**Exhibit 13.1**

 

**FinancialContents**

 
| Consolidated Financial Statements           |   |
|---------------------------------------------|--------|
|                                        |   |
| Notes to  Consolidated Financial Statements |   |
|                                        |   |
| Report of Independent Auditors              |   |
|                                        |   |
| Five-Year Financial Highlights              |   |
|                                        |   |
| Management’s Discussion & Analysis |   |

 

----

 

**Consolidated Balance Sheets**

*(In Thousands, Except for Share Data)*

 
| **December 31,**                                                                                                                             |   | **2003**    |          | **2002** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------|---------------|----------|--------|
|                                                                                                                                         |   |        |          |     |   |
| **Assets**                                                                                                                                   |   |        |          |     |   |
|                                                                                                                                         |   |        |          |     |   |
| Cash and due from other financial  institutions                                                                                              |   | **$**       | **27,021**    |     | $      | 21,399 |   |
| Interest-bearing deposits in other  financial institutions                                                                                   |   | **1,400**   |          | 20,170   |   |
| **Total cash and cash equivalents**                                                                                                          |   | **28,421**  |          | 41,569   |   |
|                                                                                                                                         |   |        |          |     |   |
| Investment securities, available for sale,  at fair value, amortized cost of $223,165 at December 31, 2003 and $214,017  at December 31,2002 |   | **223,209** |          | 219,438  |   |
| Loans and leases, net of unearned income                                                                                                     |   | **679,977** |          | 608,601  |   |
| Less:allowance for loan and lease losses                                                                                                     |   | **7,754**   |          | 6,206    |   |
| Loans and leases, net                                                                                                                        |   | **672,223** |          | 602,395  |   |
|                                                                                                                                         |   |        |          |     |   |
| Bank premises and equipment, net                                                                                                             |   | **27,256**  |          | 15,809   |   |
| Goodwill                                                                                                                                     |   | **29,431**  |          | 22,924   |   |
| Intangibles with finite lives                                                                                                                |   | **3,690**   |          | —   |   |
| Accrued interest                                                                                                                             |   | **3,378**   |          | 3,501    |   |
| Bank-owned life insurance                                                                                                                    |   | **33,174**  |          | 30,800   |   |
| Other assets                                                                                                                                 |   | **7,054**   |          | 14,738   |   |
| **Total assets**                                                                                                                             |   | **$**       | **1,027,836** |     | $      | 951,174 |   |
|                                                                                                                                         |   |        |          |     |   |
| **Liabilities and Shareholders’ Equity**                                                                                                |   |        |          |     |   |
|                                                                                                                                         |   |        |          |     |   |
| **Deposits:**                                                                                                                                |   |        |          |     |   |
| Non-interest-bearing                                                                                                                         |   | **$**       | **69,640**    |     | $      | 59,181 |   |
| Interest-bearing                                                                                                                             |   | **544,910** |          | 528,299  |   |
| **Total deposits**                                                                                                                           |   | **614,550** |          | 587,480  |   |
|                                                                                                                                         |   |        |          |     |   |
| Short-term borrowings                                                                                                                        |   | **65,388**  |          | 29,682   |   |
| Long-term borrowings, Federal Home Loan  Bank                                                                                                |   | **225,595** |          | 220,000  |   |
| Long-term borrowings, other                                                                                                                  |   | **11,900**  |          | —   |   |
| Subordinated debentures                                                                                                                      |   | **18,866**  |          | 19,655   |   |
| Accrued interest and other liabilities                                                                                                       |   | **12,355**  |          | 13,110   |   |
| **Total liabilities**                                                                                                                        |   | **948,654** |          | 869,927  |   |
|                                                                                                                                         |   |        |          |     |   |
| Commitments and contingencies (see Note 20)                                                                                                  |   |        |          |     |   |
|                                                                                                                                         |   |        |          |     |   |
| **Shareholders’ equity:**                                                                                                               |   |        |          |     |   |
| Common stock, no par value; 50,000,000  authorized shares; issued 7,320,225 shares in 2003 and 7,299,446 in 2002                             |   | **85,386**  |          | 84,591   |   |
| Retained earnings (deficit)                                                                                                                  |   | **(3,728**  | )             | (5,159   | )      |
| Accumulated other comprehensive income, net  of taxes                                                                                        |   | **29**      |          | 3,578    |   |
| Less:Treasury stock at cost,140,922 shares  in 2003 and 126,717 shares in 2002                                                               |   | **(2,505**  | **)**         | (1,763   | )      |
| **Total shareholders’ equity**                                                                                                          |   | **79,182**  |          | 81,247   |   |
| **Total liabilities and shareholders’ equity**                                                                                          |   | **$**       | **1,027,836** |     | $      | 951,174 |   |

 

*See accompanying notes to consolidated financialstatements.*

 

----

 

**Consolidated Statements of Income**

*(In Thousands, Except for Share Data)*

 
| **Years Ended December 31,**                                       |   | **2003**      |       | **2002**  |   | **2001**  |   |
|--------------------------------------------------------------------|--------|---------------|------------|-----------|--------|-----------|--------|
| **Interest and dividend income:**                                  |   |          |       |      |   |      |   |
| Loans and leases, including fees                                   |   | **$**         | **40,467** |      | $      | 40,310    |   | $ | 38,603 |   |
| Investment securities                                              |   |          |       |      |   |      |   |
| Taxable                                                            |   | **7,600**     |       | 12,380    |   | 17,089    |   |
| Tax exempt                                                         |   | **869**       |       | 1,015     |   | 1,137     |   |
| Dividends                                                          |   | **358**       |       | 475       |   | 1,520     |   |
| Deposits in other financial institutions                           |   | **125**       |       | 363       |   | 1,345     |   |
| **Total interest and dividend income**                             |   | **49,419**    |       | 54,543    |   | 59,694    |   |
| **Interest expense:**                                              |   |          |       |      |   |      |   |
| Deposits                                                           |   | **11,366**    |       | 14,733    |   | 21,164    |   |
| Short-term borrowings                                              |   | **456**       |       | 325       |   | 430       |   |
| Long-term borrowings                                               |   | **12,478**    |       | 12,698    |   | 12,787    |   |
| Subordinated debentures                                            |   | **1,845**     |       | 1,892     |   | 1,578     |   |
| **Total interest expense**                                         |   | **26,145**    |       | 29,648    |   | 35,959    |   |
|                                                               |   |          |       |      |   |      |   |
| Net interest income                                                |   | **23,274**    |       | 24,895    |   | 23,735    |   |
| Provision for loan and lease losses                                |   | **1,620**     |       | 1,460     |   | 1,500     |   |
| **Net interest income after provision for  loan and lease losses** |   | **21,654**    |       | 23,435    |   | 22,235    |   |
|                                                               |   |          |       |      |   |      |   |
| **Non-interest income:**                                           |   |          |       |      |   |      |   |
| Service charges on deposit accounts                                |   | **4,094**     |       | 3,041     |   | 1,903     |   |
| Trust income                                                       |   | **726**       |       | 759       |   | 745       |   |
| Net securities gains                                               |   | **3,194**     |       | 616       |   | 844       |   |
| Investment product sales                                           |   | **377**       |       | 406       |   | 309       |   |
| Bank-owned life insurance                                          |   | **1,271**     |       | 720       |   | —    |   |
| Insurance subsidiary                                               |   | **1,257**     |       | 77        |   | 183       |   |
| Net gain on sale of loans                                          |   | **397**       |       | 255       |   | 130       |   |
| Gain on sale of branches                                           |   | **—**    |       | —    |   | 4,892     |   |
| Leasing fees                                                       |   | **1,089**     |       | —    |   | —    |   |
| Other income                                                       |   | **1,825**     |       | 794       |   | 502       |   |
| **Total non-interest income**                                      |   | **14,230**    |       | 6,668     |   | 9,508     |   |
|                                                               |   |          |       |      |   |      |   |
| **Non-interest expense:**                                          |   |          |       |      |   |      |   |
| Salaries and employee benefits                                     |   | **13,069**    |       | 11,800    |   | 9,680     |   |
| Net occupancy expenses                                             |   | **1,358**     |       | 1,083     |   | 995       |   |
| Furniture and equipment expenses                                   |   | **2,219**     |       | 1,790     |   | 1,745     |   |
| Pennsylvania shares tax                                            |   | **627**       |       | 800       |   | 699       |   |
| Amortization of intangibles with finite  lives                     |   | **531**       |       | —    |   | 1,567     |   |
| Other expenses                                                     |   | **10,689**    |       | 7,149     |   | 5,363     |   |
| **Total non-interest expense**                                     |   | **28,493**    |       | 22,622    |   | 20,049    |   |
| Income before income tax provision                                 |   | **7,391**     |       | 7,481     |   | 11,694    |   |
| Income tax provision                                               |   | **863**       |       | 1,065     |   | 3,344     |   |
| **Net income**                                                     |   | **$**         | **6,528**  |      | $      | 6,416     |   | $ | 8,350 |   |
| **Net income per share — Basic**                              |   | **$**         | **0.91**   |      | $      | 0.90      |   | $ | 1.20 |   |
|                                                               |   |          |       |      |   |      |   |
| **Net income per share — Diluted**                            |   | **$**         | **0.90**   |      | $      | 0.89      |   | $ | 1.20 |   |
|                                                               |   |          |       |      |   |      |   |
| **Cash dividends paid per share**                                  |   | **$**         | **0.71**   |      | $      | 0.65      |   | $ | 0.60 |   |
|                                                               |   |          |       |      |   |      |   |
| **Average shares outstanding — Basic**                        |   | **7,190,140** |       | 7,154,107 |   | 6,942,122 |   |
|                                                               |   |          |       |      |   |      |   |
| **Average shares outstanding — Diluted**                      |   | **7,215,066** |       | 7,196,534 |   | 6,945,504 |   |

 

*See accompanying notes to consolidated financialstatements.*

 

----

 

**Consolidated Statements of Changes inShareholders’ Equity**

*(In Thousands, Except for Share Data)*

** **

**Years Ended December 31, 2003, 2002 and 2001**

 

 
|                                                                                                                                     |   | **Common Stock** |       | **Retained  Earnings  (Deficit)** |       | **Accumulated  Other  Comprehensive**

**Income  (Loss)** |       | **Treasury  Stock** |       | **Total  Shareholders’  Equity** |       |
|------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------|------------|-----------------------------------|------------|-----------------------------------------------------------|------------|---------------------|------------|---------------------------------------|------------|
|                                                                                                                                     |   | **Shares**       |       | **Amount**                        |       |
| **Balance, January 1, 2001**                                                                                                             |   | 7,227            |       | $                                 | 81,632     |                                                      | $          | (11,177             | )          | $                                     | (1,591     | ) | $ | (6,337 | ) | $ | 62,527 |   |
| **Comprehensive income:**                                                                                                                |   |             |       |                              |       |                                                      |       |                |       |                                  |       |   |   |
| Net income                                                                                                                               |   | —           |       | —                            |       | 8,350                                                     |       | —              |       | —                                |       | 8,350 |   |
| Unrealized gains on investment securities available for sale, net of  reclassification adjustment of $(844) and tax effect of $(1,885)   |   | —           |       | —                            |       | —                                                    |       | 3,660               |       | —                                |       | 3,660 |   |
| **Total comprehensive income**                                                                                                           |   |             |       |                              |       |                                                      |       |                |       |                                  |       | 12,010 |   |
|                                                                                                                                     |   |             |       |                              |       |                                                      |       |                |       |                                  |       |   |   |
| Stock issued:                                                                                                                            |   |             |       |                              |       |                                                      |       |                |       |                                  |       |   |   |
| Employee benefit plans                                                                                                                   |   | 9                |       | 123                               |       | —                                                    |       | —              |       | —                                |       | 123 |   |
| Purchase of Guaranty Bank, N.A. (553,558 treasury shares)                                                                                |   | —           |       | 1,810                             |       | —                                                    |       | —              |       | 6,388                                 |       | 8,198 |   |
| Purchase of treasury stock (80,535 shares)                                                                                               |   | —           |       | —                            |       | —                                                    |       | —              |       | (1,213                                | )          | (1,213 | ) |
| Cash dividends declared, $0.60 per share                                                                                                 |   | —           |       | —                            |       | (4,134                                                    | )          | —              |       | —                                |       | (4,134 | ) |
| **Balance, December 31, 2001**                                                                                                           |   | 7,236            |       | 83,565                            |       | (6,961                                                    | )          | 2,069               |       | (1,162                                | )          | 77,511 |   |
| **Comprehensive income:**                                                                                                                |   |             |       |                              |       |                                                      |       |                |       |                                  |       |   |   |
| Net income                                                                                                                               |   | —           |       | —                            |       | 6,416                                                     |       | —              |       | —                                |       | 6,416 |   |
| Unrealized gains on investment securities available for sale, net of  reclassification adjustment of $(616) and tax effect of $(777)     |   | —           |       | —                            |       | —                                                    |       | 1,509               |       | —                                |       | 1,509 |   |
| **Total comprehensive income**                                                                                                           |   |             |       |                              |       |                                                      |       |                |       |                                  |       | 7,925 |   |
|                                                                                                                                     |   |             |       |                              |       |                                                      |       |                |       |                                  |       |   |   |
| Stock issued:                                                                                                                            |   |             |       |                              |       |                                                      |       |                |       |                                  |       |   |   |
| Employee benefit plans                                                                                                                   |   | 63               |       | 1,007                             |       | —                                                    |       | —              |       | —                                |       | 1,007 |   |
| Purchase of treasury stock (33,300 shares)                                                                                               |   | —           |       | —                            |       | —                                                    |       | —              |       | (601                                  | )          | (601 | ) |
| Cash dividends declared, $0.645 per share                                                                                                |   | —           |       | —                            |       | (4,614                                                    | )          | —              |       | —                                |       | (4,614 | ) |
| Tax benefit of exercised stock options                                                                                                   |   | —           |       | 19                                |       | —                                                    |       | —              |       | —                                |       | 19 |   |
| **Balance, December 31, 2002**                                                                                                           |   | 7,299            |       | 84,591                            |       | (5,159                                                    | )          | 3,578               |       | (1,763                                | )          | 81,247 |   |
| **Comprehensive income:**                                                                                                                |   |             |       |                              |       |                                                      |       |                |       |                                  |       |   |   |
| Net income                                                                                                                               |   | **—**       | ** ** | **—**                        | ** ** | **6,528**                                                 | ** ** | **—**          | ** ** | **—**                            | ** ** | **6,528** | ** ** |
| Unrealized losses on investment securities available for sale, net of  reclassification adjustment of $(3,194) and tax benefit of $1,828 |   | **—**       | ** ** | **—**                        | ** ** | **—**                                                | ** ** | **(3,549**          | **)**      | **—**                            | ** ** | **(3,549** | **)** |
| **Total comprehensive income**                                                                                                           |   |             | ** ** |                              | ** ** |                                                      | ** ** |                | ** ** |                                  | ** ** | **2,979** | ** ** |
|                                                                                                                                     |   |             |       |                              |       |                                                      |       |                |       |                                  |       |   |   |
| Stock issued:                                                                                                                            |   |             |       |                              |       |                                                      |       |                |       |                                  |       |   |   |
| Employee benefit plans                                                                                                                   |   | **21**           | ** ** | **278**                           | ** ** | **—**                                                | ** ** | **—**          | ** ** | **—**                            | ** ** | **278** | ** ** |
| Purchase of Bank Capital (25,109 treasury shares)                                                                                        |   | **—**       | ** ** | **121**                           | ** ** | **—**                                                | ** ** | **—**          | ** ** | **351**                               | ** ** | **472** | ** ** |
| Purchase of Mid-Penn Insurance (85,936 treasury shares)                                                                                  |   | **—**       | ** ** | **396**                           | ** ** | **—**                                                | ** ** | **—**          | ** ** | **1,329**                             | ** ** | **1,725** | ** ** |
| Purchase of treasury stock (125,250 shares)                                                                                              |   | **—**       | ** ** | **—**                        | ** ** | **—**                                                | ** ** | **—**          | ** ** | **(2,422**                            | **)**      | **(2,422** | **)** |
| Cash dividends declared, $0.7095 per share                                                                                               |   | **—**       | ** ** | **—**                        | ** ** | **(5,097**                                                | **)**      | **—**          | ** ** | **—**                            | ** ** | **(5,097** | **)** |
| **Balance, December 31, 2003**                                                                                                           |   | **7,320**        | ** ** | **$**                             | **85,386** | ** **                                                | **$**      | **(3,728**          | **)**      | **$**                                 | **29**     | ** ** | **$** | **(2,505** | **)** | **$** | **79,182** | ** ** |

 

*See accompanying notes to consolidated financialstatements.*

 

----

 

**Consolidated Statements of Cash Flows**

*(In Thousands)*

 
| **Years Ended December 31,**                                                                     |   | **2001**     |       | **2003**   |   | **2002** |   |
|--------------------------------------------------------------------------------------------------|--------|--------------|------------|------------|--------|----------|--------|
| **Cash flows from operating activities:**                                                        |   |         | ** ** |       |   |     |   |
| Net income                                                                                       |   | **$**        | **6,528**  | ** ** | $      | 6,416    |   | $ | 8,350 |   |
| Adjustments to reconcile net income to net cash provided by (used in)  operating activities:     |   |         | ** ** |       |   |     |   |
| Provision for loan and lease losses                                                              |   | **1,620**    | ** ** | 1,460      |   | 1,500    |   |
| Depreciation                                                                                     |   | **1,756**    | ** ** | 1,049      |   | 977      |   |
| Amortization of intangibles                                                                      |   | **531**      | ** ** | —     |   | 1,567    |   |
| Amortization and accretion of premium and discounts on investment  securities available for sale |   | **1,961**    | ** ** | 1,081      |   | 418      |   |
| Net gain on sale of investment securities available for sale                                     |   | **(3,194**   | **)**      | (616       | )      | (844     | )      |
| Gain on sale of branches                                                                         |   | **—**   | ** ** | —     |   | (4,892   | )      |
| Proceeds from loan sales                                                                         |   | **20,267**   | ** ** | 30,363     |   | —   |   |
| Mortgage loans originated for resale                                                             |   | **(19,394**  | **)**      | (31,236    | )      | —   |   |
| Net gain on sale of loans                                                                        |   | **(397**     | **)**      | (255       | )      | —   |   |
| Loss (gain) on sale of bank premises and equipment                                               |   | **18**       | ** ** | (6         | )      | (71      | )      |
| Increase (decrease) in other assets and liabilities, net                                         |   | **2,295**    | ** ** | (12,654    | )      | (7,321   | )      |
| **Net cash provided by (used in) operating activities**                                          |   | **11,991**   | ** ** | 4,398      |   | (316     | )      |
|                                                                                             |   |         |       |       |   |     |   |
| **Cash flows from investing activities:**                                                        |   |         | ** ** |       |   |     |   |
| Proceeds from sales of investment securities available for sale                                  |   | **83,751**   | ** ** | 26,417     |   | 43,252   |   |
| Proceeds from maturities, calls, and prepayments of investment  securities available for sale    |   | **114,348**  | ** ** | 156,665    |   | 109,051  |   |
| Purchase of bank-owned life insurance                                                            |   | **—**   | ** ** | (30,000    | )      | —   |   |
| Cash provided by branch acquisitions                                                             |   | **—**   | ** ** | —     |   | 92,852   |   |
| Cash used in sale of branches                                                                    |   | **—**   | ** ** | —     |   | (32,431  | )      |
| Purchases of investment securities available for sale                                            |   | **(186,104** | **)**      | (95,087    | )      | (135,464 | )      |
| Net cash used in acquisitions                                                                    |   | **(131**     | **)**      | —     |   | —   |   |
| Net increase in loans and leases                                                                 |   | **(50,571**  | **)**      | (68,790    | )      | (59,981  | )      |
| Proceeds from branch sales                                                                       |   | **—**   | ** ** | —     |   | 4,892    |   |
| Proceeds from sale of bank premises and equipment                                                |   | **18**       | ** ** | 6          |   | 222      |   |
| Capital expenditures                                                                             |   | **(10,780**  | **)**      | (2,396     | )      | (596     | )      |
| **Net cash (used in) provided by investing activities**                                          |   | **(49,469**  | **)**      | (13,185    | )      | 21,797   |   |
|                                                                                             |   |         |       |       |   |     |   |
| **Cash flows from financing activities:**                                                        |   |         | ** ** |       |   |     |   |
| Net (decrease) increase in deposits                                                              |   | **(9,427**   | **)**      | 13,603     |   | (8,557   | )      |
| Net increase in short-term borrowings                                                            |   | **35,285**   | ** ** | 7,544      |   | 5,506    |   |
| Proceeds from long-term borrowings, other                                                        |   | **11,900**   | ** ** | —     |   | —   |   |
| Repayments of long-term borrowings, FHLB                                                         |   | **(5,398**   | **)**      | (2,000     | )      | —   |   |
| Proceeds from issuance of subordinated debentures                                                |   | **—**   | ** ** | —     |   | 16,500   |   |
| Repayments of subordinated debentures                                                            |   | **(789**     | **)**      | (789       | )      | —   |   |
| Cash dividends paid                                                                              |   | **(5,097**   | **)**      | (4,614     | )      | (4,134   | )      |
| Proceeds from sale of stock for employee benefits program                                        |   | **278**      | ** ** | 1,026      |   | 123      |   |
| Purchase of treasury stock                                                                       |   | **(2,422**   | **)**      | (601       | )      | (1,213   | )      |
| **Net cash provided by financing activities**                                                    |   | **24,330**   | ** ** | 14,169     |   | 8,225    |   |
| Net (decrease) increase in cash and cash equivalents                                             |   | **(13,148**  | **)**      | (3,414     | )      | 29,706   |   |
| Cash and cash equivalents at beginning of year                                                   |   | **41,569**   | ** ** | 44,983     |   | 15,277   |   |
| **Cash and cash equivalents at end of year**                                                     |   | **$**        | **28,421** | ** ** | $      | 41,569   |   | $ | 44,983 |   |
|                                                                                             |   |         | ** ** |       |   |     |   |
| **Supplemental disclosure of cash flow information:**                                            |   |         | ** ** |       |   |     |   |
| Interest paid                                                                                    |   | **$**        | **27,363** | ** ** | $      | 29,650   |   | $ | 34,598 |   |
|                                                                                             |   |         |       |       |   |     |   |
| Income taxes paid                                                                                |   | **$**        | **—** | ** ** | $      | 1,950    |   | $ | 2,450 |   |

 

Supplementalschedule of noncash investing and financing activities:

Noncash investing activityconsisted of transfers of loans in liquidation to foreclosed assets held forsale with an estimated value of $873 in 2003, $459 in 2002 and $837 in 2001.

 

*See accompanying notes to consolidated financial statements.*

 

----

 

**Notes****to Consolidated Financial Statements**

*(For the Years Ended December 31, 2003, 2002and 2001, in thousands)*

 

**1. Basis of Presentation and Summary ofSignificant Accounting Policies**

Sun Bancorp, Inc. and subsidiaries (“Sun”) accounting and financialreporting policies conform with accounting principles generally accepted in theUnited States of America and with general financial industry practices. Certainprior year amounts were reclassified to conform to current yearclassifications. The net effect of the reclassifications had no material impacton the overall financial position or statement of net income. The followingsummary addresses the most significant policies with amounts presented inthousands:

** **

**Consolidation Basis**

Consolidated financial statements include the accounts of Sun Bancorp,Inc. (parent company) and its wholly owned subsidiaries: SunBank (Bank), SUBIInvestment Company, Mid-Penn Insurance (Mid-Penn), Sun Trust I, and Beacon LifeInsurance Company (Beacon). Sun also holds thirty percent ownership in SunAbstract and Settlement Services (Sun Abstract), which is accounted for underthe equity method. SunBank includes its wholly owned subsidiaries: SUBI ServiceLLC, Bank Capital Services (Bank Capital), and Sun Investment Services.Beacon’s and Sun Abstract’s transactions are not material to the consolidatedfinancial statements. All significant intercompany balances and transactionshave been eliminated in consolidation.

** **

**Operations**

Sun provides a full range of community and commercial banking servicesthrough 23 SunBank offices in northeast and central Pennsylvania. SunBank’sprimary deposit products include checking, savings, money market, andcertificate of deposit accounts. SunBank’s primary loan products includecommercial loans and leases, consumer loans and leases, and single-familyresidential mortgages. In addition, Sun has subsidiaries and ownershipinterests in partnerships that engage in various business activities, includingcredit, life, and disability insurance (Beacon), title insurance and settlementservices (Sun Abstract), equipment and consumer auto leasing (Bank Capital),investment product sales (SunInvestment), insurance product sales (Mid-Penn) and affordable housing forsenior citizens.

** **

**Use of Estimates**

In preparing the financial statements, management is required to makeestimates and assumptions that affect the reported amounts of assets andliabilities as of the date of the balance sheets, the disclosed amounts ofcontingent assets and liabilities as of the date of the balance sheets, and thereported amounts of revenues and expenses for the periods presented. Actualresults could differ significantly from those estimates. In particular,management relies on estimates and assumptions when determining an adequateallowance for loan and lease losses. Refer to the heading “Allowance for Loanand Lease Losses (ALLL)” in this note for additional information. In addition,management relies on estimates and assumptions when determining the residualvalue for SunBank’s auto and equipment leasing business. Refer to the heading“Residual Value” in this note for additional information. Deferred tax assetsand liabilities also represent significant estimates (see Note 18).

** **

**Investment Securities**

Sun reports all investment securities, including debt instruments,restricted equities, and unrestricted equities as available for sale. Exceptfor restricted equities, Sun reports all investment securities at fair value.Unrealized gains or losses, net of related taxes, are excluded from earningsand reported as a component of accumulated other comprehensive income withinshareholders’ equity. Restricted equities consist solely of Federal Home LoanBank of Pittsburgh (FHLB) stock.

 

Management estimates fair values based on observable market prices. Whenbid prices are not available, management estimates fair value based onobservable market prices for instruments with similar cash flow and riskcharacteristics.

 

Premium amortization and discount accretion are recorded using the levelyield method over each investment security’s remaining contractual or expectedlife (whichever is shorter), adjusted for actual prepayment experience.Realized gains and losses from investment securities sales are computed basedon each security’s specific carrying value.

** **

**Interest Income on Loans and Leases**

Interest income on loans and leases is recognized on an accrual basis.Loan fees and certain direct loan origination costs are deferred and amortizedas an adjustment to the related loan yield using the effective interest method,generally over the contractual life of the related loans.

 

Nonaccrual loans are those on which the accrual of interest has ceasedand where all previously accrued, but not collected, interest is reversed.Loans, other than consumer loans, are placed on nonaccrual status whenprincipal or interest is past due 90 days or more and the loan is not wellcollateralized and in the process of collection or immediately, if in theopinion of management, full collection is doubtful. Interest accrued, but notcollected, as of the date of placement on nonaccrual status, is reversed andcharged against current income. Sun does not accrue interest on impaired loans.While a loan is considered impaired or on nonaccrual status, subsequent cashinterest payments received are either applied to the outstanding principalbalance or recorded as interest income, based on management’s assessment of theultimate collectibility of principal and interest. In any case, the deferral ornon-recognition of interest does not constitute forgiveness of the borrower’sobligation. Consumer loans are recorded in accordance with the Uniform RetailClassification regulation. Generally, the regulation requires that consumerloans be charged off to the allowance for loan and lease losses when theybecome 120 days or more past due.

 

----

 

**Lease Fee/Expense Recognition**

Sun recognizes fees and expenses on direct financing leases using theimplied interest rate, which results in a level yield. Fees and expenses onoperating leases are recognized using the straight-line method.

** **

**Loan Servicing**

Mortgage loans serviced for third parties are not included in Sun’sconsolidated balance sheets. Unpaid principal balances of mortgage loansserviced for third parties totaled $16,181 at December 31, 2003 and $18,132 atDecember 31, 2002. Capitalized mortgage servicing rights (MSRs), includedwithin other assets in the consolidated balance sheets, totaled approximately$12 at December 31,2003 and $38 at December 31, 2002.

 

Sun records MSRs at fair value and amortizes the balance over the periodof estimated net servicing income or loss. Sun relies on a valuation model tocalculate the net present value of expected future cash flows that determinesthe MSRs fair value. Sun’s valuation model incorporates assumptions that marketparticipants use to estimate future net servicing income, including loan types,interest rates, servicing costs, prepayment speeds, and discount rates. Sunevaluates the MSR’s value for impairment semi-annually.

** **

**Leases**

In accordance with SFAS 13, Accounting for Leases, Sun reflects leaseseither as direct financing leases within loans or operating leases within fixedassets on the balance sheet. Sun determines the classification based on acalculation of the present value of contractual payments for leases plus thepresent value of the guaranteed residual and subtracting a 20% residualdeductible. Sun divides the result by the capitalized cost. If the ratio is 90%or greater, Sun classifies the lease as a direct finance lease. If the ratio isless than 90%, Sun classifies the lease as an operating lease.

