**FORM 10-K**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON,DC 20549**

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

**For the fiscal year endedDecember 31, 2006**

**OR**

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

**For thetransition period from                                       to                      **

**Commission file number 0-17077**

**PENNS WOODS BANCORP, INC.**

(exact name ofregistrant as specified in its charter)

| **Pennsylvania**                                                           |   | **23-2226454**       |
|----------------------------------------------------------------------------|--------|----------------------|
| (State or other  jurisdiction                                              |   | (I.R.S. Employer     |
| of incorporation  or organization)                                         |   | 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** |

 

Securitiesregistered pursuant to Section 12(b) of the Act:

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

 

Securities to beregistered pursuant to Section 12(g) of the Act:

**None**

(Title of Class)

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

o Yes x No

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

o Yes x No

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports) and (2) has been subject to such filing requirements for the past90 days.YesxNoo

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

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the ExchangeAct. (Check one):

Large accelerated filer oAcceleratedfiler x Non-accelerated filer o

Indicate by check mark whether the registrantis a shell company (as defined in Rule 12b-2 of the Exchange Act).

o Yes x No

State the aggregatemarket value of the voting stock held by non-affiliates of the registrant **$151,295,164 at June 30, 2006.**

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 6, 2007** |
|--------------------------------|------------|-----------------------------------|
| Common Stock,  $8.33 Par Value |       | 3,896,492 Shares                  |

 

**DOCUMENTSINCORPORATED BY REFERENCE**

Portions of theregistrant’s definitive proxy statement prepared in connection with its annualmeeting of shareholders to be held on April 25, 2007 are incorporated byreference in Part III hereof.

 

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**INDEX**
| ** **                    | **PART I**                                                                                                             |   |
|-------------------------------|------------------------------------------------------------------------------------------------------------------------|--------|
| ** **                    | ** **                                                                                                             |   |
| **ITEM**                      |                                                                                                                   |   |
| Item 1.                       | Business                                                                                                               |   |
| Item 1A.                      | Risk Factors                                                                                                           |   |
| Item  1B.                     | Unresolved  Staff Comments                                                                                             |   |
| Item 2.                       | Properties                                                                                                             |   |
| Item 3.                       | Legal  Proceedings                                                                                                     |   |
| Item  4.                      | Submission  of Matters to a Vote of Security Holders                                                                   |   |
|                          |                                                                                                                   |   |
| ** **                    | **PART II**                                                                                                            |   |
| ** **                    | ** **                                                                                                             |   |
| Item  5.                      | Market  for the Registrant’s Common Stock, Related Stockholder Matters, and Issuer  Purchase of Equity Securities |   |
| Item 6.                       | Selected Financial  Data                                                                                               |   |
| Item 7.                       | Management’s  Discussion and Analysis of Consolidated Financial Condition and Results of  Operations              |   |
| Item 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                                                                            |   |
| Index to Exhibits             |                                                                                                                   |
| Signatures and Certifications |                                                                                                                   |

 

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**PART I**

 

**ITEM 1****                    BUSINESS**

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

##### On January 7,1983, Penns Woods Bancorp, Inc. (the “Company”) was incorporated under the lawsof the Commonwealth of Pennsylvania as a bank holding company.  The Jersey Shore State Bank (the “Bank”)became a wholly owned subsidiary of the Company, and each outstanding share ofBank common stock was converted into one share of Company common stock.  This transaction was approved by theshareholders of the Bank on April 11, 1983 and was officially effective on July12, 1983.  The Company’s two otherwholly-owned subsidiaries are Woods Real Estate Development Company, Inc. andWoods Investment Company, Inc.  TheCompany’s business has consisted primarily of managing and supervising theBank, and its principal source of income has been dividends paid by the Bankand Woods Investment Company, Inc.

The Bank isengaged in commercial and retail which includes the acceptance of time,savings, and demand deposits, the funding of commercial, consumer, and mortgageloans, and safe deposit services. Utilizing a thirteen branch office network, ATMs, internet, andtelephone banking delivery channels, the Bank delivers its products andservices to the communities it resides in.

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

Neither the Company northe Bank anticipates that compliance with environmental laws and regulationswill have any material effect on capital expenditures, earnings, or on itscompetitive position.  The Bank is not dependenton a single customer or a few customers, the loss of whom would have a materialeffect on the business of the Bank.

The Bank employed187 persons as of December 31, 2006 in either a full-time or part-timecapacity.  The Company does not have anyemployees.  The principal officers of theBank also serve as officers of the Company.

Woods InvestmentCompany, Inc., a Delaware holding company, maintains an investment portfoliothat is managed for total return and to fund dividend payments to the Company.

Woods Real EstateDevelopment Company, Inc. serves the Company through its acquisition andownership of certain properties utilized by the Bank.

A copy of the Codeof Ethics and Code of Conduct for the Corporation can be requested from BrianKnepp, Vice President of Finance, at 300 Market Street, Williamsport, PA  17701. A link with access to the Corporation’s SEC 10K filings, annual reports,and quarterly filings can be found at www.jssb.com.

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

The Company isalso subject to the provisions of the Bank Holding Company Act of 1956, asamended (the “BHCA”) and to supervision and examination by the Board ofGovernors of the Federal Reserve System (the “FRB”).  The Bank is subject to the supervision andexamination by the Federal Deposit Insurance Corporation (the “FDIC”), as itsprimary federal regulator and as the insurer of the Bank’s deposits.  The Bank is also regulated and examined bythe Pennsylvania Department of Banking (the “Department”).

The insuranceactivities 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.

The FRB has issuedregulations under the BHCA that require a bank holding company to serve as asource of financial and managerial strength to its subsidiary banks.  As a result, the FRB, pursuant to such regulations,may require the Company to

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stand ready to useits resources to provide adequate capital funds to the Bank during periods offinancial stress or adversity.  The BHCArequires the Company to secure the prior approval of the FRB before it can acquireall or substantially all of the assets of any bank, or acquire ownership orcontrol of 5% or more of any voting shares of any bank.  Such a transaction would also requireapproval of the Department.

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

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

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

**C.  Regulation of the Bank**

From time to time,various types of federal and state legislation have been proposed that couldresult in additional regulation of, and restrictions of, the business of theBank.  It cannot be predicted whether anysuch legislation will be adopted or how such legislation would affect thebusiness of the Bank.  As a consequenceof the extensive regulation of commercial banking activities in the United States,the Bank’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 atwhich an insured institution will be considered “well-capitalized,” “adequatelycapitalized,” “undercapitalized,” and “critically undercapitalized.” In theevent an institution’s capital deteriorates to the “undercapitalized” categoryor below, the Federal Deposit Insurance Act (the “FDIA”) and FDIC regulationsprescribe an increasing amount of regulatory intervention, including: (1) theinstitution of a capital restoration plan by a bank and a guarantee of the planby a parent institution; and (2) the placement of a hold on increases in assets,number of branches, or lines of business. If capital has reached the significantly or critically undercapitalizedlevels, further material restrictions can be imposed, including restrictions oninterest payable on accounts, dismissal of management and (in criticallyundercapitalized situations) appointment of a receiver.  For well-capitalized institutions, the FDIAprovides authority for regulatory intervention where the institution is deemedto be engaging in unsafe or unsound practices or receives a less thansatisfactory examination report rating for asset quality, management, earningsor liquidity.

**DepositInsurance** — Historically, there were two deposit insurancefunds administered by the FDIC - the Savings Association Insurance Fund (“SAIF”)and the Bank Insurance Fund (“BIF”).  TheBank’s deposits were insured under the BIF; however, the deposits assumed bythe Bank in connection with the merger of Lock Haven Savings Bank were treatedand assessed as SAIF-insured deposits. The FDIC has implemented a risk-related premium schedule for all insureddepository institutions that results in the assessment of premiums based oncapital and supervisory measure.  Underthe risk-related premium schedule, the FDIC assigns, on a semiannual basis,each institution to one of three capital groups (well-capitalized, adequatelycapitalized or undercapitalized) and further assigns such institution to one ofthree subgroups

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within a capitalgroup. The institution’s subgroup assignment is based upon the FDIC’s judgmentof the institution’s strength in light of supervisory evaluations, includingexamination reports, statistical analyses, and other information relevant togauging the risk posed by the institution. Only institutions with a total capital to risk-adjusted assets ratio of10.0% or greater, a Tier 1 capital  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, 2006, the Bank’s ratioswere well above required minimum ratios.

The assessmentrates range from zero for those institutions with the least risk, to $0.27 forevery $100 of insured deposits for institutions deemed to have the highestrisk.  The Bank is in the category ofinstitutions that presently pay nothing for deposit insurance.  While the Bank presently pays no premiums fordeposit insurance, it is subject to assessments to pay the interest onFinancing Corporation (“FICO”) bonds. FICO was created by Congress to issue bonds to finance the resolution offailed thrift institutions.  The currentannual FICO assessment for the Bank (and all banks) is $.0132 per $100 of BIFdeposits.

In February 2006, deposit insurance modernization legislation wasenacted.  The legislation merged the BIFand SAIF into a single Deposit Insurance Fund, increased deposit insurancecoverage for IRAs to $250,000, provided for the future increase of depositinsurance on all accounts by authorizing the FDIC to index the coverage to therate of inflation, authorized the FDIC to set the reserve ratio of the combinedDeposit Insurance Fund at a level between 1.15% and 1.50%, and permited theFDIC to establish assessments to be paid by insured banks to maintain theminimum ratios.

##### **OtherLegislation**

The Fair and Accurate Credit Transactions Act (“FACT”) was signed intolaw on December 4, 2003.  This lawextends the previously existing Fair Credit Reporting Act.  New provisions added by FACT address thegrowing problem of identity theft. Consumers will be able to initiate a fraud alert when they are victimsof identity theft, and credit reporting agencies will have additionalduties.  Consumers will also be entitledto obtain free credit reports, and will be granted certain additional privacyrights.

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 generally applies to all companies, including theCompany, that file or are required to file periodic reports with the Securitiesand Exchange Commission under the Securities Exchange Act of 1934, or theExchange 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 and NASDAQ have adopted new rules relating tocertain matters, including the independence of members of a company’s auditcommittee as a condition to listing or continued listing.

In addition,Congress is often considering some financial industry legislation. The Companycannot predict how any new legislation, or new rules adopted by the federalbanking agencies, may affect its business in the future.

In addition tofederal banking law, the Bank is subject to the Pennsylvania Banking Code. TheBanking Code was amended in late 2000 to provide more complete “parity” in thepowers of state-chartered institutions compared to national banks and federalsavings banks doing business in Pennsylvania. Pennsylvania banks have the sameability to form financial subsidiaries authorized by the Gramm-Leach-BlileyAct, as do national banks.

##### **EnvironmentalLaws**

Environmentallyrelated hazards have become a source of high risk and potential liability forfinancial institutions relating to their loans. Environmentally contaminated properties owned by an institution’sborrowers may result in a drastic reduction in the value of the collateral securingthe institution’s loans to such borrowers, high environmental clean up costs tothe borrower affecting its ability to repay the loans, the subordination of anylien in favor of the institution to a state or

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federal liensecuring clean up costs, and liability to the institution for clean up costs ifit forecloses on the contaminated property or becomes involved in themanagement of the borrower.  The Companyis not aware of any borrower who is currently subject to any environmentalinvestigation or clean up proceeding which is likely to have a material adverseeffect on the financial condition or results of operations of the Company.

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

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

##### **DESCRIPTIONOF BANK**

**Historyand Business**

Jersey Shore StateBank (“Bank”) was incorporated under the laws of the Commonwealth ofPennsylvania as a state bank in 1934 and became a wholly owned subsidiary ofthe Company on July 12, 1983.

As of December 31,2006, the Bank had total assets of $576,896,000; total shareholders’ equity of$57,789,000 and total deposits of $396,204,000. The Bank’s deposits are insured by the Federal Deposit InsuranceCorporation for the maximum amount provided under current law.

The Bank engagesin business as a commercial bank, doing business at several locations inLycoming, Clinton, and Centre Counties, Pennsylvania.  The Bank offers insurance, securitiesbrokerage services, annuity and mutual fund investment products, and financialplanning through its wholly owned subsidiary, The M Group, Inc. D/B/A TheComprehensive Financial Group.

Services offeredby the Bank include accepting time, demand and savings deposits including SuperNOW accounts, statement savings accounts, money market accounts, fixed ratecertificates of deposit, and club accounts. Its services also include making secured and unsecured business andconsumer loan that include financing commercial transactions as well asconstruction and residential mortgage loans and revolving credit loans withoverdraft protection.

The Bank’s loan portfolio mix can be classified intofour principal categories.  These arereal estate, agricultural, commercial, and consumer.  Real estate loans can be further segmentedinto construction and land development, farmland, one-to-four familyresidential, multi-family, and commercial or industrial.  Qualified borrowers are defined by policy andour underwriting standards.   Ownerprovided equity requirements range from 20% to 30% with a first lien statusrequired.  Terms are generally restrictedto between 10 and 20 years with the exception of construction and landdevelopment, which are limited to one to five years.  Real estate appraisals, property constructionverifications, and site visitations comply with policy and industry regulatorystandards.

Prospectiveresidential mortgage customer’s repayment ability is determined frominformation contained in the application and recent income tax returns.   Emphasis is on credit, employment, income,and residency verification.  Broad hazardinsurance is always required and flood insurance where applicable.  In the case of construction mortgages, buildersrisk insurance is requested.

Agricultural loansfor the purchase or improvement of real estate must meet the Bank’s real estateunderwriting criteria.  The onlypermissible exception is when a Farmers Home Loan Administration guaranty isobtained.  Agricultural loans made forthe purchase of equipment are usually payable in five years, but never morethan seven, depending upon the useful life of the purchased asset.  Minimum borrower equity ranges from 20% to30%.  Livestock financing criteriadepends upon the nature of the operation. Agricultural loans are also made for crop production purposes.  Such loans are structured to repay within theproduction cycle and not carried over into a subsequent year.

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Commercial loans are madefor the acquisition and improvement of real estate, purchase of equipment, andfor working capital purposes on a seasonal or revolving basis.  General purpose working capital loans arealso available with repayment expected within one year.  Equipment loans are generally amortized overthree to seven years, with an owner equity contribution required of at least20% of the purchase price.  Insurancecoverage with the Bank as loss payee is required, especially in the case wherethe equipment is rolling stock. It is also a general policy to collateralizenon-real estate loans with the asset purchased and, dependant upon loan terms,junior liens are filed on other available assets.  Financial information required on allcommercial mortgages includes the most current three years balance sheets andincome statements and projections on income to be developed through theproject.  In the case of corporations andpartnerships, the principals are often asked to indebt themselves personally aswell.

Seasonal andrevolving lines of credit are offered for working capital purposes.  Collateral for such a loan includes thepledge of inventory and/or receivables. Drawing availability is usually 50% of inventory and 75% of eligiblereceivables.  Eligible receivables aredefined as invoices less than 90 days delinquent.  Exclusive reliance is very seldom placed onsuch collateral; therefore, other lienable assets are also taken into thecollateral pool.  Where reliance isplaced on inventory and accounts receivable, the applicant must providefinancial information including agings on a monthly basis.  In addition, the guaranty of the principalsis usually obtained.

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

Consumer loanproducts include second mortgages, automobile financing, small loan requests,overdraft check lines, and PHEAA referral loans.  Our policy includes standards used in theindustry on debt service ratios and terms are consistent with prudentunderwriting standards and the use of proceeds.   Verifications are made of employment andresidency, along with credit history. Second mortgages are confined to equity borrowing and homeimprovements.  Terms are generally tenyears or less and rates are fixed.  Loanto collateral value criteria is 80% or less and verifications are made todetermine values.   Automobile financingis generally restricted to five years and done on a direct basis.  The Bank, as a practice, does not floor planand therefore does not discount dealer paper. Small loan requests are to accommodate personal needs such as thepurchase of small appliances or for the payment of taxes.  Overdraft check lines are limited to $5,000or less.

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

The bankingenvironment in Lycoming, Clinton, and Centre Counties, Pennsylvania is highlycompetitive.  The Bank operates thirteenfull service offices in these markets and competes for loans and deposits withnumerous commercial banks, savings and loan associations, and other financialinstitutions. The economic base of the region is developed around smallbusiness, health care, educational facilities (college and public schools),light manufacturing industries, and agriculture.

The Bank has arelatively stable deposit base and no material amount of deposits is obtainedfrom a single depositor or group of depositors, excluding public entities thataccount for approximately 10% of total deposits.  Although the Bank has regular opportunities tobid on pools of funds of $100,000 or more in the hands of municipalities,hospitals, and others, it does not rely on these monies to fund loans orintermediate or longer-term investments.

The Bank has notexperienced any significant seasonal fluctuations in the amount of itsdeposits.

**Supervisionand Regulation**

The earnings ofthe Bank are affected by the policies of regulatory authorities including theFDIC and the FRB. An important function of the FRB is to regulate the moneysupply and interest rates.  Among theinstruments used to implement these objectives are open market operations inU.S. Government Securities, changes in reserve requirements against member bankdeposits, and limitations on interest rates that member banks may pay on timeand savings deposits.

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These instrumentsare used in varying combinations to influence overall growth and distributionof bank loans, investments on deposits, and their use may also affect interestrates charged on loans or paid for deposits.

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

**ITEM 1A****          ****RISK FACTORS**

Thefollowing sets forth several risk factors that are unique to the Company.

**Changesin interest rates could reduce our income, cash flows and asset values.**

Our income and cash flows and the value of our assets depend to a greatextent on the difference between the interest rates we earn on interest-earningassets, such as loans and investment securities, and the interest rates we payon interest-bearing liabilities such as deposits and borrowings.  These rates are highly sensitive to manyfactors which are beyond our control, including general economic conditions andpolicies of various governmental and regulatory agencies and, in particular,the Board of Governors of the Federal Reserve System. Changes in monetarypolicy, including changes in interest rates, will influence not only theinterest we receive on our loans and investment securities and the amount ofinterest we pay on deposits and borrowings but will also affect our ability tooriginate loans and obtain deposits and the value of our investmentportfolio.  If the rate of interest wepay on our deposits and other borrowings increases more than the rate ofinterest we earn on our loans and other investments, our net interest income,and therefore our earnings, could be adversely affected.  Our earnings also could be adversely affectedif the rates on our loans and other investments fall more quickly than those onour deposits and other borrowings.

****Economic conditions either nationally or locally in areas in which ouroperations are concentrated may adversely affect our business******.**

Deterioration in local, regional, national or global economicconditions could cause us to experience a reduction in deposits and new loans,an increase in the number of borrowers who default on their loans and areduction in the value of the collateral securing their loans, all of whichcould adversely affect our performance and financial condition. Unlike largerbanks that are more geographically diversified, we provide banking andfinancial services locally.  Therefore,we are particularly vulnerable to adverse local economic conditions.

**Our financialcondition and results of operations would be adversely affected if ourallowance for loan losses is not sufficient to absorb actual losses or if weare required to increase our allowance.**

Despite our underwriting criteria, we may experience loan delinquenciesand losses.  In order to absorb lossesassociated with nonperforming loans, we maintain an allowance for loan lossesbased on, among other things, historical experience, an evaluation of economicconditions, and regular reviews of delinquencies and loan portfolioquality.  Determination of the allowanceinherently involves a high degree of subjectivity and requires us to makesignificant estimates of current credit risks and future trends, all of whichmay undergo material changes.  At anytime there are likely to be loans in our portfolio that will result in lossesbut that have not been identified as nonperforming or potential problemcredits. We cannot be sure that we will be able to identify deterioratingcredits before they become nonperforming assets or that we will be able tolimit losses on those loans that are identified. We may be required to increaseour allowance for loan losses for any of several reasons.  Federal regulators, in reviewing our loanportfolio as part of a regulatory examination, may request that we increase ourallowance for loan losses.  Changes ineconomic conditions affecting borrowers, new information regarding existingloans, identification of additional problem loans and other factors, bothwithin and outside of our control, may require an increase in ourallowance.  In addition, if charge-offsin future periods exceed our allowance for loan losses, we will need additionalincreases in our allowance for loan losses. Any increases in our allowance for loan losses will result in a decreasein our net income and, possibly, our capital, and may materially affect ourresults of operations in the period in which the allowance is increased.

**Many ofour loans are secured, in whole or in part, with real estate collateral whichis subject to declines in value.**

In addition to considering the financialstrength and cash flow characteristics of a borrower, we often secure our loanswith real estate collateral.  Real estatevalues and the real estate market are generally affected by, among otherthings, changes in local, regional or national economic conditions,fluctuations in interest rates and the availability of loans to potentialpurchasers, changes in tax laws and other governmental statutes, regulationsand policies, and acts of nature.  Thereal

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estate collateral provides an alternatesource of repayment in the event of default by the borrower.  If real estate prices in our markets decline,the value of the real estate collateral securing our loans could be reduced.  If we are required to liquidate real estatecollateral securing loans during a period of reduced real estate values tosatisfy the debt, our earnings and capital could be adversely affected.

**Competitionmay decrease our growth or profits.**

We face substantial competition in all phases of our operations from avariety of different competitors, including commercial banks, savings and loanassociations, mutual savings banks, credit unions, consumer finance companies,factoring companies, leasing companies, insurance companies, and money marketmutual funds.  There is very strongcompetition among financial services providers in our principal servicearea.  Our competitors may have greater resources,higher lending limits, or larger branch systems than we do.  Accordingly, they may be able to offer abroader range of products and services as well as better pricing for thoseproducts and services than we can.

In addition, some of the financial services organizations with which wecompete are not subject to the same degree of regulation as is imposed onfederally insured financial institutions. As a result, those nonbank competitors may be able to access funding andprovide various services more easily or at less cost than we can, adverselyaffecting our ability to compete effectively.

**We maybe adversely affected by government regulation.**

The banking industry is heavily regulated. Banking regulations areprimarily intended to protect the federal deposit insurance funds anddepositors, not shareholders. Changes in the laws, regulations, and regulatorypractices affecting the banking industry may increase our costs of doingbusiness or otherwise adversely affect us and create competitive advantages forothers. Regulations affecting banks and financial services companies undergocontinuous change, and we cannot predict the ultimate effect of these changes,which could have a material adverse effect on our profitability or financialcondition.

**We relyon our management and other key personnel, and the loss of any of them may adverselyaffect our operations.**

We are and will continue to be dependent upon the services of ourexecutive management team. In addition, we will continue to depend on ourability to retain and recruit key commercial loan officers. The unexpected lossof services of any key management personnel or commercial loan officers couldhave an adverse effect on our business and financial condition because of theirskills, knowledge of our market, years of industry experience, and thedifficulty of promptly finding qualified replacement personnel.

**Environmentalliability associated with lending activities could result in losses**.

In the course of our business, we may foreclose on and take title toproperties securing our loans.  Ifhazardous substances were discovered on any of these properties, we could beliable to governmental entities or third parties for the costs of remediationof the hazard, as well as for personal injury and property damage.  Many environmental laws can impose liabilityregardless of whether we knew of, or were responsible for, thecontamination.  In addition, if wearrange for the disposal of hazardous or toxic substances at another site, wemay be liable for the costs of cleaning up and removing those substances fromthe site even if we neither own nor operate the disposal site.  Environmental laws may require us to incursubstantial expenses and may materially limit use of properties we acquirethrough foreclosure, reduce their value or limit our ability to sell them inthe event of a default on the loans they secure.  In addition, future laws or more stringentinterpretations or enforcement policies with respect to existing laws mayincrease our exposure to environmental liability.

**Failure to implement new technologies in our operations mayadversely affect our growth or profits.**

The market for financial services, including banking services andconsumer finance services, is increasingly affected by advances in technology,including developments in telecommunications, data processing, computers,automation, Internet-based banking, and telebanking. Our ability to competesuccessfully in our markets may depend on the extent to which we are able toexploit such technological changes. However, we can provide no assurance thatwe will be able to properly or timely anticipate or implement such technologiesor properly train our staff to use such technologies.  Any failure to adapt to new technologiescould adversely affect our business, financial condition or operating results.

9

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**Aninvestment in our common stock is not an insured deposit.**

Our common stock is not a bank deposit and, therefore, is not insuredagainst loss by the Federal Deposit Insurance Corporation, commonly referred toas the FDIC, any other deposit insurance fund or by any other public or privateentity.  Investment in our common stockis subject to the same market forces that affect the price of common stock inany company.

**ITEM 1B****          ****UNRESOLVED STAFF COMMENTS**

None.

**ITEM 2****                    PROPERTIES**

The Company ownsand leases its properties.  Listed herewithare the locations of properties owned or leased, in which the banking officesare located; all properties are in good condition and adequate for the Bank’spurposes:
| Office        | ** ** | **Address**                                  | ** ** | **Ownership**    |
|---------------|------------|----------------------------------------------|------------|------------------|
| Main          |       | 115 South Main Street                        |       | Owned            |
|               |       | P.O. Box 5098                                |       |             |
|               |       | Jersey Shore, Pennsylvania 17740             |       |             |
|          |       |                                         |       |             |
| Bridge Street |       | 112 Bridge Street                            |       | Owned            |
|               |       | Jersey Shore, Pennsylvania 17740             |       |             |
|          |       |                                         |       |             |
| DuBoistown    |       | 2675 Euclid Avenue                           |       | Owned            |
|               |       | Williamsport, Pennsylvania 17702             |       |             |
|          |       |                                         |       |             |
| Williamsport  |       | 300 Market Street                            |       | Owned            |
|               |       | P.O. Box 967                                 |       |             |
|               |       | Williamsport, Pennsylvania 17703-0967        |       |             |
|          |       |                                         |       |             |
| Montgomery    |       | 9094 Rt. 405 Highway                         |       | Under Lease      |
|               |       | Montgomery, Pennsylvania 17752               |       |             |
|          |       |                                         |       |             |
| Lock Haven    |       | 4 West Main Street                           |       | Owned            |
|               |       | Lock Haven, Pennsylvania 17745               |       |             |
|          |       |                                         |       |             |
| Mill Hall     |       | (Inside Wal-Mart), 173 Hogan Boulevard       |       | Under Lease      |
|               |       | Mill Hall, Pennsylvania 17751                |       |             |
|          |       |                                         |       |             |
| Spring Mills  |       | 3635 Penns Valley Road, P.O. Box 66          |       | Owned            |
|               |       | Spring Mills, Pennsylvania 16875             |       |             |
|          |       |                                         |       |             |
| Centre Hall   |       | 2842 Earlystown Road                         |       | Land Under Lease |
|               |       | Centre Hall, Pennsylvania 16828              |       |             |
|          |       |                                         |       |             |
| Zion          |       | 100 Cobblestone Road                         |       | Under Lease      |
|               |       | Bellefonte, Pennsylvania 16823               |       |             |
|          |       |                                         |       |             |
| State College |       | (Inside Wal-Mart), 1665 North Atherton Place |       | Under Lease      |
|               |       | State College, Pennsylvania 16803            |       |             |
|          |       |                                         |       |             |
| State College |       | 2050 North Atherton Street                   |       | Land Under Lease |
|               |       | State College, Pennsylvania 16803            |       |             |

 

10

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| Montoursville     |   | 820 Broad Street                  |   | Under Lease |
|-------------------|--------|-----------------------------------|--------|-------------|
|                   |   | Montoursville, Pennsylvania 17754 |   |        |
|              |   |                              |   |        |
| The M Group, Inc. |   | 705 Washington Boulevard          |   | Under Lease |
| D/B/A The         |   | Williamsport, Pennsylvania 17701  |   |        |
| Comprehensive     |   |                              |   |        |
| Financial Group   |   |                              |   |        |

 

**ITEM 3****                    LEGALPROCEEDINGS**

The Company is subject to lawsuits and claims arising out of itsbusiness.  In the opinion of management,after review and consultation with counsel, any proceedings that may beassessed will not have a material adverse effect on the consolidated financialposition of the Company.

