** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, DC. 20549**

 

**FORM 10-K**

 
| **x** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|-------|------------------------------------------------------------------------------------------------------|

 

**For the fiscal year ended  December 31, 2008**

 

**OR**

 
| **o****** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE  REQUIRED)** |
|-----------|----------------------------------------------------------------------------------------------------------------------------|

 

**Commission file number  0-17077**

 

**PENNSWOODS BANCORP, INC.**

(Exact name of registrantas specified in its charter)

 

| **Pennsylvania**

State or other

jurisdiction of  incorporation or

organization | ** ** | **23-2226454**

(I.R.S.

Employer Identification

No.) |
|-----------------------------------------------------------------------------------|------------|--------------------------------------------------------|
| ** **                                                                        | ** ** | ** **                                             |
| **300  Market Street, P.O. Box 967  Williamsport, Pennsylvania**             | ** ** | **17703-0967**                                         |
| (Address of principal  executive offices)                                         | ** ** | (Zip Code)                                             |

 
| Registrant’s telephone number, including area code  (**570)  322-1111** |
|-----------------------------------------------------------------------------------|
|                                                                              |
| Securities registered pursuant to  Section 12(b) of the Act:            |

 

| **Title of each class**       | ** ** | **Name of each exchange which registered** |
|----------------------------------------------|------------|---------------------------------------------------------------------|
| **Common  Stock, par value $8.33 per share** | ** ** | **The NASDAQ  Stock Market LLC**                                    |

 

**Securities to be registered pursuant to Section 12(g) ofthe Act:**

 

**None**

(Title of Class)

 

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.

o Yes x No

 

Indicate by check mark if the registrant isnot required to file reports pursuant to Section 13 or Section 15(d) ofthe Act.

o Yes  x No

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.   Yes xNo o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not be contained,to the best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K orany amendment to this Form 10-K. x

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a nonaccelerated filer, or a smaller reportingcompany. See the definition of “large accelerated filer”,  “accelerated filer”, and “smaller reportingcompany” in Rule 12b-2 of the Exchange Act.
| Large accelerated filer o | Accelerated filer x | Non-accelerated filer o (Do not check if a smaller reporting company) | Smaller reporting company o |
|---------------------------|---------------------|-----------------------------------------------------------------------|-----------------------------|

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act). oYes  xNo

 

State the aggregate market value of the voting stock held bynon-affiliates of the registrant **$119,734,375 at June 30,2008.**

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date.

 

| **Class**                          | ** ** | **Outstanding at March 3, 2009** |
|------------------------------------|------------|------------------------------------------------------|
| **Common  Stock, $8.33 Par Value** | ** ** | **3,831,989  Shares**                                |

 

**DOCUMENTS INCORPORATED BYREFERENCE**

 

Portions of the registrant’s definitive proxy statement prepared inconnection with its annual meeting of shareholders to be held on April 29,2009 are incorporated by reference in Part III hereof.

 

 

 

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**PART I**

 

**ITEM 1                   BUSINESS**

**A. General Development ofBusiness and History**

On January 7, 1983, Penns Woods Bancorp, Inc.(the “Company”) was incorporated under the laws of the Commonwealth ofPennsylvania as a bank holding company. The Jersey Shore State Bank, aPennsylvania state-charted bank, (the “Bank”) became a wholly owned subsidiaryof the Company, and each outstanding share of Bank common stock was convertedinto one share of Company common stock. This transaction was approved by the shareholders of the Bank on April 11,1983 and was effective on July 12, 1983. The Company’s two other wholly-owned subsidiaries are Woods Real EstateDevelopment Company, Inc. and Woods Investment Company, Inc.  The Company’s business has consistedprimarily of managing and supervising the Bank, and its principal source ofincome has been dividends paid by the Bank and Woods Investment Company, Inc.

 

The Bank is engaged in commercial and retailbanking which includes the acceptance of time, savings, and demand deposits,the funding of commercial, consumer, and mortgage loans, and safe depositservices.  Utilizing a thirteen branchoffice network, ATMs, internet, and telephone banking delivery channels, theBank delivers its products and services to the communities it resides in.

 

In October 2000, the Bank acquired The MGroup, Inc. D/B/A The Comprehensive Financial Group (“The M Group”). The MGroup, which operates as a subsidiary of the Bank, offers insurance andsecurities brokerage services. Securities are offered by The M Group throughING Financial Partners, Inc., a registered broker-dealer.

 

Neither the Company nor the Bank anticipatesthat compliance with environmental laws and regulations will have any materialeffect on capital expenditures, 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 employed 192 persons as of December 31,2008 in either a full-time or part-time capacity.  The Company does not have any employees.  The principal officers of the Bank also serveas officers of the Company.

 

Woods Investment Company, Inc., aDelaware holding company, maintains an investment portfolio that is managed fortotal return and to fund dividend payments to the Company.

 

Woods Real Estate Development Company, Inc.serves the Company through its acquisition and ownership of certain propertiesutilized by the Bank.

 

A copy of the Code of Ethics and Code ofConduct for the Corporation can be requested from Brian Knepp, Chief FinancialOfficer, at 300 Market Street, Williamsport, PA 17701. A link with access tothe Corporation’s SEC filings, annual reports, and quarterly filings can befound at www.jssb.com.

 

**B. Regulation and Supervision**

The Company is also subject to the provisionsof the Bank Holding Company Act of 1956, as amended (the “BHCA”) and tosupervision and examination by the Board of Governors of the Federal ReserveSystem (the “FRB”).  The Bank is subjectto the supervision and examination by the Federal Deposit Insurance Corporation(the “FDIC”), as its primary federal regulator and as the insurer of the Bank’sdeposits.  The Bank is also regulated andexamined by the Pennsylvania Department of Banking (the “Department”).

 

The insurance activities of The M Group aresubject to regulation by the insurance departments of the various states inwhich The M Group conducts business including principally the PennsylvaniaDepartment of Insurance. The securities brokerage activities of The M Group aresubject to regulation by federal and state securities commissions.

 

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The FRB has issued regulations under the BHCAthat require a bank holding company to serve as a source of financial andmanagerial strength to its subsidiary banks. As a result, the FRB, pursuant to such regulations, may require theCompany to stand ready to use its resources to provide adequate capital fundsto the Bank during periods of financial stress or adversity.  The BHCA requires the Company to secure theprior approval of the FRB before it can acquire all or substantially all of theassets of any bank, or acquire ownership or control of 5% or more of any votingshares of any bank.  Such a transactionwould also require approval of the Department.

 

A bank holding company is prohibited underthe BHCA from engaging in, or acquiring direct or indirect control of, morethan 5% of the voting shares of any company engaged in non-banking activitiesunless the FRB, by order or regulation, has found such activities to be soclosely related to banking or managing or controlling banks as to be a properincident thereto.  Under the BHCA, theFRB has the authority to require a bank holding company to terminate anyactivity or relinquish control of a non-bank subsidiary (other than a non-banksubsidiary of a bank) upon the FRB’s determination that such activity orcontrol constitutes a serious risk to the financial soundness and stability ofany bank subsidiary of the bank holding company.

 

Bank holding companies are required to complywith the FRB’s risk-based capital guidelines. The risk-based capital rules are designed to make regulatorycapital requirements more sensitive to differences in risk profiles among banksand bank holding companies and to minimize disincentives for holding liquidassets.  Currently, the required minimumratio of total capital to risk-weighted assets (including certain off-balancesheet 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”) mayconsist of certain preferred stock, a limited amount of subordinated debt,certain hybrid capital instruments and other debt securities, 45% of netunrealized gains on marketable equity securities, and a limited amount of thegeneral loan loss allowance.  Therisk-based capital guidelines are required to take adequate account of interestrate risk, concentration of credit risk, and risks of nontraditionalactivities.

 

In addition to the risk-based capitalguidelines, the FRB requires each bank holding company to comply with theleverage ratio, under which the bank holding company must maintain a minimumlevel of Tier 1 capital to average total consolidated assets of 3% for thosebank holding companies which have the highest regulatory examination ratingsand are not contemplating or experiencing significant growth or expansion.  All other bank holding companies are expectedto maintain a leverage ratio of at least 4% to 5%. The Bank is subject to similarcapital requirements adopted by the FDIC.

 

**Dividends**

Federal and state law impose limitations onthe payment of dividends by the Bank. The Pennsylvania Banking Code restricts the availability of capitalfunds for payment of dividends by the Bank to its additional paid-in capital.

 

In addition to the dividend restrictionsdescribed above, the banking regulators have the authority to prohibit or tolimit the payment of dividends by the Bank if, in the banking regulator’sopinion, payment of a dividend would constitute an unsafe or unsound practicein light of the financial condition of the Bank.

 

Under Pennsylvania law, the Company may notpay a dividend, if, after giving effect thereto, it would be unable to pay itsdebts as they become due in the usual course of business and, after giving effectto the dividend, the total assets of the Company would be less than the sum ofits total liabilities plus the amount that would be needed, if the Company wereto be dissolved at the time of distribution, to satisfy the preferential rightsupon dissolution of shareholders whose rights are superior to those receivingthe dividend.

 

It is also the policy of the FRB that a bankholding company generally only pay dividends on common stock out of net incomeavailable to common shareholders over the past year and only if the prospectiverate of earnings retention appears consistent with a bank holding company’scapital needs, asset quality, and overall 

 

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financial condition.  In the current financial and economicenvironment, the FRB has indicated that bank holding companies should carefullyreview their dividend policy and has discouraged dividend pay-out ratios at the100% level unless both asset quality and capital are very strong.  A bank holding company also should notmaintain a dividend level that places undue pressure on the capital of suchinstitution’s subsidiaries, or that may undermine the bank holding company’sability to serve as a source of strength for such subsidiaries.

 

**C. Regulation of the Bank**

From time to time, various types of federaland state legislation have been proposed that could result in additionalregulation of, and restrictions of, the business of the Bank. It cannot bepredicted whether any such legislation will be adopted or how such legislationwould affect the business of the Bank. As a consequence of the extensive regulation of commercial bankingactivities in the United States, the Bank’s business is particularlysusceptible to being affected by federal legislation and regulations that mayincrease the costs of doing business.

 

**Prompt Corrective Action**

The FDIC has specified the levels at which aninsured institution will be considered “well-capitalized,” “adequatelycapitalized,” “undercapitalized,” and “critically undercapitalized.” In theevent an institution’s capital deteriorates to the “undercapitalized” categoryor below, the Federal Deposit Insurance Act (the “FDIA”) and FDIC regulationsprescribe an increasing amount of regulatory intervention, including: (1) theinstitution of a capital restoration plan by a bank and a guarantee of the planby a parent institution and liability for civil money damages for failure tofulfill its commitment on that guarantee; and (2) the placement of a holdon increases in assets, number of branches, or lines of business.  If capital has reached the significantly orcritically undercapitalized levels, further material restrictions can beimposed, including restrictions on interest payable on accounts, dismissal ofmanagement and (in critically undercapitalized situations) appointment of areceiver.  For well-capitalizedinstitutions, the FDIA provides authority for regulatory intervention where theinstitution is deemed to be engaging in unsafe or unsound practices or receivesa less than satisfactory examination report rating for asset quality,management, earnings or liquidity.

 

**Deposit Insurance**

The enactment of the Emergency EconomicStabilization Act of 2008 (“EESA”) temporarily raised the limit on federaldeposit insurance coverage from $100,000 to $250,000 per depositor.  The limits are scheduled to return to$100,000 on January 1, 2010. Additionally, the Bank has chosen toparticipate in the FDIC’s Temporary Liquidity Guarantee Program (TLGP) as itapplies to the FDIC guarantee of noninterest-bearing transaction accountdeposits of the Bank. In return for these guarantees, the FDIC is paid a feebased on the amount of the deposit. Under the transaction account guaranteecomponent of the TLGP, all noninterest-bearing transaction accounts maintainedat the Bank are insured in full by the FDIC until December 31, 2009,regardless of the standard maximum deposit insurance amount.

 

On February 27, 2009, the FDIC Board ofDirectors took further action to strengthen the Deposit Insurance Fund (“DIF”)by adopting an interim rule imposing a special assessment on insuredinstitutions of 20 basis points with the option of imposing an emergencyspecial assessment after June 30, 2009 of up to 10 basis points, adoptinga final rule implementing changes to the risk-based assessment system, andsetting assessment rates beginning with the second quarter of 2009.  The ultimate goal of these FDIC is to restorethe DIF reserve ratio to 1.15% within the next seven years.  The FDIC increased the DIF reserve ratiorestoration period from five to seven years due to recent economic pressuresimpacting banks and the financial system.

 

Assessment rates beginning April 1, 2009will increase.  Banks in the top tierrisk category currently pay any where from 12 cents per $100 of deposits to 14cents per $100 of deposits for FDIC insurance. FDIC insurance assessment ratesfor these banks will increase and will now include an initial base rate ofbetween 12 cents per $100 of deposits to 16 cents per $100 of deposits withhigher assessment rates for those institutions that rely significantly onsecured borrowings and brokered deposits. The FDIC will reduce assessment rates for smaller banks, banks with highlevels of tier 1 capital and banks that hold long-term unsecured debt.

 

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The Bank continues to be required to makepayments for the servicing of obligations of the Financing Corporation (FICO)that were issued in connection with the resolution of savings and loan associations,so long as such obligations remain outstanding.

 

**Federal Home Loan Bank System**

The Bank is a member of the Federal Home LoanBank of Pittsburgh (the “FHLB”), which is one of 12 regional Federal Home LoanBanks. Each Federal Home Loan Bank serves as a reserve or central bank for itsmembers within its assigned region.  Itis funded primarily from funds deposited by member institutions and proceedsfrom the sale of consolidated obligations of the Federal Home Loan Bank System.It makes loans to members (i.e., advances) in accordance with policies andprocedures established by the board of directors of the Federal Home LoanBank.  At December 31, 2008, theBank had $147,791,000 in FHLB advances.

 

As a member, the Bank is required to purchaseand maintain stock in the FHLB in an amount equal to the greater of 1% of itsaggregate unpaid residential mortgage loans, home purchase contracts or similarobligations at the beginning of each year or 5% of its outstanding advancesfrom the FHLB.  At December 31, 2008,the Bank had $7,101,000 million in stock of the FHLB which was in compliancewith this requirement.

 

**Emergency Economic StabilizationAct of 2008, Financial Stability Plan, American Recovery and Reinvestment Actof 2009, Homeowner Affordability and Stability Plan, and Other RegulatoryDevelopments**

 

***Emergency Economic StabilizationAct of 2008***

On October 3, 2008, EESA wasenacted.  EESA enables the federalgovernment, under terms and conditions to be developed by the Secretary of theTreasury, to insure troubled assets, including mortgage-backed securities, andcollect premiums from participating financial institutions.  EESA includes, among other provisions: (a) the$700 billion Troubled Assets Relief Program (TARP), under which the Secretaryof the Treasury is authorized to purchase, insure, hold, and sell a widevariety of financial instruments, particularly those that are based on orrelated to residential or commercial mortgages originated or issued on orbefore March 14, 2008; and (b) an increase in the amount of depositinsurance provided by the FDIC.

 

***Financial Stability Plan***

On February 10, 2009, the FinancialStability Plan (FSP) was announced by the U.S. Treasury Department.  The FSP is a comprehensive set of measuresintended to shore up the financial system. The core elements of the plan include making bank capital injections,creating a public-private investment fund to buy troubled assets, establishingguidelines for loan modification programs and expanding the Federal Reservelending program.  The U.S. TreasuryDepartment has indicated more details regarding the FSP are to be announced ona newly created government website, FinancialStability.gov, in the next severalweeks.  We continue to monitor thesedevelopments and assess their potential impact on our business.

 

***American Recovery andReinvestment Act of 2009***

On February 17, 2009, the AmericanRecovery and Reinvestment Act of 2009 (ARRA) was enacted.  ARRA is intended to provide a stimulus to theU.S. economy in the wake of the economic downturn brought about by the subprimemortgage crisis and the resulting credit crunch.  The bill includes federal tax cuts, expansionof unemployment benefits and other social welfare provisions, and domesticspending in education, healthcare, and infrastructure, including the energystructure.  The new law also includesnumerous non-economic recovery related items, including a limitation onexecutive compensation in federally aided banks.

 

***Homeowner Affordability andStability Plan***

On February 18, 2009, the HomeownerAffordability and Stability Plan (HASP) was announced by the President of theUnited States. HASP is intended to support a recovery in the housing market andensure that workers can continue to pay off their mortgages through thefollowing elements:

·              Provideaccess to low-cost refinancing for responsible homeowners suffering fromfalling home prices.

 

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·              A$75 billion homeowner stability initiative to prevent foreclosure and helpresponsible families stay in their homes.

·              Supportlow mortgage rates by strengthening confidence in Fannie Mae and Freddie Mac.

 

More details regarding HASP are expected tobe announced.  We continue to monitorthese developments and assess their potential impact on our business.

 

**Other Legislation**

The Fair and Accurate Credit Transactions Act(“FACT”) was signed into law on December 4, 2003.  This law extends the previously existing FairCredit Reporting Act.  New provisionsadded by FACT address the growing problem of identity theft. Consumers will beable to initiate a fraud alert when they are victims of identity theft, andcredit reporting agencies will have additional duties. Consumers will also beentitled to obtain free credit reports through the credit bureaus, and will begranted certain additional privacy rights.

 

The Sarbanes-Oxley Act of 2002 was enacted toenhance penalties for accounting and auditing improprieties at publicly tradedcompanies and to protect investors by improving the accuracy and reliability ofcorporate disclosures under the federal securities laws.  The Sarbanes-Oxley Act generally applies toall companies, including the Company, that file or are required to fileperiodic reports with the Securities and Exchange Commission under theSecurities Exchange Act of 1934, or the Exchange Act.  The legislation includes provisions, amongother things, governing the services that can be provided by a public company’sindependent auditors and the procedures for approving such services, requiringthe chief executive officer and principal accounting officer to certify certainmatters relating to the company’s periodic filings under the Exchange Act,requiring expedited filings of reports by insiders of their securitiestransactions and containing other provisions relating to insider conflicts ofinterest, increasing disclosure requirements relating to critical financialaccounting policies and their application, increasing penalties for securitieslaw violations, and creating a new public accounting oversight board, aregulatory body subject to SEC jurisdiction with broad powers to set auditing,quality control, and ethics standards for accounting firms.  In response to the legislation, the nationalsecurities exchanges and NASDAQ have adopted new rules relating to certainmatters, including the independence of members of a company’s audit committeeas a condition to listing or continued listing.

 

In addition, Congress is often consideringsome financial industry legislation. The Company cannot predict how any newlegislation, or new rules adopted by the federal banking agencies, mayaffect its business in the future.

 

In addition to federal banking law, the Bankis subject to the Pennsylvania Banking Code. The Banking Code was amended inlate 2000 to provide more complete “parity” in the powers of state-charteredinstitutions compared to national banks and federal savings banks doingbusiness in Pennsylvania. Pennsylvania banks have the same ability to formfinancial subsidiaries authorized by the Gramm-Leach-Bliley Act, as do nationalbanks.

 

**Environmental Laws**

Environmentally related hazards have become asource of high risk and potential liability for financial institutions relatingto their loans. Environmentally contaminated properties owned by an institution’sborrowers may result in a drastic reduction in the valueof the collateral securing the institution’sloans to such borrowers, high environmental clean up costs to the borroweraffecting its ability to repay the loans, the subordination of any lien infavor of the institution to a state or federal lien securing clean up costs,and liability to the institution for clean up costs if it forecloses on the contaminatedproperty or becomes involved in the management of the borrower. The Company isnot aware of any borrower who is currently subject to any environmentalinvestigation or clean up proceeding which is likely to have a material adverseeffect on the financial condition or results of operations of the Company.

 

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**Effect of Government MonetaryPolicies**

The earnings of the Company are and will beaffected by domestic economic conditions and the monetary and fiscal policiesof the United States Government and its agencies.   The monetary policies of the FRB have had,and will likely continue to have, an important impact on the operating resultsof commercial banks through its power to implement national monetary policy inorder, among other things, to curb inflation or combat a recession. The FRB hasa major effect upon the levels of bank loans, investments, and deposits throughits open market operations in the United States Government securities andthrough its regulation of, among other things, the discount rate on borrowingof member banks 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.

 

**DESCRIPTION OF BANK**

**History and Business**

Jersey Shore State Bank (“Bank”) wasincorporated under the laws of the Commonwealth of Pennsylvania as a state bankin 1934 and became a wholly owned subsidiary of the Company on July 12,1983.

 

As of December 31, 2008, the Bank hadtotal assets of $643,302,000; total shareholders’ equity of $49,327,000 andtotal deposits of $423,411,000. The Bank’s deposits are insured by the FederalDeposit Insurance Corporation for the maximum amount provided under currentlaw.

 

The Bank engages in business as a commercialbank, doing business at several locations in Lycoming, Clinton, and CentreCounties, Pennsylvania.  The Bank offersinsurance, securities brokerage services, annuity and mutual fund investmentproducts, and financial planning through its wholly owned subsidiary, The MGroup, Inc. D/B/A The Comprehensive Financial Group.

 

Services offered by the Bank includeaccepting time, demand and savings deposits including Super NOW accounts,statement savings accounts, money market accounts, fixed rate certificates ofdeposit, and club accounts.  Its servicesalso include making secured and unsecured business and consumer loans thatinclude financing commercial transactions as well as construction andresidential mortgage loans and revolving credit loans with overdraftprotection.

 

The Bank’s loan portfolio mix can beclassified into four principal categories. These are real estate, agricultural, commercial, and consumer.  Real estate loans can be further segmentedinto construction and land development, farmland, one-to-four familyresidential, multi-family, and commercial or industrial.  Qualified borrowers are defined by policy andour underwriting standards. Owner provided equity requirements range from 20%to 30% with a first lien status required. Terms are generally restricted to between 10 and 20 years with theexception of construction and land development, which are limited to one tofive years.  Real estate appraisals,property construction verifications, and site visitations comply with policyand industry regulatory standards.

 

Prospective residential mortgage customer’srepayment ability is determined from information contained in the applicationand recent income tax returns.  Emphasisis on credit, employment, income, and residency verification.  Broad hazard insurance is always required andflood insurance where applicable.  In thecase of construction mortgages, builders risk insurance is requested.

 

Agricultural loans for the purchase orimprovement of real estate must meet the Bank’s real estate underwritingcriteria.  The only permissible exceptionis when a Farmers Home Loan Administration guaranty is obtained.  Agricultural loans made for the purchase ofequipment are usually payable in five years, but never more than seven,depending upon the useful life of the purchased asset. Minimum borrower equityranges from 20% to 30%.  Livestockfinancing criteria depends upon the nature of the operation. Agricultural loansare also made for crop production purposes. Such loans are structured to repay within the production cycle and notcarried over into a subsequent year.

 

Commercial loans are made for the acquisitionand improvement of real estate, purchase of equipment, and for working capitalpurposes on a seasonal or revolving basis. General purpose working capital loans are also 

 

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available with repayment expected within oneyear.  Equipment loans are generallyamortized over three to seven years, with an owner equity contribution requiredof at least 20% of the purchase price. Insurance coverage with the Bank as losspayee is required, especially in the case where the equipment is rolling stock.It is also a general policy to collateralize non-real estate loans with theasset purchased and, dependant upon loan terms, junior liens are filed on otheravailable assets.  Financial informationrequired on all commercial mortgages includes the most current three yearsbalance sheets and income statements and projections on income to be developedthrough the project. In the case of corporations and partnerships, theprincipals are often asked to indebt themselves personally as well.

 

Seasonal and revolving lines of credit areoffered for working capital purposes. Collateral for such a loan includes the pledge of inventory and/orreceivables.  Drawing availability isusually 50% of inventory and 75% of eligible receivables.  Eligible receivables are defined as invoicesless than 90 days delinquent.  Exclusivereliance is very seldom placed on such collateral; therefore, other lienableassets are also taken into the collateral pool. Where reliance is placed on inventory and accounts receivable, theapplicant must provide financial information including agings on a monthlybasis.  In addition, the guaranty of theprincipals is usually obtained.

 

Letter of Credit availability is limited tostandbys where the customer is well known to the Bank.  Credit criteria is the same as that utilizedin making a direct loan. Collateral is obtained in most cases, and whenever theexpiration date is beyond one year.

 

Consumer loan products include secondmortgages, automobile financing, small loan requests, overdraft check lines,and PHEAA referral loans.  Our policyincludes standards used in the industry on debt service ratios and terms areconsistent with prudent underwriting standards and the use of proceeds.Verifications are made of employment and residency, along with credit history.

 

Second mortgages are confined to equityborrowing and home improvements.  Termsare generally ten years or less and rates are fixed.  Loan to collateral value criteria is 80% orless and verifications are made to determine values.   Automobile financing is generally restrictedto five years and done on a direct basis. The Bank, as a practice, does not floor plan and therefore does notdiscount dealer paper.  Small loanrequests are to accommodate personal needs such as the purchase of smallappliances or for the payment of taxes. Overdraft check lines are limited to $5,000 or less.

 

The Bank’s investment portfolio is analyzedand priced on a monthly basis. Investments are made in U.S. Treasuries, U.S.Agency issues, bank qualified municipal bonds, corporate bonds, and corporatestocks which consist of Pennsylvania bank stocks.  Bonds with BAA or better ratings are used,unless a local issue is purchased that has a lesser or no rating.  Factors taken into consideration wheninvestments are purchased include liquidity, the Company’s tax position, taxequivalent yield, third party investment ratings, and the policies of theAsset/Liability Committee.

 

The banking environment in Lycoming, Clinton,and Centre Counties, Pennsylvania is highly competitive.  The Bank operates thirteen full serviceoffices in these markets and competes for loans and deposits with numerouscommercial banks, savings and loan associations, and other financialinstitutions. The economic base of the region is developed around smallbusiness, health care, educational facilities (college and public schools),light manufacturing industries, and agriculture.

 

The Bank has a relatively stable deposit baseand no material amount of deposits is obtained from a single depositor or groupof depositors, excluding public entities that account for approximately 10% oftotal 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 or intermediate or longer-term investments.

 

The Bank has not experienced any significantseasonal fluctuations in the amount of its deposits.

 

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**Supervision and Regulation**

The earnings of the Bank are affected by thepolicies of regulatory authorities including the FDIC and the FRB. An importantfunction of the FRB is to regulate the money supply and interest rates.  Among the instruments used to implement theseobjectives are open market operations in U.S. Government Securities, changes inreserve requirements against member bank deposits, and limitations on interestrates that member banks may pay on time and savings deposits.  These instruments are used in varyingcombinations to influence overall growth and distribution of bank loans,investments on deposits, and their use may also affect interest rates chargedon loans or paid for deposits.

 

The policies and regulations of the FRB havehad and will probably continue to have a significant effect on the Bank’sdeposits, loans and investment growth, as well as the rate of interest earnedand paid, and are expected to affect the Bank’s operation in the future. Theeffect of such policies and regulations upon the future business and earningsof the Bank cannot accurately be predicted.

 

**ITEM 1A                RISK FACTORS**

The following sets forth several risk factorsthat are unique to the Company.

 

**Changes in interest rates couldreduce our income, cash flows and asset values.**

Our income and cash flows and the value ofour assets depend to a great extent on the difference between the interestrates we earn on interest-earning assets, such as loans and investmentsecurities, and the interest rates we pay on interest-bearing liabilities suchas deposits and borrowings.  These ratesare highly sensitive to many factors which are beyond our control, includinggeneral economic conditions and policies of various governmental and regulatoryagencies and, in particular, the Board of Governors of the Federal ReserveSystem. Changes in monetary policy, including changes in interest rates, willinfluence not only the interest we receive on our loans and investmentsecurities and the amount of interest we pay on deposits and borrowings butwill also affect our ability to originate loans and obtain deposits and thevalue of our investment portfolio.  Ifthe rate of interest we pay on our deposits and other borrowings increases morethan the rate of interest we earn on our loans and other investments, our netinterest income, and therefore our earnings, could be adversely affected.  Our earnings also could be adversely affectedif the rates on our loans and other investments fall more quickly than those onour deposits and other borrowings.

 

**Economic conditions eithernationally or locally in areas in which our operations are concentrated mayadversely affect our business.**

Deterioration in local, regional, national orglobal economic conditions could cause us to experience a reduction in depositsand new loans, an increase in the number of borrowers who default on theirloans and a reduction in the value of the collateral securing their loans, allof which could adversely affect our performance and financial condition. Unlikelarger banks that are more geographically diversified, we provide banking andfinancial services locally. Therefore, we are particularly vulnerable toadverse local economic conditions.

 

**Our financial condition andresults of operations would be adversely affected if our allowance for loanlosses is not sufficient to absorb actual losses or if we are required to increaseour allowance.**

Despite our underwriting criteria, we mayexperience loan delinquencies and losses. In order to absorb losses associated with nonperforming loans, wemaintain an allowance for loan losses based on, among other things, historicalexperience, an evaluation of economic conditions, and regular reviews ofdelinquencies and loan portfolio quality. Determination of the allowance inherently involves a high degree ofsubjectivity and requires us to make significant estimates of current creditrisks and future trends, all of which may undergo material changes.  At any time there are likely to be loans inour portfolio that will result in losses but that have not been identified asnonperforming or potential problem credits. We cannot be sure that we will beable to identify deteriorating credits before they become nonperforming assetsor that we will be able to limit losses on those loans that are identified. Wemay be required to increase our allowance for loan losses for any of severalreasons.  Federal regulators, inreviewing our loan portfolio as part of a regulatory examination, may requestthat we increase our allowance for loan losses. Changes in economic conditions affecting borrowers, new 

 

9

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information regarding existing loans,identification of additional problem loans and other factors, both within andoutside of our control, may require an increase in our allowance.  In addition, if charge-offs in future periodsexceed our allowance for loan losses, we will need additional increases in ourallowance for loan losses.  Any increasesin our allowance for loan losses will result in a decrease in our net incomeand, possibly, our capital, and may materially affect our results of operationsin the period in which the allowance is increased.

 

**Many of our loans are secured, inwhole or in part, with real estate collateral which is subject to declines invalue.**

In addition to considering the financialstrength and cash flow characteristics of a borrower, we often secure our loanswith real estate collateral. Real estate values and the real estate market aregenerally affected by, among other things, changes in local, regional ornational economic conditions, fluctuations in interest rates and theavailability of loans to potential purchasers, changes in tax laws and othergovernmental statutes, regulations and policies, and acts of nature.  The real estate collateral provides analternate source of repayment in the event of default by the borrower.  If real estate prices in our markets decline,the value of the real estate collateral securing our loans could be reduced. Ifwe are required to liquidate real estate collateral securing loans during aperiod of reduced real estate values to satisfy the debt, our earnings andcapital could be adversely affected.

 

**Competition may decrease ourgrowth or profits.**

We face substantial competition in all phasesof our operations from a variety of different competitors, including commercialbanks, savings and loan associations, mutual savings banks, credit unions,consumer finance companies, factoring companies, leasing companies, insurancecompanies, and money market mutual funds. There is very strong competition among financial services providers inour principal service area.  Ourcompetitors may have greater resources, higher lending limits, or larger branchsystems than we do.  Accordingly, theymay be able to offer a broader range of products and services as well as betterpricing for those products and services than we can.

