**FORM 10-K**

 

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

 

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

 

**For the fiscal year ended December 31,2007**

 

**OR**

 

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

 

**For the transition period from                                      to**

 

**Commission file number 0-17077**

 

**PENNSWOODS BANCORP, INC.**

(exact name ofregistrant as specified in its charter)

 

| **Pennsylvania**                           | ** ** | **23-2226454**       |
|--------------------------------------------|------------|----------------------|
| (State or other  jurisdiction              |       | (I.R.S. Employer     |
| of incorporation  or organization)         |       | Identification  No.) |
|                                       |       |                 |
| **300  Market Street, P.O. Box 967**  |
| **Williamsport,  Pennsylvania 17703-0967** |
| (Address of  principal executive offices)  |

 

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

 

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

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

 

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

 

**None**

(Title of Class)

 

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.o Yes  xNo

 

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act. ̈ Yes  xNo

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports) and (2) has been subject to such filing requirements for thepast 90 days.     Yes    x    No   o

 

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

 

Indicateby check mark whether the registrant is a large accelerated filer, acceleratedfiler, a non-accelerated filer or a smaller reporting company.  See definition of “large accelerated filer,”accelerated filer” and “smaller reporting company” in Rule 12b-2 of theExchange Act.

Largeaccelerated filer   ̈   Acceleratedfiler  x   Non-acceleratedfiler  ̈   Smallerreporting company  ̈

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). ̈ Yes  x No

 

State the aggregatemarket value of the voting stock held by non-affiliates of the registrant **$133,109,369 at June 30, 2007.**

 

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

 
| **Class**                         | ** ** | **Outstanding at March 4, 2008** | ** ** |
|-----------------------------------|------------|------------------------------------------------------|------------|
| **Common Stock, $8.33 Par Value** | ** ** | **3,876,114  Shares**                                | ** ** |

 

 

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** **

**DOCUMENTSINCORPORATED BY REFERENCE**

** **

Portions of theregistrant’s definitive proxy statement prepared in connection with its annualmeeting of shareholders to be held on April 30, 2008 are incorporated byreference in Part III hereof.

 

**INDEX**

 
| **PART I**   |
|-------------------|
| **ITEM**          |   |   |
| Item 1.           | Business | 3 |
| Item 1A.          | Risk Factors | 9 |
| Item  1B.         | Unresolved Staff Comments | 11 |
| Item 2.           | Properties | 11 |
| Item  3.          | Legal Proceedings | 12 |
| Item 4.           | Submission of  Matters to a Vote of Security Holders | 12 |
|              |   |   |
| **PART II**  |
| ** **        |
| Item 5.           | Market for the Registrant’s Common Stock,  Related Stockholder Matters, and Issuer Purchase of Equity Securities | 12 |
| Item 6.           | Selected Financial  Data | 15 |
| Item 7.           | Management’s Discussion and Analysis of  Consolidated Financial Condition and Results of Operations | 16 |
| Item 7A.          | Quantitative  and Qualitative Disclosure About Market Risk | 36 |
| Item 8.           | Financial  Statements and Supplementary Data | 37 |
| Item 9.           | Changes in and Disagreements with  Accountants on Accounting and Financial Disclosure | 67 |
| Item 9A.          | Controls and Procedures | 67 |
| Item 9B.          | Other Information | 70 |
|              |   |
| **PART III** |
| ** **        |
| **Item 10.**      | **Directors and  Executive Officers of the Registrant** | **70** |
| Item 11.          | Executive Compensation | 70 |
| Item 12.          | Security Ownership and Certain Beneficial  Owners and Management and Related Stockholder Matters | 70 |
| Item 13.          | Certain Relationships and Related  Transactions | 70 |
| Item 14.          | Principal Accountant Fees and Services | 71 |
|              |   |
|              | **PART IV** |
|              | ** ** |
| Item 15.          | Exhibits and Financial Statement Schedules | 71 |
| Index to Exhibits | 72 |
| Signatures        | 73 |

 

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**PART I**

** **

**ITEM1   BUSINESS**

 

##### **A.  GeneralDevelopment of Business and History**

##### ** **

##### **On January 7, 1983, Penns Woods Bancorp, Inc.(the “Company”) was incorporated under the laws of the Commonwealth ofPennsylvania as a bank holding company. The Jersey Shore State Bank (the “Bank”) became a wholly ownedsubsidiary of the Company, and each outstanding share of Bank common stock wasconverted into one share of Company common stock.  This transaction was approved by theshareholders of the Bank on April 11, 1983 and was officially effective onJuly 12, 1983.  The Company’s twoother wholly-owned subsidiaries are Woods Real Estate Development Company, Inc.and Woods Investment Company, Inc. The Company’s business has consisted primarily of managing andsupervising the Bank, and its principal source of income has been dividendspaid by the Bank and Woods Investment Company, Inc.**

##### ** **

The Bank is engaged incommercial and retail banking which includes the acceptance of time, savings,and demand deposits, the funding of commercial, consumer, and mortgage loans,and safe deposit services.  Utilizing athirteen branch office network, ATMs, internet, and telephone banking deliverychannels, the Bank delivers its products and services to the communities itresides in.

 

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

 

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

 

The Bank employed 191persons as of December 31, 2007 in either a full-time or part-timecapacity.  The Company does not have anyemployees.  The principal officers of theBank also serve as officers of the Company.

