholders' equity. The only element of "other comprehensive income" that the Corporation has is the unrealized gain or loss on available for sale securities. The components of the change in net unrealized gains (losses) on securities were as follows: (Dollars in thousands) 2004 2003 2002 Gross unrealized holding gains (losses) arising during the year ($ 379) ($ 1,187) $ 2,701 Reclassification adjustment for (gains) losses realized in net ( 88) ( 199) ( 21) income ---------- ---------- ---------- Net unrealized holding gains (losses) before taxes ( 467) ( 1,386) 2,680 Tax effect 159 471 ( 911) ---------- ---------- ---------- Net change ($ 308) ($ 915) $ 1,769 ---------- ---------- ----------
NOTE 2. INVESTMENTS At December 31, 2004 and 2003 the investment securities portfolio was comprised of securities classified as "available for sale", resulting in investment securities being carried at fair value. The amortized cost and fair values of investment securities available for sale at December 31 were: Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value (Dollars in thousands) 2004 U. S. Treasury securities and obligations of U.S. Government corporations and agencies $ 12,370 $ 38 $ 70 $ 12,338 Obligations of states and political subdivisions 23,885 1,001 56 24,830 Mortgage-backed securities 39,663 236 261 39,638 Equity securities 2,660 401 38 3,023 ---------- ------------ ----------- ------------- Totals $ 78,578 $ 1,676 $ 425 $ 79,829 ---------- ---------- ---------- ---------- 2003 U. S. Treasury securities and obligations of U.S. Government corporations and agencies $ 15,050 $ 51 $ 115 $ 14,986 Obligations of states and political subdivisions 22,022 1,185 3 23,204 Mortgage-backed securities 45,867 448 186 46,129 Corporate bonds 1,945 0 18 1,927 Equity securities 2,472 395 39 2,828 ---------- ---------- ---------- ---------- Totals $ 87,356 $ 2,079 $ 361 $ 89,074 ---------- ---------- ---------- ----------
NOTE 2. INVESTMENTS (Continued) The following table shows gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2004 Less Than 12 Months 12 Months or More Total Fair Unrealized Fair Unrealized Fair Unrealized (Dollars in thousands) Value Losses Value Losses Value Losses U. S. Treasury securities and obligations of U. S. Government corporations and agencies $ 8,322 $ 68 $ 26 $ 2 $ 8,348 $ 70 Obligations of states and political 1,740 51 495 5 2,235 56 subdivisions Mortgage-backed securities 15,531 94 8,392 167 23,923 261 ---------- ---------- ---------- ---------- --------- --------- Total debt securities 25,593 213 8,913 174 34,506 387 ---------- ---------- ---------- ---------- --------- --------- Equity securities 127 13 27 25 154 38 ---------- ---------- ---------- ---------- --------- --------- Total temporarily impaired securities $ 25,720 $ 226 $ 8,940 $ 199 $ 34,660 $ 425 ---------- ---------- ---------- ---------- --------- ---------
The above table represents thirty-eight investment securities where the current fair value is less than the related amortized cost. Management believes the impairments to be temporary in all cases. Consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. At December 31, 2004, sixteen issues of mortgage-backed securities have unrealized losses. Of these, nine issues have been in a loss position for twelve months or more. Five issues were purchased in the previous year in a lower rate environment creating a lower current yield. Four issues are nearing payoff which lowers their market value. Three issues of state and political subdivision have unrealized losses with one issue in a loss position for twelve months or more. Six issues of US Treasury bonds have unrealized losses with one issue in a loss position for twelve months or more. The one state and political bond and the one US Treasury bond were purchased in a lower rate environment in the prior year. As management has the ability to hold these securities until maturity, or for the foreseeable future, no decline is deemed to be other than temporary. At December 31, 2004, thirteen marketable equity securities have unrealized losses with four issues in a loss position for twelve months or more. Although their prices have fluctuated, the price has been higher in the past fifty-two week period. Since the past two year chart has been generally up, there is certainly the possibility of price appreciation in the stock moving forward. These impairments are considered temporary due to the tremendous potential of the technology sector and our belief that these investments could rebound. The amortized cost and fair values of investment securities available for sale at December 31, 2004, by contractual maturity are shown below. Contractual maturities will differ from expected maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Amortized Fair (Dollars in thousands) Cost Value Due in one year or less $ 902 $ 913 Due after one year through five years 12,343 12,312 Due after five years through ten years 2,018 2,117 Due after ten years 20,992 21,826 Mortgage-backed securities 39,663 39,638 Equity securities 2,660 3,023 ------------ ------------ $ 78,578 $ 79,829 ------------ ------------
Proceeds from sales of securities available for sale for the years ended December 31, 2004, 2003, and 2002, were $6,407,000, $ 20,839,000 and $ 1,223,000, respectively. Gross gains and losses on 2004 sales were $ 164,013 and $ 75,959 respectively. Gross gains and losses on 2003 sales were $ 525,612 and $ 326,485, respectively. Gross gains and losses on 2002 sales were $ 65,533 and $ 44,872, respectively. The Corporation owned $ 2,728,900 of Federal Home Loan Bank stock, $ 54,000 of Atlantic Central Bankers Bank stock and $ 189,000 of Federal Reserve Bank stock at December 31, 2004. At December 31, 2003 the Corporation's stock ownership was $ 2,668,800 of Federal Home Loan Bank stock, $ 54,000 of Atlantic Central Bankers Bank stock and $189,000 of Federal Reserve Bank stock. Market value approximates cost since none of the stocks are actively traded. Securities with a market value of $ 62,201,000 and $ 70,143,000 at December 31, 2004 and 2003, respectively, were pledged to secure public funds and for other purposes as required or permitted by law. NOTE 3. CONCENTRATION OF CREDIT RISK The Corporation grants agribusiness, commercial, residential and consumer loans to customers in South Central Pennsylvania, principally Franklin and Cumberland Counties. Although the Corporation maintains a diversified loan portfolio, a significant portion of its customers' ability to honor their contracts is dependent upon economic sectors for construction contractors, non- residential building operators, sales finance, sub-dividers and developers. Management evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon the extension of credit, is based on management's credit evaluation of the customer. Collateral held varies but generally includes equipment and real estate. NOTE 4. ALLOWANCE FOR LOAN LOSSES Activity in the allowance for loan losses is summarized as follows: (Dollars in thousands) 2004 2003 2002 Balance at beginning of period $ 4,161 $ 3,734 $ 3,104 Recoveries 32 17 11 Provision for loan losses charged to income 210 491 720 ------------ ------------ ------------ Total 4,403 4,242 3,835 Losses 85 81 101 ------------ ------------ ------------ Balance at end of period $ 4,318 $ 4,161 $ 3,734 ------------ ------------ ------------
NOTE 5. LOANS TO RELATED PARTIES The Corporation has granted loans to the officers and directors of the Corporation and its subsidiary and to their associates. Related party loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons and do not involve more than normal risk of collectibility. The aggregate dollar amount of these loans was $ 2,637,000 at December 31, 2004, and $ 2,630,000 at December 31, 2003. During 2004, $ 1,114,000 of new advances were made and repayments totaled $ 1,107,000. Outstanding loans to employees totaled $ 2,323,000 and $ 2,218,000 at December 31, 2004 and 2003, respectively. NOTE 6. DELINQUENT AND NONACCRUAL LOANS Loans 90 days or more past due (still accruing interest) were as follows at December 31: (Dollars in thousands) 2004 2003 2002 Commercial, financial and agricultural $ 0 $ 12 $ 190 Real estate 2,541 2,716 1,245 Consumer 9 15 11 ----------- ----------- ----------- Total $ 2,550 $ 2,743 $ 1,446 ----------- ----------- -----------
The following table shows the principal balances of nonaccrual loans as of December 31: (Dollars in thousands) 2004 2003 2002 Nonaccrual loans $ 314 $ 130 $ 85 ----------- ----------- ----------- Interest income that would have been accrued at original contract rates 31 12 9 Amount recognized as interest income 13 0 2 ----------- ----------- ----------- Foregone revenue $ 18 $ 12 $ 7 ----------- ----------- -----------
The Corporation had no impairment of loans as of December 31, 2004, 2003, and 2002. During 2004, the Corporation foreclosed on loans secured by one real estate property. This property was sold during 2004 at a gain of $ 6,166. A property that was obtained through foreclosure during 2001 was sold in 2004 for a loss of $51,517. Both of these amounts are included in other income on the statements of income. Gains from sales of foreclosed property for the years ended December 31, 2003 and 2002 were $ 5,764 and $ 2,736, respectively. At December 31, 2004, the Corporation was not holding any properties obtained through foreclosure on the balance sheet. NOTE 7. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK The Corporation is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financial needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets. The contract amounts of those instruments reflect the extent of involvement the Corporation has in particular classes of financial instruments. The Corporation's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual amount of those instruments. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on- balance-sheet instruments. Contract or Notional Amount (Dollars in thousands) 2004 2003 Financial instruments whose contract amounts represent credit risk at December 31: Commitments to extend credit $ 108,840 $ 86,481 Standby letters of credit and financial guarantees written 10,610 9,469