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

No matters weresubmitted to a vote of security holders during the fourth quarter of 2006.

##### **PART II**

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

The Common Stockis listed on the NASDAQ Global Market under the symbol “PWOD”.  The following table sets forth (1) thequarterly high and low prices for a share of the Company’s Common Stock duringthe periods indicated, and (2) quarterly dividends on a share of the CommonStock with respect to each quarter since January 1, 2004.
|                | ** ** | ** ** | ** ** | ** ** | ** ** | **Dividends** | ** ** |
|----------------|------------|------------|------------|------------|------------|---------------|------------|
| ** **     | ** ** | **HIGH**   | ** ** | **LOW**    | ** ** | **Declared**  | ** ** |
| **2004**       |       |       |       |       |       |          |       |
| First quarter  |       | $          | 40.33      |       | $          | 35.92         |       | $ | 0.29 |   |
| Second quarter |       | 39.09      |       | 35.39      |       | 0.29          |       |
| Third quarter  |       | 42.29      |       | 36.80      |       | 0.29          |       |
| Fourth quarter |       | 41.77      |       | 37.72      |       | 0.60          |       |
| **2005**       |       |       |       |       |       |          |       |
| First quarter  |       | $          | 41.67      |       | $          | 38.58         |       | $ | 0.38 |   |
| Second quarter |       | 41.58      |       | 37.08      |       | 0.38          |       |
| Third quarter  |       | 38.30      |       | 36.76      |       | 0.39          |       |
| Fourth quarter |       | 39.76      |       | 36.67      |       | 0.41          |       |
| **2006**       |       |       |       |       |       |          |       |
| First quarter  |       | $          | 38.75      |       | $          | 37.75         |       | $ | 0.42 |   |
| Second quarter |       | 39.50      |       | 36.50      |       | 0.43          |       |
| Third quarter  |       | 38.48      |       | 37.02      |       | 0.44          |       |
| Fourth quarter |       | 38.59      |       | 36.20      |       | 0.44          |       |

 

The Bank has paidcash dividends since 1941.  The Companyhas paid dividends since the effective date of its formation as a bank holdingcompany.  It is the present intention ofthe Registrant’s Board of Directors to continue the dividend payment policy;however, further dividends must necessarily depend upon earnings, financialcondition, appropriate legal restrictions, and other factors relevant at thetime the Board of Directors of the Registrant considers dividend policy.  Cash available for dividend distributions toshareholders of the Registrant primarily comes from dividends paid by the Bankto the Company.  Therefore, therestrictions on the Bank’s dividend payments are directly applicable to theCompany.  See also the informationappearing in Note 18 to Notes to Consolidated Financial Statements included inthe Annual Report on

11

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Form 10-K foradditional information related to dividend restrictions.

Under thePennsylvania Business Corporation Law of 1988 a corporation may not pay adividend, if after giving effect thereto, the corporation would be unable topay its debts as they become due in the usual course of business and aftergiving effect thereto the total assets of the corporation would be less thanthe sum of its total liabilities plus the amount that would be needed, if thecorporation were to be dissolved at the time of the distribution, to satisfythe preferential rights upon dissolution of the shareholders whose preferentialrights are superior to those receiving the dividend.

As of March 6, 2007, theCompany had approximately 1,300 shareholders of record.

Followingis a schedule of the shares of the Company’s common stock purchased by theCompany during the fourth quarter of 2006.
| ** **                               | ** ** | **Total**           | ** ** | **Average**         | ** ** | **Total Number of**           | ** ** | **Maximum Number (or**                    | ** ** |
|------------------------------------------|------------|---------------------|------------|---------------------|------------|-----------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                               | ** ** | **Number of**  | ** ** | **Price Paid** | ** ** | **Shares (or Units)**         | ** ** | **Approximate Dollar Value)**             | ** ** |
| ** **                               | ** ** | **Shares (or** | ** ** | **per Share**  | ** ** | **Purchased as Part of** | ** ** | **of Shares (or Units) that**   | ** ** |
| ** **                               | ** ** | **Units)**          | ** ** | **(or Units)** | ** ** | **Publicly Announced**             | ** ** | **May Yet Be Purchased**             | ** ** |
| **Period**                               | ** ** | **Purchased**       | ** ** | **Purchased**       | ** ** | **Plans or Programs**         | ** ** | **Under the Plans or Programs** | ** ** |
|                                     |       |                |       |                |       |                                    |       |                                                |       |
| Month#1(October 1- October  31, 2006)    |       | —              |       | $                   | —     |                                    | —     |                                                | —     |   |
|                                     |       |                |       |                |       |                                    |       |                                                |       |
| Month#2 (November 1- November  30, 2006) |       | 11,400              |       | 38.40               |       | 11,400                                  |       | 159,600                                             |       |
|                                     |       |                |       |                |       |                                    |       |                                                |       |
| Month#3 (December 1- December 31, 2006)  |       | 5,000               |       | 37.65               |       | 5,000                                   |       | 154,600                                             |       |
|                                          |            |                     |            |                     |            |                                         |            |                                                     |            |  |

 

Set forth below isa line graph comparing the yearly dollar changes in the cumulative shareholderreturn on the Company’s common stock against the cumulative total return of theS&P 500 Stock Index, NASDAQ Bank Index, and NASDAQ Composite for the periodof five fiscal years assuming the investment of $100.00 on December 31, 2001and assuming the reinvestment of dividends. The shareholder return shown on the graph below is not necessarilyindicative of future performance.

12

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| ** **                 | ** ** | **Period Ending** | ** ** |
|----------------------------|------------|------------------------|------------|
| **Index**                  | ** ** | **12/31/01**           | ** ** | **12/31/02** | ** ** | **12/31/03** | ** ** | **12/31/04** | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** |
| Penns Woods Bancorp,  Inc. |       | 100.00                 |       | 107.85 |   | 157.86 |   | 169.44 |   | 170.79 |   | 173.77 |   |
| S&P 500                |       | 100.00                 |       | 77.90 |   | 100.24 |   | 111.14 |   | 116.59 |   | 135.00 |   |
| NASDAQ Composite           |       | 100.00                 |       | 68.76 |   | 103.67 |   | 113.16 |   | 115.57 |   | 127.58 |   |
| NASDAQ Bank Index          |       | 100.00                 |       | 106.95 |   | 142.29 |   | 161.73 |   | 158.61 |   | 180.53 |   |

13

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**ITEM 6       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, 2006.
| **(In Thousands, Except Per Share Data)** | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|--------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                         | ** ** | ** ** | ** ** | ** ** |       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Consolidated  Statement of Income Data:                            |       |       |       |       |       |       |       |       |       |       |       |
| Interest income                                                    |       | $          | 33,753     |       | $          | 30,903     |       | $          | 29,845     |       | $          | 28,384 |   | $ | 28,465 |   |
| Interest expense                                                   |       | 14,210     |       | 10,381     |       | 8,768      |       | 9,265      |       | 10,846     |       |
| Net interest  income                                               |       | 19,543     |       | 20,522     |       | 21,077     |       | 19,119     |       | 17,619     |       |
| Provision for  loan losses                                         |       | 635        |       | 720        |       | 465        |       | 255        |       | 365        |       |
| Net interest  income after provision for loan losses               |       | 18,908     |       | 19,802     |       | 20,612     |       | 18,864     |       | 17,254     |       |
| Noninterest  income                                                |       | 9,029      |       | 9,431      |       | 8,918      |       | 9,150      |       | 5,965      |       |
| Noninterest  expense                                               |       | 16,329     |       | 15,108     |       | 14,184     |       | 13,137     |       | 12,086     |       |
| Income before  income taxes                                        |       | 11,608     |       | 14,125     |       | 15,346     |       | 14,877     |       | 11,133     |       |
| Applicable  income taxes                                           |       | 1,961      |       | 3,224      |       | 4,263      |       | 3,703      |       | 2,247      |       |
| Net Income                                                         |       | $          | 9,647      |       | $          | 10,901     |       | $          | 11,083     |       | $          | 11,174 |   | $ | 8,886 |   |
|                                                               |       |       |       |       |       |       |       |       |       |       |       |
| Consolidated  Balance Sheet at End of Period:                      |       |       |       |       |       |       |       |       |       |       |       |
| Total assets                                                       |       | $          | 592,285    |       | $          | 568,668    |       | $          | 546,703    |       | $          | 527,381 |   | $ | 472,206 |   |
| Loans                                                              |       | 360,384    |       | 338,438    |       | 324,505    |       | 275,828    |       | 257,845    |       |
| Allowance for  loan losses                                         |       | (4,185     | )          | (3,679     | )          | (3,338     | )          | (3,069     | )          | (2,953     | )          |
| Deposits                                                           |       | 395,191    |       | 352,529    |       | 356,836    |       | 334,318    |       | 339,848    |       |
| Long-term debt —  other                                       |       | 82,878     |       | 84,478     |       | 75,878     |       | 70,878     |       | 51,778     |       |
| Shareholders’  equity                                         |       | 74,594     |       | 73,919     |       | 73,165     |       | 69,769     |       | 63,142     |       |
|                                                               |       |       |       |       |       |       |       |       |       |       |       |
| Per Share Data:                                                    |       |       |       |       |       |       |       |       |       |       |       |
| Earnings per  share - Basic                                        |       | $          | 2.45       |       | $          | 2.75       |       | $          | 2.78       |       | $          | 2.79 |   | $ | 2.22 |   |
| Earnings per  share - Diluted                                      |       | 2.45       |       | 2.74       |       | 2.78       |       | 2.79       |       | 2.22       |       |
| Cash dividends  declared                                           |       | 1.73       |       | 1.56       |       | 1.47       |       | 1.24       |       | 1.03       |       |
| Book value                                                         |       | 19.12      |       | 18.59      |       | 18.36      |       | 17.50      |       | 15.78      |       |
| Number of shares  outstanding, at end of period                    |       | 3,900,742  |       | 3,975,787  |       | 3,985,832  |       | 3,985,872  |       | 3,637,595  |       |
| Average number  of shares outstanding-basic                        |       | 3,934,138  |       | 3,971,926  |       | 3,990,008  |       | 3,996,702  |       | 4,003,575  |       |
|                                                               |       |       |       |       |       |       |       |       |       |       |       |
| Selected  financial ratios:                                        |       |       |       |       |       |       |       |       |       |       |       |
| Return on  average shareholders’ equity                       |       | 12.93      | %          | 14.54      | %          | 15.49      | %          | 16.60      | %          | 15.00      | %          |
| Return on  average total assets                                    |       | 1.67       | %          | 1.97       | %          | 2.06       | %          | 2.24       | %          | 2.01       | %          |
| Net interest  income to average interest earning assets            |       | 4.06       | %          | 4.29       | %          | 4.32       | %          | 4.36       | %          | 4.25       | %          |
| Dividend payout  ratio                                             |       | 70.51      | %          | 57.10      | %          | 52.72      | %          | 44.76      | %          | 46.40      | %          |
| Average  shareholders’ equity to average total assets         |       | 12.92      | %          | 13.56      | %          | 13.30      | %          | 13.51      | %          | 13.39      | %          |
| Loans to deposits, at  end of period                               |       | 91.19      | %          | 96.00      | %          | 90.94      | %          | 82.50      | %          | 75.87      | %          |

 

Per share data andnumber of shares outstanding have been adjusted in each reporting period togive retroactive effect to a 10% stock dividend issued October 30, 2003 and asix for five stock split issued November 18, 2005.

14

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**ITEM 7       MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATION**

**RESULTS OF OPERATIONS**

**NETINTEREST INCOME**

Net interest income is determined by calculating the difference betweenthe yields earned on interest-earning assets and the rates paid oninterest-bearing liabilities.  To comparethe tax-exempt asset yields to taxable yields, amounts are adjusted to taxableequivalents based on the marginal corporate federal tax rate of 34%.  The tax equivalent adjustments to netinterest income for 2006, 2005, and 2004 were $2,245,000, $1,764,000, and$906,000, respectively.

**2006 vs2005**

Reported netinterest income decreased $979,000 or 4.8% to $19,543,000 for the year endedDecember 31, 2006 as compared to the year ended December 31, 2005 as the yieldon earning assets increased to 6.70% from 6.29%, respectively.  On a tax equivalent basis the change in net interest income was adecrease of $498,000 which is the result of the rate paid on interest bearingliabilities increasing at nearly twice the rate of increases in the yield onearning assets.  Total interestincome increased 9.2% or $2,850,000 primarily due to growth in the averagebalance of the loan portfolio of $22,150,000 coupled with an increase in loanyield to 7.10% from 6.73% at December 31, 2005. Interest and dividend income generated from the investment portfolio andinterest bearing cash deposits increased $98,000.  The increase was the result of the yield onthe investment portfolio increasing 39 basis points while the average balanceof the investment portfolio declined by $3,474,000.

Interest expense increased $3,829,000 to $14,210,000 for the year endedDecember 31, 2006 as compared to 2005. The majority of the increase, 82% or $3,134,000, is related to increasedrates being paid on deposit accounts, which had an average rate paid of 2.88%and 1.98% for the years ended December 31, 2006 and 2005, respectively.  The increases were driven by marketcompetition and rate increases enacted by the Federal Open Markets Committee(FOMC).  Interest expense related to timedeposits increased $2,827,000 as the average rate paid on time depositsincreased to 4.11% from 3.02% for the year ended December 31, 2005.  The increase in time deposit rates was theresult of competitive pressure, FOMC rate increases, rate specials related to theopening of a new branch and the one year anniversary of a second, and incentiveto customers to invest in short-term time deposits.  In addition, the average balance in timedeposits increased $30,130,000 due to the before mentioned rate specials, transferof dollars from transaction accounts due to the increasing rate disparitybetween products, and the use of brokered deposits to limit the reliance onshort-term FHLB funding

The rate paid on borrowings increased to 4.50% from 4.08% for the yearended December 31, 2006.  The increase inrate resulted in interest expense on borrowings increasing $695,000 with themajority of the increase occurring in the short-term borrowing category.  The short-term borrowing rate increased 144basis points to 4.34% due to the FOMC rate increases since the start of2005.  Interest expense associated withlong-term borrowings increased $123,000 due to the average balance of long-termFHLB borrowings increasing $2,417,000 while the weighted average interest rateon the long-term debt remained constant.

**2005 vs2004**

Reported netinterest income decreased $555,000 or 2.6 % from the year ended December 31,2004 to 2005.  Total interest incomeincreased $1,058,000 and is attributed to the increase of $27,940,000 in theaverage balance of the loan portfolio coupled with an increase of the taxequivalent yield on investment securities of 45 basis points offset partiallyby a decrease in the average balance of the investment securities of$17,608,000.

On a tax equivalent basis, net interest income increased to $22,286,000from $21,983,000 for the year ended December 31, 2004.  The tax equivalent interest income on theinvestment portfolio remained stable despite a decrease in the average

15

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balance of the investment portfolio of $17,608,000.  Offsetting the decline in average balance ofthe portfolio was a shift in the portfolio to tax-exempt bonds fromtaxable.  This repositioning wasundertaken to provide portfolio call protection, strategic investment at thecommunity level, and as part of the Company’s tax strategy.  The net growth in the volume of the loanportfolio was the driving force behind the increase in loan interest income asthe yield on loans increased 3 basis points to 6.73% at December 31, 2005.

For the year ended December 31, 2005, reported interest expense increased$1,613,000 over the same period of 2004. Over half of the increased level of interest expense was due to marketdriven increases in the rates paid on deposit accounts.  The increases are primarily the result of thecontinued rate increases enacted by the FOMC coupled with aggressive pricingdue to competition for deposits.  Inaddition, deposit dollars have shifted from lower rate transaction basedaccounts to higher rate time deposits during 2005.  This shift has resulted in the averagebalance of time deposits increasing $16,051,000 in 2005 as compared to2004.  The shift in dollars and the FOMCrate increases resulted in the average rate paid on deposits increasing to1.98% from 1.65% for the year ended December 31, 2004 with the time deposit portfolioaverage rate increasing 40 basis points over the time period.

The Company increased long-term borrowing during 2005 through the FHLBto manage future borrowing costs and to enhance liability positioning.  These additional borrowings were utilized bymanagement to replace maturing debt and to supplement the funding of the growthin the loan portfolio.  The increase inthe expense on long-term borrowings is the result of average balances oflong-term FHLB borrowings increasing $5,093,000 while the weighted averageinterest rate on the long-term debt remained constant.  Short-term borrowing interest increased$392,000 as a result of the before mentioned FOMC rate increases and anincrease of the average balances outstanding during the year of $257,000.

**AVERAGE BALANCES 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 and costs are derived by dividingincome or expense by the average balance of assets or liabilities,respectively, for the periods presented.

16

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| ** **                                       | ** ** | **2006**                 | ** ** |
|--------------------------------------------------|------------|--------------------------|------------|
| **(In Thousands)**                          | ** ** | **Average Balance** | ** ** | **Interest** | ** ** | **Average Rate** | ** ** |
| ASSETS:                                          |       |                     |       |   |   |   |   |
| Tax-exempt loans                                 |       | $                        | 8,173      |   | $ | 503 |   | 6.15 | % |
| All other loans                                  |       | 344,524                  |       | 24,545 |   | 7.12 | % |
| Total loans                                      |       | 352,697                  |       | 25,048 |   | 7.10 | % |
|                                             |       |                     |       |   |   |   |   |
| Taxable  securities                              |       | 91,767                   |       | 4,837 |   | 5.27 | % |
| Tax-exempt  securitites                          |       | 92,692                   |       | 6,102 |   | 6.58 | % |
| Total securities                                 |       | 184,459                  |       | 10,939 |   | 5.93 | % |
|                                             |       |                     |       |   |   |   |   |
| Interest-bearing  deposits                       |       | 152                      |       | 11 |   | 7.24 | % |
|                                             |       |                     |       |   |   |   |   |
| Total  interest-earning assets                   |       | 537,308                  |       | 35,998 |   | 6.70 | % |
|                                             |       |                     |       |   |   |   |   |
| Other assets                                     |       | 40,413                   |       |   |   |   |   |
|                                             |       |                     |       |   |   |   |   |
| Total assets                                     |       | $                        | 577,721    |   |   |   |   |   |
|                                             |       |                     |       |   |   |   |   |
| LIABILITIES:                                     |       |                     |       |   |   |   |   |
| Savings                                          |       | $                        | 61,958     |   | 509 |   | 0.82 | % |
| Super Now  deposits                              |       | 47,294                   |       | 655 |   | 1.38 | % |
| Money market  deposits                           |       | 23,905                   |       | 493 |   | 2.06 | % |
| Time deposits                                    |       | 176,521                  |       | 7,251 |   | 4.11 | % |
| Total deposits                                   |       | 309,678                  |       | 8,908 |   | 2.88 | % |
|                                             |       |                     |       |   |   |   |   |
| Short-term  borrowings                           |       | 34,612                   |       | 1,503 |   | 4.34 | % |
| Long-term  borrowings                            |       | 83,237                   |       | 3,799 |   | 4.56 | % |
| Total borrowings                                 |       | 117,849                  |       | 5,302 |   | 4.50 | % |
|                                             |       |                     |       |   |   |   |   |
| Total  interest-bearing liabilities              |       | 427,527                  |       | 14,210 |   | 3.32 | % |
|                                             |       |                     |       |   |   |   |   |
| Demand deposits                                  |       | 69,668                   |       |   |   |   |   |
| Other  liabilities                               |       | 5,899                    |       |   |   |   |   |
| Shareholders’  equity                       |       | 74,627                   |       |   |   |   |   |
|                                             |       |                     |       |   |   |   |   |
| TOTAL LIABILITIES  AND SHAREHOLDERS’ EQUITY |       | $                        | 577,721    |   |   |   |   |   |
| Interest rate  spread                            |       |                     |       |   |   | 3.38 | % |
| Net interest  income/margin                      |       |                     |       | $ | 21,788 |   | 4.06 | % |

 

Fees on loans are included with interest onloans.  Loan fees are included ininterest income as follows:  2006 $478,000,2005 $491,000, 2004 $470,000

Information onthis table has been calculated using average daily balances to obtain average balances.

Nonaccrual loanshave been included with loans for the purpose of analyzing net interestearnings.

Income and rates on a fully taxable equivalent basisinclude an adjustment for the difference between annual income from tax-exemptobligations and the taxable equivalent of such income at the standard 34% taxrate.

17

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| ** **                                       | ** ** | **2005**                 | ** ** | **2004**     | ** ** |
|--------------------------------------------------|------------|--------------------------|------------|--------------|------------|
| **(In Thousands)**                          | ** ** | **Average Balance** | ** ** | **Interest** | ** ** | **Average Rate** | ** ** | **Average Balance** | ** ** | **Interest** | ** ** | **Average Rate** | ** ** |
| ASSETS:                                          |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Tax-exempt loans                                 |       | $                        | 5,370      |         | $          | 307 |   | 5.72 | % | $ | 1,359 |   | $ | 82 |   | 6.03 | % |
| All other loans                                  |       | 325,177                  |       | 21,924       |       | 6.74 | % | 301,248 |   | 20,207 |   | 6.71 | % |
| Total loans                                      |       | 330,547                  |       | 22,231       |       | 6.73 | % | 302,607 |   | 20,289 |   | 6.70 | % |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Taxable  securities                              |       | 115,041                  |       | 5,529        |       | 4.81 | % | 170,876 |   | 7,872 |   | 4.61 | % |
| Tax-exempt  securitites                          |       | 72,892                   |       | 4,882        |       | 6.70 | % | 34,665 |   | 2,586 |   | 7.46 | % |
| Total securities                                 |       | 187,933                  |       | 10,411       |       | 5.54 | % | 205,541 |   | 10,458 |   | 5.09 | % |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits                       |       | 873                      |       | 25           |       | 2.86 | % | 434 |   | 4 |   | 0.92 | % |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Total  interest-earning assets                   |       | 519,353                  |       | 32,667       |       | 6.29 | % | 508,582 |   | 30,751 |   | 6.05 | % |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Other assets                                     |       | 33,308                   |       |         |       |   |   | 29,064 |   |   |   |   |   |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Total assets                                     |       | $                        | 552,661    |         |       |   |   |   | $ | 537,646 |   |   |   |   |   |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| LIABILITIES:                                     |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Savings                                          |       | $                        | 64,795     |         | 500        |   | 0.77 | % | $ | 69,796 |   | 578 |   | 0.83 | % |
| Super Now  deposits                              |       | 50,756                   |       | 438          |       | 0.86 | % | 54,690 |   | 391 |   | 0.71 | % |
| Money market  deposits                           |       | 29,317                   |       | 412          |       | 1.41 | % | 35,164 |   | 392 |   | 1.11 | % |
| Time deposits                                    |       | 146,391                  |       | 4,424        |       | 3.02 | % | 130,340 |   | 3,414 |   | 2.62 | % |
| Total deposits                                   |       | 291,259                  |       | 5,774        |       | 1.98 | % | 289,990 |   | 4,775 |   | 1.65 | % |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Short-term  borrowings                           |       | 32,114                   |       | 931          |       | 2.90 | % | 31,857 |   | 539 |   | 1.69 | % |
| Long-term  borrowings                            |       | 80,820                   |       | 3,676        |       | 4.55 | % | 75,727 |   | 3,454 |   | 4.56 | % |
| Total borrowings                                 |       | 112,934                  |       | 4,607        |       | 4.08 | % | 107,584 |   | 3,993 |   | 3.71 | % |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Total  interest-bearing liabilities              |       | 404,193                  |       | 10,381       |       | 2.57 | % | 397,574 |   | 8,768 |   | 2.21 | % |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| Demand deposits                                  |       | 69,457                   |       |         |       |   |   | 64,434 |   |   |   |   |   |
| Other liabilities                                |       | 4,057                    |       |         |       |   |   | 4,091 |   |   |   |   |   |
| Shareholders’  equity                       |       | 74,954                   |       |         |       |   |   | 71,547 |   |   |   |   |   |
|                                             |       |                     |       |         |       |   |   |   |   |   |   |   |   |
| TOTAL LIABILITIES  AND SHAREHOLDERS’ EQUITY |       | $                        | 552,661    |         |       |   |   |   | $ | 537,646 |   |   |   |   |   |
| Interest rate  spread                            |       |                     |       |         |       | 3.72 | % |   |   |   |   | 3.84 | % |
| Net interest  income/margin                      |       |                     |       | $            | 22,286     |   | 4.29 | % |   |   | $ | 21,983 |   | 4.32 | % |

 

**Reconcilement of Taxable EquivalentNet Interest Income**

 
| ** **                                      | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                            |       |     |       |     |       |     |       |
| Total interest  income                          |       | $        | 33,753     |     | $          | 30,903   |       | $ | 29,845 |   |
| Total interest  expense                         |       | 14,210   |       | 10,381   |       | 8,768    |       |
|                                            |       |     |       |     |       |     |       |
| Net interest  income                            |       | 19,543   |       | 20,522   |       | 21,077   |       |
| Tax equivalent  adjustment                      |       | 2,245    |       | 1,764    |       | 906      |       |
|                                            |       |     |       |     |       |     |       |
| Net interest income  (fully taxable equivalent) |       | $        | 21,788     |     | $          | 22,286   |       | $ | 21,983 |   |

 

18

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**Rate/VolumeAnalysis**

The table belowsets forth certain information regarding changes in our interest income andinterest expense for the periods indicated. For interest-earning assets andinterest-bearing liabilities, information is provided on changes attributableto (i) changes in volume (changes in average volume multiplied by old rate) and(ii) changes in rates (changes in rate multiplied by old average volume).Increases and decreases due to both interest rate and volume, which cannot beseparated, have been allocated proportionally to the change due to volume andthe change due to interest rate.  Incomeand interest rates are on a taxable equivalent basis.
|                                    | ** ** | **Year Ended December 31,**                        | ** ** |
|------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                         | ** ** | **2006 vs 2005  Increase (Decrease)  Due to** | ** ** | **2005 vs 2004  Increase (Decrease)  Due to** | ** ** |
| **(In Thousands)**            | ** ** | **Volume**                                                        | ** ** | **Rate** | ** ** | **Net** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Net** | ** ** |
| **Interest  income:**              |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |
| Loans,  tax-exempt                 |       | $                                                                 | 174        |   | $ | 22 |   | $ | 196 |   | $ | 229 |   | $ | (4 | ) | $ | 225 |   |
| Loans                              |       | 1,342                                                             |       | 1,279 |   | 2,621 |   | 1,614 |   | 103 |   | 1,717 |   |
| Taxable  investment securities     |       | (1,192                                                            | )          | 500 |   | (692 | ) | (2,670 | ) | 327 |   | (2,343 | ) |
| Tax-exempt  investment securities  |       | 1,304                                                             |       | (84 | ) | 1,220 |   | 2,585 |   | (289 | ) | 2,296 |   |
| Interest-bearing  deposits         |       | (32                                                               | )          | 18 |   | (14 | ) | 7 |   | 14 |   | 21 |   |
| Total interest-earning assets      |       | 1,596                                                             |       | 1,735 |   | 3,331 |   | 1,765 |   | 151 |   | 1,916 |   |
|                               |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |
| **Interest  expenses:**            |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |
| Savings deposits                   |       | (23                                                               | )          | 32 |   | 9 |   | (40 | ) | (38 | ) | (78 | ) |
| Super Now  deposits                |       | (32                                                               | )          | 249 |   | 217 |   | (29 | ) | 76 |   | 47 |   |
| Money market  deposits             |       | (86                                                               | )          | 167 |   | 81 |   | (72 | ) | 92 |   | 20 |   |
| Time deposits                      |       | 471                                                               |       | 2,356 |   | 2,827 |   | 161 |   | 849 |   | 1,010 |   |
| Short-term  borrowings             |       | 65                                                                |       | 507 |   | 572 |   | 4 |   | 388 |   | 392 |   |
| Long-term  borrowings              |       | 110                                                               |       | 13 |   | 123 |   | 231 |   | (9 | ) | 222 |   |
| Total interest-bearing liabilities |       | 505                                                               |       | 3,324 |   | 3,829 |   | 255 |   | 1,358 |   | 1,613 |   |
| Change in net interest  income     |       | $                                                                 | 1,091      |   | $ | (1,589 | ) | $ | (498 | ) | $ | 1,510 |   | $ | (1,207 | ) | $ | 303 |   |

 

### **PROVISION FOR LOAN LOSSES**

**2006 vs 2005**

The provision for loan losses is based upon management’s quarterlyreview of the loan portfolio.  Thepurpose 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 marketsserved.  An external independent loanreview is also performed annually for the Bank. Management remains committed to an aggressive program of problem loanidentification and resolution.