** **

**Residual Value – Auto**

Sun’s residual value represents the estimated wholesale market value ofeach leased vehicle at the end of the lease term, which is established at thebeginning of the lease term by the Automotive Lease Guide (ALG). Recordedresidual values, which are above the wholesale market value at the end of thelease term, could lead to financial losses. To mitigate the possible loss, Sunhas two different residual insurance policies. One policy covers leasedvehicles booked prior to April 1, 2003, and has a $500 per vehicle deductibleusing Black Book Wholesale Average as the standard. The second policy, whichwent into effect on April 1, 2003, uses a 20% per vehicle deductible usingBlack Book Wholesale Clean as the standard. In both cases, the guarantee is basedon each lease, not the value of the portfolio. The Black Book values aredetermined by the national wholesale value of each vehicle accumulated andpublished by Black Book.

** **

**Residual Value – Equipment**

Sun’s residual value represents the estimated wholesale market value ofthe leased equipment at the end of the lease term, which is established at thebeginning of the lease term. The majority of equipment leases carry no residualvalue. Those equipment leases that carry a residual amount are predominantly valuedat 10% of fair market value at the beginning of the lease, which managementfeels limits the risk of loss to a minimal level. Any equipment lease writtenwith a 20% or higher residual value, includes a provision that the lessee isresponsible for the residual or will purchase the equipment at the end of thelease.

** **

**Residual Value Impairment**

Sun tests residual values for impairment annually. Sun compares theportfolio against an equity table, which sets forth the insurance carrier’sprojections of vehicle values based on a comparison of the Automotive LeaseGuide residual values to Black Book values. The result of this comparison willbe used by Sun in determining residual impairment so that any necessarywrite-downs may be taken in the period of impairment.

** **

**Residual Value Insurance Receivables**

Sun has not filed any claims with the residual value guarantor. When aclaim arises, Sun will record the receivable within other assets at the time aclaim is filed with the guarantor.

** **

**Loans and Leases Available for Sale**

Sun has contracted with a third party to purchase certain newresidential mortgages originated by Sun within seven days of closing. Mortgagesare selected based on predefined terms and conditions agreed upon by Sun andthe third party. Due to the origination of these mortgage loans at market ratesand the relatively short holding period, the market value and book value arenot deemed to be materially different.

 

It is the intent of Sun to hold to maturity all other loans and leases,except the mortgages noted above. However, from time to time management mayelect to sell certain loans or leases out of the portfolio in order to redeploycapital or to maintain internal or external risk guidelines.

** **

**Gains and Losses on Loans and Leases Sold**

Sun recognizes gains or losses on the sale of loans or leases at thetime of sale. The proceeds of the sale are first applied to accrued interestand fees receivable with the remaining proceeds applied to principal. Anyremaining proceeds or deficit is recognized as a gain or loss. Loans or leasesare sold without recourse; however, Sun does retain servicing rights, which arerecorded as an asset at fair value and amortized over the weighted average lifeof the servicing asset. These amounts are deemed insignificant.

 

----

 

**Allowance for Loan and Lease Losses (ALLL)**

Sun’s ALLL reflects periodic provisions for loan and lease losses, andthat provision is reported as an expense. Loan and lease losses are chargedagainst the ALLL in the period in which they have been determined to beuncollectible. Recoveries of previously charged off loans and leases arecredited to the allowance as they are received. Management maintains the ALLLat a level it believes will be adequate to absorb probable losses in theexisting loan and lease portfolio.

 

Sun’s loan portfolio consists primarily of residential mortgage loans,consumer loans and commercial loans concentrated in northeast and centralPennsylvania (Lycoming, Snyder, Union, Northumberland, Clinton, Dauphin andLuzerne counties). These regions’ economies depend on the manufacturing andservice industries. Management’s analysis incorporates many factors, includingcurrent economic conditions, loss experience, loan portfolio composition, andanticipated losses. For significant real estate properties, management obtainsindependent value appraisals. However, unforeseen developments may requiremanagement to increase the ALLL. Such developments could include changingeconomic conditions or negative developments with borrowers. In addition, bankregulators periodically assess Sun’s ALLL and may, consistent with examinationguidelines and current information, require an increased provision to the ALLL.As a result, several factors may materially change management’s analysis andestimates in the future.

** **

**Foreclosed Assets**

Sun classifies all foreclosed assets as held for sale and reportsforeclosed assets at the lower of cost or fair value (less estimated sellingcosts). Foreclosed assets, which are included within other assets in theconsolidated balance sheets, totaled $1,331 at December 31, 2003 and $912 atDecember 31, 2002.

** **

**Premises and Equipment**

Sun reports premises and equipment at cost less accumulateddepreciation. Depreciation expense is computed and recognized using thestraight-line method and recognized over the estimated useful life of theasset. Sun generally expenses repair and maintenance expenditures as incurred,and capitalizes such expenditures only when they extend an asset’s useful life.When Sun retires or sells premises or equipment, the remaining cost andaccumulated depreciation are removed from the account and any gain or loss isreported in current income.

** **

**Intangible Asset – Goodwill**

Sun’s goodwill resulted from the acquisition of Bucktail Bank and TrustCompany (Bucktail) in 1997, Guaranty Bank N.A. in 2001, three Mellon branchesduring 2001, Bank Capital in 2003, Mid-Penn Insurance in 2003, and SteeltonBancorp in 2003. Goodwill represents the excess cost of acquired assetsrelative to those assets’ fair value at the time of purchase. Sun adopted SFAS147, Acquisition of Certain Financial Institutions in 2002 as described in Note8. Prior to 2002, Sun amortized goodwill and unidentifiable intangible assetsusing the straight-line method based on 15-20 year lives. Under the provisionsof SFAS 142, goodwill arising from acquisitions may no longer be amortized forthe 2002 fiscal year and forward. Amortization of goodwill totaled $1,567 in2001. Annually, Sun contracts an independent third party to evaluate thecarrying value of goodwill for impairment based on the fair value of Sun. Basedon impairment evaluations, management believes no material impairment ofintangibles existed at December 31, 2003 and December 31, 2002.

** **

**Intangible Asset – Core Deposit Intangible**

Sun’s core deposit intangible (CDI) resulted from the acquisition ofthree Mellon branches during 2001 and Steelton Bancorp in 2003. The CDI foreach transaction is being amortized over the average life of the depositsacquired as determined by an independent third party. The carrying value of CDIwas $1,912 at December 31, 2003 with $445 in amortization expense recognizedduring 2003. There was no carrying value and corresponding amortization priorto 2003, as the CDI resulting from the branch purchases was reclassified fromgoodwill to CDI during 2003 due to a retrospective analysis of the transaction.

** **

**Intangible Asset – Customer List Intangible**

Sun’s customer list intangible (CLI) resulted from the acquisition ofMid-Penn Insurance in 2003. The CLI represents the implied value of thecustomer list acquired and is being amortized over a 15-year period asdetermined by an independent third party. The carrying value of CLI was $1,778at December 31, 2003 with $86 in amortization expense recognized during 2003.

** **

**Investments in Limited Partnerships**

Sun is a limited partner in six partnerships at December 31, 2003 thatprovide low income elderly housing in Sun’s geographic market area . Thecarrying value of Sun’s investments in limited partnerships was $3,852 at December31, 2003 and $3,922 at December 31,2002. Sun is amortizing the investment ineach partnership to 50% of the initial investment over the life of the ten-yeartax credits generated by the investment. This write-down approximates thechange in equity and allows for the decreased value of the property at the endof the tax credit period. Amortization of limited partnership investmentstotaled $239 in 2003, $236 in 2002 and $177 in 2001.

 

Sun is also a partner in two partnerships at December 31, 2003 thatprovide office space in areas designated as empowerment zones by theCommonwealth of Pennsylvania. These partnerships provide Sun with PennsylvaniaShares Tax credits and had a book value of $2,927 at December 31, 2003 and$2,901 at December 31, 2002. Amortization of these limited partnershipinvestments totaled $45 in 2003 and $0 in 2002.

 

----

 

**Income Taxes**

Deferred tax assets and liabilities are recognized for the future taxconsequences attributable to the differences between financial reporting andincome tax accounting methods, using enacted tax rates in effect for the yearin which the difference is expected to reverse. These differences primarilyinvolve timing differences for recognition of loan and lease losses,depreciation, and lease operations.

** **

**Off-Balance Sheet Financial Instruments**

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

** **

**Standby Letters of Credit and Financial Guarantees**

Sun enters into standby letters of credit and financial guarantees withits customers to guarantee a customer’s performance to a third party. Theseguarantees are primarily issued to support borrowing arrangements and relatedtransactions. Terms vary from one to 24 months and may have renewal features.Fees associated with standby letters of credit and financial guarantees aredeferred and amortized over the life of the guarantee. At December 31,2003 and2002, the amount of deferred fees were $20 and $0, respectively.

** **

**Defined Benefit Plan**

Sun maintains a defined benefit plan for certain key employees. Theexpense recognized includes interest earned based on the average Fed Funds ratefor the year and annual funding requirements as set forth by the plan.

** **

**Cash and Cash Equivalents**

Cash equivalents include cash and due from banks and interest-bearingdeposits in banks. Deposits maintained at each financial institution areinsured by the Federal Deposit Insurance Corporation (FDIC) up to $100,000. Sunmaintains cash and cash equivalents with financial institutions in excess ofthe insured amount.

** **

**Restrictions on Cash and Cash Equivalents**

Based on deposit levels, Sun must maintain cash and other reserves withthe Federal Reserve Bank of Philadelphia (FRB). Those reserves averaged $2,025in 2003, $1,284 in 2002 and $1,186 in 2001. These reserves were $2,468 atDecember 31, 2003 and $1,356 at December 31, 2002.

** **

**Trust Assets and Income**

Assets held in a fiduciary or agency capacity are not Sun’s assets andare excluded from Sun’s consolidated financial statements. Trust income isreported on the accrual basis based on those accounts on a monthly billingcycle. Accounts not on a monthly billing cycle are excluded from the accrual asthe fees are based on the market value of the trust assets and fluctuations inthe market would not allow for a reasonable estimate. The amount eliminatedfrom the accrual is not deemed to be material.

** **

**Insurance Revenue Recognition**

Sun recognizes revenue from the insurance subsidiaries, Mid-Penn andBeacon, as commissions become receivable.

** **

**Segment Reporting**

Statement of Financial Accounting Standards No. 131, “Disclosure aboutSegments of an Enterprise and Related Information,” requires that pubicbusiness enterprises report financial and descriptive information about theirreportable operating segments. Based  onthe guidance provided by the Statement, Sun has determined that its onlyreportable segment is Community Banking.

** **

**Common Stock Plans**

Sun has three common stock plans for employees and directors. The 1998Stock Incentive Plan, administered by an independent committee of the Board ofDirectors, allows 716,625 shares of common stock for key officers and othermanagement employees in the form of qualified options, nonqualified options,stock appreciation rights, or restrictive stock. The 1998 Independent DirectorsStock Option Plan allows 115,763 shares of common stock to be issued tonon-employee directors. Options, under those plans, expire ten years after thegrant date. Both of these plans terminate in 2008.

 

The 1998 Employee Stock Purchase Plan, which permits all employees topurchase common stock at an option price per share not less than 85% of themarket value on the exercise date, was allocated 248,063 shares. Optionsgranted to date have been awarded at 90% of the market value on the exercisedate. Each option under the 1998 Employee Stock Purchase Plan expires no laterthan 5 years from the grant date. This plan terminates in 2008.

 

Sun applies Accounting Principles Board Opinion 25 and relatedinterpretations to account for its common stock plans. Accordingly, Sun has notrecognized compensation expense for the plans.

** **

**Other Comprehensive Income**

Generally accepted accounting principles require recognized revenues,expenses, gains, and losses be included in net income. Certain changes inassets and liabilities, including unrealized gains and losses on available forsale securities, are reported as a separate equity component and as componentsof comprehensive income.

 

----

 

**Notes to Consolidated Financial Statements**

 

**2. Net Income Per Share**

Net income per share is computed based on the weighted average number ofshares of stock outstanding for each year presented. Statement of FinancialAccounting Standards (SFAS) No. 128, “Earnings Per Share,” requirespresentation of two amounts; basic and diluted net income per share.

 

The following data shows the amounts used in computing net income pershare and the weighted average number of shares of dilutive stock options:

 
| **(In  Thousands, Except for Share Data)**                             |   | **Net  Income** |      | **Weighted  Average  Common Shares** |          | **Net Income  Per Share** |   |
|------------------------------------------------------------------------|--------|-----------------|-----------|--------------------------------------|---------------|---------------------------|--------|
|                                                                   |   |            |      |                                 |          |                      |   |
| **2003**                                                               |   |            |      |                                 |          |                      |   |
| Net income per share — Basic                                      |   | **$**           | **6,528** | ** **                           | **7,190,140** | ** **                | **$**  | **0.91** | ** ** |
| Dilutive effect of potential common stock  arising from stock options: |   |            |      |                                 |          |                      |   |
| Exercise of options outstanding                                        |   |            |      | **231,598**                          |          |                      |   |
| Hypothetical share repurchase at $19.59                                |   |            |      | **(206,672**                         | **)**         |                      |   |
| **Net income per share — Diluted**                                |   | **$**           | **6,528** | ** **                           | **7,215,066** | ** **                | **$**  | **0.90** | ** ** |
|                                                                   |   |            |      |                                 |          |                      |   |
| **2002**                                                               |   |            |      |                                 |          |                      |   |
| Net income per share — Basic                                      |   | $               | 6,416     |                                 | 7,154,107     |                      | $      | 0.90 |   |
| Dilutive effect of potential common stock  arising from stock options: |   |            |      |                                 |          |                      |   |
| Exercise of options outstanding                                        |   |            |      | 250,207                              |          |                      |   |
| Hypothetical share repurchase at $19.63                                |   |            |      | (207,780                             | )             |                      |   |
| **Net income per share — Diluted**                                |   | $               | 6,416     |                                 | 7,196,534     |                      | $      | 0.89 |   |
|                                                                   |   |            |      |                                 |          |                      |   |
| **2001**                                                               |   |            |      |                                 |          |                      |   |
| Net income per share — Basic                                      |   | $               | 8,350     |                                 | 6,942,122     |                      | $      | 1.20 |   |
| Dilutive effect of potential common stock  arising from stock options: |   |            |      |                                 |          |                      |   |
| Exercise of options outstanding                                        |   |            |      | 236,334                              |          |                      |   |
| Hypothetical share repurchase at $15.63                                |   |            |      | (232,952                             | )             |                      |   |
| **Net income per share — Diluted**                                |   | $               | 8,350     |                                 | 6,945,504     |                      | $      | 1.20 |   |

 

Not included within this analysis were219,609 shares in 2003, 229,138 shares in 2002 and 214,128 shares in 2001 dueto the fact that the exercise of these shares would be anti-dilutive.

 

**3. Other Comprehensive Income**

Other comprehensive income components andrelated tax effects were:

 

*(In Thousands)*

 
| **Years Ended December 31,**                                        |   | **2003**   |       | **2002** |   | **2001** |   |
|---------------------------------------------------------------------|--------|------------|------------|----------|--------|----------|--------|
| Unrealized holding (losses) gains on  available for sale securities |   | **$**      | **(2,184** | **)**    | $      | 2,902    |   | $ | 6,389 |   |
| Less: Reclassification adjustment for gains  realized in income     |   | **(3,194** | **)**      | (616     | )      | (844     | )      |
| Net unrealized (losses) gains                                       |   | **(5,378** | **)**      | 2,286    |   | 5,545    |   |
| Income tax benefit (expense)                                        |   | **1,829**  | ** ** | (777     | )      | (1,885   | )      |
| **Net other comprehensive (loss) income**                           |   | **$**      | **(3,549** | **)**    | $      | 1,509    |   | $ | 3,660 |   |

 

----

 

**4. Investment Securities**

SunBank holds one bond within other corporate obligations that hasexperienced a 12% unrealized loss at December 31, 2003 and a 9% unrealized lossat December 31, 2002. The amortized cost of the bond was $236 and $320 atDecember 31, 2003 and 2002, respectively. Management believes this loss istemporary, due the continued AAA rating of the bond and the continued receiptof principal and interest payments. There are no other investments with anunrealized loss greater than one year as of December 31, 2003.

 

A summary of investment securities available for sale is as follows:

 

*(In Thousands)*

 
|                                                |   | **Amortized** |        | **Gross  Unrealized** |       | **Fair**   |       |
|-----------------------------------------------------|--------|---------------|-------------|-----------------------|------------|------------|------------|
|                                                |   | **Cost**      |        | **Gains**             |       | **Losses** |       | **Value** |   |
| **December 31, 2003**                               |   |          |        |                  |       |       |       |   |   |
| **Debt securities:**                                |   |          |        |                  |       |       |       |   |   |
| Mortgage backed — pass through                 |   | **$**         | **84,935**  | ** **            | **$**      | **407**    | ** ** | **$** | **(559** | **)** | **$** | **84,783** | ** ** |
| Mortgage backed — other                        |   | **101,393**   | ** **  | **263**               | ** ** | **(992**   | **)**      | **100,664** | ** ** |
| Obligations of U.S. government agencies             |   | **3,190**     | ** **  | **11**                | ** ** | **(73**    | **)**      | **3,128** | ** ** |
| Obligations of state and political  subdivisions    |   | **17,654**    | ** **  | **1,030**             | ** ** | **(62**    | **)**      | **18,622** | ** ** |
| Other corporate obligations                         |   | **1,206**     | ** **  | **19**                | ** ** | **—** | ** ** | **1,225** | ** ** |
| **Total debt securities**                           |   | **208,378**   | ** **  | **1,730**             | ** ** | **(1,686** | **)**      | **208,422** | ** ** |
|                                                |   |          |        |                  |       |       |       |   |   |
| **Equity securities:**                              |   |          |        |                  |       |       |       |   |   |
| Marketable equity securities                        |   | **330**       | ** **  | **—**            | ** ** | **—** | ** ** | **330** | ** ** |
| Restricted equity securities                        |   | **14,457**    | ** **  | **—**            | ** ** | **—** | ** ** | **14,457** | ** ** |
| **Total equity securities**                         |   | **14,787**    | ** **  | **—**            | ** ** | **—** | ** ** | **14,787** | ** ** |
| **Total investment securities available for  sale** |   | **$**         | **223,165** | ** **            | **$**      | **1,730**  | ** ** | **$** | **(1,686** | **)** | **$** | **223,209** | ** ** |
|                                                |   |          | ** **  |                  | ** ** |       | ** ** |   | ** ** |
| **December 31, 2002**                               |   |          |        |                  |       |       |       |   |   |
|                                                |   |          |        |                  |       |       |       |   |   |
| **Debt securities:**                                |   |          |        |                  |       |       |       |   |   |
| Mortgage backed — pass through                 |   | $             | 98,705      |                  | $          | 1,446      |       | $ | (133 | ) | $ | 100,018 |   |
| Mortgage backed — other                        |   | 24,559        |        | 767                   |       | —     |       | 25,326 |   |
| Obligations of U.S. government agencies             |   | 50,288        |        | 2,371                 |       | —     |       | 52,659 |   |
| Obligations of state and political  subdivisions    |   | 19,767        |        | 836                   |       | —     |       | 20,603 |   |
| Other corporate obligations                         |   | 5,575         |        | 388                   |       | (75        | )          | 5,888 |   |
| **Total debt securities**                           |   | 198,894       |        | 5,808                 |       | (208       | )          | 204,494 |   |
|                                                |   |          |        |                  |       |       |       |   |   |
| **Equity securities:**                              |   |          |        |                  |       |       |       |   |   |
| Marketable equity securities                        |   | 3,111         |        | 136                   |       | (315       | )          | 2,932 |   |
| Restricted equity securities                        |   | 12,012        |        | —                |       | —     |       | 12,012 |   |
| **Total equity securities**                         |   | 15,123        |        | 136                   |       | (315       | )          | 14,944 |   |
| **Total investment securities available for  sale** |   | $             | 214,017     |                  | $          | 5,944      |       | $ | (523 | ) | $ | 219,438 |   |
|                                                |   |          |        |                  |       |       |       |   |   |
| **December 31, 2001**                               |   |          |        |                  |       |       |       |   |   |
|                                                |   |          |        |                  |       |       |       |   |   |
| **Debt securities:**                                |   |          |        |                  |       |       |       |   |   |
| Mortgage backed — pass through                 |   | $             | 112,804     |                  | $          | 1,138      |       | $ | (191 | ) | $ | 113,751 |   |
| Mortgage backed — other                        |   | 97,694        |        | 1,137                 |       | (366       | )          | 98,465 |   |
| Agency obligations                                  |   | 46,734        |        | 1,705                 |       | —     |       | 48,439 |   |
| U.S. Treasury obligations                           |   | 1,002         |        | 2                     |       | —     |       | 1,004 |   |
| Obligations of state and political  subdivisions    |   | 22,054        |        | 312                   |       | (161       | )          | 22,205 |   |
| Other corporate obligations                         |   | 7,239         |        | 253                   |       | (40        | )          | 7,452 |   |
| **Total debt securities**                           |   | 287,527       |        | 4,547                 |       | (758       | )          | 291,316 |   |
|                                                |   |          |        |                  |       |       |       |   |   |
| **Equity securities:**                              |   |          |        |                  |       |       |       |   |   |
| Marketable equity securities                        |   | 3,836         |        | 13                    |       | (667       | )          | 3,182 |   |
| Restricted equity securities                        |   | 11,114        |        | —                |       | —     |       | 11,114 |   |
| **Total equity securities**                         |   | 14,950        |        | 13                    |       | (667       | )          | 14,296 |   |
| **Total investment securities available for  sale** |   | $             | 302,477     |                  | $          | 4,560      |       | $ | (1,425 | ) | $ | 305,612 |   |

 

----

 

The amortized cost and estimated fair value of Sun’s securities atDecember 31, 2003 and 2002, by contractual maturity, are shown below. Actualmaturities will differ from contractual maturities because some borrowers havethe right to call or prepay obligations with or without prepayment penalties.

 

**Securities by Contractual Maturity:**

 

*(In Thousands)*

 
|                                   |   | **2003**            |        | **2002**       |   |
|----------------------------------------|--------|---------------------|-------------|----------------|--------|
| **December 31,**                       |   | **Amortized  Cost** |        | **Fair Value** |   | **Amortized  Cost** |   | **Fair Value** |   |
| **Debt securities:**                   |   |                |        |           |   |   |   |   |   |
| Due in one year or less                |   | **$**               | **1,214**   | ** **     | **$**  | **1,234** |   | $ | 2,148 |   | $ | 2,177 |   |
| Due after one year through five years  |   | **14,097**          | ** **  | **14,348**     |   | 14,683 |   | 14,909 |   |
| Due after five years through ten years |   | **11,479**          | ** **  | **11,458**     |   | 18,107 |   | 19,240 |   |
| Due after ten years                    |   | **96,653**          | ** **  | **96,599**     |   | 15,555 |   | 16,110 |   |
| Mortgage-backed securities             |   | **84,935**          | ** **  | **84,783**     |   | 148,401 |   | 152,058 |   |
| Total debt securities                  |   | **208,378**         | ** **  | **208,422**    |   | 198,894 |   | 204,494 |   |
| **Equity securities**                  |   | **14,787**          | ** **  | **14,787**     |   | 15,123 |   | 14,944 |   |
| **Total**                              |   | **$**               | **223,165** | ** **     | **$**  | **223,209** |   | $ | 214,017 |   | $ | 219,438 |   |

 

Securities with a carrying value of $163,422 at December 31, 2003 and$174,991 at December 31, 2002 were pledged to secure public deposits, trustdeposits, securities sold under agreements to repurchase, FHLB borrowings andother balances required by law.

 

Sun’s securities do not include any concentrations exceeding 10% ofshareholders’ equity from any individual issuer (excluding those guaranteed bythe U.S. government or its agencies).

 

**Sales of Securities:**

* *

*(In Thousands)*

 
| **For the Years Ended December 31,** |   | **2003** |      | **2002** |   | **2001** |   |
|--------------------------------------|--------|----------|-----------|----------|--------|----------|--------|
| Realized Gains                       |   | **$**    | **3,251** |     | $      | 1,286    |   | $ | 1,044 |   |
| Realized Losses                      |   | **(57**  | **)**     | (670     | )      | (200     | )      |
| Net Realized Gains                   |   | **$**    | **3,194** |     | $      | 616      |   | $ | 844 |   |

 

**5. Loans and Leases**

Loan activity is well diversified and focused within Sun’s definedmarket area. However, borrowers’ ability to repay loans depends in part oneconomic conditions in Sun’s market area.

 

Loan and leases are summarized as follows:

 

*(In Thousands)*

 
| **December 31,**                                             |   | **2003**    |        | **2002** |   |
|--------------------------------------------------------------|--------|-------------|-------------|----------|--------|
| Real estate:                                                 |   |        |        |     |   |
| Residential mortgages                                        |   | **$**       | **178,831** |     | $      | 205,885 |   |
| Commercial                                                   |   | **194,237** |        | 198,465  |   |
| Construction                                                 |   | **32,157**  |        | 17,721   |   |
| Agricultural                                                 |   | **268**     |        | 138      |   |
| Commercial and industrial                                    |   | **96,028**  |        | 54,624   |   |
| Lease — Auto                                            |   | **80,582**  |        | 48,574   |   |
| Lease — Equipment                                       |   | **9,404**   |        | 4,955    |   |
| Individual                                                   |   | **98,193**  |        | 85,920   |   |
| Other                                                        |   | **321**     |        | 328      |   |
| **Total**                                                    |   | **690,021** |        | 616,610  |   |
|                                                         |   |        |        |     |   |
| Less: Deferred fees and unearned income on  loans and leases |   | **(10,541** | **)**       | (7,945   | )      |
| Allowance for loan and lease losses                          |   | **(7,754**  | **)**       | (6,206   | )      |
| Add: Unamortized net premium (discount) on  purchased loans  |   | **497**     |        | (64      | )      |
| **Net loans and leases**                                     |   | **$**       | **672,223** |     | $      | 602,395 |   |

 

Loans held for sale at December 31, 2003 were $0 and at December 31,2002 were $1,309.

 

----

 

The following is a summary of past due and impaired loans and thecorresponding allowance for impaired loans:

* *

*(In Thousands)*

 
| **At December 31,**                                                   |   | **2003**   |       | **2002**   |   | **2001** |   |
|-----------------------------------------------------------------------|--------|------------|------------|------------|--------|----------|--------|
| Impaired loans                                                        |   | **$**      | **2,746**  | ** ** | $      | 4,775    |   | $ | 5,592 |   |
| Accruing loans past due 90 days or more as  to principal and interest |   | **776**    | ** ** | 315        |   | 560      |   |
| Amount of impaired loans with a related  allowance for possible loss  |   | **2,746**  | ** ** | 4,775      |   | 5,592    |   |
| Amount of impaired loans with no related  allowance                   |   | **—** | ** ** | —     |   | —   |   |
| Total allowance for impaired loans                                    |   | **1,322**  | ** ** | 2,831      |   | 2,339    |   |
|                                                                       |        |            |            |            |        |          |        |  |  |  |

 
| **Years  Ended December 31,**                                  |   | **2003** |      | **2002**   |   | **2001** |   |
|----------------------------------------------------------------|--------|----------|-----------|------------|--------|----------|--------|
| Average investment in impaired loans                           |   | **$**    | **8,423** | ** ** | $      | 5,161    |   | $ | 4,977 |   |
| Interest income recognized on impaired  loans (all cash basis) |   | **$**    | **629**   | ** ** | $      | 387      |   | $ | 437 |   |

 

**Net Investment in Direct Financing Leases:**

* *

*(In Thousands)*

 
| **Years Ended December 31,**          |   | **2003**    |       | **2002**   |   |
|---------------------------------------|--------|-------------|------------|------------|--------|
| Minimum lease payments receivable     |   | **$**       | **55,684** | ** ** | $      | 34,653 |   |
| Unearned income under lease contracts |   | **(10,488** | **)**      | (7,874     | )      |
| Residual                              |   | **34,301**  | ** ** | 18,876     |   |
| **Net investment**                    |   | **$**       | **79,497** | ** ** | $      | 45,655 |   |

 

The net investment in directfinancing leases is reported as loans in the consolidated balance sheet.

 

Thefollowing table shows the expected lease payments over the next five years.