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer's credit-worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based on management's credit evaluation of the customer. Collateral held varies but may include accounts receivable, inventory, real estate, equipment, and income- producing commercial properties. Standby letters of credit and financial guarantees written are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The Corporation holds collateral supporting those commitments when deemed necessary by management. During 2004, the Corporation entered into purchase commitments of $ 1,208,068 related to the construction of a new branch office. At December 31, 2004, $ 913,601 of these commitments had been paid. NOTE 8. PREMISES AND EQUIPMENT A summary of bank premises and equipment is as follows: (Dollars in thousands) 2004 2003 Land $ 2,045 $ 1,358 Buildings and improvements 9,517 7,870 Leasehold improvements 199 199 Furniture and equipment 8,592 7,587 Construction in progress 48 334 ------------ ------------ Total 20,401 17,348 Less accumulated depreciation and 7,179 6,180 amortization ------------ ------------ Bank premises and equipment, net $ 13,222 $ 11,168 ------------ ------------
Depreciation expense amounted to $1,072,976, $ 943,484, and $ 803,123 for the years ended December 31, 2004, 2003 and 2002, respectively. NOTE 9. RETIREMENT PLANS The Corporation maintains a 401(k) profit-sharing plan for those employees who meet the eligibility requirements set forth in the plan. Employer contributions to the plan are based on corporate performance and are at the discretion of the Corporation's Board of Directors. In addition, there is a provision for an employer match of 50 cents on the dollar for employee contributions up to 6% of the employees' eligible compensation. Substantially all of the Corporation's employees are covered by the plan and the contributions charged to operations were $ 898,609, $ 754,498 and $ 650,065 for the years ended December 31, 2004, 2003, and 2002, respectively. NOTE 9. RETIREMENT PLANS (Continued) The Corporation has a deferred compensation arrangement with certain present and former board directors whereby a director or his beneficiaries will receive a monthly retirement benefit at age 65. The arrangement is funded by an amount of life insurance on the participating director calculated to meet the Corporation's obligations under the compensation agreement. The cash value of the life insurance policies is an unrestricted asset of the Corporation. The estimated present value of future benefits to be paid, which is included in other liabilities, amounted to $ 121,009 and $ 122,029 at December 31, 2004 and 2003, respectively. Total annual expense for this deferred compensation plan was $ 11,520, $ 12,325, and $ 12,456 for the years ended December 31, 2004, 2003 and 2002, respectively. The Corporation also has a supplemental discretionary deferred compensation plan for executive officers and directors. The plan is funded annually with salary and fee reductions which are placed in a trust account invested by the Corporation's trust department. Total amount contributed to the plan was $ 77,200, $ 58,800 and $ 27,050, for the years ended December 31, 2004, 2003, and 2002, respectively. The Corporation adopted three supplemental retirement and salary continuation plans for directors and executive officers. These plans are funded with single premium life insurance on the plan participants. The cash value of the life insurance policies is an unrestricted asset of the Corporation. The Revenue Neutral plan was paid out in March 2004 and there was no related expense for this plan in 2004. The estimated present value of future benefits to be paid totaled $ 1,134,986 and $ 952,296 at December 31, 2004 and 2003, respectively, which is included in other liabilities. Total annual expense for these plans amounted to $216,890, $ 245,460 and $ 257,468, for the years ended December 31, 2004, 2003, and 2002, respectively. NOTE 10. STOCK COMPENSATION PLANS During 2000 the Corporation implemented two stock option plans (one for employees and one for nonemployee directors). Under the Corporation's stock option plans the Corporation may grant options to its directors, officers, and employees for up to 507,150 shares of common stock. Both incentive stock options and nonqualified stock options may be granted under the plans. The exercise price of each option equals the market price of the Corporation's stock on the date of grant and an option's maximum term is ten years. A summary of the status of the Corporation's stock option plans at December 31, 2004, 2003, and 2002 is presented below: Weighted Weighted Weighted Average Average Average Exercise Exercise Exercise Shares Price Shares Price Shares Price 2004 2003 2002 Outstanding at beginning of year 181,550 $20.98 134,726 $18.78 86,184 $17.65 Granted 45,908 40.83 49,028 26.85 49,644 20.70 Exercised (25,682) 18.08 (2,204) 17.01 0 0 Forfeited 0 0.00 0 0.00 (1,102) 17.01 ---------- ---------- ---------- --------- ---------- ---------- Options exercisable at year end 201,776 $25.87 181,550 $20.98 134,726 $18.78 ---------- ---------- ---------- --------- ---------- ----------
Information pertaining to options outstanding at December 31, 2004 is as follows: Options Outstanding Options Exercisable Weighted Average Range of Number Remaining Weighted Number Weighted Average Contractual Average Exercise Prices Outstanding Life Exercise Exercisable Exercise Price (Years) Price $17.01 - $17.91 21,802 5.44 $17.23 21,802 $17.23 $17.97 - $18.19 40,618 6.46 18.16 40,618 18.16 $18.69 - $20.95 44,820 7.47 20.67 44,820 20.67 $22.99 - $27.26 48,628 8.48 26.85 48,628 26.85 $40.70 - $43.13 45,908 9.49 40.83 45,908 40.83 ---------- ------ ------ -------- ------- $17.01 - $43.13 201,776 7.75 $25.87 201,776 $25.87 ---------- ------ ------ -------- -------
NOTE 10. STOCK COMPENSATION PLANS (Continued) The fair value of each option granted is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions: Grant-Date Dividend Expected Risk Free Life Fair Value Yield Volatility Interest (Years) Rate Nonemployee director stock option plan 2004 $14.75 1.11% 32.80% 3.38% 7 2003 7.59 1.40 25.36 3.40 10 2002 3.45 1.61 26.68 3.50 6 Employee stock option plan 2004 $12.60 1.18% 32.18% 3.85% 5 2003 6.83 1.40 16.32 3.40 10 2002 4.39 1.48 30.04 3.50 6
The Corporation accounts for the plans under the recognition and measurement principles of APB Opinion No. 25 and related Interpretations. No stock-based employee compensation cost is reflected in net income for options granted since all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value recognition provisions of FASB Statement No.123 to stock-based employee compensation. In thousands, except per share data) 2004 2003 2002 Net income As reported $ 7,770 $ 6,980 $ 5,915 Pro forma 7,385 6,757 5,712 Basic earnings per share As reported $ 1.52 $ 1.38 $ 1.18 Pro forma 1.45 1.34 1.14 Diluted earnings per share As reported $ 1.47 $ 1.34 $ 1.15 Pro forma 1.39 1.30 1.11
During 2000 the Corporation implemented an employee stock purchase plan under which 165,375 shares of common stock have been reserved for issuance to employees. The number of shares which may be issued to each participant is determined annually, based on individual earnings, and their cost is equal to 85% of the fair market value as established by the average of the average of the daily high bid and daily low offer quotations for the shares reported in the OTC Bulletin Board service, during the ten trading days immediately preceding the date of purchase. If no bid or offer quotation for the shares is reported through the OTC Bulletin Board service during the ten business day period, the fair market value is the price of the last trade reported through the OTC Bulletin Board service prior to the purchase date. A total of 142,564 shares of common stock remained reserved at December 31, 2004 for future grants under the plan. Employees purchased 3,916, 8,561, and 4,152 shares at a weighted average price of $ 32.74, $ 19.71, and $ 17.30 per share in 2004, 2003, and 2002, respectively. Shares of common stock registered and available for issuance through approved plans at December 31, 2004 are as follows: Number of Shares Stock option plans 276,948 Employee stock purchase plan 142,564 Dividend reinvestment plan 729,095 ---------- Total registered shares 1,148,607 ----------
NOTE 11. INCOME TAXES The components of federal income tax expense are summarized as follows: (Dollars in thousands) 2004 2003 2002 Current year provision $ 3,149 $ 2,788 $ 2,356 Deferred income taxes (benefits) 28 (110) (131) --------------- --------------- --------------- Net federal income tax expense $ 3,177 $ 2,678 $ 2,225 --------------- --------------- ---------------
Federal income taxes were computed after reducing pretax accounting income for non-taxable income in the amount of $ 1,713,461, $ 1,835,294, and $ 1,857,654 for 2004, 2003, and 2002, respectively. A reconciliation of the effective applicable income tax rate to the federal statutory rate is as follows: 2004 2003 2002 Federal income tax rate 34.0% 34.0% 34.0% Reduction resulting from 5.0% 6.3% 6.7% nontaxable income ------ ------ ------ Effective income tax rate 29.0% 27.7% 27.3% ------ ------ ------
Deferred tax liabilities have been provided for taxable temporary differences related to accumulated depreciation, unrealized gains on available for sale securities and deductible amortization expense of goodwill and intangibles. Deferred tax assets have been provided for deductible temporary differences related to the allowance for loan losses, asset impairment, and directors' deferred compensation and retirement plans. The Corporation has not recorded a valuation allowance for deferred tax assets as they feel that it is more likely than not that they will be ultimately realized. The net deferred tax assets (liabilities) included in the accompanying consolidated balance sheets includes the following significant components: (Dollars in thousands) 2004 2003 Deferred tax assets Allowance for loan losses $ 1,409 $ 1,373 Asset impairment 13 0 Deferred compensation 232 205 Retirement plans and salary continuation 386 324 -------------- -------------- Total deferred tax assets 2,040 1,902 -------------- -------------- Deferred tax liabilities Net unrealized (gains) on securities available for sale (425) (584) Depreciation (1,024) (866) Goodwill and intangibles (8) 0 --------------- --------------- Total deferred tax liabilities (1,457) (1,450) -------------- -------------- Net deferred tax asset $ 583 $ 452 -------------- --------------
