**FORM10-K**

 

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, DC 20549**

 
| **ý**                                                                                                                                                                                                                                                                                                                                               | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**                       |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                                                     |
| **For the fiscal year ended December 31,  2004**                                                                                                                                                                                                                                                                                                    |
|                                                                                                                                                                                                                                                                                                                                                     |
| **OR**                                                                                                                                                                                                                                                                                                                                                   |
|                                                                                                                                                                                                                                                                                                                                                     |
| **o**                                                                                                                                                                                                                                                                                                                                                    | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934 (NO FEE REQUIRED)** |
|                                                                                                                                                                                                                                                                                                                                                     |
| **For the transition period from                                  to                   ** |

 

**Commission file number 0-17077**

 

**PENNS WOODS BANCORP, INC.**

(exact name of registrant asspecified in its charter)

 
| **Pennsylvania**                                                            | ** ** | **23-2226454**                         |
|-----------------------------------------------------------------------------|------------|----------------------------------------|
| (State or  other jurisdiction  of incorporation or organization)            |       | (I.R.S.  Employer  Identification No.) |
|                                                                        |       |                                   |
| **300 Market Street, P.O. Box 967  Williamsport, Pennsylvania 17703-0967**  |
| (Address of principal executive offices)                                    |
|                                                                        |       |                                   |
| 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** |
|-------------------------|------------|---------------------------------------------|
| **None**                |       | **None**                                    |

 

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

 

**CommonStock, par value $10 per share**(Title of Class)

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports) and (2) has been subject to suchfiling requirements for the past 90 days.    Yes ý   No 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 or anyamendment to this Form 10-K.                                  ý

 

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

 

State the aggregate market value of the voting stock held bynon-affiliates of the registrant **$135,611,421 at June 30,2004.**

 

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

 
| **Class**                       | ** ** | **Outstanding at March 7,  2005** |
|---------------------------------|------------|----------------------------------------|
| **Common Stock, $10 Par Value** | ** ** | **3,321,637  Shares**                  |

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

Portions of the registrant’s definitive proxy statement prepared inconnection with its annual meeting of shareholders to be held on April 27,2005 are incorporated by reference in Part III hereof.

 

 

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**INDEX**

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

 

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**PARTI**

 

**ITEM1 BUSINESS**

 

**A. GeneralDevelopment of Business and History**

 

OnJanuary 7, 1983, Penns Woods Bancorp, Inc. (the “Company”) wasincorporated under the laws of the Commonwealth of Pennsylvania as a bankholding company. The Jersey Shore State Bank (the “Bank”) became a wholly ownedsubsidiary of the Company, and each outstanding share of Bank common stock wasconverted into one share of Company common stock. This transaction was approvedby the shareholders of the Bank on April 11, 1983 and was officiallyeffective on July 12, 1983. The Company’s business has consisted primarilyof managing and supervising the Bank, and its principal source of income hasbeen dividends paid by the Bank. The Company’s two other wholly-ownedsubsidiaries are Woods Real Estate Development Co, Inc. and Woods InvestmentCo., Inc.

 

TheBank is engaged in commercial and retail banking and the taking of time andregular savings and demand deposits, the making of commercial and consumerloans and mortgage loans, and safe deposit services. Auxiliary services, suchas cash management, are provided to commercial customers. The Bank operatesfull banking services with eleven branch offices and a Mortgage/Loan Center inNorthcentral Pennsylvania.

 

InOctober 2000, the Bank acquired The M Group, Inc. D/B/A The ComprehensiveFinancial Group (“The M Group”). The M Group, which operates as a subsidiary ofthe Bank, offers insurance and securities brokerage services. Securities areoffered by The M Group through ING Financial Partners, Inc., a registeredbroker-dealer.

 

Neitherthe Company nor the Bank anticipates that compliance with environmental lawsand regulations will have any material effect 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.

 

TheBank employed approximately 149 persons as of December 31, 2004. TheCompany does not have any employees. The principal officers of the Bank alsoserve as officers of the Company.

 

**B.Regulation and Supervision**

 

TheCompany is also subject to the provisions of the Bank Holding Company Act of1956, as amended (the “BHCA”) and to supervision and examination by the Boardof Governors of the Federal Reserve System (the “FRB”). The Bank is subject tothe 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 and examined by the PennsylvaniaDepartment of Banking (the “Department”).

 

Theinsurance activities of The M Group are subject to regulation by the insurancedepartments of the various states in which The M Group conducts businessincluding principally the Pennsylvania Department of Insurance. The securitiesbrokerage activities of The M Group are subject to regulation by federal andstate securities commissions.

 

3

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TheFRB has issued regulations under the BHCA that require a bank holding companyto serve as a source of financial and managerial strength to its subsidiarybanks. 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 requiresthe Company to secure the prior approval of the FRB before it can acquire allor substantially all of the assets of any bank, or acquire ownership or controlof 5% or more of any voting shares of any bank. Such a transaction would alsorequire approval of the Department.

 

Abank holding company is prohibited under the BHCA from engaging in, oracquiring direct or indirect control of, more than 5% of the voting shares ofany company engaged in non-banking activities unless the FRB, by order orregulation, has found such activities to be so closely related to banking ormanaging or controlling banks as to be a proper incident thereto. Under theBHCA, the FRB has the authority to require a bank holding company to terminateany activity 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.

 

Bankholding companies are required to comply with the FRB’s risk-based capitalguidelines. 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 minimum ratio of total capital to riskweightedassets (including certain off-balance sheet activities, such as standby lettersof credit) is 8%. At least half of the total capital is required to be Tier 1capital, consisting principally of common shareholders’ equity, less certainintangible assets. The remainder (“Tier 2 capital”) may consist of certainpreferred stock, a limited amount of subordinated debt, certain hybrid capitalinstruments and other debt securities, 45% of net unrealized gains onmarketable equity securities and a limited amount of the general loan lossallowance. The risk-based capital guidelines are required to take adequateaccount of interest rate risk, concentration of credit risk, and risks of nontraditionalactivities. In addition to the risk-based capital guidelines, the FRB requireseach bank holding company to comply with the leverage ratio, under which thebank holding company must maintain a minimum level of Tier 1 capital to averagetotal consolidated assets of 3% for those bank holding companies which have thehighest regulatory examination ratings and are not contemplating orexperiencing significant growth or expansion. All other bank holding companiesare expected to maintain a leverage ratio of at least 4% to 5%. The Bank issubject to similar capital requirements adopted by the FDIC.

 

**C.Regulation of the Bank**

 

From time to time, varioustypes of federal and state legislation have been proposed that could result inadditional regulation of, and restrictions of, the business of the Bank. Itcannot be predicted whether any such legislation will be adopted or how suchlegislation would affect the business of the Bank. As a consequence of theextensive regulation of commercial banking activities in the United States, theBank’s business is particularly susceptible to being affected by federallegislation and regulations that may increase the costs of doing business.

 

**PromptCorrective Action**-The FDIC has specified the levels at which an insured institution will beconsidered “wellcapitalized,” “adequately capitalized,” “undercapitalized,” and“critically undercapitalized.” In the event an institution’s capitaldeteriorates to the “undercapitalized” category or below, the Federal DepositInsurance Act (the “FDIA”) and FDIC regulations prescribe an increasing amountof regulatory intervention, including: (1) the institution of a capitalrestoration plan by a bank and a guarantee of the plan by a parent institution;and (2) the placement of a hold on increases in assets, number of branches orlines of business. If capital has reached the significantly or criticallyundercapitalized levels, further material restrictions can be imposed,including restrictions on interest payable on accounts, dismissal of managementand (in critically undercapitalized situations) appointment of a receiver. Forwell-capitalized institutions, the FDIA provides authority for regulatoryintervention where the institution is deemed to be engaging in unsafe orunsound practices or receives a less than satisfactory examination reportrating for asset quality, management, earnings or liquidity.

 

**DepositInsurance**- There aretwo deposit insurance funds administered by the FDIC - the Savings AssociationInsurance Fund (“SAIF”) and the Bank Insurance Fund (“BIF”). The Bank’sdeposits are

 

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insured under the BIF;however, the deposits assumed by the Bank in connection with the merger of LockHaven Savings Bank are treated and assessed as SAIF-insured deposits. The FDIChas implemented a risk-related premium schedule for all insured depositoryinstitutions that results in the assessment of premiums based on capital andsupervisory measure. Under the risk-related premium schedule, the FDIC assigns,on a semiannual basis, each institution to one of three capital groups(well-capitalized, adequately capitalized or undercapitalized) and furtherassigns such institution to one of three subgroups within a capital group. Theinstitution’s subgroup assignment is based upon the FDIC’s judgment of theinstitution’s strength in light of supervisory evaluations, includingexamination reports, statistical analyses and other information relevant togauging the risk posed by the institution. Only institutions with a totalcapital to risk-adjusted assets ratio of 10.0% or greater, a Tier 1 capital torisk-adjusted assets ratio of 6.0% or greater and a Tier 1 leverage ratio of5.0% or greater, are assigned to the well-capitalized group. As of December 31,2004, the Bank’s ratios were well above required minimum ratios.

 

Boththe BIF and SAIF are presently fully funded at more than the minimum amountrequired by law. Accordingly, the BIF and SAIF assessment rates range from zerofor those institutions with the least risk, to $0.27 for every $100 of insureddeposits for institutions deemed to have the highest risk. The Bank is in thecategory of institutions that presently pay nothing for deposit insurance. TheFDIC adjusts the rates every six months. The FDIC indicated that all banks mayagain be required to pay deposit insurance premiums in the future if thecurrent trend of the size of the deposit insurance funds relative to allinsured deposits continues. While the Bank presently pays no premiums for depositinsurance, it is subject to assessments to pay the interest on FinancingCorporation (“FICO”) bonds. FICO was created by Congress to issue bonds tofinance the resolution of failed thrift institutions. The current annual FICOassessment for the Bank (and all banks) is $.0144 per $100 of BIF deposits.

 

**OtherLegislation**

 

The Fair and Accurate CreditTransactions Act (“FACT”) was signed into law on December 4, 2003. Thislaw extends the previously existing Fair Credit 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, and will be granted certain additionalprivacy rights.

 

Regulators will be issuingrules to implement FACT over the next year, and some of these rules will likelyimpose additional duties on the Bank, although the Company does not believe thatthe application of these new rules will have a material effect on itsoperations. The Sarbanes-Oxley Act of 2002 was enacted to enhance penalties foraccounting and auditing improprieties at publicly traded companies and toprotect investors by improving the accuracy and reliability of corporatedisclosures under the federal securities laws. The Sarbanes-Oxley Act generallyapplies to all companies, including the Company, that file or are required tofile periodic reports with the Securities and Exchange Commission under theSecurities Exchange Act of 1934, or the Exchange Act. The legislation includesprovisions, among other things, governing the services that can be provided bya public company’s independent auditors and the procedures for approving suchservices, requiring the chief executive officer and principal accountingofficer to certify certain matters relating to the company’s periodic filingsunder the Exchange Act, requiring expedited filings of reports by insiders oftheir securities transactions and containing other provisions relating toinsider conflicts of interest, increasing disclosure requirements relating tocritical financial accounting policies and their application, increasingpenalties for securities law violations, and creating a new public accountingoversight board, a regulatory body subject to SEC jurisdiction with broadpowers to set auditing, quality control and ethics standards for accountingfirms. In response to the legislation, the national securities exchanges andNASDAQ have adopted new rules relating to certain matters, including theindependence of members of a company’s audit committee as a condition tolisting or continued listing. The Company does not believe that the applicationof these new rules to the Company will have a material effect on its results ofoperations. In addition, Congress is often considering some financial industrylegislation. The Company cannot predict how any new legislation, or new rulesadopted by the federal banking agencies, may affect its business in the future.

 

Inaddition to federal banking law, the Bank is subject to the PennsylvaniaBanking Code. The Banking Code was amended in late 2000 to provide morecomplete “parity” in the powers of state-chartered institutions compared tonational banks and federal savings banks doing business in Pennsylvania.

 

5

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Pennsylvania banks have thesame ability to form financial subsidiaries authorized by theGramm-Leach-Bliley Act, as do national banks.

 

**EnvironmentalLaws**

 

Environmentally relatedhazards have become a source of high risk and potential liability for financialinstitutions relating to their loans. Environmentally contaminated propertiesowned by an institution’s borrowers may result in a drastic reduction in thevalue of the collateral securing the institution’s loans to such borrowers,high environmental clean up costs to the borrower affecting its ability torepay the loans, the subordination of any lien in favor of the institution to astate or federal lien securing clean up costs, and liability to the institutionfor clean up costs if it forecloses on the contaminated property or becomesinvolved in the management of the borrower. The Company is not aware of anyborrower who is currently subject to any environmental investigation or cleanup proceeding which is likely to have a material adverse effect on thefinancial condition or results of operations of the Company.

 

**Effect ofGovernment Monetary Policies**

 

The earnings of the Companyare and will be affected by domestic economic conditions and the monetary andfiscal policies of the United States Government and its agencies. The monetarypolicies of the FRB have had, and will likely continue to have, an importantimpact on the operating results of commercial banks through its power toimplement national monetary policy in order, among other things, to curbinflation or combat a recession. The FRB has a major effect upon the levels ofbank loans, investments and deposits through its open market operations in theUnited States Government securities and through its regulation of, among otherthings, the discount rate on borrowing of member banks and the reserverequirements against member bank deposits. It is not possible to predict thenature and impact of future changes in monetary and fiscal policies.

 

**DESCRIPTIONOF BANK**

 

**a. Historyand Business**

 

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

 

As of December 31,2004, the Bank had total assets of $530,736,000; total shareholders’ equity of$56,743,000 and total deposits of $357,479,000. The Bank’s deposits are insuredby the Federal Deposit Insurance Corporation for the maximum amount providedunder current law.

 

The Bank engages in businessas a commercial bank, doing business at several locations in Lycoming, Clintonand Centre Counties, Pennsylvania. The Bank offers insurance and securitiesbrokerage services through its wholly owned subsidiary, The M Group, Inc. D/B/AThe Comprehensive Financial Group.

 

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

 

The Bank’s loan portfoliomix can be classified into four principal categories of real estate,agricultural, commercial and consumer. Real estate loans can be furthersegmented into construction and land development, farmland, one-to-four familyresidential, multi-family and commercial or industrial. Qualified borrowers aredefined by policy or by industry underwriting standards. Owner provided equityrequirements range from 20% to 30% with a first lien status required. Terms arerestricted to between 10 and 20 years with the exception of construction andland development, which is limited to one to five years.

 

Appraisals, verificationsand visitations comply with industry standards.

 

Financial information thatis required on all commercial mortgages includes the most current three years’balance 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. Residentialmortgages, repayment ability is determined from information contained in theapplication and recent income tax returns. Emphasis is on credit, employment,income and residency verification. Broad hazard insurance is always requiredand flood insurance where applicable. In the case of construction mortgages,builders risk insurance is requested.

 

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Agricultural loans for thepurchase or improvement of real estate must meet the Bank’s real estateunderwriting criteria. The only permissible exception is when a Farmers HomeLoan Administration guaranty is obtained. Agricultural loans made for the purchaseof equipment 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%. Livestock financing criteria depends upon the nature ofthe operation. A dairy herd could be financed over three years, but a feederoperation would require cleanup in intervals of less than one year.

 

Agricultural loans are alsomade for crop production purposes. Such loans are structured to repay withinthe production cycle and not carried over into a subsequent year. Generalpurpose working capital loans are also a possibility with repayment expectedwithin one year. It is also a general policy to collateralize non-real estateloans with not only the asset purchased but also junior liens on all otheravailable assets. Insurance and credit criteria is the same as mentionedpreviously. In addition, annual visits are made to our agricultural customersto determine the general condition of assets. Personal credit requirements arehandled as consumer loans. Commercial loans are made for the acquisition andimprovement of real estate, purchase of equipment and for working capitalpurposes on a seasonal or revolving basis. Criteria was discussed under realestate financing for such loans, but it is important to note that such loansmay be made in conjunction with the Pennsylvania Industrial DevelopmentAuthority. Caution is also exercised in taking industrial property forcollateral by requiring, on a selective basis, environmental audits.

 

Equipmentloans are generally amortized over three to seven years, with an owner equitycontribution required of at least 20% of the purchase price. Unusuallyexpensive pieces may be financed for a longer period depending upon the asset’suseful life. The increased cash flow resulting from the additional piece,through improved income or greater depreciation expense, serves in establishingthe terms. Insurance coverage with the Bank as loss payee is required,especially in the case where the equipment is rolling stock. Seasonal andrevolving lines of credit are offered for working capital purposes. Collateralfor such a loan includes the pledge of inventory and/or receivables. Drawingavailability is usually 50% of inventory and 75% of eligible receivables.Eligible receivables are defined as invoices less than 90 days delinquent.Exclusive reliance is very seldom placed on such collateral, therefore, otherlienable assets are also taken into the collateral pool. Where reliance isplaced on inventory and accounts receivable, the applicant must providefinancial information including agings on a monthly basis. In addition, theguaranty of the principals is usually obtained.

 

Itis unusual for the Bank to make unsecured commercial loans. But when such aloan is a necessity, credit information in the file must support that decision.

 

Letter of Creditavailability is limited to standbys where the customer is well known to theBank. Credit criteria is the same as that utilized in making a direct loan andcollateral is obtained in most cases, and whenever the expiration date is formore than one year. Consumer loan products include second mortgages, automobilefinancing, small loan requests, overdraft check lines and PHEAA referral loans.Our policy includes standards used in the industry on debt service ratios andterms are consistent with prudent underwriting standards and the use ofproceeds. Verifications are made of employment and residency, along with credithistory. Second mortgages are confined to equity borrowing and homeimprovements. Terms are generally ten years or less and rates are fixed. Loanto collateral value criteria is 80% or less and verifications are made todetermine values. Automobile financing is generally restricted to five yearsand done on a direct basis. The Bank, as a practice, does not floor plan andtherefore does not discount dealer paper. Small loan requests are toaccommodate personal needs such as the purchase of small appliances or for thepayment of taxes. Overdraft check lines are limited to $5,000 or less.

 

The Bank’s investmentportfolio is analyzed and priced on a monthly basis. Investments are made inU.S. Treasuries, U.S. Government Agency issues, bank qualified municipal bonds,corporate bonds and corporate stocks which consist of Pennsylvania bank stocks.Bonds with BAA or better ratings are used, unless a local issue is purchasedthat has a lesser or no rating. Factors taken into consideration wheninvestments are made include liquidity, the Company’s tax position and thepolicies of the Asset/Liability Committee. Although the Bank has regularopportunities to bid on pools of funds of $100,000 or more in the hands ofmunicipalities, hospitals and others, it does not rely on these monies to fundloans on intermediate or longer-term investments. Minor seasonal growth indeposits is experienced at or near the year-end.

 

It is the policy of the Bankto generally maintain a rate sensitive asset (RSA) to rate sensitive liability(RSL) ratio of 150% of equity for a 6-month time horizon, 150% of equity for a2-year time horizon and 150% of equity for a 5-year time horizon. The Bank operateseleven full service offices in Lycoming,

 

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Clinton, and CentreCounties, Pennsylvania, and a Mortgage/Loan Center in Centre County,Pennsylvania. The economic base of the region is developed around service,light manufacturing industries and agriculture. The banking environment inLycoming, Clinton and Centre Counties, Pennsylvania is highly competitive. TheBank competes for loans and deposits with commercial banks, savings and loanassociations and other financial institutions. The Bank has a relatively stabledeposit base and no material amount of deposits is obtained from a singledepositor or group of depositors (including federal, state and localgovernments). The Bank has not experienced any significant seasonalfluctuations in the amount of its deposits.

 

**b.Supervision and Regulation**

 

The earnings of the Bank areaffected by the policies of regulatory authorities including the FDIC and theFRB. An important function of the FRB is to regulate the money supply andinterest rates. Among the instruments used to implement these objectives areopen market operations in U.S. Government Securities, changes in reserverequirements against member bank deposits and limitations on interest ratesthat member banks may pay on time and savings deposits. These instruments areused in varying combinations to influence overall growth and distribution ofbank loans, investments on deposits, and their use may also affect interestrates charged on loans or paid for deposits.

 

The policies and regulationsof the FRB have had and will probably continue to have a significant effect onthe Bank’s deposits, loans and investment growth, as well as the rate ofinterest earned and paid, and are expected to affect the Bank’s operation inthe future. The effect of such policies and regulations upon the futurebusiness and earnings of the Bank cannot accurately be predicted.

 

**EXECUTIVEOFFICERS OF THE REGISTRANT:**

 
| **NAME**            | ** ** | **AGE** | ** ** | **FIVE-YEAR ANALYSIS OF DUTIES**                                                                                                                                                                                                                                                                                                          | ** ** |
|---------------------|------------|---------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Ronald A.  Walko    |       | 58      |       | President and Chief Executive Officer of  the Company; the Bank; The M Group; and Woods Investment Company, Inc.; President  of Woods Real Estate Development Co, Inc.; and Federal Bank examiner prior to  1986 for an eighteen-year period.                                                                                             |       |
|                |       |    |       |                                                                                                                                                                                                                                                                                                                                      |       |
| Hubert A.  Valencik |       | 63      |       | Senior Vice President of the Company;  Senior Vice President and Operations Officer of the Bank; Assistant Secretary  of Woods Investment Company, Inc.Vice President of Woods Real Estate  Development Co, Inc.; Vice President - Operations of The M Group; Vice  President with another bank prior to 1985 for a fourteen-year period. |       |

 

**ITEM2 PROPERTIES**

 

The Company owns and leasesits properties. Listed herewith are the locations of properties owned orleased, in which the banking offices and Financial Center are located; allproperties are in good condition and adequate for the Bank’s purposes:

 
| **Office**     | ** ** | **Address**                                                            | ** ** | ** **  | ** ** |
|----------------|------------|------------------------------------------------------------------------|------------|-------------|------------|
| Main           |       | 115 South Main Street  P.O. Box 5098  Jersey Shore, Pennsylvania 17740 |       | Owned       |       |
| Bridge  Street |       | 112 Bridge Street  Jersey Shore, Pennsylvania 17740                    |       | Owned       |       |
| DuBoistown     |       | 2675 Euclid Avenue  DuBoistown, Pennsylvania 17702                     |       | Owned       |       |
| Williamsport   |       | 300 Market Street  P.O. Box 967  Williamsport, Pennsylvania 17703-0967 |       | Owned       |       |
| Montgomery     |       | 9094 Rt 405 Highway  Montgomery, Pennsylvania 17752                    |       | Under Lease |       |
| Lock Haven     |       | 4 West Main Street  Lock Haven, Pennsylvania 17745                     |       | Owned       |       |

 

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| Mill Hall                                                      |   | (Inside Wal-Mart), 167 Hogan Boulevard  Mill Hall, Pennsylvania 17751            |   | Under Lease      |   |
|----------------------------------------------------------------|--------|----------------------------------------------------------------------------------|--------|------------------|--------|
| Spring Mills                                                   |   | Ross Hill Road, P.O. Box 66  Spring Mills, Pennsylvania 16875                    |   | Owned            |   |
| Centre Hall                                                    |   | 2842 Earlystown Road  Centre Hall, Pennsylvania 16828                            |   | Land Under Lease |   |
| Zion                                                           |   | 100 Cobblestone Road  Bellefonte, Pennsylvania 16823                             |   | Under Lease      |   |
| **Jersey  Shore State Bank Financial Center**State College     |   | 1952 Waddle Road, Suite 106  State College, Pennsylvania 16803                   |   | Under Lease      |   |
| ** **                                                     |   |                                                                             |   |             |   |
| **The M  Group, Inc.**D/B/A The Comprehensive  Financial Group |   | 705 Washington Boulevard  Williamsport, Pennsylvania 17701                       |   | Under Lease      |   |
| State  College                                                 |   | (Inside Wal-Mart), 1665 North Atherton  Place  State College, Pennsylvania 16803 |   | Under Lease      |   |
| State  College                                                 |   | 2050 North Atherton Street  State College, Pennsylvania 16803                    |   | Land Under Lease |   |

 

**ITEM3 LEGAL PROCEEDINGS**

 

In the normal course ofbusiness, various lawsuits and claims arise against the Company and itssubsidiary. There are no such legal proceedings or claims currently pending orthreatened.

 

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

 

No matters were submitted toa vote of security holders during the fourth quarter of 2004.

