**FORM 10-K**

 

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

**ý****                                ****ANNUAL REPORT PURSUANT TO SECTION13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**Forthe fiscal year ended            December31, 2003**

 

**OR**

 

**o****                                ****TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NOFEE REQUIRED)**

 

**For thetransition period from                                 to                                 **

 

**Commissionfile number            0-17077**

 

**PENNS WOODS BANCORP, INC.**

(exact name ofregistrant as specified in its charter)

 

| **Pennsylvania**                                                 |   | **23-2226454**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction  of incorporation or organization) |   | (I.R.S. Employer  Identification No.) |

 

**300 Market Street, P.O. Box 967**

**Williamsport, Pennsylvania 17703-0967**

(Address of principalexecutive offices)

 

Registrant’s telephonenumber, including area code        (**570)322-1111**

 

Securities registeredpursuant to Section 12(b) of the Act:

 

| **Title of  each class** |   | **Name of  each exchange  which registered** |
|--------------------------|--------|----------------------------------------------|
| **None**                 |   | **None**                                     |

 

Securitiesto be registered pursuant to Section 12(g) of the Act:

 

**Common Stock, parvalue $10 per share**

(Title of Class)

 

 

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Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports) and (2) has been subject to such filing requirements for the past90 days.     Yes    ý     No   o

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form10-K.  ý

 

Indicate by check marke whether the registrant is an accelerated fileras of defined in Rule 12b-2 of the Act.    Yes   ý  No   o

State the aggregatemarket value of the voting stock held by non-affiliates of the registrant **$117,137,176****at June30, 2003.**

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date.

 

| **Class**                       |   | **Outstanding  at March 5, 2004** |
|---------------------------------|--------|-----------------------------------|
| **Common Stock, $10 Par Value** |   | **3,322,420 Shares**              |

 

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**DOCUMENTSINCORPORATED BY REFERENCE**

 

Portions of theregistrant’s definitive proxy statement prepared in connection with its annualmeeting of shareholders to be held on April 28, 2004 are incorporated byreference in Part III hereof.

 

**INDEX**

 
| **PART I**                    |
|-------------------------------|
| **ITEM**                      |   |   |
| Item 1.                       | Business. |   |
| Item 2.                       | Properties. |   |
| Item 3.                       | Legal Proceedings |   |
| Item 4.                       | Submission of Matters to a Vote of Security  Holders. |   |
|                          |   |   |
| **PART II**                   |
| Item 5.                       | Market for the Registrant’s Common Stock,  Related Stockholder Matters, and Issuer Purchase of Equity Securities |   |
| Item 6.                       | Selected Financial Data |   |
| Item 7.                       | Management’s Discussion and Analysis of  Consolidated Financial Condition and Results of Operations |   |
| Item  7.A                     | Quantitative  and Qualitative Disclosure About Market Risk |   |
| Item  8.                      | Financial  Statements and Supplementary Data |   |
| Item  9.                      | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure. |   |
| Item 9A.                      | Controls and Procedures |   |
|                          |   |   |
| **PART III**                  |
| Item 10.                      | Directors and Executive Officers of the  Registrant. |   |
| Item 11.                      | Executive Compensation. |   |
| Item 12.                      | Security Ownership and Certain Beneficial  Owners and Management |   |
| Item 13.                      | Certain Relationships and Related Transactions. |   |
| Item 14.                      | Principal Accountant Fees and Services. |   |
|                          |   |   |
| **PART IV**                   |
| Item 15.                      | Exhibits, Financial Statement Schedules and  Reports on Form 8-K |   |
| Index to Exhibits             |   |
| Signatures and Certifications |   |

 

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**PART I**

 

**ITEM 1****   BUSINESS**

 

##### **A.  General Development of Business and History**

 

On January 7, 1983, PennsWoods Bancorp, Inc. (the “Company”) was incorporated under the laws of theCommonwealth of Pennsylvania as a bank holding company.  The Jersey Shore State Bank (the “Bank”)became a wholly owned subsidiary of the Company, and each outstanding share ofBank common stock was converted into one share of Company common stock.  This transaction was approved by theshareholders of the Bank on April 11, 1983 and was officially effective on July12, 1983.  The Company’s business hasconsisted primarily of managing and supervising the Bank, and its principalsource of income has been dividends paid by the Bank.  The Company’s two other wholly-owned subsidiaries are Woods RealEstate Development Co, Inc. and Woods Investment Co., Inc.

 

The Bank is engaged incommercial and retail banking and the taking of time and regular savings anddemand deposits, the making of commercial and consumer loans and mortgageloans, and safe deposit services. Auxiliary services, such as cash management, are provided to commercialcustomers.  The Bank operates fullbanking services with eleven branch offices and a Mortgage/Loan Center inNorthcentral Pennsylvania.

 

In October 2000, the Bankacquired The M Group, Inc. D/B/A The Comprehensive Financial Group (“The MGroup”). The M Group, which operates as a subsidiary of the Bank, offersinsurance and securities brokerage services. Securities are offered by The MGroup through ING Financial Partners, Inc., a registered broker-dealer.

 

Neither the Company nor the Bank anticipates that compliance withenvironmental laws and regulations will have any material effect on capitalexpenditures, earnings, or on its competitive position.  The Bank is not dependent on a singlecustomer or a few customers, the loss of whom would have a material effect onthe business of the Bank.

 

The Bank employedapproximately 150 persons as of December 31, 2003.  The Company does not have any employees.  The principal officers of the Bank alsoserve as officers of the Company.

 

A copy of the Code of Ethics and Code of Conduct forthe Corporation can be requested from Sonya E. Scott, the Secretary of theCorporation, at 300 Market Street, Williamsport, PA  17701.  A link with accessto the Corporation’s SEC 10K filings, annual reports, and quarterly filingscand be found at www.jssb.com.

 

##### **B.  Regulation and Supervision**

 

The Company is alsosubject to the provisions of the Bank Holding Company Act of 1956, as amended(the “BHCA”) and to supervision and examination by the Board of Governors ofthe Federal Reserve System (the “FRB”). The Bank is subject to the supervision and examination by the FederalDeposit Insurance Corporation (the “FDIC”), as its primary federal regulatorand as the insurer of the Bank’s deposits. The Bank is also regulated and examined by the Pennsylvania Departmentof Banking (the “Department”).

 

The insurance activitiesof The M Group are subject to regulation by the insurance departments of thevarious states in which The M Group conducts business including principally thePennsylvania Department of Insurance. The securities brokerage activities ofThe M Group are subject to regulation by federal and state securitiescommissions.

 

The FRB has issuedregulations under the BHCA that require a bank holding company to serve as asource of financial and managerial strength to its subsidiary banks.  As a result, the FRB, pursuant to suchregulations, may require the Company to stand ready to use its resources toprovide adequate capital funds to the Bank during periods of financial stressor adversity.  The BHCA requires theCompany to secure the prior approval of the FRB before it can acquire all orsubstantially all of the assets of any bank, or acquire ownership or control of5% or more of any voting shares of any bank. Such a transaction would also require approval of the Department.

 

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A bank holding company isprohibited under the BHCA from engaging in, or acquiring direct or indirectcontrol of, more than 5% of the voting shares of any company engaged innon-banking activities unless the FRB, by order or regulation, has found suchactivities to be so closely related to banking or managing or controlling banksas to be a proper incident thereto. Under the BHCA, the FRB has the authority to require a bank holdingcompany to terminate any activity or relinquish control of a non-banksubsidiary (other than a non-bank subsidiary of a bank) upon the FRB’sdetermination that such activity or control constitutes a serious risk to thefinancial soundness and stability of any bank subsidiary of the bank holdingcompany.

 

Bank holding companiesare required to comply with the FRB’s risk-based capital guidelines.  The risk-based capital rules are designed tomake regulatory capital requirements more sensitive to differences in riskprofiles among banks and bank holding companies and to minimize disincentivesfor holding liquid assets.  Currently,the required minimum ratio of total capital to risk-weighted assets (includingcertain off-balance sheet activities, such as standby letters of credit) is 8%.  At least half of the total capital isrequired to be Tier 1 capital, consisting principally of common shareholders’equity, less certain intangible assets. The remainder (“Tier 2 capital”) may consist of certain preferred stock,a limited amount of subordinated debt, certain hybrid capital instruments andother debt securities, 45% of net unrealized gains on marketable equitysecurities and a limited amount of the general loan loss allowance.  The risk-based capital guidelines arerequired to take adequate account of interest rate risk, concentration ofcredit risk, and risks of nontraditional activities.

 

In addition to therisk-based capital guidelines, the FRB requires each bank holding company tocomply with the leverage ratio, under which the bank holding company mustmaintain a minimum level of Tier 1 capital to average total consolidated assetsof 3% for those bank holding companies which have the highest regulatoryexamination ratings and are not contemplating or experiencing significantgrowth or expansion.  All other bankholding companies are expected to maintain a leverage ratio of at least 4% to5%.  The Bank is subject to similarcapital requirements adopted by the FDIC.

 

**C.  Regulation of theBank**

 

From time to time,various types of federal and state legislation have been proposed that couldresult in additional regulation of, and restrictions of, the business of theBank.  It cannot be predicted whetherany such legislation will be adopted or how such legislation would affect thebusiness of the Bank.  As a consequenceof the extensive regulation of commercial banking activities in the UnitedStates, the Bank’s business is particularly susceptible to being affected byfederal legislation and regulations that may increase the costs of doingbusiness.

 

**Prompt Corrective Action** - The FDIC hasspecified the levels at which an insured institution will be considered “well-capitalized,” “adequately capitalized,” “undercapitalized,” and “criticallyundercapitalized.” In the event an institution’s capital deteriorates to the“undercapitalized” category or below, the Federal Deposit Insurance Act (the“FDIA”) and FDIC regulations prescribe an increasing amount of regulatoryintervention, including: (1)  theinstitution of a capital restoration plan by a bank and a guarantee of the planby a parent institution; and (2) the placement of a hold on increases inassets, number of branches or lines of business. If capital has reached thesignificantly or critically undercapitalized levels, further materialrestrictions can be imposed, including restrictions on interest payable onaccounts, dismissal of management and (in critically undercapitalizedsituations) appointment of a receiver. For well-capitalized institutions, the FDIA provides authority forregulatory intervention where the institution is deemed to be engaging inunsafe or unsound practices or receives a less than satisfactory examinationreport rating for asset quality, management, earnings or liquidity.

 

**Deposit Insurance** - There are two depositinsurance funds administered by the FDIC - the Savings Association InsuranceFund (“SAIF”) and the Bank Insurance Fund (“BIF”).  The Bank’s deposits are insured under the BIF; however, thedeposits assumed by the Bank in connection with the merger of Lock HavenSavings Bank are treated and assessed as SAIF-insured deposits.  The FDIC has implemented a risk-relatedpremium schedule for all insured depository institutions that results in theassessment of premiums based on capital and 

 

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supervisory measure.  Under the risk-related premium schedule, theFDIC assigns, on a semiannual basis, each institution to one of three capitalgroups (well-capitalized, adequately capitalized or undercapitalized) andfurther assigns such institution to one of three subgroups within a capitalgroup. The institution’s subgroup assignment is based upon the FDIC’s judgmentof the institution’s strength in light of supervisory evaluations, includingexamination reports, statistical analyses and other information relevant togauging the risk posed by the institution. Only institutions with a total capital to risk-adjusted assets ratio of10.0% or greater, a Tier 1 capital to risk-adjusted assets ratio of 6.0% orgreater and a Tier 1 leverage ratio of 5.0% or greater, are assigned to thewell-capitalized group.   As of December31, 2003, the Bank’s ratios were well above required minimum ratios.

 

Both the BIF and SAIF arepresently fully funded at more than the minimum amount required by law.Accordingly, the BIF and SAIF assessment rates range from zero for thoseinstitutions with the least risk, to $0.27 for every $100 of insured depositsfor institutions deemed to have the highest risk.  The Bank is in the category of institutions that presently paynothing for deposit insurance.  The FDICadjusts the rates every six months.  TheFDIC indicated that all banks may again be required to pay deposit insurancepremiums in the future if the current trend of the size of the depositinsurance funds relative to all insured deposits continues.

 

While the Bank presentlypays no premiums for deposit insurance, it is subject to assessments to pay theinterest on Financing Corporation (“FICO”) bonds.  FICO was created by Congress to issue bonds to finance theresolution of failed thrift institutions. The current annual FICO assessment for the Bank (and all banks) is$.0154 $100 of BIF deposits.

 

##### **OtherLegislation**

 

The Fair and Accurate Credit Transactions Act (“FACT”)was signed into law on December 4, 2003. This law extends the previously existing Fair Credit Reporting Act.  New provisions added by FACT address thegrowing problem of identifying theft. Consumers will be able to initiate a fraud alert when they are victimsof identity theft, and credit reporting agencies will have additionalduties.  Consumers will also be entitledto obtain free credit reports, and will be granted certain additional privacyrights.  Regulators will be issuingrules to implement FACT over the next year, and some of these rules will likelyimpose additional duties on the Bank, although the Company does not believethat the application of these new rules will have a material effect on itsoperations.

 

The Sarbanes-Oxley Act of2002 was enacted to enhance penalties for accounting and auditing improprietiesat publicly traded companies and to protect investors by improving the accuracyand reliability of corporate disclosures under the federal securitieslaws.  The Sarbanes-Oxley Act generallyapplies to all companies, including the Company, that file or are required tofile periodic reports with the Securities and Exchange Commission under theSecurities Exchange Act of 1934, or the Exchange Act.  The legislation includes provisions, among other things,governing the services that can be provided by a public company’s independentauditors and the procedures for approving such services, requiring the chiefexecutive officer and chief financial officer to certify certain mattersrelating to the company’s periodic filings under the Exchange Act, requiringexpedited filings of reports by insiders of their securities transactions andcontaining other provisions relating to insider conflicts of interest,increasing disclosure requirements relating to critical financial accountingpolicies and their application, increasing penalties for securities lawviolations, and creating a new public accounting oversight board, a regulatorybody subject to SEC jurisdiction with broad powers to set auditing, qualitycontrol and ethics standards for accounting firms.  In response to the legislation, the national securities exchangesand NASDAQ have adopted new rules relating to certain matters, including theindependence of members of a company’s audit committee as a condition tolisting or continued listing.  The Companydoes not believe that the application of these new rules to the Company willhave a material effect on its results of operations.

 

In addition, Congress isoften considering some financial industry legislation. The Company cannotpredict how any new legislation, or new rules adopted by the federal bankingagencies, may affect its business in the future.

 

In addition to federalbanking law, the Bank is subject to the Pennsylvania Banking Code. The BankingCode was amended in late 2000 to provide more complete “parity” in the powersof state-chartered institutions compared to national banks and federal savingsbanks doing business in Pennsylvania. Pennsylvania banks have all the sameability to form financial subsidiaries authorized by the Gramm-Leach-BlileyAct, as do national banks.

 

##### **EnvironmentalLaws**

 

Environmentally relatedhazards have become a source of high risk and potential liability for financialinstitutions relating to their loans. Environmentally contaminated 

 

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properties owned by an institution’s borrowers may result in a drasticreduction in the value of the collateral securing the institution’s loans tosuch borrowers, high environmental clean up costs to the borrower affecting itsability to repay the loans, the subordination of any lien in favor of theinstitution to a state or federal lien securing clean up costs, and liabilityto the institution for clean up costs if it forecloses on the contaminatedproperty or becomes involved in the management of the borrower.  The Company is not aware of any borrower whois currently subject to any environmental investigation or clean up proceedingwhich is likely to have a material adverse effect on the financial condition orresults of operations of the Company.

 

##### **Effectof Government Monetary Policies**

 

The earnings of theCompany are and will be affected by domestic economic conditions and themonetary and fiscal policies of the United States Government and itsagencies.   The monetary policies of theFRB have had, and will likely continue to have, an important impact on theoperating results of commercial banks through its power to implement nationalmonetary policy in order, among other things, to curb inflation or combat arecession.  The FRB has a major effectupon the levels of bank loans, investments and deposits through its open marketoperations in the United States Government securities and through itsregulation of, among other things, the discount rate on borrowing of memberbanks and the reserve requirements against member bank deposits.  It is not possible to predict the nature andimpact of future changes in monetary and fiscal policies.

 

##### **DESCRIPTIONOF BANK**

##### ** **

**a.  History andBusiness**

 

Jersey Shore State Bank“(“Bank”)” was incorporated under the laws of the Commonwealth of Pennsylvaniaas a state bank in 1934 and became a wholly owned subsidiary of the Company onJuly 12, 1983.

 

As of December 31, 2003,the Bank had total assets of $511,634,000; total shareholders’ equity of$54,130,000 and total deposits of $334,828,000.  The Bank’s deposits are insured by the Federal Deposit InsuranceCorporation for the maximum amount provided under current law.

 

The Bank engages inbusiness as a commercial bank, doing business at several locations in Lycoming,Clinton and Centre Counties, Pennsylvania. The Bank offers insurance and securities brokerage services         through its wholly owned subsidiary,The M Group, Inc. D/B/A The Comprehensive Financial Group.

 

Services offered by theBank include accepting time, demand and savings deposits including Super NOWaccounts, regular savings accounts, money market accounts, investmentcertificates, fixed rate certificates of deposit and club accounts.  Its services also include making secured andunsecured commercial and consumer loans, financing commercial transactions,making construction and mortgage loans and the renting of safe depositfacilities.  Additional services includemaking residential mortgage loans, revolving credit loans with overdraftprotection, small business loans, etc. Business loans include seasonal credit collateral loans and term loans.

 

TheBank’s loan portfolio mix can be classified into four principal categories ofreal estate, agricultural, commercial and consumer.

 

Real estate loans can befurther segmented into construction and land development, farmland, one-to-fourfamily residential, multi-family and commercial or industrial.  Qualified borrowers are defined by policy orby industry underwriting standards.  Owner provided equity requirements range from 20% to 30% with a firstlien status required.  Terms arerestricted to between 10 and 20 years with the exception of construction andland development, which is limited to one to five years.  Appraisals, verifications and visitationscomply with industry standards.

 

Financial informationthat is required on all commercial mortgages includes the most current threeyears’ balance sheets and income statements and projections on income to bedeveloped through the project.  In thecase of corporations and partnerships, the principals are often asked to indebtthemselves personally as well. Residential mortgages, repayment ability 

 

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is determined from information contained in the application and recentincome tax returns.   Emphasis is oncredit, employment, income and residency verification.  Broad hazard insurance is always requiredand flood insurance where applicable. In the case of construction mortgages, builders risk insurance isrequested.

 

Agricultural loans forthe purchase or improvement of real estate must meet the Bank’s real estateunderwriting criteria.  The onlypermissible exception is when a Farmers Home Loan Administration guaranty isobtained.  Agricultural loans made forthe purchase of equipment are usually payable in five years, but never morethan seven, depending upon the useful life of the purchased asset.  Minimum borrower equity required is20%.  Livestock financing criteria dependsupon the nature of the operation.  Adairy herd could be financed over three years, but a feeder operation wouldrequire cleanup in intervals of less than one year.  Agricultural loans are also made for crop productionpurposes.  Such loans are structured torepay within the production cycle and not carried over into a subsequentyear.   General purpose working capitalloans are also a possibility with repayment expected within one year.  It is also a general policy to collateralizenon-real estate loans with not only the asset purchased but also junior lienson all other available assets. Insurance and credit criteria is the same as mentioned previously.  In addition, annual visits are made to ouragricultural customers to determine the general condition of assets.   Personal credit requirements are handled asconsumer loans.

 

Commercial loans are madefor the acquisition and improvement of real estate, purchase of equipment andfor working capital purposes on a seasonal or revolving basis.  Criteria was discussed under real estatefinancing for such loans, but it is important to note that such loans may bemade in conjunction with the Pennsylvania Industrial DevelopmentAuthority.  Caution is also exercised intaking industrial property for collateral by requiring, on a selective basis, environmentalaudits.

 

Equipmentloans are generally amortized over three to seven years, with an owner equitycontribution required of at least 20% of the purchase price.  Unusually expensive pieces may be financedfor a longer period depending upon the asset’s useful life.  The increased cash flow resulting from theadditional piece, through improved income or greater depreciation expense,serves in establishing the terms. Insurance coverage with the Bank as loss payee is required, especiallyin the case where the equipment is rolling stock.

 

Seasonal and revolvinglines of credit are offered for working capital purposes.  Collateral for such a loan includes thepledge of inventory and/or receivables. Drawing availability is usually 50% of inventory and 75% of eligiblereceivables.  Eligible receivables aredefined as invoices less than 90 days delinquent.  Exclusive reliance is very seldom placed on such collateral,therefore, other lienable assets are also taken into the collateral pool.  Where reliance is placed on inventory andaccounts receivable, the applicant must provide financial information includingagings on a monthly basis.  In addition,the guaranty of the principals is usually obtained.

 

It is unusual for theBank to make unsecured commercial loans. But when such a loan is a necessity, credit information in the file mustsupport that decision.

 

Letter of Creditavailability is limited to standbys where the customer is well known to theBank.  Credit criteria is the same asthat utilized in making a direct loan and collateral is obtained in most cases,and whenever the expiration date is for more than one year.

 

Consumer loan productsinclude second mortgages, automobile financing, small loan requests, overdraftcheck lines and PHEAA referral loans. Our policy includes standards used in the industry on debt serviceratios and terms are consistent with prudent underwriting standards and the useof proceeds.   Verifications are made ofemployment and residency, along with credit history.  Second mortgages are confined to equity borrowing and homeimprovements.  Terms are generally tenyears or less and rates are fixed.  Loanto collateral value criteria is 80% or less and verifications are made todetermine values.   Automobile financingis generally restricted to five years and done on a direct basis.  The Bank, as a practice, does not floor planand therefore does not discount dealer paper. Small loan requests are to accommodate personal needs such as the purchaseof small appliances or for 

 

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the payment of taxes.  Overdraftcheck lines are limited to $5,000 or less.

 

The Bank’s investmentportfolio is analyzed and priced on a     monthly basis. Investments are made in U.S. Treasuries, U.S. Agency issues,bank qualified municipal bonds, corporate bonds and corporate stocks whichconsist of Pennsylvania bank stocks. Bonds with BAA or better ratings are used, unless a local issue ispurchased that has a lesser or no rating.

 

Factors taken intoconsideration when investments are made include liquidity, the Company’s taxposition and the policies of the Asset/Liability Committee.

 

The Bank has experienceddeposit growth in the range of .96% to 11.37% over the last five years.  This growth has primarily come in the formof core deposits.  Although the Bank hasregular opportunities to bid on pools of funds of $100,000 or more in the handsof municipalities, hospitals and others, it does not rely on these monies tofund loans on intermediate or longer-term investments.  Minor seasonal growth in deposits isexperienced at or near the year-end.

 

It is the policy of theBank to generally maintain a rate sensitive asset (RSA) to rate sensitiveliability (RSL) ratio of 150% of equity for a 6-month time horizon, 150% ofequity for a 2-year time horizon and 150% of equity for a 5-year time horizon.

 

The Bank operates elevenfull service offices in Lycoming, Clinton, and Centre Counties, Pennsylvania,and a Mortgage/Loan Center in Centre County, Pennsylvania.  The economic base of the region is developedaround service, light manufacturing industries and agriculture.  The banking environment in Lycoming, Clintonand Centre Counties, Pennsylvania is highly competitive.  The Bank competes for loans and depositswith commercial banks, savings and loan associations and other financialinstitutions.

 

The Bank has a relativelystable deposit base and no material amount of deposits is obtained from asingle depositor or group of depositors (including federal, state and localgovernments).  The Bank has not experiencedany significant seasonal fluctuations in the amount of its deposits.

 

**b.  Supervision andRegulation**

 

The earnings of the Bankare affected by the policies of regulatory authorities including the FDIC andthe FRB. An important function of the FRB is to regulate the money supply andinterest rates.  Among the instrumentsused to implement these objectives are open market operations in U.S.Government Securities, changes in reserve requirements against member bankdeposits and limitations on interest rates that member banks may pay on timeand savings deposits.  These instrumentsare used in varying combinations to influence overall growth and distributionof bank loans, investments on deposits, and their use may also affect interestrates charged on loans or paid for deposits.

 

The policies andregulations of the FRB have had and will probably continue to have asignificant effect on the Bank’s deposits, loans and investment growth, as wellas the rate of interest earned and paid, and are expected to affect the Bank’soperation in the future.  The effect ofsuch policies and regulations upon the future business and earnings of the Bankcannot accurately be predicted.

 

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**EXECUTIVE OFFICERS OF THE REGISTRANT:**

 
| **NAME**           |   | **AGE** |   | **FIVE-YEAR  ANALYSIS OF DUTIES**                                                                                                                                                                                                                                                    |
|--------------------|--------|---------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Ronald A. Walko    |   | 57      |   | President and Chief  Executive Officer of the Company; the Bank; The M Group; and Woods Investment  Company, Inc.; Vice President of Woods Real Estate Development Co, Inc.; and  Federal Bank examiner prior to 1986 for an eighteen-year period.                                   |
|               |   |    |   |                                                                                                                                                                                                                                                                                 |
| Hubert A. Valencik |   | 62      |   | Senior Vice President  of the Company; Senior Vice President and Operations Officer of the Bank;  Vice President of Woods Real Estate Development Co, Inc.; Vice President -  Operations of The M Group; Vice President with another bank prior to 1985 for  a fourteen-year period. |
|               |   |    |   |                                                                                                                                                                                                                                                                                 |
| Sonya E. Scott     |   | 44      |   | Secretary of the  Company; Senior Vice President and Chief Financial Officer of the Bank;  Secretary and Treasurer of Woods Real Estate Development Co, Inc.; Woods  Investment Co.,Inc.; and The M Group.                                                                           |

 

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##### **ITEM  2**    PROPERTIES

 

The Company owns andleases its properties.  Listed herewithare the locations of properties owned or leased, in which the banking officesand Financial Center are located; all properties are in good condition andadequate for the Bank’s purposes:

 
| **Office**    |   | **Address**                                  |   |        |
|---------------|--------|----------------------------------------------|--------|-------------|
| Main          |   | 115 South Main Street                        |   | Owned       |
|          |   | P.O. Box 5098                                |   |        |
|          |   | Jersey Shore,  Pennsylvania 17740            |   |        |
|          |   |                                         |   |        |
| Bridge Street |   | 112 Bridge Street                            |   | Owned       |
|          |   | Jersey Shore,  Pennsylvania 17740            |   |        |
|          |   |                                         |   |        |
| DuBoistown    |   | 2675 Euclid Avenue                           |   | Under Lease |
|          |   | DuBoistown,  Pennsylvania 17702              |   |        |
|          |   |                                         |   |        |
| Williamsport  |   | 300 Market Street                            |   | Owned       |
|          |   | P.O. Box 967                                 |   |        |
|          |   | Williamsport,  Pennsylvania  17703-0967 |   |        |

 

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| Montgomery                                                   |   | 9094 Rt 405 Highway                                         |   | Under Lease      |
|--------------------------------------------------------------|--------|-------------------------------------------------------------|--------|------------------|
|                                                         |   | Montgomery,  Pennsylvania 17752                             |   |             |
|                                                         |   |                                                        |   |             |
| Lock Haven                                                   |   | 4 West Main Street                                          |   | Owned            |
|                                                         |   | Lock Haven,  Pennsylvania 17745                             |   |             |
|                                                         |   |                                                        |   |             |
| Mill Hall                                                    |   | (Inside Wal-Mart), 167  Hogan Boulevard                     |   | Under Lease      |
|                                                         |   | Mill Hall, Pennsylvania  17751                              |   |             |
|                                                         |   |                                                        |   |             |
| Spring Mills                                                 |   | Ross Hill Road, P.O.  Box 66                                |   | Owned            |
|                                                         |   | Spring Mills,  Pennsylvania 16875                           |   |             |
|                                                         |   |                                                        |   |             |
| Centre Hall                                                  |   | 2842 Earlystown Road                                        |   | Land Under Lease |
|                                                         |   | Centre Hall, Pennsylvania  16828                            |   |             |
|                                                         |   |                                                        |   |             |
| Zion                                                         |   | 100 Cobblestone Road                                        |   | Under Lease      |
|                                                         |   | Bellefonte,  Pennsylvania 16823                             |   |             |
|                                                         |   |                                                        |   |             |
| Jersey Shore State Bank                                      |   | 1952 Waddle Road, Suite  106                                |   | Under Lease      |
| Financial Center                                             |   | State College,  Pennsylvania 16803                          |   |             |
| State College                                                |   |                                                        |   |             |
|                                                         |   |                                                        |   |             |
| The M Group, Inc.  D/B/A The  Comprehensive  Financial Group |   | 705 Washington  Boulevard  Williamsport, Pennsylvania 17701 |   | Under Lease      |
|                                                         |   |                                                        |   |             |
| State College                                                |   | (Inside Wal-Mart), 1665  North Atherton Place               |   | Under Lease      |
|                                                         |   | State College,  Pennsylvania 16803                          |   |             |

 

##### **ITEM  3**    LEGAL PROCEEDINGS

 

In the normalcourse of business, various lawsuits and claims arise against the Company andits subsidiary.  There are no such legalproceedings or claims currently pending or threatened.