NOTE 12. DEPOSITS Included in interest bearing deposits at December 31 are NOW account products with balances totaling $ 142,583,000 and $ 146,627,000 for 2004 and 2003, respectively. Also included in interest bearing deposits at December 31, 2004 and 2003 are money market account products with balances totaling $ 43,284,000 and $ 29,641,000, respectively. At December 31, 2004 and 2003 time deposits of $ 100,000 and over aggregated $ 33,686,000 and $ 18,845,000, respectively. Interest expense on time deposits of $ 100,000 and over was $ 788,000, $ 546,000 and $ 710,000 for the years ended December 31, 2004, 2003, and 2002, respectively. At December 31, 2004 the scheduled maturities of certificates of deposit are as follows: (Dollars in thousands) 2005 $ 52,011 2006 35,115 2007 16,938 2008 3,643 2009 and thereafter 9,891 ------------- $ 117,598 -------------
NOTE 12. DEPOSITS (Continued) The Corporation accepts deposits of the officers and directors of the Corporation and its subsidiary on the same terms, including interest rates, as those prevailing at the time for comparable transactions with unrelated persons. The aggregate dollar amount of deposits of officers and directors totaled $ 614,000 and $ 992,000 at December 31, 2004 and 2003, respectively. Total overdrafts of the Bank of $ 866,000 and $ 343,000 at December 31, 2004 and 2003, respectively, were reclassified as loans for financial reporting purposes. NOTE 13. LIABILITIES FOR BORROWED MONEY Federal funds purchased and securities sold under agreements to repurchase generally mature within one day from the transaction date. Information concerning securities sold under agreements to repurchase is summarized as follows: (Dollars in Thousands) 2004 2003 Average balance during the year $ 22,708 $ 23,014 Average interest rate during the year 1.22% 1.04% Maximum month-end balance during the year $ 35,373 $ 29,440 Securities underlying the agreements at year-end: Carrying value 37,532 39,152 Estimated fair value 37,868 39,640
At December 31, the Corporation had notes outstanding with the Federal Home Loan Bank of Pittsburgh as follows: (Dollars in Thousands) Convertible Frequency & Basis Amount Maturity Interest to Adjustable for Adjustable 2004 2003 Date Rate Rate Rate $ 0 $ 1,000 01/04 6.42% Fixed Rate 350 350 04/05 7.35 Fixed Rate 1,000 1,000 05/05 1.67 Fixed Rate 5,000 5,000 05/06 2.08 Fixed Rate 1,393 1,779 05/08 2.43 Fixed Rate 7,500 7,500 09/08 5.06 09/15/03 (1) Quarterly based on 3 months LIBOR plus .15% 5,000 5,000 10/08 4.66 10/07/03 (1) Quarterly based on 3 months LIBOR plus .15% 1,582 1,848 05/10 2.85 Fixed Rate 5,000 5,000 02/11 4.50 02/07/02 (1) Quarterly based on 3 months LIBOR plus .19% 3,000 3,000 03/11 3.94 03/25/02 (1) Quarterly based on 3 months LIBOR plus .13% 5,000 5,000 02/12 4.70 (2) 350 350 04/20 7.40 Fixed Rate ----------- ---------- $ 35,175 $ 36,827 ----------- ----------
(1) The rate can adjust to an adjustable rate based on market rates. (2) The 3 month LIBOR is evaluated quarterly and the loan converts to an adjustable rate if the 3 month LIBOR is greater than 8%. The rate would then adjust quarterly based on 3 month LIBOR plus .20%. Interest rates are fixed, but, as indicated above, some of the notes can convert to adjustable rates. Interest only is paid on a monthly basis. The notes contain prepayment penalty charges, but management has no intention to pay off early. Two of the above borrowings are term notes that require monthly principal reductions of the note balance. The aggregate amount of future principal payments required on these two notes at December 31, 2004 is as follows: NOTE 13. LIABILITIES FOR BORROWED MONEY (Continued) (Dollars in Thousands) 2005 $ 670 2006 687 2007 705 2008 475 2009 307 Thereafter 131 ------------ $ 2,975 ------------
The Corporation also has available a $ 15 million line of credit with the Federal Home Loan Bank of Pittsburgh (FHLB). The interest rate is variable and can change daily based on FHLB's cost of borrowing. Collateral for all outstanding advances and the line consists of certain securities and the Corporation's 1-4 family mortgage loans totaling $ 212,998,000 and $ 188,944,000 at December 31, 2004 and 2003, respectively. The Corporation also has available a line of credit with Atlantic Central Bankers Bank of $8.5 million at December 31, 2004 and $ 6 million at December 31, 2003 and a $5 million available line of credit with the Bank of Lancaster County at December 31, 2004. The ACBB and Bank of Lancaster County lines of credit are unsecured and the rates are based on the daily Federal Funds rate. There were no borrowings under these lines of credit at December 31, 2004 or 2003. Also included in other borrowed funds are borrowings against certain life insurance policies that are used to fund deferred compensation benefits for certain directors. Interest rates are fixed at 8%. Collateral is the cash surrender value of the policies as disclosed in Note 9. The total balance of these loans was $ 394,000 and $ 366,000 at December 31, 2004 and 2003, respectively. Total interest expense on borrowed funds charged to operations was $ 1,502,425, $ 1,498,734 and $ 1,517,619 for the years ended December 31, 2004, 2003, and 2002, respectively. NOTE 14. ORRSTOWN FINANCIAL SERVICES, INC. (PARENT COMPANY ONLY) FINANCIAL INFORMATION The following are the condensed balance sheets, income statements and statements of cash flows for the parent company: BALANCE SHEETS At December 31, (Dollars in Thousands) 2004 2003 Assets Cash $ 2,667 $ 1,385 Securities available for sale 2,964 2,794 Investment in wholly-owned subsidiaries 45,074 40,043 Other assets 49 32 -------- -------- Total assets $ 50,754 $ 44,254 -------- -------- Liabilities Accrued expenses $ 681 $ 593 Deferred taxes 123 126 Notes payable 700 700 -------- -------- Total liabilities 1,504 1,419 -------- -------- Shareholders' Equity Common stock, no par value - $ .05205 stated value per share 50,000,000 shares authorized with 5,126,205 shares issued at December 31, 2004 and $.1041 stated value per share 10,000,000 shares authorized with 2,537,011 shares issued at December 31, 2003 267 264 Additional paid-in capital 34,434 32,928 Retained earnings 13,723 8,509 Accumulated other comprehensive income 826 1,134 --------- --------- Total shareholders' equity 49,250 42,835 --------- --------- Total liabilities and shareholders' equity $ 50,754 $ 44,254 --------- ---------
NOTE 14. ORRSTOWN FINANCIAL SERVICES, INC. (PARENT COMPANY ONLY) FINANCIAL INFORMATION (Continued) INCOME STATEMENTS Years Ended December 31, (Dollars in Thousands) 2004 2003 2002 Income Dividends from wholly-owned subsidiary $ 2,475 $ 1,415 $ 1,010 Other interest and dividend income 145 134 130 Other income 44 92 29 Gain on sale of investment securities 51 128 6 ---------- ---------- ---------- Total income 2,715 1,769 1,175 ---------- ---------- ---------- Expenses Interest on borrowings 52 52 52 Other expenses 238 190 179 ---------- ---------- ---------- Total expenses 290 242 231 ---------- ---------- ---------- Income before income taxes and equity in undistributed income of subsidiaries 2,425 1,527 944 Income tax expense (benefit) (12) 30 (29) ---------- ---------- ---------- Income before equity in undistributed income of subsidiaries 2,437 1,497 973 ---------- ---------- ---------- Equity in undistributed income of subsidiaries Net income of subsidiaries 7,808 6,898 5,952 Less: dividends (2,475) (1,415) (1,010) ---------- ---------- ---------- Equity in undistributed income of subsidiaries 5,333 5,483 4,942 ---------- ---------- ---------- Net income $ 7,770 $ 6,980 $ 5,915 ---------- ---------- ----------
STATEMENTS OF CASH FLOWS Years Ended December 31, (Dollars in Thousands) 2004 2003 2002 Cash flows from operating activities: Net income $ 7,770 $ 6,980 $ 5,915 Adjustments to reconcile net income to cash provided by operating activities: Security (gains) (51) (128) (6) Equity in undistributed income of subsidiary (5,333) (5,483) (4,942) Increase (decrease) in other liabilities 88 104 95 (Increase) decrease in other assets (17) 40 (14) -------- -------- -------- Net cash provided by operating activities 2,457 1,513 1,048 -------- -------- -------- Cash flows from investing activities: Purchase of available for sale securities (522) (791) (329) Sales of available for sale securities 393 543 208 Sales of property and equipment 0 0 5 -------- -------- -------- Net cash provided (used) by investing activities (129) (248) (116) -------- -------- -------- Cash flows from financing activities: Cash dividends paid (2,556) (2,126) (1,722) Cash paid in lieu of fractional stock dividends 0 (22) 0 Proceeds from sale of stock 1,510 956 838 -------- -------- -------- Net cash provided (used) by financing activities (1,046) (1,192) (884) -------- -------- -------- Net increase (decrease) in cash 1,282 73 48 Cash, beginning balance 1,385 1,312 1,264 -------- -------- -------- Cash, ending balance $ 2,667 $ 1,385 $ 1,312 -------- -------- --------
NOTE 15. REGULATORY MATTERS Dividends paid by Orrstown Financial Services, Inc. are generally provided from the subsidiary bank's dividends to the parent company. Under provisions of the Pennsylvania Banking Code, cash dividends may be paid from accumulated net earnings (retained earnings) as long as minimum capital requirements are met. The minimum capital requirements stipulate that the bank's surplus or additional paid-in capital be equal to the amount of capital. Orrstown Bank is well above these requirements and the balance of $ 38,066,000 in its retained earnings at December 31, 2004 is fully available for cash dividends. Orrstown Financial Services' balance of retained earnings at December 31, 2004 is $ 13,723,000 and would be available for cash dividends, although payment of dividends to such extent would not be prudent or likely. The Federal Reserve Board, which regulates bank holding companies, establishes guidelines which indicate that cash dividends should be covered by current period earnings. The Corporation is also subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Corporation's financial statements. Under capital adequacy guidelines, the Corporation is required to maintain minimum capital ratios. The leverage ratio compares capital to total adjusted balance sheet assets, while the risk-based ratios compare capital to risk-weighted assets and off-balance-sheet activity in order to make capital levels more sensitive to risk profiles of individual banks. A comparison of Orrstown Financial Services' capital ratios to regulatory minimums at December 31 is as follows: Orrstown Financial Regulatory Services Minimum 2004 2003 Requirement s Leverage ratio 9.25% 8.92% 4% Risk-based capital ratios: Tier I (core capital) 12.19% 12.15% 4% Combined Tier I and Tier II (core capital plus allowance for loan losses) 13.35% 13.38% 8%
