ITEM 1. BUSINESS
Citizens & Northern Corporation ("Corporation") is a one-bank holding company whose principal subsidiary is Citizens & Northern Bank ("Bank"). The Corporation's principal office is located in Wellsboro, Pennsylvania. The Corporation's other wholly-owned subsidiaries are Citizens & Northern Investment Corporation and Bucktail Life Insurance Company ("Bucktail"). Citizens & Northern Investment Corporation was formed in 1999 to engage in investment activities. Bucktail reinsures credit and mortgage life and accident and health insurance on behalf of the Bank. The operations of Citizens & Northern Investment Corporation and Bucktail are insignificant in relation to the total business of the Corporation.
The Bank is a Pennsylvania banking institution that was formed by the consolidation of Northern National Bank of Wellsboro and Citizens National Bank of Towanda on October 1, 1971. Subsequent mergers included: First National Bank of Ralston in May 1972; Sullivan County National Bank in October 1977; Farmers National Bank of Athens in January 1984; and First National Bank of East Smithfield in May 1990. The Bank has held its current name since May 6, 1975, at which time the Bank changed its charter from a National bank to a Pennsylvania bank.
The Bank provides an extensive range of banking services, including deposit and loan products for personal and commercial customers. The Bank also maintains a trust division that provides a wide range of financial services, such as 401(k) Plans, retirement planning, estate planning, estate settlements and asset management. In January 2000, the Bank formed a subsidiary, C&N Financial Services Corporation ("C&NFSC"). C&NFSC is a licensed insurance agency that provides insurance products to individuals and businesses. In 2001, C&NFSC added a broker-dealer division, which offers mutual funds, annuities, educational savings accounts and other investment products through registered agents. C&NFSC's operations are not significant in relation to the total operations of the Bank.
All phases of the Bank's business are competitive. The Bank primarily competes in Tioga, Bradford and Sullivan counties and portions of Lycoming County. The Bank competes with local commercial banks headquartered in our market area as well as other commercial banks with branches in our market area. Some of the banks that have branches in the Bank's market area are larger in overall size than the Bank. With respect to lending activities and attracting deposits, the Bank also competes with savings banks, savings and loan associations, insurance companies, regulated small loan companies and credit unions. Also, the Bank competes with mutual funds for deposits. The Bank competes with insurance companies, investment counseling firms, mutual funds and other business firms and individuals for trust, investment management, broker dealer and insurance services. The Bank is generally competitive with all 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. The Bank serves a diverse customer base, and is not economically dependent on any small group of customers or on any individual industry.
Although there have been no mergers or acquisitions within the last 5 years, the Bank has engaged in several ventures designed to improve customer service and generate financial growth. These ventures included the following major initiatives:
- - expanded trust and financial services capabilities, including investment management, employee benefits and insurance services;
- - installed 18 automated teller machines, beginning in 1997;
- - created the "customer repurchase agreement" cash management service for commercial customers in 1998;
- - established internet banking services in 1999; and
- - constructed and opened new branches in Mansfield, PA (1998) and Muncy, PA (2000).
At December 31, 2002, the Bank had total assets of $996,644,000, total deposits of $641,164,000 and net loans outstanding of $445,356,000. At December 31, 2002, the Bank had a total of 265 full-time equivalent employees.
Most of the activities of the Corporation and its subsidiaries are regulated by federal or state agencies. The primary regulatory relationships are described as follows:
- - The Corporation is a one-bank holding company formed under the provisions of Section 3 of the Federal Reserve Act. The Corporation is under the direct supervision of the Federal Reserve and must comply with the reporting requirements of the Federal Bank Holding Company Act.
- - The Bank is a state-chartered, nonmember bank, supervised by the Pennsylvania Department of Banking and the Federal Deposit Insurance Corporation.
- - C&NFSC is a Pennsylvania corporation. The Pennsylvania Department of Insurance regulates C&NFSC's insurance activities. Through October 31, 2002, the broker dealer division offered brokerage products as an office of supervisory jurisdiction of Hackett Associates, Inc. Effective November 1, 2002, brokerage products are offered through a third party networking agreement between the Bank and UVEST Financial Services, Inc.
- - Bucktail is incorporated in the state of Arizona and supervised by the Arizona Department of Insurance.
ITEM 2.
ITEM 2. PROPERTIES
The Bank owns each of its properties, except for the facility located at 68 Main Street, Wellsboro, which is leased. All of the properties are in good condition. In 2001, the Bank entered into a lease of the property at 68 Main Street, Wellsboro. This facility is used for C&NFSC's operations and for training. None of the owned properties are subject to encumbrance.
A listing of properties is as follows:
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Corporation and the Bank are involved in various legal proceedings incidental to their business. Management believes the aggregate liability, if any, resulting from such pending and threatened legal proceedings will not have a material, adverse effect on the Corporation's financial condition or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of 2002, no matters were submitted to a vote of security holders, through the solicitation of proxies or otherwise.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
QUARTERLY SHARE DATA
Trades of the Corporation's stock are executed through various brokers who maintain a market in the Corporation's stock. Information regarding sales prices of the Corporation's stock is available through the OTC Bulletin Board (www.otcbb.com). The Corporation's stock is not listed or traded on Nasdaq or a national securities exchange. As of December 31, 2002, there were 2,406 shareholders of record of the Corporation's common stock.
The following table sets forth the approximate high and low sales prices of the common stock during 2002 and 2001:
Known "market makers" who handle Citizens & Northern Corporation stock transactions are:
INVESTOR INFORMATION
GENERAL SHAREHOLDER INQUIRIES SHOULD BE SENT TO:
CITIZENS & NORTHERN CORPORATION 90-92 Main Street, P.O. Box 58 Wellsboro, PA 16901
COMMON STOCK AND PER SHARE DATA
(a) For purposes of this computation, the number of outstanding shares has been increased for the effects of 1% stock dividends issued in January following each year-end.
EQUITY COMPENSATION PLAN INFORMATION
The following table sets forth information concerning the Stock Incentive Plan and Independent Directors Stock Incentive Plan, both of which have been approved by the Corporation's shareholders. The shareholders have approved all of the Corporation's equity compensation plans. The figures shown are as of December 31, 2002, and do not include awards made in January 2003. More details related to the Corporation's equity compensation plans are provided in Notes 1 and 12 to the consolidated financial statements.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA (IN THOUSANDS)
(1) Includes available-for-sale and held-to-maturity securities, and interest-bearing cash and due from banks (2) Financial ratios calculated based on average balance sheet data
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Certain statements in this section and elsewhere in this Annual Report on Form 10-K are forward-looking statements. Citizens & Northern Corporation and its wholly-owned subsidiaries (collectively, the Corporation) intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995. Forward-looking statements, which are not historical facts, are based on certain assumptions and describe future plans, business objectives and expectations, and are generally identifiable by the use of words such as, "believe", "expect", "intend", "anticipate", "estimate", "project", and similar expressions. These forward-looking statements are subject to risks and uncertainties that are difficult to predict, may be beyond management's control and could cause results to differ materially from those currently anticipated. Factors which could have a material, adverse impact on the operations and future prospects of the Corporation include, but are not limited to, the following:
- - changes in monetary and fiscal policies of the Federal Reserve Board and the U.S. Government, particularly related to changes in interest rates - - changes in general economic conditions - - legislative or regulatory changes - - downturn in demand for loan, deposit and other financial services in the Corporation's market area - - increased competition from other banks and non-bank providers of financial services - - technological changes and increased technology-related costs - - changes in accounting principles, or the application of generally accepted accounting principles (see "Critical Accounting Policies," later in Management's Discussion and Analysis).
These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.
EARNINGS OVERVIEW
The Corporation has enjoyed 2 consecutive years with record-high levels of net income in 2002 and 2001. In 2002, net income was $14,959,000, or $2.80 per share - - basic and $2.79 per share - diluted. This represents a 24.1% increase over 2001 net income of $12,052,000 ($2.25 per share - basic and diluted). Net income for 2001 was 42.2% higher than in 2000. In 2000, net income amounted to $8,476,000 ($1.58 per share - basic and diluted).
The most significant income statement changes between 2002 and 2001, and between 2001 and 2000, are as follows:
- The interest margin (excess of interest income over interest expense) increased significantly in both 2002 and 2001. The interest margin increased to $30,970,000 in 2002 from $26,305,000 in 2001, an increase of $4,665,000 or 17.7%. Further, the interest margin in 2001 was $4,807,000, or 22.4%, higher in 2001 than in 2000. As discussed in more detail in the "Net Interest Margin" section of Management's Discussion and Analysis, growth in the net interest margin over the last 2 years has resulted from increases in volume of earning assets, and from falling interest rates paid on deposits and borrowed funds. For a variety of reasons, including market conditions, the opening of the Muncy, PA, branch in October 2000, and the hiring of additional commercial lending staff, the Corporation has achieved significant growth in loans and deposits in 2002 and 2001. Also, management has identified opportunities to borrow funds and invest the proceeds in securities at positive spreads. Changes in interest rates have also had a dramatic impact on operating results over the last 3 years. As widely publicized, the Federal Reserve Board lowered its targeted federal funds rate 11 times during 2001, from 6.5% to 1.75%. The federal funds target rate remained at 1.75% throughout most of 2002, until the Fed lowered it to its current level of 1.25% in November 2002. The ripple effects of the Fed's actions throughout the national and local economy have substantially lowered the Corporation's cost of funds. In contrast, in 2000, the Fed increased its target rate several times, which resulted in increases in the Corporation's cost of funds.
- Other (noninterest) income (excluding securities gains) was $6,624,000 in 2002, an increase of $504,000 (8.2%) over 2001. As described in more detail later in Management's Discussion and Analysis, the major sources of increased noninterest revenue in 2002 were from Service Charges on Deposit Accounts and Trust and Financial Management services. Noninterest income increased $1,118,000, or 22.4%, in 2001 over 2000. The major source of this revenue growth in 2001 was from recognition of an increase in cash surrender value of insurance of $905,000. In late December 2000, the Corporation purchased bank-owned life insurance (BOLI) at a cost of $15,000,000. The Corporation purchased BOLI to help fund future anticipated increases in employee benefits. Prior to December 2000, the Corporation had no BOLI holdings.
- Net realized securities gains amounted to $2,888,000 in 2002, $1,920,000 in 2001 and $1,377,000 in 2000. Most of the gains realized throughout the 3-year period ended December 31, 2002, were from sales of bank stocks. The amounts of such gains realized in any accounting period depend on management's evaluation of the specific stocks owned by the Corporation.
- Other (noninterest) operating expenses increased $2,178,000, or 11.7%, in 2002 over 2001, and 10.4% in 2001 over 2000. Higher operating expenses reflect increases in payroll costs, professional fees, depreciation and maintenance expense associated with computer hardware and software. These types of costs have increased as a result of the need to add personnel and supplement existing systems to keep up with expansions of services and growth in lending activity over the last few years. Also, in 2001, the Corporation's operating expenses increased due to the opening of the Muncy branch. Noninterest expenses are discussed in more detail later in Management's Discussion and Analysis.
- The income tax provision increased to $3,734,000 in 2002 from $3,022,000 in 2001 and $1,819,000 in 2000, primarily because pre-tax income was higher. The income tax provision, as a percentage of pre-tax income, was 19.98% in 2002, 20.05% in 2001 and 17.67% in 2000. More details related to the Corporation's income taxes are provided in Note 13 to the Consolidated Financial Statements (included in Item 8 of this Form 10-K).
OUTLOOK FOR 2003
Looking into the future, management anticipates another year of good financial performance in 2003. However, management believes it will be difficult to continue the pace of earnings growth achieved in 2001 and 2002. With interest rates at historic lows, there is not much farther for them to fall. Most economists are predicting a rising interest rate environment as the U. S. economy recovers from the brief recession and when the uncertainty of war with Iraq is resolved. The Corporation's interest margin will be affected as higher yielding loans mature or are refinanced and as higher yielding investments mature or are called. The Corporation began seeing some reduction in the margin in the last quarter of 2002. If interest rates do begin to rise, the Corporation will experience some additional stress on the interest margin because its interest-bearing liabilities (deposits and borrowings) reprice faster than its earning assets (primarily, loans and investment securities). Management continues to look for opportunities to increase noninterest revenues, in an effort to reduce the Corporation's reliance upon interest rates. The Corporation's interest rate risk is discussed in more detail in Section 7A of this Annual Report on Form 10-K.