 

**PARTII**

 

**ITEM 5 MARKET FOR THE REGISTRANT’S COMMONEQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASE OF EQUITY SECURITIES**

 

The Common Stock is listedon The NASDAQ National Market under the symbol “PWOD”. The following table setsforth (1) the quarterly high and low bid information for a share of the Company’sCommon Stock during the periods indicated, and (2) quarterly dividends on ashare of the Common Stock with respect to each quarter since January 1,2003. The following quotations reflect inter-dealer prices and do not includeretail markup, markdown or commission. They may not necessarily representactual transactions.

 
| ** **      | ** ** | **High** | ** ** | **Low** | ** ** | **Dividends  Declared** | ** ** |
|-----------------|------------|----------|------------|---------|------------|-------------------------|------------|
| **2003:**       |       |     |       |    |       |                    |       |
| First  Quarter  |       | $        | 41.27      |    | $          | 32.86                   |       | $ | 0.27 |   |
| Second  Quarter |       | 47.43    |       | 37.71   |       | 0.27                    |       |
| Third  Quarter  |       | 42,32    |       | 38.64   |       | 0.27                    |       |
| Fourth  Quarter |       | 47.91    |       | 40.85   |       | 0.68                    |       |
|            |       |     |       |    |       |                    |       |
| **2004:**       |       |     |       |    |       |                    |       |
| First  Quarter  |       | $        | 48.39      |    | $          | 43.10                   |       | $ | 0.35 |   |
| Second  Quarter |       | 46.91    |       | 42.47   |       | 0.35                    |       |
| Third  Quarter  |       | 50.75    |       | 44.16   |       | 0.35                    |       |
| Fourth  Quarter |       | 50.12    |       | 45.26   |       | 0.71                    |       |

 

The Bank has paid cashdividends since 1941. The Company has paid dividends since the effective dateof its formation as a bank holding company. It is the present intention of theCompany Board of Directors to

 

9

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continue the dividendpayment policy; however, further dividends must necessarily depend uponearnings, financial condition, appropriate legal restrictions and other factorsrelevant at the time the Board of Directors of the Company considers dividendpolicy. Cash available for dividend distributions to shareholders of theCompany must initially come from dividends paid by the Bank to the Company.Therefore, the restrictions on the Bank’s dividend payments are directlyapplicable to the Company.

 

Under the PennsylvaniaBusiness Corporation Law of 1988, a corporation may not pay a dividend, ifafter giving effect thereto, the corporation would be unable to pay its debtsas they become due in the usual course of business and after giving effectthereto the total assets of the corporation would be less than the sum of itstotal liabilities plus the amount that would be needed, if the corporation wereto be dissolved at the time of the distribution, to satisfy the preferentialrights upon dissolution of the shareholders whose preferential rights aresuperior to those receiving the dividend.

 

As of March 7, 2005,the Company had approximately 1,234 shareholders of record.

 

10

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**ITEM6 SELECTED FINANCIAL DATA**

 

The following table setsforth certain financial data as of and for each of the years in the five-yearperiod ended December 31, 2004.

 
| **(In Thousands, Except Per Share Data)**                  | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** | **2001**   | ** ** | **2000**   | ** ** |
|------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Consolidated  Statement of Income Data:                    |       |       |       |       |       |       |       |       |       |       |       |
| Interest  income                                           |       | $          | 30,947     |       | $          | 29,232     |       | $          | 29,302     |       | $          | 28,736 |   | $ | 28,454 |   |
| Interest  expense                                          |       | 8,768      |       | 9,265      |       | 10,846     |       | 12,481     |       | 12,778     |       |
| Net interest  income                                       |       | 22,179     |       | 19,967     |       | 18,456     |       | 16,255     |       | 15,676     |       |
| Provision  for loan losses                                 |       | 465        |       | 255        |       | 365        |       | 372        |       | 286        |       |
| Net interest  income after provision for loan losses       |       | 21,714     |       | 19,712     |       | 18,091     |       | 15,883     |       | 15,390     |       |
| Noninterest  income                                        |       | 7,949      |       | 8,454      |       | 5,255      |       | 5,109      |       | 2,615      |       |
| Noninterest  expense                                       |       | 14,317     |       | 13,289     |       | 12,213     |       | 11,272     |       | 9,820      |       |
| Income  before income taxes                                |       | 15,346     |       | 14,877     |       | 11,133     |       | 9,720      |       | 8,185      |       |
| Applicable  income taxes                                   |       | 4,263      |       | 3,703      |       | 2,247      |       | 1,978      |       | 1,619      |       |
| Net Income                                                 |       | $          | 11,083     |       | $          | 11,174     |       | $          | 8,886      |       | $          | 7,742 |   | $ | 6,566 |   |
|                                                       |       |       |       |       |       |       |       |       |       |       |       |
| Consolidated  Balance Sheet at End of Period:              |       |       |       |       |       |       |       |       |       |       |       |
| Total assets                                               |       | $          | 546,703    |       | $          | 527,381    |       | $          | 472,206    |       | $          | 424,810 |   | $ | 394,913 |   |
| Loans                                                      |       | 324,505    |       | 275,828    |       | 257,845    |       | 251,623    |       | 244,798    |       |
| Allowance  for loan losses                                 |       | (3,338     | )          | (3,069     | )          | (2,953     | )          | (2,927     | )          | (2,879     | )          |
| Deposits                                                   |       | 356,836    |       | 334,318    |       | 339,848    |       | 305,150    |       | 278,134    |       |
| Long-term  debt – other                               |       | 75,878     |       | 70,878     |       | 51,778     |       | 41,778     |       | 31,778     |       |
| Shareholders’  equity                                 |       | 73,165     |       | 69,769     |       | 63,142     |       | 55,252     |       | 50,514     |       |
|                                                       |       |       |       |       |       |       |       |       |       |       |       |
| Per Share  Data:                                           |       |       |       |       |       |       |       |       |       |       |       |
|                                                       |       |       |       |       |       |       |       |       |       |       |       |
| Earnings per  share - Basic                                |       | $          | 3.33       |       | $          | 3.35       |       | $          | 2.66       |       | $          | 2.30 |   | $ | 1.91 |   |
| Earnings per  share - Diluted                              |       | 3.33       |       | 3.35       |       | 2.66       |       | 2.30       |       | 1.91       |       |
| Cash  dividends declared                                   |       | 1.76       |       | 1.49       |       | 1.24       |       | 1.11       |       | 1.00       |       |
| Book value                                                 |       | 22.03      |       | 21.00      |       | 18.94      |       | 16.53      |       | 14.83      |       |
| Number of  shares outstanding, at end of period            |       | 3,321,527  |       | 3,321,560  |       | 3,031,329  |       | 3,039,590  |       | 3,097,293  |       |
| Average  number of shares outstanding-basic                |       | 3,325,007  |       | 3,330,585  |       | 3,336,312  |       | 3,371,845  |       | 3,431,494  |       |
| Selected  financial ratios:                                |       |       |       |       |       |       |       |       |       |       |       |
| Return on  average shareholders’ equity               |       | 15.49      | %          | 16.60      | %          | 15.00      | %          | 14.38      | %          | 13.77      | %          |
| Return on  average total assets                            |       | 2.06       | %          | 2.24       | %          | 2.01       | %          | 1.95       | %          | 1.74       | %          |
|                                                       |       |       |       |       |       |       |       |       |       |       |       |
| Net interest  income to average interest earning assets    |       | 4.41       | %          | 4.28       | %          | 4.45       | %          | 4.39       | %          | 4.35       | %          |
| Dividend  payout ratio                                     |       | 52.72      | %          | 44.76      | %          | 46.40      | %          | 48.17      | %          | 52.18      | %          |
| Average  shareholders’ equity to average total assets |       | 13.30      | %          | 13.51      | %          | 13.39      | %          | 13.54      | %          | 12.62      | %          |
| Loans to  deposits, at end of period                       |       | 90.94      | %          | 82.50      | %          | 75.87      | %          | 82.46      | %          | 88.01      | %          |

 

Per share data and number of shares outstanding have been adjusted ineach reporting period to give retroactive effect to a stock split effected inthe form of a 100% stock dividend issued January 15, 1998, a 10% stock dividendissued June 9, 1999 and a 10% stock dividend issued November 13, 2003.

 

11

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

 

**RESULTS OF OPERATIONS**

 

**NETINTEREST INCOME**

 

Netinterest income is determined by calculating the difference between the yieldsearned on interest-earning assets and the rates paid on interest-bearingliabilities. To compare the tax-exempt asset yields to taxable yields, amountsare adjusted to taxable equivalents based on the marginal corporate federal taxrate of 34%. The tax equivalent adjustments to net interest income for 2004,2003, and 2002 were $907,000, $1,367,000, and $1,738,000, respectively.

 

**2004 vs2003**

 

Reportednet interest income increased $2,212,000 or 11.1% from fiscal 2003 to 2004.Total interest income increased $1,715,000 and is attributed to the increase of$41,067,000 in the average balance of the loan portfolio, offset partially by adecrease of the return on investment securities of 4 basis points, the decreasein the average balance of the investment securities of $1,270,000, and adecrease in the return on loans of 57 basis points.

 

Ona tax equivalent basis, net interest income increased 8.2% or $1,752,000, to$23,086,000 in a period when both average interest earning assets and averageinterest-bearing liabilities increased. The increase of taxable security incomeof $1,216,000 is due to the purchases of U.S. Government Agency securities overthe past year, with the average of these securities increasing $13,585,000,while the decrease in the average of tax-exempt State & Politicalsecurities decreased tax equivalent interest income $1,366,000. The investmentportfolio has been repositioned from longer term assets to shorter term assetsto take advantage of the cash flow opportunities for reinvestment inanticipation of rising rates. The net growth in the volume of the loanportfolio has generated additional interest income that has offset the 57 basispoint decline in the overall portfolios weighted average interest rate.

 

Withinthe loan portfolio, a 27 basis point decrease of the tax equivalent return onloans was offset by an increase of $41,067,000 in the average balance of loanswhen comparing the year 2004 to the year 2003. For the year ended December 31,2004, reported interest expense decreased $497,000 or 5.4% over the same periodof 2003. Lower rates on deposit accounts contributed the most substantialdecrease in interest expense. The weighted average rate on deposits declined 38basis points for 2004 as compared to 2003. The overall average balance ofsavings deposits increased $12,481,000, offset by a decrease in the weightedaverage rate for a net decrease in interest expense of $343,000. Interestexpense on time deposits decreased $538,000 due to both the 39 basis pointdecline in the weighted average rate and the decrease in the average balance of$1,020,000.

 

During2004, the Company borrowed an additional $5 million in long term advancesthrough the FHLB to minimize future borrowing costs and to enhance liabilitypositioning. These additional borrowings were utilized by management to fundthe substantial loan growth of 2004. The $273,000 increase in expense onlong-term borrowings is the result of average balances of long term FHLBborrowings increasing $8,442,000 partially offset by the 17 basis point declinein the resulting weighted average interest rate for the year ending December 31,2004 compared to the same period in 2003. Interest paid on short-termborrowings increased $111,000 as a result of an increase of the averagebalances outstanding during the year of $6,866,000 offset partially by adecline in the weighted average interest rate of 3 basis points. Theopportunity to borrow from the Federal Home Loan Bank at historically lowinterest rates was utilized to assist the funding of the loan portfolio growthand is attributed to the increase of interest expense paid on borrowings.

 

**2003 vs2002**

 

Reportednet interest income increased $1,511,000 or 8.2% from year end 2002 to year end2003. The decrease in total interest income of $70,000 is the result of anincrease of $44,185,000 in the average balance of investment securities heldfor the current period relative to the same period a year ago offset by

 

12

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a decrease in the return onloans of approximately 62 basis points. Overall, interest income generated fromthe net increase in volume of interest earning assets was offset by a declinein rates of approximately 95 basis points.

 

Ona tax equivalent basis, net interest income increased 5.6% or $1,140,000, to$21,334,000 in a period when both average interest earning assets and averageinterest-bearing liabilities increased. The increase of taxable security incomeof $1,522,000 is due to the significant purchase of U.S. Government securitiesover the past year, with the average of these securities increasing$70,159,000, while the decrease in the average of tax-exempt State & Politicalsecurities decreased tax equivalent interest income $975,000. The investmentportfolio has been repositioned from longer term assets to shorter term assetsto take advantage of the cash flow opportunities for reinvestment inanticipation of rising rates. The net growth in the volume of investmentholdings has generated additional interest income that has offset the 115 basispoint decline in the overall portfolios weighted average interest rates.

 

Withinthe loan portfolio, a 62 basis point decrease in the tax equivalent return onloans was partially offset by an increase of $7,612,000 in the average balanceof loans when comparing the year 2003 to the year 2002. Variable rate loanswithin the portfolio and other new loan originations at lower effective ratesaided in the reduction of new income compared to a year ago because of thehistorically low rates.

 

Forthe year ended December 31, 2003, reported interest expense decreased$1,581,000 or 14.6% over the same period of 2002. Lower rates for all depositaccounts contribute the most substantial decrease in interest expense. Theweighted average rate on interest paid on deposits declined 92 basis points forthe year 2003 as compared to 2002. The overall average balance of savingsdeposits increased $17,925,000, offset by a decrease in the weighted averagerate for a net decrease in the related interest expense of $997,000. Interestexpense on time deposits decreased $1,204,000 due to both the 76 basis pointdecline in the weighted average rate and the decrease in the average balance of$5,453,000.

 

Favorablelong-term borrowing rates offer opportunities to reduce interest expenses overthe coming years. Throughout 2003, the Company borrowed an additional $19.1million in long term advances through the FHLB to minimize future borrowingcosts and to enhance liability positioning. These additional borrowings wereutilized by management to take advantage of current investment opportunitieswhile minimizing interest rate risk. The $693,000 increase in expense onlong-term borrowings is the result of these additional advances with averagebalances of $20,986,000 partially offset by the 64 basis point decline in theresulting weighted average interest rate for the year ending December 31,2003 compared to the same period in 2002. Interest paid on short-termborrowings decreased $73,000 as a result of an overall decline in the weightedaverage interest rate of 131 basis points while the average balancesoutstanding during the year increased $8,322,000. The increase in short-termborrowings is the result of taking advantage of the opportunity to borrow fromFederal Home Loan Bank at historically low rates.

 

**AVERAGE BALANCERS AND INTEREST RATES**

 

The following tables setforth certain information relating to the Company’s average balance sheet andreflects the average yield on assets and average cost of liabilities for theperiods indicated and the average yields earned and rates paid. Such yields andcosts are derived by dividing income or expense by the average balance ofassets or liabilities, respectively, for the periods presented.

 

13

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| ** **                                         | ** ** | **2004**                | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|
| **(In Thousands)**                                 | ** ** | **AVERAGE  BALANCE(2)** | ** ** | **INTEREST** | ** ** | **AVERAGE  RATE** | ** ** |
| ** **                                         | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** |
| ASSETS:                                            |       |                    |       |   |   |   |   |
| Interest-earning  assets:                          |       |                    |       |   |   |   |   |
| Securities:                                        |       |                    |       |   |   |   |   |
| U.S.  Treasury and federal agency                  |       | $                       | 138,434    |   | $ | 6,555 |   | 4.74 | % |
| State and  political subdivisions(4)               |       | 34,665                  |       | 2,586 |   | 7.46 | % |
| Other                                              |       | 26,174                  |       | 1,322 |   | 5.05 | % |
| Total  securities                                  |       | 199,273                 |       | 10,463 |   | 5.25 | % |
| LOANS:                                             |       |                    |       |   |   |   |   |
| Tax-exempt  loans(4)                               |       | 1,359                   |       | 82 |   | 6.03 | % |
| All other  loans, net of discount where applicable |       | 301,248                 |       | 21,309 |   | 7.07 | % |
| Total  loans(1),(3)                                |       | 302,607                 |       | 21,391 |   | 7.07 | % |
| Total  interest-earning assets                     |       | 501,880                 |       | $ | 31,854 |   | 6.35 | % |
|                                               |       |                    |       |   |   |   |   |
| Other assets                                       |       | 35,766                  |       |   |   |   |   |
|                                               |       |                    |       |   |   |   |   |
| TOTAL ASSETS                                       |       | $                       | 537,646    |   |   |   |   |   |
|                                               |       |                    |       |   |   |   |   |
| LIABILITIES  AND SHAREHOLDERS’ EQUITY:        |       |                    |       |   |   |   |   |
| Interest-bearing  liabilities:                     |       |                    |       |   |   |   |   |
| Deposits:                                          |       |                    |       |   |   |   |   |
| Savings                                            |       | $                       | 159,650    |   | $ | 1,361 |   | 0.85 | % |
| Other time                                         |       | 130,340                 |       | 3,414 |   | 2.62 | % |
| Total interest-bearing  deposits                   |       | 289,990                 |       | 4,775 |   | 1.65 | % |
|                                               |       |                    |       |   |   |   |   |
| Short-term  borrowings                             |       | 31,653                  |       | 539 |   | 1.70 | % |
| Other  borrowings                                  |       | 75,727                  |       | 3,454 |   | 4.56 | % |
| Total  interest-bearing liabilities                |       | 397,370                 |       | $ | 8,768 |   | 2.21 | % |
|                                               |       |                    |       |   |   |   |   |
| Demand  deposits                                   |       | 64,434                  |       |   |   |   |   |
| Other  liabilities                                 |       | 4,295                   |       |   |   |   |   |
| Shareholders’  equity                         |       | 71,547                  |       |   |   |   |   |
| TOTAL  LIABILITIES AND SHAREHOLDERS’ EQUITY   |       | $                       | 537,646    |   |   |   |   |   |
|                                               |       |                    |       |   |   |   |   |
| Interest  rate spread                              |       |                    |       |   |   | 4.14 | % |
|                                               |       |                    |       |   |   |   |   |
| Net interest  income/margin                        |       |                    |       | $ | 23,086 |   | 4.60 | % |

 

14

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| ** **                                         | ** ** | **2003**                | ** ** | **2002**     | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|--------------|------------|
| **(In Thousands)**                                 | ** ** | **AVERAGE  BALANCE(2)** | ** ** | **INTEREST** | ** ** | **AVERAGE  RATE** | ** ** | **AVERAGE  BALANCE(2)** | ** ** | **INTEREST** | ** ** | **AVERAGE  RATE** | ** ** |
| ** **                                         | ** ** | ** **              | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ASSETS:                                            |       |                    |       |         |       |   |   |   |   |   |   |   |   |
| Interest-earning  assets:                          |       |                    |       |         |       |   |   |   |   |   |   |   |   |
| Securities:                                        |       |                    |       |         |       |   |   |   |   |   |   |   |   |
| U.S.  Treasury and federal agency                  |       | $                       | 124,849    |         | $          | 5,584 |   | 4.47 | % | $ | 54,690 |   | $ | 2,923 |   | 5.34 | % |
| State and  political subdivisions(4)               |       | 50,822                  |       | 3,952        |       | 7.78 | % | 77,216 |   | 4,927 |   | 6.38 | % |
| Other                                              |       | 24,872                  |       | 1,077        |       | 4.33 | % | 24,452 |   | 2,216 |   | 9.06 | % |
| Total  securities                                  |       | 200,543                 |       | 10,613       |       | 5.29 | % | 156,358 |   | 10,066 |   | 6.44 | % |
| LOANS:                                             |       |                    |       |         |       |   |   |   |   |   |   |   |   |
| Tax-exempt  loans(4)                               |       | 1,008                   |       | 68           |       | 6.75 | % | 2,309 |   | 185 |   | 8.01 | % |
| All other  loans, net of discount where applicable |       | 260,532                 |       | 19,918       |       | 7.65 | % | 251,619 |   | 20,789 |   | 8.26 | % |
| Total  loans(1),(3)                                |       | 261,540                 |       | 19,986       |       | 7.64 | % | 253,928 |   | 20,974 |   | 8.26 | % |
| Total  interest-earning assets                     |       | 462,083                 |       | $            | 30,599     |   | 6.62 | % | 410,286 |   | $ | 31,040 |   | 7.57 | % |
|                                               |       |                    |       |         |       |   |   |   |   |   |   |   |   |
| Other assets                                       |       | 36,297                  |       |         |       |   |   | 31,977 |   |   |   |   |   |
|                                               |       |                    |       |         |       |   |   |   |   |   |   |   |   |
| TOTAL ASSETS                                       |       | $                       | 498,380    |         |       |   |   |   | $ | 442,263 |   |   |   |   |   |
|                                               |       |                    |       |         |       |   |   |   |   |   |   |   |   |
| LIABILITIES  AND SHAREHOLDERS’ EQUITY:        |       |                    |       |         |       |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:                     |       |                    |       |         |       |   |   |   |   |   |   |   |   |
| Deposits:                                          |       |                    |       |         |       |   |   |   |   |   |   |   |   |
| Savings                                            |       | $                       | 147,169    |         | $          | 1,704 |   | 1.16 | % | $ | 129,244 |   | $ | 2,701 |   | 2.09 | % |
| Other time                                         |       | 131,360                 |       | 3,952        |       | 3.01 | % | 136,813 |   | 5,156 |   | 3.77 | % |
| Total  interest-bearing deposits                   |       | 278,529                 |       | 5,656        |       | 2.03 | % | 266,057 |   | 7,857 |   | 2.95 | % |
|                                               |       |                    |       |         |       |   |   |   |   |   |   |   |   |
| Short-term  borrowings                             |       | 24,787                  |       | 428          |       | 1.73 | % | 16,465 |   | 501 |   | 3.04 | % |
| Other  borrowings                                  |       | 67,285                  |       | 3,181        |       | 4.73 | % | 46,299 |   | 2,488 |   | 5.37 | % |
| Total  interest-bearing liabilities                |       | 370,601                 |       | $            | 9,265      |   | 2.50 | % | 328,821 |   | $ | 10,846 |   | 3.30 | % |
|                                               |       |                    |       |         |       |   |   |   |   |   |   |   |   |
| Demand  deposits                                   |       | 56,672                  |       |         |       |   |   | 50,877 |   |   |   |   |   |
| Other liabilities                                  |       | 3,780                   |       |         |       |   |   | 3,334 |   |   |   |   |   |
| Shareholders’  equity                         |       | 67,327                  |       |         |       |   |   | 59,231 |   |   |   |   |   |
| TOTAL  LIABILITIES AND SHAREHOLDERS’ EQUITY   |       | $                       | 498,380    |         |       |   |   |   | $ | 442,263 |   |   |   |   |   |
|                                               |       |                    |       |         |       |   |   |   |   |   |   |   |   |
| Interest  rate spread                              |       |                    |       |         |       | 4.12 | % |   |   |   |   | 4.27 | % |
|                                               |       |                    |       |         |       |   |   |   |   |   |   |   |   |
| Net interest  income/margin                        |       |                    |       | $            | 21,334     |   | 4.62 | % |   |   | $ | 20,194 |   | 4.92 | % |

 

----

1.Fees on loans are included with interest on loans. Loan fees are included ininterest income as follows: 2004 $889,000, 2003 $1,032,000, 2002, $803,000.

2.Information on this table has been calculated using average daily balancesheets to obtain average balances.

3.Non-accrual loans have been included with loans for the purpose of analyzingnet interest earnings.

4.Income and rates on a fully taxable equivalent basis include an adjustment forthe difference between annual income from tax-exempt obligations and thetaxable equivalent of such income at the standard 34% tax rate.

