ITEM 1. BUSINESS
Citizens & Northern Corporation (“Corporation”) is a holding company whose principal activity is community banking. The Corporation’s principal office is located in Wellsboro, Pennsylvania. The largest subsidiary is Citizens & Northern Bank (“C&N Bank”). In the third quarter 2005, the Corporation completed the acquisition of Canisteo Valley Corporation and its subsidiary, First State Bank, a New York State chartered commercial bank with offices in Canisteo and South Hornell, NY. The acquisition of Canisteo Valley Corporation and First State Bank permits expansion of Citizens & Northern Corporation’s banking operations into communities located in the southern tier of New York State, in close proximity to many of the northern Pennsylvania branch locations. Management considers the New York State branches to be part of the same community banking operating segment as the Pennsylvania locations; however, the separate New York State charter for First State Bank has been maintained because of certain regulatory advantages. 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.
In December 2006, the Corporation, along with Citizens Bancorp, Inc. (“Citizens”), announced the signing of an Agreement and Plan of Merger. Citizens is the parent company of Citizens Trust Company (“CTC”), a commercial bank with offices in the Pennsylvania communities of Coudersport, Emporium and Port Allegany. As of December 31, 2006, Citizens reported total assets of $144.4 million. Under the terms of the Agreement and Plan of Merger, Citizens will merge into the Corporation, and CTC will merge into C&N Bank. In the aggregate, 50% of the shares of Citizens common stock will be purchased for cash and 50% of the shares of Citizens common stock will be exchanged for shares of Corporation common stock. Based on the number of Citizens common shares outstanding on December 31, 2006, and the last trading price of the Corporation’s common stock in 2006, the total purchase consideration is valued at approximately $29 million. The transaction, which has been approved by the Board of Directors of both companies, is expected to be completed during the second quarter 2007. Consummation of the Merger is subject to approval by Citizens’ shareholders, regulatory approvals and other customary conditions of closing.
C&N Bank is a Pennsylvania banking institution that was formed by the consolidation of Northern National Bank of Wellsboro and Citizens National Bank of Towanda on October 1, 1971. Subsequent mergers included: First National Bank of Ralston in May 1972; Sullivan County National Bank in October 1977; Farmers National Bank of Athens in January 1984; and First National Bank of East Smithfield in May 1990. C&N Bank has held its current name since May 6, 1975, at which time C&N Bank changed its charter from a national bank to a Pennsylvania bank.
C&N Bank and First State Bank (collectively, the “Banks”) provide an extensive range of banking services, including deposit and loan products for personal and commercial customers. C&N Bank also maintains a trust division that provides a wide range of financial services, such as 401(k) plans, retirement planning, estate planning, estate settlements and asset management. In January 2000, C&N Bank formed a subsidiary, C&N Financial Services Corporation (“C&NFSC”). C&NFSC is a licensed insurance agency that provides insurance products to individuals and businesses. In 2001, C&NFSC added a broker-dealer division, which offers mutual funds, annuities, educational savings accounts and other investment products through registered agents. C&NFSC’s operations are not significant in relation to the total operations of the Corporation.
All phases of the Banks’ business are competitive. The Banks primarily compete in Tioga, Bradford, Sullivan and Lycoming counties in Pennsylvania, and Steuben and Allegany counties in New York. The Banks compete with local commercial banks headquartered in our market area as well as other commercial banks with branches in our market area. Some of the banks that have branches in the Banks’ market area are larger in overall size than the Banks. With respect to lending activities and attracting deposits, the Banks also compete with savings banks, savings and loan associations, insurance companies, regulated small loan companies and credit unions. Also, the Banks compete with mutual funds for deposits. C&N Bank competes with insurance companies, investment counseling firms, mutual funds and other business firms and individuals for trust, investment management, brokerage and insurance services. The Banks are generally competitive with all financial institutions in our service area with respect to interest rates paid on time and savings deposits, service charges on deposit accounts and interest rates charged on loans. The Banks serve a diverse customer base, and are not economically dependent on any small group of customers or on any individual industry.
Major initiatives over the last 5 years included the following:
•
expanded trust and financial services capabilities, including investment management, employee benefits and insurance services;
•
purchased and remodeled a former bank operations center in Williamsport, PA, and began offering trust and financial management, commercial lending, branch banking and other services, in 2004;
•
opened a branch office at a leased facility in South Williamsport, PA in 2004;
•
replaced the core banking computer system in 2004;
•
constructed and opened a branch facility in Jersey Shore, PA in 2005;
•
closed on the merger with Canisteo Valley Corporation in 2005;
•
constructed and opened a branch facility in Old Lycoming Township, PA, which opened in March 2006
•
constructed an administration building in Wellsboro, PA, which opened in March 2006; and
•
as described above, in December 2006, entered into an agreement to acquire Citizens Bancorp, Inc., which is expected to close in 2007.
At December 31, 2006, C&N Bank had total assets of $1,063,970,000, total deposits of $725,983,000, net loans outstanding of $659,370,000 and 346 full-time equivalent employees. At December 31, 2006, First State Bank had total assets of $42,889,000, total deposits of $35,241,000, net loans outstanding of $19,930,000 and 20 full-time equivalent employees.
Most of the activities of the Corporation and its subsidiaries are regulated by federal or state agencies. The primary regulatory relationships are described as follows:
•
The Corporation is a bank holding company formed under the provisions of Section 3 of the Federal Reserve Act. The Corporation is under the direct supervision of the Federal Reserve and must comply with the reporting requirements of the Federal Bank Holding Company Act.
•
C&N Bank is a state-chartered, nonmember bank, supervised by the Federal Deposit Insurance Corporation and the Pennsylvania Department of Banking.
•
Canisteo Valley Corporation is the holding company for First State Bank. The Federal Reserve is the primary regulator for Canisteo Valley Corporation.
•
First State Bank is a state-chartered, Federal Reserve member bank, supervised by the Federal Reserve and the New York State Department of Banking.
•
C&NFSC is a Pennsylvania corporation. The Pennsylvania Department of Insurance regulates C&NFSC’s insurance activities. Brokerage products are offered through a third party networking agreement between C&N Bank and UVEST Financial Services, Inc.
•
Bucktail is incorporated in the state of Arizona and supervised by the Arizona Department of Insurance.
A copy of the Corporation’s annual report on Form 10-K, quarterly reports on Form 10-Q, current events reports on Form 8-K, and amendments to these reports, will be furnished without charge upon written request to the Corporation’s Treasurer at P.O. Box 58, Wellsboro, PA 16901. Copies of these reports will be furnished as soon as reasonably possible, after they are filed electronically with the Securities and Exchange Commission. The information is also available through the Corporation’s web site at www.cnbankpa.com.
ITEM 1A.
ITEM 1A. RISK FACTORS
The Corporation is subject to the many risks and uncertainties applicable to all banking companies, as well as risks specific to the Corporation’s geographic locations. Although the Corporation seeks to effectively manage risks, and maintains a level of equity that exceeds the banking regulatory agencies’ thresholds for being considered “well capitalized” (see Note 21 to the consolidated financial statements), management cannot predict the future and cannot eliminate the possibility of credit, operational or other losses. Accordingly, actual results may differ materially from management’s expectations. Some of the Corporation’s significant risks and uncertainties are discussed below.
Credit Risk from Lending Activities - A significant source of risk is the possibility that losses will be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loan agreements. Most of the Corporation’s loans are secured, but some loans are unsecured. With respect to secured loans, the collateral securing the repayment of these loans may be insufficient to cover the obligations owed under such loans. Collateral values may be adversely affected by changes in economic, environmental and other conditions, including declines in the value of real estate, changes in interest rates, changes in monetary and fiscal policies of the federal government, wide-spread disease, terrorist activity, environmental contamination and other external events. In addition, collateral appraisals that are out of date or that do not meet industry recognized standards may create the impression that a loan is adequately collateralized when it is not. The Corporation has adopted underwriting and credit monitoring procedures and policies, including regular reviews of appraisals and borrower financial statements, that management believes are appropriate to mitigate the risk of loss. Also, as discussed further in the “Provision and Allowance for Loan Losses” section of Management’s Discussion and Analysis, the Corporation attempts to estimate the amount of losses that may be inherent in the portfolio through a quarterly evaluation process that includes several members of management and that addresses specifically identified problem loans, as well as other quantitative data and qualitative factors. Such risk management and accounting policies and procedures, however, may not prevent unexpected losses that could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.
Interest Rate Risk - Business risk arising from changes in interest rates is an inherent factor in operating a banking organization. The Corporation’s assets are predominantly long-term, fixed rate loans and debt securities. Funding for these assets comes principally from shorter-term deposits and borrowed funds. Accordingly, there is an inherent risk of lower future earnings or decline in fair value of the Corporation’s financial instruments when interest rates change. Significant fluctuations in interest rates could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity. For additional information regarding interest rate risk, see Part II, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk.”
Equity Securities Risk - The Corporation’s equity securities portfolio consists primarily of investments in stocks of banks and bank holding companies, mainly based in Pennsylvania. Investments in bank stocks are subject to the risk factors affecting the banking industry, and that could cause a general market decline in the value of bank stocks. Also, losses could occur in individual stocks held by the Corporation because of specific circumstances related to each bank. Further, because of the concentration of its holdings in Pennsylvania banks, these investments could decline in value if there were a downturn in the state’s economy. These factors could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity. For additional information regarding equity securities risk, see Part II, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk.”
Breach of Information Security and Technology Dependence - The Corporation relies on software, communication, and information exchange on a variety of computing platforms and networks and over the Internet. Despite numerous safeguards, the Corporation cannot be certain that all of its systems are entirely free from vulnerability to attack or other technological difficulties or failures. The Corporation relies on the services of a variety of vendors to meet its data processing and communication needs. If information security is breached or other technology difficulties or failures occur, information may be lost or misappropriated, services and operations may be interrupted and the Corporation could be exposed to claims from customers. Any of these results could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.
Limited Geographic Diversification - The Corporation grants commercial, residential and personal loans to customers primarily in the Pennsylvania Counties of Tioga, Bradford, Sullivan and Lycoming, and in Steuben and Allegany Counties in New York State. Although the Corporation has a diversified loan portfolio, a significant portion of its debtors’ ability to honor their contracts is dependent on the local economic conditions within the region. Deterioration in economic conditions could adversely affect the quality of the Corporation’s loan portfolio and the demand for its products and services, and accordingly, could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.
Growth Strategy - In recent years, the Corporation has expanded its operations by adding new branches in Lycoming County, Pennsylvania, and by acquiring Canisteo Valley Corporation in the southern tier of New York State. Also, as described in Item 1, in December 2006, the Corporation entered into an agreement to acquire Citizens Bancorp, Inc., a banking company with total assets of approximately $144.4 million as of December 31, 2006. Management expects the acquisition of Citizens Bancorp, inc. to close in 2007. The Corporation’s future financial performance will depend on its ability to execute its strategic plan and manage its future growth. Failure to execute these plans could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.
Competition - All phases of the Corporation’s business are competitive. Some competitors are much larger in total assets and capitalization than the Corporation, have greater access to capital markets and can offer a broader array of financial services. There can be no assurance that the Corporation will be able to compete effectively in its markets. Furthermore, developments increasing the nature or level of competition could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.
Government Regulation and Monetary Policy - The Corporation and the banking industry are subject to extensive regulation and supervision under federal and state laws and regulations. The restrictions imposed by such laws and regulations limit the manner in which the Corporation conducts its business, undertakes new investments and activities and obtains financing. These regulations are designed primarily for the protection of the deposit insurance funds and consumers and not to benefit the Corporation’s shareholders. Financial institution regulation has been the subject of significant legislation in recent years and may be the subject of further significant legislation in the future, none of which is in the control of the Corporation. Significant new laws or changes in, or repeals of, existing laws could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity. Further, federal monetary policy, particularly as implemented through the Federal Reserve System, significantly affects short-term interest rates and credit conditions, and any unfavorable change in these conditions could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.