As of December 31, 2004 the most recent notification, from the Federal Reserve Board, categorized the Corporation as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Corporation's category. NOTE 16. LEASES The Corporation leases land and building space associated with certain branch offices, remote automated teller machines, and certain data processing equipment under agreements which expire at various times from 2005 through 2022. Total rent expense charged to operations in connection with these leases was $ 243,990, $ 218,769 and $ 180,766 for the years ended December 31, 2004, 2003, and 2002, respectively. The total minimum rental commitments under operating leases at December 31, 2004 are as follows: (Dollars in Thousands) Due in the Year Ending December 31, 2005 $ 127 2006 108 2007 105 2008 98 2009 79 ---------------- $ 517 ----------------
NOTE 17. COMPENSATING BALANCE ARRANGEMENTS The Corporation maintains deposit balances at several correspondent banks which provide check collection and item processing services to the Corporation. The balances with these correspondent banks, at times, exceed federally insured limits; management considers this to be a normal business risk. Required deposit balances at the Federal Reserve were $ 65,000 at both December 31, 2004 and 2003. Required deposit balances at Atlantic Central Bankers Bank were $ 540,000 at both December 31, 2004 and 2003. NOTE 18. FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair values of the Corporation's financial instruments were as follows at December 31: - - - - - - - 2004 - - - - - - - - - - - - - 2003 - - - - - - Carrying Fair Carrying Fair (Dollars in Thousands) Amount Value Amount Value Financial Assets Cash, due from banks, and short-term investments $ 12,580 $ 12,580 $ 13,284 $ 13,284 Federal funds sold 8,393 8,393 3,829 3,829 Securities available for sale 79,829 79,829 89,074 89,074 Restricted bank stocks 2,972 2,972 2,912 2,912 Loans 389,268 345,054 Allowance for loan losses (4,318) (4,161) ----------- ----------- ----------- ----------- Net loans 384,950 378,670 340,893 344,897 Accrued interest receivable 1,775 1,775 1,647 1,647 ----------- ----------- ----------- ----------- Total financial assets $ 490,499 $ 484,219 $ 451,639 $ 455,643 ----------- ----------- ----------- ----------- Financial Liabilities Deposits $ 405,363 $ 405,278 $ 358,643 $ 360,997 Short-term borrowed funds 19,493 19,493 29,440 29,440 Long-term borrowed funds 35,569 36,478 37,193 38,497 Accrued interest payable 431 431 397 397 ----------- ----------- ----------- ----------- Total financial liabilities $ 460,856 $ 461,680 $ 425,673 $ 29,331 ----------- ----------- ----------- -----------
NOTE 19. GOODWILL AND INTANGIBLE ASSETS On July 14, 2004 Orrstown Bank purchased an investment management business and the related registered trademark. The following intangible assets were recorded as part of this transaction: Gross (Dollars in Thousands) Amount Amortization Period Goodwill $ 748 Subject to impairment evaluation -------- Intangible assets: Restrictive covenant 5 18 months Customer list 402 15 years -------- Total intangible assets $ 407 --------
The identifiable intangible assets that are related to acquisitions of deposits and other intangibles are amortized on a straight-line basis over fifteen years. The following table shows the amount of good will and intangible assets included in other assets on the balance sheet at December 31: Gross Accumulated Net Amount Amortization Amount (Dollars in thousands) 2004 Goodwill $ 748 $ 0 $ 748 ------------ ----------- ------------ Intangible assets: Deposit premiums 683 407 276 Customer list 402 13 389 Other 61 56 5 ------------ ----------- ------------ Total intangible assets $ 1,146 $ 476 $ 670 ------------ ----------- ------------ 2003 Intangible assets: Deposit premiums $ 683 $ 361 $ 322 Other 56 49 7 ------------ ----------- ------------ Total intangible assets $ 739 $ 410 $ 329 ------------ ----------- ------------
Amortization expense was $66,000, $54,000, and $57,000 for the years ended December 31, 2004, 2003 and 2002, respectively. The estimated aggregate amortization expense for the next five years is as follows: (Dollars in Thousands) 2005 $ 77 2006 72 2007 72 2008 72 2009 72 -------- $ 365 -------- Item 7. Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations The following is a discussion of our consolidated financial condition and results of operations for each of the three years ended December 31, 2004, 2003 and 2002. Some statements and information contained in this "Management's Discussion and Analysis of Financial Condition and Results of Operations" are not historical facts but are forward-looking statements. For a discussion of these forward-looking statements and important factors that could cause results to differ materially from the forward-looking statements contained in this Annual Report, see "Important Factors Relating to Forward Looking Statements". The following discussion and analysis should be read in conjunction with our Consolidated Financial Statements and Notes to Consolidated Financial Statements presented in this report. Certain prior period amounts presented in this discussion and analysis, have been reclassified to conform to current period classifications. Overview Orrstown Financial Services, Inc. (the Corporation) is a financial holding company maintaining two wholly-owned subsidiaries, Orrstown Bank (the Bank) and Pennbanks Insurance Company Cell P1, a provider of credit life and disability insurance. The Bank is dedicated to maintaining its strong community roots and providing a wide array of services to the customers in the markets we serve. Deposit services include a variety of checking, savings, time and money market deposits along with related debit card services. The Branch Executive Officers, Customer Service Officers and tellers are trained to provide the best personal, professional service in our market areas. Lending services include commercial loans, residential loans, commercial mortgages and various forms of consumer lending. Business Development Officers are assigned in each of the communities we serve and they are a vital part of our continued strong loan growth. The Bank completed another record year for the production of net income and earnings per share. We have grown consistently throughout the past five years, as evidenced by the following financial data, while maintaining excellent loan quality. The Corporation is committed to providing both shareholder value and unparalleled customer service. The Corporation reached a milestone in July 2004 by increasing asset size to more than $ 500 million. Assets exceeded $ 500 million through year end. This will entail changes in reporting requirements for 2005 for the Bank and the Corporation. Also in July of 2004, the Bank purchased a Chambersburg, Pennsylvania-based investment management business and the related "Integrity Financial" Pennsylvania registered trademark. Orrstown Bank operates the Integrity Financial business as part of the Bank's Investment Management Division. The addition of this business contributed to noninterest income during the second half of 2004. The Bank's Investment Management Division has increased its assets under management consistently even through down markets, but realizes that great opportunities exist to continue this expansion as customers get to know our growing Bank. The Corporation will strive to continue the pattern of growth shown in the past by increasing the customer base with loan and deposit growth within our existing branches and markets, through select branch expansion into neighboring markets, and by watching for compatible acquisitions or opportunities as they arise. For the year ended December 31, 2004, the Corporation recorded net income of $ 7,770,000, an increase of 11.3% over 2003 earnings of $ 6,980,000, which was an 18.0% increase over net income of $ 5,915,000 in 2002. Basic earnings per share have increased over this time period from $1.18 in 2002 to $ 1.38 in 2003 and $ 1.52 in 2004. The per share amounts have been restated to reflect the 5% stock dividend paid to shareholders on May 30, 2003 and the 2-for-1 stock split effective February 10, 2004. In April 2004 the shareholders of the Corporation voted to increase the number of authorized shares of common stock from 10 million shares to 50 million shares thus allowing for future splits or stock dividends. The Corporation's earnings performance continues to be well above peer group averages as measured by various ratio analyses. Two widely recognized performance indicators are the return on average assets (ROA) and the return on average equity (ROE). The return on average assets was 1.57% in 2004, 1.57% in 2003, and 1.53% in 2002. The return on average equity was 17.19% in 2002, 17.24% in 2003, and 16.78% in 2004. Peer averages for publicly traded community banks with $500 million in assets or less, have been less than 1% for ROA and under 10% for ROE during the past few years. Economic Climate The historically low, flat interest rate environment of 2003 continued midway through 2004 before interest rates started to rise. In July 2004, the Federal Reserve Board raised the federal funds rate for the first time in four years. The prime lending rate followed the federal funds rate. From June 2004, both rates increased 125 basis points within seven months in 25 basis point increments. The prime lending rate stood at 5.25 at December 31, 2004. The economy continued to grow slowly but steadily and the Federal Reserve is closely monitoring the expansion with a long term eye on inflation. This view leads to the expectation of additional prime lending rate increases during 2005. The anticipated rate increases should bode well for the Corporation's earnings stream since the balance sheet is positioned to prosper in a rising rate environment. Net Interest Income Net interest income is the amount by which interest income on earning assets exceeds interest paid on interest