 

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**ITEM  4****   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

No matters were submittedto a vote of security holders during the fourth quarter of 2003.

 

##### **PARTII**

 

**ITEM  5**    **MARKET FOR THE REGISTRANT’S COMMON STOCK, RELATEDSTOCKHOLDER MATTERS, AND ISSUER PURCHASE OF EQUITY SECURITIES**

 
|           |   | **HIGH** |   | **LOW** |   | **Dividends  Declared** |   |
|----------------|--------|----------|--------|---------|--------|-------------------------|--------|
| **2001**       |   |     |   |    |   |                    |   |
| First quarter  |   | $        | 30.45  |    | $      | 24.77                   |   | $ | 0.23 |   |
| Second quarter |   | 30.00    |   | 24.77   |   | 0.23                    |   |
| Third quarter  |   | 29.09    |   | 27.95   |   | 0.23                    |   |
| Fourth quarter |   | 32.27    |   | 28.32   |   | 0.42                    |   |
| **2002**       |   |     |   |    |   |                    |   |
| First quarter  |   | $        | 31.82  |    | $      | 29.39                   |   | $ | 0.25 |   |
| Second quarter |   | 33.06    |   | 30.00   |   | 0.25                    |   |
| Third quarter  |   | 32.45    |   | 29.27   |   | 0.25                    |   |
| Fourth quarter |   | 33.50    |   | 30.00   |   | 0.49                    |   |
| **2003**       |   |     |   |    |   |                    |   |
| First quarter  |   | $        | 41.27  |    | $      | 32.86                   |   | $ | 0.27 |   |
| Second quarter |   | 47.43    |   | 37.71   |   | 0.27                    |   |
| Third quarter  |   | 42.32    |   | 38.64   |   | 0.27                    |   |
| Fourth quarter |   | 47.91    |   | 40.85   |   | 0.68                    |   |

 

The Common Stock islisted on the Nasdaq National Market under symboe “PWOD”.  The following table sets forth (1) thequarterly high and low prices for a share of the Company’s Common Stock duringthe periods indicated, and (2) quarterly dividends on a share of the CommonStock with respect to each quarter since January 1, 2001.  The following quotations represent pricesbetween buyers and sellers and do not include retail markup, markdown orcommission.  They may not necessarilyrepresent actual transactions.

 

The Bank has paid cash dividends since 1941.  The Company has paid dividends since theeffective date of its formation as a bank holding company.  It is the present intention of theRegistrant’s Board of Directors to continue the dividend payment policy;however, further dividends must necessarily depend upon earnings, financialcondition, appropriate legal restrictions and other factors relevant at thetime the Board of Directors of the Registrant considers dividend policy.  Cash available for dividend distributions toshareholders of the Registrant must initially come from dividends paid by theBank to the Company.  Therefore, therestrictions on the Bank’s dividend payments are directly applicable to theCompany.

 

Under the Pennsylvania Business Corporation Law of1988 a corporation may not pay a dividend, if after giving effect thereto, thecorporation would be unable to pay its debts as they become due in the usualcourse of business and after giving effect thereto the total assets of thecorporation would be less than the sum of its total liabilities plus the amountthat would be needed, if the corporation were to be dissolved at the time of thedistribution, to satisfy the preferential rights upon dissolution of theshareholders whose preferential rights are superior to those receiving thedividend.

 

As of March 5, 2004, the Registrant had approximately1,224 shareholders of record.

 

13

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##### ** **

##### **ITEM  6**    SELECTED FINANCIAL DATA

 

The following table sets forth certain financial dataas of and for each of the years in the five-year period ended December 31,2003.

 

14

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|                                                       |   | **2003**                                              |    | **2002**  |   | **2001**  |   | **2000**  |    | **1999**  |   |
|------------------------------------------------------------|--------|-------------------------------------------------------|---------|-----------|--------|-----------|--------|-----------|---------|-----------|--------|
|                                                       |   | **(Dollars  in thousands, except per share amounts)** |    |
|                                                       |   |                                                  |    |      |   |      |   |      |    |      |   |
| Consolidated  Statement of Income Data:                    |   |                                                  |    |      |   |      |   |      |    |      |   |
| Interest  income                                           |   | $                                                     | 29,052  |      | $      | 29,104    |   | $         | 28,736  |      | $      | 28,454 |   | $ | 26,030 |   |
| Interest  expense                                          |   | 9,265                                                 |    | 10,846    |   | 12,481    |   | 12,778    |    | 10,518    |   |
| Net  interest income                                       |   | 19,787                                                |    | 18,258    |   | 16,255    |   | 15,676    |    | 15,512    |   |
| Provision  for loan losses                                 |   | 255                                                   |    | 365       |   | 372       |   | 286       |    | 286       |   |
| Net  interest income after provision for loan losses       |   | 19,532                                                |    | 17,893    |   | 15,883    |   | 15,390    |    | 15,226    |   |
| Other  income                                              |   | 8,634                                                 |    | 5,453     |   | 5,109     |   | 2,615     |    | 3,527     |   |
| Other  expense                                             |   | 13,289                                                |    | 12,213    |   | 11,272    |   | 9,820     |    | 9,339     |   |
| Income  before income taxes                                |   | 14,877                                                |    | 11,133    |   | 9,720     |   | 8,185     |    | 9,414     |   |
| Applicable  income taxes                                   |   | 3,703                                                 |    | 2,247     |   | 1,978     |   | 1,619     |    | 2,224     |   |
| Net  Income                                                |   | $                                                     | 11,174  |      | $      | 8,886     |   | $         | 7,742   |      | $      | 6,566 |   | $ | 7,190 |   |
|                                                       |   |                                                  |    |      |   |      |   |      |    |      |   |
| Consolidated  Balance Sheet at End of Period:              |   |                                                  |    |      |   |      |   |      |    |      |   |
| Total  assets                                              |   | $                                                     | 527,381 |      | $      | 472,206   |   | $         | 424,810 |      | $      | 394,913 |   | $ | 373,742 |   |
| Loans                                                      |   | 275,828                                               |    | 257,845   |   | 251,623   |   | 244,798   |    | 231,815   |   |
| Allowance  for loan losses                                 |   | (3,069                                                | )       | (2,953    | )      | (2,927    | )      | (2,879    | )       | (2,823    | )      |
| Deposits                                                   |   | 334,318                                               |    | 339,848   |   | 305,150   |   | 278,134   |    | 255,573   |   |
| Long-term  debt — other                               |   | 70,878                                                |    | 51,778    |   | 41,778    |   | 31,778    |    | 27,278    |   |
| Shareholders’  equity                                 |   | 69,769                                                |    | 63,142    |   | 55,252    |   | 50,514    |    | 46,085    |   |
|                                                       |   |                                                  |    |      |   |      |   |      |    |      |   |
| Per  Share Data:                                           |   |                                                  |    |      |   |      |   |      |    |      |   |
| Net  income                                                |   |                                                  |    |      |   |      |   |      |    |      |   |
| Earnings  per share - Basic                                |   | $                                                     | 3.35    |      | $      | 2.66      |   | $         | 2.30    |      | $      | 1.91 |   | $ | 2.09 |   |
| Earnings  per share - Diluted                              |   | 3.35                                                  |    | 2.66      |   | 2.30      |   | 1.91      |    | 2.09      |   |
| Cash  dividends declared                                   |   | 1.49                                                  |    | 1.24      |   | 1.11      |   | 1.00      |    | 0.92      |   |
| Adjusted  Book value                                       |   | 21.00                                                 |    | 18.94     |   | 16.53     |   | 14.83     |    | 13.41     |   |
| Number  of shares outstanding, at end of period            |   | 3,321,560                                             |    | 3,031,329 |   | 3,039,590 |   | 3,097,293 |    | 3,123,372 |   |
| Average  number of shares outstanding                      |   | 3,330,585                                             |    | 3,336,312 |   | 3,371,845 |   | 3,431,494 |    | 3,433,554 |   |
| Selected  financial ratios:                                |   |                                                  |    |      |   |      |   |      |    |      |   |
| Return  on average shareholders’ equity               |   | 16.60                                                 | %       | 15.00     | %      | 14.38     | %      | 13.77     | %       | 14.96     | %      |
| Return  on average total assets                            |   | 2.24                                                  | %       | 2.01      | %      | 1.95      | %      | 1.74      | %       | 1.99      | %      |
|                                                       |   |                                                  |    |      |   |      |   |      |    |      |   |
| Net  interest income to average interest earning assets    |   | 4.28                                                  | %       | 4.45      | %      | 4.39      | %      | 4.35      | %       | 4.63      | %      |
| Dividend  payout ratio                                     |   | 44.76                                                 | %       | 46.40     | %      | 48.17     | %      | 52.18     | %       | 44.20     | %      |
| Average  shareholders’ equity to average total assets |   | 13.51                                                 | %       | 13.39     | %      | 13.54     | %      | 12.62     | %       | 13.81     | %      |
| Loans  to deposits, at end of period                       |   | 83.94                                                 | %       | 76.65     | %      | 83.77     | %      | 88.62     | %       | 90.39     | %      |

 

Per share data and numberof shares outstanding have been adjusted in each reporting period to giveretroactive effect to a stock split effected in the form of a 10% stockdividend issued October 30,2003.

 

15

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##### **ITEM7**     MANAGEMENT’SDISCUSSIONA AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

 

# **RESULTSOF OPERATIONS**

 

**NET INTEREST INCOME**

 

Net interest income is determined by calculating the difference betweenthe yields earned on interest-earning assets and the rates paid oninterest-bearing liabilities.  Tocompare the tax-exempt asset yields to taxable yields, amounts are adjusted topretax equivalents based on the marginal corporate federal tax rate of34%.  The tax equivalent adjustment tonet interest income for 2003, 2002, and 2001 were $1,367,000, $1,739,000, and$1,689,000, respectively.

 

**2003 vs 2002**

 

Reported net interest income increased $1,529,000 or8.4% from year end 2002 to year end 2003. The decrease in total interest income of $52,000 is the result of anincrease of $44,185,000 in the average balance of investment securities heldfor the current period relative to the same period a year ago offset by adecrease in the return on loans of approximately 62 basis points.  Overall, interest income generated from thenet increase in volume of interest earning assets was offset by a decline inrates of approximately 94 basis points.

 

On a tax equivalent basis, net interest incomeincreased 5.8% or $1,157,000, to $21,154,000 in a period when both averageinterest earning assets and average interest-bearing liabilitiesincreased.  The increase of taxablesecurity income of $2,646,000 is due to the significant purchase of U.S.Government securities over the past year, with the average of these securitiesincreasing $70,159,000, while the decrease in the average of tax-exempt State& Political securities decreased tax equivalent interest income$2,082,000.  The investment portfoliohas been repositioned from longer term assets to shorter term assets to takeadvantage of the cash flow opportunities for reinvestment in anticipation ofrising rates.  The net growth in thevolume of investment holdings has generated additional interest income that hasoffset the 111 basis point decline in the overall portfolios weighted averageinterest rates.

 

Within the loan portfolio, a 62 basis point decreaseof the tax equivalent return on loans was partially offset by an increase of$7,612,000 in the average balance of loans when comparing the year 2003 to theyear 2002.  Variable rate loans withinthe portfolio and other new loan originations at lower effective rates aided inthe reduction of new income compared to a year ago because of the historicallylow rates.

 

For the year ended December 31, 2003, reportedinterest expense decreased $1,581,000 or 14.6% over the same period of2002.  Lower rates for all depositaccounts contribute the most substantial decrease in interest expense.  The weighted average rate on interest paidon deposits declined 92 basis points for the year 2003 since the year end2002.  The overall average balance ofsavings deposits increased $17,925,000, offset by a decrease in the weightedaverage rate for a net decrease in the related interest expense of $997,000.Interest expense on time deposits decreased $1,204,000 due to both the 76 basis point decline in the weightedaverage rate and the decrease in the average balance of $5,453,000.

 

Favorable long-term borrowing rates offeropportunities to reduce interest expenses over the coming years.  Throughout 2003, the Company borrowed anadditional $19.1 million in long term advances through the FHLB to minimizefuture borrowing costs and to enhance liability positioning.  These additional borrowings were utilized bymanagement to take advantage of current investment opportunities whileminimizing interest rate risk.  The$693,000 increase in expense on long-term borrowings is the result of theseadditional advances with average balances of $20,986,000 partially offset bythe 64 basis point decline in the resulting weighted average interest rate forthe year ending December 31, 2003 compared to the same period in 2002.  Interest paid on short-term borrowingsdecreased $73,000 as a result of an overall decline in the weighted averageinterest rate of 131 basis points while the average balances outstanding duringthe year increased $8,322,000.  Theincrease in short-term borrowings is the result of taking advantage of theopportunity to borrow from Federal Home Loan Bank at historically low rates.

 

16

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**2002 vs 2001**

 

Fully taxable equivalent net interest income increased$2,053,000 or 11.44% to $19,997,000 during the year 2002. The net interestincome growth was the result of an increase in interest income of $418,000 anda decrease in interest expense of $1,635,000.

 

The effective interest differential increased 3 basispoints to 4.87% from December 31, 2001 to December 31, 2002.  Prime rates and federal funds rates heldsteady most of the year declining 50 basis points in November.  The low rates had a greater impact on therepricing of deposits than they had on loans and investment securities.  The Company’s assets and liabilities werepositioned to benefit from the rate environment.  Overall, rates had a positive impact on earnings.  Although interest-earning assets suffered areduction in income due to rates of $2,033,000, interest expense relating tointerest-bearing liabilities also declined by $2,326,000.  The net effect was an increase in income of$293,000 due to rates.

 

Total average interest earning assets increased$39,805,000 during 2002 which contributed $2,451,000 to net interest income.

 

Interest income on loans decreased during 2002 by$1,055,000.  This was the result of adecrease in interest income of $1,669,000 due to rate offset by an increase ininterest income of $614,000 due to volume. Total average loans increased from 2001 to 2002 by $7,021,000 whichcontributed to the volume increase. Although the volume increased, as loans were paid off and new loansoriginated, low prime rates caused a reduction in interest income.  Bank prime rates remained relatively low in2002 compared to historical standards and were directly responsible for thedecline in interest income of $1,669,000. This is evident by the decline of the average rate on total loans from8.92% in 2001 to 8.26% in 2002.

 

Investment securites interest income contributed$1,473,000 of additional income in 2002 relative to 2001.  Taxable securities income represented themajority of the increase at $1,390,000 while tax-exempt investment securitiesadded $83,000.  Together, an increase ofinvestment securities income of $1,837,000 due to volume more than offset adecrease of $364,000 due to rates. Total average securities increased $32,784,000 or 26.53% from 2001 to2002.  This increase explains thesubstantial increase in income related to volume.

 

Total average interest-bearing liabilities increased$35,898,000 or 12.26% during 2002.  Theinterest expense related to volume increased $691,000 while rates subtractedinterest expenses totaling $2,326,000.

 

Due to successful marketing strategies and marketpenetration in the Centre County region, the bank increased total averagedeposits by $31,166,000.  Averagesavings deposits increased $35,893,000 while average time deposits decreased$9,010,000.  Non-interest-bearing demanddeposits increased $4,283,000.  Depositrates held steady through most of 2002. Savings deposits had little change in average rate while other timedeposits repriced throughout the year into the current low rates.  The average rate on other time depositsdeclined from 5.28% in 2001 to 3.77% in 2002.

 

The increase in funding due to deposits added to anincrease in average other borrowings of $12,672,000 and offset the reduction ofaverage short-term borrowings of $3,657,000.  The bank had less need for overnight borrowings to fund assets with theincrease of deposits and other borrowings. The bank acquired two loans totaling $10,000,000 with the Federal HomeLoan Bank that are reflected in the increase of other borrowings.  The Federal Home Loan Bank borrowings wereintended to match investment security purchases that generate long-terminterest income with minimal risk.

 

17

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**AVERAGEBALANCES AND INTEREST RATES**

 

The followingtables set forth certain information relating to the Company’s average balancesheet and reflects the average yield on assets and average cost of liabilitiesfor the periods indicated and the average yields earned and rates paid.  Such yields and costs are derived bydividing income or expense by the average balance of assets or liabilities,respectively, for the periods presented.

** **

**AVERAGE BALANCES AND INTEREST RATES**

**(INCOME AND RATES ON A FULLY TAXABLE EQUIVALENT BASIS)**

**(IN THOUSANDS)**

** **
|                                               |   | **2003**                |       | **2002**     |       | **2001**          |       |
|----------------------------------------------------|--------|-------------------------|------------|--------------|------------|-------------------|------------|
|                                               |   | **AVERAGE  BALANCE(2)** |       | **INTEREST** |       | **AVERAGE  RATE** |       | **AVERAGE  BALANCE(2)** |   | **INTEREST** |   | **AVERAGE  RATE** |   | **AVERAGE  BALANCE** |   | **INTEREST** |   | **AVERAGE  RATE** |   |
|                                               |   |                    | ** ** |         | ** ** |              | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| ASSETS:                                            |   |                    |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets:                           |   |                    |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Securities:                                        |   |                    |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury and federal agency                   |   | $                       | 124,849    |         | $          | 5,584             |       | 4.47 | % | $ | 54,690 |   | $ | 2,923 |   | 5.34 | % | $ | 22,877 |   | $ | 1,466 |   | 6.41 | % |
| State and political subdivisions(4)                |   | 50,822                  |       | 3,952        |       | 7.78              | %          | 77,216 |   | 6,034 |   | 7.81 | % | 75,556 |   | 5,951 |   | 7.88 | % |
| Other                                              |   | 24,872                  |       | 897          |       | 3.61              | %          | 24,452 |   | 912 |   | 3.73 | % | 25,141 |   | 979 |   | 3.89 | % |
| Total securities                                   |   | 200,543                 |       | 10,433       |       | 5.20              | %          | 156,358 |   | 9,869 |   | 6.31 | % | 123,574 |   | 8,396 |   | 6.79 | % |
| LOANS:                                             |   |                    |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Tax-exempt loans(4)                                |   | 1,008                   |       | 68           |       | 6.75              | %          | 2,309 |   | 185 |   | 8.01 | % | 3,935 |   | 322 |   | 8.18 | % |
| All other loans, net of discount where  applicable |   | 260,532                 |       | 19,918       |       | 7.65              | %          | 251,619 |   | 20,789 |   | 8.26 | % | 242,972 |   | 21,707 |   | 8.93 | % |
| Total loans(1),(3)                                 |   | 261,540                 |       | 19,986       |       | 7.64              | %          | 253,928 |   | 20,974 |   | 8.26 | % | 246,907 |   | 22,029 |   | 8.92 | % |
| Total interest-earning assets                      |   | 462,083                 |       | $            | 30,419     |              | 6.58       | % | 410,286 |   | $ | 30,843 |   | 7.52 | % | 370,481 |   | $ | 30,425 |   | 8.21 | % |
| Other assets                                       |   | 36,297                  |       |         |       |              |       | 31,977 |   |   |   |   |   | 27,081 |   |   |   |   |   |
| TOTAL ASSETS                                       |   | $                       | 498,380    |         |       |              |       |   | $ | 442,263 |   |   |   |   |   | $ | 397,562 |   |   |   |   |   |
|                                               |   |                    |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES AND SHAREHOLDERS’ EQUITY:         |   |                    |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                      |   |                    |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                          |   |                    |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings                                            |   | $                       | 147,169    |         | $          | 1,704             |       | 1.16 | % | $ | 129,244 |   | $ | 2,701 |   | 2.09 | % | $ | 93,351 |   | $ | 1,961 |   | 2.10 | % |
| Other time                                         |   | 131,360                 |       | 3,952        |       | 3.01              | %          | 136,813 |   | 5,156 |   | 3.77 | % | 145,823 |   | 7,696 |   | 5.28 | % |
| Total interest-bearing deposits                    |   | 278,529                 |       | 5,656        |       | 2.03              | %          | 266,057 |   | 7,857 |   | 2.95 | % | 239,174 |   | 9,657 |   | 4.04 | % |
|                                               |   |                    |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Short-term borrowings                              |   | 24,787                  |       | 428          |       | 1.73              | %          | 16,465 |   | 501 |   | 3.04 | % | 20,122 |   | 903 |   | 4.49 | % |
| Other borrowings                                   |   | 67,285                  |       | 3,181        |       | 4.73              | %          | 46,299 |   | 2,488 |   | 5.37 | % | 33,627 |   | 1,921 |   | 5.71 | % |
| Total interest-bearing liabilities                 |   | 370,601                 |       | $            | 9,265      |              | 2.50       | % | 328,821 |   | $ | 10,846 |   | 3.30 | % | 292,923 |   | $ | 12,481 |   | 4.26 | % |
| Demand deposits                                    |   | 56,672                  |       |         |       |              |       | 50,877 |   |   |   |   |   | 46,594 |   |   |   |   |   |
| Other liabilities                                  |   | 3,780                   |       |         |       |              |       | 3,334 |   |   |   |   |   | 4,214 |   |   |   |   |   |
| Shareholders’ equity                          |   | 67,327                  |       |         |       |              |       | 59,231 |   |   |   |   |   | 53,831 |   |   |   |   |   |
| TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY    |   | $                       | 498,380    |         |       |              |       |   | $ | 442,263 |   |   |   |   |   | $ | 397,562 |   |   |   |   |   |
| Interest rate margin                               |   |                    |       |         |       | 4.08              | %          |   |   |   |   | 4.22 | % |   |   |   |   | 3.95 | % |
| Effective interest differential                    |   |                    |       | $            | 21,154     |              | 4.58       | % |   |   | $ | 19,997 |   | 4.87 | % |   |   | $ | 17,944 |   | 4.84 | % |
|                                                    |        |                         |            |              |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1).  Fees on loans are includedwith interest on loans.  Loan fees areincluded in interest income as follows: 2003 $1,032,000, $, 2002, $803,000, 2001, $668,000

(2).  Information on this tablehas been calculated using average daily balance sheets to obtain averagebalances.

(3).  Nonaccrual loans have beenincluded with loans for the purpose of analyzing net interest earnings.

(4).  Income and rates on a fullytaxable equivalent basis include an adjustment for the difference betweenannual income from tax-exempt obligations and the taxable equivalent of suchincome at the standard 34% tax rate (derived by dividing tax-exempt interest by66%).

 

 

18

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**(IN THOUSANDS)**

 

**Rate/Volume Analysis**

 

The table below setsforth certain information regarding changes in our interest income and interestexpense for the periods indicated. For interest-earning assets andinterest-bearing liabilities, information is provided on changes attributableto (i) changes in volume (changes in average volume multiplied by old rate);(ii) changes in rates (changes in rate multiplied by old average volume).Increases and decreases due to both rate and volume, which cannot be separated,have been allocated proportionally to the change due to volume and the changedue to rate.

 
|                                |   | **Year Ended December 31,**                   |   |
|-------------------------------------|--------|-----------------------------------------------|--------|
|                                |   | **2003 vs 2002  Increase (Decrease)  Due to** |   | **2002 vs 2001  Increase (Decrease)  Due to** |   |
|                                |   | **Volume**                                    |   | **Rate** | ** ** | **Net** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Net** | ** ** |
| **Interest  income:**               |   |                                          |   |   |   |   |   |   |   |   |   |   |   |
| Taxable investment  securities      |   | $                                             | 3,223  |   | $ | (577 | ) | $ | 2,646 |   | $ | 1,707 |   | $ | (317 | ) | $ | 1,390 |   |
| Tax-exempt investment  securities   |   | (2,054                                        | )      | (28 | ) | (2,082 | ) | 130 |   | (47 | ) | 83 |   |
| Loans                               |   | 616                                           |   | (1,604 | ) | (988 | ) | 614 |   | (1,669 | ) | (1,055 | ) |
| Total interest-earning  assets      |   | $                                             | 1,785  |   | $ | (2,209 | ) | $ | (424 | ) | $ | 2,451 |   | $ | (2,033 | ) | $ | 418 |   |
|                                |   |                                          |   |   |   |   |   |   |   |   |   |   |   |
| **Interest  expenses:**             |   |                                          |   |   |   |   |   |   |   |   |   |   |   |
| Savings deposits                    |   | $                                             | 335    |   | $ | (1,332 | ) | $ | (997 | ) | $ | 750 |   | $ | (10 | ) | $ | 740 |   |
| Other time deposits                 |   | (216                                          | )      | (988 | ) | (1,204 | ) | (514 | ) | (2,026 | ) | (2,540 | ) |
| Short-term borrowings               |   | 194                                           |   | (267 | ) | (73 | ) | (232 | ) | (170 | ) | (402 | ) |
| Other borrowings                    |   | 1,021                                         |   | (328 | ) | 693 |   | 687 |   | (120 | ) | 567 |   |
| Total interest-bearing  liabilities |   | $                                             | 1,334  |   | $ | (2,915 | ) | $ | (1,581 | ) | $ | 691 |   | $ | (2,326 | ) | $ | (1,635 | ) |
|                                |   |                                          |   |   |   |   |   |   |   |   |   |   |   |
| Change in net interest  income      |   | $                                             | 451    |   | $ | 706 |   | $ | 1,157 |   | $ | 1,760 |   | $ | 293 |   | $ | 2,053 |   |

 

PROVISION FOR LOAN LOSSES

 

**2003 vs 2002**

 

The provision forloan losses is based upon management’s quarterly review of the loanportfolio.  The purpose of the review isto assess loan quality, identify impaired loans, analyze delinquencies,ascertain loan growth, evaluate potential charge-offs and recoveries, andassess general economic conditions in the markets served.  An external independent loan review is alsoperformed annually for the Bank. Management remains committed to an aggressive program of problem loanidentification and resolution.