The allowance is calculated by applying loss factors to outstandingloans by type, excluding loans for which a specific allowance has beendetermined.  Loss factors are based onmanagement’s consideration of the nature of the portfolio segments, changes inmix and volume of the loan portfolio, and historical loan loss experience.  In addition, management considers industrystandards and trends with respect to nonperforming loans and its knowledge andexperience with specific lending segments.

Although management believes that it uses the best informationavailable to make such determinations and that the allowance for loan losses isadequate at December 31, 2006, future adjustments could be necessary if circumstancesor economic conditions differ substantially from the assumptions used in makingthe initial determinations.  A downturnin the local economy or employment and delays in receiving financialinformation from borrowers could result in increased levels ofnonperforming assets and charge-offs, increased loan loss provisions andreductions in interest income. Additionally, as an integral part of the

19

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examinationprocess, bank regulatory agencies periodically review the Bank’s loan lossallowance.  The banking regulators could require the recognition of additions to theloan loss allowance based on their judgment of information available to them atthe time of their examination.

The allowance for loan losses increased from $3,679,000 at December 31,2005 to $4,185,000 at December 31, 2006. At December 31, 2006, allowance for loan losses was 1.16% of total loanscompared to 1.09% of total loans at December 31, 2005.  Management’s conclusion is that the allowancefor loan losses is adequate to provide for probable losses inherent in its loanportfolio as of the consolidated balance sheet date.

The provision for loan losses totaled $635,000 for the year endedDecember 31, 2006.  The provision for thesame period in 2005 was $720,000. Management concluded that the decrease of the provision was appropriatewhen considering the gross loan growth experienced during 2006 of $21,946,000coupled with the low levels of charge-offs, delinquencies and economic changesduring the year.  Utilizing both internaland external resources, as noted, senior management has concluded that theallowance for loan losses remains at a level adequate to provide for probablelosses inherent in the loan portfolio.

**2005 vs 2004**

The allowance for loan losses increased 10.2% or $341,000 from fiscal2004 after net charge-offs of $379,000 contributed to a year-end allowance forloan losses of  $3,679,000 or 1.09% oftotal loans.** **Basedupon this analysis, as well as the others noted above, senior managementconcluded that the allowance for loan losses was at a level adequate to providefor probable losses inherent in the loan portfolio at December 31, 2005.

Following is a table showing the changes in the allowance for loanlosses for the years ended December 31:
| (In Thousands)                                                                        | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Balance at  beginning of period                                                            |       | $        | 3,679      |     | $          | 3,338    |       | $        | 3,069      |     | $          | 2,953 |   | $ | 2,927 |   |
| Charge-offs:                                                                               |       |     |       |     |       |     |       |     |       |     |       |
| Real estate                                                                                |       | 50       |       | 132      |       | 121      |       | 63       |       | 262      |       |
| Commercial and industrial                                                                  |       | 28       |       | 206      |       | 50       |       | 37       |       | 80       |       |
| Installment loans to individuals                                                           |       | 249      |       | 108      |       | 112      |       | 116      |       | 60       |       |
| Total charge-offs                                                                          |       | 327      |       | 446      |       | 283      |       | 216      |       | 402      |       |
| Recoveries:                                                                                |       |     |       |     |       |     |       |     |       |     |       |
| Real estate                                                                                |       | 68       |       | 45       |       | 50       |       | 42       |       | 25       |       |
| Commercial and industrial                                                                  |       | 40       |       | 8        |       | 4        |       | 16       |       | 21       |       |
| Installment loans to individuals                                                           |       | 90       |       | 14       |       | 33       |       | 19       |       | 17       |       |
| Total recoveries                                                                           |       | 198      |       | 67       |       | 87       |       | 77       |       | 63       |       |
| Net charge-offs                                                                            |       | 129      |       | 379      |       | 196      |       | 139      |       | 339      |       |
| Additions  charged to operations                                                           |       | 635      |       | 720      |       | 465      |       | 255      |       | 365      |       |
| Balance at end  of period                                                                  |       | $        | 4,185      |     | $          | 3,679    |       | $        | 3,338      |     | $          | 3,069 |   | $ | 2,953 |   |
| Ratio of net  charge-offs during the period to average loans outstanding during the period |       | 0.04     | %          | 0.11     | %          | 0.06     | %          | 0.05     | %          | 0.13     | %          |

 

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### **NON-INTEREST INCOME**

**2006 vs2005**

Total non-interest income decreased $402,000 from  the year ended December 31, 2005 to2006.  Excluding security gains and thegain on sale of loans, non-interest income increased $120,000.  Service charges increased $138,000 due to thefull year impact of an overdraft protection program that was started in May2005.  Earnings on bank-owned lifeinsurance decreased $194,000, however, the year ended December 31, 2005included the receipt of $196,000 due to a death benefit claim.  Insurance commissions decreased $46,000 dueto a reduction in the overall commission, from the underwriter, that The MGroup receives on each insurance contract written.  Management of The M Group continues to pursuenew and build upon current relationships. However, the sales cycle for insurance and investment products can taketypically from six months to one year or more to complete. The sales callprogram continues to expand to other financial institutions, which results inadditional revenue for The M Group.  Theincrease in other income was primarily due to increases in revenues from debitcards and fees associated with the origination of mortgage loans on the behalfof PHFA and other secondary market entities.
|                            | ** ** | **2006**   | ** ** | **2005**         | ** ** | **Change** | ** ** |
|----------------------------|------------|------------|------------|------------------|------------|------------|------------|
| **(In Thousands)**    | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Deposit service  charges   |       | $          | 2,366      |             | 26.20      | %          | $          | 2,228 |   | 23.62 | % | $ | 138 |   | 6.19 | % |
| Securities  gains, net     |       | 1,679      |       | 18.60            |       | 2,190      |       | 23.22 |   | (511 | ) | (23.33 | ) |
| Bank-owned life  insurance |       | 374        |       | 4.14             |       | 568        |       | 6.02 |   | (194 | ) | (34.15 | ) |
| Gain on sale of  loans     |       | 853        |       | 9.45             |       | 864        |       | 9.16 |   | (11 | ) | (1.27 | ) |
| Insurance  commissions     |       | 2,281      |       | 25.26            |       | 2,327      |       | 24.68 |   | (46 | ) | (1.98 | ) |
| Other income               |       | 1,476      |       | 16.35            |       | 1,254      |       | 13.30 |   | 222 |   | 17.70 |   |
| Total  non-interest income |       | $          | 9,029      |             | 100.00     | %          | $          | 9,431 |   | 100.00 | % | $ | (402 | ) | (4.26 | )% |

 

**2005 vs2004**

Total non-interestincome increased $513,000 from fiscal 2004 to 2005.  Excluding security gains and the gain on saleof loans, non-interest income increased $604,000.  Service charges increased $245,000 due to theimplementation of a new overdraft protection program that was started in May2005.  Earnings on bank-owned lifeinsurance increased $274,000 due in large part to the receipt of  $196,000 due to a death benefit claim.  Commissions earned on the sale of insuranceproducts increased $45,000 as The M Group continued to expand its market areaby adding sales representatives to meet commitments made with other financialinstitutions to provide these same services to their customers.  Gain on sale of loans decreased as the volumeof loans sold decreased as compared to 2004. The increase in other income was primarily due to increases in cardrevenues from both ATM and debit cards offset by decreases in other areas ofother income.  Transaction volumeincreases attributed to our customers increased utilization of debit cardsresulting in debit card fees increasing $74,000.
|                            | ** ** | **2005**   | ** ** | **2004**         | ** ** | **Change** | ** ** |
|----------------------------|------------|------------|------------|------------------|------------|------------|------------|
| **(In Thousands)**    | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Deposit service  charges   |       | $          | 2,228      |             | 23.62      | %          | $          | 1,983 |   | 22.24 | % | $ | 245 |   | 12.36 | % |
| Securities  gains, net     |       | 2,190      |       | 23.22            |       | 2,176      |       | 24.40 |   | 14 |   | 0.64 |   |
| Bank-owned life  insurance |       | 568        |       | 6.02             |       | 294        |       | 3.30 |   | 274 |   | 93.20 |   |
| Gain on sale of  loans     |       | 864        |       | 9.16             |       | 969        |       | 10.87 |   | (105 | ) | (10.84 | ) |
| Insurance  commissions     |       | 2,327      |       | 24.68            |       | 2,282      |       | 25.58 |   | 45 |   | 1.97 |   |
| Other income               |       | 1,254      |       | 13.30            |       | 1,214      |       | 13.61 |   | 40 |   | 3.29 |   |
| Total  non-interest income |       | $          | 9,431      |             | 100.00     | %          | $          | 8,918 |   | 100.00 | % | $ | 513 |   | 5.75 | % |

 

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### **NON-INTEREST EXPENSES**

**2006 vs2005**

Total non-interestexpenses increased $1,221,000 from the year ended December 31, 2005 to December31, 2006. Salaries and employee benefits increased by $519,000 and was theresult of increased staffing due in part to two new branches since mid 2005,standard wage increases, and increased health insurance costs.  Occupancy expense and furniture and equipmentexpenses increased primarily due to the before mentioned branch additions andincreased maintenance costs related to the software and equipment utilized bythe Bank.  Other expenses increased$377,000 as amortization of the low income housing partnership investmentsincreased $155,000 and due to general increases in the cost of businessspecifically Pennsylvania shares tax, donations, and director fees.   The increase in low income housingpartnership investment amortization is the result of the Bank’s involvementwith two partnerships that became eligible for tax credit recognition during2006.
|                                 | ** ** | **2006**   | ** ** | **2005**         | ** ** | **Change** | ** ** |
|---------------------------------|------------|------------|------------|------------------|------------|------------|------------|
| **(In Thousands)**         | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Salaries and  employee benefits |       | $          | 8,833      |             | 54.09      | %          | $          | 8,314 |   | 55.03 | % | $ | 519 |   | 6.24 | % |
| Occupancy, net                  |       | 1,137      |       | 6.96             |       | 1,089      |       | 7.21 |   | 48 |   | 4.41 |   |
| Furniture and  equipment        |       | 1,201      |       | 7.36             |       | 973        |       | 6.44 |   | 228 |   | 23.43 |   |
| Pennsylvania  shares tax        |       | 598        |       | 3.66             |       | 549        |       | 3.63 |   | 49 |   | 8.93 |   |
| Other expenses                  |       | 4,560      |       | 27.93            |       | 4,183      |       | 27.69 |   | 377 |   | 9.01 |   |
| Total  non-interest expense     |       | $          | 16,329     |             | 100.00     | %          | $          | 15,108 |   | 100.00 | % | $ | 1,221 |   | 8.08 | % |

 

**2005 vs2004**

Total non-interestexpenses increased $924,000 from the year ended December 31, 2004 to December31, 2005. Salaries and employee benefits increased by $510,000 and was theresult of increased staffing due in part to a new branch in the State Collegearea, standard wage increases, and increased pension and health insurancecosts.  Occupancy expense increased dueprimarily to the new State College office which was operational since May2005.  Furniture and equipment expensesdeclined due in part to the reduction of several computer, hardware, and equipmentmaintenance contracts deemed unnecessary. Other expenses increased $286,000 due to general increases in the costof business specifically ATM transaction processing, advertising, telephone,stationery, and office supplies.
|                                 | ** ** | **2005**   | ** ** | **2004**         | ** ** | **Change** | ** ** |
|---------------------------------|------------|------------|------------|------------------|------------|------------|------------|
| **(In Thousands)**         | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Salaries and  employee benefits |       | $          | 8,314      |             | 55.03      | %          | $          | 7,804 |   | 55.03 | % | $ | 510 |   | 6.54 | % |
| Occupancy, net                  |       | 1,089      |       | 7.21             |       | 959        |       | 6.76 |   | 130 |   | 13.56 |   |
| Furniture and  equipment        |       | 973        |       | 6.44             |       | 1,016      |       | 7.16 |   | (43 | ) | (4.23 | ) |
| Pennsylvania  shares tax        |       | 549        |       | 3.63             |       | 508        |       | 3.58 |   | 41 |   | 8.07 |   |
| Other expenses                  |       | 4,183      |       | 27.69            |       | 3,897      |       | 27.47 |   | 286 |   | 7.34 |   |
| Total  non-interest expense     |       | $          | 15,108     |             | 100.00     | %          | $          | 14,184 |   | 100.00 | % | $ | 924 |   | 6.51 | % |

 

### **INCOME TAXES**

**2006 vs2005**

The provision for income taxes for the year ended December 31, 2006resulted in an effective income tax rate of 16.9% compared to 22.8% for2005.  This decrease is the result of ashift in the investment portfolio from taxable mortgage-backed bonds totax-exempt municipal bonds coupled with the receipt of tax credits related tolow income housing partnerships.

22

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**2005 vs2004**

The provision for income taxes for the year ended December 31, 2005resulted in an effective income tax rate of 22.8% compared to 27.8% for 2004.  This decrease is the result of a shift in theinvestment portfolio from taxable mortgage-backed bonds to tax-exempt municipalbonds.

### **FINANCIALCONDITION**

### **INVESTMENTS**

**2006**

The investment portfoliodecreased $1,800,000 or 0.96% from December 31, 2005 to 2006.  The decrease was the result of the cash flowfrom the portfolio being utilized to assist in the funding of the higheryielding loan portfolio.  Within theportfolio, the asset allocation continued to be weighted in tax-exemptmunicipal bonds.  This continued shift toa tax-exempt weighting was part of a strategy to increase yield, provide callprotection, and to reduce the Company’s overall effective tax rate.  At December 31, 2006 the portfolio wascomprised of 55.56% tax-exempt bonds as compared to 47.66% at December 31,2005.  The taxable portion of theportfolio was revamped to reduce exposure to falling interest rates, while atthe same time increasing the current yield.

**2005**

The investment portfolioincreased $2,562,000 or 1.39% from December 31, 2004 to 2005.  During 2005 the investment portfoliocomponents were shifted from taxable bonds to tax-exempt municipal bonds.  This shift was part of a strategy to increaseyield, provide call protection, and to reduce the Company’s overall effectivetax rate.  This strategy resulted instate and political tax-exempt holdings increasing $42,197,000 or 89.65% fromyear end 2004 to 2005, while the investment in government agencies andtreasuries has decreased by $40,076,000 or 38.5%.

The carryingamounts of investment securities at the dates indicated are summarized asfollows for the years ended December 31:
|                                                 | ** ** | **2006**    | ** ** | **2005**             | ** ** | **2004**    | ** ** |
|-------------------------------------------------|------------|-------------|------------|----------------------|------------|-------------|------------|
| **(In Thousands)**                         | ** ** | **Balance** | ** ** | **% Portfolio** | ** ** | **Balance** | ** ** | **% Portfolio** | ** ** | **Balance** | ** ** | **% Portfolio** | ** ** |
| U.S. Treasury  securities:                      |       |        |       |                 |       |        |       |   |   |   |   |   |   |
| Available for Sale                              |       | $           | —     |                 | —     |        | $          | — |   | — |   | $ | 1,024 |   | 0.55 | % |
| U.S. Government  agencies:                      |       |        |       |                 |       |        |       |   |   |   |   |   |   |
| Held to Maturity                                |       | 26          |       | 0.01                 | %          | 28          |       | 0.01 | % | 32 |   | 0.02 | % |
| Available for Sale                              |       | 54,152      |       | 29.20                | %          | 63,953      |       | 34.15 | % | 103,001 |   | 55.76 | % |
| State and  political subdivisions (tax-exempt): |       |        |       |                 |       |        |       |   |   |   |   |   |   |
| Held to Maturity                                |       | —      |       | —               |       | —      |       | — |   | 248 |   | 0.13 | % |
| Available for Sale                              |       | 103,057     |       | 55.56                | %          | 89,265      |       | 47.66 | % | 47,068 |   | 25.48 | % |
| State and  political subdivisions (taxable):    |       |        |       |                 |       |        |       |   |   |   |   |   |   |
| Held to Maturity                                |       | —      |       | —               |       | —      |       | — |   | — |   | — |   |
| Available for Sale                              |       | 2,889       |       | 1.56                 | %          | 4,826       |       | 2.58 | % | — |   | — |   |
| Other bonds,  notes and debentures:             |       |        |       |                 |       |        |       |   |   |   |   |   |   |
| Held to Maturity                                |       | 257         |       | 0.14                 | %          | 237         |       | 0.13 | % | 278 |   | 0.15 | % |
| Available for Sale                              |       | 2,024       |       | 1.09                 | %          | 1,719       |       | 0.92 | % | 1,342 |   | 0.73 | % |
| Total bonds, notes and debentures               |       | 162,405     |       | 87.56                | %          | 160,028     |       | 85.45 | % | 152,993 |   | 82.82 | % |
| Corporate stock  - Available for Sale           |       | 23,078      |       | 12.44                | %          | 27,255      |       | 14.55 | % | 31,728 |   | 17.18 | % |
| Total                                           |       | $           | 185,483    |                 | 100.00     | %           | $          | 187,283 |   | 100.00 | % | $ | 184,721 |   | 100.00 | % |

 

The followingtable shows the maturities and repricing of investment securities, at amortizedcost, at December 31, 2006 and the weighted average yields (for tax-exemptobligations on a fully taxable basis assuming a 34% tax rate) of such:

23

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| ** **                                     | ** ** | **Within** | ** ** | **After One**  | ** ** | **After Five** | ** ** | **After** | ** ** | **Amortized** | ** ** |
|------------------------------------------------|------------|------------|------------|---------------------|------------|---------------------|------------|-----------|------------|---------------|------------|
| ** **                                     | ** ** | **One**    | ** ** | **But Within** | ** ** | **But Within** | ** ** | **Ten**   | ** ** | **Cost**      | ** ** |
| **(in thousands)**                        | ** ** | **Year**   | ** ** | **Five Years** | ** ** | **Ten Years**  | ** ** | **Years** | ** ** | **Total**     | ** ** |
| U.S. Treasury  securities:                     |       |       |       |                |       |                |       |      |       |          |       |
| HTM Amount                                     |       | $          | —     |                | $          | —              |       | $         | —     |          | $          | — |   | $ | — |   |
| Yield                                          |       | —     |       | —              |       | —              |       | —    |       | —        |       |
| AFS Amount                                     |       | —     |       | —              |       | —              |       | —    |       |          |       |
| Yield                                          |       | —     |       | —              |       | —              |       | —    |       | —        |       |
| U.S. Government  agencies:                     |       |       |       |                |       |                |       |      |       |          |       |
| HTM Amount                                     |       | —     |       | —              |       | —              |       | 26        |       | 26            |       |
| Yield                                          |       | —     |       | —              |       | —              |       | 8.95      | %          | 8.96          | %          |
| AFS Amount                                     |       | —     |       | —              |       | 1,500               |       | 53,449    |       | 54,949        |       |
| Yield                                          |       | —     |       | —              |       | 5.14                | %          | 5.37      | %          | 5.36          | %          |
| State and political  subdivisions(tax-exempt): |       |       |       |                |       |                |       |      |       |          |       |
| HTM Amount                                     |       | —     |       | —              |       | —              |       | —    |       | —        |       |
| Yield                                          |       | —     |       | —              |       | —              |       | —    |       | —        |       |
| AFS Amount                                     |       | —     |       | —              |       | 15                  |       | 101,633   |       | 101,648       |       |
| Yield                                          |       | —     |       | —              |       | 6.42                | %          | 6.70      | %          | 6.70          | %          |
| State and political  subdivisions(taxable):    |       |       |       |                |       |                |       |      |       |          |       |
| HTM Amount                                     |       | —     |       | —              |       | —              |       | —    |       | —        |       |
| Yield                                          |       | —     |       | —              |       | —              |       | —    |       | —        |       |
| AFS Amount                                     |       | —     |       | —              |       | —              |       | 3,010     |       | 3,010         |       |
| Yield                                          |       | —     |       | —              |       | —              |       | 5.02      | %          | 5.02          | %          |
| Other bonds, notes and  debentures:            |       |       |       |                |       |                |       |      |       |          |       |
| HTM Amount                                     |       | —     |       | 125                 |       | 132                 |       | —    |       | 257           |       |
| Yield                                          |       | —     |       | 6.24                | %          | 5.91                | %          | —    |       | 6.07          | %          |
| AFS Amount                                     |       | —     |       | 25                  |       | —              |       | 1,973     |       | 1,998         |       |
| Yield                                          |       | —     |       | 5.05                | %          | —              |       | 6.39      | %          | 6.31          | %          |
| Total Amount                                   |       | $          | —     |                | $          | 150                 |       | $         | 1,647      |          | $          | 160,091 |   | $ | 161,888 |   |
| Total Yield                                    |       | —     |       | 6.04                | %          | 5.21                | %          | 6.12      | %          | 6.21          | %          |
|                                           |       |       |       |                |       |                |       |      |       |          |       |
| Equity Securities                              |       |       |       |                |       |                |       |      |       | $             | 20,353     |   |
| Total Investment  Portfolio Value              |       |       |       |                |       |                |       |      |       | $             | 182,241    |   |
| Total Investment Portfolio Yield               |       |       |       |                |       |                |       |      |       | 5.51          | %          |

 

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

### **LOAN PORTFOLIO**

**2006**

Grossloans of $360,384,000 at December 31, 2006 represented an increase of$21,946,000 from December 31, 2005.  Thecontinued emphasis on well collateralized real estate loans resulted in realestate secured loans increasing $22,560,000 from December 31, 2005 to2006.  The success in carrying out thislong term strategy has played a significant role in limiting net charge-offsfor 2006 to 0.04% of average loans. Commercial and agricultural loans declined due to the before mentionedemphasis on real estate secured loans versus equipment, receivables, orinventory secured loans.

24

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**2005**

Grossloans for the year ended December 31, 2005 increased 4.29% to $338,438,000 from$324,505,000 at December 31, 2004.  Theincrease was concentrated in real estate mortgages which increased $8,229,000as a whole from December 31, 2004 to 2005. Commercial and agricultural loans and installment loans increased$4,304,000 and $1,366,000 respectively. The growth in real estate secured loans is part of the Company’s overalllending strategy to underwrite well collateralized real estate loans. Theopening of the Atherton Street, State College branch along with a home equityloan campaign also assisted in increasing real estate loans.  Commercial and individuals loan categoriesincreased modestly as the Company broadens its lending base and expands itsmarket coverage.

Theamounts of loans outstanding at the indicted dates are shown in the followingtable according to type of loan:
| **(In Thousands)**           | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Commercial and  agricultural      |       | $        | 28,555     |     | $          | 34,407   |       | $        | 30,103     |     | $          | 23,523 |   | $ | 23,708 |   |
| Real estate mortgage:             |       |     |       |     |       |     |       |     |       |     |       |
| Residential                       |       | 158,219  |       | 150,000  |       | 147,461  |       | 147,697  |       | 140,724  |       |
| Commercial                        |       | 135,404  |       | 127,131  |       | 123,757  |       | 82,896   |       | 75,892   |       |
| Construction                      |       | 16,749   |       | 10,681   |       | 8,365    |       | 7,652    |       | 3,356    |       |
| Installment loans to  individuals |       | 22,475   |       | 17,281   |       | 15,915   |       | 15,000   |       | 14,934   |       |
| Less: Net deferred loan  fees     |       | 1,018    |       | 1,062    |       | 1,096    |       | 940      |       | 769      |       |
| Gross loans                       |       | $        | 360,384    |     | $          | 338,438  |       | $        | 324,505    |     | $          | 275,828 |   | $ | 257,845 |   |

 

The amounts ofdomestic loans at December 31, 2006 are presented below by category andmaturity:
| ** **                                | ** ** | ** **           | ** ** | **Commercial** | ** ** | **Installment**   | ** ** | ** ** | ** ** |
|-------------------------------------------|------------|----------------------|------------|----------------|------------|-------------------|------------|------------|------------|
| ** **                                | ** ** | ** **           | ** ** | **and**        | ** ** | **Loans to** | ** ** | ** ** | ** ** |
| **(In Thousands)**                   | ** ** | **Real Estate** | ** ** | **Other**      | ** ** | **Individuals**   | ** ** | **Total**  | ** ** |
| Loans with floating  interest rates:      |       |                 |       |           |       |              |       |       |       |
| 1 year or less                            |       | $                    | 25,282     |           | $          | 8,588             |       | $          | 2,368      |   | $ | 36,238 |   |
| 1 through 5 years                         |       | 10,390               |       | 1,692          |       | 179               |       | 12,261     |       |
| 5 through 10 years                        |       | 29,124               |       | 3,458          |       | 283               |       | 32,865     |       |
| After 10 years                            |       | 188,788              |       | 1,916          |       | 282               |       | 190,986    |       |
| Total floating  interest rate loans       |       | 253,584              |       | 15,654         |       | 3,112             |       | 272,350    |       |
| Loans with  predetermined interest rates: |       |                 |       |           |       |              |       |       |       |
| 1 year or less                            |       | 5,800                |       | 660            |       | 917               |       | 7,377      |       |
| 1 through 5 years                         |       | 17,800               |       | 9,845          |       | 10,850            |       | 38,495     |       |
| 5 through 10 years                        |       | 19,156               |       | 2,243          |       | 7,596             |       | 28,995     |       |
| After 10 years                            |       | 12,996               |       | 153            |       | 18                |       | 13,167     |       |
| Total  predetermined interest rate loans  |       | 55,752               |       | 12,901         |       | 19,381            |       | 88,034     |       |
| Total                                     |       | $                    | 309,336    |           | $          | 28,555            |       | $          | 22,493     |   | $ | 360,384 |   |

 

----

*                 The loan maturity information is based uponoriginal loan terms and is not adjusted for “rollovers.”  In the ordinary course of business, loansmaturing within one year may be renewed, in whole or in part, as to principalamount at interest rates prevailing at the date of renewal.

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

The Bank does not make loans that provide for negative amortization nordo any loans contain conversion features. The Bank does not have any foreignloans outstanding at December 31, 2006.

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### **ALLOWANCEFOR LOAN LOSSES**

**2006**

The allowance for loan losses represents theamount which management estimates is adequate to provide for probable lossesinherent in its loan portfolio, as of the consolidated balance sheet date.  The allowance method is used in providing forloan losses.  Accordingly, all loanlosses are charged to the allowance and all recoveries are credited to it.  The allowance for loan losses is establishedthrough a provision for loan losses charged to operations. ** **The provision for loan losses is based upon management’s quarterlyreview of the loan portfolio.  Thepurpose 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 marketsserved.  An external independent loanreview is also performed annually for the Bank. Management remains committed to an aggressive program of problem loanidentification and resolution.