CRITICAL ACCOUNTING POLICIES
The presentation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect many of the reported amounts and disclosures. Actual results could differ from these estimates.
A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses. Management believes that the allowance for loan losses is adequate and reasonable. The Corporation's methodology for determining the allowance for loan losses is described in a separate section later in Management's Discussion and Analysis. Given the very subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make materially different assumptions, and could, therefore calculate a materially different allowance value. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation's allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination. Further, in 2003, the American Institute of Certified Public Accountants is expected to issue an exposure draft of a statement of position that would establish detailed implementation guidance for calculating the allowance for loan losses. This statement of position is expected to call for implementation of its provisions beginning in 2004. Implementation of that detailed implementation guidance, if it is approved, could result in an adjustment to the Corporation's allowance.
Another material estimate is the calculation of fair values of the Corporation's debt securities. The Corporation receives estimated fair values of debt securities from an independent valuation service, or from brokers. In developing these fair values, the valuation service and the brokers use estimates of cash flows, based on historical performance of similar instruments in similar interest rate environments. Based on experience, management is aware that estimated fair values of debt securities tend to vary among brokers and other valuation services. Accordingly, when selling debt securities, management typically obtains price quotes from more than one source. As described in Notes 1 and 11 of the consolidated financial statements, the large majority of the Corporation's securities are classified as available-for-sale. Accordingly, these securities are carried at fair value on the consolidated balance sheet, with unrealized gains and losses excluded from earnings and reported separately through accumulated other comprehensive income (included in stockholders' equity).
NET INTEREST MARGIN 2003/2002/2001
The Corporation's primary source of operating income is represented by the net interest margin. The net interest margin is equal to the difference between the amounts of interest income and interest expense. Tables I, II and III include information regarding the Corporation's net interest margin in 2002, 2001 and 2000. In each of these tables, the amounts of interest income earned on tax-exempt securities and loans have been adjusted to a fully taxable-equivalent basis. Accordingly, the net interest margin amounts presented in these tables exceed the amounts presented in the consolidated financial statements. Also, dividends from the Corporation's investment in the Federal Home Loan Bank of Pittsburgh (FHLB - Pittsburgh), which were included in interest and dividend income in prior years, have been excluded from the amounts included in the Tables for 2002, 2001 and 2000 in this year's Annual Report on Form 10-K. Dividends from FHLB - Pittsburgh stock are now included in Other (Noninterest) Income in the consolidated statement of income. The discussion that follows is based on amounts in the Tables.
The net interest margin (also referred to as net interest income), on a taxable-equivalent basis, was $33,963,000 in 2002, an increase of $5,413,000 or 19.0% over 2001. In turn, fully taxable-equivalent net interest income was $5,038,000, or 21.4% higher in 2001 than in 2000. As described in the "Earnings Overview" section of Management's Discussion and Analysis, these increases in net interest margin were caused mainly by increases in volume of earning assets, and from declining interest rates on the Corporation's deposits and borrowed funds. Table III shows the effect of volume and rate changes on the Corporation's major interest earning assets and interest-bearing liabilities. Table III shows that changes in volume of earning assets and interest-bearing liabilities resulted in an increase in net interest income of $4,264,000 in 2002, while changes in rates increased net interest income $1,149,000. In 2001, when (as discussed in the "Earnings Overview" section) short-term interest rates fell dramatically, rate changes had the effect of increasing net interest income $4,472,000, and volume changes increased net interest income $566,000. Table II, which shows average daily balances and rates, shows that the "Interest Rate Spread" (excess of average rate of return on interest-earning assets over average cost of funds on interest-bearing liabilities) widened substantially in 2001 over 2000, and widened a bit more in 2002 over 2001. The Interest Rate Spread was 3.38% in 2002, 3.17% in 2001 and 2.53% in 2000.
INTEREST INCOME AND EARNING ASSETS
The Corporation's major categories of interest-bearing assets are available-for-sale investment securities and loans. Total interest income increased $3,372,000, or 5.9%, in 2002 over 2001. Interest and dividends from available-for-sale securities increased $1,758,000, or 6.5%, and interest and fees from loans increased $1,864,000, or 6.3%. In Table III, the growth in interest income is broken down between the impact of volume changes and the impact of interest rate changes. Higher average balances of available-for-sale securities and loans in 2002 than in 2001 resulted in increases in interest income in 2001, despite lower average rates of return.
Similarly, total interest income increased $3,249,000, or 6.1%, in 2001 over 2000, with the effects of increased average volume of earning assets more than offsetting the impact of lower average rates. Income from available-for-sale securities increased $1,544,000, or 6.1% in 2001 over 2000. Interest and fees from loans increased $1,644,000, or 5.9%, in 2001 over 2000.
As shown in Table II, the average balance of the available-for-sale investment portfolio (at amortized cost) was $465,650,000 in 2002, $395,908,000 in 2001 and $359,265,000 in 2000. The major components of the portfolio are mortgage-backed securities, obligations of state and political subdivisions (municipal bonds), and U. S. Government Agency securities. Also, the Corporation holds other corporate debt securities and equity securities (primarily stocks of banks and bank holding companies). In total, available-for-sale securities grew because management was able to identify opportunities to borrow funds and invest the proceeds in securities at a positive spread. These opportunities were available because of the "steep yield curve" (longer-term interest rates much higher than shorter-term rates) that existed throughout most of 2002 and 2001. The average rate of return on available-for-sale securities was 6.16% for 2002, considerably lower than the 2001 (6.80%) and 2000 (6.92%). The average return on available-for-sale securities was 5.87% in the 4th quarter 2002.
Table II also shows that the composition of the available-for-sale securities portfolio has changed significantly. The average balance of U.S. Government agency securities fell to 16% of the average balance of the total portfolio in 2002 from 29% in 2001 and 37% in 2000. In contrast, the average balance of mortgage-backed securities increased to 45% of the total portfolio in 2002 from 38% in 2001 and 28% in 2000. In 2002 and in the latter part of 2001, as a result of declining interest rates, substantial amounts of U.S. Government agency securities were called. The Corporation reinvested much of the proceeds in mortgage-backed securities. Also, much of the leveraged security purchases described above consisted of mortgage-backed securities. The portfolio's increased weighting in mortgage-backed securities is designed to provide increased cash flow, in the form of monthly principal and interest payments. This increased level of cash inflows will be available to be reinvested at higher rates when interest rates rise.
Obligations of state and political subdivisions (municipal bonds) also were a larger portion of the portfolio in 2002 than in 2001 and 2000. The average balance of municipal bonds grew to $113,540,000, or 24% of the portfolio, in 2002 from 20% of the portfolio in 2001 and 23% of the portfolio in 2000. On a taxable equivalent basis, municipal bonds are the highest yielding category of available-for-sale security. The Corporation determines the levels of its municipal bond holdings based on income tax planning and other considerations.
Other securities consist of corporate obligations, mainly "Trust Preferred Securities" issued by financial institutions. Trust Preferred Securities are long-term obligations (usually 20-40 year maturities, often callable at the issuer's option after 5-10 years) which bear interest at fixed or variable rates. The average balance of other securities increased to $43,826,000 in 2002 from $29,577,000 in 2001 and $22,572,000, primarily as a result of purchases of Trust Preferred Securities.
The loan portfolio makes up most of the balance of the earning asset base and is the largest contributor to total interest income. The Corporation's market area consists of small rural communities. Consequently, the loan portfolio is retail-oriented, consisting mostly of real estate secured mortgages on one-to-four family dwellings. Total average real estate secured mortgage loans made up approximately 80% of the loan portfolio during 2002, 2001 and 2000. In 2002 and 2001, there has been significant growth in lending activities. Average loans outstanding increased $64,317,000, or 18.6%, in 2002, and $27,971,000, or 8.8%, in 2001. Much of the growth in the loan portfolio in 2002 and 2001 has been in real estate secured loans, including commercial as well as residential real estate loans. Lower market interest rates, which have spurred significant levels of refinancing, and have resulted in many individuals' and businesses' willingness to take on more debt, have contributed to the Corporation's loan growth. Also, the Corporation's loan growth is attributable to the opening of the Muncy office, along with the hiring of several additional lending personnel in 2002 and 2001. The balance of the loan portfolio includes consumer installment loans and commercial loans. The Corporation also has a credit card operation, which is operated for the Corporation's customers and for other banks.
The average return on the total loan portfolio for 2002 was 7.67%, down from 8.56% in 2001 and 8.79% in 2000. The lower return in 2002 was impacted by significant levels of mortgage refinancings, and by lower returns on commercial loans with variable rates. The average return on loans was 7.42% in the 4th quarter 2002.
INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES
Interest expense fell to $26,315,000 in 2002 from $28,356,000 in 2001 and $30,145,000 in 2000. As reflected in Table III, lower average interest rates had the effect of lowering expense $7,184,000 in 2002 and $5,994,000 in 2001. The impact of lower rates more than offset the effects on interest expense of higher average balances of interest-bearing liabilities. As shown in Table II. average balances of interest-bearing liabilities increased 18.1%, to $760,738,000 in 2002, and 13.8%, to $643,980,000 in 2001.
As reflected in Table III, lower rates caused interest expense from money market accounts to fall $1,392,000 in 2002, and $2,518,000 in 2001. Money market accounts are repriced weekly, and thus are highly rate sensitive. As shown in Table II, the average cost of money market funds was 2.31% in 2002, 3.49% in 2001 and 5.39% in 2000.
Table III also shows that interest expense from savings accounts declined in 2002 and 2001. Interest expense from savings accounts fell $508,000 in 2002 and $132,000 in 2001. In 2001, the Corporation's savings rate fell 2 times, from 2.5% to 2%, and then to its current level of 1%. As a result, the average interest rate incurred on savings accounts fell to 1.01% in 2002 from 2.16% in 2001 and 2.49% in 2000.
Interest expense from CDs decreased $1,532,000 in 2002 and increased $1,109,000 in 2001. Because CDs have terms that may range from 3 months to 5 years, they do not reprice as quickly as money market accounts or IRAs. The average rate incurred on CDs was 3.97% in 2002, 5.48% in 2001 and 5.64% in 2000.
In contrast to the other major types of deposits, interest expense from Individual Retirement Accounts (IRAs) increased $455,000 in 2002. As shown in Table II, in 2002, the average balance of IRAs increased 14.3%, to $90,856,000. Throughout 2002, the Corporation offered the highest IRA rate in its marketplace, which was instrumental in this growth. For several years, the Corporation's IRA product was adjustable rate, repriced quarterly based on an index, with a floor of 5%. Effective September 1, 2002, the Corporation made changes to its IRA products, including: (1) for new IRAs, reduced the floor to 4%, and removed the tie to an external index, on the quarterly repricing IRA product, and (2) began to offer the Index Powered CD as an additional IRA product. (Index Powered CDs are described in detail in Note 10 to the consolidated financial statements.) In 2001, interest expense from IRAs fell $756,000, as falling interest rates gradually caused the Corporation's IRA rate to fall to the floor of 5%. The average rate incurred on IRAs was 4.98% in 2002, 5.12% in 2001 and 6.32% in 2000.
As you can calculate from Table II, average total deposits (interest-bearing and noninterest-bearing) increased $68,813,000, or 12.6%, in 2002. In 2001, average total deposits increased $40,731,000, or 8.1%. In addition to IRAs, as described above, the other major types of deposits that increased in 2002 and 2001 were CDs, money market accounts and demand (checking) accounts. Management believes that deposit growth has resulted, in part, from declines in the U.S stock market, which has caused some investors to move funds to less volatile investments. Also, deposit growth has been enhanced by the expansion of the branch system in recent years, with relatively new offices opened in Mansfield (1998) and Muncy (2000).
Interest expense on borrowed funds is presented in Table I in 2 categories - "Overnight borrowings" and "Other borrowed funds." Overnight borrowings include federal funds purchased from other banks and overnight repurchase agreements with FHLB - Pittsburgh. Other borrowed funds include overnight repurchase agreements with customers (the Corporation's "RepoSweep" accounts), borrowings from FHLB - Pittsburgh and other repurchase agreements.