 

The allowance is calculated by applying loss factorsto outstanding loans by type, excluding loans for which a specific allowancehas been determined.  Loss factors arebased on management’s consideration of the nature of the portfolio segments,changes in mix and volume of the loan portfolio, and historical loan lossexperience.  In addition, managementconsiders industry standards and trends with respect to nonperforming loans andits knowledge and experience with specific lending segments.

 

Although management believes that it uses the bestinformation available to make such determinations and that the allowance forloan losses was adequate at December 31, 2003, future adjustments could benecessary if circumstances or economic conditions differ substantially from theassumptions used in making the initial determinations.  A downturn in the local economy, employmentand delays in receiving financial information from borrowers could result inincreased levels of nonperforming assets and charge-offs, increased loan loss 

 

19

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provisions and reductions in income. Additionally, as an integral part of the examination process, bankregulatory agencies periodically review the Bank’s loan loss allowance.  The banking agencies could require therecognition of additions to the loan loss allowance based on their judgement ofinformation available to them at the time of their examination.

 

The allowance for loan losses increased 3.9% or$116,000 from fiscal 2002 after net charge-offs of $139,000 contributing to ayear-end allowance for loan losses of $3,069,000 or 1.1% of total loans.

 

**2002 vs 2001**

 

The allowance for loan losses increased 0.9% or $26,000 from fiscal2001 after net charge-offs of $339,000 contributing to a year-end allowance forloan losses of  $2,953,000 or 1.1% oftotal loans.  This percentage isconsistent with the guidelines of regulators and peer banks.  Management’s conclusion is that theprovision for loan loss is adequate.

 
|                                                                                        |   | **YEAR ENDED  DECEMBER 31,  (IN THOUSANDS)** |   |
|---------------------------------------------------------------------------------------------|--------|----------------------------------------------|--------|
|                                                                                        |   | **2003**                                     |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
| Balance at  beginning of period                                                             |   | $                                            | 2,953  |   | $ | 2,927 |   | $ | 2,879 |   | $ | 2,823 |   | $ | 2,681 |   |
| Charge-offs:                                                                                |   |                                         |   |   |   |   |   |   |   |   |   |
| Domestic:                                                                                   |   |                                         |   |   |   |   |   |   |   |   |   |
| Real estate                                                                                 |   | 63                                           |   | 262 |   | 154 |   | 165 |   | 50 |   |
| Commercial and industrial.                                                                  |   | 37                                           |   | 80 |   | 122 |   | 38 |   | 28 |   |
| Installment  loans to individuals.                                                          |   | 116                                          |   | 60 |   | 82 |   | 66 |   | 98 |   |
| Total  charge-offs.                                                                         |   | 216                                          |   | 402 |   | 358 |   | 269 |   | 176 |   |
| Recoveries:                                                                                 |   |                                         |   |   |   |   |   |   |   |   |   |
| Real estate                                                                                 |   | 42                                           |   | 25 |   | 9 |   | 8 |   | 4 |   |
| Commercial and  industrial.                                                                 |   | 16                                           |   | 21 |   | 8 |   | 20 |   | 11 |   |
| Installment  loans to individuals.                                                          |   | 19                                           |   | 17 |   | 17 |   | 11 |   | 17 |   |
| Total  recoveries.                                                                          |   | 77                                           |   | 63 |   | 34 |   | 39 |   | 32 |   |
| Net charge-offs                                                                             |   | 139                                          |   | 339 |   | 324 |   | 230 |   | 144 |   |
| Additions  charged to operations.                                                           |   | 255                                          |   | 365 |   | 372 |   | 286 |   | 286 |   |
| Balance at end  of period.                                                                  |   | $                                            | 3,069  |   | $ | 2,953 |   | $ | 2,927 |   | $ | 2,879 |   | $ | 2,823 |   |
| Ratio of net  charge-offs during the period to average loans outstanding during the period. |   | 0.05                                         | %      | 0.13 | % | 0.13 | % | 0.10 | % | 0.06 | % |

 

**OTHER INCOME**

 

**2003 vs 2002**

 

Total other income for 2003 was $8,634,000, anincrease of $3,181,000 from the prior year. Excluding security gains of $3,659,000 in 2003 and $233,000 in 2002,other income decreased $245,000. Service charges increased 4.58% or $84,000 to $1,917,000 in 2003.

 

Decreases in commission income from the sale offinancial products sold by the Bank’s subsidiary, The M Group,  accounted for $209,000 of the total decreaseof other operating income. Other operating income decreased $108,000 primarilydue to a non-recurring life insurance income item included in 2002, but not in2003, resulting in a $116,00 decrease.

 

**2002 vs 2001**

 

Total other income for 2002 was $5,453,000, anincrease of $344,000 from the prior year. Excluding security gains of $233,000 in 2002 and $1,033,000 in 2001,other income increased $1,144,000. Service charges increased 17.12% or $268,000 to $1,833,000 in 2002.  

 

20

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The rate charged for overdraft fees was increased in 2002 whichresulted in $229,000 additional service charge income.

 

Other operating income increased $876,000 from 2001 to2002.  Commission income growth from thesale of financial products sold by the Bank’s subsidiary, The M Group,  account for $401,000 of the total increaseof other operating income.  Income oncash surrender value adjustments on bank owned life insurance increased$242,000.  The year 2002 was the firstfull year the life insurance policies were in effect, resulting in a greateradjustment.  Life insurance proceedsalso added $102,000.  The remaining contributorswere credit card merchant machine processing fees, debit card fees and ATMsurcharge revenue.

 

**OTHER EXPENSES**

 

**2003 vs 2002**

 

Total other expenses increased $1,076,000 or 8.81%from the year ended December 31, 2002 to December 31, 2003. Salaries andemployee benefits increased of $318,000. This change was the result of the decline in commission earned by the MGroup and the retirement of an executive officer offset by the standard cost ofliving salary increases and an extra pay paid in 2003 when compared to2002.  Expenses such as rent,maintenance, and utilities for the new State College Wal-Mart Branch caused themajority of the $46,000 increase to occupancy expense.  The depreciation of a new Wide Area Networkhas resulted in most of the  $162,000increase to furniture and equipment expense. Advertising expense increased $16,000 due to a decrease in normaladvertising expenses offset by the purchase of new brochures for $22,000.  Other operating expenses increased $490,000consistent with the addition of the aforementioned branch.

 

**2002 vs 2001**

 

Total other expenses increased $941,000 or 8.35% fromthe year ended December 31, 2001 to December 31, 2002.  Salaries and employee benefits increased$1,152,000, the most substantial of the other expenses category.  Employee salaries and benefits increasedmore than $500,000 as a result of increased salaries that correspond with thegrowth in sales of financial products offered by The M Group and the cost of staffat the new State College Wal-Mart Branch. The Bank’s pension expense increased $320,000 in 2002.  The remaining expenses were due to normalwage increases. The new branch also caused the majority of the $44,000  increase to occupancy expense.  The Bank has substantially upgraded itscomputer networking capabilities which has resulted in most of the  $98,000 increase to furniture and equipmentexpense.  Other operating expensesdecreased $353,000.  The elimination ofgoodwill amortization as per the adoption of FAS No. 142 represents $221,000 ofthe decrease in expenses.  Bookkeepingexpenses increased due to securities transactions and maintenance.  The other miscellaneous operating expensesdecrease was additionally offset by a $55,000 expense as a result of a checkkiting incident.

 

**INCOME TAXES**

 

**2003 vs 2002**

 

The provision for income taxes for the year endedDecember 31, 2003 resulted in an effective income tax rate of 24.9% compared to20.2% for 2002.  This increase is theresult of management’s current investment strategy of reinvesting proceeds fromtax-exempt portfolio into other U.S. Government securities.

 

**2002 vs 2001**

 

The provision for income taxes for the year endedDecember 31, 2002 resulted in an effective income tax rate of 20.2% compared to20.3% for 2001.

 

21

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**FINANCIAL CONDITION**

 

**INVESTMENTS**

 

**2003**

 

The investment portfolio increased $33,680,000 or 19%in 2003.  The growth is largelyattributed to management’s strategic plan to benefit from the low borrowingrates by taking advantage of over a 200 basis point interest rate spread ofinvestments with similar maturity periods. The bank borrowed $19,100,000 inlong-term FHLB advances to purchase securities and take advantage of interestrate imbalances in the market. Short-term borrowing funded the balance of the additional investmentsecurities purchased.  Most of theincrease is attributable to an increase of $61,980,000 in U.S. Governmentagencies category, and a $10,331,000 increase in the equity securitiescategory.  There was a $185,000 decreasein other bonds, notes and debentures, $1,168,000 decrease in U.S. Treasurysecurities category, and State and Political subdivisions catergory decreased$37,278,000.  The investment portfolioat year-end 2003 was comprised of 70.9% U.S. Government agency and Treasurysecurities, 16.2% state and political subdivisions, 12.0% equity securities,and .9% other bonds, notes and debentures. Held to maturity securities had a carrying value of $686,000.  Available for sale securities occupied 99.66%of the total portfolio and had an amoritized cost of $201,321,000 with anestimated market value of $210,611,000. The unrealized gain of $9,290,000 effected shareholders’ equity by$6,132,000, net of deferred taxes.

 

**2002**

 

The investment portfolioincreased $44,330,000 or 33.3% in 2002. Deposits grew faster than loan demand with the excess funding thepurchase of additional investment securities. Most of the increase is attributable to an increase of  $62,906,000 in U.S. Government agenciescategory, $975,000 in other bonds, notes and debentures and $170,000 in U.S.Treasury securities category.  State andPolitical subdivisions category decreased $12,575,000 and a $7,146,000 decreasewas also found in the equity securities category.  The investment portfolio at year-end 2002 comprised of 50.2% U.S.Government agency and Treasury securities, 40.2% state and politicalsubdivisions, 8.4% equity securities, and 1.2% other bonds, notes anddebentures.  Held to maturity securitieshad a carrying value of $1,181,000. Available for sale securities occupied 99%of the total portfolio and had an amortized cost of $168,641,000 with anestimated market value of $176,436,000. The unrealized gain of $7,795,000 effected shareholders’ equity by$5,145,000, net of deferred taxes.

 

22

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The carrying amounts ofinvestment securities at the dates indicated are summarized as follows (inthousands):

 
|                                  |   | **DECEMBER  31,** |    |
|---------------------------------------|--------|-------------------|---------|
|                                  |   | **2003**          |    | **2002** |   | **2001** |   |
| U.S. Treasury  securities:            |   |              |    |   |   |   |   |
| Available for  Sale                   |   | $                 | 3,128   |   | $ | 4,296 |   | $ | 4,126 |   |
| U.S. Government  agencies:            |   |              |    |   |   |   |   |
| Held to Maturity                      |   | 75                |    | 94 |   | 196 |   |
| Available for  Sale                   |   | 146,701           |    | 84,702 |   | 21,694 |   |
| State and  political subdivisions:    |   |              |    |   |   |   |   |
| Held to Maturity                      |   | 347               |    | 796 |   | 796 |   |
| Available for  Sale                   |   | 33,852            |    | 70,681 |   | 83,256 |   |
| Other bonds,  notes and debentures:   |   |              |    |   |   |   |   |
| Held to Maturity                      |   | 264               |    | 291 |   | 310 |   |
| Available for  Sale                   |   | 1,652             |    | 1,810 |   | 816 |   |
| Total bonds,  notes and debentures    |   | 186,019           |    | 162,670 |   | 111,194 |   |
| Corporate stock  - Available for Sale |   | 25,278            |    | 14,947 |   | 22,093 |   |
| Total                                 |   | $                 | 211,297 |   | $ | 177,617 |   | $ | 133,287 |   |

 

The following table showsthe maturities and repricing of investment securities at December 31, 2003 andthe weighted average yields (for tax-exempt obligations on a fully taxablebasis assuming a 34% tax rate) of such securities (in thousands):

 
|                               |   | **WITHIN  ONE  YEAR** |   | **AFTER ONE  BUT WITHIN  FIVE YEARS** |   | **AFTER FIVE  BUT WITHIN  TEN YEARS** |   | **AFTER  TEN  YEARS** |   |
|------------------------------------|--------|-----------------------|--------|---------------------------------------|--------|---------------------------------------|--------|-----------------------|--------|
| U.S. Treasury securities:          |   |                  |   |                                  |   |                                  |   |                  |   |
| AFS Amount                         |   | $                     | 2,061  |                                  | $      | 1,067                                 |   | $                     | — |   | $ | — |   |
| Yield                              |   | 4.37                  | %      | 3.43                                  | %      | —                                | %      | —                | %      |
| U.S. Government agencies:          |   |                  |   |                                  |   |                                  |   |                  |   |
| HTM Amount                         |   | —                |   | —                                |   | —                                |   | 75                    |   |
| Yield                              |   | —                | %      | —                                | %      | —                                | %      | 8.80                  | %      |
| AFS Amount                         |   | 1,026                 |   | 3,718                                 |   | 44,372                                |   | 97,585                |   |
| Yield                              |   | 4.96                  | %      | 4.00                                  | %      | 4.43                                  | %      | 5.25                  | %      |
| State and political subdivisions:  |   |                  |   |                                  |   |                                  |   |                  |   |
| HTM Amount                         |   | —                |   | —                                |   | —                                |   | 347                   |   |
| Yield                              |   | —                | %      | —                                | %      | —                                | %      | 8.26                  | %      |
| AFS Amount                         |   | —                |   | —                                |   | 15                                    |   | 33,837                |   |
| Yield                              |   | —                | %      | —                                | %      | 6.58                                  | %      | 7.67                  | %      |
| Other bonds, notes and debentures: |   |                  |   |                                  |   |                                  |   |                  |   |
| HTM Amount                         |   | —                |   | 125                                   |   | 139                                   |   | —                |   |
| Yield                              |   | —                | %      | 7.05                                  | %      | 7.04                                  | %      | —                | %      |
| AFS Amount                         |   | —                |   | —                                |   | —                                |   | 1,652                 |   |
| Yield                              |   | —                | %      | —                                | %      | —                                | %      | 7.36                  | %      |
| Total Amount                       |   | $                     | 3,087  |                                  | $      | 4,910                                 |   | $                     | 44,526 |   | $ | 133,496 |   |
| Total Yield                        |   | 4.57                  | %      | 3.95                                  | %      | 4.44                                  | %      | 5.90                  | %      |

 

All yields representweighted average yields expressed on a tax equivalent basis.  They are calculated on the basis of thecost, adjusted for amortization of premium and accretion of discount andeffective yields weighted for the scheduled maturity of each security.  The taxable equivalent adjustment representsthe difference between annual income from tax-exempt obligations and thetaxable equivalent of such income at the standard 34% tax rate (derived bydividing tax-exempt interest by 66%).

 

23

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**LOAN PORTFOLIO**

 

**2003**

 

Gross loans for the year ended December 31, 2003, were$275,828,000 or $17,983,000 (6.97%) more than the prior year.  Real estate mortgages increased $ 18,103,000as a whole with residential, commercial and conuction real estate loansincreasing $6,902,000, $6,905,000, and $4,296,000 respectively.  Commercial and agricultural loans decreased$185,000,  while installment loans toindividuals increased $65,000.  Giventhe current market conditions, management has directed its conservative lendingapproach toward well collateralized real estate loans.

 

**2002**

** **

Gross loans for the year ended December 31, 2002, were$257,845,000 or $6,222,000 (2.47%) more than the prior year.  Real estate mortgages increased $8,128,000as a whole with residential and commercial real estate loans increasing $49,000and $8,800,000, respectively. Construction real estate mortgages decreased $721,000.  Commercial and agricultural loans increased$1,079,000,  while installment loans toindividuals decreased $2,985,000.

 

Theamount of loans outstanding at the indicated dates are shown in the followingtable according to type of loan (in thousands):

 
|                              |   | **December  31,** |    |
|-----------------------------------|--------|-------------------|---------|
|                              |   | **2003**          |    | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
| Domestic:                         |   |              |    |   |   |   |   |   |   |   |   |
| Commercial  and agricultural      |   | $                 | 23,523  |   | $ | 23,708 |   | $ | 22,629 |   | $ | 26,471 |   | $ | 31,735 |   |
| Real  estate mortgage:            |   |              |    |   |   |   |   |   |   |   |   |
| Residential                       |   | 147,697           |    | 140,724 |   | 140,614 |   | 131,761 |   | 121,734 |   |
| Commercial                        |   | 82,896            |    | 75,892 |   | 67,038 |   | 60,856 |   | 51,641 |   |
| Construction                      |   | 7,652             |    | 3,356 |   | 4,077 |   | 4,748 |   | 3,732 |   |
| Installment  loans to individuals |   | 15,000            |    | 14,934 |   | 17,896 |   | 21,503 |   | 23,470 |   |
| Less:  Net deferred loan fees     |   | 940               |    | 769 |   | 631 |   | 541 |   | 497 |   |
| Gross  loans                      |   | $                 | 275,828 |   | $ | 257,845 |   | $ | 251,623 |   | $ | 244,798 |   | $ | 231,815 |   |

 

The amount of domesticloans at December 31, 2003 are presented below by category and maturity (inthousands):

 
|                                     |   | **REAL  ESTATE** |    | **COMMERCIAL  AND  OTHER** |   | **INSTALLMENT  LOANS TO  INDIVIDUALS** |   | **TOTAL** |   |
|------------------------------------------|--------|------------------|---------|----------------------------|--------|----------------------------------------|--------|-----------|--------|
| Loans with floating interest rates:      |   |             |    |                       |   |                                   |   |      |   |
| 1 year or less                           |   | $                | 11,859  |                       | $      | 8,145                                  |   | $         | 1,526  |   | $ | 21,530 |   |
| 1 through 5 years                        |   | 6,180            |    | 2,799                      |   | 18                                     |   | 8,997     |   |
| 5 through 10 years                       |   | 26,730           |    | 3,088                      |   | 208                                    |   | 30,026    |   |
| After 10 years                           |   | 112,351          |    | 672                        |   | 6                                      |   | 113,029   |   |
| Sub Total                                |   | 157,120          |    | 14,704                     |   | 1,758                                  |   | 173,582   |   |
| Loans with predetermined interest rates: |   |             |    |                       |   |                                   |   |      |   |
| 1 year or less                           |   | 3,822            |    | 867                        |   | 1,146                                  |   | 5,835     |   |
| 1 through 5 years                        |   | 22,060           |    | 7,295                      |   | 10,532                                 |   | 39,887    |   |
| 5 through 10 years                       |   | 23,488           |    | 111                        |   | 1,561                                  |   | 25,160    |   |
| After 10 years                           |   | 30,804           |    | 546                        |   | 14                                     |   | 31,364    |   |
| Sub Total                                |   | 80,174           |    | 8,819                      |   | 13,253                                 |   | 102,246   |   |
| Total                                    |   | $                | 237,294 |                       | $      | 23,523                                 |   | $         | 15,011 |   | $ | 275,828 |   |

 

----

(1)          Theloan maturity information is based upon original loan terms and is not adjustedfor “rollovers.”  In the ordinary courseof business, loans maturing within one year may be 

 

24

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renewed, in wholeor in part, as to principal amount at interest rates prevailing at the date ofrenewal.

(2) Scheduled repaymentsare reported in maturity categories in which the payment is due.

 

The Bank does not makeloans that provide for negative amortization nor do any loans containconversion features. The Bank does not have any foreign loans outstanding atDecember 31, 2003.

 

**ALLOWANCE FOR LOAN LOSSES**

**2003**

 

The allowance for loan losses represents the amountthat management estimates is adequate to provide for probable losses inherentin the loan portfolio as of the balance sheet date.  Accordingly, all loan losses are charged to the allowance, andall recoveries are credited to it.  Theallowance for loan losses is established through a provision for loan losses,which is charged to operations.  Theprovision is based on management’s quarterly evaluation of the adequacy of theallowance for loan losses, taking into account the overall risk characteristicsof the various portfolio segments, past experience with losses, the impact ofeconomic conditions on borrowers, and other relevant factors.  Underwriting continues to emphasize the needfor security and adequate collateral margins. The total allowance for loan losses is a combination of a specificallowance for identified problem loans, and a homogeneous pool allowance.

 

At December 31, 2003, the allowance for loan losses asa percent of gross loans remained the same as December 31, 2002 at 1.1%.  Gross loans increased by $17,983,000 from$257,845,000 at December 31, 2002 to $275,828,000 at December 31, 2003.

 

Nonaccruing loans decreased $44,000 from year-end2002. Overall nonperforming loans decreased $840,000 to $1,256,000 from fiscalyear end 2002.

 

Based on management’s loan-by-loan review, the pastperformance of the borrowers and current economic conditions, including recentbusiness closures and bankruptcy levels, management does not anticipate anycurrent losses related to nonaccrual, nonperforming, or classified loans abovethat have already been considered in its overall judgment of the adequacy ofthe reserve.

 

**2002**

 

At December 31, 2002, the allowance for loan losses asa percent of gross loans declined from December 31, 2001 to 1.1%.  Gross loans increased by $6,222,000 from$251,623,000 at December 31, 2001 to $257,845,000 at December 31, 2002.

 

Nonaccruing loans increased $590,000 to $871,000 fromyear-end 2001. Overall nonperforming loans increased $1,477,000 to $2,096,000from fiscal 2001.

 

The following table presents information concerningnonperforming loans.  The accrual ofinterest will be discontinued when the principal or interest of a loan is indefault for 90 days or more, or as soon as payment is questionable, unless theloan is well secured and in the process of collection.  Consumer loans and residential real estateloans secured by 1 to 4 family dwellings shall ordinarily not be subject tothose guidelines.  The reversal ofpreviously accrued but uncollected interest applicable to any loan placed in anonaccrual status and the treatment of subsequent payments of either principalor interest will be handled in accordance with accounting principles generallyaccepted in the United States of America. These principles do not require a write-off of previously accrued interestif principal and interest are ultimately protected by sound collateralvalues.  A nonperforming loan may berestored to an accruing status when:

 

1.  Principal and interest is no longer due andunpaid.

2.  It becomes well secured and in the processof collection.

3.  Prospectsfor future contractual payments are no longer in doubt.

 

25

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|   |   | **TOTAL  NONPERFORMING LOANS** |   |
|--------|--------|--------------------------------|--------|
|   |   | **(IN  THOUSANDS)**            |   |
|   |   | **NONACCRUAL**                 |   | **90 DAYS  PAST DUE** |   |
| 2003   |   | $                              | 827    |   | $ | 429 |   |
| 2002   |   | $                              | 871    |   | $ | 1,225 |   |
| 2001   |   | $                              | 281    |   | $ | 338 |   |
| 2000   |   | $                              | 777    |   | $ | 27 |   |
| 1999   |   | $                              | 284    |   | $ | 241 |   |

 

If interesthad been recorded at the original rate on those loans, such income would haveapproximated $55,000, $24,000, and $28,000 for the years ended December 31,2003, 2002, and 2001, respectively. Interest income on such loans, which is recorded as received, amountedto approximately $7,000, $17,000 and $19,000 for the years ended December 31,2003, 2002 and 2001, respectively.

 

The level of nonaccruing loanscontinues to fluctuate annually and is attributed to the various economicfactors experienced both regionally and nationally.  Overall the portfolio is well secured with a majority of thebalance making regular payments or scheduled to be satisfied in the nearfuture.  Presently there are nosignificant amounts of loans where serious doubts exist as to the ability ofthe borrower to comply with the current loan payment terms which are notincluded in the nonperforming categories as indicated above.

 

Management’s judgment indetermining the amount of the additions to the allowance charged to operatingexpense considers the following factors:

 

1.  Economic conditions and the impact on the loan portfolio.

2.  Analysis of past loan charge-offs experienced by category andcomparison to outstanding loans.

3.  Problem loans on overall portfolio quality.

4.  Reports of examination of the loan portfolio by the PennsylvaniaState Banking Department and the Federal Deposit Insurance Corporation.