The allowance is calculated by applying loss factors to outstandingloans by type, excluding loans for which a specific allowance has beendetermined.  Loss factors are based onmanagement’s consideration of the nature of the portfolio segments, changes inmix and volume of the loan portfolio, and historical loan loss experience.  In addition, management considers industrystandards and trends with respect to nonperforming loans and its knowledge andexperience with specific lending segments.

Although management believes that it uses the best informationavailable to make such determinations and that the allowance for loan losses isadequate at December 31, 2006, future adjustments could be necessary ifcircumstances or economic conditions differ substantially from the assumptionsused in making the initial determinations. A downturn in the local economy or employment and delays in receivingfinancial information from borrowers could result in increased levels ofnonperforming assets and charge-offs, increased loan loss provisions andreductions in interest income. Additionally, as an integral part of the examination process, bankregulatory agencies periodically review the Bank’s loan loss allowance.  The banking agencies could require the recognition of additions to theloan loss allowance based on their judgment of information available to them atthe time of their examination.

The allowance for loan losses increased from $3,679,000 at December 31,2005 to $4,185,000 at December 31, 2006. At December 31, 2006, allowance for loan losses was 1.16% of total loanscompared to 1.09% of total loans at December 31, 2005.  This percentage is consistent with the Bank’shistorical experience and peer 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.

**2005**

At December 31, 2005, the allowance for loan losses as a percent oftotal loans increased to 1.09% from 1.03% at December 31, 2004.  Gross loans increased by $13,933,000 from$324,505,000 at December 31, 2004 to $338,438,000 at December 31, 2005.

Based on management’s loan-by-loan review, the past performance of theborrowers and current economic conditions, including recent business closuresand bankruptcy levels, management does not anticipate any

26

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current losses related to nonaccrual, nonperforming, or classifiedloans above that have already been considered in its overall judgment of theadequacy of the reserve.

**NONPERFORMING LOANS**

Non-accrual loans decreased to $370,000 at December 31, 2006 primarilydue to settlement of a commercial real estate relationship which previouslyfiled for bankruptcy. Overall nonperforming loans decreased $114,000 to$489,000 from fiscal year end 2005.

The following table presents information concerning nonperformingloans.  The accrual of interest will bediscontinued when the principal or interest of a loan is in default for 90 daysor more, or as soon as payment is questionable, unless the loan is well securedand in the process of collection. Consumer loans and residential real estate loans secured by 1 to 4family dwellings shall ordinarily not be subject to those guidelines.  The reversal of previously accrued butuncollected interest applicable to any loan placed in a nonaccrual status andthe treatment of subsequent payments of either principal or interest will behandled in accordance with U.S. generally accepted accounting principles.  These principles do not require a write-offof previously accrued interest if principal and interest are ultimatelyprotected by sound collateral values.  Anonperforming loan may be restored to an accruing status when:

1.  Principal and interest is no longer due andunpaid.

2.  It becomes well secured and in the process ofcollection.

3.  Prospects for futurecontractual payments are no longer in doubt.
|                         | ** ** | **Total Nonperforming Loans** | ** ** |
|-------------------------|------------|-----------------------------------------|------------|
| ** **              | ** ** | ** **                              | ** ** | **90 Days** | ** ** | ** ** | ** ** |
| **(In Thousands)** | ** ** | **Nonaccrual**                          | ** ** | **Past Due** | ** ** | **Total** | ** ** |
| 2006                    |       | $                                       | 370        |   | $ | 119 |   | $ | 489 |   |
| 2005                    |       | 540                                     |       | 63 |   | 603 |   |
| 2004                    |       | 1,381                                   |       | 345 |   | 1,726 |   |
| 2003                    |       | 827                                     |       | 429 |   | 1,256 |   |
| 2002                    |       | 871                                     |       | 1,225 |   | 2,096 |   |
|                         |            |                                         |            |  |  |  |  |  |  |  |

 

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

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

1.             Economicconditions and the impact on the loan portfolio.

2.             Analysisof past loan charge-offs experienced by category and comparison to outstandingloans.

3.               Problem loans on overall portfolio quality.

4.           Reportsof examination of the loan portfolio by the Pennsylvania State Banking Departmentand the Federal Deposit Insurance Corporation.

27

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**Allocation In The Allowance For Loan Losses**
| ** **                               | ** ** | ** ** | ** ** | **Percent Of**  | ** ** |
|------------------------------------------|------------|------------|------------|----------------------|------------|
| ** **                               | ** ** | ** ** | ** ** | **Loan In**     | ** ** |
| ** **                               | ** ** | ** ** | ** ** | **Each**             | ** ** |
| ** **                               | ** ** | ** ** | ** ** | **Category To** | ** ** |
| **(In Thousands)**                  | ** ** | **Amount** | ** ** | **Total Loans** | ** ** |
| **December  31, 2006:**                  |       |       |       |                 |       |
| Balance at end  of period applicable to: |       |       |       |                 |       |
| Commercial and agricultural              |       | $          | 679        |                 | 7.9        | % |
| Real estate mortgage:                    |       |       |       |                 |       |
| Residential                              |       | 951        |       | 43.8                 | %          |
| Commercial                               |       | 1,972      |       | 37.5                 | %          |
| Construction                             |       | 108        |       | 4.6                  | %          |
| Installment loans to individuals         |       | 295        |       | 6.2                  | %          |
| Unallocated                              |       | 180        |       | —               |       |
| Total                                    |       | $          | 4,185      |                 | 100.0      | % |
| **December  31, 2005:**                  |       |       |       |                 |       |
| Balance at end  of period applicable to: |       |       |       |                 |       |
| Commercial and agricultural              |       | $          | 582        |                 | 10.1       | % |
| Real estate mortgage:                    |       |       |       |                 |       |
| Residential                              |       | 1,107      |       | 44.2                 | %          |
| Commercial                               |       | 1,482      |       | 37.5                 | %          |
| Construction                             |       | 79         |       | 3.1                  | %          |
| Installment loans to individuals         |       | 192        |       | 5.1                  | %          |
| Unallocated                              |       | 237        |       | —               |       |
| Total                                    |       | $          | 3,679      |                 | 100.0      | % |
| **December  31, 2004:**                  |       |       |       |                 |       |
| Balance at end  of period applicable to: |       |       |       |                 |       |
| Commercial and agricultural              |       | $          | 361        |                 | 9.1        | % |
| Real estate mortgage:                    |       |       |       |                 |       |
| Residential                              |       | 1,280      |       | 46.1                 | %          |
| Commercial                               |       | 1,399      |       | 37.5                 | %          |
| Construction                             |       | 75         |       | 2.5                  | %          |
| Installment loans to individuals         |       | 207        |       | 4.8                  | %          |
| Unallocated                              |       | 16         |       | —               |       |
| Total                                    |       | $          | 3,338      |                 | 100.0      | % |
| **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      | % |
| **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      | % |

 

28

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**DEPOSITS**

 

**2006 vs2005**

Totalaverage deposits were $379,346,000 for 2006, an increase of $18,630,000 or5.16% from 2005.  Non-interest bearingdeposits increased slightly to $69,668,000. Time deposits increased $30,130,000 or 20.58% as deposits shifted fromtransaction accounts to time deposits due to the continued rate disparitybetween time deposits and other deposit types. The rate on time deposits has been increasing due to the actions takenby the FOMC and market competition.  Inaddition, the Bank utilized brokered time deposits to supplement market areadeposit funding.

**2005 vs2004**

Totalaverage deposits were $360,716,000 for 2005, an increase of $6,292,000 or 1.78%from 2004.  Non-interest bearing depositsincreased $5,023,000 or 7.80% year over year. Time deposits increased $16,051,000 or 12.31% as deposits shifted fromtransaction accounts to time deposits in light of the increasing spread ininterest rates between the deposit types. Increases in rates paid were the result of the FOMC rate increasesduring 2004 and increased competition for deposits.

The average amount and the average rate paid on deposits are summarizedbelow:
|                         | ** ** | **2006**    | ** ** | **2005**   | ** ** | **2004**    | ** ** |
|-------------------------|------------|-------------|------------|------------|------------|-------------|------------|
| ** **              | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** |
| **(In Thousands)** | ** ** | **Amount**  | ** ** | **Rate**   | ** ** | **Amount**  | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
| Noninterest-bearing     |       | $           | 69,668     |       | 0.00       | %           | $          | 69,457 |   | 0.00 | % | $ | 64,434 |   | 0.00 | % |
| Savings                 |       | 61,958      |       | 0.82       | %          | 64,795      |       | 0.77 | % | 69,796 |   | 0.83 | % |
| Super Now               |       | 47,294      |       | 1.38       | %          | 50,756      |       | 0.86 | % | 54,690 |   | 0.71 | % |
| Money Market            |       | 23,905      |       | 2.06       | %          | 29,317      |       | 1.41 | % | 35,164 |   | 1.11 | % |
| Time                    |       | 176,521     |       | 4.11       | %          | 146,391     |       | 3.02 | % | 130,340 |   | 2.62 | % |
| Total average  deposits |       | $           | 379,346    |       | 2.35       | %           | $          | 360,716 |   | 1.60 | % | $ | 354,424 |   | 1.35 | % |

 

##### **SHAREHOLDERS’EQUITY**

**2006**

Shareholders’equity increased $675,000 to $74,594,000 at December 31, 2006 as net incomeoutpaced dividends paid, accumulated comprehensive income increased $710,000,and $2,929,000 in treasury stock was strategically purchased as part of thepreviously announced stock buyback plan. The increase in accumulated comprehensive income is the result of anincrease in market value, or net unrealized gains, of the investment portfolioat December 31, 2006 as compared to December 31, 2005, offset by the net excessof the projected benefit obligation over the market value of the plan assets ofthe defined benefit pension plan.  Thecurrent level of shareholders’ equity equates to a book value per share of$19.12 at December 31, 2006 as compared to $18.59 at December 31, 2005 and anequity to asset ratio of 12.59% at December 31, 2006.  During the twelve months ended December 31,2006 cash dividends of $1.73 per share were paid to shareholders.  The dividends represented an 11% increase or$0.17 per share over the dividends paid during the comparable period of 2005.

**2005**

Shareholders’ equity increased $754,000 to $73,919,000 at December 31,2005 as net retained earnings outpaced a decline in accumulated othercomprehensive income of $3,481,000.  Thedecrease in accumulated other comprehensive income is a reflection of a declinein market value, unrealized gains and losses, for our investment portfolio, netof gains and losses realized in the available for sale portfolio during theyear, at December 31, 2005 as compared to December 31, 2004. The level ofshareholders’ equity equated to a book value per share of $18.59 as compared to$18.36 at December 31, 2004.  During theyear ended December 31, 2005 a dividend of $1.56 per share was paid toshareholders in addition to a 6 for 5 stock split that occurred in December2005 prior to the cash dividend payment. The dividend represented a 6.12% increase over the dividend paid during2004.

29

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Bank regulatorshave risk based capital guidelines. Under these guidelines the Company and Bank are required to maintainminimum ratios of core capital and total qualifying capital as a percentage ofrisk weighted assets and certain off-balance sheet items.  At December 31, 2006, both the Company’s andBank’s required ratios were well above the minimum ratios as follows:
|                       | ** ** | ** **  | ** ** | ** ** | ** ** | **2006**      | ** ** |
|-----------------------|------------|-------------|------------|------------|------------|---------------|------------|
| ** **            | ** ** | ** **  | ** ** | ** ** | ** ** | **Minimum**   | ** ** |
| ** **            | ** ** | **Company** | ** ** | **Bank**   | ** ** | **Standards** | ** ** |
| Tier 1 capital  ratio |       | 11.8        | %          | 9.3        | %          | 4.0           | %          |
| Total capital ratio   |       | 20.3        | %          | 16.2       | %          | 8.0           | %          |

 

For a more comprehensivediscussion of these requirements, see “Regulations and Supervision” in Item 1of the Annual Report on Form 10-K. Management believes that the Company will continue to exceed regulatory capitalrequirements.

##### **RETURNON EQUITY AND ASSETS**

The ratio of netincome to average total assets and average shareholders’ equity and othercertain equity ratios are presented as follows:
| ** **                                                               | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Percentage of  net income to:                                            |       |     |       |     |       |     |       |
| Average total assets                                                     |       | 1.67     | %          | 1.97     | %          | 2.06     | %          |
| Average shareholders’ equity                                        |       | 12.93    | %          | 14.54    | %          | 15.49    | %          |
| Percentage of  dividends declared to net income                          |       | 70.51    | %          | 57.10    | %          | 52.72    | %          |
| Percentage of average  shareholders’ equity to average total assets |       | 12.92    | %          | 13.56    | %          | 13.30    | %          |

 

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

Fundamental objectives of the Company’sasset/liability management process are to maintain adequate liquidity whileminimizing interest rate risk.  Themaintenance of adequate liquidity provides the Company with the ability to meetits financial obligations to depositors, loan customers, and shareholders.  Additionally, it provides funds for normaloperating expenditures and business opportunities as they arise.  The objective of interest rate sensitivitymanagement is to increase net interest income by managing interest sensitiveassets and liabilities in such a way that they can be repriced in response tochanges in market interest rates.

The Company, like other financial institutions, musthave sufficient funds available to meet its liquidity needs for depositwithdrawals, loan commitments, and expenses.  In order to control cash flow, the bank estimates future flows of cashfrom deposits and loan payments.  Theprimary sources of funds are deposits, principal and interest payments on loansand mortgage-backed securities, as well as Federal Home Loan Bankborrowings.  Funds generated are usedprincipally to fund loans and purchase investment securities.  Management believes the Company has adequateresources to meet its normal funding requirements.

Management monitors the Company’s liquidity on botha long and short-term basis thereby, providing management necessary informationto react to current balance sheet trends. Cash flow needs are assessed and sources of funds are determined.  Funding strategies consider both customerneeds and economical cost.  Both shortand long term funding needs are addressed by maturities and sales of availablefor sale investment securities, loan repayments and maturities, and liquidatingmoney market investments such as federal funds sold.  The use of these resources, in conjunctionwith access to credit provides core ingredients to satisfy depositor, borrower,and creditor needs.

Management monitors and determines the desirablelevel of liquidity.  Consideration isgiven to loan demand, investment opportunities, deposit pricing and growthpotential as well as the current cost of borrowing funds.  The Company has a current borrowing capacityat the Federal Home Loan Bank of $225,122,000 with $101,584,000 utilized,leaving

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$123,538,000 available.  In addition to this credit arrangement, theCompany has additional lines of credit with correspondent banks of $28,048,000.The Company’s management believes that it has sufficient liquidity to satisfyestimated short-term and long-term funding needs.

Interest rate sensitivity, which is closely relatedto liquidity management, is a function of the repricing characteristics of theCompany’s portfolio of assets and liabilities. Asset/liability management strives to match maturities and rates betweenloan and investment security assets with the deposit liabilities and borrowingsthat fund them.  Successfulasset/liability management results in a balance sheet structure which can copeeffectively with market rate fluctuations. The matching process is affected bysegmenting both assets and liabilities into future time periods (usually 12months, or less) based upon when repricing can be effected.  Repriceable assets are subtracted from repriceableliabilities, for a specific time period to determine the “gap”, or difference.Once known, the gap is managed based on predictions about future marketinterest rates.  Intentional mismatching,or gapping, can enhance net interest income if market rates move aspredicted.  However, if market ratesbehave in a manner contrary to predictions, net interest income willsuffer.  Gaps, therefore, contain anelement of risk and must be prudently managed. In addition to gap management, the Company has an asset liabilitymanagement policy which incorporates a market value at risk calculation whichis used to determine the effects of interest rate movements on shareholders’equity and a simulation analysis to monitor the effects of interest ratechanges on the Company’s balance sheets.

**INTERESTRATE SENSITIVITY**

In this analysis the Company examines the result of a 100 and 200 basispoint change in market interest rates and the effect on net interestincome.  It is assumed that the change isinstantaneous and that all rates move in a parallel manner.  Assumptions are also made concerningprepayment speeds on mortgage loans and mortgage securities.

The following is a rate shock forecast for the twelve month periodended December 31, 2007 assuming a static balance sheet as of December 31,2006.
|                         | ** ** | **Parallel Rate Shock in Basis Points** | ** ** |
|-------------------------|------------|------------------------------------------------------------------|------------|
| **(In Thousands)** | ** ** | **-200**                                                         | ** ** | **-100** | ** ** | **Static** | ** ** | **+100** | ** ** | **+200** | ** ** |
| Net interest  income    |       | $                                                                | 19,509     |   | $ | 18,945 |   | $ | 18,102 |   | $ | 16,930 |   | $ | 15,731 |   |
| Change from static      |       | 1,407                                                            |       | 843 |   | — |   | (1,172 | ) | (2,371 | ) |
|                         |            |                                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The model utilized to create the report presented above makes variousestimates at each level of interest rate change regarding cash flow fromprincipal repayment on loans and mortgage-backed securities and or callactivity on investment securities. Actual results could differ significantly from these estimates whichwould result in significant differences in the calculated projectedchange.  In addition, the limits statedabove do not necessarily represent the level of change under which managementwould undertake specific measures to realign its portfolio in order to reducethe projected level of change. Generally, management believes the Company is well positioned to respondexpeditiously when the market interest rate outlook changes.

##### **INFLATION**

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

**CRITICALACCOUNTING POLICIES**

The Company’saccounting policies are integral to understanding the results reported.  The accounting policies are described indetail in Note 1 of the consolidated financial statements.  Our most complex accounting policies require

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management’sjudgment to ascertain the valuation of assets, liabilities, commitments, andcontingencies.  We have establisheddetailed policies and control procedures that are intended to ensure valuationmethods are well controlled and applied consistently from period to period.  In addition, the policies and procedures are intendedto ensure that the process for changing methodologies occurs in an appropriatemanner.  The following is a briefdescription of our current accounting policies involving significant managementvaluation judgments.

*OtherThan Temporary Impairment of Equity Securities*

Equity securitiesare evaluated periodically to determine whether a decline in their value isother than temporary. Management utilizes criteria such as the magnitude andduration of the decline, in addition to the reason underlying the decline, todetermine whether the loss in value is other than temporary. The term “otherthan temporary” is not intended to indicate that the decline is permanent.  It indicates that the prospects for a nearterm recovery of value are not necessarily favorable, or that there is a lackof evidence to support fair values equal to, or greater than, the carryingvalue of the investment.  Once a declinein value is determined to be other than temporary, the value of the security isreduced and a corresponding charge to earnings is recognized.  For a full discussion of the Company’s methodology of assessingimpairment, refer to Note 3 of “Notes and Consolidated FinancialStatements” of the Annual Report on Form 10-K.

*Allowancefor Loan Losses*

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

Management useshistorical information to assess the adequacy of the allowance for loan lossesas well as the prevailing business environment; as it is affected by changingeconomic conditions and various external factors, which may impact theportfolio in ways currently unforeseen. The allowance is increased by provisions for loan losses and byrecoveries of loans previously charged-off and reduced by loanscharged-off.  For a full discussion ofthe Company’s methodologyof assessing the adequacy of the reserve for loan losses, refer to Note 1 of “Notesand Consolidated Financial Statements” of the Form 10-K.

*Goodwilland Other Intangible Assets*

As discussed inNote 6 of the “Notes to Consolidated Financial Statements” of the Annual Reporton Form 10-K, the Company must assess goodwill and other intangible assets eachyear for impairment.  This assessmentinvolves estimating cash flows for future periods.  If the future cash flows were less than therecorded goodwill and other intangible assets balances, we would be required totake a charge against earnings to write down the assets to the lower value.

*DeferredTax Assets*

We use an estimateof future earnings to support our position that the benefit of our deferred taxassets will be realized.  If futureincome should prove non-existent or less than the amount of the deferred taxassets within the tax years to which they may be applied, the asset may not berealized and our net income will be reduced. Our deferred tax assets are described further in Note 10 of  “Notes to Consolidated Financial Statements” of the Annual Report on Form 10-K.

**CONTRACTUALOBLIGATIONS**

The Company  has various financial obligations, includingcontractual obligations which may require future cash payments. The followingtable presents, as of December 31, 2006, significant fixed and determinablecontractual obligations to third parties by payment date.   Further discussion of the nature of eachobligation is included in “Notes to the Consolidated Financial Statements” ofthe Annual Report on Form 10-K.

32

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| ** **                              | ** ** | **Payments Due in** | ** ** |
|-----------------------------------------|------------|-------------------------------|------------|
| ** **                              | ** ** | ** **                    | ** ** | **One to** | ** ** | **Three to** | ** ** | **Over** | ** ** | ** ** | ** ** |
| ** **                              | ** ** | **One Year**             | ** ** | **Three** | ** ** | **Five** | ** ** | **Five** | ** ** | ** ** | ** ** |
| **(In Thousands)**                 | ** ** | **or Less**              | ** ** | **Years** | ** ** | **Years** | ** ** | **Years** | ** ** | **Total** | ** ** |
| **Deposits  without a stated maturity** |       | $                             | 200,313    |   | $ | — |   | $ | — |   | $ | — |   | $ | 200,313 |   |
| **Time  Deposits**                      |       | 157,818                       |       | 31,035 |   | 3,791 |   | 805 |   | 193,449 |   |
| **Repurchase  agreements**              |       | 15,991                        |       | — |   | — |   | — |   | 15,991 |   |
| **Short-term  borrowings, FHLB**        |       | 18,706                        |       | — |   | — |   | — |   | 18,706 |   |
| **Long-term  borrowings, FHLB**         |       | 11,500                        |       | 34,600 |   | 15,500 |   | 21,278 |   | 82,878 |   |
| **Operating leases**                    |       | 411                           |       | 531 |   | 220 |   | 1,282 |   | 2,444 |   |
|                                         |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The Corporation’soperating lease obligations represent short and long-term lease and rentalpayments for branch facilities.  The Bankleases certain facilities under operating leases which expire on various datesthrough 2024.  Renewal options areavailable on these leases.

**CAUTIONARYSTATEMENT FOR PURPOSES OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995**

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

The PrivateSecurities Litigation Reform Act of 1995 provides a safe harbor forforward-looking statements. In order to comply with the terms of the safeharbor, the Company notes that a variety of factors could cause the Company’sactual results and experience to differ materially from the anticipated resultsor other expectations expressed in the Company’s forward-looking statements.The risks and uncertainties that may affect the operations, performance, developmentand results 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 regulatoryenvironment; rapidly changing technology and evolving banking industrystandards; the effect of changes in accounting policies and practices,including increased competition with community, regional and national financialinstitutions; new service and product offerings by competitors and pricepressures; changes in the Company’s organization, compensation and benefitplans; and similar items.

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**[Letterhead of S.R. Snodgrass, A.C.]**

# REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Shareholders

Penns Woods Bancorp, Inc.

We have audited the consolidated balance sheets of Penns Woods Bancorp,Inc. and subsidiaries as of December 31, 2006 and 2005, and the relatedconsolidated statements of income, shareholders’ equity, and cash flows foreach of the years in the three-year period ended December 31, 2006.  These consolidated financial statements arethe responsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States).  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management as wellas evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of Penns WoodsBancorp, Inc. and subsidiaries as of December 31, 2006 and 2005, and theconsolidated results of their operations and their cash flows for each of theyears in the three-year period ended December 31, 2006, in conformity with U.S.generally accepted accounting principles.

As discussed in Note 11 to the consolidated financial statements,Penns Woods Bancorp, Inc. changed its method of accounting for its definedbenefit pension plan as of December 31, 2006, in accordance with FinancialAccounting Standards Board Statement No. 158, *Employers’Accounting for Defined Benefit Pension and Other Postretirement Plans*.

We also have audited, in accordance with the standards of the PublicCompany Accounting Oversight Board (United States), the effectiveness of PennsWoods Bancorp, Inc.’s internal control over financial reporting as of December31, 2006, based on criteria established in “Internal Control – IntegratedFramework” issued by the Committee of Sponsoring Organizations of the TreadwayCommission and our report dated March 9, 2007, expressed an unqualified opinionon management’s assessment of the effectiveness of Penns Woods Bancorp, Inc.’sinternal control over financial reporting and an unqualified opinion on theeffectiveness of Penns Woods Bancorp, Inc.’s internal control over financialreporting.

 
| /s/ S.R. Snodgrass, A.C. |   |
|--------------------------|--------|
| Wexford,  Pennsylvania   |
| March 9, 2007            |

 

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**Item 7A.     QUANTITATIVE ANDQUALITATIVE DISCLOSURE ABOUT MARKET RISK**

Market risk for the Company is comprisedprimarily from interest rate risk exposure and liquidity risk.  Interest rate risk and liquidity riskmanagement is performed at the Bank level as well as the Company level.  The Company’s interest rate sensitivity ismonitored by management through selected interest rate risk measures producedinternally.  Additional information anddetails are provided in the Interest Sensitivity section of Item 7. Management’sDiscussion and Analysis of Financial Condition and Results of Operations.

Generally, management believes the Company is wellpositioned to respond expeditiously when the market interest rate outlookchanges.

**ITEM 8       FINANCIAL STATEMENTS AND SUPPLEMENTARYDATA**

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PENNS WOODS BANCORP, INC.