** **

**Lease Payment Receivable:**

* *

*(In Thousands)*

 
| **Years Ending December 31:** |   |   |   |
|-------------------------------|--------|--------|--------|
| 2004                          |   | $      | 17,020 |   |
| 2005                          |   | 16,088 |   |
| 2006                          |   | 13,331 |   |
| 2007                          |   | 7,476  |   |
| 2008                          |   | 1,681  |   |
| Thereafter                    |   | 88     |   |
| **Total**                     |   | $      | 55,684 |   |

 

**6. Allowance for Loan and Lease Losses**

The following is a summary ofactivity in the allowance for loan and lease losses (ALLL) encompassing bothreserves attributable to loans and leases held for investment and also loansfor sale:

 

*(In Thousands)*

 
| **Years Ended December 31,**              |   | **2003**   |       | **2002**   |   | **2001** |   |
|-------------------------------------------|--------|------------|------------|------------|--------|----------|--------|
| Balance, beginning of year                |   | **$**      | **6,206**  | ** ** | $      | 6,204    |   | $ | 5,074 |   |
| Provision for loan and lease losses       |   | **1,620**  | ** ** | 1,460      |   | 1,500    |   |
| ALLL assumed upon acquisition of Steelton |   | **693**    | ** ** | —     |   | —   |   |
| ALLL assumed upon acquisition of Guaranty |   | **—** | ** ** | —     |   | 572      |   |
| Recoveries                                |   | **680**    | ** ** | 455        |   | 341      |   |
| Loans and leases charged off              |   | **(1,445** | **)**      | (1,913     | )      | (1,283   | )      |
| **Balance, end of year**                  |   | **$**      | **7,754**  | ** ** | $      | 6,206    |   | $ | 6,204 |   |

 

----

 

**7. Bank Premises and Equipment**

*(In Thousands)*

 
| **December 31,**                     |   | **2003**   |       | **2002**   |   |
|--------------------------------------|--------|------------|------------|------------|--------|
| Land                                 |   | **$**      | **3,631**  | ** ** | $      | 2,046 |   |
| Buildings                            |   | **15,033** | ** ** | 13,175     |   |
| Furniture and equipment              |   | **9,455**  | ** ** | 6,954      |   |
| Autos under operating lease          |   | **7,195**  | ** ** | —     |   |
| **Total cost**                       |   | **35,314** | ** ** | 22,175     |   |
|                                 |   |       | ** ** |       |   |
| Less: Accumulated depreciation       |   | **(8,058** | **)**      | (6,366     | )      |
| **Bank premises and equipment, net** |   | **$**      | **27,256** | ** ** | $      | 15,809 |   |

 

During 2003 a loss of $18 was recognized on the disposal of premises andequipment as compared to gains of $6 and $71 during 2002 and 2001,respectively. Depreciation expense was $1,756, $1,049 and $977 in 2003, 2002and 2001, respectively.

** **

**8. Goodwill**

Upon the adoption of SFAS 142, on January 1, 2002, Sun ceased amortizingits goodwill. This result was a decrease in non-interest expense and increasein net income for 2002 as compared to 2001. Sun also adopted SFAS 147 inOctober 2002, resulting in a reclassification of previously recordedunidentifiable intangible assets to goodwill and the ceasing of amortizationcorresponding to this intangible asset effective January 1, 2002. The followingtable shows the pro forma effects of applying SFAS 142 and SFAS 147.

* *

*(In Thousands, Except for Net Income Per Share)*

 
| **Years Ending December 31,**        |   | **2003**   |       | **2002**   |   | **2001** |   |
|--------------------------------------|--------|------------|------------|------------|--------|----------|--------|
| Goodwill amortization:               |   |       | ** ** |       |   |     |   |
| Pre-tax                              |   | **$**      | **—** | ** ** | $      | —   |   | $ | 1,567 |   |
| After-tax                            |   | **—** | ** ** | —     |   | 1,034    |   |
| Net income:                          |   |       | ** ** |       |   |     |   |
| Reported net income                  |   | **6,528**  | ** ** | 6,416      |   | 8,350    |   |
| Add: after-tax goodwill amortization |   | **—** | ** ** | —     |   | 1,034    |   |
| **Adjusted net income**              |   | **$**      | **6,528**  | ** ** | $      | 6,416    |   | $ | 9,384 |   |
| Basic net income per share           |   |       | ** ** |       |   |     |   |
| Reported net income per share        |   | **$**      | **0.91**   | ** ** | $      | 0.90     |   | $ | 1.20 |   |
| Add: goodwill amortization per share |   | **—** | ** ** | —     |   | 0.15     |   |
| **Adjusted net income per share**    |   | **$**      | **0.91**   | ** ** | $      | 0.90     |   | $ | 1.35 |   |
| Diluted net income per share         |   |       | ** ** |       |   |     |   |
| Reported net income per share        |   | **$**      | **0.90**   | ** ** | $      | 0.89     |   | $ | 1.20 |   |
| Add: goodwill amortization per share |   | **—** | ** ** | —     |   | 0.15     |   |
| **Adjusted net income per share**    |   | **$**      | **0.90**   | ** ** | $      | 0.89     |   | $ | 1.35 |   |

 

As of December 31, 2003, Sun had goodwillassets of $29,431 and $22,924 at December 31, 2002.

 

----

 

**9. Intangibles**

In April 2003, the Company acquired Mid-Penn Insurance. The net assetsof Mid-Penn Insurance included an identifiable intangible asset, a customerlist, that was valued by a third party and will be tested annually by the thirdparty for impairment using the same methodology as used at the time ofvaluation. The third party used an income approach to value the customer list.Assumptions used in this approach include, but are not limited to (1) an attritionrate of 8.65%, (2) an inflation rate of 5.4%, (3) a discount rate of 12%, and(4) after tax cash flow. The customer list was classified as an identifiableintangible of $1,864. The annual amortization amounts to $124 using a 15-yearestimated life, in accordance with the determination by the third party.

 

In April 2003, the Company acquired Steelton Bancorp. The net assets ofSteelton Bancorp included a core deposit intangible that was valued by a thirdparty to be $792 with a ten-year estimated life resulting in amortization of$79 for each of the next five years. The valuation involved the use of severalassumptions including, but not limited to (1) run off data based on nationalcore deposit behavior, (2) national norms for non-interest expense, and (3)discount rates equivalent to obtaining Federal Home Loan Bank financing.

 

In January 2003, the Company acquired Bank Capital. The acquisition ofBank Capital did not result in an identifiable intangible asset, as BankCapital is a lease originator and servicer and had no customer list or otheridentifiable intangible assets. The purchase price was solely allocated togoodwill based on the fair value of liabilities assumed over the fair value ofassets purchased.

 

The weighted average life of the aggregate core deposit intangible is9.3 years.

 

The following is a schedule of intangibles acquired and associatedamortization. There were no additions or corresponding amortization ofintangibles recognized in 2002. During 2003, management conducted a review of the2001 branch purchases and determined that a core deposit intangible in theamount of $1,566 existed and was reclassified from goodwill to core depositintangible. The amount of core deposit intangible at inception was $1,700.

* *

*(In Thousands)*

 
|     |   | **December  31, 2001** |   | **Acquired** |   | **Amortization** |   | **December  31, 2002** |   |
|----------|--------|------------------------|--------|--------------|--------|------------------|--------|------------------------|--------|
| Goodwill |   | $                      | 22,924 |         | — |             | — |                   | $      | 22,924 |   |
|          |        |                        |        |              |        |                  |        |                        |        |  |  |

 

*(In Thousands)*

 
|                     |   |                   |   | **Acquired**      |   |    |   |         |   |            |   |
|--------------------------|--------|------------------------|--------|-------------------|--------|---------|--------|--------------|--------|-----------------|--------|
|                     |   | **December  31, 2002** |   | **Bank  Capital** |   | **MPI** |   | **Steelton** |   | **CDI Reclass** |   | **Amortization** |   | **December 31, 2003** |   |
| Goodwill                 |   | $                      | 22,924 |              | $      | 421     |   | $            | 1,453  |            | $      | 6,199 |   | $ | (1,566 | ) | $ | 0 | ** ** | **$** | **29,431** | ** ** |
| Core Deposit Intangible  |   | —                 |   | —            |   | —  |   | 791          |   | 1,566           |   | (445 | ) | **1,912** | ** ** |
| Customer List Intangible |   | —                 |   | —            |   | 1,864   |   | —       |   |            |   | (86 | ) | 1,778 | ** ** |
| **Total**                |   | $                      | 22,924 |              | $      | 421     |   | $            | 3,317  |            | $      | 6,990 |   | $ | 0 |   | $ | (531 | ) | **$** | **33,121** | ** ** |

 

----

 

**10. Hedging Activities**

Sun maintains an overall interest rate risk-management strategy thatincorporates the use of derivative instruments to minimize significantunplanned fluctuations in earnings that are caused by interest rate volatility.Sun’s goal is to manage interest rate sensitivity by modifying the repricing ormaturity characteristics of certain balance sheet liabilities so that movementsin interest rates do not, on a material basis, adversely affect the fair valuesof these liabilities. As a result of interest rate fluctuations, hedgedfixed-rate liabilities will appreciate or depreciate in market value. Theeffect of this unrealized appreciation or depreciation is expected to besubstantially offset by Sun’s gains or losses on the derivative instrumentsthat are linked to these hedged liabilities. Another result of interest ratefluctuations is that the interest expense of hedged variable-rate liabilitieswill increase or decrease. The effect of this variability in earnings isexpected to be substantially offset by Sun’s derivative instruments that arelinked to these hedged liabilities. Sun considers its strategic use ofderivatives to be a prudent method of managing interest-rate sensitivity, as itreduces the exposure to earnings from undue risk posed by changes in interestrates.

 

Sun uses interest rate swaps as part of the interest raterisk-management strategy. These interest rate swaps have indices related to thepricing of specific balance sheet liabilities. As a matter of policy, Sun doesnot use highly leveraged derivative instruments for interest rate riskmanagement. Interest rate swaps generally involve the exchange of fixed andvariable-rate interest payments between two parties, based on a common notionalprincipal amount and maturity date. The derivative instruments entered into bySun gives Sun the right to enter into additional interest rate swaps with thewriter of the option in the event that the liabilities are repriced by theissuer.

 

By using derivative instruments, Sun exposes itself to credit and marketrisk. If a counterparty fails to fulfill its performance obligations under aderivative contract, Sun’s credit risk will equal the fair value gain in aderivative. Generally, when the fair value of a derivative contract ispositive, this indicates that the counterparty owes Sun, thus creating a creditrisk for Sun. When the fair value of a derivative contract is negative, Sunowes the counterparty and, therefore, assumes no credit risk. Sun minimizes thecredit (or repayment) risk in derivative instruments by entering intotransactions with high quality counterparties that are reviewed periodically bySun’s Asset/Liability Committee.

 

Market risk is the adverse effect that a change in interest rates,currency, or implied volatility might have on the value of a financialinstrument. Sun manages the market risk associated with interest rate contractsby establishing and monitoring limits for the types and degree of risk that maybe undertaken. Sun’s derivative activities are monitored by its Asset/LiabilityCommittee as part of that committee’s oversight of Sun’s asset/liabilityposition. The Asset/Liability Committee is responsible for approving hedgingstrategies that are developed through its analysis of data derived from financialsimulation models and other internal and industry sources. The resultinghedging strategies are then incorporated into Sun’s overall interest raterisk-management strategy.

 

Sun, as of December 31, 2003, had entered into four pay-variable,receive-fixed interest rate swaps with a $100,000 total notional amount tohedge changes in the fair value of certain Federal Home Loan Bank long-termborrowings. The swaps also contain an embedded option to enter into an interestrate swap with opposite terms in the event the FHLB long-term borrowingsconvert to a variable rate. This occurrence would effectively fix the ratebeing paid on the borrowings at approximately the original coupon and wouldreduce the net interest volatility caused in a rising interest rateenvironment. Sun includes all components of each derivative gain or loss in theassessment of hedge effectiveness. Sun recognizes the change in fair value ofthe hedge and associated borrowings through the income statement within otherincome. The cost of the swaption is embedded within the rate of its host, thefixed to variable swap. The cost of the swaption will increase interestexpense. Premiums/discounts are reflected in the rates received/paid and thusreflected in interest expense. Because this swaption is a fair value hedge, Sunreports changes in the fair value of the swaption in other income/other expenseduring the applicable period. For the year ended December 31, 2003, there was achange in value recognized in the hedge and associated long-term FHLBborrowings of $5,156 due to the mark to market adjustment. Sun also recognizeda reduction of $774 in interest on long-term FHLB borrowings as a result of thehedge transaction. A summary of Sun’s fair value hedges at December 31, 2003follows:

* *

*(In Thousands)*

 
|                                                   |   |                 |        |       |       |          |   | **Weighted  Average** |       |
|--------------------------------------------------------|--------|----------------------|-------------|------------|------------|---------------|--------|-----------------------|------------|
| **December  31, 2003**                                 |   | **Notional  Amount** |        | **Asset**  |       | **Liability** |   | **Receive  Rate**     |       | **Pay Rate** |   | **Life  (Years)** |   |
| Fair Value Hedges:                                     |   |                 |        |       |       |          |   |                  |       |   |   |   |   |
| Receive fixed — pay variable interest rate  swaps |   | **$**                | **100,000** | ** ** | **—** | ** **    | **$**  | **5,156**             | ** ** | **2.65** | **%** | **1.13** | **%** | **6.3** | ** ** |
|                                                        |        |                      |             |            |            |               |        |                       |            |  |  |  |  |  |  |

 

----

 

**11. Deposits**

Deposits as of December 31, 2003 and 2002 included:

* *

*(In Thousands)*

 
| **December 31,**                                  |   | **2003**    |        | **2002** |   |
|---------------------------------------------------|--------|-------------|-------------|----------|--------|
| Non-interest-bearing deposits                     |   | **$**       | **69,640**  |     | $      | 59,181 |   |
| NOW accounts                                      |   | **164,803** |        | 155,144  |   |
| Insured Money Market Accounts                     |   | **22,461**  |        | 29,827   |   |
| Savings deposits                                  |   | **82,416**  |        | 76,712   |   |
| Time deposits                                     |   | **217,593** |        | 220,016  |   |
| Time certificates of deposit of $100,000 or  more |   | **57,637**  |        | 46,630   |   |
| **Total deposits**                                |   | **$**       | **614,550** |     | $      | 587,480 |   |

 

The following table reflectscertificates of deposit and other time deposits and their remaining maturitiesas of December 31,2003:

 

*(InThousands)*

 
| **Years Ending December 31:** |   |       |        |
|-------------------------------|--------|------------|-------------|
| 2004                          |   | **$**      | **160,187** |   |
| 2005                          |   | **49,445** |        |
| 2006                          |   | **30,579** |        |
| 2007                          |   | **26,657** |        |
| 2008                          |   | **8,362**  |        |
| Thereafter                    |   | **—** |        |
| **Total**                     |   | **$**      | **275,230** |   |

 

The totals above includecertificates of deposit and other time deposits issued in amounts of $100,000or more. These deposits and their remaining maturities, at December 31, 2003were:

 

*(InThousands)*

 
| **December 31,**          |   | **2003**   |       |
|---------------------------|--------|------------|------------|
| Three months or less      |   | **$**      | **20,487** |   |
| Three through six months  |   | **12,818** |       |
| Six through twelve months |   | **8,515**  |       |
| Over twelve months        |   | **15,817** |       |
| **Total**                 |   | **$**      | **57,637** |   |

 

Interest on deposits of $100,000 or more amounted to approximately$2,063 in 2003, $2,087 in 2002 and $3,179 in 2001.

 

----

 

**12. Borrowed Funds**

At December 31, 2003, Sun’s maximum borrowing capacity at the FHLB was$265,600 and $315,206 at December 31, 2002. Sun also maintains lines of creditwith other financial institutions of $23,000, which were not in use at December31, 2003 or 2002.

* *

*(In Thousands)*

 
| **December 31,**                                    |   | **2003**    |        | **2002** |   |
|-----------------------------------------------------|--------|-------------|-------------|----------|--------|
|                                                |   |        |        |     |   |
| **Short-term borrowings:**                          |   |        |        |     |   |
| FHLB  repurchase agreements (1)                     |   | **$**       | **17,570**  |     | $      | — |   |
| FHLB advances (2)                                   |   | **20,000**  |        | —   |   |
| Securities  sold under agreements to repurchase (3) |   | **27,693**  |        | 29,557   |   |
| Treasury tax and loan note option (4)               |   | **125**     |        | 125      |   |
| **Total short-term borrowings**                     |   | **65,388**  |        | 29,682   |   |
|                                                |   |        |        |     |   |
| **Long-term borrowings:**                           |   |        |        |     |   |
| FHLB  advances (2)                                  |   | **225,595** |        | 220,000  |   |
| Subordinated debentures (5)                         |   | **18,866**  |        | 19,655   |   |
| Other borrowings (6)                                |   | **11,900**  |        | —   |   |
| Total long-term borrowings                          |   | **256,361** |        | 239,655  |   |
| **Total borrowed funds**                            |   | **$**       | **321,749** |     | $      | 269,337 |   |

 

(1) Sun utilizes an FHLBrepurchase program as an overnight source of funds. As of December 31, 2003,the total commitment was $50,000. The maximum month end amount of suchborrowings was $24,877 in 2003, $9,870 in 2002 and $0 in 2001. The dailyaverage amount of such borrowings was $7,014 in 2003, $625 in 2002 and $0 in2001, and the weighted average interest rates were 1.31% in 2003 and 1.99% in2002.

 

(2) FHLB advances representvariable and fixed rate borrowings collateralized by first-lien mortgages andinvestment securities issued by U.S. government agencies. These borrowingscarry substantial prepayment penalties of $29,418 at December 31, 2003 and$32,613 at December 31, 2002. Sun does have the right to prepay, withoutpenalty, the variable rate advances at any point that the FHLB increases theinterest rate which would require the base rate,90 day LIBOR, to first increaseby approximately 450 basis points. The maximum month end amount of long-termFHLB advances was $238,707 in 2003 and $221,000 in 2002. The average dailyamount of the long-term advances was $235,148 in 2003 and $220,849 in 2002, andthe weighted average interest rates were 5.23% in 2003 and 5.75% in 2002. Themaximum month end amount of short-term advances was $20,000 in 2003, with noadvances in 2002 and 2001. The average daily amount of the short-term advanceswas $4,963 with a weighted average interest rate of 1.34% in 2003.

 

(3) Securities sold underagreements to repurchase represent deposit customers’ cash management accounts.These repurchase agreements are collateralized by a blanket agreement with theFHLB in which the actual ownership of the securities is not transferred. Themaximum month end amount of securities sold under agreements to repurchase was$35,516 in 2003, $29,557 in 2002 and $22,673 in 2001. The average daily amountof such borrowings was $28,853 in 2003, $22,107 in 2002 and $17,101 in 2001,and the weighted average interest rates were 1.02% in 2003, 1.91% in 2002 and2.47% in 2001.

 

(4) Borrowings on theTreasury Tax and Loan Note Option (TT&L) represent tax funds deposited andheld until the U.S. Treasury calls the balance.At December 31, 2003, the maximum amountavailable to borrow through the Note Options was $125. The maximum month endamount of such borrowings was $125 in 2003, 2002 and 2001. The average dailyamount of such borrowings was $125 in 2003, 2002 and 2001, and  the weighted average interest rates were0.88% in 2003, 1.41% in 2002 and 3.46% in 2001.

 

(5) Subordinated debenturesinclude $16,500 due to Sun Trust 1 (the Trust) related to trust preferralsecuritites issued by the Trust and $2,366 in debt related to the purchase ofGuaranty in 2001. The trust preferred securities have a rate of 10.2% with amaturity of 2031 and an early redemption option of 2011. The issuer of thesesecurities, Sun Trust I, is a wholly owned subsidiary of the parent company andas such, Sun Bancorp fully and unconditionally guarantees these securities. Thedebt related to Guaranty carries a rate of 6% and has a maturity of 2006. Themaximum month end amount of subordinated debentures was $19,655 for 2003 and$20,444 for 2002. The average daily amount of such borrowings was $19,255 in2003 and $20,083 in 2002, and the weighted average interest rates were 9.58% in2003 and 9.42% in 2002.

 

(6) Other borrowingsrepresent borrowings with other institutions with which Sun has pledgedsecurities as collateral. The maximum month end amount of other borrowings was$11,900 in 2003 and $0 in 2002. The average daily amount of such borrowings was$10,796 in 2003 and $0 in 2002, and the weighted average interest rate was2.92% in 2003.

 

----

 

The following represents outstanding long-term borrowings by contractualmaturities at December 31, 2003 and 2002:

* *

*(In Thousands)*

 
| **December 31,**                                                |   | **2003**   |        | **2002**   |   |
|-----------------------------------------------------------------|--------|------------|-------------|------------|--------|
| Variable rate of 1.99%, maturing in 2005                        |   | **$**      | **2,000**   | ** ** | $      | — |   |
| Variable rates between 4.63% and 5.04%,  maturing  in 2008 |   | **26,000** | ** **  | 70,000     |   |
| Variable rates between 4.93% and 5.88%,  maturing in 2009       |   | **49,360** | ** **  | 50,000     |   |
| Variable rates between 5.86% and 6.36%,  maturing in 2010       |   | **98,985** | ** **  | 100,000    |   |
| Variable rate of 5.24%, maturing in 2011                        |   | **3,000**  | ** **  | —     |   |
| Variable rates between 5.08% and 5.15%,  maturing in 2013       |   | **46,250** | ** **  | —     |   |
| Fixed rate of 6.00%, maturing in 2003                           |   | **—** | ** **  | 789        |   |
| Fixed rate of 6.00%, maturing in 2004                           |   | **789**    | ** **  | 789        |   |
| Fixed rates between 1.90% and 6.00%,  maturing in 2005          |   | **5,489**  | ** **  | 789        |   |
| Fixed rates between 2.42% and 6.00%,  maturing in 2006          |   | **4,388**  | ** **  | 788        |   |
| Fixed rate of 2.84%, maturing in 2007                           |   | **3,600**  | ** **  | —     |   |
| Fixed rate of 10.20%, maturing in 2031                          |   | **16,500** | ** **  | 16,500     |   |
| **Total**                                                       |   | **$**      | **256,361** | ** ** | $      | 239,655 |   |

 

**13. Acquisitions**

During 2003 Sun completed three acquisitions: Bank Capital ServicesCorporation in January, Mid-Penn Insurance Associates in April and SteeltonBancorp in April. Bank Capital, an auto and equipment lease broker andservicer, services Sun’s leases and provides fee income due to theirpartnership with other financial institutions. Mid-Penn Insurance, an insuranceagency located in central Pennsylvania, provides Sun with a respected agencythat shares Sun’s focus on customer service. Steelton, representing twobranches in the Harrisburg market, provides Sun an entry into the capitalregion. The following is a summary of the purchases.

 

*(In Thousands)*

 
|                           |   | **Bank  Capital** |   | **Mid-Penn  Insurance** |   | **Steelton  Bancorp** |   | **Total** |   |
|--------------------------------|--------|-------------------|--------|-------------------------|--------|-----------------------|--------|-----------|--------|
| Assets                         |   | $                 | 223    |                    | $      | 875                   |   | $         | 63,903 |   | $ | 65,001 |   |
| Identifiable intangible assets |   | —            |   | 1,864                   |   | 791                   |   | 2,655     |   |
| Less: liabilities assumed      |   | 54                |   | 1,184                   |   | 61,013                |   | 62,251    |   |
| Net assets acquired            |   | 169               |   | 1,555                   |   | 3,681                 |   | 5,405     |   |
| Purchase price                 |   | 590               |   | 2,374                   |   | 9,180                 |   | 12,144    |   |
| **Unidentifiable assets**      |   | $                 | 421    |                    | $      | 819                   |   | $         | 5,499  |   | $ | 6,739 |   |
|                           |   |              |   |                    |   |                  |   |      |   |
| **Consideration paid:**        |   |              |   |                    |   |                  |   |      |   |
| Cash                           |   | $                 | 118    |                    | $      | 649                   |   | $         | 9,180  |   | $ | 9,947 |   |
| Stock                          |   | $                 | 472    |                    | $      | 1,725                 |   | —    |   | $ | 2,197 |   |

 

----

 

**14. Estimated Fair Value of FinancialInstruments**

SFAS 107, “Disclosures about Fair Value of Financial Instruments,”requires Sun to disclose estimated fair values for its financial instruments.Fair value estimates are made at a specific point in time, based on relevantmarket and financial instrument information. These estimates do not reflect anypremium or discount that could result from a sale of any particular financialinstrument or group of instruments. Fair value estimates are based on judgmentsregarding current economic conditions, return rates, and anticipated riskcharacteristics. These estimates are highly subjective, involve considerableuncertainty, and cannot be precisely determined. Changes to those assumptionscan significantly affect the estimated fair values.

 

Sun determines estimated fair value using historical data and reasonableestimation methodology for each financial instrument category. Estimated fairvalue for Sun’s investment securities is detailed in Note 4. All other fairvalue estimates, methods, and assumptions are set forth below:

 

Sun’s investment policy specifically prohibits the existence of atrading account portfolio.

 

On a periodic basis, management evaluates each security where amortizedcost exceeds net realizable value. If the decline is judged to be other thantemporary, the cost of the security is written down to estimated net realizablevalue with the write-down included in net securities gains (losses). Realizedgains and losses are computed principally under the specific identificationmethod.

** **

**Cash and Due From Banks:**

For these short-term instruments, the carrying amount is a reasonableestimate of fair value.

** **

**Assets:**

Management segregates loans into categories with homogeneous types,financial structure, and risk characteristics. For performing loans, expectedcash flows until full repayment are discounted at a rate which managementbelieves fairly reflects credit, interest rate, and other risks. Cash flows andmaturities are estimated based on Sun’s historical experience with each loancategory.

 

Assumptions regarding credit risk, cash flows and discount rates werejudgmentally determined using available market and internal information whichmanagement believes to be reasonable. However, because there are no activemarkets for many loan types, Sun has no basis to determine whether theestimated fair value presented would be indicative of the value negotiated inan actual sale. Loans held for sale are carried at the lower of cost or marketvalue obtained through secondary market bid quotations, net of any reserve forloan losses. Therefore, the carrying amount is a reasonable estimate of fairvalue.

 

Management estimates fair value for significant nonperforming loansbased on current external appraisals. If appraisals are not available,estimated cash flows are discounted using a rate commensurate with the riskassociated with the estimated cash flows. Credit risk, cash flows, and discountrate assumptions are determined using market information using methodsmanagement believes to be reasonable.

 

Investment securities are all classified as available for sale andtherefore the market value approximates carrying value.

 

Other earning assets are comprised entirely of Bank-Owned LifeInsurance. The fair value of Bank-Owned Life Insurance is based on the cashsurrender value of premiums.

** **

**Deposit Liabilities:**

The fair value of deposit liabilities, with no stated maturity, such asdemand deposits, NOW accounts, savings accounts and certain money marketdeposits is the amount payable on demand as of December 31, 2003. The fairvalue of deposits with frequent reset, adjustable rates or managed rates areestimated at carrying value. The fair value of fixed-maturity certificates ofdeposit is estimated using the discounted cash flows at observable market ratesfor time deposits with similar characteristics and remaining maturities. Fairvalue estimates do not include the value of depositor relationships or thevalue of the low-cost funding provided by deposits.

** **

**Federal Home Loan Bank and Other Borrowings:**

The fair value is estimated using rates currently offered for borrowingswith similar terms and remaining maturities.

** **

**Commitments to Extend Credit, Standby Letters ofCredit and Financial Guarantees:**

The fair value of commitments is estimated using fees currently chargedto enter into similar agreements, taking into account the remaining terms ofthe agreements and the present creditworthiness of the counterparties. Forfixed-rate loan commitments, fair value also considers the difference betweencurrent levels of interest rates and the committed rates. The fair value ofguarantees and letters of credit is based on fees currently charged for similaragreements or on the estimated cost to terminate them or otherwise settle theobligations with the counterparties at the reporting date. The fair valueestimate also considers the allowance for unfunded commitments and letters ofcredit. The fair value of commitments, guarantees and letters of credit isinsignificant after considering the aforementioned factors.

 

The carrying amount represents accruals or deferred fees arising fromthe unrecognized financial instrument. The carrying amount to determine thecreditworthiness of the counter parties includes the established allowance forunfunded commitments and letters of credit.

** **

**Off-balance Sheet Items:**

There is no material difference between the carrying value and theestimated fair value of off-balance sheet items. Those items primarily consistof unfunded loan commitments, which are generally priced at market when funded.