 

15

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**Rate/VolumeAnalysis**

 

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 changesattributable to (i) changes in volume (changes in average volume multiplied byold rate); (ii) changes in rates (changes in rate multiplied by old averagevolume). Increases and decreases due to both rate and volume, which cannot beseparated, have been allocated proportionally to the change due to volume andthe change due to rate. Income and rates are on a taxable equivalent basis.

 
| ** **                          | ** ** | **Year Ended December 31,**              | ** ** |
|-------------------------------------|------------|-----------------------------------------------|------------|
| ** **                          | ** ** | **2004 vs 2003  Increase (Decrease)  Due to** | ** ** | **2003 vs 2002  Increase (Decrease)  Due to** | ** ** |
| **(In Thousands)**                  | ** ** | **Volume**                                    | ** ** | **Rate** | ** ** | **Net** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Net** | ** ** |
| **Interest  income:**               |       |                                          |       |   |   |   |   |   |   |   |   |   |   |
| Taxable  investment securities      |       | $                                             | 737        |   | $ | 479 |   | $ | 1,216 |   | $ | 3,223 |   | $ | (577 | ) | $ | 2,646 |   |
| Tax-exempt  investment securities   |       | (1,197                                        | )          | (169 | ) | (1,366 | ) | (2,054 | ) | (28 | ) | (2,082 | ) |
| Loans                               |       | 2,979                                         |       | (1,574 | ) | 1,405 |   | 616 |   | (1,604 | ) | (988 | ) |
| Total  interest-earning assets      |       | $                                             | 2,519      |   | $ | (1,264 | ) | $ | 1,255 |   | $ | 1,785 |   | $ | (2,209 | ) | $ | (424 | ) |
|                                |       |                                          |       |   |   |   |   |   |   |   |   |   |   |
| **Interest  expenses:**             |       |                                          |       |   |   |   |   |   |   |   |   |   |   |
| Savings  deposits                   |       | $                                             | 136        |   | $ | (479 | ) | $ | (343 | ) | $ | 335 |   | $ | (1,332 | ) | $ | (997 | ) |
| Other time  deposits                |       | (31                                           | )          | (507 | ) | (538 | ) | (216 | ) | (988 | ) | (1,204 | ) |
| Short-term  borrowings              |       | 116                                           |       | (5 | ) | 111 |   | 194 |   | (267 | ) | (73 | ) |
| Long-term  borrowings               |       | 388                                           |       | (115 | ) | 273 |   | 1,021 |   | (328 | ) | 693 |   |
| Total  interest-bearing liabilities |       | $                                             | 609        |   | $ | (1,106 | ) | $ | (497 | ) | $ | 1,334 |   | $ | (2,915 | ) | $ | (1,581 | ) |
|                                |       |                                          |       |   |   |   |   |   |   |   |   |   |   |
| Change in  net interest income      |       | $                                             | 1,910      |   | $ | (158 | ) | $ | 1,752 |   | $ | 451 |   | $ | 706 |   | $ | 1,157 |   |

 

**PROVISIONFOR LOAN LOSSES**

 

**2004 vs2003**

 

Theprovision for loan losses is based upon management’s quarterly review of theloan portfolio. The purpose of the review is to assess loan quality, identifyimpaired loans, analyze delinquencies, ascertain loan growth, evaluatepotential charge-offs and recoveries, and assess general economic conditions inthe markets served. An external independent loan review is also performedannually for the Bank. Management remains committed to an aggressive program ofproblem 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, and historical loanloss experience. In addition, management considers industry standards andtrends with respect to nonperforming loans and its knowledge and experiencewith 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 31,2004, 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, employment and delays inreceiving financial information from borrowers could result in increased levelsof nonperforming assets and chargeoffs, increased loan loss provisions andreductions in income. Additionally, as an integral part of the examination process,bank regulatory agencies periodically review the Bank’s loan loss allowance.The banking agencies could require the recognition of additions to the loanloss allowance based on their judgment of information available to them at thetime of their examination.

 

16

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Theallowance for loan losses increased from $3,069,000 at December 31, 2003to $3,338,000 at December 31, 2004. At December 31, 2004, allowancefor loan losses was 1.01% of total loans compared to 1.10% of total loans at December 31,2003. Management’s conclusion is that the allowance for loan losses is adequateto provide for probable losses inherent in its loan portfolio as of the balancesheet date.

 

Theprovision for loan losses totaled $465,000 for the year ended December 31,2004. The provision for the same period in 2003 was $255,000. Managementconcluded that the increase of the provision is adequate with the loan growthexperienced during 2004 and economic changes during the year. Based upon thisanalysis, as well as the others noted above, senior management has concludedthat the allowance for loan losses remains at a level adequate to provide forprobable losses inherent in the loan portfolio.

 

**2003 vs2002**

 

Theallowance for loan losses increased 3.9% or $116,000 from fiscal 2002 after netcharge-offs of $139,000 contributing to a year-end allowance for loan losses of$3,069,000 or 1.10% of total loans. Based upon this analysis, as well as theothers noted above, senior management has concluded that the allowance for loanlosses remains at a level adequate to provide for probable losses inherent inthe loan portfolio.

 
| ** **                                                                                 | ** ** | **YEAR ENDED DECEMBER 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                 | ** ** | **(IN THOUSANDS)**               | ** ** |
| ** **                                                                                 | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| Balance at  beginning of period                                                            |       | $                                | 3,069      |   | $ | 2,953 |   | $ | 2,927 |   | $ | 2,879 |   | $ | 2,823 |   |
| Charge-offs:                                                                               |       |                             |       |   |   |   |   |   |   |   |   |
| Real estate                                                                                |       | 121                              |       | 63 |   | 262 |   | 154 |   | 165 |   |
| Commercial  and industrial                                                                 |       | 50                               |       | 37 |   | 80 |   | 122 |   | 38 |   |
| Installment  loans to individuals                                                          |       | 111                              |       | 116 |   | 60 |   | 82 |   | 66 |   |
| Total  charge-offs                                                                         |       | 282                              |       | 216 |   | 402 |   | 358 |   | 269 |   |
| Recoveries:                                                                                |       |                             |       |   |   |   |   |   |   |   |   |
| Real estate                                                                                |       | 50                               |       | 42 |   | 25 |   | 9 |   | 8 |   |
| Commercial  and industrial                                                                 |       | 4                                |       | 16 |   | 21 |   | 8 |   | 20 |   |
| Installment  loans to individuals                                                          |       | 32                               |       | 19 |   | 17 |   | 17 |   | 11 |   |
| Total  recoveries                                                                          |       | 86                               |       | 77 |   | 63 |   | 34 |   | 39 |   |
| Net  charge-offs                                                                           |       | 196                              |       | 139 |   | 339 |   | 324 |   | 230 |   |
| Additions  charged to operations                                                           |       | 465                              |       | 255 |   | 365 |   | 372 |   | 286 |   |
| Balance at  end of period                                                                  |       | $                                | 3,338      |   | $ | 3,069 |   | $ | 2,953 |   | $ | 2,927 |   | $ | 2,879 |   |
| Ratio of net  charge-offs during the period to average loans outstanding during the period |       | 0.06                             | %          | 0.05 | % | 0.13 | % | 0.13 | % | 0.10 | % |

 

**NON-INTERESTINCOME**

 

**2004 vs2003**

 

Totalnon-interest income decreased $505,000 from fiscal 2003 to 2004. Security gainsrealized decreased $1,303,000. Excluding the security gains, non-interest incomeincreased $798,000. Service charges increased $66,000 due to an increased feestructure. Earnings on bank-owned life insurance decreased $110,000 due to thedecrease of the average crediting rate paid on the policies as a result of thelow rate environment. Commissions earned on the sales of insurance increased$684,000 due to the expanded staff and market area of the sales. The majorityof the increase in other income of $158,000 was attributed to commissionsgenerated from the new addition of title insurance to the bank’s product line.

 

17

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| **(In Thousands)**         | ** ** | **2004** | ** ** | **2003** | ** ** | **%****Change** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|-----------------|------------|
|                       |       |     |       |     |       |            |       |
| Service  charges           |       | 1,983    |       | 1,917    |       | 3.4             | %          |
| Securities  gains, net     |       | 2,176    |       | 3,479    |       | (37.5           | )          |
| Bank-owned  life insurance |       | 294      |       | 404      |       | (27.2           | )          |
| Insurance  commissions     |       | 2,282    |       | 1,598    |       | 42.8            |       |
| Other income               |       | 1,214    |       | 1,056    |       | 15.0            |       |
|                       |       |     |       |     |       |            |       |
| Total  non-interest income |       | 7,949    |       | 8,454    |       | (6.0            | )%         |

 

**2003 vs2002**

 

Totalnon-interest income for 2003 was $8,454,000, an increase of $3,199,000 from theprior year. Excluding security gains of $3,479,000 in 2003 and $35,000 in 2002,other income decreased $245,000. Service charges increased 4.6% or $84,000 to$1,917,000 in 2003.

 

Decreasesin commission income from the sale of financial products sold by the Bank’ssubsidiary, The M Group, accounted for $209,000 of the total decrease of otheroperating income. Other operating income decreased $108,000 primarily due to anonrecurring life insurance income item included in 2002, resulting in a $116,000decrease.

 
| **(In Thousands)**         | ** ** | **2004** | ** ** | **2002** | ** ** | **%****Change** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|-----------------|------------|
|                       |       |     |       |     |       |            |       |
| Service  charges           |       | 1,917    |       | 1,833    |       | 4.6             | %          |
| Securities  gains, net     |       | 3,479    |       | 35       |       | 9,840.0         |       |
| Bank-owned  life insurance |       | 404      |       | 416      |       | (2.9            | )          |
| Insurance  commissions     |       | 1,598    |       | 1,807    |       | (11.6           | )          |
| Other income               |       | 1,056    |       | 1,164    |       | (9.3            | )          |
|                       |       |     |       |     |       |            |       |
| Total  non-interest income |       | 8,454    |       | 5,255    |       | 60.9            | %          |

 

**NON-INTERESTEXPENSES**

 

**2004 vs2003**

 

Totalnon-interest expenses increased $1,028,000 or 7.7% from the year ended December 31,2003 to December 31, 2004. Salaries and employee benefits increase of$675,000 was the result of the increase in commission earned by the M Group andstandard cost of living increases. Expenses related to the new State CollegeAtherton Street branch caused the majority of the $82,000 increase in occupancyexpense. Increased maintenance and repairs contributed the $17,000 increase tofurniture and equipment expense. Advertising expense decreased $44,000 as theresult of a purchase of brochures in 2003 for $22,000 and a decrease in normaladvertising expenses. Pennsylvania shares taxes increased $53,000 from 2003 to2004. Other expenses increased $245,000. This increase was primarily theincrease of computer software amortization due to the implementation of tellermachines, the increase of legal, audit, and consultant fees in relation toSarbanes-Oxley compliance, and expenses on the new title insurance product.

 
| **(In Thousands)**               | ** ** | **2004** | ** ** | **2003** | ** ** | **% Change** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|--------------|------------|
|                             |       |     |       |     |       |         |       |
| Salaries and  employee benefits  |       | 7,937    |       | 7,262    |       | 9.3          | %          |
| Occupancy  expense, net          |       | 959      |       | 877      |       | 9.4          |       |
| Furniture  and equipment expense |       | 1,016    |       | 999      |       | 1.7          |       |
| Advertising  Expense             |       | 344      |       | 388      |       | (11.3        | )          |
| Pennsylvania  shares tax expense |       | 508      |       | 455      |       | 11.6         |       |
| Other  expenses                  |       | 3,553    |       | 3,308    |       | 7.4          |       |
|                             |       |     |       |     |       |         |       |
| Total  non-interest expenses     |       | 14,317   |       | 13,289   |       | 7.7          | %          |

 

18

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**2003 vs2002**

 

Totalnon-interest expenses increased $1,076,000 or 8.8% from the year ended December 31,2002 to December 31, 2003. Salaries and employee benefits increased$318,000. This change was the result of the decline in commission earned by theM Group and the retirement of an executive officer offset by the standard costof living salary increases and an extra pay cycle in 2003 when compared to2002. Expenses such as rent, maintenance, and utilities for the new StateCollege Wal-Mart Branch caused the majority of the $46,000 increase tooccupancy expense. The depreciation of a new Wide Area Network has resulted inmost of the $162,000 increase to furniture and equipment expense. Advertisingexpense increased $16,000 due to a decrease in normal advertising expensesoffset by the purchase of new brochures for $22,000. Other operating expensesincreased $490,000 consistent with the addition of the aforementioned branch.

 
| **(In Thousands)**               | ** ** | **2003** | ** ** | **2002** | ** ** | **% Change** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|--------------|------------|
|                             |       |     |       |     |       |         |       |
| Salaries and  employee benefits  |       | 7,262    |       | 6,944    |       | 4.6          | %          |
| Occupancy  expense, net          |       | 877      |       | 831      |       | 5.5          |       |
| Furniture  and equipment expense |       | 999      |       | 837      |       | 19.4         |       |
| Advertising  Expense             |       | 388      |       | 372      |       | 4.3          |       |
| Pennsylvania  shares tax expense |       | 455      |       | 411      |       | 10.7         |       |
| Other  expenses                  |       | 3,308    |       | 2,818    |       | 17.4         |       |
|                             |       |     |       |     |       |         |       |
| Total  non-interest expenses     |       | 13,289   |       | 12,213   |       | 8.8          | %          |

 

**INCOMETAXES**

 

**2004 vs2003**

 

Theprovision for income taxes for the year ended December 31, 2004 resultedin an effective income tax rate of 27.8% compared to 24.9% for 2003. Thisincrease is the result of an overall decline in revenue from tax-exempt loansand investment securities as compared to revenue as a whole.

 

**2003 vs2002**

 

Theprovision for income taxes for the year ended December 31, 2003 resultedin an effective income tax rate of 24.9% compared to 20.2% for 2002. Thisincrease is the result of management’s current investment strategy ofreinvesting proceeds from tax-exempt portfolio into other U.S. Governmentsecurities.

 

**FINANCIAL CONDITION**

 

**INVESTMENTS**

 

**2004**

 

Theinvestment portfolio decreased $32,782,000 or 15.5% in 2004. The decline in theinvestments is attributed to a $45,847,000 decrease in U.S. Treasury andGovernment Agency securities, $13,117,000 increase in states and politicalsecurities, $296,000 decrease in other debt securities and $244,000 increase inequity securities. The proceeds from the sale of securities was utilized tofund loan growth. The total realized gains on the securities for 2004 was $2,176,000a decrease of $1,303,000 from December 31, 2003. The investment portfolioat year-end 2004 comprised of 58.3% U.S. Government agency and Treasurysecurities, 26.5% state and political subdivisions, 14.3% equity securities and0.9% other bonds, notes and debentures. Held to maturity securities had acarrying value of $558,000. Available for sale securities had an amortized costof $171,394,000 with an estimated market value of $177,957,000.

 

**2003**

 

Theinvestment portfolio increased $33,680,000 or 19.0% in 2003. The growth islargely attributed to management’s strategic plan to benefit from the lowborrowing rates by taking advantage of over a 200

 

19

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basis point interest ratespread of investments with similar maturity periods. The bank borrowed$19,100,000 in long-term FHLB advances to purchase securities and takeadvantage of interest rate imbalances in the market. Short-term borrowingfunded the balance of the additional investment securities purchased. Most ofthe increase is attributable to an increase of $61,980,000 in U.S. Governmentagencies category, and a $10,331,000 increase in the equity securitiescategory. There was a $185,000 decrease in other bonds, notes and debentures,$1,168,000 decrease in the U.S. Treasury securities category, and the state andpolitical subdivisions category decreased $37,278,000. The investment portfolioat year-end 2003 was comprised of 70.9% U.S. Government agency and Treasurysecurities, 16.2% state and political subdivisions, 12.0% equity securities,and 0.9% other bonds, notes and debentures. Held to maturity securities had acarrying value of $686,000. Available for sale securities occupied 99.7% of thetotal portfolio and had an amortized cost of $201,321,000 with an estimatedmarket value of $210,611,000. The unrealized gain of $9,290,000 effectedshareholders’ equity by $6,132,000, net of deferred taxes.

 

The carrying amounts ofinvestment securities at the dates indicated are summarized as follows for theyears ended December 31:

 
| **(In Thousands)**                    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| U.S.  Treasury securities:            |       |     |       |     |       |     |       |
| Available  for Sale                   |       | $        | 1,024      |     | $          | 3,128    |       | $ | 4,296 |   |
| U.S.  Government agencies:            |       |     |       |     |       |     |       |
| Held to  Maturity                     |       | 32       |       | 75       |       | 94       |       |
| Available  for Sale                   |       | 103,001  |       | 146,701  |       | 84,702   |       |
| State and  political subdivisions:    |       |     |       |     |       |     |       |
| Held to  Maturity                     |       | 248      |       | 347      |       | 796      |       |
| Available  for Sale                   |       | 47,068   |       | 33,852   |       | 70,681   |       |
| Other bonds,  notes and debentures:   |       |     |       |     |       |     |       |
| Held to  Maturity                     |       | 278      |       | 264      |       | 291      |       |
| Available  for Sale                   |       | 1,342    |       | 1,652    |       | 1,810    |       |
| Total bonds,  notes and debentures    |       | 152,993  |       | 186,019  |       | 162,670  |       |
| Corporate  stock - Available for Sale |       | 25,522   |       | 25,278   |       | 14,947   |       |
| Total                                 |       | $        | 178,515    |     | $          | 211,297  |       | $ | 177,617 |   |

 

The following table showsthe maturities and repricing of investment securities at December 31, 2004and the weighted average yields (for tax-exempt obligations on a fully taxablebasis assuming a 34% tax rate) of such:

 

20

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| **(In Thousands)**                  | ** ** | **WITHIN  ONE  YEAR** | ** ** | **AFTER ONE  BUT WITHIN  FIVE YEARS** | ** ** | **AFTER FIVE  BUT WITHIN  TEN YEARS** | ** ** | **AFTER  TEN  YEARS** | ** ** |
|-------------------------------------|------------|-----------------------|------------|---------------------------------------|------------|---------------------------------------|------------|-----------------------|------------|
| U.S.  Treasury securities:          |       |                  |       |                                  |       |                                  |       |                  |       |
| AFS Amount                          |       | $                     | 1,024      |                                  | $          | —                                |       | $                     | —     |   | $ | — |   |
| Yield                               |       | 3.43                  | %          | —                                |       | —                                |       | —                |       |
| U.S.  Government agencies:          |       |                  |       |                                  |       |                                  |       |                  |       |
| HTM Amount                          |       | —                |       | —                                |       | —                                |       | 32                    |       |
| Yield                               |       | —                |       | —                                |       | —                                |       | 8.85                  | %          |
| AFS Amount                          |       | —                |       | 3,473                                 |       | —                                |       | 99,528                |       |
| Yield                               |       | —                |       | 5.31                                  | %          | —                                |       | 5.06                  | %          |
| State and  political subdivisions:  |       |                  |       |                                  |       |                                  |       |                  |       |
| HTM Amount                          |       | —                |       | —                                |       | 248                                   |       | —                |       |
| Yield                               |       | —                |       | —                                |       | 5.75                                  | %          | —                |       |
| AFS Amount                          |       | —                |       | —                                |       | 16                                    |       | 47,052                |       |
| Yield                               |       | —                |       | —                                |       | 6.58                                  | %          | 7.41                  | %          |
| Other bonds,  notes and debentures: |       |                  |       |                                  |       |                                  |       |                  |       |
| HTM Amount                          |       | 75                    |       | 75                                    |       | 128                                   |       | —                |       |
| Yield                               |       | 7.13                  | %          | 6.48                                  | %          | 7.39                                  | %          | —                |       |
| AFS Amount                          |       | —                |       | —                                |       | —                                |       | 1,342                 |       |
| Yield                               |       | —                |       | —                                |       | —                                |       | 7.14                  | %          |
| Total Amount                        |       | $                     | 1,099      |                                  | $          | 3,548                                 |       | $                     | 392        |   | $ | 147,954 |   |
| Total Yield                         |       | 3.68                  | %          | 5.33                                  | %          | 6.32                                  | %          | 5.83                  | %          |

 

All yields representweighted average yields expressed on a tax equivalent basis. They arecalculated on the basis of the cost, adjusted for amortization of premium andaccretion of discount and effective yields weighted for the scheduled finalmaturity of each security. Scheduled maturities and actual maturities maydiffer due to certain investment securities having the ability to prepay orcall the bond without penalty. The taxable equivalent adjustment represents thedifference between annual income from tax-exempt obligations and the taxableequivalent of such income at the standard 34% tax rate (derived by dividingtax-exempt interest by 66%).

 

**LOANPORTFOLIO**

 

**2004**

 

Grossloans for the year ended December 31, 2004 increased 17.7% to $324,505,000from $275,828,000 at December 31, 2003. Real estate mortgages increased$41,338,000 as a whole with commercial and construction real estate loansincreasing $40,861,000 and $713,000 respectively, while residential loansdecreased $236,000. Commercial and agricultural loans and installment loansincreased $6,580,000 and $915,000 respectively. Net deferred loan feesincreased $156,000. Given the current market conditions, management hasdirected its conservative lending approach toward well collateralized realestate loans. Commercial real estate projects provided the greatest opportunityfor growth in 2004. During 2004, gross loans grew $48,677,000 as a result ofcontinued expansion into the Centre County commercial market as well asincreases in Lycoming and Clinton counties.

 

**2003**

 

Gross loans for the yearended December 31, 2003 increased 7.0% to $275,828,000 from $257,845,000.Real estate mortgages increased $18,273,000 as a whole with residential,commercial and construction real estate loans increasing $6,973,000,$7,004,000, and $4,296,000 respectively. Commercial and agricultural loansdecreased $185,000, while installment loans to individuals increased $66,000.

 

The amounts of loansoutstanding are shown in the following table according to type of loan for theyears ended December 31:

 

21

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| **(In Thousands)**                | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Commercial  and agricultural      |       | $        | 30,103     |     | $          | 23,523   |       | $        | 23,708     |     | $          | 22,629 |   | $ | 26,471 |   |
| Real estate  mortgage:            |       |     |       |     |       |     |       |     |       |     |       |
| Residential                       |       | 147,461  |       | 147,697  |       | 140,724  |       | 140,614  |       | 131,761  |       |
| Commercial                        |       | 123,757  |       | 82,896   |       | 75,892   |       | 67,038   |       | 60,856   |       |
| Construction                      |       | 8,365    |       | 7,652    |       | 3,356    |       | 4,077    |       | 4,748    |       |
| Installment  loans to individuals |       | 15,915   |       | 15,000   |       | 14,934   |       | 17,896   |       | 21,503   |       |
| Less: Net  deferred loan fees     |       | 1,096    |       | 940      |       | 769      |       | 631      |       | 541      |       |
| Gross loans                       |       | $        | 324,505    |     | $          | 275,828  |       | $        | 257,845    |     | $          | 251,623 |   | $ | 244,798 |   |

 

The amount of loansoutstanding at December 31, 2004 are presented below by category andmaturity:

 
| **(In Thousands)**                        | ** ** | **REAL ESTATE** | ** ** | **COMMERCIAL  AND  OTHER** | ** ** | **INSTALLMENT  LOANS TO  INDIVIDUALS** | ** ** | **TOTAL** | ** ** |
|-------------------------------------------|------------|-----------------|------------|----------------------------|------------|----------------------------------------|------------|-----------|------------|
| Loans with  floating interest rates:      |       |            |       |                       |       |                                   |       |      |       |
| 1 year or  less                           |       | $               | 17,641     |                       | $          | 9,497                                  |       | $         | 1,724      |   | $ | 28,862 |   |
| 1 through 5  years                        |       | 7,004           |       | 3,615                      |       | 74                                     |       | 10,693    |       |
| 5 through 10  years                       |       | 30,891          |       | 3,112                      |       | 149                                    |       | 34,152    |       |
| After 10  years                           |       | 154,310         |       | 2,340                      |       | 128                                    |       | 156,778   |       |
| Sub Total                                 |       | 209,846         |       | 18,564                     |       | 2,075                                  |       | 230,485   |       |
| Loans with  predetermined interest rates: |       |            |       |                       |       |                                   |       |      |       |
| 1 year or  less                           |       | 3,370           |       | 718                        |       | 1,038                                  |       | 5,126     |       |
| 1 through 5  years                        |       | 22,001          |       | 7,985                      |       | 11,066                                 |       | 41,052    |       |
| 5 through 10  years                       |       | 23,511          |       | 2,697                      |       | 1,682                                  |       | 27,890    |       |
| After 10  years                           |       | 19,749          |       | 139                        |       | 64                                     |       | 19,952    |       |
| Sub Total                                 |       | 68,631          |       | 11,539                     |       | 13,850                                 |       | 94,020    |       |
| Total                                     |       | $               | 278,477    |                       | $          | 30,103                                 |       | $         | 15,925     |   | $ | 324,505 |   |

----

(1) The loan maturityinformation is based upon original loan terms and is not adjusted for “rollovers.”In the ordinary course of business, loans maturing within one year may berenewed, in whole or in part, as to principal amount at interest ratesprevailing at the date of renewal.

(2) Scheduled repayments arereported in maturity categories in which the payment is due.

 

The Bank does not make loansthat provide for negative amortization nor do any loans contain conversionfeatures. The Bank does not have any foreign loans outstanding at December 31,2004.

 

**ALLOWANCEFOR LOAN LOSSES**

 

**2004**

 

Theallowance for loan losses represents the amount which management estimates isadequate to provide for probable losses inherent in its loan portfolio, as ofthe balance sheet date. The allowance method is used in providing for loanlosses. Accordingly, all loan losses are charged to the allowance and allrecoveries are credited to it. The allowance for loan losses is establishedthrough a provision for loan losses charged to operations. The provision forloan losses is based upon management’s quarterly review of the loan portfolio.The purpose of the review is to assess loan quality, identify impaired loans,analyze delinquencies, ascertain loan growth, evaluate potential charge-offsand recoveries, and assess general economic conditions in the markets served.An external independent loan review is also performed annually for the Bank.Management remains committed to an aggressive program of problem loanidentification and resolution.