Interest expense on average other borrowed funds increased $1,278,000 in 2002 and $1,125,000 in 2001. Average other borrowed funds balances increased to $211,092,000 in 2002 from $151,615,000 in 2001 and $108,581,000 in 2000. As discussed in the "Interest Income - Earning Assets" section above, the Corporation borrowed funds in 2002 and 2001 to fund purchases of available-for-sale securities. Because of a favorable interest rate environment, the Corporation extended the terms of most of its borrowings from very short term (as of the end of 2000) to a "ladder" of staggered maturities extending out (primarily) over 5 years. Note 9 to the consolidated financial statements provides more details regarding the composition of borrowed funds as of December 31, 2002 and 2001. Average interest rates on other borrowed funds amounted to 4.29% in 2002, 5.13% in 2001 and 6.13% in 2000. Overall, Table III shows that lower rates had the effect of reducing interest expense associated with other borrowed funds in 2002 by $1,421,000, while higher average borrowing balances increased interest expense $2,699,000. In 2001, lower average rates decreased interest expense $1,208,000, while the increase in average borrowings increased interest expense by $2,333,000.
TABLE I - ANALYSIS OF INTEREST INCOME AND EXPENSE
(1) Interest income from tax-exempt securities and loans has been adjusted to a fully taxable-equivalent basis, using the Corporation's marginal federal income tax rate of 34%.
(2) Fees on loans are included with interest on loans and amounted to $1,286,000 in 2002, $1,054,000 in 2001 and $761,000 in 2000.
TABLE II - ANALYSIS OF AVERAGE DAILY BALANCES AND RATES
(1) Rates of return on tax-exempt securities and loans are calculated on a fully-taxable equivalent basis, using the Corporation's marginal federal income tax rate of 34%.
(2) Nonaccrual loans are included in the loan balances above.
TABLE III - THE EFFECT OF VOLUME AND RATE CHANGES ON INTEREST INCOME AND INTEREST EXPENSE
(1) Changes in interest income on tax-exempt securities and loans are presented on a fully taxable-equivalent basis, using the Corporation's marginal federal income tax rate of 34%.
(2) The change in interest due to both volume and rates has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.
NONINTEREST INCOME 2002/2001/2000
Total noninterest income increased $1,472,000, or 18.3%, in 2002 compared to 2001. The increase in net realized security gains is discussed in the "Earnings Overview" section of Management's Discussion and Analysis. Other items of significance are as follows:
2002 VS. 2001
- - Service charges on deposit accounts increased $349,000, or 25.4%. This increase resulted from growth in deposits, as well as fee increases implemented in the second half of 2001 on certain types of services.
- - Trust and financial management revenue increased $179,000, or 11.4%. This increase resulted from fee increases implemented in the latter part of 2001, and from receipt of certain fees for services provided prior to 2002. Trust revenue is recorded on a cash basis, which does not vary materially from the accrual basis.
2001 VS. 2000
Total noninterest income increased $1,661,000, or 26.0%, in 2001 compared to 2000. The most significant changes - the increase in security gains and income from the (BOLI) life insurance contract - are discussed in the "Earnings Overview" section of Management's Discussion and Analysis. Other items of significance are as follows:
- - Service charges on deposit accounts increased $226,000, or 19.7%. This increase resulted from increased numbers of accounts and higher average balances, as well as fee increases on certain types of services.
- - Insurance revenue increased $210,000, or 56.5%. This increase is mainly attributable to revenue from the insurance agency division of C&N Financial Services Corporation (C&NFSC). C&NFSC began operations in 2000, with minimal revenues. C&NFSC generated insurance revenue of $216,000 in 2001 and $22,000 in 2000.
- - Noninterest fees from the credit card operation decreased $347,000, or 38.7%. In late 1999, the Corporation sold its merchant processing program, which dramatically reduced the amount of interchange fees earned and costs incurred. In the first quarter 2000, the Corporation recorded final residual fees.
- - Other operating income increased $146,000. In 2001, C&NFSC began operating a broker dealer division, which offers annuities, mutual funds and other non-bank investment products. The broker dealer division generated revenue of $84,000 in 2001. Another significant change within the items included in other operating income is interchange fees received from the Bank's VISA check card product. This product was introduced in late 1999, and has grown in numbers of accounts and usage. These fees increased to $87,000 in 2001 from $42,000 in 2000. Also within other operating income, gains from sales of other real estate properties increased to $135,000 in 2001 from $104,000 in 2000.
TABLE IV - COMPARISON OF NONINTEREST INCOME
OTHER NONINTEREST EXPENSE 2002/2001/2000
Total noninterest expense increased 11.7% in 2002, to $20,849,000. In 2001, total noninterest expense was $18,671,000, a 10.4% increase over 2000.
2002 VS. 2001
Salaries and wages increased $925,000, or 10.9%, in 2002 compared to 2001. The increase is the result of annual merit raises ranging from 2%-5%, an increase in the number of employees and an increase in incentive bonus expense. Increases in staff during the last half of 2001 and throughout 2002 included the addition of new positions in branch and commercial lending, branch administration, compliance and marketing. The incentive bonus plan provides for compensation to be paid to certain key officers based on a combination of corporate and personal performance. Total incentive bonus expense increased $185,000 in 2002.
Pensions and other employee benefits increased $438,000, or 19.8%, in 2002 over 2001. A portion of this increase is directly related to the increase in salaries and wages. Also, pension expense from the Corporation's defined benefit pension plan increased $245,000 in 2002 over 2001. A decline in the market value of plan assets was the main cause of the increase in expense in 2002. Note 12 to the consolidated financial statements provides more information related to the defined benefit pension plan.
Other expense increased $704,000, or 15.9%, in 2002 over 2001. This category includes many different types of expenses. Some of the overall increase in this category was caused by increases in number of transactions processed and number of employees. The most significant changes within this category are as follows:
- Expenses of Bucktail Life Insurance Company, increased $111,000, to $335,000. This increase resulted mainly from a larger amount of life insurance claims incurred.
- Professional fees increased $101,000, to $276,000. This increase reflected costs associated with organizational and product profitability consultants, human resources consultants and other consultants related to various aspects of the Corporation's operations.
- Office and other supplies increased $77,000, to $502,000, as a result of increased volumes of employees and customers.
- Restricted stock amortization increased $58,000, to $80,000. This category of expense included amortization associated with 2 years of awards to Directors and certain employees in 2002, compared to only 1 year in 2001 (the first year for which there were restricted stock awards). Stock-based compensation plans are described in more detail in Note 12 to the financial statements.
- In 2002, the Corporation wrote off asset-liability reporting software of $41,000, due to management's decision to change to an outsourcing provider of asset-liability reports.
2001 VS. 2000
Salaries and wages increased $896,000, or 11.8%, in 2001 compared to 2000. The increase is the result of annual merit raises ranging from 2%-5%, and an increase in the number of employees. Higher staffing levels were required for the Muncy branch, commercial and retail lending, trust and financial management and insurance sales and service.
Pensions and other employee benefits increased $274,000, or 14.1%, in 2001. In addition to increased costs resulting from the higher number of employees, the Corporation experienced an increase in medical insurance premium rates.
Occupancy expense increased $90,000, or 9.7%, in 2001. This increase is mainly due to additional facilities. In 2000, the Corporation constructed a new branch in Muncy, purchased a building for credit card operations, and purchased 2 buildings near the Wellsboro branch/administrative building for additional administrative space.
Furniture and equipment expense increased $237,000, or 19.8%, in 2001. The major categories of furniture and equipment expense that increased in 2001 compared to 2000 were maintenance costs associated with computer hardware and software, and depreciation. The increase in computer maintenance costs is mainly attributable to the timing of certain maintenance costs. Increased depreciation expense resulted primarily from the addition of the Muncy branch, which began operations in the 4th quarter 2000, and the opening of the new credit card operations facility in mid-2000.
Credit card expenses decreased in 2001 because of lower interchange fees paid. This change resulted from the sale of the merchant banking program, as discussed in the "Noninterest Income" section of Management's Discussion and Analysis.
Other expense increased $346,000, or 8.5%, in 2001. This category includes many different types of expenses. Some of the overall increase in this category was caused by increases in number of transactions processed and number of employees. The most significant fluctuations in individual types of expenses between years are as follows:
- - Customer support and maintenance charges related to software products increased $74,000, to $144,000, in 2001. This reflects increased use of third-party software programs for specialized applications, which are used as a complement to the Corporation's core, in house programs.
- - In 2001, the Corporation incurred consulting expense of $51,000 related to sales and service training. This training program is a substantial undertaking, aimed at improving the sales and service skills of virtually all employees. The amount of expense noted here does not include costs of miscellaneous training materials, nor more significantly, any allocation of internal payroll-related costs associated with sales and service training.
- - Telephone expenses related to data lines increased $47,000, to $254,000, in 2001. These costs are mainly related to the Corporation's computer network that allows all branches and operating locations to access mainframe and PC applications. The Corporation's monthly data line costs increased to approximately the current level starting in the 2nd quarter 2000.
- - Public relations expense increased $45,000, to $189,000, in 2001. This increase includes new sponsorships of several community-oriented programs located in the Corporation's market area, as well as costs related to promotion of the Muncy office.
- - Expenses associated with maintaining other real estate properties increased $42,000, to $76,000, in 2001.
- - In 2000, the Corporation incurred professional fees of $193,000 related to a proposed merger with Peoples, Ltd. of Wyalusing, PA. In November 2000, the vote by Peoples, Ltd.'s shareholders did not result in the 75% affirmative count required to approve the deal.
TABLE V - COMPARISON OF NONINTEREST EXPENSE
FINANCIAL CONDITION
Significant changes in the average balances of the Corporation's earning assets and interest-bearing liabilities are described in the "NET INTEREST MARGIN" section of Management's Discussion and Analysis. In particular, the discussion of changes in available-for-sale securities, loans, deposits and borrowed funds in 2002 is sufficient to explain the overall change in the year-end balances in 2002 compared to 2001. Other significant balance sheet items - the allowance for loan losses and stockholders' equity - are discussed in separate sections of Management's Discussion and Analysis.
Table VI shows the composition of the investment portfolio at December 31, 2002, 2001 and 2000.
Premises and equipment, net of accumulated depreciation, increased to $10,333,000 at December 31, 2002 from $9,967,000 at December 31, 2001. The total cost of premises and equipment purchases was $1,712,000 in 2002, $1,935,000 in 2001 and $2,426,000 in 2000. In 2002, the most significant capital purchases included renovations of the Tioga and Athens offices, and completion of renovations to the leased facility on Main Street in Wellsboro. Other major categories of capital purchases in 2002 included purchases of computer hardware and software, and purchase and demolition of property adjacent to the Wysox office. In 2001, the most significant capital purchases were for new proof of deposit software, renovations to branches and a new telephone system. The most significant capital investment in 2000 was the addition of the Muncy branch, for which land, building construction and initial furniture and equipment cost slightly more than $1,000,000. Depreciation expense amounted to $1,346,000 in 2002, $1,300,000 in 2001 and $1,086,000 in 2000.
The total cost of capital expenditures for 2003 is expected to be in the range of the amounts spent in 2000-2002. Capital expenditures will not have a detrimental effect on the Corporation's financial condition in 2003.
TABLE VI - INVESTMENT SECURITIES
PROVISION AND ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is maintained at a level which, in management's judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management's evaluation of the collectibility of the loan portfolio. In evaluating collectibility, management considers a number of factors, including the status of specific impaired loans, trends in historical loss experience, delinquency trends, credit concentrations, comparison of historical loan loss data to that of other financial institutions and economic conditions within the Corporation's market area. Allowances for impaired loans are determined based on collateral values or the present value of estimated cash flows. The allowance is increased by a provision for loan losses, which is charged to expense, and reduced by charge-offs, net of recoveries.
Each quarter, management performs a detailed assessment of the allowance and the provision for loan losses. The loan quality committee performs this assessment. This committee includes the Bank's President, Chief Financial Officer, Executive Vice Presidents in charge of loans and branch administration and additional commercial lending staff. The committee reviews the identified risk elements in the loan portfolio, including the "Watch List", past due reports and other information. The "Watch List" is a collection of loans that have a history of delinquency, collateral deficiency, cash flow problems, or other factors that have come to management's attention to create the need for special monitoring.