 

----

 

The estimated fair values of Sun’s financial instruments are as follows:

 

*(In Thousands)*

 
|                                         |   | **2003**             |        | **2002**       |        |
|----------------------------------------------|--------|----------------------|-------------|----------------|-------------|
| **December 31,**                             |   | **Carrying  Amount** |        | **Fair Value** |        | **Carrying  Amount** |   | **Fair Value** |   |
| **Financial Assets:**                        |   |                 |        |           |        |   |   |   |   |
| Cash and due from banks                      |   | **$**                | **27,021**  | ** **     | **$**       | **27,021** | ** ** | $ | 21,399 |   | $ | 21,399 |   |
| Investment securities                        |   | **223,209**          | ** **  | **223,209**    | ** **  | 219,438 |   | 219,438 |   |
| Loans                                        |   | **672,223**          | ** **  | **676,150**    | ** **  | 602,395 |   | 600,238 |   |
| Less: reserve for loan losses                |   | **(7,754**           | **)**       | **—**     | ** **  | (6,206 | ) | — |   |
| Other earning assets                         |   | **33,174**           | ** **  | **33,174**     | ** **  | 30,800 |   | 30,800 |   |
|                                         |   | **$**                | **947,873** |           | **$**       | **959,554** | ** ** | $ | 867,826 | ** ** | $ | 871,875 |   |
|                                         |   |                 | ** **  |           | ** **  |   |   |   |   |
| **Financial Liabilities:**                   |   |                 | ** **  |           | ** **  |   |   |   |   |
| Deposits                                     |   | **$**                | **614,550** | ** **     | **$**       | **617,027** | ** ** | $ | 587,480 |   | $ | 570,149 |   |
| Federal Home Loan Bank and other borrowings  |   | **321,749**          | ** **  | **358,933**    | ** **  | 269,337 |   | 282,294 |   |
|                                         |   | **$**                | **936,299** |           | **$**       | **975,960** | ** ** | $ | 856,817 | ** ** | $ | 852,443 |   |
|                                         |   |                 | ** **  |           | ** **  |   |   |   |   |
| **Off-balance sheet financial instruments:** |   |                 | ** **  |           | ** **  |   |   |   |   |
| Commitments to extend credit                 |   | **—**           | ** **  | **$**          | **169,647** | ** ** | — |   | $ | 139,373 |   |
|                                              |        |                      |             |                |             |  |  |  |  |  |  |  |  |  |  |  |

 

----

 

**15. Common Stock Plans**

Sun follows applicable accounting principles in accounting for itscommon stock plans. Had compensation costs been determined on fair values atthe grant dates (pursuant to SFAS 123), Sun’s net income and earnings per sharefor 2003,2002, and 2001 would have been adjusted to the pro forma amountsindicated below:

 
|                                 |   | **2003** |      | **2002** |   | **2001** |   |
|--------------------------------------|--------|----------|-----------|----------|--------|----------|--------|
| **Net income:**                      |   |     |      |     |   |     |   |
| As reported                          |   | **$**    | **6,528** |     | $      | 6,416    |   | $ | 8,350 |   |
| Pro forma                            |   | **$**    | **6,624** |     | $      | 6,316    |   | $ | 8,158 |   |
| **Earnings per share — Basic:** |   |     |      |     |   |     |   |
| As reported                          |   | **$**    | **0.91**  |     | $      | 0.90     |   | $ | 1.20 |   |
| Pro forma                            |   | **$**    | **0.92**  |     | $      | 0.88     |   | $ | 1.18 |   |

 

For the pro formacalculations above, the fair value of each option was estimated on the grantdate using the Black-Scholes option-pricing model and the following weightedaverage assumptions for grants issued in 2003, 2002 and 2001:

 
|                          |   | **2003**    |       | **2002** |   | **2001** |   |
|-------------------------------|--------|-------------|------------|----------|--------|----------|--------|
| Dividend yield                |   | **4**       | **%**      | 4        | %      | 4        | %      |
| Volatility                    |   | **24**      | **%**      | 24       | %      | 24       | %      |
| **Risk-free interest rates:** |   |        | ** ** |     |   |     |   |
| Stock Incentive Plan          |   | **2.96**    | **%**      | 3.77     | %      | 4.50     | %      |
| Independent Directors Plan    |   | **2.64**    | **%**      | 4.19     | %      | 4.88     | %      |
| Employee Stock Purchase Plan  |   | **2.45**    | **%**      | 4.59     | %      | 4.51     | %      |
|                          |   |        | ** ** |     |   |     |   |
| Expected option lives         |   | **4 years** | ** ** | 4 years  |   | 4 years  |   |

 

----

 
|                                              |   | **2003**    |       | **2002**                              |      | **2001**   |    |
|---------------------------------------------------|--------|-------------|------------|---------------------------------------|-----------|------------|---------|
|                                              |   | **Shares**  |       | **Weighted  Average  Exercise Price** |      | **Shares** |    | **Weighted  Average  Exercise Price** |   | **Shares** |   | **Weighted Average  Exercise Price** |   |
| Outstanding, at beginning of year                 |   | **486,733** | ** ** | **$**                                 | **24.32** |       | 503,846 |   | $ | 22.79 |   | 510,887 |   | $ | 22.35 |   |
| Granted                                           |   | **112,482** | ** ** | **21.89**                             |      | 110,409    |    | 23.38 |   | 117,105 |   | 16.53 |   |
| Exercised                                         |   | **(15,307** | **)**      | **16.21**                             |      | (65,879    | )       | 14.99 |   | (9,085 | ) | 14.53 |   |
| Forfeited                                         |   | **(80,524** | **)**      | **24.26**                             |      | (61,643    | )       | 20.09 |   | (115,061 | ) | 15.11 |   |
| **Outstanding, at end of year**                   |   | **503,384** | ** ** | **$**                                 | **24.03** |       | 486,733 |   | $ | 24.32 |   | 503,846 |   | $ | 22.79 |   |
| **Options exercisable at year end**               |   | **426,934** | ** ** |                                  |      | 420,633    |    |   |   | 417,264 |   |   |   |
| **Fair value of options granted during the year** |   | **$**       | **2.26**   | ** **                            |      |       | $       | 3.24 |   |   |   | $ |  2.48 |   |   |   |
|                                                   |        |             |            |                                       |           |            |         |  |  |  |  |  |  |  |  |  |  |  |  |

 

The following table summarizes the fixed stock options outstanding underthe Stock Incentive Plan, Independent Directors Plan, and the Employee StockPurchase Plan at December 31, 2003:

 
| **Exercise  Prices** |              | **Number  Outstanding  at December 31, 2003** |   | **Remaining  Contractual Life** |   | **Number  Exercisable  at December 31, 2003** |   |
|----------------------|-------------------|-----------------------------------------------|--------|---------------------------------|--------|-----------------------------------------------|--------|
|                 | $10.76            |                                          |   | 5,470                           |   | 1 years                                       |   | 5,470 |   |
|                 | $17.06            |                                          |   | 8,759                           |   | 1 years                                       |   | 8,759 |   |
|                 | $11.22            |                                          |   | 823                             |   | 2 years                                       |   | 823 |   |
|                 | $13.71            |                                          |   | 6,314                           |   | 2 years                                       |   | 6,314 |   |
|                 | $17.06            |                                          |   | 9,699                           |   | 2 years                                       |   | 9,699 |   |
|                 | $16.24            |                                          |   | 3,861                           |   | 3 years                                       |   | 3,861 |   |
|                 | $  7.06 |                                          |   | 12,102                          |   | 3 years                                       |   | 12,102 |   |
|                 | $18.43            |                                          |   | 24,688                          |   | 3 years                                       |   | 24,688 |   |
|                 | $19.19            |                                          |   | 5,761                           |   | 4 years                                       |   | 5,761 |   |
|                 | $17.06            |                                          |   | 15,077                          |   | 4 years                                       |   | 15,077 |   |
|                 | $21.89            |                                          |   | 31,250                          |   | 4 years                                       |   | 31,250 |   |
|                 | $33.70            |                                          |   | 8,230                           |   | 5 years                                       |   | 8,230 |   |
|                 | $17.06            |                                          |   | 19,475                          |   | 5 years                                       |   | 19,475 |   |
|                 | $34.29            |                                          |   | 35,434                          |   | 5 years                                       |   | 35,434 |   |
|                 | $22.28            |                                          |   | 7,870                           |   | 6 years                                       |   | 7,870 |   |
|                 | $25.71            |                                          |   | 40,419                          |   | 6 years                                       |   | 40,419 |   |
|                 | $16.56            |                                          |   | 7,083                           |   | 7 years                                       |   | 7,083 |   |
|                 | $16.00            |                                          |   | 39,000                          |   | 7 years                                       |   | 39,000 |   |
|                 | $16.00            |                                          |   | 8,657                           |   | 8 years                                       |   | 8,657 |   |
|                 | $16.83            |                                          |   | 59,400                          |   | 8 years                                       |   | 59,400 |   |
|                 | $18.00            |                                          |   | 10,231                          |   | 9 years                                       |   | 10,231 |   |
|                 | $26.38            |                                          |   | 57,100                          |   | 9 years                                       |   | 57,100 |   |
|                 | $20.20            |                                          |   | 10,231                          |   | 10 years                                      |   | 10,231 |   |
|                 | $23.35            |                                          |   | 76,450                          |   | 10 years                                      |   | — |   |
|                 |              | 503,384                                       |   | 6.6 years                       |   | 426,934                                       |   |

 

----

 

**16. Employee Benefit Plans**

Sun provides a defined contribution pension plan that coverssubstantially all employees. Sun’s contributions are based on employeecontributions and compensation. The contributions are accrued and funded to theemployee’s account once a year with the employee maintaining control over theallocation of the funds between stocks and bonds.

 

In addition to the defined contribution plan, Sun also has a definedbenefit plan which provides supplemental payments to certain key employees uponretirement. The supplemental payment expense included interest of $4 in 2003,$5 in 2002 and $11 in 2001. During 2003, there was $61 in benefits paid fromthe plan. With the Guaranty acquisition in 2001 and the Steelton acquisition in2003, Sun will also provide supplemental payments to certain former directors.Life insurance contracts are being used to fund this supplemental payment tothe former directors. Expenses related to these plans and the carrying value ofthe defined benefit plan for the years ended December 31 were:

* *

*(In Thousands)*

 
| **December 31,**                                       |   | **2003** |    | **2002** |   | **2001** |   |
|--------------------------------------------------------|--------|----------|---------|----------|--------|----------|--------|
| Defined pension contributions                          |   | **$**    | **578** |     | $      | 653      |   | $ | 482 |   |
| Supplemental payment expense for defined  benefit plan |   | **$**    | **32**  |     | $      | 33       |   | $ | 36 |   |
| Defined benefit plan, carrying value                   |   | **$**    | **323** |     | $      | 352      |   | $ | 319 |   |

 

The estimated payments underthe defined contribution pension plan and defined benefit plan for each of thenext five years ended December 31 are as follows:

 
| **December 31,** |   | **2004** |   | **2005** |   | **2006** |   | **2007** |   | **2008** |   |
|------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
| Defined pension  |   | $        | 595    |     | $      | 613      |   | $        | 632    |     | $      | 651 |   | $ | 670 |   |
| Defined benefit  |   | $        | 12     |     | $      | 12       |   | $        | 12     |     | $      | 12 |   | $ | 12 |   |

 

**17. Gain on Branch Sales**

During 2001, Sun sold its Emporium and Johnsonburg branches recognizinga pre-tax gain of $4,892. The gain was determined by adjusting the premium paidof $5,707 for a loss on the sale of certain fixed assets, which was based onthe straight-line depreciation of the purchase price, and other differencesbetween the carrying values and negotiated price of other balance sheet itemsallocated to the branches.

** **

**18. Income Taxes**

Temporary differences produced a deferred tax liability at December31,2003 and 2002, which is summarized below:

 
| **(In Thousands)**                        |   | **2003**   |       | **2002** |   |
|-------------------------------------------|--------|------------|------------|----------|--------|
|                                      |   |       |       |     |   |
| **Deferred tax assets:**                  |   |       |       |     |   |
| Loan losses                               |   | **$**      | **2,401**  |     | $      | 2,110 |   |
| Discount on loans acquired from Bucktail  |   | **50**     |       | 83       |   |
| Loan fees and costs                       |   | **149**    |       | 135      |   |
| Nonaccrual interest                       |   | **69**     |       | 81       |   |
| Supplemental compensation plan            |   | **110**    |       | 120      |   |
| NOL carryover                             |   | **153**    |       | —   |   |
| AMT credit carryover                      |   | **469**    |       | —   |   |
| Tax credit carryover                      |   | **1,205**  |       | 602      |   |
| Other                                     |   | **236**    |       | 112      |   |
| **Total**                                 |   | **$**      | **4,842**  |     | $      | 3,243 |   |
|                                      |   |       |       |     |   |
| **Deferred tax liabilities:**             |   |       |       |     |   |
| Bank premises and equipment               |   | **$**      | **816**    |     | $      | 723 |   |
| Unrealized gains on investment securities |   | **14**     |       | 1,843    |   |
| Auto leases                               |   | **9,696**  |       | 4,923    |   |
| Intangibles                               |   | **354**    |       | 142      |   |
| Other                                     |   | **89**     |       | 202      |   |
| **Total**                                 |   | **10,969** |       | 7,833    |   |
|                                      |   |       |       |     |   |
| **Deferred tax liability, net**           |   | **$**      | **(6,127** | )        | $      | (4,590 | ) |

 

----

 

Sun’s income tax provision for 2003, 2002, and 20001 consists of thefollowing:

* *

*(In Thousands)*

 
| **Years Ended December 31,**            |   | **2003**  |       | **2002**   |   | **2001** |   |
|-----------------------------------------|--------|-----------|------------|------------|--------|----------|--------|
| Current provision                       |   | **$**     | **(2,503** | **)**      | $      | (3,261   | )      | $ | 3,649 |   |
| Deferred income tax provision (benefit) |   | **3,366** | ** ** | 4,326      |   | (305     | )      |
| **Income tax provision**                |   | **$**     | **863**    | ** ** | $      | 1,065    |   | $ | 3,344 |   |

 

Actual income tax expensereconciles to the tax amount, which would have been recognized at the federalstatutory rate as follows:

* *

*(In Thousands)*

 
| **Years Ended December 31,**          |   | **2003**   |       | **2002**   |   | **2001** |   |
|---------------------------------------|--------|------------|------------|------------|--------|----------|--------|
| Federal income tax at statutory rate  |   | **$**      | **2,513**  | ** ** | $      | 2,546    |   | $ | 4,093 |   |
| Tax exempt income                     |   | **(574**   | **)**      | (595       | )      | (834     | )      |
| Amortization of goodwill              |   | **—** | ** ** | —     |   | 328      |   |
| Tax credits from limited partnerships |   | **(602**   | **)**      | (602       | )      | (443     | )      |
| CSV officers’ life insurance     |   | **(432**   | **)**      | (245       | )      | —   |   |
| Other items                           |   | **(42**    | **)**      | (39        | )      | 200      |   |
| **Income tax provision**              |   | **$**      | **863**    | ** ** | $      | 1,065    |   | $ | 3,344 |   |

 

**19. Related Party Transactions**

Certain executive officers, corporate directors, or companies in whichthe individuals have a 10 percent or more beneficial ownership were indebted toSun or held deposit accounts with Sun during 2003. All transactions were madein the ordinary course of business on substantially the same terms, includinginterest rates and collateral, as those prevailing at the time for comparabletransactions with other persons and do not involve more than normal creditrisk. Other changes represent transfers in and out of the related party category.

 

A summary of activity for directors, executive officers and theirassociates is as follows:

** **

**Related Party Indebtedness:**

* *

*(In Thousands)*

 
| **Year Ended  December 31,**                |   | **Beginning  Balance** |       | **Loans**  |   | **Repayments** |       | **Other  Changes** |        | **Ending  Balance** |   |
|---------------------------------------------|--------|------------------------|------------|------------|--------|----------------|------------|--------------------|-------------|---------------------|--------|
| **17 Directors, 4 Executive Officers 2003** |   | **$**                  | **10,480** | ** ** | **$**  | **23,310**     | ** ** | **$**              | **(21,779** | **)**               | **$**  | **(3,111** | **)** | **$** | **8,900** | ** ** |
| 15 Directors, 4 Executive Officers 2002     |   | 10,846                 |       | 27,085     |   | (25,069        | )          | (2,382             | )           | 10,480              |   |
|                                             |        |                        |            |            |        |                |            |                    |             |                     |        |  |  |  |  |  |

 

**Related Party Deposits:**

*(In Thousands)*

 
| **December 31,** |   | **2003** |      | **2002** |   |
|------------------|--------|----------|-----------|----------|--------|
| Deposit Balances |   | **$**    | **3,061** |     | $      | 6,119 |   |
|                  |        |          |           |          |        |  |  |

 

----

 

**20. Commitments and Contingencies**

Sun is a party to financial instruments with off-balance sheet risk inthe normal course of business to meet customers’ financing needs. Thesefinancial instruments include commitments to extend credit and standby lettersof credit containing, in varying degrees, credit and interest rate riskexceeding the amount recognized in the balance sheet .

 

At December 31, 2003, there are various commitments to extend credit ofapproximately $158,291 and standby letters of credit and financial guaranteesof approximately $11,356 as compared to $128,796 and $10,577, respectively atDecember 31, 2002.

 

Credit risk from nonperformance by counterparties to commitments toextend credit and standby letters of credit is represented by the contractualamount of those instruments. Sun uses the same credit policies to guidecommitments and conditional obligations as it does for direct, funded loans.

 

Commitments to extend credit are agreements to lend to a customer as longas no contract conditions are violated. Commitments generally include fixedexpiration dates or other termination clauses and certain fee payments. Sincemany commitments are expected to expire without being drawn upon, the totalcommitment amounts do not necessarily represent future cash requirements. Eachcustomer’s creditworthiness is evaluated on a case-by-case basis. Thecollateral amount obtained, if deemed necessary, is based on management’scredit evaluation of the customer. Collateral types vary but may includeaccounts receivable, inventory, property, equipment, and income-producingcommercial properties.

 

Standby letters of credit are conditional commitments that guarantee acustomer’s performance to a third party. Those guarantees are primarily issuedto support borrowing arrangements and related transactions. Terms vary from onemonth to 24 months and may have renewal features. Credit risk differs littlefrom direct loans to customers. When warranted, Sun holds collateral againstthose commitments. Sun recognizes a liability for financial guarantees at theinception of the contract. This liability is equivalent to the premium receivedand is amortized over the life of the guarantee.

** **

**21. Regulatory Matters**

Sun and SunBank are subject to various regulatory capital requirementsadministered by certain federal and state banking agencies. SunBank is alsosubject to the regulatory framework for prompt corrective action (“PCA”).Failure to meet minimum capital requirements can initiate certain mandatory,and possibly additional discretionary actions by regulators that, ifundertaken, could have a direct material effect on SunBank’s financialstatements. Capital adequacy guidelines and the regulatory framework for promptcorrective action define specific capital requirements that involvequantitative measures of Sun and SunBank’s assets, liabilities, and certainoff-balance-sheet items as calculated under regulatory accounting practices.Sun and SunBank’s capital amounts and SunBank’s PCA classification are alsosubject to qualitative judgments by the regulators about components, riskweightings, and other factors.

 

Quantitative measures, established by regulation to ensure capitaladequacy require SunBank to maintain minimum amounts and ratios (set forth inthe following table) of total and Tier 1 capital (as defined in theregulations) to risk-weighted assets (as defined), and of Tier 1 capital (asdefined) to average assets (as defined). Management believes, as of December31, 2003, that Sun and SunBank meet all capital adequacy requirements to whichthey are subject.

 

As of December 31, 2003, and December 31, 2002, the most recentnotification from SunBank’s primary federal regulator, the Federal DepositInsurance Corporation (FDIC), categorized SunBank as well capitalized under theregulatory framework for prompt corrective action. To be categorized as wellcapitalized, SunBank must maintain minimum total risk-based, Tier 1 risk-based,Tier 1 leverage ratios as set forth in the table. There are no conditions orevents since that notification that management believes have changed SunBank’scategory.

 

----

 

*(In Thousands)*

 
|                          |   |       |       |                   |     |                   |   |                         |       | **To Be Well  Capitalized** |   |
|-------------------------------|--------|------------|------------|------------------------|----------|------------------------|--------|------------------------------|------------|-----------------------------|--------|
|                          |   |       |       |                   |     | **For  Capital**       |   | **Under  Prompt Corrective** |       |
|                          |   | **Actual** |       | **Adequacy  Purposes** |     | **Action  Provisions** |   |
|                          |   | **Amount** |       | **Ratio**              |     | **Amount**             |   | **Ratio**                    |       | **Amount**                  |   | **Ratio** |   |
| **As of December 31, 2003:**  |   |       |       |                   |     |                   |   |                         |       |                        |   |   |   |
| **Tier 1 capital:**           |   |       |       |                   |     |                   |   |                         |       |                        |   |   |   |
| **Sun**                       |   | **$**      | **63,864** | ** **             | **8.5**  | **%**                  | **$**  | **30,021**                   | ** ** | **4.0**                     | **%**  | **N/A** | ** ** | **N/A** | ** ** |
| **SunBank**                   |   | **$**      | **69,126** | ** **             | **9.2**  | **%**                  | **$**  | **29,971**                   | ** ** | **4.0**                     | **%**  | **$** | **44,956** | ** ** | **6.0** | **%** |
|                          |   |       |       |                   |     |                   |   |                         |       |                        |   |   |   |
| **Total risk based capital:** |   |       |       |                   |     |                   |   |                         |       |                        |   |   |   |
| **Sun**                       |   | **$**      | **73,984** | ** **             | **9.9**  | **%**                  | **$**  | **60,041**                   | ** ** | **8.0**                     | **%**  | **N/A** | ** ** | **N/A** | ** ** |
| **SunBank**                   |   | **$**      | **76,880** | ** **             | **10.3** | **%**                  | **$**  | **59,941**                   | ** ** | **8.0**                     | **%**  | **$** | **74,926** | ** ** | **10.0** | **%** |
|                          |   |       |       |                   |     |                   |   |                         |       |                        |   |   |   |
| **Leverage ratio:**           |   |       |       |                   |     |                   |   |                         |       |                        |   |   |   |
| **Sun**                       |   | **$**      | **63,864** | ** **             | **6.4**  | **%**                  | **$**  | **39,744**                   | ** ** | **4.0**                     | **%**  | **N/A** | ** ** | **N/A** | ** ** |
| **SunBank**                   |   | **$**      | **69,126** | ** **             | **6.9**  | **%**                  | **$**  | **39,876**                   | ** ** | **4.0**                     | **%**  | **$** | **49,845** | ** ** | **5.0** | **%** |
|                          |   |       |       |                   |     |                   |   |                         |       |                        |   |   |   |
| **As of December 31, 2002:**  |   |       |       |                   |     |                   |   |                         |       |                        |   |   |   |
|                          |   |       |       |                   |     |                   |   |                         |       |                        |   |   |   |
| Tier 1 capital:               |   |       |       |                   |     |                   |   |                         |       |                        |   |   |   |
| Sun                           |   | $          | 71,123     |                   | 11.1     | %                      | $      | 25,661                       |       | 4.0                         | %      | N/A |   | N/A |   |
| SunBank                       |   | $          | 70,969     |                   | 11.1     | %                      | $      | 25,558                       |       | 4.0                         | %      | $ | 38,337 |   | 6.0 | % |
|                          |   |       |       |                   |     |                   |   |                         |       |                        |   |   |   |
| Total risk based capital:     |   |       |       |                   |     |                   |   |                         |       |                        |   |   |   |
| Sun                           |   | $          | 80,484     |                   | 12.6     | %                      | $      | 51,322                       |       | 8.0                         | %      | N/A |   | N/A |   |
| SunBank                       |   | $          | 77,175     |                   | 12.1     | %                      | $      | 51,116                       |       | 8.0                         | %      | $ | 63,895 |   | 10.0 | % |
|                          |   |       |       |                   |     |                   |   |                         |       |                        |   |   |   |
| Leverage ratio:               |   |       |       |                   |     |                   |   |                         |       |                        |   |   |   |
| Sun                           |   | $          | 71,123     |                   | 7.8      | %                      | $      | 37,598                       |       | 4.0                         | %      | N/A |   | N/A |   |
| SunBank                       |   | $          | 70,969     |                   | 7.9      | %                      | $      | 36,168                       |       | 4.0                         | %      | $ | 45,210 |   | 5.0 | % |

 

**Payment of Dividends**

Sun Bancorp, Inc. is a legal entity separate and distinct from itssubsidiaries. The majority of Sun’s revenue is from dividends paid to SunBancorp, Inc. by its banking subsidiary, SunBank. SunBank is subject to lawsand regulations that limit the amount of dividends it can pay. In addition,both Sun and SunBank are subject to various regulatory restrictions relating tothe payment of dividends, including requirements to maintain capital at orabove regulatory minimums. Banking regulators have indicated that bankingorganizations should generally pay dividends only if (1) the organization’s netincome available to common shareholders over the past year has been sufficientto fully fund the dividends and (2) the prospective rate of earnings retentionappears consistent with the organization’s capital needs, asset quality andoverall financial condition. Sun does not expect that any of these laws,regulations or policies will materially affect the ability of SunBank to paydividends. During the year ended December 31, 2003, Sun’s subsidiaries declared$18,529 in dividends payable to Sun Bancorp, Inc..

 

----

 

 

**22. Condensed Financial Information – ParentCompany Only**

**CONDENSED BALANCE SHEETS**

*(In Thousands)*

 
| **December 31,**                                    |   | **2003**   |        | **2002**   |   |    |   |
|-----------------------------------------------------|--------|------------|-------------|------------|--------|---------|--------|
| **Assets:**                                         |   |       |        |       |   |    |   |
| Cash                                                |   | **$**      | **917**     |       | $      | 105     |   |   |   |
| Investment securities available for sale            |   | **500**    |        | 500        |   |    |   |
| Subsidiary investments:                             |   |       |        |       |   |    |   |
| SunBank                                             |   | **98,345** |        | 97,636     |   |    |   |
| SUBI Investment Company                             |   | **11**     |        | 2,064      |   |    |   |
| Beacon Life Insurance Company                       |   | **562**    |        | 528        |   |    |   |
| Sun Trust I                                         |   | **511**    |        | 511        |   |    |   |
| Sun Abstract & Settlement Services              |   | **9**      |        | 15         |   |    |   |
| Mid-Penn Insurance                                  |   | **2,233**  |        | —     |   |    |   |
| Receivable from Sun Trust I                         |   | **18**     |        | 19         |   |    |   |
| Subordinated debenture issuance costs               |   | **347**    |        | 397        |   |    |   |
| Other assets                                        |   | **615**    |        | 593        |   |    |   |
| **Total assets**                                    |   | **$**      | **104,068** |       | $      | 102,368 |   |   |   |
|                                                |   |       |        |       |   |    |   |   |   |
| **Liabilities:**                                    |   |       |        |       |   |    |   |
| Subordinated debentures                             |   | **$**      | **19,377**  | ** ** | $      | 20,166  |   |   |   |
| Subordinated debenture interest payable             |   | **629**    | ** **  | 633        |   |    |   |
| Accounts payable                                    |   | **4,880**  | ** **  | 322        |   |    |   |
| **Total liabilities**                               |   | **24,886** | ** **  | 21,121     |   |    |   |
|                                                |   |       | ** **  |       |   |    |   |
| Shareholders’ Equity:                          |   |       | ** **  |       |   |    |   |
| Common stock                                        |   | **85,386** | ** **  | 84,591     |   |    |   |
| Retained earnings (deficit)                         |   | **(3,728** | **)**       | (5,159     | )      |    |   |
| Accumulated other comprehensive income              |   | **29**     | ** **  | 3,578      |   |    |   |
| Treasury stock                                      |   | **(2,505** | **)**       | (1,763     | )      |    |   |
| **Total shareholders’ equity**                 |   | **79,182** | ** **  | 81,247     |   |    |   |
| **Total liabilities and shareholders’ equity** |   | **$**      | **104,068** | ** ** | $      | 102,368 |   |   |   |

 

**CONDENSEDSTATEMENTS OF INCOME**

*(InThousands)*

 
| **December 31,**                                                                        |   | **2003**    |       | **2002**   |   | **2001** |   |
|-----------------------------------------------------------------------------------------|--------|-------------|------------|------------|--------|----------|--------|
| **Income:**                                                                             |   |        |       |       |   |     |   |
| Dividends from Subsidiaries                                                             |   | **$**       | **18,529** | ** ** | $      | 7,331    |   | $ | 1,059 |   |
| Net security gains                                                                      |   | **25**      | ** ** | —     |   | —   |   |
| Interest and other income                                                               |   | **104**     | ** ** | 69         |   | 75       |   |
| **Total income**                                                                        |   | **18,658**  | ** ** | 7,400      |   | 1,134    |   |
| **Expenses:**                                                                           |   |        | ** ** |       |   |     |   |
| Subordinated debenture interest                                                         |   | **1,899**   | ** ** | 1,944      |   | 1,623    |   |
| Stationery and printing                                                                 |   | **106**     | ** ** | 51         |   | 61       |   |
| Professional fees                                                                       |   | **230**     | ** ** | 288        |   | 197      |   |
| Other expenses                                                                          |   | **490**     | ** ** | 243        |   | 260      |   |
| **Total expenses**                                                                      |   | **2,725**   | ** ** | 2,526      |   | 2,141    |   |
| Income (loss) before income taxes and  equity in undistributed earnings of subsidiaries |   | **15,933**  | ** ** | 4,874      |   | (1,007   | )      |
| Income tax benefit                                                                      |   | **(824**    | **)**      | (855       | )      | (698     | )      |
| Income (loss) before equity in  undistributed earnings of subsidiaries                  |   | **16,757**  | ** ** | 5,729      |   | (309     | )      |
| Equity in undistributed earnings (losses)  of subsidiaries                              |   | **(10,229** | **)**      | 687        |   | 8,659    |   |
| **Net income**                                                                          |   | **$**       | **6,528**  | ** ** | $      | 6,416    |   | $ | 8,350 |   |

 

----

 