bearing liabilities. The amount of net interest income is affected by changes in interest rates, account balances or volume and the mix of earning assets and interest bearing liabilities. Net interest income is still the primary source of commercial bank profits despite the continued industry wide push to build noninterest income streams. This is particularly true for community banks. For the year ended December 31, 2004, net interest income totaled $ 18,906,000, an increase of $ 2,179,000, or 13.0%, over 2003. The 2003 total was $ 16,727,000, or 10.1%, over 2002 results. On a taxable equivalent basis, net interest income increased by 12.2% in 2004 and 9.5% in 2003. Marginal tax rates used in the taxable equivalent equation were 34% for all three years presented. The Corporation's taxable equivalent net interest spread was 4.06% in 2002, 3.90% in 2003, and 3.91% in 2004. The net interest margin, which factors in noninterest bearing funds sources, has moved from 4.43% to 4.20% to 4.21%, respectively. Average earning assets represented 94.0% of total average assets in 2004, 94.0% in 2003, and 93.5% in 2002 as growth in interest bearing assets has consistently outstripped growth in nonearning assets. Even though rates increased in the second half of 2004, volume factors were still primarily responsible for the increase in interest income. The variable commercial loan portfolio was the only portfolio with an increase in interest income partially due to an increase in interest rate environment in the second half of 2004. The Bank is positioned to increase net interest income if expected interest rate increases materialize during 2005. This will make the rate variance a more material contributor to net interest income gains in 2005. Interest earning assets grew 11.8%, or $ 49,102,000, during 2004 on an average daily basis, with the commercial loan portfolio responsible for $38,763,000 of the total growth. Commercial loans secured by real estate, continue to be the fastest growing segment of the loan portfolio. Interest income increased $2,365,000 or 9.7%, on a fully taxable basis, for the same period. Interest bearing liabilities grew 10.1%, or $ 35,483,000, on an average daily basis, split fairly evenly between interest bearing transaction accounts and growth in time deposits. Our deposit mix, which is heavily laden with variable rate transaction accounts that are discretionarily priced, enables us great flexibility in pricing. Free funds were up by $ 13,619,000, while net interest margin remained almost flat at 4.21% verses the 4.20% realized during 2003. The net interest margin increased as 2004 progressed, however, with prime rate increases widening the net interest margin. The Corporation's balance sheet is positioned to hold spreads in a flat or slightly falling interest rate environment but is well positioned for spread increases as rates rise as is evident from the fourth quarter's performance. 2004 2003 2002 Tax Tax Tax Tax Tax Tax Average Equivalent Average Equivalent Average Equivalent Equivalent Equivalent Equivalent (Dollars in thousands) Balance Interest Rate Balance Interest Rate Balance Interest Rate Assets Interest Earning Assets: Federal funds sold & interest bearing bank balances $12,764 $ 178 1.39% $ 14,678 $ 158 1.08% $ 16,830 $ 277 1.65% ------- -------- ------ -------- --------- ------ --------- --------- ------ Taxable investment Securities 60,888 2,277 3.74 63,972 2,381 3.72 54,643 2,891 5.29 Tax-exempt investment Securities 23,033 1,828 7.94 24,509 2,022 8.25 24,853 2,076 8.35 ------- -------- ------ -------- --------- ------ --------- --------- ------ Total investment Securities 83,921 4,105 4.89 88,481 4,403 4.98 79,496 4,967 6.25 ------- -------- ------ -------- --------- ------ --------- --------- ------ Taxable loans 364,678 22,021 6.04 310,311 19,444 6.27 261,114 18,473 7.07 Tax-exempt loans 4,731 318 6.72 3,522 252 7.16 3,182 245 7.70 ------- -------- ------ -------- --------- ------ --------- --------- ------ Total Loans 369,409 22,339 6.05 313,833 19,696 6.28 264,296 18,718 7.08 ------- -------- ------ -------- --------- ------ --------- --------- ------ Total interest-earning assets 466,094 26,622 5.71 416,992 24,257 5.82 360,622 23,962 6.64 Non-Interest Earning Assets: Cash and due from banks 10,687 9,580 8,853 Bank premises and equipment 11,852 10,505 9,427 Other assets 11,602 10,604 10,229 Less allowance for loan losses (4,316) (3,944) (3,366) ------- -------- ------ -------- --------- ------ --------- --------- ------ Total $495,919 $443,737 385,765 ------- -------- ------ -------- --------- ------ --------- --------- ------ Liabilities and Shareholders' Equity Interest Bearing Liabilities: Interest bearing demand deposits $183,649 $ 1,942 1.06 $170,832 $ 2,035 1.19 $136,500 $ 2,202 1.61 Savings deposits 29,752 135 0.45 26,602 140 0.53 23,558 201 0.85 Time deposits 114,181 3,124 2.74 97,539 2,840 2.91 94,043 3,666 3.90 Short term borrowings 24,296 304 1.25 23,294 243 1.04 24,057 398 1.65 Long term borrowings 35,885 1,481 4.13 34,013 1,499 4.41 30,400 1,518 4.99 ------- -------- ------ -------- --------- ------ --------- --------- ------ Total interest bearing liabilities 387,763 6,986 1.80 352,280 6,757 1.92 308,558 7,985 2.59 Non-Interest Bearing Liabilities: Demand deposits 57,762 47,416 39,688 Other 4,085 3,550 3,111 ------- -------- ------ -------- --------- ------ --------- --------- ------ Total Liabilities 449,610 403,246 351,357 Shareholders' Equity 46,309 40,491 34,408 ------- -------- ------ -------- --------- ------ --------- --------- ------ Total $495,919 1.50 $443,737 1.62 $385,765 2.21 ------- -------- ------ -------- --------- ------ --------- --------- ------ Net interest income / net interest spread $ 19,636 3.91% $ 17,500 3.90% $ 15,977 4.06% ------- -------- ------ -------- --------- ------ --------- --------- ------ Net interest margin 4.21% 4.20% 4.43% ------- -------- ------ -------- --------- ------ --------- --------- ------
Noninterest Income and Expenses Other income, excluding securities gains, increased $ 648,000, or 10.4% in 2004. $ 438,000 of the growth was in service charges on deposit accounts which included a $ 154,000 increase in bounce protection fees due to continued growth of the deposit base. In addition, there was a $ 90,000 increase in merchant account fees as growth in business accounts remains very good. Loan fees decreased from 2003 levels, due primarily to a decline in residential mortgage lending following the robust growth of 2003, which had been fueled by refinancing activity. Trust department income increased $400,000 over last year due to an increase in trust assets under management of $55,000,000. Brokerage income also increased by $123,000 over 2003 due in part growth from the investment management acquisition previously mentioned. Securities gains were down from the prior year and included a $38,000 permanent impairment of an equity investment that was recorded during the fourth quarter. Average daily assets increased by 11.8% during 2004 and generally contributed to the 13.1% increase in operating expenses. The growth of the Corporation required additional hiring throughout the year and loan growth contributed to an increase in incentive compensation, both increasing salary expense by $ 661,000 over 2003. Employee benefits followed suit, increasing $461,000 over 2003 due to the addition of employees and included a 20% increase in health care rates, which resulted in a 38% increase in 2004 health care costs. Occupancy and equipment increased $ 289,000 over the prior year due to improvements in technology and the opening of the Bank's thirteenth full service branch during May 2004 in Carlisle, Pennsylvania and the fourteenth full service branch in December 2004 in Chambersburg, Pennsylvania. The new Chambersburg branch will replace the in store Wal-Mart branch, which will close in March 2005, thus reducing lease expense. Professional fees expense included in other expenses, increased $ 72,000 over 2003 due in part to compliance with the Sarbanes-Oxley Act section 404. Despite the growth in noninterest expenses, the Corporation was able to generate an efficiency ratio for the year of 55.2% for 2004, following 54.6% for 2003 and 54.5% during 2002. The table that follows provides additional information regarding noninterest income and noninterest expense changes over the past three years: ANALYSES OF NONINTEREST INCOME AND EXPENSES Year Ended December 31, % Change (Dollars in thousands) 2004 2003 2002 2004-2003 2003-2002 Other Income Service charges on deposit accounts $ 3,066 $ 2,628 $ 2,257 16.7% 16.4% Loan service charges and fees 688 848 485 -18.9% 74.8% ATM fees 227 167 177 35.9% -5.6% Other service charges, commissions and 101 223 252 -54.7% -11.5% fees Trust department income 1,863 1,463 1,386 27.3% 5.6% Brokerage income 608 485 394 25.4% 23.1% Cash surrender value increases 298 335 327 -11.0% 2.4% Other operating income 30 84 61 -64.3% 37.7% --------- ---------- ---------- ------ ------- Subtotal before securities transactions 6,881 6,233 5,339 10.4% 16.7% Securities gains (losses) 88 199 21 -55.8% 847.6% --------- ---------- ---------- ------ ------- Total other income $ 6,969 $ 6,432 $ 5,360 8.3% 20.0% --------- ---------- ---------- ------ ------- Other Expenses Salaries 5,117 4,456 4,035 14.8% 10.4% Employee benefits 2,792 2,331 1,958 19.8% 19.1% Occupancy and equipment 2,398 2,109 1,800 13.7% 17.2% Data processing 582 535 493 8.8% 8.5% ATM expense 142 203 176 -30.0% 15.3% Telephone 259 230 265 12.6% -13.2% Printing and supplies 239 268 246 -10.8% 8.9% Postage 187 191 189 -2.1% 1.1% Directors fees 326 308 253 5.8% 21.7% Advertising 291 267 218 9.0% 22.5% Pennsylvania shares tax 306 287 245 6.6% 17.1% Contributions 163 194 251 -16.0% -22.7% Other operating expenses 1,916 1,631 1,559 17.5% 4.6% --------- ---------- ---------- ------ ------- Total operating expenses $ 14,718 $ 13,010 $ 11,688 13.1% 11.3% --------- ---------- ---------- ------ ------- noninterest income as a % of noninterest expense 47.4% 49.4% 45.9%