The Bank also engages a consulting firm each year to perform an independent credit review. Their review is performed annually on credit relationships of $250,000 and higher as well as other selected credit relationships. The loan quality committee gives substantial consideration to the classifications and recommendations of the independent credit reviewer in determining the allowance for loan losses.
The allowance for loan losses includes two components, allocated and unallocated. The allocated component of the allowance for loan losses reflects expected losses resulting from the analysis of individual loans and historical loss experience, as modified for identified trends and concerns, for each loan category. The historical loan loss experience element is determined based on the ratio of net charge-offs to average loan balances over a five-year period, for each significant type of loan, modified for risk adjustment factors identified by management for each type of loan. The charge-off ratio, as modified, is then applied to the current outstanding loan balance for each type of loan (net of Watch List and other loans that are individually evaluated).
The unallocated portion of the allowance is determined based on management's assessment of general economic conditions as well as specific economic factors in the market area. This determination inherently involves a higher degree of uncertainty and considers current risk factors that may not have yet manifested themselves in the Bank's historical loss factors used to determine the allocated component of the allowance, and it recognizes that management's knowledge of specific losses within the portfolio may be incomplete.
Table IX reflects an allowance of $1,877,000 for losses related to impaired loans as of December 31, 2002. This reflects management's evaluation of impairment associated with several commercial loan relationships. Management believes it has been conservative, but reasonable, in its commercial loan impairment calculations. However, the actual losses realized from these relationships could vary materially from the allowances calculated as of December 31, 2002.
As you can see in Table IX, the allowance for loan losses related to impaired loans was much higher at December 31, 2002 than as of the ends of each of the previous 4 years. In years prior to 2002, amounts disclosed related to impaired loans were limited to commercial loans that had been classified as nonaccrual. Effective in the fourth quarter 2002, management changed its method of identifying impaired loans to include all individual loans for which an allowance was calculated. Management believes this method of determining disclosure information is more consistent with the applicable requirements of FASB Statements No. 114 and 118. This change affects disclosures related to impaired loans, and the allocation of the allowance for loan losses as presented in Table IX, but does not represent a change in management's method for calculating the allowance for loan losses.
As noted in Table IX, the unallocated portion of the allowance for loan losses was $1,759,000 at December 31, 2002 and $2,187,000 at December 31, 2001. The unallocated balances ranged from $1,759,000 to $2,222,000 in 2002 and $1,983,000 to $2,364,000 during 2001. In evaluating the unallocated portion of the allowance, management considers several trends, including comparisons of loan loss data to other financial institutions and tracking of delinquency and charge-off trends. Loan delinquency data has been fairly consistent over the last 2 years. Total 90 day or more past due loans, plus nonaccrual loans, amounted to $3,570,000 (0.79% of total loans) at December 31, 2002, and $3,117,000 (0.82% of total loans) at December 31, 2001. Total 30-89 day past due loans amounted to $8,853,000 (1.96% of total loans) at December 31, 2002, and $7,066,000 (1.86% of total loans) at December 31, 2001. As reflected in Table VIII, gross and net charge-offs were slightly lower in 2002 than in any of the previous 4 years; however, in light of the increase in allowances on impaired loans, this may not be a sustainable trend.
The provision for loan losses amounted to $940,000 in 2002, $600,000 in 2001 and $676,000 in 2000. The higher provision in 2002 reflects increased estimates of allowances on impaired or Watch List loans, as described above. The amount of the provision in each year is determined based on the amount required to maintain an appropriate allowance in light of the factors described above.
Tables VII, VIII, IX and X present an analysis of the loan portfolio, the allowance for loan losses, the allocation of the allowance and a five-year summary of loans by type.
TABLE VII - FIVE-YEAR HISTORY OF LOAN LOSSES (IN THOUSANDS)
TABLE VIII - ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES
TABLE IX - ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES BY TYPE
The above allocation is based on estimates and subjective judgments and is not necessarily indicative of the specific amounts or loan categories in which losses may occur. The calculation for 1998 did not include specific amounts for "Watch List" loans. These loans were included in the total population of loans and historical loss ratios applied.
TABLE X - FIVE-YEAR SUMMARY OF LOANS BY TYPE
LIQUIDITY
Liquidity is the ability to quickly raise cash at a reasonable cost. An adequate liquidity position permits the Corporation to pay creditors, compensate for unforeseen deposit fluctuations and fund unexpected loan demand. The Corporation maintains overnight borrowing facilities with several correspondent banks that provide a source of day-to-day liquidity. Also, the Corporation maintains borrowing facilities with FHLB - Pittsburgh, secured by various securities and mortgage loans. At December 31, 2002, the Corporation had unused borrowing availability with correspondent banks and FHLB - Pittsburgh totaling approximately $205,000,000. Additionally, the Corporation uses repurchase agreements placed with brokers to borrow short-term funds secured by investment assets, and uses "RepoSweep" arrangements to borrow funds from commercial banking customers on an overnight basis.
On a longer-term basis, one of the tools used to measure liquidity is the loan to deposit ratio. As of December 31, 2002, this ratio was 70%, which (by banking industry standards) is a relatively low ratio (which indicates a relatively high level of liquidity). This low loan to deposit ratio permits the Corporation to utilize "excess" funds to purchase investment securities. If required to raise cash in an emergency situation, the Corporation could sell non-pledged investment securities to meet its obligations.
Management believes the combination of its strong capital position (discussed in the next section), ample available borrowing facilities and low loan to deposit ratio have placed the Corporation in a position of minimal short-term and long-term liquidity risk.
STOCKHOLDERS' EQUITY AND CAPITAL ADEQUACY
The Corporation and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. For many years, the Corporation and the Bank have maintained strong capital positions. Details concerning the Corporation's and the Bank's regulatory capital amounts and ratios are presented in Note 16 to the consolidated financial statements. As reflected in Note 16, at December 31, 2002 and 2001, the ratios of total capital to risk-weighted assets, tier 1 capital to risk-weighted assets and tier 1 capital to average total assets are well in excess of the amounts necessary to be classified as "well-capitalized" by the banking agencies.
The Corporation's total stockholders' equity is affected by fluctuations in the fair values of available-for-sale securities. The difference between amortized cost and fair value of available-for-sale securities, net of deferred income tax, is classified as "Accumulated Other Comprehensive Income" within stockholders' equity. Changes in accumulated other comprehensive income are excluded from earnings and directly increase or decrease stockholders' equity.
COMPREHENSIVE INCOME
Comprehensive income is a measure of all changes in the equity of a corporation, excluding transactions with owners in their capacity as owners (such as proceeds from issuances of stock and dividends). The difference between net income and comprehensive income is termed "Other Comprehensive Income". For the Corporation, other comprehensive income consists of unrealized gains and losses on available-for-sale securities, net of deferred income tax. Comprehensive income should not be construed to be a measure of net income. The amount of unrealized gains or losses reflected in comprehensive income may vary widely from period-to-period, depending on the financial markets as a whole and how the portfolio of available-for-sale securities is affected by interest rate movements. Total comprehensive income (loss) was $21,821,000 in 2002, $17,254,000 in 2001 and $17,442,000 in 2000. Other comprehensive income amounted to $6,862,000 in 2002, $5,202,000 in 2001 and $8,966,000 in 2000.
INFLATION
Over the last several years, direct inflationary pressures on the Corporation's payroll-related and other noninterest costs have been modest. In fact, some economists have warned of the threat of deflationary pressures, similar to recent experiences in Japan. The Corporation is significantly affected by the Federal Reserve Board's efforts to control inflation through changes in interest rates. Management monitors the impact of economic trends, including any indicators of inflationary (or deflationary) pressure, in managing interest rate and other financial risks.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 2001, The Financial Accounting Standard Board ("FASB") issued Statement No. 143, "Accounting for Asset Retirement Obligations." This statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. It applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and (or) the normal operation of a long-lived asset, except for certain obligations of lessees. As used in this Statement, a legal obligation is an obligation that a party is required to settle as a result of an existing or enacted law, statute, ordinance or written or oral contract or by legal construction of a contract under the doctrine of promissory estopple. This Statement requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. This Statement amends FASB Statement No. 19 "Financial Accounting and Reporting by Oil and Gas Producing Companies" and it applies to all entities. It is effective for financial statements issued for fiscal years beginning after June 15, 2002. The adoption of this Statement on January 1, 2003 is not expected to have an impact on the Corporation's earnings, financial condition or equity.
In August 2001, the FASB issued Statement No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." This Statement addresses financial accounting and reporting for the impairment or disposal of long-lived assets, and supersedes FASB Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of." However, the Statement retains the fundamental provisions of Statement No. 121 for (a) recognition and measurement of the impairment of long-lived assets to be held and used and (b) measurement of long-lived assets to be disposed of by sale. This Statement supersedes the accounting and recording provisions of APB Opinion No. 30, "Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions," for the disposal of a segment of a business. However, this Statement retains the requirement of Opinion No. 30 to report discontinued operations separately from continuing operations and extends that reporting to a component of an entity that either has been disposed of (by sale, by abandonment or in the distribution to owners) or is classified as held for sale. This Statement also amends ARB No. 51, "Consolidated Financial Statements", to eliminate the exception to consolidation for a temporarily-controlled subsidiary. The provisions of this Statement were effective for financial statements issued for fiscal years beginning after December 15, 2001. The Adoption of this Statement on January 1, 2002 did not have an impact on the Corporation's earnings, financial condition or equity.
In April 2002, the FASB issued Statement No. 145 "Rescission of FASB Statements No. 4, 44, and 64 Amendment of FASB Statement No. 13, and Technical Corrections." "This Statement rescinds FASB Statement No. 4, "Reporting Gains and Losses from Extinguishment of Debt, " and an amendment of that Statement, FASB Statement No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements," along with rescinding FASB Statement No. 44, "Accounting for Intangible Assets of Motor Carriers and amending FASB Statement No. 13, Accounting for Leases." This Statement (1) eliminates an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions, (2) eliminates the extraordinary item treatment of reporting gains and losses from extinguishments of debt, and (3) makes certain other technical corrections. The provisions of this Statement related to the rescission of Statement 4 shall be applied in fiscal years beginning after May 15, 2002. Any gain or loss on extinguishments of debt that was classified as an extraordinary item in prior periods presented that does not meet the criteria in Opinion 30 for classification as an extraordinary item shall be reclassified. The provisions of this Statement related to Statement 13 shall be effective for transactions occurring after May 15, 2002. All other provisions of this Statement shall be effective for financial statements issued on or after May 15, 2002. The adoption of the effective portions of this Statement did not have an impact on the Corporation's earnings, financial condition or equity, except that (as described in Note 9 to the consolidated financial statements) the Corporation incurred prepayment penalties from the early retirement of debt of $101,000 in 2002, and included these costs in interest expense (prior to this Statement, the prepayment penalties would have been presented as extraordinary items in the income statement). The adoption of the remaining portions of this Statement is not expected to have an impact on the Corporation's earnings, financial condition or equity.
In June 2002, the FASB issued Statement No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." This Statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002. The Corporation does not expect the adoption of this Statement to have an impact on its earnings, financial condition or equity.