 

Woods Investment Company, Inc.,a Delaware holding company, maintains an investment portfolio that is managedfor total return and to fund dividend payments to the Company.

 

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

 

A copy of the Code ofEthics and Code of Conduct for the Corporation can be requested from BrianKnepp, Vice President of Finance, at 300 Market Street, Williamsport, PA 17701.  A link with access to the Corporation’s SEC10-K filings, annual reports, and quarterly filings can be found at www.jssb.com.

 

##### **B.  Regulationand Supervision**

##### ** **

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

 

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Bank’s deposits.  The Bank is also regulated and examined bythe Pennsylvania Department of Banking (the “Department”).

 

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

 

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

 

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

 

Bank holding companiesare required to comply with the FRB’s risk-based capital guidelines.  The risk-based capital rules aredesigned to make regulatory capital requirements more sensitive to differencesin risk profiles among banks and bank holding companies and to minimizedisincentives for holding liquid assets. Currently, the required minimum ratio of total capital to risk-weightedassets (including certain off-balance sheet activities, such as standby lettersof credit) is 8%.  At least half of thetotal capital is required to be Tier 1 capital, consisting principally ofcommon shareholders’ equity, less certain intangible assets.  The remainder (“Tier 2 capital”) may consistof certain preferred stock, a limited amount of subordinated debt, certainhybrid capital instruments and other debt securities, 45% of net unrealizedgains on marketable equity securities, and a limited amount of the general loanloss allowance.  The risk-based capitalguidelines are required to take adequate account of interest rate risk,concentration of credit risk, and risks of nontraditional activities.

 

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

 

**C.  Regulation of the Bank**

 

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

 

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

 

**Deposit Insurance** – Historically, there were two depositinsurance funds administered by the FDIC - the Savings Association InsuranceFund (“SAIF”) and the Bank Insurance Fund (“BIF”).  The Bank’s deposits were insured under theBIF; however, the deposits assumed by the Bank in connection with the merger ofLock Haven Savings Bank were treated and assessed as SAIF-insureddeposits.  The FDIC has implemented arisk-related premium schedule for all insured depository institutions thatresults in the assessment of premiums based on capital and supervisorymeasure.  Under the risk-related premiumschedule, the FDIC assigns, on a semiannual basis, each institution to one ofthree capital groups (well-capitalized, adequately capitalized orundercapitalized) and further assigns such institution to one of threesubgroups within a capital group. The institution’s subgroup assignment isbased upon the FDIC’s judgment of the institution’s strength in light ofsupervisory evaluations, including examination reports, statistical analyses,and other information relevant to gauging the risk posed by theinstitution.  Only institutions with atotal capital to risk-adjusted assets ratio of 10.0% or greater, a Tier 1capital to risk-adjusted assets ratio of 6.0% or greater and a Tier 1 leverageratio of 5.0% or greater, are assigned to the well-capitalized group.   As of December 31, 2007, the Bank’sratios were well above required minimum ratios.

 

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

 

InFebruary 2006, deposit insurance modernization legislation wasenacted.  The legislation merged the BIFand SAIF into a single Deposit Insurance Fund, increased deposit insurancecoverage for IRAs to $250,000, provided for the future increase of deposit insuranceon all accounts by authorizing the FDIC to index the coverage to the rate ofinflation, authorized the FDIC to set the reserve ratio of the combined DepositInsurance Fund at a level between 1.15% and 1.50%, and permited the FDIC toestablish assessments to be paid by insured banks to maintain the minimumratios.

 

##### **Other Legislation**

TheFair and Accurate Credit Transactions Act (“FACT”) was signed into law on December 4,2003.  This law extends the previouslyexisting Fair Credit Reporting Act.  Newprovisions added by FACT address the growing problem of identity theft.  Consumers will be able to initiate a fraudalert when they are victims of identity theft, and credit reporting agencieswill have additional duties.  Consumerswill also be entitled to obtain free credit reports through the credit beaures,and will be granted certain additional privacy rights.

 

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TheSarbanes-Oxley Act of 2002 was enacted to enhance penalties for accounting andauditing improprieties at publicly traded companies and to protect investors byimproving the accuracy and reliability of corporate disclosures under thefederal securities laws.  TheSarbanes-Oxley Act generally applies to all companies, including the Company,that file or are required to file periodic reports with the Securities andExchange Commission under the Securities Exchange Act of 1934, or the ExchangeAct.  The legislation includesprovisions, among other things, governing the services that can be provided bya public company’s independent auditors and the procedures for approving suchservices, requiring the chief executive officer and principal accountingofficer to certify certain matters relating to the company’s periodic filingsunder the Exchange Act, requiring expedited filings of reports by insiders oftheir securities transactions and containing other provisions relating toinsider conflicts of interest, increasing disclosure requirements relating tocritical financial accounting policies and their application, increasingpenalties for securities law violations, and creating a new public accountingoversight board, a regulatory body subject to SEC jurisdiction with broadpowers to set auditing, quality control, and ethics standards for accountingfirms.  In response to the legislation,the national securities exchanges and NASDAQ have adopted new rules relatingto certain matters, including the independence of members of a company’s auditcommittee as a condition to listing or continued listing.