 

In addition, some of the financial servicesorganizations with which we compete are not subject to the same degree ofregulation as is imposed on federally insured financial institutions.  As a result, those nonbank competitors may beable to access funding and provide various services more easily or at less costthan we can, adversely affecting our ability to compete effectively.

 

**The value of certain investmentsecurities is volatile and future declines or other-than-temporary impairmentscould materially adversely affect our future earnings and regulatory capital.**

Continued volatility in the market value forcertain of our investment securities, whether caused by changes in marketperceptions of credit risk, as reflected in the expected market yield of thesecurity, or actual defaults in the portfolio could result in significantfluctuations in the value of the securities. This could have a material adverseimpact on our accumulated other comprehensive loss and shareholders’ equity dependingon the direction of the fluctuations. Furthermore, future downgrades ordefaults in these securities could result in future classifications ofinvestment securities as other than temporarily impaired. This could have amaterial impact on our future earnings, although the impact on shareholders’equity will be offset by any amount already included in other comprehensiveincome for securities where we have recorded temporary impairment.

 

**We may be adversely affected bygovernment regulation.**

The banking industry is heavily regulated.Banking regulations are primarily intended to protect the federal depositinsurance funds and depositors, not shareholders. Changes in the laws,regulations, and regulatory practices affecting the banking industry may increaseour costs of doing business or otherwise adversely affect us and createcompetitive advantages for others. Regulations affecting banks and financialservices companies undergo continuous change, and we cannot predict theultimate effect of these changes, which could have a material adverse effect onour profitability or financial condition.

 

10

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**We rely on our management andother key personnel, and the loss of any of them may adversely affect ouroperations.**

We are and will continue to be dependent uponthe services of our executive management team. In addition, we will continue todepend on our ability to retain and recruit key commercial loan officers. Theunexpected loss of services of any key management personnel or commercial loanofficers could have an adverse effect on our business and financial conditionbecause of their skills, knowledge of our market, years of industry experience,and the difficulty of promptly finding qualified replacement personnel.

 

**Environmental liabilityassociated with lending activities could result in losses.**

In the course of our business, we mayforeclose on and take title to properties securing our loans.  If hazardous substances were discovered onany of these properties, we could be liable to governmental entities or thirdparties for the costs of remediation of the hazard, as well as for personalinjury and property damage.  Manyenvironmental laws can impose liability regardless of whether we knew of, orwere responsible for, the contamination. In addition, if we arrange for the disposal of hazardous or toxicsubstances at another site, we may be liable for the costs of cleaning up andremoving those substances from the site even if we neither own nor operate thedisposal site.  Environmental laws mayrequire us to incur substantial expenses and may materially limit use ofproperties we acquire through foreclosure, reduce their value or limit ourability to sell them in the event of a default on the loans they secure.  In addition, future laws or more stringentinterpretations or enforcement policies with respect to existing laws mayincrease our exposure to environmental liability.

 

**Failure to implement newtechnologies in our operations may adversely affect our growth or profits.**

The market for financial services, includingbanking services and consumer finance services is increasingly affected byadvances in technology, including developments in telecommunications, dataprocessing, computers, automation, Internet-based banking, and telebanking. Ourability to compete successfully in our markets may depend on the extent towhich we are able to exploit such technological changes. However, we canprovide no assurance that we will be able to properly or timely anticipate orimplement such technologies or properly train our staff to use suchtechnologies.  Any failure to adapt tonew technologies could adversely affect our business, financial condition oroperating results.

 

**An investment in our common stockis not an insured deposit.**

Our common stock is not a bank deposit and,therefore, is not insured against loss by the Federal Deposit InsuranceCorporation, commonly referred to as the FDIC, any other deposit insurance fundor by any other public or private entity. Investment in our common stock is subject to the same market forces thataffect the price of common stock in any company.

 

**ITEM 1B – UNRESOLVED STAFF COMMENTS**

None.

 

**ITEM 2                   PROPERTIES**

The Company owns and leases itsproperties.  Listed herewith are thelocations of properties owned or leased as of December 31, 2008, in whichthe banking offices are located; all properties are in good condition and adequatefor the Bank’s purposes:

 
| **Office**    | ** ** | **Address**                      | ** ** | **Ownership** |
|---------------|------------|----------------------------------|------------|---------------|
| 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               |       | Owned         |
|          |       | Williamsport, Pennsylvania 17702 |       |          |

 

11

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| Williamsport           |   | 300 Market Street                            |   | Owned            |
|------------------------|--------|----------------------------------------------|--------|------------------|
|                   |   | P.O. Box 967                            |   |             |
|                   |   | Williamsport, Pennsylvania 17703-0967        |   |             |
|                   |   |                                         |   |             |
| Montgomery             |   | 9094 Rt. 405 Highway                         |   | Owned            |
|                   |   | Montgomery, Pennsylvania 17752               |   |             |
|                   |   |                                         |   |             |
| Lock Haven             |   | 4 West Main Street                           |   | Owned            |
|                   |   | Lock Haven, Pennsylvania 17745               |   |             |
|                   |   |                                         |   |             |
| Mill Hall              |   | (Inside Wal-Mart), 173 Hogan Boulevard       |   | Under Lease      |
|                   |   | Mill Hall, Pennsylvania 17751                |   |             |
|                   |   |                                         |   |             |
| Spring Mills           |   | 3635 Penns Valley 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               |   |             |
|                   |   |                                         |   |             |
| State College          |   | (Inside Wal-Mart), 1665 North Atherton Place |   | Under Lease      |
|                   |   | State College, Pennsylvania 16803            |   |             |
|                   |   |                                         |   |             |
| State College          |   | 2050 North Atherton  Street                  |   | Land Under Lease |
|                   |   | State College, Pennsylvania 16803            |   |             |
|                   |   |                                         |   |             |
| Montoursville          |   | 820 Broad Street                             |   | Under Lease      |
|                   |   | Montoursville, Pennsylvania 17754            |   |             |
|                   |   |                                         |   |             |
| The M Group, Inc. |   | 705 Washington Boulevard                     |   | Under Lease      |
| D/B/A The              |   | Williamsport, Pennsylvania 17701             |   |             |
| Comprehensive          |   |                                         |   |             |
| Financial Group        |   |                                         |   |             |

 

**ITEM 3                   LEGALPROCEEDINGS**

 

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.

 

**ITEM 4                   SUBMISSION OF MATTERS TO AVOTE OF SECURITY HOLDERS**

No matters were submitted to a vote ofsecurity holders during the fourth quarter of 2008.

 

12

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##### **PART II**

##### ** **

| **ITEM 5** | ** ** | **MARKET FOR THE REGISTRANT’S COMMON STOCK,  RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES** |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------|

 

The Common Stock is listed on the NASDAQ Global Select Market under thesymbol “PWOD”.  The following table setsforth (1) the quarterly high and low close prices for a share of theCompany’s Common Stock during the periods indicated, and (2) quarterlydividends on a share of the Common Stock with respect to each quarter since January 1,2006.  The following quotations representprices between buyers and sellers and do not include retail markup, markdown orcommission.  They may not necessarilyrepresent actual transactions.

 
| ** **     | ** ** | ** ** | ** ** | ** ** | ** ** | **Dividends** | ** ** |
|----------------|------------|------------|------------|------------|------------|---------------|------------|
| ** **     | ** ** | **High**   | ** ** | **Low**    | ** ** | **Declared**  | ** ** |
| **2006**       |       |       |       |       |       |          |       |
| First quarter  |       | $          | 38.75      |       | $          | 37.75         |       | $ | 0.42 |   |
| Second quarter |       | 39.50      |       | 36.50      |       | 0.43          |       |
| Third quarter  |       | 38.48      |       | 37.02      |       | 0.44          |       |
| Fourth quarter |       | 38.59      |       | 36.20      |       | 0.44          |       |
| **2007**       |       |       |       |       |       |          |       |
| First quarter  |       | $          | 37.75      |       | $          | 35.00         |       | $ | 0.44 |   |
| Second quarter |       | 35.00      |       | 33.86      |       | 0.44          |       |
| Third quarter  |       | 35.00      |       | 30.80      |       | 0.45          |       |
| Fourth quarter |       | 32.50      |       | 30.33      |       | 0.46          |       |
| **2008**       |       |       |       |       |       |          |       |
| First quarter  |       | $          | 33.47      |       | $          | 29.66         |       | $ | 0.46 |   |
| Second quarter |       | 33.15      |       | 33.01      |       | 0.46          |       |
| Third quarter  |       | 35.00      |       | 29.00      |       | 0.46          |       |
| Fourth quarter |       | 30.40      |       | 23.00      |       | 0.46          |       |

 

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 the Registrant’sBoard of Directors to continue the dividend payment policy; however, furtherdividends must necessarily depend upon earnings, financial condition,appropriate legal restrictions, and other factors relevant at the time theBoard of Directors of the Company considers dividend policy.  Cash available for dividend distributions toshareholders of the Company primarily comes from dividends paid by the Bank tothe Company. Therefore, the restrictions on the Bank’s dividend payments aredirectly applicable to the Company.  Seealso the information appearing in Note 18 to Notes to Consolidated FinancialStatements included in the Annual Report on Form 10-K for additionalinformation related to dividend restrictions.

 

Under the Pennsylvania Business Corporation Law of 1988 a corporationmay not pay a dividend, if after giving effect thereto, the corporation wouldbe unable to pay its debts as they become due in the usual course of businessand after giving effect thereto the total assets of the corporation would beless than the sum of its total liabilities plus the amount that would beneeded, 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 3, 2009, the Company had approximately 1,261shareholders of record.

 

13

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Following is a schedule of the shares of the Company’s common stockpurchased by the Company during the fourth quarter of 2008.

 
| ** **              | ** ** | **Total**           | ** ** | **Average**         | ** ** | **Total Number of**           | ** ** | **Maximum Number (or**                    | ** ** |
|-------------------------|------------|---------------------|------------|---------------------|------------|-----------------------------------------|------------|-----------------------------------------------------|------------|
| ** **              | ** ** | **Number of**  | ** ** | **Price Paid** | ** ** | **Shares (or Units)**         | ** ** | **Approximate Dollar Value)**             | ** ** |
| ** **              | ** ** | **Shares (or** | ** ** | **per Share**  | ** ** | **Purchased as Part of** | ** ** | **of Shares (or Units) that**   | ** ** |
| ** **              | ** ** | **Units)**          | ** ** | **(or Units)** | ** ** | **Publicly Announced**             | ** ** | **May Yet Be Purchased**             | ** ** |
| **Period**              | ** ** | **Purchased**       | ** ** | **Purchased**       | ** ** | **Plans or Programs**         | ** ** | **Under the Plans or Programs** | ** ** |
|                    |       |                |       |                |       |                                    |       |                                                |       |
| Month#1 (October  1 -   |       |                |       |                |       |                                    |       |                                                |       |
| October 31,  2008)      |       | 5,000               |       | $                   | 25.55      |                                    | 5,000      |                                                | 93,344     |   |
|                    |       |                |       |                |       |                                    |       |                                                |       |
| Month#2  (November 1 -  |       |                |       |                |       |                                    |       |                                                |       |
| November 30,  2008)     |       | 10,000              |       | 25.60               |       | 10,000                                  |       | 83,344                                              |       |
|                    |       |                |       |                |       |                                    |       |                                                |       |
| Month#3  (December 1, - |       |                |       |                |       |                                    |       |                                                |       |
| December 31,  2008)     |       | 5,000               |       | 25.25               |       | 5,000                                   |       | 78,344                                              |       |
|                         |            |                     |            |                     |            |                                         |            |                                                     |            |  |

 

Set forth below is a line graph comparing the yearly dollar changes inthe cumulative shareholder return on the Company’s common stock against thecumulative total return of the S&P 500 Stock Index, NASDAQ Bank Index, andNASDAQ Composite for the period of five fiscal years assuming the investment of$100.00 on December 31, 2003 and assuming the reinvestment of dividends.The shareholder return shown on the graph below is not necessarily indicativeof future performance.

 

 

14

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| ** **                 | ** ** | **Period Ending** | ** ** |
|----------------------------|------------|------------------------|------------|
| **Index**                  | ** ** | **12/31/03**           | ** ** | **12/31/04** | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** | **12/31/07** | ** ** | **12/31/08** | ** ** |
| Penns Woods  Bancorp, Inc. |       | 100.00                 |       | 107.34 |   | 108.19 |   | 110.08 |   | 99.89 |   | 75.28 |   |
| S&P 500                |       | 100.00                 |       | 110.88 |   | 116.33 |   | 134.70 |   | 142.10 |   | 89.53 |   |
| NASDAQ Composite           |       | 100.00                 |       | 108.59 |   | 110.08 |   | 120.56 |   | 132.39 |   | 78.72 |   |
| NASDAQ Bank  Index         |       | 100.00                 |       | 110.99 |   | 106.18 |   | 117.87 |   | 91.85 |   | 69.88 |   |

 

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

##### ** **

The following table sets forth certain financial data as of and foreach of the years in the five-year period ended December 31, 2008.

 
| **(In Thousands, Except Per Share Amounts)** | ** ** | **2008**  | ** ** | **2007**  | ** ** | **2006**  | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|-----------------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|-----------|------------|-----------|------------|
|                                                                  |       |      |       |      |       |      |       |      |       |      |       |
| Consolidated  Statement of Income Data:                               |       |      |       |      |       |      |       |      |       |      |       |
| Interest income                                                       |       | $         | 36,108     |      | $          | 35,949    |       | $         | 33,753     |      | $          | 30,903 |   | $ | 29,845 |   |
| Interest expense                                                      |       | 14,832    |       | 16,447    |       | 14,210    |       | 10,381    |       | 8,768     |       |
| Net interest  income                                                  |       | 21,276    |       | 19,502    |       | 19,543    |       | 20,522    |       | 21,077    |       |
| Provision for  loan losses                                            |       | 375       |       | 150       |       | 635       |       | 720       |       | 465       |       |
| Net interest  income after provision for loan losses                  |       | 20,901    |       | 19,352    |       | 18,908    |       | 19,802    |       | 20,612    |       |
| Noninterest  income                                                   |       | 5,456     |       | 7,478     |       | 9,029     |       | 9,431     |       | 8,918     |       |
| Noninterest  expense                                                  |       | 17,949    |       | 17,316    |       | 16,329    |       | 15,108    |       | 14,184    |       |
| Income before  income taxes                                           |       | 8,408     |       | 9,514     |       | 11,608    |       | 14,125    |       | 15,346    |       |
| Applicable  income taxes                                              |       | 405       |       | 637       |       | 1,961     |       | 3,224     |       | 4,263     |       |
| Net Income                                                            |       | $         | 8,003      |      | $          | 8,877     |       | $         | 9,647      |      | $          | 10,901 |   | $ | 11,083 |   |
|                                                                  |       |      |       |      |       |      |       |      |       |      |       |
| Consolidated  Balance Sheet at End of Period:                         |       |      |       |      |       |      |       |      |       |      |       |
| Total assets                                                          |       | $         | 652,803    |      | $          | 628,138   |       | $         | 592,285    |      | $          | 568,668 |   | $ | 546,703 |   |
| Loans                                                                 |       | 381,478   |       | 360,478   |       | 360,384   |       | 338,438   |       | 324,505   |       |
| Allowance for  loan losses                                            |       | (4,356    | )          | (4,130    | )          | (4,185    | )          | (3,679    | )          | (3,338    | )          |
| Deposits                                                              |       | 421,368   |       | 389,022   |       | 395,191   |       | 352,529   |       | 356,836   |       |
| Long-term debt —  other                                          |       | 86,778    |       | 106,378   |       | 82,878    |       | 84,478    |       | 75,878    |       |
| Shareholders’  equity                                            |       | 61,027    |       | 70,559    |       | 74,594    |       | 73,919    |       | 73,165    |       |
|                                                                  |       |      |       |      |       |      |       |      |       |      |       |
| Per Share Data:                                                       |       |      |       |      |       |      |       |      |       |      |       |
| Earnings per  share - Basic                                           |       | $         | 2.07       |      | $          | 2.28      |       | $         | 2.45       |      | $          | 2.75 |   | $ | 2.78 |   |
| Earnings per  share - Diluted                                         |       | 2.07      |       | 2.28      |       | 2.45      |       | 2.74      |       | 2.78      |       |
| Cash dividends  declared                                              |       | 1.84      |       | 1.79      |       | 1.73      |       | 1.56      |       | 1.47      |       |
| Book value                                                            |       | 15.93     |       | 18.21     |       | 19.12     |       | 18.59     |       | 18.36     |       |
| Number of shares  outstanding, at end of period                       |       | 3,831,500 |       | 3,875,632 |       | 3,900,742 |       | 3,975,787 |       | 3,985,832 |       |
| Average number  of shares outstanding-basic                           |       | 3,859,724 |       | 3,886,277 |       | 3,934,138 |       | 3,971,926 |       | 3,990,008 |       |
|                                                                  |       |      |       |      |       |      |       |      |       |      |       |
| Selected  financial ratios:                                           |       |      |       |      |       |      |       |      |       |      |       |
| Return on  average shareholders’ equity                          |       | 12.02     | %          | 12.14     | %          | 12.93     | %          | 14.54     | %          | 15.49     | %          |
| Return on  average total assets                                       |       | 1.27      | %          | 1.49      | %          | 1.67      | %          | 1.97      | %          | 2.06      | %          |
| Net interest  income to average interest earning assets               |       | 4.14      | %          | 3.95      | %          | 4.06      | %          | 4.29      | %          | 4.32      | %          |
| Dividend payout  ratio                                                |       | 88.67     | %          | 78.33     | %          | 70.51     | %          | 57.10     | %          | 52.72     | %          |
| Average  shareholders’ equity to average total assets            |       | 10.53     | %          | 12.23     | %          | 12.92     | %          | 13.56     | %          | 13.30     | %          |
| Loans to  deposits, at end of period                                  |       | 90.53     | %          | 92.66     | %          | 91.19     | %          | 96.00     | %          | 90.94     | %          |

 

Per share data and numberof shares outstanding have been adjusted to give retroactive effect to a sixfor five stock split issued November 18, 2005.

 

15

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**ITEM 7****                 ****MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION**

 

**RESULTS OF OPERATIONS**

** **

**NET INTEREST INCOME**

 

Net interest income isdetermined by calculating the difference between the yields earned oninterest-earning assets and the rates paid on interest-bearing liabilities. Tocompare the tax-exempt asset yields to taxable yields, amounts are adjusted totaxable equivalents based on the marginal corporate federal tax rate of34%.  The tax equivalent adjustments tonet interest income for 2008, 2007, and 2006 were $2,714,000, $2,410,000, and$2,245,000, respectively.

 

**2008 vs2007**

 

Reported net interestincome increased $1,774,000 or 9.10% to $21,276,000 for the year ended December 31,2008 compared to the year ended December 31, 2007, although the yield onearning assets decreased to 6.68% from 6.91%, respectively.  On a tax equivalent basis the change in netinterest income was an increase of $2,078,000 or 9.48% to $23,990,000 for theyear ended December 31, 2008 compared to the year ended December 31,2007.  Total interest income increased$159,000 primarily due to growth in the average balance of the loan andsecurities portfolios.  The increase inearning asset volume compensated for the negative impact on earning asset yieldscaused by the rate reductions enacted by the Federal Open Markets Committee (“FOMC”).Interest income recognized on the loan portfolio decreased $871,000 as aportion of the portfolio repriced downward due to the FOMC actions that loweredthe prime rate from 7.25% at December 31, 2007 to 3.25% at December 31,2008 coupled with the market dictating that new loan generation occurred atlower rates than during 2007.  Interestand dividend income generated from the investment portfolio and interestbearing cash deposits increased $1,030,000. The increase was the result of the yield on the investment portfolioincreasing 12 basis points (“bp”) while the average balance of the investmentportfolio increased by $17,067,000. The majority of the increase in the securitiesportfolio was from a leverage strategy undertaken during the second half of2007.

 

Interest expensedecreased $1,615,000 to $14,832,000 for the year ended December 31, 2008as compared to 2007.  Leading thedecrease in interest expense was a decline of 11.70% or $1,281,000 related todeposits.  The FOMC actions notedpreviously together with a strategic shortening of the duration of theportfolio led to an 81 bp decline in the rate paid on time deposits from 4.73%for the year ended December 31, 2007 to 3.92% for the year ended December 31,2008 resulting in a $1,502,000 decline in expense.  The economic turmoil experienced over thepast year has led to a significant decline in short-term interest rates whichhas allowed for a 214 bp decline in the rate paid on short-termborrowings.  Several long-term debtmaturities paved the way for a decline in the rate paid on long-term borrowingsof 23 bp to 4.39% for the year ended December 31, 2008 versus 4.62% forthe year ended December 31, 2007.

 

**2007 vs2006**

 

Reported netinterest income decreased $41,000 or 0.21% to $19,502,000 for the year ended December 31,2007 as compared to the year ended December 31, 2006 although the yield onearning assets increased to 6.91% from 6.70%, respectively.  On a tax equivalent basis the change in netinterest income was an increase of $124,000, which is primarily the result ofthe yield on investment securities increasing to 6.25% at December 31,2007 from 5.93% at December 31, 2006. Total interest income increased 6.5% or $2,196,000 primarily due togrowth in the average balance of the loan portfolio of $8,688,000 coupled withan increase in the loan yield to 7.27% at December 31, 2007 from 7.10% at December 31,2006. Interest and dividend income generated from the investment portfolio andinterest bearing cash deposits increased $975,000.  The increase was the result of the yield onthe investment portfolio increasing 32 basis points while the average balanceof the investment portfolio increased by $8,749,000.

 

Interest expenseincreased $2,237,000 to $16,447,000 for the year ended December 31, 2007as compared to 2006.  The majority of theincrease, 91% or $2,043,000, is related to increased levels of average depositsand increased

 

16

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rates being paid ondeposit accounts, which had an average rate paid of 3.35% and 2.88% for theyears ended December 31, 2007 and 2006, respectively.  The increases were driven by marketcompetition and rate increases enacted throughout 2006 by the FOMC resulting ina higher average prime rate during 2007 than 2006.  Interest expense related to time depositsincreased $2,121,000 as the average rate paid on time deposits increased to4.73% from 4.11% for the year ended December 31, 2006.  The increase in time deposit rates was theresult of competitive pressure, FOMC rate increases, rate specials related tothe opening of a new branch and the one year anniversary of a second, andincentive to customers to invest in short-term time deposits.  In addition, the average balance in timedeposits increased $21,508,000 due to the before mentioned rate specials,transfer of dollars from transaction accounts due to the increasing ratedisparity between products, and the use of brokered deposits to limit thereliance on short-term FHLB funding.

 

The rate paid onborrowings increased to 4.57% from 4.50% for the year ended December 31,2007.  The increase in rate resulted ininterest expense on borrowings increasing $194,000 with the majority of the increaseoccurring in the short-term borrowing category. The short-term borrowing rateincreased 11 basis points to 4.45% due to the FOMC rate increases since thestart of 2006. Interest expense associated with long-term borrowings increased$58,000 due to the average balance of long-term FHLB borrowings increasing$253,000 and a weighted average interest rate on the long-term debt increase of6 basis points to 4.62% at December 31, 2007.

 

17

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**AVERAGE BALANCES ANDINTEREST RATES**

 

Thefollowing tables set forth certain information relating to the Company’saverage balance sheet and reflect the average yield on assets and average costof liabilities for the periods indicated and the average yields earned andrates paid.  Such yields and costs arederived by dividing income or expense by the average balance of assets orliabilities, respectively, for the periods presented.

 

(Dollars InThousands)

 
| ** **                                       | ** ** | **2008**                 | ** ** |
|--------------------------------------------------|------------|--------------------------|------------|
| ** **                                       | ** ** | **Average Balance** | ** ** | **Interest** | ** ** | **Average Rate** | ** ** |
| ASSETS:                                          |       |                     |       |   |   |   |   |
| Tax-exempt loans                                 |       | $                        | 9,230      |   | $ | 603 |   | 6.53 | % |
| All other loans                                  |       | 361,945                  |       | 24,830 |   | 6.86 | % |
| Total loans                                      |       | 371,175                  |       | 25,433 |   | 6.85 | % |
|                                             |       |                     |       |   |   |   |   |
| Taxable  securities                              |       | 104,245                  |       | 6,008 |   | 5.76 | % |
| Tax-exempt  securities                           |       | 106,030                  |       | 7,380 |   | 6.96 | % |
| Total securities                                 |       | 210,275                  |       | 13,388 |   | 6.37 | % |
|                                             |       |                     |       |   |   |   |   |
| Interest-bearing  deposits                       |       | 10                       |       | 1 |   | 10.00 | % |
|                                             |       |                     |       |   |   |   |   |
| Total  interest-earning assets                   |       | 581,460                  |       | 38,822 |   | 6.68 | % |
|                                             |       |                     |       |   |   |   |   |
| Other assets                                     |       | 50,779                   |       |   |   |   |   |
|                                             |       |                     |       |   |   |   |   |
| Total assets                                     |       | $                        | 632,239    |   |   |   |   |   |
|                                             |       |                     |       |   |   |   |   |
| LIABILITIES:                                     |       |                     |       |   |   |   |   |
| Savings                                          |       | $                        | 60,324     |   | 443 |   | 0.73 | % |
| Super Now  deposits                              |       | 52,117                   |       | 658 |   | 1.26 | % |
| Money market  deposits                           |       | 30,921                   |       | 699 |   | 2.26 | % |
| Time deposits                                    |       | 200,572                  |       | 7,870 |   | 3.92 | % |
| Total deposits                                   |       | 343,934                  |       | 9,670 |   | 2.81 | % |
|                                             |       |                     |       |   |   |   |   |
| Short-term  borrowings                           |       | 50,545                   |       | 1,181 |   | 2.31 | % |
| Long-term  borrowings                            |       | 89,256                   |       | 3,981 |   | 4.39 | % |
| Total borrowings                                 |       | 139,801                  |       | 5,162 |   | 3.64 | % |
|                                             |       |                     |       |   |   |   |   |
| Total  interest-bearing liabilities              |       | 483,735                  |       | 14,832 |   | 3.05 | % |
|                                             |       |                     |       |   |   |   |   |
| Demand deposits                                  |       | 73,618                   |       |   |   |   |   |
| Other liabilities                                |       | 8,282                    |       |   |   |   |   |
| Shareholders’  equity                       |       | 66,604                   |       |   |   |   |   |
|                                             |       |                     |       |   |   |   |   |
| TOTAL  LIABILITIES AND SHAREHOLDERS’ EQUITY |       | $                        | 632,239    |   |   |   |   |   |
| Interest rate  spread                            |       |                     |       |   |   | 3.63 | % |
| Net interest  income/margin                      |       |                     |       | $ | 23,990 |   | 4.14 | % |

 

·                  Fees on loans are included withinterest on loans. Loan fees are included in interest income as follows:2008-$472,000, 2007-$453,000, 2006-$478,000.

·                  Information on this table hasbeen calculated using average daily balance sheets to obtain average balances.

·                  Nonaccrual loans have been includedwith loans for the purpose of analyzing net interest earnings.

·                  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.

 

18

----

 
| ** **                                       | ** ** | **2007**                 | ** ** | **2006**     | ** ** |
|--------------------------------------------------|------------|--------------------------|------------|--------------|------------|
| ** **                                       | ** ** | **Average Balance** | ** ** | **Interest** | ** ** | **Average Rate** | ** ** | **Average Balance** | ** ** | **Interest** | ** ** | **Average Rate** | ** ** |
| ASSETS:                                          |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Tax-exempt loans                                 |       | $                        | 7,857      |         | $          | 485 |   | 6.17 | % | $ | 8,173 |   | $ | 503 |   | 6.15 | % |
| All other loans                                  |       | 353,528                  |       | 25,779       |       | 7.29 | % | 344,524 |   | 24,545 |   | 7.12 | % |
| Total loans                                      |       | 361,385                  |       | 26,264       |       | 7.27 | % | 352,697 |   | 25,048 |   | 7.10 | % |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Taxable  securities                              |       | 93,480                   |       | 5,474        |       | 5.86 | % | 91,767 |   | 4,837 |   | 5.27 | % |
| Tax-exempt  securities                           |       | 99,728                   |       | 6,602        |       | 6.62 | % | 92,692 |   | 6,102 |   | 6.58 | % |
| Total securities                                 |       | 193,208                  |       | 12,076       |       | 6.25 | % | 184,459 |   | 10,939 |   | 5.93 | % |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits                       |       | 345                      |       | 19           |       | 5.51 | % | 152 |   | 11 |   | 7.24 | % |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Total interest-earning  assets                   |       | 554,938                  |       | 38,359       |       | 6.91 | % | 537,308 |   | 35,998 |   | 6.70 | % |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Other assets                                     |       | 42,602                   |       |         |       |   |   | 40,413 |   |   |   |   |   |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Total assets                                     |       | $                        | 597,540    |         |       |   |   |   | $ | 577,721 |   |   |   |   |   |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| LIABILITIES:                                     |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Savings                                          |       | $                        | 58,710     |         | 428        |   | 0.73 | % | $ | 61,958 |   | 509 |   | 0.82 | % |
| Super Now  deposits                              |       | 46,596                   |       | 611          |       | 1.31 | % | 47,294 |   | 655 |   | 1.38 | % |
| Money market  deposits                           |       | 23,920                   |       | 540          |       | 2.26 | % | 23,905 |   | 493 |   | 2.06 | % |
| Time deposits                                    |       | 198,029                  |       | 9,372        |       | 4.73 | % | 176,521 |   | 7,251 |   | 4.11 | % |
| Total deposits                                   |       | 327,255                  |       | 10,951       |       | 3.35 | % | 309,678 |   | 8,908 |   | 2.88 | % |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Short-term  borrowings                           |       | 36,816                   |       | 1,639        |       | 4.45 | % | 34,612 |   | 1,503 |   | 4.34 | % |
| Long-term  borrowings                            |       | 83,490                   |       | 3,857        |       | 4.62 | % | 83,237 |   | 3,799 |   | 4.56 | % |
| Total borrowings                                 |       | 120,306                  |       | 5,496        |       | 4.57 | % | 117,849 |   | 5,302 |   | 4.50 | % |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Total  interest-bearing liabilities              |       | 447,561                  |       | 16,447       |       | 3.67 | % | 427,527 |   | 14,210 |   | 3.32 | % |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Demand deposits                                  |       | 69,953                   |       |         |       |   |   | 69,668 |   |   |   |   |   |
| Other  liabilities                               |       | 6,924                    |       |         |       |   |   | 5,899 |   |   |   |   |   |
| Shareholders’  equity                       |       | 73,102                   |       |         |       |   |   | 74,627 |   |   |   |   |   |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| TOTAL  LIABILITIES AND SHAREHOLDERS’ EQUITY |       | $                        | 597,540    |         |       |   |   |   | $ | 577,721 |   |   |   |   |   |
| Interest rate  spread                            |       |                     |       |         |       | 3.24 | % |   |   |   |   | 3.38 | % |
| Net interest  income/margin                      |       |                     |       | $            | 21,912     |   | 3.95 | % |   |   | $ | 21,788 |   | 4.06 | % |

 

**Reconcilementof Taxable Equivalent Net Interest Income**

 
| ** **                  | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|----------|------------|
|                        |       |     |       |     |       |     |       |
| Total interest  income      |       | $        | 36,108     |     | $          | 35,949   |       | $ | 33,753 |   |
| Total interest  expense     |       | 14,832   |       | 16,447   |       | 14,210   |       |
|                        |       |     |       |     |       |     |       |
| Net interest  income        |       | 21,276   |       | 19,502   |       | 19,543   |       |
| Tax equivalent  adjustment  |       | 2,714    |       | 2,410    |       | 2,245    |       |
|                        |       |     |       |     |       |     |       |
| Net interest  income        |       |     |       |     |       |     |       |
| (fully taxable  equivalent) |       | $        | 23,990     |     | $          | 21,912   |       | $ | 21,788 |   |

 

**Rate/Volume Analysis**

 

Thetable below sets forth certain information regarding changes in our interestincome and interest expense for the periods indicated. For interest-earningassets and interest-bearing liabilities, information is provided on changes

 

19

----

 

attributableto (i) changes in volume (changes in average volume multiplied by oldrate) and (ii) changes in rates (changes in rate multiplied by old averagevolume). Increases and decreases due to both interest rate and volume, whichcannot be separated, have been allocated proportionally to the change due tovolume and the change due to interest rate. Income and interest rates are on a taxable equivalent basis.