On October 1, 2002, the FASB issued Statement No. 147, "Acquisitions of Certain Financial Institutions," effective for all business combinations initiated after October 1, 2002. This Statement addresses the financial accounting and reporting for the acquisition of all or part of a financial institution except for a transaction between two or more mutual enterprises. This Statement removes acquisitions of financial institutions, other than transactions between two or more mutual enterprises, from the scope of Statement No 72, "Accounting for Certain Acquisitions of Banking or Thrift Institutions," and FASB Interpretation No. 9, "Applying APB Opinions No. 16 and 17 When a Savings and Loan Association or a Similar Institution is Acquired in a Business Combination Accounted for by the Purchase Method." The acquisition of all or part of a financial institution that meets the definition of a business combination shall be accounted for by the purchase method in accordance with Statement No. 141, "Business Combinations," and Statement No. 142, "Goodwill and Other Intangible Assets." This Statement also provides guidance on the accounting for the impairment or disposal of acquired long-term customer-relationship intangible assets (such as depositor-and-borrower-relationship intangible assets and credit cardholder intangible assets), including those acquired in transactions between two or more mutual enterprises. The Adoption of this Statement has not had an impact on the Corporation's earnings, financial condition or equity.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirement for Guarantees, Including Indirect Guarantees of the Indebtedness of Others." This Interpretation clarifies the requirements for a guarantor's accounting for and disclosures of certain guarantees issued and outstanding. The Interpretation requires a guarantor to recognize a liability for the fair value of the obligation it assumes under that guarantee. The initial recognition and initial measurement provisions of the Interpretation are applied on a prospective basis to guarantees issued or modified after December 31, 2002. The guarantor's accounting for guarantees issued prior to the date of initial application should not be revised or restated to reflect the effect of the recognition and measurement provisions of the Interpretation. The Interpretation's disclosure requirements were implemented during the year ended December 31, 2002 (see Note 15 to the consolidated financial statements for expanded disclosures related to standby letters of credit). The adoption of the recognition and measurement provisions of this statement are not expected to have a significant impact on the Corporation's earnings, financial condition or equity.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
The Corporation's two major categories of market risk, interest rate and equity securities risk, are discussed in the following sections.
INTEREST RATE RISK
Business risk arising from changes in interest rates is an inherent factor in operating a bank. The Corporation's assets are predominantly long-term, fixed rate loans and debt securities. Funding for these assets comes principally from shorter-term deposits and borrowed funds. Accordingly, there is an inherent risk of lower future earnings or decline in fair value of the Corporation's financial instruments when interest rates change.
The Bank uses a simulation model to calculate the potential effects of interest rate fluctuations on net interest income and the market value of portfolio equity. Only assets and liabilities of the Bank are included in management's monthly simulation model calculations. Since the Bank makes up more than 90% of the Corporation's total assets and liabilities, and because the Bank is the source of the most volatile interest rate risk, management does not consider it necessary to run the model for the remaining entities within the consolidated group. For purposes of these calculations, the market value of portfolio equity includes the fair values of financial instruments, such as securities, loans, deposits and borrowed funds, and the book values of nonfinancial assets and liabilities, such as premises and equipment and accrued interest. The model measures and projects potential changes in net interest income, and calculates the discounted present value of anticipated cash flows of financial instruments, assuming an immediate increase or decrease in interest rates. Management ordinarily runs a variety of scenarios within a range of plus or minus 50-300 basis points of current rates.
In the 3rd quarter 2002, the Bank changed to a different simulation (software) model, and also changed some of the key methodologies and assumptions. The new simulation model is run on an outsourcing basis, using data supplied by the Bank. These changes were made in an effort to improve the accuracy and relevance of the Bank's interest rate risk measurements. The more significant changes are as follows:
- The new model permits more precise measurements, in that the estimated impact of interest rate changes is calculated for each individual investment security and for each individual loan and deposit instrument. In contrast, the old model required management to make assumptions regarding contractual cash flows for fairly broad categories of investment securities, loans and deposits.
- Using the new model, the average principal repayment term for callable investment securities has been substantially lengthened. This change has increased the calculated impact of interest rate changes on the fair value of investment securities under each interest rate scenario.
- Prior to the model change, management assumed no difference between book value and fair value of nonmaturity deposits and borrowings, such as money market accounts, NOW accounts, savings, customer repurchase agreements and checking accounts. Using the new model, management has estimated the "run-off" of nonmaturity deposits and borrowings, and has calculated the fair value of these liabilities using market interest rates consistent with the estimated terms. The effect of this change was to increase the market value of portfolio equity in all interest rate scenarios.
- Also related to nonmaturity deposits and borrowings, management has changed its assumptions regarding the impact of rate changes on interest expense. In the past, management estimated the impact of a rate change based on 100% of the "shock" amount - e.g., the rate paid on savings accounts would be assumed to increase from 1% to 3% in a "+200 basis point" calculation. Using the new model, management has limited the estimated impact of rate changes on interest expense. For example, in a +200 basis point calculation, the rate paid on savings accounts would be assumed to increase 50% of 200 basis points, or 1%, resulting in an increase in rate from 1% to 2%. The effect of this change was to decrease the impact of rate changes on net interest income in all interest rate scenarios.
- In the past, the Bank's interest rate shock calculations compared "Base Most Likely" values to amounts calculated assuming an immediate increase or decrease in rates. In developing the Base Most Likely calculations, management made assumptions regarding growth in loans and deposits, and other balance sheet changes. Also, management used an interest rate forecast to estimate changes in interest rates on a monthly basis throughout the period of net interest income calculations. Using the new model, management's baseline calculation assumes a "flat" balance sheet, and uses current interest rates with no forecasted changes in rates. Management believes this change in methodology provides a measurement of interest rate risk that is more consistent with the majority of the financial institutions industry.
The Bank's Board of Directors has established policy guidelines for acceptable levels of interest rate risk, based on an immediate increase or decrease in interest rates of 200 basis points. The policy limit for fluctuation in net interest income is minus 20% from the baseline one-year scenario. The policy limit for market value variance is minus 30% from the baseline one-year scenario. The most sensitive scenario presented in Table XII below is the "+200 basis points" scenario. As the table below shows, as of December 31, 2002, the result of the Bank's net interest income calculation is well within the policy threshold. However, if interest rates were to immediately increase 200 basis points, the Bank's calculations based on the model show that the market value of portfolio equity would decrease 34.2%, which exceeds the policy threshold. Over the next several months, management will evaluate whether to make any changes to asset or liability holdings in an effort to reduce exposure to decline in market value in a rising interest rate environment. The table also shows that, if interest rates were to immediately rise 200 basis points, net interest income over the next 12 months would decline by 1.8%, which is well under the 20% policy mark. This estimated exposure level is also significantly less than the 18.9% decline calculated as of December 31, 2001. Changes in the model, particularly the assumptions referred to above concerning the impact of rate changes on nonmaturity deposits and borrowings, had a substantial impact on these revised results. Also, some of management's actions during 2002, including an increased concentration of the investment securities portfolio in mortgage-backed securities (as discussed in the "Net Interest Margin" section of Management's Discussion and Analysis), have helped to reduce the exposure of net interest income to rising rates in the near term.
The table that follows was prepared using the simulation models described above. The models make estimates, at each level of interest rate change, regarding cash flows from principal repayments on loans and mortgage-backed securities and call activity on other investment securities. Actual results could vary significantly from these estimates, which could result in significant differences in the calculations of projected changes in net interest margin and market value of portfolio equity. Also, the models do not make estimates related to changes in the composition of the deposit portfolio that could occur due to rate competition and the table does not necessarily reflect changes that management would make to realign the portfolio as a result of changes in interest rates.
THE EFFECT OF HYPOTHETICAL CHANGES IN INTEREST RATES
EQUITY SECURITIES RISK
The Corporation's equity securities portfolio consists primarily of investments in stocks of banks and bank holding companies, mainly based in Pennsylvania. The Corporation also owns some other stocks and mutual funds.
Investments in bank stocks are subject to the risk factors affecting the banking industry generally, including competition from non-bank entities, credit risk, interest rate risk and other factors that could result in a decline in market prices. Also, losses could occur in individual stocks held by the Corporation because of specific circumstances related to each bank. Further, because of the concentration of its holdings in Pennsylvania banks, these investments could decline in value if there were a downturn in the state's economy.
The Corporation's management monitors its risk associated with its equity securities holdings by reviewing its holdings on a detailed, individual security basis, at least monthly, considering all of the factors described above.
Equity securities held as of December 31, 2002 and 2001 are as follows:
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
CONSOLIDATED BALANCE SHEET
The accompanying notes are an integral part of the consolidated financial statements.
CONSOLIDATED STATEMENT OF INCOME
The accompanying notes are an integral part of the consolidated financial statements.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (IN THOUSANDS EXCEPT PER SHARE DATA)
The accompanying notes are an integral part of the consolidated financial statements.
The accompanying notes are an integral part of the consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF CONSOLIDATION - The consolidated financial statements include the accounts of Citizens & Northern Corporation ("Corporation"), and its subsidiaries, Citizens & Northern Bank ("Bank"), Bucktail Life Insurance Company and Citizens & Northern Investment Corporation. The consolidated financial statements also include the accounts of the Bank's wholly-owned subsidiary, C&N Financial Services Corporation, which began operations in 2000. All material intercompany balances and transactions have been eliminated in consolidation.
NATURE OF OPERATIONS - The Corporation is primarily engaged in providing a full range of banking and mortgage services to individual and corporate customers in Northcentral Pennsylvania. Lending products include mortgage loans, commercial loans, consumer loans and credit cards, as well as specialized instruments such as commercial letters-of-credit. Deposit products include various types of checking accounts, passbook and statement savings, money market accounts, interest checking accounts, individual retirement accounts and certificates of deposit. The Corporation also offers non-insured "Repo Sweep" accounts.
The Corporation provides Trust and Financial Management services, including administration of trusts and estates, retirement plans, and other employee benefit plans, and investment management services. In 2000, the Corporation began offering a variety of personal and commercial insurance products through C&N Financial Services Corporation. In 2001, C&N Financial Services Corporation added a broker-dealer division, which offers mutual funds, annuities, educational savings accounts and other investment products through registered agents.
The Corporation is subject to competition from other financial institutions. It is also subject to regulation by certain federal and state agencies and undergoes periodic examination by those regulatory authorities.
USE OF ESTIMATES - The presentation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect reported amounts and disclosures. Actual results could differ from these estimates.
A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses. Management believes that the allowance for loan losses is adequate and reasonable. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation's allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.
INVESTMENT SECURITIES - Investment securities are accounted for as follows:
HELD-TO-MATURITY SECURITIES - includes debt securities that the Corporation has the positive intent and ability to hold to maturity. These securities are reported at cost adjusted for amortization of premiums and accretion of discounts, computed using the level-yield method.
AVAILABLE-FOR-SALE SECURITIES - includes debt securities not classified as held-to-maturity and unrestricted equity securities. Such securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported separately through accumulated other comprehensive income, net of tax. Amortization of premiums and accretion of discounts on available-for-sale securities are recorded using the level yield method over the remaining contractual life of the securities, adjusted for actual prepayments.
Realized gains and losses on sales of available-for-sale securities are computed on the basis of specific identification of the adjusted cost of each security.
RESTRICTED EQUITY SECURITIES - Restricted equity securities consist primarily of Federal Home Loan Bank of Pittsburgh stock, and are carried at cost and evaluated for impairment. Holdings of restricted equity securities are included in Other Assets in the Consolidated Balance Sheet, and dividends received on restricted securities are included in Other Income in the Consolidated Statement of Income.
LOANS - Loans are stated at unpaid principal balances, less the allowance for loan losses and net deferred loan fees.
Loan origination and commitment fees, as well as certain direct origination costs, are deferred and amortized as a yield adjustment over the lives of the related loans using the interest method. Amortization of deferred loan fees is discontinued when a loan is placed on nonaccrual status.
Loans are placed on nonaccrual status when, in the opinion of management, collection of interest is doubtful. Any unpaid interest previously accrued on those loans is reversed from income. Interest income is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on such loans are applied as a reduction of the loan principal balance. Interest income on other nonaccrual loans is recognized only to the extent of interest payments received.
The allowance for loan losses is maintained at a level which, in management's judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management's evaluation of the collectibility of the loan portfolio, based on factors such as credit concentrations, trends in historical loss experience, specific impaired loans, and economic conditions. Allowances for impaired loans are determined based on collateral values or the present value of estimated cash flows. The allowance is increased by a provision for loan losses, which is charged to expense, and reduced by charge-offs, net of recoveries.
BANK PREMISES AND EQUIPMENT - Bank premises and equipment are stated at cost less accumulated depreciation. Repair and maintenance expenditures which extend the useful lives of assets are capitalized, and other repair and maintenance expenditures are expensed as incurred. Depreciation expense is computed using the straight-line method.
FORECLOSED ASSETS HELD FOR SALE - Foreclosed assets held for sale consist of real estate acquired by foreclosure and are carried at estimated fair value, less selling cost.