 

26

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**ALLOCATION IN THE ALLOWANCE FORLOAN LOSSES**

**(IN THOUSANDS)**

 
|                                    |   | **AMOUNT** |   | **PERCENT OF  LOANS IN  EACH  CATEGORY TO  TOTAL LOANS** |   |
|-----------------------------------------|--------|------------|--------|----------------------------------------------------------|--------|
| **DECEMBER 31, 2003:**                  |   |       |   |                                                     |   |
| Balance at end of period applicable to: |   |       |   |                                                     |   |
| Domestic:                               |   |       |   |                                                     |   |
| Commercial and agricultural             |   | $          | 353    |                                                     | 8.5    | % |
| Real estate mortgage:                   |   |       |   |                                                     |   |
| Residential                             |   | 1,483      |   | 53.4                                                     | %      |
| Commercial                              |   | 916        |   | 29.9                                                     | %      |
| Construction                            |   | 77         |   | 2.8                                                      | %      |
| Installment loans to individuals        |   | 240        |   | 5.4                                                      | %      |
| Total                                   |   | $          | 3,069  |                                                     | 100.0  | % |
|                                    |   |       |   |                                                     |   |
| **DECEMBER 31, 2002:**                  |   |       |   |                                                     |   |
| Balance at end of period applicable to: |   |       |   |                                                     |   |
| Domestic:                               |   |       |   |                                                     |   |
| Commercial and agricultural             |   | $          | 471    |                                                     | 9.2    | % |
| Real estate mortgage:                   |   |       |   |                                                     |   |
| Residential                             |   | 1,162      |   | 54.4                                                     | %      |
| Commercial                              |   | 1,082      |   | 29.3                                                     | %      |
| Construction                            |   | 66         |   | 1.3                                                      | %      |
| Installment loans to individuals        |   | 172        |   | 5.8                                                      | %      |
| Total                                   |   | $          | 2,953  |                                                     | 100.0  | % |
|                                    |   |       |   |                                                     |   |
| **DECEMBER 31, 2001:**                  |   |       |   |                                                     |   |
| Balance at end of period applicable to: |   |       |   |                                                     |   |
| Domestic:                               |   |       |   |                                                     |   |
| Commercial and agricultural             |   | $          | 414    |                                                     | 9.0    | % |
| Real estate mortgage:                   |   |       |   |                                                     |   |
| Residential                             |   | 1,379      |   | 55.8                                                     | %      |
| Commercial                              |   | 763        |   | 26.5                                                     | %      |
| Construction                            |   | 74         |   | 1.6                                                      | %      |
| Installment loans to individuals        |   | 271        |   | 7.1                                                      | %      |
| Unallocated general allowance           |   | 26         |   | —                                                   |   |
| Total                                   |   | $          | 2,927  |                                                     | 100.0  | % |
|                                    |   |       |   |                                                     |   |
| **DECEMBER 31, 2000:**                  |   |       |   |                                                     |   |
| Balance at end of period applicable to: |   |       |   |                                                     |   |
| Domestic:                               |   |       |   |                                                     |   |
| Commercial and agricultural             |   | $          | 541    |                                                     | 10.8   | % |
| Real estate mortgage:                   |   |       |   |                                                     |   |
| Residential                             |   | 1,211      |   | 53.7                                                     | %      |
| Commercial                              |   | 723        |   | 24.8                                                     | %      |
| Construction                            |   | 71         |   | 1.9                                                      | %      |
| Installment loans to individuals        |   | 306        |   | 8.8                                                      | %      |
| Unallocated general allowance           |   | 27         |   | —                                                   |   |
| Total                                   |   | $          | 2,879  |                                                     | 100.0  | % |
|                                    |   |       |   |                                                     |   |
| **DECEMBER 31, 1999:**                  |   |       |   |                                                     |   |
| Balance at end of period applicable to: |   |       |   |                                                     |   |
| Domestic:                               |   |       |   |                                                     |   |
| Commercial and agricultural             |   | $          | 531    |                                                     | 13.7   | % |
| Real estate mortgage:                   |   |       |   |                                                     |   |
| Residential                             |   | 1,186      |   | 52.4                                                     | %      |
| Commercial                              |   | 710        |   | 22.2                                                     | %      |
| Construction                            |   | 70         |   | 1.6                                                      | %      |
| Installment loans to individuals        |   | 300        |   | 10.1                                                     | %      |
| Unallocated general allowance           |   | 26         |   | —                                                   |   |
| Total                                   |   | $          | 2,823  |                                                     | 100.0  | % |

 

27

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##### **DEPOSITS**

 

**2003**

 

Total averagedeposits were $335,201,000 for 2003, an increase of $18,267,000 or 5.76%.  Total demand deposits increased$16,517,000.  Noninterest-bearing demanddeposits increased $5,795,000 and interest-bearing demand deposits increased$10,722,000.  Savings deposits increased$7,203,000 while time deposits decreased $5,453,000.  Historically low rate levels have influenced investors away fromlonger term commitments which has resulted in an increase in more liquidaccounts such as demand deposits and savings and a decrease in time depositaccounts.  The shift from time depositsto demand and savings deposits have also had a positive impact on earnings.  More details pertaining to the changes ininterest expense are stated in the Net Interest Income discussion.

 

**2002**

 

Total averagedeposits were $316,934,000 for 2002, an increase of $31,166,000 or 10.9%.  Unlike the previous year, the majority ofthe increase was in the demand deposit category.  Total demand deposits increased $29,903,000.  Noninterest-bearing demand depositsincreased $4,283,000 and interest-bearing demand deposits increased$25,620,000.  Savings deposits increased$10,273,000 while time deposits decreased $9,010,000.  The Bank continues to penetrate into the Centre County marketwith the opening of a new branch office inside the State College Wal-Mart onNorth Atherton Street.  Historically lowrate levels have influenced investors away from longer term commitments whichhas resulted in a decrease in time deposits and a significant increase in moreliquid accounts such as demand deposits and savings.  The shift from time deposits to demand and savings deposits havealso had a positive impact on earnings. More details pertaining to the changes in interest expense are stated inthe Net Interest Income discussion.

 

28

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The average amount and theaverage rate paid on deposits are summarized below (in thousands):

 
|                                   |   | **2003  AVERAGE  AMOUNT** |    | **RATE** |   | **2002  AVERAGE  AMOUNT** |   | **RATE** |   | **2001  AVERAGE  AMOUNT** |   | **RATE** |    |
|----------------------------------------|--------|---------------------------|---------|----------|--------|---------------------------|--------|----------|--------|---------------------------|--------|----------|---------|
| **DEPOSITS IN DOMESTIC BANK OFFICES:** |   |                      |    |     |   |                      |   |     |   |                      |   |     |    |
| Demand deposits:                       |   |                      |    |     |   |                      |   |     |   |                      |   |     |    |
| Noninterest-bearing                    |   | $                         | 56,672  |     | 0.00   | %                         | $      | 50,877   |   | 0.00                      | %      | $        | 46,594  |   | 0.00 | % |
| Interest-bearing                       |   | 82,496                    |    | 1.15     | %      | 71,774                    |   | 2.13     | %      | 46,154                    |   | 2.17     | %       |
| Savings deposits                       |   | 64,673                    |    | 1.17     | %      | 57,470                    |   | 2.04     | %      | 47,197                    |   | 2.03     | %       |
| Time deposits                          |   | 131,360                   |    | 2.25     | %      | 136,813                   |   | 3.77     | %      | 145,823                   |   | 5.28     | %       |
| Total average deposits . .             |   | $                         | 335,201 |     |   |                      | $      | 316,934  |   |                      |   | $        | 285,768 |   |   |   |

##### ** **

##### **SHAREHOLDERS’ EQUITY**

 

**2003**

 

Shareholders’equity is evaluated in relation to total assets and the risks associated withthose assets.  A company is more likelyto meet its cash obligations and absorb unforeseen losses when the capitalresources are greater.  Total shareholders’equity at December 31, 2003 was $69,769,000, increasing $6,627,000 from thebalance at December 31, 2002 of $63,142,000. Net income and the exercising of stock options contributed $11,174,000and $87,000, respectively, to shareholders’ equity.  The unrealized appreciation on securities also added $987,000 tototal equity.  Shareholders’ equity wasreduced by  $5,001,000 that was paid outin dividends.

 

**2002**

 

Totalshareholders’ equity at December 31, 2002 was $63,142,000, increasing$7,890,000 from the balance at December 31, 2001 of $55,252,000.  Net income and the exercising of stockoptions contributed $8,886,000 and $113,000, respectively, to shareholders’equity.  The unrealized appreciation onsecurities also added $3,416,000 to total equity.  Reductions to shareholders’ equity included $4,124,000 that waspaid out in dividends and $401,000 for the purchase of treasury stock.

 

**2001**

 

Totalshareholders’ equity at December 31, 2001 was $55,252,000, increasing$4,738,000 from the balance at December 31, 2000 of $50,514,000.  Net income and the exercising of stockoptions contributed $7,742,000 and $24,000, respectively, to shareholders’equity.  The unrealized appreciation onsecurities also added $2,539,000 to total equity.  Reductions to shareholders’ equity included $3,729,000 that waspaid out in dividends and $1,838,000 for the purchase of treasury stock.

 

Bankregulators have risk based capital guidelines. Under these guidelines, banks are required to maintain minimum ratios ofcore capital and total qualifying capital as a percentage of risk weightedassets and certain off-balance sheet items. At December 31, 2003, the Company’s required ratios were well above theminimum ratios as follows:

 

|                 |   | **Company** |   | **2003  Minimum  Standards** |   |
|----------------------|--------|-------------|--------|------------------------------|--------|
| Tier 1 capital ratio |   | 20.9        | %      | 4.0                          | %      |
| Total capital ratio  |   | 23.0        | %      | 8.0                          | %      |

 

For a morecomprehensive discussion of these requirements, see “Regulations andSupervision” on the Form 10-K. Management believes that the Company will continue to exceed regulatorycapital requirements.

 

29

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##### **RETURN ON EQUITY AND ASSETS**

 

The ratio of net income toaverage total assets and average shareholders’ equity and certain ratios arepresented as follows:

 
|                                                                     |   | **2003** |   | **2002** |   | **2001** |   |
|--------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Percentage of net income to:                                             |   |     |   |     |   |     |   |
| Average total assets                                                     |   | 2.24     | %      | 2.01     | %      | 1.95     | %      |
| Average shareholders’ equity                                        |   | 16.60    | %      | 15.00    | %      | 14.38    | %      |
| Percentage of dividends declared per common  share                       |   | 44.76    | %      | 46.40    | %      | 48.17    | %      |
| Percentage of average shareholders’ equity  to average total assets |   | 13.51    | %      | 13.39    | %      | 13.54    | %      |

 

##### **LIQUIDITY, INTEREST RATE SENSITIVITY AND MARKET RISK**

 

Fundamentalobjectives of the Company’s asset/liability management process are to maintainadequate liquidity while minimizing interest rate risk.  The maintenance of adequate liquidityprovides the Company with the ability to meet its financial obligations todepositors, loan customers and stockholders. Additionally, it provides funds for normal operating expenditures andbusiness opportunities as they arise. The objective of interest rate sensitivity management is to increase netinterest income by managing interest sensitive assets and liabilities in such away that they can be repriced in response to changes in market interest rates.

 

The Company,like other financial institutions, must have sufficient funds available to meetits liquidity needs for deposit withdrawals, loan commitments andexpenses.   In order to control cashflow, the bank estimates future flows of cash from deposits and loanpayments.  The primary sources of fundsare deposits, principal and interest payments on loans and mortgage-backedsecurities, as well as Federal Home Loan Bank borrowings.  Funds generated are used principally to fundloans and purchase investment securities. Management believes the Company has adequate resources to meet itsnormal funding requirements.

 

Managementmonitors the Company’s liquidity on both a long and short-term basis thereby,providing management necessary information to react to current balance sheettrends.  Cash flow needs are assessedand sources of funds are determined. Funding strategies consider both customer needs and economicalcost.  Both short and long term fundingneeds are addressed by maturities and sales of available for sale investmentsecurities, loan repayments and maturities, and liquidating money marketinvestments such as federal funds sold. The use of these resources, in conjunction with access to creditprovides core ingredients to satisfy depositor, borrower and creditor needs.

 

Managementmonitors and determines the desirable level of liquidity.  Consideration is given to loan demand,investment opportunities, deposit pricing and growth potential as well as thecurrent cost of borrowing funds.  TheCompany has a current borrowing capacity at the Federal Home Loan Bank of$166,870,000.  In addition to thiscredit arrangement the Company has additional lines of credit withcorrespondent banks of $10,500,000. The Company’s management believes that ithas sufficient liquidity to satisfy estimated short-term and long-term fundingneeds.  Federal Home Loan Bank advancestotaled $107,918,000 as of December 31, 2003.

 

Interest ratesensitivity, which is closely related to liquidity management, is a function ofthe repricing characteristics of the Company’s portfolio of assets andliabilities.  Asset/liability managementstrives to match maturities and rates between loan and investment securityassets with the deposit liabilities and borrowings that fund them.  Successful asset/liability management resultsin a balance sheet structure which can cope effectively with market ratefluctuations. The matching process is affected by segmenting both assets andliabilities into future time periods (usually 12 months, or less) based uponwhen repricing can be effected. Repriceable assets are subtracted from repriceable liabilities, for aspecific time period to determine the “gap”, or difference. Once known, the gapis managed based on predictions about future market interest rates.  Intentional mismatching, or gapping, canenhance net interest income if market rates move as predicted.  However, if market rates behave in a mannercontrary to predictions, net interest income will suffer.  Gaps, therefore, contain an element of riskand must be prudently managed.  Inaddition to gap management,

 

30

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the Company has an assetliability management policy which incorporates a market value at riskcalculation which is used to determine the effects of interest rate movementson shareholders’ equity and a simulation analysis to monitor the effects ofinterest rate changes on the Company’s balance sheets.

 

**INTEREST RATE SENSITIVITY**

 

The following table sets forththe Company’s interest rate sensitivity as of December 31, 2003:

 
|                                   |   | **WITHIN  ONE YEAR** |    | **AFTER ONE  BUT WITHIN  TWO YEARS** |   | **AFTER TWO  BUT WITHIN  FIVE YEARS** |   | **AFTER  FIVE  YEARS** |    |
|----------------------------------------|--------|----------------------|---------|--------------------------------------|--------|---------------------------------------|--------|------------------------|---------|
| Earning assets:                        |   |                 |    |                                 |   |                                  |   |                   |    |
| Investment securities (1)              |   | $                    | 42,246  |                                 | $      | 81,433                                |   | $                      | 26,870  |   | $ | 58,056 |   |
| Loans (2)                              |   | 70,067               |    | 40,471                               |   | 123,384                               |   | 46,709                 |    |
| Total earning assets                   |   | 112,313              |    | 121,904                              |   | 150,254                               |   | 104,765                |    |
|                                   |   |                 |    |                                 |   |                                  |   |                   |    |
| Interest-bearing liabilities:          |   |                 |    |                                 |   |                                  |   |                   |    |
| Deposits (3)                           |   | 94,565               |    | 47,829                               |   | 84,027                                |   | 43,022                 |    |
| Borrowings                             |   | 47,225               |    | 1,400                                |   | 37,728                                |   | 31,790                 |    |
| Total interest-bearing liabilities     |   | 141,790              |    | 49,229                               |   | 121,755                               |   | 74,812                 |    |
|                                   |   |                 |    |                                 |   |                                  |   |                   |    |
| Net noninterest-bearing funding (4)    |   | 10,165               |    | 10,165                               |   | 30,495                                |   | 50,825                 |    |
| Total net funding sources              |   | $                    | 151,955 |                                 | $      | 59,394                                |   | $                      | 152,250 |   | $ | 125,637 |   |
| Excess assets (liabilities)            |   | (39,642              | )       | 62,510                               |   | (1,996                                | )      | (20,872                | )       |
| Cumulative excess assets (liabilities) |   | (39,642              | )       | 22,868                               |   | 20,872                                |   | —                 |    |

 

----

(1) Investment balances reflectestimated prepayments on mortgage-backed securities and are inclusive of FHLBstock.

(2) Loan balances includeannual repayment assumptions based on projected cash flow from the loanportfolio.             The cash flowprojections are based on the terms of the credit facilities and estimatedprepayments on fixed rate mortgage loans. Loans include loans held for sale.

(3) Adjustments to the interestsensitivity of Savings, NOW and MMDA account balances reflect managerialassumptions based on historical experience, expected behavior in future rateenvironments and the Company’s positioning for these products.

(4) Net noninterest-bearingfunds are the sum of noninterest-bearing liabilities and shareholders’ equityminus noninterest-earning assets and reflect managerial assumptions as to theappropriate investment maturity categories.

 

In this analysisthe Company examines the result of a 100 and 200 basis point change in marketinterest rates and the effect on net interest income.  It is assumed that the change is instantaneous and that all ratesmove in a parallel manner.  Assumptionsare also made concerning prepayment speeds on mortgage loans and mortgagesecurities.  The following is a rateshock analysis for the period indicated:

 
| **Changes in  Rates** |   | **December  31, 2003  Net Interest  Income Change (After Tax)** |   |
|-----------------------|--------|-----------------------------------------------------------------|--------|
|                  |   | **(in  thousands)**                                             |   |
| -200                  |   | $                                                               | (1,172 | ) |
| -100                  |   | $                                                               | (397   | ) |
| +100                  |   | $                                                               | 356    |   |
| +200                  |   | $                                                               | 598    |   |

 

31

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The model utilizedto create the report presented above makes various estimates at each level ofinterest rate change regarding cash flow from principal repayment on loans andmortgage-backed securities and or call activity on investment securities.  Actual results could differ significantlyfrom these estimates which would result in significant differences in thecalculated projected change.  Inaddition, the limits stated above do not necessarily represent the level ofchange under which management would undertake specific measures to realign itsportfolio in order to reduce the projected level of change.  Generally, management believes the Companyis well positioned to respond expeditiously when the market interest rateoutlook changes.

 

##### **INFLATION**

 

The asset andliability structure of a financial institution is primarily monetary in nature,therefore, interest rates rather than inflation have a more significant impacton the Company’s performance.  Interestrates are not always affected in the same direction or magnitude as prices ofother goods and services, but are reflective of fiscal policy initiatives oreconomic factors that are not measured by a price index.

 

**CRITICAL ACCOUNTING POLICIES**

 

The Company’saccounting policies are intergral to understanding the results reported.  The accounting policies are described indetail in Note A of the consolidated financial statements.  Our most complex accounting policies requiremanagement’s judgment to ascertain the valuation of assets, liabilities,commitments and contingencies.  We haveestablished detailed policies and control procedures that are intended toensure valuation methods are well controlled and applied consistently fromperiod to period.  In addition, thepolicies and procedures are intended to ensure that the process for changingmethodologies occurs in an appropriate manner. The following is a brief description or our current accounting policiesinvolving significant management valuation judgments.

 

*Other Than Temporary Impairment of EquitySecurities*

 

Equitysecurities are evaluated periodically to determine whether a decline in theirvalue is other than temporary, management utilized criteria such as themagnitude and duration of the decline, in addition to the reason underlying thedecline, to determine whether the loss in value is other than temporary,  The term “other than temporary” is notintended to indicate that the decline is permanent.  It indicates that the prospects for a near tem recovery of valueare not necessarily favorable, or that there is a lack of evidence to supportfair values equal to, or greater than, the carrying value of theinvestment.  Once a decline in value isdetermined to be other than temporary, the value of the security is reduced anda corresponding charge to earnings is recognized.

 

*Allowance for Loan Losses*

 

Arriving at anappropriate level of allowance for loan losses involves a high degree ofjudgment.  The Company’s allowance forloan losses provides for probable losses based upon evaluations of known, andinherent risks in the loan portfolio.

 

Managementuses historical information to assess the adequacy of the allowance for loanlosses as well as the prevailing business environment; as it is affected bychanging economic conditions and various external factors, which may impact theportfolio in ways curreltly unforeseen. The allowance is increased by provisions for loan losses and byrecoveries of loans previously chared-off and reduced by loanscharged-off.  For a full discussion ofthe Company’s methodology of assessing the adequacy of the reserve for loanlosses, refer to Note D of  “Notes andConsolidated Finanical Statements” commencing on page 13 of the Form 10-K.

 

32

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*Goodwill and Other Intangible Assets*

 

As discussedin Note F of the consolidated financial statements, the Company must assessgoodwill and other intangible assets each year for impairment.  This assessment involves estimating cashflows for future periods.  If the futurecash flows were less than the recorded goodwill and other intangible assetsbalances, we would be required to take a charege against earnings to write downthe assets to the lower value.

 

*Deferred Tax Assets*

 

We use anestimate of future earnings to support our position that the benefit of ourdeferred tax assets will be realized. If future income should prove non-existent or less than the amount ofthe dererred tax assets within the tax years to which they may be applied, theasset may not be realized and our net income will be reduced.  Our deferred tax assets are describedfurther in Note J of the consolidated financial statements.

 

**CONTRACTUAL OBLIGATIONS, COMMITMENTS,CONTINGENT LIABLITIES, AND OFF-BALANCE SHEET ARRANGEMENTS**

 

TheCorporation has various financial obligations, including contractualobligations and commitments, which may require future cash payments.

 

*Contractual Obligations:*  The following table presents in thousands,as of December 31, 2003, significant fixed and determinable contractualobligations to third parties by payment date.  Further discussion of the nature of each obligations is included in thereferenced note to be consolidated financial statements.

 
|                                    |   | **Payments  Due in**  |    |                     |   |
|-----------------------------------------|--------|-----------------------|---------|--------------------------|--------|
|                                    |   | **One Year  or Less** |    | **One to  Three  Years** |   | **Three to  Five  Years** |   | **Over  Five  Years** |   | **Total** |   |
|                                    |   |                  |    |                     |   |   |   |   |   |   |   |
| **Deposits  without a stated maturity** |   | $                     | 209,418 |                     | — |   | — |   | — |   | $ | 209,418 |   |
|                                    |   |                  |    |                     |   |   |   |   |   |   |   |
| **Time  Deposits**                      |   | 75,977                |    | 38,216                   |   | 9,658 |   | 1,049 |   | 124,900 |   |
|                                    |   |                  |    |                     |   |   |   |   |   |   |   |
| **Security repurchase  agreements**     |   | 10,225                |    | —                   |   | — |   | — |   | 10,225 |   |
|                                    |   |                  |    |                     |   |   |   |   |   |   |   |
| **Borrowed  funds**                     |   | 37,040                |    | —                   |   | — |   | — |   | 37,040 |   |
|                                    |   |                  |    |                     |   |   |   |   |   |   |   |
| **Long-term  debt**                     |   | —                |    | 3,000                    |   | 31,100 |   | 36,778 |   | 70,878 |   |
|                                    |   |                  |    |                     |   |   |   |   |   |   |   |
| **Operating  leases**                   |   | 262                   |    | 469                      |   | 278 |   | 53 |   | 1,062 |   |
|                                         |        |                       |         |                          |        |  |  |  |  |  |  |  |  |

 

The Corporation’soperating lease obligations represent short and long-temn lease and rentalpayment for facilities, certain software and data processing and otherequipment.

 

*Commitments: *The following table details the amounts andexpected maturities of significant commitments as of December 31, 2003, inthousands.  Further discussion of thesecommitments is included in Note O to the consolidated financial statements.

 
|                                  |   | **One Year  or Less** |   | **One to  Three  Years** |   | **Three to  Five  Years** |   | **Over  Five  Years** |   | **Total** |   |
|---------------------------------------|--------|-----------------------|--------|--------------------------|--------|---------------------------|--------|-----------------------|--------|-----------|--------|
| **Commitments to extend credit:**     |   |                  |   |                     |   |                      |   |                  |   |      |   |
|                                  |   |                  |   |                     |   |                      |   |                  |   |      |   |
| **Commercial**                        |   | $                     | 10,589 |                     | $      | —                    |   | $                     | — |      | $      | — |   | $ | 10,589 |   |
| **Commercial real estate**            |   | 29,139                |   | 167                      |   | 549                       |   | 4,455                 |   | 34,310    |   |
| **Home Equity**                       |   | 59                    |   | —                   |   | 83                        |   | 2,413                 |   | 2,555     |   |
| **Standby letters letters of credit** |   | 258                   |   | —                   |   | —                    |   | —                |   | 258       |   |
|                                       |        |                       |        |                          |        |                           |        |                       |        |           |        |  |  |  |  |  |

 

Commitments to extend credit,including loan commitments, standby letters of credit, and commercial lettersof credit do not necessarily represent future cash requirements, in that thesecommitments often expire without being drawn upon.

 

33

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**CAUTIONARY STATEMENT FOR PURPOSES OF THEPRIVATE SECURITIES LITIGATION REFORM ACT OF 1995**

 

This Reportcontains certain “forward-looking statements” including statements concerningplans, objectives, future events or performance and assumptions and otherstatements which are other than statements of historical fact.

 

The PrivateSecurities Litigation Reform Act of 1995 provides a safe harbor forforward-looking statements. In order to comply with the terms of the safeharbor, the Company notes that a variety of factors could cause the Company’sactual results and experience to differ materially from the anticipated resultsor other expectations expressed in the Company’s forward-looking statements.The risks and uncertainties that may affect the operations, performance,development and results of the Company’s business include the following:general economic conditions and changes in interest rates including theirimpact on capital expenditures; business conditions in the banking industry;the regulatory environment; rapidly changing technology and evolving bankingindustry standards; the effect of changes in accounting policies and practices,including increased competition with community, regional and national financialinstitutions; new service and product offerings by competitors and pricepressures; changes in the Company’s organization, compensation and benefitplans; and similar items.

 

**Item 7A. Quantitative and Qualitative Disclosure About Market Risk**

 

Market riskfor the Company is comprised primarily from interest rate risk exposure andliquidity risk.  Interest rate risk andliquidity risk management is performed at the Bank level as well as the Companylevel.  The Company’s interest ratesensitivity is monitored by management through selected interest rate riskmeasures produced internally. Additional information and details are provided in the InterestSensitivity section of Item 2. Management’s Discussion and Analysis of FinancialCondition and Results of Operations.

 

Generally,management believes the Company is well positioned to respond expeditiouslywhen the market interest rate outlook changes.

 

##### **ITEM  8   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

 

# **REPORT OF INDEPENDENT AUDITORS**

 

Board ofDirectors and Shareholders

PennsWoods Bancorp, Inc.

 

We haveaudited the accompanying consolidated balance sheet of Penns Woods Bancorp,Inc. and subsidiaries, as of December 31, 2003 and 2002, and the relatedconsolidated statements of income, changes in shareholders’ equity, and cashflows for each of the three years in the period ended December 31, 2003.  These consolidated financial statements arethe responsibility of the Company’s management.  Our responsibility is to express an opinion on these financialstatements based on our audits.

 

Weconducted our audits in accordance with auditing standards generally acceptedin the United States of America.  Thosestandards require that we plan and perform the audit to obtain reasonable assuranceabout whether the financial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

In ouropinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of Penns WoodsBancorp, Inc. and subsidiaries as of December 31, 2003 and 2002, and theresults of their operations and their cash flows for each

 

34

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of thethree years in the period ended December 31, 2003 in conformity with accountingprinciples generally accepted in the United States of America.

**PENNS WOODS BANCORP, INC.**

**CONSOLIDATED BALANCE SHEET**

 
|                                                                                             |   | **December  31,**   |    |
|--------------------------------------------------------------------------------------------------|--------|---------------------|---------|
|                                                                                             |   | **2003**            |    | **2002** |   |
|                                                                                             |   | **(in  thousands)** |    |
| **ASSETS:**                                                                                      |   |                |    |   |   |
| Cash and due from banks                                                                          |   | $                   | 10,230  |   | $ | 11,731 |   |
| Securities available for sale                                                                    |   | 210,611             |    | 176,436 |   |
| Securities held to maturity (fair value of  $701 and $1,289)                                     |   | 686                 |    | 1,181 |   |
| Loans held for sale                                                                              |   | 4,803               |    | 2,651 |   |
| Loans, net of unearned discount of $940 and  $769                                                |   | 275,828             |    | 257,845 |   |
| Less: Allowance for loan losses                                                                  |   | 3,069               |    | 2,953 |   |
| Loans, net                                                                                       |   | 272,759             |    | 254,892 |   |
| Premises and equipment, net                                                                      |   | 4,625               |    | 4,856 |   |
| Accrued interest receivable                                                                      |   | 2,242               |    | 2,460 |   |
| Bank-owned life insurance                                                                        |   | 8,908               |    | 8,537 |   |
| Goodwill                                                                                         |   | 3,032               |    | 3,032 |   |
| Other assets                                                                                     |   | 9,485               |    | 6,430 |   |
|                                                                                             |   |                |    |   |   |
| TOTAL                                                                                            |   | $                   | 527,381 |   | $ | 472,206 |   |
|                                                                                             |   |                |    |   |   |
| **LIABILITIES:**                                                                                 |   |                |    |   |   |
| Interest-bearing deposits                                                                        |   | $                   | 269,443 |   | $ | 272,787 |   |
| Noninterest-bearing deposits                                                                     |   | 64,875              |    | 67,061 |   |
| TOTAL DEPOSITS                                                                                   |   | 334,318             |    | 339,848 |   |
|                                                                                             |   |                |    |   |   |
| Short-term borrowings                                                                            |   | 47,265              |    | 13,563 |   |
| Other borrowings                                                                                 |   | 70,878              |    | 51,778 |   |
| Accrued interest payable                                                                         |   | 836                 |    | 1,092 |   |
| Other liabilities                                                                                |   | 4,315               |    | 2,783 |   |
| TOTAL LIABILITIES                                                                                |   | 457,612             |    | 409,064 |   |
|                                                                                             |   |                |    |   |   |
| **SHAREHOLDERS’ EQUITY:**                                                                   |   |                |    |   |   |
| Common stock, par value $10; 10,000,000  shares authorized 3,326,560 and 3,136,832 shares issued |   | 33,265              |    | 31,368 |   |
| Additional paid-in capital                                                                       |   | 17,559              |    | 18,291 |   |
| Retained earnings                                                                                |   | 13,022              |    | 11,749 |   |
| Accumulated other comprehensive income                                                           |   | 6,132               |    | 5,145 |   |
| Treasury stock, at cost (5,000 and 105,503  shares)                                              |   | (209                | )       | (3,411 | ) |
| TOTAL SHAREHOLDERS’ EQUITY                                                                  |   | 69,769              |    | 63,142 |   |
|                                                                                             |   |                |    |   |   |
| TOTAL                                                                                            |   | $                   | 527,381 |   | $ | 472,206 |   |

 

See Accompanying Notes to theConsolidated Financial Statements.