 

(In Thousands)

 
| ** **                          | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------|------------|--------------------------------------------|------------|
| ** **                          | ** ** | **2008 vs 2007**                 | ** ** | **2007 vs 2006** | ** ** |
| ** **                          | ** ** | **Increase (Decrease)**               | ** ** | **Increase (Decrease)** | ** ** |
| ** **                          | ** ** | **Due to**                            | ** ** | **Due to** | ** ** |
| ** **                          | ** ** | **Volume**                                 | ** ** | **Rate** | ** ** | **Net** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Net** | ** ** |
| **Interest  income:**               |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Loans,  tax-exempt                  |       | $                                          | 92         |   | $ | 26 |   | $ | 118 |   | $ | (20 | ) | $ | 2 |   | $ | (18 | ) |
| Loans                               |       | 638                                        |       | (1,587 | ) | (949 | ) | 650 |   | 584 |   | 1,234 |   |
| Taxable  investment securities      |       | 621                                        |       | (87 | ) | 534 |   | 88 |   | 549 |   | 637 |   |
| Tax-exempt  investment securities   |       | 532                                        |       | 246 |   | 778 |   | 466 |   | 34 |   | 500 |   |
| Interest-bearing  deposits          |       | (27                                        | )          | 9 |   | (18 | ) | 12 |   | (4 | ) | 8 |   |
| Total  interest-earning assets      |       | 1,856                                      |       | (1,393 | ) | 463 |   | 1,196 |   | 1,165 |   | 2,361 |   |
|                                |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| **Interest  expense:**              |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Savings deposits                    |       | 12                                         |       | 3 |   | 15 |   | (30 | ) | (51 | ) | (81 | ) |
| Super Now  deposits                 |       | 71                                         |       | (24 | ) | 47 |   | (10 | ) | (34 | ) | (44 | ) |
| Money market  deposits              |       | 158                                        |       | 1 |   | 159 |   | — |   | 47 |   | 47 |   |
| Time deposits                       |       | 119                                        |       | (1,621 | ) | (1,502 | ) | 344 |   | 1,777 |   | 2,121 |   |
| Short-term  borrowings              |       | 484                                        |       | (942 | ) | (458 | ) | 100 |   | 36 |   | 136 |   |
| Long-term  borrowings               |       | 260                                        |       | (136 | ) | 124 |   | 12 |   | 46 |   | 58 |   |
| Total  interest-bearing liabilities |       | 1,104                                      |       | (2,719 | ) | (1,615 | ) | 416 |   | 1,821 |   | 2,237 |   |
| Change in net  interest income      |       | $                                          | 752        |   | $ | 1,326 |   | 2,078 |   | $ | 780 |   | $ | (656 | ) | $ | 124 |   |
|                                     |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**PROVISION FOR LOAN LOSSES**

** **

**2008 vs 2007**

 

Theprovision for loan losses is based upon management’s quarterly review of theloan portfolio.  The purpose of thereview is to assess loan quality, identify impaired loans, analyzedelinquencies, ascertain loan growth, evaluate potential charge-offs andrecoveries, and assess 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.

 

Theallowance is calculated by applying loss factors to outstanding loans by type,excluding loans for which a specific allowance has been determined.  Loss factors are based on management’sconsideration of the nature of the portfolio segments, changes in mix andvolume of the loan portfolio, and historical loan loss experience.  In addition, management considers industrystandards and trends with respect to nonperforming loans and its knowledge andexperience with specific lending segments.

 

Althoughmanagement believes that it uses the best information available to make suchdeterminations and that the allowance for loan losses is adequate at December 31,2008, future adjustments could be necessary if circumstances or economicconditions differ substantially from the assumptions used in making the initialdeterminations.  A downturn in the localeconomy or employment and delays in receiving financial information fromborrowers could result in increased levels of nonperforming assets andcharge-offs, increased loan loss provisions and reductions in interestincome.  Additionally, as an integralpart of the examination process, bank regulatory agencies periodically reviewthe Bank’s loan loss allowance adequacy. The banking regulators could requirethe recognition of additions to the loan loss allowance based on their judgmentof information available to them at the time of their examination.

 

Theallowance for loanlosses increased from $4,130,000 at December 31, 2007 to $4,356,000 at December 31,2008.  At December 31, 2008,allowance for loan losses was 1.14% of total loans compared to 1.15% of totalloans at December 31, 2007.

 

Theprovision for loan losses totaled $375,000 for the year ended December 31,2008 compared to $150,000 for the year ended December 31, 2007. Managementconcluded that the increase of the provision was appropriate when considering

 

20

----

 

thegross loan growth experienced during 2008 of $21,000,000 coupled with netcharge-offs to average loans for the year ended December 31, 2008 of0.04%. Utilizing both internal and external resources, as noted, seniormanagement has concluded that the allowance for loan losses remains at a leveladequate to provide for probable losses inherent in the loan portfolio.

** **

**2007 vs 2006**

 

Theallowance for loan losses decreased 1.31% or $55,000 from December 31,2006 after net charge-offs of $205,000 contributed to a year-end 2007 allowancefor loan losses of  $4,130,000 or 1.15%of total loans. Based upon this analysis, as well as the others noted above,senior management concluded that the allowance for loan losses was at a leveladequate to provide for probable losses inherent in the loan portfolio at December 31,2007.

 

Following is a table showing the changes in theallowance for loan losses for the years ended December 31, 2008, 2007,2006, 2005, and 2004:

 

(In Thousands)

 
| ** **                                                                                 | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Balance at  beginning of period                                                            |       | $        | 4,130      |     | $          | 4,185    |       | $        | 3,679      |     | $          | 3,338 |   | $ | 3,069 |   |
| Charge-offs:                                                                               |       |     |       |     |       |     |       |     |       |     |       |
| Real estate                                                                                |       | 48       |       | —   |       | 50       |       | 132      |       | 121      |       |
| Commercial and  industrial                                                                 |       | 51       |       | 103      |       | 28       |       | 206      |       | 50       |       |
| Installment  loans to individuals                                                          |       | 214      |       | 201      |       | 249      |       | 108      |       | 112      |       |
| Total charge-offs                                                                          |       | 313      |       | 304      |       | 327      |       | 446      |       | 283      |       |
| Recoveries:                                                                                |       |     |       |     |       |     |       |     |       |     |       |
| Real estate                                                                                |       | 17       |       | 13       |       | 68       |       | 45       |       | 50       |       |
| Commercial and  industrial                                                                 |       | 60       |       | 1        |       | 40       |       | 8        |       | 4        |       |
| Installment  loans to individuals                                                          |       | 87       |       | 85       |       | 90       |       | 14       |       | 33       |       |
| Total recoveries                                                                           |       | 164      |       | 99       |       | 198      |       | 67       |       | 87       |       |
| Net charge-offs                                                                            |       | 149      |       | 205      |       | 129      |       | 379      |       | 196      |       |
| Additions  charged to operations                                                           |       | 375      |       | 150      |       | 635      |       | 720      |       | 465      |       |
| Balance at end  of period                                                                  |       | $        | 4,356      |     | $          | 4,130    |       | $        | 4,185      |     | $          | 3,679 |   | $ | 3,338 |   |
| Ratio of net  charge-offs during the period to average loans outstanding during the period |       | 0.04     | %          | 0.06     | %          | 0.04     | %          | 0.11     | %          | 0.06     | %          |

 

**NON-INTEREST INCOME**

** **

**2008 vs 2007**

 

Totalnon-interest income decreased $2,022,000 from the year ended December 31,2007 to 2008.  Excluding security losses,non-interest income decreased $45,000. Service charges increased as overdraftprotection fees increased $100,000 and offset customer migrations to checkingaccounts having reduced or no service charges. Earnings on bank-owned life insurance increased as additional policieswere purchased. Insurance commissions decreased due to the general economicdownturn, which has led to a decrease in volume of sales.  Management of The M Group continues to pursuenew and build upon current relationships. However, the sales cycle for insurance and investment products can taketypically from six months to one year or more to complete. The increase inother income was primarily due to increases in revenues from debit cardtransactions, merchant card commissions, and title insurance.

 

(InThousands)

 
| ** **                      | ** ** | **2008**   | ** ** | **2007**         | ** ** | **Change** | ** ** |
|---------------------------------|------------|------------|------------|------------------|------------|------------|------------|
| ** **                      | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Deposit service  charges        |       | $          | 2,289      |             | 41.95      | %          | $          | 2,246 |   | 30.03 | % | $ | 43 |   | 1.91 | % |
| Securities  (losses) gains, net |       | (2,031     | )          | (37.23           | )          | (54        | )          | (0.72 | ) | (1,977 | ) | 3,661.11 |   |
| Bank-owned life  insurance      |       | 472        |       | 8.65             |       | 410        |       | 5.48 |   | 62 |   | 15.12 |   |
| Gain on sale of  loans          |       | 882        |       | 16.17            |       | 921        |       | 12.32 |   | (39 | ) | (4.23 | ) |
| Insurance  commissions          |       | 1,928      |       | 35.34            |       | 2,222      |       | 29.72 |   | (294 | ) | (13.23 | ) |
| Other income                    |       | 1,916      |       | 35.12            |       | 1,733      |       | 23.17 |   | 183 |   | 10.56 |   |
| Total non-interest  income      |       | $          | 5,456      |             | 100.00     | %          | $          | 7,478 |   | 100.00 | % | $ | (2,022 | ) | (27.04 | )% |

 

21

----

 

**2007 vs 2006**

** **

Total non-interest income decreased $1,551,000from the year ended December 31, 2007 to 2006.  Excluding security (losses) gains and thegain on sale of loans, non-interest income increased $114,000. Service chargesdecreased $120,000 as overdraft protection fees declined and customers migratedto new checking accounts having reduced or no service charges.  Earnings on bank-owned life insuranceincreased $36,000. Insurance commissions decreased $59,000 due to a reductionin the overall commission from the underwriter that The M Group receives oneach insurance contract written.  Theincrease in other income was primarily due to increases in revenues from debitcard transactions, merchant card commissions, and commissions generated by The M Group for securities transactions.

 

(In Thousands)

 
| ** **                      | ** ** | **2007**   | ** ** | **2006**         | ** ** | **Change** | ** ** |
|---------------------------------|------------|------------|------------|------------------|------------|------------|------------|
| ** **                      | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Deposit service  charges        |       | $          | 2,246      |             | 30.03      | %          | $          | 2,366 |   | 26.20 | % | $ | (120 | ) | (5.07 | )% |
| Securities  (losses) gains, net |       | (54        | )          | (0.72            | )          | 1,679      |       | 18.60 |   | (1,733 | ) | (103.22 | ) |
| Bank-owned life  insurance      |       | 410        |       | 5.48             |       | 374        |       | 4.14 |   | 36 |   | 9.63 |   |
| Gain on sale of  loans          |       | 921        |       | 12.32            |       | 853        |       | 9.45 |   | 68 |   | 7.97 |   |
| Insurance  commissions          |       | 2,222      |       | 29.72            |       | 2,281      |       | 25.26 |   | (59 | ) | (2.59 | ) |
| Other income                    |       | 1,733      |       | 23.17            |       | 1,476      |       | 16.35 |   | 257 |   | 17.41 |   |
| Total  non-interest income      |       | $          | 7,478      |             | 100.00     | %          | $          | 9,029 |   | 100.00 | % | $ | (1,551 | ) | (17.18 | )% |

 

**NON-INTERESTEXPENSE**

 

**2008 vs 2007**

** **

Total non-interest expenses increased $633,000 from the year ended December 31,2007 to December 31, 2008. Salaries and employee benefits increased due toseveral factors including standard cost of living wage adjustments foremployees, increased benefit costs, and expenses associated with thepost-retirement segment of split-dollar bank owned life insurance.  Pennsylvania shares tax decreased due to taxcredits associated with an investment in low income housing within the LycomingCounty market. Other expenses increased primarily due to increases in legal andinsurance costs coupled with our continued emphasis on giving back to thecommunities that we serve resulting in a doubling of donations during 2008compared to 2007.

 

(In Thousands)

 
| ** **                                         | ** ** | **2008**   | ** ** | **2007**         | ** ** | **Change** | ** ** |
|----------------------------------------------------|------------|------------|------------|------------------|------------|------------|------------|
| ** **                                         | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Salaries and  employee benefits                    |       | $          | 9,634      |             | 53.67      | %          | $          | 9,078 |   | 52.43 | % | $ | 556 |   | 6.12 | % |
| Occupancy, net                                     |       | 1,288      |       | 7.18             |       | 1,306      |       | 7.54 |   | (18 | ) | (1.38 | ) |
| Furniture and  equipment                           |       | 1,182      |       | 6.59             |       | 1,126      |       | 6.50 |   | 56 |   | 4.97 |   |
| Pennsylvania  shares tax                           |       | 421        |       | 2.35             |       | 643        |       | 3.71 |   | (222 | ) | (34.53 | ) |
| Amortization of  investment in limited partnership |       | 712        |       | 3.97             |       | 761        |       | 4.39 |   | (49 | ) | (6.44 | ) |
| Other expenses                                     |       | 4,712      |       | 26.24            |       | 4,402      |       | 25.43 |   | 310 |   | 7.04 |   |
| Total  non-interest expense                        |       | $          | 17,949     |             | 100.00     | %          | $          | 17,316 |   | 100.00 | % | $ | 633 |   | 3.66 | % |

 

**2007 vs 2006**

** **

Total non-interest expenses increased $987,000 from the year ended December 31,2006 to December 31, 2007. Salaries and employee benefits increased by$245,000 and were attributed to several factors including standard cost ofliving wage adjustments for employees, full year impact of the Montoursvillebranch, and increased benefit costs. Occupancy expense increased due to the newbranch in Montoursville, which opened in the third quarter of 2006, andincreased cost of maintenance and property taxes. Amortization increase attributedto low income housing partnership that began operation during the fourthquarter of 2006.

 

22

----

 

(In Thousands)

 
| ** **                                         | ** ** | **2007**   | ** ** | **2006**         | ** ** | **Change** | ** ** |
|----------------------------------------------------|------------|------------|------------|------------------|------------|------------|------------|
| ** **                                         | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Salaries and  employee benefits                    |       | $          | 9,078      |             | 52.43      | %          | $          | 8,833 |   | 54.09 | % | $ | 245 |   | 2.77 | % |
| Occupancy, net                                     |       | 1,306      |       | 7.54             |       | 1,137      |       | 6.96 |   | 169 |   | 14.86 |   |
| Furniture and  equipment                           |       | 1,126      |       | 6.50             |       | 1,201      |       | 7.36 |   | (75 | ) | (6.24 | ) |
| Pennsylvania  shares tax                           |       | 643        |       | 3.71             |       | 598        |       | 3.66 |   | 45 |   | 7.53 |   |
| Amortization of  investment in limited partnership |       | 761        |       | 4.39             |       | 245        |       | 1.50 |   | 516 |   | 210.61 |   |
| Other expenses                                     |       | 4,402      |       | 25.43            |       | 4,315      |       | 26.43 |   | 87 |   | 2.02 |   |
| Total  non-interest expense                        |       | $          | 17,316     |             | 100.00     | %          | $          | 16,329 |   | 100.00 | % | $ | 987 |   | 6.04 | % |

 

**INCOMETAXES**

 

**2008 vs 2007**

** **

The provision for income taxes for the year ended December 31,2008 resulted in an effective income tax rate of 4.8% compared to 6.7% for2007. This decrease is the result of the continued shift in the investmentportfolio from taxable mortgage-backed bonds to tax-exempt municipal bondscoupled with the recognition of tax credits related to low income housingpartnerships investments.

 

**2007 vs 2006**

 

The provision for income taxes for the year ended December 31,2007 resulted in an effective income tax rate of 6.7% compared to 16.9% for2006. This decrease is the result of a shift in the investment portfolio fromtaxable mortgage-backed bonds to tax-exempt municipal bonds coupled with thereceipt of tax credits related to low income housing partnerships investments.

 

**FINANCIALCONDITION**

** **

**INVESTMENTS**

 

**2008**

 

The estimated fair value of the investment portfolio decreased$6,346,000 or 2.96% from December 31, 2007 to 2008, while the amortizedcost increased $3,241,000 over the same period. The majority of the changes in value occurred within the state andmunicipal segment of the portfolio.  Theamortized cost position in state and political securities increased $22,607,000as the Bank continued to build call protection, maintain taxable equivalent yields,reduce the effective federal income tax rate, and invest in communities acrossthe Commonwealth of Pennsylvania and the country. The amortized cost positionof U.S. Government and agency securities decreased $15,934,000 due to the focuson building the municipal bond segment of the portfolio.  The increased level of unrealized losses,which offset the increase in amortized cost, was the result of changes in theyield curve and illiquid markets, not credit quality, as the credit quality ofthe portfolio remained sound.

 

**2007**

** **

The estimated fair value of the investment portfolio increased$29,429,000 or 15.77% from December 31, 2006 to 2007, while the amortizedcost increased $35,762,000 over the same period.  The majority of the changes in value occurredwithin the state and municipal segment of the portfolio.  The amortized cost position in state andpolitical securities increased $14,993,000 as the Bank continued to build callprotection, maintain taxable equivalent yields, reduce the effective federalincome tax rate, and invest in communities across the Commonwealth ofPennsylvania and the country. The amortized cost position of other debtsecurities increased $13,919,000 as the Bank began a new leverage transactionto enhance net interest income, return on average assets, and return on averageequity.  The increased level ofunrealized losses, which offset the increase in amortized cost, was the resultof changes in the yield curve, not credit quality, as the credit quality of theportfolio remained sound.

 

The carrying amounts of investment securities at the dates indicatedare summarized as follows for the years ended 

 

23

----

 

December 31, 2008, 2007, and 2006:

 

(In Thousands)

 
| ** **                                      | ** ** | **2008**    | ** ** | **2007**             | ** ** | **2006**    | ** ** |
|-------------------------------------------------|------------|-------------|------------|----------------------|------------|-------------|------------|
| ** **                                      | ** ** | **Balance** | ** ** | **% Portfolio** | ** ** | **Balance** | ** ** | **% Portfolio** | ** ** | **Balance** | ** ** | **% Portfolio** | ** ** |
| U.S. Government  agencies:                      |       |        |       |                 |       |        |       |   |   |   |   |   |   |
| Held to Maturity                                |       | $           | 10         |                 | 0.00       | %           | $          | 14 |   | 0.01 | % | $ | 26 |   | 0.01 | % |
| Available for  Sale                             |       | 47,586      |       | 22.84                | %          | 62,904      |       | 29.29 | % | 54,152 |   | 29.20 | % |
| State and political  subdivisions (tax-exempt): |       |        |       |                 |       |        |       |   |   |   |   |   |   |
| Held to Maturity                                |       | —      |       | —               |       | —      |       | — |   | — |   | — |   |
| Available for  Sale                             |       | 103,173     |       | 49.51                | %          | 107,314     |       | 49.98 | % | 103,057 |   | 55.56 | % |
| State and  political subdivisions (taxable):    |       |        |       |                 |       |        |       |   |   |   |   |   |   |
| Held to Maturity                                |       | —      |       | —               |       | —      |       | — |   | — |   | — |   |
| Available for  Sale                             |       | 28,668      |       | 13.76                | %          | 10,501      |       | 4.89 | % | 2,889 |   | 1.56 | % |
| Other bonds,  notes and debentures:             |       |        |       |                 |       |        |       |   |   |   |   |   |   |
| Held to Maturity                                |       | 125         |       | 0.06                 | %          | 263         |       | 0.12 | % | 257 |   | 0.14 | % |
| Available for  Sale                             |       | 15,554      |       | 7.46                 | %          | 15,767      |       | 7.34 | % | 2,024 |   | 1.09 | % |
| Total bonds,  notes and debentures              |       | 195,116     |       | 93.63                | %          | 196,763     |       | 91.63 | % | 162,405 |   | 87.56 | % |
| Corporate stock  - Available for Sale           |       | 13,270      |       | 6.37                 | %          | 17,969      |       | 8.37 | % | 23,078 |   | 12.44 | % |
| Total                                           |       | $           | 208,386    |                 | 100.00     | %           | $          | 214,732 |   | 100.00 | % | $ | 185,483 |   | 100.00 | % |

 

The following table shows the maturities and repricing of investmentsecurities, at amortized cost and the weighted average yields (for tax-exemptobligations on a fully taxable basis assuming a 34% tax rate) of such at December 31,2008:

 

(In Thousands)

 
| ** **                                      | ** ** | **Within** | ** ** | **After One**  | ** ** | **After Five** | ** ** | **After** | ** ** | **Amortized** | ** ** |
|-------------------------------------------------|------------|------------|------------|---------------------|------------|---------------------|------------|-----------|------------|---------------|------------|
| ** **                                      | ** ** | **One**    | ** ** | **But Within** | ** ** | **But Within** | ** ** | **Ten**   | ** ** | **Cost**      | ** ** |
| ** **                                      | ** ** | **Year**   | ** ** | **Five Years** | ** ** | **Ten Years**  | ** ** | **Years** | ** ** | **Total**     | ** ** |
| U.S. Government  agencies:                      |       |       |       |                |       |                |       |      |       |          |       |
| HTM Amount                                      |       | $          | —     |                | $          | —              |       | $         | —     |          | $          | 10 |   | $ | 10 |   |
| Yield                                           |       | —     |       | —              |       | —              |       | 8.95      | %          | 8.95          | %          |
| AFS Amount                                      |       | —     |       | —              |       | —              |       | 46,452    |       | 46,452        |       |
| Yield                                           |       | —     |       | —              |       | —              |       | 5.79      | %          | 5.79          | %          |
| State and  political subdivisions (tax-exempt): |       |       |       |                |       |                |       |      |       |          |       |
| HTM Amount                                      |       | —     |       | —              |       | —              |       | —    |       | —        |       |
| Yield                                           |       | —     |       | —              |       | —              |       | —    |       | —        |       |
| AFS Amount                                      |       | —     |       | —              |       | 416                 |       | 110,654   |       | 111,070       |       |
| Yield                                           |       | —     |       | —              |       | 8.95                | %          | 6.61      | %          | 6.62          | %          |
| State and  political subdivisions (taxable):    |       |       |       |                |       |                |       |      |       |          |       |
| HTM Amount                                      |       | —     |       | —              |       | —              |       | —    |       | —        |       |
| Yield                                           |       | —     |       | —              |       | —              |       | —    |       | —        |       |
| AFS Amount                                      |       | —     |       | —              |       | —              |       | 31,188    |       | 31,188        |       |
| Yield                                           |       | —     |       | —              |       | —              |       | 5.94      | %          | 5.94          | %          |
| Other bonds,  notes and debentures:             |       |       |       |                |       |                |       |      |       |          |       |
| HTM Amount                                      |       | 25         |       | 100                 |       | —              |       | —    |       | 125           |       |
| Yield                                           |       | 5.55       | %          | 6.55                | %          | —              |       | —    |       | 6.35          | %          |
| AFS Amount                                      |       | —     |       | 75                  |       | 2                   |       | 16,339    |       | 16,416        |       |
| Yield                                           |       | —     |       | 2.89                | %          | 2.37                | %          | 6.26      | %          | 6.24          | %          |
| Total Amount                                    |       | $          | 25         |                | $          | 175                 |       | $         | 418        |          | $          | 204,643 |   | $ | 205,261 |   |
| Total Yield                                     |       | 5.55       | %          | 4.98                | %          | 8.92                | %          | 6.29      | %          | 6.30          | %          |
|                                            |       |       |       |                |       |                |       |      |       |          |       |
| Equity  Securities                              |       |       |       |                |       |                |       |      |       | $             | 16,429     |   |
| Total Investment  Portfolio Value               |       |       |       |                |       |                |       |      |       | $             | 221,690    |   |
| Total Investment  Portfolio Yield               |       |       |       |                |       |                |       |      |       | 5.83          | %          |

 

All yields represent weighted average yields expressed on a taxequivalent basis.  They are calculated onthe basis of the cost, adjusted for amortization of premium and accretion ofdiscount, and effective yields weighted for the scheduled maturity of eachsecurity.  The taxable equivalentadjustment represents the difference between annual income from tax-exempt 

 

24

----

 

obligations and the taxable equivalent of such income at the standard34% tax rate (derived by dividing tax-exempt interest by 66%).

 

**LOAN PORTFOLIO**

 

**2008**

** **

Gross loans of $381,478,000 at December 31, 2008 represented anincrease of $21,000,000 from December 31, 2007. The continued emphasis onwell collateralized real estate loans resulted in real estate secured loansincreasing $17,039,000 from December 31, 2007 to 2008. The success incarrying out this long term strategy has played a significant role in limitingnet chargeoffs for 2008 to 0.04% of average loans.  Despite the softening economy, the Bank hasincreased outstanding loans while maintaining its lending practices and iscapitalizing on opportunities because larger regional banks have withdrawn, inpart, from select market segments.

 

**2007**

** **

Gross loans of $360,478,000 at December 31, 2007 represented anincrease of $94,000 from December 31, 2006. The continued emphasis on wellcollateralized real estate loans resulted in real estate secured loansincreasing $1,991,000 from December 31, 2006 to 2007. The success incarrying out this long term strategy has played a significant role in limitingnet charge-offs for 2007 to 0.06% of average loans.  Commercial and agricultural loans declineddue to the before mentioned emphasis on real estate secured loans versusequipment, receivables, or inventory secured loans.

 

The amounts of loans outstanding at theindicted dates are shown in the following table according to type of loan at December 31,2008. 2007, 2006, 2005, and 2004:

 

(In Thousands)

 
| ** **                        | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Commercial and  agricultural      |       | $        | 40,602     |     | $          | 35,739   |       | $        | 36,995     |     | $          | 37,553 |   | $ | 31,100 |   |
| Real estate  mortgage:            |       |     |       |     |       |     |       |     |       |     |       |
| Residential                       |       | 177,406  |       | 163,268  |       | 158,219  |       | 150,000  |       | 147,461  |       |
| Commercial                        |       | 136,158  |       | 132,943  |       | 135,404  |       | 127,131  |       | 123,757  |       |
| Construction                      |       | 15,838   |       | 16,152   |       | 16,749   |       | 10,681   |       | 8,365    |       |
| Installment  loans to individuals |       | 12,487   |       | 13,317   |       | 14,035   |       | 14,135   |       | 14,918   |       |
| Less: Net  deferred loan fees     |       | 1,013    |       | 941      |       | 1,018    |       | 1,062    |       | 1,096    |       |
| Gross loans                       |       | $        | 381,478    |     | $          | 360,478  |       | $        | 360,384    |     | $          | 338,438 |   | $ | 324,505 |   |

 

The amounts of domestic loans at December 31, 2008 are presentedbelow by category and maturity:

 

(In Thousands)

 
| ** **                                | ** ** | ** **           | ** ** | **Commercial** | ** ** | **Installment**   | ** ** | ** ** | ** ** |
|-------------------------------------------|------------|----------------------|------------|----------------|------------|-------------------|------------|------------|------------|
| ** **                                | ** ** | ** **           | ** ** | **and**        | ** ** | **Loans to** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | **Real Estate** | ** ** | **Other**      | ** ** | **Individuals**   | ** ** | **Total**  | ** ** |
| Loans with  floating interest rates:      |       |                 |       |           |       |              |       |       |       |
| 1 year or less                            |       | $                    | 18,770     |           | $          | 9,022             |       | $          | 2,317      |   | $ | 30,109 |   |
| 1 through 5  years                        |       | 11,593               |       | 1,686          |       | 35                |       | 13,314     |       |
| 5 through 10  years                       |       | 27,411               |       | 3,814          |       | 6                 |       | 31,231     |       |
| After 10 years                            |       | 217,414              |       | 8,472          |       | 678               |       | 226,564    |       |
| Total floating  interest rate loans       |       | 275,188              |       | 22,994         |       | 3,036             |       | 301,218    |       |
| Loans with  predetermined interest rates: |       |                 |       |           |       |              |       |       |       |
| 1 year or less                            |       | 5,747                |       | 1,329          |       | 761               |       | 7,837      |       |
| 1 through 5  years                        |       | 13,705               |       | 12,196         |       | 8,018             |       | 33,919     |       |
| 5 through 10  years                       |       | 21,897               |       | 3,692          |       | 718               |       | 26,307     |       |
| After 10 years                            |       | 11,545               |       | 621            |       | 31                |       | 12,197     |       |
| Total  predetermined interest rate loans  |       | 52,894               |       | 17,838         |       | 9,528             |       | 80,260     |       |
| Total                                     |       | $                    | 328,082    |           | $          | 40,832            |       | $          | 12,564     |   | $ | 381,478 |   |

 

·                  The loanmaturity information is based upon original loan terms and is not adjusted for “rollovers.”  In the ordinary course of business, loansmaturing within one year may be renewed, in whole or in part, at interest ratesprevailing at the date of renewal.

 

25

----

 

·                  Scheduledrepayments are reported in maturity categories in which the payment is due.

 

The Bank does not make loans that provide for negative amortization nordo any loans contain conversion features. The Bank does not have any foreignloans outstanding at December 31, 2008.

 

**ALLOWANCE FOR LOAN LOSSES**

** **

**2008**

** **

The allowance for loan losses represents theamount which management estimates is adequate to provide for probable lossesinherent in its loan portfolio, as of the consolidated balance sheet date.  All loan losses are charged to the allowanceand all recoveries are credited to it per the allowance method of providing forloan losses.  The allowance for loanlosses is established through a provision for loan losses charged tooperations.  The provision for loanlosses is based upon management’s quarterly review of the loan portfolio.  The purpose of the review is to assess loanquality, identify impaired loans, analyze delinquencies, ascertain loan growth,evaluate potential charge-offs and recoveries, and assess general economicconditions 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 factors to outstandingloans by type, excluding loans for which a specific allowance has beendetermined.  Loss factors are based onmanagement’s consideration of the nature of the portfolio segments, changes inmix and volume of the loan portfolio, and historical loan loss experience.  In addition, management considers industrystandards and trends with respect to nonperforming loans and its knowledge andexperience with specific lending segments.