CONSOLIDATED BALANCE SHEET

 
| ** **                                                                                          | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| **(In Thousands, Except Share Data)**                                           | ** ** | **2006**              | ** ** | **2005**              | ** ** |
|                                                                                                |       |                  |       |                  |       |
| ASSETS:                                                                                             |       |                  |       |                  |       |
| Noninterest-bearing  balances                                                                       |       | $                     | 15,348     |                  | $          | 14,065 |   |
| Interest-bearing  deposits in other financial institutions                                          |       | 25                    |       | 25                    |       |
| Total cash and  cash equivalents                                                                    |       | 15,373                |       | 14,090                |       |
|                                                                                                |       |                  |       |                  |       |
| Investment securities,  available for sale, at fair value                                           |       | 185,200               |       | 187,018               |       |
| Investment securities  held to maturity (fair value of $286 and $238)                               |       | 283                   |       | 265                   |       |
| Loans held for sale                                                                                 |       | 3,716                 |       | 3,545                 |       |
|                                                                                                |       |                  |       |                  |       |
| Loans                                                                                               |       | 360,384               |       | 338,438               |       |
| Less: Allowance for  loan losses                                                                    |       | 4,185                 |       | 3,679                 |       |
| Loans, net                                                                                          |       | 356,199               |       | 334,759               |       |
|                                                                                                |       |                  |       |                  |       |
| Premises and equipment,  net                                                                        |       | 6,737                 |       | 6,409                 |       |
| Accrued interest  receivable                                                                        |       | 2,939                 |       | 2,828                 |       |
| Bank-owned life  insurance                                                                          |       | 11,346                |       | 10,718                |       |
| Investment in limited  partnerships                                                                 |       | 4,950                 |       | 3,549                 |       |
| Goodwill                                                                                            |       | 3,032                 |       | 3,032                 |       |
| Other assets                                                                                        |       | 2,510                 |       | 2,455                 |       |
| TOTAL ASSETS                                                                                        |       | $                     | 592,285    |                  | $          | 568,668 |   |
|                                                                                                |       |                  |       |                  |       |
| LIABILITIES:                                                                                        |       |                  |       |                  |       |
| Interest-bearing  deposits                                                                          |       | $                     | 322,031    |                  | $          | 281,150 |   |
| Noninterest-bearing  deposits                                                                       |       | 73,160                |       | 71,379                |       |
| Total deposits                                                                                      |       | 395,191               |       | 352,529               |       |
|                                                                                                |       |                  |       |                  |       |
| Short-term borrowings                                                                               |       | 34,697                |       | 54,003                |       |
| Long-term borrowings,  Federal Home Loan Bank (FHLB)                                                |       | 82,878                |       | 84,478                |       |
| Accrued interest  payable                                                                           |       | 1,532                 |       | 1,108                 |       |
| Other liabilities                                                                                   |       | 3,393                 |       | 2,631                 |       |
| TOTAL LIABILITIES                                                                                   |       | 517,691               |       | 494,749               |       |
|                                                                                                |       |                  |       |                  |       |
| SHAREHOLDERS’ EQUITY:                                                                          |       |                  |       |                  |       |
| Common stock, par value  $8.33, 10,000,000 shares authorized; 4,003,514 and 4,002,159 shares issued |       | 33,362                |       | 33,351                |       |
| Additional paid-in  capital                                                                         |       | 17,810                |       | 17,772                |       |
| Retained earnings                                                                                   |       | 25,783                |       | 22,938                |       |
| Accumulated other  comprehensive income(loss):                                                      |       |                  |       |                  |       |
| Net unrealized  gain on available-for-sale securities                                               |       | 2,139                 |       | 850                   |       |
| Defined benefit  plan                                                                               |       | (579                  | )          | —                |       |
| Less: Treasury stock at  cost, 102,772 and 26,372 shares                                            |       | (3,921                | )          | (992                  | )          |
| TOTAL  SHAREHOLDERS’ EQUITY                                                                    |       | 74,594                |       | 73,919                |       |
| TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY                                                     |       | $                     | 592,285    |                  | $          | 568,668 |   |

 

See Accompanying Notes to the Consolidated FinancialStatements

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PENNSWOODS BANCORP, INC.CONSOLIDATED STATEMENT OF INCOME

 
| ** **                                                         | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------------|------------|
| **(In Thousands, Except Per Share Data)** | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                               |       |                                       |       |   |   |   |   |
| INTEREST AND  DIVIDEND INCOME:                                     |       |                                       |       |   |   |   |   |
| Loans including  fees                                              |       | $                                          | 24,878     |   | $ | 22,126 |   | $ | 20,261 |   |
| Investment  Securities:                                            |       |                                       |       |   |   |   |   |
| Taxable                                                            |       | 3,577                                      |       | 4,351 |   | 6,686 |   |
| Tax-exempt                                                         |       | 4,027                                      |       | 3,223 |   | 1,708 |   |
| Dividend and other interest income                                 |       | 1,271                                      |       | 1,203 |   | 1,190 |   |
|                                                               |       |                                       |       |   |   |   |   |
| TOTAL INTEREST AND DIVIDEND INCOME                                 |       | 33,753                                     |       | 30,903 |   | 29,845 |   |
|                                                               |       |                                       |       |   |   |   |   |
| INTEREST  EXPENSE:                                                 |       |                                       |       |   |   |   |   |
| Deposits                                                           |       | 8,908                                      |       | 5,774 |   | 4,775 |   |
| Short-term  borrowings                                             |       | 1,503                                      |       | 931 |   | 539 |   |
| Long-term  borrowings                                              |       | 3,799                                      |       | 3,676 |   | 3,454 |   |
|                                                               |       |                                       |       |   |   |   |   |
| TOTAL INTEREST EXPENSE                                             |       | 14,210                                     |       | 10,381 |   | 8,768 |   |
|                                                               |       |                                       |       |   |   |   |   |
| NET INTEREST  INCOME                                               |       | 19,543                                     |       | 20,522 |   | 21,077 |   |
|                                                               |       |                                       |       |   |   |   |   |
| PROVISION FOR  LOAN LOSSES                                         |       | 635                                        |       | 720 |   | 465 |   |
|                                                               |       |                                       |       |   |   |   |   |
| NET INTEREST  INCOME AFTER PROVISION FOR LOAN LOSSES               |       | 18,908                                     |       | 19,802 |   | 20,612 |   |
|                                                               |       |                                       |       |   |   |   |   |
| NON-INTEREST  INCOME:                                              |       |                                       |       |   |   |   |   |
| Service charges                                                    |       | 2,366                                      |       | 2,228 |   | 1,983 |   |
| Securities  gains, net                                             |       | 1,679                                      |       | 2,190 |   | 2,176 |   |
| Bank-owned life  insurance                                         |       | 374                                        |       | 568 |   | 294 |   |
| Gain on sale of  loans                                             |       | 853                                        |       | 864 |   | 969 |   |
| Insurance  commissions                                             |       | 2,281                                      |       | 2,327 |   | 2,282 |   |
| Other income                                                       |       | 1,476                                      |       | 1,254 |   | 1,214 |   |
|                                                               |       |                                       |       |   |   |   |   |
| TOTAL NON-INTEREST INCOME                                          |       | 9,029                                      |       | 9,431 |   | 8,918 |   |
|                                                               |       |                                       |       |   |   |   |   |
| NON-INTEREST  EXPENSES:                                            |       |                                       |       |   |   |   |   |
| Salaries and  employee benefits                                    |       | 8,833                                      |       | 8,314 |   | 7,804 |   |
| Occupancy  expense, net                                            |       | 1,137                                      |       | 1,089 |   | 959 |   |
| Furniture and  equipment expense                                   |       | 1,201                                      |       | 973 |   | 1,016 |   |
| Pennsylvania  shares tax expense                                   |       | 598                                        |       | 549 |   | 508 |   |
| Other expenses                                                     |       | 4,560                                      |       | 4,183 |   | 3,897 |   |
|                                                               |       |                                       |       |   |   |   |   |
| TOTAL NON-INTEREST EXPENSES                                        |       | 16,329                                     |       | 15,108 |   | 14,184 |   |
|                                                               |       |                                       |       |   |   |   |   |
| INCOME BEFORE  INCOME TAX PROVISION                                |       | 11,608                                     |       | 14,125 |   | 15,346 |   |
|                                                               |       |                                       |       |   |   |   |   |
| INCOME TAX  PROVISION                                              |       | 1,961                                      |       | 3,224 |   | 4,263 |   |
|                                                               |       |                                       |       |   |   |   |   |
| NET INCOME                                                         |       | $                                          | 9,647      |   | $ | 10,901 |   | $ | 11,083 |   |
|                                                               |       |                                       |       |   |   |   |   |
| NET INCOME PER  SHARE - BASIC                                      |       | $                                          | 2.45       |   | $ | 2.75 |   | $ | 2.78 |   |
|                                                               |       |                                       |       |   |   |   |   |
| NET INCOME PER  SHARE - DILUTED                                    |       | $                                          | 2.45       |   | $ | 2.74 |   | $ | 2.78 |   |
|                                                               |       |                                       |       |   |   |   |   |
| WEIGHTED AVERAGE  SHARES OUTSTANDING - BASIC                       |       | 3,934,138                                  |       | 3,971,926 |   | 3,990,008 |   |
|                                                               |       |                                       |       |   |   |   |   |
| WEIGHTED AVERAGE SHARES  OUTSTANDING - DILUTED                     |       | 3,934,617                                  |       | 3,974,055 |   | 3,994,352 |   |

 

See Accompanying Notes to the Consolidated Financial Statements.

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PENNSWOODS BANCORP, INC.CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

 
| ** **                                                                                                       | ** ** | ** **            | ** ** | ** **  | ** ** | ** **     | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** **             | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|----------------|------------|-------------------|------------|------------------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                                       | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional** | ** ** | ** **        | ** ** | **Other**              | ** ** | ** **             | ** ** | **Total**  | ** ** |
| ** **                                                                                                       | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Retained**   | ** ** | **Comprehensive** | ** ** | **Treasury**           | ** ** | **Shareholders’** | ** ** |
| **(In Thousands, Except Per Share Data)**                                               | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**    | ** ** | **Earnings**      | ** ** | **Income (Loss)** | ** ** | **Stock**              | ** ** | **Equity** | ** ** |
|                                                                                                             |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Balance, December  31, 2003                                                                                      |       | 3,991,872             |       | $           | 33,265     |           | $          | 17,559            |       | $                      | 13,022     |                   | $          | 6,132      |       | $ | (209 | ) | $ | 69,769 |   |
|                                                                                                             |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Comprehensive  income:                                                                                           |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Net income                                                                                                       |       |                  |       |        |       |           |       | 11,083            |       |                   |       |                   |       | 11,083     |       |
| Unrealized loss on available for sale securities, net  of reclassification adjustments and tax benefit of $926   |       |                  |       |        |       |           |       |              |       | (1,801                 | )          |                   |       | (1,801     | )          |
| Total comprehensive income                                                                                       |       |                  |       |        |       |           |       |              |       |                   |       |                   |       | 9,282      |       |
| Dividends  declared ($1.47 per share)                                                                            |       |                  |       |        |       |           |       | (5,843            | )          |                   |       |                   |       | (5,843     | )          |
| Stock options  exercised                                                                                         |       | 6,332                 |       | 53          |       | 141            |       |              |       |                   |       |                   |       | 194        |       |
| Purchase of  treasury stock (6,372 shares)                                                                       |       |                  |       |        |       |           |       |              |       |                   |       | (237                   | )          | (237       | )          |
|                                                                                                             |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Balance, December  31, 2004                                                                                      |       | 3,998,204             |       | 33,318      |       | 17,700         |       | 18,262            |       | 4,331                  |       | (446                   | )          | 73,165     |       |
|                                                                                                             |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Stock split  fractional shares                                                                                   |       | (293                  | )          | (2          | )          | 2              |       |              |       |                   |       |                   |       | —     |       |
| Comprehensive  income:                                                                                           |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Net income                                                                                                       |       |                  |       |        |       |           |       | 10,901            |       |                   |       |                   |       | 10,901     |       |
| Unrealized loss on available for sale securities, net  of reclassification adjustments and tax benefit of $1,793 |       |                  |       |        |       |           |       |              |       | (3,481                 | )          |                   |       | (3,481     | )          |
| Total  comprehensive income                                                                                      |       |                  |       |        |       |           |       |              |       |                   |       |                   |       | 7,420      |       |
| Dividends  declared ($1.56 per share)                                                                            |       |                  |       |        |       |           |       | (6,225            | )          |                   |       |                   |       | (6,225     | )          |
| Stock options  exercised                                                                                         |       | 4,248                 |       | 35          |       | 70             |       |              |       |                   |       |                   |       | 105        |       |
| Purchase of  treasury stock (14,000 shares)                                                                      |       |                  |       |        |       |           |       |              |       |                   |       | (546                   | )          | (546       | )          |
|                                                                                                             |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Balance, December  31, 2005                                                                                      |       | 4,002,159             |       | 33,351      |       | 17,772         |       | 22,938            |       | 850                    |       | (992                   | )          | 73,919     |       |
|                                                                                                             |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Comprehensive  income:                                                                                           |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Net income                                                                                                       |       |                  |       |        |       |           |       | 9,647             |       |                   |       |                   |       | 9,647      |       |
| Unrealized gain on available for sale securities, net  of reclassification adjustments and tax of $664           |       |                  |       |        |       |           |       |              |       | 1,289                  |       |                   |       | 1,289      |       |
| Total comprehensive income                                                                                       |       |                  |       |        |       |           |       |              |       |                   |       |                   |       | 10,936     |       |
| Cumulative effect  of change in accounting for pension obligations, net of tax bemefit of $298                   |       |                  |       |        |       |           |       |              |       | (579                   | )          |                   |       | (579       | )          |
| Dividends  declared ($1.73 per share)                                                                            |       |                  |       |        |       |           |       | (6,802            | )          |                   |       |                   |       | (6,802     | )          |
| Common shares  issued for employee stock purchase plan                                                           |       | 1,355                 |       | 11          |       | 38             |       |              |       |                   |       |                   |       | 49         |       |
| Purchase of  treasury stock (76,400 shares)                                                                      |       |                  |       |        |       |           |       |              |       |                   |       | (2,929                 | )          | (2,929     | )          |
|                                                                                                             |       |                  |       |        |       |           |       |              |       |                   |       |                   |       |       |       |
| Balance, December  31, 2006                                                                                      |       | 4,003,514             |       | $           | 33,362     |           | $          | 17,810            |       | $                      | 25,783     |                   | $          | 1,560      |       | $ | (3,921 | ) | $ | 74,594 |   |

 
| ** **                                                                       | ** ** | ** ** | ** ** | ** ** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------|------------|------------|------------|------------|------------|----------|------------|----------|------------|----------|------------|------------|------------|------------|------------|
| Components of  comprehensive income (loss):                                      |       |       |       |       |       |     |       |     |       |     |       |       |       |       |       |
| Change in net unrealized gain (loss) on investments  available for sale          |       |       |       |       |       | $   | 2,397      |     | $     | (2,036   | )          | $     | (365       | )          |       |   |   |   |
| Net realized  gains included in net income, net of taxes of $571, $745, and $740 |       |       |       |       |       | (1,108   | )          | (1,445   | )          | (1,436   | )          |       |       |       |       |
|                                                                             |       |       |       |       |       |     |       |     |       |     |       |       |       |       |       |
| Total                                                                            |       |       |       |       |       | $        | 1,289      |     | $          | (3,481   | )          | $          | (1,801     | )          |       |   |   |   |

 

See Accompanying Notes to theConsolidated Financial Statements.

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PENNSWOODS BANCORP, INC.CONSOLIDATED STATEMENT OF CASH FLOWS

 
| ** **                                                                         | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| **(In Thousands)**                                                            | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                               |       |                                       |       |   |   |   |   |
| OPERATING  ACTIVITIES                                                              |       |                                       |       |   |   |   |   |
| Net income                                                                         |       | $                                          | 9,647      |   | $ | 10,901 |   | $ | 11,083 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                       |       |   |   |   |   |
| Depreciation and amortization                                                      |       | 744                                        |       | 549 |   | 585 |   |
| Provision for loan losses                                                          |       | 635                                        |       | 720 |   | 465 |   |
| Accretion and amortization of investment security  discounts and premiums          |       | (784                                       | )          | (453 | ) | (132 | ) |
| Securities gains, net                                                              |       | (1,679                                     | )          | (2,190 | ) | (2,176 | ) |
| Originations of loans held for sale                                                |       | (37,192                                    | )          | (30,353 | ) | (34,398 | ) |
| Proceeds of loans held for sale                                                    |       | 37,874                                     |       | 32,296 |   | 35,546 |   |
| Gain on sale of loans                                                              |       | (853                                       | )          | (864 | ) | (969 | ) |
| Increases in bank-owned life insurance                                             |       | (628                                       | )          | (568 | ) | (294 | ) |
| Other, net                                                                         |       | (29                                        | )          | 254 |   | 482 |   |
|                                                                               |       |                                       |       |   |   |   |   |
| Net cash provided by operating activities                                          |       | 7,735                                      |       | 10,292 |   | 10,192 |   |
|                                                                               |       |                                       |       |   |   |   |   |
| INVESTING  ACTIVITIES                                                              |       |                                       |       |   |   |   |   |
| Investment  securities available for sale:                                         |       |                                       |       |   |   |   |   |
| Proceeds from sales                                                                |       | 76,249                                     |       | 123,546 |   | 162,796 |   |
| Proceeds from calls and maturities                                                 |       | 7,477                                      |       | 12,664 |   | 28,732 |   |
| Purchases                                                                          |       | (78,241                                    | )          | (141,798 | ) | (159,295 | ) |
| Investment  securities held to maturity:                                           |       |                                       |       |   |   |   |   |
| Proceeds from calls and maturities                                                 |       | 25                                         |       | 328 |   | 142 |   |
| Purchases                                                                          |       | (25                                        | )          | (35 | ) | (14 | ) |
| Net increase in  loans                                                             |       | (22,353                                    | )          | (14,745 | ) | (49,002 | ) |
| Acquisition of  bank premises and equipment                                        |       | (1,072                                     | )          | (2,076 | ) | (842 | ) |
| Proceeds from  the sale of foreclosed assets                                       |       | 329                                        |       | 329 |   | 237 |   |
| Proceeds from  bank-owned life insurance death benefit                             |       | —                                     |       | 826 |   | — |   |
| Purchase of  bank-owned life insurance                                             |       | —                                     |       | — |   | (1,774 | ) |
| Investment in  limited partnership                                                 |       | (1,646                                     | )          | (3,124 | ) | — |   |
| Proceeds from  redemption of regulatory stock                                      |       | 3,630                                      |       | 4,862 |   | 3,322 |   |
| Purchases of  regulatory stock                                                     |       | (2,899                                     | )          | (4,760 | ) | (2,940 | ) |
|                                                                               |       |                                       |       |   |   |   |   |
| Net cash used for investing activities                                             |       | (18,526                                    | )          | (23,983 | ) | (18,638 | ) |
|                                                                               |       |                                       |       |   |   |   |   |
| FINANCING  ACTIVITIES                                                              |       |                                       |       |   |   |   |   |
| Net increase  (decrease) in interest-bearing deposits                              |       | 40,881                                     |       | (1,636 | ) | 13,343 |   |
| Net increase  (decrease) in noninterest-bearing deposits                           |       | 1,781                                      |       | (2,671 | ) | 9,175 |   |
| Net (decrease)  increase in short-term borrowings                                  |       | (19,306                                    | )          | 17,528 |   | (10,790 | ) |
| Proceeds from  long term borrowings, FHLB                                          |       | —                                     |       | 10,000 |   | 5,000 |   |
| Repayment of  long term borrowings, FHLB                                           |       | (1,600                                     | )          | (1,400 | ) | — |   |
| Dividends paid                                                                     |       | (6,802                                     | )          | (6,225 | ) | (5,843 | ) |
| Issuance of  common stock                                                          |       | 49                                         |       | — |   | — |   |
| Stock options  exercised                                                           |       | —                                     |       | 105 |   | 194 |   |
| Purchase of  treasury stock                                                        |       | (2,929                                     | )          | (546 | ) | (237 | ) |
|                                                                               |       |                                       |       |   |   |   |   |
| Net cash provided by financing activities                                          |       | 12,074                                     |       | 15,155 |   | 10,842 |   |
|                                                                               |       |                                       |       |   |   |   |   |
| NET INCREASE IN  CASH AND CASH EQUIVALENTS                                         |       | 1,283                                      |       | 1,464 |   | 2,396 |   |
|                                                                               |       |                                       |       |   |   |   |   |
| CASH AND CASH  EQUIVALENTS, BEGINNING                                              |       | 14,090                                     |       | 12,626 |   | 10,230 |   |
|                                                                               |       |                                       |       |   |   |   |   |
| CASH AND CASH  EQUIVALENTS, ENDING                                                 |       | $                                          | 15,373     |   | $ | 14,090 |   | $ | 12,626 |   |
|                                                                               |       |                                       |       |   |   |   |   |
| SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION:                                |       |                                       |       |   |   |   |   |
|                                                                               |       |                                       |       |   |   |   |   |
| Interest paid                                                                      |       | $                                          | 13,786     |   | $ | 10,123 |   | $ | 8,754 |   |
| Income taxes  paid                                                                 |       | 2,645                                      |       | 2,625 |   | 4,350 |   |
| Transfer of loans to  foreclosed real estate                                       |       | 278                                        |       | 433 |   | 129 |   |

 

See Accompanying Notes to theConsolidated Financial Statements.

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**PENNS WOODS BANCORP, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**NOTE 1 - OPERATIONS AND SUMMARY OF SIGNIFICANT 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 ComprehensiveFinancial Group (“The M Group”), a wholly owned subsidiary of the Bank  (collectively, the “Company”).  All significant intercompany balances andtransactions have been eliminated.

**Nature of Business**

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, and varioustypes of time and demand deposits including, but not limited to, checkingaccounts, savings accounts, clubs, money market deposit accounts, certificatesof deposit, and IRAs.  Deposits areinsured by the Federal Deposit Insurance Corporation (“FDIC”) to the extentprovided by law.

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

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

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

The M Group engages in securities brokerage and financial planningservices, which include the sale of life insurance products, annuities, andestate planning services.

Operations are managedand financial performance is evaluated on a corporate-wide basis.  Accordingly, all financial services operationsare considered by management to be aggregated in one reportable operatingsegment.

# **Use of Estimates**

The preparation of financial statements in conformity with U.S. generallyaccepted accounting principles requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the consolidatedfinancial statements and the reported amounts of revenues and expenses duringthe reporting period.  Actual results maydiffer 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.

**Stock Split**

During the fourth quarter of 2005 the Company initiated a 6 for 5 stocksplit.  Previously reported share and pershare amounts have been adjusted to reflect the split.

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**Cash and Cash Equivalents**

 

Cash equivalents include cash on hand and in banks and interest-earningdeposits.  Interest-earning depositsmature within one year and are carried at cost. Net cash flows are reported for loan, deposit, and short term borrowingtransactions.

**Restrictionson Cash and Cash Equivalents**

Based on deposit levels, the Company must maintain cash and otherreserves with the Federal Reserve Bank of Philadelphia (FRB).

**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 holdinggains and losses, net of tax, on available for sale securities are reported asa net amount in a separate component of shareholders’ equity until realized.

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

All investment securities, regardless of classification, are monitoredand tested for impairment.  An investmentsecurity is considered to be impaired when the unrealized loss is considered tobe other than temporary.  When this occurs,the investment is written down to the current fair market value with the write-downbeing reflected as a realized loss.

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

Investment securities fair values are based onobserved market prices.  Certaininvestment securities do not have observed bid prices and their fair value isbased on instruments with similar risk elements. Since regulatory stock isredeemable at par, the Company carries it at cost.

**Loans**

Loans are stated at the principal amount outstanding,net of deferred fees, unamortized loan fees and costs, and the allowance forloan losses.  Interest on loans isrecognized as income when earned 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 recognized only to the extent that cash paymentsare received provided the loan is not delinquent in payment and, in management’sjudgment, the borrower has the ability and intent to make future principalpayments.

Loan origination and commitment fees as well ascertain direct loan origination costs are being deferred and amortized as anadjustment to the related loan’s yield over the contractual lives of therelated 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 allowance method is used in providing forloan losses.  Accordingly, all loanlosses are charged to the allowance and all recoveries are credited to it.  The allowance for loan losses is establishedthrough a provision for loan losses charged to operations.  The provision for loan losses is based upon management’s quarterlyreview of the loan portfolio.  Thepurpose of the review is to assess loan quality, identify impaired

41

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loans, analyze delinquencies, ascertain loan growth, evaluate potentialcharge-offs and recoveries, and assess general economic conditions in themarkets served.  An external independentloan review is also performed annually for the Bank.  Management remains committed to an aggressiveprogram of problem loan 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 onmanagement’s consideration of the nature of the portfolio segments, changes inmix and volume of the loan portfolio, historical loan loss experience, andgeneral economic conditions.  Inaddition, management considers industry standards and trends with respect tononperforming loans and its knowledge and experience with specific lendingsegments.

Although management believes that it uses the best informationavailable to make such determinations and that the allowance for loan losses isadequate at December 31, 2006, 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, rising unemployment, or negativeperformance trends in financial information from borrowers could be indicatorsof subsequent increased levels of nonperforming assets and possiblecharge-offs, which would normally require increased loan loss provisions.   An integral part of the periodic regulatoryexamination process is the review of the adequacy of the Bank’s loan lossallowance.  The regulatory agencies couldrequire the Bank based on their evaluation of information available at the timeof their examination to provide additional loan loss provisions to furthersupplement the allowance.

Impaired loans are commercialand commercial real estate loans for which it is probable the Bank will not beable to collect all amounts due according to the contractual terms of the loanagreement.  The Bank individuallyevaluates such loans for impairment and does not aggregate loans by major riskclassifications.  The definition of “impairedloans” is not the same as the definition of “nonaccrual loans,” although the two categories overlap.  The Bank may choose to place a loan onnonaccrual status due to payment delinquency or uncertain collectibility, whilenot classifying the loan as impaired if the loan is not a commercial orcommercial real estate loan.  Factorsconsidered by management in determining impairment include payment status andcollateral value.  The amount ofimpairment for these types of loans is determined by the difference between thepresent value of the expected cash flows related to the loan, using theoriginal interest rate, and its recorded value, or as a practical expedient inthe case of collateralized loans, the difference between the fair value of thecollateral and the recorded amount of the loans.  When foreclosure is probable, impairment ismeasured based on 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 ofpayment delays on a case-by-case basis taking into consideration allcircumstances surrounding the loan and the borrower including the length of thedelay, the borrower’s prior payment record, and the amount of shortfall inrelation to the principal and interest owed.

**LoansHeld for Sale**

Ingeneral, fixed rate residential mortgage loans originated by the Bank are heldfor sale and are carried at cost due to their short holding period which canrange from less than two weeks up to thirty days.  Sold loans are not serviced by the Bank.  Proceeds from the sale of loans in excess ofthe carrying value are accounted for as a gain. Total gains on the sale of loans are shown as a component ofnon-interest income within the consolidated statement of income.

**ForeclosedAssets Held for Sale**

Foreclosed assets held for sale are carried atthe lower of cost or fair value minus estimated selling costs.  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.  Any subsequent write-downs are chargedagainst operating expenses.  Netoperating expenses and gains and losses realized from disposition are includedin non-interest expense and income, respectively.

42

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**Premisesand Equipment**

Premises and equipment are stated at cost less accumulateddepreciation.  Depreciation is computedusing straight-line and accelerated methods over the estimated useful lives ofthe related assets, which range from five to ten years for furniture, fixtures,and equipment and fifteen to forty years for buildings and improvements.  Costs incurred for routine maintenance andrepairs are charged to operations as incurred. Costs of major additions and improvements are capitalized.

**Bank-OwnedLife Insurance**

The Company has purchasedlife insurance policies on certain officers, and is the sole beneficiary onthose policies.  Bank-owned lifeinsurance is recorded at its cash surrender value, or the amount that can berealized.  Increases in the cashsurrender value are recognized as non-interest income.

**Goodwill**

The Companyaccounts for goodwill in accordance with Statement of Financial AccountingStandards (“FAS”) No. 142, *Goodwill andOther Intangible Assets.*  Thisstatement, among other things, requires a two-step process for testing theimpairment of goodwill on at least an annual basis.  This approach could cause more volatility inthe Company’s reported net income because impairment losses, if any, couldoccur irregularly and in varying amounts. The Company performs an annual impairment analysis of goodwill for itspurchased subsidiary, The M Group.  Basedon the fair value of this reporting unit, estimated using the expected presentvalue of future cash flows, no impairment of goodwill was recognized in 2006and 2005.

**Investmentsin Limited Partnerships**

The Company is a limitedpartner in three partnerships at December 31, 2006 that provide low incomeelderly housing in the Company’s geographic market area. The carrying value ofthe Company’s investments in limited partnerships was $4,950,000 at December31, 2006 and $3,549,000 at December 31, 2005. The Company is fully amortizingthe investment in the partnership entered into prior to 2005 over thefifteen-year holding period.  Thepartnerships entered into after 2004 are being fully amortized over theten-year tax credit receipt period utilizing the straight-line method.  The partnerships began being amortized oncethe projects reached the level of occupancy needed to begin the ten year taxcredit recognition period.  Amortizationof limited partnership investments amounted to $245,000 in 2006 and $90,000 for2005 and 2004.

**Off-BalanceSheet Financial Instruments**

In the ordinary course ofbusiness, the Company enters into off-balance sheet financial instruments.Those instruments consist of commitments to extend credit and standby lettersof credit. When those instruments are funded or become payable, the Companyreports the amounts in its financial statements.

**AdvertisingCost**

Advertisingcosts are generally expensed as incurred.