Federal Income Taxes The Corporation's effective federal income tax rate for the year ended December 31, 2004 was 29.0% as compared to 27.7% in 2003 and 27.3% in 2002. Corporate income tax rates for 2005 are forecast to be similar but slightly above 2004 levels due to maturing tax free debt securities. The Corporation is firmly entrenched in the 34% bracket so all taxable income will be taxed at 34% in 2005. Asset Quality The quality of the Corporation's asset structure continues to be strong. A substantial amount of time is devoted by management to overseeing the investment of funds in loans and securities and the formulation of policies directed toward the profitability and minimization of risk associated with the investments. Credit Risk Analysis The Bank follows generally conservative lending practices and continues to carry a high quality loan portfolio with no unusual or undue concentrations of credit. No loans are extended to non domestic borrowers or governments, consistent with past practice and policy. Net charge-offs historically have been quite low, when compared to industry standards, and represented only .01% of average outstanding loans during 2004 and .02% of average 2003 loans. Nonperforming loans, as represented by nonaccrual and restructured items, were ..08% and .45% of outstanding loans at December 31, 2004 and 2003, respectively. Loans 90 days or more past due and still accruing represented .66% and .79% of outstanding loans at December 31, 2004 and 2003, respectively. Allowance for Loan Losses Historically, the Corporation has had an enviable record regarding its control of loan losses, but lending is a banking service that inherently contains elements of risk. The Bank policy related to the allowance for loan losses is considered to be a critical accounting policy because the allowance for loan losses represents a particularly sensitive accounting estimate. The amount of the allowance is based on management's evaluation of the collectibility of the loan portfolio, including the nature of the loan portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, and economic conditions. The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance for loan losses when management believes that the collectibility of the principal is unlikely. The allowance is an amount that management believes will be adequate to absorb possible losses on existing loans that may become uncollectible, based on evaluations of the collectibility of loans and prior loan loss experience. The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current economic conditions that may affect the borrowers' ability to pay. Through this review and evaluation process, an amount deemed adequate to meet current growth and future loss expectations is charged to operations. The provision for loan losses amounted to $ 210,000, $ 491,000, and $ 720,000 for 2004, 2003 and 2002, respectively. These provisions compared to net charge-offs of $ 53,000, $ 64,000 and $ 90,000 for 2004, 2003 and 2002, respectively. The provision for loan losses was decreased 57.2% during 2004 while loans increased 12.8%. This served to reduce the unallocated portion of the reserve, under internal evaluation procedures, to approximately 44%. The reserve at December 31, 2004 represented 1.11% of loans outstanding. Net charge-offs for 2004 represented only .01% of average loans outstanding. SUMMARY OF LOAN LOSS EXPERIENCE Year Ended December 31, (Dollars in thousands) 2004 2003 2002 2001 2000 Amount of loans outstanding at end of period $ 389,268 $ 345,054 $ 281,391 $ 249,816 $ 209,181 ---------- ---------- ---------- ---------- ---------- Daily average loans outstanding $ 369,409 $ 313,833 $ 264,296 $ 233,103 $ 192,902 ---------- ---------- ---------- ---------- ---------- Balance of allowance for possible loan losses at beginning of period $ 4,161 $ 3,734 $ 3,104 $ 2,691 $ 2,455 Loans charged off Commercial, financial and agricultural 21 4 0 0 90 Real estate 9 13 48 67 9 Consumer 55 64 53 31 30 ---------- ---------- ---------- ---------- ---------- Total loans charged off 85 81 101 98 129 ---------- ---------- ---------- ---------- ---------- Recoveries of loans previously charged off Commercial, financial and agricultural 0 0 0 0 1 Real estate 3 3 3 3 0 Consumer 29 14 8 4 4 ---------- ---------- ---------- ---------- ---------- Total recoveries 32 17 11 7 5 ---------- ---------- ---------- ---------- ---------- Net loans charged off (recovered) 53 64 90 91 124 Additions to allowance charged to expense 210 491 720 504 360 ---------- ---------- ---------- ---------- ---------- Balance at end of period $ 4,318 $ 4,161 $ 3,734 $ 3,104 $ 2,691 ---------- ---------- ---------- ---------- ---------- Ratio of net charge-offs to average loans outstanding 0.01% 0.02% 0.03% 0.04% 0.06% ---------- ---------- ---------- ---------- ---------- Ratio of reserve to gross loans outstanding at December 31 1.11% 1.21% 1.33% 1.24% 1.29% ---------- ---------- ---------- ---------- ----------
Risk Elements Nonperforming assets are comprised of nonaccrual and restructured loans and other real estate owned (OREO) not including bank premises. OREO represents property acquired through foreclosure or settlements of loans and is carried at the lower of the principal amount of the loan outstanding at the time acquired or the estimated fair value of the property. The excess, if any, of the principal balance at the time acquired over the carrying amount is charged against the reserve for loan losses. The Bank's loan loss history has been much better than peer standards and analysis of the current credit risk position is favorable. The allowance for loan losses is ample given the current composition of the loan portfolio and adequately covers the credit risk management sees under present economic conditions. Management is prepared to make any reserve adjustments that may become necessary as economic conditions change. NONPERFORMING ASSETS December 31, (Dollars in thousands) 2004 2003 2002 2001 2000 Loans on nonaccrual (cash) basis $ 314 $ 130 $ 85 $ 56 $ 12 Loans whose terms have been renegotiated to provide a reduction or deferral of interest or principal because of a deterioration in the financial position of the borrower 0 1,410 1,428 0 0 OREO 0 211 211 211 0 ----------- --------- --------- --------- ---------- Total nonperforming loans and OREO $ 314 $ 1,751 $ 1,724 $ 267 $ 12 ----------- --------- --------- --------- ---------- Ratio of nonperforming assets to total loans and OREO 0.08% 0.51% 0.61% 0.11% 0.01% ----------- --------- --------- --------- ---------- Ratio of nonperforming assets to total assets 0.06% 0.37% 0.42% 0.07% 0.00% ----------- --------- --------- --------- ---------- OTHER CREDIT RISK ELEMENTS: Loans past due 90 or more days and still accruing $ 2,550 $ 2,743 $ 1,446 $ 644 $ 814 ----------- --------- --------- --------- ---------- Ratio of other credit risk elements to total loans and OREO 0.66% 0.79% 0.51% 0.26% 0.39% ----------- --------- --------- --------- ---------- Ratio of other credit risk elements to total assets 0.50% 0.58% 0.35% 0.17% 0.26% ----------- --------- --------- --------- ---------- Total nonperforming and other risk assets $ 2,864 $ 4,494 $ 3,170 $ 911 $ 826 ----------- --------- --------- --------- ---------- Ratio of total risk assets to total loans and OREO 0.74% 1.30% 1.13% 0.36% 0.39% ----------- --------- --------- --------- ---------- Ratio of total risk assets to total assets 0.56% 0.95% 0.77% 0.24% 0.26% ----------- --------- --------- --------- ----------
Critical Accounting Estimates The Bank policy related to the allowance for loan losses is considered to be a critical accounting policy because the allowance for loan losses represents a particularly sensitive accounting estimate. The amount of the allowance is based on management's evaluation of the collectibility of the loan portfolio, including the nature of the loan portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, and economic conditions. The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance for loan losses when management believes that the collectibility of the principal is unlikely. The allowance is an amount that management believes will be adequate to absorb possible losses on existing loans that may become uncollectible, based on evaluations of the collectibility of loans and prior loan loss experience. The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, grouping of like loans, grading of individual loan quality, review of specific problem loans, the examination of underlying collateral and current economic conditions that may affect the borrowers' ability to pay. Liquidity, Rate Sensitivity and Interest Rate Risk Analysis The primary function of asset/liability management is to assure adequate liquidity and rate sensitivity. Liquidity management involves the ability to meet the cash flow requirements of customers who may be either depositors wanting to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. Interest rate sensitivity management requires the maintenance of an appropriate balance between interest sensitive assets and liabilities. Interest bearing assets and liabilities that are maturing or repricing should be adequately balanced to avoid fluctuating net interest margins and to enhance consistent growth of net interest income through periods of changing interest rates. The Corporation has consistently followed a strategy of pricing assets and liabilities according to prevailing market rates while largely matching maturities, within the guidelines of sound marketing and competitive practices. The goal is to maintain a predominantly matched position with very few planned mismatches. Rate spreads will be sacrificed at times in order to enable the overall rate sensitivity position to stay within the guidelines called for by asset/liability management policy. Rate sensitivity is measured by monthly gap analysis, quarterly rate shocks, and periodic simulation. Investment and pricing decisions are made using both liquidity and sensitivity analyses as tools. The schedule that follows reflects the degree to which the Corporation can adjust its various portfolios to meet interest rate changes. Additionally, the Bank is a Federal Home Loan Bank (FHLB) member, and standard credit arrangements available to FHLB members provide increased liquidity. RATE SENSITIVITY ANALYSIS AT DECEMBER 31, 2004 Interest Sensitivity Period After 3 After 6 Within 3 Within 6 Within 12 After (Dollars in thousands) Months Months Months 1 Year Total Rate Sensitive Assets (RSA) Loans 181,434 10,973 17,912 178,949 389,268 Investment securities 11,415 7,725 9,666 53,995 82,801 Other earning assets 9,517 0 0 0 9,517 -------- -------- -------- -------- -------- Total RSA 202,366 18,698 27,578 232,944 481,586 -------- -------- -------- -------- -------- Rate Sensitive Liabilities (RSL) Interest bearing deposits 83,080 8,016 21,531 225,952 338,579 Short term borrowed funds 19,493 0 0 0 19,493 Long term borrowed funds 0 1,350 0 34,219 35,569 -------- -------- -------- -------- -------- Total RSL 102,573 9,366 21,531 260,171 393,641 -------- -------- -------- -------- -------- Rate Sensitive GAP Period 99,793 9,332 6,047 (27,227) 87,945 Cumulative 99,793 109,125 115,172 87,945 GAP as a Percent of Total Assets Period 19.39% 1.81% 1.17% -5.29% Cumulative 19.39% 21.20% 22.38% 17.09% RSA/RSL cumulative 1.97 1.97 1.86 1.22