 

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

 

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

 

##### **Environmental Laws**

Environmentally relatedhazards have become a source of high risk and potential liability for financialinstitutions relating to their loans. Environmentally contaminated properties owned by an institution’sborrowers may result in a drastic reduction in the value of the collateralsecuring the institution’s loans to such borrowers, high environmental clean upcosts to the borrower affecting its ability to repay the loans, thesubordination of any lien in favor of the institution to a state or federallien securing clean up costs, and liability to the institution for clean upcosts if it forecloses on the contaminated property or becomes involved in themanagement of the borrower.  The Companyis not aware of any borrower who is currently subject to any environmentalinvestigation or clean up proceeding which is likely to have a material adverseeffect on the financial condition or results of operations of the Company.

 

##### **Effect of Government Monetary Policies**

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

 

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##### **DESCRIPTION OF BANK**

##### ** **

**History and Business**

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

 

As of December 31,2007, the Bank had total assets of $615,285,000; total shareholders’ equity of$56,971,000 and total deposits of $389,659,000. The Bank’s deposits are insured by the Federal Deposit InsuranceCorporation for the maximum amount provided under current law.

 

The Bank engages inbusiness as a commercial bank, doing business at several locations in Lycoming,Clinton, and Centre Counties, Pennsylvania. The Bank offers insurance, securities brokerage services, annuity andmutual fund investment products, and financial planning through its whollyowned subsidiary, The M Group, Inc. D/B/A The Comprehensive FinancialGroup.

 

Servicesoffered by the Bank include accepting time, demand and savings depositsincluding Super NOW accounts, statement savings accounts, money marketaccounts, fixed rate certificates of deposit, and club accounts.  Its services also include making secured andunsecured business and consumer loans that include financing commercialtransactions as well as construction and residential mortgage loans andrevolving credit loans with overdraft protection.

 

TheBank’s loan portfolio mix can be classified into four principalcategories.  These are real estate,agricultural, commercial, and consumer. Real estate loans can be further segmented into construction and landdevelopment, farmland, one-to-four family residential, multi-family, andcommercial or industrial.  Qualifiedborrowers are defined by policy and our underwriting standards.   Owner provided equity requirements rangefrom 20% to 30% with a first lien status required.  Terms are generally restricted to between 10and 20 years with the exception of construction and land development, which arelimited to one to five years.  Realestate appraisals, property construction verifications, and site visitationscomply with policy and industry regulatory standards.

 

Prospective residentialmortgage customer’s repayment ability is determined from information containedin the application and recent income tax returns.   Emphasis is on credit, employment, income,and residency verification.  Broad hazardinsurance is always required and flood insurance where applicable.  In the case of construction mortgages,builders risk insurance is requested.

 

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

 

Commercial loans are made for the acquisition and improvement of realestate, purchase of equipment, and for working capital purposes on a seasonalor revolving basis.  General purposeworking capital loans are also available with repayment expected within oneyear.  Equipment loans are generallyamortized over three to seven years, with an owner equity contribution requiredof at least 20% of the purchase price. Insurance coverage with the Bank as loss payee is required, especiallyin the case where the equipment is rolling stock. It is also a general policyto collateralize non-real estate loans with the asset purchased and, dependantupon loan terms, junior liens are filed on other available assets.  Financial information required on allcommercial mortgages includes the most 

 

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current three years balance sheets and income statements andprojections on income to be developed through the project.  In the case of corporations and partnerships,the principals are often asked to indebt themselves personally as well.

 

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

 

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

 

Consumer loan productsinclude second mortgages, automobile financing, small loan requests, overdraftcheck lines, and PHEAA referral loans. Our policy includes standards used in the industry on debt serviceratios and terms are consistent with prudent underwriting standards and the useof proceeds.   Verifications are made ofemployment and residency, along with credit history.  Second mortgages are confined to equityborrowing and home improvements.  Termsare generally ten years or less and rates are fixed.  Loan to collateral value criteria is 80% orless and verifications are made to determine values.   Automobile financing is generally restrictedto five years and done on a direct basis. The Bank, as a practice, does not floor plan and therefore does notdiscount dealer paper.  Small loanrequests are to accommodate personal needs such as the purchase of smallappliances or for the payment of taxes. Overdraft check lines are limited to $5,000 or less.

 

The Bank’s investmentportfolio is analyzed and priced on a      monthlybasis. Investments are made in U.S. Treasuries, U.S. Agency issues, bankqualified municipal bonds, corporate bonds, and corporate stocks which consistof Pennsylvania bank stocks.  Bonds withBAA or better ratings are used, unless a local issue is purchased that has alesser or no rating.  Factors taken intoconsideration when investments are purchased include liquidity, the Company’stax position, tax equivalent yield, third party investment ratings, and thepolicies of the Asset/Liability Committee.

 

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

 

The Bank has a relativelystable deposit base and no material amount of deposits is obtained from asingle depositor or group of depositors, excluding public entities that accountfor approximately 10% of total deposits. Although the Bank has regular opportunities to bid on pools of funds of$100,000 or more in the hands of municipalities, hospitals, and others, it doesnot rely on these monies to fund loans or intermediate or longer-terminvestments.