Bank Secrecy Act and Related Laws and Regulations - These laws and regulations have significant implications for all financial institutions. They increase due diligence requirements and reporting obligations for financial institutions, create new crimes and penalties, and require the federal banking agencies, in reviewing merger and other acquisition transactions, to consider the effectiveness of the parties to such transactions in combating money laundering activities. Even innocent noncompliance and inconsequential failure to follow the regulations could result in significant fines or other penalties, which could have a material adverse impact on the Corporation’s financial condition, results of operations or liquidity.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
Not applicable.
ITEM 2.
ITEM 2. PROPERTIES
The Banks owns each of their properties, except for the facility located at 2 East Mountain Avenue, South Williamsport, which is leased. All of the properties are in good condition. None of the owned properties are subject to encumbrance.
A listing of properties is as follows:
Main administrative offices:
90-92 Main Street
or
10 Nichols Street
Wellsboro, PA 16901
Wellsboro, PA 16901
Facilities management office:
Water Street
Wellsboro, PA 16901
Branch offices - C&N Bank:
428 S. Main Street
1085 S. Main Street
Courthouse Square
Athens, PA 18810
Mansfield, PA 16933
Troy, PA 16947
111 Main Street
Route 220
90-92 Main Street
Dushore, PA 18614
Monroeton, PA 18832
Wellsboro, PA 16901
Main Street
3461 Route 405 Highway
1510 Dewey Avenue
East Smithfield, PA 18817
Muncy, PA 17756
Williamsport, PA 17701
104 Main Street
Thompson Street
130 Court Street
Elkland, PA 16920
Ralston, PA 17763
Williamsport, PA 17701
230-232 Railroad Street
503 N. Elmira Street
Route 6
Jersey Shore, PA 17740
Sayre, PA 18840
Wysox, PA 18854
102 E. Main Street
2 East Mountain Avenue
Knoxville, PA 16928
South Williamsport, PA 17702
Main Street
41 Main Street
Laporte, PA 18626
Tioga, PA 16946
Main Street
428 Main Street
Liberty, PA 16930
Towanda, PA 18848
First State Bank offices:
3 Main Street
111 Main Street
Canisteo, NY 14823
Hornell, NY 14843
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Corporation and the Banks are involved in various legal proceedings incidental to their business. Management believes the aggregate liability, if any, resulting from such pending and threatened legal proceedings will not have a material, adverse effect on the Corporation’s financial condition or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of 2006, 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, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
QUARTERLY SHARE DATA
Trades of the Corporation’s stock are executed through various brokers who maintain a market in the Corporation’s stock. Effective January 13, 2005, the Corporation’s stock began to be listed on the NASDAQ Capital Markets (formerly known as NASDAQ SmallCap) with the trading symbol CZNC. Previously, the Corporation’s stock was available through the Over-The-Counter Bulletin Board. As of December 31, 2006, there were 2,422 shareholders of record of the Corporation’s common stock.
The following table sets forth the high and low sales prices of the common stock during 2006 and 2005.
In addition to the cash dividends reflected in the table above, the Corporation declared a 1% stock dividend in the 4th quarter of each year presented, which was issued in January of the following year.
While the Corporation expects to continue its policy of regular quarterly dividend payments, future dividend payments will depend upon maintenance of a strong financial condition, future earnings and capital and regulatory requirements. Also, the Corporation, C&N Bank and First State Bank are subject to restrictions on the amount of dividends that may be paid without approval of banking regulatory authorities. These restrictions are described in Note 21 to the consolidated financial statements.
PERFORMANCE GRAPH
Set forth below is a chart comparing the Corporation’s cumulative return to stockholders against the cumulative return of the Russell 2000 and a Peer Group Index of similar banking organizations selected by the Corporation for the five year period commencing December 31, 2001 and ended December 31, 2006. The index values are market-weighted dividend-reinvestment numbers which measure the total return for investing $100.00 five years ago. This meets Securities & Exchange Commission requirements for showing dividend reinvestment share performance over a five year period and measures the return to an investor for placing $100.00 into a group of bank stocks and reinvesting any and all dividends into the purchase of more of the same stock for which dividends were paid.
COMPARISON OF 5 YEAR CUMULATIVE RETURN
The C&N peer group consists of banks headquartered in Pennsylvania with total assets of $500 million to $1.3 billion. This peer group consists of ACNB Corporation, Gettysburg; American Bank Incorporated, Allentown; AmeriServ Financial, Inc., Johnstown; Bryn Mawr Bank Corporation, Bryn Mawr; CNB Financial Corporation, Clearfield; Citizens Financial Services, Inc., Mansfield; Comm Bankcorp, Inc., Clarks Summit; Ephrata National Bank, Ephrata; Fidelity D & D Bancorp, Inc., Dunmore; First Chester County Corp., West Chester; First Keystone Corporation, Berwick; First National Community Bankcorp, Inc., Dunmore; Franklin Financial Services Corporation, Chambersburg; IBT Bancorp, Inc., Irwin; Leesport Financial Corp., Wyomissing; Orrstown Financial Services, Inc., Shippensburg; Penns Woods Bancorp, Inc., Williamsport; Penseco Financial Services Corporation, Scranton; PSB Bancorp, Inc., Philadelphia; QNB Corp., Quakertown; Republic First Bancorp, Inc. ; Philadelphia; FNB Bankcorp, Inc., Newtown; Palm Bancorp, Palmerton; Tower Bancorp, Inc., Greencastle; Codorus Valley Bancorp, Inc., York; Union National Financial Corporation, Lancaster, and DNB Financial Corporation, Downingtown.
The data for this graph was obtained from SNL Financial L.C.
EQUITY COMPENSATION PLAN INFORMATION
The following table sets forth information concerning the Stock Incentive Plan and Independent Directors Stock Incentive Plan, both of which have been approved by the Corporation’s shareholders. The figures shown in the table below are as of December 31, 2006.
More details related to the Corporation’s equity compensation plans are provided in Notes 1 and 15 to the consolidated financial statements.
SALES OF UNREGISTERED SECURITIES
During the 3-month period ended December 31, 2006, the Corporation issued 420 shares of common stock held in treasury upon the exercise of stock options by a director under the Corporation’s equity compensation plans. The exercise price was $17.00 per share and resulted in cash proceeds to the Corporation of $7,140. Treasury shares were issued upon exercise of options by a small number of employees and directors in reliance upon the private placement exemption from registration under Section 4(2) of the Securities Act of 1933.
ISSUER PURCHASES OF EQUITY SECURITIES
On August 24, 2006, the Corporation announced the extension of a plan, through August 31, 2007, that permits repurchase of shares of its outstanding common stock. There were no share repurchases during the fourth quarter 2006. As of December 31, 2006, the maximum additional value available for purchases under this program is $10,666,392.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
(1)
All share and per share data have been restated to give effect to stock dividends and splits.
(2)
Rates of return on tax-exempt securities and loans are calculated on a fully-taxable equivalent basis.
(3)
The efficiency ratio is calculated by dividing total noninterest expense by the sum of net interest income and noninterest income excluding securities gains and gains from sale of credit card loans.
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, “should”, “likely”, “expect”, “plan”, “anticipate”, “target”, “forecast”, and “goal”. These forward-looking statements are subject to risks and uncertainties that are difficult to predict, may be beyond management’s control and could cause results to differ materially from those expressed or implied by such forward-looking statements. Factors which could have a material, adverse impact on the operations and future prospects of the Corporation include, but are not limited to, the following:
•
changes in monetary and fiscal policies of the Federal Reserve Board and the U.S. Government, particularly related to changes in interest rates
•
changes in general economic conditions
•
legislative or regulatory changes
•
downturn in demand for loan, deposit and other financial services in the Corporation’s market area
•
increased competition from other banks and non-bank providers of financial services
•
technological changes and increased technology-related costs
•
changes in accounting principles, or the application of generally accepted accounting principles.
These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.
EARNINGS OVERVIEW
2006 vs. 2005
Net income in 2006 was $11,986,000, or $1.44 per share - basic and $1.43 per share - diluted. Net income for 2006 was down from $1.55 per share - basic and $1.54 per share - diluted in 2005. In 2006, the trends of the past few years that have negatively impacted the Corporation’s earnings results continued, as the yield curve moved from flat to inverted, and noninterest expense continued to increase.
The net interest margin decreased $1,733,000, or 4.9%, in 2006 as compared to 2005. The flat or inverted yield curve, along with competitive pressures, caused interest rates paid on liabilities (mainly deposits and borrowings) to increase more than the rates of interest earned on loans and investment securities. Further, the flat or inverted yield curve resulted in limited opportunities to earn a positive spread from maintaining borrowed funds and holding investment securities. Accordingly, the Corporation sold securities and repaid borrowings throughout much of 2006. The balance of available-for-sale securities was $70,633,000 lower at December 31, 2006 than one year earlier, and the December 31, 2006 balance of short-term and long-term borrowings was $40,023,000 lower than one year earlier.
Noninterest expense increased $2,652,000 (9.2%) in 2006 over 2005. Much of the increase in noninterest expense in 2006 has been attributable to operations and start-up costs in new markets, including the First State Bank offices (Canisteo and South Hornell) in New York State, and the Jersey Shore and Old Lycoming Township offices in Pennsylvania.
Gains related to sales of credit card loans totaled $340,000 in 2006 and $1,906,000 in 2005. In the fourth quarter 2005, the Corporation sold the C&N Bank credit card receivables, and recorded a gain of $1,906,000. After the sale, the Corporation continued to provide servicing of credit cards for a portion of 2006, and was subject to possible losses associated with credit card receivables sold with recourse. In the fourth quarter 2006, the Corporation recorded an additional gain of $325,000 for the difference between the initial estimates of post-sale servicing expenses and recourse losses, and the actual amounts incurred. Also in 2006, the Corporation sold First State Bank’s credit card portfolio for a gain of $15,000.
Net realized gains from sales of securities amounted to $5,046,000 in 2006, an increase of $3,244,000 over 2005. Most of the gains realized in 2006 have been from sales of bank stocks. Also, in the fourth quarter 2005, C&N had net losses from sales of securities of $586,000. The fourth quarter 2005 losses were mainly from sales of debt securities that were purchased in 2003 and 2004, when market yields were lower than in 2005.
The provision for loan losses was $672,000 in 2006, down from $2,026,000 in 2005. In 2006, negotiations and workout of a few large, commercial loans were completed, resulting in charge-offs that were significantly less than the estimated allowances that had been previously established.
2005 vs. 2004
Net income in 2005 totaled $12,984,000, or $1.55 per share - basic, and $1.54 per share - diluted. Net income per share for 2005 was down from $1.78 per share - basic and $1.77 per share - diluted in 2004. As in 2006, the Corporation’s lower 2005 earnings than had been realized in 2004 resulted mainly from the flattening yield curve and a significant increase in noninterest expense, along with other factors. Despite substantial loan growth in 2005, the net interest margin increased only slightly in 2005 over 2004 (as noted in the “Net Interest Margin” section of Management’s Discussion and Analysis, when calculated on a fully taxable equivalent basis, net interest income was lower by $651,000 in 2005 than in 2004). Similar to 2006, management decided to shrink the investment portfolio and repay borrowings in 2005. Accordingly, the December 31, 2005 balance of available-for-sale securities was $47,787,000 lower than the year-end 2004 balance, and the December 31, 2005 balance of short-term and long-term borrowings was $38,066,000 lower than year-end 2004.
Noninterest expense increased $2,961,000 (11.4%) in 2005 over 2004. Total salaries and benefit expenses increased $1,483,000, or 10.1% in 2005 over 2004, primarily due to new hires to accommodate expansion into new branches and for several support functions. Furniture and equipment expense increased $859,000, or 47.6%, mainly due to depreciation and maintenance costs associated with the new core banking software system, which was implemented in the fourth quarter 2004.