**IncomeTaxes**

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

**EarningsPer Share**

The Company provides dual presentation of basic and diluted earnings pershare.  Basic earnings per share iscalculated utilizing net income as reported in the numerator and weightedaverage shares outstanding in the denominator. The computation of diluted earnings per share differs in that thedilutive effects of any stock options are adjusted in the denominator.

**EmployeeBenefits**

Pension and employee benefits include contributions, determinedactuarially, to a defined benefit retirement plan covering the eligibleemployees of the Bank.  The plan isfunded on a current basis to the extent that it is deductible under existingfederal tax regulations.  Pension andother employee benefits also include contributions to a defined contributionSection 401(k) plan covering eligible employees.  Contributions matching those made by eligibleemployees are funded throughout the year. In addition, an elective contributionis made annually at the discretion of the Board of Directors.

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**The M Group Products and Income Recognition**

The M Group product line is comprised primarily of annuities, lifeinsurance, and mutual funds.  Therevenues generated from life insurance sales are commission only, as The MGroup does not underwrite the policies. Life insurance sales include permanent and term policies with themajority of the policies written being permanent.  Term life insurance policies are written for10, 15, 20, and 30 year terms with the majority of the policies being writtenfor 20 years.  None of these products areoffered as an integral part of lending activities.

Commissions from the sale of annuities are recognized at the timenotice is received from the third party broker/dealer or an insurance companythat the transaction has been accepted and approved, which is also the timewhen commission income is received.

Life insurance commissions are recognized at varying points based onthe payment option chosen by the customer. Commissions from monthly and annual payment plans are recognized at thestart of each annual period for the life insurance, while quarterly andsemi-annual premium payments are recognized quarterly and semi-annually whenthe earnings process is complete.  Forexample, semi-annual payments on the first of January and July would result incommission income recognition on the first of January and July, while paymentson the first of January, April, July, and October would result in commissionincome recognition on those dates.  Thepotential for chargebacks only exists for those policies on a monthly paymentplan since income is recognized at the beginning of the annual coverage periodversus at the time of each monthly payment. No liability is maintained for chargebacks as these are removed fromincome at the time of the occurrence.

**StockOptions**

The Company maintains a stock option plan for directors and certainofficers and employees. For all options granted prior to January 1, 2006,when the exercise price of the Company’s stock options was greater than orequal to the market price of the underlying stock on the date of the grant, nocompensation expense was recognized in the Company’s financial statements.

**AccumulatedOther Comprehensive Income**

The Company is required to present accumulatedother comprehensive income in a full set of general-purpose financialstatements for all periods presented. Accumulated other comprehensive income is comprised of unrealizedholding gains (losses) on the available for sale securities portfolio and theunrecognized components of  net periodicbenefit costs of the defined benefit pension plan.

**Segment Reporting**

Statement of Financial Accounting Standards No. 131, *Disclosure about Segments of an Enterprise and Related Information*,requires that public business enterprises report financial and descriptive informationabout their reportable operating segments. Based on the guidance provided bythe Statement, the company has determined that its only reportable segment isCommunity Banking.

**Reclassificationof Comparative Amounts**

Certain itemspreviously reported have been reclassified to conform to the current year’sreporting format.  Such reclassificationsdid not affect net income or shareholders’ equity.

**Recent Accounting Pronouncements**

In February 2006, the Financial Accounting StandardsBoard (“FASB”) issued FAS No. 155, *Accounting for CertainHybrid Instruments, as an amendment of FASB Statements No. 133 and 140*.  FAS No. 155 allows financial instruments thathave embedded derivatives to be accounted for as a whole (eliminating the needto bifurcate the derivative from its host) if the holder elects to account forthe whole instrument on a fair value basis. This statement is effective for all financial instruments acquired orissued after the beginning of an entity’s first fiscal year that begins afterSeptember 15, 2006.  The adoption of thisstandard is not expected to have a material effect on the Company’s results ofoperations or financial position.

44

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In March 2006, the FASBissued FAS No. 156, *Accounting for Servicingof Financial Assets*.  Thisstatement, which is an amendment to FAS No. 140, will simplify the accountingfor servicing assets and liabilities, such as those common with mortgagesecuritization activities.  Specifically,FAS No. 156 addresses the recognition and measurement of separately recognizedservicing assets and liabilities and provides an approach to simplify effortsto obtain hedge-like (offset) accounting. FAS No. 156 also clarifies when an obligation to service financialassets should be separately recognized as a servicing asset or a servicingliability; requires that a separately recognized servicing asset or servicingliability be initially measured at fair value, if practicable; and permits anentity with a separately recognized servicing asset or servicing liability tochoose either of the amortization or fair value methods for subsequentmeasurement.  The provisions of FAS No.156 are effective as of the beginning of the first fiscal year that beginsafter September 15, 2006.   The adoptionof this standard is not expected to have a material effect on the Company’sresults of operations or financial position.

In September 2006, theFASB issued FAS No. 157, *Fair Value Measurements*,which provides enhanced guidance for using fair value to measure assets andliabilities. The standard applies whenever other standards require or permitassets or liabilities to be measured at fair value. The standard does notexpand the use of fair value in any new circumstances.  FAS No. 157 is effective for financialstatements issued for fiscal years beginning after November 15, 2007, andinterim periods within those fiscal years. Early adoption is permitted.  Theadoption of this standard is not expected to have a material effect on theCompany’s results of operations or financial position.

In September 2006, the FASB issued FAS No. 158, *Employers’ Accounting for Defined Benefit Pension and Other Postretirement  Plans, an amendment of FASB Statements  No.  87, 88, 106 and 132(R)*.  FAS No. 158 requires that a company  recognize the overfunded or underfunded  status of its defined benefit post  retirement  plans (other than  multiemployer  plans) as an asset or liability in its statement of financial  position and that it recognize changes  in the funded  status in the year in which the  changes  occur  through other  comprehensive  income.  FAS No. 158 also requires the  measurement  of defined  benefit  plan  assets and  obligations  as of the fiscal  year-end,  in addition  to  footnote  disclosures.  On December 31, 2006, the Company adopted FAS No. 158, except for the measurement provisions, which are effective for fiscal years ending after December 15, 2008.  The adoption of this standard is not expected to have a material effect on the Company’s results of operations or financial position.

In June 2006, the FASBissued FASB Interpretation No. 48 (“FIN 48”), *Accountingfor Uncertainty in Income Taxes*. FIN 48 is an interpretation of FASNo. 109, *Accounting for Income Taxes*, andit seeks to reduce the diversity in practice associated with certain aspects ofmeasurement and recognition in accounting for income taxes. ThisInterpretation clarifies that management is expected to evaluate an income taxposition taken or expected to be taken for likelihood of realization beforerecording any amounts for such position in the financial statement.  FIN 48 also requires expanded disclosure withrespect to income tax positions taken that are not certain to be realized.  This Interpretation is effective for fiscalyears beginning after December 15, 2006, and will require management toevaluate every open tax position that exists in every jurisdiction on the dateof initial adoption.  The Company is currently evaluating theimpact the adoption of the standard will have on the Company’s results ofoperations.

In September 2006, the FASBreached consensus on the guidance provided by Emerging Issues Task Force Issue06-4 (“EITF 06-4”), *Accounting for DeferredCompensation and Postretirement Benefit Aspects of Endorsement Split-DollarLife Insurance Arrangements*. The guidance is applicable to endorsement split-dollar life insurancearrangements, whereby the employer owns and controls the insurance policy, thatare associated with a postretirement benefit. EITF 06-4 requires that for a split-dollar life insurance arrangementwithin the scope of the issue, an employer should recognize a liability forfuture benefits in accordance with FAS No. 106 (if, in substance, apostretirement benefit plan exists) or Accounting Principles Board Opinion No.12 (if the arrangement is, in substance, an individual deferred compensationcontract) based on the substantive agreement with the employee.  EITF 06-4 is effective for fiscal yearsbeginning after December 15, 2007.  TheCompany is currently evaluating the impact the adoption of the standard willhave on the Company’s results of operations or financial condition.

In September 2006, theFASB reached consensus on the guidance provided by Emerging Issues Task ForceIssue 06-5 (“EITF 06-5”), *Accounting for Purchasesof Life Insurance—Determining the Amount That Could Be Realized in Accordancewith FASB Technical Bulletin No. 85-4, Accounting for Purchases of LifeInsurance*.  EITF 06-5 statesthat a policyholder should consider any additional amounts included in thecontractual terms of the insurance policy other than the

45

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cash surrender value indetermining the amount that could be realized under the insurancecontract.  EITF 06-5 also states that apolicyholder should determine the amount that could be realized under the lifeinsurance contract assuming the surrender of an individual-life byindividual-life policy (or certificate by certificate in a group policy). EITF06-5 is effective for fiscal years beginning after December 15, 2006.   The Company is currently evaluating theimpact the adoption of the standard will have on the Company’s results ofoperations or financial condition.

**NOTE 2 - PER SHARE DATA**

There are no convertible securities, which would affect the numerator incalculating basic and dilutive earnings per share, therefore, net income aspresented on the consolidated statement of income will be used as thenumerator.  The following table setsforth the composition of the weighted average common shares (denominator) usedin the basic and dilutive per share computation.
|                                                                                                            | ** ** | **2006**  | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
|                                                                                                       |       |      |       |      |       |      |       |
| Weighted average common shares outstanding                                                                 |       | 4,002,416 |       | 3,986,569 |       | 3,993,336 |       |
|                                                                                                       |       |      |       |      |       |      |       |
| Average treasury stock shares                                                                              |       | (68,278   | )          | (14,643   | )          | (3,328    | )          |
|                                                                                                       |       |      |       |      |       |      |       |
| Weighted average common shares and common stock equivalents used to calculate  basic earnings per share    |       | 3,934,138 |       | 3,971,926 |       | 3,990,008 |       |
|                                                                                                       |       |      |       |      |       |      |       |
| Additional common stock equivalents (stock options) used to calculate diluted  earnings per share          |       | 479       |       | 2,129     |       | 4,344     |       |
|                                                                                                       |       |      |       |      |       |      |       |
| Weighted  average common shares and common stock equivalents used to calculate diluted  earnings per share |       | 3,934,617 |       | 3,974,055 |       | 3,994,352 |       |

 

Options to purchase 9,002 shares of common stock at a price of $40.29were outstanding during 2006 and 2005, and 10,455 shares of common stock at aprice of $40.29 were outstanding during 2004. The options were not included in the computation of diluted earnings pershare as they were anti-dilutive due to the strike price at December 31, ofeach period presented being greater than the market value at that time.

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**NOTE 3 - INVESTMENT SECURITIES**

The amortized cost and estimated fair values of investment securities atDecember 31, 2006 and 2005 are as follows:
| ** **                             | ** ** | **2006**      | ** ** |
|----------------------------------------|------------|---------------|------------|
| ** **                             | ** ** | ** **    | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                             | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **(In Thousands)**                | ** ** | **Cost**      | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                                   |       |          |       |   |   |   |   |   |   |
| Available for sale  (AFS)              |       |          |       |   |   |   |   |   |   |
| U.S. Government  and agency securities |       | $        | 54,949     |   | $  | 24 |   | $  | (821 | ) | $  | 54,152 |   |
| State and  political securities        |       | 104,658       |       | 1,646 |   | (358 | ) | 105,946 |   |
| Other debt  securities                 |       | 1,998         |       | 37 |   | (11 | ) | 2,024 |   |
| Total debt securities                  |       | 161,605       |       | 1,707 |   | (1,190 | ) | 162,122 |   |
| Equity  securities                     |       | 20,353        |       | 2,883 |   | (158 | ) | 23,078 |   |
| Total investment  securities AFS       |       | $             | 181,958    |   | $ | 4,590 |   | $ | (1,348 | ) | $ | 185,200 |   |
|                                   |       |          |       |   |   |   |   |   |   |
| Held to maturity  (HTM)                |       |          |       |   |   |   |   |   |   |
| U.S. Government  and agency securities |       | $        | 26         |   | $  | 2 |   | $  | — |   | $  | 28 |   |
| Other debt  securities                 |       | 257           |       | 1 |   | — |   | 258 |   |
| Total investment securities  HTM       |       | $             | 283        |   | $ | 3 |   | $ | — |   | $ | 286 |   |

 
| ** **                             | ** ** | **2005**      | ** ** |
|----------------------------------------|------------|---------------|------------|
| ** **                             | ** ** | ** **    | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                             | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **(In Thousands)**                | ** ** | **Cost**      | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                                   |       |          |       |   |   |   |   |   |   |
| Available for sale  (AFS)              |       |          |       |   |   |   |   |   |   |
| U.S. Government  and agency securities |       | $        | 65,496     |   | $  | 30 |   | $  | (1,573 | ) | $  | 63,953 |   |
| State and  political securities        |       | 93,769        |       | 1,390 |   | (1,068 | ) | 94,091 |   |
| Other debt  securities                 |       | 1,750         |       | 12 |   | (43 | ) | 1,719 |   |
| Total debt securities                  |       | 161,015       |       | 1,432 |   | (2,684 | ) | 159,763 |   |
| Equity  securities                     |       | 24,715        |       | 2,951 |   | (411 | ) | 27,255 |   |
| Total investment  securities AFS       |       | $             | 185,730    |   | $ | 4,383 |   | $ | (3,095 | ) | $ | 187,018 |   |
|                                   |       |          |       |   |   |   |   |   |   |
| Held to maturity  (HTM)                |       |          |       |   |   |   |   |   |   |
| U.S. Government  and agency securities |       | $        | 28         |   | $  | 2 |   | $  | — |   | $  | 30 |   |
| Other debt  securities                 |       | 237           |       | — |   | (29 | ) | 208 |   |
| Total investment securities  HTM       |       | $             | 265        |   | $ | 2 |   | $ | (29 | ) | $ | 238 |   |

 

The following tables showthe Company’s gross unrealized losses and fair value, aggregated by investmentcategory and length of time, that the individual securities have been in acontinuous unrealized loss position, at December 31, 2006 and 2005.

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| ** **                             | ** ** | **2006**                                   | ** ** |
|----------------------------------------|------------|--------------------------------------------|------------|
| ** **                             | ** ** | **Less than Twelve Months** | ** ** | **Twelve Months or Greater** | ** ** | **Total** | ** ** |
| ** **                             | ** ** | ** Estimated **                  | ** ** | **Gross** | ** ** | ** Estimated ** | ** ** | **Gross** | ** ** | **Estimated** | ** ** | **Gross** | ** ** |
| ** **                             | ** ** | **Fair**                                   | ** ** | ** Unrealized ** | ** ** | **Fair** | ** ** | ** Unrealized ** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| **(In Thousands)**                | ** ** | **Value**                                  | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
|                                   |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| U.S. Government  and agency securities |       | $                                          | 24,552     |   | $ | 97 |   | $ | 25,053 |   | $ | 724 |   | $ | 49,605 |   | $ | 821 |   |
| State and  political securities        |       | 31,286                                     |       | 195 |   | 11,706 |   | 163 |   | 42,992 |   | 358 |   |
| Other debt  securities                 |       | 292                                        |       | 7 |   | 146 |   | 4 |   | 438 |   | 11 |   |
| Total debt securities                  |       | 56,130                                     |       | 299 |   | 36,905 |   | 891 |   | 93,035 |   | 1,190 |   |
| Equity securities                      |       | 726                                        |       | 33 |   | 2,592 |   | 125 |   | 3,318 |   | 158 |   |
| Total                                  |       | $                                          | 56,856     |   | $ | 332 |   | $ | 39,497 |   | $ | 1,016 |   | $ | 96,353 |   | $ | 1,348 |   |

 
| ** **                             | ** ** | **2005**                                   | ** ** |
|----------------------------------------|------------|--------------------------------------------|------------|
| ** **                             | ** ** | **Less than Twelve Months** | ** ** | **Twelve Months or Greater** | ** ** | **Total** | ** ** |
| ** **                             | ** ** | ** Estimated **                  | ** ** | **Gross** | ** ** | ** Estimated ** | ** ** | **Gross** | ** ** | **Estimated** | ** ** | **Gross** | ** ** |
| ** **                             | ** ** | **Fair**                                   | ** ** | ** Unrealized ** | ** ** | **Fair** | ** ** | ** Unrealized ** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| **(In Thousands)**                | ** ** | **Value**                                  | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
|                                   |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| U.S. Government  and agency securities |       | $                                          | 34,028     |   | $ | 925 |   | $ | 26,038 |   | $ | 648 |   | $ | 60,066 |   | $ | 1,573 |   |
| State and  political securities        |       | 46,864                                     |       | 1,063 |   | 586 |   | 5 |   | 47,450 |   | 1,068 |   |
| Other debt  securities                 |       | 707                                        |       | 54 |   | 232 |   | 18 |   | 939 |   | 72 |   |
| Total debt securities                  |       | 81,599                                     |       | 2,042 |   | 26,856 |   | 671 |   | 108,455 |   | 2,713 |   |
| Equity  securities                     |       | 2,721                                      |       | 249 |   | 1,340 |   | 162 |   | 4,061 |   | 411 |   |
| Total                                  |       | $                                          | 84,320     |   | $ | 2,291 |   | $ | 28,196 |   | $ | 833 |   | $ | 112,516 |   | $ | 3,124 |   |

 

At December 31, 2006 there were a total of 88 and 32 individualsecurities that were in a continuous unrealized loss position for less thantwelve months and greater than twelve months, respectively.

The policy of the Company is to recognize other than temporary impairmentof equity securities where the fair value has been significantly below cost forfour consecutive quarters.  For fixedmaturity investments with unrealized losses due to interest rates where theCompany has the positive intent and ability to hold the investment for a periodof time sufficient to allow a market recovery, declines in value below cost arenot assumed to be other than temporary. The Company reviews its position quarterly and has asserted that atDecember 31, 2006, the declines outlined in the above table represent temporarydeclines and the Company does have the intent and ability to hold thosesecurities either to maturity or to allow a market recovery.

The Company has concluded that any impairment of its investmentsecurities portfolio is not other than temporary but is the result of interestrate changes that are not expected to result in the non-collection of principaland interest during the period.

The amortized cost and fair value of debt securities at December 31,2006, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities sinceborrowers may have the right to call or prepay obligations with or without callor prepayment penalties.
| ** **                         | ** ** | **Available for Sale** | ** ** | **Held to Maturity** | ** ** |
|------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                         | ** ** | **Amortized**                    | ** ** | **Estimated**                  | ** ** | **Amortized** | ** ** | **Estimated** | ** ** |
| **(In Thousands)**            | ** ** | **Cost**                         | ** ** | **Fair Value**            | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
| Due in one year  or less           |       | $                                | —     |                           | $          | — |   | $ | — |   | $ | — |   |
| Due after one  year to five years  |       | 25                               |       | 25                             |       | 125 |   | 125 |   |
| Due after five  years to ten years |       | 1,515                            |       | 1,477                          |       | 132 |   | 133 |   |
| Due after ten  years               |       | 160,065                          |       | 160,620                        |       | 26 |   | 28 |   |
| Total                              |       | $                                | 161,605    |                           | $          | 162,122 |   | $ | 283 |   | $ | 286 |   |

 

48

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Total gross proceeds from sales of securitiesavailable for sale were $76,249,000, $123,546,000, and $162,796,000 for 2006,2005, and 2004, respectively.  Thefollowing table represents gross realized gains and losses on thosetransactions:

 
| (In Thousands)                   | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Gross realized  gains:                |       |     |       |     |       |     |       |
| U.S. Government and agency securities |       | $        | —     |     | $          | 128      |       | $ | 459 |   |
| State and political securities        |       | 1,248    |       | 819      |       | 1,191    |       |
| Other debt securities                 |       | —   |       | —   |       | 1        |       |
| Equity securities                     |       | 1,655    |       | 2,209    |       | 2,192    |       |
| Total gross realized gains            |       | $        | 2,903      |     | $          | 3,156    |       | $ | 3,843 |   |
|                                  |       |     |       |     |       |     |       |
| Gross realized  losses:               |       |     |       |     |       |     |       |
| U.S. Government and agency securities |       | $        | 913        |     | $          | 791      |       | $ | 1,623 |   |
| State and political securities        |       | 302      |       | 116      |       | 23       |       |
| Other debt securities                 |       | —   |       | 59       |       | —   |       |
| Equity securities                     |       | 9        |       | —   |       | 21       |       |
| Total gross  realized losses          |       | $        | 1,224      |     | $          | 966      |       | $ | 1,667 |   |

 

Investment securities with a carrying value of approximately $64,821,000and $72,642,000 at December 31, 2006 and 2005, respectively, were pledged tosecure certain deposits, repurchase agreements, and for other purposes asrequired by law.

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

**NOTE 4 – LOANS**

 

Major loan classifications as of December 31, 2006 and 2005 aresummarized as follows:
|                                   | ** ** | **2006**    | ** ** |
|-----------------------------------|------------|-------------|------------|
| ** **                        | ** ** | ** **  | ** ** | ** ** | ** ** | **Past Due** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **  | ** ** | ** ** | ** ** | **90 Days** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **  | ** ** | **Past Due** | ** ** | **Or More** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **  | ** ** | **30 To 90** | ** ** | **& Still** | ** ** | **Non-** | ** ** | ** ** | ** ** |
| **(In Thousands)**           | ** ** | **Current** | ** ** | **Days** | ** ** | **Accruing** | ** ** | **Accrual** | ** ** | **Total** | ** ** |
| Commercial and  agricultural      |       | $           | 27,682     |   | $ | 764 |   | $ | 109 |   | $ | — |   | $ | 28,555 |   |
| Real estate  mortgage:            |       |        |       |   |   |   |   |   |   |   |   |
| Residential                       |       | 156,976     |       | 1,050 |   | 8 |   | 185 |   | 158,219 |   |
| Commercial                        |       | 133,813     |       | 1,406 |   | — |   | 185 |   | 135,404 |   |
| Construction                      |       | 16,695      |       | 54 |   | — |   | — |   | 16,749 |   |
| Installment  loans to individuals |       | 22,127      |       | 346 |   | 2 |   | — |   | 22,475 |   |
|                              |       | 357,293     |       | $ | 3,620 |   | $ | 119 |   | $ | 370 |   | 361,402 |   |
| Less: Net deferred loan fees      |       | 1,018       |       |   |   |   |   |   |   | 1,018 |   |
|  Allowance for loan losses   |       | 4,185       |       |   |   |   |   |   |   | 4,185 |   |
| Loans, net                        |       | $           | 352,090    |   |   |   |   |   |   |   | $ | 356,199 |   |

 
|                                   | ** ** | **2005**    | ** ** |
|-----------------------------------|------------|-------------|------------|
| ** **                        | ** ** | ** **  | ** ** | ** ** | ** ** | **Past Due** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **  | ** ** | ** ** | ** ** | **90 Days** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **  | ** ** | **Past Due** | ** ** | **Or More** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **  | ** ** | **30 To 90** | ** ** | **& Still** | ** ** | **Non-** | ** ** | ** ** | ** ** |
| **(In Thousands)**           | ** ** | **Current** | ** ** | **Days** | ** ** | **Accruing** | ** ** | **Accrual** | ** ** | **Total** | ** ** |
| Commercial and  agricultural      |       | $           | 34,000     |   | $ | 238 |   | $ | — |   | $ | 169 |   | $ | 34,407 |   |
| Real estate  mortgage:            |       |        |       |   |   |   |   |   |   |   |   |
| Residential                       |       | 148,190     |       | 1,413 |   | 34 |   | 363 |   | 150,000 |   |
| Commercial                        |       | 125,587     |       | 1,544 |   | — |   | — |   | 127,131 |   |
| Construction                      |       | 10,599      |       | 79 |   | — |   | 3 |   | 10,681 |   |
| Installment  loans to individuals |       | 16,859      |       | 388 |   | 29 |   | 5 |   | 17,281 |   |
|                              |       | 335,235     |       | $ | 3,662 |   | $ | 63 |   | $ | 540 |   | 339,500 |   |
| Less: Net deferred loan fees      |       | 1,062       |       |   |   |   |   |   |   | 1,062 |   |
|  Allowance for loan losses   |       | 3,679       |       |   |   |   |   |   |   | 3,679 |   |
| Loans, net                        |       | $           | 330,494    |   |   |   |   |   |   |   | $ | 334,759 |   |

 

49

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Impaired loans totaled$574,000 at December 31, 2006.  Theportion of the allowance for loan losses allocated for impaired loans was$42,000 at December 31, 2006. The average recorded investment in impaired loansduring the year ended December 31, 2006 was approximately $504,000.  There were no impaired loans for the yearsended December 31, 2005 and 2004.

The Company recognizedinterest income on impaired loans in the amount of $72,000 for the year endedDecember 31, 2006.  On a cash basisinterest income on impaired loans amounted to $58,000 for the year endedDecember 31, 2006.

No additional funds arecommitted to be advanced in connection with impaired loans.

Loans on which theaccrual of interest has been discontinued or reduced, exclusive of impaired loans,  amounted to approximately $370,000 and$540,000 at December 31, 2006 and 2005, respectively.  If interest had been recorded based on theoriginal loan agreement terms and rate of interest for those loans, incomewould have approximated $23,000, $39,000, and $64,000 for the years endedDecember 31, 2006, 2005, and 2004, respectively.  Interest income on such loans, is recorded asreceived and amounted to approximately $15,000, $18,000, and $10,000, for theyears ended December 31, 2006, 2005, and 2004, respectively.

Changes in the allowance for loan losses for the years ended December 31,are as follows:
|                                  | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                             |       |     |       |     |       |     |       |
| Balance,  beginning of year      |       | $        | 3,679      |     | $          | 3,338    |       | $ | 3,069 |   |
| Provision  charged to operations |       | 635      |       | 720      |       | 465      |       |
| Loans charged  off               |       | (327     | )          | (446     | )          | (283     | )          |
| Recoveries                       |       | 198      |       | 67       |       | 87       |       |
| Balance, end of year             |       | $        | 4,185      |     | $          | 3,679    |       | $ | 3,338 |   |

 

The Company has a concentration of loans to both owners of commercial andresidential rental properties at December 31, 2006 and 2005 of 15.38% and15.09% and 15.82% and 15.92% of total loans, respectively.

The Company grants commercial, industrial, residential, and installmentloans to customers throughout north-central Pennsylvania.  Although the Company has a diversified loanportfolio at December 31, 2006 and 2005, a substantial portion of its debtors’ability to honor their contracts is dependent on the economic conditions withinthis region.

50

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**NOTE 5 - PREMISES AND EQUIPMENT**

Majorclassifications of premises and equipment are summarized as follows at December31:
| (In Thousands)                             | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
|                                            |       |     |       |     |       |
| Land                                            |       | $        | 1,370      |     | $          | 1,046 |   |
| Premises                                        |       | 6,038    |       | 6,022    |       |
| Furniture and  equipment                        |       | 4,844    |       | 4,118    |       |
| Leasehold  improvements                         |       | 811      |       | 805      |       |
| Total                                           |       | 13,063   |       | 11,991   |       |
| Less accumulated  depreciation and amortization |       | 6,326    |       | 5,582    |       |
| Net premises and  equipment                     |       | $        | 6,737      |     | $          | 6,409 |   |

 

Depreciation and amortization charged to operations for the years ended2006, 2005, and 2004 was $744,000, $549,000, and $585,000, respectively.

**NOTE 6 – GOODWILL**

As of December 31, 2006, 2005, and 2004 goodwill had a gross carryingvalue of $3,308,000 and accumulated amortization of $276,000 resulting in a netcarrying amount of $3,032,000.

The gross carrying amount of goodwill is tested for impairment in thethird quarter of each fiscal year.  Basedon fair value of the reporting unit, estimated using the expected present valueof future cash flows, there was no evidence of impairment of the carryingamount at December 31, 2006 and 2005, respectively.