 

 

Wexford,PA

February13, 2004

 

35

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**PENNS WOODS BANCORP, INC.**

**CONSOLIDATED STATEMENT OF INCOME**

 
|                                                 |   | **Year Ended  December 31,**               |   |
|------------------------------------------------------|--------|--------------------------------------------|--------|
|                                                 |   | **2003**                                   |   | **2002** |   | **2001** |   |
|                                                 |   | **(in  thousands, except per share data)** |   |
| INTEREST AND DIVIDEND INCOME:                        |   |                                       |   |   |   |   |   |
| Interest and fees on loans                           |   | $                                          | 19,963 |   | $ | 20,911 |   | $ | 21,919 |   |
| Interest and dividends on investments:               |   |                                       |   |   |   |   |   |
| Taxable interest                                     |   | 6,370                                      |   | 4,314 |   | 3,112 |   |
| Tax-exempt interest                                  |   | 2,608                                      |   | 3,252 |   | 3,066 |   |
| Other dividend income                                |   | 111                                        |   | 627 |   | 639 |   |
| TOTAL INTEREST AND DIVIDEND INCOME                   |   | 29,052                                     |   | 29,104 |   | 28,736 |   |
|                                                 |   |                                       |   |   |   |   |   |
| INTEREST EXPENSE:                                    |   |                                       |   |   |   |   |   |
| Interest on deposits                                 |   | 5,656                                      |   | 7,857 |   | 9,657 |   |
| Interest on short-term borrowings                    |   | 428                                        |   | 501 |   | 903 |   |
| Interest on other borrowings                         |   | 3,181                                      |   | 2,488 |   | 1,921 |   |
| TOTAL INTEREST EXPENSE                               |   | 9,265                                      |   | 10,846 |   | 12,481 |   |
|                                                 |   |                                       |   |   |   |   |   |
| NET INTEREST INCOME                                  |   | 19,787                                     |   | 18,258 |   | 16,255 |   |
|                                                 |   |                                       |   |   |   |   |   |
| PROVISION FOR LOAN LOSSES                            |   | 255                                        |   | 365 |   | 372 |   |
|                                                 |   |                                       |   |   |   |   |   |
| NET INTEREST INCOME AFTER PROVISION FOR  LOAN LOSSES |   | 19,532                                     |   | 17,893 |   | 15,883 |   |
|                                                 |   |                                       |   |   |   |   |   |
| OTHER INCOME:                                        |   |                                       |   |   |   |   |   |
| Service charges                                      |   | 1,917                                      |   | 1,833 |   | 1,565 |   |
| Securities gains, net                                |   | 3,659                                      |   | 233 |   | 1,033 |   |
| Earnings on bank-owned life insurance                |   | 404                                        |   | 416 |   | 174 |   |
| Insurance commissions                                |   | 1,598                                      |   | 1,807 |   | 1,416 |   |
| Other operating income                               |   | 1,056                                      |   | 1,164 |   | 921 |   |
| TOTAL OTHER INCOME                                   |   | 8,634                                      |   | 5,453 |   | 5,109 |   |
|                                                 |   |                                       |   |   |   |   |   |
| OTHER EXPENSES:                                      |   |                                       |   |   |   |   |   |
| Salaries and employee benefits                       |   | 7,262                                      |   | 6,944 |   | 5,792 |   |
| Occupancy expense, net                               |   | 877                                        |   | 831 |   | 787 |   |
| Furniture and equipment expense                      |   | 999                                        |   | 837 |   | 739 |   |
| Advertising Expense                                  |   | 388                                        |   | 372 |   | 344 |   |
| Pennsylvania shares tax expense                      |   | 455                                        |   | 411 |   | 370 |   |
| Other operating expenses                             |   | 3,308                                      |   | 2,818 |   | 3,240 |   |
| TOTAL OTHER EXPENSES                                 |   | 13,289                                     |   | 12,213 |   | 11,272 |   |
|                                                 |   |                                       |   |   |   |   |   |
| INCOME BEFORE INCOME TAX PROVISION                   |   | 14,877                                     |   | 11,133 |   | 9,720 |   |
|                                                 |   |                                       |   |   |   |   |   |
| INCOME TAX PROVISION                                 |   | 3,703                                      |   | 2,247 |   | 1,978 |   |
|                                                 |   |                                       |   |   |   |   |   |
| NET INCOME                                           |   | $                                          | 11,174 |   | $ | 8,886 |   | $ | 7,742 |   |
|                                                 |   |                                       |   |   |   |   |   |
| EARNINGS PER SHARE - BASIC                           |   | $                                          | 3.35   |   | $ | 2.66 |   | $ | 2.30 |   |
|                                                 |   |                                       |   |   |   |   |   |
| EARNINGS PER SHARE - DILUTED                         |   | $                                          | 3.35   |   | $ | 2.66 |   | $ | 2.30 |   |

 

See accompanying notes to theconsolidated financial statements.

 

36

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**PENNS WOODS BANCORP, INC.**

**CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY**

 
|                                                                                                     |   | **Common  Stock  Shares**                 |       | **Amount** |       | **Additional  Paid-in  Capital** |       | **Retained  Earnings** |       | **Accumulated  Other  Comprehensive  Income (Loss)** |       | **Treasury  Stock** |       | **Total  Shareholders’  Equity** |   |
|----------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|------------|------------|------------|----------------------------------|------------|------------------------|------------|------------------------------------------------------|------------|---------------------|------------|---------------------------------------|--------|
|                                                                                                     |   | **(in thousands, except per share data)** | ** ** |       | ** ** |                             | ** ** |                   | ** ** |                                                 | ** ** |                | ** ** |
|                                                                                                     |   |                                      |       |       |       |                             |       |                   |       |                                                 |       |                |       |                                  |   |
| Balance, December 31, 2000                                                                               |   | 3,130,844                                 |       | $          | 31,308     |                             | $          | 18,214                 |       | $                                                    | 2,974      |                | $          | (810                                  | )      | $ | (1,172 | ) | $ | 50,514 |   |
|                                                                                                     |   |                                      |       |       |       |                             |       |                   |       |                                                 |       |                |       |                                  |   |
| Comprehensive income:                                                                                    |   |                                      |       |       |       |                             |       |                   |       |                                                 |       |                |       |                                  |   |
| Net income                                                                                               |   |                                      |       |       |       |                             |       | 7,742                  |       |                                                 |       |                |       | 7,742                                 |   |
| Unrealized gain on available for sale  securities, net of reclassification adjustments and tax of $1,308 |   |                                      |       |       |       |                             |       |                   |       | 2,539                                                |       |                |       | 2,539                                 |   |
| Total comprehensive income                                                                               |   |                                      |       |       |       |                             |       |                   |       |                                                 |       |                |       | 10,281                                |   |
| Dividends declared, ($1.11 per share)                                                                    |   |                                      |       |       |       |                             |       | (3,729                 | )          |                                                 |       |                |       | (3,729                                | )      |
| Stock options exercised                                                                                  |   | 800                                       |       | 8          |       | 16                               |       |                   |       |                                                 |       |                |       | 24                                    |   |
| Treasury stock acquired, 58,503 shares                                                                   |   |                                      |       |       |       |                             |       |                   |       |                                                 |       | (1,838              | )          | (1,838                                | )      |
|                                                                                                     |   |                                      |       |       |       |                             |       |                   |       |                                                 |       |                |       |                                  |   |
| Balance, December 31, 2001                                                                               |   | 3,131,644                                 |       | 31,316     |       | 18,230                           |       | 6,987                  |       | 1,729                                                |       | (3,010              | )          | 55,252                                |   |
|                                                                                                     |   |                                      |       |       |       |                             |       |                   |       |                                                 |       |                |       |                                  |   |
| Comprehensive income:                                                                                    |   |                                      |       |       |       |                             |       |                   |       |                                                 |       |                |       |                                  |   |
| Net income                                                                                               |   |                                      |       |       |       |                             |       | 8,886                  |       |                                                 |       |                |       | 8,886                                 |   |
| Unrealized gain on available for sale  securities, net of reclassification adjustments and tax of $1,760 |   |                                      |       |       |       |                             |       |                   |       | 3,416                                                |       |                |       | 3,416                                 |   |
| Total comprehensive income                                                                               |   |                                      |       |       |       |                             |       |                   |       |                                                 |       |                |       | 12,302                                |   |
| Dividends declared, ($1.24 per share)                                                                    |   |                                      |       |       |       |                             |       | (4,124                 | )          |                                                 |       |                |       | (4,124                                | )      |
| Stock options exercised                                                                                  |   | 5,188                                     |       | 52         |       | 61                               |       |                   |       |                                                 |       |                |       | 113                                   |   |
| Treasury stock acquired, 13,449 shares                                                                   |   |                                      |       |       |       |                             |       |                   |       |                                                 |       | (401                | )          | (401                                  | )      |
|                                                                                                     |   |                                      |       |       |       |                             |       |                   |       |                                                 |       |                |       |                                  |   |
| Balance, December 31, 2002                                                                               |   | 3,136,832                                 |       | 31,368     |       | 18,291                           |       | 11,749                 |       | 5,145                                                |       | (3,411              | )          | 63,142                                |   |
|                                                                                                     |   |                                      |       |       |       |                             |       |                   |       |                                                 |       |                |       |                                  |   |
| Stock split effected in the form of a 10%  dividend                                                      |   | 187,143                                   |       | 1,871      |       | (793                             | )          | (4,900                 | )          |                                                 |       | 3,822               |       |                                  |   |
| Comprehensive income:                                                                                    |   |                                      |       |       |       |                             |       |                   |       |                                                 |       |                |       |                                  |   |
| Net income                                                                                               |   |                                      |       |       |       |                             |       | 11,174                 |       |                                                 |       |                |       | 11,174                                |   |
| Unrealized gain on available for sale  securities, net of reclassification adjustments and tax of $508   |   |                                      |       |       |       |                             |       |                   |       | 987                                                  |       |                |       | 987                                   |   |
| Total comprehensive income                                                                               |   |                                      |       |       |       |                             |       |                   |       |                                                 |       |                |       | 12,161                                |   |
| Dividends declared, ($1.49 per share)                                                                    |   |                                      |       |       |       |                             |       | (5,001                 | )          |                                                 |       |                |       | (5,001                                | )      |
| Stock options exercised                                                                                  |   | 2,585                                     |       | 26         |       | 61                               |       |                   |       |                                                 |       |                |       | 87                                    |   |
| Treasury stock acquired, 14,787 shares                                                                   |   |                                      |       |       |       |                             |       |                   |       |                                                 |       | (620                | )          | (620                                  | )      |
|                                                                                                     |   |                                      |       |       |       |                             |       |                   |       |                                                 |       |                |       |                                  |   |
| Balance, December 31, 2003                                                                               |   | 3,326,560                                 |       | $          | 33,265     |                             | $          | 17,559                 |       | $                                                    | 13,022     |                | $          | 6,132                                 |   | $ | (209 | ) | $ | 69,769 |   |

 
| **Components  of comprehensive income:**                                 |   |   |   |   |   | **2003** |   | **2002** |   | **2001** |   |   |   |   |   |
|--------------------------------------------------------------------------|--------|--------|--------|--------|--------|----------|--------|----------|--------|----------|--------|--------|--------|--------|--------|
|                                                                     |   |   |   |   |   |     |   |     |   |     |   |   |   |   |   |
| Change in net unrealized gain on  investments available for sale         |   |   |   |   |   | $        | 3,402  |     | $      | 3,570    |   | $      | 3,221  |   |   |   |   |   |
| Realized gains included in net income, net  of tax $1,244, $79, and $351 |   |   |   |   |   | (2,415   | )      | (154     | )      | (682     | )      |   |   |   |   |
|                                                                     |   |   |   |   |   |     |   |     |   |     |   |   |   |   |   |
| Total                                                                    |   |   |   |   |   | $        | 987    |     | $      | 3,416    |   | $      | 2,539  |   |   |   |   |   |

 

See accompanying notes to theconsolidated financial statements.

 

37

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**PENNS WOODS BANCORP, INC.**

**CONSOLIDATED STATEMENT OF CASH FLOWS**

 
|                                                                               |   | **Year Ended  December 31,** |   |     |   |     |   |
|------------------------------------------------------------------------------------|--------|------------------------------|--------|----------|--------|----------|--------|
|                                                                               |   | **2003**                     |   | **2002** |   | **2001** |   |
|                                                                               |   | **(in  thousands)**          |   |     |   |     |   |
| OPERATING ACTIVITIES                                                               |   |                         |   |     |   |     |   |
| Net income                                                                         |   | $                            | 11,174 |     | $      | 8,886    |   | $ | 7,742 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |   |                         |   |     |   |     |   |
| Depreciation                                                                       |   | 631                          |   | 526      |   | 489      |   |
| Provision for loan losses                                                          |   | 255                          |   | 365      |   | 372      |   |
| Accretion and amortization of investment  security discounts and premiums          |   | (194                         | )      | (906     | )      | (843     | )      |
| Securities gains, net                                                              |   | (3,659                       | )      | (233     | )      | (1,033   | )      |
| Loss (gain) on sale of foreclosed assets                                           |   | —                       |   | —   |   | —   |   |
| Originations of loans held for sale                                                |   | (15,983                      | )      | (16,597  | )      | (24,311  | )      |
| Proceeds of loans held for sale                                                    |   | 13,831                       |   | 17,939   |   | 22,006   |   |
| Earnings on bank-owned life insurance                                              |   | (404                         | )      | (416     | )      | (174     | )      |
| Increase in all other assets                                                       |   | (490                         | )      | (1,465   | )      | (577     | )      |
| Increase in all other liabilities                                                  |   | 1,276                        |   | 473      |   | 59       |   |
| Net cash provided by operating activities                                          |   | 6,437                        |   | 8,572    |   | 3,730    |   |
|                                                                               |   |                         |   |     |   |     |   |
| INVESTING ACTIVITIES                                                               |   |                         |   |     |   |     |   |
| Investment securities available for sale:                                          |   |                         |   |     |   |     |   |
| Proceeds from sales                                                                |   | 82,489                       |   | 79,022   |   | 22,156   |   |
| Proceeds from calls and maturities                                                 |   | 48,046                       |   | 13,047   |   | 12,765   |   |
| Purchases                                                                          |   | (159,363                     | )      | (130,328 | )      | (48,151  | )      |
| Investment securities held to maturity:                                            |   |                         |   |     |   |     |   |
| Proceeds from calls and maturities                                                 |   | 520                          |   | 137      |   | 1,963    |   |
| Purchases                                                                          |   | (24                          | )      | (41      | )      | (25      | )      |
| Net increase in loans                                                              |   | (18,390                      | )      | (6,800   | )      | (7,148   | )      |
| Acquisition of bank premises and equipment                                         |   | (400                         | )      | (992     | )      | (323     | )      |
| Proceeds from the sale of foreclosed assets                                        |   | 341                          |   | 344      |   | 592      |   |
| Purchase of bank-owned life insurance                                              |   | —                       |   | —   |   | (5,589   | )      |
| Gross proceeds from redemption of  regulatory stock                                |   | 1,507                        |   | 1,262    |   | 943      |   |
| Gross purchases of regulatory stock                                                |   | (4,402                       | )      | (2,080   | )      | (941     | )      |
| Net cash used for investing activities                                             |   | (49,676                      | )      | (46,429  | )      | (23,758  | )      |
|                                                                               |   |                         |   |     |   |     |   |
| FINANCING ACTIVITIES                                                               |   |                         |   |     |   |     |   |
| Net increase (decrease) in interest-bearing  deposits                              |   | (3,344                       | )      | 22,914   |   | 19,208   |   |
| Net increase (decrease) in  noninterest-bearing deposits                           |   | (2,186                       | )      | 11,784   |   | 7,808    |   |
| Net increase (decrease) in short-term  borrowings                                  |   | 33,702                       |   | (5,542   | )      | (11,916  | )      |
| Proceeds from other borrowings                                                     |   | 19,100                       |   | 10,000   |   | 10,000   |   |
| Dividends paid                                                                     |   | (5,001                       | )      | (4,124   | )      | (3,729   | )      |
| Stock options exercised                                                            |   | 87                           |   | 113      |   | 21       |   |
| Purchase of treasury stock                                                         |   | (620                         | )      | (401     | )      | (1,838   | )      |
| Net cash provided by financing activities                                          |   | 41,738                       |   | 34,744   |   | 19,554   |   |
| NET DECREASE IN CASH AND CASH EQUIVALENTS                                          |   | (1,501                       | )      | (3,113   | )      | (474     | )      |
| CASH AND CASH EQUIVALENTS, BEGINNING                                               |   | 11,731                       |   | 14,844   |   | 15,318   |   |
| CASH AND CASH EQUIVALENTS, ENDING                                                  |   | $                            | 10,230 |     | $      | 11,731   |   | $ | 14,844 |   |

 

SUPPLEMENTALDISCLOSURES OF CASH FLOW INFORMATION:

The Companypaid approximately $9,521,000, $10,944,000, and $12,743,000 in interest ondeposits and other borrowings during 2003, 2002, and 2001, respectively.

The Companymade income tax payments of approximately $3,500,000, $3,394,000, and$2,136,000 during 2003, 2002, and 2001, respectively.

 

See accompanying notes to theconsolidated financial statements.

 

38

----

 

**PENNSWOODS BANCORP, INC.**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE A - NATUREOF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

**Principles ofConsolidation**

 

The accompanying consolidated financial statements include the accountsof Penns Woods Bancorp, Inc. and its wholly owned subsidiaries, Jersey ShoreState Bank (the “Bank”), Woods Real Estate Development Co., Inc., WoodsInvestment Company, Inc. and The M Group Inc. D/B/A The Comprehensive FinancialGroup (“The M Group”), a wholly owned subsidiary of the Bank  (collectively, the “Company”).  All significant intercompany balances andtransactions have been eliminated.

 

**Nature of Business**

 

The Bank engages in a full-service commercial banking business, makingavailable to the community a wide range of financial services including, butnot limited to, installment loans, credit cards, mortgage and home equityloans, lines of credit, construction financing, farm loans, communitydevelopment loans, loans to nonprofit entities and local government loans andvarious types of time and demand deposits including, but not limited to,checking accounts, savings accounts, clubs, money market deposit accounts,certificates of deposit and IRAs. Deposits are insured by the Federal Deposit Insurance Corporation(“FDIC”) to the extent provided by law.

 

The financial services are provided by the bank to individuals,partnerships, non-profit organizations and corporations through its elevenoffices and Financial Center located in Clinton, Lycoming, and Centre Counties,Pennsylvania.

 

Woods Real Estate Development Co., Inc. engages in real estatetransactions on behalf of Penns Woods Bancorp, Inc. and the Bank.

 

Woods Investment Company, Inc. is engaged in investing activities.

 

The M Group engages in securities brokerage and insurance activities.

 

# **Use of Estimates**

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the consolidated financial statements and the reported amountsof revenues and expenses during the reporting period.  Actual results may differ from those estimates.

 

Material estimates that are particularly susceptible to significantchange relate to the determination of the allowance for loan losses and thevaluation of real estate acquired through, or in lieu of, foreclosure onsettlement of debt.

 

**Investment Securities**

 

Investment securities are classified as held to maturity, trading, oravailable for sale.

 

Securities held to maturity include bonds, notes, and debentures forwhich the Company has the positive intent and ability to hold to maturity andare reported at amortized cost.

 

Trading account securities are recorded at their fair values.  Unrealized gains and losses on tradingaccount securities are included in other income.  The Company has no trading account securities as of December 31,2003 or 2002.

 

Available for sale securities consist of bonds, notes, debentures, andcertain equity securities not classified as trading securities nor as held tomaturity securities.  Unrealized holdinggains and losses, net of tax, on available for sale securities are reported asa net amount in a separate component of shareholders’ equity until realized.

 

Gains and losses on the sale of equity securities are determined usingthe average cost method, while all other investment securities use the specificcost method.

 

Declines in the fair value of individual securities held to maturityand available for sale below their cost that are other than temporary result inwrite-downs of the individual securities to their fair value and are includedin earnings as realized losses.

 

Premiums and discounts on all securities are recognized in interestincome using the interest method over the period to maturity.

 

The fair value of investments andmortgage-backed securities, except certain state and political securities, isestimated based on bid prices published in financial newspapers, quotationsreceived from securities dealers, or, in the case of equity securities, theclosing price of the day as listed on the Internet.  The fair value of certain state and political securities is notreadily available through market sources other than dealer quotations,therefore these fair value estimates are then based on

 

39

----

 

quoted market prices of similarinstruments, adjusted for differences between the quoted instruments and theinstruments being valued.

 

**Loans**

 

Loans are stated at the principal amount outstanding, net of unearneddiscount, unamortized loan fees and costs, and the allowance for loanlosses.  Interest on loans is recognizedas income when earned on the accrual method. The Company’s general policy has been to stop accruing interest on loanswhen it is determined a reasonable doubt exists as to the collectibility ofadditional interest.  Income issubsequently recognized only to the extent that cash payments are received providedthe loan is not delinquent in payment and, in management’s judgment, theborrower has the ability and intent to make future principal payments.

 

Loan origination and commitment fees as well as certain direct loanorigination costs are being deferred and the net amount amortized as anadjustment to the related loan’s yield. These amounts are being amortized over the contractual lives of therelated loans.

 

**Allowance for LoanLosses**

 

The allowance for loan losses represents the amount which managementestimates is adequate to provide for probable losses inherent in its loanportfolio, as of the balance sheet date. The allowance method is used in providing for loan losses.  Accordingly, all loan losses are charged tothe allowance and all recoveries are credited to it.  The allowance for loan losses is established through a provisionfor loan losses charged to operations. The provision for loan losses is based on management’s periodicevaluation of individual loans, economic factors, past loan loss experience,changes in the composition and volume of the portfolio, and other relevantfactors.  The estimates used indetermining the adequacy of the allowance for loan losses, including theamounts and timing of future cash flows expected on impaired loans, areparticularly susceptible to changes in the near term.

 

Impaired loans are commercial and commercial real estate loans forwhich it is probable the Company will not be able to collect all amounts dueaccording to the contractual terms of the loan agreement.  The Company individually evaluates suchloans for impairment and does not aggregate loans by major riskclassifications.  The definition of“impaired loans” is not the same as the definition of  “nonaccrual loans,” although the two categories overlap.  The Company may choose to place a loan onnonaccrual status due to payment delinquency or uncertain collectibility, whilenot classifying the loan as impaired if the loan is not a commercial orcommercial real estate loan.  Factorsconsidered by management in determining impairment include payment status andcollateral value.  The amount ofimpairment for these types of impaired loans is determined by the differencebetween the present value of the expected cash flows related to the loan, usingthe original interest rate, and its recorded value, or as a practical expedientin the case of collateralized loans, the difference between the fair value ofthe collateral and the recorded amount of the loans.  When foreclosure is probable, impairment is measured based on thefair value of the collateral.

 

Mortgage loans on one-to-four familyproperties and all consumer loans are large groups of smaller-balancehomogeneous loans and are measured for impairment collectively. Loans thatexperience insignificant payment delays, which are defined as 90 days or less,generally are not classified as impaired. Management determines the significance of payment delays on acase-by-case basis taking into consideration all circumstances surrounding theloan and the borrower including the length of the delay, the borrower’s priorpayment record, and the amount of shortfall in relation to the principal andinterest owed.

 

# **Loans Held for Sale**

 

In general, fixed rate residentialmortgage loans originated by the Bank are held for sale and are carried at theaggregate lower of cost or market.  Suchloans sold are not serviced by the Bank.

 

# **Foreclosed Assets Held for Sale**

 

Foreclosed assets held for sale are carried at the lower of cost orfair value minus estimated costs to sell. Prior to foreclosure, the value of the underlying loan is written downto the fair value of the real estate to be acquired by a charge to theallowance for loan losses, if necessary. Any subsequent write-downs are charged against operating expenses.  Operating expenses of such properties, netof related income, and gains and losses on their disposition are included inother expenses.

 

# **Premises and Equipment**

 

Premises and equipment are stated at cost less accumulateddepreciation.  Depreciation is computed usingstraight-line and accelerated methods over the estimated useful lives of therelated assets, which range from five to seven years for furniture, fixturesand equipment and thirty-one and a half years for buildings and improvements.  Costs incurred for

 

40

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routinemaintenance and repairs are charged to operations as incurred.  Costs of major additions and improvementsare capitalized.

 

# **Goodwill**

 

On January 1,2002, the Company adopted Statement of Financial Accounting Standards (“FAS”)No. 142, *Goodwilland Other Intangible Assets.* This statement changed the accountingfor goodwill from an amortization method to an impairment-only approach.  Thus, amortization of goodwill, includinggoodwill recorded in past business combinations, ceased upon adoption of thisstatement.

 

Thisstatement, among other things, eliminates the regularly scheduled amortizationof goodwill and replaces this method with a two-step process for testing theimpairment of goodwill on at least an annual basis.  This approach could cause more volatility in the Company’sreported net income because impairment losses, if any, could occur regularlyand in varying amounts.  The Company,upon adoption of this statement at the beginning fo its fiscal year,immediately stopped amortizing goodwill with a carrying value of $3.0million.  In addition, the Companyperforms an annual impairment analysis of goodwill.  Based on fair value fo the reporting unit, estimated using theexpected present value of future cash flows, no impairment of goodwill wasrecognized in 2003 and 2002.

 

# **Advertising Costs**

 

Advertisingcosts are generally expensed as incurred.

 

# **Income Taxes**

 

Deferred tax assets and liabilitiesresult from temporary differences in financial and income tax methods ofaccounting, and are reflected at currently enacted income tax rates applicableto the period in which the deferred tax assets or liabilities are expected tobe realized or settled.  As changes intax laws or rates are enacted, deferred tax assets and liabilities are adjustedthrough the provision for income taxes.