The provision for loan losses increased $626,000 in 2005 over 2004, mainly due to estimates of possible future charge-offs on several large commercial loans, as well as volume-related increases in the portions of the provision determined based on historical net charge-off and subjective factors.
As referenced above, in the fourth quarter 2005 the Corporation realized a gain from the sale of credit card receivables of $1,906,000. Also in the fourth quarter 2005, the Corporation had net losses from sales of securities of $586,000, contributing to a $1,075,000 reduction in net securities gains in 2005 as compared to 2004.
OUTLOOK FOR 2007
In looking ahead to 2007, it is important to consider the Corporation’s prospects in light of the environment and activity of the past few years. The historically long (over 2 years) flat and inverted yield curve has challenged the Corporation’s ability to achieve earnings growth. Despite this challenging environment, the Corporation has continued to implement its strategic plan by opening four new C&N Bank branches and acquiring the two New York State (First State Bank) branches, during this time frame. Further, the Corporation has experienced significant increases in its operating costs as a result of acquiring and implementing a new core banking software system late in 2004, added personnel to keep up with increases in regulatory burden and built a new administrative building to house the higher numbers of employees. All of these issues - the yield curve, branches with less than “mature” market share and operating expense pressures - are expected to continue in 2007, and management expects that it will be difficult to generate earnings at a level much greater in 2007 than was realized in 2006.
While management acknowledges the challenges cited above, there are many reasons for long-term optimism going into 2007. The Lycoming County offices have contributed significantly to loan and deposit growth over the past few years, and management anticipates continued growth in that market. In the fourth quarter 2006, two new lenders were hired with the expectation for increased commercial and consumer business in the New York State market. The Trust and Financial Management Group has grown Assets Under Management to $517,775,000 at December 31, 2006, an increase of 23.8% since the end of 2005, and increased revenue by 15.4% in 2006 over 2005. Management is focused on this area of noninterest revenue in an effort to reduce reliance on the net interest margin, and believes the prospects for continued growth in this area are encouraging.
In December 2006, the Corporation signed a definitive merger agreement with Citizens Bancorp, Inc. (“Citizens”) of Coudersport. Citizens is the parent company of Citizens Trust Company (“CTC”), a commercial bank with offices in the Pennsylvania communities of Coudersport, Emporium and Port Allegany. As of December 31, 2006, Citizens reported total assets of $144.4 million. The agreement provides for Citizens to merge into the Corporation, and CTC to merge into C&N Bank. In the aggregate, 50% of the shares of Citizens common stock will be purchased for cash and 50% of the shares of Citizens common stock will be exchanged for shares of Corporation common stock. The estimated total purchase consideration is valued at approximately $29 million. Management expects the transaction to be completed during the second quarter 2007. Consummation of the merger is subject to approval by Citizens’ shareholders, regulatory approvals and other customary conditions of closing.
Management believes the prospects for both organizations, and the addition of Citizens’ management group to the Corporation’s team will result in increased opportunities for the combined organization. In 2007, management anticipates start-up and duplicate operating costs will result in the transaction being slightly dilutive to earnings per share; however, in 2008, management expects the impact of the transaction on earnings to be accretive.
Another major variable that affects the Corporation’s earnings is securities gains and losses. Management’s decisions regarding sales of securities are based on a variety of factors, with the overall goal of maximizing portfolio return over a long-term horizon. It is difficult to predict, with any reasonable degree of certainty, the amount of net securities gains and losses that will be realized in 2007.
Total capital purchases for 2007 are estimated at $2.5-$3 million, with renovations of existing facilities and computer equipment and software the largest planned categories of expenditure. This would be the Corporation’s lowest total capital purchases amount since 2002 (with the exception of the Citizens acquisition), as management has no current plans to build or acquire new branches in 2007.
CRITICAL ACCOUNTING POLICIES
The presentation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect many of the reported amounts and disclosures. Actual results could differ from these estimates.
A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses. Management believes that the allowance for loan losses is adequate and reasonable. The Corporation’s methodology for determining the allowance for loan losses is described in a separate section later in Management’s Discussion and Analysis. Given the very subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make materially different assumptions, and could, therefore calculate a materially different allowance value. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.
Another material estimate is the calculation of fair values of the Corporation’s debt securities. The Corporation receives estimated fair values of debt securities from an independent valuation service, or from brokers. In developing these fair values, the valuation service and the brokers use estimates of cash flows, based on historical performance of similar instruments in similar interest rate environments. Based on experience, management is aware that estimated fair values of debt securities tend to vary among brokers and other valuation services. Accordingly, when selling debt securities, management typically obtains price quotes from more than one source. As described in Note 1 to the consolidated financial statements, the large majority of the Corporation’s securities are classified as available-for-sale. Accordingly, these securities are carried at fair value on the consolidated balance sheet, with unrealized gains and losses excluded from earnings and reported separately through accumulated other comprehensive income (included in stockholders’ equity).
NET INTEREST MARGIN
2006/2005/2004
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 2006, 2005 and 2004. In each of these tables, the amounts of interest income earned on tax-exempt securities and loans have been adjusted to a fully taxable-equivalent basis. Accordingly, the net interest margin amounts presented in these tables exceed the amounts presented in the consolidated financial statements. The discussion that follows is based on amounts in the Tables.
On a fully taxable-equivalent basis, net interest income fell 6.4%, to $36,105,000 in 2006 from $38,567,000 in 2005. As reflected in Table III, interest rate changes had the effect of decreasing net interest income $3,327,000 in 2006 as compared to 2005, as rising short-term interest rates caused increases in interest expense. Table III also shows that volume changes had the effect of increasing net interest income $865,000 in 2006 over 2005. The major components of the increase in net interest income from volume changes in 2006 were an increase of $2,958,000 attributable to loan growth and a decrease in interest expense of $2,392,000 related to lower long-term borrowings, partially offset by $3,386,000 lower interest income from a lower volume of available-for-sale securities. As presented in Table II, the “Interest Rate Spread” (excess of average rate of return on interest-bearing assets over average cost of funds on interest-bearing liabilities) shrunk to 2.90% in 2006 from 3.22% in 2005.
In 2005, the net interest margin was $38,567,000, down $651,000, or 1.7%, from 2004. Similar to 2006’s results, Table III shows that interest rate changes caused a decrease in net interest income of $2,310,000 in 2005 compared to 2004, while volume changes (mainly attributable to loan growth) increased net interest income $1,659,000. As shown in Table II, the Interest Rate Spread of 3.22% in 2005 was down from 3.43% in 2004.
INTEREST INCOME AND EARNING ASSETS
Interest income totaled $66,879,000 in 2006, or 4.1% higher than in 2005. Interest and fees from loans increased $4,749,000, or 11.8%, while income from available-for-sale securities decreased $2,334,000, or 9.8%. The majority of the increase in interest income resulted from higher loan volume, along with an increase in the average rate earned on loans, which more than offset the effect of the lower average volume of available-for-sale securities.
Total average gross loans increased 7.2% in 2006 over 2005, to $662,714,000 from $618,344,000. While loan growth was not at the 10% or more levels experienced for each of the immediately prior several years, loan demand has remained good for both commercial and mortgage loans throughout the Corporation’s market area. In addition, the acquisition of First State Bank, which was added to the Corporation’s balance sheet for the final 4 months of 2005, contributed to the increase in average loans in 2006 compared to 2005. Excluding First State Bank, average total deposits increased 5.0% in 2006 compared to 2005. The average rate of return on loans was 6.81% in 2006, up from 6.53% in 2005.
As indicated in Table II, total average available-for-sale securities in 2006 fell to $385,119,000, a decrease of $57,406,000 or 13.0% from 2005. Proceeds from sales and maturities of securities have been used, in part, to help fund loans and pay off borrowings. Within the available-for-sale securities portfolio, the average balance of municipal bonds shrunk to $89,981,000 in 2006 from $123,295,000 in 2005. Management decided to reduce the Corporation’s investment in municipal bonds in order to reduce the alternative minimum tax liability. Also, because short-term interest rates have been rising faster than long-term rates, there have been only limited opportunities to purchase mortgage-backed securities or other taxable bonds at spreads sufficient to justify the applicable interest rate risk. The average rate of return on available-for-sale securities was 5.55% for 2006, up from 5.35% in 2005.
Similar to 2006, in 2005 the average balance of loans grew while available-for-sale securities fell. As reflected in Table II, total average gross loans increased 12.2% in 2005 over 2004, to $618,344,000 from $551,352,000. The acquisition of loans from First State Bank contributed 1.4% of the growth in average loans. The average yield on loans was 6.53% in 2005, up slightly from the average yield for 2004 of 6.47%. The total average balance of available-for-sale securities decreased 8.3% in 2005 as compared to 2004, for the same reasons as the portfolio continued to shrink in 2006 (as discussed above). The average rate of return on available-for-sale securities of 5.35% for in 2005 was slightly lower than the 5.41% generated in 2004.
INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES
Interest expense rose $5,087,000, or 19.8%, to $30,774,000 in 2006 from $25,687,000 in 2005. Table II shows that the overall cost of funds on interest-bearing liabilities rose to 3.44% in 2006, from 2.81% in 2005.
From Table II, you can calculate that total average deposits (interest-bearing and noninterest-bearing) increased 6.9% to $750,982,000 in 2006 from $702,404,000 in 2005. The most significant increases in average deposits by categories were $21,961,000 for interest checking accounts (47.3%), $18,295,000 for certificates of deposit (9.3%), and $14,304,000 (16.3%) for demand deposit accounts. Average money market account balances decreased $9,219,000, or 4.9%, in 2006 as compared to 2005, as some depositors’ have moved balances to higher-rate certificates of deposit or withdrawn funds to invest in equities. Most of the increase in interest checking balances is attributable to one local governmental customer, for which the Corporation became the primary depository institution in September 2005. In addition, the acquisition of First State Bank contributed significantly to the increase in average deposits in 2006 compared to 2005. Excluding First State Bank, average total deposits increased 3.7% in 2006 compared to 2005.
The combined average total short-term and long-term borrowed funds decreased $54,571,000 to $244,683,000 in 2006 from $299,254,000 in 2005. As discussed earlier in Management’s Discussion and Analysis, because the yield curve has been flat or inverted, the Corporation’s opportunities have been limited for earning a positive spread by purchasing or holding investment securities as compared to interest costs associated with maintaining borrowed funds. Accordingly, the Corporation has been paying off borrowings as they mature, or rolling them over at terms of less than one year. The pace of such changes or trends is reflected in the Corporation’s consolidated balance sheet, as total short-term borrowings increased to $49,258,000 at December 31, 2006 from $34,734,000 at December 31, 2005, while total long-term borrowings decreased to $179,182,000 at December 31, 2006 from $232,205,000 at December 31, 2005.
In 2005, interest expense rose $3,081,000, or 13.6% over 2004. The overall cost of funds on interest-bearing liabilities rose to 2.81% in 2005, from 2.53% in 2004. In Table II, you can see that rising short-term interest rates caused increases in the average rates incurred on money market accounts, certificates of deposit, interest checking accounts and short-term borrowings. Helping to offset some of the impact of rising short-term market rates were passbook Individual Retirement Accounts (IRAs), for which the average rate fell to 3.46% from 3.75%, and long-term borrowings, for which the average rate fell to 3.47% from 3.55%. In the first quarter 2004, the average rate paid on the majority of the Corporation’s IRAs was 5%, which was the “floor” on 18-month variable IRAs that existed prior to October 1, 2003. Effective April 1, 2004, the floor on those IRAs fell to 3%, and the Corporation’s variable IRA rate ranged from 3.25% to 3.60% over the remainder of 2004 and 2005. The decrease in average rate incurred on long-term borrowings resulted from repayment of borrowings originated in earlier interest rate cycles at higher rates.