INCOME TAXES - Provisions for deferred income taxes are made as a result of temporary differences in financial and income tax methods of accounting. These differences relate principally to loan losses, securities gains or losses, depreciation, pension and other postretirement benefits and amortization of loan origination fees and costs.
STOCK COMPENSATION PLANS - As permitted by Accounting Principles Board Opinion No. 25, the Corporation uses the intrinsic value method of accounting for stock compensation plans. Utilizing the intrinsic value method, compensation cost is measured by the excess of the quoted market price of the stock as of the grant date (or other measurement date) over the amount an employee or director must pay to acquire the stock. Stock options issued under the Corporation's stock option plans have no intrinsic value, and accordingly, no compensation cost is recorded for them.
The Corporation has also made awards of restricted stock. Compensation cost related to restricted stock is recognized based on the market price of the stock at the grant date over the vesting period.
The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-based Compensation," to stock options.
(NET INCOME IN THOUSANDS)
OFF-BALANCE SHEET FINANCIAL INSTRUMENTS - In the ordinary course of business, the Corporation has entered into off-balance sheet financial instruments consisting of commitments to extend credit and standby letters of credit. Such financial instruments are recorded in the financial statements when they become payable.
CASH FLOWS - The Corporation utilizes the net reporting of cash receipts and cash payments for certain deposit and lending activities. The Corporation considers all cash and amounts due from depository institutions, interest-bearing deposits in other banks, and federal funds sold to be cash equivalents.
TRUST ASSETS AND INCOME - Assets held by the Corporation in a fiduciary or agency capacity for its customers are not included in the financial statements since such items are not assets of the Corporation. Trust income is recorded on a cash basis, which is not materially different from the accrual basis.
RECLASSIFICATION - Certain 2001 and 2000 amounts have been reclassified to conform to the 2002 presentation.
2. COMPREHENSIVE INCOME
Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income. The components of other comprehensive income and the related tax effects are as follows:
3. PER SHARE DATA
Net income per share is based on the weighted-average number of shares of common stock outstanding. The number of shares used in calculating net income and cash dividends per share reflect the retroactive effect of stock dividends declared in the fourth quarter of each year presented, payable in the first quarter of the following year. The following data show the amounts used in computing basic and diluted net income per share. The dilutive effect of stock options is computed as the weighted-average common shares available from the exercise of all dilutive stock options, less the number of shares that could be repurchased with the proceeds of stock option exercises based on the average share price of the Corporation's common stock during the period.
WEIGHTED- AVERAGE EARNINGS NET COMMON PER INCOME SHARES SHARE Earnings per share - basic $ 14,959,000 5,339,449 $2.80 Dilutive effect of stock options 14,592 - ------------------------------------------------------------------------------ Earnings per share - diluted $ 14,959,000 5,354,041 $2.79 ==============================================================================
Earnings per share - basic $ 12,052,000 5,348,963 $2.25 Dilutive effect of stock options 1,489 - ------------------------------------------------------------------------------ Earnings per share - diluted $ 12,052,000 5,350,452 $2.25 ==============================================================================
Earnings per share - basic $ 8,476,000 5,363,232 $1.58 Dilutive effect of stock options 1,154 - ------------------------------------------------------------------------------ Earnings per share - diluted $ 8,476,000 5,364,386 $1.58 ==============================================================================
4. CASH AND DUE FROM BANKS
Banks are required to maintain reserves consisting of vault cash and deposit balances with the Federal Reserve Bank in their district. The reserves are based on deposit levels during the year and account activity and other services provided by the Federal Reserve Bank. Average daily currency, coin, and cash balances with the Federal Reserve Bank needed to cover reserves against deposits for 2002 ranged from $2,161,000 to $6,458,000. For 2001, these balances ranged from $1,489,000 to $5,923,000. Average daily cash balances with the Federal Reserve Bank required for services provided to the Bank ranged from $1,500,000 to $2,500,000 in 2002 and amounted to $1,500,000 throughout 2001. Total balances restricted amounted to $6,332,000 at December 31, 2002 and $4,735,000 at December 31, 2001.
Deposits with one financial institution are insured up to $100,000. The Corporation maintains cash and cash equivalents with certain financial institutions in excess of the insured amount.
5. SECURITIES
Amortized cost and fair value of securities at December 31, 2002 and 2001 are summarized as follows:
The amortized cost and fair value of investment debt securities at December 31, 2002 follow. Maturities of debt securities (including mortgage-backed securities) are presented based on contractual maturities. Expected maturities differ from contractual maturities because monthly principal payments are received from mortgage-backed securities, and because borrowers may have the right to prepay obligations with or without prepayment penalties.
The following table shows the amortized cost and maturity distribution of the debt securities portfolio at December 31, 2002:
Investment securities carried at $90,655,000 at December 31, 2002 and $69,962,000 at December 31, 2001, were pledged as collateral for public deposits, trusts and certain other deposits as provided by law. Also, see Note 9 for information concerning securities pledged to secure borrowing arrangements.
Gross realized gains and losses from the sales of available-for-sale securities, and the income tax provision related to net realized gains, for 2002, 2001 and 2000 were as follows:
6. LOANS
Major categories of loans and leases included in the loan portfolio are as follows:
Net unamortized loan fees and costs of $1,564,000 at December 31, 2002 and $1,512,000 at December 31, 2001 have been offset against the carrying value of loans.
There is no concentration of loans to borrowers engaged in similar businesses or activities that exceed 10% of total loans at December 31, 2002.
The Corporation grants commercial, residential and personal loans to customers primarily in Tioga, Bradford, Sullivan and Lycoming Counties. Although the Corporation has a diversified loan portfolio, a significant portion of its debtors' ability to honor their contracts is dependent on the local economic conditions within the region.
LOAN MATURITY DISTRIBUTION
Loans in the preceding table that are due on demand are shown as one year or less.
Loans on which the accrual of interest has been discontinued or reduced amounted to $1,252,000 at December 31, 2002 and $1,050,000 at December 31, 2001. Interest income on such loans is recorded only as received.
Loans on which the original terms have been restructured totaled $66,000 at December 31, 2002 and $75,000 at December 31, 2001. None of the loans on which the original terms were changed were past due at December 31, 2002 and 2001.
Loans which were more than 90 days past due and still accruing interest totaled $2,318,000 at December 31, 2002 and $2,067,000 at December 31, 2001.
Transactions in the allowance for loan losses were as follows:
(IN THOUSANDS)
2002 2001 2000 Balance at beginning of year $ 5,265 $ 5,291 $ 5,131 Provision charged to operations 940 600 676 Loans charged off (552) (713) (616) Recoveries 136 87 100 - ------------------------------------------------------------------------- Balance at end of year $ 5,789 $ 5,265 $ 5,291 =========================================================================
Information related to impaired loans as of December 31, 2002 and 2001 is as follows:
(IN THOUSANDS)
2002 2001
Balance of impaired loans $ 3,714 $ 582 Specific allowance related to impaired loans $ 1,877 $ 73
The average balance of impaired loans amounted to $3,838,000 in 2002, $781,000 in 2001 and $1,079,000 in 2000.
The following is a summary of cash receipts on impaired loans and how they were applied.
(IN THOUSANDS) 2002 2001 2000 Cash receipts applied to principal $ 497 $ 35 $ 503 Cash receipts recognized as interest income 247 14 87 - ---------------------------------------------------------------------------- Total cash receipts $ 744 $ 49 $ 590 ============================================================================
7. BANK PREMISES AND EQUIPMENT
Bank premises and equipment are summarized as follows:
(IN THOUSANDS) DECEMBER 31, 2002 2001
Land $ 1,275 $ 1,126 Buildings and improvements 12,295 11,313 Furniture and equipment 9,022 8,565 - ------------------------------------------------------------------------ Total 22,592 21,004 Less: accumulated depreciation (12,259) (11,037) - ------------------------------------------------------------------------ Net $ 10,333 $ 9,967 ========================================================================
Depreciation expense included in occupancy expense and furniture and equipment expense was as follows:
(IN THOUSANDS)
2002 2001 2000
Occupancy expense $ 432 $ 401 $ 370
Furniture and equipment expense 914 899 716 - ---------------------------------------------------------------------------- Total $ 1,346 $ 1,300 $ 1,086 ============================================================================
8. DEPOSITS
Balances and maturities of time deposits are as follows:
Included in interest-bearing deposits are time deposits in the amount of $100,000 or more. As of December 31, 2002, the remaining maturities or repricing frequency of time deposits of $100,000 or more are as follows:
(IN THOUSANDS)
Three months or less $28,973 Over 3 months through 12 months 33,212 Over 1year through 3 years 4,919 Over 3 years 5,859 - --------------------------------------------------- Total $72,963 ===================================================
Interest expense from deposits of $100,000 or more amounted to $3,238,000 in 2002, $3,220,000 in 2001 and $1,925,000 in 2000.
9. BORROWED FUNDS
SHORT-TERM BORROWINGS
Short-term borrowings include the following:
(IN THOUSANDS) AT DECEMBER 31, 2002 2001 Overnight borrowings (a) $ 14,350 $ 6,300 Federal Home Loan Bank of Pittsburgh borrowings (b) 2,500 22,000 Customer repurchase agreements (c) 20,218 19,764 Other repurchase agreements (d) 6,567 10,000 - -------------------------------------------------------------------------------- Total short-term borrowings $ 43,635 $ 58,064 ================================================================================
The weighted average interest rate on total short-term borrowings outstanding was 1.77% at December 31, 2002 and 3.44% at December 31, 2001. The maximum amount of total short-term borrowings outstanding at any month-end was $43,635,000 in 2002 and $96,167,000 in 2001.
(a) Overnight borrowings include federal funds purchased overnight from correspondent banks and overnight borrowings from the Federal Home Loan Bank of Pittsburgh (FHLB-Pittsburgh) on the "Open Repo Plus" facility. The maximum month-end amount of such borrowings was $14,350,000 in 2002, $20,000,000 in 2001 and $16,500,000 in 2000. The average amount of such borrowings was $2,347,000 in 2002, $4,012,000 in 2001 and $5,721,000 in 2000. Weighted average interest rates were 1.86% in 2002, 4.58% in 2001 and 6.70% in 2000.
(b) Short-term FHLB - Pittsburgh loans are as follows:
AT DECEMBER 31, (IN THOUSANDS) 2002 2001
Fixed Rate 5.25% matured January 24, 2002 $ - $ 5,000 Fixed Rate 5.20% matured February 19, 2002 - 7,000 Fixed Rate 2.38% matured October 30, 2002 - 10,000 Fixed Rate 1.51% maturing February 19, 2003 1,000 - Fixed Rate 1.68% maturing November 19, 2003 1,500 - - -------------------------------------------------------------------------------- Total short-term FHLB - Pittsburgh borrowings $ 2,500 $ 22,000 ================================================================================
Collateral for FHLB - Pittsburgh loans is described under the "Long-term Borrowings" section of this note.
(c) Customer repurchase agreements mature overnight, and are collateralized by securities with a carrying value of $23,305,000 at December 31, 2002 and $32,431,000 at December 31, 2001.
(d) Other repurchase agreements included in short-term borrowings are as follows:
AT DECEMBER 31, (IN THOUSANDS) 2002 2001
Fixed Rate 5.72% matured January 3, 2002 $ - $ 10,000 Fixed Rate 2.91% maturing March 25, 2003 6,567 - - -------------------------------------------------------------------------------- Total short-term other repurchase agreements $ 6,567 $ 10,000 ================================================================================
The terms and collateral related to repurchase agreements are described under the "Long-term Borrowings" section of this note.
LONG-TERM BORROWINGS
Long-term borrowings are as follows:
(e) Long-term borrowings from FHLB - Pittsburgh are as follows:
(*) In November 2002, the Corporation paid off these loans, and incurred prepayment penalties totaling $101,000. The prepayment penalties are included in interest expense in the Consolidated Statement of Income.
The FHLB - Pittsburgh loan facilities are collateralized by qualifying securities and mortgage loans with a book value totaling $387,091,000 at December 31, 2002. Also, the FHLB - Pittsburgh loan facilities require the Corporation to invest in established amounts of FHLB - Pittsburgh stock. The carrying values of the Corporation's holdings of FHLB - Pittsburgh stock were $10,202,000 at December 31, 2002 and $8,129,000 at December 31, 2001.