 

# **Earnings Per Share**

 

The Company provides dual presentation of basic and diluted earningsper share.  Basic earnings per share iscalculated utilizing net income as reported in the numerator and average sharesoutstanding in the denominator.  Thecomputation of diluted earnings per share differs in that the dilutive effectsof any stock options are adjusted in the denominator.

 

# **Employee Benefits**

 

Pension andemployee benefits include contributions, determined actuarially, to a definedbenefit retirement plan covering the eligible employees of the Bank.  The plan is funded on a current basis to theextent that it is deductible under existing federal tax regulations.  Pension and other employee benefits alsoinclude contributions to a defined contribution Section 401(k) plan coveringeligible employees.  Contributionsmatching those made by eligible employees and an elective contributions aremade annually at the discretion of the Board of Directors.

 

# **Stock Options**

 

The Company maintains a stock option plan for the directors, officersand employees. When the exercise price of the Company’s stock options isgreater than or equal to the market price of the underlying stock on the dateof the grant, no compensation expense is recognized in the Company’s financialstatements.  Pro forma net income andearnings per share are presented to reflect the impact of the stock option planassuming compensation expense had been recognized based on the fair value ofthe stock options granted under the plan.

 

The Company applies Accounting Principles Board Opinion No. 25 andrelated interpretations in accounting for these options.  Accordingly, compensation expense isrecognized on the grant date, in the amount equivalent to the intrinsic valueof the options (stock price less exercise price, at measurement date).

 

Had compensation costs for these options been determined based on thefair values at the grant dates for awards consistent with the method of FAS No.123, there would be no effect on the Company’s net income and earnings pershare for 2003, 2002, and 2001.

 

# **Comprehensive Income**

 

The Company is required to present comprehensive income in a full setof general-purpose financial statements for all periods presented.  Other comprehensive income is comprisedexclusively of unrealized holding gains (losses) on the available for salesecurities portfolio.  The Company haselected to report the effects of other comprehensive income as part of theConsolidated Statement of Changes in Shareholders’ Equity.

 

# **Cash Flows**

 

The Company utilizes the net reporting of cash receipts and cashpayments for deposit and lending activities.

 

The Company considers amounts due from banks as cash equivalents.

 

**Reclassification of Comparative Amounts**

 

Certain items previously reported have been reclassifiedto conform to the current year’s reporting format.  Such reclassifications did not affect net income or shareholders’equity.

 

41

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**Recent AccountingPronouncements**

 

In December 2003, the Financial AccountingStandards Board (“FASB”) revised FAS No. 132, *Employers’ Disclosures about Pensionand Other Postretirement Benefit.* This statement retains the disclosures required by FAS No. 132,which standardized the disclosure requirements for pensions and otherpostretirement benefits to the extent practicable and requires additionalinformation on changes in the benefit obligations and fair value of planassets.  Additional disclosures includeinformation describing the types of plan assets, investment strategy,measurement date(s), plan obligations, cash flows, and components of netperiodic benefit cost recognized during interim periods.  This statement retains reduced disclosurerequirements for nonpublic entities from FAS No. 132, and it includes reduceddisclosure for certain of the new requirements.  This statement is effective for financial statements with fiscalyears ending after December 15, 2003. The interim disclosures required by this statement are effective forinterim periods beginning after December 15, 2003.

 

In August 2001, the FASB issued FAS No. 143, *Accountingfor Asset Retirement Obligations*, which requires that the fair valueof a liability be recognized when incurred for the retirement of a long-livedasset and the value of the asset be increased by that amount.  The statement also requires that theliability be maintained at its present value in subsequent periods and outlinescertain disclosures for such obligations. The adoption of this statement, which was effective January 1, 2003, didnot have a material effect on the Company’s financial position or results ofoperations.

 

In July 2002, the FASB issued FAS No. 146, *Accountingfor Costs Associated with Exit or Disposal Activities*, whichrequires companies to recognize costs associated with exit or disposalactivities when they are incurred rather than at the date of a commitment to anexit or disposal plan.  This statementreplaces EITF Issue No. 94-3, *Liability Recognition for Certain EmployeeTermination Benefits and Other Costs to Exit an Activity (Including CertainCosts Incurred in a Restructuring)*. The new statement is effective for exit or disposal activities initiatedafter December 31, 2002.  The adoptionof this statement did not have a material effect on the Company’s financialposition or results of operations.

 

On December 31, 2002, the FASB issued FAS No.148, *Accountingfor Stock-Based Compensation – Transition and Disclosure*, which amendsFAS No. 123, Accounting for Stock-Based Compensation.  FAS No. 148 amends the disclosure requirements of FAS No. 123 torequire more prominent and more frequent disclosures in financial statementsabout the effects of stock-based compensation. Under the provisions of FAS No. 123, companies that adopted thepreferable, fair value based method were required to apply that methodprospectively for new stock option awards. This contributed to a “ramp-up” effect on stock-based compensationexpense in the first few years following adoption, which caused concern forcompanies and investors because of the lack of consistency in reportedresults.  To address that concern, FASNo. 148 provides two additional methods of transition that reflect an entity’sfull complement of stock-based compensation expense immediately upon adoption,thereby eliminating the ramp-up effect. FAS No. 148 also improves the clarity and prominence of disclosuresabout the pro forma effects of using the fair value based method of accountingfor stock-based compensation for all companies—regardless of the accountingmethod used—by requiring that the data be presented more prominently and in amore user-friendly format in the footnotes to the financial statements.  In addition, the statement improves thetimeliness of those disclosures by requiring that this information be includedin interim as well as annual financial statements. The transition guidance andannual disclosure provisions of FAS No. 148 are effective for fiscal years endingafter December 15, 2002, with earlier application permitted in certaincircumstances.  The interim disclosureprovisions are effective for financial reports containing financial statementsfor interim periods beginning after December 15, 2002.

 

In April 2003, the FASB issued FAS No. 149, *Amendment ofStatement 133 on Derivative Instruments and Hedging Activities*.  This statement amends and clarifiesaccounting for derivative instruments, including certain derivative instrumentsembedded in other contracts, and for hedging activities under FAS No. 133.  The amendments set forth in FAS No. 149improve financial reporting by requiring that contracts with comparablecharacteristics be accounted for similarly. In particular, this statementclarifies under what circumstances a contract with an initial net investmentmeets the characteristic of a derivative as discussed in FAS No. 133. Inaddition, it clarifies when a derivative contains a financing component thatwarrants special reporting in the statement of cash flows. FAS No.149 amendscertain other existing pronouncements. Those changes will result in moreconsistent reporting of contracts that are derivatives in their entirety orthat contain embedded derivatives that warrant separate accounting.   This statement is effective for contractsentered into or modified after September 30, 2003, except as stated below andfor hedging relationships designated after September 30, 2003. The guidanceshould be applied prospectively.  Theprovisions of this statement that relate to FAS No. 133 Implementation Issuesthat have been effective for fiscal quarters that began prior to September 15,2003, should continue to be applied in accordance with their respectiveeffective dates. In addition, certain provisions relating to forward purchasesor sales of when-issued securities or other securities that do not yet exist,should be applied to existing contracts as well as new contracts entered intoafter September 30, 2003.   The adoptionof this statement did not have a material effect on the Company’s financialposition or results of operations.

 

42

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In May 2003, the FASB issued FAS No. 150, *Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity*. This statement establishes standards for how an issuerclassifies and measures certain financial instruments with characteristics ofboth liabilities and equity. It requires that an issuer classify a financialinstrument that is within its scope as a liability (or an asset in somecircumstances). Such instruments may have been previously classified as equity.This statement is effective for financial instruments entered into or modifiedafter May 31, 2003, and otherwise is effective at the beginning of the firstinterim period beginning after September 15, 2003.  The adoption of this statement did not have a material effect onthe Company’s reported equity.

 

In November 2002, the FASB issuedInterpretation No. 45, *Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others*.  This interpretation elaborates on thedisclosures to be made by a guarantor in its interim and annual financialstatements about its obligations under certain guarantees that it hasissued.  This interpretation clarifiesthat a guarantor is required to disclose (a) the nature of the guarantee,including the approximate term of the guarantee, how the guarantee arose, andthe events or circumstances that would require the guarantor to perform underthe guarantee; (b) the maximum potential amount of future payments under theguarantee; (c) the carrying amount of the liability, if any, for theguarantor’s obligations under the guarantee; and (d) the nature and extent of anyrecourse provisions or available collateral that would enable the guarantor torecover the amounts paid under the guarantee. This interpretation also clarifies that a guarantor is required torecognize, at the inception of a guarantee, a liability for the obligations ithas undertaken in issuing the guarantee, including its ongoing obligation tostand ready to perform over the term of the guarantee in the event that thespecified triggering events or conditions occur.  The objective of the initial measurement of that liability is thefair value of the guarantee at its inception. The initial recognition and initial measurement provisions of thisinterpretation are applicable on a prospective basis to guarantees issued ormodified after December 31, 2002, irrespective of the guarantor’s fiscalyear-end. The disclosure requirements in this interpretation are effective forfinancial statements of interim or annual periods ending after December 15,2002.  The adoption of thisinterpretation did not have a material effect on the Company’s financialposition or results of operations.

 

In December2003, the FASB issued a revision to Interpretation No. 46, *Consolidation of Variable InterestEntities*, which established standards for identifying a variableinterest entity (“VIE”) and for determining under what circumstances a VIEshould be consolidated with its primary beneficiary.  Application of this Interpretation is required in financialstatements of public entities that have interests in special-purpose entities forperiods ending after December 15, 2003. Application by public entities, other than small business issuers, forall other types of VIEs is required in financial statements for periods endingafter March 15, 2004.  Small businessissuers must apply this Interpretation to all other types of VIEs at the end ofthe first reporting period ending after December 15, 2004.  The adoption of this Interpretation has notand is not expected to have a material effect on the Company’s financialposition or results of operations.

 

**NOTEB - PER SHARE DATA**

 

There are no convertiblesecurities, which would affect the numerator in calculating basic and dilutiveearnings per share, therefore, net income as presented on the consolidatedstatement of income will be used as the numerator.  The following table sets forth the composition of the weightedaverage common shares (denominator) used in the basic and dilutive per sharecomputation.

 

43

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|                                                                                                      |   | **2003**  |   | **2002**  |   | **2001**  |   |
|-----------------------------------------------------------------------------------------------------------|--------|-----------|--------|-----------|--------|-----------|--------|
|                                                                                                      |   |      |   |      |   |      |   |
| Weighted average common shares outstanding                                                                |   | 3,430,302 |   | 3,445,477 |   | 3,443,930 |   |
|                                                                                                      |   |      |   |      |   |      |   |
| Average treasury stock shares                                                                             |   | (99,717   | )      | (109,165  | )      | (72,085   | )      |
|                                                                                                      |   |      |   |      |   |      |   |
| Weighted average common shares and common  stock equivalents used to calculate basic earnings per share   |   | 3,330,585 |   | 3,336,312 |   | 3,371,845 |   |
|                                                                                                      |   |      |   |      |   |      |   |
| Additional common stock equivalents (stock  options) used to calculate diluted earnings per share         |   | 3,213     |   | 2,937     |   | 2,241     |   |
|                                                                                                      |   |      |   |      |   |      |   |
| Weighted average common shares and common  stock equivalents used to calculate diluted earnings per share |   | 3,333,798 |   | 3,339,249 |   | 3,374,086 |   |

 

Optionsto purchase 10,890 shares of common stock at a price of $48.35 were outstandingduring 2003 and 22,385 shares of common stock at prices from $38.18 to $48.35were outstanding during 2002 and 2001, but were not included in the computationof diluted earnings per share because to do so would have been anti-dilutive.

 

**NOTE C - INVESTMENTSECURITIES**

 

Theamortized cost of investment securities and their approximate fair values areas follows (in thousands):

 
|                                  |   | **2003**            |    |
|---------------------------------------|--------|---------------------|---------|
|                                  |   | **Amortized  Cost** |    | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Fair  Value** |   |
|                                  |   |                |    |   |   |   |   |   |   |
| Available for Sale                    |   |                |    |   |   |   |   |   |   |
| U.S. Government and agency securities |   | $                   | 150,218 |   | $ | 626 |   | $ | (1,015 | ) | $ | 149,829 |   |
| State and political securities        |   | 31,364              |    | 2,510 |   | (22 | ) | 33,852 |   |
| Other debt securities                 |   | 1,581               |    | 75 |   | (4 | ) | 1,652 |   |
| Total debt securities                 |   | 183,163             |    | 3,211 |   | (1,041 | ) | 185,333 |   |
| Equity securities                     |   | 18,158              |    | 7,146 |   | (26 | ) | 25,278 |   |
|                                  |   | $                   | 201,321 |   | $ | 10,357 |   | $ | (1,067 | ) | $ | 210,611 |   |
|                                  |   |                |    |   |   |   |   |   |   |
| Held to Maturity                      |   |                |    |   |   |   |   |   |   |
| U.S. Government and agency securities |   | $                   | 75      |   | $ | — |   | $ | (1 | ) | $ | 74 |   |
| State and political securities        |   | 347                 |    | 16 |   | — |   | 363 |   |
| Other debt securities                 |   | 264                 |    | — |   | — |   | 264 |   |
|                                  |   | $                   | 686     |   | $ | 16 |   | $ | (1 | ) | $ | 701 |   |

 

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|                                  |   | **2002**            |    |
|---------------------------------------|--------|---------------------|---------|
|                                  |   | **Amortized  Cost** |    | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Fair  Value** |   |
|                                  |   |                |    |   |   |   |   |   |   |
| Available for Sale                    |   |                |    |   |   |   |   |   |   |
| U.S. Government and agency securities |   | $                   | 87,142  |   | $ | 1,856 |   | $ | — |   | $ | 88,998 |   |
| State and political securities        |   | 67,319              |    | 3,596 |   | (234 | ) | 70,681 |   |
| Other debt securities                 |   | 1,766               |    | 46 |   | (2 | ) | 1,810 |   |
| Total debt securities                 |   | 156,227             |    | 5,498 |   | (236 | ) | 161,489 |   |
| Equity securities                     |   | 12,414              |    | 2,989 |   | (456 | ) | 14,947 |   |
|                                  |   | $                   | 168,641 |   | $ | 8,487 |   | $ | (692 | ) | $ | 176,436 |   |
|                                  |   |                |    |   |   |   |   |   |   |
| Held to Maturity                      |   |                |    |   |   |   |   |   |   |
| U.S. Government and agency securities |   | $                   | 94      |   | $ | — |   | $ | — |   | $ | 94 |   |
| State and political securities        |   | 796                 |    | 109 |   | — |   | 905 |   |
| Other debt securities                 |   | 291                 |    | — |   | (1 | ) | 290 |   |
|                                  |   | $                   | 1,181   |   | $ | 109 |   | $ | (1 | ) | $ | 1,289 |   |

 

The following table shows theCompany’s gross unrealized losses and fair value, aggregated by investmentcategory and length of time, that the individual securities have been in acontinuous unrealized loss position, at December 31, 2003.

 
|                                  |   | **Less than  Twelve Months** |   | **Twelve  Months or Greater** |   | **Total**       |   |
|---------------------------------------|--------|------------------------------|--------|-------------------------------|--------|-----------------|--------|
|                                  |   | **Fair  Value**              |   | **Gross  Unrealized  Losses** |   | **Fair  Value** |   | **Gross  Unrealized  Losses** |   | **Fair  Value** |   | **Gross  Unrealized  Losses** |   |
|                                  |   |                         |   |                          |   |            |   |   |   |   |   |   |   |
| U.S. Government and agency Securities |   | $                            | 80,605 |                          | $      | 1,015           |   | $ | 62 |   | $ | 1 |   | $ | 80,667 |   | $ | 1,016 |   |
| State and political securities        |   | 198                          |   | 22                            |   | 0               |   | 0 |   | 198 |   | 22 |   |
| Other debt securities                 |   | 196                          |   | 4                             |   | 0               |   | 0 |   | 196 |   | 4 |   |
| Total debt securities                 |   | 80,999                       |   | 1,041                         |   | 62              |   | 1 |   | 81,061 |   | 1,042 |   |
| Equity securities                     |   | 203                          |   | 3                             |   | 405             |   | 23 |   | 608 |   | 26 |   |
| Total                                 |   | $                            | 81,202 |                          | $      | 1,044           |   | $ | 467 |   | $ | 24 |   | $ | 81,669 |   | $ | 1,068 |   |

 

The Company’sinvestment securities portfolio contains unrealized losses of directobligations of the U.S.  government,including mortgage-related instruments issued or backed by the full faith andcredit of the United States government or are generally viewed as having theimplied guarantee of the U.S. government, debt obligations of U.S. states andpolitical subdivisions, corporate entities, and equity securities of commonstock in publicly traded companies.

 

45

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On a monthly basisthe Company evaluates the severity and duration of impairment for itsinvestment securities portfolio unless the Company has the ability to hold thesecurity to maturity without incurring a loss. Generally, impairment is considered other than temporary when aninvestment security has sustained a declined of ten percent or more for oneyear.

 

The Companyhas concluded that any impairment of its investment securities portfolio is notother than temporary as of December 31, 2003 but is the result of interest ratechanges that are not expected to result in the noncollection of principal andinterest, during the period.

 

Theamortized cost and fair value of debt securities at December 31, 2003, bycontractual maturity, are shown below (in thousands).  Expected maturities will differ from contractual maturitiesbecause borrowers may have the right to call or prepay obligations with orwithout call or prepayment penalties.

 
|                              |   | **Held to  Maturity** |   | **Available  for Sale** |   |
|-----------------------------------|--------|-----------------------|--------|-------------------------|--------|
|                              |   | **Amortized  Cost**   |   | **Fair  Value**         |   | **Amortized  Cost** |   | **Fair  Value** |   |
| Due in one year or less           |   | $                     | — |                    | — |   | $ | 3,032 |   | $ | 3,087 |   |
| Due after one year to five years  |   | 125                   |   | 125                     |   | 4,779 |   | 4,785 |   |
| Due after five years to ten years |   | 139                   |   | 139                     |   | 44,538 |   | 44,387 |   |
| Due after ten years               |   | 422                   |   | 437                     |   | 130,814 |   | 133,074 |   |
|                              |   |                  |   |                    |   |   |   |   |   |
| Total                             |   | $                     | 686    |                    | $      | 701 |   | $ | 183,163 |   | $ | 185,333 |   |
|                                   |        |                       |        |                         |        |  |  |  |  |  |  |  |  |

 

Totalgross proceeds from sales of securities available for sale were $82,489,000,$79,022,000 and $22,156,000 for 2003, 2002 and 2001, respectively.  The following table represents grossrealized gains and gross realized losses on those transactions (in thousands):

 
|                                  |   | **2003** |   | **2002** |   | **2001** |   |
|---------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Gross realized gains:                 |   |     |   |     |   |     |   |
| U.S. Government and agency securities |   | $        | 254    |     | $      | 204      |   | $ | 133 |   |
| State and political securities        |   | 3,345    |   | 2,234    |   | 20       |   |
| Other debt securities                 |   | 27       |   | 6        |   | —   |   |
| Equity securities                     |   | 1,195    |   | 1,803    |   | 1,226    |   |
|                                  |   | $        | 4,821  |     | $      | 4,247    |   | $ | 1,379 |   |
|                                  |   |     |   |     |   |     |   |
| Gross realized losses:                |   |     |   |     |   |     |   |
| U.S. Government and agency securities |   | $        | 742    |     | $      | 125      |   | $ | 13 |   |
| State and political securities        |   | 50       |   | 67       |   | 149      |   |
| Other debt securities                 |   | 2        |   |     |   |     |   |
| Equity securities                     |   | 368      |   | 3,822    |   | 184      |   |
|                                  |   | $        | 1,162  |     | $      | 4,014    |   | $ | 346 |   |

 

In 2003, the Company recorded an investment securitygain of $24,000 resulting from a business combination where the Companyreceived the common stock of the acquirer in a non-monetary exchange.  This gain is included in the above table.

 

A charge of $292,000 wasrecorded in 2003 and $2,083,000 was recorded in 2002 to recognize other thantemporary declines in the value of marketable equity securities.  This loss is included in the above table.

 

46

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Investmentsecurities with a carrying value of approximately $34,059,000 and $34,914,000at December 31, 2003 and 2002, respectively, were pledged to secure certaindeposits, security repurchase agreements, and for other purposes as required bylaw.

 

There isno concentration of investments that exceed ten percent of shareholders’ equityfor any individual issuer, excluding those guaranteed by the U.S. Government.

 

**NOTE D - LOANS**

 

Majorloan classifications loans are summarized as follows (in thousands):

 
|                             |   | **2003**    |    |
|----------------------------------|--------|-------------|---------|
|                             |   | **Current** |    | **Past Due  30 to 90  Days** |   | **Past Due  90 Days  or More  & Still  Accruing** |   | **Non-  Accrual** |   | **Total** |   |
| Commercial and agricultural      |   | $           | 23,105  |   | $ | 215 |   | $ | 21 |   | $ | 182 |   | $ | 23,523 |   |
| Real estate mortgage:            |   |        |    |   |   |   |   |   |   |   |   |
| Residential                      |   | 144,102     |    | 2,625 |   | 383 |   | 587 |   | 147,697 |   |
| Commercial                       |   | 82,156      |    | 667 |   | 15 |   | 58 |   | 82,896 |   |
| Construction                     |   | 7,637       |    | 15 |   | — |   | — |   | 7,652 |   |
| Installment loans to individuals |   | 14,738      |    | 252 |   | 10 |   | — |   | 15,000 |   |
|                             |   | 271,738     |    | $ | 3,774 |   | $ | 429 |   | $ | 827 |   | 276,768 |   |
| Less: Net deferred loan fees     |   | 940         |    |   |   |   |   |   |   | 940 |   |
| Allowance for loan losses        |   | 3,069       |    |   |   |   |   |   |   | 3,069 |   |
| Loans, net                       |   | $           | 267,729 |   |   |   |   |   |   |   | $ | 272,759 |   |

 
|                             |   | **2002**    |    |
|----------------------------------|--------|-------------|---------|
|                             |   | **Current** |    | **Past Due  30 to 90  Days** |   | **Past Due  90 Days  or More  & Still  Accruing** |   | **Non-  Accrual** |   | **Total** |   |
| Commercial and agricultural      |   | $           | 22,652  |   | $ | 769 |   | $ | 7 |   | $ | 280 |   | $ | 23,708 |   |
| Real estate mortgage:            |   |        |    |   |   |   |   |   |   |   |   |
| Residential                      |   | 137,271     |    | 2,752 |   | 175 |   | 526 |   | 140,724 |   |
| Commercial                       |   | 74,317      |    | 504 |   | 1,006 |   | 65 |   | 75,892 |   |
| Construction                     |   | 3,335       |    | 21 |   | — |   | — |   | 3,356 |   |
| Installment loans to individuals |   | 14,581      |    | 316 |   | 37 |   | — |   | 14,934 |   |
|                             |   | 252,156     |    | $ | 4,362 |   | $ | 1,225 |   | $ | 871 |   | 258,614 |   |
| Less: Net deferred loan fees     |   | 769         |    |   |   |   |   |   |   | 769 |   |
| Allowance for loan losses        |   | 2,953       |    |   |   |   |   |   |   | 2,953 |   |
| Loans, net                       |   | $           | 248,434 |   |   |   |   |   |   |   | $ | 254,892 |   |

 

Loans on which the accrual of interest has been discontinuedor reduced amounted to approximately $827,000 and $871,000 at December 31, 2003and 2002, respectively.  If interest hadbeen recorded at the original rate on those loans, such income would have approximated$55,000, $24,000, and $28,000 for the years ended December 31, 2003, 2002 and

 

47

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2001, respectively. Interest income on such loans, which is recorded as received, amountedto approximately $7,000, $17,000, and $19,000 for the years ended December 31,2003, 2002 and 2001, respectively.

 

Changesin the allowance for loan losses for the years ended December 31, are asfollows (in thousands):

 
|                            |   | **2003** |   | **2002** |   | **2001** |   |
|---------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                            |   |     |   |     |   |     |   |
| Balance, beginning of year      |   | $        | 2,953  |     | $      | 2,927    |   | $ | 2,879 |   |
| Provision charged to operations |   | 255      |   | 365      |   | 372      |   |
| Loans charged off               |   | (216     | )      | (402     | )      | (358     | )      |
| Recoveries                      |   | 77       |   | 63       |   | 34       |   |
| Balance, end of year            |   | $        | 3,069  |     | $      | 2,953    |   | $ | 2,927 |   |

 

TheCompany had no concentration of loans to borrowers engaged in similarbusinesses or activities which exceed five percent of total assets at December31, 2003 or December 31, 2002.

 

TheCompany grants commercial, industrial, residential, and installment loans tocustomers throughout north-central Pennsylvania.  Although the Company has a diversified loan portfolio at December31, 2003 and 2002, a substantial portion of its debtors’ ability to honor theircontracts is dependent on the economic conditions within this region.

 

**NOTE E - PREMISES ANDEQUIPMENT**

 

Majorclassifications of premises and equipment are summarized as follows at December31, (in thousands):

 
|                          |   | **2003** |   | **2002** |   |
|-------------------------------|--------|----------|--------|----------|--------|
|                          |   |     |   |     |   |
| Land                          |   | $        | 566    |     | $      | 566 |   |
| Premises                      |   | 4,883    |   | 4,855    |   |
| Furniture and equipment       |   | 6,348    |   | 6,001    |   |
| Leasehold improvements        |   | 867      |   | 842      |   |
| Total                         |   | 12,664   |   | 12,264   |   |
| Less accumulated depreciation |   | 8,039    |   | 7,408    |   |
| Net                           |   | $        | 4,625  |     | $      | 4,856 |   |

 

Depreciationcharges to operations for the years ended 2003, 2002 and 2001 was $631,000,$526,000, and $489,000, respectively.

 

**NOTE F – GOODWILL**

 

As ofDecember 31, 2003 and 2002, goodwill has a gross carrying value amount of$3,308,000 and an accumulated amortization amount of $276,000 resulting in anet carrying amount of $3,032,000.  Thegoodwill amortization for 2001 was $221,000 with a net income of $146,000 or$.04 per share resulting in an adjusted diluted earnings per share of $2.34.

 

The grosscarrying amount of goodwill is tested for impairment in the third quarter.  Based on fair value of the reporting unit,estimated using the expected present value of future cash flows, no goodwillimpairment loss was recognized in the current year.

 

48

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**NOTE G - DEPOSITS**

 

Time deposits of $100,000 or more totaled approximately$27,386,000 on December 31, 2003 and $29,126,000 on December 31, 2002.  Interest expense related to such depositswas approximately  $829,000, $1,098,000,and $1,913,000, for the years ended December 31, 2003, 2002 and 2001,respectively.

 

Maturitieson time deposits of $100,000 or more are as follows (in thousands):

 
|                        |   | **2003** |   |
|-----------------------------|--------|----------|--------|
|                        |   |     |   |
| Three months or less        |   | $        | 5,891  |   |
| Three months to six months  |   | 4,960    |   |
| Six months to twelve months |   | 5,427    |   |
| Over twelve months          |   | 11,108   |   |
|                        |   |     |   |
| Total                       |   | $        | 27,386 |   |

 

Time deposits at December 31, 2003 mature as follows: 2004 -$75,977,000; 2005 - $25,794,000; 2006 - $12,422,000; 2007 - $8,312,000; 2008 –$1,346,000; thereafter - $1,049,000.