**CONDENSED STATEMENTS OF CASH FLOWS**

*(In Thousands)*

 
| **Years Ended December 31,**                                                                 |   | **2003**    |       | **2002**   |   | **2001** |   |
|----------------------------------------------------------------------------------------------|--------|-------------|------------|------------|--------|----------|--------|
| **Cash flows from operating activities:**                                                    |   |        | ** ** |       |   |     |   |
| Net income                                                                                   |   | **$**       | **6,528**  | ** ** | $      | 6,416    |   | $ | 8,350 |   |
| Adjustments to reconcile net income to net  cash provided by (used in) operating activities: |   |        | ** ** |       |   |     |   |
| Equity in undistributed losses (earnings)  of subsidiaries                                   |   | **10,229**  | ** ** | (687       | )      | (8,659   | )      |
| Realized net investment securities gains                                                     |   | **(25**     | **)**      | —     |   | —   |   |
| Decrease (increase) in other assets                                                          |   | **765**     | ** ** | (487       | )      | (487     | )      |
| Increase in other liabilities                                                                |   | **3,577**   | ** ** | 191        |   | 642      |   |
| **Net cash provided by (used in) operating  activities**                                     |   | **21,074**  | ** ** | 5,433      |   | (154     | )      |
|                                                                                         |   |        | ** ** |       |   |     |   |
| **Cash flows from investing activities:**                                                    |   |        | ** ** |       |   |     |   |
| Purchase of investment in SunBank                                                            |   | **(3,070**  | **)**      | —     |   | —   |   |
| Purchase of investment in Mid-Penn  Insurance                                                |   | **(856**    | **)**      | —     |   | —   |   |
| Purchases of investment securities  available for sale                                       |   | **—**  | ** ** | (500       | )      | (7       | )      |
| Purchase of investment in SUBI Investment  Company                                           |   | **—**  | ** ** | —     |   | (8,460   | )      |
| Purchase of investment in Sun Trust I                                                        |   | **—**  | ** ** | —     |   | (511     | )      |
| Cash provided by acquisitions                                                                |   | **617**     | ** ** | —     |   | —   |   |
| Proceeds from sales of investment  securities                                                |   | **375**     | ** ** | —     |   | —   |   |
| Proceeds from return of capital of  investment in Sun Abstract                               |   | **—**  | ** ** | —     |   | 7        |   |
| **Net cash (used in) provided by investing  activities**                                     |   | **(2,934**  | **)**      | (500       | )      | (8,971   | )      |
|                                                                                         |   |        | ** ** |       |   |     |   |
| **Cash flows from financing activities:**                                                    |   |        | ** ** |       |   |     |   |
| Proceeds from issuance of subordinated  debentures                                           |   | **—**  | ** ** | —     |   | 17,011   |   |
| Cash dividends                                                                               |   | **(5,097**  | **)**      | (4,614     | )      | (4,134   | )      |
| Repayment of subordinated debentures                                                         |   | **(789**    | **)**      | (789       | )      |     |   |
| Return of capital, Sun Abstract                                                              |   | **—**  | ** ** | —     |   | 4        |   |
| Purchase of Steelton                                                                         |   | **(9,180**  | **)**      | —     |   | —   |   |
| Purchase of Bank Capital                                                                     |   | **(118**    | **)**      | —     |   | —   |   |
| Purchase of Guaranty Bank                                                                    |   | **—**  | ** ** | —     |   | (2,544   | )      |
| Purchase of treasury stock                                                                   |   | **(2,422**  | **)**      | (601       | )      | (1,213   | )      |
| Proceeds from sale of common stock for  employee benefit program                             |   | **278**     | ** ** | 1,026      |   | 123      |   |
| **Net cash (used in) provided by financing  activities**                                     |   | **(17,328** | **)**      | (4,978     | )      | 9,247    |   |
| Net increase (decrease) in cash and cash  equivalents                                        |   | **812**     | ** ** | (45        | )      | 122      |   |
| Cash and cash equivalents at beginning of  year                                              |   | **105**     | ** ** | 150        |   | 28       |   |
| **Cash and cash equivalents at end of year**                                                 |   | **$**       | **917**    | ** ** | $      | 105      |   | $ | 150 |   |

 

----

 

**23. Consolidated Quarterly Financial Data(Unaudited)**

*(Dollars in Thousands, Except for Per Share Data)*

 
| **2003**                                |   | **1st Qtr.** |       | **2nd Qtr.** |       | **3rd Qtr.** |       | **4th Qtr.** |       | **Total**   |       |
|-----------------------------------------|--------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|-------------|------------|
| **Interest income**                     |   | **$**        | **12,388** | ** **   | **$**      | **12,946**   | ** ** | **$**        | **12,262** | ** **  | **$**      | **11,823** | ** ** | **$** | **49,419** | ** ** |
| **Interest expense**                    |   | **(6,840**   | **)**      | **(7,022**   | **)**      | **(6,289**   | **)**      | **(5,994**   | **)**      | **(26,145** | **)**      |
|                                    |   |         |       |         |       |         |       |         |       |        |       |
| **Net interest income**                 |   | **5,548**    | ** ** | **5,924**    | ** ** | **5,973**    | ** ** | **5,829**    | ** ** | **23,274**  | ** ** |
| **Provision for loan and lease losses** |   | **(405**     | **)**      | **(405**     | **)**      | **(405**     | **)**      | **(405**     | **)**      | **(1,620**  | **)**      |
| **Net security gains**                  |   | **1,496**    | ** ** | **1,001**    | ** ** | **697**      | ** ** | **—**   | ** ** | **3,194**   | ** ** |
| **Non-interest income**                 |   | **2,133**    | ** ** | **2,503**    | ** ** | **2,971**    | ** ** | **3,032**    | ** ** | **10,639**  | ** ** |
| **Gain on sale of loans**               |   | **261**      | ** ** | **43**       | ** ** | **60**       | ** ** | **33**       | ** ** | **397**     | ** ** |
| **Non-interest expense**                |   | **(6,563**   | **)**      | **(7,141**   | **)**      | **(7,155**   | **)**      | **(7,634**   | **)**      | **(28,493** | **)**      |
| **Income before income tax provision**  |   | **2,470**    | ** ** | **1,925**    | ** ** | **2,141**    | ** ** | **855**      | ** ** | **7,391**   | ** ** |
| **Income tax provision**                |   | **(436**     | **)**      | **(235**     | **)**      | **(320**     | **)**      | **128**      | ** ** | **(863**    | **)**      |
| **Net income**                          |   | **$**        | **2,034**  | ** **   | **$**      | **1,690**    | ** ** | **$**        | **1,821**  | ** **  | **$**      | **983** | ** ** | **$** | **6,528** | ** ** |
| **Net income per share – Basic**   |   | **$**        | **0.28**   | ** **   | **$**      | **0.23**     | ** ** | **$**        | **0.25**   | ** **  | **$**      | **0.14** | ** ** | **$** | **0.91** | ** ** |
| **Net income per share – Diluted** |   | **$**        | **0.28**   | ** **   | **$**      | **0.23**     | ** ** | **$**        | **0.25**   | ** **  | **$**      | **0.14** | ** ** | **$** | **0.90** | ** ** |

 

Quarterlyinformation has been restated to reflect the adoption of SFAS 142 and SFAS 147as described in Note 8.

 
| **2002**                                |   | **1st Qtr.** |   | **2nd Qtr.** |   | **3rd Qtr.** |   | **4th Qtr.** |   | **Total** |   |
|-----------------------------------------|--------|--------------|--------|--------------|--------|--------------|--------|--------------|--------|-----------|--------|
| Interest income                         |   | $            | 13,741 |         | $      | 14,144       |   | $            | 13,727 |      | $      | 12,931 |   | $ | 54,543 |   |
| Interest expense                        |   | (7,705       | )      | (7,411       | )      | (7,351       | )      | (7,181       | )      | (29,648   | )      |
|                                    |   |         |   |         |   |         |   |         |   |      |   |
| Net interest income                     |   | 6,036        |   | 6,733        |   | 6,376        |   | 5,750        |   | 24,895    |   |
| Provision for loan and lease losses     |   | (405         | )      | (405         | )      | (450         | )      | (200         | )      | (1,460    | )      |
| Net security gains                      |   | 95           |   | 45           |   | 3            |   | 473          |   | 616       |   |
| Non-interest income                     |   | 997          |   | 1,486        |   | 1,564        |   | 1,750        |   | 5,797     |   |
| Gain on sale of loans                   |   | 28           |   | 45           |   | 63           |   | 119          |   | 255       |   |
| Non-interest expenses                   |   | (4,900       | )      | (5,428       | )      | (5,651       | )      | (6,643       | )      | (22,622   | )      |
| Income before income tax provision      |   | 1,851        |   | 2,476        |   | 1,905        |   | 1,249        |   | 7,481     |   |
| Income tax provision                    |   | (299         | )      | (535         | )      | (210         | )      | (21          | )      | (1,065    | )      |
| **Net income**                          |   | $            | 1,552  |         | $      | 1,941        |   | $            | 1,695  |      | $      | 1,228 |   | $ | 6,416 |   |
| **Net income per share – Basic**   |   | $            | 0.22   |         | $      | 0.27         |   | $            | 0.24   |      | $      | 0.17 |   | $ | 0.90 |   |
| **Net income per share – Diluted** |   | $            | 0.22   |         | $      | 0.27         |   | $            | 0.24   |      | $      | 0.16 |   | $ | 0.89 |   |

 

----

 

**24. Recent Accounting Pronouncements**

** **

**Employers’ Disclosures About Pensions and OtherPostretirement Benefits:**

In December 2003, the FASB revised SFAS 132 Employers’ Disclosures aboutPensions and Other Postretirement Benefits. This Statement retains thedisclosures required by the original SFAS 132 and requires additional disclosuresabout the assets, obligations, cash flows and net periodic benefit cost ofdefined benefit pension and postretirement plans. In addition, this Statementrequires interim period disclosure of the components of net period benefit costand contributions if significantly different from previously reported amounts.

** **

**Amendment of Statement 133 on Derivative Instrumentsand Hedging Activities**

In April 2003, the FASB issued SFAS 149, Amendment  of Statement 133 on Derivative Instrumentsand Hedging Activities, which amends and clarifies financial accounting andreporting for derivative instruments and hedging activities under SFAS 133, aswell as amends certain other existing FASB pronouncements. In general, SFAS 149is effective for derivative transactions entered into or modified and forhedging relationships designated after June 30, 2003. The adoption of thisstandard did not have a material impact on financial condition, the results ofoperations, or liquidity.

** **

**Consolidation of Variable Interest Entities:**

In January 2003, the FASB issued FIN 46, which provides guidance on howto identify a variable interest entity (VIE) and determine when the assets,liabilities, noncontrolling  interests,and results of operations of a VIE are to be included in an entity’sconsolidated financial statements. A VIE exists when either the total equityinvestment at risk is not sufficient to permit the entity to finance itsactivities by itself, or the equity investors lack one of three characteristicsassociated with owning a controlling financial interest. Those characteristicsinclude the direct or indirect ability to make decisions about an entity’sactivities through voting rights or similar rights, the obligation to absorbthe expected losses of an entity if they occur, or the right to receive theexpected residual returns of the entity if they occur.

 

In December 2003, the FASB reissued FIN 46 with certain modificationsand clarifications. Application of this guidance was effective for interests incertain VIEs commonly referred to as special-purpose entities (SPEs) as ofDecember 31, 2003. Application for all other types of entities is required forperiods ending after March 15, 2004, unless previously applied.

 

Management continues to evaluate the applicability of FIN 46 onlow-income housing partnership interests. Sun does not believe that theapplication of FIN 46 will have a material impact on financial condition,results of operations, or liquidity.

** **

**25. Subsequent Events**

The company anticipates that on January 29, 2004, the Board of Directorswill declare a quarterly cash dividend of $0.1815 per common share. Thedividend will be payable March 12, 2004 to shareholders of record on February27, 2004.

 

The company anticipates the closing of Sentry Trust Company to occur onor about February 27, 2004.

 

----

 

**Report of Independent Auditors**

 

**To the Shareholders and Board of Directors ofSUN BANCORP, INC:**

 

In our opinion, the accompanying consolidated balance sheets and therelated consolidated statements of income, changes in shareholders’ equity andcash flows present fairly, in  allmaterial respects, the financial position of Sun Bancorp, Inc. and itssubsidiaries (Company) at December 31, 2003 and 2002, and the results of theiroperations and their cash flows for the years then ended in conformity withaccounting principles generally accepted in the United States of America. Thesefinancial statements are the responsibility of the Company’s management; ourresponsibility is to express an opinion on these financial statements based onour audits. We conducted our audit of these statements in accordance withauditing standards generally accepted in the United States of America, whichrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement. An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation. We believe that our audit provides areasonable basis for our opinion. The financial statements of the Company forthe year ended December 31, 2001 were audited by other independent accountantswhose report dated February 19, 2002 expressed an unqualified opinion on thosestatements.

 

As discussed in notes 1 and 8 to the consolidated financial statements,on January 1, 2002, the Company adopted Statement of Financial AccountingStandard No. 142, Goodwill and Other Intangible Assets, and No. 147,Acquisition of Certain Financial Institutions.

 

 
| /s/ PricewaterhouseCoopers LLP |   |
|--------------------------------|--------|
|                           |
| PricewaterhouseCoopers LLP     |
|                           |
| Harrisburg, Pennsylvania       |
|                           |
| February 22, 2004              |

 

----

 

**Five-Year Financial Highlights**

 

**Selected Financial Data**

 
| **Balance Sheet Data*****(In Thousands)***                     |   | **2003**      |          | **2002**   |   | **2001**  |   | **2000**  |    | **1999**  |   |
|----------------------------------------------------------------|--------|---------------|---------------|------------|--------|-----------|--------|-----------|---------|-----------|--------|
| Assets                                                         |   | **$**         | **1,027,836** | ** ** | $      | 951,174   |   | $         | 922,050 |      | $      | 743,588 |   | $ | 710,921 |   |
| Deposits                                                       |   | **614,550**   | ** **    | 587,480    |   | 573,877   |   | 444,566   |    | 400,121   |   |
| Loans                                                          |   | **672,223**   | ** **    | 602,395    |   | 515,520   |   | 406,775   |    | 377,485   |   |
| Securities available for sale                                  |   | **223,209**   | ** **    | 219,438    |   | 305,612   |   | 290,513   |    | 282,616   |   |
| Shareholders’ equity                                      |   | **79,182**    | ** **    | 81,247     |   | 77,511    |   | 62,527    |    | 56,013    |   |
| Average equity                                                 |   | **81,117**    | ** **    | 79,966     |   | 68,207    |   | 57,768    |    | 63,537    |   |
| Average assets                                                 |   | **1,012,618** | ** **    | 931,320    |   | 866,053   |   | 724,435   |    | 661,099   |   |
|                                                           |   |          | ** **    |       |   |      |   |      |    |      |   |
| **Earnings Data***(In Thousands)*                              |   |          | ** **    |       |   |      |   |      |    |      |   |
| Interest income                                                |   | **$**         | **49,419**    | ** ** | $      | 54,543    |   | $         | 59,694  |      | $      | 53,360 |   | $ | 47,454 |   |
| Interest expense                                               |   | **26,145**    | ** **    | 29,648     |   | 35,959    |   | 31,825    |    | 26,230    |   |
| Net interest income                                            |   | **23,274**    | ** **    | 24,895     |   | 23,735    |   | 21,735    |    | 21,224    |   |
| Provision for loan and lease losses                            |   | **1,620**     | ** **    | 1,460      |   | 1,500     |   | 2,500     |    | 1,925     |   |
| Net interest income after provision for  loan and lease losses |   | **21,654**    | ** **    | 23,435     |   | 22,235    |   | 19,235    |    | 19,299    |   |
| Net security gains (losses)                                    |   | **3,194**     | ** **    | 616        |   | 844       |   | (1,955    | )       | 1,962     |   |
| Non-interest income                                            |   | **11,036**    | ** **    | 6,052      |   | 3,772     |   | 2,939     |    | 2,998     |   |
| Gain on sale of branches                                       |   | **—**    | ** **    | —     |   | 4,892     |   | —    |    | —    |   |
| Non-interest expenses                                          |   | **28,493**    | ** **    | 22,622     |   | 20,049    |   | 14,095    |    | 12,079    |   |
| Income before income tax provision                             |   | **7,391**     | ** **    | 7,481      |   | 11,694    |   | 6,124     |    | 12,180    |   |
| Income tax provision                                           |   | **863**       | ** **    | 1,065      |   | 3,344     |   | 1,526     |    | 3,425     |   |
| Net income                                                     |   | **6,528**     | ** **    | 6,416      |   | 8,350     |   | 4,598     |    | 8,755     |   |
| Dividends paid                                                 |   | **5,097**     | ** **    | 4,613      |   | 4,134     |   | 5,277     |    | 6,135     |   |
|                                                           |   |          | ** **    |       |   |      |   |      |    |      |   |
| **Ratios**                                                     |   |          | ** **    |       |   |      |   |      |    |      |   |
| Return on average assets                                       |   | **0.64**      | **%**         | 0.69       | %      | 0.93      | %      | 0.63      | %       | 1.32      | %      |
| Return on average equity                                       |   | **8.05**      | **%**         | 8.02       | %      | 12.24     | %      | 7.96      | %       | 13.78     | %      |
| Efficiency ratio                                               |   | **81.50**     | **%**         | 71.82      | %      | 57.04     | %      | 54.07     | %       | 46.75     | %      |
| Expense ratio                                                  |   | **2.81**      | **%**         | 2.43       | %      | 2.31      | %      | 1.95      | %       | 1.83      | %      |
| Net interest margin                                            |   | **2.70**      | **%**         | 3.09       | %      | 3.12      | %      | 3.46      | %       | 3.57      | %      |
| Equity to assets (year end)                                    |   | **7.70**      | **%**         | 8.54       | %      | 8.42      | %      | 8.41      | %       | 7.88      | %      |
| Loans to deposits (year end)                                   |   | **109.38**    | **%**         | 102.53     | %      | 89.83     | %      | 91.50     | %       | 94.34     | %      |
| Loans to assets (year end)                                     |   | **65.40**     | **%**         | 63.33      | %      | 55.98     | %      | 54.70     | %       | 53.10     | %      |
| Average equity to average assets                               |   | **8.01**      | **%**         | 8.59       | %      | 7.88      | %      | 7.97      | %       | 9.61      | %      |
| Dividend payout (percentage of net income)                     |   | **78.08**     | **%**         | 71.91      | %      | 49.51     | %      | 114.77    | %       | 70.07     | %      |
|                                                           |   |          | ** **    |       |   |      |   |      |    |      |   |
| **Per Share Data**                                             |   |          | ** **    |       |   |      |   |      |    |      |   |
| Net income per share — Basic                              |   | **$**         | **0.91**      | ** ** | $      | 0.90      |   | $         | 1.20    |      | $      | 0.68 |   | $ | 1.28 |   |
| Net income per share — Diluted                            |   | **$**         | **0.90**      | ** ** | $      | 0.89      |   | $         | 1.20    |      | $      | 0.68 |   | $ | 1.28 |   |
| Cash dividends per share                                       |   | **$**         | **0.7095**    | ** ** | $      | 0.645     |   | $         | 0.60    |      | $      | 0.78 |   | $ | 0.90 |   |
| Book value per share                                           |   | **$**         | **11.03**     | ** ** | $      | 11.33     |   | $         | 10.85   |      | $      | 9.39 |   | $ | 8.25 |   |
| Average shares outstanding — Basic                        |   | **7,190,140** | ** **    | 7,154,107  |   | 6,942,122 |   | 6,769,924 |    | 6,813,956 |   |
| Average shares outstanding — Diluted                      |   | **7,215,066** | ** **    | 7,196,534  |   | 6,945,504 |   | 6,784,262 |    | 6,860,114 |   |
| Approximate number of shareholders                             |   | **2,238**     | ** **    | 2,236      |   | 2,207     |   | 2,159     |    | 2,105     |   |

 

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**Management’s Discussion and Analysis**

 

**Forward Looking Statements (FLSs)**

In addition to historical information, this report contains statementsrelating to future events and Sun’s future results. These statements are“forward-looking”within the meaning of the Private Securities Litigation ReformAct of 1995 and include, but are not limited to, statements that relate toprojections of future results of operations, liquidity, capital expenditures orother financial items, discussions of estimated future revenue enhancements andcost savings, and potential exposure to various types of market risk, includinginterest rate risk and credit risk. These statements may also relate to Sun’sbusiness strategy, goals and expectations concerning its market position,future operations, margins, profitability, liquidity and capital resources.Generally, words such as “anticipate”, “believe”, “continue”, “could”,“estimate”, “expect”, “intend”, “may”, “plan”, “predict”, “project”, “should”,“will”and similar terms and phrases are used to identify forward-lookingstatements in this report. These forward-looking statements are made as of thedate of this report.

 

Readers should note that many factors, some of which are discussedelsewhere in this report, could affect the future financial results of Sun, andcould cause those results to differ materially from those expressed in theforward-looking statements contained or incorporated by reference in thisreport. These factors include:

 

• operating, legal and regulatory risks;

 

• economic, political and competitive forcesaffecting banking, securities, asset management and credit services businesses;

 

• interest rate fluctuations, which couldfurther increase Sun’s cost of funds or decrease Sun’s yield on earning assetsand therefore reduce net interest income;

 

• adverse changes in Sun’s loan and leaseportfolios and the resulting credit risk and related losses and expenses;

 

• the levels of Sun’s loan quality andorigination volume;

 

• the adequacy of loss reserves;

 

• the loss of certain key officers which couldadversely impact Sun’s business;

 

• Sun’s ability to maintain customerrelationships;

 

• an inability to continue to grow the businessinternally and through acquisition and successful integration of bank andnon-bank entities while controlling costs;

 

• competition from other financial institutionsin originating loans, attracting deposits, and providing various financialservices that may affect Sun’s profitability;

 

• the inability to hedge certain riskseconomically;

 

• Sun’s ability to effectively implementtechnology-driven products and services;

 

• changes in consumer confidence, spending, andsavings habits relative to the bank and non-bank financial services that Sunprovides; and

 

• the risk that management’s analysis of theserisks and forces could be incorrect and/or that the strategies developed toaddress them could be unsuccessful.

 

Sun undertakes no obligation to publicly revise or update theseforward-looking statements to reflect events or circumstances that arise afterthe date of this report. Readers should carefully review the risk factorsdescribed in other documents that Sun files periodically with the Securitiesand Exchange Commission.

 

The following is management’s discussion and analysis of the significantchanges in the results of operations, capital resources, and liquiditypresented in its accompanying consolidated financial statements for SunBancorp, Inc., a financial holding company, and its wholly-owned subsidiaries,SunBank, Mid-Penn Insurance Associates, Inc., Beacon Life Insurance Company,and Sun Bancorp Statutory Trust I. Sun Bancorp, Inc. also holds thirty percentownership in Sun Abstract and Settlement Services. Sun Bancorp, Inc.’sconsolidated financial condition and results of operations consist almostentirely of SunBank’s financial condition and results of operations.Performance does not guarantee or assure similar performance in the future, andmay not be indicative of future results.

 

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**Executive Summary**

With over $1 billion in total assets, Sun is the leading communityfinancial services provider in central Pennsylvania. Headquartered inLewisburg, Pennsylvania, Sun operates 26 offices in Dauphin, Luzerne, Lycoming,Snyder, Union, Clinton, and Northumberland counties. Sun serves the personaland commercial financial service needs for residents and businesses throughoutcentral and northeastern Pennsylvania by focusing on a relationship-basedapproach which is built around identifying and anticipating customer needs, andproviding the financial expertise, advice, products, and services to helpclients reach their dreams and manage life’s challenges. Sun also operatesMid-Penn Insurance Associates, SunBank Wealth Management and Private Banking,Sun Investment Services, SunBank Dealer Center, Bank Capital Services, and is30% owner of Sun Abstract & Settlement Services, LLC.

 

In general, the buying (deposits, borrowings) and selling (loans,investments) of funds is the single largest component of revenue and net incomefor many community financial services providers. A community financial servicesprovider’s ability to generate earnings depends heavily on interest rates. Therates at which an institution can obtain funds has a direct impact on its netinterest income, i.e, the difference between the cost of funds and the revenueearned by those funds. More recently however, many financial institutions,including those with a community banking focus, have embarked on revenuediversification programs by offering insurance, mortgage servicing, leasing,and investment products and services.

 

Sun is a community financial services provider that fits this profile.In 2003, interest income represented approximately 80% of Sun’s total revenue.However, non-interest income generated by insurance services, investmentproducts, and equipment and leasing services is rapidly becoming a strongcomponent of Sun’s revenue. In 2003, non-interest income representsapproximately 20% of total revenue, excluding gains from the sale ofsecurities, compared to 10% and 13% of total revenue in 2002 and 2001.Management is continually exploring opportunities to expand sources of thenon-interest income component.

 

Management addresses a multiplicity of important matters in operatingSun. The net interest margin has declined over the last eight quarters in adeclining interest rate environment. This decline is principally caused by thehigh cost of $220 million of Federal Home Loan Bank debt generated by priormanagement’s leverage program. The cost of these funds is relatively high inthe current interest rate environment. A very high prepayment penalty isassociated with these borrowings, and accordingly retiring this debt on termsfavorable to Sun presents a challenge. Management is evaluating variousstrategies to reduce the amount of these borrowings.

 

Managing Sun’s growth and the execution of management’s strategyrequires continuous awareness of the volatility of the financial markets. Thetimeliness of response to changes in the financial markets is the focus ofSun’s risk management. Management is focused on all areas of risks inherent inSun’s business — including, among the most critical, credit, interest rate,operational, legal, and reputational risks. With interest revenue providingsuch a large component of Sun’s total revenue, interest rate risk managementremains the most important focus of the management team. In recent years, Sunhas placed more emphasis on strengthening credit quality. Maintaining strongcredit quality in Sun’s loan portfolio ranks among the highest priorities forSun’s lenders and credit officers.

 

Sun attempts to capitalize on opportunities through a relationship-basedmethodology of identifying and fulfilling customers’ needs. Sun attempts toidentify customer segments within its geographic market area and providetailored services specific to the needs of these groups. Continuing toimplement this approach will enable Sun to more efficiently deliver itsproducts and services in an effort to attract additional customers and enhancerevenue. Management also believes that there are opportunities to expand itsgeographic market area into Luzerne and contiguous counties, as well as Dauphinand Cumberland counties. Sun expects to open a branch in each of Luzerne andCumberland counties in 2004.

 

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**Management’s Discussion and Analysis**

 

**Application of Critical Accounting Policies**

Sun’s consolidated financial statements are prepared in accordance withaccounting principles generally accepted in the United States and followgeneral practices within the industry in which it operates. Application ofthese principles requires management to make estimates, assumptions, andjudgments that affect the amounts reported in the financial statements andaccompanying notes. These estimates, assumptions, and judgments are based oninformation available as of the date of the financial statements; accordingly,as this information changes, the financial statements could reflect differentestimates, assumptions, and judgments. Certain policies inherently have agreater reliance on the use of estimates, assumptions, and judgments and assuch have a greater possibility of producing results that could be materiallydifferent than originally reported. Estimates, assumptions, and judgments arenecessary when assets and liabilities are required to be recorded at fairvalue, when a decline in the value of an asset, not carried on the financialstatements at fair value, warrants an impairment write-down or valuationreserve to be established, or when an asset or liability needs to be recordedcontingent upon a future event. Carrying assets and liabilities at fair valueinherently results in more financial statement volatility. The fair values andthe information used to record valuation adjustments for certain assets andliabilities are based either on quoted market prices or are provided by otherthird-party sources, when available. When third-party information is notavailable, valuation adjustments are estimated in good faith by management primarilythrough the use of internal cash flow modeling techniques.

 

The most significant accounting policies followed by Sun are presentedin Note 1 to the consolidated financial statements. These policies, along withthe disclosures presented in the other financial statement notes and in thisfinancial review, provide information on how significant assets and liabilitiesare valued in the financial statements and how those values are determined.Based on the valuation techniques used and the sensitivity of financialstatement amounts to the methods, assumptions, and estimates underlying thoseamounts, management has identified the determination of the allowance for loanlosses, and the valuation of leased asset residuals to be the accounting areasthat require the most subjective or complex judgments, and as such could bemost subject to revision as new information becomes available.

 

The allowance for loan and lease losses represents management’s estimateof probable credit losses inherent in the loan and lease portfolio. Determiningthe amount of the allowance for loan and lease losses is considered a criticalaccounting estimate because it requires significant judgment and the use ofestimates related to the amount and timing of expected future cash flows onimpaired loans, estimated losses on pools of homogeneous loans and leases basedon historical loss experience, and consideration of current economic trends andconditions, all of which may be susceptible to significant change. The loan andlease portfolio also represents the largest asset type on the consolidatedbalance sheet. Refer to Note 1 to the consolidated financial statements and tothe Allowance for Loan and Lease Losses section of Management’s Discussion andAnalysis for additional information on the methodology used to determine theallowance for loan and lease losses and a discussion of the factors drivingchanges in the amount of the allowance for loan and lease losses is included inthe Allowance for Loan and Lease Losses section of this financial review.