 

Although management believes that it uses the best informationavailable to make such determinations and that the allowance for loan losses isadequate at December 31, 2008, future adjustments could be necessary ifcircumstances or economic conditions differ substantially from the assumptionsused in making the initial determinations. A downturn in the local economy or employment, and delays in receivingfinancial information from borrowers could result in increased levels of nonperformingassets and charge-offs, increased loan loss provisions and reductions ininterest income.  Additionally, as anintegral part of the examination process, bank regulatory agencies periodicallyreview the Bank’s allowance for loan losses. The banking agencies could require the recognition of additions to theloan loss allowance based on their judgment of information available to them atthe time of their examination.

 

The allowance for loan losses increased from $4,130,000 at December 31,2007 to $4,356,000 at December 31, 2008. At December 31, 2008, allowance for loan losses was 1.14% of totalloans compared to 1.15% of total loans at December 31, 2007. Thispercentage is consistent with the Bank’s historical experience and peerbanks.  Management’s conclusion is thatthe allowance for loan losses is adequate to provide for probable lossesinherent in its loan portfolio as of the balance sheet date.

 

Based on management’s loan-by-loan review, the past performance of theborrowers, and current economic conditions, including recent business closuresand bankruptcy levels, management does not anticipate any current lossesrelated to nonaccrual, nonperforming, or classified loans above those that havealready been considered in its overall judgment of the adequacy of the reserve.

 

**2007**

** **

At December 31, 2007, the allowance for loan losses as a percentof total loans decreased to 1.15% from 1.16% at December 31, 2006. Anincrease in gross loans of $94,000 from $360,384,000 at December 31, 2006to $360,478,000 at December 31, 2007 coupled with net charge-offs of$205,000 led to the slight decline in the allowance for loan losses as apercent of total loans.

 

**NONPERFORMING LOANS**

** **

Nonaccrual loans increased $541,000 to $1,496,000 at December 31,2008 as several commercial real estate relationships deteriorated in quality.Overall nonperforming loans increased $435,000 to $1,755,000 from fiscal yearend 2007.

 

The following table presents information concerning nonperformingloans.  The accrual of interest will bediscontinued when the principal or interest of a loan is in default for 90 daysor more, or as soon as payment is questionable, unless the loan is well securedand in the process of collection. Consumer loans and residential real estateloans secured by 1 to 4 family dwellings are not ordinarily subject to thoseguidelines.  The reversal of previouslyaccrued but uncollected interest applicable to any loan placed in a nonaccrualstatus and the treatment of subsequent payments of either principal or interestwill be handled in accordance with U.S. generally accepted accountingprinciples.  These principles do notrequire a write-off of previously accrued interest if principal and interestare ultimately protected by sound collateral values.  A nonperforming loan may be restored toaccruing status when:

 

26

----

 

1.               Principal andinterest is no longer due and unpaid;

2.               It becomes wellsecured and in the process of collection;

3.               Prospects forfuture contractual payments are no longer in doubt;

 

(In Thousands)

 
| ** ** | ** ** | **Total Nonperforming Loans** | ** ** |
|------------|------------|-----------------------------------------|------------|
| ** ** | ** ** | ** **                              | ** ** | **90 Days** | ** ** | ** ** | ** ** |
| ** ** | ** ** | **Nonaccrual**                          | ** ** | **Past Due** | ** ** | **Total** | ** ** |
| 2008       |       | $                                       | 1,476      |   | $ | 259 |   | $ | 1,735 |   |
| 2007       |       | 955                                     |       | 365 |   | 1,320 |   |
| 2006       |       | 370                                     |       | 119 |   | 489 |   |
| 2005       |       | 540                                     |       | 63 |   | 603 |   |
| 2004       |       | 1,381                                   |       | 345 |   | 1,726 |   |
| 2003       |       | 827                                     |       | 429 |   | 1,256 |   |
|            |            |                                         |            |  |  |  |  |  |  |  |

 

The level of nonaccruing loans continues to fluctuate annually and isattributed to the various economic factors experienced both regionally andnationally.  Overall; the portfolio iswell secured with a majority of the balance making regular payments orscheduled to be satisfied in the near future. Presently, there are no significant amounts of loans where seriousdoubts exist as to the ability of the borrower to comply with the current loanpayment terms which are not included in the nonperforming categories asindicated above.

 

Management’s judgment in determining the amount of the additions to theallowance charged to operating expense considers the following factors:

 

1.               Economic conditionsand the impact on the loan portfolio.

2.               Analysis of pastloan charge-offs experienced by category and comparison to outstanding loans.

3.               Problem loans onoverall portfolio quality.

4.               Reports ofexamination of the loan portfolio by the Pennsylvania State Department ofBanking and the FDIC.

 

27

----

 

**Allocation In The Allowance For Loan Losses**

(In Thousands)

 
| ** **                               | ** ** | ** ** | ** ** | **Percent Of**  | ** ** |
|------------------------------------------|------------|------------|------------|----------------------|------------|
| ** **                               | ** ** | ** ** | ** ** | **Loan In**     | ** ** |
| ** **                               | ** ** | ** ** | ** ** | **Each**             | ** ** |
| ** **                               | ** ** | ** ** | ** ** | **Category To** | ** ** |
| ** **                               | ** ** | **Amount** | ** ** | **Total Loans** | ** ** |
| **December 31,  2008:**             |       |       |       |                 |       |
| Balance at end  of period applicable to: |       |       |       |                 |       |
| Commercial and  agricultural             |       | $          | 580        |                 | 10.6       | % |
| Real estate  mortgage:                   |       |       |       |                 |       |
| Residential                              |       | 659        |       | 46.4                 | %          |
| Commercial                               |       | 1,326      |       | 35.6                 | %          |
| Construction                             |       | 1,471      |       | 4.1                  | %          |
| Installment  loans to individuals        |       | 250        |       | 3.3                  | %          |
| Unallocated                              |       | 70         |       | —               |       |
| Total                                    |       | $          | 4,356      |                 | 100.0      | % |
| **December 31,  2007:**             |       |       |       |                 |       |
| Balance at end  of period applicable to: |       |       |       |                 |       |
| Commercial and  agricultural             |       | $          | 823        |                 | 9.9        | % |
| Real estate  mortgage:                   |       |       |       |                 |       |
| Residential                              |       | 1,031      |       | 45.1                 | %          |
| Commercial                               |       | 1,634      |       | 36.8                 | %          |
| Construction                             |       | 112        |       | 4.5                  | %          |
| Installment  loans to individuals        |       | 228        |       | 3.7                  | %          |
| Unallocated                              |       | 302        |       | —               |       |
| Total                                    |       | $          | 4,130      |                 | 100.0      | % |
| **December 31,  2006:**             |       |       |       |                 |       |
| Balance at end  of period applicable to: |       |       |       |                 |       |
| Commercial and  agricultural             |       | $          | 679        |                 | 10.2       | % |
| Real estate  mortgage:                   |       |       |       |                 |       |
| Residential                              |       | 951        |       | 43.8                 | %          |
| Commercial                               |       | 1,972      |       | 37.5                 | %          |
| Construction                             |       | 108        |       | 4.6                  | %          |
| Installment  loans to individuals        |       | 295        |       | 3.9                  | %          |
| Unallocated                              |       | 180        |       | —               |       |
| Total                                    |       | $          | 4,185      |                 | 100.0      | % |
| **December 31,  2005:**             |       |       |       |                 |       |
| Balance at end  of period applicable to: |       |       |       |                 |       |
| Commercial and  agricultural             |       | $          | 582        |                 | 10.1       | % |
| Real estate  mortgage:                   |       |       |       |                 |       |
| Residential                              |       | 1,107      |       | 44.2                 | %          |
| Commercial                               |       | 1,482      |       | 37.5                 | %          |
| Construction                             |       | 79         |       | 3.1                  | %          |
| Installment  loans to individuals        |       | 192        |       | 5.1                  | %          |
| Unallocated                              |       | 237        |       | —               |       |
| Total                                    |       | $          | 3,679      |                 | 100.0      | % |
| **December 31,  2004:**             |       |       |       |                 |       |
| Balance at end  of period applicable to: |       |       |       |                 |       |
| Commercial and  agricultural             |       | $          | 361        |                 | 9.1        | % |
| Real estate  mortgage:                   |       |       |       |                 |       |
| Residential                              |       | 1,280      |       | 46.1                 | %          |
| Commercial                               |       | 1,399      |       | 37.5                 | %          |
| Construction                             |       | 75         |       | 2.5                  | %          |
| Installment  loans to individuals        |       | 207        |       | 4.8                  | %          |
| Unallocated                              |       | 16         |       | —               |       |
| Total                                    |       | $          | 3,338      |                 | 100.0      | % |

 

**DEPOSITS**

 

**2008 vs 2007**

 

Totalaverage deposits were $417,552,000 for 2008, an increase of $20,344,000 or5.12% from 2007.  Core deposits, 

 

28

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whichexcludes time deposits, increased due to renewed focus on deposit gatheringefforts and the impact of natural gas exploration through out our marketfootprint.  Time deposits remained stableas the Bank focused on service rather than attracting deposits purely on rate.  In addition, the Bank has been able tocapitalize on its reputation of safety and soundness during the events of 2008that unsettled consumer confidence. Additionally, the FDIC temporarily raisedthe limit on federal deposit insurance from $100,000 to $250,000. The Bank hasalso chosen to participate in an FDIC program pursuant to which allnoninterest-bearing transaction accounts are guaranteed in full by the FDICuntil December 31, 2009, regardless of the standard maximum depositinsurance amount.

 

**2007 vs 2006**

 

Totalaverage deposits were $397,208,000 for 2007, an increase of $17,862,000 or4.71% from 2006.  Noninterest-bearingdeposits increased slightly to $69,953,000. Time deposits increased $21,508,000 or 12.19% as deposits shifted fromtransaction accounts to time deposits, due to the continued rate disparitybetween time deposits and other deposit types. The rate on time deposits increased due to the actions taken by the FOMCduring 2006, which increased the overall rate paid on time deposits.  In addition, the Bank utilized brokered timedeposits to supplement market area deposit funding with the level of brokereddeposits decreasing $16,197,000 to $8,831,000 at December 31, 2007.

 

The average amount and the average rate paid ondeposits are summarized below for the years ended December 31, 2008, 2007,and 2006:

 

(In Thousands)

 
| ** **              | ** ** | **2008**    | ** ** | **2007**   | ** ** | **2006**    | ** ** |
|-------------------------|------------|-------------|------------|------------|------------|-------------|------------|
| ** **              | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** |
| ** **              | ** ** | **Amount**  | ** ** | **Rate**   | ** ** | **Amount**  | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
| Noninterest-bearing     |       | $           | 73,618     |       | 0.00       | %           | $          | 69,953 |   | 0.00 | % | $ | 69,668 |   | 0.00 | % |
| Savings                 |       | 60,324      |       | 0.73       | %          | 58,710      |       | 0.73 | % | 61,958 |   | 0.82 | % |
| Super Now               |       | 52,117      |       | 1.26       | %          | 46,596      |       | 1.31 | % | 47,294 |   | 1.38 | % |
| Money Market            |       | 30,921      |       | 2.26       | %          | 23,920      |       | 2.26 | % | 23,905 |   | 2.06 | % |
| Time                    |       | 200,572     |       | 3.92       | %          | 198,029     |       | 4.73 | % | 176,521 |   | 4.11 | % |
| Total average  deposits |       | $           | 417,552    |       | 2.31       | %           | $          | 397,208 |   | 2.76 | % | $ | 379,346 |   | 2.35 | % |

##### ** **

##### **SHAREHOLDERS’ EQUITY**

##### ** **

**2008**

 

Shareholders’equity decreased $9,532,000 to $61,027,000 at December 31, 2008 asaccumulated comprehensive loss increased $6,327,000, and $1,371,000 in commonstock was strategically repurchased as part of the previously announced stockbuyback plan, while net income outpaced dividends paid.  The decrease in accumulated othercomprehensive income is a result of a decline in the market value of certainsecurities held in the investment portfolio at December 31, 2008 comparedto December 31, 2007, resulting in a net unrealized loss of $8,486,000 at December 31,2008 compared to a net unrealized loss of $2,159,000 at December 31, 2007.In addition, the net excess of the projected benefit obligation over the marketvalue of the plan assets of the defined benefit pension plan increased$2,405,000 due to a decline in the market value of the plan assets caused bythe significant downturn in the stock and bond markets over the past year.  The current level of shareholders’ equityequates to a book value per share of $15.93 at December 31, 2008 comparedto $18.21 at December 31, 2007 and an equity to asset ratio of 9.35% at December 31,2008. Book value per share, excluding accumulated other comprehensive loss, was$19.13 at December 31, 2008 compared to $19.12 at December 31, 2007.During the three and twelve months ended December 31, 2008 cash dividendsof $0.46 and $1.84 per share were paid to shareholders compared to $0.46 and$1.79 for the comparable periods of 2007.

 

**2007**

 

Shareholders’equity decreased $4,035,000 to $70,559,000 at December 31, 2007 as netincome outpaced dividends paid, accumulated comprehensive income decreased$5,094,000, and $972,000 in treasury stock was strategically purchased as partof the previously announced stock buyback plan. The decrease in accumulated comprehensive income is the result of adecrease in market value, or net unrealized loss, of the investment portfolioat December 31, 2007 as compared to December 31, 2006, and the netexcess of the projected benefit obligation over the market value of the planassets of the defined benefit pension plan. The current level of shareholders’ equity equates to a book value pershare of $19.12 at December 31, 2007 as compared to $18.21 at December 31,2006 and an equity to asset ratio of 11.23% at December 31,

 

29

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2007.During the twelve months ended December 31, 2007 cash dividends of $1.79per share were paid to shareholders.  Thedividends represented a 3% increase or $0.06 per share over the dividends paidduring the comparable period of 2006.

 

Bankregulators have risk based capital guidelines. Under these guidelines the Company and Bank are required to maintainminimum ratios of core capital and total qualifying capital as a percentage ofrisk weighted assets and certain off-balance sheet items. At December 31,2008, both the Company’s and Bank’s required ratios were well above the minimumratios as follows:

 
| ** **            | ** ** | ** **  | ** ** | ** ** | ** ** | **Minimum**   | ** ** |
|-----------------------|------------|-------------|------------|------------|------------|---------------|------------|
| ** **            | ** ** | **Company** | ** ** | **Bank**   | ** ** | **Standards** | ** ** |
| Tier 1 capital  ratio |       | 9.7         | %          | 8.3        | %          | 4.0           | %          |
| Total capital  ratio  |       | 16.0        | %          | 13.9       | %          | 8.0           | %          |

 

Fora more comprehensive discussion of these requirements, see “Regulations andSupervision” in Item 1 of the Annual Report on Form 10-K.  Management believes that the Company willcontinue to exceed regulatory capital requirements.

 

**RETURN ON EQUITY AND ASSETS**

 

Theratio of net income to average total assets and average shareholders’ equityand other certain equity ratios are presented as follows:

 
| ** **                                                               | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Percentage of  net income to:                                            |       |     |       |     |       |     |       |
| Average total  assets                                                    |       | 1.27     | %          | 1.49     | %          | 1.67     | %          |
| Average  shareholders’ equity                                       |       | 12.02    | %          | 12.14    | %          | 12.93    | %          |
| Percentage of  dividends declared to net income                          |       | 88.67    | %          | 78.33    | %          | 70.51    | %          |
| Percentage of  average shareholders’ equity to average total assets |       | 10.53    | %          | 12.23    | %          | 12.92    | %          |

 

**LIQUIDITY, INTEREST RATE SENSITIVITY, AND MARKETRISK**

 

Fundamentalobjectives of the Company’s asset/liability management process are to maintainadequate liquidity while minimizing interest rate risk. The maintenance ofadequate liquidity provides the Company with the ability to meet its financialobligations to depositors, loan customers, and shareholders. Additionally, itprovides funds for normal operating expenditures and business opportunities asthey arise.  The objective of interestrate sensitivity management is to increase net interest income by managinginterest sensitive assets and liabilities in such a way that they can berepriced in response to changes in market interest rates.

 

TheCompany, like other financial institutions, must have sufficient fundsavailable to meet its liquidity needs for deposit withdrawals, loancommitments, and expenses.  In order tocontrol cash flow, the bank estimates future flows of cash from deposits andloan payments.  The primary sources offunds are deposits, principal and interest payments on loans andmortgage-backed securities, as well as FHLB borrowings.  Funds generated are used principally to fundloans and purchase investment securities. Management believes the Company hasadequate resources to meet its normal 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 assessed andsources of funds are determined.  Fundingstrategies consider both customer needs and economical cost.  Both short and long term funding needs areaddressed by maturities and sales of available for sale investment securities,loan repayments and maturities, and liquidating money market investments suchas federal funds sold. The use of these resources, in conjunction with accessto credit, provides core ingredients to satisfy depositor, borrower, and creditorneeds.

 

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 FHLB of $213,839,000 with$147,791,000 utilized, leaving $66,048,000 available.  In addition to this credit arrangement, theCompany has additional lines of credit with correspondent banks of $13,845,000.The Company’s management believes that it has sufficient liquidity to satisfyestimated short-term and long-term funding needs.

 

30

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Interestrate sensitivity, which is closely related to liquidity management, is afunction of the repricing characteristics of the Company’s portfolio of assetsand liabilities.  Asset/liabilitymanagement strives to match maturities and rates between loan and investmentsecurity assets 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 gap is managed based onpredictions about future market interest rates. Intentional mismatching, or gapping, can enhance net interest income ifmarket rates move as predicted.  However,if market rates behave in a manner contrary to predictions, net interest incomewill suffer.  Gaps, therefore, contain anelement of risk and must be prudently managed. In addition to gap management, the Company has an asset liabilitymanagement policy which incorporates a market value at risk calculation whichis used to determine the effects of interest rate movements on shareholders’equity and a simulation analysis to monitor the effects of interest ratechanges on the Company’s balance sheet.

 

**INTEREST RATE SENSITIVITY**

 

Inthis analysis the Company examines the result of a 100 and 200 basis pointchange in market interest rates and the effect on net interest income. It isassumed that the change is instantaneous and that all rates move in a parallelmanner.  Assumptions are also madeconcerning prepayment speeds on mortgage loans and mortgage securities.

 

Thefollowing is a rate shock forecast for the twelve month period ended December 31,2009 assuming a static balance sheet as of December 31, 2008.

 

(In Thousands)

 
| ** **                  | ** ** | **Parallel Rate Shock in Basis Points** | ** ** |
|-----------------------------|------------|------------------------------------------------------------------|------------|
| ** **                  | ** ** | **-200**                                                         | ** ** | **-100** | ** ** | **Static** | ** ** | **+100** | ** ** | **+200** | ** ** |
| Net interest  income        |       | $                                                                | 23,038     |   | $ | 22,336 |   | $ | 21,287 |   | $ | 20,344 |   | $ | 19,333 |   |
| Change from  static         |       | 1,751                                                            |       | 1,049 |   | — |   | (943 | ) | (1,954 | ) |
| Percent change  from static |       | 8.23                                                             | %          | 4.93 | % | — |   | -2.63 | % | -6.33 | % |
|                             |            |                                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Themodel utilized to create the report presented above makes various estimates ateach level of interest rate change regarding cash flow from principal repaymenton loans and mortgage-backed securities and or call activity on investmentsecurities.  Actual results could differsignificantly from these estimates which would result in significant differencesin the calculated 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 Company iswell positioned to respond expeditiously when the market interest rate outlookchanges.

 

**INFLATION**

 

Theasset and liability structure of a financial institution is primarily monetaryin nature; therefore, interest rates rather than inflation have a moresignificant impact on the Company’s performance.  Interest rates are not always affected in thesame direction or magnitude as prices of other goods and services, but arereflective of fiscal policy initiatives or economic factors that are notmeasured by a price index.

 

**CRITICAL ACCOUNTING POLICIES**

 

TheCompany’s accounting policies are integral to understanding the resultsreported.  The accounting policies aredescribed in detail in Note 1 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 of our current accounting policiesinvolving significant management valuation judgments.

 

**Other Than Temporary Impairmentof Debt and Equity Securities**

Debtand Equity securities are evaluated periodically to determine whether a declinein their value is other than temporary. Management utilizes criteria such asthe magnitude and duration of the decline, in addition to the reason underlyingthe

 

31

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decline,to determine whether the loss in value is other than temporary. The term “otherthan temporary” is not intended to indicate that the decline is permanent.  It indicates that the prospects for a nearterm recovery of value are not necessarily favorable, or that there is a lackof evidence to support fair values equal to, or greater than, the carryingvalue of the investment.  Once a declinein value is determined to be other than temporary, the value of the security isreduced and a corresponding charge to earnings is recognized. For a fulldiscussion of the Company’s methodology of assessing impairment, refer to Note3 of “Notes and Consolidated Financial Statements” of the Annual Report on Form 10-K.

 

**Allowance for Loan Losses**

Arrivingat an appropriate 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 currently unforeseen. The allowance is increased by provisions for loan losses and byrecoveries of loans previously charged-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 1 of “Notes and Consolidated Financial Statements” of theAnnual Report of Form 10-K.

 

**Goodwill and Other IntangibleAssets**

Asdiscussed in Note 6 of the “Notes to Consolidated Financial Statements” of theAnnual Report on Form 10-K, the Company must assess goodwill and otherintangible assets each year for impairment. This assessment involves estimating cash flows for future periods. Ifthe future cash flows were less than the recorded goodwill and other intangibleassets balances, we would be required to take a charge against earnings to writedown the assets to the lower value.

 

**Deferred Tax Assets**

Weuse an estimate of future earnings to support our position that the benefit ofour deferred tax assets will be realized. If future income should prove non-existent or less than the amount of thedeferred 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 described furtherin Note 10 of “Notes to Consolidated Financial Statements” of  the Annual Report on Form 10-K.

 

**Pension Benefits**

Pensioncosts and liabilities are dependent on assumptions used in calculating suchamounts.  These assumptions includediscount rates, benefits earned, interest costs, expected return on planassets, mortality rates, and other factors. In accordance with generally accepted accounting principles, actualresults that differ from the assumptions are accumulated and amortized overfuture periods and, therefore, generally affect recognized expense and therecorded obligation of future periods. While management believes that the assumptions used are appropriate,differences in actual experience or changes in assumptions may affect theCompany’s pension obligations and future expense.  Our pension benefits are described further inNote 11 of “Notes to Consolidated Financial Statements” of the Annual Report onForm 10-K.

 

**CONTRACTUAL OBLIGATIONS**

 

The Company has various financial obligations,including contractual obligations which may require future cash payments. The followingtable presents, as of December 31, 2008, significant fixed anddeterminable contractual obligations to third parties by payment date.  Further discussion of the nature of eachobligation is included in “Notes to the Consolidated Financial Statements” ofthe Annual Report on Form 10-K.

 

(In Thousands)

 
| ** **                          | ** ** | **Payments Due In** | ** ** |
|-------------------------------------|------------|-------------------------------|------------|
| ** **                          | ** ** | ** **                    | ** ** | **One to** | ** ** | **Three to** | ** ** | **Over** | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **One Year**             | ** ** | **Three** | ** ** | **Five** | ** ** | **Five** | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **or Less**              | ** ** | **Years** | ** ** | **Years** | ** ** | **Years** | ** ** | **Total** | ** ** |
| Deposits without  a stated maturity |       | $                             | 224,373    |   | $ | — |   | $ | — |   | $ | — |   | $ | 224,373 |   |
| Time Deposits                       |       | 158,473                       |       | 33,913 |   | 3,832 |   | 778 |   | 196,996 |   |
| Repurchase  agreements              |       | 12,933                        |       | — |   | — |   | — |   | 12,933 |   |
| Short-term  borrowings, FHLB        |       | 61,013                        |       | — |   | — |   | — |   | 61,013 |   |
| Long-term  borrowings, FHLB         |       | —                        |       | 25,500 |   | 20,528 |   | 40,750 |   | 86,778 |   |
| Operating leases                    |       | 387                           |       | 700 |   | 523 |   | 1,703 |   | 3,313 |   |
|                                     |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The Corporation’s operating lease obligationsrepresent short and long-term lease and rental payments for branch facilities.

 

32

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The Bank leases certain facilities underoperating leases which expire on various dates through 2024.  Renewal options are available on the majorityof these leases.

 

**CAUTIONARY STATEMENT FOR PURPOSES OF THE PRIVATE SECURITIESLITIGATION REFORM ACT OF 1995**

 

ThisReport contains certain “forward-looking statements” including statementsconcerning plans, objectives, future events or performance and assumptions andother statements which are other than statements of historical fact.  The Company wishes to caution readers that thefollowing important factors, among others, may have affected and could in thefuture affect the Company’s actual results and could cause the Company’s actualresults for subsequent periods to differ materially from those expressed in anyforward-looking statement made by or on behalf of the Company herein:  (i) the effect of changes in laws andregulations, including federal and state banking laws and regulations, withwhich the Company must comply, and the associated costs of compliance with suchlaws and regulations either currently or in the future as applicable; (ii) theeffect of changes in accounting policies and practices, as may be adopted bythe regulatory agencies as well as by the Financial Accounting Standards Board,or of changes in the Company’s organization, compensation and benefit plans; (iii) theeffect on the Company’s competitive position within its market area of the  increasing consolidation within the bankingand financial services industries, including the increased competition fromlarger regional and out-of-state banking organizations as well as non-bankproviders of various financial services; (iv) the effect of changes ininterest rates; and (v) the effect of changes in the business cycle anddownturns in the local, regional or national economies.

 

**ITEM 7AQUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Market risk forthe 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 providedin the Interest Sensitivity section of Item 7 Management’s Discussion andAnalysis of Financial Condition 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 ANDSUPPLEMENTARY DATA**

 

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

 

Boardof Directors and Shareholders

 

PennsWoods Bancorp, Inc.

 

Wehave audited the accompanying consolidated balance sheets of Penns WoodsBancorp, Inc. (the “Company”) and subsidiaries as of December 31,2008 and 2007, and the related consolidated statements of income, comprehensiveincome, stockholders’ equity, and cash flows for each of the three years in theperiod ended December 31, 2008. These financial statements are theresponsibility 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 the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation.  We believe that our auditsprovide a reasonable basis for our opinion.

 

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of the Company andsubsidiaries as of December 31, 2008 and 2007, and the results of theiroperations and their cash flows for each of the three years in the period endedDecember 31, 2008, in conformity with U.S. generally accepted accountingprinciples.

 

Asdiscussed in Note 1 to the consolidated financial statements, effective January 1,2008, the Company adopted Emerging Issues Task Force No. 06-4, *Accounting for Deferred Compensation andPost-retirement Benefit Aspects of Endorsement Split Dollar Life InsuranceArrangements*. Also, as discussed in Note 19 to the consolidatedfinancial statements, effective January 1, 2008, the Company adoptedStatement of Financial Accounting Standards No. 157, *Fair Value Measurements*.

 

Wehave also audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the Company’s and subsidiaries’internal control over financial reporting as of December 31, 2008, basedon criteria established in *Internal Control— Integrated Framework*issued by the Committee of SponsoringOrganizations of the Treadway Commission, and our report dated March 10,2009 expressed an unqualified opinion on the effectiveness of the Company’sinternal control over financial reporting.

 

 
| /s/ S.R. Snodgrass, A.C. |   |
|--------------------------|--------|
|                     |   |
| Wexford, PA              |   |
| March 10, 2009      |   |

 

33

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**PENNSWOODS BANCORP, INC.**

**CONSOLIDATEDBALANCE SHEET**

 

(In Thousands, Except Share Data)

 
| ** **                                                                                           | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                           | ** ** | **2008**              | ** ** | **2007** | ** ** |
|                                                                                                 |       |                  |       |   |   |
| **ASSETS:**                                                                                          |       |                  |       |   |   |
| Noninterest-bearing  balances                                                                        |       | $                     | 16,563     |   | $ | 15,417 |   |
| Interest-bearing  deposits in other financial institutions                                           |       | 18                    |       | 16 |   |
| Total cash and  cash equivalents                                                                     |       | 16,581                |       | 15,433 |   |
|                                                                                                 |       |                  |       |   |   |
| Investment  securities, available for sale, at fair value                                            |       | 208,251               |       | 214,455 |   |
| Investment  securities, held to maturity, (fair value of $136 and $279)                              |       | 135                   |       | 277 |   |
| Loans held for  sale                                                                                 |       | 3,622                 |       | 4,214 |   |
|                                                                                                 |       |                  |       |   |   |
| Loans                                                                                                |       | 381,478               |       | 360,478 |   |
| Less: Allowance  for loan losses                                                                     |       | 4,356                 |       | 4,130 |   |
| Loans, net                                                                                           |       | 377,122               |       | 356,348 |   |
|                                                                                                 |       |                  |       |   |   |
| Premises and  equipment, net                                                                         |       | 7,865                 |       | 6,774 |   |
| Accrued interest  receivable                                                                         |       | 3,614                 |       | 3,343 |   |
| Bank-owned life  insurance                                                                           |       | 14,546                |       | 12,375 |   |
| Investment in  limited partnerships                                                                  |       | 4,727                 |       | 5,439 |   |
| Goodwill                                                                                             |       | 3,032                 |       | 3,032 |   |
| Other assets                                                                                         |       | 13,308                |       | 6,448 |   |
| **TOTAL  ASSETS**                                                                                    |       | $                     | 652,803    |   | $ | 628,138 |   |
|                                                                                                 |       |                  |       |   |   |
| **LIABILITIES:**                                                                                     |       |                  |       |   |   |
| Interest-bearing  deposits                                                                           |       | $                     | 345,333    |   | $ | 314,351 |   |
| Noninterest-bearing  deposits                                                                        |       | 76,035                |       | 74,671 |   |
| Total deposits                                                                                       |       | 421,368               |       | 389,022 |   |
|                                                                                                 |       |                  |       |   |   |
| Short-term  borrowings                                                                               |       | 73,946                |       | 55,315 |   |
| Long-term  borrowings, Federal Home Loan Bank (FHLB)                                                 |       | 86,778                |       | 106,378 |   |
| Accrued interest  payable                                                                            |       | 1,317                 |       | 1,744 |   |
| Other  liabilities                                                                                   |       | 8,367                 |       | 5,120 |   |
| TOTAL  LIABILITIES                                                                                   |       | 591,776               |       | 557,579 |   |
|                                                                                                 |       |                  |       |   |   |
| **SHAREHOLDERS’  EQUITY:**                                                                      |       |                  |       |   |   |
| Common stock,  par value $8.33, 10,000,000 shares authorized; 4,010,528 and 4,006,934 shares  issued |       | 33,421                |       | 33,391 |   |
| Additional paid-in  capital                                                                          |       | 17,959                |       | 17,888 |   |
| Retained  earnings                                                                                   |       | 28,177                |       | 27,707 |   |
| Accumulated  other comprehensive loss:                                                               |       |                  |       |   |   |
| Net unrealized  loss on available for sale securities                                                |       | (8,486                | )          | (2,159 | ) |
| Defined benefit  plan                                                                                |       | (3,780                | )          | (1,375 | ) |
| Less: Treasury  stock at cost, 179,028 and 131,302 shares                                            |       | (6,264                | )          | (4,893 | ) |
| TOTAL  SHAREHOLDERS’ EQUITY                                                                     |       | 61,027                |       | 70,559 |   |
| **TOTAL  LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                 |       | $                     | 652,803    |   | $ | 628,138 |   |

 

See Accompanying Notes tothe Consolidated Financial Statements

 

34

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PENNS WOODS BANCORP, INC.