 

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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, and historical loanloss experience. In addition, management considers industry standards andtrends with respect to nonperforming loans and its knowledge and experiencewith 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 31,2004, 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, employment and delays inreceiving financial information from borrowers could result in increased levelsof nonperforming assets and chargeoffs, increased loan loss provisions andreductions in income. Additionally, as an integral part of the examinationprocess, bank regulatory agencies periodically review the Bank’s loan lossallowance. The banking agencies could require the recognition of additions tothe loan loss allowance based on their judgment of information available tothem at the time of their examination.

 

Theallowance for loan losses increased from $3,069,000 at December 31, 2003to $3,338,000 at December 31, 2004. At December 31, 2004, allowancefor loan losses was 1.01% of total loans compared to 1.10% of total loans at December 31,2003. This percentage is consistent with the Bank’s historical experience andpeer banks. Management’s conclusion is that the allowance for loan losses isadequate to provide for probable losses inherent in its loan portfolio as ofthe balance sheet date.

 

Basedupon this analysis, as well as the others noted above, senior management hasconcluded that the allowance for loan losses remains at a level adequate toprovide for probable losses inherent in its loan portfolio.

 

**2003**

 

AtDecember 31, 2003, the allowance for loan losses as a percent of grossloans remained the same as December 31, 2002 at 1.10%. Gross loansincreased by $17,983,000 from $257,845,000 at December 31, 2002 to$275,828,000 at December 31, 2003.

 

Non-accruingloans decreased $44,000 from year-end 2002. Overall nonperforming loansdecreased $840,000 to $1,256,000 from fiscal year end 2002.

 

Basedon management’s loan-by-loan review, the past performance of the borrowers andcurrent economic conditions, including recent business closures and bankruptcylevels, management does not anticipate any current losses related tonon-accrual, non-performing, or classified loans that have already beenconsidered in its overall judgment of the adequacy of the reserve.

 

Thefollowing table presents information concerning nonperforming loans. Theaccrual of interest will be discontinued when the principal or interest of aloan is in default for 90 days or more, or as soon as payment is questionable,unless the loan is well secured and in the process of collection. Consumerloans and residential real estate loans secured by 1 to 4 family dwellingsshall ordinarily not be subject to those guidelines. The reversal of previouslyaccrued but uncollected interest applicable to any loan placed in a non-accrualstatus and the treatment of subsequent payments of either principal or interestwill be handled in accordance with U.S. generally accepted accountingprinciples. These principles do not require a write-off of previously accruedinterest if principal and interest are ultimately protected by sound collateralvalues. A nonperforming loan may be restored to an accruing status when:

 

1. Principal and interest isno longer due and unpaid.

2. It becomes well securedand in the process of collection.

3. Prospects for futurecontractual payments are no longer in doubt.

 
| ** **         | ** ** | **TOTAL NONPERFORMING LOANS** | ** ** |
|--------------------|------------|-------------------------------|------------|
| **(In Thousands)** | ** ** | **NONACCRUAL**                | ** ** | **90 DAYS  PAST DUE  & STILL  ACCRUING** | ** ** |
| 2004               |       | $                             | 1,381      |   | $ | 345 |   |
| 2003               |       | $                             | 827        |   | $ | 429 |   |
| 2002               |       | $                             | 871        |   | $ | 1,225 |   |
| 2001               |       | $                             | 281        |   | $ | 338 |   |
| 2000               |       | $                             | 777        |   | $ | 27 |   |

 

23

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If interest had beenrecorded at the original rate on those loans, such income would haveapproximated $64,000, $55,000, and $24,000 for the years ended December 31,2004, 2003, and 2002, respectively. Interest income on such loans, which isrecorded as received, amounted to approximately $10,000, $7,000, and $17,000for the years ended December 31, 2004, 2003 and 2002, respectively.

 

The level of non-accruingloans continues to fluctuate annually and is attributed to the various economicfactors experienced both regionally and nationally. 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 nosignificant amounts of loans where serious doubts exist as to the ability ofthe borrower to comply with the current loan payment terms which are notincluded in the nonperforming categories as indicated above.

 

**ALLOCATION IN THE ALLOWANCE FOR LOAN LOSSES**

 
| **(In Thousands)**                      | ** ** | **AMOUNT** | ** ** | **PERCENT OF  LOANS IN  EACH  CATEGORY TO  TOTAL LOANS** | ** ** |
|-----------------------------------------|------------|------------|------------|----------------------------------------------------------|------------|
| **DECEMBER  31, 2004:**                 | ** ** | ** ** | ** ** | ** **                                               | ** ** |
| Balance at end of period applicable to: |       |       |       |                                                     |       |
| Commercial and agricultural             |       | $          | 361        |                                                     |       |   |
| Real estate mortgage:                   |       |       |       | 9.1                                                      | %          |
| 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      | % |
| **DECEMBER 31, 2003:**                  |       |       |       |                                                     |       |
| Balance at end of period applicable to: |       |       |       |                                                     |       |
| Commercial and agricultural             |       | $          | 353        |                                                     | 8.5        | % |
| Real estate mortgage:                   |       |       |       |                                                     |       |
| Residential                             |       | 1,483      |       | 53.4                                                     | %          |
| Commercial                              |       | 916        |       | 29.9                                                     | %          |
| Construction                            |       | 77         |       | 2.8                                                      | %          |
| Installment loans to individuals        |       | 240        |       | 5.4                                                      | %          |
| Total                                   |       | $          | 3,069      |                                                     | 100.0      | % |

 

24

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| **DECEMBER  31, 2002:**                  | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------|------------|------------|------------|------------|------------|
| Balance at  end of period applicable to: |       |       |       |       |       |
| Commercial and agricultural              |       | $          | 471        |       | 9.2        | % |
| Real estate mortgage:                    |       |       |       |       |       |
| Residential                              |       | 1,162      |       | 54.4       | %          |
| Commercial                               |       | 1,082      |       | 29.3       | %          |
| Construction                             |       | 66         |       | 1.3        | %          |
| Installment loans to individuals         |       | 172        |       | 5.8        | %          |
| Total                                    |       | $          | 2,953      |       | 100.0      | % |
| **DECEMBER 31, 2001:**                   |       |       |       |       |       |
| Balance at end of period applicable to:  |       |       |       |       |       |
| Commercial and agricultural              |       | $          | 414        |       | 9.0        | % |
| Real estate mortgage:                    |       |       |       |       |       |
| Residential                              |       | 1,379      |       | 55.8       | %          |
| Commercial                               |       | 763        |       | 26.5       | %          |
| Construction                             |       | 74         |       | 1.6        | %          |
| Installment loans to individuals         |       | 271        |       | 7.1        | %          |
| Unallocated general allowance            |       | 26         |       | —     |       |
| Total                                    |       | $          | 2,927      |       | 100.0      | % |
| **DECEMBER 31, 2000:**                   |       |       |       |       |       |
| Balance at end of period applicable to:  |       |       |       |       |       |
| Commercial and agricultural              |       | $          | 541        |       | 10.8       | % |
| Real estate mortgage:                    |       |       |       |       |       |
| Residential                              |       | 1,211      |       | 53.7       | %          |
| Commercial                               |       | 723        |       | 24.8       | %          |
| Construction                             |       | 71         |       | 1.9        | %          |
| Installment loans to individuals         |       | 306        |       | 8.8        | %          |
| Unallocated general allowance            |       | 27         |       | —     |       |
| Total                                    |       | $          | 2,879      |       | 100.0      | % |

 

**DEPOSITS**

 

**2004**

 

Total average deposits were$354,424,000 for 2004, an increase of $19,223,000 or 5.7%. Total demanddeposits increased $15,120,000. Noninterest-bearing demand deposits increased$7,762,000 and interest-bearing demand deposits increased $7,358,000. Savingsdeposits increased $5,123,000 while time deposits decreased $1,020,000. Lowrates have influenced investors away from longer term commitments which hasresulted in an increase in more liquid accounts such as demand deposits andsavings and a decrease in time deposit accounts.

 

**2003**

 

Total average deposits were$335,201,000 for 2003, an increase of $18,267,000 or 5.8%. Total demand depositsincreased $16,517,000. Noninterest-bearing demand deposits increased $5,795,000and interest-bearing demand deposits increased $10,722,000. Savings depositsincreased $7,203,000 while time deposits decreased $5,453,000. Historically lowrate levels have influenced investors away from longer term commitments whichhas resulted in an increase in more liquid accounts such as demand deposits andsavings and a decrease in time deposit accounts. The shift from time depositsto demand and savings deposits have also had a positive impact on earnings.More details pertaining to the changes in interest expense are stated in theNet Interest Income discussion.

 

The average amount and theaverage rate paid on deposits are summarized below:

 

25

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| **(In Thousands)**                      | ** ** | **2004  AVERAGE  AMOUNT** | ** ** | **RATE** | ** ** | **2003  AVERAGE  AMOUNT** | ** ** | **RATE** | ** ** | **2002  AVERAGE  AMOUNT** | ** ** | **RATE** | ** ** |
|-----------------------------------------|------------|---------------------------|------------|----------|------------|---------------------------|------------|----------|------------|---------------------------|------------|----------|------------|
| **DEPOSITS IN DOMESTIC  BANK OFFICES:** |       |                      |       |     |       |                      |       |     |       |                      |       |     |       |
| Demand deposits:                        |       |                      |       |     |       |                      |       |     |       |                      |       |     |       |
| Noninterest-bearing                     |       | $                         | 64,434     |     | 0.00       | %                         | $          | 56,672   |       | 0.00                      | %          | $        | 50,877     |   | 0.00 | % |
| Interest-bearing                        |       | 89,854                    |       | 0.87     | %          | 82,496                    |       | 1.15     | %          | 71,774                    |       | 2.13     | %          |
| Savings deposits                        |       | 69,796                    |       | 0.83     | %          | 64,673                    |       | 1.17     | %          | 57,470                    |       | 2.04     | %          |
| Time deposits                           |       | 130,340                   |       | 2.62     | %          | 131,360                   |       | 3.01     | %          | 136,813                   |       | 3.77     | %          |
| Total average deposits                  |       | $                         | 354,424    |     | 1.35       | %                         | $          | 335,201  |       | 1.39                      | %          | $        | 316,934    |   | 2.48 | % |

 

**SHAREHOLDERS’ EQUITY**

 

**2004**

 

Total shareholders’ equityat December 31, 2004 was $73,165,000, an increase of $3,396,000 from thebalance at December 31, 2003 of $69,769,000. Net income and the exercising ofstock options contributed $11,083,000 and $194,000, respectively, toshareholders’ equity. The net change in the unrealized appreciation onsecurities available for sale from year end 2003 to 2004 reduced shareholders’equity by $1,801,000. Additional reductions to shareholders’ equity included$5,843,000 in dividends to shareholders and $237,000 for the purchase oftreasury stock.

 

**2003**

 

Shareholders’ equity isevaluated in relation to total assets and the risks associated with thoseassets. A company is more likely to meet its cash obligations and absorbunforeseen losses when the capital resources are greater. Total shareholders’equity at December 31, 2003 was $69,769,000, an increase of $6,627,000 from thebalance at December 31, 2002 of $63,142,000. Net income and the exercising ofstock options contributed $11,174,000 and $87,000, respectively, toshareholders’ equity. The unrealized appreciation on securities also added$987,000 to total equity. The increases in shareholders’ equity were offset by$5,001,000 in dividends to shareholders. Bank regulators have risk basedcapital guidelines. Under these guidelines, banks 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, 2004,the Company’s required ratios were well above the minimum ratios as follows:

 
| ** **           | ** ** | **COMPANY** | ** ** | **2004  MINIMUM  STANDARDS** | ** ** |
|----------------------|------------|-------------|------------|------------------------------|------------|
| Tier 1 capital ratio |       | 19.9        | %          | 4.0                          | %          |
| Total capital ratio  |       | 21.8        | %          | 8.0                          | %          |

 

For a more comprehensive discussion of these requirements, see“Regulations and Supervision” on the Form 10-K. Management believes that theCompany will continue to exceed regulatory capital requirements.

 

**RETURN ONEQUITY AND ASSETS:**

 

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

 
| ** **                                                               | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|--------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Percentage  of net income to:                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Average total assets                                                     |       | 2.06       | %          | 2.24       | %          | 2.01       | %          |
| Average shareholders’ equity                                        |       | 15.49      | %          | 16.60      | %          | 15.00      | %          |
| Percentage of dividends declared per common  share                       |       | 52.72      | %          | 44.76      | %          | 46.41      | %          |
| Percentage of average shareholders’ equity  to average total assets |       | 13.30      | %          | 13.51      | %          | 13.39      | %          |

 

26

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

 

Fundamental objectives ofthe Company’s asset/liability management process are to maintain adequateliquidity while minimizing interest rate risk. The maintenance of adequateliquidity 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 interest rate sensitivity management is toincrease net interest income by managing interest sensitive assets andliabilities in such a way that they can be repriced in response to changes inmarket interest rates.

 

The Company, like otherfinancial institutions, must have sufficient funds available to meet its liquidityneeds for deposit withdrawals, loan commitments and expenses. In order tocontrol cash flow, the bank estimates future flows of cash from deposits andloan payments. The primary sources of funds are deposits, principal andinterest payments on loans and mortgage-backed securities, as well as FederalHome Loan Bank borrowings. Funds generated are used principally to fund loansand purchase investment securities. Management believes the Company hasadequate resources to meet its normal funding requirements.  Management monitors the Company’s liquidityon both a long and short-term basis thereby, providing management necessaryinformation to react to current balance sheet trends. Cash flow needs areassessed and sources of funds are determined. Funding strategies consider bothcustomer 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.

 

Management monitors anddetermines the desirable level of liquidity. Consideration is given to loandemand, investment opportunities, deposit pricing and growth potential as wellas the current cost of borrowing funds. The Company has a current borrowingcapacity at the Federal Home Loan Bank of $145,110,000. In addition to thiscredit arrangement the Company has additional lines of credit withcorrespondent banks of $10,500,000. The Company’s management believes that ithas sufficient liquidity to satisfy estimated short-term and long-term fundingneeds. Federal Home Loan Bank advances totaled $98,508,000 as of December 31,2004. The Bank borrowed an additional $5,000,000, in FHLB long term borrowingsin 2004 to supplement the securities proceeds to fund loan growth.

 

Interest rate sensitivity,which is closely related to liquidity management, is a function of therepricing characteristics of the Company’s portfolio of assets and liabilities.Asset/liability management strives to match maturities and rates between loanand investment security assets with the deposit liabilities and borrowings thatfund them. Successful asset/liability management results in a balance sheetstructure which can cope effectively with market rate fluctuations. Thematching process is affected by segmenting both assets and liabilities intofuture time periods (usually 12 months, or less) based upon when repricing canbe effected. Repriceable assets are subtracted from repriceable liabilities,for a specific time period to determine the “gap”, or difference. Once known,the gap is managed based on predictions about future market interest rates.Intentional mismatching, or gapping, can enhance net interest income if marketrates move as predicted. However, if market rates behave in a manner contraryto predictions, net interest income will suffer. Gaps, therefore, contain anelement of risk and must be prudently managed. In addition to gap management,the Company has an asset liability management policy which incorporates amarket value at risk calculation which is used to determine the effects ofinterest rate movements on shareholders’ equity and a simulation analysis tomonitor the effects of interest rate changes on the Company’s balance sheets.

 

**INTERESTRATE SENSITIVITY**

 

In this analysis the Companyexamines the result of a 100 and 200 basis point change in market interestrates and the effect on net interest income. It is assumed that the change isinstantaneous and that all rates move in a parallel manner. Assumptions arealso made concerning prepayment speeds on mortgage loans and mortgagesecurities. The following is a rate shock analysis for the period indicated:

 
| ** **            | ** ** | **DECEMBER  31, 2004**                                      | ** ** |
|-----------------------|------------|-------------------------------------------------------------|------------|
| **CHANGES IN  RATES** | ** ** | **NET INTEREST  INCOME CHANGE (AFTER TAX)  (IN THOUSANDS)** | ** ** |
| -100                  |       | $                                                           | (1,093     | ) |
| +100                  |       | $                                                           | 72         |   |
| +200                  |       | $                                                           | 255        |   |
| +300                  |       | $                                                           | 694        |   |

 

27

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The model utilized to createthe report presented above makes various estimates at each level of interestrate change regarding cash flow from principal repayment on loans andmortgage-backed securities and or call activity on investment securities.Actual results could differ significantly from these estimates which wouldresult in significant differences in 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 is well positioned to respond expeditiouslywhen the market interest rate outlook changes.

 

**INFLATION**

 

The asset and liabilitystructure of a financial institution is primarily monetary in nature,therefore, interest rates rather than inflation have a more significant impacton 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.

 

**CRITICALACCOUNTING POLICIES**

 

The Company’s accountingpolicies are integral to understanding the results reported. The accountingpolicies are described in detail in Note 1 of the consolidated financialstatements. Our most complex accounting policies require management’s judgmentto ascertain the valuation of assets, liabilities, commitments andcontingencies. We have established detailed policies and control proceduresthat are intended to ensure valuation methods are well controlled and appliedconsistently from period to period. In addition, the policies and proceduresare intended to ensure that the process for changing methodologies occurs in anappropriate manner. The following is a brief description or our currentaccounting policies involving significant management valuation judgments.

 

**Other ThanTemporary Impairment of Equity Securities**

 

Equity securities areevaluated periodically to determine whether a decline in their value is otherthan temporary, management utilized criteria such as the magnitude and durationof the decline, in addition to the reason underlying the decline, to determinewhether the loss in value is other than temporary, The term “other thantemporary” is not intended to indicate that the decline is permanent. Itindicates that the prospects for a near term recovery of value are notnecessarily favorable, or that there is a lack of evidence to support fairvalues equal to, or greater than, the carrying value of the investment. Once adecline in value is determined to be other than temporary, the value of thesecurity is reduced and a corresponding charge to earnings is recognized.

 

**Allowancefor Loan Losses**

 

Arriving at an appropriatelevel of allowance for loan losses involves a high degree of judgment. TheCompany’s allowance for loan losses provides for probable losses based uponevaluations of known, and inherent risks in the loan portfolio.

 

Management uses historicalinformation to assess the adequacy of the allowance for loan losses as well asthe prevailing business environment; as it is affected by changing economicconditions and various external factors, which may impact the portfolio in wayscurrently unforeseen. The allowance is increased by provisions for loan lossesand by recoveries of loans previously charged-off and reduced by loanscharged-off. For a full discussion of the Company’s methodology of assessingthe adequacy of the reserve for loan losses, refer to Note 4 of “Notes andConsolidated Finanical Statements” of the Form 10-K.

 

**Goodwilland Other Intangible Assets**

 

As discussed in Note 6 ofthe consolidated financial statements, the Company must assess goodwill andother intangible assets each year for impairment. This assessment involvesestimating cash flows for future periods. If the future cash flows were lessthan the recorded goodwill and other intangible assets balances, we would be requiredto take a charge against earnings to write down the assets to the lower value.

 

28

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**DeferredTax 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 provenon-existent or less than the amount of the deferred tax assets within the taxyears to which they may be applied, the asset may not be realized and our netincome will be reduced. Our deferred tax assets are described further in Note10 of the consolidated financial statements.

 

**CONTRACTUALOBLIGATIONS**

 

TheCorporation has various financial obligations, including contractualobligations which may require future cash payments. The following table presentsin thousands, as of December 31, 2004, significant fixed and determinablecontractual obligations to third parties by payment date. Further discussion ofthe nature of each obligation is included in the referenced note to theconsolidated financial statements.

 
| ** **                              | ** ** | **Payments Due in**   | ** ** |
|-----------------------------------------|------------|-----------------------|------------|
| **(In Thousands)**                      | ** ** | **One Year  or Less** | ** ** | **One to  Three  Years** | ** ** | **Three to  Five  Years** | ** ** | **Over  Five  Years** | ** ** | **Total** | ** ** |
|                                    |       |                  |       |   |   |   |   |   |   |   |   |
| **Deposits  without a stated maturity** |       | $                     | 231,445    |   | — |   | — |   | — |   | $ | 231,445 |   |
|                                    |       |                  |       |   |   |   |   |   |   |   |   |
| **Time  Deposits**                      |       | 81,340                |       | 36,235 |   | 6,463 |   | 1,353 |   | 125,391 |   |
|                                    |       |                  |       |   |   |   |   |   |   |   |   |
| **Security  repurchase agreements**     |       | 13,845                |       |   |   |   |   |   |   | 13,845 |   |
|                                    |       |                  |       |   |   |   |   |   |   |   |   |
| **Borrowed  funds**                     |       | 22,630                |       |   |   |   |   |   |   | 22,630 |   |
|                                    |       |                  |       |   |   |   |   |   |   |   |   |
| **Long-term  debt**                     |       | 1,400                 |       | 13,100 |   | 34,600 |   | 26,778 |   | 75,878 |   |
|                                    |       |                  |       |   |   |   |   |   |   |   |   |
| **Operating  leases**                   |       | 348                   |       | 619 |   | 299 |   | 1,837 |   | 3,103 |   |
|                                         |            |                       |            |  |  |  |  |  |  |  |  |  |  |

 

The Corporation’s operatinglease obligations represent short and long-term lease and rental payment forfacilities, certain software and data processing and other equipment.

 

**CAUTIONARYSTATEMENT FOR PURPOSES OF THE PRIVATE SECURITIES LITIGATION 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 Private SecuritiesLitigation Reform Act of 1995 provides a safe harbor for forward-lookingstatements. In order to comply with the terms of the safe harbor, the Companynotes that a variety of factors could cause the Company’s actual results andexperience to differ materially from the anticipated results or otherexpectations expressed in the Company’s forward-looking statements. The risksand uncertainties that may affect the operations, performance, development andresults of the Company’s business include the following: general economicconditions and changes in interest rates including their impact on capitalexpenditures; business conditions in the banking industry; the regulatory environment;rapidly changing technology and evolving banking industry standards; the effectof changes in accounting policies and practices, including increasedcompetition with community, regional and national financial institutions; newservice and product offerings by competitors and price pressures; changes inthe Company’s organization, compensation and benefit plans; and similar items.

 

**ITEM 7A QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

Market risk for the Companyis comprised primarily from interest rate risk exposure and liquidity risk.Interest rate risk and liquidity risk management is performed at the Bank levelas well as the Company level. The Company’s interest rate sensitivity ismonitored by management through selected interest rate risk measures producedinternally. Additional information and details are provided in “Management’sDiscussion and Analysis of Consolidated Financial Condition” and Results ofOperations “Liquidity, Interest Rates Sensitivity and Market Risk-Interst RateSensitivity” at the Annual Report.

 

29

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Generally, management believes the Company is well positioned torespond expeditiously when the market interest rate outlook changes.

 

**ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

 

30

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

Boardof Directors and Shareholders

PennsWoods Bancorp, Inc.

 

Wehave audited the consolidated balance sheet of Penns Woods Bancorp, Inc. andsubsidiaries as of December 31, 2004 and 2003, and the related consolidatedstatements of income, changes in stockholders’ equity, and cash flows for eachof the three years in the period ended December 31, 2004. These financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour 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 also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

 

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of Penns WoodsBancorp, Inc. and subsidiaries as of December 31, 2004 and 2003, and theconsolidated results of their operations and cash flows for each of the threeyears in the period ended December 31, 2004, in conformity with U.S.generally accepted accounting principles.