 

Lease financing receivables include a residual value component, whichrepresents the estimated wholesale market value of the leased asset upon theexpiration of the lease. Sun leases various types of equipment under commerciallease financing arrangements and also has a portfolio of automobile financingleases. The valuation of residual assets is considered critical due to thesensitivity in forecasting the impact of product and technology changes,consumer behavior, competitor initiatives, shifts in supply and demand, andeconomic conditions, among other factors, on the fair value of residual assets.

** **

**Operations**

Sun provides community-based commercial banking, insurance, leasing andwealth management services through 26 offices in Lycoming, Snyder, Union,Northumberland, Clinton, Luzerne, and Dauphin counties in northeast and centralPennsylvania. The offices are located in diversified local economies with solidmanufacturing and service bases. Those local economies have not been subjected toobservable significant adverse economic effects during 2003. During the fourthquarter of 2003, Sun closed its branches in Squire Hayes and Glen Lyon, inpart, due to their proximity to other Sun branches.

 

Sun’s business is focused in community banking, commercial banking,insurance services, wealth management, leasing and treasury. Through communitybanking, Sun delivers financial products and services to retail customers viaits office network, telephone systems, and internet systems. Community banking productsand services include a wide range of deposit products, residential mortgageloans, vehicle and personal loans, insurance services, auto leasing and otherservices. Sun’s commercial banking business line provides credit, deposit, cashmanagement, and other services to businesses, municipalities, and nonprofitorganizations. The insurance services provide personal and commercial productsand services to all customers. The wealth management group provides assetmanagement and trust services to retail and corporate customers. The treasuryarea manages Sun’s investment securities portfolio and overall asset/liabilitystrategy. In addition, Sun has subsidiaries and ownership interests inpartnerships that engage in various business activities, including credit lifeand disability insurance, title insurance and settlement services, equipmentleasing, consumer auto leasing and affordable housing for senior citizens.

 

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**Operating Performance**

** **

**Summary:**

During 2003, management implemented several new initiatives and programsand enhanced other strategies undertaken in prior years, which managementexpects to improve Sun’s performance. Management’s 2003 efforts wereconcentrated on strengthening credit quality, establishing Sun’s brand ofcommunity-focused commercial banking, expanding core markets, building aneffective sales culture, and introducing and strengthening products andservices to increase fee income, such as that attributable to the 2003acquisitions of a leasing broker (Bank Capital) and an insurance agency(Mid-Penn Insurance). Management expects to continue building upon thesesuccesses throughout 2004.

 

Management believes that Sun’s 2003 financial results illustrate boththe potential for growth and improved performance, but also show the lingeringeffects of past leverage strategies. Management believes Sun’s strategies,culture, and services are aligned to enable continued improvement and thatSun’s 2003 completed acquisitions of Bank Capital Services Corp., Mid-PennInsurance, and Steelton Bancorp and the announced agreement to aquire SentryTrust Company have provided attractive new markets in which Sun had no previousmeaningful presence. Management expects these new markets to provide anopportunity for growth. Management intends to vigorously pursue improvedperformance in 2004 and beyond through its focus on credit quality, coredeposit growth, effective risk management, fee income growth, and marketexpansion.

 

Sun reported net income of $6,528 for the year ended December 31, 2003,or $0.91 per share (basic) as compared to $6,416 or $0.90 per share (basic) forthe year ended December 31, 2002, and $8,350 or $1.20 per share (basic) for theyear ended December 31, 2001. The results for the year ended December 31, 2003represent a 1.75% increase in net income from the year ended 2002, and adecline of 21.82% from the year ended 2001. The year ended December 31, 2001was impacted positively by a pre-tax gain of $4,892 related to the sale of twobranches. Excluding the sale of branches in 2001, net income for the year ended2003 would have increased 27.45% from the year ended 2001.

 

In 2001, Sun purchased three bank branches. In connection with thesetransactions, Sun acquired an intangible asset valued at approximately $9.3million. Sun inadvertently described the entire amount of the intangible assetassociated with these branch acquisitions as a “core deposit intangible” in thebalance sheet for December 31, 2001 that appears as part of Sun’s Form 10-K forthe year ended December 31, 2001. In its 2002 financial statements, Sun treatedthe entire intangible asset as goodwill as a result of the adoption ofStatement of Financial Accounting Standard No. 147. During 2003, Sun recognizedthe inconsistency between the 2001 and 2002 financial statements and undertooka review of the intangibles associated with the 2001 branch acquisitions. Aspart of this review, Sun engaged a financial consultant to conduct anindependent, objective study of the identifiable intangibles associated withthe transactions as of the date of the acquisitions. The identifiableintangibles include a core deposit, a one-year non-compete agreement and anagreement that restricted the seller from establishing new branches within themarket areas of the acquired branches for a period of two years.

 

The evaluation resulted in the identification of a core depositintangible valued at $1,700 with a weighted average life of nine years. Thefinancial consultant determined that it would not be appropriate to separatelyvalue the non-compete and location restriction agreements from the core depositintangible. Accordingly, the value associated with these agreements is includedin the core deposit intangible. The excess of the fair value of the liabilitiesover the fair value of the tangible and identified core deposit intangibleasset acquired in the branch purchases constitutes an unidentifiable intangibleasset in 2001. In adopting Statement of Financial Accounting Standard No. 147,effective January 1, 2002, the Company determined that the branch acquisitionsmet the definition of a business combination. Accordingly, the remainingcarrying amount of the unidentifiable intangible asset has been reclassified togoodwill.

 

The amortization associated with the core deposit intangible results ina reduction of $127 in net income, or approximately $0.02 per share, in 2002and $95, or approximately $0.01 per share, in the nine-months ended September30, 2003. Because Sun had amortized the entire intangible asset in 2001, theimpact of the amortization of the core deposit intangible in accordance withthe results of the evaluation was insignificant with respect to the 2001financial statements. The reduction in net income associated with theamortization of the core deposit intangible is a non-cash expense. Theaggregate amount of the amortization expense associated with the core depositintangible in 2002 and 2003 is $254. Based on the immateriality of the amountsinvolved to the 2002 financial statements and each of the first three quartersof 2003, Sun recognized the entire amount during the fourth quarter of 2003.

 

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**Interest Earning Assets**

** **

**Loans and Leases**

Loans and leases represent Sun’s largest interest earning assetcomponent and largest area of risk. Sun extends credit principally to customersin its core market areas of central and northeastern Pennsylvania. Sun’slending activity focuses on three segments: commercial and industrial,residential mortgage, and consumer loans. Commercial credit products includedemand notes, term notes, credit lines, equipment leasing, and real estatefinancing. Residential mortgage lending includes a variety of programs andterms consistent with the national and local markets, which are predominatelyset by the secondary market. Consumer loans consist of primarily home equitylines, term loans and direct and indirect vehicle financing. Sun prefers tolend predominately on a secured basis and loan officers are discouraged bysenior management from processing unsecured loans . Because commercial andindustrial loans are typically underwritten for higher dollar amounts, one or aseries of poor loan or lease decisions could negatively impact the earnings andcapital of SunBank. The increased credit risk is also the result of severalother factors, including the mobility of collateral, the effects of generaleconomic conditions and the increased difficulty of evaluating and monitoringthese types of loans. In addition, unlike residential mortgage loans, whichgenerally are made on the basis of the borrower’s ability to make repaymentfrom his or her employment and other income and which are secured by realproperty, the value of which tends to be more easily ascertainable, commercialand industrial loans typically are made on the basis of the borrower’s abilityto make repayment from the cash flow of the borrower’s business. As a result,the availability of funds for the repayment of commercial business loans may besubstantially dependent on  the successof the business itself and the general economic environment. While managementbelieves that SunBank has established adequate reserves for loan losses, asignificant loss would necessitate a replenishment of the reserve, which wouldhave a negative effect on earnings. To reduce the risk associated with any oneloan, management has set the internal lending limit at $8,000, which is belowthe legal lending limit of $11,595. Management’s emphasis on credit quality andprudent underwriting standards have aided in reducing the risk in commercialand industrial loans. The result of this process is evidenced by the currentcommercial loan delinquency percentages which are below the overall SunBank’spercentage. Consumer loans, despite lower loan balances, present similar risks.Approval of these loans is subject to centralized underwriting policies in aneffort to reduce the associated risks. The risks associated with long-termfixed rate residential mortgages have been greatly reduced as Sun sells mostnew residential mortgages within seven days of the loan closing. This allowsSun to reduce the credit and interest rate risks associated with residentialmortgages, but allows Sun to provide a needed product and service to itscustomers. To reduce the level of risk associated with all loans, Sun’s loanofficers are held to strict underwriting standards.

 

All categories of loans also carry interest rate risk. In a decliningrate environment, for example, higher rate fixed rate loans will prepay causinga decline in the aggregate yield on loans. The potential exists for the declinein aggregate yield to outpace the decline in Sun’s cost of funds. Sun hasentered into $100,000 notional amount in interest rate swaps involving the costof funds in an attempt to stabilize the volatility in interest income caused byrate changes.

 

Net total loans and leases increased $69,828 to $672,223 at December 31,2003, from $602,395 at December 31, 2002 and $515,520 at December 31, 2001,which represents 11.6% growth from 2002 and 30.40% from 2001. The largestincreases occurred in the commercial and industrial loans and in auto leasingportfolios, which reflected execution of Sun’s strategic plan to grow thoseportfolios. Real estate — mortgage loans have decreased as Sun sells most newresidential mortgages within seven days of the loan closing while the existingresidential mortgage portfolio is naturally reduced due to principal payments.Management believes the loan portfolio is adequately diversified. No commercialcredit concentration exceeds 50% of SunBank’s Tier 1 capital.

 

The following table identifies the loan and lease portfolio composition,net of unearned income, unamortized premiums and discounts on purchased loans,deferred loan and lease fees, and the ALLL, for the five years ended December31:

 
| **(In Thousands)**                                    |   | **2003**    |        | **2002**   |   | **2001** |   | **2000** |    | **1999** |   |
|-------------------------------------------------------|--------|-------------|-------------|------------|--------|----------|--------|----------|---------|----------|--------|
| Real estate — Mortgage (1)                       |   | **$**       | **373,068** | ** ** | $      | 404,350  |   | $        | 377,045 |     | $      | 203,371 |   | $ | 178,876 |   |
| Real estate — Construction                       |   | **32,157**  | ** **  | 17,721     |   | 6,893    |   | 5,340    |    | 3,318    |   |
| Agricultural                                          |   | **268**     | ** **  | 138        |   | 503      |   | 617      |    | 1,059    |   |
| Commercial and industrial                             |   | **96,028**  | ** **  | 54,624     |   | 34,914   |   | 117,096  |    | 114,193  |   |
| Consumer                                              |   | **98,193**  | ** **  | 85,920     |   | 93,200   |   | 86,123   |    | 85,255   |   |
| Lease — Auto                                     |   | **80,582**  | ** **  | 48,574     |   | 8,489    |   | —   |    | —   |   |
| Lease — Equipment                                |   | **9,404**   | ** **  | 4,955      |   | 2,287    |   | —   |    | —   |   |
| Other                                                 |   | **321**     | ** **  | 328        |   | 1,619    |   | 54       |    | 104      |   |
| Deferred fees and unearned income on loans            |   | **(10,541** | **)**       | (7,945     | )      | (3,089   | )      | (538     | )       | (955     | )      |
| Unamortized net premium (discount) on purchased loans |   | **497**     | ** **  | (64        | )      | (137     | )      | (214     | )       | (508     | )      |
| ALLL                                                  |   | **(7,754**  | **)**       | (6,206     | )      | (6,204   | )      | (5,074   | )       | (3,857   | )      |
| **Total loans and leases, net**                       |   | **$**       | **672,223** | ** ** | $      | 602,395  |   | $        | 515,520 |     | $      | 406,775 |   | $ | 377,485 |   |

 

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(1) The real estate –mortgage category includes all residential and commercial and industrial realestate collateralized loans.

 

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The following tables report gross loan balances by contractualmaturities for agricultural, commercial and industrial and real estate —construction loans, and interest rate repricing for agricultural, commercialand industrial, and real estate — construction loans at December 31, 2003.

 
| **(In  Thousands)**                     |   | **Within  One Year** |   | **After One  But  Within Five Years** |   | **After  Five Years** |   | **Total** |   |
|-----------------------------------------|--------|----------------------|--------|---------------------------------------|--------|-----------------------|--------|-----------|--------|
| Agricultural, commercial and industrial |   | $                    | 64,570 |                                  | $      | 22,248                |   | $         | 9,210  |   | $ | 96,028 |   |
| Real estate — Construction         |   | 15,855               |   | 16,131                                |   | 171                   |   | 32,157    |   |
| **Total**                               |   | $                    | 80,425 |                                  | $      | 38,379                |   | $         | 9,381  |   | $ | 128,185 |   |

 
|                |   | **Interest  Rate Sensitivity** |   |               |   |
|---------------------|--------|--------------------------------|--------|--------------------|--------|
| **(In  Thousands)** |   | **Fixed  Rate**                |   | **Variable  Rate** |   | **Total** |   |   |   |
| Due within one year |   | $                              | 3,678  |               | $      | 76,949 |   | $ | 80,627 |   |   |   |
| Due after one year  |   | 40,636                         |   | 6,922              |   | 47,558 |   |   |   |
| **Total**           |   | $                              | 44,314 |               | $      | 83,871 |   | $ | 128,185 |   |   |   |

 

**Credit Quality**

Despite a continuance in adverse national economic developments, Sun’scredit quality remained healthy during 2003. During 2002 and into 2003, somebanks began reporting credit difficulties and bank regulatory agenciescautioned that overall bank credit quality might be pressured. In contrast toindustry trends, Sun’s credit quality remained solid and loan and lease demandcontinued to be strong during this period of economic downturn. Net loans andleases grew $69,828, or 11.6%, to $672,223 from $602,395 at December 31, 2002 and$515,520 at December 31, 2001. While net loans and leases increasedsubstantially, past due and nonperforming loans and leases remained stable as apercentage of total loans. At December 31,2003, past due and nonperformingloans and leases totaled $8,435, or 1.25% of net loans and leases compared to$7,695, or 1.28% of net loans and leases as of December 31, 2002. The increasein past due and nonperforming loans and leases is primarily due to the growthin the leasing portfolio as leases past due 30 to 89 days totaled $1,101 or87.31% of the growth in past due and nonperforming loans and leases.

 

Sun primarily extends credit on a secured basis, and management closelyevaluates collateral both prior to extending credit and periodicallythereafter. Sun’s credit evaluation process includes the use of a matrixapproval system. The matrix approval system is designed to produce a consistentcredit-scoring process tailored for each loan segment, to enable loan officersto carefully evaluate each borrower’s credit risk. Risk-based pricing enablesmanagement to price loans according to each borrower’s unique riskcharacteristics. While efforts in this area have been successful, managementcontinues to seek improvement.

 

In addition to the focused review of each credit application, Sun’s loanquality committee meets regularly to concentrate exclusively on potentialcredit issues. This senior level management committee also includesrepresentatives from the Board of Directors. Larger loans are presenteddirectly to the Board of Directors for consideration.

 

Sun’s formal loan review process provides management with independentcredit assessment. Equally important, however, is management’s use of thesereviews to evaluate internal loan review effectiveness. Sun believes its loanreview program provides adequate coverage and independent analysis formanagement’s credit quality assessments.

 

Past due and nonperforming loans and leases include past due,nonaccrual, and restructured loans and leases. Sun places loans and leases onnonaccrual status when management concludes that collection of interest incomeappears doubtful, or when the loan or lease reaches 90 days past due (unlesswell-secured and in the process of collection). Interest on loans classified asnonaccrual is recognized as it is received. Restructured loans have termsrenegotiated to reduce or defer interest or principal.

 

----

 

**Nonaccrual, past due, and restructured loans andleases for the five years ended December 31, 2003:**

 
| **(In Thousands)**                         |   | **2003**   |      | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|--------------------------------------------|--------|------------|-----------|----------|--------|----------|--------|----------|--------|----------|--------|
| **Loans past due 30 to 89 days**           |   |       |      |     |   |     |   |     |   |     |   |
| Real estate — mortgage (1)            |   | **$**      | **1,455** |     | $      | 1,764    |   | $        | 1,539  |     | $      | 1,440 |   | $ | 2,208 |   |
| Real estate — commercial (1)          |   | **202**    |      | 480      |   | 244      |   | 570      |   | 394      |   |
| Commercial and industrial                  |   | **341**    |      | 384      |   | 880      |   | 200      |   | 349      |   |
| Consumer                                   |   | **789**    |      | 1,034    |   | 857      |   | 975      |   | 2,003    |   |
| Lease (2)                                  |   | **1,101**  |      | 521      |   | —   |   | —   |   | —   |   |
| **Total loans past due 30 to 89 days**     |   | **3,888**  |      | 4,183    |   | 3,520    |   | 3,185    |   | 4,954    |   |
|                                       |   |       |      |     |   |     |   |     |   |     |   |
| **Loans past due 90 days or more**         |   |       |      |     |   |     |   |     |   |     |   |
| Real estate — mortgage (1)            |   | **532**    |      | 150      |   | 402      |   | 994      |   | 378      |   |
| Real estate — commercial (1)          |   | **86**     |      | 73       |   | 49       |   | 69       |   | 122      |   |
| Commercial and industrial                  |   | **9**      |      | 50       |   | 47       |   | 171      |   | 191      |   |
| Consumer                                   |   | **149**    |      | 42       |   | 62       |   | 195      |   | 324      |   |
| Lease (2)                                  |   | **—** |      | —   |   | —   |   | —   |   | —   |   |
| **Total loans past due 90 days**           |   | **776**    |      | 315      |   | 560      |   | 1,429    |   | 1,015    |   |
|                                       |   |       |      |     |   |     |   |     |   |     |   |
| **Nonaccrual loans**                       |   |       |      |     |   |     |   |     |   |     |   |
| Real estate — mortgage (1)            |   | **1,296**  |      | 988      |   | 1,249    |   | 570      |   | 693      |   |
| Real estate — commercial (1)          |   | **2,176**  |      | 1,675    |   | 734      |   | —   |   | 813      |   |
| Commercial and industrial                  |   | **—** |      | 18       |   | 659      |   | 244      |   | 365      |   |
| Consumer                                   |   | **144**    |      | 253      |   | 209      |   | 23       |   | 94       |   |
| Lease (2)                                  |   | **—** |      | —   |   | —   |   | —   |   | —   |   |
| **Total nonaccrual loans**                 |   | **3,616**  |      | 2,934    |   | 2,851    |   | 837      |   | 1,965    |   |
|                                       |   |       |      |     |   |     |   |     |   |     |   |
| Restructured loans                         |   | **155**    |      | 263      |   | 358      |   | 368      |   | 320      |   |
| **Total past due and nonperforming loans** |   | **$**      | **8,435** |     | $      | 7,695    |   | $        | 7,289  |     | $      | 5,819 |   | $ | 8,254 |   |

 

----

(1) Real estate – mortgageand real estate – commercial include real estate construction loans, dependingon the collateral classification.

(2)The lease category includes auto and equipment leases.

 

Total past due andnonperforming loans and leases above include “impaired” loans of approximately$2,746 at December 31, 2003, and $4,775 at December 31, 2002. In accordancewith SFAS 114, a loan is considered impaired when, based on current informationand events, it appears probable that all amounts due will not be collectedaccording to the loan’s contractual terms. This category does not apply tolarge groups of smaller balance loans collectively evaluated for impairment,such as residential mortgage and consumer loans. Refer to the following forinformation on interest reported on the cash basis.

 
| **For Years Ended December 31,**              |   | **2003** |      | **2002** |   | **2001** |   |
|-----------------------------------------------|--------|----------|-----------|----------|--------|----------|--------|
| Lost interest income on nonaccrual loans      |   | **$**    | **376**   |     | $      | 237      |   | $ | 322 |   |
| Average investment in impaired loans          |   | **$**    | **8,423** |     | $      | 5,161    |   | $ | 4,977 |   |
| Interest income recognized on impaired  loans |   | **$**    | **629**   |     | $      | 387      |   | $ | 437 |   |

 

----

 

**Allowancefor Loan and Lease Losses**

Sun maintains an Allowancefor Loan and Lease Losses (ALLL) in an effort to provide a reserve for lossesinherent in its loan and lease portfolio. Loan and lease losses are chargedagainst the ALLL in the period in which they have been determineduncollectible. Recoveries of previously charged-off loans and leases arecredited to the ALLL when received. Management believes the ALLL is adequate asof December 31,2003.

Sun’s methodology forcalculating its ALLL consists of three components:

• specific allocations for loans deemed to havehigher inherent risks;

• a general allocation, which varies for eachtype of loan within the portfolio; and

• qualitative factors as discussed below.

Specific reserves areestablished for loans of all types that management deems to be risk-rated asOther Assets Especially Mentioned (OAEM) or worse. The allocation based onspecific risk-rated credits is calculated by applying a risk factor (from 3% to100%) against the loan based on the severity of risk-rating. All loans arerisk-rated; however, consumer loans and residential mortgages generally receivea favorable rating unless and until a history of delinquency becomes evident.Commercial loans are continuously reviewed and a specific reserve is allocatedonce a loan has fallen to OAEM status or worse.

Loans of all types for whichthere are no specific reserves are evaluated as a group. Management determinesthe general allocation by applying Sun’s charge-off rate for each type of loanbased on the experience of the previous five complete years and the currentpartial year.

Management made furtherrefinements to the methodology for calculating its ALLL in the first quarter of2003 to expand the qualitative factors that allow for a more sophisticatedassessment. As a result of these refinements, Sun enhanced its estimates toinclude consideration of additional qualitative factors reflective of economicconditions, management’s lending policies, the nature and volume of the loanportfolio changes, credit management, credit review, risk profile, classifiedassets, historic collection and charge-off practices, portfolio concentrations,and external factors such as competition, legal and regulatory requirements.These modifications provide a more comprehensive basis for quantifying risk asopposed to the factor utilized previously which was based primarily onmanagement’s assessment of economic conditions and the impact on the variousloan types.

Management’s decision torefine its methodology was driven largely by the results of improved creditunderwriting processes and policies. Beginning in 1998, new senior loanmanagement significantly revised loan policies and underwriting guidelines withthe goal of reducing loan delinquencies and loss experience. As part of thiseffort, senior management attracted more expertise and loan officers withstronger lending qualifications. Management limited unsecured lending and introducedan enhanced loan review process and quality procedure, which included theimplementation of risk-based pricing in the loan review process, all of whichcontributed to an improvement of quality in the loan portfolio. Sun alsoestablished a loan quality committee, comprised of members of senior managementand representatives of the Board of Directors, who meet monthly, to beresponsible for overseeing overall credit quality. Furthermore, managementimplemented a more efficient collection process with respect to delinquentloans. The benefits of a more prudent approach toward credit quality becameevident during the third quarter of 2002.

Net losses were less thananticipated during 2002, despite the loss associated with a previously-reportedfraud. In 2002, Sun began a process of refining its estimates that managementutilized to assess economic conditions. Sun adjusted projected loss rates oncertain loan categories within the portfolio during the fourth quarter of 2002,most notably the provision for indirect automobile loans. In the fourth quarterof 2002, Sun uncovered a fraud associated with its loan portfolio. The lossassociated with the fraud was offset by the effects of improved creditexperience. Accordingly, the combination of these events resulted in littlechange to the provision for 2002 as a result of the fraud. At the end of 2002,net charge-offs for the year (excluding the $1,046 charge-off associated withthe fraud) were approximately $412, which represented a significant decreasefrom $942 in 2001 and $1,283 in 2000.

Management continued toclosely monitor credit quality during 2003 in an effort to establish thereasonableness of the ALLL. The ALLL, as a percentage of total loans andleases, increased to 1.14% at December 31,2003 from 1.02% of total loans atDecember 31,2002. The increase was primarily due to a significant improvementin net charge-offs compared to 2002, an increase in the provision for loan andlease losses, and by adding to the ALLL the $693 reserve balance Sun obtained inconnection with the acquisition of Steelton Bancorp during 2003. Changes in thecomposition of the loan and lease portfolio affected the allocation withinALLL. Most notably, commercial and industrial loans and real estatecollateralized commercial loans, included within the real estate category, havebecome an increasing percentage of the overall loan portfolio as Sun has beenselling new residential mortgages on the secondary market within seven days ofclosing. Accordingly, because commercial and industrial loans and real estatecollateralized commercial loans are generally associated with a higher elementof risk compared to residential mortgages, a higher percentage of the ALLL isdirected toward commercial and industrial loans. Moreover, increases in autoleases have required a higher general allocation in the ALLL because of theassociated anticipated higher loss rate. A continuation of this trend wouldserve to increase the ALLL at a faster rate than if all types of loans wereincreasing proportionately.

Sun’s ALLL reflects periodicprovisions for loan and lease losses determined through the application ofSun’s ALLL methodology discussed above. The provision for loan and lease lossesis the expense necessary to maintain the ALLL at a level necessary to encompassmanagement’s best estimate of possible losses in the loan and lease portfolio.Management increased the provision for the loan and lease losses to $1,620during 2003 compared to $1,460 in 2002, down slightly from $1,500 in 2001. Theprovision was increased in 2003 based on a larger loan portfolio, in part dueto a merger with Steelton Bancorp, and due to the changing mix of loans withinthe portfolio as discussed above. The provision decreased slightly in 2002despite Sun incurring a loss of approximately $1,046 net of recovery, due tothe previously reported fraud that evidenced itself in the fourth quarter of2002.

Determining the level of theallowance for possible loan and lease losses at any given period is difficult,particularly during deteriorating or uncertain economic periods. Managementmust make estimates using information and assumptions that are often subjectiveand changing rapidly. Management continues to review the loan and leaseportfolios in light of a changing economy and the dynamics of the banking andregulatory environment.

Management cannot preciselyquantify that amount due to many uncertainties, including future global,national, and local economic conditions and other factors. As a result,unforeseen developments may require management to increase the ALLL. Suchdevelopments could include changing economic conditions or negativedevelopments with borrowers. In addition, bank regulators periodically assessSun’s ALLL and may, consistent with examination guidelines and currentinformation, require  an increased ALLL.As a result, any number of factors may materially change management’s analysisin the future.

 

----

 

The table bellows illustrates the allocation of the allowance for loanand lease losses and the activity within the reserve.

** **

**ALLL Allocation and ALLL Changes for the five yearsended December 31:**

 
|                          |   | **2003**      |      | **2002**               |       | **2001**      |   | **2000**               |   | **1999**      |   |
|-------------------------------|--------|---------------|-----------|------------------------|------------|---------------|--------|------------------------|--------|---------------|--------|
| **(In Thousands)**            |   | **Allowance** |      | **% of  Total  Loans** |       | **Allowance** |   | **% of  Total  Loans** |   | **Allowance** |   | **% of  Total  Loans** |   | **Allowance** |   | **% of  Total  Loans** |   | **Allowance** |   | **% of  Total  Loans** |   |
| Real estate (1)               |   | **$**         | **3,049** |                   | **39.32**  | **%**         | $      | 1,107                  |   | 17.84         | %      | $ | 2,357 |   | 37.99 | % | $ | 1,870 |   | 36.85 | % | $ | 844 |   | 47.59 | % |
| Commercial and industrial (2) |   | **2,197**     |      | **28.33**              | **%**      | 2,849         |   | 45.91                  | %      | 1,922         |   | 30.98 | % | 1,990 |   | 39.22 | % | 908 |   | 30.13 | % |
| Consumer (3)                  |   | **2,508**     |      | **32.35**              | **%**      | 2,250         |   | 36.25                  | %      | 1,925         |   | 31.03 | % | 1,214 |   | 23.93 | % | 2,105 |   | 22.28 | % |
| **Total ALLL**                |   | **$**         | **7,754** |                   | **100.00** | **%**         | $      | 6,206                  |   | 100.00        | %      | $ | 6,204 |   | 100.00 | % | $ | 5,074 |   | 100.00 | % | $ | 3,857 |   | 100.00 | % |

 
| **(In Thousands)**                                   |   | **2003**   |       | **2002**   |   | **2001** |   | **2000** |   | **1999** |   |
|------------------------------------------------------|--------|------------|------------|------------|--------|----------|--------|----------|--------|----------|--------|
| Balance, beginning of year                           |   | **$**      | **6,206**  | ** ** | $      | 6,204    |   | $        | 5,074  |     | $      | 3,857 |   | $ | 3,327 |   |
| **Loans and leases charged off:**                    |   |       | ** ** |       |   |     |   |     |   |     |   |
| Real estate (1)                                      |   | **(617**   | **)**      | (231       | )      | (303     | )      | (223     | )      | (389     | )      |
| Commercial and industrial (2)                        |   | **(99**    | **)**      | (1,140     | )      | (321     | )      | (618     | )      | (169     | )      |
| Consumer (3)                                         |   | **(729**   | **)**      | (542       | )      | (659     | )      | (712     | )      | (1,048   | )      |
| **Total loans and leases charged off**               |   | **(1,445** | **)**      | (1,913     | )      | (1,283   | )      | (1,553   | )      | (1,606   | )      |
|                                                 |   |       | ** ** |       |   |     |   |     |   |     |   |
| **Recoveries:**                                      |   |       | ** ** |       |   |     |   |     |   |     |   |
| Real estate (1)                                      |   | **511**    | ** ** | 230        |   | 63       |   | 40       |   | 36       |   |
| Commercial and industrial (2)                        |   | **28**     | ** ** | 41         |   | 139      |   | 37       |   | 26       |   |
| Consumer (3)                                         |   | **141**    | ** ** | 184        |   | 139      |   | 193      |   | 149      |   |
| **Total recoveries of loans and leases charged off** |   | **680**    | ** ** | 455        |   | 341      |   | 270      |   | 211      |   |
| Net loans charged off                                |   | **(765**   | **)**      | (1,458     | )      | (942     | )      | (1,283   | )      | (1,395   | )      |
| Provision for loan and lease losses                  |   | **1,620**  | ** ** | 1,460      |   | 1,500    |   | 2,500    |   | 1,925    |   |
| ALLL assumed upon acquisition of Steelton            |   | **693**    | ** ** | —     |   | —   |   | —   |   | —   |   |
| ALLL assumed upon acquisition of Guaranty            |   | **—** | ** ** | —     |   | 572      |   | —   |   | —   |   |
| **Balance, end of year**                             |   | **$**      | **7,754**  | ** ** | $      | 6,206    |   | $        | 6,204  |     | $      | 5,074 |   | $ | 3,857 |   |
|                                                 |   |       | ** ** |       |   |     |   |     |   |     |   |
| **Ratios:**                                          |   |       | ** ** |       |   |     |   |     |   |     |   |
| **Net charge-offs to average loans**                 |   | **0.12**   | **%**      | 0.25       | %      | 0.19     | %      | 0.32     | %      | 0.40     | %      |
|                                                 |   |       | ** ** |       |   |     |   |     |   |     |   |
| **ALLL to total loans at December 31**               |   | **1.14**   | **%**      | 1.02       | %      | 1.20     | %      | 1.23     | %      | 1.01     | %      |
|                                                 |   |       | ** ** |       |   |     |   |     |   |     |   |
| **ALLL to total nonperforming loans**                |   | **170.53** | **%**      | 176.71     | %      | 164.61   | %      | 192.63   | %      | 116.88   | %      |

 

----

(1)The real estate category includes all real estate collateralized loans.