CONSOLIDATED STATEMENT OF INCOME

** **

(In Thousands, Except Per Share Data)

** **
| ** **                                               | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                               | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                     |       |                                       |       |   |   |   |   |
| **INTEREST  AND DIVIDEND INCOME:**                       |       |                                       |       |   |   |   |   |
| Loans including  fees                                    |       | $                                          | 25,228     |   | $ | 26,099 |   | $ | 24,878 |   |
| Investment  securities:                                  |       |                                       |       |   |   |   |   |
| Taxable                                                  |       | 5,241                                      |       | 4,098 |   | 3,577 |   |
| Tax-exempt                                               |       | 4,871                                      |       | 4,357 |   | 4,027 |   |
| Dividend and  other interest income                      |       | 768                                        |       | 1,395 |   | 1,271 |   |
|                                                     |       |                                       |       |   |   |   |   |
| TOTAL INTEREST  AND DIVIDEND INCOME                      |       | 36,108                                     |       | 35,949 |   | 33,753 |   |
|                                                     |       |                                       |       |   |   |   |   |
| **INTEREST  EXPENSE:**                                   |       |                                       |       |   |   |   |   |
| Deposits                                                 |       | 9,670                                      |       | 10,951 |   | 8,908 |   |
| Short-term  borrowings                                   |       | 1,181                                      |       | 1,639 |   | 1,503 |   |
| Long-term  borrowings                                    |       | 3,981                                      |       | 3,857 |   | 3,799 |   |
|                                                     |       |                                       |       |   |   |   |   |
| TOTAL INTEREST  EXPENSE                                  |       | 14,832                                     |       | 16,447 |   | 14,210 |   |
|                                                     |       |                                       |       |   |   |   |   |
| **NET  INTEREST INCOME**                                 |       | 21,276                                     |       | 19,502 |   | 19,543 |   |
|                                                     |       |                                       |       |   |   |   |   |
| PROVISION FOR  LOAN LOSSES                               |       | 375                                        |       | 150 |   | 635 |   |
|                                                     |       |                                       |       |   |   |   |   |
| **NET  INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES** |       | 20,901                                     |       | 19,352 |   | 18,908 |   |
|                                                     |       |                                       |       |   |   |   |   |
| **NON-INTEREST  INCOME:**                                |       |                                       |       |   |   |   |   |
| Service charges                                          |       | 2,289                                      |       | 2,246 |   | 2,366 |   |
| Securities  (losses) gains, net                          |       | (2,031                                     | )          | (54 | ) | 1,679 |   |
| Bank-owned life  insurance                               |       | 472                                        |       | 410 |   | 374 |   |
| Gain on sale of  loans                                   |       | 882                                        |       | 921 |   | 853 |   |
| Insurance  commissions                                   |       | 1,928                                      |       | 2,222 |   | 2,281 |   |
| Other income                                             |       | 1,916                                      |       | 1,733 |   | 1,476 |   |
|                                                     |       |                                       |       |   |   |   |   |
| TOTAL  NON-INTEREST INCOME                               |       | 5,456                                      |       | 7,478 |   | 9,029 |   |
|                                                     |       |                                       |       |   |   |   |   |
| **NON-INTEREST  EXPENSE:**                               |       |                                       |       |   |   |   |   |
| Salaries and  employee benefits                          |       | 9,634                                      |       | 9,078 |   | 8,833 |   |
| Occupancy  expense, net                                  |       | 1,288                                      |       | 1,306 |   | 1,137 |   |
| Furniture and  equipment expense                         |       | 1,182                                      |       | 1,126 |   | 1,201 |   |
| Pennsylvania  shares tax expense                         |       | 421                                        |       | 643 |   | 598 |   |
| Amortization of  investment in limited partnerships      |       | 712                                        |       | 761 |   | 245 |   |
| Other expenses                                           |       | 4,712                                      |       | 4,402 |   | 4,315 |   |
|                                                     |       |                                       |       |   |   |   |   |
| TOTAL  NON-INTEREST EXPENSE                              |       | 17,949                                     |       | 17,316 |   | 16,329 |   |
|                                                     |       |                                       |       |   |   |   |   |
| **INCOME  BEFORE INCOME TAX PROVISION**                  |       | 8,408                                      |       | 9,514 |   | 11,608 |   |
|                                                     |       |                                       |       |   |   |   |   |
| INCOME TAX  PROVISION                                    |       | 405                                        |       | 637 |   | 1,961 |   |
|                                                     |       |                                       |       |   |   |   |   |
| **NET  INCOME**                                          |       | $                                          | 8,003      |   | $ | 8,877 |   | $ | 9,647 |   |
|                                                     |       |                                       |       |   |   |   |   |
| **NET  INCOME PER SHARE - BASIC**                        |       | $                                          | 2.07       |   | $ | 2.28 |   | $ | 2.45 |   |
|                                                     |       |                                       |       |   |   |   |   |
| **NET  INCOME PER SHARE - DILUTED**                      |       | $                                          | 2.07       |   | $ | 2.28 |   | $ | 2.45 |   |
|                                                     |       |                                       |       |   |   |   |   |
| **WEIGHTED  AVERAGE SHARES OUTSTANDING - BASIC**         |       | 3,859,724                                  |       | 3,886,277 |   | 3,934,138 |   |
|                                                     |       |                                       |       |   |   |   |   |
| **WEIGHTED  AVERAGE SHARES OUTSTANDING - DILUTED**       |       | 3,859,833                                  |       | 3,886,514 |   | 3,934,617 |   |

 

See Accompanying Notes tothe Consolidated Financial Statements.

 

35

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PENNS WOODS BANCORP, INC.

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

 

(InThousands, Except Per Share Data)

 
| ** **                                                                                           | ** ** | ** **            | ** ** | ** **  | ** ** | ** **     | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** **             | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|----------------|------------|-------------------|------------|------------------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                           | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional** | ** ** | ** **        | ** ** | **Other**              | ** ** | ** **             | ** ** | **Total**  | ** ** |
| ** **                                                                                           | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Retained**   | ** ** | **Comprehensive** | ** ** | **Treasury**           | ** ** | **Shareholders’** | ** ** |
| ** **                                                                                           | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**    | ** ** | **Earnings**      | ** ** | **Income (Loss)** | ** ** | **Stock**              | ** ** | **Equity** | ** ** |
|                                                                                                 |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Balance,  December 31, 2005                                                                     |       | 4,002,159             |       | $           | 33,351     |           | $          | 17,772            |       | $                      | 22,938     |                   | $          | 850        |       | $ | (992 | ) | $ | 73,919 |   |
|                                                                                                 |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Cumulative  effect of change in accounting for pension obligations, net of tax benefit of  $298      |       |                  |       |        |       |           |       |              |       | (579                   | )          |                   |       | (579       | )          |
| Comprehensive  income:                                                                               |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Net income                                                                                           |       |                  |       |        |       |           |       | 9,647             |       |                   |       |                   |       | 9,647      |       |
| Other  comprehensive income                                                                          |       |                  |       |        |       |           |       |              |       | 1,289                  |       |                   |       | 1,289      |       |
| Dividends  declared ($1.73 per share)                                                                |       |                  |       |        |       |           |       | (6,802            | )          |                   |       |                   |       | (6,802     | )          |
| Common shares  issued for employee stock purchase plan                                               |       | 1,355                 |       | 11          |       | 38             |       |              |       |                   |       |                   |       | 49         |       |
| Purchase of  treasury stock (76,400 shares)                                                          |       |                  |       |        |       |           |       |              |       |                   |       | (2,929                 | )          | (2,929     | )          |
|                                                                                                 |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Balance,  December 31, 2006                                                                     |       | 4,003,514             |       | 33,362      |       | 17,810         |       | 25,783            |       | 1,560                  |       | (3,921                 | )          | 74,594     |       |
|                                                                                                 |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Comprehensive  income:                                                                               |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Net income                                                                                           |       |                  |       |        |       |           |       | 8,877             |       |                   |       |                   |       | 8,877      |       |
| Other  comprehensive loss                                                                            |       |                  |       |        |       |           |       |              |       | (5,094                 | )          |                   |       | (5,094     | )          |
| Dividends  declared ($1.79 per share)                                                                |       |                  |       |        |       |           |       | (6,953            | )          |                   |       |                   |       | (6,953     | )          |
| Stock options  exercised                                                                             |       | 330                   |       | 3           |       | 5              |       |              |       |                   |       |                   |       | 8          |       |
| Common shares  issued for employee stock purchase plan                                               |       | 3,090                 |       | 26          |       | 73             |       |              |       |                   |       |                   |       | 99         |       |
| Purchase of  treasury stock (28,530 shares)                                                          |       |                  |       |        |       |           |       |              |       |                   |       | (972                   | )          | (972       | )          |
|                                                                                                 |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Balance,  December 31, 2007                                                                     |       | 4,006,934             |       | 33,391      |       | 17,888         |       | 27,707            |       | (3,534                 | )          | (4,893                 | )          | 70,559     |       |
|                                                                                                 |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Cumulative  effect of change in accounting for endorsement split-dollar life insurance  arrangements |       |                  |       |        |       |           |       | (437              | )          |                   |       |                   |       | (437       | )          |
| Comprehensive  loss:                                                                                 |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Net income                                                                                           |       |                  |       |        |       |           |       | 8,003             |       |                   |       |                   |       | 8,003      |       |
| Other comprehensive  loss                                                                            |       |                  |       |        |       |           |       |              |       | (8,732                 | )          |                   |       | (8,732     | )          |
| Dividends  declared ($1.84 per share)                                                                |       |                  |       |        |       |           |       | (7,096            | )          |                   |       |                   |       | (7,096     | )          |
| Stock options  exercised                                                                             |       | 330                   |       | 3           |       | 8              |       |              |       |                   |       |                   |       | 11         |       |
| Common shares  issued for employee stock purchase plan                                               |       | 3,264                 |       | 27          |       | 63             |       |              |       |                   |       |                   |       | 90         |       |
| Purchase of  treasury stock (47,726 shares)                                                          |       |                  |       |        |       |           |       |              |       |                   |       | (1,371                 | )          | (1,371     | )          |
|                                                                                                 |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Balance,  December 31, 2008                                                                     |       | 4,010,528             |       | $           | 33,421     |           | $          | 17,959            |       | $                      | 28,177     |                   | $          | (12,266    | )          | $ | (6,264 | ) | $ | 61,027 |   |

 

**PENNSWOODS BANCORP, INC.**

** CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME(LOSS)**

 
| ** **                                                                                           | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                           | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                                                 |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Net Income                                                                                           |       |                                       |       | $ | 8,003 |   |   |   | $ | 8,877 |   |   |   | $ | 9,647 |   |
| Other  Comprehensive (loss) income, net of tax:                                                      |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Change in  unrealized (loss) gain on available for sale securities                                   |       | (7,667                                     | )          |   |   | (4,334 | ) |   |   | 2,397 |   |   |   |
| Net realized  loss (gain) included in net income, net of (benefit) taxes of $(691), $(18),  and $571 |       | 1,340                                      |       |   |   | 36 |   |   |   | (1,108 | ) |   |   |
|                                                                                                 |       | (6,327                                     | )          |   |   | (4,298 | ) |   |   | 1,289 |   |   |   |
| Defined benefit  pension plans:                                                                      |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Net transition  asset                                                                                |       | (2                                         | )          |   |   | (2 | ) |   |   | — |   |   |   |
| Prior service  cost                                                                                  |       | 17                                         |       |   |   | 17 |   |   |   | — |   |   |   |
| Net loss                                                                                             |       | (2,420                                     | )          |   |   | (811 | ) |   |   | — |   |   |   |
| Other  comprehensive (loss) income, net of tax                                                       |       |                                       |       | (8,732 | ) |   |   | (5,094 | ) |   |   | 1,289 |   |
| Comprehensive  (loss) income                                                                         |       |                                       |       | $ | (729 | ) |   |   | $ | 3,783 |   |   |   | $ | 10,936 |   |

 

See AccompanyingNotes to the Consolidated Financial Statements

 

36

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PENNS WOODS BANCORP, INC.

CONSOLIDATED STATEMENT OFCASH FLOWS

 

(In Thousands)

 
| ** **                                                                         | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                         | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                               |       |                                       |       |   |   |   |   |
| **OPERATING  ACTIVITIES:**                                                         |       |                                       |       |   |   |   |   |
| Net income                                                                         |       | $                                          | 8,003      |   | $ | 8,877 |   | $ | 9,647 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                       |       |   |   |   |   |
| Depreciation and  amortization                                                     |       | 663                                        |       | 680 |   | 744 |   |
| Provision for  loan losses                                                         |       | 375                                        |       | 150 |   | 635 |   |
| Accretion and  amortization of investment security discounts and premiums, net     |       | (1,361                                     | )          | (1,011 | ) | (784 | ) |
| Securities  losses (gains), net                                                    |       | 2,031                                      |       | 54 |   | (1,679 | ) |
| Originations of  loans held for sale                                               |       | (39,456                                    | )          | (43,783 | ) | (37,192 | ) |
| Proceeds of  loans held for sale                                                   |       | 40,930                                     |       | 44,206 |   | 37,874 |   |
| Gain on sale of  loans                                                             |       | (882                                       | )          | (921 | ) | (853 | ) |
| Increases in  bank-owned life insurance                                            |       | (472                                       | )          | (410 | ) | (374 | ) |
| Other, net                                                                         |       | (2,830                                     | )          | (214 | ) | (29 | ) |
|                                                                               |       |                                       |       |   |   |   |   |
| Net cash  provided by operating activities                                         |       | 7,001                                      |       | 7,628 |   | 7,989 |   |
|                                                                               |       |                                       |       |   |   |   |   |
| **INVESTING  ACTIVITIES:**                                                         |       |                                       |       |   |   |   |   |
| Investment  securities available for sale:                                         |       |                                       |       |   |   |   |   |
| Proceeds from  sales                                                               |       | 40,169                                     |       | 60,485 |   | 76,249 |   |
| Proceeds from  calls and maturities                                                |       | 6,759                                      |       | 5,233 |   | 7,477 |   |
| Purchases                                                                          |       | (50,995                                    | )          | (98,799 | ) | (78,241 | ) |
| Investment  securities held to maturity:                                           |       |                                       |       |   |   |   |   |
| Proceeds from  calls and maturities                                                |       | 4                                          |       | 12 |   | 25 |   |
| Purchases                                                                          |       | 176                                        |       | — |   | (25 | ) |
| Net increase in  loans                                                             |       | (21,613                                    | )          | (374 | ) | (22,353 | ) |
| Acquisition of  bank premises and equipment, net                                   |       | (1,754                                     | )          | (717 | ) | (1,072 | ) |
| Proceeds from  the sale of foreclosed assets                                       |       | 112                                        |       | 65 |   | 329 |   |
| Purchase of  bank-owned life insurance                                             |       | (1,699                                     | )          | (619 | ) | (254 | ) |
| Investment in  limited partnership                                                 |       | —                                     |       | (1,250 | ) | (1,646 | ) |
| Proceeds from  redemption of regulatory stock                                      |       | (4,629                                     | )          | 5,081 |   | 3,630 |   |
| Purchases of  regulatory stock                                                     |       | 4,606                                      |       | (6,816 | ) | (2,899 | ) |
|                                                                               |       |                                       |       |   |   |   |   |
| Net cash used  for investing activities                                            |       | (28,864                                    | )          | (37,699 | ) | (18,780 | ) |
|                                                                               |       |                                       |       |   |   |   |   |
| **FINANCING  ACTIVITIES:**                                                         |       |                                       |       |   |   |   |   |
| Net increase  (decrease) in interest-bearing deposits                              |       | 30,982                                     |       | (7,680 | ) | 40,881 |   |
| Net increase in  noninterest-bearing deposits                                      |       | 1,364                                      |       | 1,511 |   | 1,781 |   |
| Net increase  (decrease) in short-term borrowings                                  |       | 18,631                                     |       | 20,618 |   | (19,306 | ) |
| Proceeds from  long-term borrowings, FHLB                                          |       | 10,000                                     |       | 40,000 |   | — |   |
| Repayment of  long-term borrowings, FHLB                                           |       | (29,600                                    | )          | (16,500 | ) | (1,600 | ) |
| Dividends paid                                                                     |       | (7,096                                     | )          | (6,953 | ) | (6,802 | ) |
| Issuance of  common stock                                                          |       | 90                                         |       | 99 |   | 49 |   |
| Stock options  exercised                                                           |       | 11                                         |       | 8 |   | — |   |
| Purchase of  treasury stock                                                        |       | (1,371                                     | )          | (972 | ) | (2,929 | ) |
|                                                                               |       |                                       |       |   |   |   |   |
| Net cash  provided by financing activities                                         |       | 23,011                                     |       | 30,131 |   | 12,074 |   |
|                                                                               |       |                                       |       |   |   |   |   |
| NET INCREASE IN  CASH AND CASH EQUIVALENTS                                         |       | 1,148                                      |       | 60 |   | 1,283 |   |
|                                                                               |       |                                       |       |   |   |   |   |
| CASH AND CASH  EQUIVALENTS, BEGINNING                                              |       | 15,433                                     |       | 15,373 |   | 14,090 |   |
|                                                                               |       |                                       |       |   |   |   |   |
| CASH AND CASH  EQUIVALENTS, ENDING                                                 |       | $                                          | 16,581     |   | $ | 15,433 |   | $ | 15,373 |   |
|                                                                               |       |                                       |       |   |   |   |   |
| **SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION:**                            |       |                                       |       |   |   |   |   |
|                                                                               |       |                                       |       |   |   |   |   |
| Interest paid                                                                      |       | $                                          | 15,259     |   | $ | 16,235 |   | $ | 13,786 |   |
| Income taxes  paid                                                                 |       | 2,085                                      |       | 1,610 |   | 2,645 |   |
| Transfer of  loans to foreclosed real estate                                       |       | 464                                        |       | 75 |   | 278 |   |

 

See Accompanying Notes to the Consolidated Financial Statements.

 

37

----

** **

**PENNS WOODS BANCORP,INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1 — OPERATIONS AND SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

**Principles ofConsolidation**

Theaccompanying consolidated financial statements include the accounts of PennsWoods Bancorp, Inc. and its wholly owned subsidiaries, Jersey Shore StateBank (the “Bank”), Woods Real Estate Development Co., Inc., WoodsInvestment Company, Inc., and The M Group Inc. D/B/A The ComprehensiveFinancial Group (“The M Group”), a wholly owned subsidiary of the Bank(collectively, the “Company”). All significant intercompany balances andtransactions have been eliminated.

 

**Nature of Business**

TheBank engages in a full-service commercial banking business, making available tothe community a wide range of financial services including, but not limited to,installment loans, credit cards, mortgage and home equity loans, lines ofcredit, construction financing, farm loans, community development loans, loansto non-profit entities and local government, and various types of time anddemand deposits including, but not limited to, checking accounts, savingsaccounts, clubs, money market deposit accounts, certificates of deposit, andIRAs. Deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”)to the extent provided by law.

 

Thefinancial services are provided by the Bank to individuals, partnerships,non-profit organizations, and corporations through its thirteen offices locatedin Clinton, Lycoming, and Centre Counties, Pennsylvania.

 

WoodsReal Estate Development Co., Inc. engages in real estate transactions onbehalf of Penns Woods Bancorp, Inc. and the Bank.

 

WoodsInvestment Company, Inc., a Delaware holding company, is engaged ininvesting activities.

 

TheM Group engages in securities brokerage and financial planning services, whichinclude the sale of life insurance products, annuities, and estate planningservices.

 

Operationsare managed and financial performance is evaluated on a corporate-wide basis. Accordingly,all financial service operations are considered by management to be aggregatedin one reportable operating segment.

 

**Use of Estimates**

Thepreparation of financial statements in conformity with U.S. generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the consolidated financialstatements and the reported amounts of revenues and expenses during thereporting 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, deferredtax assets and liabilities, and the valuation of real estate acquired through,or in lieu of, foreclosure on settlement of debt.

 

**Cash and Cash Equivalents**

Cashequivalents include cash on hand and in banks and interest-earning deposits. Interest-earningdeposits mature within one year and are carried at cost. Net cash flows arereported for loan, deposit, and short-term borrowing transactions.

 

**Restrictions on Cash and CashEquivalents**

Basedon deposit levels, the Company must maintain cash and other reserves with theFederal Reserve Bank of Philadelphia (FRB).

 

**Investment Securities**

Investmentsecurities are classified at the time of purchase, based on management’sintention and ability, as securities held to maturity or securities availablefor sale. Debt securities acquired with the intent and ability to hold tomaturity are stated at cost, adjusted for amortization of premium and accretionof discount, which are computed using the interest method and recognized asadjustments of interest income. Certain other debt securities have beenclassified as available for sale to serve principally as a source of liquidity.Unrealized holding gains and losses for available for sale securities arereported as a separate component of stockholders’ equity, net of tax, untilrealized. Realized security gains and losses are computed using the specificidentification method for debt securities and the average cost method formarketable equity securities. Interest and dividends on investment securitiesare recognized as income when earned.

 

Securitiesare periodically reviewed for other-than-temporary impairment based upon anumber of factors, including, but not limited to, the length of time and extentto which the market value has been less than cost, the financial condition ofthe underlying issuer, the ability of the issuer to meet contractualobligations, the likelihood of the security’s ability to recover any decline inits market value, and management’s intent and ability to hold the security fora period of time

 

38

----

 

sufficientto allow for a recovery in market value. Among the factors that are consideredin determining management’s intent and ability is a review of the Company’scapital adequacy, interest rate risk position, and liquidity. The assessment ofa security’s ability to recover any decline in market value, the ability of theissuer to meet contractual obligations, and management’s intent and abilityrequires considerable judgment. A decline in value that is considered to beother-than-temporary is recorded as a loss within noninterest income in theConsolidated Statement of Income.

 

Investmentsecurities fair values are based on observed market prices. Certain investmentsecurities do not have observed bid prices and their fair value is based oninstruments with similar risk elements. Since regulatory stock is redeemable atpar, the Company carries it at cost.

 

**Loans**

Loansare stated at the principal amount outstanding, net of deferred fees,unamortized loan fees and costs, and the allowance for loan losses. Interest onloans is recognized as income when earned on the accrual method. The Company’sgeneral policy has been to stop accruing interest on loans when it isdetermined a reasonable doubt exists as to the collectability of additionalinterest. Income is subsequently recognized only to the extent that cashpayments are received provided the loan is not delinquent in payment and, inmanagement’s judgment, the borrower has the ability and intent to make futureprincipal payments.

 

Loan origination and commitmentfees as well as certain direct loan origination costs are being deferred andamortized as an adjustment to the related loan’s yield over the contractuallives of the related loans.

 

**Allowance forLoan Losses**

The allowance for loan lossesrepresents the amount which management estimates is adequate to provide forprobable losses inherent in its loan portfolio, as of the balance sheet date. Theallowance method is used in providing for loan losses. Accordingly, all loanlosses are charged to the allowance and all recoveries are credited to it. Theallowance for loan losses is established through a provision for loan lossescharged to operations. The provision for loan losses is based upon management’squarterly review of the loan portfolio. The purpose of the review is to assessloan quality, identify impaired loans, analyze delinquencies, ascertain loangrowth, evaluate potential charge-offs and recoveries, and assess generaleconomic conditions in the markets served. An external independent loan reviewis also performed annually for the Bank. Management remains committed to anaggressive program of problem loan identification and resolution.

 

Theallowance is calculated by applying loss factors to outstanding loans by type,excluding loans for which a specific allowance has been determined. Lossfactors are based on management’s consideration of the nature of the portfoliosegments, changes in mix and volume of the loan portfolio, historical loan lossexperience, and general economic conditions. In addition, management considersindustry standards and trends with respect to nonperforming loans and itsknowledge and experience with specific lending segments.

 

Althoughmanagement believes that it uses the best information available to make suchdeterminations and that the allowance for loan losses is adequate at December 31,2008, future adjustments could be necessary if circumstances or economicconditions differ substantially from the assumptions used in making the initialdeterminations. A downturn in the local economy, rising unemployment, ornegative performance trends in financial information from borrowers could beindicators of subsequent increased levels of nonperforming assets and possiblecharge-offs, which would normally require increased loan loss provisions. Anintegral part of the periodic regulatory examination process is the review ofthe adequacy of the Bank’s loan loss allowance. The regulatory agencies couldrequire the Bank, based on their evaluation of information available at thetime of their examination, to provide additional loan loss provisions tofurther supplement the allowance.

 

Impairedloans are commercial and commercial real estate loans for which it is probablethe Bank will not be able to collect all amounts due according to the contractualterms of the loan agreement. The Bank individually evaluates such loans forimpairment and does not aggregate loans by major risk classifications. Thedefinition of “impaired loans” is not the same as the definition of “nonaccrualloans,” although the two categories overlap. The Bank may choose to place aloan on nonaccrual status due to payment delinquency or uncertaincollectability, while not classifying the loan as impaired if the loan is not acommercial or commercial real estate loan. Factors considered by management indetermining impairment include payment status and collateral value. The amountof impairment for these types of loans is determined by the difference betweenthe present value of the expected cash flows related to the loan, using theoriginal interest rate, and its recorded value, or as a practical expedient inthe case of collateralized loans, the difference between the fair value of thecollateral and the recorded amount of the loans. When foreclosure is probable,impairment is measured based on the fair value of the collateral.

 

Mortgageloans on one-to-four family properties and all consumer loans are large groupsof smaller-balance homogeneous loans and are measured for impairmentcollectively. Loans that experience insignificant payment delays, which aredefined as 90 days or less, generally are not classified as impaired. Managementdetermines the significance of payment delays on

 

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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**

Ingeneral, fixed rate residential mortgage loans originated by the Bank are heldfor sale and are carried at cost due to their short holding period, which canrange from less than two weeks to a maximum of thirty days. Sold loans are notserviced by the Bank. Proceeds from the sale of loans in excess of the carryingvalue are accounted for as a gain. Total gains on the sale of loans are shownas a component of non-interest income within the consolidated statement ofincome.

 

**Foreclosed Assets Held for Sale**

Foreclosedassets held for sale are carried at the lower of cost or fair value lessestimated selling costs. Prior to foreclosure, the value of the underlying loanis written down to the fair value of the real estate to be acquired by a chargeto the allowance for loan losses, if necessary. Any subsequent write-downs arecharged against operating expenses. Net operating expenses and gains and lossesrealized from disposition are included in non-interest expense and income,respectively.

 

**Premises and Equipment**

Premisesand equipment are stated at cost less accumulated depreciation. Depreciation iscomputed using straight-line and accelerated methods over the estimated usefullives of the related assets, which range from five to ten years for furniture,fixtures, and equipment and fifteen to forty years for buildings andimprovements. Costs incurred for routine maintenance and repairs are charged tooperations as incurred. Costs of major additions and improvements arecapitalized.

 

**Bank-Owned Life Insurance**

TheCompany has purchased life insurance policies on certain officers anddirectors. Bank-owned life insurance is recorded at its cash surrender value,or the amount that can be realized. Increases in the cash surrender value arerecognized as a component of non-interest income within the consolidatedstatement of income.

 

**EndorsementSplit-Dollar Life Insurance Arrangements**

OnJanuary 1, 2008, the Company changed its accounting policy and recognizeda cumulative-effect adjustment to retained earnings totaling $437,000 relatedto account for certain endorsement split-dollar life insurance arrangements inconnection with the adoption of Emerging Issues Task Force Issue No. 06-4,*Accounting for Deferred Compensation andPostretirement Benefit Aspects of Endorsement Split Dollar Life InsuranceArrangements*.

 

**Goodwill**

TheCompany accounts for goodwill in accordance with Statement of FinancialAccounting Standards (“FAS”) No. 142, *Goodwilland Other Intangible Assets*. This statement, among other things,requires a two-step process for testing the impairment of goodwill on at leastan annual basis. This approach could cause more volatility in the Company’sreported net income because impairment losses, if any, could occur irregularlyand in varying amounts. The Company performs an annual impairment analysis ofgoodwill for its purchased subsidiary, The M Group. Based on the fair value ofthis reporting unit, estimated using the expected present value of future cashflows, no impairment of goodwill was recognized in 2008 and 2007.

 

**Investments in LimitedPartnerships**

TheCompany is a limited partner in four partnerships at December 31, 2008that provide low income elderly housing in the Company’s geographic marketarea. The carrying value of the Company’s investments in limited partnershipswas $4,727,000 at December 31, 2008 and $5,439,000 at December 31,2007. The Company is fully amortizing the investment in the partnership enteredinto prior to 2005 over the fifteen-year holding period. The partnershipsentered into after 2004 are being fully amortized over the ten-year tax creditreceipt period utilizing the straight-line method. The partnerships began beingamortized once the projects reached the level of occupancy needed to begin theten year tax credit recognition period. Amortization of limited partnershipinvestments amounted to $712,000 in 2008, $761,000 in 2007, and $245,000 in2006.

 

**Off-Balance Sheet FinancialInstruments**

Inthe ordinary course of business, the Company enters into off-balance sheetfinancial instruments. Those instruments consist of commitments to extendcredit and standby letters of credit. When those instruments are funded orbecome payable, the Company reports the amounts in its financial statements.

 

**Advertising Cost**

Advertisingcosts are generally expensed as incurred.

 

**Income Taxes**

The Company adopted theprovisions of FIN No. 48, *Accountingfor Uncertainty in Income Taxes, an interpretation of FASB Statement 109*,effective January 1, 2007. FIN No. 48 prescribes a recognitionthreshold and a measurement

 

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attribute for the financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return. Benefits from tax positions should be recognized in thefinancial statements only when it is more likely than not that the tax positionwill be sustained upon examination by the appropriate taxing authority thatwould have full knowledge of all relevant information. A tax position thatmeets the more-likely-than-not recognition threshold is measured at the largestamount of benefit that is greater than fifty percent likely of being realizedupon ultimate settlement. Tax positions that previously failed to meet themore-likely-than-not recognition threshold should be recognized in the firstsubsequent financial reporting period in which that threshold is met.Previously recognized tax positions that no longer meet themore-likely-than-not recognition threshold should be derecognized in the firstsubsequent financial reporting period in which that threshold is no longer met.FIN No. 48 also provides guidance on the accounting for and disclosure ofunrecognized tax benefits, interest and penalties. Adoption of FIN No. 48did not have a significant impact on the Company’s financial statements.

 

Deferredtax assets and liabilities result from temporary differences in financial andincome tax methods of accounting, and are reflected at currently enacted incometax rates applicable to the period in which the deferred tax assets orliabilities are expected to be realized or settled. As changes in tax laws orrates are enacted, deferred tax assets and liabilities are adjusted through theprovision for income taxes.