 

Wexford,Pennsylvania

February 11,2005

 

31

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**Penns Woods Bancorp, Inc.**

**ConsolidatedBalance Sheet**

 
| ** **                                                                                        | ** ** | **DECEMBER 31,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| **(In Thousands, Except Per Share  Data)**                                                        | ** ** | **2004**              | ** ** | **2003** | ** ** |
|                                                                                              |       |                  |       |   |   |
| **ASSETS:**                                                                                       |       |                  |       |   |   |
| Noninterest-bearing  balances in other financial institutions                                     |       | $                     | 12,602     |   | $ | 10,196 |   |
| Interest-bearing  deposits in other financial institutions                                        |       | 24                    |       | 34 |   |
| Total cash  and cash equivalents                                                                  |       | 12,626                |       | 10,230 |   |
|                                                                                              |       |                  |       |   |   |
| Investment  securities, available for sale, at fair value                                         |       | 177,957               |       | 210,611 |   |
| Investment  securities held to maturity (fair value of $561 and $701)                             |       | 558                   |       | 686 |   |
| Loans held  for sale                                                                              |       | 4,624                 |       | 4,803 |   |
| Loans, net  of unearned discount of $1,096 and $940                                               |       | 324,505               |       | 275,828 |   |
| Less:Allowance  for loan losses                                                                   |       | 3,338                 |       | 3,069 |   |
| Loans, net                                                                                        |       | 321,167               |       | 272,759 |   |
| Premises and  equipment, net                                                                      |       | 4,882                 |       | 4,625 |   |
| Accrued  interest receivable                                                                      |       | 2,246                 |       | 2,242 |   |
| Bank-owned  life insurance                                                                        |       | 10,976                |       | 8,908 |   |
| Goodwill                                                                                          |       | 3,032                 |       | 3,032 |   |
| Other assets                                                                                      |       | 8,635                 |       | 9,485 |   |
| **TOTAL  ASSETS**                                                                                 |       | $                     | 546,703    |   | $ | 527,381 |   |
| **LIABILITIES:**                                                                                  |       |                  |       |   |   |
| Interest-bearing  deposits                                                                        |       | $                     | 282,786    |   | $ | 269,443 |   |
| Noninterest-bearing  deposits                                                                     |       | 74,050                |       | 64,875 |   |
| TOTAL  DEPOSITS                                                                                   |       | 356,836               |       | 334,318 |   |
| Short-term  borrowings                                                                            |       | 36,475                |       | 47,265 |   |
| Long-term  borrowings, Federal Home Loan Bank                                                     |       | 75,878                |       | 70,878 |   |
| Accrued  interest payable                                                                         |       | 850                   |       | 836 |   |
| Other  liabilities                                                                                |       | 3,499                 |       | 4,315 |   |
| TOTAL  LIABILITIES                                                                                |       | 473,538               |       | 457,612 |   |
| **SHAREHOLDERS’EQUITY:**                                                                     |       |                  |       |   |   |
| Common  stock, par value $10; 10,000,000 shares authorized 3,331,837 and 3,326,560  shares issued |       | 33,318                |       | 33,265 |   |
| Additional  paid-in capital                                                                       |       | 17,700                |       | 17,559 |   |
| Retained  earnings                                                                                |       | 18,262                |       | 13,022 |   |
| Accumulated  other comprehensive income                                                           |       | 4,331                 |       | 6,132 |   |
| Treasury  stock, at cost (10,310 and 5,000 shares)                                                |       | (446                  | )          | (209 | ) |
| TOTAL  SHAREHOLDERS’EQUITY                                                                   |       | 73,165                |       | 69,769 |   |
| **TOTAL**                                                                                         |       | $                     | 546,703    |   | $ | 527,381 |   |

 

SeeAccompanying Notes to the Consolidated Financial Statements.

 

32

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**Penns WoodsBancorp, Inc.**

**Consolidated Statement of Income**

 
| ** **                                               | ** ** | **YEAR ENDED DECEMBER 31,** |
|----------------------------------------------------------|------------|----------------------------------|
| **(In Thousands, Except Per Share  Data)**               | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                     |       |                             |   |   |   |   |   |
| **INTEREST  AND DIVIDEND INCOME:**                       |       |                             |   |   |   |   |   |
| Loans  including fees                                    |       | $                                | 21,363 |   | $ | 19,963 |   | $ | 20,911 |   |
| Investment  Securities:                                  |       |                             |   |   |   |   |   |
| Taxable                                                  |       | 7,769                            |   | 6,550 |   | 4,999 |   |
| Tax-exempt                                               |       | 1,707                            |   | 2,608 |   | 3,252 |   |
| Other  dividend and interest income                      |       | 108                              |   | 111 |   | 140 |   |
| TOTAL  INTEREST AND DIVIDEND INCOME                      |       | 30,947                           |   | 29,232 |   | 29,302 |   |
| **INTEREST  EXPENSE:**                                   |       |                             |   |   |   |   |   |
| Deposits                                                 |       | 4,775                            |   | 5,656 |   | 7,857 |   |
| Short-term  borrowings                                   |       | 539                              |   | 428 |   | 501 |   |
| Long-term  borrowings                                    |       | 3,454                            |   | 3,181 |   | 2,488 |   |
| TOTAL  INTEREST EXPENSE                                  |       | 8,768                            |   | 9,265 |   | 10,846 |   |
| **NET  INTEREST INCOME**                                 |       | 22,179                           |   | 19,967 |   | 18,456 |   |
| **PROVISION  FOR LOAN LOSSES**                           |       | 465                              |   | 255 |   | 365 |   |
|                                                     |       |                             |   |   |   |   |   |
| **NET  INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES** |       | 21,714                           |   | 19,712 |   | 18,091 |   |
| **NON-INTEREST  INCOME:**                                |       |                             |   |   |   |   |   |
| Service  charges                                         |       | 1,983                            |   | 1,917 |   | 1,833 |   |
| Securities  gains, net                                   |       | 2,176                            |   | 3,479 |   | 35 |   |
| Bank-owned  life insurance                               |       | 294                              |   | 404 |   | 416 |   |
| Insurance  commissions                                   |       | 2,282                            |   | 1,598 |   | 1,807 |   |
| Other income                                             |       | 1,214                            |   | 1,056 |   | 1,164 |   |
| TOTAL  NON-INTEREST INCOME                               |       | 7,949                            |   | 8,454 |   | 5,255 |   |
| **NON-INTEREST  EXPENSES:**                              |       |                             |   |   |   |   |   |
| Salaries and  employee benefits                          |       | 7,937                            |   | 7,262 |   | 6,944 |   |
| Occupancy  expense, net                                  |       | 959                              |   | 877 |   | 831 |   |
| Furniture  and equipment expense                         |       | 1,016                            |   | 999 |   | 837 |   |
| Advertising  expense                                     |       | 344                              |   | 388 |   | 372 |   |
| Pennsylvania  shares tax expense                         |       | 508                              |   | 455 |   | 411 |   |
| Other  expenses                                          |       | 3,553                            |   | 3,308 |   | 2,818 |   |
| TOTAL  NON-INTEREST EXPENSES                             |       | 14,317                           |   | 13,289 |   | 12,213 |   |
|                                                     |       |                             |   |   |   |   |   |
| **INCOME  BEFORE INCOME TAX PROVISION**                  |       | 15,346                           |   | 14,877 |   | 11,133 |   |
| **INCOME  TAX PROVISION**                                |       | 4,263                            |   | 3,703 |   | 2,247 |   |
| **NET  INCOME**                                          |       | $                                | 11,083 |   | $ | 11,174 |   | $ | 8,886 |   |
| **EARNINGS  PER SHARE – BASIC**                     |       | $                                | 3.33 |   | $ | 3.35 |   | $ | 2.66 |   |
| **EARNINGS  PER SHARE – DILUTED**                   |       | $                                | 3.33 |   | $ | 3.35 |   | $ | 2.66 |   |
| **WEIGHTED  AVERAGE SHARES OUTSTANDING-BASIC**           |       | $                                | 3,325,007 |   | $ | 3,330,585 |   | $ | 3,336,312 |   |
| **WEIGHTED  AVERAGE SHARES OUTSTANDING-DILUTED**         |       | $                                | 3,328,627 |   | $ | 3,333,798 |   | $ | 3,339,249 |   |

 

See Accompanying Notes tothe Consolidated Financial Statements.

 

33

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**Penns WoodsBancorp, Inc.**

**Consolidated Statement of Changes****In Shareholders’Equity**

 
| **(In Thousands, Except Per Share  Data)**                                                               | ** ** | **COMMON STOCK  SHARES** | ** ** | **AMOUNT** | ** ** | **ADDITIONAL  PAID-IN  CAPITAL** | ** ** | **RETAINED  EARNINGS** | ** ** | **ACCUMULATED  OTHER  COMPREHENSIVE  INCOME  (LOSS)** | ** ** | **TREASURY  STOCK** | ** ** | **TOTAL  SHAREHOLDERS’  EQUITY** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|------------|------------|----------------------------------|------------|------------------------|------------|-------------------------------------------------------|------------|---------------------|------------|---------------------------------------|------------|
|                                                                                                     |       |                     |       |       |       |                             |       |                   |       |                                                  |       |                |       |                                  |       |
| Balance, December 31,  2001                                                                         |       | 3,131,644                |       | $          | 31,316     |                             | $          | 18,230                 |       | $                                                     | 6,987      |                | $          | 1,729                                 |       | $ | (3,010 | ) | $ | 55,252 |   |
|                                                                                                     |       |                     |       |       |       |                             |       |                   |       |                                                  |       |                |       |                                  |       |
| Comprehensive Income:                                                                                    |       |                     |       |       |       |                             |       |                   |       |                                                  |       |                |       |                                  |       |
| Net income                                                                                               |       |                     |       |       |       |                             |       | 8,886                  |       |                                                  |       |                |       | 8,886                                 |       |
| Unrealized gain on available  for sale securities, net of reclassification adjustments and tax of $1,760 |       |                     |       |       |       |                             |       |                   |       | 3,416                                                 |       |                |       | 3,416                                 |       |
| Total comprehensive income                                                                               |       |                     |       |       |       |                             |       |                   |       |                                                  |       |                |       | 12,302                                |       |
| Dividends declared, ($1.24  per share)                                                                   |       |                     |       |       |       |                             |       | (4,124                 | )          |                                                  |       |                |       | (4,124                                | )          |
| Stock options exercised                                                                                  |       | 5,188                    |       | 52         |       | 61                               |       |                   |       |                                                  |       |                |       | 113                                   |       |
| Purchase of treasury stock  (13,449 shares)                                                              |       |                     |       |       |       |                             |       |                   |       |                                                  |       | (401                | )          | (401                                  | )          |
| Balance, December 31,  2002                                                                         |       | 3,136,832                |       | 31,368     |       | 18,291                           |       | 11,749                 |       | 5,145                                                 |       | (3,411              | )          | 63,142                                |       |
| Stock split effected in the  form of a 10% dividend                                                      |       | 187,143                  |       | 1,871      |       | (793                             | )          | (4,900                 | )          |                                                  |       | 3,822               |       |                                  |       |
| Comprehensive Income:                                                                                    |       |                     |       |       |       |                             |       |                   |       |                                                  |       |                |       |                                  |       |
| Net income                                                                                               |       |                     |       |       |       |                             |       | 11,174                 |       |                                                  |       |                |       | 11,174                                |       |
| Unrealized gain on available  for sale securities, net of reclassification adjustments and tax of $508   |       |                     |       |       |       |                             |       |                   |       | 987                                                   |       |                |       | 987                                   |       |
| Total comprehensive income                                                                               |       |                     |       |       |       |                             |       |                   |       |                                                  |       |                |       | 12,161                                |       |
| Dividends declared, ($1.49  per share)                                                                   |       |                     |       |       |       |                             |       | (5,001                 | )          |                                                  |       |                |       | (5,001                                | )          |
| Stock options exercised                                                                                  |       | 2,585                    |       | 26         |       | 61                               |       |                   |       |                                                  |       |                |       | 87                                    |       |
| Purchase of treasury stock  (14,787 shares)                                                              |       |                     |       |       |       |                             |       |                   |       |                                                  |       | (620                | )          | (620                                  | )          |
| Balance, December 31,  2003                                                                         |       | 3,326,560                |       | 33,265     |       | 17,559                           |       | 13,022                 |       | 6,132                                                 |       | (209                | )          | 69,769                                |       |
| Comprehensive Income:                                                                                    |       |                     |       |       |       |                             |       |                   |       |                                                  |       |                |       |                                  |       |
| Net income                                                                                               |       |                     |       |       |       |                             |       | 11,083                 |       |                                                  |       |                |       | 11,083                                |       |
| Unrealized gain on available  for sale securities, net of reclassification adjustments and tax of $926   |       |                     |       |       |       |                             |       |                   |       | (1,801                                                | )          |                |       | (1,801                                | )          |
| Total comprehensive income                                                                               |       |                     |       |       |       |                             |       |                   |       |                                                  |       |                |       | 9,282                                 |       |
| Dividends declared, ($1.76  per share)                                                                   |       |                     |       |       |       |                             |       | (5,843                 | )          |                                                  |       |                |       | (5,843                                | )          |
| Stock options exercised                                                                                  |       | 5,277                    |       | 53         |       | 141                              |       |                   |       |                                                  |       |                |       | 194                                   |       |
| Purchase of treasury stock  (5,310 shares)                                                               |       |                     |       |       |       |                             |       |                   |       |                                                  |       | (237                | )          | (237                                  | )          |
| Balance, December 31,  2004                                                                         |       | 3,331,837                |       | $          | 33,318     |                             | $          | 17,700                 |       | $                                                     | 18,262     |                | $          | 4,331                                 |       | $ | (446 | ) | $ | 73,165 |   |
|                                                                                                     |       |                     |       |       |       |                             |       |                   |       |                                                  |       |                |       |                                  |       |
| **Components of comprehensive income (loss):**                                                           |       |                     |       | **2004**   | ** ** | **2003**                         | ** ** | **2002**               |       |                                                  |       |                |       |                                  |       |
| Change in net unrealized  gain (loss) on investment securities available for sale                        |       |                     |       | $          | (365       | )                                | $          | 3,283                  |       | $                                                     | 3,439      |                |       |                                  |       |   |   |   |
| Realized gains included in  net income, net of taxes of $740, $1,183 and $12                             |       |                     |       | (1,436     | )          | (2,296                           | )          | (23                    | )          |                                                  |       |                |       |                                  |       |
| Total                                                                                                    |       |                     |       | $          | (1,801     | )                                | $          | 987                    |       | $                                                     | 3,416      |                |       |                                  |       |   |   |   |

 

See Accompanying Notes tothe Consolidated Financial Statements

 

34

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**Penns WoodsBancorp, Inc.**

**ConsolidatedStatement of Cash Flows**

 
| ** **                                                                         | ** ** | **YEAR ENDED DECEMBER 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| **(In Thousands)**                                                                 | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                                               |       |                             |       |   |   |   |   |
| **OPERATING  ACTIVITIES:**                                                         |       |                             |       |   |   |   |   |
| Net income                                                                         |       | $                                | 11,083     |   | $ | 11,174 |   | $ | 8,886 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities: |       |                             |       |   |   |   |   |
| Depreciation                                                                       |       | 585                              |       | 631 |   | 526 |   |
| Provision  for loan losses                                                         |       | 465                              |       | 255 |   | 365 |   |
| Accretion  and amortization of investment security discounts and premiums          |       | (132                             | )          | (194 | ) | (906 | ) |
| Securities  gains, net                                                             |       | (2,176                           | )          | (3,479 | ) | (35 | ) |
| Originations  of loans held for sale                                               |       | (34,398                          | )          | (15,983 | ) | (16,597 | ) |
| Proceeds of  loans held for sale                                                   |       | 34,577                           |       | 13,831 |   | 17,939 |   |
| Earnings on  bank-owned life insurance                                             |       | (294                             | )          | (404 | ) | (416 | ) |
| Other, net                                                                         |       | 482                              |       | 606 |   | (1,190 | ) |
| Net cash  provided by operating activities                                         |       | 10,192                           |       | 6,437 |   | 8,572 |   |
| **INVESTING  ACTIVITIES:**                                                         |       |                             |       |   |   |   |   |
| Investment  securities available for sale:                                         |       |                             |       |   |   |   |   |
| Proceeds  from sales                                                               |       | 162,796                          |       | 82,489 |   | 79,022 |   |
| Proceeds  from calls and maturities                                                |       | 28,732                           |       | 48,046 |   | 13,047 |   |
| Purchases                                                                          |       | (159,295                         | )          | (159,363 | ) | (130,328 | ) |
| Investment  securities held to maturity:                                           |       |                             |       |   |   |   |   |
| Proceeds  from calls and maturities                                                |       | 142                              |       | 520 |   | 137 |   |
| Purchases                                                                          |       | (14                              | )          | (24 | ) | (41 | ) |
| Net increase  in loans                                                             |       | (49,002                          | )          | (18,390 | ) | (6,800 | ) |
| Acquisition  of bank premises and equipment                                        |       | (842                             | )          | (400 | ) | (992 | ) |
| Proceeds  from the sale of foreclosed assets                                       |       | 237                              |       | 341 |   | 344 |   |
| Purchase of  bank-owned life insurance                                             |       | (1,774                           | )          | — |   | — |   |
| Proceeds  from redemption of regulatory stock                                      |       | 3,322                            |       | 1,507 |   | 1,262 |   |
| Purchases of  regulatory stock                                                     |       | (2,940                           | )          | (4,402 | ) | (2,080 | ) |
|                                                                               |       |                             |       |   |   |   |   |
| Net cash  used for investing activities                                            |       | (18,638                          | )          | (49,676 | ) | (46,429 | ) |
| **FINANCING  ACTIVITIES:**                                                         |       |                             |       |   |   |   |   |
| Net increase  (decrease) in interest-bearing deposits                              |       | 13,343                           |       | (3,344 | ) | 22,914 |   |
| Net increase  (decrease) in noninterest-bearing deposits                           |       | 9,175                            |       | (2,186 | ) | 11,784 |   |
| Net  (decrease) increase in short-term borrowings                                  |       | (10,790                          | )          | 33,702 |   | (5,542 | ) |
| Proceeds  from other borrowings                                                    |       | 5,000                            |       | 20,000 |   | 10,000 |   |
| Repayment of  other borrowings                                                     |       | —                           |       | (900 | ) | — |   |
| Dividends  paid                                                                    |       | (5,843                           | )          | (5,001 | ) | (4,124 | ) |
| Stock  options exercised                                                           |       | 194                              |       | 87 |   | 113 |   |
| Purchase of  treasury stock                                                        |       | (237                             | )          | (620 | ) | (401 | ) |
| Net cash  provided by financing activities                                         |       | 10,842                           |       | 41,738 |   | 34,744 |   |
| NET INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS                              |       | 2,396                            |       | (1,501 | ) | (3,113 | ) |
| CASH AND  CASH EQUIVALENTS, BEGINNING                                              |       | 10,230                           |       | 11,731 |   | 14,844 |   |
| CASH AND  CASH EQUIVALENTS, ENDING                                                 |       | $                                | 12,626     |   | $ | 10,230 |   | $ | 11,731 |   |
|                                                                               |       |                             |       |   |   |   |   |
| **SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION:**                            |       |                             |       |   |   |   |   |
|                                                                               |       |                             |       |   |   |   |   |
| Interest  paid                                                                     |       | $                                | 8,754      |   | $ | 9,521 |   | $ | 10.944 |   |
| Income taxes  paid                                                                 |       | $                                | 4,350      |   | $ | 3,500 |   | $ | 3,394 |   |
| Transfer of  loans to foreclosed real estate                                       |       | $                                | 129        |   | $ | 173 |   | $ | 254 |   |

 

SeeAccompanying Notes to the Consolidated Financial Statements

 

35

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**PENNS WOODS BANCORP, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMEN****TS**

 

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

 

**Principles of Consolidation**

 

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

 

**Nature of Business**

 

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

 

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

 

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

 

Woods Investment Company,Inc., a Delaware holding company, is engaged in investing activities.

 

The M Group engages insecurities brokerage and insurance activities.

 

Operations are managed andfinancial performance is evaluated on a corporate-wide basis. Accordingly, allfinancial services operations are considered by management to be aggregated inone 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**

 

Cash equivalents include cash on hand and inbanks, interest-earning deposits and federal funds sold. Interest-earningdeposits mature within one year and are carried at cost. Net cash flows arereported for loan and deposit transactions.

 

**Investment Securities**

 

Investment securities are classified as available for sale or held tomaturity.

 

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

 

Available for sale securities consist of bonds, notes, debentures, andcertain equity securities not classified as trading securities nor as held tomaturity securities. Unrealized holding gains and losses, net of tax, onavailable for sale securities are reported as a net amount as a separatecomponent of shareholders’ equity until realized.

 

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

 

All investment securities, regardless of classification, are monitoredand tested for impairment. An investment security is considered to be impairedwhen the unrealized loss is considered to be other than temporary. When thisoccurs, the investment is written down to the current fair market value withthe write-downs being reflected as a realized loss.

 

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

 

Investment securities fair values are based on observed market prices.Certain investment securities do not have observed bid prices and their fairvalue is based on instruments with similar risk elements.

 

**Loans**

 

Loans are stated at the principal amountoutstanding, net of unearned discount, unamortized loan fees and costs, and theallowance for loan losses. Interest on loans is recognized as income whenearned on the accrual method. The Company’s general policy has been to stopaccruing interest on loans when it is determined a reasonable doubt exists asto the collectibility of additional interest. Income is subsequently recognizedonly to the extent that cash payments are received provided the loan is notdelinquent in payment and, in management’s judgment, the borrower has theability and intent to make future principal payments.

 

36

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

 

**Allowance for Loan Losses**

 

The allowance for loan losses represents theamount which management estimates is adequate to provide for probable lossesinherent in its loan portfolio, as of the balance sheet date. The allowancemethod is used in providing for loan losses. Accordingly, all loan losses arecharged to the allowance and all recoveries are credited to it. The allowancefor loan losses is established through a provision for loan losses charged tooperations. The provision for loan losses is based upon management’s quarterlyreview of the loan portfolio. The purpose of the review is to assess loanquality, identify impairedloans, analyze delinquencies, ascertain loan growth, evaluate potentialcharge-offs and recoveries, and assess general economic conditions in themarkets served. An external independent loan review is also performed annuallyfor the Bank. Management remains committed to an aggressive program of problemloan identification 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 on management’s consideration of the natureof the portfolio segments, changes in mix and volume of the loan portfolio, andhistorical 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 information availableto make such determinations and that the allowance for loan losses is adequateat December 31, 2004, 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,employment and delays in receiving financial information from borrowers couldresult in increased levels of nonperforming assets and charge-offs, increased loanloss provisions and reductions in income. Additionally, as an integral part ofthe examination process, bank regulatory agencies periodically review theBank’s loan loss allowance. The banking agencies could require the recognitionof additions to the loan loss allowance based on their judgment of informationavailable to them at the time of their examination.

 

Impaired loans are commercial and commercial real estate loans for whichit is probable the Company will not be able to collect all amounts due accordingto the contractual terms of the loan agreement. The Company individuallyevaluates such loans for impairment and does not aggregate loans by major riskclassifications. The definition of “impaired loans” is not the same as thedefinition of “nonaccrual loans,” although the two categories overlap. TheCompany may choose to place a loan on nonaccrual status due to paymentdelinquency or uncertain collectibility, while not classifying the loan asimpaired if the loan is not a commercial or commercial real estate loan.Factors considered by management in determining impairment include paymentstatus and collateral value. The amount of impairment for these types ofimpaired loans is determined by the difference between the present value of theexpected cash flows related to the loan, using the original interest rate, andits recorded value, or as a practical expedient in the case of collateralizedloans, the difference between the fair value of the collateral and the recordedamount of the loans. When foreclosure is probable, impairment is measured basedon the fair value of the collateral.

 

Mortgage loans on one-to-four family properties and all consumer loansare large groups of smaller-balance homogeneous loans and are measured forimpairment collectively. Loans that experience insignificant payment delays,which are defined as 90 days or less, generally are not classified as impaired.Management determines the significance of payment delays on a case-by-casebasis taking into consideration all circumstances surrounding the loan and theborrower including the length of the delay, the borrower’s prior paymentrecord, and the amount of shortfall in relation to the principal and interest owed.

 

**Loans Held for Sale**

 

In general, fixed rate residential mortgage loans originated by the Bankare held for sale and are carried at the aggregate lower of cost or market.Such loans sold are not serviced by the Bank.

 

**Foreclosed Assets Held for Sale**

 

Foreclosed assets held for sale are carried at the lower of cost or fairvalue less estimated costs to sell. Prior to foreclosure, the value of theunderlying loan is written down to the fair value of the real estate to beacquired by a charge to the allowance for loan losses, if necessary. Anysubsequent writedowns are charged against operating expenses. Operatingexpenses of such properties, net of related income, and gains and losses ontheir disposition are included in other expenses.

 

Foreclosed assets held for sale totaled $40,000 and $132,000 at December 2004and 2003, respectively.

 

**Bank Premises and Equipment**

 

Premises and equipment are stated at costless accumulated depreciation. Depreciation is computed using straight-line andaccelerated methods over the estimated useful lives of the related assets,which range from five to seven years for furniture, fixtures and equipment andthirty-one and a half years for buildings and improvements. Costs incurred forroutine maintenance and repairs are charged to operations as incurred. Costs ofmajor additions and improvements are capitalized.

 

**Bank-Owned Life Insurance**

 

The Company has purchased life insurance policies on certain officersand directors, and is the sole beneficiary on those policies. Bank-owned lifeinsurance is recorded at its cash surrender value, or the amount that can berealized. Increases in the cash surrender value are recognized as non-interestincome.

 

**Goodwill**

 

The company accounts for goodwill inaccordance with Statement of Financial Accounting Standards (“FAS”) No. 142,Goodwill and 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

 

37

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impairment analysis of goodwill. Based on the fair value of thereporting unit, estimated using the expected present value of future cashflows, no impairment of goodwill was recognized in 2004 and 2003.

 

**Advertising Costs**

 

Advertising costs are generally expensed as incurred.