The asset biased, or positive, gap position indicates that earnings are naturally enhanced, or more easily maintained, in a rising rate environment. This indicates that the balance sheet is well positioned to react to anticipated rate increases during 2005 and positioned adequately to avoid material earnings damage if rates do not rise. Capital Adequacy and Regulatory Matters The Corporation maintains a strong capital base which provides adequate resources to absorb both normal and unusual risks inherent to the banking business. Internal capital generation has been supported by net income retained after the declaration of dividends, dividend reinvestment participation and through the exercise of ESOP shares. Total shareholders' equity rose $ 6,415,000 during 2004, or an increase of 15.0% over 2003. This followed growth of 12.8% and 21.8% during 2003 and 2002, respectively. Unrealized gain on securities decreased $308,000 from the year ended 2003 to 2004. The increasing earnings stream during this period has allowed the Corporation to steadily increase cash dividends paid to shareholders. In 2004 cash dividends rose $ 430,000, or 20.2% over 2003 levels while net income rose 11.3% during the period. This followed a 23.4% increase in dividend payout for 2003 versus 2002. Dividends per share have moved from $ 0.343 to $ 0.421 to $ 0.50 for 2002 through 2004, respectively. (Dollars in thousands) 2004 2003 2002 At December 31: Shareholders' equity $ 49,250 $ 42,835 $ 37,962 Equity / assets 9.57% 9.07% 9.25% For the Year: Average equity / average assets 9.34% 9.13% 8.92% Dividend payout 32.89% 30.45% 29.12% Return on average equity 16.78% 17.24% 17.19% Dividends paid $ 2,556 $ 2,126 $ 1,722 Regulatory Regulatory Capital Measures: Minimums Tier I capital ratio 12.2% 12.2% 12.7% 4.0% Total (Tier I and Tier II) capital 13.4% 13.4% 13.9% 8.0% ratio Leverage ratio 9.3% 8.9% 8.8% 4.0%
The maintenance of a strong capital base, above regulatory risk based minimums and industry averages, has been an integral part of the Corporation's operating philosophy. Management foresees no problem in maintaining capital ratios well in excess of regulatory requirements. The Corporation and its banking subsidiary are subject to periodic examinations by the Federal Reserve Bank and the Pennsylvania Department of Banking. During 2004, three examinations were conducted at the Bank level including, but not limited to, capital adequacy, asset quality, earnings, liquidity provisions, sensitivity to market risk, asset/liability management; evaluation of lending, investment and service; and adherence to civil rights laws, banking laws and regulations. An exam of risk assessment and management practices of the Holding Company was also completed in 2004. No comments were received from regulatory agencies which, if implemented, would have a material effect on Orrstown Financial Services, Inc.'s liquidity, capital resources, or operations. Future Impact of Recently Issued Accounting Standards In December 2003, the Accounting Standards Executive Committee ("AcSEC") of the American Institute of Certified Public Accountants issued Statement of Position ("SOP") 03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer." The SOP is effective for loans acquired in fiscal years beginning after December 15, 2004. The scope of the SOP applies to unhealthy "problem" loans that have been acquired, either individually in a portfolio, or in a business acquisition. The SOP addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality. The SOP does not apply to loans originated by the Company. The Company intends to adopt the provisions of SOP 03-3 effective January 1, 2005, and does not expect the initial implementation to have a significant effect on the Company's consolidated financial position or consolidated results of operations. On March 9, 2004, the SEC Staff issued Staff Accounting Bulletin No. 105, "Application of Accounting Principles to Loan Commitments" ("SAB 105"). SAB 105 clarifies existing accounting practices relating to the valuation of issued loan commitments, including interest rate lock commitments ("IRLC"), subject to SFAS No. 149 and Derivative Implementation Group Issue C13, "Scope Exceptions: When a Loan Commitment is included in the Scope of Statement 133." Furthermore, SAB 105 disallows the inclusion of the values of a servicing component and other internally developed intangible assets in the initial and subsequent IRLC valuation. The provisions of SAB 105 were effective for loan commitments entered into after March 31, 2004. The Company has adopted the provisions of SAB 105. Since the provisions of SAB 105 affect only the timing of the recognition of mortgage banking income, management does not anticipate that this guidance will have a material adverse effect on either the Company's consolidated financial position or consolidated results of operations. Emerging Issues Task Force Issue No. (EITF) 03-1 "The Meaning of Other-Than- Temporary Impairment and Its Application to Certain Investments" was issued and is effective March 31, 2004. The EITF 03-1 provides guidance for determining the meaning of "other -than-temporarily impaired" and its application to certain debt and equity securities within the scope of Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS No. 115") and investments accounted for under the cost method. The guidance requires that investments which have declined in value due to credit concerns or solely due to changes in interest rates must be recorded as other-than-temporarily impaired unless the Company can assert and demonstrate its intention to hold the security for a period of time sufficient to allow for a recovery of fair value up to or beyond the cost of the investment which might mean maturity. This issue also requires disclosures assessing the ability and intent to hold investments in instances in which an investor determines that an investment with a fair value less than cost is not other-than-temporarily impaired. On September 30, 2004, the Financial Accounting Standards Board decided to delay the effective date for the measurement and recognition guidance contained in Issue 03-1. This delay does not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature. The disclosure guidance in Issue 03-1 was not delayed. EITF No. 03-16, "Accounting for Investments in Limited Liability Companies was ratified by the Board and is effective for reporting periods beginning after June 15, 2004." APB Opinion No. 18, "The Equity Method of Accounting Investments in Common Stock," prescribes the accounting for investments in common stock of corporations that are not consolidated. AICPA Accounting Interpretation 2, "Investments in Partnerships Ventures," of Opinion 18, indicates that "many of the provisions of the Opinion would be appropriate in accounting" for partnerships. In EITF Abstracts, Topic No. D-46, "Accounting for Limited Partnership Investments," the SEC staff clarified its view that investments of more than 3 to 5 percent are considered to be more than minor and, therefore, should be accounted for using the equity method. Limited liability companies (LLCs) have characteristics of both corporations and partnerships, but are dissimilar from both in certain respects. Due to those similarities and differences, diversity in practice exists with respect to accounting for non-controlling investments in LLCs. The consensus reached was that an LLC should be viewed as similar to a corporation or similar to a partnership for purposes of determining whether a non-controlling investment should be accounted for using the cost method or the equity method of accounting. In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment." This Statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity's equity instruments or that may be settled by the issuance of those equity instruments. The Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. The Statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award - the requisite service period (usually the vesting period). The entity will initially measure the cost of employee services received in exchange for an award of liability instruments based on its current fair value; the fair value of that award will be re-measured subsequently at each reporting date through the settlement date. Changes in fair value during the requisite service period will be recognized as compensation cost over that period. The grant-date fair value of employee share options and similar instruments will be estimated using option-pricing models adjusted for the unique characteristics of those instruments (unless observable market prices for the same or similar instruments are available). If an equity award is modified after the grant date, incremental compensation cost will be recognized in an amount equal to the excess of the fair value of the modified award over the fair value of the original award immediately before the modification. This Statement is effective for public entities that do not file as small business issuers-as of the beginning of the first interim or annual reporting period that begins after June 15, 2005. For public companies that file as small business issuers - as of the beginning of the first interim or annual reporting period that begins after December 15, 2005. Under the transition method, compensation cost is recognized on or after the required effective date for the portion of outstanding awards for which the requisite service has not yet been rendered, based on the grant- date fair value of those awards calculated under Statement 123 for either recognition or pro forma disclosures. For periods before the required effective date, entities may elect to apply a modified version of retrospective application under which financial statements for prior periods are adjusted on a basis consistent