 

**Earnings Per Share**

TheCompany provides dual presentation of basic and diluted earnings per share. Basicearnings per share is calculated utilizing net income as reported in thenumerator and weighted average shares outstanding 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**

Pensionand employee benefits include contributions, determined actuarially, to adefined benefit retirement plan covering the eligible employees of the Bank. Theplan is funded on a current basis to the extent that it is deductible underexisting federal tax regulations. Pension and other employee benefits alsoinclude contributions to a defined contribution Section 401(k) plancovering eligible employees. Contributions matching those made by eligibleemployees are funded throughout the year. In addition, an elective contributionis made annually at the discretion of the Board of Directors.

 

**The M Group Products and IncomeRecognition**

TheM Group product line is comprised primarily of annuities, life insurance, andmutual funds. The revenues generated from life insurance sales are commissiononly, as The M Group does not underwrite the policies. Life insurance salesinclude permanent and term policies with the majority of the policies writtenbeing permanent. Term life insurance policies are written for 10, 15, 20, and30 year terms with the majority of the policies being written for 20 years. Noneof these products are offered as an integral part of lending activities.

 

Commissionsfrom the sale of annuities are recognized at the time notice is received fromthe third party broker/dealer or an insurance company that the transaction hasbeen accepted and approved, which is also the time when commission income isreceived.

 

Lifeinsurance commissions are recognized at varying points based on the paymentoption chosen by the customer. Commissions from monthly and annual paymentplans are recognized at the start of each annual period for the life insurance,while quarterly and semi-annual premium payments are recognized quarterly andsemi-annually when the earnings process is complete. For example, semi-annualpayments on the first of January and July would result in commissionincome recognition on the first of January and July, while payments on thefirst of January, April, July, and October would result in commissionincome recognition on those dates. The potential for chargebacks only existsfor those policies on a monthly payment plan since income is recognized at thebeginning of the annual coverage period versus at the time of each monthlypayment. No liability is maintained for chargebacks as these are removed fromincome at the time of the occurrence.

 

**Stock Options**

TheCompany maintains a stock option plan for directors and certain officers and employeeswith the last option grant being in 2000. All options were granted when theexercise price of the Company’s stock options was greater than or equal to themarket price of the underlying stock on the date of the grant, therefore, nocompensation expense was recognized in the Company’s financial statements.

 

**Accumulated Other ComprehensiveIncome**

TheCompany is required to present accumulated other comprehensive income in a fullset of general-purpose financial statements for all periods presented. Accumulatedother comprehensive income is comprised of unrealized holding gains (losses) onthe available for sale securities portfolio and the unrecognized components ofnet periodic benefit costs of the defined benefit pension plan.

 

41

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**SegmentReporting**

FAS No. 131, Disclosureabout Segments of an Enterprise and Related Information, requires that publicbusiness enterprises report financial and descriptive information about theirreportable operating segments. Based on the guidance provided by the Statement,the Company has determined that its only reportable segment is CommunityBanking.

 

**Reclassification of ComparativeAmounts**

Certainitems previously reported have been reclassified to conform to the current year’sreporting format. Such reclassifications did not affect net income orshareholders’ equity.

 

**Recent AccountingPronouncements**

InDecember 2007, the FASB issued FAS No. 141 (revised 2007), *Business Combinations*, which establishesprinciples and requirements for how an acquirer recognizes and measures in itsfinancial statements the identifiable assets acquired, the liabilities assumed,and any noncontrolling interest in an acquiree, including the recognition andmeasurement of goodwill acquired in a business combination. FAS No. 141(R) iseffective for fiscal years beginning on or after December 15, 2008. Earlieradoption is prohibited. The adoption of this standard is not expected to have amaterial effect on the Company’s results of operations or financial position.

 

InSeptember 2006, the FASB issued FAS No. 157, *Fair Value Measurements*, which providesenhanced guidance for using fair value to measure assets and liabilities. Thestandard applies whenever other standards require or permit assets orliabilities to be measured at fair value. The Standard does not expand the useof fair value in any new circumstances. FAS No. 157 is effective forfinancial statements issued for fiscal years beginning after November 15,2007 and interim periods within those fiscal years. In February 2008, theFASB issued Staff Position No. 157-1, *Applicationof FASB Statement No. 157 to FASB Statement No. 13 and OtherAccounting Pronouncements That Address Fair Value Measurements for Purposes ofLease Classification or Measurement under Statement 13*, whichremoved leasing transactions accounted for under FAS No. 13 and relatedguidance from the scope of FAS No. 157. Also in February 2008, theFASB issued Staff Position No.157-2, *PartialDeferral of the Effective Date of Statement 157*, which deferred theeffective date of FAS No. 157 for all nonfinancial assets and nonfinancialliabilities to fiscal years beginning after November 15, 2008. Theadoption of this standard has not and is not expected to have a material effecton the Company’s results of operations or financial position.

 

InSeptember 2006, the FASB issued FAS No. 158, *Employers’Accounting for Defined Benefit Pension andOther Post Retirement Plans, an amendment of FASB Statements No. 87, 88,106 and 132(R)*. This Statement requires that employers measure planassets and obligations as of the balance sheet date. This requirement iseffective for fiscal years ending after December 15, 2008. The otherprovisions of the Statement were effective as of the end of the fiscal yearending after December 15, 2006, for public companies. The adoption of thisstandard has not and is not expected to have a material effect on the Company’sresults of operations or financial position.

 

InDecember 2007, the FASB issued FAS No. 160, *Noncontrolling Interests in Consolidated FinancialStatements - an amendment of ARB No. 51*. FAS No. 160amends ARB No. 51 to establish accounting and reporting standards for thenoncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary.It clarifies that a noncontrolling interest in a subsidiary, which is sometimesreferred to as minority interest, is an ownership interest in the consolidatedentity that should be reported as equity in the consolidated financialstatements. Among other requirements, this statement requires consolidated netincome to be reported at amounts that include the amounts attributable to boththe parent and the noncontrolling interest. It also requires disclosure, on theface of the consolidated income statement, of the amounts of consolidated netincome attributable to the parent and to the noncontrolling interest. FAS No. 160is effective for fiscal years beginning on or after December 15, 2008. Earlieradoption is prohibited. The adoption of this standard will not have an effecton the Company’s results of operations or financial position as there are nononcontrolling interests.

 

InMarch 2008, the FASB issued FAS No. 161, *Disclosures about Derivative Instruments and Hedging Activities*,to require enhanced disclosures about derivative instruments and hedgingactivities. The new standard has revised financial reporting for derivativeinstruments and hedging activities by requiring more transparency about how andwhy an entity uses derivative instruments, how derivative instruments andrelated hedged items are accounted for under FAS No. 133, *Accounting for Derivative Instruments and HedgingActivities*; and how derivative instruments and related hedged itemsaffect an entity’s financial position, financial performance, and cash flows. FASNo. 161 requires disclosure of the fair values of derivative instrumentsand their gains and losses in a tabular format. It also requires entities toprovide more information about their liquidity by requiring disclosure ofderivative features that are credit risk-related. Further, it requirescross-referencing within footnotes to enable financial statement users tolocate important information about derivative instruments. FAS No. 161 iseffective for financial statements issued for fiscal years and interim periodsbeginning after November 15, 2008, with early application encouraged. Theadoption of this standard is not expected to

 

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havea material effect on the Company’s results of operations or financial position.

 

InJune 2008, the FASB ratified EITF Issue No. 08-4, *Accounting for Convertible Securities with BeneficialConversion Features or Contingently Adjusted Conversion Ratios*. ThisIssue provides transition guidance for conforming changes made to EITF Issue No. 98-5,*Accounting for Convertible Securities withBeneficial Conversion Features or Contingently Adjusted Conversion Ratios*,that resulted from EITF Issue No. 00-27, *Applicationof Issue No. 98-5 to Certain Convertible Instruments, and FAS No. 150,Accounting for Certain Financial Instruments with Characteristics of bothLiability and Equity*. The conforming changes are effective forfinancial statements issued for fiscal years ending after December 15,2008, with earlier application permitted. The adoption of this FSP has not andis not expected to have a material effect on the Company’s results ofoperations or financial position.

 

InFebruary 2007, the FASB issued FSP No. FAS 158-1, *Conforming Amendments to the Illustrations in FASBStatements No. 87, No. 88, and No. 106 and to the Related StaffImplementation Guides*. This FSP provides conforming amendments tothe illustrations in FAS Statements No. 87, 88, and 106 and to relatedstaff implementation guides as a result of the issuance of FAS Statement No. 158.The conforming amendments made by this FSP are effective as of the effectivedates of Statement No. 158. The unaffected guidance that this FSP codifiesinto Statements No. 87, 88, and 106 does not contain new requirements andtherefore does not require a separate effective date or transition method. Theadoption of this FSP is not expected to have a material effect on the Company’sresults of operations or financial position.

 

In February 2008, the FASBissued FSP No. *FAS 140-3, Accounting forTransfers of Financial Assets and**RepurchaseFinancing Transactions*. This FSP concludes that a transferor andtransferee should not separately account for a transfer of a financial assetand a related repurchase financing unless (a) the two transactions have avalid and distinct business or economic purpose for being entered intoseparately and (b) the repurchase financing does not result in the initialtransferor regaining control over the financial asset. The FSP is effective forfinancial statements issued for fiscal years beginning on or after November 15,2008, and interim periods within those fiscal years. The adoption of this FSPis not expected to have a material effect on the Company’s results ofoperations or financial position.

 

InApril 2008, the FASB issued FSP No. 142-3, *Determination of the Useful Life of Intangible Assets*. FSP142-3 amends the factors that should be considered in developing assumptionsabout renewal or extension used in estimating the useful life of a recognizedintangible asset under FAS No. 142, *Goodwilland Other Intangible Assets*. This standard is intended to improvethe consistency between the useful life of a recognized intangible asset underFAS No. 142 and the period of expected cash flows used to measure the fairvalue of the asset under FAS No. 141R and other GAAP. FSP 142-3 iseffective for financial statements issued for fiscal years beginning after December 15,2008. The measurement provisions of this standard will apply only to intangibleassets of the Company acquired after the effective date. The adoption of thisFSP is not expected to have a material effect on the Company’s results ofoperations or financial position.

 

InMay 2008, the FASB issued FSP No. APB 14-1, *Accounting for Convertible Debt Instruments That May BeSettled in Cash upon Conversion (Including Partial Cash Settlement)*.This FSP provides guidance on the accounting for certain types of convertibledebt instruments that may be settled in cash upon conversion. Additionally,this FSP specifies that issuers of such instruments should separately accountfor the liability and equity components in a manner that will reflect theentity’s nonconvertible debt borrowing rate when interest cost is recognized insubsequent periods. The FSP is effective for financial statements issued forfiscal years beginning after December 15, 2008, and interim periods withinthose fiscal years. The adoption of this FSP is not expected to have a materialeffect on the Company’s results of operations or financial position.

 

InJune 2008, the FASB issued FSP No. EITF 03-6-1, *Determining Whether Instruments Granted inShare-Based Payment Transactions Are Participating Securities*, toclarify that instruments granted in share-based payment transactions can beparticipating securities prior to the requisite service having been rendered. Abasic principle of the FSP is that unvested share-based payment awards thatcontain nonforfeitable rights to dividends or dividend equivalents (whetherpaid or unpaid) are participating securities and are to be included in thecomputation of EPS pursuant to the two-class method. The provisions of this FSPare effective for financial statements issued for fiscal years beginning after December 15,2008, and interim periods within those years. All prior-period EPS datapresented (including interim financial statements, summaries of earnings, andselected financial data) are required to be adjusted retrospectively to conformwith the provisions of the FSP. The adoption of this FSP is not expected tohave a material effect on the Company’s results of operations or financialposition.

 

InDecember 2008, the FASB issued FSP No. FAS 132(R)-1, *Employers’ Disclosures about Postretirement BenefitPlan Assets*. This FSP amends FASB Statement No. 132 (revised2003), *Employers’ Disclosures about Pensionsand Other Postretirement Benefits*, to improve an employer’sdisclosures about plan assets of a defined benefit pension or otherpostretirement plan. The disclosures about plan assets required by the FSP areto be provided for fiscal years ending after December 15, 2009. Theadoption of this FSP is not expected to have a material effect on the Company’sresults of

 

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operationsor financial position.

 

**NOTE 2 - PER SHARE DATA**

 

There are no convertible securities which would affect the denominatorin calculating basic and dilutive earnings per share; therefore, net income aspresented on the consolidated statement of income will be used as thenumerator. The following table sets forth the composition of the weightedaverage common shares (denominator) used in the basic and dilutive per sharecomputation.

 
| ** **                                                                                                 | ** ** | **2008**  | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
|                                                                                                       |       |      |       |      |       |      |       |
| Weighted average  common shares outstanding                                                                |       | 4,008,553 |       | 4,005,181 |       | 4,002,416 |       |
|                                                                                                       |       |      |       |      |       |      |       |
| Weighted Average  treasury stock shares                                                                    |       | (148,829  | )          | (118,904  | )          | (68,278   | )          |
|                                                                                                       |       |      |       |      |       |      |       |
| Weighted average  common shares and common stock equivalents used to calculate basic earnings  per share   |       | 3,859,724 |       | 3,886,277 |       | 3,934,138 |       |
|                                                                                                       |       |      |       |      |       |      |       |
| Additional  common stock equivalents (stock options) used to calculate diluted earnings  per share         |       | 109       |       | 237       |       | 479       |       |
|                                                                                                       |       |      |       |      |       |      |       |
| Weighted average  common shares and common stock equivalents used to calculate diluted earnings  per share |       | 3,859,833 |       | 3,886,514 |       | 3,934,617 |       |

 

Options to purchase 1,980, 10,913, and 11,972shares of common stock at a range in price of $24.72 to $40.29 were outstandingat December 31, 2008, 2007, and 2006, respectively. The options wereincluded in the computation of diluted earnings per share on a weighted averagebasis determined by the length of time during each period that the market valueexceeded the strike price.

 

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**NOTE 3 - INVESTMENT SECURITIES**

 

The amortized costand estimated fair values of investment securities at December 31, 2008and 2007 are as follows:

 

(In Thousands)

 
| ** **                             | ** ** | **2008**      | ** ** |
|----------------------------------------|------------|---------------|------------|
| ** **                             | ** ** | ** **    | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                             | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                             | ** ** | **Cost**      | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                                   |       |          |       |   |   |   |   |   |   |
| Available for  sale (AFS)              |       |          |       |   |   |   |   |   |   |
| U.S. Government  and agency securities |       | $             | 46,452     |   | $ | 1,134 |   | $ | — |   | $ | 47,586 |   |
| State and  political securities        |       | 142,258       |       | 348 |   | (10,764 | ) | 131,842 |   |
| Other debt  securities                 |       | 15,970        |       | 649 |   | (1,065 | ) | 15,554 |   |
| Total debt  securities                 |       | 204,680       |       | 2,131 |   | (11,829 | ) | 194,982 |   |
| Equity  securities                     |       | 16,429        |       | 225 |   | (3,385 | ) | 13,269 |   |
| Total investment  securities AFS       |       | $             | 221,109    |   | $ | 2,356 |   | $ | (15,214 | ) | $ | 208,251 |   |
|                                   |       |          |       |   |   |   |   |   |   |
| Held to maturity  (HTM)                |       |          |       |   |   |   |   |   |   |
| U.S. Government  and agency securities |       | $             | 10         |   | $ | 1 |   | $ | — |   | $ | 11 |   |
| Other debt  securities                 |       | 125           |       | — |   | — |   | 125 |   |
| Total investment  securities HTM       |       | $             | 135        |   | $ | 1 |   | $ | — |   | $ | 136 |   |

 

(In Thousands)

 
| ** **                             | ** ** | **2007**      | ** ** |
|----------------------------------------|------------|---------------|------------|
| ** **                             | ** ** | ** **    | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                             | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                             | ** ** | **Cost**      | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                                   |       |          |       |   |   |   |   |   |   |
| Available for  sale (AFS)              |       |          |       |   |   |   |   |   |   |
| U.S. Government  and agency securities |       | $             | 62,382     |   | $ | 522 |   | $ | — |   | $ | 62,904 |   |
| State and  political securities        |       | 119,651       |       | 581 |   | (2,417 | ) | 117,815 |   |
| Other debt  securities                 |       | 15,917        |       | 290 |   | (440 | ) | 15,767 |   |
| Total debt  securities                 |       | 197,950       |       | 1,393 |   | (2,857 | ) | 196,486 |   |
| Equity  securities                     |       | 19,776        |       | 496 |   | (2,303 | ) | 17,969 |   |
| Total investment  securities AFS       |       | $             | 217,726    |   | $ | 1,889 |   | $ | (5,160 | ) | $ | 214,455 |   |
|                                   |       |          |       |   |   |   |   |   |   |
| Held to maturity  (HTM)                |       |          |       |   |   |   |   |   |   |
| U.S. Government  and agency securities |       | $             | 14         |   | $ | 1 |   | $ | — |   | $ | 15 |   |
| Other debt  securities                 |       | 263           |       | 1 |   | — |   | 264 |   |
| Total investment  securities HTM       |       | $             | 277        |   | $ | 2 |   | $ | — |   | $ | 279 |   |

 

The following tablesshow the Company’s gross unrealized losses and estimated fair value, aggregatedby investment category and length of time, that the individual securities havebeen in a continuous unrealized loss position, at December 31, 2008 and2007.

 

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(In Thousands)

 
| ** **                             | ** ** | **2008**                                   | ** ** |
|----------------------------------------|------------|--------------------------------------------|------------|
| ** **                             | ** ** | **Less than Twelve Months** | ** ** | **Twelve Months or Greater** | ** ** | **Total** | ** ** |
| ** **                             | ** ** | **Estimated**                              | ** ** | **Gross** | ** ** | **Estimated** | ** ** | **Gross** | ** ** | **Estimated** | ** ** | **Gross** | ** ** |
| ** **                             | ** ** | **Fair**                                   | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                             | ** ** | **Value**                                  | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
|                                   |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| U.S. Government  and agency securities |       | $                                          | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| State and  political securities        |       | 48,388                                     |       | 4,378 |   | 67,412 |   | 6,386 |   | 115,800 |   | 10,764 |   |
| Other debt  securities                 |       | 6,341                                      |       | 451 |   | 2,012 |   | 614 |   | 8,353 |   | 1,065 |   |
| Total debt  securities                 |       | 54,729                                     |       | 4,829 |   | 69,424 |   | 7,000 |   | 124,153 |   | 11,829 |   |
| Equity  securities                     |       | 164                                        |       | 80 |   | 5,364 |   | 3,305 |   | 5,528 |   | 3,385 |   |
| Total                                  |       | $                                          | 54,893     |   | $ | 4,909 |   | $ | 74,788 |   | $ | 10,305 |   | $ | 129,681 |   | $ | 15,214 |   |

 

(In Thousands)

 
| ** **                             | ** ** | **2007**                                   | ** ** |
|----------------------------------------|------------|--------------------------------------------|------------|
| ** **                             | ** ** | **Less than Twelve Months** | ** ** | **Twelve Months or Greater** | ** ** | **Total** | ** ** |
| ** **                             | ** ** | **Estimated**                              | ** ** | **Gross** | ** ** | **Estimated** | ** ** | **Gross** | ** ** | **Estimated** | ** ** | **Gross** | ** ** |
| ** **                             | ** ** | **Fair**                                   | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                             | ** ** | **Value**                                  | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
|                                   |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| U.S. Government  and agency securities |       | $                                          | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| State and  political securities        |       | 60,002                                     |       | 1,705 |   | 21,830 |   | 712 |   | 81,832 |   | 2,417 |   |
| Other debt  securities                 |       | 2,521                                      |       | 357 |   | 388 |   | 83 |   | 2,909 |   | 440 |   |
| Total debt  securities                 |       | 62,523                                     |       | 2,062 |   | 22,218 |   | 795 |   | 84,741 |   | 2,857 |   |
| Equity  securities                     |       | 8,200                                      |       | 1,837 |   | 996 |   | 466 |   | 9,196 |   | 2,303 |   |
| Total                                  |       | $                                          | 70,723     |   | $ | 3,899 |   | $ | 23,214 |   | $ | 1,261 |   | $ | 93,937 |   | $ | 5,160 |   |

 

At December 31,2008 there were a total of 95 and 184 individual securities that were in acontinuous unrealized loss position for less than twelve months and greaterthan twelve months, respectively.

 

The Company reviews itsposition quarterly and has asserted that at December 31, 2008, thedeclines outlined in the above table represent temporary declines and the Companydoes have the intent and ability either to hold those securities to maturity orto allow a market recovery.  There were279 positions that were temporarily impaired at December 31, 2008.  The Company has concluded that the unrealizedlosses disclosed above are not other than temporary but are the result ofinterest rate changes, sector credit ratings changes, or Company-specificratings changes that are not expected to result in the non-collection ofprincipal and interest during the period.

 

The amortized cost andestimated fair value of debt securities at December 31, 2008, bycontractual maturity, are shown below. Expected maturities may differ fromcontractual maturities since borrowers may have the right to call or prepayobligations with or without call or prepayment penalties.

 

(In Thousands)

 
|                               | ** ** | **Available for Sale** | ** ** | **Held to Maturity** | ** ** |
|------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                         | ** ** | **Amortized**                    | ** ** | **Estimated**                  | ** ** | **Amortized** | ** ** | **Estimated** | ** ** |
| ** **                         | ** ** | **Cost**                         | ** ** | **Fair Value**            | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
| Due in one year  or less           |       | $                                | —     |                           | $          | — |   | $ | 25 |   | $ | 25 |   |
| Due after one  year to five years  |       | 75                               |       | 75                             |       | 100 |   | 100 |   |
| Due after five  years to ten years |       | 418                              |       | 445                            |       | — |   | — |   |
| Due after ten  years               |       | 204,187                          |       | 194,462                        |       | 10 |   | 11 |   |
| Total                              |       | $                                | 204,680    |                           | $          | 194,982 |   | $ | 135 |   | $ | 136 |   |

 

46

----

 

Total gross proceeds from sales of securities available for sale were$40,169,000, $60,485,000, and $76,249,000 for 2008, 2007, and 2006,respectively.  The following tablerepresents gross realized gains and losses on those transactions:

 

(In Thousands)

 
| ** **                             | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Gross realized  gains:                 |       |     |       |     |       |     |       |
| U.S. Government  and agency securities |       | $        | 253        |     | $          | 68       |       | $ | — |   |
| State and  political securities        |       | 236      |       | 840      |       | 1,248    |       |
| Other debt  securities                 |       | 6        |       | 2        |       | —   |       |
| Equity  securities                     |       | 539      |       | 772      |       | 1,655    |       |
| Total gross  realized gains            |       | $        | 1,034      |     | $          | 1,682    |       | $ | 2,903 |   |
|                                   |       |     |       |     |       |     |       |
| Gross realized  losses:                |       |     |       |     |       |     |       |
| U.S. Government  and agency securities |       | $        | 36         |     | $          | 902      |       | $ | 913 |   |
| State and  political securities        |       | 204      |       | —   |       | 302      |       |
| Other debt  securities                 |       | 510      |       | —   |       | —   |       |
| Equity  securities                     |       | 2,315    |       | 834      |       | 9        |       |
| Total gross  realized losses           |       | $        | 3,065      |     | $          | 1,736    |       | $ | 1,224 |   |

 

Gross realized losses for the equity securities portfolio includeimpairment charges of $2,797,000 and $834,000 for the years ended December 31,2008 and 2007, respectively.

 

Investment securities with a carrying value of approximately$102,362,000 and $97,647,000 at December 31, 2008 and 2007, respectively,were pledged to secure certain deposits, repurchase agreements, and for otherpurposes as required by law.

 

There is no concentration of investments that exceed ten percent ofshareholders’ equity for any individual issuer, excluding those guaranteed bythe U.S. Government.

 

47

----

 

**NOTE 4 – LOANS**

Major loan classifications as of December 31, 2008 and 2007 aresummarized as follows:

 

(In Thousands)

 
| ** **                        | ** ** | **2008**    | ** ** |
|-----------------------------------|------------|-------------|------------|
| ** **                        | ** ** | ** **  | ** ** | ** ** | ** ** | **Past Due** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **  | ** ** | ** ** | ** ** | **90 Days** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **  | ** ** | **Past Due** | ** ** | **Or More** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **  | ** ** | **30 To 90** | ** ** | **& Still** | ** ** | **Non-** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | **Current** | ** ** | **Days** | ** ** | **Accruing** | ** ** | **Accrual** | ** ** | **Total** | ** ** |
| Commercial and  agricultural      |       | $           | 40,006     |   | $ | 517 |   | $ | — |   | $ | 79 |   | $ | 40,602 |   |
| Real estate  mortgage:            |       |        |       |   |   |   |   |   |   |   |   |
| Residential                       |       | 170,011     |       | 6,582 |   | 223 |   | 590 |   | 177,406 |   |
| Commercial                        |       | 134,647     |       | 775 |   | — |   | 736 |   | 136,158 |   |
| Construction                      |       | 15,652      |       | 167 |   | — |   | 19 |   | 15,838 |   |
| Installment  loans to individuals |       | 12,053      |       | 346 |   | 36 |   | 52 |   | 12,487 |   |
|                              |       | 372,369     |       | $ | 8,387 |   | $ | 259 |   | $ | 1,476 |   | 382,491 |   |
| Less: Net  deferred loan fees     |       | 1,013       |       |   |   |   |   |   |   | 1,013 |   |
| Allowance for loan  losses        |       | 4,356       |       |   |   |   |   |   |   | 4,356 |   |
| Loans, net                        |       | $           | 367,000    |   |   |   |   |   |   |   | $ | 377,122 |   |

 

(In Thousands)

 
| ** **                        | ** ** | **2007**    | ** ** |
|-----------------------------------|------------|-------------|------------|
| ** **                        | ** ** | ** **  | ** ** | ** ** | ** ** | **Past Due** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **  | ** ** | ** ** | ** ** | **90 Days** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **  | ** ** | **Past Due** | ** ** | **Or More** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **  | ** ** | **30 To 90** | ** ** | **& Still** | ** ** | **Non-** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | **Current** | ** ** | **Days** | ** ** | **Accruing** | ** ** | **Accrual** | ** ** | **Total** | ** ** |
| Commercial and  agricultural      |       | $           | 35,316     |   | $ | 236 |   | $ | 147 |   | $ | 40 |   | $ | 35,739 |   |
| Real estate  mortgage:            |       |        |       |   |   |   |   |   |   |   |   |
| Residential                       |       | 158,424     |       | 4,573 |   | 110 |   | 161 |   | 163,268 |   |
| Commercial                        |       | 130,692     |       | 1,409 |   | 88 |   | 754 |   | 132,943 |   |
| Construction                      |       | 16,113      |       | 39 |   | — |   | — |   | 16,152 |   |
| Installment  loans to individuals |       | 12,838      |       | 459 |   | 20 |   | — |   | 13,317 |   |
|                              |       | 353,383     |       | $ | 6,716 |   | $ | 365 |   | $ | 955 |   | 361,419 |   |
| Less: Net  deferred loan fees     |       | 941         |       |   |   |   |   |   |   | 941 |   |
| Allowance for loan  losses        |       | 4,130       |       |   |   |   |   |   |   | 4,130 |   |
| Loans, net                        |       | $           | 348,312    |   |   |   |   |   |   |   | $ | 356,348 |   |

 

Impaired loans totaled $5,042,000 and $1,477,000 at December 31,2008 and 2007, respectively.  The portionof the allowance for loan losses allocated for impaired loans was $166,000 and$102,000 at December 31, 2008 and 2007, respectively. The average recordedinvestment in impaired loans during the years ended December 31, 2008 and2007 was approximately $3,410,000 and $1,130,000, respectively.

 

The Company recognized interest income on impaired loans in the amountof $123,000 and $42,000 for the years ended December 31, 2008 and 2007,respectively. On a cash basis, interest income on impaired loans amounted to$7,000 and $29,000 for the years ended December 31, 2008 and 2007,respectively.

 

No additional funds are committed to be advanced in connection withimpaired loans.

 

Loans on which the accrual of interest has been discontinued orreduced, exclusive of impaired loans, amounted to approximately $1,476,000 and $955,000 at December 31,2008 and 2007, respectively.  If interesthad been recorded based on the original loan agreement terms and rate ofinterest for those loans, income would have approximated $72,000, $87,000, and$23,000 for the years ended December 31, 2008, 2007, and 2006,respectively.  Interest income on suchloans, is recorded as received and amounted to approximately $9,000, $17,000,and $15,000 for the years ended December 31, 2008, 2007, and 2006,respectively.

 

Changes in the allowance for loan losses for the years ended December 31,2008, 2007, and 2006 are as follows:

 

48

----

 

(In Thousands)

 
| ** **                       | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                             |       |     |       |     |       |     |       |
| Balance,  beginning of year      |       | $        | 4,130      |     | $          | 4,185    |       | $ | 3,679 |   |
| Provision  charged to operations |       | 375      |       | 150      |       | 635      |       |
| Loans charged  off               |       | (313     | )          | (304     | )          | (327     | )          |
| Recoveries                       |       | 164      |       | 99       |       | 198      |       |
| Balance, end of  year            |       | $        | 4,356      |     | $          | 4,130    |       | $ | 4,185 |   |

 

The Company has a concentration of loans to both owners of commercialand residential rental properties at December 31, 2008 and 2007 of 15.07%and 14.43% and 14.67% and 14.56% of total loans, respectively.

 

The Company grants commercial, industrial, residential, and installmentloans to customers throughout north-central Pennsylvania. Although the Companyhas a diversified loan portfolio at December 31, 2008 and 2007, asubstantial portion of its debtors’ ability to honor their contracts isdependent on the economic conditions within this region.

 

**NOTE 5 - PREMISES AND EQUIPMENT**

 

Major classifications of premises and equipment are summarized asfollows at December 31, 2008 and 2007:

 

(In Thousands)

 
| ** **                                      | ** ** | **2008** | ** ** | **2007** | ** ** | ** ** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|------------|------------|
|                                            |       |     |       |     |       |       |       |
| Land                                            |       | $        | 1,480      |     | $          | 1,391      |       |   |   |
| Premises                                        |       | 6,929    |       | 6,218    |       |       |       |
| Furniture and  equipment                        |       | 6,067    |       | 5,356    |       |       |       |
| Leasehold  improvements                         |       | 871      |       | 815      |       |       |       |
| Total                                           |       | 15,347   |       | 13,780   |       |       |       |
| Less accumulated  depreciation and amortization |       | 7,482    |       | 7,006    |       |       |       |
| Net premises and  equipment                     |       | $        | 7,865      |     | $          | 6,774      |       |   |   |

 

Depreciation and amortization charged to operations for the years ended2008, 2007, and 2006 was $663,000, $680,000, and $744,000, respectively.

 

**NOTE 6 - GOODWILL**

 

As of December 31, 2008, 2007, and 2006goodwill had a gross carrying value of $3,308,000 and accumulated amortizationof $276,000 resulting in a net carrying amount of $3,032,000.

 

The gross carrying amount of goodwill istested for impairment in the third quarter of each fiscal year.  Based on fair value of the reporting unit,estimated using the expected present value of future cash flows, there was noevidence of impairment of the carrying amount at December 31, 2008 and2007, respectively.