As you can calculate from Table II, total average deposits (interest-bearing and noninterest-bearing) increased to $702,404,000 in 2005 from $669,307,000 in 2004, an increase of 4.9%. Fluctuations in deposits of nonprofit and municipal customers impacted average deposit balances significantly in 2005, as the Corporation both lost and gained customers with average balances exceeding $10 million. The acquisition of deposits from First State Bank contributed $13,405,000, or 2.0%, of the increase in average deposits.
TABLE I - ANALYSIS OF INTEREST INCOME AND EXPENSE
(In Thousands)
TABLE II - ANALYSIS OF AVERAGE DAILY BALANCES AND RATES
(Dollars in Thousands)
(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
(In Thousands)
(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
2006/2005/2004
2006 vs. 2005
Total noninterest income increased $2,012,000, or 17.7%, in 2006 compared to 2005. The largest change within this category is related to securities gains, which increased $3,244,000, and which are discussed in the Earnings Overview section of Management’s Discussion and Analysis. The gains related to sale of credit card loans, which decreased $1,566,000 in 2006 as compared to 2005, is also discussed in the Earnings Overview section. Other items of significance are as follows:
2005 vs. 2004
Total noninterest income increased $1,545,000, or 15.8%, in 2005 as compared to 2004. The gain from sale of credit card loans, and reduced amount of net realized security gains in 2005 as compared to 2004 are discussed in the Earnings Overview section of Management’s Discussion and Analysis. Other items of significance are as follows:
TABLE IV - COMPARISON OF NONINTEREST INCOME
(In Thousands)
NONINTEREST EXPENSE
2006/2005/2004
Total noninterest expense increased $2,652,000, or 9.2%, in 2006 over 2005, and $2,961,000, or 11.4%, in 2005 over 2004. Increased levels of expenses in 2006 and 2005 resulted mainly from expansion, as the Corporation opened or acquired new offices in Jersey Shore, PA (August 2005), Canisteo and South Hornell, NY (August 2005) and Old Lycoming Township, PA (March 2006). Also, the Corporation built a new administrative office in Wellsboro, PA, which opened in March 2006.
2006 vs. 2005
Salaries and wages increased $1,322,000, or 10.7%, in 2006 over 2005. The increase in salaries expense relates primarily to the increase in the number of full-time equivalent employees, which has averaged 10% higher since August of 2005. For 2006, new branch operations at Jersey Shore, Old Lycoming Township and New York State added $612,000 to salaries expense.
Pension and other employee benefits increased $527,000, or 14.0%, in 2006 over 2005. The increase in number of people and covered compensation is the primary reason for the increase. In the aggregate, total pensions and other employee benefits expense, as a percentage of salaries and wages, was 31.2% in 2006, up from 30.3% in 2005 and 2004. Note 15 to the consolidated financial statements provides information concerning some of the larger expenses within this category, including the defined benefit pension and postretirement health plans, the 401(k)/ESOP and the supplemental executive retirement plan.
Occupancy expense increased $444,000, or 23.8%, in 2006 compared to 2005. The increase in total occupancy costs in 2006 includes $288,000 for the Jersey Shore, Old Lycoming and New York State locations, and $213,000 for the new administration building in Wellsboro.
Other (noninterest) expense increased $253,000 or 3.4% in 2006 compared to 2005. The increase in other expenses includes an increase of $420,000 for the New York State locations in 2006, including $128,000 for the amortization of the core deposit intangible. In addition, in the second quarter 2006, other expense included a one-time charge of $168,000 for impairment of leasehold improvements from early termination of a property lease. Included in the 2005 total is $462,000 for non-payroll related expenses associated with the credit card operation, which was sold in the fourth quarter 2005.
2005 vs. 2004
Salaries and wages increased $1,135,000, or 10.1%, in 2005 over 2004. The increase in salaries expense in 2005 was primarily a reflection of a greater number of employees, resulting from expansion into new branches and the addition of new employees for support functions.
Pensions and other employee benefit expenses increased $348,000, or 10.2%, in 2005 over 2004. Increases in numbers of employees drove up expenses for health insurance, contributions to the savings and retirement (401(k)) plan and payroll taxes. Helping to mitigate some of the expense increases within this category were reductions in expense associated with the defined benefit plan and professional fees related to employee benefit plan matters.
Occupancy expense increased $201,000, or 12.1%, in 2005 over 2004, primarily as a result of higher depreciation and maintenance costs associated with new facilities.
Furniture and equipment expense increased $868,000, or 48.1%, in 2005 over 2004. Depreciation expense within this category increased $586,000, to $1,601,000 in 2005 from $1,015,000 in 2004, including an increase of $468,000 in 2005 from the new core banking software system that was placed in service during the fourth quarter 2004. Similarly, maintenance and repair expense within this category increased $241,000 in 2005 over 2004, primarily because of inclusion of a full year of maintenance costs associated with the new core banking software system of approximately $377,000 in 2005, up from 2 months’ of costs totaling $60,000 in 2004.
Other operating expense increased $451,000, or 6.4%, in 2005 over 2004. Most of the line items within this category increased in 2005, in part due to expansion into more locations and the resulting higher volume of transactions and costs. Total other operating expense incurred by Canisteo Valley Corporation and First State Bank in the final 4 months of 2005 totaled $281,000, or 4.0% of the total increase. The most significant increases within this category were: (1) expenses associated with maintaining and preparing other real estate properties for sale, which increased $210,000 in 2005 to $304,000; (2) attorney fees, which increased $164,000 in 2005 to $203,000, mainly because of collection activities on a large commercial credit, and (3) Bucktail expenses, which increased $117,000 to $323,000, due to a larger volume of claims. Helping to reduce the overall increase in this category was a decrease in professional fees of $530,000, to $215,000 in 2005. In 2004, the Corporation incurred a significant amount of professional fees expense associated with the core banking system conversion.
TABLE V - COMPARISON OF NONINTEREST EXPENSE
(In Thousands)
INCOME TAXES
The income tax provision was $2,772,000, or 18.8% of pre-tax income, in 2006, as compared to 17.7% in 2005 and 16.1% in 2004. The increases in the tax provision/pre-tax income rate in 2006 and 2005 reflected lower average holdings of tax-exempt securities. Management decided to reduce the Corporation’s investment in municipal bonds in order to reduce the alternative minimum tax liability in 2006 and 2005. A more complete analysis of income taxes is presented in Note 16 to the consolidated financial statements.
FINANCIAL CONDITION
Significant changes in the average balances of the Corporation’s earning assets and interest-bearing liabilities are described in the Net Interest Margin section of Management’s Discussion and Analysis. That discussion provides useful information regarding changes in the Corporation’s balance sheet over the 2-year period ended December 31, 2006, including discussions of available-for-sale securities, loans, deposits and borrowings. The acquisition of Canisteo Valley Corporation was effective at the end of August 2005. That transaction was an all-cash acquisition, which had the effect of increasing the Corporation’s assets and liabilities. At December 31, 2006, total consolidated assets of Canisteo Valley Corporation amounted to $42,954,000, including net loans of $19,929,000, while deposits totaled $35,160,000. Other significant balance sheet items - the allowance for loan losses and stockholders’ equity - are discussed in separate sections of Management’s Discussion and Analysis.
Table VI shows the composition of the investment portfolio at December 31, 2006, 2005 and 2004. Comparison of the amortized cost totals of available-for-sale securities at each year-end presented reflects a reduction from $459,123,000 at December 31, 2004 to $420,185,000 at December 31, 2005, and then a further reduction to $353,954,000 at December 31, 2006. Management’s decision to reduce the size of the securities portfolio has been attributable to 2 primary factors: (1) substantial loan growth, and (2) the need to manage interest rate risk within acceptable parameters. Specifically, in light of the flat yield curve, the opportunities have been very limited for earning a positive spread from maintaining borrowed funds and holding investment securities, and because there is almost no difference between short-term and long-term rates, the Corporation faces the risk that excessive holdings of long-term, fixed rate securities could result in future losses or diminished net interest margin results when the yield curve “normalizes.” Accordingly, management has utilized proceeds from principal repayments and sales of securities to help fund loan growth. The Corporation’s liquidity position is discussed in a separate section of Management’s Discussion and Analysis, and interest rate risk is discussed in more detail in Part II, Item 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
The Corporation’s two major categories of market risk are interest rate risk and equity securities risk, which are discussed in the following sections.
INTEREST RATE RISK
Business risk arising from changes in interest rates is an inherent factor in operating a bank. The Corporation’s assets are predominantly long-term, fixed rate loans and debt securities. Funding for these assets comes principally from shorter-term deposits and borrowed funds. Accordingly, there is an inherent risk of lower future earnings or decline in fair value of the Corporation’s financial instruments when interest rates change.
C&N Bank uses a simulation model to calculate the potential effects of interest rate fluctuations on net interest income and the market value of portfolio equity. Only assets and liabilities of C&N Bank are included in management’s monthly simulation model calculations. Since C&N Bank makes up more than 90% of the Corporation’s total assets and liabilities, and because C&N Bank is the source of the most volatile interest rate risk, presently management does not consider it necessary to run the model for the remaining entities within the consolidated group. (Management intends to add First State Bank’s data to the model, beginning sometime in 2007.) For purposes of these calculations, the market value of portfolio equity includes the fair values of financial instruments, such as securities, loans, deposits and borrowed funds, and the book values of nonfinancial assets and liabilities, such as premises and equipment and accrued expenses. The model measures and projects potential changes in net interest income, and calculates the discounted present value of anticipated cash flows of financial instruments, assuming an immediate increase or decrease in interest rates. Management ordinarily runs a variety of scenarios within a range of plus or minus 50-300 basis points of current rates.
C&N Bank’s Board of Directors has established policy guidelines for acceptable levels of interest rate risk, based on an immediate increase or decrease in interest rates. C&N Bank’s policy provides limits at +/- 100, 200 and 300 basis points from current rates for fluctuations in net interest income from the baseline (flat rates) one-year scenario. The policy also limits acceptable market value variances from the baseline values based on current rates. As the table shows, as of December 31, 2006 and 2005, the decline in net interest income and market value exceed the policy threshold marks if interest rates were to immediately rise 200 or 300 basis points. These “out of policy” positions are a reflection of the Corporation’s liability sensitive position (on average, deposits and borrowings reprice more quickly than loans and debt securities). Management has reviewed these positions with the Board of Directors quarterly throughout 2006 and 2005, and management will continue to evaluate whether to make changes to asset and liability holdings in an effort to reduce exposure to rising interest rates.
The table that follows was prepared using the simulation model described above. The model makes estimates, at each level of interest rate change, regarding cash flows from principal repayments on loans and mortgage-backed securities and call activity on other investment securities. Actual results could vary significantly from these estimates, which could result in significant differences in the calculations of projected changes in net interest margin and market value of portfolio equity. Also, the model does not make estimates related to changes in the composition of the deposit portfolio that could occur due to rate competition and the table does not necessarily reflect changes that management would make to realign the portfolio as a result of changes in interest rates.
TABLE XIV - THE EFFECT OF HYPOTHETICAL CHANGES IN INTEREST RATES
December 31, 2006 Data
(In Thousands)
Market Value of Portfolio Equity
at December 31, 2006
December 31, 2005 Data
(In Thousands)
Market Value of Portfolio Equity
at December 31, 2005
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, 2006 and 2005 are as follows:
TABLE XV - EQUITY SECURITIES RISK
(In Thousands)
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Consolidated Balance Sheet
(In Thousands Except Share Data)
The accompanying notes are an integral part of the consolidated financial statements.
Consolidated Statement of Income
(In Thousands Except Per Share Data)
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.