 

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

 

**Supervision and Regulation**

The earnings of the Bankare affected by the policies of regulatory authorities including the FDIC andthe FRB. An important function of the FRB is to regulate the money supply andinterest rates.  Among the instrumentsused to implement these objectives are open market operations in U.S.Government Securities, changes in reserve requirements against member bankdeposits, and limitations on interest 

 

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rates that member banksmay pay on time and savings deposits. These instruments are used in varying combinations to influence overallgrowth and distribution of bank loans, investments on deposits, and their usemay also affect interest rates charged on loans or paid for deposits.

 

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

 

**ITEM 1A  RISK FACTORS**

 

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

 

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

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

 

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

Deteriorationin local, regional, national or global economic conditions could cause us toexperience a reduction in deposits and new loans, an increase in the number ofborrowers who default on their loans and a reduction in the value of thecollateral securing their loans, all of which could adversely affect ourperformance and financial condition. Unlike larger banks that are moregeographically diversified, we provide banking and financial services locally.  Therefore, we are particularly vulnerable toadverse local economic conditions.

 

**Ourfinancial condition and results of operations would be adversely affected ifour allowance for loan losses is not sufficient to absorb actual losses or ifwe are required to increase our allowance.**

Despiteour underwriting criteria, we may experience loan delinquencies andlosses.  In order to absorb lossesassociated with nonperforming loans, we maintain an allowance for loan lossesbased on, among other things, historical experience, an evaluation of economicconditions, and regular reviews of delinquencies and loan portfolioquality.  Determination of the allowanceinherently involves a high degree of subjectivity and requires us to make significantestimates of current credit risks and future trends, all of which may undergomaterial changes.  At any time there arelikely to be loans in our portfolio that will result in losses but that havenot been identified as nonperforming or potential problem credits. We cannot besure that we will be able to identify deteriorating credits before they becomenonperforming assets or that we will be able to limit losses on those loansthat are identified. We may be required to increase our allowance for loanlosses for any of several reasons.  Federalregulators, in reviewing our loan portfolio as part of a regulatoryexamination, may request that we increase our allowance for loan losses.  Changes in economic conditions affectingborrowers, new information regarding existing loans, identification ofadditional problem loans and other factors, both within and outside of ourcontrol, may require an increase in our allowance.  In addition, if 

 

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charge-offsin future periods exceed our allowance for loan losses, we will need additionalincreases in our allowance for loan losses. Any increases in our allowance for loan losses will result in a decreasein our net income and, possibly, our capital, and may materially affect ourresults of operations in the period in which the allowance is increased.

 

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

Inaddition to considering the financial strength and cash flow characteristics ofa borrower, we often secure our loans with real estate collateral.  Real estate values and the real estate marketare generally affected by, among other things, changes in local, regional ornational economic conditions, fluctuations in interest rates and the availabilityof loans to potential purchasers, changes in tax laws and other governmentalstatutes, regulations and policies, and acts of nature.  The real estate collateral provides analternate source of repayment in the event of default by the borrower.  If real estate prices in our markets decline,the value of the real estate collateral securing our loans could bereduced.  If we are required to liquidatereal estate collateral securing loans during a period of reduced real estatevalues to satisfy the debt, our earnings and capital could be adverselyaffected.

 

**Competitionmay decrease our growth or profits.**

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

 

Inaddition, some of the financial services organizations with which we competeare not subject to the same degree of regulation as is imposed on federallyinsured financial institutions.  As aresult, those nonbank competitors may be able to access funding and providevarious services more easily or at less cost than we can, adversely affectingour ability to compete effectively.

 

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

Thebanking industry is heavily regulated. Banking regulations are primarilyintended to protect the federal deposit insurance funds and depositors, notshareholders. Changes in the laws, regulations, and regulatory practicesaffecting the banking industry may increase our costs of doing business orotherwise adversely affect us and create competitive advantages for others.Regulations affecting banks and financial services companies undergo continuouschange, and we cannot predict the ultimate effect of these changes, which couldhave a material adverse effect on our profitability or financial condition.

 

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

Weare and will continue to be dependent upon the services of our executivemanagement team. In addition, we will continue to depend on our ability toretain and recruit key commercial loan officers. The unexpected loss ofservices of any key management personnel or commercial loan officers could havean adverse effect on our business and financial condition because of theirskills, knowledge of our market, years of industry experience, and thedifficulty of promptly finding qualified replacement personnel.

 

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

Inthe course of our business, we may foreclose on and take title to propertiessecuring our loans.  If hazardoussubstances were discovered on any of these properties, we could be liable togovernmental entities or third parties for the costs of remediation of thehazard, as well as for personal injury and 

 

10

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propertydamage.  Many environmental laws canimpose liability regardless of whether we knew of, or were responsible for, thecontamination.  In addition, if wearrange for the disposal of hazardous or toxic substances at another site, wemay be liable for the costs of cleaning up and removing those substances fromthe site even if we neither own nor operate the disposal site.  Environmental laws may require us to incursubstantial expenses and may materially limit use of properties we acquirethrough foreclosure, reduce their value or limit our ability to sell them inthe event of a default on the loans they secure.  In addition, future laws or more stringentinterpretations or enforcement policies with respect to existing laws mayincrease our exposure to environmental liability.

 

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

Themarket for financial services, including banking services and consumer financeservices, is increasingly affected by advances in technology, includingdevelopments in telecommunications, data processing, computers, automation,Internet-based banking, and telebanking. Our ability to compete successfully inour markets may depend on the extent to which we are able to exploit suchtechnological changes. However, we can provide no assurance that we will beable to properly or timely anticipate or implement such technologies or properlytrain our staff to use such technologies. Any failure to adapt to new technologies could adversely affect ourbusiness, financial condition or operating results.