 

**NOTE 7 - TIME DEPOSITS**

 

Time deposits of $100,000 or more totaledapproximately $67,356,000 on December 31, 2008 and $59,424,000 on December 31,2007. Interest expense related to such deposits was approximately $2,894,000,$3,216,000, and $1,873,000, for the years ended December 31, 2008, 2007,and 2006, respectively.

 

49

----

 

At December 31, 2008, the scheduledmaturities on time deposits of $100,000 or more are as follows:

 

(In Thousands)

 
| ** **                   | ** ** | **2008** | ** ** |
|------------------------------|------------|----------|------------|
|                         |       |     |       |
| Three months or  less        |       | $        | 23,520     |   |
| Three months to  six months  |       | 12,785   |       |
| Six months to  twelve months |       | 19,261   |       |
| Over twelve months           |       | 11,790   |       |
| Total                        |       | $        | 67,356     |   |

 

Total time deposit maturities are as follows at December 31, 2008:

 

(In Thousands)

 
| ** ** | ** ** | **2008** | ** ** |
|------------|------------|----------|------------|
|       |       |     |       |
| 2009       |       | $        | 158,473    |   |
| 2010       |       | 22,199   |       |
| 2011       |       | 11,714   |       |
| 2012       |       | 3,212    |       |
| 2013       |       | 620      |       |
| Thereafter |       | 778      |       |
| Total      |       | $        | 196,996    |   |

 

**NOTE 8 - SHORT-TERM BORROWINGS**

 

Short-term borrowings consist of securitiessold under agreements to repurchase and primarily Federal Home Loan Bank (“FHLB”)advances which generally represent overnight or less than six monthborrowings.  In addition to theoutstanding balances noted below, the Bank also had additional lines of credittotaling $13,845,000 available from correspondent banks other than theFHLB.  The outstanding balances andrelated information for short-term borrowings are summarized as follows at December 31,2008, 2007, and 2006:

 

50

----

 

(In Thousands)

 
| ** **                                   | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Repurchase  Agreements:**                  |       |     |       |     |       |     |       |
| Balance at year  end                         |       | $        | 12,933     |     | $          | 17,155   |       | $ | 15,991 |   |
| Maximum amount  outstanding at any month end |       | 18,839   |       | 19,058   |       | 19,916   |       |
| Average balance  outstanding during the year |       | 15,840   |       | 16,746   |       | 16,028   |       |
| Weighted-average  interest rate:             |       |     |       |     |       |     |       |
| At year end                                  |       | 2.83     | %          | 3.37     | %          | 3.96     | %          |
| Paid during the  year                        |       | 2.83     | %          | 3.69     | %          | 3.55     | %          |
|                                         |       |     |       |     |       |     |       |
| **Open  Repo Plus:**                         |       |     |       |     |       |     |       |
| Balance at year  end                         |       | $        | 61,013     |     | $          | 38,160   |       | $ | 18,706 |   |
| Maximum amount  outstanding at any month end |       | 61,013   |       | 38,895   |       | 43,040   |       |
| Average balance  outstanding during the year |       | 31,495   |       | 19,299   |       | 15,301   |       |
| Weighted-average  interest rate:             |       |     |       |     |       |     |       |
| At year end                                  |       | 0.59     | %          | 4.32     | %          | 5.40     | %          |
| Paid during the  year                        |       | 2.04     | %          | 5.09     | %          | 5.07     | %          |
|                                         |       |     |       |     |       |     |       |
| **Short-Term  FHLB:**                        |       |     |       |     |       |     |       |
| Balance at year  end                         |       | $        | —     |     | $          | —   |       | $ | — |   |
| Maximum amount  outstanding at any month end |       | 10,000   |       | 15,000   |       | —   |       |
| Average balance  outstanding during the year |       | 3,210    |       | 771      |       | 3,283    |       |
| Weighted-average  interest rate:             |       |     |       |     |       |     |       |
| At year end                                  |       | —   |       | —   |       | —   |       |
| Paid during the  year                        |       | 2.58     | %          | 5.06     | %          | 4.82     | %          |

 

**NOTE 9 – LONG TERM BORROWINGS**

** **

Thefollowing represents outstanding long-term borrowings with the FHLB bycontractual maturities at December 31, 2008 and  2007:

 

(In Thousands)

 
| ** **          | ** ** | ** **   | ** ** | **Weighted-**             | ** ** | **Weighted-**             | ** ** | **Stated Interest** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------|------------|--------------|------------|---------------------------|------------|---------------------------|------------|--------------------------|------------|------------|------------|------------|------------|
| ** **          | ** ** | ** **   | ** ** | **Average Interest** | ** ** | **Average Interest** | ** ** | **Rate Range**      | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Description**     | ** ** | **Maturity** | ** ** | **Rate 2008**        | ** ** | **Rate 2007**        | ** ** | **From**                 | ** ** | **To**     | ** ** | **2008**   | ** ** | **2007** | ** ** |
| Variable            |       | 2008         |       | —                    |       | 4.77                      | %          | 3.14                     | %          | 5.56       | %          | $          | —     |   | $ | 29,600 |   |
| Variable            |       | 2010         |       | 4.87                      | %          | 4.87                      | %          | 3.98                     | %          | 6.65       | %          | 15,000     |       | 15,000 |   |
| Variable            |       | 2011         |       | 4.49                      | %          | 4.49                      | %          | 4.25                     | %          | 4.72       | %          | 10,000     |       | 10,000 |   |
| Variable            |       | 2012         |       | 4.18                      | %          | 4.18                      | %          | 3.68                     | %          | 4.43       | %          | 15,000     |       | 15,000 |   |
| Variable            |       | 2013         |       | 3.74                      | %          | 3.74                      | %          | 3.74                     | %          | 3.74       | %          | 5,000      |       | 5,000 |   |
| Variable            |       | 2015         |       | 3.97                      | %          | 3.97                      | %          | 3.97                     | %          | 3.97       | %          | 10,000     |       | 10,000 |   |
| Variable            |       | 2017         |       | 4.22                      | %          | 4.22                      | %          | 4.15                     | %          | 4.28       | %          | 20,000     |       | 20,000 |   |
| Variable            |       | 2018         |       | 3.18                      | %          | —                    |       | 3.18                     | %          | 3.18       | %          | 10,000     |       | — |   |
| **Total  Variable** | ** ** | ** **   | ** ** | **4.18**                  | **%**      | **4.44**                  | **%**      | ** **               | ** ** | ** ** | ** ** | **85,000** | ** ** | **104,600** | ** ** |
| Fixed               |       | 2011         |       | 6.92                      | %          | 6.92                      | %          | 6.92                     | %          | 6.92       | %          | 500        |       | 500 |   |
| Fixed               |       | 2013         |       | 5.87                      | %          | 5.87                      | %          | 5.87                     | %          | 5.87       | %          | 528        |       | 528 |   |
| Fixed               |       | 2015         |       | 6.92                      | %          | 6.92                      | %          | 6.92                     | %          | 6.92       | %          | 750        |       | 750 |   |
| **Total  Fixed**    | ** ** | ** **   | ** ** | **6.61**                  | **%**      | **6.61**                  | **%**      | ** **               | ** ** | ** ** | ** ** | **1,778**  | ** ** | **1,778** | ** ** |
| **Total**           | ** ** | ** **   | ** ** | **4.23**                  | **%**      | **4.48**                  | **%**      | ** **               | ** ** | ** ** | ** ** | **$**      | **86,778** | ** ** | **$** | **106,378** | ** ** |

 

51

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(In Thousands)

 
| **Year Ending**  | ** ** | ** ** | ** ** | **Weighted-**         | ** ** |
|-----------------------|------------|------------|------------|-----------------------|------------|
| **December 31,** | ** ** | **Amount** | ** ** | **Average Rate** | ** ** |
| 2009                  |       | $          | —     |                  | —     |   |
| 2010                  |       | 15,000     |       | 4.87                  | %          |
| 2011                  |       | 10,500     |       | 4.60                  | %          |
| 2012                  |       | 15,000     |       | 4.18                  | %          |
| 2013 and after        |       | 46,278     |       | 3.95                  | %          |
| ** **            | ** ** | **$**      | **86,778** | ** **            | **4.23**   | **%** |

 

The terms of the convertible borrowings allow the FHLB to convert theinterest rate to an adjustable rate based on the three month London InterbankOffered Rate (“LIBOR”) at a predetermined anniversary date of the borrowing’sorigination, ranging from three months to five years.  If the FHLB converts the interest rate on oneof the predetermined dates, the Bank has the ability to payoff the debt on theconversion date and quarterly thereafter without incurring the customarypre-payment penalty.

 

The Bank maintains a credit arrangement which includes a revolving lineof credit with the FHLB.  Under thiscredit arrangement, the Bank has a remaining borrowing capacity of $66,048,000at December 31, 2008, which is subject to annual renewal, and typicallyincurs no service charges.  Under termsof a blanket agreement, collateral for the FHLB borrowings must be secured bycertain qualifying assets of the Bank which consist principally of firstmortgage loans and mortgage-backed securities.

 

**NOTE 10 - INCOME TAXES**

 

The following temporary differences gave riseto the net deferred tax asset position at December 31, 2008 and 2007:

 

(In Thousands)

 
| ** **                                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax  assets:                             |       |     |       |     |       |
| Allowance for  loan losses                        |       | $        | 1,481      |     | $          | 1,404 |   |
| Deferred  compensation                            |       | 402      |       | 408      |       |
| Pension                                           |       | 2,014    |       | 870      |       |
| Loan fees and  costs                              |       | 344      |       | 320      |       |
| Investment  securities allowance                  |       | 548      |       | 278      |       |
| Unrealized loss  on available for sale securities |       | 4,372    |       | 1,112    |       |
| Low income  housing credit carryforward           |       | 1,571    |       | 827      |       |
| Capital loss                                      |       | 503      |       | —   |       |
| Other                                             |       | 373      |       | 212      |       |
| Total                                             |       | 11,608   |       | 5,431    |       |
|                                              |       |     |       |     |       |
| Deferred tax  liabilities:                        |       |     |       |     |       |
| Bond accretion                                    |       | 61       |       | 44       |       |
| Depreciation                                      |       | 141      |       | 117      |       |
| Amortization                                      |       | 526      |       | 451      |       |
| Total                                             |       | 728      |       | 612      |       |
|                                              |       |     |       |     |       |
| Deferred tax  asset, net                          |       | $        | 10,880     |     | $          | 4,819 |   |

 

52

----

 

No valuation allowance was established at December 31, 2008 and2007, in view of the Company’s ability to carry back capital losses to recovertaxes paid in previous years and certain tax strategies, together with theanticipated future taxable income as evidenced by the Company’s earningpotential.

 

The provision for income taxes is comprised of the following for theyear ended December 31, 2008, 2007, and 2006:

** **

(In Thousands)

 
| ** **         | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------|------------|----------|------------|----------|------------|----------|------------|
|               |       |     |       |     |       |     |       |
| Currently  payable |       | $        | 1,967      |     | $          | 1,758    |       | $ | 2,112 |   |
| Deferred benefit   |       | (1,562   | )          | (1,121   | )          | (151     | )          |
|               |       |     |       |     |       |     |       |
| Total provision    |       | $        | 405        |     | $          | 637      |       | $ | 1,961 |   |

 

A reconciliation between the expected income tax and the effectiveincome tax rate on income before income tax provision follows for the yearended December 31, 2008, 2007, and 2006:

 

(In Thousands)

 
| ** **                       | ** ** | **2008**   | ** ** | **2007** | ** ** | **2006**   | ** ** |
|----------------------------------|------------|------------|------------|----------|------------|------------|------------|
| ** **                       | ** ** | **Amount** | ** ** | **%**    | ** ** | **Amount** | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** |
|                             |       |       |       |     |       |       |       |   |   |   |   |   |   |
| Provision at  expected rate      |       | $          | 2,859      |     | 34.0       | %          | $          | 3,235 |   | 34.0 | % | $ | 3,947 |   | 34.0 | % |
| Decrease in tax  resulting from: |       |       |       |     |       |       |       |   |   |   |   |   |   |
| Tax-exempt  income               |       | (1,757     | )          | (20.9    | )          | (1,512     | )          | (15.9 | ) | (1,425 | ) | (12.3 | ) |
| Tax credits                      |       | (601       | )          | (7.2     | )          | (1,048     | )          | (11.0 | ) | (363 | ) | (3.1 | ) |
| Other, net                       |       | (96        | )          | (1.1     | )          | (38        | )          | (0.4 | ) | (198 | ) | (1.7 | ) |
|                             |       |       |       |     |       |       |       |   |   |   |   |   |   |
| Effective income  tax and rate   |       | $          | 405        |     | 4.8        | %          | $          | 637 |   | 6.7 | % | $ | 1,961 |   | 16.9 | % |

 

**NOTE 11 - EMPLOYEE BENEFIT PLANS**

**Defined Benefit Pension Plan**

 

The Company has a noncontributory defined benefit pension plan (the “Plan”)for all employees meeting certain age and length of service requirements thatwere hired prior to January 1, 2004, at which time entrance into the Planwas frozen.  Benefits are based primarilyon years of service and the average annual compensation during the highest fiveconsecutive years within the final ten years of employment.

 

The following table sets forth the obligation and funded status as of December 31,2008 and 2007:

 

(In Thousands)

 
| ** **                                      | ** ** | **2008** | ** ** | **2007** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| **Change  in benefit obligation:**              |       |     |       |     |       |
| Benefit  obligation at beginning of year        |       | $        | 10,450     |     | $          | 8,510 |   |
| Service cost                                    |       | 546      |       | 466      |       |
| Interest cost                                   |       | 609      |       | 486      |       |
| Actuarial (gain)  loss                          |       | (166     | )          | 80       |       |
| Benefits paid                                   |       | (210     | )          | (210     | )          |
| Other, change in  actuarial assumptions         |       | 758      |       | 1,118    |       |
| Benefit  obligation at end of year              |       | 11,987   |       | 10,450   |       |
|                                            |       |     |       |     |       |
| **Change  in plan assets:**                     |       |     |       |     |       |
| Fair value of  plan assets at beginning of year |       | 7,891    |       | 6,990    |       |
| Actual return on  plan assets                   |       | (2,504   | )          | 531      |       |
| Employer  contribution                          |       | 875      |       | 580      |       |
| Benefits paid                                   |       | (210     | )          | (210     | )          |
| Adjustment to  fair value of plan assets        |       | 13       |       | —   |       |
| Fair value of  plan assets at end of year       |       | 6,065    |       | 7,891    |       |
| Funded status                                   |       | $        | (5,922     | )        | $          | (2,559 | ) |
|                                            |       |     |       |     |       |
| **Accounts  recognized on balance sheet as:**   |       |     |       |     |       |
| Total  liabilities                              |       | $        | (5,922     | )        | $          | (2,559 | ) |

 
| **Amounts not yet recognized as a component of net** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **periodic pension cost:**                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Amounts  recognized in accumulated other comprehensive income (loss) consist of:             |       |       |       |       |       |
| Net transition  asset                                                                        |       | $          | (9         | )          | $          | (12 | ) |
| Prior service  cost                                                                          |       | 127        |       | 153        |       |
| Net loss                                                                                     |       | 5,609      |       | 1,942      |       |
| Total                                                                                        |       | $          | 5,727      |       | $          | 2,083 |   |

 

The accumulated benefit obligation for the Plan was $9,410,000 and$7,835,000 at December 31, 2008 and 2007, respectively.

 

53

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Components of Net Periodic Cost and Other Amounts Recognized in otherComprehensive Income as of December 31, 2008, 2007, and 2006 are asfollows:

 

(In Thousands)

 
| ** **                             | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Net periodic  pension cost:            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service cost                           |       | $          | 546        |       | $          | 467        |       | $ | 467 |   |
| Interest cost                          |       | 609        |       | 486        |       | 434        |       |
| Expected return  on plan assets        |       | (641       | )          | (562       | )          | (485       | )          |
| Amortization of  transition asset      |       | (3         | )          | (3         | )          | (3         | )          |
| Amortization of  prior service cost    |       | 25         |       | 26         |       | 26         |       |
| Amortization of  unrecognized net loss |       | 57         |       | —     |       | 22         |       |
| Net periodic  benefit cost             |       | $          | 593        |       | $          | 414        |       | $ | 461 |   |

 

The estimated net transition asset and prior service cost for thedefined benefit pension plan that will be amortized from accumulated othercomprehensive income (loss) into net periodic benefit cost over the next fiscalyear are $3,000 and $25,000, respectively.

 

**Assumptions**

 

Weighted-average assumptions used to determine benefit obligations at December 31,2008, 2007, and 2006:

 
| ** **                     | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Discount rate                  |       | 5.75     | %          | 6.00     | %          | 5.75     | %          |
| Rate of  compensation increase |       | 4.75     | %          | 5.00     | %          | 4.75     | %          |

 

Weighted-average assumptions used to determine net periodic cost foryears ended December 31, 2008, 2007, and 2006:

 
| ** **                                | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Discount rate                             |       | 6.00     | %          | 5.75     | %          | 5.50     | %          |
| Expected  long-term return on plan assets |       | 8.00     | %          | 8.00     | %          | 8.00     | %          |
| Rate of  compensation increase            |       | 5.00     | %          | 4.75     | %          | 4.50     | %          |

 

The expected long-term rate of return was estimated using marketbenchmarks by which the plan assets would outperform the market value in thefuture, based on historical experience adjusted for changes in asset allocationand expectations for overall lower future returns on similar investmentscompared to past periods.

 

**Plan Assets**

 

The Plan’s weighted-average asset allocations at December 31, 2008and 2007 by asset category are as follows:

 
| **Asset Category**  | ** ** | **2008** | ** ** | **2007** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Cash                     |       | 0.3      | %          | 0.2      | %          |
| Fixed income  securities |       | 39.2     | %          | 39.6     | %          |
| Equity                   |       | 60.5     | %          | 60.2     | %          |
| Total                    |       | 100.0    | %          | 100.0    | %          |

 

The investment objective for the Plan is to maximize total return withtolerance for slightly above average risk, meaning the fund is able to tolerateshort-term volatility to achieve above-average returns over the long term.

 

Asset allocation favors equities, with target allocation ofapproximately 60% equity securities, 37.5% fixed income securities and 2.5%cash. Due to volatility in the market, the target allocation is not alwaysdesirable and asset allocations will fluctuate between the acceptableranges.  The equity portfolio’s exposureis primarily in mid and large capitalization 

 

54

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domestic equities with limited exposure to small capitalization andinternational stocks.

 

It is management’s intent to give the investment managers flexibility,within the overall guidelines, with respect to investment decisions and theirtiming. However, certain investments require specific review and approval bymanagement.  Management is also informedof anticipated, significant modifications of any previously approvedinvestment, or anticipated use of derivatives to execute investment strategies.

 

The following benefit payments that reflect expected future service, asappropriate, are expected to be paid:

 

**Estimated future benefit payments (in thousands):**

 
| 2009      |   | $      | 309    |   |
|-----------|--------|--------|--------|--------|
| 2010      |   | 330    |   |
| 2011      |   | 357    |   |
| 2012      |   | 528    |   |
| 2013      |   | 555    |   |
| 2014-2018 |   | 3,278  |   |
|      |   |   |   |
|      |   | $      | 5,357  |   |

 

The company expects to contribute a minimum of $325,000 to its PensionPlan in 2009.

 

**401(k) Savings Plan**

 

The Company also offers a 401(k) savings plan in which eligibleparticipating employees may elect to contribute up to a maximum percentageallowable not to exceed the limits of Code Sections 401(k), 404, and 415.  The Company may make matching contributionsequal to a discretionary percentage that is determined by the Board ofDirectors.  Participants are at all timesfully vested in their contributions and vest over a period of five yearsregarding the employer contribution. Contribution expense was approximately $97,000, $97,000, and $96,000 forthe years ended December 31, 2008, 2007, and 2006, respectively.

 

**Deferred Compensation Plan**

 

The Company has a deferred compensation plan whereby participatingdirectors elect to forego directors’ fees paid in cash.  Under this plan, the Company will makepayments for a ten-year period beginning at age 65 in most cases or at death,if earlier, at which time payments would be made to their designatedbeneficiaries.

 

To fund benefits under the deferred compensation plan, the Company hasacquired bank-owned life insurance policies on the lives of the participatingdirectors for which insurance benefits are payable to the Company. The Companyincurred expenses related to the plan of $96,000, $85,000, and $69,000 for theyears ended December 31, 2008, 2007, and 2006, respectively.  Benefits paid under the plan wereapproximately $180,000, $125,000, and $122,000 in 2008, 2007, and 2006,respectively.

 

**NOTE 12 - EMPLOYEE STOCK PURCHASE PLAN**

 

Effective April 26, 2006, the Companyimplemented the Penns Woods Bancorp, Inc. 2006 Employee Stock PurchasePlan (“Plan”). The Plan is intended to encourage employee participation in theownership and economic progress of the Company. The Plan allows for up to1,000,000 shares to be purchased by employees. The purchase price of the shares is 95% of market value with an employeeeligible to purchase up to the lesser of 15% of base compensation or $12,000 inmarket value annually. There were 3,264 and 3,090 shares issued under the planfor the years ended December 31, 2008 and 2007, respectively.

 

55

----

 

**NOTE 13 - STOCK OPTIONS**

 

In 1998, the Company adopted the 1998 StockOption Plan (“1998 Plan”) for key employees and directors.  Incentive stock options and nonqualifiedstock options may be granted to eligible employees of the Bank and nonqualifiedoptions may be granted to directors of the Company.  Incentive nonqualified stock options granted underthe 1998 Plan may be exercised not later than ten years after the date ofgrant.  Each option granted under the1998 Plan shall be exercisable only after the expiration of six monthsfollowing the date of grant of such options.

 

A summary of the status of the Company’s common stock option plans arepresented below:

 
| ** **                       | ** ** | **2008**   | ** ** | **2007**     | ** ** |
|----------------------------------|------------|------------|------------|--------------|------------|
| ** **                       | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                       | ** ** | ** ** | ** ** | **Average**  | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                       | ** ** | ** ** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                       | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Shares** | ** ** | **Price** | ** ** |
|                             |       |       |       |         |       |   |   |   |   |
| Outstanding,  beginning of year  |       | 10,913     |       | $            | 37.60      |   | 11,972 |   | $ | 37.41 |   |
| Granted                          |       | —     |       | —       |       | — |   | — |   |
| Exercised                        |       | (330       | )          | 31.82        |       | (330 | ) | 24.72 |   |
| Forfeited                        |       | (8,603     | )          | 39.97        |       | (729 | ) | 40.29 |   |
|                             |       |       |       |         |       |   |   |   |   |
| Outstanding, end  of year        |       | 1,980      |       | 28.27        |       | 10,913 |   | 37.60 |   |
|                             |       |       |       |         |       |   |   |   |   |
| Options  exercisable at year-end |       | 1,980      |       | $            | 28.27      |   | 10,913 |   | $ | 37.60 |   |

 

The following table summarizes information about nonqualified andincentive stock options outstanding at December 31, 2008:

 
| ** **              | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
|-------------------------|------------|-----------------|------------|-----------------|------------|
| ** **              | ** ** | ** **      | ** ** | ** **      | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **              | ** ** | ** **      | ** ** | **Average**     | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| **Exercise Price** | ** ** | **Shares**      | ** ** | **Life**        | ** ** | **Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
| $                       | 31.82      |            | 990        |            | 1          |   | $ | 31.82 |   | 990 |   | $ | 31.82 |   |
| 24.72                   |       | 990             |       | 2               |       | 24.72 |   | 990 |   | 24.72 |   |
|                         |            |                 |            |                 |            |  |  |  |  |  |  |  |  |  |

 

**NOTE 14 - RELATED PARTY TRANSACTIONS**

 

Certain directors and executive officers ofthe Company and the Bank, including their immediate families and companies inwhich they are principal owners (more than ten percent), are indebted to theCompany.  Such indebtedness was incurredin the ordinary course of business on the same terms and at those ratesprevailing at the 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 years ended December 31, 2008 and 2007:

 

(In Thousands)

 
| ** ** | ** ** | **Beginning** | ** ** | ** **    | ** ** | ** **   | ** ** | **Other**   | ** ** | **Ending**  | ** ** |
|------------|------------|---------------|------------|---------------|------------|--------------|------------|-------------|------------|-------------|------------|
| ** ** | ** ** | **Balance**   | ** ** | **Additions** | ** ** | **Payments** | ** ** | **Changes** | ** ** | **Balance** | ** ** |
|       |       |          |       |          |       |         |       |        |       |        |       |
| 2008       |       | $             | 9,335      |          | $          | 1,626        |       | $           | 1,776      |        | $          | 243 |   | $ | 8,942 |   |
| 2007       |       | 9,742         |       | 1,711         |       | 2,118        |       | —      |       | 9,335       |       |
|            |            |               |            |               |            |              |            |             |            |             |            |  |  |  |  |  |

 

Depositsfrom related parties held by the Bank amounted to $7,377,000 at December 31,2008 and $7,796,000 at December 31, 2007.

 

56

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**NOTE 15 - COMMITMENTS AND CONTINGENT LIABILITIES**

 

The following schedule shows future minimumrental payments under operating leases with noncancellable terms in excess ofone year as of December 31, 2008:

 

(In thousands)

 
| 2009       |   | $     | 387    |   |
|------------|--------|-------|--------|--------|
| 2010       |   | 383   |   |
| 2011       |   | 317   |   |
| 2012       |   | 296   |   |
| 2013       |   | 227   |   |
| Thereafter |   | 1,703 |   |
| Total      |   | $     | 3,313  |   |

 

The Company’s operating lease obligations represent short and long-termlease and rental payments for facilities. Total rental expense for all operating leases for the years ended December 31,2008, 2007, and 2006 were $406,000, $423,000, and $380,000.

 

The Company is subject to lawsuits and claims arising out of itsbusiness.  There are no such legalproceedings or claims currently pending or threatened other than thoseencountered during the normal course of business.

 

**NOTE 16 - OFF-BALANCE SHEET RISK**

** **

The Company is a party to financial instruments with off-balance sheetrisk in the normal course of business to meet the financing needs of itscustomers. These financial instruments include commitments to extend credit andstandby letters of credit.  Theseinstruments involve, to varying degrees, elements of credit, interest rate, orliquidity risk in excess of the amount recognized in the consolidated balancesheet. The contract amounts of these instruments express the extent ofinvolvement the Company has in particular classes of financial instruments.

 

The Company’s exposure to credit loss from nonperformance by the otherparty to the financial instruments for commitments to extend credit and standbyletters of credit is represented by the contractual amount of theseinstruments.  The Company uses the samecredit policies in making commitments and conditional obligations as it doesfor on-balance sheet instruments.  TheCompany may require collateral or other security to support financialinstruments with off-balance sheet credit risk.

 

Financial instruments whose contract amounts represent credit risk areas follows at December 31, 2008 and 2007:

 

(In Thousands)

 
| ** **                    | ** ** | **2008** | ** ** | **2007** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
|                          |       |     |       |     |       |
| Commitments to  extend credit |       | $        | 85,871     |     | $          | 74,349 |   |
| Standby letters  of credit    |       | 841      |       | 974      |       |
|                               |            |          |            |          |            |  |  |

 

Commitments to extend credit are legally binding agreements to lend tocustomers.  Commitments generally havefixed expiration dates or other termination clauses and may require payment offees.  Since many of the commitments areexpected to expire without being drawn upon, the total commitment amounts donot necessarily represent future liquidity requirements.  The Company evaluates each customer’s creditworthiness on a case-by-case basis.  Theamount of collateral obtained, if deemed necessary by the Company, on anextension of credit is based on management’s credit 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 

 

57

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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, the collateralis typically Bank deposit instruments or customer business assets.

 

**NOTE 17 - CAPITAL REQUIREMENTS**

 

Federal regulations require the Company andthe Bank to maintain minimum amounts of capital.  Specifically, each is required to maintaincertain minimum dollar amounts and ratios of Total and Tier 1 capital to risk-weightedassets and of Tier 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 anyinstitution fail to meet the requirements to be considered “adequatelycapitalized,” it would become subject to a series of increasingly restrictiveregulatory actions.

 

As of December 31, 2008 and 2007, theFederal Deposit Insurance Corporation (“FDIC”) categorized the Bank as wellcapitalized under the regulatory framework for prompt corrective action.  To be classified as a well capitalizedfinancial institution, Total risk-based, Tier 1 risk-based, and Tier 1 leveragecapital ratios must be at least 10%, 6%, and 5%, respectively.

 

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

 

58

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| Consolidated  Company |
|-----------------------|

 

(In Thousands)

 
| ** **                              | ** ** | **2008**   | ** ** | **2007**  | ** ** |
|-----------------------------------------|------------|------------|------------|-----------|------------|
| ** **                              | ** ** | **Amount** | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| Total Capital(to Risk-weighted Assets)  |       |       |       |      |       |   |   |   |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Actual                                  |       | $          | 66,891     |      | 16.0       | % | $ | 70,381 |   | 18.0 | % |
| For Capital  Adequacy Purposes          |       | 33,410     |       | 8.0       |       | 31,280 |   | 8.0 |   |
| To Be Well  Capitalized                 |       | 41,763     |       | 10.0      |       | 39,100 |   | 10.0 |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Tier I Capital(to Risk-weighted Assets) |       |       |       |      |       |   |   |   |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Actual                                  |       | $          | 62,540     |      | 15.0       | % | $ | 66,251 |   | 16.9 | % |
| For Capital  Adequacy Purposes          |       | 16,705     |       | 4.0       |       | 15,640 |   | 4.0 |   |
| To Be Well  Capitalized                 |       | 25,058     |       | 6.0       |       | 23,460 |   | 6.0 |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Tier I Capital(to Average Assets)       |       |       |       |      |       |   |   |   |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Actual                                  |       | $          | 62,540     |      | 9.7        | % | $ | 66,251 |   | 10.8 | % |
| For Capital  Adequacy Purposes          |       | 25,773     |       | 4.0       |       | 24,664 |   | 4.0 |   |
| To Be Well  Capitalized                 |       | 32,216     |       | 5.0       |       | 30,830 |   | 5.0 |   |

 
| Bank |
|------|

 

(In Thousands)

 
| ** **                              | ** ** | **2008**   | ** ** | **2007**  | ** ** |
|-----------------------------------------|------------|------------|------------|-----------|------------|
| ** **                              | ** ** | **Amount** | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| Total Capital(to Risk-weighted Assets)  |       |       |       |      |       |   |   |   |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Actual                                  |       | $          | 56,876     |      | 13.9       | % | $ | 57,295 |   | 15.1 | % |
| For Capital  Adequacy Purposes          |       | 32,799     |       | 8.0       |       | 30,350 |   | 8.0 |   |
| To Be Well  Capitalized                 |       | 40,998     |       | 10.0      |       | 37,938 |   | 10.0 |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Tier I Capital(to Risk-weighted Assets) |       |       |       |      |       |   |   |   |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Actual                                  |       | $          | 52,520     |      | 12.8       | % | $ | 53,165 |   | 14.0 | % |
| For Capital  Adequacy Purposes          |       | 16,399     |       | 4.0       |       | 15,175 |   | 4.0 |   |
| To Be Well  Capitalized                 |       | 24,599     |       | 6.0       |       | 22,763 |   | 6.0 |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Tier I Capital(to Average Assets)       |       |       |       |      |       |   |   |   |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Actual                                  |       | $          | 52,520     |      | 8.3        | % | $ | 53,165 |   | 8.8 | % |
| For Capital  Adequacy Purposes          |       | 25,423     |       | 4.0       |       | 24,124 |   | 4.0 |   |
| To Be Well Capitalized                  |       | 31,778     |       | 5.0       |       | 30,155 |   | 5.0 |   |

 

**NOTE 18 - REGULATORY RESTRICTIONS**

 

ThePennsylvania Banking Code restricts the availability of capital funds forpayment of dividends by all state-chartered banks to the additional paid incapital of the Bank. Accordingly, at December 31, 2008, the balance in theadditional paid

 

59

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incapital account totaling $11,657,000 is unavailable for dividends.