 

##### **NOTE H - SHORT-TERM BORROWINGS**

 

Short-term borrowings consistof securities sold under agreements to repurchase and FHLB advances whichgenerally represent overnight or less than 30-day borrowings.  The outstanding balances and relatedinformation for short-term borrowings are summarized as follows (in thousands):

 
|                                        |   | **2003** |   | **2002** |   |
|---------------------------------------------|--------|----------|--------|----------|--------|
| **Repurchase Agreements:**                  |   |     |   |     |   |
| Balance at year end                         |   | $        | 10,225 |     | $      | 11,723 |   |
| Maximum amount outstanding at any month end |   | 15,665   |   | 20,870   |   |
| Average balance outstanding during the year |   | 13,214   |   | 14,819   |   |
| Weighted-average interest rate:             |   |     |   |     |   |
| At year end                                 |   | 1.91     | %      | 2.68     | %      |
| Paid during the year                        |   | 2.07     | %      | 3.17     | %      |
|                                        |   |     |   |     |   |
| **Open Repo Plus:**                         |   |     |   |     |   |
| Balance at year end                         |   | $        | 36,140 |     | $      | 1,840 |   |
| Maximum amount outstanding at any month end |   | 36,140   |   | 8,510    |   |
| Average balance outstanding during the year |   | 11,537   |   | 1,646    |   |
| Weighted-average interest rate:             |   |     |   |     |   |
| At year end                                 |   | 1.06     | %      | 1.31     | %      |
| Paid during the year                        |   | 1.16     | %      | 1.96     | %      |
|                                        |   |     |   |     |   |
| **Short-Term FHLB:**                        |   |     |   |     |   |
| Balance at year end                         |   | $        | 900    |     | $      | — |   |
| Maximum amount outstanding at any month end |   | 900      |   | —   |   |
| Average balance outstanding during the year |   | 695      |   | —   |   |
| Weighted-average interest rate:             |   |     |   |     |   |
| At year end                                 |   | 1.40     | %      | 0.00     | %      |
| Paid during the year                        |   | 1.42     | %      | 0.00     | %      |

 

49

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**NOTE I - OTHER BORROWINGS**

 

Otherborrowings are comprised of advances from the FHLB.  A schedule of other borrowings as of December 31, 2003 and 2002is summarized as follows (in thousands):

 
|            |   | **Maturity Range** |   | **Weighted  Int Rate** |   | **Stated Interest Rate** |     |   |   |   |     |
|-----------------|--------|--------------------|--------|------------------------|--------|--------------------------|----------|--------|--------|--------|----------|
| **Description** |   | **from**           |   | **to**                 |   |                     | **from** |   | **to** |   | **2003** |   | **2002** |   |
| Convertible     |   | 4/30/2007          |   | 3/25/2013              |   | 4.71                     | %        | 3.14   | %      | 6.65   | %        | $ | 64,600 |   | $ | 40,000 |   |
| Bullet Fixed    |   | 3/24/2005          |   | 3/26/2007              |   | 2.59                     | %        | 2.02   | %      | 3.13   | %        | 4,500 |   | — |   |
| Fixed           |   | 10/17/2011         |   | 5/26/2015              |   | 6.61                     | %        | 5.87   | %      | 6.92   | %        | 1,778 |   | 11,778 |   |
|            |   |               |   |                   |   |                     |     |   |   |   |     | $ | 70,878 |   | $ | 51,778 |   |

 

Maturitiesof other borrowings at December 31, 2003 are summarized as follows (inthousands) :

 
| **Year Ending** |   | **Amount** |   | **Weighted  Yield** |   |
|-----------------|--------|------------|--------|---------------------|--------|
| 2005            |   | $          | 1,400  |                | 2.02   | % |
| 2006            |   | 1,600      |   | 2.58                | %      |
| 2007            |   | 6,500      |   | 4.18                | %      |
| 2008            |   | 29,600     |   | 4.77                | %      |
| 2009 and after  |   | 31,778     |   | 4.79                | %      |
|            |   |       |   |                |   |
|            |   | $          | 70,878 |                | 4.72   | % |

 

Theterms of the convertible borrowings allow the Federal Home Loan Bank (“FHLB”)to convert the interest rate to an adjustable rate based on the three monthLondon Interbank Offered Rate (“LIBOR”) at a predetermined anniversary date ofthe borrowing’s origination, ranging from three months to five years.  These remaining conversion dates range fromFebruary 2004 through August 2005.

 

TheBank maintains a credit arrangement, which includes a revolving line of creditwith FHLB.  Under this creditarrangement, the Bank has a remaining borrowing capacity of approximately$166.9 million at December 31, 2003, is subject to annual renewal, andtypically incurs no service charges. Under terms of a blanket agreement, collateral for the FHLB borrowingsmust be secured by certain qualifying assets of the Bank which consistprincipally of first mortgage loans.

 

50

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**NOTE J - INCOMETAXES**

 

Thefollowing temporary differences gave rise to the net deferred tax liability atDecember 31, 2003 and 2002 (in thousands):

 
|                                              |   | **2003** |   | **2002** |   |
|---------------------------------------------------|--------|----------|--------|----------|--------|
| Deferred tax asset:                               |   |     |   |     |   |
| Allowance for loan losses                         |   | $        | 716    |     | $      | 693 |   |
| Deferred compensation                             |   | 346      |   | 337      |   |
| Contingencies                                     |   | 22       |   | 20       |   |
| Pension                                           |   | 429      |   | 371      |   |
| Loan fees and costs                               |   | 320      |   | 261      |   |
| Investment securities allowance                   |   | 119      |   | 92       |   |
| Total                                             |   | 1,952    |   | 1,774    |   |
|                                              |   |     |   |     |   |
| Deferred tax liability:                           |   |     |   |     |   |
| Bond accretion                                    |   | 28       |   | 31       |   |
| Depreciation                                      |   | 260      |   | 192      |   |
| Amortization                                      |   | 150      |   |     |   |
| Unrealized gains on available for sale securities |   | 3,159    |   | 2,650    |   |
| Total                                             |   | 3,597    |   | 2,873    |   |
|                                              |   |     |   |     |   |
| Deferred tax liability, net                       |   | $        | (1,645 | )        | $      | (1,099 | ) |

 

Novaluation allowance was established at December 31, 2003 and 2002, in the viewof the Company’s ability to carry back taxes paid in previous years and certaintax strategies, coupled with the anticipated future taxable income as evidencedby the Company’s earning potential.

 

The provision for income taxes is comprised of the following (inthousands):

 
|                       |   | **Year Ended  December 31,** |   |
|----------------------------|--------|------------------------------|--------|
|                       |   | **2003**                     |   | **2002** |   | **2001** |   |
|                       |   |                         |   |   |   |   |   |
| Currently payable          |   | $                            | 3,665  |   | $ | 2,363 |   | $ | 2,117 |   |
| Deferred expense (benefit) |   | 38                           |   | (116 | ) | (139 | ) |
|                       |   |                         |   |   |   |   |   |
| Total provision            |   | $                            | 3,703  |   | $ | 2,247 |   | $ | 1,978 |   |

 

Theeffective federal income tax rate for the years ended December 31, 2003, 2002,and 2001 was 24.9 percent, 20.2 percent, and 20.3 percent, respectively.  A reconciliation between the expected incometax  and the effective income tax rateon income before income tax provision follows (in thousands):

 
|                            |   | **2003**   |   | **2002** |   | **2001**   |   |
|---------------------------------|--------|------------|--------|----------|--------|------------|--------|
|                            |   | **Amount** |   | **%**    |   | **Amount** |   | **%** |   | **Amount** |   | **%** |   |
|                            |   |       |   |     |   |       |   |   |   |   |   |   |   |
| Provision at expected rate      |   | $          | 5,058  |     | 34.0   | %          | $      | 3,785 |   | 34.0 | % | $ | 3,305 |   | 34.0 | % |
| Decrease in tax resulting from: |   |       |   |     |   |       |   |   |   |   |   |   |   |
| Tax-exempt income               |   | (964       | )      | (6.4     | )      | (1,367     | )      | (12.3 | ) | (1,103 | ) | (11.4 | ) |
| Other, net                      |   | (391       | )      | (2.7     | )      | (171       | )      | (1.5 | ) | (224 | ) | (2.3 | ) |
|                            |   |       |   |     |   |       |   |   |   |   |   |   |   |
| Effective income tax and rates  |   | $          | 3,703  |     | 24.9   | %          | $      | 2,247 |   | 20.2 | % | $ | 1,978 |   | 20.3 | % |

 

51

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**NOTE K - EMPLOYEE BENEFIT PLANS**

 

Defined Benefit Pension Plan

 

TheCompany has a noncontributory defined benefit pension plan (the “Plan”) for allemployees meeting certain age and length of service requirements.  Benefits are based primarily on years ofservice and the average annual compensation during the highest five consecutiveyears within the final ten years of employment.

 

Thefollowing tables show the funded status and components of net periodic benefitcost from this defined benefit plan (in thousands):

 
|                                           |   | **2003** |   | **2002** |   |
|------------------------------------------------|--------|----------|--------|----------|--------|
| **Change in benefit obligation**               |   |     |   |     |   |
| Benefit obligation at beginning of year        |   | $        | 6,473  |     | $      | 4,976 |   |
| Service cost                                   |   | 443      |   | 381      |   |
| Interest cost                                  |   | 384      |   | 342      |   |
| Amendments                                     |   | —   |   | 97       |   |
| Actuarial loss                                 |   | 43       |   | 753      |   |
| Benefits paid                                  |   | (198     | )      | (76      | )      |
| Benefit obligation at end of year              |   | 7,145    |   | 6,473    |   |
|                                           |   |     |   |     |   |
| **Change in plan assets**                      |   |     |   |     |   |
| Fair value of plan assets at beginning of year |   | 3,131    |   | 3,115    |   |
| Actual return on plan assets                   |   | 620      |   | (384     | )      |
| Employer contribution                          |   | 506      |   | 499      |   |
| Benefits paid                                  |   | (198     | )      | (76      | )      |
| Expenses paid                                  |   | (17      | )      | (23      | )      |
| Fair value of plan assets at end of year       |   | 4,042    |   | 3,131    |   |
| Funded status                                  |   | (3,103   | )      | (3,342   | )      |
| Unrecognized net actuarial loss                |   | 1,609    |   | 1,996    |   |
| Unrecognized prior service cost                |   | 255      |   | 280      |   |
| Unrecognized tranisition asset                 |   | (22      | )      | (24      | )      |
| Net Accrued Benefit Cost Recognized            |   | $        | (1,261 | )        | $      | (1,090 | ) |

 

Theaccumulated benefit obligation for the defined benefit pension plan was$4,913,000 and $4,409,000 at December 31, 2003 and 2002, respectively.  Amounts recognized in the Statement ofIncome consist of (in thousands):

 
|                                 |   | **2003** |   | **2002** |   | **2001** |   |
|--------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                 |   |     |   |     |   |     |   |
| Service cost                         |   | 443      |   | 381      |   | 298      |   |
| Interest cost                        |   | 384      |   | 342      |   | 271      |   |
| Expected return on plan assets       |   | (256     | )      | (246     | )      | (286     | )      |
| Amortization of transition asset     |   | (3       | )      | (3       | )      | (3       | )      |
| Amortization of prior service cost   |   | 26       |   | 26       |   | 20       |   |
| Recognized net actuarial (gain) loss |   | 83       |   | 19       |   | (15      | )      |
| Net periodic benefit cost            |   | 677      |   | 519      |   | 285      |   |

 

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Thefollowing information relates to the Plan’s projected benefit obligation,accumulated benefit obligation, and Plan assets at December 31, (in thousands):

 
| Projected benefit obligation    |   | $     | 7,145  |   | $      | 6,473 |   |
|---------------------------------|--------|-------|--------|--------|--------|-------|--------|
| Accumulative benefit obligation |   | 4,913 |   | 4,409  |   |
| Fair vlaue of plan assets       |   | 4,042 |   | 3,131  |   |

 

**Assumptions**

 

Weighted-average assumptions used to determinebenefit obligations at December 31:

 
|                          |   | **2003** |   | **2002** |   | **2001** |   |
|-------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                          |   |     |   |     |   |     |   |
| Discount rate                 |   | 6.00     | %      | 6.00     | %      | 7.00     | %      |
| Rate of compensation increase |   | 5.00     |   | 5.00     |   | 5.00     |   |

 

Weighted-average assumptions used to determinenet periodic cost for years ended December 31:

 
|                                     |   | **2003** |   | **2002** |   | **2001** |   |
|------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                     |   |     |   |     |   |     |   |
| Discount rate                            |   | 6.00     | %      | 6.50     | %      | 7.00     | %      |
| Expected long-term return on plan assets |   | 8.00     |   | 8.00     |   | 8.00     |   |
| Rate of compensation increase            |   | 5.00     |   | 5.00     |   | 5.00     |   |

 

The expected long-term rate of return wasestimated using market benchmarks by which the plan assets would outperform themarket value in the future, based on historical experience adjusted for changesin asset allocation and expectations for overall lower future returns onsimilar investments compared to past periods.

 

**Plan Assets**

 

The Company’s pension plan weighted-average assetallocations at December 31 by asset category are as follows:

 
| **Asset Category**       |   | **2003** |   | **2002** |   |
|--------------------------|--------|----------|--------|----------|--------|
|                     |   |     |   |     |   |
| Cash                     |   | 0.6      | %      | 0.3      | %      |
| Fixed Income  securities |   | 38.7     | %      | 40.6     | %      |
| Equity                   |   | 60.7     | %      | 59.1     | %      |
| Total                    |   | 100.0    | %      | 100.0    | %      |

 

The investment objective for the defined pensionplan is to maximize total return with tolerance for slightly above averagerisk, meaning the fund is able to tolerate short-term volatility to achieveabove-average returns over the long term. The portfolio’s target exposure to equities is 60%, primarily investedin mid and large capitalization domestic equities. Exposure to smallcapitalization and international stocks may be allowed.

 

Asset allocation favors equities, with targetallocation of approximately 60% equity securities, 37.5% fixed incomesecurities and 2.5% cash.  Due toviolatility in the market, the target allocation is not always desirable andasset allocations will fluctuate between the acceptable ranges.

 

It is management’s intent to give the investmentmanagers flexibility within the overall guildlines with respect to investmentdecisions and their timing.  However,certain investments require specific review and approval by management.  Management is also informed of anticipated,significant modifications of any previously approved investment, or anticipateduse of derivatives to execute investment strategies.

 

53

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The following benefit payments, which reflectexpected future cost, are expected to be paid during the year ended December31, 2003 (in thousands):

 
| 2004        |   | 169   |   |
|-------------|--------|-------|--------|
| 2005        |   | 194   |   |
| 2006        |   | 241   |   |
| 2007        |   | 274   |   |
| 2008        |   | 275   |   |
| 2009 - 2013 |   | 2,130 |   |

 

The company expects to contribute $560,000 toits Pension Plan in 2004.

 

401(k) Savings Plan

 

The Company also offers a 401(k) savings plan inwhich eligible participating employees may elect to contribute up to a maximumpercentage allowable not to exceed the limits of Code Sections 401(k), 404, and415.  The Company may make matchingcontributions equal to a discretionary percentage to be determined by theCompany.  Participants are at all timesfully vested in their contributions and vest over a period of five years in theemployer contribution.  Contributionexpense was approximately $75,000, $80,000, and $65,000 for the years endedDecember 31, 2003, 2002, and 2001, respectively.

 

Deferred Compensation Plan

 

The Company has a deferred compensation planwhereby participating directors elected to forego directors’ fees for a periodof five years.  Under this plan, theCompany will make payments for a ten-year period beginning at age 65 in mostcases or at death, if earlier, at which time payments would be made to theirdesignated beneficiaries.

 

To fund benefits under the deferred compensation plan, the Company hasacquired corporate-owned life insurance policies on the lives of theparticipating directors for which insurance benefits are payable to theCompany.  The total expense charged toother expenses was $104,000, $98,000, and $67,000 for the years ended December31, 2003, 2002 and 2001, respectively. Benefits paid under the plan were approximately $132,000 in 2003, 51,000in 2002 and 51,000 in 2001.

 

**NOTE L - STOCK OPTIONS**

 

Prior to 1998, the Company granted a select groupof its officers options to purchase shares of its common stock.  These options, which are immediatelyexercisable, expire within three to ten years after having been granted.  Also, in 1998, the Company adopted the “1998Stock Option Plan” for key employees and directors.  Incentive stock options and nonqualified stock options may begranted to eligible employees of the Bank and nonqualified options may begranted to directors of the Company.  Inaddition, non-employee directors are eligible to receive grants of nonqualifiedstock options.  Incentive nonqualifiedstock options granted under the 1998 Plan may be exercised not later than tenyears after the date of grant.  Eachoption granted under the 1998 Plan shall be exercisable only after theexpiration of six months following the date of grant of such options.

 

54

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A summary of the status of the Company’s commonstock option plans are presented below:

 
|                            |   | **2003**   |   | **2002**                                |   |
|---------------------------------|--------|------------|--------|-----------------------------------------|--------|
|                            |   | **Shares** |   | **Weighted-  average  Exercise  Price** |   | **Shares** |   | **Weighted-  average  Exercise  Price** |   |
|                            |   |       |   |                                    |   |   |   |   |   |
| Outstanding, beginning of year  |   | 33,385     |   | $                                       | 38.69  |   | 45,651 |   | $ | 35.09 |   |
| Granted                         |   | —     |   | —                                  |   | — |   | — |   |
| Exercised                       |   | (2,778     | )      | 30.93                                   |   | (5,707 | ) | 23.62 |   |
| Forfeited                       |   | —     |   | —                                  |   | (6,559 | ) | 23.62 |   |
|                            |   |       |   |                                    |   |   |   |   |   |
| Outstanding, end of year        |   | 30,607     |   | $                                       | 39.39  |   | 33,385 |   | $ | 38.69 |   |
|                            |   |       |   |                                    |   |   |   |   |   |
| Options exercisable at year-end |   | 30,607     |   | $                                       | 39.39  |   | 33,385 |   | $ | 38.69 |   |

 

The following table summarizes information aboutnonqualified and incentive stock options outstanding at December 31, 2003:

 
|               |   | **Outstanding** |   | **Exercisable**   |   |
|--------------------|--------|-----------------|--------|-------------------|--------|
| **Exercise Price** |   | **Shares**      |   | **Average  Life** |   | **Average  Exercise  Price** |   | **Shares** |   | **Average  Exercise  Price** |   |
| $                  | 48.35  |            | 10,890 |              | 5      |   | $ | 48.35 |   | 10,890 |   | $ | 48.35 |   |
| $                  | 38.18  |            | 11,082 |              | 6      |   | $ | 38.18 |   | 11,082 |   | $ | 38.18 |   |
| $                  | 29.66  |            | 8,635  |              | 7      |   | $ | 29.66 |   | 8,635 |   | $ | 29.66 |   |

 

**NOTE M - RELATED PARTY TRANSACTIONS**

 

Certain directors and executive officers of the Company and the Bank,including their immediate families and companies in which they are principalowners (more than ten percent), are indebted to the Company.  Such indebtedness was incurred in theordinary course of business on the same terms and at those rates prevailing atthe time for comparable transactions with others.

 

A summary of loan activity with executiveofficers, directors, principal shareholders, and associates of such persons islisted below for the year ended December 31, 2003 (in thousands):

 
|   |   | **Beginning  Balance** |   | **Additions** |   | **Payments** |   | **Retired/  Resigned** |   | **Ending  Balance** |   |
|--------|--------|------------------------|--------|---------------|--------|--------------|--------|------------------------|--------|---------------------|--------|
|   |   |                   |   |          |   |         |   |                   |   |                |   |
| 2003   |   | $                      | 6,785  |          | $      | 2,374        |   | $                      | 1,791  |                | $      | 141 |   | $ | 7,227 |   |
|        |        |                        |        |               |        |              |        |                        |        |                     |        |  |  |  |  |  |

 

55

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**NOTE N - COMMITMENTS AND CONTINGENT LIABILITIES**

 

The following schedule of future minimum rental payments underoperating leases with noncancellable terms in excess of one year as of December31, 2003 (in thousands):

 

Year Ending December 31,

 
| 2004       |   | $   | 168    |   |
|------------|--------|-----|--------|--------|
| 2005       |   | 194 |   |
| 2006       |   | 241 |   |
| 2007       |   | 274 |   |
| 2008       |   | 275 |   |
| Thereafter |   | 53  |   |
| Total      |   | $   | 1,062  |   |

 

Total rental expense for all operating leases for the years endedDecember 31, 2003, 2002 and 2001 approximated $269,000, $258,000, and $270,000respectively.

 

The Company is subject to lawsuits and claimsarising out of its business.  In theopinion of management, after review and consultation with counsel, anyproceedings that may be assessed will not have a material adverse effect on theconsolidated financial position of the Company.

 

**NOTE O - OFF-BALANCE SHEET RISK**

 

The Company is a party to financial instrumentswith off-balance sheet risk in the normal course of business to meet thefinancing needs of its customers.  Thesefinancial instruments include commitments to extend credit and standby lettersof credit.  These instruments involve,to varying degrees, elements of credit, interest rate or liquidity risk inexcess of the amount recognized in the consolidated balance sheet.  The contract amounts of these instrumentsexpress the extent of involvement the Company has in particular classes offinancial instruments.

 

The Company’s exposure to credit loss fromnonperformance by the other party to the financial instruments for commitmentsto extend credit and standby letters of credit is represented by thecontractual amount of these instruments. The Company uses the same credit policies in making commitments andconditional obligations as it does for on-balance sheet instruments.

 

The Company may require collateral or othersecurity to support financial instruments with off-balance sheet credit risk.

 

Financial instruments whose contract amountsrepresent credit risk are as follows at December 31 (in thousands):

 
|                         |   | **2003** |   | **2002** |   |
|------------------------------|--------|----------|--------|----------|--------|
|                         |   |     |   |     |   |
| Commitments to extend credit |   | $        | 47,454 |     | $      | 29,497 |   |
|                         |   |     |   |     |   |
| Standby letters of credit    |   | $        | 258    |     | $      | 741 |   |

 

Commitments to extend credit are legally bindingagreements to lend to customers. Commitments generally have fixed expiration dates or other terminationclauses and may require payment of fees. Since many of the commitments are expected to expire without being drawnupon, the total commitment amounts do not necessarily represent futureliquidity requirements.  The Companyevaluates each customer’s credit worthiness on a case-by-case basis.  The amount of collateral obtained, if deemednecessary by the Company, on extension of credit is based on management’scredit assessment of the counterparty.

 

Standby letters of credit represent conditional commitments issued bythe Company to guarantee the performance of a customer to a third party.  These instruments are issued primarily tosupport bid or performance related contracts. The

 

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coverage period for these instruments is typically a one year periodwith an annual renewal option subject to prior approval by management.  Fees earned from the issuance of theseletters are recognized upon expiration of the coverage period.  For secured letters of credit, thecollateral is typically Bank deposit instruments or customer business assets.

 

**NOTE P - CAPITAL REQUIREMENTS**

 

Federal regulations require the Company and theBank to maintain minimum amounts of capital. Specifically, each is required to maintain certain minimum dollaramounts and ratios of Total and Tier 1 capital to risk-weighted assets and ofTier 1 capital to average total assets.

 

In addition to the capital requirements, theFederal Deposit Insurance Corporation Improvement Act (“FDICIA”) establishedfive capital categories ranging from “well capitalized” to “criticallyundercapitalized.”   Should any institutionfail to meet the requirements to be considered “adequately capitalized,” itwould become subject to a series of increasingly restrictive regulatoryactions.

 

As of December 31, 2003 and 2002, the FDICcategorized the Bank as well capitalized under the regulatory framework forprompt corrective action.  To beclassified as a well capitalized financial institution, Total risk-based, Tier1 risk-based and Tier 1 leverage capital ratios must be at least 10%, 6%, and5%, respectively.

 

The Company’s and the Bank’s actual capitalratios are presented in the following tables, which shows that both met allregulatory capital requirements.

 

57

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The Company’s actual capital amounts and ratiosare presented in the following table (in thousands):

 
|                                     |   | **2003**   |   | **2002**  |   |
|------------------------------------------|--------|------------|--------|-----------|--------|
|                                     |   | **Amount** |   | **Ratio** |   | **Amount** |   | **Ratio** |   |
| Total Capital (to Risk-weighted Assets)  |   |       |   |      |   |   |   |   |   |
|                                     |   |       |   |      |   |   |   |   |   |
| Actual                                   |   | $          | 66,820 |      | 23.0   | % | $ | 58,953 |   | 22.2 | % |
| For Capital Adequacy Purposes            |   | 23,225     |   | 8.0       |   | 21,236 |   | 8.0 |   |
| To Be Well Capitalized                   |   | 29,031     |   | 10.0      |   | 26,545 |   | 10.0 |   |
|                                     |   |       |   |      |   |   |   |   |   |
| Tier I Capital (to Risk-weighted Assets) |   |       |   |      |   |   |   |   |   |
|                                     |   |       |   |      |   |   |   |   |   |
| Actual                                   |   | $          | 60,547 |      | 20.9   | % | $ | 54,915 |   | 20.7 | % |
| For Capital Adequacy Purposes            |   | 11,613     |   | 4.0       |   | 10,618 |   | 4.0 |   |
| To Be Well Capitalized                   |   | 17,419     |   | 6.0       |   | 15,927 |   | 6.0 |   |
|                                     |   |       |   |      |   |   |   |   |   |
| Tier I Capital (to Average Assets)       |   |       |   |      |   |   |   |   |   |
|                                     |   |       |   |      |   |   |   |   |   |
| Actual                                   |   | $          | 60,547 |      | 11.6   | % | $ | 54,915 |   | 12.0 | % |
| For Capital Adequacy Purposes            |   | 20,922     |   | 4.0       |   | 18,310 |   | 4.0 |   |
| To Be Well Capitalized                   |   | 26,153     |   | 5.0       |   | 22,888 |   | 5.0 |   |

 

The Bank’s actual capital amounts and ratios are presented in thefollowing table (in thousands):

 
|                                     |   | **2003**   |   | **2002**  |   |
|------------------------------------------|--------|------------|--------|-----------|--------|
|                                     |   | **Amount** |   | **Ratio** |   | **Amount** |   | **Ratio** |   |
| Total Capital (to Risk-weighted Assets)  |   |       |   |      |   |   |   |   |   |
|                                     |   |       |   |      |   |   |   |   |   |
| Actual                                   |   | $          | 52,161 |      | 18.8   | % | $ | 47,232 |   | 18.3 | % |
| For Capital Adequacy Purposes            |   | 22,155     |   | 8.0       |   | 20,616 |   | 8.0 |   |
| To Be Well Capitalized                   |   | 27,693     |   | 10.0      |   | 25,770 |   | 10.0 |   |
|                                     |   |       |   |      |   |   |   |   |   |
| Tier I Capital (to Risk-weighted Assets) |   |       |   |      |   |   |   |   |   |
|                                     |   |       |   |      |   |   |   |   |   |
| Actual                                   |   | $          | 47,770 |      | 17.3   | % | $ | 43,723 |   | 17.0 | % |
| For Capital Adequacy Purposes            |   | 11,077     |   | 4.0       |   | 10,308 |   | 4.0 |   |
| To Be Well Capitalized                   |   | 16,616     |   | 6.0       |   | 15,462 |   | 6.0 |   |
|                                     |   |       |   |      |   |   |   |   |   |
| Tier I Capital (to Average Assets)       |   |       |   |      |   |   |   |   |   |
|                                     |   |       |   |      |   |   |   |   |   |
| Actual                                   |   | $          | 47,770 |      | 9.6    | % | $ | 43,723 |   | 9.7 | % |
| For Capital Adequacy Purposes            |   | 19,982     |   | 4.0       |   | 17,970 |   | 4.0 |   |
| To Be Well Capitalized                   |   | 24,978     |   | 5.0       |   | 22,462 |   | 5.0 |   |

 

**NOTE Q – REGULATORY RESTRICTIONS**

 

The Pennsylvania Banking Code restricts theavailability of capital funds for payment of dividend by all state-charteredbanks to the additional paid in capital of the Bank.  Accordingly, at December 31, 2003, the balance in the additionalpaid in capital account totaling approximately $11,700,000 is unavailable fordividends.