 

**Income Taxes**

 

Deferred tax assets and liabilities result from temporary differences infinancial and income tax methods of accounting, and are reflected at currentlyenacted income tax rates applicable to the period in which the deferred taxassets or liabilities are expected to be realized or settled. As changes in taxlaws or rates are enacted, deferred tax assets and liabilities are adjustedthrough the provision for income taxes.

 

**Earnings Per Share**

 

The Company provides dual presentation ofbasic and diluted earnings per share. Basic earnings per share is calculatedutilizing net income as reported in the numerator and weighted average sharesoutstanding in the denominator. The computation of diluted earnings per sharediffers in that the dilutive effects of any stock options are adjusted in thedenominator.

 

**Employee Benefits**

 

Pension and employee benefits includecontributions, determined actuarially, to a defined benefit retirement plancovering the eligible employees of the Bank. The plan is funded on a currentbasis to the extent that it is deductible under existing federal taxregulations. Pension and other employee benefits also include contributions toa defined contribution Section 401(k) plan covering eligible employees.Contributions matching those made by eligible employees and an electivecontribution are made annually at the discretion of the Board of Directors.

 

**Stock Options**

 

The Company maintains a stock option plan forthe directors, officers and employees. When the exercise price of the Company’sstock options is greater than or equal to the market price of the underlyingstock on the date of the grant, no compensation expense is recognized in theCompany’s financial statements. Pro forma net income and earnings per share arepresented to reflect the impact of the stock option plan assuming compensationexpense had been recognized based on the fair value of the stock optionsgranted under the plan.

 

The Company applies Accounting PrinciplesBoard Opinion No. 25 and related interpretations in accounting for theseoptions. Accordingly, compensation expense is recognized on the grant date, in theamount equivalent to the intrinsic value of the options (stock price lessexercise price, at measurement date).

 

Had compensation costs for these options beendetermined based on the fair values at the grant dates for awards consistentwith the method of FAS No. 123, there would be no effect on the Company’s netincome and earnings per share for 2004, 2003, and 2002.

 

**Comprehensive Income**

 

The Company is required to presentcomprehensive income in a full set of general-purpose financial statements forall periods presented. Other comprehensive income is comprised exclusively ofunrealized holding gains (losses) on the available for sale securitiesportfolio.

 

**Reclassification of Comparative Amounts**

 

Certain items previously reported have been reclassified to conform tothe current year’s reporting format. Such reclassifications did not affect netincome or shareholders’ equity.

 

**Recent Accounting Pronouncements**

 

In December 2004, the FinancialAccounting Standards Board (“FASB”) issued Statement of Financial AccountingStandards (“FAS”) No. 123 (Revised 2004), Share-Based Payment. The Statementrequires that compensation cost relating to share-based payment transactions berecognized in financial statements and that this cost be measured based on thefair value of the equity or liability instruments issued. FAS No. 123 (Revised2004) covers a wide range of share-based compensation arrangements includingshare options, restricted share plans, performance-based awards, shareappreciation rights, and employee share purchase plans. The Company will adoptFAS No. 123 (Revised 2004) on July 1, 2005 and is currently evaluating theimpact the adoption of the standard will have on the Company’s results ofoperations.

 

In October 2003, the American Instituteof Certified Public Accountants issued SOP 03-3, “Accounting for Loans orCertain Debt Securities Acquired in a Transfer.” SOP 03-3 applies to a loanthat is acquired where it is probable, at acquisition, that a transferee willbe unable to collect all contractually required payments receivable. SOP 03-3requires the recognition, as accretable yield, the excess of all cash flowsexpected at acquisition over the investor’s initial investment in the loan asinterest income on a level-yield basis over the life of the loan. The amount bywhich the loan’s contractually required payments exceed the amount of itsexpected cash flows at acquisition may not be recognized as an adjustment toyield, a loss accrual or a valuation allowance for credit risk. SOP 03-3 iseffective for loans acquired in fiscal years beginning after December 31,2004. Early adoption is permitted. The adoption of SOP 03-3 is not expected tohave a material impact on the consolidated financial statements.

 

**NOTE 2 - PER SHARE DATA**

 

There are no convertible securities, whichwould affect the numerator in calculating basic and dilutive earnings pershare, therefore, net income as presented on the consolidated statement ofincome will be used as the numerator. The following table sets forth thecomposition of the weighted average common shares (denominator) used in thebasic and dilutive per share computation.

 

38

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| ** **                                                                                                 | ** ** | **2004**  | ** ** | **2003**  | ** ** | **2002**  | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
|                                                                                                       |       |      |       |      |       |      |       |
| Weighted  average common shares outstanding                                                                |       | 3,327,780 |       | 3,430,302 |       | 3,445,477 |       |
|                                                                                                       |       |      |       |      |       |      |       |
| Weighted  average treasury stock shares                                                                    |       | (2,773    | )          | (99,717   | )          | (109,165  | )          |
|                                                                                                       |       |      |       |      |       |      |       |
| Weighted  average common shares and common stock equivalents used to calculate basic  earnings per share   |       | 3,325,007 |       | 3,330,585 |       | 3,336,312 |       |
|                                                                                                       |       |      |       |      |       |      |       |
| Additional  common stock equivalents (stock options) used to calculate diluted earnings  per share         |       | 3,620     |       | 3,213     |       | 2,937     |       |
|                                                                                                       |       |      |       |      |       |      |       |
| Weighted  average common shares and common stock equivalents used to calculate diluted  earnings per share |       | 3,328,627 |       | 3,333,798 |       | 3,339,249 |       |

 

Options to purchase 8,713 shares of common stock at a price of $48.35were outstanding during 2004, 10,890 shares of common stock at a price of$48.35 were outstanding during 2003 and 22,385 shares of common stock at pricesfrom $38.18 to $48.35 were outstanding during 2002, but were not included inthe computation of diluted earnings per share as they were anti-dilutive due tothe strike price being greater than the market price as of the end of thefiscal year.

 

39

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**NOTE 3 – INVESTMENT SECURITIES**

Theamortized cost of investment securities and their approximate fair values areas follows:

 
| ** **                             | ** ** | **2004**            | ** ** |
|----------------------------------------|------------|---------------------|------------|
| **(In Thousands)**                     | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
|                                   |       |                |       |   |   |   |   |   |   |
| Available  for Sale (AFS)              |       |                |       |   |   |   |   |   |   |
| U.S.  Government and agency securities |       | $                   | 104,248    |   | $ | 207 |   | $ | (430 | ) | $ | 104,025 |   |
| State and  political securities        |       | 46,829              |       | 766 |   | (527 | ) | 47,068 |   |
| Other debt  securities                 |       | 1,302               |       | 47 |   | (7 | ) | 1,342 |   |
| Total debt  securities                 |       | 152,379             |       | 1,020 |   | (964 | ) | 152,435 |   |
| Equity  securities                     |       | 19,015              |       | 6,579 |   | (72 | ) | 25,522 |   |
| Total  Investment Securities AFS       |       | $                   | 171,394    |   | $ | 7,599 |   | $ | (1,036 | ) | $ | 177,957 |   |
|                                   |       |                |       |   |   |   |   |   |   |
| Held to  Maturity (HTM)                |       |                |       |   |   |   |   |   |   |
| U.S. Government  and agency securities |       | $                   | 32         |   | $ | — |   | $ | — |   | $ | 32 |   |
| State and  political securities        |       | 248                 |       | 3 |   | — |   | 251 |   |
| Other debt  securities                 |       | 278                 |       | — |   | — |   | 278 |   |
| Total  Investment Securities HTM       |       | $                   | 558        |   | $ | 3 |   | $ | — |   | $ | 561 |   |
|                                   |       |                |       |   |   |   |   |   |   |
| ** **                             | ** ** | **2003**            | ** ** |
| ** **                             | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
|                                   |       |                |       |   |   |   |   |   |   |
| Available  for Sale (AFS)              |       |                |       |   |   |   |   |   |   |
| U.S.  Government and agency securities |       | $                   | 150,218    |   | $ | 626 |   | $ | (1,015 | ) | $ | 149,829 |   |
| State and  political securities        |       | 31,364              |       | 2,510 |   | (22 | ) | 33,852 |   |
| Other debt  securities                 |       | 1,581               |       | 75 |   | (4 | ) | 1,652 |   |
| Total debt  securities                 |       | 183,163             |       | 3,211 |   | (1,041 | ) | 185,333 |   |
| Equity  securities                     |       | 18,158              |       | 7,146 |   | (26 | ) | 25,278 |   |
| Total  Investment Securities AFS       |       | $                   | 201,321    |   | $ | 10,357 |   | $ | (1,067 | ) | $ | 210,611 |   |
|                                   |       |                |       |   |   |   |   |   |   |
| Held to  Maturity (HTM)                |       |                |       |   |   |   |   |   |   |
| U.S.  Government and agency securities |       | $                   | 75         |   | $ | — |   | $ | (1 | ) | $ | 74 |   |
| State and  political securities        |       | 347                 |       | 16 |   | — |   | 363 |   |
| Other debt  securities                 |       | 264                 |       | — |   | — |   | 264 |   |
| Total  Investment Securities HTM       |       | $                   | 686        |   | $ | 16 |   | $ | (1 | ) | $ | 701 |   |

 

40

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The following table shows the Company’s gross unrealized losses and fairvalue, aggregated by investment category and length of time, that theindividual securities have been in a continuous unrealized loss position, atDecember 31, 2004.

 
| ** **                            | ** ** | **Less than Twelve Months** | ** ** | **Twelve Months or Greater**  | ** ** | **Total**       | ** ** |
|---------------------------------------|------------|-----------------------------|------------|-------------------------------|------------|-----------------|------------|
| **(In Thousands)**                    | ** ** | **Fair  Value**             | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  Losses** | ** ** |
|                                  |       |                        |       |                          |       |            |       |   |   |   |   |   |   |
| U.S. Government and agency Securities |       | $                           | 51,636     |                          | $          | 226             |       | $ | 28,598 |   | $ | 204 |   | $ | 80,234 |   | $ | 430 |   |
| State and political securities        |       | 17,339                      |       | 527                           |       | —          |       | — |   | 17,339 |   | 527 |   |
| Other debt securities                 |       | 142                         |       | 3                             |       | 146             |       | 4 |   | 288 |   | 7 |   |
| Total debt securities                 |       | 69,117                      |       | 756                           |       | 28,744          |       | 208 |   | 97,861 |   | 964 |   |
| Equity securities                     |       | 1,187                       |       | 64                            |       | 298             |       | 8 |   | 1,485 |   | 72 |   |
| Total                                 |       | $                           | 70,304     |                          | $          | 820             |       | $ | 29,042 |   | $ | 216 |   | $ | 99,346 |   | $ | 1,036 |   |

 

The policy of the Company isto recognize other than temporary impairment of equity securities where thefair value has been significantly below cost for one year. For fixed maturityinvestments with unrealized losses due to interest rates where the Company hasthe positive intent and ability to hold the investment for a period of timesufficient to allow a market recovery, declines in value below cost are notassumed to be other than temporary.  TheCompany reviews its position quarterly and has asserted that at December 31,2004, the declines outlined in the above table represent temporary declines andthe Company does have the intent and ability to hold those securities either tomaturity or to allow a market recovery.

 

The Company has concludedthat any impairment of its investment securities portfolio is not other thantemporary but is the result of interest rate changes, sector credit ratingchanges, or company-specific rating changes that are not expected to result inthe non-collection of principal and interest during the period.

 

The amortized cost and fairvalue of debt securities at December 31, 2004, by contractual maturity, areshown below. Expected maturities will differ from contractual maturitiesbecause borrowers may have the right to call or prepay obligations with orwithout call or prepayment penalties.

 
| ** **                        | ** ** | **HELD TO MATURITY** | ** ** | **AVAILABLE FOR SALE** | ** ** |
|-----------------------------------|------------|----------------------|------------|------------------------|------------|
| **(In Thousands)**                | ** ** | **AMORTIZED  COST**  | ** ** | **FAIR  VALUE**        | ** ** | **AMORTIZED  COST** | ** ** | **FAIR  VALUE** | ** ** |
| Due in one year or less           |       | $                    | 75         |                   | $          | 75 |   | $ | 1,019 |   | $ | 1,024 |   |
| Due after one year to five years  |       | 75                   |       | 75                     |       | 3,420 |   | 3,473 |   |
| Due after five years to ten years |       | 376                  |       | 379                    |       | 15 |   | 16 |   |
| Due after ten years               |       | 32                   |       | 32                     |       | 147,925 |   | 147,922 |   |
|                              |       |                 |       |                   |       |   |   |   |   |
|                              |       | $                    | 558        |                   | $          | 561 |   | $ | 152,379 |   | $ | 152,435 |   |

 

Total gross proceeds fromsales of securities available for sale were $162,796,000, $82,489,000, and$79,022,000 for 2004, 2003, and 2002, respectively. The following tablerepresents gross realized gains and gross realized losses on thosetransactions:

 

41

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| **(In Thousands)**                    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Gross realized gains:                 |       |     |       |     |       |     |       |
| U.S. Government and agency securities |       | $        | 459        |     | $          | 254      |       | $ | 204 |   |
| State and political securities        |       | 1,191    |       | 3,345    |       | 2,234    |       |
| Other debt securities                 |       | 1        |       | 27       |       | 6        |       |
| Equity securities                     |       | 2,192    |       | 1,015    |       | 1,605    |       |
|                                  |       | $        | 3,843      |     | $          | 4,641    |       | $ | 4,049 |   |
|                                  |       |     |       |     |       |     |       |
| Gross realized losses:                |       |     |       |     |       |     |       |
| U.S. Government and agency securities |       | $        | 1,623      |     | $          | 742      |       | $ | 125 |   |
| State and political securities        |       | 23       |       | 50       |       | 67       |       |
| Other debt securities                 |       | —   |       | 2        |       | —   |       |
| Equity securities                     |       | 21       |       | 368      |       | 3,822    |       |
|                                  |       | $        | 1,667      |     | $          | 1,162    |       | $ | 4,014 |   |

 

In 2003, the Companyrecorded an investment security gain of $24,000 resulting from a businesscombination where the Company received the common stock of the acquirer in anon-monetary exchange. This gain is included in the above table. There were nogains of this nature in 2004.

 

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

 

Investment securities with acarrying value of approximately $71,730,000 and $34,059,000 at December 31,2004 and 2003, respectively, were pledged to secure certain deposits, securityrepurchase agreements, and for other purposes as required by law.

 

There is no concentration ofinvestments that exceed ten percent of shareholders’ equity for any individualissuer, excluding those guaranteed by the U.S. Government.

 

**NOTE4 - LOANS**

 

Major loan classificationsare summarized as follows:

 

42

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| ** **                            | ** ** | **2004**    | ** ** |
|---------------------------------------|------------|-------------|------------|
| **(In Thousands)**                    | ** ** | **CURRENT** | ** ** | **PAST DUE  30 TO 90  DAYS** | ** ** | **PAST DUE  90 DAYS  OR MORE  & STILL  ACCRUING** | ** ** | **NON-  ACCRUAL** | ** ** | **TOTAL** | ** ** |
| Commercial and agricultural           |       | $           | 29,467     |   | $ | 389 |   | $ | 82 |   | $ | 165 |   | $ | 30,103 |   |
| Real estate mortgage:                 |       |        |       |   |   |   |   |   |   |   |   |
| Residential                           |       | 143,028     |       | 3,530 |   | 254 |   | 649 |   | 147,461 |   |
| Commercial                            |       | 121,951     |       | 1,257 |   | — |   | 549 |   | 123,757 |   |
| Construction                          |       | 8,359       |       | — |   | — |   | 6 |   | 8,365 |   |
| Installment loans to individuals      |       | 15,495      |       | 399 |   | 9 |   | 12 |   | 15,915 |   |
|                                  |       | 318,300     |       | $ | 5,575 |   | $ | 345 |   | $ | 1,381 |   | 325,601 |   |
| Less: Net deferred loan fees          |       | 1,096       |       |   |   |   |   |   |   | 1,096 |   |
|   Allowance for loan losses |       | 3,338       |       |   |   |   |   |   |   | 3,338 |   |
| Loans, net                            |       | $           | 313,866    |   |   |   |   |   |   |   | $ | 321,167 |   |

 
| ** **                       | ** ** | **2003**    | ** ** |
|----------------------------------|------------|-------------|------------|
| ** **                       | ** ** | **CURRENT** | ** ** | **PAST DUE  30 TO 90  DAYS** | ** ** | **PAST DUE  90 DAYS  OR MORE  & STILL  ACCRUING** | ** ** | **NON-  ACCRUAL** | ** ** | **TOTAL** | ** ** |
| Commercial and agricultural      |       | $           | 23,105     |   | $ | 215 |   | $ | 21 |   | $ | 182 |   | $ | 23,523 |   |
| Real estate mortgage:            |       |        |       |   |   |   |   |   |   |   |   |
| Residential                      |       | 144,102     |       | 2,625 |   | 383 |   | 587 |   | 147,697 |   |
| Commercial                       |       | 82,156      |       | 667 |   | 15 |   | 58 |   | 82,896 |   |
| Construction                     |       | 7,637       |       | 15 |   | — |   | — |   | 7,652 |   |
| Installment loans to individuals |       | 14,738      |       | 252 |   | 10 |   | — |   | 15,000 |   |
|                             |       | 271,738     |       | $ | 3,774 |   | $ | 429 |   | $ | 827 |   | 276,768 |   |
| Less: Net deferred loan fees     |       | 940         |       |   |   |   |   |   |   | 940 |   |
| Allowance for loan losses        |       | 3,069       |       |   |   |   |   |   |   | 3,069 |   |
| Loans, net                       |       | $           | 267,729    |   |   |   |   |   |   |   | $ | 272,759 |   |

 

Loans on which the accrualof interest has been discontinued or reduced amounted to approximately$1,381,000 and $827,000 at December 31, 2004 and 2003, respectively. Ifinterest had been recorded at the original rate on those loans, such incomewould have approximated $64,000, $55,000, and $24,000 for the years endedDecember 31, 2004, 2003 and 2002, respectively. Interest income on such loans,which is recorded as received, amounted to approximately $10,000, $7,000, and$17,000, for the years ended December 31, 2004, 2003 and 2002, respectively.

 

Charges in theallowance for loan losses for the years ended December 31, are as follows:

 
| **(In Thousands)**              | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|---------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance, beginning of year      |       | $          | 3,069      |       | $          | 2,953      |       | $ | 2,927 |   |
| Provision charged to operations |       | 465        |       | 255        |       | 365        |       |
| Loans charged off               |       | (283       | )          | (216       | )          | (402       | )          |
| Recoveries                      |       | 87         |       | 77         |       | 63         |       |
| Balance, end of year            |       | $          | 3,338      |       | $          | 3,069      |       | $ | 2,953 |   |

 

43

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The Company had no concentrationof loans to borrowers engaged in similar businesses or activities which exceedfive percent of total assets at December 31, 2004 or December 31, 2003.

 

The Company grantscommercial, industrial, residential, and installment loans to customers throughoutnorth-central Pennsylvania. Although the Company has a diversified loanportfolio at December 31, 2004 and 2003, a substantial portion of its debtors’ability to honor their contracts is dependent on the economic conditions withinthis region.

 

**NOTE5 - PREMISES AND EQUIPMENT**

 

Major classifications ofpremises and equipment are summarized as follows at December 31:

 
| **(In Thousands)**            | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
|                          |       |     |       |     |       |
| Land                          |       | $        | 566        |     | $          | 566 |   |
| Premises                      |       | 5,290    |       | 4,883    |       |
| Furniture and equipment       |       | 6,756    |       | 6,348    |       |
| Leasehold improvements        |       | 894      |       | 867      |       |
| Total                         |       | 13,506   |       | 12,664   |       |
| Less accumulated depreciation |       | 8,624    |       | 8,039    |       |
| Net                           |       | $        | 4,882      |     | $          | 4,625 |   |

 

Depreciation charges tooperations for the years ended 2004, 2003, and 2002 were $585,000, $631,000,and $526,000, respectively.

 

The Bank has committed to$1,000,000 for the premises and equipment of a new branch in State College, PA.

 

**NOTE6 - GOODWILL**

 

As of December 31, 2004,2003, and 2002 goodwill had a gross carrying value of $3,308,000 andaccumulated amortization of $276,000 resulting in a net carrying amount of$3,032,000.

 

The gross carrying amount ofgoodwill is tested for impairment in the third quarter of each fiscal year.Based on fair value of the reporting unit, estimated using the expected presentvalue of future cash flows, no goodwill impairment loss was recognized in thecurrent year.

 

**NOTE7 - DEPOSITS**

 

Time deposits of $100,000 ormore totaled approximately $30,212,000 on December 31, 2004 and $27,386,000 onDecember 31, 2003. Interest expense related to such deposits was approximately$818,000, $829,000, and $1,098,000, for the years ended December 31, 2004, 2003and 2002, respectively.

 

Maturities on time depositsof $100,000 or more are as follows:

 
| **(In Thousands)**          | ** ** | **2004** | ** ** |
|-----------------------------|------------|----------|------------|
|                        |       |     |       |
| Three months or less        |       | $        | 6,869      |   |
| Three months to six months  |       | 5,316    |       |
| Six months to twelve months |       | 8,807    |       |
| Over twelve months          |       | 9,220    |       |
|                        |       |     |       |
| Total                       |       | $        | 30,212     |   |

 

44

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Total time deposits atDecember 31, 2004 mature as follows:

 
| **(In Thousands)** | ** ** | **2004** | ** ** |
|--------------------|------------|----------|------------|
|               |       |     |       |
| 2005               |       | $        | 81,340     |   |
| 2006               |       | 22,237   |       |
| 2007               |       | 13,998   |       |
| 2008               |       | 5,811    |       |
| 2009               |       | 652      |       |
| Thereafter         |       | 1,353    |       |
|               |       |     |       |
| Total              |       | $        | 125,391    |   |

 

Total deposits at December31 are as follows:

 
| **(In Thousands)**               | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|
|                             |       |     |       |     |       |
| Demand deposits                  |       | $        | 74,050     |     | $          | 64,875 |   |
| Interest-bearing demand deposits |       | 87,588   |       | 77,245   |       |
| Saviings deposits                |       | 69,807   |       | 67,298   |       |
| Time deposits                    |       | 125,391  |       | 124,900  |       |
|                             |       |     |       |     |       |
| Total deposits                   |       | $        | 356,836    |     | $          | 334,318 |   |

 

**NOTE8 - SHORT-TERM BORROWINGS**

 

Short-term borrowings consistof securities sold under agreements to repurchase and FHLB advances whichgenerally represent overnight or less than 30-day borrowings. The outstandingbalances and related information for short-term borrowings are summarized asfollows:

 
| **(In Thousands)**                          | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|
| **Repurchase  Agreements:**                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance at year end                         |       | $          | 13,845     |       | $          | 10,225 |   |
| Maximum amount outstanding at any month end |       | 15,301     |       | 15,665     |       |
| Average balance outstanding during the year |       | 13,317     |       | 13,214     |       |
| Weighted-average interest rate:             |       |       |       |       |       |
| At year end                                 |       | 1.82       | %          | 1.91       | %          |
| Paid during the year                        |       | 1.77       | %          | 2.07       | %          |
| **Open Repo Plus:**                         |       |       |       |       |       |
| Balance at year end                         |       | $          | 22,630     |       | $          | 36,140 |   |
| Maximum amount outstanding at any month end |       | 32,480     |       | 36,140     |       |
| Average balance outstanding during the year |       | 18,336     |       | 11,537     |       |
| Weighted-average interest rate:             |       |       |       |       |       |
| At year end                                 |       | 2.24       | %          | 1.06       | %          |
| Paid during the year                        |       | 1.64       | %          | 1.16       | %          |
| **Short Term FHLB:**                        |       |       |       |       |       |
| Balance at year end                         |       | $          | —     |       | $          | 900 |   |
| Maximum amount outstanding at any month end |       | 900        |       | 900        |       |
| Average balance outstanding during the year |       | 204        |       | 695        |       |
| Weighted-average interest rate:             |       |       |       |       |       |
| At year end                                 |       | —     |       | 1.40       | %          |
| Paid during the year                        |       | 1.42       | %          | 1.42       | %          |

 

45

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**NOTE9 - OTHER BORROWINGS**

 

The following representsoutstanding long-term borrowings by contractual maturities at December 31, 2004and 2003:

 
| **(In Thousands)**                                        | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------|------------|----------|------------|----------|------------|
| Variable rate of 4.49%, maturing in 2007                  |       | $        | 5,000      |     | $          | 5,000 |   |
| Variable rates between 3.14% and 5.56%,  maturing in 2008 |       | 29,600   |       | 29,600   |       |
| Variable rate of 5.06%, maturing in 2009                  |       | 5,000    |       | 5,000    |       |
| Variable rate of 6.65%, maturing in 2010                  |       | 5,000    |       | 5,000    |       |
| Variable rates of 4.25% and 4.72%, maturing  in 2011      |       | 10,000   |       | 10,000   |       |
| Variable rate of 3.68%, maturing in 2012                  |       | 5,000    |       | 5,000    |       |
| Variable rate of 3.74%, maturing in 2013                  |       | 5,000    |       | 5,000    |       |
| Fixed rate of 2.02%, maturing in 2005                     |       | 1,400    |       | 1,400    |       |
| Fixed rate of 2.58%, maturing in 2006                     |       | 1,600    |       | 1,600    |       |
| Fixed rates between 2.67% and 3.13%,  maturing in 2007    |       | 6,500    |       | 1,500    |       |
| Fixed rate of 6.95%, maturing in 2011                     |       | 500      |       | 500      |       |
| Fixed rate of 5.87%, maturing in 2013                     |       | 528      |       | 528      |       |
| Fixed rate of 6.92%, maturing in 2015                     |       | 750      |       | 750      |       |
| Total                                                     |       | $        | 75,878     |     | $          | 70,878 |   |

 

The terms of the convertibleborrowings allow the Federal Home Loan Bank (“FHLB”) to convert the interestrate to an adjustable rate based on the three month London Interbank OfferedRate (“LIBOR”) at a predetermined anniversary date of the borrowing’sorigination, ranging from three months to five years.