Consolidated Statement of Cash Flows
(In Thousands)
Consolidated Statement of Cash Flows
(In Thousands) (Continued)
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 (“C&N Bank”), Canisteo Valley Corporation (acquired in 2005 - see Note 4), Bucktail Life Insurance Company and Citizens & Northern Investment Corporation. The consolidated financial statements also include the accounts of Canisteo Valley Corporation’s wholly-owned subsidiary, First State Bank, and C&N Bank’s wholly-owned subsidiary, C&N Financial Services Corporation. All material intercompany balances and transactions have been eliminated in consolidation.
NATURE OF OPERATIONS - The Corporation is primarily engaged in providing a full range of banking and mortgage services to individual and corporate customers in Northcentral Pennsylvania and Southern New York State. Lending products include mortgage loans, commercial loans, consumer loans and credit cards, as well as specialized instruments such as commercial letters-of-credit. Deposit products include various types of checking accounts, passbook and statement savings, money market accounts, interest checking accounts, individual retirement accounts and certificates of deposit. The Corporation also offers non-insured “Repo Sweep” accounts.
The Corporation provides Trust and Financial Management services, including administration of trusts and estates, retirement plans, and other employee benefit plans, and investment management services. The Corporation offers a variety of personal and commercial insurance products through C&N Financial Services Corporation. C&N Financial Services Corporation also has a broker-dealer division, which offers mutual funds, annuities, educational savings accounts and other investment products through registered agents.
The Corporation is subject to competition from other financial institutions. It is also subject to regulation by certain federal and state agencies and undergoes periodic examination by those regulatory authorities.
USE OF ESTIMATES - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect reported amounts and disclosures. Actual results could differ from these estimates.
A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses. Management believes that the allowance for loan losses is adequate and reasonable. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.
INVESTMENT SECURITIES - Investment securities are accounted for as follows:
HELD-TO-MATURITY SECURITIES - includes debt securities that the Corporation has the positive intent and ability to hold to maturity. These securities are reported at cost adjusted for amortization of premiums and accretion of discounts, computed using the level-yield method.
AVAILABLE-FOR-SALE SECURITIES - includes debt securities not classified as held-to-maturity and unrestricted equity securities. Such securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported separately through accumulated other comprehensive income, net of tax. Amortization of premiums and accretion of discounts on available-for-sale securities are recorded using the level yield method over the remaining contractual life of the securities, adjusted for actual prepayments. Realized gains and losses on sales of available-for-sale securities are computed on the basis of specific identification of the adjusted cost of each security.
RESTRICTED EQUITY SECURITIES - Restricted equity securities consist primarily of Federal Home Loan Bank of Pittsburgh stock, and are carried at cost and evaluated for impairment. Holdings of restricted equity securities are included in Other Assets in the Consolidated Balance Sheet, and dividends received on restricted securities are included in Other Income in the Consolidated Statement of Income.
LOANS - Loans are stated at unpaid principal balances, less the allowance for loan losses and net deferred loan fees. Loan origination and commitment fees, as well as certain direct origination costs, are deferred and amortized as a yield adjustment over the lives of the related loans using the interest method. Amortization of deferred loan fees is discontinued when a loan is placed on nonaccrual status.
Loans are placed on nonaccrual status when, in the opinion of management, collection of interest is doubtful. Any unpaid interest previously accrued on those loans is reversed from income. Interest income is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on loans for which the risk of further loss is greater than remote are applied as a reduction of the loan principal balance. Interest income on other nonaccrual loans is recognized only to the extent of interest payments received.
The allowance for loan losses is maintained at a level which, in management’s judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management’s evaluation of the collectibility of the loan portfolio, based on factors such as credit concentrations, past due or delinquency status, trends in historical loss experience, specific impaired loans, and economic conditions. Past due or delinquency status of loans is computed based on the contractual terms of the loans. Allowances for impaired loans are determined based on collateral values or the present value of estimated cash flows. The allowance is increased by a provision for loan losses, which is charged to expense, and reduced by charge-offs, net of recoveries. Loan balances are charged off when it becomes evident that such balances are not fully collectible.
BANK PREMISES AND EQUIPMENT - Bank premises and equipment are stated at cost less accumulated depreciation. Repair and maintenance expenditures which extend the useful lives of assets are capitalized, and other repair and maintenance expenditures are expensed as incurred. Depreciation expense is computed using the straight-line method.
INTEREST COSTS - The Corporation capitalizes interest as a component of the cost of premises and equipment constructed or acquired for its own use. In 2006, total interest incurred was $30,799,000, of which $30,774,000 was charged to expense and $25,000 was capitalized. In 2005, total interest incurred was $25,755,000, of which $25,687,000 was charged to expense and $68,000 was capitalized. In 2004, total interest incurred was $22,649,000, of which $22,606,000 was charged to expense and $43,000 was capitalized.
FORECLOSED ASSETS HELD FOR SALE - Foreclosed assets held for sale consist of real estate acquired by foreclosure and are carried at estimated fair value, less selling cost.
GOODWILL AND CORE DEPOSIT INTANGIBLE ASSETS - Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. Goodwill is tested at least annually for impairment. The core deposit intangible is being amortized over a period of time that represents its expected life using a method of amortization that reflects the pattern of economic benefit. The core deposit intangible is subject to impairment testing whenever events or changes in circumstances indicate its carrying amount may not be recoverable .
INCOME TAXES - Provisions for deferred income taxes are made as a result of temporary differences in financial and income tax methods of accounting. These differences relate principally to loan losses, securities gains or losses, depreciation, pension and other postretirement benefits, alternative minimum tax, investments in limited partnerships, loan origination fees and costs and differences arising from an acquisition.
STOCK COMPENSATION PLANS - Effective in 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 123R, which replaces SFAS No. 123 and supersedes Accounting Principles Board (APB) Opinion 25. SFAS No. 123R requires the Corporation to record stock option expense based on estimated fair value calculated using an option valuation model. The provisions of SFAS 123R must be applied to any new awards granted, and to any modifications of existing awards. Since the Corporation has neither modified, nor issued, any new options in 2006, and all options issued prior to December 31, 2005 are fully vested, the provisions of SFAS No. 123R have no impact on net income in 2006.
Prior to 2006, the Corporation used the intrinsic value method of accounting for stock compensation plans, with compensation cost 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 had no intrinsic value as of the grant date; therefore, no compensation cost was recorded for them.
The Corporation has also made prior awards of restricted stock. Compensation cost related to restricted stock is recognized based on the market price of the stock at the grant date over the vesting period.
The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value provisions of SFAS No. 123 to stock options.
(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.
2. COMPREHENSIVE INCOME
U.S. generally accepted accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although unrealized gains and losses on available-for-sale securities are reported as a separate component of the equity section of the balance sheet, changes in unrealized gains and losses on available-for-sale securities, along with net income, are components of comprehensive income.
The components of other comprehensive income, and the related tax effects, are as follows:
Effective December 31, 2006, the Corporation applied SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans. As a result of implementing SFAS No. 158, the Corporation recorded a reduction in stockholders’ equity (accumulated other comprehensive income) of $1,181,000. Note 15 has more details related to the implementation of SFAS No. 158. Beginning in 2007, changes in accumulated other comprehensive income attributable to the impact of SFAS No. 158 on defined benefit plans will be included in other comprehensive income.
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 1% stock dividends declared in the fourth quarter of each year presented, payable in the first quarter of the following year. The following data show the amounts used in computing basic and diluted net income per share. As shown in the table that follows, diluted earnings per share is computed using weighted average common shares outstanding, plus weighted-average common shares available from the exercise of all dilutive stock options, less the number of shares that could be repurchased with the proceeds of stock option exercises based on the average share price of the Corporation’s common stock during the period.
4. 2005 ACQUISITION
On August 31, 2005, Citizens & Northern Corporation acquired 100% of Canisteo Valley Corporation in an all-cash merger transaction. Accordingly, the results of operations for Canisteo Valley Corporation have been included in the accompanying consolidated financial statements from that date forward. Canisteo Valley Corporation is the parent company of First State Bank, a New York State chartered commercial bank with offices in Canisteo and South Hornell, NY. The acquisition of Canisteo Valley Corporation and First State Bank permits expansion of Citizens & Northern Corporation’s banking operations into communities located in the southern tier of New York State, in close proximity to many of the northern Pennsylvania branch locations, and provides First State Bank with the administrative and credit management resources of a larger organization.
Following is a condensed balance sheet showing the fair values of the assets acquired and the liabilities assumed as of the date of acquisition:
The core deposit intangible is being amortized over the weighted-average useful life of 3.7 years, with no estimated residual value. None of the goodwill arising from the acquisition is deductible for income tax purposes.
5. SALE OF CREDIT CARD LOANS
Gains related to sales of credit card loans totaled $340,000 in 2006 and $1,906,000 in 2005. In the fourth quarter 2005, the Corporation sold C&N Bank credit card receivables with a book value of $8.3 million. After the sale, the Corporation continued to provide servicing of credit cards for a portion of 2006, and was subject to possible losses associated with credit card receivables sold with recourse. The gain in 2005 of $1,906,000 was net of estimated liabilities of $280,000 for servicing expenses and $175,000 for losses on receivables sold with recourse. In the fourth quarter 2006, the Corporation recorded an additional gain of $325,000 for the difference between the initial estimates of post-sale servicing expenses and recourse losses, and the actual amounts incurred. Also in 2006, the Corporation sold First State Bank’s credit card portfolio, with a book value of $71,000, for a gain of $15,000.
6. CASH AND DUE FROM BANKS
Banks are required to maintain reserves consisting of vault cash and deposit balances with the Federal Reserve Bank in their district. The reserves are based on deposit levels during the year and account activity and other services provided by the Federal Reserve Bank. Average daily currency, coin, and cash balances with the Federal Reserve Bank needed to cover reserves against deposits for 2006 ranged from $4,022,000 to $7,688,000. For 2005, theses balances ranged from $1,775,000 to $6,616,000. Average daily cash balances with the Federal Reserve Bank required for services provided to the Banks were $2,600,000 in 2006 and 2005. Total balances restricted amounted to $7,210,000 at December 31, 2006 and $6,616,000 at December 31, 2005.
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.
7. SECURITIES
Amortized cost and fair value of securities at December 31, 2006 and 2005 are summarized as follows:
The following table presents gross unrealized losses and fair value of investments with unrealized loss positions that are not deemed to be other-than-temporarily impaired, aggregated by length of time that individual securities have been in a continuous unrealized loss position at December 31, 2006 and 2005:
Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.
The unrealized losses on debt securities are primarily the result of volatility in interest rates. Based on the credit worthiness of the issuers, which are almost exclusively U.S. Government-sponsored agencies or state and political subdivisions, management believes the Corporation’s debt securities at December 31, 2006 were not other-than-temporarily impaired.
The amortized cost and fair value of investment debt securities at December 31, 2006 are presented in the following table. 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, 2006:
Investment securities carried at $97,566,000 at December 31, 2006 and $129,692,000 at December 31, 2005 were pledged as collateral for public deposits, trusts and certain other deposits as provided by law. Also, the Federal Home Loan Bank of Pittsburgh (FHLB-Pittsburgh) issued a $40,000,000 letter of credit on the Corporation’s behalf for security on certain public deposits as of December 31, 2006. See Note 12 for information concerning securities pledged to secure borrowing arrangements.
Gross realized gains and losses from the sales of available-for-sale securities, and the income tax provision related to net realized gains, for 2006, 2005 and 2004 were as follows:
8. LOANS
Major categories of loans and leases included in the loan portfolio are as follows:
Net unamortized loan fees of $1,582,000 at December 31, 2006 and $1,508,000 at December 31, 2005 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, 2006.
The Corporation grants commercial, residential and personal loans to customers primarily in the Pennsylvania Counties of Tioga, Bradford, Sullivan and Lycoming, and in Steuben and Allegany Counties in New York State. Although the Corporation has a diversified loan portfolio, a significant portion of its debtors’ ability to honor their contracts is dependent on the local economic conditions within the region.