(f) Repurchase agreements included in long-term borrowings are as follows:
AT DECEMBER 31, (IN THOUSANDS) 2002 2001
Fixed Rate 2.53% maturing February 25, 2003 $ 7,500 $ - Fixed Rate 3.45% maturing February 25, 2004 7,500 - Fixed Rate 3.96% maturing March 25, 2004 6,567 - Fixed Rate 4.15% maturing February 25, 2005 5,000 - Fixed Rate 4.63% maturing March 25, 2005 6,766 - Fixed Rate 4.63% maturing February 25, 2006 4,820 - - ----------------------------------------------------------------------------- Total long-term repurchase agreements $ 38,153 $ - =============================================================================
Securities sold under repurchase agreements were delivered to the broker-dealers who arranged the transactions. The broker-dealers may have sold, loaned or otherwise disposed of such securities to other parties in the normal course of their operations, and have agreed to resell to the Corporation substantially identical securities at the maturities of the agreements. The carrying value of the underlying securities was $54,763,000 at December 31, 2002 and $9,975,000 at December 31, 2001. Average daily repurchase agreement borrowings amounted to $36,482,000 in 2002, $14,217,000 in 2001 and $14,372,000 in 2000. During 2002, 2001 and 2000, the maximum amounts of outstanding borrowings under repurchase agreements with broker-dealers were $44,720,000, $19,450,000 and $35,731,000. The weighted average interest rate on repurchase agreements was 3.72%, 6.20% in 2001 and 5.68% in 2000.
10. DERIVATIVE FINANCIAL INSTRUMENTS
In June 2001, the Corporation began to utilize derivative financial instruments related to a new certificate of deposit product called the "Index Powered Certificate of Deposit" (IPCD). IPCDs have a term of 5 years, with interest paid at maturity based on 90% of the appreciation (as defined) in the S&P 500 index. There is no guaranteed interest payable to a depositor of an IPCD - however, assuming an IPCD is held to maturity, a depositor is guaranteed the return of his or her principal, at a minimum.
Statement of Financial Accounting Standards No. 133 requires the Corporation to separate the amount received from each IPCD issued into 2 components: (1) an embedded derivative, and (2) the principal amount of each deposit. Embedded derivatives are derived from the Corporation's obligation to pay each IPCD depositor a return based on appreciation in the S&P 500 index. Embedded derivatives are carried at fair value, and are included in other liabilities in the consolidated balance sheet. Changes in fair value of the embedded derivative are included in other expense in the consolidated income statement. The difference between the contractual amount of each IPCD issued, and the amount of the embedded derivative, is recorded as the initial deposit (included in interest-bearing deposits in the consolidated balance sheet). Interest expense is added to principal ratably over the term of each IPCD at an effective interest rate that will increase the principal balance to equal the contractual IPCD amount at maturity.
In connection with IPCD transactions, the Corporation has entered into Equity Indexed Call Option (Swap) contracts with FHLB-Pittsburgh. Under the terms of the Swap contracts, the Corporation must pay FHLB-Pittsburgh quarterly amounts calculated based on the contractual amount of IPCDs issued times a negotiated rate. In return, FHLB-Pittsburgh is obligated to pay the Corporation, at the time of maturity of the IPCDs, an amount equal to 90% of the appreciation (as defined) in the S&P 500 index. If the S&P 500 index does not appreciate over the term of the related IPCDs, the FHLB-Pittsburgh would make no payment to the Corporation. The effect of the Swap contracts is to limit the Corporation's cost of IPCD funds to the market rate of interest paid to FHLB-Pittsburgh. (In addition, the Corporation pays a fee of 0.75% to a consulting firm at inception of each deposit. This fee is amortized to interest expense over the term of the IPCDs.) Swap liabilities are carried at fair value, and included in other liabilities in the consolidated balance sheet. Changes in fair value of swap liabilities are included in other expense in the consolidated income statement.
Amounts recorded as of and for the years ended December 31, 2002 and 2001 related to IPCDs are as follows (in thousands):
AT DECEMBER 31, 2002 2001 Contractual amount of IPCDs (equal to notional amount of Swap contracts) $ 3,028 $ 1,410 Carrying value of IPCDs 2,572 1,154 Carrying value of embedded derivative liabilities 156 233 Carrying value of Swap contract liabilities 309 31
FOR THE YEARS ENDED DECEMBER 31, 2002 2001 Interest expense 88 17 Other expense 8 7
11. FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Corporation's financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. Statement of Financial Accounting Standards No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Therefore, the aggregate fair value amounts presented may not represent the underlying fair value of the Corporation.
The Corporation used the following methods and assumptions in estimating fair value disclosures for financial instruments:
CASH AND CASH EQUIVALENTS - The carrying amounts of cash and short-term instruments approximate fair values.
SECURITIES - Fair values for securities, excluding restricted equity securities, are based on quoted market prices. The carrying value of restricted equity securities approximates fair value based on applicable redemption provisions.
LOANS - Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, commercial real estate, residential mortgage, credit card and other consumer. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories. The fair value of performing loans, except residential mortgage and credit card loans, is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loans. The estimate of maturity is based on the Corporation's historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions. For performing residential mortgage loans, fair value is estimated by discounting contractual cash flows adjusted for prepayment estimates based on historical experience. For credit card loans, cash flows and maturities are estimated based on contractual interest rates and historical experience. Fair value of nonperforming loans is based on recent appraisals or estimates prepared by the Corporation's lending officers.
DEPOSITS - The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, savings, money market and interest checking accounts, is (by definition) equal to the amount payable on demand at December 31, 2002 and 2001. The fair value of all other deposit categories is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities. The fair value estimates of deposits do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market, commonly referred to as the core deposit intangible.
BORROWED FUNDS - The fair value of borrowings is estimated using discounted cash flow analyses based on rates currently available to the Corporation for similar types of borrowing arrangements.
ACCRUED INTEREST - The carrying amounts of accrued interest receivable and payable approximate fair values.
EMBEDDED DERIVATIVE LIABILITIES - IPCDS - The fair values of embedded derivatives are calculated by a third party. Factors that affect the fair value of embedded derivatives include term to maturity, market interest rates and other market factors that affect the present value of the Corporation's obligation to pay each IPCD depositor a return based on appreciation in the S&P 500 index.
EMBEDDED DERIVATIVE LIABILITIES - EQUITY OPTION SWAP CONTRACTS - The fair values of equity option Swap contracts are calculated by a third party. Factors that affect the fair value of equity option Swap contracts include: (1) the negotiated rate associated with the Corporation's obligation to make quarterly payments to the FHLB-Pittsburgh over the term of each IPCD; and (2) term to maturity, market interest rates and other market factors that affect the present value of the FHLB-Pittsburgh's obligation to pay the Corporation a return based on appreciation in the S&P 500 index.
The estimated fair values, and related carrying amounts, of the Corporation's financial instruments are as follows:
12. EMPLOYEE AND POSTRETIREMENT BENEFIT PLANS
DEFINED BENEFIT PLANS
The Corporation has a noncontributory defined benefit pension plan for all employees meeting certain age and length of service requirements. Benefits are based primarily on years of service and the average annual compensation during the highest five consecutive years within the final ten years of employment.
Also, the Corporation sponsors a defined benefit health care plan that provides postretirement medical benefits and life insurance to employees who meet certain age and length of service requirements. This plan contains a cost-sharing feature, which causes participants to pay for all future increases in costs related to benefit coverage. Accordingly, actuarial assumptions related to health care cost trend rates do not affect the liability balance at December 31, 2002 and 2001, and will not affect the Corporation's future expenses.
The following tables show the funded status and components of net periodic benefit cost from these defined benefit plans:
PROFIT SHARING AND DEFERRED COMPENSATION PLANS
The Corporation has a profit sharing plan that incorporates the deferred salary savings provisions of Section 401(k) of the Internal Revenue Code. The Corporation's matching contributions to the Plan depend upon the tax deferred contributions of employees. The Corporation's total basic and matching contributions were $667,000 in 2002, $588,000 in 2001 and $511,000 in 2000.
Effective December 31, 2001, the Corporation amended the 401(k) Plan to convert the "Basic Stock Fund" component of the Plan to an Employee Stock Ownership Plan (ESOP). A portion of the Corporation's basic contributions to the Plan are made to the ESOP, and the Plan uses these funds to purchase Corporation stock for the accounts of Plan participants. These purchases are made on the market (not directly from the Corporation), and employees are not permitted to purchase Corporation stock under the Plan. The Plan includes a diversification feature which permits Plan participants, upon reaching age 55 and 10 years of service (as defined), to sell up to 50% of their Corporation shares back to the Plan over a period of 6 years. This diversification feature will become effective in 2003, and accordingly, as of December 31, 2002, there were no shares allocated for repurchase by the Plan.
Dividends paid on shares held by the ESOP are charged to retained earnings. All Corporation shares owned through the ESOP are included in the calculation of weighted-average shares outstanding for purposes of calculating earnings per share - basic and diluted. As of December 31, 2002, the ESOP held 189,263 shares of Corporation stock, all of which had been allocated to Plan participants. The Corporation's contributions to the ESOP portion of the Plan for 2002 (included in total contributions reported above) totaled $343,000.
The Corporation also has a nonqualified supplemental deferred compensation arrangement with its key officers. Charges to expense for officers' supplemental deferred compensation were $44,000 in 2002, $38,000 in 2001 and $70,000 in 2000.
STOCK-BASED COMPENSATION PLANS
The Corporation has a Stock Incentive Plan for a selected group of senior officers. A total of 180,000 shares of common stock may be issued under the Stock Incentive Plan. Awards may be made under the Stock Incentive Plan in the form of qualified options ("Incentive Stock Options," as defined in the Internal Revenue Code), nonqualified options, stock appreciation rights or restricted stock. Through 1999, all awards under the Stock Incentive Plan were Incentive Stock Options, with exercise prices equal to the market price of the stock at the date of grant, ratable vesting over 5 years and a contractual expiration of 10 years. In 2000 and 2002, there were awards of Incentive Stock Options and restricted stock. The Incentive Stock Options granted in 2000 and 2002 have an exercise price equal to the market value of the stock at the date of grant, vest after 6 months and expire after 10 years. The restricted stock awards vest ratably over 3 years.
Also, the Corporation has an Independent Directors Stock Incentive Plan (formerly called the Independent Directors Stock Option Plan). In 2001, this plan was amended to permit awards of nonqualified stock options and/or restricted stock to non-employee directors. As amended, a total of 50,000 shares of common stock may be issued under the Independent Directors Stock Incentive Plan. The recipients' rights to exercise stock options under this plan expire 10 years from the date of grant. The exercise prices of all stock options awarded under the Independent Directors Stock Incentive Plan are equal to market value as of the dates of grant. The restricted stock awards vest ratably over 3 years.
Effective January 2, 2003, the Corporation granted options to purchase a total of 30,942 shares of common stock through the Stock Incentive and Independent Directors Stock Incentive Plans. The exercise price for these options is $31.10 per share, which was the market price at the date of grant. Also, effective January 2, 2003, the Corporation awarded a total of 3,444 shares of restricted stock under the Stock Incentive and Independent Directors Stock Incentive Plans. The stock options and restricted stock awards that were awarded in January 2003 are not included in the tables that follow.
As described in Note 1, the Corporation applies Accounting Principles Board Opinion 25 and related interpretations in accounting for stock options. Accordingly, no compensation expense has been recognized for the stock options. Had compensation cost for the stock options been determined based on the fair value at the grant dates for awards consistent with the method of SFAS No. 123, the effect on the Corporation's net income and earnings per share would have been adjusted to the pro forma amounts indicated in the following table.