(2)Commercial and industrial includes equipment leases.

(3)Consumer loans include auto leases.

 

----

 

**Investment Securities Available for Sale**

 

Management’s investment portfolio strategy focuses on maximizingrisk-adjusted returns through effective analysis of cash flows and embeddedoptions related to prepayments of mortgage-backed securities. Generally, Sundoes not take material credit risk in its investment securities portfolio asinvestments are concentrated in obligations of U.S. government agencies. Sun’sinvestment activities emphasize instruments with well structured cash flows,competitive returns, and moderate market risk. Through careful monitoring andtransaction timing, management has successfully reduced the investmentsecurities portfolio’s embedded market risk. Management intends to pursuefurther risk reduction strategies during 2004 whenever warranted. Includedwithin Obligations of U.S. Government Agencies are $84,935 in amortized cost ofmortgage pass-through securities with a fair value of $84,783. See Note 4 foradditional information regarding the investment portfolio.

 

The following table reflects the contract maturities of investmentsecurities available for sale as of December 31,2003:

 
|                                                 |   | **Within  One Year** |   | **After One  But  Within Five Years** |   | **After Five  But  Within Ten Years** |   | **After  Ten Years** |   | **Total**           |   |
|------------------------------------------------------|--------|----------------------|--------|---------------------------------------|--------|---------------------------------------|--------|----------------------|--------|---------------------|--------|
| **(In Thousands)**                                   |   | **Amortized  Cost**  |   | **Amortized  Yield**                  |   | **Amortized  Cost**                   |   | **Yield**            |   | **Amortized  Cost** |   | **Yield** |   | **Amortized  Cost** |   | **Yield** |   | **Amortized  Cost** |   | **Yield** |   |
| Obligations of U.S. government agencies              |   | $                    | 5      |                                  | 6.22   | %                                     | $      | 10,672               |   | 4.13                | %      | $ | 26,399 |   | 3.78 | % | $ | 152,442 |   | 3.78 | % | $ | 189,518 |   | 3.80 | % |
| Obligations of states and political subdivisions (1) |   | 1,214                |   | 3.96                                  | %      | 2,917                                 |   | 4.26                 | %      | 944                 |   | 4.07 | % | 12,579 |   | 4.86 | % | 17,654 |   | 4.66 | % |
| Corporate                                            |   | —               |   | —                                |   | 706                                   |   | 5.61                 | %      | —              |   | — |   | 500 |   | 9.25 | % | 1,206 |   | 7.12 | % |
| **Total**                                            |   | $                    | 1,219  |                                  | 3.97   | %                                     | $      | 14,295               |   | 4.23                | %      | $ | 27,343 |   | 3.79 | % | $ | 165,521 |   | 3.88 | % | 208,378 |   | 3.89 | % |
|                                                 |   |                 |   |                                  |   |                                  |   |                 |   |                |   |   |   |   |   |   |   |   |   |   |   |
| Equity securities (2)                                |   |                 |   |                                  |   |                                  |   |                 |   |                |   |   |   |   |   |   |   | 14,787 |   |   |   |
| **Total investment securities**                      |   |                 |   |                                  |   |                                  |   |                 |   |                |   |   |   |   |   |   |   | $ | 223,165 |   | 3.63 | % |

 

----

(1)Tax – equivalent income is calculated using a 34% federal income tax rate.

(2)Equity securities have no stated maturity or dividend rate.

 

----

 

**Funding**

** **

**Deposits:**

 

Sun’s total deposits increased $27,070, or 4.61%, to $614,550 atDecember 31, 2003, compared to $587,480 at December 31, 2002. Sun concentratesits deposit gathering efforts on core deposits to reduce the reliance on highercost certificates of deposit and borrowed funds. Higher cost certificates ofdeposit and borrowed funds result in increased interest expense, decreased netinterest income, and consequently a compression of the net interest margin. Sunconsiders only deposit accounts without stated maturities as core deposits.These transaction and savings products generally represent longer term, lowercost relationships. At December 31,2003, Sun had $339,320 in core deposits, anincrease of $18,353, or 5.72%, from $320,967 at December 31,2002. This increaseis largely the result of SunBank’s efforts in attracting non-interest-bearingdemand deposits by focusing on its customer relationship programs, and depositsacquired in connection with the Steelton Bancorp acquisition.

 

The composition of total deposits for the years ended December 31,2003and 2002 are as follows:

 

*(In Thousands)*

 
| **December 31,**                                 |   | **2003**    | ** **  | **% of  Total** | ** ** | **% Change  from Prior Year** | ** ** |
|--------------------------------------------------|--------|-------------|-------------|-----------------|------------|-------------------------------|------------|
| Demand deposits                                  |   | **$**       | **69,640**  | ** **      | **11.33**  | **%**                         | **17.67**  | **%** |
| NOW accounts                                     |   | **164,803** | ** **  | **26.82**       | ** ** | **6.25**                      | ** ** |
| Insured Money Market Accounts                    |   | **22,461**  | ** **  | **3.65**        | ** ** | **(24.70**                    | **)**      |
| Savings deposits                                 |   | **82,416**  | ** **  | **13.41**       | ** ** | **7.25**                      | ** ** |
| Time Certificates of Deposit of $100,000 or more |   | **57,637**  | ** **  | **9.38**        | ** ** | **23.60**                     | ** ** |
| Time deposits                                    |   | **217,593** | ** **  | **35.41**       | ** ** | **(1.04**                     | **)**      |
| **Total deposits**                               |   | **$**       | **614,550** | ** **      | **100.00** | **%**                         | **4.61**   | **%** |

 
| **December  31,**                                 |   | **2002** |    | **% of  Total** |   | **% Change  from Prior Year** |   |
|---------------------------------------------------|--------|----------|---------|-----------------|--------|-------------------------------|--------|
| Demand deposits                                   |   | $        | 59,181  |            | 10.07  | %                             | 1.93   | % |
| NOW accounts                                      |   | 155,114  |    | 26.40           |   | 6.00                          |   |
| Insured Money Market Accounts                     |   | 29,827   |    | 5.08            |   | 65.17                         |   |
| Savings deposits                                  |   | 76,845   |    | 13.08           |   | 9.12                          |   |
| Time Certificates of Deposit of $100,000 or  more |   | 46,630   |    | 7.94            |   | (5.77                         | )      |
| Time deposits                                     |   | 219,883  |    | 37.43           |   | (5.02                         | )      |
| **Total deposits**                                |   | $        | 587,480 |            | 100.00 | %                             | 2.37   | % |

 

The following table reflects certificates of deposit and other timedeposits and their remaining maturities as of December 31, 2003:

 

*(In Thousands)*

 
| **Years  Ending December 31:** |   |   |    |
|--------------------------------|--------|--------|---------|
| 2004                           |   | $      | 160,187 |   |
| 2005                           |   | 49,445 |    |
| 2006                           |   | 30,579 |    |
| 2007                           |   | 26,657 |    |
| 2008                           |   | 8,362  |    |
| Thereafter                     |   | — |    |
| **Total**                      |   | $      | 275,230 |   |

 

The totals above include certificates of deposit and other time depositsissued in amounts of $100,000 or more. These deposits and their remainingmaturities, at December 31,2003 were:

 

*(In Thousands)*

 
| **December  31,**         |   | **2003**   |       |
|---------------------------|--------|------------|------------|
| Three months or less      |   | **$**      | **20,487** |   |
| Three through six months  |   | **12,818** |       |
| Six through twelve months |   | **8,515**  |       |
| Over twelve months        |   | **15,817** |       |
| **Total**                 |   | **$**      | **57,637** |   |

 

Interest on deposits of $100,000 or more amounted to approximately$2,063 in 2003, $2,087 in 2002 and $3,179 in 2001.

 

----

**Other Funding:**

 

Sun continued using borrowed funds to supplement deposits during 2003.At December 31, 2003, the  $225,595 inFHLB term advances were fixed, convertible to variable, rate advances thatmature between 2008 and 2013.  In additionto the term borrowings, Sun also had short-term borrowings of $37,570 with theFHLB at December 31, 2003, which were used to fund normal operations. Refer toNote 12, Borrowed Funds, for additional information on Sun’s borrowings.

 

FHLB advances are collateralized by pledged investment securities (U.S.government agency debt) and residential and commercial real estate loans. Otherfunding sources include deposit customers’ cash management accounts (classifiedas securities sold under agreements to repurchase), the Treasury Tax and LoanNote Option, repurchase agreements and lines of credit with correspondentbanks. Sun continually monitors its borrowed funds positions and marketconditions in order to maintain an effective funding structure. Whenappropriate, Sun may take future action to modify its borrowed funds structure.

 

**Net Interest Income and Net Interest Margin**

 

Net interest income, the difference between interest income and interestexpense, is the largest component of Sun’s earnings. The net interest margin(NIM) measures the difference between the interest earning assets yield and theaggregate funding cost. The NIM is calculated as taxable equivalent netinterest income divided by average interest earning assets.

 

NIM narrowed by 34 basis points to 2.70% or 2003 compared to 3.04% for2002 and 3.12% for 2001. The compression resulted principally from theprepayment of loans and investments, caused by the rate reductions by theFederal Reserve, and their reinvestment rates decreasing faster than thedecline in deposit rates over the past two years.

 

Net interest income was $23,274 for 2003, compared with $24,895 for 2002and $23,735 for 2001. On a taxable equivalent basis, net interest incomedecreased $1,717 to $24,196 for 2003 versus $25,913 for 2002, which haddeclined $360 from $26,273 for 2001. The decline in net interest income from2002 to 2003 and also, from 2001 to 2002 was primarily the result of the volumeof prepayments from the loan and investment portfolio and these funds beingreinvested in lower coupon instruments. While the higher coupon assets havebeen prepaying, Sun has been lowering its deposit rates significantly to keeppace with the rate reductions by the Federal Reserve. However, Sun has beenunable to significantly lower the cost of its borrowing over the same timeframe as the long-term FHLB advances carry significant prepayment penalties.

 

To alleviate the compression in the NIM and constrain the volatility innet interest income in an up or down interest rate environment, Sun has enteredinto $100 million in derivative contracts effective June 30, 2003. Thecontracts, which involve the Federal Home Loan Bank (FHLB) advances (otherborrowings), increased net interest income by $774 (NIM by 9 basis points) forthe year ended December 31, 2003. Embedded in the swap is an option to reversethe original swap (receive fixed-pay variable), at any time, to payfixed-receive variable if the FHLB notifies SunBank that it is going toexercise the option to increase SunBank’s interest rate on the debt. Thus, in arising rate environment, SunBank has locked in a fixed rate. Despite being ableto lock in a fixed rate, an upward movement in the 90-day LIBOR rate willreduce the positive NIM impact of the swap and will cause a negative NIM impactduring the period that 90-day LIBOR is above 2.65% and the point that the FHLBwould reprice the debt. Readers are encouraged to refer to Note 10 for furtherinformation on hedging activities. Management continues to access strategicoptions to address the negative impact on the net interest margin presented bythe FHLB advances.

 

----

 

**Distribution of Assets, Liabilities, andShareholders’ Equity**

 

The following table provides additional information related to netinterest income and presents the average daily balance composition and netinterest income on a fully taxable equivalent basis:

 
|                                                                 |   | **2003**             |          | **2002**     |       | **2001**   |       |
|----------------------------------------------------------------------|--------|----------------------|---------------|--------------|------------|------------|------------|
| **(In Thousands)**                                                   |   | **Average  Balance** |          | **Interest** |       | **Rate**   |       | **Average  Balance** |   | **Interest** |   | **Rate** |   | **Average  Balance** |   | **Interest** |   | **Rate** |   |
|                                                                 |   |                 |          |         |       |       | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |
| **ASSETS**                                                           |   |                 |          |         |       |       | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |
| **Interest-earning  assets:**                                        |   |                 |          |         |       |       | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets:                                             |   |                 |          |         |       |       | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits                                            |   | **$**                | **11,731**    | ** **   | **$**      | **125**    | ** ** | **1.07** | **%** | $ | 17,195 |   | $ | 363 |   | 2.11 | % | $ | 37,753 |   | $ | 1,345 |   | 3.56 | % |
| Loans (net of unearned  income) (1) (2)                              |   | **644,292**          | ** **    | **40,941**   | ** ** | **6.35**   | ** ** | 581,101 |   | 40,806 |   | 7.02 |   | 483,817 |   | 40,555 |   | 8.38 |   |
| **Investments:**                                                     |   |                 |          |         |       |       | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |
| Taxable (3)                                                          |   | **221,083**          | ** **    | **7,958**    | ** ** | **3.60**   | ** ** | 232,911 |   | 12,855 |   | 5.52 |   | 298,346 |   | 18,609 |   | 6.24 |   |
| Tax exempt (3)                                                       |   | **19,267**           | ** **    | **1,317**    | ** ** | **6.83**   | ** ** | 21,009 |   | 1,537 |   | 7.32 |   | 21,950 |   | 1,723 |   | 7.85 |   |
| **Total  interest-earning assets**                                   |   | **896,373**          | ** **    | **50,341**   | ** ** | **5.62**   | **%**      | 852,216 |   | 55,561 |   | 6.52 | % | 841,866 |   | 62,232 |   | 7.39 | % |
|                                                                 |   |                 |          |         |       |       | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |
| **Non-interest-earning  assets:**                                    |   |                 |          |         |       |       | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks                                              |   | **24,302**           |          |         |       |       |       | 19,444 |   |   |   |   |   | 15,082 |   |   |   |   |   |
| Bank premises and equipment                                          |   | **20,581**           |          |         |       |       |       | 14,783 |   |   |   |   |   | 13,604 |   |   |   |   |   |
| Intangible assets                                                    |   | **29,564**           |          |         |       |       |       | 22,924 |   |   |   |   |   | 18,000 |   |   |   |   |   |
| Accrued interest and other  assets                                   |   | **48,504**           |          |         |       |       |       | 28,671 |   |   |   |   |   | 13,298 |   |   |   |   |   |
|                                                                 |   |                 |          |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Less:**                                                            |   |                 |          |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| ALLL                                                                 |   | **(7,023**           | )             |         |       |       |       | (6,840 | ) |   |   |   |   | (5,807 | ) |   |   |   |   |
| Unamortized loan fees                                                |   | **317**              |          |         |       |       |       | 122 |   |   |   |   |   | 10 |   |   |   |   |   |
| **Total  assets**                                                    |   | **$**                | **1,012,618** |         |       |       |       | ** ** | $ | 931,320 |   |   |   |   |   | $ | 896,053 |   |   |   |   |   |
|                                                                 |   |                 |          |         |       |       | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                       |   |                 |          |         |       |       | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |
| **Interest-bearing  liabilities:**                                   |   |                 |          |         |       |       | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |
| NOW Accounts                                                         |   | **$**                | **164,418**   | ** **   | **$**      | **1,166**  | ** ** | **0.71** | **%** | $ | 151,004 |   | $ | 1,974 |   | 1.31 | % | $ | 136,075 |   | $ | 3,285 |   | 2.41 | % |
| Insured Money Market  Accounts                                       |   | **26,698**           | ** **    | **299**      | ** ** | **1.12**   | ** ** | 22,329 |   | 412 |   | 1.85 |   | 20,945 |   | 568 |   | 2.71 |   |
| Savings deposits                                                     |   | **84,717**           | ** **    | **596**      | ** ** | **0.70**   | ** ** | 76,656 |   | 1,200 |   | 1.57 |   | 63,090 |   | 1,241 |   | 1.97 |   |
| Time deposits                                                        |   | **288,822**          | ** **    | **9,305**    | ** ** | **3.22**   | ** ** | 275,373 |   | 11,147 |   | 4.05 |   | 291,327 |   | 16,070 |   | 5.52 |   |
| Short-term borrowings                                                |   | **40,962**           | ** **    | **456**      | ** ** | **1.11**   | ** ** | 22,897 |   | 325 |   | 1.42 |   | 17,270 |   | 430 |   | 2.49 |   |
| Subordinated debentures                                              |   | **19,255**           | ** **    | **1,845**    | ** ** | **9.58**   | ** ** | 20,083 |   | 1,892 |   | 9.42 |   | 16,051 |   | 1,578 |   | 9.83 |   |
| Other borrowed funds                                                 |   | **238,707**          | ** **    | **12,478**   | ** ** | **5.23**   | ** ** | 220,849 |   | 12,698 |   | 5.75 |   | 222,000 |   | 12,787 |   | 5.76 |   |
| **Total  interest-bearing liabilities**                              |   | **863,579**          | ** **    | **26,145**   | ** ** | **3.03**   | **%**      | 789,191 |   | 29,648 |   | 3.76 | % | 766,758 |   | 35,959 |   | 4.69 | % |
|                                                                 |   |                 |          |         |       |       | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |
| **Non-interest-bearing  liabilities and shareholders’ equity:** |   |                 |          |         |       |       | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                                      |   | **62,717**           |          |         |       |       | ** ** | 57,310 |   |   |   |   |   | 57,478 |   |   |   |   |   |
| Accrued interest and other  liabilities                              |   | **5,205**            |          |         |       |       | ** ** | 4,853 |   |   |   |   |   | 3,610 |   |   |   |   |   |
| Shareholders’ equity                                            |   | **81,117**           |          |         |       |       | ** ** | 79,966 |   |   |   |   |   | 68,207 |   |   |   |   |   |
| **Total  liabilities and shareholders’ equity**                 |   | **$**                | **1,012,618** |         |       |       |       | ** ** | $ | 931,320 |   |   |   |   |   | $ | 896,053 |   |   |   |   |   |
|                                                                 |   |                 |          |         |       |       | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |
| **Interest  rate spread**                                            |   |                 |          |         |       | **2.59**   | **%**      |   |   |   |   | 2.76 | % |   |   |   |   | 2.70 | % |
|                                                                 |   |                 |          |         |       |       | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |
| **Net interest income/margin**                                       |   |                 |          | **$**        | **24,196** | ** ** | **2.70**   | **%** |   |   | $ | 25,913 |   | 3.04 | % |   |   | $ | 26,273 |   | 3.12 | % |

 

----

(1)   Average loan balances include non-accrualloans and interest income includes fees on loans.

(2)   Yields on tax exempt loans and investmentshave been adjusted to a fully taxable equivalent basis using a 34% federalincome tax rate.

(3)   Investment yields are calculated based on theamortized cost.

 

----

 

**Volume and Rates**

 

Changes in interest income and interest expense can result fromvariances in both volume and rates. The following table shows an analysis ofthe effect of volume and rate variances on taxable equivalent interest income,interest expense, and net interest income:

 
|                                    |   | **2003  Compared to 2002  Increase (Decrease)** |       | **2002 Compared to 2001  Increase (Decrease)** |       |
|-----------------------------------------|--------|-------------------------------------------------|------------|------------------------------------------------|------------|
| **(In  Thousands)**                     |   | **Volume**                                      |       | **Rate**                                       | ** ** | **Net** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Net** | ** ** |
|                                    |   |                                            |       |                                           |       |   | ** ** |   |   |   |   |   |   |
| **Interest  earned on:**                |   |                                            |       |                                           |       |   | ** ** |   |   |   |   |   |   |
| Interest-bearing deposits               |   | **$**                                           | **(115**   | **)**                                          | **$**      | **(123** | **)** | **$** | **(238** | **)** | $ | (733 | ) | $ | (249 | ) | $ | (982 | ) |
| Loans                                   |   | **4,430**                                       | ** ** | **(4,295**                                     | **)**      | **135** | ** ** | 7,061 |   | (6,810 | ) | 251 |   |
| Investments:                            |   |                                            |       |                                           |       |   | ** ** |   |   |   |   |   |   |
| Taxable                                 |   | **(652**                                        | **)**      | **(4,245**                                     | **)**      | **(4,897** | **)** | (4,077 | ) | (1,677 | ) | (5,754 | ) |
| Tax exempt                              |   | **(127**                                        | **)**      | **(93**                                        | **)**      | **(220** | **)** | (74 | ) | (112 | ) | (186 | ) |
| **Total  interest-earning assets**      |   | **3,536**                                       | ** ** | **(8,756**                                     | **)**      | **(5,220** | **)** | 2,177 |   | (8,848 | ) | (6,671 | ) |
|                                    |   |                                            |       |                                           |       |   | ** ** |   |   |   |   |   |   |
| **Interest  paid on:**                  |   |                                            |       |                                           |       |   | ** ** |   |   |   |   |   |   |
| NOW Accounts                            |   | **176**                                         | ** ** | **(984**                                       | **)**      | **(808** | **)** | 359 |   | (1,670 | ) | (1,311 | ) |
| Insured Money Market  Accounts          |   | **81**                                          | ** ** | **(194**                                       | **)**      | **(113** | **)** | 38 |   | (194 | ) | (156 | ) |
| Savings deposits                        |   | **127**                                         | ** ** | **(731**                                       | **)**      | **(604** | **)** | 268 |   | (309 | ) | (41 | ) |
| Time deposits                           |   | **545**                                         | ** ** | **(2,387**                                     | **)**      | **(1,842** | **)** | (879 | ) | (4,044 | ) | (4,923 | ) |
| Short-term borrowings                   |   | **257**                                         | ** ** | **(126**                                       | **)**      | **131** | ** ** | 140 |   | (245 | ) | (105 | ) |
| Subordinated debentures                 |   | **(78**                                         | **)**      | **31**                                         | ** ** | **(47** | **)** | 396 |   | (82 | ) | 314 |   |
| Other borrowed funds                    |   | **1,027**                                       | ** ** | **(1,247**                                     | **)**      | **(220** | **)** | (66 | ) | (23 | ) | (89 | ) |
| **Total  interest-bearing liabilities** |   | **2,135**                                       | ** ** | **(5,638**                                     | **)**      | **(3,503** | **)** | 256 |   | (6,567 | ) | (6,311 | ) |
| **Net  interest income**                |   | **$**                                           | **1,401**  | ** **                                     | **$**      | **(3,118** | **)** | **$** | **(1,717** | **)** | $ | 1,921 |   | $ | (2,281 | ) | $ | (360 | ) |

 

----

(1)   Income on tax exempt loans and investmentshave been adjusted to a fully taxable equivalent basis using a 34% federalincome tax rate.

(2)   Loan fees are included within interest earnedon loans.

(3)   Changes in interest income and interestexpense attributable to the combined impact of both volume and rate wereallocated in proportion to the absolute amount of changein each.