Transactions in the allowance for loan losses were as follows:
Information related to impaired and nonaccrual loans, and loans past due 90 days or more, as of December 31, 2006 and 2005 is as follows:
The following is a summary of information related to impaired loans for 2006, 2005 and 2004:
No additional funds are committed to be advanced in connection with impaired loans.
9. BANK PREMISES AND EQUIPMENT
Bank premises and equipment are summarized as follows:
Depreciation expense included in occupancy expense and furniture and equipment expense was as follows:
The Corporation entered into a lease of a facility in 2001, with an initial lease term of five years, and provisions for up to two additional 5-year terms. The Corporation recorded depreciation of leasehold improvement costs using an estimated useful life of 10 years, based on management’s plan to utilize the facility for at least one term beyond the initial term. In 2006, the Corporation made a decision not to renew the lease, and moved out of the property at the end of the initial 5-year term. As a result, an impairment loss of $168,000 was recognized, which is included in other operating expense in the consolidated statement of income. The amount of impairment loss represents the remaining net book value of leasehold improvements at the end of the initial lease term.
10. INTANGIBLE ASSETS
Information related to the core deposit intangible asset is as follows:
Amortization expense was $128,000 in 2006 and $83,000 in 2005. Estimated amortization expense for each of the ensuing five years is as follows:
Changes in the carrying amount of goodwill in 2006 and 2005 are summarized in the following table:
11. DEPOSITS
At December 31, 2006, the scheduled 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, 2006, the remaining maturities or repricing frequency of time deposits of $100,000 or more are as follows:
Interest expense from deposits of $100,000 or more amounted to $3,267,000 in 2006, $2,975,000 in 2005 and $2,214,000 in 2004.
12. BORROWED FUNDS
SHORT-TERM BORROWINGS
Short-term borrowings include the following:
The weighted average interest rate on total short-term borrowings outstanding was 3.93% at December 31, 2006 and 2.80% at December 31, 2005. The maximum amount of total short-term borrowings outstanding at any month-end was $74,514,000 in 2006 and $60,037,000 in 2005.
(a) At December 31, 2005, one short-term, fixed-rate FHLB - Pittsburgh loan was outstanding with a rate of 3.76% and a maturity of April 26, 2006.
Collateral for FHLB - Pittsburgh loans is described under the “Long-term Borrowings” section of this note.
(b) Customer repurchase agreements mature overnight, and are collateralized by securities with a carrying value of $35,551,000 at December 31, 2006 and $34,521,000 at December 31, 2005.
(c) Other repurchase agreements included in short-term borrowings consisted of an adjustable-rate repurchase agreement with a maturity of February 22, 2009. The rate adjusts quarterly to the three-month LIBOR less 50 basis points; at December 31, 2006, the rate was 4.87%. On February 22, 2007, and quarterly thereafter, the issuer may call the repurchase agreement or convert it to a fixed rate of 4.915%.
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:
(d) Long-term borrowings from FHLB - Pittsburgh are as follows:
The FHLB - Pittsburgh loan facilities are collateralized by qualifying securities and mortgage loans. The FHLB - Pittsburgh determines C&N Bank’s maximum borrowing capacity quarterly, based on Call Report data. The book value of pledged assets was $323,621,000 as of September 30, 2006, the most recent data used by the FHLB - Pittsburgh.
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 $8,492,000 at December 31, 2006 and $10,128,000 at December 31, 2005.
(e) Repurchase agreements included in long-term borrowings are as follows:
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 $55,902,000 at December 31, 2006 and $54,966,000 at December 31, 2005. Average daily repurchase agreement borrowings amounted to $50,839,000 in 2006, $51,022,000 in 2005 and $58,663,000 in 2004. During 2006, 2005 and 2004, the maximum amounts of outstanding borrowings under repurchase agreements with broker-dealers were $56,900,000, $67,386,000 and $67,386,000. The weighted average interest rate on repurchase agreements was 3.49% in 2006, 2.92% in 2005 and 3.20% in 2004.
13. DERIVATIVE FINANCIAL INSTRUMENTS
The Corporation has utilized derivative financial instruments related to a certificate of deposit product called the “Index Powered Certificate of Deposit” (IPCD). IPCDs have a term of 5 years, with interest paid at maturity based on 90% of the appreciation (as defined) in the S&P 500 index. There is no guaranteed interest payable to a depositor of an IPCD - however, assuming an IPCD is held to maturity, a depositor is guaranteed the return of his or her principal, at a minimum. In 2004, the Corporation stopped originating new IPCDs, but continues to maintain and account for IPCDs and the related derivative contracts entered into between 2001 and 2004.
Statement of Financial Accounting Standards No. 133 requires the Corporation to separate the amount received from each IPCD issued into 2 components: (1) an embedded derivative, and (2) the principal amount of each deposit. Embedded derivatives are derived from the Corporation’s obligation to pay each IPCD depositor a return based on appreciation in the S&P 500 index. Embedded derivatives are carried at fair value, and are included in other liabilities in the consolidated
balance sheet. Changes in fair value of the embedded derivative are included in other expense in the consolidated income statement. The difference between the contractual amount of each IPCD issued, and the amount of 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 makes no payment to the Corporation. The effect of the Swap contracts is to limit the Corporation’s cost of IPCD funds to the market rate of interest paid to FHLB-Pittsburgh. (In addition, the Corporation paid a fee of 0.75% to a consulting firm at inception of each deposit. This fee is amortized to interest expense over the term of the IPCDs.) Swap liabilities are carried at fair value, and included in other liabilities in the consolidated balance sheet. Changes in fair value of swap liabilities are included in other expense in the consolidated income statement.
Amounts recorded related to IPCDs are as follows (in thousands):
14. FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Corporation’s financial instruments. In cases where quoted market prices are not available, fair
values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. SFAS No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Therefore, the aggregate fair value amounts presented may not represent the underlying fair value of the Corporation.
The Corporation used the following methods and assumptions in estimating fair value disclosures for financial instruments:
CASH AND CASH EQUIVALENTS - The carrying amounts of cash and short-term instruments approximate fair values.
SECURITIES - Fair values for securities, excluding restricted equity securities, are based on quoted market prices. The carrying value of restricted equity securities approximates fair value based on applicable redemption provisions.
LOANS - Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, commercial real estate, residential mortgage, credit card and other consumer. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories. The fair value of performing loans, except residential mortgage and credit card loans, is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the 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. 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, 2006 and 2005. 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:
15. EMPLOYEE AND POSTRETIREMENT BENEFIT PLANS
DEFINED BENEFIT PLANS
The Corporation has a noncontributory defined benefit pension plan for all employees meeting certain age and length of service requirements. Benefits are based primarily on years of service and the average annual compensation during the highest five consecutive years within the final ten years of employment.
Also, the Corporation sponsors a defined benefit health care plan that provides postretirement medical benefits and life insurance to employees who meet certain age and length of service requirements. This plan contains a cost-sharing feature, which causes participants to pay for all future increases in costs related to benefit coverage. Accordingly, actuarial assumptions related to health care cost trend rates do not affect the liability balance at December 31, 2006 and 2005, and will not affect the Corporation’s future expenses.
Effective December 31, 2006, the Corporation applied SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans. SFAS No. 158 requires the Corporation to recognize the underfunded or overfunded status of defined benefit postretirement plans as a liability or asset in the balance sheet. As a result of implementing SFAS No. 158, the Corporation recorded a reduction in stockholders’ equity (accumulated other comprehensive income) of $1,181,000 on December 31, 2006. Beginning in 2007, changes in accumulated other comprehensive income attributable to the impact of SFAS No. 158 on defined benefit plans will be included in other comprehensive income.
The Corporation uses a December 31 measurement date for its plans. Accordingly, the provisions of SFAS No. 158 requiring the use of fiscal year-end measurement dates for defined benefit plans do not affect the Corporation.
The following table shows the incremental effect of implementing SFAS No. 158 on individual line items in the consolidated balance sheet as of December 31, 2006:
The following table shows the funded status of the defined benefit plans:
At December 31, 2006, pension plan assets and liabilities recognized in the consolidated balance sheet were $385,000 and $1,563,000, respectively. Postretirement benefit plan liabilities recognized in the consolidated balance sheet were $1,185,000.
At December 31, 2005, assets recognized were $208,000 related to the pension benefit plan and liabilities recognized were $825,000 related to the postretirement plan.
Items recognized as a component of accumulated other comprehensive income in 2006 and unrecognized in 2005 are as follows:
Net actuarial loss (gain), transition amount and prior service cost have been recognized in accumulated other comprehensive loss, net of a tax benefit of $615,000, at December 31, 2006.
The accumulated benefit obligation for the defined benefit pension plan was $9,764,000 at December 31, 2006 and $9,442,000 at December 31, 2005.
The components of net periodic benefit costs from these defined benefit plans are as follows:
For the defined benefit pension plan, the estimated amount of net actuarial loss and prior service cost that will be amortized from accumulated other comprehensive income into net periodic benefit cost in 2007 are $25,000 and $8,000, respectively. For the postretirement plan, there is no amortization of the net actuarial gain expected in 2007, and the estimated amount of transition obligation and prior service cost that will be amortized from accumulated other comprehensive income into net periodic benefit cost in 2007 are $36,000 and $2,000, respectively.
The weighted-average assumptions used to determine benefit obligations as of December 31, 2006 and 2005 are as follows:
The expected return on pension plan assets is a significant assumption used in the calculation of net periodic benefit cost. This assumption reflects the average long-term rate of earnings expected on the funds invested or to be invested to provide for the benefits included in the projected benefit obligation. The selected rate considers the historical and expected future investment trends of the present and expected future assets in the plan. Management believes the assumed 8.50% return on plan assets, which was used for net periodic benefit cost calculations in 2006, 2005 and 2004, is reasonable. Management has calculated the average annual return on pension plan assets over the period 1991-2006 to be 9.37%, with annual returns ranging from a low of -7.23% to a high of +19.87% over that period.
The Corporation’s pension plan weighted-average asset allocations at December 31, 2006 and 2005 are as follows:
C&N Bank’s Trust and Financial Management Department manages the investment of pension plan assets. The targeted asset allocation for the pension plan is 60% equity securities, 35% debt securities and 5% cash. This targeted asset allocation reflects a balanced approach, considering the need for growth of plan assets to meet future demand, as well as the need for ongoing liquidity to fund benefit payments. Specifically, the Trust Department attempts to match the maturities of zero-coupon bonds with the estimated amounts of benefit payments over the ensuing 10-year period. Within the equity portion of pension plan investments, the Trust Department employs a strategy of diversification. Holdings include large capitalization stocks from many different industries and market sectors, as well as mid-cap and foreign mutual funds. The pension plan’s assets do not include any shares of the Corporation’s common stock.
At this time, the Corporation cannot estimate the amount it will contribute to the defined benefit pension plan in 2007. The estimated total contribution to the postretirement benefit plan in 2007 is $42,000.
Estimated future benefit payments (including, for the postretirement plan, only the estimated employer contributions), which reflect expected future service, are as follows:
In December 2003, the Medicare Prescription Drug, Improvement and Modernization Act (the “Act”) was signed into law. The Act introduces a prescription drug benefit under Medicare (Medicare Part D) as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least “actuarially equivalent” to Medicare Part D. The Corporation has been informed that the Medicare program has determined that benefits provided under the Corporation’s postretirement plan for the plan year ending June 30, 2006 are considered to be actuarially equivalent to benefits available under Medicare Part D. The Corporation has not yet received reimbursement from the Medicare program for the plan year ended June 30, 2006. The amounts disclosed in the tables above for employer contributions to the postretirement benefit plan assume reimbursement will be received from the Medicare program in amounts ranging from $18,000 to $21,000 per year for 2006 through 2010.
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 $957,000 in 2006, $834,000 in 2005 and $727,000 in 2004.