 

TheBank is subject to regulatory restrictions, which limit its ability to loanfunds to Penns Woods Bancorp, Inc.  At December31, 2008, the regulatory lending limit amounted to approximately $8,531,000.

 

**Cash and Due from Banks**

Includedin cash and due from banks are reserves required by the district Federal ReserveBank of $1,046,000 and $1,009,000 at December 31, 2008 and 2007,respectively.  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 19 - FAIR VALUE MEASUREMENTS**

 

EffectiveJanuary 1, 2008, the Company adopted the provisions of FAS No. 157, Fair ValueMeasurements, for financial assets and financial liabilities.  FAS No. 157 provides enhanced guidance forusing fair value to measure assets and liabilities.  The standard applies whenever other standardsrequire or permit assets or liabilities to be measured at fair value.  The standard does not expand the use of fairvalue in any new circumstances.  The FASBissued Staff Position No. 157-1, Application of FASB Statement No. 157 to FASBStatement No. 13 and Other Accounting Pronouncements That Address Fair ValueMeasurements for Purposes of Lease Classification or Measurement under Statement13, which removed leasing transactions accounted for under FAS No. 13 andrelated guidance from the scope of FAS No. 157. The FASB also issued Staff Position No.157-2, Partial Deferral of theEffective Date of Statement 157, which deferred the effective date of FAS No. 157for all nonfinancial assets and nonfinancial liabilities to fiscal yearsbeginning after November 15, 2008.

 

FASNo. 157 establishes a hierarchal disclosure framework associated with the levelof pricing observability utilized in measuring assets and liabilities at fairvalue. The three broad levels defined by FAS No. 157 hierarchy are as follows:

 

LevelI: Quoted prices are available in active markets for identical assets orliabilities as of the reported date.

 

LevelII: Pricing inputs are other than the quoted prices in active markets, whichare either directly or indirectly observable as of the reported date.  The nature of these assets and liabilitiesincludes items for which quoted prices are available but traded less frequentlyand items that are fair-valued using other financial instruments, theparameters of which can be directly observed.

 

Level III:    Assets and liabilities that have little to no pricing observability asof the reported date.  These items do nothave two-way markets and are measured using management’s best estimate of fairvalue, where the inputs into the determination of fair value requiresignificant management judgment or estimation.

 

Thefollowing table presents the assets reported on the balance sheet at their fairvalue as of December 31, 2008, by level within the fair value hierarchy. Asrequired by FAS No. 157, financial assets and liabilities are classified intheir entirety based on the lowest level of input that is significant to thefair value measurement.

 

(In Thousands)

 
| ** **                                 | ** ** | **December 31, 2008** | ** ** |
|--------------------------------------------|------------|----------------------------|------------|
| ** **                                 | ** ** | **Level I**           | ** ** | **Level II** | ** ** | **Level III** | ** ** | **Total** | ** ** |
| Assets:                                    |       |                       |       |   |   |   |   |   |   |
| Investment  securities, available for sale |       | $                          | 13,269     |   | $ | 194,982 |   | $ | — |   | $ | 208,251 |   |
|                                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |

 

**NOTE 20 - ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS**

 

TheCompany is required to disclose estimated fair values for its financialinstruments.  Fair value estimates aremade at a specific point in time, based on relevant market information andinformation about the financial instrument. These estimates do not reflect any premium or discount that could resultfrom offering for sale at one time the Company’s entire holdings of aparticular financial instrument.  Also,it is the Company’s general practice and intention to hold most of itsfinancial instruments to maturity and not to engage in trading or salesactivities.  Because no market exists fora significant portion of the Company’s financial instruments, fair valueestimates are based on judgments regarding future expected loss experience,current economic conditions, risk characteristics of various financialinstruments, and other factors.  Theseestimates are subjective in nature and involve uncertainties and matters ofsignificant judgment and therefore cannot be

 

60

----

 

determinedwith precision.  Changes in assumptionscan significantly affect the estimates.

 

Estimatedfair values have been determined by the Company using historical data and anestimation methodology suitable for each category of financial instruments.  The Company’s fair value estimates, methods,and assumptions are set forth below for the Company’s other financialinstruments.

 

Ascertain assets and liabilities, such as deferred tax assets, premises andequipment, and many other operational elements of the Company, are notconsidered financial instruments but have value, this estimated fair value offinancial instruments would not represent the full market value of the Company.

 

Theestimated fair values of the Company’s financial instruments are as follows at December 31,2008 and 2007:

 

(In Thousands)

 
| ** **                    | ** ** | **2008**     | ** ** | **2007**  | ** ** |
|-------------------------------|------------|--------------|------------|-----------|------------|
| ** **                    | ** ** | **Carrying** | ** ** | **Fair**  | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| ** **                    | ** ** | **Value**    | ** ** | **Value** | ** ** | **Value** | ** ** | **Value** | ** ** |
| Financial  assets:            |       |         |       |      |       |   |   |   |   |
| Cash and cash  equivalents    |       | $            | 16,581     |      | $          | 16,581 |   | $ | 15,433 |   | $ | 15,433 |   |
| Investment securities:        |       |         |       |      |       |   |   |   |   |
| Available for  sale           |       | 208,251      |       | 208,251   |       | 214,455 |   | 214,455 |   |
| Held to maturity              |       | 135          |       | 136       |       | 277 |   | 279 |   |
| Loans held for  sale          |       | 3,622        |       | 3,622     |       | 4,214 |   | 4,214 |   |
| Loans, net                    |       | 377,122      |       | 380,771   |       | 356,348 |   | 357,628 |   |
| Bank-owned life  insurance    |       | 14,546       |       | 14,546    |       | 12,375 |   | 12,375 |   |
| Accrued interest  receivable  |       | 3,614        |       | 3,614     |       | 3,343 |   | 3,343 |   |
|                          |       |         |       |      |       |   |   |   |   |
| Financial  liabilities:       |       |         |       |      |       |   |   |   |   |
| Interest-bearing  deposits    |       | $            | 345,333    |      | $          | 347,657 |   | $ | 314,351 |   | $ | 314,501 |   |
| Noninterest-bearing  deposits |       | 76,035       |       | 76,035    |       | 74,671 |   | 74,671 |   |
| Short-term  borrowings        |       | 73,946       |       | 73,946    |       | 55,315 |   | 55,315 |   |
| Long-term  borrowings, FHLB   |       | 86,778       |       | 88,188    |       | 106,378 |   | 106,154 |   |
| Accrued interest  payable     |       | 1,317        |       | 1,317     |       | 1,744 |   | 1,744 |   |

 

**Cash and Cash Equivalents,Loans Held for Sale, Accrued Interest Receivable, Short-term Borrowings, andAccrued Interest Payable:**

Thefair value is equal to the carrying value.

 

**Investment Securities:**

Thefair value of investment securities available for sale and held to maturity isequal to the available quoted market price. If no quoted market price isavailable, fair value is estimated using the quoted market price for similarsecurities.  Regulatory stocks’ fairvalue is equal to the carrying value.

 

**Loans:**

Fairvalues are estimated for portfolios of loans with similar financialcharacteristics.  Loans are segregated bytype such as commercial, commercial real estate, residential real estate,construction real estate, and other consumer. Each loan category is further segmented into fixed and adjustable rateinterest terms and by performing and nonperforming categories.

 

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.

 

Fairvalue for significant nonperforming loans is based on recent externalappraisals.  If appraisals are notavailable, estimated cash flows are discounted using a rate commensurate withthe risk associated with the estimated cash flows.  

 

61

----

 

Assumptionsregarding credit risk, cash flows, and discounted rates are judgmentallydetermined using available market information and specific borrowerinformation.

 

**Bank-Owned Life Insurance:**

Thefair value is equal to the cash surrender value of the life insurance policies.

 

**Deposits:**

Thefair value of deposits with no stated maturity, such as noninterest-bearingdemand deposits, savings, NOW, and money market accounts, is equal to theamount payable on demand as of December 31, 2008 and 2007.  The fair value of certificates of deposit isbased on the discounted value of contractual cash flows.

 

Thefair value estimates above do not include the benefit that results from thelow-cost funding provided by the deposit liabilities compared to the cost ofborrowing funds in the market, commonly referred to as the core depositintangible.

 

**LongTerm Borrowings:**

Thefair value of long term borrowings is based on the discounted value ofcontractual cash flows.

 

**Commitments to 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, 2008 and2007.  The contractual amounts ofunfunded commitments and letters of credit are presented in Note 16.

 

**NOTE 21- PARENT COMPANY ONLY FINANCIAL STATEMENTS**

 

Condensed financial information for Penns Woods Bancorp, Inc. follows:

 

**CONDENSED BALANCE SHEET, DECEMBER 31,**

(In Thousands)

** **
| ** **                                     | ** ** | **2008** | ** ** | **2007** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|
|                                           |       |     |       |     |       |
| ASSETS:                                        |       |     |       |     |       |
| Cash                                           |       | $        | 94         |     | $          | 15 |   |
| Investment in  subsidiaries:                   |       |     |       |     |       |
| Bank                                           |       | 49,327   |       | 56,971   |       |
| Nonbank                                        |       | 11,463   |       | 13,473   |       |
| Other assets                                   |       | 225      |       | 234      |       |
|                                           |       |     |       |     |       |
| Total Assets                                   |       | $        | 61,109     |     | $          | 70,693 |   |
|                                           |       |     |       |     |       |
| LIABILITIES AND SHAREHOLDERS’  EQUITY:    |       |     |       |     |       |
| Other  liabilities                             |       | $        | 82         |     | $          | 134 |   |
| Shareholders’  equity                     |       | 61,027   |       | 70,559   |       |
|                                           |       |     |       |     |       |
| Total liability  and shareholders’ equity |       | $        | 61,109     |     | $          | 70,693 |   |

 

62

----

 

**CONDENSEDSTATEMENT OF INCOME**

**FOR THEYEARS ENDED DECEMBER 31,**

(In Thousands)

 
| ** **                                          | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                |       |     |       |     |       |     |       |
| Operating  income:                                  |       |     |       |     |       |     |       |
| Dividends from  subsidiaries                        |       | $        | 8,763      |     | $          | 8,039    |       | $ | 9,890 |   |
| Equity in  undistributed net income of subsidiaries |       | (485     | )          | 1,152    |       | 53       |       |
|                                                |       |     |       |     |       |     |       |
| Operating  expenses:                                |       | (275     | )          | (314     | )          | (296     | )          |
|                                                |       |     |       |     |       |     |       |
| Net income                                          |       | $        | 8,003      |     | $          | 8,877    |       | $ | 9,647 |   |

 

**CONDENSEDSTATEMENT OF CASH FLOWS**

**FOR THEYEARS ENDED DECEMBER 31,**

(In Thousands)

 
| ** **                                                                         | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                               |       |     |       |     |       |     |       |
| OPERATING  ACTIVITIES:                                                             |       |     |       |     |       |     |       |
| Net income                                                                         |       | $        | 8,003      |     | $          | 8,877    |       | $ | 9,647 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |     |       |     |       |     |       |
| Equity in  undistributed net income of subsidiaries                                |       | 485      |       | (1,152   | )          | (53      | )          |
| Other, net                                                                         |       | (43      | )          | 67       |       | (30      | )          |
| Net cash provided  by operating activities                                         |       | 8,445    |       | 7,792    |       | 9,564    |       |
|                                                                               |       |     |       |     |       |     |       |
| INVESTING  ACTIVITIES:                                                             |       |     |       |     |       |     |       |
| Additional  investment in subsidiaries                                             |       | —   |       | —   |       | —   |       |
|                                                                               |       |     |       |     |       |     |       |
| FINANCING  ACTIVITIES:                                                             |       |     |       |     |       |     |       |
| Dividends paid                                                                     |       | (7,096   | )          | (6,953   | )          | (6,802   | )          |
| Issuance of common  stock                                                          |       | 90       |       | 99       |       | 49       |       |
| Stock options  exercised                                                           |       | 11       |       | 8        |       | —   |       |
| Purchase of  treasury stock                                                        |       | (1,371   | )          | (972     | )          | (2,929   | )          |
| Net cash used  for financing activities                                            |       | (8,366   | )          | (7,818   | )          | (9,682   | )          |
|                                                                               |       |     |       |     |       |     |       |
| NET INCREASE  (DECREASE) IN CASH                                                   |       | 79       |       | (26      | )          | (118     | )          |
| CASH, BEGINNING  OF YEAR                                                           |       | 15       |       | 41       |       | 159      |       |
|                                                                               |       |     |       |     |       |     |       |
| CASH, END OF  YEAR                                                                 |       | $        | 94         |     | $          | 15       |       | $ | 41 |   |

 

63

----

 

**NOTE 22 –CONSOLIDATED QUARTERLY FINANCIAL DATA (UNAUDITED)**

 

(In Thousands, Except Per Share Data)

 
| ** **                             | ** ** | **For The Three Months Ended** | ** ** |
|----------------------------------------|------------|----------------------------------------------------|------------|
| **2008**                               | ** ** | **March 31,**                                 | ** ** | **June 30,** | ** ** | **Sept. 30,** | ** ** | **Dec. 31,** | ** ** |
| Interest income                        |       | $                                                  | 9,048      |   | $ | 8,936 |   | $ | 9,108 |   | $ | 9,016 |   |
| Interest expense                       |       | 4,167                                              |       | 3,780 |   | 3,595 |   | 3,290 |   |
|                                   |       |                                               |       |   |   |   |   |   |   |
| Net interest  income                   |       | 4,881                                              |       | 5,156 |   | 5,513 |   | 5,726 |   |
|                                   |       |                                               |       |   |   |   |   |   |   |
| Provision for  loan losses             |       | 60                                                 |       | 60 |   | 110 |   | 145 |   |
| Non-interest  income                   |       | 1,876                                              |       | 1,872 |   | 1,976 |   | 1,763 |   |
| Securities gains  (losses), net        |       | 38                                                 |       | (251 | ) | (1,504 | ) | (314 | ) |
| Non-interest  expense                  |       | 4,445                                              |       | 4,511 |   | 4,451 |   | 4,542 |   |
|                                   |       |                                               |       |   |   |   |   |   |   |
| Income before  income tax provision    |       | 2,290                                              |       | 2,206 |   | 1,424 |   | 2,488 |   |
| Income tax  provision (benefit)        |       | 159                                                |       | 149 |   | (128 | ) | 225 |   |
|                                   |       |                                               |       |   |   |   |   |   |   |
| Net income                             |       | $                                                  | 2,131      |   | $ | 2,057 |   | $ | 1,552 |   | $ | 2,263 |   |
|                                   |       |                                               |       |   |   |   |   |   |   |
| Earnings per  share - basic            |       | $                                                  | 0.55       |   | $ | 0.53 |   | $ | 0.40 |   | $ | 0.59 |   |
|                                   |       |                                               |       |   |   |   |   |   |   |
| Earnings per  share - diluted          |       | $                                                  | 0.55       |   | $ | 0.53 |   | $ | 0.40 |   | $ | 0.59 |   |
|                                   |       |                                               |       |   |   |   |   |   |   |
| (In Thousands,  Except Per Share Data) | ** ** | ** **                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **For The Three Months Ended**                     | ** ** |
| **2007**                               | ** ** | **March 31,**                                 | ** ** | **June 30,** | ** ** | **Sept. 30,** | ** ** | **Dec. 31,** | ** ** |
| Interest income                        |       | $                                                  | 8,679      |   | $ | 8,793 |   | $ | 8,977 |   | $ | 9,500 |   |
| Interest expense                       |       | 3,939                                              |       | 3,999 |   | 4,112 |   | 4,397 |   |
|                                   |       |                                               |       |   |   |   |   |   |   |
| Net interest  income                   |       | 4,740                                              |       | 4,794 |   | 4,865 |   | 5,103 |   |
|                                   |       |                                               |       |   |   |   |   |   |   |
| Provision for  loan losses             |       | 40                                                 |       | 10 |   | 10 |   | 90 |   |
| Non-interest  income                   |       | 1,648                                              |       | 1,893 |   | 2,006 |   | 1,985 |   |
| Securities gains  (losses), net        |       | 326                                                |       | 293 |   | — |   | (673 | ) |
| Non-interest  expense                  |       | 4,128                                              |       | 4,340 |   | 4,430 |   | 4,418 |   |
|                                   |       |                                               |       |   |   |   |   |   |   |
| Income before  income tax provision    |       | 2,546                                              |       | 2,630 |   | 2,431 |   | 1,907 |   |
| Income tax  provision (benefit)        |       | 265                                                |       | 295 |   | 109 |   | (32 | ) |
|                                   |       |                                               |       |   |   |   |   |   |   |
| Net income                             |       | $                                                  | 2,281      |   | $ | 2,335 |   | $ | 2,322 |   | $ | 1,939 |   |
|                                   |       |                                               |       |   |   |   |   |   |   |
| Earnings per  share - basic            |       | $                                                  | 0.59       |   | $ | 0.60 |   | $ | 0.59 |   | $ | 0.50 |   |
|                                   |       |                                               |       |   |   |   |   |   |   |
| Earnings per  share - diluted          |       | $                                                  | 0.59       |   | $ | 0.60 |   | $ | 0.59 |   | $ | 0.50 |   |

 

64

----

 

**ITEM 9                CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None

 

**ITEM9A             CONTROLS AND PROCEDURES**

 

TheCompany, under the supervision and with the participation of the Company’smanagement, including the Company’s President and Chief Executive Officer alongwith the Company’s Chief Financial Officer, conducted an evaluated of theeffectiveness as of December 31, 2008 of the design and operation of theCompany’s disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgatedunder the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  Based upon that evaluation, the Company’sPresident and Chief Executive Officer along with the Company’s Chief FinancialOfficer concluded that the Company’s disclosure controls and procedures wereeffective as of December 31, 2008.

 

Therehave been no material changes in the Company’s internal control over financialreporting during the fourth quarter of 2008 that have materially affected, orare reasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

**Management’s Report on Internal Control Over Financial Reporting**

 

Managementof the Company is responsible for establishing and maintaining adequateinternal control over financial reporting as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act. The Company’s internal control overfinancial reporting is designed to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with generally accepted accountingprinciples.

 

Becauseof its inherent limitations, internal control over financial reporting may notprevent or detect misstatements. Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

 

Amaterial weakness is a significant deficiency (as defined in Public CompanyAccounting Oversight Board Auditing Standard No. 2), or a combination ofsignificant deficiencies, that results in there being more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected on a timely basis by management oremployees in the normal course of performing their assigned functions.

 

Managementassessed the effectiveness of the Company’s internal control over financial reportingas of December 31, 2008. Management’s assessment did not identify anymaterial weaknesses in the Company’s internal control over financial reporting.

 

Inmaking this assessment, management used the criteria set forth by the Committeeof Sponsoring Organizations of the Treadway Commission (COSO) in InternalControl-Integrated Framework. Because there were no material weaknessesdiscovered, management believes that, as of December 31, 2008, the Company’sinternal control over financial reporting was effective.

 

S.R.Snodgrass, A.C. an independent registered public accounting firm, has auditedthe consolidated financial statements included in this Annual Report on Form 10-K,as part of the audit, has issued a report, which appears below, on the effectivenessof the Company’s internal control over financial reporting as of December 31,2008.

 
| Date:  March 10, 2009 | /s/  Ronald A. Walko     |   | /s/  Brian L. Knepp      |
|----------------------------|--------------------------|--------|--------------------------|
|                       | Chief  Executive Officer |   | Chief  Financial Officer |

 

----

 

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

Board of Directors and Shareholders

Penns Woods Bancorp, Inc.

 

We have audited Penns Woods Bancorp, Inc. and subsidiaries’internal control over financial reporting as of December 31, 2008, basedon criteria established in Internal Control — Integrated Framework issued bythe Committee of Sponsoring Organizations of the Treadway Commission.  Penns Woods Bancorp, Inc. management isresponsible for maintaining effective internal control over financial reportingand for its assessment of the effectiveness of internal control over financialreporting included in the accompanying Report on Management’s Assessment ofInternal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internalcontrol over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audits to obtain reasonable assurance aboutwhether effective internal control over financial reporting was maintained inall material respects.  Our auditincluded obtaining an understanding of internal control over financialreporting, assessing the risk that a material weakness exists, and testing andevaluating the design and operating effectiveness of internal control based onthe assessed risk.  Our audits alsoincluded performing such other procedures as we considered necessary in thecircumstances.  We believe that ouraudits provide a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a processdesigned to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles. A company’s internalcontrol over financial reporting includes those policies and procedures that (1) pertainto the maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financialreporting may not prevent or detect misstatements.  Also, projections of any evaluation of effectivenessto future periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

 

In our opinion, Penns Woods Bancorp, Inc. maintained, in allmaterial respects, effective internal control over financial reporting as of December 31,2008, based on criteria established in Internal Control — Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

We have also audited, in accordance with the standards of the PublicCompany Accounting Oversight Board (United States), the consolidated balancesheets of Penns Woods Bancorp, Inc. as of December 31, 2008 and 2007,and the related consolidated statements of income, comprehensive income,stockholders’ equity, and cash flows for each of the three years in the periodended December 31, 2008, and our report dated March 10, 2009,expressed an unqualified opinion.

 

 

Wexford, Pennsylvania

March 10, 2009

 

----

 

**ITEM 9B– OTHER INFORMATION**

 

None.

 

**PART III**

** **

**ITEM 10    DIRECTORS,EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE**

 

The information appearingunder the captions “The Board of Directors and Committees,” “Election ofDirectors,” “Section 16(a) Beneficial Ownership Reporting Compliance,”“Principal Officers of the Corporation,” “Certain Transactions,” and “AuditCommittee Financial Expert” in the Company’s Proxy Statement dated March 24,2009 (the “Proxy Statement”) is incorporated herein by reference.

 

##### **ITEM 11**    EXECUTIVECOMPENSATION

##### ** **

Information appearingunder the captions “Compensation of Directors,” “Compensation CommitteeInterlocks and Insider Participation,” “Compensation Discussion and Analysis,” “CompensationCommittee and Benefits Committee Report,” and “Executive Compensation” in theProxy Statement is incorporated herein by reference.

 

**ITEM 12    SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS**

 

The information appearingunder the caption “Security Ownership of Certain Beneficial Owners andManagement” in the Proxy Statement 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     |       | 1,980                                                                                                                                             |       | $                                                                                                       | 28.27      |                                                                                                                                                                                                     | —     |   |
|                                                        |       |                                                                                                                                              |       |                                                                                                    |       |                                                                                                                                                                                                     |       |
| Equity  compensation plans not approved by security holders |       | —                                                                                                                                            |       | —                                                                                                  |       | —                                                                                                                                                                                                   |       |
| Total                                                       |       | 1,980                                                                                                                                             |       | $                                                                                                       | 28.27      |                                                                                                                                                                                                     | —     |   |

 

**ITEM13    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, ANDDIRECTOR INDEPENDENCE**

 

There have been nomaterial transactions between the Company and the Bank, nor any materialtransactions proposed, with any Director or Executive Officer of the Companyand the Bank, or any associate of the foregoing persons.  The Company and the Bank have had, and intendto continue to have, banking and financial transactions in the ordinary courseof business with Directors and Officers of the Company and the Bank and theirassociates on comparable terms and with similar interest rates as thoseprevailing from time to time for other customers of the Company and the Bank.

 

Total loans outstandingfrom the Bank at December 31, 2008 to the Company’s and the Bank’sOfficers and Directors as a group and members of their immediate families andcompanies in which they had an ownership interest of 10% or more was $8,942,000or approximately 14.65% of the total equity capital of the Company.  Loans to such persons were made in theordinary course of business, were made on substantially the same terms,including interest rates and collateral, as those prevailing at the time forcomparable transactions with other persons, and did not involve more than thenormal risk of collectability or present other unfavorable features.  See also the information appearing in Note 14to the Consolidated Financial Statements included elsewhere in the AnnualReport.

 

In addition, theinformation appearing under the caption “Election of Directors” in the ProxyStatement is incorporated herein by reference.

 

----

 

**ITEM 14PRINCIPAL ACCOUNTANT FEES AND SERVICES**

 

The information appearingin the Proxy Statement under the captions, “Audit Fees,” “Audit-Related Fees,” “TaxFees,” “All Other Fees,” and “Audit Committee Pre-Approval Policies andProcedures” is incorporated herein by reference.

 

**PART IV**

** **

**ITEM 15    EXHIBITSAND FINANCIAL STATEMENT SCHEDULES**

 
|  (a) | 1.             | Financial Statements                                                                  |                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                             |
|-----------|----------------|---------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|      |           | The following  consolidated financial statements and reports are set forth in Item 8: |
|      |           |                                                                                  | 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.             |                                                                                  | Financial Statement  Schedules                                                                                                                                                                   |
|      |           |                                                                                  | Financial statement  schedules are omitted because the required information is either not  applicable, not required or is shown in the respective financial statements  or in the notes thereto. |
|      |           |                                                                                  |                                                                                                                                                                                             |
| (b)       |  Exhibits |                                                                                  |                                                                                                                                                                                             |
|      |           | (3)   (i)                                                              |                                                                                                                                                                                             | Articles of  Incorporation of the Registrant, as presently in effect (incorporated by  reference to Exhibit 3(i) of the Registrant’s Annual Report on  Form 10-K for the year ended December 31, 2005).                                                                 |
|      |           | (3)  (ii)                                                                   |                                                                                                                                                                                             | Bylaws of the  Registrant as presently in effect (incorporated by reference to  Exhibit 3(ii) of the Registrant’s Current Report on Form 8-K  filed on June 17, 2005).                                                                                                  |
|      |           | (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  Registration Statement on Form S-4, No. 333-65821).*                                                              |
|      |           | (10) (ii)                                                                        |                                                                                                                                                                                             | Employee Severance  Benefit Plan, dated May 30, 1996, for Ronald A. Walko (incorporated by  reference to Exhibit 10.4 of the Registrant’s Registration Statement on  form S-4, No. 333-65821).*                                                                              |
|      |           | (10) (iii)                                                                       |                                                                                                                                                                                             | Consulting Agreement,  dated July 18, 2005 between Hubert A. Valencik and Penns Woods  Bancorp, Inc. (incorporated by reference to Exhibit 10.1 of the  Registrant’s Current Report on Form 8-K filed on July 18, 2005).                                           |
|      |           | (10) (iv)                                                                        |                                                                                                                                                                                             | Employment Agreement,  dated January 11, 1999, among Penns Woods Bancorp, Inc., Jersey  Shore State Bank and William H. Rockey (incorporated by reference to  Exhibit 10.7 of the Registrant’s Annual Report on Form 10-K filed on  March 14, 2008).*                   |
|      |           | (10) (v)                                                                         |                                                                                                                                                                                             | Penns Woods  Bancorp, Inc. 1998 Stock Option Plan (incorporated by reference to  Exhibit 10.1 of the Registrant’s Registration Statement on form S-4,  No. 333-65821).*                                                                                                      |
|      |           | (10) (vi)                                                                        |                                                                                                                                                                                             | Amendment and  Restatement of the Jersey Shore State Bank Deferred Fee Agreement, dated as  of October 1, 2004 (incorporated by reference to Exhibit 10(vii) of the  Registrant’s Annual Report on Form 10-K for the year ended December 31,  2005).*                                       |
|      |           | (10) (vii)                                                                       |                                                                                                                                                                                             | Form of First  Amendment to the Jersey Shore State Bank Amendment and Restatement of the  Director Fee Agreement, dated as of October 1, 2004 (incorporated by  reference to Exhibit 10.7 of the Registrant’s Current Report on  Form 8-K filed on June 29, 2006). |
|      |           | (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.                                                                                                                                                                                                                                     |
|           |                |                                                                                       |                                                                                                                                                                                                  |                                                                                                                                                                                                                                                                                                  |  |  |  |  |  |

 

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*Denotes compensatory plan or arrangement.

 

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**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 or15(d) of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
| March 10, 2009 | PENNS WOODS BANCORP,  INC. |
|---------------------|----------------------------|
|                | BY:                        | /s/ RONALD A. WALKO |
|                |                       | President &  Chief Executive Officer |

 

Pursuant to therequirements of the Securities and Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the Registrant and in thecapacities and on the dates indicated:

 
| /s/ Ronald A. Walko                                 |   |                 |
|-----------------------------------------------------|--------|----------------------|
| Ronald A. Walko,  President, Chief Executive        |   | March 10,  2009 |
| Officer and Director  (Principal Executive Officer) |   |                 |
|                                                |   |                 |
|                                                |   |                 |
| /s/ Brian L. Knepp                                  |   |                 |
| Brian L. Knepp, Chief  Financial Officer            |   | March 10,  2009 |
| (Principal Financial  Officer)                      |   |                 |
|                                                |   |                 |
|                                                |   |                 |
| /s/ Michael J.  Casale, Jr.                    |   |                 |
| Michael J.  Casale, Jr., Director              |   | March 10,  2009 |
|                                                |   |                 |
|                                                |   |                 |
| /s/ H. Thomas  Davis, Jr.                      |   |                 |
| H. Thomas  Davis, Jr., Director                |   | March 10,  2009 |
|                                                |   |                 |
|                                                |   |                 |
| /s/ James M. Furey III                              |   |                 |
| James M. Furey II,  Director                        |   | March 10,  2009 |
|                                                |   |                 |
|                                                |   |                 |
| /s/ D. Michael Hawbaker                             |   |                 |
| D. Michael Hawbaker,  Director                      |   | March 10,  2009 |
|                                                |   |                 |
|                                                |   |                 |
| /s/ Leroy H.. Keiler  III                           |   |                 |
| Leroy H. Keiler III,  Director                      |   | March 10,  2009 |

 

----

 
| /s/ R. Edward  Nestlerode, Jr.                            |   |                 |
|----------------------------------------------------------------|--------|----------------------|
| R. Edward  Nestlerode, Jr., Director                      |   | March 10,  2009 |
|                                                           |   |                 |
|                                                           |   |                 |
| /s/ James E. Plummer                                           |   |                 |
| James E. Plummer,  Director                                    |   | March 10,  2009 |
|                                                           |   |                 |
|                                                           |   |                 |
| /s/ William H.  Rockey, Sr.                               |   |                 |
| William H.  Rockey, Sr. Vice President &Director |   | March 10,  2009 |
|                                                           |   |                 |
|                                                           |   |                 |
| /s/ Hubert A. Valencik,  Director                              |   |                 |
| Hubert A. Valencik,  Director                                  |   | March 10,  2009 |

 

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