 

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

Ourcommon stock is not a bank deposit and, therefore, is not insured against lossby the Federal Deposit Insurance Corporation, commonly referred to as the FDIC,any other deposit insurance fund or by any other public or private entity.  Investment in our common stock is subject tothe same market forces that affect the price of common stock in any company.

 

**ITEM 1B   UNRESOLVED STAFF COMMENTS**

 

None.

 

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

 

The Company owns andleases its properties.  Listed herewithare the locations of properties owned or leased as of December 31, 2007,in which the banking offices are located; all properties are in good conditionand adequate for the Bank’s purposes:

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

 

11

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| Montgomery                                                        |   | 9094 Rt. 405 Highway  Montgomery, Pennsylvania 17752                             |   | Under Lease      |
|-------------------------------------------------------------------|--------|----------------------------------------------------------------------------------|--------|------------------|
|                                                              |   |                                                                             |   |             |
| Lock Haven                                                        |   | 4 West Main Street  Lock Haven, Pennsylvania 17745                               |   | Owned            |
|                                                              |   |                                                                             |   |             |
| Mill Hall                                                         |   | (Inside Wal-Mart), 173  Hogan Boulevard  Mill Hall, Pennsylvania 17751           |   | Under Lease      |
|                                                              |   |                                                                             |   |             |
| Spring Mills                                                      |   | 3635 Penns Valley Road,  P.O. Box 66  Spring Mills, Pennsylvania 16875      |   | Owned            |
|                                                              |   |                                                                             |   |             |
| Centre Hall                                                       |   | 2842 Earlystown Road  Centre Hall, Pennsylvania 16828                            |   | Land Under Lease |
|                                                              |   |                                                                             |   |             |
| Zion                                                              |   | 100 Cobblestone Road  Bellefonte, Pennsylvania 16823                             |   | Under Lease      |
|                                                              |   |                                                                             |   |             |
| State College                                                     |   | (Inside Wal-Mart), 1665  North Atherton Place  State College, Pennsylvania 16803 |   | Under Lease      |
|                                                              |   |                                                                             |   |             |
| State College                                                     |   | 2050 North Atherton  Street  State College, Pennsylvania 16803                   |   | Land Under Lease |
|                                                              |   |                                                                             |   |             |
| Montoursville                                                     |   | 820 Broad Street  Montoursville, Pennsylvania 17754                              |   | Under Lease      |
|                                                              |   |                                                                             |   |             |
| The M Group, Inc.  D/B/A The  Comprehensive  Financial Group |   | 705 Washington  Boulevard  Williamsport, Pennsylvania 17701                      |   | Under Lease      |

 

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

 

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

 

**ITEM  4    SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

 

No matters were submittedto a vote of security holders during the fourth quarter of 2007.

 

##### **PART II**

 

**ITEM  5**    **MARKET FOR THE REGISTRANT’SCOMMON STOCK, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITYSECURITIES**

 

The Common Stock islisted on the NASDAQ Global Select Market under the symbol “PWOD”.  The following table sets forth (1) thequarterly high and low close prices for a share of the Company’s

 

12

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Common Stock during theperiods indicated, and (2) quarterly dividends on a share of the CommonStock with respect to each quarter since January 1, 2005.  The following quotations represent pricesbetween buyers and sellers and do not include retail markup, markdown orcommission.  They may not necessarilyrepresent actual transactions.

 
| ** **     | ** ** | **HIGH** | ** ** | **LOW** | ** ** | **Dividends  Declared** | ** ** |
|----------------|------------|----------|------------|---------|------------|-------------------------|------------|
| **2005**       |       |     |       |    |       |                    |       |
| First quarter  |       | $        | 41.67      |    | $          | 38.58                   |       | $ | 0.38 |   |
| Second quarter |       | 41.58    |       | 37.08   |       | 0.38                    |       |
| Third quarter  |       | 38.30    |       | 36.76   |       | 0.39                    |       |
| Fourth quarter |       | 39.76    |       | 36.67   |       | 0.41                    |       |
| **2006**       |       |     |       |    |       |                    |       |
| First quarter  |       | $        | 38.75      |    | $          | 37.75                   |       | $ | 0.42 |   |
| Second quarter |       | 39.50    |       | 36.50   |       | 0.43                    |       |
| Third quarter  |       | 38.48    |       | 37.02   |       | 0.44                    |       |
| Fourth quarter |       | 38.59    |       | 36.20   |       | 0.44                    |       |
| **2007**       |       |     |       |    |       |                    |       |
| First quarter  |       | $        | 37.75      |    | $          | 35.00                   |       | $ | 0.44 |   |
| Second quarter |       | 35.00    |       | 33.86   |       | 0.44                    |       |
| Third quarter  |       | 35.00    |       | 30.80   |       | 0.45                    |       |
| Fourth quarter |       | 32.50    |       | 30.33   |       | 0.46                    |       |

 

The Bank has paid cashdividends since 1941.  The Company haspaid dividends since the effective date of its formation as a bank holdingcompany.  It is the present intention ofthe Registrant’s Board of Directors to continue the dividend payment policy;however, further dividends must necessarily depend upon earnings, financialcondition, appropriate legal restrictions, and other factors relevant at thetime the Board of Directors of the Registrant considers dividend policy.  Cash available for dividend distributions toshareholders of the Registrant primarily comes from dividends paid by the Bankto the Company.  Therefore, therestrictions on the Bank’s dividend payments are directly applicable to theCompany.  See also the informationappearing in Note 18 to Notes to Consolidated Financial Statements included inthe Annual Report on Form 10-K for additional information related todividend restrictions.