Through December 31, 2006, the profit sharing/401(k) Plan included an Employee Stock Ownership Plan (ESOP). A portion of the Corporation’s basic contributions to the Plan were made to the ESOP, and the Plan used these funds to purchase Corporation stock for the accounts of Plan participants. These purchases were made on the market (not directly from the Corporation), and employees have not been permitted to purchase Corporation stock under the Plan. The Plan included a diversification feature which allowed Plan participants, upon reaching age 55 and 10 years of service (as defined), to sell up to 50% of their Corporation shares back to the Plan over a period of 6 years. As of December 31, 2006 and 2005, there were no shares allocated for repurchase by the Plan.
As of January 1, 2007, the Corporation established an ESOP, with essentially all of the same features as the previous ESOP, except that it was removed from the profit sharing/401(k) Plan. The value of participants’ ESOP accounts, which were 100% vested as of December 31, 2006, were transferred from the profit sharing/401(k) Plan to the new ESOP.
Dividends paid on shares held by the ESOP are charged to retained earnings. All Corporation shares owned through the ESOP are included in the calculation of weighted-average shares outstanding for purposes of calculating earnings per share - basic and diluted. The ESOP held 263,248 shares of Corporation stock at December 31, 2006 and 257,873 shares at December 31, 2005, all of which had been allocated to Plan participants. The Corporation’s contributions to the ESOP portion of the Plan (included in total contributions reported above) totaled $504,000 in 2006, $433,000 in 2005 and $385,000 in 2004.
The Corporation also has a nonqualified supplemental deferred compensation arrangement with its key officers. Charges to expense for officers’ supplemental deferred compensation were $60,000 in 2006, $32,000 in 2005 and $4,000 in 2004.
STOCK-BASED COMPENSATION PLANS
The Corporation has a Stock Incentive Plan for a selected group of senior officers. A total of 400,000 shares of common stock may be issued under the Stock Incentive Plan. Awards may be made under the Stock Incentive Plan in the form of qualified options (“Incentive Stock Options,” as defined in the Internal Revenue Code), nonqualified options, stock appreciation rights or restricted stock. Through 1999, all awards under the Stock Incentive Plan were Incentive Stock Options, with exercise prices equal to the market price of the stock at the date of grant, ratable vesting over 5 years and a contractual expiration of 10 years. In 2000, 2002, 2003, 2004 and 2005, there were awards of Incentive Stock Options and restricted stock. The Incentive Stock Options granted in 2000, 2002, 2003, 2004 and 2005 have an exercise price equal to
the market value of the stock at the date of grant, vest after 6 months and expire after 10 years. The restricted stock awards vest ratably over 3 years. A balance of 131,705 shares are available for issuance under the Stock Incentive Plan as of December 31, 2006.
Also, the Corporation has an Independent Directors Stock Incentive Plan. This plan permits awards of nonqualified stock options and/or restricted stock to non-employee directors. A total of 75,000 shares of common stock may be issued under 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. A balance of 30,973 shares are available for issuance under the Independent Directors Stock Incentive Plan as of December 31, 2006.
The Corporation has issued shares from treasury stock for all stock option exercises through December 31, 2006. The Corporation may repurchase shares of its common stock in 2007; however, management does not anticipate that stock repurchases will be necessary to accommodate stock option exercises in 2007 and cannot estimate the number of shares that may need to be repurchased.
As discussed in Note 1, through December 31, 2005, the Corporation applied APB Opinion 25 and related interpretations in accounting for stock options. As permitted by APB Opinion 25, the Corporation used the intrinsic value method of accounting for stock compensation plans, with compensation cost 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 had no intrinsic value at the date of grant; therefore, no compensation cost was recorded for them.
Effective in 2006, SFAS No. 123R requires the Corporation to record stock option expense based on estimated fair value calculated using an option valuation model. The provisions of SFAS 123R must be applied to any new awards granted, and to any modifications of existing awards. Since the Corporation has neither modified, nor issued, any new options in 2006, and all options issued prior to December 31, 2005 were fully vested, the provisions of SFAS No. 123R had no impact on net income in 2006.
Prior to 2006, if compensation cost for stock options had 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.
For purposes of the pro forma 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:
In calculating the estimated fair value of stock option awards made in 2005 and 2004, the Corporation utilized its historical volatility and dividend yield over the immediately prior 6-year periods to estimate future levels of volatility and dividend yield. In calculating dividend yield, the Corporation included an assumed 1% stock dividend annually, consistent with its practice for many years. The risk-free interest rate was based on the published yield of zero-coupon U.S. Treasury strips with 6-year maturities as of the grant dates. The 6-year term was based on management’s estimate of the average term for all options issued under both plans.
A summary of stock option activity is presented below:
The weighted-average remaining contractual term of outstanding stock options at December 31, 2006 was 5.1 years. The aggregate intrinsic value of stock options outstanding at December 31, 2006 (excluding options issued at exercise prices greater than the final closing price of the Corporation’s stock in 2006) was $416,000. There were no nonvested stock options outstanding in 2006. The total intrinsic value of options exercised was $30,000 in 2006, $460,000 in 2005 and $241,000 in 2004. The fair value of options vested was $91,000 in 2005 and $85,000 in 2004.
Compensation cost related to restricted stock is recognized based on the market price of the stock at the grant date over the vesting period. Compensation expense related to restricted stock was $39,000 in 2006, $93,000 in 2005 and $85,000 in 2004. The following table summarizes restricted stock awards in 2006, 2005 and 2004:
Effective January 3, 2007, the Corporation granted options to purchase a total of 43,385 shares of common stock through the Stock Incentive and Independent Directors Stock Incentive Plans. The exercise price for these options is $22.325 per share, which was the market price at the date of grant. The Corporation has not yet determined the amount of stock option-related compensation expense expected to be recognized in 2007 from these awards; however, based on a preliminary estimated fair value of $3.00 per share, total compensation expense in 2007 would be approximately $130,000. Management expects to use the Black-Scholes option-pricing model to measure compensation cost for these options. Also, effective January 3, 2007, the Corporation awarded a total of 5,835 shares of restricted stock under the Stock Incentive and Independent Directors Stock Incentive Plans. Total estimated restricted stock expense for 2007 is $130,000. The stock options and restricted stock awards made in January 2007 are not included in the tables above.
16. INCOME TAXES
The following temporary differences gave rise to the net deferred tax asset at December 31, 2006 and liability at December 31, 2005:
In 2005, the Corporation assumed an unused operating loss carryforward related to the acquisition of Canisteo Valley Corporation. As of December 31, 2006, the remaining unused operating loss carryforward totaled approximately $150,000. This operating loss carryforward may be applied against future taxable income through its expiration in 2024; however, the amount that may be utilized in any year is limited to the amount of taxable income generated by Canisteo Valley Corporation. Goodwill was reduced by $83,000 in 2006 and $25,000 in 2005 as a result of a portion of the deferred tax asset related to the operating loss being realized. If in the future more of the deferred tax asset related to the operating loss is realized, the associated valuation allowance will be allocated to reduce goodwill.
17. RELATED PARTY TRANSACTIONS
Loans to executive officers, directors of the Corporation and its subsidiaries and any associates of the foregoing persons are as follows:
The above transactions were made in the ordinary course of business on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and do not involve more than normal risks of collectibility. Other changes represent net increases in existing lines of credit and transfers in and out of the related party category.
Deposits from related parties held by the Corporation amounted to $3,379,000 at December 31, 2006 and $2,900,000 at December 31, 2005.
18. OFF-BALANCE SHEET RISK
The Corporation is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financial needs of its customers. These financial instruments include commitments to extend credit and financial standby letters of credit. These instruments involve, to varying degrees, elements of credit, interest rate or liquidity risk in excess of the amount recognized in the consolidated balance sheet. The contract amounts of these instruments express the extent of involvement the Corporation has in particular classes of financial instruments.
The Corporation’s exposure to credit loss from nonperformance by the other party to the financial instruments for commitments to extend credit and financial standby letters of credit is represented by the contractual amount of these instruments. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
Financial instruments whose contract amounts represent credit risk at December 31, 2006 and 2005 are as follows:
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, 2006 and 2005.
Financial standby letters of credit as of December 31, 2006 expire as follows:
19. OPERATING LEASES AND OTHER PURCHASE COMMITMENTS
The Corporation leases facilities and office equipment under operating leases expiring through 2009. Rental expense under operating leases totaled approximately $215,000 in 2006, $213,000 in 2005 and $89,000 in 2004. Minimum future rental payments under non-cancelable operating leases having remaining terms in excess of 1 year as of December 31, 2006 are as follows:
In 2004, the Corporation purchased the license to utilize banking software, and entered into contractual commitments to pay annual maintenance fees associated with the software. Maintenance expense amounted to $393,000 in 2006, $360,000 in 2005 and $60,000 in 2004, and maintenance fees payable will be approximately $400,000 per year through 2008 and $340,000 in 2009. Through October 2009, the Corporation would also be required to pay additional software license fees, based on the Bank’s asset size, determined based on the following schedule (additional licensing fees in thousands):
Effective in October 2007, the Corporation has the right to terminate its contractual commitment to the software vendor, subject to payment of 25% of any remaining annual maintenance fees.
The agreement between the software vendor and the Corporation contains options for an unlimited number of additional 5-year renewals. The agreement includes formulas to determine the amounts of maintenance fees and additional licensing fees, if the Corporation exercises the renewal options.
20. CONTINGENCIES
In the normal course of business, the Corporation is subject to pending and threatened litigation in which claims for monetary damages are asserted. In management’s opinion, the Corporation’s financial position and results of operations would not be materially affected by the outcome of these legal proceedings.
21. REGULATORY MATTERS
The Corporation (on a consolidated basis) and the subsidiary Banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Corporation’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation and the Banks must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
Quantitative measures established by regulation to ensure capital adequacy require the Corporation and the Banks to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2006 and 2005, that the Corporation and the Banks meet all capital adequacy requirements to which they are subject.
To be categorized as well capitalized, an institution must maintain minimum total risk based, Tier I risk based and Tier I leverage ratios as set forth in the following table. The Corporation’s and the Banks’ actual capital amounts and ratios are also presented in the following table.
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 2007 may not exceed $9,413,000, plus consolidated net income for 2007. Additionally, banking regulators limit the amount of dividends that may be paid by the Banks to the Corporation. Retained earnings against which dividends may be paid without prior approval of the banking regulators amounted to approximately $87,445,000 at December 31, 2006, subject to the minimum capital ratio requirements noted above.
Restrictions imposed by federal law prohibit the Corporation from borrowing from the Banks unless the loans are secured in specific amounts. Such secured loans to the Corporation are generally limited to 10% of the Banks’ tangible stockholder’s equity (excluding accumulated other comprehensive income) or $10,127,000 at December 31, 2006.
22. PARENT COMPANY ONLY
The following is condensed financial information for Citizens & Northern Corporation.
23. SUMMARY OF QUARTERLY CONSOLIDATED FINANCIAL DATA (Unaudited)
The following table presents summarized quarterly financial data for 2006 and 2005:
24. PENDING MERGER
In December 2006, the Corporation, along with Citizens Bancorp, Inc. (“Citizens”), announced the signing of an Agreement and Plan of Merger. Citizens is the parent company of Citizens Trust Company (“CTC”), a commercial bank with offices in the Pennsylvania communities of Coudersport, Emporium and Port Allegany. As of December 31, 2006, Citizens reported total assets of $144.4 million. Under the terms of the Agreement and Plan of Merger, Citizens will merge into the Corporation, and CTC will merge into C&N Bank.