 

The Bank maintains a creditarrangement, which includes a revolving line of credit with the FHLB. Underthis credit arrangement, the Bank has a remaining borrowing capacity ofapproximately $145 million at December 31, 2004, is subject to annual renewal,and typically incurs no service charges. Under terms of a blanket agreement,collateral for the FHLB borrowings must be secured by certain qualifying assetsof the Bank which consist principally of first mortgage loans.

 

**NOTE10 - INCOME TAXES**

 

The following temporarydifferences gave rise to the net deferred tax liability at December 31, 2004and 2003:

 
| **(In Thousands)**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax  asset:                               |       |     |       |     |       |
| Allowance for loan losses                          |       | $        | 841        |     | $          | 716 |   |
| Deferred compensation                              |       | 353      |       | 346      |       |
| Contingencies                                      |       | 24       |       | 22       |       |
| Pension                                            |       | 515      |       | 429      |       |
| Loan fees and costs                                |       | 368      |       | 320      |       |
| Investment securities allowance                    |       | 98       |       | 119      |       |
| Other                                              |       | 15       |       | —   |       |
| Total                                              |       | 2,214    |       | 1,952    |       |
|                                               |       |     |       |     |       |
| Deferred tax liability:                            |       |     |       |     |       |
| Bond accretion                                     |       | 21       |       | 28       |       |
| Depreciation                                       |       | 205      |       | 260      |       |
| Amortization                                       |       | 225      |       | 150      |       |
| Unrealized gains on available for sale  securities |       | 2,231    |       | 3,159    |       |
| Total                                              |       | 2,682    |       | 3,597    |       |
|                                               |       |     |       |     |       |
| Deferred tax liability, net                        |       | $        | (468       | )        | $          | (1,645 | ) |

 

46

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No valuation allowance wasestablished at December 31, 2004 and 2003, in the view of the Company’s abilityto carry back taxes paid in previous years and certain tax strategies, coupledwith the anticipated future taxable income as evidenced by the Company’searning potential.

 

The provision for incometaxes is comprised of the following for the years ended December 31:

 
| **(In Thousands)**        | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|----------|------------|
|                      |       |     |       |     |       |     |       |
| Currently payable         |       | $        | 4,512      |     | $          | 3,666    |       | $ | 2,363 |   |
| Deferred (benfit) expense |       | (249     | )          | 37       |       | (116     | )          |
|                      |       |     |       |     |       |     |       |
| Total provision           |       | $        | 4,263      |     | $          | 3,703    |       | $ | 2,247 |   |

 

The effective federal incometax rate for the years ended December 31, 2004, 2003, and 2002 was 27.8%, 24.9%and 20.2%, respectively.  Areconciliation between the expected income tax and the effective income taxrate on income before income tax provision follows:

 
| ** **                      | ** ** | **2004**   | ** ** | **2003** | ** ** | **2002**   | ** ** |
|---------------------------------|------------|------------|------------|----------|------------|------------|------------|
| ** **                      | ** ** | **AMOUNT** | ** ** | **%**    | ** ** | **AMOUNT** | ** ** | **%** | ** ** | **AMOUNT** | ** ** | **%** | ** ** |
|                            |       |       |       |     |       |       |       |   |   |   |   |   |   |
| Provision at expected rate      |       | $          | 5,218      |     | 34.0       | %          | $          | 5,058 |   | 34.0 | % | $ | 3,785 |   | 34.0 | % |
| Decrease in tax resulting from: |       |       |       |     |       |       |       |   |   |   |   |   |   |
| Tax-exempt income               |       | (632       | )          | (4.1     | )          | (964       | )          | (6.4 | ) | (1,367 | ) | (12.3 | ) |
| Other, net                      |       | (323       | )          | (2.1     | )          | (391       | )          | (2.7 | ) | (171 | ) | (1.5 | ) |
|                            |       |       |       |     |       |       |       |   |   |   |   |   |   |
| Effective income tax and rates  |       | $          | 4,263      |     | 27.8       | %          | $          | 3,703 |   | 24.9 | % | $ | 2,247 |   | 20.2 | % |

 

**NOTE11 - EMPLOYEE BENEFIT PLANS**

 

**DEFINEDBENEFIT PENSION PLAN**

 

The Company has a noncontributorydefined benefit pension plan (the “Plan”) for all employees hired prior toJanuary 1, 2004, meeting certain age and length of service requirements.Benefits are based primarily on years of service and the average annualcompensation during the highest five consecutive years within the final tenyears of employment.

 

The following tables showthe funded status and components of net periodic benefit cost from this definedbenefit plan:

 

47

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| ** **                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| **Change in benefit obligation**                |       |     |       |     |       |
| Benefit obligation at beginning of year         |       | $        | 7,145      |     | $          | 6,473 |   |
| Service cost                                    |       | 447      |       | 443      |       |
| Interest cost                                   |       | 398      |       | 384      |       |
| Actuarial (gain) loss                           |       | (225     | )          | 43       |       |
| Benefits paid                                   |       | (216     | )          | (198     | )          |
| Benefit obligation at end of year               |       | $        | 7,549      |     | $          | 7,145 |   |
|                                            |       |     |       |     |       |
| **Change in plan assets**                       |       |     |       |     |       |
| Fair value of plan assets at beginning of  year |       | $        | 4,042      |     | $          | 3,131 |   |
| Actual return on plan assets                    |       | 394      |       | 620      |       |
| Employer contribution                           |       | 347      |       | 506      |       |
| Benefits paid                                   |       | (216     | )          | (198     | )          |
| Expenses paid                                   |       | (18      | )          | (17      | )          |
| Fair value of plan assets at end of year        |       | 4,549    |       | 4,042    |       |
| Funded status                                   |       | (3,000   | )          | (3,103   | )          |
| Unrecognized net actuarial loss                 |       | 1,275    |       | 1,609    |       |
| Unrecognized prior service cost                 |       | 229      |       | 255      |       |
| Unrecognized tranisition asset                  |       | (19      | )          | (22      | )          |
| Net Accrued Benefit Cost Recognized             |       | $        | (1,515     | )        | $          | (1,261 | ) |

 

The accumulated benefit obligation for thedefined benefit pension plan was $5,606,000, and $4,913,000 at December 31,2004 and 2003, respectively. Amounts recognized in the Statement of Incomeconsist of:

 
| **(In Thousands)**                 | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service cost                       |       | $          | 447        |       | $          | 443        |       | $ | 381 |   |
| Interest cost                      |       | 398        |       | 384        |       | 342        |       |
| Expected return on plan assets     |       | (376       | )          | (256       | )          | (246       | )          |
| Amortization of transition asset   |       | (3         | )          | (3         | )          | (3         | )          |
| Amortization of prior service cost |       | 26         |       | 26         |       | 26         |       |
| Recognized net actuarial gain      |       | 109        |       | 83         |       | 19         |       |
| Net periodic benefit cost          |       | $          | 601        |       | $          | 677        |       | $ | 519 |   |

 

The plan was amended,effective January 1, 2004, to cease eligibility for employees with a hire dateof January 1, 2004 or later. Employees with a hire date of January 1, 2004 orlater are eligible to receive, after meeting certain age and length of servicerequirements, an annual discretionary pension contribution from the Bank equalto a percentage of an employee’s base compensation. The dollars will be placedin a separate account within the 401(k) plan with a vesting requirement.

 

The following information relates to the Plan’sprojected obligation, accumulated benefit obligation, and plan assets atDecember 31:

 
| **(In Thousands)**              | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Projected  benefit obligation   |       | $        | 7,549      |     | $          | 7,145 |   |
| Accumulative benefit obligation |       | 5,606    |       | 4,913    |       |
| Fair value of plan assets       |       | 4,549    |       | 4,042    |       |
|                                 |            |          |            |          |            |  |  |

 

48

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**Assumptions**

 

Weighted-average assumptionsused to determine benefit obligations at December 31:

 
| ** **                    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Discount rate                 |       | 5.75     | %          | 6.00     | %          | 6.00     | %          |
| Rate of compensation increase |       | 4.75     | %          | 5.00     | %          | 5.00     | %          |

 

Weighted-averageassumptions used to determine net periodic cost for years ended December 31:

 
| ** **                               | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Discount rate                            |       | 6.00     | %          | 6.00     | %          | 6.50     | %          |
| Expected long-term return on plan assets |       | 8.00     | %          | 8.00     | %          | 8.00     | %          |
| Rate of compensation increase            |       | 5.00     | %          | 5.00     | %          | 5.00     | %          |

 

The expected long-term rate of return 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 Company’s pension planweighted-average asset allocations at December 31 by asset category are asfollows:

 
| **Asset Category**      | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------------|------------|------------|------------|------------|------------|
| ** **              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash                    |       | 0.3        | %          | 0.6        | %          |
| Fixed Income securities |       | 37.9       | %          | 38.7       | %          |
| Equity                  |       | 61.8       | %          | 60.7       | %          |
| Total                   |       | 100.0      | %          | 100.0      | %          |

 

The investment objective forthe defined pension plan is to maximize total return with tolerance forslightly above average risk, meaning the fund is able to tolerate short-termvolatility to achieve above-average returns over the long term. The portfolio’starget exposure to equities is 60%, primarily invested in mid and largecapitalization domestic equities. Exposure to small capitalization andinternational stocks may be allowed.

 

Asset allocation favorsequities, with target allocation of approximately 60% equity securities, 37.5%fixed income securities and 2.5% cash. Due to volatility in the market, thetarget allocation is not always desirable and asset allocations will fluctuatebetween the acceptable ranges.

 

It is management’s intent togive the investment managers flexibility within the overall guidelines withrespect to investment decisions and their timing. However, certain investmentsrequire specific review and approval by management. Management is also informedof anticipated, significant modifications of any previously approvedinvestment, or anticipated use of derivatives to execute investment strategies.

 

The following benefitpayments, which reflect expected future cost, are expected to be paid duringthe years ended December 31:

 

49

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**Estimatedfuture benefit payments:**

 
| **(In Thousands)** | ** ** | ** ** | ** ** |
|--------------------|------------|------------|------------|
| 2005               |       | $          | 181        |   |
| 2006               |       | 192        |       |
| 2007               |       | 235        |       |
| 2008               |       | 272        |       |
| 2009               |       | 277        |       |
| 20010 - 2014       |       | 2,242      |       |
|               |       |       |       |
|               |       | $          | 3,399      |   |

 

The company expects tocontribute $575,000 to its Pension Plan in 2005.

 

**401(k)SAVINGS PLAN**

 

The Company also offers a401(k) savings plan in which eligible participating employees may elect tocontribute up to a maximum percentage allowable not to exceed the limits ofCode Sections 401(k), 404, and 415. The Company may make matching contributionsequal to a discretionary percentage to be determined by the Company.Participants are at all times fully vested in their contributions and vest overa period of five years in the employer contribution. Contribution expense wasapproximately $83,000, $75,000, and $80,000 for the years ended December 31,2004, 2003, and 2002, respectively.

 

**DEFERREDCOMPENSATION PLAN**

 

Certain directors haveentered into deferred compensation agreements with the Corporation pursuant towhich all or a specified portion of their directors’ fees are deferred untiltheir retirement or termination of service. Interest on amounts credited to theaccount balance for each director accrues at an amount equal to one half of theCorporation’s return on equity for the prior year. To fund benefits under thedeferred compensation plan, the Company has acquired corporate-owned lifeinsurance policies on the lives of the participating directors for whichinsurance benefits are payable to the Company. The total expense charged toother expenses was $73,000, $104,000, and $98,000 for the years ended December31, 2004, 2003 and 2002, respectively. Benefits paid under the plan wereapproximately $127,000 in 2004, $132,000 in 2003 and $51,000 in 2002.

 

**NOTE12 - STOCK OPTIONS**

 

Prior to 1998, the Companygranted a select group of its officers options to purchase shares of its commonstock. These options, which are immediately exercisable, expire within three toten years after having been granted. Also, in 1998, the Company adopted the “1998Stock Option Plan” for key employees and directors. Incentive stock options andnonqualified stock options may be granted to eligible employees of the Bank andnonqualified options may be granted to directors of the Company. In addition,non-employee directors are eligible to receive grants of nonqualified stockoptions. Incentive nonqualified stock options granted under the 1998 Plan maybe exercised not later than ten years after the date of grant. Each optiongranted under the 1998 Plan shall be exercisable only after the expiration ofsix months following the date of grant of such options.

 

A summary of the status ofthe Company’s common stock option plans are presented below:

 

50

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| ** **                      | ** ** | **2004**   | ** ** | **2003**                               | ** ** |
|---------------------------------|------------|------------|------------|----------------------------------------|------------|
| ** **                      | ** ** | **SHARES** | ** ** | **WEIGHTED  AVERAGE  EXERCISE  PRICE** | ** ** | **SHARES** | ** ** | **WEIGHTED  AVERAGE  EXERCISE  PRICE** | ** ** |
|                            |       |       |       |                                   |       |   |   |   |   |
| Outstanding, beginning of year  |       | 30,607     |       | $                                      | 39.39      |   | 33,385 |   | $ | 38.69 |   |
| Granted                         |       | —     |       | —                                 |       | — |   | — |   |
| Exercised                       |       | (5,277     | )          | 36.73                                  |       | (2,778 | ) | 30.93 |   |
| Forfeited                       |       | (9,365     | )          | 38.63                                  |       | — |   | — |   |
|                            |       |       |       |                                   |       |   |   |   |   |
| Outstanding, end of year        |       | 15,965     |       | 40.24                                  |       | 30,607 |   | 39.39 |   |
|                            |       |       |       |                                   |       |   |   |   |   |
| Options exercisable at year-end |       | 15,965     |       | $                                      | 40.24      |   | 30,607 |   | $ | 39.39 |   |

 

Thefollowing table summarizes information about nonqualified and incentive stockoptions outstanding at December 31, 2004:

 
| ** **         | ** ** | **OUTSTANDING** | ** ** | **EXERCISABLE**   | ** ** |
|--------------------|------------|-----------------|------------|-------------------|------------|
| **EXERCISE PRICE** | ** ** | **SHARES**      | ** ** | **AVERAGE  LIFE** | ** ** | **AVERAGE  EXERCISE  PRICE** | ** ** | **SHARES** | ** ** | **AVERAGE  EXERCISE  PRICE** | ** ** |
| $                  | 48.35      |            | 8,410      |              | 4          |   | $ | 48.35 |   | 8,410 |   | $ | 48.35 |   |
| $                  | 38.18      |            | 1,375      |              | 5          |   | $ | 38.18 |   | 1,375 |   | $ | 38.18 |   |
| $                  | 29.66      |            | 6,180      |              | 2          |   | $ | 29.66 |   | 6,180 |   | $ | 29.66 |   |

 

**NOTE 13 - RELATED PARTY TRANSACTIONS**

 

Certain directors and executive officers of theCompany and the Bank, including their immediate families and companies in whichthey are principal owners (more than ten percent), are indebted to the Company.Such indebtedness was incurred in the ordinary course of business on the sameterms and at those rates prevailing at the time for comparable transactionswith others.

 

A summary of loan activity with executive officers,directors, principal shareholders, and associates of such persons is listedbelow for the years ended December 31:

 
| ** **         | ** ** | **BEGINNING** | ** ** | ** **    | ** ** | ** **   | ** ** | **ENDING**   | ** ** |
|--------------------|------------|---------------|------------|---------------|------------|--------------|------------|--------------|------------|
| **(In Thousands)** | ** ** | **BALANCE**   | ** ** | **ADDITIONS** | ** ** | **PAYMENTS** | ** ** | **RESIGNED** | ** ** | **BALANCE** | ** ** |
|               |       |          |       |          |       |         |       |         |       |   |   |
| 2004               |       | $             | 7,227      |          | $          | 5,720        |       | $            | 1,273      |   | $ | — |   | $ | 11,674 |   |
| 2003               |       | $             | 6,785      |          | $          | 2,374        |       | $            | 1,791      |   | $ | 141 |   | $ | 7,227 |   |

 

**NOTE 14 - COMMITMENTS AND CONTINGENTLIABILITIES**

 

The following schedule of future minimum rentalpayments under operating leases with noncancellable terms in excess of one yearas of December 31, 2004:

 

51

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| **Year Ending December 31,  (In Thousands)** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
|                                         |       |       |       |
| 2005                                         |       | $          | 348        |   |
| 2006                                         |       | 326        |       |
| 2007                                         |       | 293        |       |
| 2008                                         |       | 194        |       |
| 2009                                         |       | 105        |       |
| Thereafter                                   |       | 1,837      |       |
| Total                                        |       | $          | 3,103      |   |

 

Total rental expense for all operating leases for theyears ended December 31, 2004, 2003 and 2002 were $320,000, $269,000, and$258,000 respectively.

 

The Company is subject to lawsuits and claims arisingout of its business. In the opinion of management, after review andconsultation with counsel, any proceedings that may be assessed will not have amaterial adverse effect on the consolidated financial position of the Company.

 

**NOTE 15 - OFF-BALANCE SHEET RISK**

 

The Company is a party to financial instruments withoff-balance sheet risk in the normal course of business to meet the financingneeds of its customers. These financial instruments include commitments toextend credit and standby letters of credit. These instruments involve, tovarying degrees, elements of credit, interest rate or liquidity risk in excessof the amount recognized in the consolidated balance sheet. The contractamounts of these instruments express the extent of involvement the Company hasin particular classes of financial instruments.

 

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

 

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

 

Financial instruments whose contract amounts representcredit risk are as follows at December 31:

 
| **(In Thousands)**           | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|
| Commitments to extend credit |       | $        | 42,537     |     | $          | 47,454 |   |
| Standby letters of credit    |       | $        | 1,321      |     | $          | 258 |   |

 

Commitments to extend credit are legally bindingagreements to lend to customers. Commitments generally have fixed expirationdates or other termination clauses and may require payment of fees. Since manyof the commitments are expected to expire without being drawn upon, the totalcommitment amounts do not necessarily represent future liquidity requirements.The Company evaluates each customer’s credit worthiness on a case-by-casebasis. The amount of collateral obtained, if deemed necessary by the Company,on extension of credit is based on management’s credit assessment of thecounterparty.

 

Standby letters of credit represent conditionalcommitments issued by the Company to guarantee the performance of a customer toa third party. These instruments are issued primarily to support bid orperformance related contracts. The coverage period for these instruments istypically a one year period with an annual renewal option subject to priorapproval by management. Fees earned from the issuance of these letters arerecognized upon expiration of the coverage period. For secured letters ofcredit, the collateral is typically Bank deposit instruments or customerbusiness assets.

 

**NOTE 16 - CAPITAL REQUIREMENTS**

 

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

 

In addition to the capital requirements, the FederalDeposit Insurance Corporation Improvement Act (“FDICIA”) established fivecapital categories ranging from “well capitalized” to “critically

 

52

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undercapitalized.” Should any institution fail to meetthe requirements to be considered “adequately capitalized,” it would becomesubject to a series of increasingly restrictive regulatory actions. As ofDecember 31, 2004 and 2003, the FDIC categorized the Bank as well capitalizedunder the regulatory framework for prompt corrective action. To be classifiedas a well capitalized financial institution, Total risk-based, Tier 1risk-based and Tier 1 leverage capital ratios must be at least 10%, 6%, and 5%,respectively.

 

The Company’s and the Bank’s actual capital ratios arepresented in the following tables, which shows that both met all regulatorycapital requirements.

 

The Company’s actual capital amounts and ratios arepresented in the following table:

 
| ** **                    | ** ** | **2004**   | ** ** | **2003**  | ** ** |
|-------------------------------|------------|------------|------------|-----------|------------|
| **(In Thousands)**            | ** ** | **AMOUNT** | ** ** | **RATIO** | ** ** | **AMOUNT** | ** ** | **RATIO** | ** ** |
| **Total Capital**             |       |       |       |      |       |   |   |   |   |
| **(to Risk-weighted Assets)** |       |       |       |      |       |   |   |   |   |
| Actual                        |       | $          | 72,042     |      | 21.8       | % | $ | 66,820 |   | 23.0 | % |
| For Capital Adequacy Purposes |       | 26,475     |       | 8.0       |       | 23,225 |   | 8.0 |   |
| To Be Well Capitalized        |       | 33,094     |       | 10.0      |       | 29,031 |   | 10.0 |   |
| **Tier 1 Capital**            |       |       |       |      |       |   |   |   |   |
| **(to Risk-weighted Assets)** |       |       |       |      |       |   |   |   |   |
| Actual                        |       | $          | 65,776     |      | 19.9       | % | $ | 60,547 |   | 20.9 | % |
| For Capital Adequacy Purposes |       | 13,238     |       | 4.0       |       | 11,613 |   | 4.0 |   |
| To Be Well Capitalized        |       | 19,856     |       | 6.0       |       | 17,419 |   | 6.0 |   |
| **Tier 1 Capital**            |       |       |       |      |       |   |   |   |   |
| **(to Average Assets)**       |       |       |       |      |       |   |   |   |   |
| Actual                        |       | $          | 65,776     |      | 12.1       | % | $ | 60,547 |   | 11.6 | % |
| For Capital Adequacy Purposes |       | 21,750     |       | 4.0       |       | 20,922 |   | 4.0 |   |
| To Be Well Capitalized        |       | 27,187     |       | 5.0       |       | 26,153 |   | 5.0 |   |
|                               |            |            |            |           |            |  |  |  |  |  |  |  |  |  |  |

 

The Bank’s actual capital amounts and ratios are presented in the followingtable:

 
| ** **                    | ** ** | **2004**   | ** ** | **2003**  | ** ** |
|-------------------------------|------------|------------|------------|-----------|------------|
| **(In Thousands)**            | ** ** | **AMOUNT** | ** ** | **RATIO** | ** ** | **AMOUNT** | ** ** | **RATIO** | ** ** |
| **Total Capital**             |       |       |       |      |       |   |   |   |   |
| **(to Risk-weighted Assets)** |       |       |       |      |       |   |   |   |   |
| Actual                        |       | $          | 55,717     |      | 17.6       | % | $ | 52,161 |   | 18.8 | % |
| For Capital Adequacy Purposes |       | 25,311     |       | 8.0       |       | 22,155 |   | 8.0 |   |
| To Be Well Capitalized        |       | 31,639     |       | 10.0      |       | 27,693 |   | 10.0 |   |
| **Tier 1 Capital**            |       |       |       |      |       |   |   |   |   |
| **(to Risk-weighted Assets)** |       |       |       |      |       |   |   |   |   |
| Actual                        |       | $          | 51,213     |      | 16.2       | % | $ | 47,770 |   | 17.3 | % |
| For Capital Adequacy Purposes |       | 12,656     |       | 4.0       |       | 11,077 |   | 4.0 |   |
| To Be Well Capitalized        |       | 18,983     |       | 6.0       |       | 16,616 |   | 6.0 |   |
| **Tier 1 Capital**            |       |       |       |      |       |   |   |   |   |
| **(to Average Assets)**       |       |       |       |      |       |   |   |   |   |
| Actual                        |       | $          | 51,213     |      | 9.7        | % | $ | 47,770 |   | 9.6 | % |
| For Capital Adequacy Purposes |       | 21,039     |       | 4.0       |       | 19,982 |   | 4.0 |   |
| To Be Well Capitalized        |       | 26,299     |       | 5.0       |       | 24,978 |   | 5.0 |   |

 

**NOTE 17 - REGULATORY RESTRICTIONS**

 

The Pennsylvania Banking Code restricts theavailability of capital funds for payment of dividend by all state-charteredbanks to the additional paid in capital of the Bank. Accordingly, at December31, 2004, the balance in the additional paid in capital account totalingapproximately $11,700,000 is unavailable for dividends.