 

Under the PennsylvaniaBusiness Corporation Law of 1988 a corporation may not pay a dividend, if aftergiving effect thereto, the corporation would be unable to pay its debts as theybecome due in the usual course of business and after giving effect thereto thetotal assets of the corporation would be less than the sum of its totalliabilities plus the amount that would be needed, if the corporation were to bedissolved at the time of the distribution, to satisfy the preferential rightsupon dissolution of the shareholders whose preferential rights are superior tothose receiving the dividend.

 

As of March 4, 2008, the Company had approximately 1,273shareholders of record.

 

Followingis a schedule of the shares of the Company’s common stock purchased by theCompany during the fourth quarter of 2007.

 

13

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| **Period**                               | ** ** | **Total********Number of********Shares (or********Units)  Purchased** | ** ** | **Average********Price Paid********per Share********(or Units)  Purchased** | ** ** | **Total Number of********Shares (or Units)********Purchased as Part of********Publicly Announced********Plans or Programs** | ** ** | **Maximum Number (or********Approximate Dollar Value)********of Shares (or Units) that********May Yet Be Purchased  Under the Plans or Programs** | ** ** |
|------------------------------------------|------------|---------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|                                     |       |                                                                            |       |                                                                                       |       |                                                                                                                                                                          |       |                                                                                                                                                                                                                         |       |
| Month#1(October  1- October 31,  2007)   |       | —                                                                          |       | —                                                                                     |       | —                                                                                                                                                                        |       | —                                                                                                                                                                                                                       |       |
|                                     |       |                                                                            |       |                                                                                       |       |                                                                                                                                                                          |       |                                                                                                                                                                                                                         |       |
| Month#2  (November 1-November 30, 2007)  |       | —                                                                          |       | —                                                                                     |       | —                                                                                                                                                                        |       | —                                                                                                                                                                                                                       |       |
|                                     |
|                                     |       |                                                                            |       |                                                                                       |       |                                                                                                                                                                          |       |                                                                                                                                                                                                                         |       |
| Month#3  (December 1,-December 31, 2007) |       | 2,500                                                                           |       | $                                                                                          | 32.11      |                                                                                                                                                                          | 2,500      |                                                                                                                                                                                                                         | 126,070    |   |
|                                          |            |                                                                                 |            |                                                                                            |            |                                                                                                                                                                               |            |                                                                                                                                                                                                                              |            |  |

 

Set forth below is a linegraph comparing the yearly dollar changes in the cumulative shareholder returnon the Company’s common stock against the cumulative total return of theS&P 500 Stock Index, NASDAQ Bank Index, and NASDAQ Composite for the periodof five fiscal years assuming the investment of $100.00 on December 31,2002 and assuming the reinvestment of dividends.  The shareholder return shown on the graphbelow is not necessarily indicative of future performance.

 

 
| ** **                 | ** ** | **Period Ending** | ** ** |
|----------------------------|------------|------------------------|------------|
| **Index**                  | ** ** | **12/31/02**           | ** ** | **12/31/03** | ** ** | **12/31/04** | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** | **12/31/07** | ** ** |
| Penns Woods  Bancorp, Inc. |       | 100.00                 |       | 146.37 |   | 157.11 |   | 158.36 |   | 161.13 |   | 146.21 |   |
| S&P 500                |       | 100.00                 |       | 128.68 |   | 142.69 |   | 149.70 |   | 173.34 |   | 182.86 |   |
| NASDAQ Composite           |       | 100.00                 |       | 150.01 |   | 162.89 |   | 165.13 |   | 180.85 |   | 198.60 |   |
| NASDAQ Bank                |       | 100.00                 |       | 129.93 |   | 144.21 |   | 137.97 |   | 153.15 |   | 119.35 |   |

 

14

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

##### ** **

The following table setsforth certain financial data as of and for each of the years in the five-yearperiod ended December 31, 2007.