Shareholders of Citizens will have the right to elect to receive, for each share of Citizens common stock they own (1) 1.297 shares of Corporation common stock, or (2) $28.57 in cash, or (3) a mixed election of stock and cash. Citizens’ shareholder elections are subject to allocation procedures designed to ensure that in the aggregate, 50% of the shares of Citizens common stock will be exchanged for cash and 50% of the shares of Citizens common stock will be exchanged for shares of Corporation common stock. Based on the number of Citizens common shares outstanding on December 31, 2006, and the last trading price of the Corporation’s common stock in 2006, the total purchase consideration is valued at approximately $29 million.
The transaction, which has been approved by the Board of Directors of both companies, is expected to be completed during the second quarter 2007. Consummation of the Merger is subject to approval by Citizens’ shareholders, regulatory approvals and other customary conditions of closing.
Report of Independent Registered Public Accounting Firm
Stockholders and Board of Directors of Citizens & Northern Corporation:
We have audited the accompanying consolidated balance sheet of Citizens & Northern Corporation and subsidiaries (collectively, the “Corporation”) as of December 31, 2006 and 2005, 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, 2006. These financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Citizens & Northern Corporation and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Corporation’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee on Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 1, 2007 expressed an unqualified opinion on management’s assessment of internal control over financial reporting and an unqualified opinion on the effectiveness of internal control over financial reporting.
Parente Randolph, LLC /s/
Williamsport, Pennsylvania
March 1, 2007
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
The Corporation’s management, under the supervision of and with the participation of the Corporation’s Chief Executive Officer and Chief Financial Officer, has carried out an evaluation of the design and effectiveness of the Corporation’s disclosure controls and procedures as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Securities Exchange Act of 1934 as of the end of period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Corporation’s disclosure controls and procedures are effective to ensure that all material information required to be disclosed in reports the Corporation files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms.
There were no significant changes in the Corporation’s internal control over financial reporting that occurred during the period covered by this report that has materially affected, or that is reasonably likely to affect, our internal control over financial reporting.
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The Corporation’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as that term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). The Corporation’s system of internal control over financial reporting has been designed to provide reasonable assurance to the Corporation’s management and board of directors regarding the reliability of financial reporting and the preparation and fair presentation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.
Any system of internal control over financial reporting, no matter how well designed, has inherent limitations, including the possibility that a control can be circumvented or overridden and misstatements due to error or fraud may occur and not be detected. Also, because of changes in conditions, internal control effectiveness may vary over time. Accordingly, even an effective system of internal control will provide only reasonable assurance with respect to financial statement preparation and presentation.
The Corporation’s management has assessed the effectiveness of the Corporation’s internal control over financial reporting as of December 31, 2006. To make this assessment, we used the criteria for effective internal control over financial reporting described in Internal Control - Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our assessment and based on such criteria, we believe that, as of December 31, 2006, the Corporation’s internal control over financial reporting was effective.
Parente Randolph, LLC, the independent registered public accounting firm that audited the Corporation’s consolidated financial statements, has issued an audit report on management’s assessment of internal control over financial reporting as of December 31, 2006. That report appears below.
February 27, 2007
Date
By:
Craig G. Litchfield /s/
Chairman, President and Chief Executive Officer
February 27, 2007
Date
By:
Mark A. Hughes /s/
Treasurer and Chief Financial Officer
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Stockholders and Board of Directors of Citizens & Northern Corporation:
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Citizens & Northern Corporation and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Citizens & Northern Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Citizens & Northern Corporation and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Citizens & Northern Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Citizens & Northern Corporation and subsidiaries as of December 31, 2006 and 2005, 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, 2006, and our report dated March 1, 2007 expressed an unqualified opinion.
Parente Randolph, LLC /s/
Williamsport, Pennsylvania
March 1, 2007
ITEM 9B.
ITEM 9B. OTHER INFORMATION
There was no information the Corporation was required to disclose in a report on Form 8-K during the fourth quarter 2006 that was not disclosed.
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,” “Section 16(a) Beneficial Ownership Reporting Compliance,” “Board of Director Committees, Attendance at Meetings and Compensation of Directors” and “Stockholder Proposals” of the Corporation’s proxy statement dated March 20, 2007 for the annual meeting of stockholders to be held on April 17, 2007.
The Corporation’s Board of Directors has adopted a Code of Ethics, available on the Corporation’s web site at www.cnbankpa.com for the Corporation’s employees, officers and directors. (The provisions of the Code of Ethics are also included in the Corporation’s employee handbook.)
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information concerning executive compensation is incorporated herein by reference to disclosure under the captions “Compensation Discussion and Analysis,” “Executive Compensation,” “Outstanding Equity Awards at Fiscal Year-end,” “Options Exercised and Stock Vested,” “Pension Benefits,” “401(k) Savings Plan/ESOP,” “Non-qualified Deferred Compensation” and “Change in Control Agreements” of the Corporation’s proxy statement dated March 20, 2007 for the annual meeting of stockholders to be held on April 17, 2007.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED MATTERS
Information concerning security ownership of certain beneficial owners and management is incorporated herein by reference to disclosure under the caption “Security Ownership of Management” of the Corporation’s proxy statement dated March 20, 2007 for the annual meeting of stockholders to be held on April 17, 2007.
“Equity Compensation Plan Information” as required by Item 201(d) of Regulation S-K is incorporated by reference herein from Item 5 (Market for Registrant’s Common Equity and Related Stockholder Matters) of this Form 10-K.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information concerning loans and deposits with Directors and Executive Officers is provided in Note 17 to the Consolidated Financial Statements, which is included in Part II, Item 8 of this Annual Report on Form 10-K. Additional information is incorporated herein by reference to disclosure appearing under the caption “Certain Transactions” of the Corporation’s proxy statement dated March 20, 2007 for the annual meeting of stockholders to be held on April 17, 2007.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information concerning services provided by the Corporation’s independent auditors, Parente Randolph, LLC, the audit committee’s pre-approval policies and procedures for such services, and fees paid by the Corporation to that firm, is incorporated herein by reference to disclosure under the caption “Audit Committee” of the Corporation’s proxy statement dated March 20, 2007 for the annual meeting of stockholders to be held on April 17, 2007.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(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.
(a)(3) Exhibits (numbered as in Item 601 of Regulation S-K):
2. Plan of acquisition, reorganization, arrangement, liquidation or succession
Incorporated by reference to Annex A in the Proxy Statement/Prospectus included in the Corporation’s registration statement on Form S-4 filed on February 12, 2007
3. (i) Articles of Incorporation
Incorporated by reference to Exhibit 4.1 to the Corporation’s Form S-8 registration statement filed November 3, 2006
3. (ii) By-laws
Incorporated by reference to Exhibit 3.1 of the Corporation’s Form 8-K filed August 25, 2004
4. Instruments defining the rights of security holders, including indentures
Not applicable
9. Voting trust agreement
Not applicable
10. Material contracts:
10.1 Change in Control Agreement dated July 21, 2005 between the Corporation and Harold F. Hoose, III
Incorporated by reference to Exhibit 10.1 filed with the Corporation’s Form 10-K on March 3, 2006
10.2 Form of Stock Option and Restricted Stock Agreements dated January 3, 2005 between the Corporation and certain officers pursuant to the Citizens & Northern Corporation Stock Incentive Plan
Incorporated by reference to Exhibit 10.2 filed with the Corporation’s Form 10-K on March 3, 2006
10.3 Form of Stock Option and Restricted Stock Agreements dated January 3, 2005 between the Corporation and the Directors pursuant to the Citizens & Northern Corporation Independent Directors Stock Incentive Plan
Incorporated by reference to Exhibit 10.3 filed with the Corporation’s Form 10-K on March 3, 2006
10.4 Form of Indemnification Agreements dated May 2004
Incorporated by reference to Exhibit 10.1
between the Corporation and the Directors and certain
filed with the Corporation’s Form 10-K
officers
on March 11, 2005
10.5 Change in Control Agreement dated December 31, 2003
Incorporated by reference to Exhibit 10.2
between the Corporation and Thomas L. Rudy, Jr.
filed with the Corporation's Form 10-K
on March 11, 2005
10.6 Change in Control Agreement dated December 31, 2003
Incorporated by reference to Exhibit 10.1
between the Corporation and Craig G. Litchfield
filed with the Corporation’s Form 10-K
on March 10, 2004
10.7 Change in Control Agreement dated December 31, 2003
Incorporated by reference to Exhibit 10.2
between the Corporation and Mark A. Hughes
filed with the Corporation’s Form 10-K
on March 10, 2004
10.8 Change in Control Agreement dated December 31, 2003
Incorporated by reference to Exhibit 10.4
between the Corporation and Deborah E. Scott
filed with the Corporation’s Form 10-K
on March 10, 2004
10.9 Second Amendment to Citizens & Northern Corporation
Incorporated by reference to Exhibit 10.5
Stock Incentive Plan
filed with the Corporation’s Form 10-K
on March 10, 2004
10.10 First Amendment to Citizens & Northern Corporation
Incorporated by reference to Exhibit 10.6
Stock Incentive Plan
filed with the Corporation’s Form 10-K
on March 10, 2004
10.11 Citizens & Northern Corporation Stock Incentive Plan
Incorporated by reference to Exhibit 10.7
filed with the Corporation’s Form 10-K
on March 10, 2004
10.12 Citizens & Northern Corporation Independent Directors
Incorporated by reference to Exhibit A to
Stock Incentive Plan
the Corporation’s proxy statement
dated March 19, 2001 for the annual
meeting of stockholders held on
April 17, 2001.
10.13 Amendment #1 to Citizens & Northern Bank
Incorporated by reference to Exhibit 10.2(b)
Supplemental Executive Retirement Plan
filed with the Corporation’s Form 10-K
on March 19, 2001
10.14 Amendment #2 to Citizens & Northern Bank
Incorporated by reference to Exhibit 10.2(a)
Supplemental Executive Retirement Plan
filed with the Corporation’s Form 10-K
on March 19, 2001
10.15 Citizens & Northern Bank Supplemental
Incorporated by reference to Exhibit 10.2
Executive Retirement Plan
filed with the Corporation’s Form 10-K
on March 19, 2001
11. Statement re: computation of per share earnings
Information concerning the computation of
earnings per share is provided in Note 3
to the Consolidated Financial Statements,
which is included in Part II, Item 8 of
Form 10-K.
12. Statements re: computation of ratios
Not applicable
13. Annual report to security holders, Form 10-Q or quarterly report to security holders
Not applicable
14. Code of ethics
The Code of Ethics is available through the Corporation’s website at www.cnbankpa.com. To access the Code of Ethics, click on “Shareholder News & Info.,” followed by “Corporate Governance” and “Code of Ethics.”
16. Letter re: change in certifying accountant
Not applicable
18. Letter re: change in accounting principles
Not applicable
21. Subsidiaries of the registrant
Filed herewith
22. Published report regarding matters submitted to vote of security holders
Not applicable
23. Consents of experts and counsel
Not applicable
24. Power of attorney
Not applicable
31. Rule 13a-14(a)/15d-14(a) certifications:
31.1 Certification of Chief Executive Officer
Filed herewith
31.2 Certification of Chief Financial Officer
Filed herewith
32. Section 1350 certifications
Filed herewith
33. Report on assessment of compliance with servicing criteria for asset-backed securities
Not applicable
34. Attestation report on assessment of compliance with servicing criteria for asset-backed securities
Not applicable
35. Service compliance statement
Not applicable
99. Additional exhibits:
99.1 Additional information mailed to stockholders with proxy statement and Form 10-K on March 20, 2007
Filed herewith
(b) Exhibits - The required exhibits are listed under Part IV, Item 15(a)(3) of Form 10-K.
(c) Financial statement schedules are omitted because the required information is not applicable or is included elsewhere in Form 10-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Citizens & Northern Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized:
By: Craig G. Litchfield /s/
Craig G. Litchfield
Chairman, President and Chief Executive Officer
Date: March 2, 2007
By: Mark A. Hughes /s/
Treasurer and Principal Accounting Officer
Date: March 2, 2007
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