 

----

 

**Income and Expense Changes**

 

The table below presents the consolidated comparative changes in incomeand expense, and  it reflects changes inaverage asset and liability volumes. Tax exempt income is not shown on a taxequivalent basis.

 
|                                                           |   | **2003  Compared to 2002** |       | **2002 Compared to 2001** |       |
|----------------------------------------------------------------|--------|----------------------------|------------|---------------------------|------------|
|                                                           |   | **Average  $ Change**      |       | **Volume  %****Change**   |       | **Income/Expense** |   | **Average$Change** |   | **Volume  % Change** |   | **Income/Expense** |   |
| ***(In Thousands)***                                           |   |                       |       | **$ Change**              |       | **% Change** |   |   |   | **$****Change** |   | **% Change** |   |
| Loans, net                                                     |   | **$**                      | **63,191** | ** **                | **10.87**  | **%** | **$** | **157** | ** ** | **0.39** | **%** | $ | 84,337 |   | 17.43 | % | $ | 1,707 |   | 4.42 | % |
| Investment securities                                          |   | **(13,570**                | **)**      | **(5.34**                 | **)**      | **(5,043** | **)** | **(36.36** | **)** | (66,376 | ) | (20.72 | ) | (5,876 | ) | (29.76 | ) |
| Interest-bearing deposits                                      |   | **(5,464**                 | **)**      | **(31.78**                | **)**      | **(238** | **)** | **(65.56** | **)** | (20,558 | ) | (54.45 | ) | (982 | ) | (73.01 | ) |
| **Total  interest-earning assets**                             |   | **$**                      | **44,157** | ** **                | **5.18**   | **%** | **$** | **(5,124** | **)** | **(9.39** | **)%** | $ | (2,597 | ) | (0.31 | )**%** | $ | (5,151 | ) | (8.63 | )% |
|                                                           |   |                       |       |                      | ** ** |   |   |   | ** ** |   |   |   |   |   |   |   |   |
| NOW Accounts                                                   |   | **$**                      | **13,414** | ** **                | **8.88**   | **%** | **$** | **(808** | **)** | **(40.93** | **)%** | $ | 14,929 |   | 10.97 | % | $ | (1,311 | ) | (39.91 | )% |
| Insured Money Market  Accounts                                 |   | **4,369**                  | ** ** | **19.57**                 | ** ** | **(113** | **)** | **(27.43** | **)** | 1,384 |   | 6.61 |   | (156 | ) | (27.46 | ) |
| Savings deposits                                               |   | **8,061**                  | ** ** | **10.52**                 | ** ** | **(604** | **)** | **(50.33** | **)** | 13,566 |   | 21.50 |   | (41 | ) | (3.30 | ) |
| Time deposits                                                  |   | **13,449**                 | ** ** | **4.88**                  | ** ** | **(1,842** | **)** | **(16.52** | **)** | (15,954 | ) | (5.48 | ) | (4,923 | ) | (30.63 | ) |
| Short-term borrowings                                          |   | **18,065**                 | ** ** | **78.90**                 | ** ** | **131** | ** ** | **40.31** | ** ** | 5,627 |   | 32.58 |   | (105 | ) | (24.42 | ) |
| Subordinated debentures                                        |   | **(828**                   | **)**      | **(4.12**                 | **)**      | **(47** | **)** | **(2.48** | **)** | 4,032 |   | 25.12 |   | 314 |   | 19.90 |   |
| Other borrowed funds                                           |   | **17,858**                 | ** ** | **8.09**                  | ** ** | **(220** | **)** | **(1.73** | **)** | (1,151 | ) | (0.52 | ) | (89 | ) | (0.70 | ) |
| **Total  interest-bearing liabilities**                        |   | **$**                      | **74,388** | ** **                | **9.43**   | **%** | **$** | **(3,503** | **)** | **(11.82** | **)%** | $ | 22,433 |   | 2.93 | % | $ | (6,311 | ) | (17.55 | )% |
|                                                           |   |                       |       |                      | ** ** |   |   |   | ** ** |   |   |   |   |   |   |   |   |
| Net interest income                                            |   |                       |       |                      |       | **$** | **(1,621** | **)** | **(6.51** | **)%** |   |   |   |   | $ | 1,160 |   | 4.89 | % |
| Provision for loan and lease  losses                           |   |                       |       |                      |       | **160** | ** ** | **10.96** | ** ** |   |   |   |   | (40 | ) | (2.67 | ) |
| Net interest income after  provision for loan and lease losses |   |                       |       |                      |       | **(1,781** | **)** | **(7.60** | **)** |   |   |   |   | 1,200 |   | 5.40 |   |
| Service charges on deposit  accounts                           |   |                       |       |                      |       | **1,053** | ** ** | **34.63** | ** ** |   |   |   |   | 1,138 |   | 59.80 |   |
| Trust income                                                   |   |                       |       |                      |       | **(33** | **)** | **(4.35** | **)** |   |   |   |   | 14 |   | 1.88 |   |
| Net securities gains                                           |   |                       |       |                      |       | **2,578** | ** ** | **418.51** | ** ** |   |   |   |   | (228 | ) | (27.01 | ) |
| Income from Investment sales                                   |   |                       |       |                      |       | **(29** | **)** | **(7.14** | **)** |   |   |   |   | 97 |   | 31.39 |   |
| Bank-owned life insurance                                      |   |                       |       |                      |       | **551** | ** ** | **76.53** | ** ** |   |   |   |   | 720 |   | 100.00 |   |
| Insurance subsidiary                                           |   |                       |       |                      |       | **1,180** | ** ** | **1,532.47** | ** ** |   |   |   |   | (106 | ) | (57.92 | ) |
| Net gain on sale of loans                                      |   |                       |       |                      |       | **142** | ** ** | **55.69** | ** ** |   |   |   |   | 125 |   | 96.15 |   |
| Leasing fees                                                   |   |                       |       |                      |       | **1,089** | ** ** | **—** | ** ** |   |   |   |   | — |   | — |   |
| Other income                                                   |   |                       |       |                      |       | **1,031** | ** ** | **129.85** | ** ** |   |   |   |   | 292 |   | 58.17 |   |
| Gain on sale of branches                                       |   |                       |       |                      |       | **—** | ** ** | **—** | ** ** |   |   |   |   | (4,892 | ) | (100.00 | ) |
| **Total other  operating income**                              |   |                       |       |                      |       | **7,562** | ** ** | **113.41** | ** ** |   |   |   |   | (2,840 | ) | (29.87 | ) |
|                                                           |   |                       |       |                      |       |   |   |   | ** ** |   |   |   |   |   |   |   |   |
| Salaries and employee benefits                                 |   |                       |       |                      |       | **1,269** | ** ** | **10.75** | ** ** |   |   |   |   | 2,120 |   | 21.90 |   |
| Net occupancy expenses                                         |   |                       |       |                      |       | **275** | ** ** | **25.39** | ** ** |   |   |   |   | 88 |   | 8.84 |   |
| Furniture and equipment  expenses                              |   |                       |       |                      |       | **429** | ** ** | **23.97** | ** ** |   |   |   |   | 45 |   | 2.58 |   |
| Pennsylvania shares tax                                        |   |                       |       |                      |       | **(173** | **)** | **(21.63** | **)** |   |   |   |   | 101 |   | 14.45 |   |
| Amortization of intangibles                                    |   |                       |       |                      |       | **531** | ** ** | **—** | ** ** |   |   |   |   | (1,567 | ) | (100.00 | ) |
| Other expenses                                                 |   |                       |       |                      |       | **3,540** | ** ** | **49.52** | ** ** |   |   |   |   | 1,786 |   | 33.30 |   |
| **Total other  operating expense**                             |   |                       |       |                      |       | **5,871** | ** ** | **25.95** | ** ** |   |   |   |   | 2,573 |   | 12.83 |   |
|                                                           |   |                       |       |                      |       |   |   |   | ** ** |   |   |   |   |   |   |   |   |
| Income before income tax  provision                            |   |                       |       |                      |       | **(90** | **)** | **(1.20** | **)** |   |   |   |   | (4,213 | ) | (36.03 | ) |
| Income tax provision                                           |   |                       |       |                      |       | **(202** | **)** | **(18.97** | **)** |   |   |   |   | (2,279 | ) | (68.15 | ) |
| **Net income**                                                 |   |                       |       |                      |       | **$** | **112** | ** ** | **1.75** | **%** |   |   |   |   | $ | (1,934 | ) | (23.16 | )% |

 

----

 

**Non-Interest Income**

 

Non-interest income, excluding net securities gains, increased $4,984 or82.35%, from 2002 to 2003, as compared to an increase of 60.45%, from 2001 to2002, when excluding net securities gains and gain on the sale of branches in2001. The increase from 2002 to 2003 is the result of several items, includingthe acquisitions of Mid-Penn Insurance and Bank Capital, which accounted forthe increases in income from the insurance subsidiary and leasing fees,respectively. In addition, the full year impact of a $15,000 BOLI policypurchased in October 2002 increased non-interest income by $551. An increase of$1,053 in service charges on deposits accounted for the majority of theremaining increase.

 

Service charges on deposit accounts demonstrated continued growth to$4,094 or 34.63% from 2002 to 2003 as compared to an increase of 59.80% from2001 to 2002. This growth resulted from the continued expansion of an overdrafthonor program, increased transaction account fee income, and increased ATMusage fees. Trust income decreased 4.35% during 2003 from 2002 due tofluctuations in the investment market which caused the fair market value of theaccounts to remain stable coupled with the movement of certain trust customersto non-trust products within the organization that would better serve thecustomers’ objectives. The fair market value of trust assets has a directimpact on fees generated. Gains on loan sales increased $142 from 2002 to 2003as Sun sold a pool of SBA guaranteed loans during 2003. Other income increased$1,031 or 129.85%, from  2002 to 2003 asa result of increased miscellaneous income, debit  card transaction fees, non-yield related loan fees and rentalincome from operating leases.

 

The following is a summary of changes in non-interest income for theyears ended December 31:

 
| **(In Thousands)**                   |   | **2003**   |       | **% Change** |       | **2002** |   | **% Change** |   | **2001** |   |
|--------------------------------------|--------|------------|------------|--------------|------------|----------|--------|--------------|--------|----------|--------|
|                                 |   |       |       |         | ** ** |     |   |         |   |     |   |
| Service charges on deposit  accounts |   | **$**      | **4,094**  | ** **   | **34.63**  | **%**    | $      | 3,041        |   | 59.80    | %      | $ | 1,903 |   |
| Trust income                         |   | **726**    | ** ** | **(4.35**    | **)**      | 759      |   | 1.88         |   | 745      |   |
| Net securities gains                 |   | **3,194**  | ** ** | **418.51**   | ** ** | 616      |   | (27.01       | )      | 844      |   |
| Income from investment sales         |   | **377**    | ** ** | **(7.14**    | **)**      | 406      |   | 31.39        |   | 309      |   |
| Bank-owned life insurance            |   | **1,271**  | ** ** | **76.53**    | ** ** | 720      |   | 100.00       |   | —   |   |
| Insurance subsidiary                 |   | **1,257**  | ** ** | **1,532.47** | ** ** | 77       |   | (57.92       | )      | 183      |   |
| Net gain on sale of loans            |   | 3**97**    | ** ** | **55.69**    | ** ** | 255      |   | 96.15        |   | 130      |   |
| Leasing fees                         |   | **1,089**  | ** ** | **N/A**      | ** ** | —   |   | 0.00         |   | —   |   |
| Other income                         |   | **1,825**  | ** ** | **129.85**   | ** ** | 794      |   | 58.17        |   | 502      |   |
| Gain on sale of branches             |   | **—** | ** ** | **N/A**      | ** ** | —   |   | (100.00      | )      | 4,892    |   |
| **Total  non-interest income**       |   | **$**      | **14,230** | ** **   | **113.41** | **%**    | $      | 6,668        |   | (29.87   | )%     | $ | 9,508 |   |

 

**Non-Interest Expenses**

 

Non-interest expenses increased $5,871 or 25.95 %, from 2002 to 2003compared to an increase of 12.83% from 2001 to 2002. Costs associated withoutsourcing operational processing of daily transactions and reports, certainsupport functions and the acquisitions of Bank Capital, Mid-Penn Insurance andSteelton Bancorp are the principal components of this increase from 2002 to2003. Salaries and employee benefits increased $1,269 or 10.75%, from 2002 to2003, primarily attributable to an increase in the number of employeesresulting from the acquisitions completed during 2003. Occupancy and furnitureand equipment expenses increased due to the acquisitions in addition toinfrastructure improvements. Other expenses increased $3,540 from 2002 to 2003due to costs associated with acquisitions in 2003, outsourcing operationalprocessing of daily transactions and reports, certain support functions,increases in consulting fees and general business expenses. Amortization ofintangibles increased $531 due to amortization of the intangibles acquired in2003, as well as the effect of the amortization associated with a core depositintangible in 2002 and 2003, which Sun recognized during the fourth quarter of2003. The amortization associated with this intangible is $193 per year withthe amortization for prior years and 2003 being expensed during 2003.

 

Changes in non-interest expense for the years ended December 31 arepresented below:

 
| **(In Thousands)**                    |   | **2003**   |       | **% Change** |       | **2002** |   | **% Change** |   | **2001** |   |
|---------------------------------------|--------|------------|------------|--------------|------------|----------|--------|--------------|--------|----------|--------|
|                                  |   |       |       |         | ** ** |     |   |         |   |     |   |
| Salaries and employee  benefits       |   | **$**      | **13,069** | ** **   | **10.75**  | **%**    | $      | 11,800       |   | 21.90    | %      | $ | 9,680 |   |
| Net occupancy expenses                |   | **1,358**  | ** ** | **25.39**    | ** ** | 1,083    |   | 8.84         |   | 995      |   |
| Furniture and equipment  expenses     |   | **2,219**  | ** ** | **23.97**    | ** ** | 1,790    |   | 2.58         |   | 1,745    |   |
| Pennsylvania shares tax               |   | **627**    | ** ** | **(21.63**   | **)**      | 800      |   | 14.45        |   | 699      |   |
| Amortization of intangibles           |   | **531**    | ** ** | **N/A**      | ** ** | —   |   | (100.00      | )      | 1,567    |   |
| Other expenses                        |   | **10,689** | ** ** | **49.52**    | ** ** | 7,149    |   | 33.30        |   | 5,363    |   |
| **Total****non-interest****expenses** |   | **$**      | **28,493** | ** **   | **25.95**  | **%**    | $      | 22,622       |   | 12.83    | %      | $ | 20,049 |   |

 

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**Contractual Obligations**

 

The following table presents certain contractual obligations regardinglease payments on branches and debt maturities.

 

*(In Thousands)*

 
| **December 31,2003**                                          |   | **Less Than 1 Year** |   | **1-3 Years** |   | **4-5 Years** |   | **Over 5 Years** |   | **Total** |   |
|---------------------------------------------------------------|--------|----------------------|--------|---------------|--------|---------------|--------|------------------|--------|-----------|--------|
|                                                          |   |                 |   |          |   |          |   |             |   |      |   |
| Long-term debt                                                |   | $                    | — |          | $      | 10,299        |   | $                | 29,600 |      | $      | 200,188 |   | $ | 240,087 |   |
| Subordinated debt                                             |   | 789                  |   | 1,578         |   | —        |   | 16,500           |   | 18,867    |   |
| Operating leases                                              |   | 167                  |   | 158           |   | —        |   | —           |   | 325       |   |
| Outsourcing of daily  processing and certain support services |   | 1,501                |   | 2,802         |   | 569           |   | —           |   | 4,872     |   |
| **Total**                                                     |   | $                    | 2,457  |          | $      | 14,837        |   | $                | 30,169 |      | $      | 216,688 |   | $ | 264,151 |   |

 

**Liquidity**

 

Management must ensure sufficient liquidity to meet current and futurebusiness needs, including customer cash withdrawals and loan fundings. Inaddition, management must maintain additional contingency liquidity sources tomeet unexpected needs.

 

Sun’s liquidity depends on its ability to acquire funds or convertassets to cash without material loss. Sun’s primary liquidity sources includeregular principal and interest payments on loans and securities, short-termsecurities, and normal deposit funding. Supplemental liquidity sources includelonger-term securities, lines of credit, other borrowing sources, andadditional sources for new deposits. Notably, management does not consider cashand due from banks amounts to be liquidity sources. Those amounts are typicallyneeded by banks for daily operations.

 

At December 31, 2003, Sun’s maximum borrowing capacity at the FHLB was$265,600 and $315,206 at December 31, 2002 with $263,165 and $220,000outstanding, respectively. Sun also maintains lines of credit with otherfinancial institutions of $23,000, which were not in use at December 31, 2003.

 

**Market Risk**

 

For Sun, market risk results predominantly from interest rate risk andequity price risk. Although Sun’s market risks may change in the future,management currently focuses its risk management efforts on those twocomponents.

 

**Interest Rate Risk (IRR)**

 

IRR represents potential current or future earnings and capitalvolatility due to interest rate changes. Interest rate fluctuations affect earningsby changing net interest income and other interest-sensitive income, as well ascertain expense levels. Interest rate changes affect capital by altering thebanks’ economic value of equity (EVE). EVE represents the net present value ofall asset, liability, and off-balance sheet cash flows. Interest ratefluctuations change the present values of those cash flows.

 

As financial intermediaries, banks cannot completely avoid IRR. However,excessive IRR can threaten earnings, capital, liquidity, and solvency. IRR hasmany components, including repricing risk, basis risk, yield curve risk, optionrisk, and price risk. Sun’s primary, but not sole, IRR source is balance sheetoptionality from residential mortgages and mortgage-backed securities. Thoseassets may prepay principal at changing speeds depending on interest ratelevels and other factors beyond management’s control. When prepayments occur,management must reinvest those cash flows at current market rates in loans orsecurities. Thus, future interest levels and paths may negatively or positivelyaffect Sun’s net interest income.

 

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Management seeks to minimize net interest income volatility by carefullymeasuring, monitoring, and controlling IRR. Management has implemented acomprehensive market risk management program to measure, monitor, and controlrisk. Market risk can result in fluctuating net interest income due to interestrate and other economic changes. Using simulation models, management canmeasure market risk by forecasting net interest income volatility under variousinterest rate scenarios. However, these models depend on many significantassumptions that may not accurately reflect future conditions.

 

**Rate Shock Forecast for next fiscal year at December31, 2003 and 2002:**

 

The following is a summary of the impact in Sun’s net interest income,based on simulation model results:

 

 
|                 |   | **Parallel rate shock in basis points (bp)** |       |
|----------------------|--------|----------------------------------------------|------------|
| **(In Thousands)**   |   | **-200bp**                                   |       | **-100bp** |   | **0bp** |   | **+100bp** |   | **+200bp** |   |
| December 2003        |   |                                         |       |   |   |   |   |   |   |   |   |
|                 |   |                                         |       |   |   |   |   |   |   |   |   |
| Net Interest income: |   | **$**                                        | **15,099** | ** ** | **$** | **19,695** | ** ** | **$** | **21,947** | ** ** | **$** | **22,520** | ** ** | **$** | **22,561** | ** ** |
| Change from flat:    |   | **(31.21**                                   | **)%**     | **(10.26** | **)%** | **0.00** | **%** | **2.61** | **%** | **2.80** | **%** |
|                 |   |                                         |       |   |   |   |   |   |   |   |   |
| December 2002        |   |                                         |       |   |   |   |   |   |   |   |   |
|                 |   |                                         |       |   |   |   |   |   |   |   |   |
| Net Interest income: |   | $                                            | 21,632     |   | $ | 22,837 |   | $ | 25,738 |   | $ | 27,118 |   | $ | 28,588 |   |
| Change from flat:    |   | (15.95                                       | )%         | (7.39 | )% | 0.00 | % | 5.36 | % | 11.07 | % |

 

**Major rate shock forecast assumptions:**

 

• Floors were setat 0% to eliminate potential negative interest rates.

 

• Investmentanalytics from a third party.

 

• Loanmaturities/repricing are derived from the individual loan characteristics andindustry standard prepayment tables are applied.

 

• Todetermine a discount rate for loans, investments and CDs, a spread was appliedto the Treasury Curve or key rate to reflect current market yields.

 

• DemandDeposits, Savings, NOW, and Money Market Accounts are presented at carryingvalue less a core deposit premium. The premium for each interest rate scenariois calculated using asset/liability pricing tables provided by the Office ofThrift Supervision (OTS) from the U.S. Treasury. The OTS provides separate tables for each type of interest-bearingdeposit account with non-contractual maturities as well as demand deposits.

 

• Repricingrates for Savings, Clubs, and NOW Accounts are adjusted to reflect a 25 basispoint shift for every 100 basis point market shock. In addition, Money MarketAccount repricing rates shift 40 basis points for every 100 basis point shock. 

 

• Time deposits modeled fromcharacteristics of each time deposit.

 

• Debt modeling isderived from the contractual obligations.

 

To minimize interest income volatility, on June 30, 2003, managemententered into four pay-variable receive-fixed interest rate swaps of $100,000 intotal notional amount to hedge changes in the fair value of certain FHLBlong-term borrowings (other borrowed funds). The swaps also contain an embeddedoption to reverse the swap to pay-fixed receive-variable in the event that theFHLB long-term borrowings reprice and become variable rate. The exercise of theoption would effectively fix the rate Sun pays on the borrowings atapproximately the original coupon and would reduce the net interest incomevolatility caused in an increasing interest rate environment. Managementincludes all components of each derivatives, gain or loss in the assessment ofhedge effectiveness. Management recognizes the change in fair value of thehedge and associated borrowings through the income statement. For the yearended December 31,2003, there was a change of $5,156in value recognized in thehedge or associated borrowing. The following is a summary of Sun’s fair valueshedges:

 
| **December 31, 2003**                                  |   | **Notional Amount** |        | **Asset**        |       | **Liability** |   | **Weighted Average** |       |
|--------------------------------------------------------|--------|---------------------|-------------|------------------|------------|---------------|--------|----------------------|------------|
|                                                   |   |                |        | **Receive Rate** |       | **Pay Rate**  |   | **Life (Years)**     |       |
|                                                   |   |                |        |             |       |          |   |                 |       |   |   |   |   |
| **Fair Value  Hedges:**                                |   |                |        |             |       |          |   |                 |       |   |   |   |   |
| Receive fixed — pay  variable interest rate swaps |   | **$**               | **100,000** | ** **       | **—** | ** **    | **$**  | **5,156**            | ** ** | **2.65** | **%** | **1.13** | **%** | **6.3** | ** ** |
|                                                        |        |                     |             |                  |            |               |        |                      |            |  |  |  |  |  |  |

 

----

 

**Equity Securities Risk**

 

Sun’s equity securities consist of marketable equities and restrictedstock. Marketable equities consist entirely of common stock of bank andfinancial holding companies. Because Federal Home Loan Bank stock is redeemableat par, management carries it at cost and periodically evaluates the stock forimpairment. Possible impairment factors include potential dramatic changes tothe housing and residential mortgage industry or the related regulatoryenvironment. Management currently does not believe any factors exist to suggestpotential impairment.

 

Bank and financial holding company stocks are subject to generalindustry risks, including competition from non-bank entities, credit risk,interest rate risk, and other factors. Individual stocks could suffer pricedecreases due to circumstances at specific banks. In addition, Sun’s bank stockinvestments are concentrated in Pennsylvania entities, so these investmentscould decline in value if there were a downturn in the state’s economy.

 

*(In Thousands)*

 
| **December 31, 2003**                           |   | **Book Cost** |       | **Gross  Unrealized Gains** |       | **Gross  Unrealized Losses** |       | **Fair Value** |       |
|-------------------------------------------------|--------|---------------|------------|-----------------------------|------------|------------------------------|------------|----------------|------------|
|                                            |   |          |       |                        |       |                         |       |           |       |
| Banks and bank and  financial holding companies |   | **$**         | **330**    | ** **                  | **$**      | **—**                   |       | $              | —     | ** ** | **$** | **330** | ** ** |
| FHLB stock                                      |   | **14,457**    | ** ** | **—**                  | ** ** | **—**                   | ** ** | **14,457**     | ** ** |
| Non-bank companies                              |   | **—**    | ** ** | **—**                  | ** ** | **—**                   | ** ** | **—**     | ** ** |
| **Total**                                       |   | **$**         | **14,787** | ** **                  | **$**      | **—**                   |       | $              | —     | ** ** | **$** | **14,787** | ** ** |

 
| **December 31, 2002**                           |   | **Book Cost** | ** ** | **Gross  Unrealized Gains** | ** ** | **Gross  Unrealized Losses** | ** ** | **Fair Value** | ** ** |
|-------------------------------------------------|--------|---------------|------------|-----------------------------|------------|------------------------------|------------|----------------|------------|
|                                            |   |          |       |                        |       |                         |       |           |       |
| Banks and bank and  financial holding companies |   | $             | 3,024      |                        | $          | 136                          |       | $              | (293       | ) | $ | 2,867 |   |
| FHLB stock                                      |   | 12,012        |       | —                      |       | —                       |       | 12,012         |       |
| Non-bank companies                              |   | 87            |       | —                      |       | (22                          | )          | 65             |       |
| **Total**                                       |   | $             | 15,123     |                        | $          | 136                          |       | $              | (315       | ) | $ | 14,944 |   |

 

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**Capital Adequacy**

 

Sun and SunBank are subject to various regulatory capital requirementsadministered by the federal banking agencies. Failure to meet minimum capitalrequirements could prompt regulatory action that, if undertaken, mightmaterially affect Sun’s financial statements. Under regulatory capital adequacyguidelines, Sun and SunBank must meet specific capital requirements involvingquantitative measures of assets, liabilities, and certain off-balance sheetitems (calculated using regulatory accounting practices). All related factorsare subject to qualitative judgments by the regulators.

 

Sun is currently, and has been in the past, designated as awell-capitalized institution. Shareholders’ equity increased $2,065 to $79,182,at December 31, 2003, from $81,247 at December 31,2002. Changes in unrealizedgains or losses, net of taxes, on securities available for sale are reported asaccumulated other comprehensive income within shareholders’ equity. Sun hadunrealized gains, net of tax, of $29 at December 31,2003, and unrealized gains,net of tax, of $3,578 at December 31, 2002, which provided for the decline inshareholder equity. Sun paid cash dividends of $5,097 and $4,614 during 2003and 2002, respectively. Management is not aware of any events or regulatoryrestrictions that would have a material effect on Sun’s capital adequacy.

 

**Outlook**

 

During 2003, Sun continued to execute on its strategy of building fullcustomer relationships by providing trusted advice and solutions that includecomprehensive financial services such as insurance, real estate settlementservices, automobile and equipment leasing, retirement planning, wealthmanagement, investment management, as well as traditional banking products suchas loans and deposits.

 

Through its execution of this strategy, Sun increased loans by 12%,total deposits increased by 5% with core deposits increasing by 6%, and feeincome increased by 76%. Our new partners in Mid-Penn Insurance Associates andBank Capital Services (our leasing affiliate) are contributing to the increasedfee income. In addition, our courtesy overdraft honor program, enhanced cashmanagement programs and retail investment sales are contributing to ourcontinued non-interest income growth. As we complete the acquisition of SentryTrust Company, we expect that our fee income growth will be sustained in 2004.

 

The composition of the loan portfolio continues to evolve as Sun nowsells virtually all residential mortgages in the secondary market and isfocused on commercial loan growth. As expected, the percentage of residentialmortgages in the loan portfolio continues to decline while the percentage ofcommercial loans is increasing. This trend will continue in 2004.

 

In addition, Sun remains focused on growing low-cost, stable coredeposits, i.e., non-maturing deposits.

 

In 2003, we completed our acquisition of Steelton Bancorp, Inc., whichmarked our entry into the Capital Region (Harrisburg area). This acquisitionhas been a positive for Sun and has presented significant commercialopportunities relative to loans, leasing, insurance, etc. This geographicdiversification has been positive as we entered a market that has proven to bemore recession-proof, is experiencing population growth and has strongdemographics. The region has also been disrupted by large bank mergers. In2004, we will add a branch in this region as we look to capitalize on theopportunities that exist in the market.

 

We also plan to add a branch in the Wilkes-Barre market, whichrepresents a tremendous opportunity. Luzerne County is a $4 billion depositmarket, and Sun currently has less than 2% market share. The additional branchwill increase our exposure in the market and provide an additional outlet forgathering deposits.

 

We remain confident that our relationship-focused approach to the marketwill differentiate us from our competitors, create high levels of customersatisfaction and loyalty, and lead to sustained success for the Sunorganization.

 

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**Shareholder Information**

 

**Common Stock Market Prices and Dividends PerShare**

 

The common stock of Sun Bancorp, Inc. is traded publicly on the NASDAQnational market system under the symbol SUBI. The high and low bid informationdoes not include retail mark-ups or mark-downs or any commission to thebroker-dealer.

 
|               |   | **2003**             |   | **2002**            |   |
|--------------------|--------|----------------------|--------|---------------------|--------|
|               |   | **Bid  Information** |   | **Cash  Dividends** |   | **Bid Information** |   | **Cash Dividends** |   |
| **Quarter  Ended** |   | **High**             |   | **Low**             |   | **Paid** |   | **High** |   | **Low** |   | **Paid** |   |
|               |   |                 |   |                |   |   |   |   |   |   |   |   |   |
| March 31           |   | $                    | 20.50  |                | $      | 18.02 |   | $ | .1650 |   | $ | 18.05 |   | $ | 16.28 |   | $ | .150 |   |
|               |   |                 |   |                |   |   |   |   |   |   |   |   |   |
| June 30            |   | 22.50                |   | 19.46               |   | .1815 |   | 24.49 |   | 17.65 |   | .165 |   |
|               |   |                 |   |                |   |   |   |   |   |   |   |   |   |
| September 30       |   | 22.30                |   | 17.75               |   | .1815 |   | 23.98 |   | 21.85 |   | .165 |   |
|               |   |                 |   |                |   |   |   |   |   |   |   |   |   |
| December 31        |   | 21.29                |   | 18.36               |   | .1815 |   | 22.44 |   | 17.84 |   | .165 |   |
|                    |        |                      |        |                     |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Market Makers Include:

 

Janney Montgomery Scott, Inc.

Wolfe Plaza

309 N. Fifth Street, Suite C

Sunbury, PA 17801

1-800-831-2741

 

F.J. Morrissey & Co., Inc.

1700 Market Street, Suite 1420

Philadelphia, PA 19103

1-215-563-8500

 

Ferris, Baker, Watts

3100 Market Street

Camp Hill, PA 17011

1-717-737-5800

 

First Tennessee Securities Corp.

845 Crossover Lane

Memphis, TN 38117

1-800-456-5460

 

Legg Mason

The Stadium Office Park, Suite 201

330 Montage Mountain Road

Scranton, PA 18507

1-800-346-4346

 

Sandler O’Neill & Partners, LP

919 Third Avenue

Sixth Floor

New York, NY 10022

1-800-635-6860

 

Wachovia Securities

P.O. Box 1357

Richmond, VA 23218

1-800-627-8625

 

Keefe, Bruyette & Woods

787 7th Avenue, 8th Floor

New York, NY 10019

1-212-887-8950

 

Ryan, Beck & Co.

Millennium 1

20 Ash Street

Conshohocken, PA 19428

1-800-342-2325

 

Ferris, Baker, Watts

100 Light Street

Baltimore, MD 21202

1-410-659-4616

 

Herzog, Heine & Geduld, Inc.

2 Penn Center, Suite 1708

Philadelphia, PA 19102

1-215-972-0813

 

Boenning & Scattergood, Inc.

Four Tower Bridge

200 Barr Harbor Drive, Suite 300

West Conshohocken, PA 19428

1-800-883-8383

 

Spear, Leads & Kellog

1900 Market Street

Philadelphia, PA 19103

1-212-422-2405

 

Knight Securities

525 Washington Boulevard

Newport Tower

Jersey City, NJ 07310

1-800-544-7508

 

Goldman, Sachs & Company

10 Exchange Place

11th Floor

Jersey City, NJ 07302

1-212-902-1000

 

**Availability of Form 10-K**

 

Upon written request of any shareholder, a copy of the Corporation’sAnnual Report on Form 10-K for its fiscal year ended December 31, 2003,including the financial statements, and schedules thereto required to be filedwith the Securities and Exchange Commission pursuant to Rule 13a-l under theSecurities Exchange Act of 1934, as amended, may be obtained, without charge,from Shareholder Services, 155 North 15th Street, Lewisburg, PA 17837.

 

**Information on Dividend Reinvestment Plan**

 

A voluntary Dividend Reinvestment Plan is available to Sun shareholders.Participants may elect full dividend reinvestment and/or optional cash paymentsto purchase additional shares. Information about the plan may be obtained bycontacting Registrar and Transfer Company, 10 Commerce Drive, Cranford, NJ07016-3572, Attn: Dividend Reinvestment Department,1-800-368-5948.

 

The Annual Report and other Company reports are also filed electronicallythrough the Electronic Data Gathering Analysis and Retrieval System (EDGAR)which performs automated collection, validation, indexing, acceptance, andforwarding of submissions to the Securities and Exchange Commission (SEC) andis accessible by the public, using the Internet address *http://www.sec.gov/edgarhp*

 

The Annual Report, other Company reports, and news releases areavailable on Sun’s website at *http://www.sunbankpa.com*

 

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