 

58

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The Bank is subject to regulatory restrictions,which limit its ability to loan funds to Penns Woods Bancorp, Inc.  At December 31, 2003, the regulatory lendinglimit amounted to approximately $5,081,000.

 

**Cash and Due from Banks**

 

Included in cash and due from banks are reservesrequired by the district Federal Reserve Bank of $1,151,000 and  $1,152,000 at December 31, 2003 and2002.  The required reserves arecomputed by applying prescribed ratios to the classes of average depositbalances.  These are held in the form ofcash on hand and a balance maintained directly with the Federal Reserve Bank.

 

**NOTE R - ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS**

 

The Company is required to disclose estimated fair values for itsfinancial instruments.  Fair valueestimates are made at a specific point in time, based on relevant marketinformation and information about the financial instrument.  These estimates do not reflect any premiumor discount that could result from offering for sale at one time the Company’sentire holdings of a particular financial instrument.  Also, it is the Company’s general practice and intention to holdmost of its financial instruments to maturity and not to engage in trading orsales activities.  Because no marketexists for a significant portion of the Company’s financial instruments, fairvalue estimates are based on judgments regarding future expected lossexperience, current economic conditions, risk characteristics of variousfinancial instruments and other factors. These estimates are subjective in nature and involve uncertainties andmatters of significant judgment and therefore cannot be determined withprecision.  Changes in assumptions cansignificantly affect the estimates.

 

Estimated fair values have been determined by theCompany using historical data and an estimation methodology suitable for eachcategory of financial instruments.  Theestimated fair value of the Company’s investment securities is described inNote A.  The Company’s fair valueestimates, methods, and assumptions are set forth below for the Company’s otherfinancial instruments.

 

As certain assets and liabilities, such asdeferred tax assets, premises and equipment, and many other operationalelements of the Company, are not considered financial instruments but havevalue, this estimated fair value of financial instruments would not representthe full market value of the Company.

 

The estimated fair values of the Company’s financial instruments are asfollows:

 
|                         |   | **2003**            |    | **2002**        |   |
|------------------------------|--------|---------------------|---------|-----------------|--------|
|                         |   | **Carrying  Value** |    | **Fair  Value** |   | **Carrying  Value** |   | **Fair  Value** |   |
| Financial assets:            |   |                |    |            |   |   |   |   |   |
| Cash and due from banks      |   | $                   | 10,230  |            | $      | 10,230 |   | $ | 11,731 |   | $ | 11,731 |   |
| Investment securitites:      |   |                |    |            |   |   |   |   |   |
| Available for sale           |   | 210,611             |    | 210,611         |   | 176,436 |   | 176,436 |   |
| Held to maturity             |   | 686                 |    | 701             |   | 1,181 |   | 1,289 |   |
| Loans held for sale          |   | 4,803               |    | 4,803           |   | 2,651 |   | 2,651 |   |
| Loans, net                   |   | 272,759             |    | 287,310         |   | 254,892 |   | 267,563 |   |
| Bank-owned life insurance    |   | 8,908               |    | 8,908           |   | 8,537 |   | 8,537 |   |
| Regulatory stock             |   | 6,588               |    | 6,588           |   | 3,963 |   | 3,963 |   |
| Accrued interest receivable  |   | 2,242               |    | 2,242           |   | 2,460 |   | 2,460 |   |
|                         |   |                |    |            |   |   |   |   |   |
| Financial liabilities:       |   |                |    |            |   |   |   |   |   |
| Interest-bearing deposits    |   | $                   | 269,443 |            | $      | 271,200 |   | $ | 272,787 |   | $ | 276,881 |   |
| Noninterest-bearing deposits |   | 64,875              |    | 64,875          |   | 67,061 |   | 67,061 |   |
| Short-term borrowings        |   | 47,265              |    | 47,265          |   | 13,563 |   | 13,563 |   |
| Other borrowings             |   | 70,878              |    | 73,107          |   | 51,778 |   | 56,384 |   |
| Accrued interest payable     |   | 836                 |    | 836             |   | 1,092 |   | 1,092 |   |

 

59

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**Cash anddue from banks, loans held for sale, regulatory stock, accrued interestreceivable, short-term borrowings, and accrued interest payable:**

 

The fair value is equal to the carrying value.

 

**Investment securities:**

 

The fair value of investment securities available for sale and held tomaturity is equal to the available quoted market price.  If no quoted market price is available, fairvalue is estimated using the quoted market price for similar securities.

 

**Loans:**

 

Fair values are estimated for portfolios of loanswith similar financial characteristics. Loans are segregated by type such as commercial, commercial real estate,residential real estate, contruction real estate, and other consumer.  Each loan category is further segmented intofixed and adjustable rate interest terms and by performing and nonperformingcategories.

 

The fair value of performing loans is calculatedby discounting scheduled cash flows through the estimated maturity usingestimated market discount rates that reflect the credit and interest rate riskinherent in the loan.  The estimate ofmaturity is based on the Company’s historical experience with repayments foreach loan classification, modified, as required, by an estimate of the effectof current economic and lending conditions.

 

Fair value for significant nonperforming loans isbased on recent external appraisals.  Ifappraisals are not available, estimated cash flows are discounted using a ratecommensurate with the risk associated with the estimated cash flows.  Assumptions regarding credit risk, cashflows, and discounted rates are judgmentally determined using available marketinformation and specific borrower information.

 

**Bank-OwnedLife Insurance:**

 

The fair value is equal to the Cash Surrender Value of life insurancepolicies.

 

**Deposits:**

 

The fair value of deposits with no statedmaturity, such as noninterest-bearing demand deposits, savings and NOWaccounts, and money market and checking accounts, is equal to the amountpayable on demand as of December 31, 2003 and 2002.  The fair value of certificates of deposit is based on thediscounted value of contractual cash flows.

 

The fair value estimates above do not include thebenefit that results from the low-cost funding provided by the depositliabilities compared to the cost of borrowing funds in the market, commonlyreferred to as the core deposit intangible.

 

**OtherBorrowings:**

 

The fair value of other borrowings is based on the discounted value ofcontractual cash flows.

 

**Commitmentsto Extend Credit, Standby Letters of Credit, and Financial Guarantees Written:**

 

There is no material difference between the notional amount and theestimated fair value of off-balance sheet items at December 31, 2003 and 2002respectively.  The contractual amountsof unfunded commitments and letters of credit are presented in Note O.

 

**NOTE S- PARENT COMPANY ONLY FINANCIAL STATEMENTS**

 

Condensed financial information for Penns WoodsBancorp, Inc. follows:

 

60

----

 

**CONDENSEDBALANCE SHEET, DECEMBER 31,**

 
|                                            |   | **2003**            |   | **2002** |   |
|-------------------------------------------------|--------|---------------------|--------|----------|--------|
|                                            |   | **(in  thousands)** |   |
| ASSETS                                          |   |                |   |     |   |
| Cash                                            |   | $                   | 369    |     | $      | 481 |   |
| Investment in subsidiaries:                     |   |                |   |     |   |
| Bank                                            |   | 54,133              |   | 51,019   |   |
| Nonbank                                         |   | 15,307              |   | 11,760   |   |
| Other assets                                    |   | 91                  |   | 20       |   |
|                                            |   |                |   |     |   |
| Total Assets                                    |   | $                   | 69,900 |     | $      | 63,280 |   |
|                                            |   |                |   |     |   |
| LIABILITIES AND SHAREHOLDERS’ EQUITY       |   |                |   |     |   |
| Other liabilities                               |   | $                   | 131    |     | $      | 138 |   |
| Shareholders’ equity                       |   | 69,769              |   | 63,142   |   |
|                                            |   |                |   |     |   |
| Total Liabilities and Shareholders’ Equity |   | $                   | 69,900 |     | $      | 63,280 |   |

 

**CONDENSEDSTATEMENT OF INCOME FOR THE YEARS ENDED DECEMBER 31,**

 
|                                               |   | **2003**            |   | **2002** |   | **2001** |   |
|----------------------------------------------------|--------|---------------------|--------|----------|--------|----------|--------|
|                                               |   | **(in  thousands)** |   |
| OPERATING INCOME                                   |   |                |   |     |   |     |   |
| Dividends from subsidiaries                        |   | $                   | 6,651  |     | $      | 4,878    |   | $ | 5,984 |   |
| Equity in undistributed net income of subsidiaries |   | 4,649               |   | 4,121    |   | 1,899    |   |
|                                               |   |                |   |     |   |     |   |
| OPERATING EXPENSES                                 |   | (126                | )      | (113     | )      | (141     | )      |
|                                               |   |                |   |     |   |     |   |
| NET INCOME                                         |   | $                   | 11,174 |     | $      | 8,886    |   | $ | 7,742 |   |

 

**CONDENSEDSTATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31,**

 
|                                                                               |   | **2003**            |   | **2002** |   | **2001** |   |
|------------------------------------------------------------------------------------|--------|---------------------|--------|----------|--------|----------|--------|
|                                                                               |   | **(in  thousands)** |   |     |
| OPERATING  ACTIVITIES                                                         |   |                |   |     |   |     |   |
| Net income                                                                         |   | $                   | 11,174 |     | $      | 8,886    |   | $ | 7,742 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |   |                |   |     |   |     |   |
| Equity in undistributed net income of subsidiaries                                 |   | (4,649              | )      | (4,121   | )      | (1,899   | )      |
| Other, net                                                                         |   | (64                 | )      | (23      | )      | (26      | )      |
| Net cash provided by operating activities                                          |   | 6,461               |   | 4,742    |   | 5,817    |   |
|                                                                               |   |                |   |     |   |     |   |
| INVESTING ACTIVITIES                                                               |   |                |   |     |   |     |   |
| Additional investment in subsidiaries                                              |   | (1,039              | )      | —   |   | (276     | )      |
|                                                                               |   |                |   |     |   |     |   |
| FINANCING ACTIVITIES                                                               |   |                |   |     |   |     |   |
| Dividends paid                                                                     |   | (5,001              | )      | (4,124   | )      | (3,729   | )      |
| Proceeds from exercise of stock options                                            |   | 87                  |   | 113      |   | 21       |   |
| Purchase/retirement of treasury stock                                              |   | (620                | )      | (401     | )      | (1,838   | )      |
| Net cash used for financing activities                                             |   | (5,534              | )      | (4,412   | )      | (5,546   | )      |
|                                                                               |   |                |   |     |   |     |   |
| NET INCREASE (DECREASE) IN CASH                                                    |   | (112                | )      | 330      |   | (5       | )      |
| CASH, BEGINNING OF YEAR                                                            |   | 481                 |   | 151      |   | 156      |   |
| CASH, END OF YEAR                                                                  |   | $                   | 369    |     | $      | 481      |   | $ | 151 |   |

 

61

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**NOTE T -CONSOLIDATED QUARTERLY FINANCIAL DATA (UNAUDITED)**

 
|                               |   | **FOR THE  THREE MONTHS ENDED  (in thoussands, except per share data)** |   |
|------------------------------------|--------|-------------------------------------------------------------------------|--------|
| **2003**                           |   | **March  31**                                                           |   | **June  30** |   | **September  30** |   | **December  31** |   |
|                               |   |                                                                    |   |   |   |   |   |   |   |
| Interest income                    |   | $                                                                       | 7,092  |   | $ | 7,251 |   | $ | 7,281 |   | $ | 7,428 |   |
| Interest expense                   |   | 2,386                                                                   |   | 2,395 |   | 2,327 |   | 2,157 |   |
|                               |   |                                                                    |   |   |   |   |   |   |   |
| Net interest income                |   | 4,706                                                                   |   | 4,856 |   | 4,954 |   | 5,271 |   |
|                               |   |                                                                    |   |   |   |   |   |   |   |
| Provision for loan losses          |   | 90                                                                      |   | 45 |   | 90 |   | 30 |   |
| Other income                       |   | 1,182                                                                   |   | 1,195 |   | 1,325 |   | 1,274 |   |
| Securities gains, net              |   | 101                                                                     |   | 1,750 |   | 1,247 |   | 561 |   |
| Other expenses                     |   | 3,139                                                                   |   | 3,186 |   | 3,290 |   | 3,675 |   |
|                               |   |                                                                    |   |   |   |   |   |   |   |
| Income before income tax provision |   | 2,760                                                                   |   | 4,570 |   | 4,146 |   | 3,401 |   |
| Income tax provision               |   | 573                                                                     |   | 1,233 |   | 1,135 |   | 762 |   |
|                               |   |                                                                    |   |   |   |   |   |   |   |
| Net income                         |   | $                                                                       | 2,187  |   | $ | 3,337 |   | $ | 3,011 |   | $ | 2,639 |   |
|                               |   |                                                                    |   |   |   |   |   |   |   |
| Earnings per share - basic         |   | $                                                                       | 0.72   |   | $ | 1.10 |   | $ | 1.00 |   | $ | 0.53 |   |
|                               |   |                                                                    |   |   |   |   |   |   |   |
| Earnings per share - diluted       |   | $                                                                       | 0.72   |   | $ | 1.10 |   | $ | 0.99 |   | $ | 0.54 |   |

 
|                               |   | **FOR THE  THREE MONTHS ENDED  (in thoussands, except per share data)** |   |
|------------------------------------|--------|-------------------------------------------------------------------------|--------|
| **2002**                           |   | **March  31**                                                           |   | **June  30** |   | **September  30** |   | **December  31** |   |
|                               |   |                                                                    |   |   |   |   |   |   |   |
| Interest income                    |   | $                                                                       | 7,076  |   | $ | 7,199 |   | $ | 7,399 |   | $ | 7,430 |   |
| Interest expense                   |   | 2,719                                                                   |   | 2,740 |   | 2,715 |   | 2,672 |   |
|                               |   |                                                                    |   |   |   |   |   |   |   |
| Net interest income                |   | 4,357                                                                   |   | 4,459 |   | 4,684 |   | 4,758 |   |
|                               |   |                                                                    |   |   |   |   |   |   |   |
| Provision for loan losses          |   | 105                                                                     |   | 80 |   | 90 |   | 90 |   |
| Other income                       |   | 1,401                                                                   |   | 1,317 |   | 1,231 |   | 1,271 |   |
| Securities gains (losses), net     |   | (119                                                                    | )      | (72 | ) | 281 |   | 143 |   |
| Other expenses                     |   | 2,952                                                                   |   | 3,056 |   | 3,070 |   | 3,135 |   |
|                               |   |                                                                    |   |   |   |   |   |   |   |
| Income before income tax provision |   | 2,582                                                                   |   | 2,568 |   | 3,036 |   | 2,947 |   |
| Income tax provision               |   | 485                                                                     |   | 528 |   | 660 |   | 574 |   |
|                               |   |                                                                    |   |   |   |   |   |   |   |
| Net income                         |   | $                                                                       | 2,097  |   | $ | 2,040 |   | $ | 2,376 |   | $ | 2,373 |   |
|                               |   |                                                                    |   |   |   |   |   |   |   |
| Earnings per share - basic         |   | $                                                                       | 0.62   |   | $ | 0.61 |   | $ | 0.71 |   | $ | 0.72 |   |
|                               |   |                                                                    |   |   |   |   |   |   |   |
| Earnings per share - diluted       |   | $                                                                       | 0.62   |   | $ | 0.61 |   | $ | 0.71 |   | $ | 0.72 |   |

 

**ITEM  9   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING ANDFINANCIAL DISCLOSURE**

 

None

 

62

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**ITEM 9A****     CONTROLS AND PROCEDURES**

 

The Company, under the supervision and with theparticipaton of the Company’s management, including the Company’s President andChief Executive Officer along with the Company’s Chief Finanical Officer, hasevaluated the effectiveness as of December 31, 2003 of the design and operationof the Company’s disclosure controls and procedures pursuant to Exchange ActRule 13a-14.  Based upon thatevaluation, the Company’s President and Chief Executive Officer along with theCompany’s Chief Financial Officer concluded that the Company’s disclosurecontrols and procedures are effective as of December 31, 2003 in timelyalerting them to material information relating to the Company (including its’consolidated subsidiaries) required to be included in the Company’s periodicSEC filing.  There have been nosignificant changes in the Company’s internal controls or in other factorswhich could significantly affect internal controls subsequent to the date theCompany carried out its’ evaluation.

 

**PART III**

 

**ITEM 10****   DIRECTORS AND EXECUTIVE OFFICERS OF THEREGISTRANT**

 

Information appearing in the Proxy Statement under the caption“Election of Directors” is incorporated herein by reference.   (a) Identification of directors.  The information appearing under the caption“Election of Directors” in the Company’s Proxy Statement dated March 23, 2003(at page 3 thereto) is incorporated herein by reference.

 

**ITEM 11****    EXECUTIVECOMPENSATION**

 

Information appearing under the caption “Executive Compensation” in theCompany’s Proxy Statement (at page 5 thereto) is incorporated herein byreference.

 

**ITEM 12****    SECURITY OWNERSHIP OF CERTAIN BENEFICIALOWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS**

 

The information appearing under the caption “Security Ownership ofCertain Beneficial Owners and Management” in the Company’s Proxy Statement (atpage 2 thereto) is incorporated herein by reference.

 

**Equity Compensation Plan Information**

 
| **Plan Category**                                           |   | **Number of  securities to be  issued upon  exercise of  outstanding options,  warrants and rights  (a)** |   | **Weighted-  average  exercise of  outstanding options,  warrants and rights  (b)** |   | **Number of  securities remaining  available for future  issuance under  equity compensation  plans (excluding  securities reflected in  column (a))  (c)** |   |
|-------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                        |   |                                                                                                      |   |                                                                                |   |                                                                                                                                                        |   |
| Equity  compensation plans approved by security holders     |   | 30,607                                                                                                    |   | $                                                                                   | 39.39  |                                                                                                                                                        | 0      |   |
|                                                        |   |                                                                                                      |   |                                                                                |   |                                                                                                                                                        |   |
| Equity  compensation plans not approved by security holders |   | 0                                                                                                         |   | 0                                                                                   |   | 0                                                                                                                                                           |   |
|                                                        |   |                                                                                                      |   |                                                                                |   |                                                                                                                                                        |   |
| Total                                                       |   | 30,607                                                                                                    |   | $                                                                                   | 39.39  |                                                                                                                                                        | 0      |   |

 

63

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**ITEM 13****    CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

 

There have been no material transactions between the Company and theBank, nor any material transactions proposed, with any Director or ExecutiveOfficer of the Company and the Bank, or any associate of the foregoingpersons.  The Company and the Bank havehad, and intend to continue to have, banking and financial transactions in theordinary course of business with Directors and Officers of the Company and theBank and their associates on comparable terms and with similar interest ratesas those prevailing from time to time for other customers of the Company andthe Bank.

 

Total loans outstanding from the Bank at December 31, 2003 to theCompany’s and the Bank’s Officers and Directors as a group and members of theirimmediate families and companies in which they had an ownership interest of 10%or more was $7,227,000 or approximately 13.4% of the total equity capital ofthe Company.  Loans to such persons weremade in the ordinary course of business, were made on substantially the sameterms, including interest rates and collateral, as those prevailing at the timefor comparable transactions with other persons, and did not involve more thanthe normal risk of collectability or present other unfavorable features.  See also the information appearing infootnote M to the Consolidated Financial Statements included elsewhere in theAnnual Report.

 

**ITEM 14****     PRINCIPAL ACCOUNTANT FEES & SERVICES**

 

The information appearing in the Proxy Statement underthe captions, “Audit Fees,” “Audit-Related Fees,” “Tax Fees,” “All Other Fees,”and “Audit Committee Pre-Approval Policies and Procedures” (at page 9) isincorporated herein by reference.

 

**PART IV**

** **

**ITEM 15****     EXHIBITS, FINANCIAL STATEMENT SCHEDULESAND**  **REPORTS ON FORM 8-K**

 

(a) Financial Statements

1.  Thefollowing consolidated financial statements and reports are set forth in Item8:

Report of Independent Auditors

Consolidated Balance Sheet

Consolidated Statement of Income

Consolidated Statement of Changes in Shareholders’Equity

Consolidated Statement of Cash Flows

Notes to the Consolidated Financial Statements

2.  Thefollowing  schedules is submittedherewith:

I.  Indebtedness of Related Parties

 

The schedules not included are omitted because the required matter orconditions are not present, the data is insignificant or the requiredinformation is submitted as part of the consolidated financial statements andnotes thereto.

 

(b) Reports on Form 8-K

 

None.

 

(c) Exhibits:

 

3(i)          Articles of Incorporation of the Registrant, as presently ineffect (incorporated by reference to Exhibit 3.1 of  the Registrant’s Registration Statement on Form S-4, No.333-65821).

3(ii)         Bylaws of theRegistrant as presently in effect (incorporated by reference to Exhibit 3.2 ofthe Registrant’s Registration Statement on Form S-4, No. 333-65821).

10(i)        Employment Agreement,dated August, 1991, between Jersey Shore State Bank and Ronald A. Walko(incorporated by reference to Exhibit 10.3 of the Registrant’s RegistrationStatement on form S-4, No. 333-65821).*

10(ii)       Employment Agreement,dated November 5, 1984, between Jersey Shore State Bank and Hubert A. Valencik(incorporated by reference to Exhibit (10)(iii) of the Registrant’s AnnualReport on Form 10-K for the fiscal year ended December 31, 2000).*

10(iii)      Employee SeveranceBenefit Plan, dated May 30, 1996, for Ronald A. Walko (incorporated byreference to Exhibit 10.4 of the Registrant’s Registration Statement on formS-4, No. 333-65821).*

 

64

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10(iv)      Employee SeveranceBenefit Plan, dated May 30, 1996, for Hubert A. Valencik (incorporated byreference to Exhibit (10)(v) of the Registrant’s Annual Report on Form 10-K forthe fiscal year ended December 31, 2000).*

10(v)       Penns Woods Bancorp,Inc. 1998 Stock Option Plan (incorporated by reference to Exhibit 10.1 of theRegistrant’s Registration Statement on form S-4, No. 333-65821).*

 
| 21     |   | Subsidiaries of the Registrant.                                         |
|--------|--------|-------------------------------------------------------------------------|
| 23     |   | Consent of Independent Certified Public Accountants.                    |
| 31(i)  |   | Rule 13a-14(a)/Rule 15d-14(a) Certification of Chief  Executive Officer |
| 31(ii) |   | Rule 13a-14(a)/Rule 15d-14(a) Certification of Chief  Financial Officer |
| 32(i)  |   | Section 1350   Certification of Chief Executive Officer            |
| 32(ii) |   | Section 1350   Certification of Chief Financial Officer            |

 

----

* Denotes compensatory plan or arrangement.

 

**EXHIBIT INDEX**

 
| 21     |   | Subsidiaries of the  Registrant.                                        |
|--------|--------|-------------------------------------------------------------------------|
| 23     |   | Consent of Independent Certified Public Accountants.                    |
| 31(i)  |   | Rule 13a-14(a)/Rule 15d-14(a) Certification of Chief  Executive Officer |
| 31(ii) |   | Rule 13a-14(a)/Rule 15d-14(a) Certification of Chief  Financial Officer |
| 32(i)  |   | Section 1350   Certification of Chief Executive Officer            |
| 32(ii) |   | Section 1350   Certification of Chief Financial Officer            |

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

 
|          | /s/ Ronald A. Walko                                                 |
|---------------|---------------------------------------------------------------------|
| March 4, 2004 | PENNS WOODS BANCORP, INC.                                           |
|          | BY:  RONALD  A. WALKO, President & Chief Executive Officer |

 

Pursuant to the requirements of the Securities and Exchange Act of1934, this report has been signed below by the following persons on behalf ofthe Registrant and in the capacities and on the dates indicated:

 

 
| /s/ Ronald A. Walko                                |   |          |
|----------------------------------------------------|--------|---------------|
| Ronald A. Walko, President, Chief Executive        |   | March 4, 2004 |
| Officer and Director                               |   |          |
|                                               |   |          |
| /s/ Sonya E. Scott                                 |   |          |
| Sonya E. Scott, Principal Accounting Officer & |   | March 4, 2004 |
| Principal Financial Officer                        |   |          |
|                                               |   |          |
| /s/ Phillip H. Bower                               |   |          |
| Phillip H. Bower, Director                         |   | March 4, 2004 |
|                                               |   |          |
| /s/ Lynn S. Bowes                                  |   |          |
| Lynn S. Bowes, Director                            |   | March 4, 2004 |

 

65

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| /s/ Michael J. Casale, Jr.                  |   |          |
|---------------------------------------------|--------|---------------|
| Michael J. Casale, Jr., Director            |   | March 4, 2004 |
|                                        |   |          |
| /s/ H. Thomas Davis, Jr.                    |   |          |
| H. Thomas Davis, Jr., Director              |   | March 4, 2004 |
|                                        |   |          |
| /s/ James M. Furey II                       |   |          |
| James M. Furey II, Director                 |   | March 4, 2004 |
|                                        |   |          |
| /s/ Jay H. McCormick                        |   |          |
| Jay H. McCormick, Director                  |   | March 4, 2004 |
|                                        |   |          |
| /s/ R. Edward Nestlerode, Jr.               |   |          |
| R. Edward Nestlerode, Jr., Director         |   | March 4, 2004 |
|                                        |   |          |
| /s/ James E. Plummer                        |   |          |
| James E. Plummer, Director                  |   | March 4, 2004 |
|                                        |   |          |
| /s/ William H. Rockey                       |   |          |
| William H. Rockey, Sr. Vice President & |   | March 4, 2004 |
| Director                                    |   |

 

66

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