with the pro forma disclosures required for those periods by Statement 123. Important Factors Relating to Forward Looking Statements This Report contains statements that are considered "forward-looking statements" as defined in the Private Securities Litigation Reform Act of 1995. In addition, the Corporation may make other written and oral communications from time to time that contain such statements. Forward-looking statements, including statements as to industry trends, future expectations and other matters that do not relate strictly to historical facts, are based on certain assumptions by management, and are often identified by words or phrases such as "anticipated", "believe", "expect", "intend", "seek", "plan", "objective", "trend", and "goal". Forward-looking statements are subject to various assumptions, risks, and uncertainties, which change over time, and speak only as of the date they are made. The Corporation undertakes no obligation to update any forward-looking statements. Actual results could differ materially from those anticipated in forward-looking statements and future results could differ materially from historical performance. In addition to factors mentioned elsewhere in this Report or previously disclosed in our SEC reports (accessible on the SEC's website at www.sec.gov or on our website at www.orrstown.com), the following factors, among others, could cause actual results to differ materially from forward-looking statements and future results could differ materially from historical performance: - - general political and economic conditions may be less favorable than expected; - - developments concerning credit quality in various corporate lending industry sectors as well as consumer and other types of credit, may result in an increase in the level of our provision for credit losses, nonperforming assets, net charge-offs and reserve for credit losses; - - customer borrowing, repayment, investment, and deposit practices generally may be less favorable than anticipated; and interest rate and currency fluctuations, equity and bond market fluctuations, and inflation may be grater than expected; - - the mix of interest rates and maturities of our interest earning assets and interest bearing liabilities (primarily loans and deposits) may be less favorable than expected; - - competitive product and pricing pressures among financial institutions within our markets may increase; - - legislative or regulatory developments, including changes in laws or regulations concerning taxes, banking, securities, capital requirements and risk-based capital guidelines, reserve methodologies, deposit insurance and other aspects of the financial services industry, may adversely affect the businesses in which we are engaged or our financial results; - - legal and regulatory proceedings and related matters with respect to the financial services industry, including those directly involving the Corporation and its subsidiaries, could adversely affect the Corporation or the financial services industry generally; - - pending and proposed changes in accounting rules, policies, practices, and procedures could adversely affect our financial results; - - instruments and strategies used to manage exposure to various types of market and credit risk could be less effective than anticipated, and we may not be able to effectively mitigate our risk exposures in particular market environments or against particular types of risk; - - terrorist activities or other hostilities, including the situation surrounding Iraq, may adversely affect the general economy, financial and capital markets, specific industries, and the Corporation; and " technological changes, including the impact of the Internet on our businesses, may be more difficult or expensive than anticipated. SUMMARY OF QUARTERLY FINANCIAL DATA The unaudited quarterly results of operations for the years ended December 31, are as follows: 2004 2003 Quarter Ended Quarter Ended (Dollars in thousands) March June September December March June September December Interest income $ 6,127 $ 6,282 $ 6,606 $ 6,877 $ 5,700 $ 5,884 $ 5,843 $ 6,057 Interest expense 1,661 1,683 1,802 1,840 1,702 1,716 1,667 1,672 Net interest income 4,466 4,599 4,804 5,037 3,998 4,168 4,176 4,385 Provision for loan 150 30 30 0 252 24 24 191 losses Net interest income after provision for loan 4,316 4,569 4,774 5,037 3,746 4,144 4,152 4,194 losses Securities gains (losses) 67 48 0 (27) 178 (7) 23 5 Other income 1,550 1,696 1,818 1,817 1,395 1,591 1,679 1,568 Other expense 3,397 3,696 3,770 3,855 3,119 3,218 3,228 3,445 Income before income 2,536 2,617 2,822 2,972 2,200 2,510 2,626 2,322 taxes Applicable income taxes 730 726 856 865 656 693 891 438 Net income $ 1,806 $ 1,891 $ 1,966 $ 2,107 $ 1,544 $ 1,817 $ 1,735 $ 1,884 Per Common Share Data Net income $ $ 0.37 $ 0.39 $ 0.41 $ 0.31 $ 0.36 $ 0.34 $ 0.37 0.35 Diluted net income $ $ 0.36 $ 0.37 $ 0.40 $ 0.30 $ 0.35 $ 0.33 $ 0.36 0.34 Dividends 0.12 0.12 0.13 0.13 0.0955 0.105 0.105 0.115 Performance Statistics Return on average assets 1.54% 1.55% 1.53% 1.64% 1.52% 1.67% 1.50% 1.60% Return on average equity 16.47% 16.62% 16.77% 17.22% 16.15% 18.38% 16.70% 17.68% Average equity / avg. 9.37% 9.33% 9.12% 9.53% 9.41% 9.08% 8.96% 9.07% assets
All per share amounts have been adjusted to give retroactive recognition to a 5% stock dividend effective May 30, 2003 and a 2-for-1 stock split paid February 10, 2004. SELECTED FIVE -YEAR FINANCIAL DATA ORRSTOWN FINANCIAL SERVICES, INC. AND ITS WHOLLY-OWNED SUBSIDIARIES Year Ended December 31, (Dollars in thousands) 2004 2003 2002 2001 2000 Summary of Operations Interest income $ 25,892 $ 23,484 $ 23,173 $ 23,978 $ 21,758 Interest expense 6,986 6,757 7,985 10,677 10,318 -------- -------- -------- -------- -------- Net interest income 18,906 16,727 15,188 13,301 11,440 Provision for loan losses 210 491 720 504 360 -------- -------- -------- -------- -------- Net interest income after provision for loan losses 18,696 16,236 14,468 12,797 11,080 Securities gains (losses) 88 199 21 11 114 Other operating income 6,881 6,233 5,339 4,469 3,628 Other operating expenses 14,718 13,010 11,688 10,247 9,113 -------- -------- -------- -------- -------- Income before income taxes 10,947 9,658 8,140 7,030 5,709 Applicable income tax 3,177 2,678 2,225 1,938 1,537 -------- -------- -------- -------- -------- Net income $ 7,770 $ 6,980 $ 5,915 $ 5,092 $ 4,172 -------- -------- -------- -------- -------- Per Common Share Data* Income before taxes $ 2.14 $ 1.91 $ 1.62 $ 1.41 $ 1.16 Applicable income taxes 0.62 0.53 0.44 0.39 0.31 Net income 1.52 1.38 1.18 1.02 0.85 Diluted net income 1.47 1.34 1.15 1.01 0.84 Cash dividend paid 0.500 0.421 0.343 0.284 0.259 Book value at December 31 9.61 8.44 7.54 6.24 5.40 Average shares outstanding - basic 5,106,683 5,054,370 5,020,288 4,970,084 4,915,753 Average shares outstanding - diluted 5,294,165 5,215,538 5,133,363 5,036,082 4,939,464 Stock Price Statistics* Close $ 45.00 $ 33.50 $ 22.38 $ 18.57 $ 18.14 High 50.00 34.00 23.81 21.32 19.95 Low 32.50 22.38 18.36 16.67 16.89 Price earnings ratio at close 29.6 24.3 19.0 18.1 21.4 Price to book at close 4.7 4.0 3.0 3.0 3.4 Year-End Balance Sheet Data Total assets $ 514,651 $ 472,393 $ 410,298 $ 373,728 $ 311,903 Total loans 389,268 345,054 281,391 249,816 209,181 Total investment securities 82,801 92,374 70,125 72,053 91,986 Deposits - noninterest bearing 66,784 42,704 39,881 31,716 52,276 Deposits - interest bearing 338,579 306,367 276,464 241,287 210,292 Total deposits 405,363 358,643 319,168 281,168 242,008 Liabilities for borrowed money 55,062 49,347 58,043 40,228 66,633 Total shareholders' equity 49,250 37,962 31,162 26,674 42,835 Trust assets under management - market value 349,000 294,000 231,000 221,000 206,000 Performance Statistics Average equity / average assets 9.34% 9.13% 8.92% 8.70% 8.38% Return on average equity 16.78% 17.24% 17.19% 17.20% 17.42% Return on average assets 1.57% 1.57% 1.53% 1.50% 1.46%
* Per share amounts have been restated to reflect: The 2-for-1 stock split paid February 10, 2004 The 5% stock dividend paid May 30, 2003 The 5% stock dividend paid September 15, 2001 Market, Dividend & Investor Information Market and Dividend Information The common stock of Orrstown Financial Services, Inc. is traded in the over-the- counter market under the symbol ORRF. At the close of business December 31, 2004, there were approximately 2,555 shareholders of record, with a total of 5,126,205 shares outstanding. The table below sets forth the range of high and low quarterly sales prices and dividends declared per common share. 2004 2003 Market Price Market Price Quarterly Quarterly High Low Dividend High Low Dividend First quarter $50.00 $32.50 $0.12 $24.29 $22.38 $0.0955 Second quarter $44.00 $40.00 $0.12 $29.00 $23.10 $0.1050 Third quarter $47.00 $40.30 $0.13 $33.75 $30.00 $0.1050 Fourth quarter $45.25 $42.00 $0.13 $34.00 $31.88 $0.1150 $0.50 $0.4205
Investor Information Annual Meeting The annual meeting of Orrstown Financial Services, Inc. stockholders is scheduled for May 3, 2005 at 9:00 a.m. at Shippensburg University Conference Center, 500 Newburg Road, Shippensburg, PA 17257. All stockholders are cordially invited to attend. Annual and Quarterly Reports Copies of the annual and quarterly reports may be obtained at any office of Orrstown Bank, or by writing to Registrar and Transfer Company or by contacting Charlene Feuchtenberger, Orrstown Bank, P.O. Box 250, Shippensburg, PA 17257. Form 10-K A copy of the corporation's Form 10-K, as filed with the Securities and Exchange Commission, may be obtained by writing to Orrstown Bank, P.O. Box 250, Shippensburg, PA 17257. Transfer Agent The transfer agent for Orrstown Financial Services, Inc. is Registrar and Transfer Company, 10 Commerce Drive, Cranford, New Jersey 07016-3572. E-mail: info@rtco.com. Internet address: www.rtco.com. Phone (800) 368-5948. Market Makers Arthurs Lestrange & Co., Inc. Ryan, Beck & Co., Inc. Boenning & Scattergood, Inc. 1405 McFarland Road 220 South Orange Avenue Four Tower Bridge Pittsburgh, PA 15216 Livingston, NJ 07039 200 Barr Harbor Drive, Suite 300 (877) 282-1941 (800) 342-2325 West Conshohocken, PA 19428 (800) 883-1212 Ferris, Baker Watts, Inc. Janney Montgomery Scott, LLC 100 Light Street 1801 Market Street Baltimore, MD 21202 10th Floor (800) 436-2000 Philadelphia, PA 19103 (800) 526-6397
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