**NOTE 7 – TIME DEPOSITS**

Time deposits of $100,000or more totaled approximately $49,793,000 on December 31, 2006 and $36,762,000on December 31, 2005.  Interest expenserelated to such deposits was approximately $1,873,000, $1,417,000, and $818,000,for the years ended December 31, 2006, 2005, and 2004, respectively.

At December 31, 2006, thescheduled maturities on time deposits of $100,000 or more are as follows:
| (In Thousands)          | ** ** | **2006** | ** ** |
|------------------------------|------------|----------|------------|
|                         |       |     |       |
| Three months or  less        |       | $        | 18,963     |   |
| Three months to  six months  |       | 11,230   |       |
| Six months to  twelve months |       | 11,705   |       |
| Over twelve  months          |       | 7,895    |       |
| Total                        |       | $        | 49,793     |   |

 

51

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Total time depositmaturities are as follows:
| (In Thousands) | ** ** | **2006** | ** ** |
|---------------------|------------|----------|------------|
|                |       |     |       |
| 2007                |       | $        | 157,818    |   |
| 2008                |       | 23,983   |       |
| 2009                |       | 7,052    |       |
| 2010                |       | 3,245    |       |
| 2011                |       | 546      |       |
| Thereafter          |       | 805      |       |
| Total               |       | $        | 193,449    |   |

 

##### **NOTE 8 - SHORT-TERM BORROWINGS**

Short-termborrowings consist of securities sold under agreements to repurchase and FHLBadvances which generally represent overnight or less than six month borrowings.  In addition to the outstanding balances notedbelow, the Bank also had additional lines of credit totaling $28,048,000available from correspondent banks other than the FHLB.  The outstanding balances and relatedinformation for short-term borrowings are summarized as follows:
| (In Thousands)                          | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|----------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **Repurchase Agreements:**                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance at year end                          |       | $          | 15,991     |       | $          | 15,263     |       | $ | 13,845 |   |
| Maximum amount  outstanding at any month end |       | 19,916     |       | 16,754     |       | 15,301     |       |
| Average balance  outstanding during the year |       | 16,028     |       | 14,268     |       | 13,317     |       |
| Weighted-average  interest rate:             |       |       |       |       |       |       |       |
| At year end                                  |       | 3.96       | %          | 2.74       | %          | 1.82       | %          |
| Paid during the  year                        |       | 3.55       | %          | 2.19       | %          | 1.77       | %          |
|                                         |       |       |       |       |       |       |       |
| **Open Repo Plus:**                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance at year end                          |       | $          | 18,706     |       | $          | 1,740      |       | $ | 22,630 |   |
| Maximum amount  outstanding at any month end |       | 43,040     |       | 24,990     |       | 32,480     |       |
| Average balance  outstanding during the year |       | 15,301     |       | 10,765     |       | 18,336     |       |
| Weighted-average  interest rate:             |       |       |       |       |       |       |       |
| At year end                                  |       | 5.40       | %          | 4.25       | %          | 2.24       | %          |
| Paid during the  year                        |       | 5.07       | %          | 3.33       | %          | 1.64       | %          |
|                                         |       |       |       |       |       |       |       |
| **Short-Term FHLB:**                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance at year end                          |       | $          | —     |       | $          | 37,000     |       | $ | — |   |
| Maximum amount  outstanding at any month end |       | —     |       | 37,000     |       | 900        |       |
| Average balance  outstanding during the year |       | 3,283      |       | 7,081      |       | 204        |       |
| Weighted-average  interest rate:             |       |       |       |       |       |       |       |
| At year end                                  |       | —     |       | 4.24       | %          | —     |       |
| Paid during the year                         |       | 4.82       | %          | 3.66       | %          | 1.42       | %          |

 

52

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**NOTE 9 – LONG TERM BORROWINGS**

 

The following represents outstanding long-term borrowings with the FHLBby contractual maturities at December 31, 2006 and 2005:

 
| (In Thousands)                                       | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                      |       |     |       |     |       |
| 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  between 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    |       |
| Variable rate of  3.97%, maturing in 2015                 |       | 10,000   |       | 10,000   |       |
| Fixed rate of  2.58%, maturing in 2006                    |       | —   |       | 1,600    |       |
| Fixed rates  between 2.67% and 3.13%, maturing in 2007    |       | 6,500    |       | 6,500    |       |
| Fixed rate of  6.92%, 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                                                     |       | $        | 82,878     |     | $          | 84,478 |   |

 

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

The Bank maintains a credit arrangement, which includes a revolving lineof credit with the FHLB.  Under thiscredit arrangement, the Bank has a remaining borrowing capacity of $123,538,000at December 31, 2006, which is subject to annual renewal, and typically incursno service charges.  Under terms of ablanket agreement, collateral for the FHLB borrowings must be secured bycertain qualifying assets of the Bank which consist principally of firstmortgage loans and mortgage-backed securities.

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**NOTE 10 - INCOME TAXES**

The following temporary differences gave rise to the net deferred taxposition at December 31, 2006 and 2005:
| (In Thousands)                               | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax  assets:                             |       |     |       |     |       |
| Allowance for loan losses                         |       | $        | 1,292      |     | $          | 1,022 |   |
| Deferred compensation                             |       | 386      |       | 368      |       |
| Pension                                           |       | 517      |       | 249      |       |
| Loan fees and costs                               |       | 346      |       | 356      |       |
| Investment securities allowance                   |       | 2        |       | 97       |       |
| Other                                             |       | 134      |       | 59       |       |
| Total                                             |       | 2,677    |       | 2,151    |       |
|                                              |       |     |       |     |       |
| Deferred tax  liabilities:                        |       |     |       |     |       |
| Bond accretion                                    |       | 49       |       | 27       |       |
| Depreciation                                      |       | 85       |       | 96       |       |
| Amortization                                      |       | 376      |       | 301      |       |
| Unrealized gains on available for sale securities |       | 1,102    |       | 438      |       |
| Total                                             |       | 1,612    |       | 862      |       |
|                                              |       |     |       |     |       |
| Deferred tax  asset, net                          |       | $        | 1,065      |     | $          | 1,289 |   |

 

No valuation allowance was established at December 31, 2006 and 2005, inthe view of the Company’s ability to carry back taxes paid in previous yearsand certain tax strategies, coupled with the anticipated future taxable incomeas evidenced by the Company’s earning potential.

The provision for incometaxes is comprised of the following:
| (In Thousands)         | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|----------|------------|
|                        |       |     |       |     |       |     |       |
| Currently  payable          |       | $        | 2,103      |     | $          | 3,188    |       | $ | 4,512 |   |
| Deferred  (benefit) expense |       | (142     | )          | 36       |       | (249     | )          |
|                        |       |     |       |     |       |     |       |
| Total provision             |       | $        | 1,961      |     | $          | 3,224    |       | $ | 4,263 |   |

 

A reconciliation between the expected income tax and the effective incometax rate on income before income tax provision follows:
|                                  | ** ** | **2006**   | ** ** | **2005** | ** ** | **2004**   | ** ** |
|----------------------------------|------------|------------|------------|----------|------------|------------|------------|
| **(In Thousands)**          | ** ** | **Amount** | ** ** | **%**    | ** ** | **Amount** | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** |
|                             |       |       |       |     |       |       |       |   |   |   |   |   |   |
| Provision at  expected rate      |       | $          | 3,947      |     | 34.0       | %          | $          | 4,803 |   | 34.0 | % | $ | 5,218 |   | 34.0 | % |
| Decrease in tax resulting  from: |       |       |       |     |       |       |       |   |   |   |   |   |   |
| Tax-exempt income                |       | (1,425     | )          | (12.3    | )          | (1,275     | )          | (9.0 | ) | (651 | ) | (4.2 | ) |
| Other, net                       |       | (561       | )          | (4.8     | )          | (304       | )          | (2.2 | ) | (304 | ) | (2.0 | ) |
|                             |       |       |       |     |       |       |       |   |   |   |   |   |   |
| Effective income  tax and rate   |       | $          | 1,961      |     | 16.9       | %          | $          | 3,224 |   | 22.8 | % | $ | 4,263 |   | 27.8 | % |

 

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**NOTE 11 - EMPLOYEE BENEFIT PLANS**

### DefinedBenefit Pension Plan

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

The Company adopted the recognition provisions of FAS No. 158*, Employers’ Accounting for Defined Benefit Pension and OtherPostretirement Plans* and initially applied them to the funded statusof its defined benefit pension plan as of December 31, 2006.  The initial recognition of the funded statusof its defined benefit pension plan resulted in a decrease in Shareholder’sequity of $579,000, which was net of a tax benefit of $298,000.

The following table sets forth the incremental effect of applying FAS No.158 on individual line items in the Consolidated Balance Sheet at December 31,2006:
|                                                  | ** ** | **Before**                | ** ** | ** **      | ** ** | **After**                 | ** ** |
|--------------------------------------------------|------------|---------------------------|------------|-----------------|------------|---------------------------|------------|
| ** **                                       | ** ** | **Application of**   | ** ** | ** **      | ** ** | **Application of**   | ** ** |
| **(In Thousands)**                          | ** ** | **FAS No. 158** | ** ** | **Adjustments** | ** ** | **FAS No. 158** | ** ** |
|                                             |       |                      |       |            |       |                      |       |
| Other assets                                     |       | $                         | 2,212      |            | $          | 298                       |       | $ | 2,510 |   |
| Total assets                                     |       | 591,987                   |       | 298             |       | 592,285                   |       |
| Other  liabilities                               |       | 2,516                     |       | 877             |       | 3,393                     |       |
| Total  liabilities                               |       | 516,814                   |       | 877             |       | 517,691                   |       |
| Accumulated  other comprehensive income          |       | 2,139                     |       | (579            | )          | 1,560                     |       |
| Total  shareholders’ equity                 |       | 75,173                    |       | (579            | )          | 74,594                    |       |
| Total liabilities and  shareholders’ equity |       | 591,987                   |       | 298             |       | 592,285                   |       |
|                                                  |            |                           |            |                 |            |                           |            |  |  |  |

 

55

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The following table sets forth the obligation andfunded status as of December 31:

 
| (In Thousands)                                                                   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Change  in benefit obligation**                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Benefit  obligation at beginning of year                                              |       | $          | 8,780      |       | $          | 7,549 |   |
| Service cost                                                                          |       | 467        |       | 505        |       |
| Interest cost                                                                         |       | 434        |       | 446        |       |
| Actuarial (gain)  loss                                                                |       | (785       | )          | 280        |       |
| Benefits paid                                                                         |       | (186       | )          | (218       | )          |
| Other, change in  actuarial assumptions                                               |       | (200       | )          | 218        |       |
| Benefit  obligation at end of year                                                    |       | 8,510      |       | 8,780      |       |
|                                                                                  |       |       |       |       |       |
| **Change  in plan assets**                                                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Fair value of  plan assets at beginning of year                                       |       | 6,011      |       | 4,549      |       |
| Actual return on  plan assets                                                         |       | 629        |       | 272        |       |
| Employer  contribution                                                                |       | 550        |       | 1,420      |       |
| Benefits paid                                                                         |       | (186       | )          | (218       | )          |
| Expenses paid                                                                         |       | (14        | )          | (12        | )          |
| Fair value of  plan assets at end of year                                             |       | 6,990      |       | 6,011      |       |
| Funded status                                                                         |       | $          | (1,520     | )          | $          | (2,769 | ) |
|                                                                                  |       |       |       |       |       |
| **Amounts  not yet recognized as a component of net periodic pension cost:**          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Amounts  recognized in accumulated other comprehensive income (loss) consists of:     |       |       |       |       |       |
| Net transition asset                                                                  |       | $          | (15        | )          | $          | — |   |
| Prior service cost                                                                    |       | 179        |       | —     |       |
| Net loss                                                                              |       | 713        |       | —     |       |
| Amounts not  recognized in accumulated other comprehensive income (loss) consists of: |       |       |       |       |       |
| Net transition asset                                                                  |       | —     |       | (17        | )          |
| Prior service cost                                                                    |       | —     |       | 204        |       |
| Net loss                                                                              |       | —     |       | 1,849      |       |
| Total                                                                                 |       | $          | 877        |       | $          | 2,036 |   |

 

The accumulated benefit obligation for the Plan was $6,451,000 and$6,560,000 at December 31, 2006 and 2005, respectively.

Components of Net Periodic Cost and Other Amounts Recognized in other ComprehensiveIncome as of December 31, 2006, 2005, and 2004, respectively, are as follows:
| (In Thousands)                    | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net periodic  pension cost:            |       |     |       |     |       |     |       |
| Service cost                           |       | $        | 467        |     | $          | 505      |       | $ | 447 |   |
| Interest cost                          |       | 434      |       | 446      |       | 398      |       |
| Expected return  on plan assets        |       | (485     | )          | (402     | )          | (376     | )          |
| Amortization of  transition asset      |       | (3       | )          | (2       | )          | (3       | )          |
| Amortization of  prior service cost    |       | 26       |       | 25       |       | 26       |       |
| Recognized net  actuarial gain         |       | —   |       | —   |       | 109      |       |
| Amortization of  unrecognized net loss |       | 22       |       | 65       |       | —   |       |
| Net periodic benefit  cost             |       | $        | 461        |     | $          | 637      |       | $ | 601 |   |

 

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The estimated nettransition asset and prior service cost for the defined benefit pension planthat will be amortized from accumulated other comprehensive income (loss) intonet periodic benefit cost over the next fiscal year are $3,000 and $25,000,respectively.

 

**Assumptions**

Weighted-average assumptions used to determine benefit obligations atDecember 31:
|                                | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Discount rate                  |       | 5.75     | %          | 5.50     | %          | 5.75     | %          |
| Rate of compensation  increase |       | 4.75     | %          | 4.50     | %          | 4.75     | %          |

 

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

 
|                                           | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Discount rate                             |       | 5.50     | %          | 5.75     | %          | 6.00     | %          |
| Expected  long-term return on plan assets |       | 8.00     | %          | 8.00     | %          | 8.00     | %          |
| Rate of compensation  increase            |       | 4.50     | %          | 4.75     | %          | 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 Plan’s weighted-average asset allocations at December 31 by assetcategory are as follows:
| Asset Category      | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Cash                     |       | 0.4      | %          | 0.4      | %          |
| Fixed income  securities |       | 39.2     | %          | 39.4     | %          |
| Equity                   |       | 60.4     | %          | 60.2     | %          |
| Total                    |       | 100.0    | %          | 100.0    | %          |

 

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

Asset allocation favors equities, with target allocation of approximately60% equity securities, 37.5% fixed income securities and 2.5% cash.  Due to volatility in the market, the targetallocation is not always desirable and asset allocations will fluctuate betweenthe acceptable ranges.  The equityportfolio’s exposure is in mid and large capitalization domestic equities.Exposure to small capitalization and international stocks may be allowed.

It is management’s intent to give the investment managers flexibility,within the overall guidelines, with respect to investment decisions and theirtiming.  However, certain investmentsrequire specific review and approval by management.  Management is also informed of anticipated,significant modifications of any previously approved investment, or anticipateduse of derivatives to execute investment strategies.

57

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

**Estimatedfuture benefit payments(in thousands):**

 
| 2007      |   | $      | 240    |   |
|-----------|--------|--------|--------|--------|
| 2008      |   | 246    |   |
| 2009      |   | 287    |   |
| 2010      |   | 315    |   |
| 2011      |   | 339    |   |
| 2012-2016 |   | 2,791  |   |
|      |   |   |   |
|      |   | $      | 4,218  |   |

 

The company expects to contribute $500,000 to its Pension Plan in 2007.

### 401(k) SavingsPlan

The Company also offers a 401(k) savings plan in which eligibleparticipating employees may elect to contribute up to a maximum percentageallowable not to exceed the limits of Code Sections 401(k), 404, and 415.  The Company may make matching contributionsequal to a discretionary percentage that is determined by the Board ofDirectors.  Participants are at all timesfully vested in their contributions and vest over a period of five years in theemployer contribution.  Contributionexpense was approximately $96,000, $80,000, and $83,000 for the years endedDecember 31, 2006, 2005, and 2004, respectively.

### DeferredCompensation Plan

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

To fund benefits underthe deferred compensation plan, the Company has acquired bank-owned lifeinsurance policies on the lives of the participating directors for whichinsurance benefits are payable to the Company. The Company incurred expenses related to the plan of $69,000, $69,000,and $73,000 for the years ended December 31, 2006, 2005, and 2004,respectively.  Benefits paid under theplan were approximately $122,000, $112,000, and $127,000 in 2006, 2005, and2004 respectively.

**NOTE 12 – EMPLOYEE STOCK PURCHASE PLAN**

Effective April 26, 2006 the Company implemented the Penns Woods Bancorp,Inc. 2006 Employee Stock Purchase Plan (“Plan”).  The Plan is intended to encourage employeeparticipation in the ownership and economic progress of the Company.  The Plan allows for up to 1,000,000 shares tobe purchased by employees.  The purchaseprice of the shares is 95% of market value with an employee eligible topurchase up to the lesser of 15% of base compensation or $12,000 in marketvalue annually.  For the year endedDecember 31, 2006, there were 1,355 shares issued under the plan.

**NOTE 13 - STOCK OPTIONS**

Prior to 1998, the Company granted a select group of its officers optionsto purchase shares of its common stock. These options, which are immediately exercisable, expire within three toten years after having been granted. Also, in 1998, the Company adopted the “1998 Stock Option Plan” for keyemployees and directors.  Incentive stockoptions and nonqualified stock options may be granted to eligible employees ofthe Bank and nonqualified options may be granted to directors of theCompany.  Incentive nonqualified stockoptions granted under the 1998 Plan may be exercised not later than ten yearsafter

58

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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 of the Company’s common stock option plans arepresented below:
|                                  | ** ** | **2006**   | ** ** | **2005**     | ** ** |
|----------------------------------|------------|------------|------------|--------------|------------|
| ** **                       | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                       | ** ** | ** ** | ** ** | **Average**  | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                       | ** ** | ** ** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                       | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Shares** | ** ** | **Price** | ** ** |
|                             |       |       |       |         |       |   |   |   |   |
| Outstanding,  beginning of year  |       | 11,972     |       | $            | 37.41      |   | 19,158 |   | $ | 33.53 |   |
| Granted                          |       | —     |       | —       |       | — |   | — |   |
| Exercised                        |       | —     |       | —       |       | (4,248 | ) | 24.76 |   |
| Forfeited                        |       | —     |       | —       |       | (2,938 | ) | 30.43 |   |
| Outstanding, end  of year        |       | 11,972     |       | 37.41        |       | 11,972 |   | 37.41 |   |
|                             |       |       |       |         |       |   |   |   |   |
| Options exercisable at  year-end |       | 11,972     |       | $            | 37.41      |   | 11,972 |   | $ | 37.41 |   |

 

The following table summarizes information about nonqualified andincentive stock options outstanding at December 31, 2006:
|                         | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
|-------------------------|------------|-----------------|------------|-----------------|------------|
| ** **              | ** ** | ** **      | ** ** | ** **      | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **              | ** ** | ** **      | ** ** | **Average**     | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| **Exercise Price** | ** ** | **Shares**      | ** ** | **Life**        | ** ** | **Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
| $                       | 40.29      |            |       | 9,002           |       | 2 |   | $ | 40.29 |   | 9,002 |   | $ | 40.29 |   |
| 31.82                   |       |            | 1,650      |            | 3          |   | 31.82 |   | 1,650 |   | 31.82 |   |
| 24.72                   |       |            | 1,320      |            | 4          |   | 24.72 |   | 1,320 |   | 24.72 |   |
|                         |            |                 |            |                 |            |  |  |  |  |  |  |  |  |  |  |

 

**NOTE 14 -RELATED PARTY TRANSACTIONS**

Certain directors andexecutive officers of the Company and the Bank, including their immediatefamilies and companies in which they are principal owners (more than tenpercent), are indebted to the Company. Such indebtedness was incurred in the ordinary course of business on thesame terms and at those rates prevailing at the time for comparabletransactions with others.

A summary of loan activity with executive officers, directors, principalshareholders, and associates of such persons is listed below for the yearsended December 31:
|                         | ** ** | **Beginning** | ** ** | ** **    | ** ** | ** **   | ** ** | **Ending**  | ** ** |
|-------------------------|------------|---------------|------------|---------------|------------|--------------|------------|-------------|------------|
| **(In Thousands)** | ** ** | **Balance**   | ** ** | **Additions** | ** ** | **Payments** | ** ** | **Balance** | ** ** |
|                    |       |          |       |          |       |         |       |        |       |
| 2006                    |       | $             | 9,635      |          | $          | 2,001        |       | $           | 1,894      |   | $ | 9,742 |   |
| 2005                    |       | 10,295        |       | 781           |       | 1,441        |       | 9,635       |       |
|                         |            |               |            |               |            |              |            |             |            |  |  |  |  |

 

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**NOTE 15 - COMMITMENTS AND CONTINGENT LIABILITIES**

The following schedule offuture minimum rental payments under operating leases with noncancellable termsin excess of one year as of December 31, 2006:
| (In Thousands) | ** ** | ** ** | ** ** |
|---------------------|------------|------------|------------|
|                |       |       |       |
| 2007                |       | $          | 411        |   |
| 2008                |       | 288        |       |
| 2009                |       | 243        |       |
| 2010                |       | 212        |       |
| 2011                |       | 128        |       |
| Thereafter          |       | 1,162      |       |
| Total               |       | $          | 2,444      |   |

 

The Company’s operatinglease obligations represent short and long-term lease and rental payments forfacilities.  Total rental expense for alloperating leases for the years ended December 31, 2006, 2005, and 2004 were$380,000, $361,000, and $320,000 respectively.

TheCompany is subject to lawsuits and claims arising out of its business.  There are no such legal proceedings or claimscurrently pending or threatened other than those encountered during the normalcourse of business.

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

The Company is a party to financial instruments with off-balance sheetrisk in the normal course of business to meet the financing needs of itscustomers.  These financial instrumentsinclude commitments to extend credit and standby letters of credit.  These instruments involve, to varyingdegrees, elements of credit, interest rate, or liquidity risk in excess of theamount recognized in the consolidated balance sheet.  The contract amounts of these instrumentsexpress the extent of involvement the Company has in particular classes offinancial instruments.

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

Financial instruments whose contract amounts represent credit risk are asfollows at December 31:
| (In Thousands)           | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
|                          |       |     |       |     |       |
| Commitments to  extend credit |       | $        | 61,736     |     | $          | 72,583 |   |
| Standby letters of  credit    |       | 1,033    |       | 2,193    |       |
|                               |            |          |            |          |            |  |  |

 

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

60

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Standby letters ofcredit represent conditional commitments issued by the Company to guarantee theperformance of a customer to a third party. These instruments are issued primarily to support bid or performancerelated contracts.  The coverage periodfor these instruments is typically a one year period with an annual renewaloption subject to prior approval by management. Fees earned from the issuance of these letters are recognized upon expirationof the coverage period.  For securedletters of credit, the collateral is typically Bank deposit instruments orcustomer business assets.

**NOTE 17 - CAPITAL REQUIREMENTS**

Federal regulations require the Company and the Bank to maintain minimumamounts of capital.  Specifically, eachis required to maintain certain minimum dollar amounts and ratios of Total andTier 1 capital to risk-weighted assets and of Tier 1 capital to average totalassets.

In addition to the capital requirements, the Federal Deposit InsuranceCorporation Improvement Act (“FDICIA”) established five capital categoriesranging from “well capitalized” to “critically undercapitalized.”   Should any institution fail to meet therequirements to be considered “adequately capitalized,” it would become subjectto a series of increasingly restrictive regulatory actions.

As of December 31, 2006 and 2005, the Federal Deposit InsuranceCorporation (“FDIC”) categorized the Bank as well capitalized under theregulatory framework for prompt corrective action.  To be classified as a well capitalizedfinancial institution, Total risk-based, Tier 1 risk-based, and Tier 1 leveragecapital ratios must be at least 10%, 6%, and 5%, respectively.

The Company’s and the Bank’s actual capital ratios are presented in thefollowing tables, which shows that both met all regulatory capitalrequirements.

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**ConsolidatedCompany**
| ** **                              | ** ** | **2006**   | ** ** | **2005**  | ** ** |
|-----------------------------------------|------------|------------|------------|-----------|------------|
| **(In Thousands)**                 | ** ** | **Amount** | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| Total Capital(to Risk-weighted Assets)  |       |       |       |      |       |   |   |   |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Actual                                  |       | $          | 74,342     |      | 20.3       | % | $ | 73,210 |   | 21.0 | % |
| For Capital Adequacy  Purposes          |       | 29,299     |       | 8.0       |       | 27,937 |   | 8.0 |   |
| To Be Well Capitalized                  |       | 36,623     |       | 10.0      |       | 34,921 |   | 10.0 |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Tier I Capital(to Risk-weighted Assets) |       |       |       |      |       |   |   |   |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Actual                                  |       | $          | 68,931     |      | 18.8       | % | $ | 68,388 |   | 19.6 | % |
| For Capital Adequacy  Purposes          |       | 14,649     |       | 4.0       |       | 13,968 |   | 4.0 |   |
| To Be Well Capitalized                  |       | 21,974     |       | 6.0       |       | 20,952 |   | 6.0 |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Tier I Capital(to Average Assets)       |       |       |       |      |       |   |   |   |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Actual                                  |       | $          | 68,931     |      | 11.8       | % | $ | 68,388 |   | 12.2 | % |
| For Capital Adequacy  Purposes          |       | 23,332     |       | 4.0       |       | 22,495 |   | 4.0 |   |
| To Be Well Capitalized                  |       | 29,165     |       | 5.0       |       | 28,119 |   | 5.0 |   |

 

**Bank**
| ** **                              | ** ** | **2006**   | ** ** | **2005**  | ** ** |
|-----------------------------------------|------------|------------|------------|-----------|------------|
| **(In Thousands)**                 | ** ** | **Amount** | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| Total Capital(to Risk-weighted Assets)  |       |       |       |      |       |   |   |   |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Actual                                  |       | $          | 57,260     |      | 16.2       | % | $ | 56,604 |   | 17.0 | % |
| For Capital Adequacy  Purposes          |       | 28,243     |       | 8.0       |       | 26,716 |   | 8.0 |   |
| To Be Well Capitalized                  |       | 35,304     |       | 10.0      |       | 33,394 |   | 10.0 |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Tier I Capital(to Risk-weighted Assets) |       |       |       |      |       |   |   |   |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Actual                                  |       | $          | 52,860     |      | 15.0       | % | $ | 52,527 |   | 15.7 | % |
| For Capital Adequacy  Purposes          |       | 14,121     |       | 4.0       |       | 13,358 |   | 4.0 |   |
| To Be Well Capitalized                  |       | 21,182     |       | 6.0       |       | 20,037 |   | 6.0 |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Tier I Capital(to Average Assets)       |       |       |       |      |       |   |   |   |   |
|                                    |       |       |       |      |       |   |   |   |   |
| Actual                                  |       | $          | 52,860     |      | 9.3        | % | $ | 52,527 |   | 9.6 | % |
| For Capital Adequacy  Purposes          |       | 22,671     |       | 4.0       |       | 21,809 |   | 4.0 |   |
| To Be Well Capitalized                  |       | 28,339     |       | 5.0       |       | 27,261 |   | 5.0 |   |

 

**NOTE18 – REGULATORY RESTRICTIONS**

The Pennsylvania Banking Code restricts the availability of capital fundsfor payment of dividends by all state-chartered banks to the additional paid incapital of the Bank.  Accordingly, atDecember 31, 2006, the balance in the additional paid in capital accounttotaling $11,657,000 is unavailable for dividends.