 

The Bank is subject to regulatory restrictions, whichlimit its ability to loan funds to Penns Woods Bancorp, Inc. At

 

53

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December 31, 2004, the regulatory lending limitamounted to approximately $5,502,000.

 

**Cash and Due from Banks**

 

Included in cash and due from banks are reservesrequired by the district Federal Reserve Bank of $1,197,000 and $1,151,000 atDecember 31, 2004 and 2003. The required reserves are computed by applyingprescribed ratios to the classes of average deposit balances. These are held inthe form of cash on hand and a balance maintained directly with the FederalReserve Bank.

 

**NOTE 18 - ESTIMATED FAIR VALUE OFFINANCIAL INSTRUMENTS**

 

The Company is required to disclose estimated fairvalues for its financial instruments. Fair value estimates are made at aspecific point in time, based on relevant market information and informationabout the financial instrument. These estimates do not reflect any premium ordiscount that could result from offering for sale at one time the Company’sentire holdings of a particular financial instrument. Also, it is the Company’sgeneral practice and intention to hold most of its financial instruments tomaturity and not to engage in trading or sales activities. Because no marketexists for a significant portion of the Company’s financial instruments, fairvalue estimates are based on judgments regarding future expected lossexperience, current economic conditions, risk characteristics of variousfinancial instruments and other factors. These estimates are subjective innature and involve uncertainties and matters of significant judgment andtherefore cannot be determined with precision. Changes in assumptions cansignificantly affect the estimates.

 

Estimated fair values have been determined by theCompany using historical data and an estimation methodology suitable for eachcategory of financial instruments. The estimated fair value of the Company’sinvestment securities is described in Note 1.

 

The Company’s fair value estimates, methods, andassumptions are set forth below for the Company’s other financial instruments.

 

As certain assets and liabilities, such as deferredtax assets, premises and equipment, and many other operational elements of theCompany, are not considered financial instruments but have value, thisestimated fair value of financial instruments would not represent the fullmarket value of the Company.

 

The estimated fair values of the Company’s financialinstruments are as follows at December 31,:

 
| ** **                    | ** ** | **2004**            | ** ** | **2003**        | ** ** |
|-------------------------------|------------|---------------------|------------|-----------------|------------|
| **(In Thousands)**            | ** ** | **CARRYING  VALUE** | ** ** | **FAIR  VALUE** | ** ** | **CARRYING  VALUE** | ** ** | **FAIR  VALUE** | ** ** |
|                          |       |                |       |            |       |   |   |   |   |
| Financial assets:             |       |                |       |            |       |   |   |   |   |
| Cash and due from equivalents |       | $                   | 12,626     |            | $          | 12,626 |   | $ | 10,230 |   | $ | 10,230 |   |
| Investment securities:        |       |                |       |            |       |   |   |   |   |
| Available for sale            |       | 177,957             |       | 177,957         |       | 210,611 |   | 210,611 |   |
| Held to maturity              |       | 558                 |       | 561             |       | 686 |   | 701 |   |
| Loans held for sale           |       | 4,624               |       | 4,624           |       | 4,803 |   | 4,803 |   |
| Loans, net                    |       | 321,167             |       | 331,350         |       | 272,759 |   | 287,310 |   |
| Bank-owned life insurance     |       | 10,976              |       | 10,976          |       | 8,908 |   | 8,908 |   |
| Regulatory stock              |       | 6,206               |       | 6,206           |       | 6,588 |   | 6,588 |   |
| Accrued interest receivable   |       | 2,246               |       | 2,246           |       | 2,242 |   | 2,242 |   |
|                          |       |                |       |            |       |   |   |   |   |
| Financial liabilities:        |       |                |       |            |       |   |   |   |   |
| Interest-bearing deposits     |       | $                   | 282,786    |            | $          | 263,509 |   | $ | 269,443 |   | $ | 271,200 |   |
| Noninterest-bearing deposits  |       | 74,050              |       | 74,050          |       | 64,875 |   | 64,875 |   |
| Short-term borrowings         |       | 36,475              |       | 36,475          |       | 47,265 |   | 47,265 |   |
| Long-term borrowings, FHLB    |       | 75,878              |       | 77,858          |       | 70,878 |   | 73,107 |   |
| Accrued interest payable      |       | 850                 |       | 850             |       | 836 |   | 836 |   |

 

54

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**Cashand Cash Equivalents, Loans Held for Sale, Regulatory Stock, Accrued InterestReceivable, Short-term Borrowings, and Accrued Interest Payable:**

 

The fair value is equal to the carrying value.

 

**Investment securities****:**

 

The fair value of investment securities available forsale and held to maturity is equal to the available quoted market price. If noquoted market price is available, fair value is estimated using the quotedmarket price for similar securities.

 

**Loans:**

 

Fair values are estimated for portfolios of loans withsimilar financial characteristics. Loans are segregated by type such ascommercial, commercial real estate, residential real estate, construction realestate, and other consumer. Each loan category is further segmented into fixedand adjustable rate interest terms and by performing and nonperformingcategories.

 

The fair value of performing loans is calculated bydiscounting scheduled cash flows through the estimated maturity using estimatedmarket discount rates that reflect the credit and interest rate risk inherentin the loan. The estimate of maturity is based on the Company’s historicalexperience with repayments for each loan classification, modified, as required,by an estimate of the effect of current economic and lending conditions.

 

Fair value for significant nonperforming loans isbased on recent external appraisals. If appraisals are not available, estimatedcash flows are discounted using a rate commensurate with the risk associatedwith the estimated cash flows. Assumptions regarding credit risk, cash flows,and discounted rates are judgmentally determined using available market informationand specific borrower information.

 

**Bank-owned life insurance:**

 

The fair value is equal to the Cash Surrender Value oflife insurance policies.

 

**Deposits:**

 

The fair value of deposits with no stated maturity,such as noninterest-bearing demand deposits, savings and NOW accounts, andmoney market and checking accounts, is equal to the amount payable on demand asof December 31, 2004 and 2003. The fair value of certificates of deposit isbased on the discounted value of contractual cash flows.

 

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

 

**Other borrowings****:**

 

The fair value of other borrowings is based on thediscounted value of contractual cash flows.

 

**Commitments to extend credit, standbyletters of credit, and financial guarantees written:**

 

There is no material difference between the notionalamount and the estimated fair value of off-balance sheet items at December 31,2004 and 2003, respectively. The contractual amounts of unfunded commitmentsand letters of credit are presented in Note 15.

 

**NOTE 19 - PARENT COMPANY ONLYFINANCIAL STATEMENTS**

 

Condensed financial information for Penns WoodsBancorp, Inc. follows:

 

55

----

 

**CONDENSED BALANCE SHEET, DECEMBER 31,**

 
| **(In Thousands)**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|
|                                          |       |     |       |     |       |
| ASSETS                                        |       |     |       |     |       |
| Cash                                          |       | $        | 453        |     | $          | 369 |   |
| Investment in subsidiaries:                   |       |     |       |     |       |
| Bank                                          |       | 56,743   |       | 54,133   |       |
| Nonbank                                       |       | 15,980   |       | 15,307   |       |
| Other assets                                  |       | 104      |       | 91       |       |
|                                          |       |     |       |     |       |
| Total Assets                                  |       | $        | 73,280     |     | $          | 69,900 |   |
|                                          |       |     |       |     |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY     |       |     |       |     |       |
| Other liabilities                             |       | $        | 115        |     | $          | 131 |   |
| Shareholders’ equity                     |       | 73,165   |       | 69,769   |       |
|                                          |       |     |       |     |       |
| Total liability and shareholders’ equity |       | $        | 73,280     |     | $          | 69,900 |   |

 

56

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**CONDENSED STATEMENT OF INCOME**

**FOR THE YEARS ENDED DECEMBER 31,**

 
| **(In Thousands)**                                 | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                               |       |     |       |     |       |     |       |
| Operating income:                                  |       |     |       |     |       |     |       |
| Dividends from subsidiaries                        |       | $        | 6,440      |     | $          | 6,651    |       | $ | 4,878 |   |
| Equity in undistributed net income of subsidiaries |       | 4,833    |       | 4,649    |       | 4,121    |       |
|                                               |       |     |       |     |       |     |       |
| Operating expenses:                                |       | (190     | )          | (126     | )          | (113     | )          |
|                                               |       |     |       |     |       |     |       |
| Net income                                         |       | $        | 11,083     |     | $          | 11,174   |       | $ | 8,886 |   |

 

**CONDENSED STATEMENT OF CASH FLOWS**

**FOR THE YEARS ENDED DECEMBER 31,**

 
| **(In Thousands)**                                                                      | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                                    |       |     |       |     |       |     |       |
| OPERATING ACTIVITIES                                                                    |       |     |       |     |       |     |       |
| Net income                                                                              |       | $        | 11,083     |     | $          | 11,174   |       | $ | 8,886 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |     |       |     |       |     |       |
| Equity in undistributed net income of  subsidiaries                                |       | (4,833   | )          | (4,649   | )          | (4,121   | )          |
| Other, net                                                                              |       | (9       | )          | (64      | )          | (23      | )          |
| Net cash provided by operating activities                                               |       | 6,241    |       | 6,461    |       | 4,742    |       |
|                                                                                    |       |     |       |     |       |     |       |
| INVESTING ACTIVITIES                                                                    |       |     |       |     |       |     |       |
| Additional investment in subsidiaries                                                   |       | (271     | )          | (1,039   | )          | —   |       |
|                                                                                    |       |     |       |     |       |     |       |
| FINANCING ACTIVITIES                                                                    |       |     |       |     |       |     |       |
| Dividends paid                                                                          |       | (5,843   | )          | (5,001   | )          | (4,124   | )          |
| Proceeds from exercise of stock options                                                 |       | 194      |       | 87       |       | 113      |       |
| Purchase/retirement of treasury stock                                                   |       | (237     | )          | (620     | )          | (401     | )          |
| Net cash used for financing activities                                                  |       | (5,886   | )          | (5,534   | )          | (4,412   | )          |
|                                                                                    |       |     |       |     |       |     |       |
| NET INCREASE (DECREASE) IN CASH                                                         |       | 84       |       | (112     | )          | 330      |       |
| CASH, BEGINNING OF YEAR                                                                 |       | 369      |       | 481      |       | 151      |       |
| CASH, END OF YEAR                                                                       |       | $        | 453        |     | $          | 369      |       | $ | 481 |   |

 

57

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**NOTE 20 - CONSOLIDATED QUARTERLYFINANCIAL DATA (UNAUDITED)**

 

(In Thousands, Except Per Share Data)

 
| ** **                         | ** ** | **FOR THE THREE MONTHS ENDED** | ** ** |
|------------------------------------|------------|--------------------------------|------------|
| **2004**                           | ** ** | **March 31,**                  | ** ** | **June 30,** | ** ** | **Sept. 30,** | ** ** | **Dec. 31,** | ** ** |
|                               |       |                           |       |   |   |   |   |   |   |
| Interest income                    |       | $                              | 7,327      |   | $ | 7,532 |   | $ | 7,924 |   | $ | 8,164 |   |
| Interest expense                   |       | 2,124                          |       | 2,142 |   | 2,229 |   | 2,273 |   |
|                               |       |                           |       |   |   |   |   |   |   |
| Net interest income                |       | 5,203                          |       | 5,390 |   | 5,695 |   | 5,891 |   |
|                               |       |                           |       |   |   |   |   |   |   |
| Provision for loan losses          |       | 75                             |       | 75 |   | 165 |   | 150 |   |
| Non-interest income                |       | 1,492                          |       | 1,467 |   | 1,548 |   | 1,266 |   |
| Securities gains, net              |       | 545                            |       | 583 |   | 407 |   | 641 |   |
| Non-interest expenses              |       | 3,473                          |       | 3,453 |   | 3,509 |   | 3,882 |   |
|                               |       |                           |       |   |   |   |   |   |   |
| Income before income tax provision |       | 3,692                          |       | 3,912 |   | 3,976 |   | 3,766 |   |
| Income tax provision               |       | 1,019                          |       | 1,108 |   | 1,150 |   | 986 |   |
|                               |       |                           |       |   |   |   |   |   |   |
| Net income                         |       | $                              | 2,673      |   | $ | 2,804 |   | $ | 2,826 |   | $ | 2,780 |   |
|                               |       |                           |       |   |   |   |   |   |   |
| Earnings per share - basic         |       | $                              | 0.80       |   | $ | 0.85 |   | $ | 0.85 |   | $ | 0.83 |   |
|                               |       |                           |       |   |   |   |   |   |   |
| Earnings per share - diluted       |       | $                              | 0.80       |   | $ | 0.85 |   | $ | 0.85 |   | $ | 0.83 |   |

 

(In Thousands, Except Per Share Data)

 
| ** **                         | ** ** | **FOR THE THREE MONTHS ENDED** | ** ** |
|------------------------------------|------------|--------------------------------|------------|
| **2003**                           | ** ** | **March 31,**                  | ** ** | **June 30,** | ** ** | **Sept. 30,** | ** ** | **Dec. 31,** | ** ** |
|                               |       |                           |       |   |   |   |   |   |   |
| Interest income                    |       | $                              | 7,092      |   | $ | 7,251 |   | $ | 7,281 |   | $ | 7,608 |   |
| Interest expense                   |       | 2,386                          |       | 2,395 |   | 2,327 |   | 2,157 |   |
|                               |       |                           |       |   |   |   |   |   |   |
| Net interest income                |       | 4,706                          |       | 4,856 |   | 4,954 |   | 5,451 |   |
|                               |       |                           |       |   |   |   |   |   |   |
| Provision for loan losses          |       | 90                             |       | 45 |   | 90 |   | 30 |   |
| Non-interest income                |       | 1,182                          |       | 1,195 |   | 1,325 |   | 1,273 |   |
| Securities gains, net              |       | 101                            |       | 1,750 |   | 1,247 |   | 381 |   |
| Non-interest expenses              |       | 3,139                          |       | 3,186 |   | 3,290 |   | 3,674 |   |
|                               |       |                           |       |   |   |   |   |   |   |
| Income before income tax provision |       | 2,760                          |       | 4,570 |   | 4,146 |   | 3,401 |   |
| Income tax provision               |       | 573                            |       | 1,233 |   | 1,135 |   | 762 |   |
|                               |       |                           |       |   |   |   |   |   |   |
| Net income                         |       | $                              | 2,187      |   | $ | 3,337 |   | $ | 3,011 |   | $ | 2,639 |   |
|                               |       |                           |       |   |   |   |   |   |   |
| Earnings per share - basic         |       | $                              | 0.72       |   | $ | 1.10 |   | $ | 1.00 |   | $ | 0.53 |   |
|                               |       |                           |       |   |   |   |   |   |   |
| Earnings per share - diluted       |       | $                              | 0.72       |   | $ | 1.10 |   | $ | 0.99 |   | $ | 0.54 |   |

 

**ITEM 9CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIALDISCLOSURE**

 

None.

 

58

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**ITEM 9A CONTROLS AND PROCEDURES**

 

The Company’s management,with the participation of the Company’s principal executive officer andprincipal financial officer, has evaluated the effectiveness of the Company’sdisclosure controls and procedures, as such term is defined under Rule13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended(the Exchange Act), as of December 31, 2004. Based on this evaluation, theCompany’s principal executive officer and principal financial officer concludedthat our disclosure controls and procedures were effective as of December 31,2004. There have been no material changes in the Company’s internal controlover financial reporting during the fourth quarter of 2004 that has materiallyaffected, or are reasonably likely to materially affect, the Company’s internalcontrol over financial reporting.

 

As permitted by anapplicable SEC order, management’s annual report on internal control overfinancial reporting, required by Item 308(a) of Regulations S-K, and therelated attestation report of the independent registered accounting firm,required by Item 308(b) of Regulation S-K, will be filed by amendment to thisform 10-K within the required filing period.

 

**ITEM 9B OTHER INFORMATION**

 

None.

 

**PART III**

 

**ITEM 10DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT**

 

Information appearing in the Proxy Statement under thecaptions “The Board of Directors and Its Committees,” “Election of Directors,”“Security Ownership of Certain Beneficial Owners and Management,” and“Principal Officers of the Corporation” are incorporated herein by reference. Acopy of the Code of Ethics and Code of Conduct for the Company can be requestedfrom Brian Knepp, Vice President of Finance, at 300 Market Street,Williamsport, PA 17701. A link with access to the Company’s SEC 10- K filings,annual reports, and quarterly filings can be found at www.jssb.com.

 

**ITEM 11 EXECUTIVE COMPENSATION**

 

Information appearing under the captions “Compensationof Directors,” “Executive Compensation,” “Options/SAR Grants,” “AggregatedOption/SAR Exercises in Last Fiscal Year” and “FY-End Option/SAR Values,” and“Executive Employment and Severance Agreements,” in the Proxy Statement isincorporated herein by reference.

 

**ITEM 12SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATEDSTOCKHOLDER MATTERS**

 

The information appearing under the caption “SecurityOwnership of Certain Beneficial Owners and Management” in the Proxy Statementis incorporated herein by reference.

 
| ** **                                                  | ** ** | **Equity Compensation Plan  Information**                                                            | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|
| **Plan Category**                                           | ** ** | **Number of  securities to be  issued upon  exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted-  average  exercised of  outstanding options,  warrants and rights** | ** ** | **Number of  securities remaining  available for future  issuance under  equity compensation  plans [excluding  securities reflected in  column (a)]** | ** ** |
| ** **                                                  | ** ** | **(a)**                                                                                              | ** ** | **(b)** | ** ** | **(c)** | ** ** |
| Equity compensation plans  approved by security holders     |       | 15,695                                                                                               |       | $ | 40.24 |   | — |   |
| Equity compensation plans  not approved by security holders |       | —                                                                                               |       | — |   | — |   |
|                                                        |       |                                                                                                 |       |   |   |   |   |
| Total                                                       |       | 15,695                                                                                               |       | $ | 40.24 |   | — |   |

 

59

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**ITEM 13CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**

 

There have been no material transactions between theCompany and the Bank, nor any material transactions proposed, with any Directoror Executive Officer of the Company and the Bank, or any associate of theforegoing persons. The Company and the Bank have had, and intend to continue tohave, banking and financial transactions in the ordinary course of businesswith Directors and Officers of the Company and the Bank and their associates oncomparable terms and with similar interest rates as those prevailing from timeto time for other customers of the Company and the Bank. Total loansoutstanding from the Bank at December 31, 2004 to the Company’s and theBank’s Officers and Directors as a group and members of their immediatefamilies and companies in which they had an ownership interest of 10% or morewas $11,674,000 or approximately 15.96% of the total equity capital of theCompany. Loans to such persons were made in the ordinary course of business,were made on substantially the same terms, including interest rates andcollateral, as those prevailing at the time for comparable transactions with otherpersons, and did not involve more than the normal risk of collectability orpresent other unfavorable features. See also the information appearing infootnote 13 to the Consolidated Financial Statements included elsewhere in theAnnual Report.

 

**ITEM 14PRINCIPAL ACCOUNTANT FEES AND SERVICES**

 

The information appearing in the Proxy Statement underthe captions, “Audit Fees,” “Audit-Related Fees,” “Tax Fees,” “All Other Fees,”and “Audit Committee Pre-Approval Policies and Procedures” (at page 8) isincorporated herein by reference.

 

**PART IV**

 

**ITEM 15EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**

 

(a) Financial Statements

 

1. The following consolidated financial statements andreports 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. The following schedules is submitted herewith:

I. Indebtedness of Related Parties

 

The schedules not included are omitted because therequired matter or conditions are not present, the data is insignificant or therequired information is submitted as part of the consolidated financialstatements and notes thereto.

 

(b) Exhibits:

 

(3) (i) Articles ofIncorporation of the Registrant, as presently in effect (incorporated byreference to Exhibit 3.1 of the Registrant’s Registration Statement on FormS-4, No. 333-65821).

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

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

(10) (ii) EmploymentAgreement, dated November 5, 1984, between Jersey Shore State Bank and HubertA. Valencik (incorporated by reference to Exhibit (10)(iii) of the Registrant’sAnnual Report on Form 10-K for the fiscal year ended December 31, 2000).*

 

60

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

(10) (iv) EmployeeSeverance Benefit Plan, dated May 30, 1996, for Hubert A. Valencik(incorporated by reference to Exhibit (10)(v) of the Registrant’s Annual Reporton Form 10-K for the fiscal year ended December 31, 2000).*

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

(10) (vi) Amendment andRestatement of the Jersey Shore State Bank Director Deferred Fee Agreement,dated October 29, 2004, between Jersey Shore State Bank and Philip H.Bower.*

(10) (vii) Amendment andRestatement of the Jersey Shore State Bank Director Deferred Fee Agreement,dated October 29, 2004, between Jersey Shore State Bank and Lynn S.Bowes.*

(10) (viii) Amendment andRestatement of the Jersey Shore State Bank Director Deferred Fee Agreement,dated October 29, 2004, between Jersey Shore State Bank and Michael J.Casale.*

(10) (ix) Amendment andRestatement of the Jersey Shore State Bank Director Deferred Fee Agreement,dated October 29, 2004, between Jersey Shore State Bank and James M. FureyII.* dated October 29, 2004, between Jersey Shore State Bank and Jay H.McCormick.*

(10) (xi) Amendment andRestatement of the Jersey Shore State Bank Director Deferred Fee Agreement,dated October 29, 2004, between Jersey Shore State Bank and William H.Rockey.*

(10) (xii) Amendment andRestatement of the Jersey Shore State Bank Director Deferred Fee Agreement,dated October 29, 2004, between Jersey Shore State Bank and Ronald A.Walko.*

(21) Subsidiaries of theRegistrant.

(23) Consent ofIndependent Certified Public Accountants.

(31) (i) Rule13a-14(a)/Rule 15d-14(a) Certification of Chief Executive Officer

(31) (ii) Rule13a-14(a)/Rule 15d-14(a) Certification of Principle Accounting Officer

(32) (i) Section 1350Certification of Chief Executive Officer

(32) (ii) Section 1350Certification of Principle Accounting Officer

 

----

*Denotes compensatory plan or arrangement.

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13 or15(d) of the Securities Exchange Act of 1934, the Registrant has duly causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 
| March 8, 2005 | PENNS WOODS BANCORP, INC.                                    |
|--------------------|--------------------------------------------------------------|
|               |                                                         |
|               | /s/ Ronald A. Walko                                          |
|               | BY: RONALD A. WALKO  President & Chief Executive Officer |

 

Pursuant to the requirements of the Securities andExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the Registrant and in the capacities and on the datesindicated:

 
| /s/ Ronald A. Walko                                                    |               |   |
|------------------------------------------------------------------------|--------------------|--------|
| Ronald A. Walko, President & Chief Executive  Officer and Director | March 8, 2005 |
|                                                                   |               |
| /s/ Brian L. Knepp                                                     |               |   |
| Brian L. Knepp, Principal Financial  and Accounting Officer            | March 8, 2005 |
|                                                                   |               |
| /s/ Phillip H. Bower                                                   |               |   |
| Phillip H. Bower, Director                                             | March 8, 2005 |
|                                                                   |               |
| /s/ Lynn S. Bowes                                                      |               |   |
| Lynn S. Bowes, Director                                                | March 8, 2005 |

 

61

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| /s/ Michael J. Casale, Jr.                            |               |   |
|-------------------------------------------------------|--------------------|--------|
| Michael J. Casale, Jr., Director                      | March 8, 2005 |
|                                                  |               |
| /s/ H. Thomas Davis, Jr.                              |               |   |
| H. Thomas Davis, Jr., Director                        | March 8, 2005 |
|                                                  |               |
| /s/ James M. Furey, II                                |               |   |
| James M. Furey II, Director                           | March 8, 2005 |
|                                                  |               |
| /s/ Jay H. McCormick                                  |               |   |
| Jay H. McCormick, Director                            | March 8, 2005 |
|                                                  |               |
| /s/ R. Edward Nestlerode, Jr.                         |               |   |
| R. Edward Nestlerode, Jr., Director                   | March 8, 2005 |
|                                                  |               |
| /s/ James E. Plummer                                  |               |   |
| James E. Plummer, Director                            | March 8, 2005 |
|                                                  |               |
| /s/ William H. Rockey, Sr.                            |               |   |
| William H. Rockey, Sr. Vice President &  Director | March 8, 2005 |
|                                                       |                    |        |  |

 

62

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