 
| **(In Thousands, Except Per Share Data)** | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|--------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Consolidated  Statement of Income Data:                            |       |       |       |       |       |       |       |       |       |       |       |
| Interest income                                                    |       | $          | 35,949     |       | $          | 33,753     |       | $          | 30,903     |       | $          | 29,845 |   | $ | 28,384 |   |
| Interest expense                                                   |       | 16,447     |       | 14,210     |       | 10,381     |       | 8,768      |       | 9,265      |       |
| Net interest  income                                               |       | 19,502     |       | 19,543     |       | 20,522     |       | 21,077     |       | 19,119     |       |
| Provision for  loan losses                                         |       | 150        |       | 635        |       | 720        |       | 465        |       | 255        |       |
| Net interest  income after provision for loan losses               |       | 19,352     |       | 18,908     |       | 19,802     |       | 20,612     |       | 18,864     |       |
| Noninterest  income                                                |       | 7,478      |       | 9,029      |       | 9,431      |       | 8,918      |       | 9,150      |       |
| Noninterest  expense                                               |       | 17,316     |       | 16,329     |       | 15,108     |       | 14,184     |       | 13,137     |       |
| Income before  income taxes                                        |       | 9,514      |       | 11,608     |       | 14,125     |       | 15,346     |       | 14,877     |       |
| Applicable  income taxes                                           |       | 637        |       | 1,961      |       | 3,224      |       | 4,263      |       | 3,703      |       |
| Net Income                                                         |       | $          | 8,877      |       | $          | 9,647      |       | $          | 10,901     |       | $          | 11,083 |   | $ | 11,174 |   |
|                                                               |       |       |       |       |       |       |       |       |       |       |       |
| Consolidated  Balance Sheet at End of Period:                      |       |       |       |       |       |       |       |       |       |       |       |
| Total assets                                                       |       | $          | 628,138    |       | $          | 592,285    |       | $          | 568,668    |       | $          | 546,703 |   | $ | 527,381 |   |
| Loans                                                              |       | 360,478    |       | 360,384    |       | 338,438    |       | 324,505    |       | 275,828    |       |
| Allowance for  loan losses                                         |       | (4,130     | )          | (4,185     | )          | (3,679     | )          | (3,338     | )          | (3,069     | )          |
| Deposits                                                           |       | 389,022    |       | 395,191    |       | 352,529    |       | 356,836    |       | 334,318    |       |
| Long-term debt —  other                                       |       | 106,378    |       | 82,878     |       | 84,478     |       | 75,878     |       | 70,878     |       |
| Shareholders'  equity                                              |       | 70,559     |       | 74,594     |       | 73,919     |       | 73,165     |       | 69,769     |       |
|                                                               |       |       |       |       |       |       |       |       |       |       |       |
| Per Share Data:                                                    |       |       |       |       |       |       |       |       |       |       |       |
| Earnings per  share - Basic                                        |       | $          | 2.28       |       | $          | 2.45       |       | $          | 2.75       |       | $          | 2.78 |   | $ | 2.79 |   |
| Earnings per  share - Diluted                                      |       | 2.28       |       | 2.45       |       | 2.74       |       | 2.78       |       | 2.79       |       |
| Cash dividends  declared                                           |       | 1.79       |       | 1.73       |       | 1.56       |       | 1.47       |       | 1.24       |       |
| Book value                                                         |       | 18.21      |       | 19.12      |       | 18.59      |       | 18.36      |       | 17.50      |       |
| Number of shares  outstanding, at end of period                    |       | 3,875,632  |       | 3,900,742  |       | 3,975,787  |       | 3,985,832  |       | 3,985,872  |       |
| Average number  of shares outstanding-basic                        |       | 3,886,277  |       | 3,934,138  |       | 3,971,926  |       | 3,990,008  |       | 3,996,702  |       |
|                                                               |       |       |       |       |       |       |       |       |       |       |       |
| Selected  financial ratios:                                        |       |       |       |       |       |       |       |       |       |       |       |
| Return on  average shareholders’ equity                       |       | 12.14      | %          | 12.93      | %          | 14.54      | %          | 15.49      | %          | 16.60      | %          |
| Return on  average total assets                                    |       | 1.49       | %          | 1.67       | %          | 1.97       | %          | 2.06       | %          | 2.24       | %          |
| Net interest  income to average interest earning assets            |       | 3.95       | %          | 4.06       | %          | 4.29       | %          | 4.32       | %          | 4.36       | %          |
| Dividend payout  ratio                                             |       | 78.33      | %          | 70.51      | %          | 57.10      | %          | 52.72      | %          | 44.76      | %          |
| Average  shareholders’ equity to average total assets         |       | 12.23      | %          | 12.92      | %          | 13.56      | %          | 13.30      | %          | 13.51      | %          |
| Loans to  deposits, at end of period                               |       | 92.66      | %          | 91.19      | %          | 96.00      | %          | 90.94      | %          | 82.50      | %          |

 

Per share data and number of shares outstanding have been adjusted ineach reporting period to give retroactive effect to a 10% stock dividend issuedOctober 30, 2003 and a six for five stock split issued November 18,2005.

 

15

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

 

# **RESULTSOF OPERATIONS**

 

**NET INTEREST INCOME**

 

Netinterest income is determined by calculating the difference between the yieldsearned on interest-earning assets and the rates paid on interest-bearingliabilities.  To compare the tax-exemptasset yields to taxable yields, amounts are adjusted to taxable equivalentsbased on the marginal corporate federal tax rate of 34%.  The tax equivalent adjustments to netinterest income for 2007, 2006, and 2005 were $2,410,000, $2,245,000, and$1,764,000, respectively.