(NET INCOME IN THOUSANDS)
2002 2001 2000 Net income As reported $14,959 $12,052 $8,476 Pro forma $14,768 $11,989 $8,399
Earnings per share-basic As reported $2.80 $2.25 $1.58 Pro forma $2.77 $2.24 $1.57
Earnings per share-diluted As reported $2.79 $2.25 $1.58 Pro forma $2.76 $2.24 $1.57
For purposes of the calculations of SFAS No. 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:
2002 2001 2000 Volatility 17% 17% 18% Expected option lives 6 Years 6 Years 6 Years Risk-free interest rate 5.00% 5.08% 5.00% Dividend yield 4.16% 3.57% 3.96%
A summary of the status of the Corporation's stock option plans is presented below:
The following table summarizes information about stock options outstanding as of December 31, 2002:
OUTSTANDING EXERCISABLE AT REMAINING AT DECEMBER 31, CONTRACTUAL DECEMBER 31, EXERCISE PRICES 2002 LIFE IN YEARS 2002 $20.00 2,995 3 2,995 $25.50 - $27.84 9,700 4 9,700 $33.25-$36.50 12,850 5 12,850 $33.13-$36.38 16,500 6 13,760 $25.00-$27.00 20,400 7 13,200 $20.25-$21.25 17,587 8 17,587 $25.50 40,457 9 40,457 - ------------------------------------------------------------------------------- 120,489 110,549 ===============================================================================
The following table summarizes restricted stock awards through December 31, 2002:
2002 2001 2000 Number of shares awarded 4,431 221 1,752
Market price of stock at date of grant $ 25.50 $ 21.25 $ 20.25
Compensation expense related to restricted stock was $80,000 in 2002 and $22,000 in 2001. There was no compensation expense related to restricted stock awards in 2000.
13. INCOME TAXES The following temporary differences gave rise to the net deferred tax liability at December 31, 2002 and 2001:
(IN THOUSANDS)
2002 2001 Deferred tax liabilities: Depreciation $ 275 $ 240 Prepaid pension 155 220 Accretion on securities 6 2 Investments in limited partnerships 21 24 Unrealized holding gains on securities 6,257 2,722 - --------------------------------------------------------------------- Total 6,714 3,208 - --------------------------------------------------------------------- Deferred tax assets: Allowance for loan losses (2,026) (1,843) Postretirement and sick benefits (216) (194) Loan fees and costs (76) (60) Supplemental executive retirement plan (175) (168) Restricted stock compensation (27) - - --------------------------------------------------------------------- Total (2,520) (2,265) - --------------------------------------------------------------------- Deferred tax liability, net $ 4,194 $ 943 =====================================================================
Tax provision: 2002 2001 2000 Currently payable $ 4,018 $ 3,371 $ 1,882 Deferred (284) (349) (63) - -------------------------------------------------------------------------------- Total provision $ 3,734 $ 3,022 $ 1,819 ================================================================================
Reconciliation of tax provision:
14. RELATED PARTY TRANSACTIONS
Loans to executive officers, directors of the Corporation and its subsidiaries and any associates of the foregoing persons are as follows:
(IN THOUSANDS)
The above transactions were made in the ordinary course of business on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and do not involve more than normal risks of collectibility. Other changes represent net increases in existing lines of credit and transfers in and out of the related party category.
15. OFF-BALANCE SHEET RISK
The Corporation is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financial needs of its customers. These financial instruments include commitments to extend credit and financial standby letters of credit. These instruments involve, to varying degrees, elements of credit, interest rate or liquidity risk in excess of the amount recognized in the consolidated balance sheet. The contract amounts of these instruments express the extent of involvement the Corporation has in particular classes of financial instruments.
The Corporation's exposure to credit loss from nonperformance by the other party to the financial instruments for commitments to extend credit and financial standby letters of credit is represented by the contractual amount of these instruments. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
Financial instruments whose contract amounts represent credit risk at December 31, 2002 and 2001 are as follows:
(IN THOUSANDS) 2002 2001
Commitments to extend credit $ 103,138 $ 86,498 Financial standby letters of credit 10,753 5,508
Commitments to extend credit are legally binding agreements to lend to customers. Commitments generally have fixed expiration dates or other termination clauses and may require payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future liquidity requirements. The Corporation evaluates each customer's creditworthiness on a case-by-case basis. The amount of
collateral obtained, if deemed necessary by the Corporation, for extensions of credit is based on management's credit assessment of the counterparty.
Financial standby letters of credit are conditional commitments issued by the Corporation guaranteeing performance by a customer to a third party. Those guarantees are issued primarily to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Some of the financial standby letters of credit are collateralized by real estate or other assets, while others are unsecured. The extent to which proceeds from liquidation of collateral would be expected to cover the maximum potential amount of future payments related to financial standby letters of credit is not estimable. The Corporation has recorded no liability associated with financial standby letters of credit as of December 31, 2002 and 2001.
Financial standby letters of credit as of December 31, 2002 expire as follows:
(IN THOUSANDS)
YEAR OF EXPIRATION AMOUNT - ---------------------------------------- 2003 $ 5,462 2004 2,605 2005 1,165 2006 593 2007 928 - ---------------------------------------- Total $ 10,753 ========================================
16. CONTINGENCIES
In the normal course of business, the Corporation may be subject to pending and threatened lawsuits in which claims for monetary damages could be asserted. In management's opinion, the Corporation's financial position and results of operations would not be materially affected by the outcome of such legal proceedings.
17. REGULATORY MATTERS
The Corporation (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary - actions by regulators that, if undertaken could have a direct material effect on the Corporation's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
Quantitative measures established by regulation to ensure capital adequacy require the Corporation and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2002 and 2001, that the Corporation and the Bank meet all capital adequacy requirements to which they are subject.
To be categorized as well capitalized, an institution must maintain minimum total risk based, Tier I risk based and Tier I leverage ratios as set forth in the following table. The Corporation's and the Bank's actual capital amounts and ratios are also presented in the following table.
Restrictions imposed by Federal Reserve Regulation H limit dividend payments in any year to the current year's net income plus the retained net income of the prior two years without approval of the Federal Reserve Board. Accordingly, the Corporation's dividends in 2003 may not exceed $15,299,000, plus consolidated net income for 2003. Additionally, banking regulators limit the amount of dividends that may be paid by the Bank to the Corporation. Retained earnings against which dividends may be paid without prior approval of the banking regulators amounted to approximately $76,113,000 at December 31, 2002, subject to the minimum capital ratio requirements noted above.
Restrictions imposed by federal law prohibit the Corporation from borrowing from the Bank unless the loans are secured in specific amounts. Such secured loans to the Corporation are generally limited to 10% of the Bank's stockholder's equity (excluding accumulated other comprehensive income) or $8,614,000 at December 31, 2002.
18. PARENT COMPANY ONLY
The following is condensed financial information for Citizens & Northern Corporation.
CONDENSED BALANCE SHEET
DECEMBER 31, (IN THOUSANDS) 2002 2001
ASSETS Cash $ 592 $ 333 Investment in subsidiaries: Citizens & Northern Bank 95,879 82,914 Citizens & Northern Investment Corporation 18,929 16,383 Bucktail Life Insurance company 2,006 2,010 Other assets 45 13 - --------------------------------------------------------------------------- TOTAL ASSETS $117,451 $101,653 ===========================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY Dividends payable $ 1,586 $ 1,466 Other liabilities 28 - Stockholders' equity 115,837 100,187 - --------------------------------------------------------------------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $117,451 $101,653 ===========================================================================
CONDENSED INCOME STATEMENT
CONDENSED STATEMENT OF CASH FLOWS
19. SUMMARY OF QUARTERLY CONSOLIDATED FINANCIAL DATA (UNAUDITED)
The following table presents summarized quarterly financial data for 2002 and 2001:
INDEPENDENT AUDITORS' REPORT
To the Stockholders and Board of Directors of Citizens & Northern Corporation:
We have audited the accompanying consolidated balance sheet of Citizens & Northern Corporation and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Citizens & Northern Corporation and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America.
Parente Randolph, PC /s/
Williamsport, Pennsylvania February 7, 2003
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information concerning Directors and Executive Officers is incorporated herein by reference to disclosure under the captions "Proposal 1 - Election of Directors," "Corporation's and Bank's Executive Officers," and "Section 16(a) Beneficial Ownership Reporting Compliance" of the Corporation's proxy statement dated March 18, 2003 for the annual meeting of stockholders to be held on April 15, 2003.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information concerning executive compensation information is incorporated herein by reference to disclosure under the caption "Executive Compensation" of the Corporation's proxy statement dated March 18, 2003 for the annual meeting of stockholders to be held on April 15, 2003.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information concerning security ownership of certain beneficial owners and management is incorporated herein by reference to disclosure under the caption "Security Ownership of Management" of the Corporation's proxy statement dated March 18, 2003 for the annual meeting of stockholders to be held on April 15, 2003.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information concerning loans to Directors and Executive Officers is provided in Note 14 to the Consolidated Financial Statements, which is included in Part II, Item 8 of this Annual Report on Form 10-K. Additional information is incorporated herein by reference to disclosure appearing under the caption "Certain Transactions" of the Corporation's proxy statement dated March 18, 2003 for the annual meeting of stockholders to be held on April 15, 2003.
ITEM 14.
ITEM 14. CONTROLS AND PROCEDURES
Within 90 days prior to the filing date of this report, the Corporation's Chief Executive Officer and Chief Financial Officer carried out an evaluation of the design and effectiveness of the Corporation's disclosure controls and procedures pursuant to Rule 13a-14(c) and Rule 15d-14(c) of the Securities Exchange Act of 1934. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Corporation's disclosure controls and procedures are effective to ensure that information required to be disclosed in reports the Corporation files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms.
There have been no significant changes in the Corporation's internal controls or in other factors that could significantly affect these controls subsequent to the date of the Chief Executive Officer's and Chief Financial Officer's most recent evaluation. There were no significant deficiencies or material weaknesses noted in the evaluation, and therefore there were no corrective actions taken.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) (1). The following consolidated financial statements are set forth in Part II, Item 8:
(a)(2) Financial statement schedules are not applicable or included in the financial statements or related notes.
(b) On October 11, 2002, a Current Report on Form 8-K was filed to report the Corporation's consolidated earnings results for the three-month and nine-month periods ended September 30, 2002.
(c) Exhibits - The required exhibits are listed under Part IV, Item 14(a)(3) of Form 10-K.
(d) Financial statement schedules are omitted because the required information is not applicable or is included elsewhere in Form 10-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Citizens & Northern Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized:
CITIZENS & NORTHERN CORPORATION
By: Craig G. Litchfield /s/ - --------------------------- Craig G. Litchfield Chairman, President and Chief Executive Officer
Date: March 18, 2003
By: Mark A. Hughes /s/ - --------------------------- Treasurer and Principal Accounting Officer
Date: March 18, 2003
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
BOARD OF DIRECTORS
/s/ Dennis F. Beardslee /s/ Edward L. Learn Dennis F. Beardslee Edward L. Learn Date: March 18, 2003 Date: March 18, 2003
/s/ R. Robert DeCamp /s/ Craig G. Litchfield R. Robert DeCamp Craig G. Litchfield Date: March 18, 2003 Date: March 18, 2003
/s/ Jan E. Fisher /s/ Lawrence F. Mase Jan E. Fisher Lawrence F. Mase Date: March 18, 2003 Date: March 18, 2003
/s/ R. Bruce Haner /s/ Leonard Simpson R. Bruce Haner Leonard Simpson Date: March 18, 2003 Date: March 18, 2003
/s/ Susan E. Hartley /s/ James E. Towner Susan E. Hartley James E. Towner Date: March 18, 2003 Date: March 18, 2003
/s/ Karl W. Kroeck /s/ Ann M. Tyler Karl W. Kroeck Ann M. Tyler Date: March 18, 2003 Date: March 18, 2003
/s/ Leo F. Lambert Leo F. Lambert Date: March 18, 2003
CERTIFICATIONS
I, Craig G. Litchfield, Chairman, Chief Executive Officer and President of Citizens & Northern Corporation, certify that:
1. I have reviewed this annual report on Form 10-K of Citizens & Northern Corporation;
2. Based on my knowledge, this 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 officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures 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) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, 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 in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
March 18, 2003 By: Craig G. Litchfield /s/ - -------------- ----------------------- Date Chairman, President and Chief Executive Officer
I, Mark A. Hughes, Treasurer and Chief Financial Officer of Citizens & Northern Corporation, certify that:
1. I have reviewed this annual report on Form 10-K of Citizens & Northern Corporation;
2. Based on my knowledge, this 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 officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures 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) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, 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 in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
March 18, 2003 By: Mark A. Hughes /s/ - -------------- ----------------------- Date Treasurer and Chief Financial Officer