The Bank is subject to regulatory restrictions, which limit its abilityto loan funds to Penns Woods Bancorp, Inc. At December 31, 2006, the regulatory lending limit amounted to approximately$5,715,000.

62

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**Cash and Due from Banks**

Included in cash and due from banks are reserves required by the districtFederal Reserve Bank of $990,000 and $1,410,000 at December 31, 2006 and2005.  The required reserves are computedby applying prescribed ratios to the classes of average deposit balances.  These are held in the form of cash on handand a balance maintained directly with the Federal Reserve Bank.

**NOTE 19 - ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS**

The Company is requiredto disclose estimated fair values for its financial instruments.  Fair value estimates are made at a specificpoint in time, based on relevant market information and information about thefinancial instrument.  These estimates donot reflect any premium or discount that could result from offering for sale atone time the Company’s entire holdings of a particular financialinstrument.  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 market exists for a significantportion of the Company’s financial instruments, fair value estimates are basedon judgments regarding future expected loss experience, current economicconditions, risk characteristics of various financial instruments, and otherfactors.  These estimates are subjectivein nature and involve uncertainties and matters of significant judgment andtherefore cannot be determined with precision. Changes in assumptions can significantly affect the estimates.

Estimated fair values have been determined by the Company usinghistorical data and an estimation methodology suitable for each category offinancial instruments.  The estimatedfair value of the Company’s investment securities is described in Note 1.  The Company’s fair value estimates, methods,and assumptions are set forth below for the Company’s other financialinstruments.

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

### Theestimated fair values of the Company’s financial instruments are as follows atDecember 31:

|                               | ** ** | **2006**     | ** ** | **2005**  | ** ** |
|-------------------------------|------------|--------------|------------|-----------|------------|
| ** **                    | ** ** | **Carrying** | ** ** | **Fair**  | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| **(In Thousands)**       | ** ** | **Value**    | ** ** | **Value** | ** ** | **Value** | ** ** | **Value** | ** ** |
| Financial  assets:            |       |         |       |      |       |   |   |   |   |
| Cash and cash  equivalents    |       | $            | 15,373     |      | $          | 15,373 |   | $ | 14,090 |   | $ | 14,090 |   |
| Investment  securitites:      |       |         |       |      |       |   |   |   |   |
| Available for sale            |       | 185,200      |       | 185,200   |       | 187,018 |   | 187,018 |   |
| Held to maturity              |       | 283          |       | 286       |       | 265 |   | 238 |   |
| Loans held for  sale          |       | 3,716        |       | 3,716     |       | 3,545 |   | 3,545 |   |
| Loans, net                    |       | 356,199      |       | 356,788   |       | 334,759 |   | 337,093 |   |
| Bank-owned life  insurance    |       | 11,346       |       | 11,346    |       | 10,718 |   | 10,718 |   |
| Accrued interest  receivable  |       | 2,939        |       | 2,939     |       | 2,828 |   | 2,828 |   |
|                          |       |         |       |      |       |   |   |   |   |
| Financial  liabilities:       |       |         |       |      |       |   |   |   |   |
| Interest-bearing  deposits    |       | $            | 322,031    |      | $          | 320,906 |   | $ | 281,150 |   | $ | 278,909 |   |
| Noninterest-bearing  deposits |       | 73,160       |       | 73,160    |       | 71,379 |   | 71,379 |   |
| Short-term  borrowings        |       | 34,697       |       | 34,697    |       | 54,003 |   | 54,003 |   |
| Long-term  borrowings, FHLB   |       | 82,878       |       | 82,050    |       | 84,478 |   | 83,877 |   |
| Accrued interest  payable     |       | 1,532        |       | 1,532     |       | 1,108 |   | 1,108 |   |

 

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

The fair value is equal to the carrying value.

**InvestmentSecurities:**

Thefair value of investment securities available for sale and held to maturity isequal to the available quoted market price. If no quoted market price is available, fair value is estimated usingthe quoted market price for similar securities.

63

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**Loans:**

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

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

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

**Bank-OwnedLife Insurance:**

Thefair value is equal to the Cash Surrender Value of the life insurance policies.

**Deposits:**

The fair value of deposits with no statedmaturity, such as noninterest-bearing demand deposits, savings, NOW, and moneymarket accounts, is equal to the amount payable on demand as of December 31,2006 and 2005.  The fair value ofcertificates of deposit is based on the discounted value of contractual cashflows.

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.

**LongTerm Borrowings:**

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

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

Thereis no material difference between the notional amount and the estimated fairvalue of off-balance sheet items at December 31, 2006 and 2005,respectively.  The contractual amounts ofunfunded commitments and letters of credit are presented in Note 16.

**NOTE 20- PARENT COMPANY ONLY FINANCIAL STATEMENTS**

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

64

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| **CONDENSED BALANCE SHEET, DECEMBER 31,  (In Thousands)** | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                           |       |     |       |     |       |
| ASSETS                                                         |       |     |       |     |       |
| Cash                                                           |       | $        | 41         |     | $          | 159 |   |
| Investment in subsidiaries:                                    |       |     |       |     |       |
| Bank                                                           |       | 57,790   |       | 57,170   |       |
| Nonbank                                                        |       | 16,595   |       | 16,452   |       |
| Other assets                                                   |       | 234      |       | 186      |       |
|                                                           |       |     |       |     |       |
| Total Assets                                                   |       | $        | 74,660     |     | $          | 73,967 |   |
|                                                           |       |     |       |     |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                     |       |     |       |     |       |
| Other liabilities                                              |       | $        | 66         |     | $          | 48 |   |
| Shareholders’ equity                                      |       | 74,594   |       | 73,919   |       |
|                                                           |       |     |       |     |       |
| Total liability  and shareholders’ equity                 |       | $        | 74,660     |     | $          | 73,967 |   |

 
| **CONDENSED STATEMENT OF INCOME  FOR THE YEARS ENDED DECEMBER 31,   (In Thousands)** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                                      |       |     |       |     |       |     |       |
| Operating  income:                                                                        |       |     |       |     |       |     |       |
| Dividends from  subsidiaries                                                              |       | $        | 9,890      |     | $          | 7,311    |       | $ | 6,440 |   |
| Equity in  undistributed net income of subsidiaries                                       |       | 53       |       | 3,822    |       | 4,833    |       |
|                                                                                      |       |     |       |     |       |     |       |
| Operating  expenses:                                                                      |       | (296     | )          | (232     | )          | (190     | )          |
|                                                                                      |       |     |       |     |       |     |       |
| Net income                                                                                |       | $        | 9,647      |     | $          | 10,901   |       | $ | 11,083 |   |

 
| **CONDENSED STATEMENT OF CASH FLOWS  FOR THE YEARS ENDED DECEMBER 31,** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(In Thousands)**                                                                                              | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|                                                                                                                 |       |       |       |       |       |       |       |
| OPERATING  ACTIVITIES                                                                                                |       |       |       |       |       |       |       |
| Net income                                                                                                           |       | $          | 9,647      |       | $          | 10,901     |       | $ | 11,083 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities:                                   |       |       |       |       |       |       |       |
| Equity in undistributed net income of subsidiaries                                                                   |       | (53        | )          | (3,822     | )          | (4,833     | )          |
| Other, net                                                                                                           |       | (30        | )          | (70        | )          | (9         | )          |
| Net cash provided by operating activities                                                                            |       | 9,564      |       | 7,009      |       | 6,241      |       |
|                                                                                                                 |       |       |       |       |       |       |       |
| INVESTING  ACTIVITIES                                                                                                |       |       |       |       |       |       |       |
| Additional investment in subsidiaries                                                                                |       | —     |       | (637       | )          | (271       | )          |
|                                                                                                                 |       |       |       |       |       |       |       |
| FINANCING  ACTIVITIES                                                                                                |       |       |       |       |       |       |       |
| Dividends paid                                                                                                       |       | (6,802     | )          | (6,225     | )          | (5,843     | )          |
| Issuance of common stock                                                                                             |       | 49         |       | —     |       | —     |       |
| Proceeds from exercise of stock options                                                                              |       | —     |       | 105        |       | 194        |       |
| Purchase of treasury stock                                                                                           |       | (2,929     | )          | (546       | )          | (237       | )          |
| Net cash used for financing activities                                                                               |       | (9,682     | )          | (6,666     | )          | (5,886     | )          |
|                                                                                                                 |       |       |       |       |       |       |       |
| NET INCREASE  (DECREASE) IN CASH                                                                                     |       | (118       | )          | (294       | )          | 84         |       |
| CASH, BEGINNING  OF YEAR                                                                                             |       | 159        |       | 453        |       | 369        |       |
| CASH, END OF YEAR                                                                                                    |       | $          | 41         |       | $          | 159        |       | $ | 453 |   |

 

65

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**NOTE 21 –CONSOLIDATED QUARTERLY FINANCIAL DATA (UNAUDITED)**
| **(In Thousands, Except Per Share Data)** | ** ** | **For The Three Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| **2006**                                                           | ** ** | **March 31,**                                 | ** ** | **June 30,** | ** ** | **Sept. 30,** | ** ** | **Dec. 31,** | ** ** |
| Interest income                                                    |       | $                                                  | 8,022      |   | $ | 8,347 |   | $ | 8,547 |   | $ | 8,837 |   |
| Interest expense                                                   |       | 3,189                                              |       | 3,421 |   | 3,707 |   | 3,893 |   |
|                                                               |       |                                               |       |   |   |   |   |   |   |
| Net interest  income                                               |       | 4,833                                              |       | 4,926 |   | 4,840 |   | 4,944 |   |
|                                                               |       |                                               |       |   |   |   |   |   |   |
| Provision for  loan losses                                         |       | 198                                                |       | 198 |   | 89 |   | 150 |   |
| Non-interest  income                                               |       | 1,778                                              |       | 1,951 |   | 1,826 |   | 1,795 |   |
| Securities  gains, net                                             |       | 559                                                |       | 265 |   | 561 |   | 294 |   |
| Non-interest  expenses                                             |       | 3,951                                              |       | 4,078 |   | 4,114 |   | 4,186 |   |
|                                                               |       |                                               |       |   |   |   |   |   |   |
| Income before  income tax provision                                |       | 3,021                                              |       | 2,866 |   | 3,024 |   | 2,697 |   |
| Income tax  provision                                              |       | 566                                                |       | 432 |   | 560 |   | 403 |   |
|                                                               |       |                                               |       |   |   |   |   |   |   |
| Net income                                                         |       | $                                                  | 2,455      |   | $ | 2,434 |   | $ | 2,464 |   | $ | 2,294 |   |
|                                                               |       |                                               |       |   |   |   |   |   |   |
| Earnings per share  - basic                                        |       | $                                                  | 0.62       |   | $ | 0.62 |   | $ | 0.62 |   | $ | 0.59 |   |
|                                                               |       |                                               |       |   |   |   |   |   |   |
| Earnings per share -  diluted                                      |       | $                                                  | 0.62       |   | $ | 0.62 |   | $ | 0.62 |   | $ | 0.59 |   |

 
| **(In Thousands, Except Per Share Data)** | ** ** | **For The Three Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| **2005**                                                           | ** ** | **March 31,**                                 | ** ** | **June 30,** | ** ** | **Sept. 30,** | ** ** | **Dec. 31,** | ** ** |
| Interest income                                                    |       | $                                                  | 7,435      |   | $ | 7,654 |   | $ | 7,816 |   | $ | 7,998 |   |
| Interest expense                                                   |       | 2,249                                              |       | 2,457 |   | 2,701 |   | 2,974 |   |
|                                                               |       |                                               |       |   |   |   |   |   |   |
| Net interest  income                                               |       | 5,186                                              |       | 5,197 |   | 5,115 |   | 5,024 |   |
|                                                               |       |                                               |       |   |   |   |   |   |   |
| Provision for  loan losses                                         |       | 180                                                |       | 180 |   | 180 |   | 180 |   |
| Non-interest  income                                               |       | 1,696                                              |       | 1,788 |   | 1,991 |   | 1,766 |   |
| Securities  gains, net                                             |       | 611                                                |       | 687 |   | 556 |   | 336 |   |
| Non-interest  expenses                                             |       | 3,595                                              |       | 3,849 |   | 3,788 |   | 3,876 |   |
|                                                               |       |                                               |       |   |   |   |   |   |   |
| Income before  income tax provision                                |       | 3,718                                              |       | 3,643 |   | 3,694 |   | 3,070 |   |
| Income tax  provision                                              |       | 1,003                                              |       | 883 |   | 746 |   | 592 |   |
|                                                               |       |                                               |       |   |   |   |   |   |   |
| Net income                                                         |       | $                                                  | 2,715      |   | $ | 2,760 |   | $ | 2,948 |   | $ | 2,478 |   |
|                                                               |       |                                               |       |   |   |   |   |   |   |
| Earnings per  share - basic                                        |       | $                                                  | 0.68       |   | $ | 0.70 |   | $ | 0.74 |   | $ | 0.63 |   |
|                                                               |       |                                               |       |   |   |   |   |   |   |
| Earnings per share -  diluted                                      |       | $                                                  | 0.68       |   | $ | 0.70 |   | $ | 0.74 |   | $ | 0.62 |   |

** **

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

None

**ITEM 9A    CONTROLSAND PROCEDURES**

The Company, underthe supervision and with the participation of the Company’s management,including the Company’s President and Chief Executive Officer along with theCompany’s Principal Accounting Officer (the Principal Financial Officer), hasevaluated the effectiveness as of December 31, 2006 of the design and operationof the Company’s disclosure 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”).  Based uponthat evaluation, the Company’s President and Chief Executive Officer along with the Company’s PrincipalAccounting Officer concluded that the Company’s disclosure controls andprocedures were effective as of December 31, 2006.

Therehave been no material changes in the Company’s internal control over financialreporting during the fourth quarter of 2006 that have materially affected, orare reasonably likely to materially affect, the Company’s internal control overfinancial reporting.

**Management’s Report on InternalControl Over Financial Reporting**

Management of the Company isresponsible for establishing and maintaining adequate internal control overfinancial reporting as defined in Rules 13a-15(f) and 15d-15(f) under theExchange Act. The Company’s internal control over financial reporting isdesigned to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

A material weakness is asignificant deficiency (as defined in Public Company Accounting Oversight BoardAuditing Standard No. 2), or a combination of significant deficiencies,that results in there being more than a remote likelihood that a materialmisstatement of the annual or interim financial statements will not beprevented or detected on a timely basis by management or employees in thenormal course by management or employees in the normal course of performingtheir assigned functions.

Management assessed theeffectiveness of the Company’s internal control over financial reporting as ofDecember 31, 2006. Management’s assessment did not identify any materialweaknesses in the Company’s internal control over financial reporting.

In making this assessment,management used the criteria set forth by the Committee of SponsoringOrganizations of the Treadway Commission (COSO) in InternalControl-Integrated Framework. Because there were no material weaknessesdiscovered, management believes that, as of December 31, 2006, the Company’sinternal control over financial reporting was effective.

Ourmanagement’s assessment of the effectiveness of our internal control overfinancial reporting as of December 31, 2006, has been audited by S.R.Snodgrass, A.C., an independent registered public accounting firm, as stated inits attestation report which is included herein.
| Date: March 13, 2007 | /s/ Ronald A. Walko      |                           | /s/ Brian L. Knepp |   |
|----------------------|--------------------------|--------------------------------|--------------------|--------|
|                 | Chief Executive  Officer | Principal Accounting Officer   |
|                 |                     | (Principal  Financial Officer) |

 

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[Letterheadof S.R. Snodgrass, A.C.]

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Boardof Directors and ShareholdersPenns Woods Bancorp, Inc.

We have audited management’s assessment, included in the accompanyingReport on Management’s Assessment of Internal Control Over Financial Reporting,that Penns Woods Bancorp, Inc. (the “Company”) maintained effective internalcontrol over financial reporting as of December 31, 2006, based on criteriaestablished in “Internal Control—Integrated Framework” issued by the Committeeof Sponsoring Organizations of the Treadway Commission (COSO).  Penns Woods Bancorp, Inc.’s management isresponsible for maintaining effective internal control over financial reportingand for its assessment of the effectiveness of internal control over financialreporting.  Our responsibility is toexpress an opinion on management’s assessment and an opinion on theeffectiveness of the Company’s internal control over financial reporting basedon our audit.

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States).  Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects. Our audit included obtaining an understanding of internalcontrol over financial reporting, evaluating management’s assessment, testingand evaluating the design and operating effectiveness of internal control, andperforming such other procedures as we considered necessary in thecircumstances.  We believe that our auditprovides a reasonable basis for our opinion.

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

Because of its inherent limitations, internal control over financialreporting may not prevent or detect misstatements.  Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions or that the degree ofcompliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that Penns Woods Bancorp, Inc.maintained effective internal control over financial reporting as of December31, 2006, is fairly stated, in all material respects, based on the COSOcriteria.  Also in our opinion, PennsWoods Bancorp, Inc., maintained, in all material respects, effective internalcontrol over financial reporting as of December 31, 2006, based on the COSOcriteria.

We have also audited, in accordance with the standards of the PublicCompany Accounting Oversight Board (United States), the consolidated balancesheet of Penns Woods Bancorp, Inc. and subsidiaries as of December 31, 2006 and2005, and

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the related consolidated statement of income, changes in shareholders’equity, and cash flows for each of the three years in the period ended December31, 2006, and our report dated March 9, 2007, expressed an unqualified opinion.
| /s/ S.R. Snodgrass, A.C. |   |
|--------------------------|--------|
| Wexford,  Pennsylvania   |
| March 9, 2007            |

 

**ITEM 9B – OTHER INFORMATION**

None.

**PART III**

**ITEM 10    DIRECTORS, EXECUTIVE OFFICERS AND CORPORATEGOVERNANCE**

The informationappearing under the captions ““The Board of Directors and Committees,” “Electionof Directors,” “Section 16(a) Beneficial Ownership Reporting Compliance,” “PrincipalOfficers of the Corporation,” “Certain Transactions,” and “Audit CommitteeFinancial Expert”“ in the Company’s Proxy Statement dated March 20, 2007 (the “ProxyStatement”) is incorporated herein by reference.

**ITEM 11    EXECUTIVE COMPENSATION**

Informationappearing under the captions “Compensation of Directors,” “CompensationCommittee Interlocks and Insider Participation,” “Compensation Discussion andAnalysis,” “Compensation Committee and Benefits Committee Report,” and “ExecutiveCompensation” in the Proxy Statement is incorporated herein by reference.

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

The information appearingunder the caption “Security Ownership of Certain Beneficial Owners andManagement” in the Proxy Statement is incorporated herein by reference.

69

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**EquityCompensation Plan Information**

 
| ** **                                                  | ** ** | ** **                        | ** ** | ** **                        | ** ** | **Number of**                    | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|---------------------------------------|------------|
| ** **                                                  | ** ** | ** **                        | ** ** | ** **                        | ** ** | **securities remaining**         | ** ** |
| ** **                                                  | ** ** | **Number of**                | ** ** | ** **                        | ** ** | **available for future**    | ** ** |
| ** **                                                  | ** ** | **securities to be**    | ** ** | **Weighted-**                     | ** ** | **issuance under**               | ** ** |
| ** **                                                  | ** ** | **issued upon**              | ** ** | **average**                       | ** ** | **equity compensation**          | ** ** |
| ** **                                                  | ** ** | **exercise of**              | ** ** | **exercise of**              | ** ** | **plans (excluding**             | ** ** |
| ** **                                                  | ** ** | **outstanding options,**     | ** ** | **outstanding options,**     | ** ** | **securities reflected in** | ** ** |
| ** **                                                  | ** ** | **warrants and rights** | ** ** | **warrants and rights** | ** ** | **column (a))**                  | ** ** |
| **Plan Category**                                      | ** ** | **(a)**                           | ** ** | **(b)**                           | ** ** | **(c)**                               | ** ** |
| Equity  compensation plans approved by security holders     |       | 11,972                            |       | $                                 | 37.41      |                                  | —     |   |
|                                                        |       |                              |       |                              |       |                                  |       |
| Equity  compensation plans not approved by security holders |       | —                            |       | —                            |       | —                                |       |
| Total                                                       |       | 11,972                            |       | $                                 | 37.41      |                                  | —     |   |

 

**ITEM 13    CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE**

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

Total loansoutstanding from the Bank at December 31, 2006 to the Company’s and the Bank’sOfficers and Directors as a group and members of their immediate families andcompanies in which they had an ownership interest of 10% or more was $9,742,000or approximately 13.06% of the total equity capital of the Company.  Loans to such persons were made in theordinary course of business, were made on substantially the same terms,including interest rates and collateral, as those prevailing at the time forcomparable transactions with other persons, and did not involve more than thenormal risk of collectability or present other unfavorable features.  See also the information appearing in Note 14to the Consolidated Financial Statements included elsewhere in the AnnualReport.

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

**ITEM 14    PRINCIPAL ACCOUNTING  FEES AND SERVICES**

The informationappearing in the Proxy Statement under the captions, “Audit Fees,” “Audit-RelatedFees,” “Tax Fees,” “All Other Fees,” and “Audit Committee Pre-Approval Policiesand Procedures” is incorporated herein by reference.

**PART IV**

**ITEM 15    EXHIBITS FINANCIAL STATEMENT SCHEDULES**
| (a)1. Financial Statements                                                            |
|---------------------------------------------------------------------------------------|
| The following  consolidated financial statements and reports are set forth in Item 8: |
|                                                                                  |
| Report of Independent Auditors                                                        |
| Consolidated Balance Sheet                                                            |
| Consolidated Statement of Income                                                      |
| Consolidated Statement of Changes in Shareholders’  Equity                       |
| Consolidated Statement of Cash Flows                                                  |
| Notes to the Consolidated Financial Statements                                        |

 

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2.               Financial StatementSchedules

Financial statement schedules are omitted because therequired information is either not applicable, not required or is shown in therespective financial statements or in the notes thereto.

(b)Exhibits:

| (3)  (i)  |   | Articles of Incorporation of the Registrant, as  presently in effect (incorporated by reference to Exhibit 3(i) of the  Registrant’s Annual Report on Form 10-K for the year ended December 31,  2005).                                                           |
|---------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (3)  (ii) |   | Bylaws of the Registrant as presently in effect  (incorporated by reference to Exhibit 3(ii) of the Registrant’s Current  Report on Form 8-K filed on June 17, 2005).                                                                                             |
| (10) (i)            |   | Employment Agreement, dated August, 1991, between  Jersey Shore State Bank and Ronald A. Walko (incorporated by reference to  Exhibit 10.3 of the Registrant’s Registration Statement on form S-4, No. 333-65821).*                                               |
| (10) (ii)           |   | Employment Agreement, dated May 31, 2005, between  Jersey Shore State Bank and Thomas A. Donofrio (incorporated by reference to  Exhibit 10.1 of the Registrant’s Form 8-K filed on June 3, 2005).*                                                               |
| (10) (iii)          |   | Employee Severance Benefit Plan, dated May 30, 1996,  for Ronald A. Walko (incorporated by reference to Exhibit 10.4 of the  Registrant’s Registration Statement on form S-4, No. 333-65821).*                                                                    |
| (10) (iv)           |   | Penns Woods Bancorp, Inc. 1998 Stock Option Plan  (incorporated by reference to Exhibit 10.1 of the Registrant’s Registration  Statement on form S-4, No. 333-65821).*                                                                                            |
| (10) (v)            |   | Form of First Amendment to the Jersey Shore State  Bank Amendment and Restatement of the Director Fee Agreement, Dated as of  October 1, 2004 (incorporated by reference to Exhibit 10.7 of the  Registrant’s Current Report on Form 8-K filed on June 29, 2006). |
| (10) (vi)           |   | Consulting Agreement, dated July 18, 2005 between  Hubert A. Valencik and Penns Woods Bancorp, Inc. (incorporated by reference  to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K filed on July  18, 2005).                                          |
| (21)                |   | Subsidiaries of the Registrant.                                                                                                                                                                                                                                        |
| (23)                |   | Consent of Independent Certified Public Accountants.                                                                                                                                                                                                                   |
| (31) (i)            |   | Rule 13a-14(a)/Rule 15d-14(a) Certification of Chief  Executive Officer.                                                                                                                                                                                               |
| (31) (ii)           |   | Rule 13a-14(a)/Rule 15d-14(a) Certification of  Principle Accounting Officer.                                                                                                                                                                                          |
| (32) (i)            |   | Section 1350 Certification of Chief Executive  Officer.                                                                                                                                                                                                                |
| (32) (ii)           |   | Section 1350 Certification of Principle Accounting  Officer.                                                                                                                                                                                                           |

 

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* Denotes compensatory plan or arrangement.

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

 

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.
| March 13, 2007 |   | PENNS WOODS BANCORP, INC. |
|----------------|--------|---------------------------|
|           |   |                      |
|           |   | By:                       | /s/  Ronald A. Walko |   |
|           |   |                      | Ronald A. Walko,  President & Chief Executive Officer |

 

Pursuant to therequirements of the Securities and Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the Registrant and in thecapacities and on the dates indicated:
| /s/ Ronald A. Walko                            |   |           |   |
|-----------------------------------------------------|--------|----------------|--------|
| Ronald A. Walko,  President, Chief Executive        |   | March 13, 2007 |
| Officer and  Director (Principal Executive Officer) |   |           |
|                                                |   |           |
|                                                |   |           |
| /s/ Brian L.  Knepp                                 |   |           |   |
| Brian L. Knepp,  Principal Accounting Officer       |   | March 13, 2007 |
|                                                |   |           |
|                                                |   |           |
| /s/ Lynn S.  Bowes                                  |   |           |   |
| Lynn S. Bowes,  Director                            |   | March 13, 2007 |
|                                                |   |           |
|                                                |   |           |
| /s/ Michael J.  Casale, Jr.                         |   |           |   |
| Michael J.  Casale, Jr., Director                   |   | March 13, 2007 |
|                                                |   |           |
|                                                |   |           |
| /s/ H. Thomas  Davis, Jr.                           |   |           |   |
| H. Thomas Davis,  Jr., Director                     |   | March 13, 2007 |
|                                                |   |           |
|                                                |   |           |
| /s/ James M.  Furey II                              |   |           |   |
| James M. Furey  II, Director                        |   | March 13, 2007 |
|                                                |   |           |
|                                                |   |           |
| /s/ Leroy H.  Keiler III                            |   |           |   |
| Leroy H. Keiler  III, Director                      |   | March 13, 2007 |
|                                                |   |           |
|                                                |   |           |
| /s/ Jay H.  McCormick                               |   |           |   |
| Jay H.  McCormick, Director                         |   | March 13, 2007 |
|                                                |   |           |
|                                                |   |           |
| /s/ R. Edward  Nestlerode, Jr.                      |   |           |   |
| R. Edward Nestlerode,  Jr., Director                |   | March 13, 2007 |
|                                                |   |           |
|                                                |   |           |
| /s/ James E.  Plummer                               |   |           |   |
| James E.  Plummer, Director                         |   | March 13, 2007 |
|                                                     |        |                |        |  |  |  |  |  |  |  |  |

 

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| /s/ William H. Rockey, Sr.                            |   |           |   |
|-------------------------------------------------------|--------|----------------|--------|
| William H.  Rockey, Sr. Vice President & Director |   | March 13, 2007 |
|                                                  |   |           |
|                                                  |   |           |
| /s/ Hubert A.  Valencik                               |   |           |   |
| Hubert A.  Valencik, Director                         |   | March 13, 2007 |
|                                                       |        |                |        |  |

 

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