 

**2007 vs2006**

 

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

 

Interestexpense increased $2,237,000 to $16,447,000 for the year ended December 31,2007 as compared to 2006.  The majorityof the increase, 91% or $2,043,000, is related to increased levels of averagedeposits and increased rates being paid on deposit accounts, which had anaverage rate paid of 3.35% and 2.88% for the years ended December 31, 2007and 2006, respectively.  The increaseswere driven by market competition and rate increases enacted throughout 2006 bythe Federal Open Markets Committee (FOMC) resulting in a higher average primerate during 2007 than 2006.  Interest expenserelated to time deposits increased $2,121,000 as the average rate paid on timedeposits increased to 4.73% from 4.11% for the year ended December 31,2006.  The increase in time deposit rateswas the result of competitive pressure, FOMC rate increases, rate specialsrelated to the opening of a new branch and the one year anniversary of asecond, and incentive to customers to invest in short-term time deposits.  In addition, the average balance in timedeposits increased $21,508,000 due to the before mentioned rate specials,transfer of dollars from transaction accounts due to the increasing ratedisparity between products, and the use of brokered deposits to limit thereliance on short-term FHLB funding

 

Therate paid on borrowings increased to 4.57% from 4.50% for the year ended December 31,2007.  The increase in rate resulted ininterest expense on borrowings increasing $194,000 with the majority of theincrease occurring in the short-term borrowing category.  The short-term borrowing rate increased 11basis points to 4.45% due to the FOMC rate increases since the start of2006.  Interest expense associated withlong-term borrowings increased $58,000 due to the average balance of long-termFHLB borrowings increasing $253,000 and a weighted average interest rate on thelong-term debt increase of 6 basis points to 4.62% at December 31, 2007.

 

**2006 vs2005**

 

Reported net interestincome decreased $979,000 or 4.8% to $19,543,000 for the year ended December 31,2006 as compared to the year ended December 31, 2005 as the yield onearning assets increased to 6.70% from 6.29%, respectively.  On a tax equivalent basis the change in net interest income was adecrease of $498,000 which is the result of the rate paid on interest bearingliabilities increasing at nearly twice the rate of increases in the yield onearning assets.  Total interestincome 

 

16

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increased 9.2% or$2,850,000 primarily due to growth in the average balance of the loan portfolioof $22,150,000 coupled with an increase in loan yield to 7.10% from 6.73% at December 31,2005.  Interest and dividend incomegenerated from the investment portfolio and interest bearing cash depositsincreased $98,000.  The increase was theresult of the yield on the investment portfolio increasing 39 basis pointswhile the average balance of the investment portfolio declined by $3,474,000.

 

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

 

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

 

**AVERAGE BALANCES AND INTEREST RATES**

 

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

 

17

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| ** **                                       | ** ** | **2007**                 | ** ** | **2006**     | ** ** | **2005**              | ** ** |
|--------------------------------------------------|------------|--------------------------|------------|--------------|------------|-----------------------|------------|
| **(In Thousands)**                               | ** ** | **Average Balance** | ** ** | **Interest** | ** ** | **Average Rate** | ** ** | **Average Balance** | ** ** | **Interest** | ** ** | **Average Rate** | ** ** | **Average Balance** | ** ** | **Interest** | ** ** | **Average Rate** | ** ** |
| ASSETS:                                          |       |                     |       |         |       |                  |       |   |   |   |   |   | ** ** |   |   |   |   |   |   |
| Tax-exempt loans                                 |       | $                        | 7,857      |         | $          | 485                   |       | 6.17 | % | $ | 8,173 |   | $ | 503 |   | 6.15 | % | $ | 5,370 |   | $ | 307 |   | 5.72 | % |
| All other loans                                  |       | 353,528                  |       | 25,779       |       | 7.29                  | %          | 344,524 |   | 24,545 |   | 7.12 | % | 325,177 |   | 21,924 |   | 6.74 | % |
| Total loans                                      |       | 361,385                  |       | 26,264       |       | 7.27                  | %          | 352,697 |   | 25,048 |   | 7.10 | % | 330,547 |   | 22,231 |   | 6.73 | % |
|                                             |       |                     |       |         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Taxable  securities                              |       | 93,480                   |       | 5,474        |       | 5.86                  | %          | 91,767 |   | 4,837 |   | 5.27 | % | 115,041 |   | 5,529 |   | 4.81 | % |
| Tax-exempt  securitites                          |       | 99,728                   |       | 6,602        |       | 6.62                  | %          | 92,692 |   | 6,102 |   | 6.58 | % | 72,892 |   | 4,882 |   | 6.70 | % |
| Total securities                                 |       | 193,208                  |       | 12,076       |       | 6.25                  | %          | 184,459 |   | 10,939 |   | 5.93 | % | 187,933 |   | 10,411 |   | 5.54 | % |
|                                             |       |                     |       |         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits                       |       | 345                      |       | 19           |       | 5.51                  | %          | 152 |   | 11 |   | 7.24 | % | 873 |   | 25 |   | 2.86 | % |
|                                             |       |                     |       |         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  interest-earning assets                   |       | 554,938                  |       | 38,359       |       | 6.91                  | %          | 537,308 |   | 35,998 |   | 6.70 | % | 519,353 |   | 32,667 |   | 6.29 | % |
|                                             |       |                     |       |         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Other assets                                     |       | 42,602                   |       |         |       |                  |       | 40,413 |   |   |   |   |   | 33,308 |   |   |   |   |   |
|                                             |       |                     |       |         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total assets                                     |       | $                        | 597,540    |         |       |                  |       |   | $ | 577,721 |   |   |   |   |   | $ | 552,661 |   |   |   |   |   |
|                                             |       |                     |       |         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES:                                     |       |                     |       |         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings                                          |       | $                        | 58,710     |         | 428        |                  | 0.73       | % | $ | 61,958 |   | 509 |   | 0.82 | % | $ | 64,795 |   | 500 |   | 0.77 | % |
| Super Now  deposits                              |       | 46,596                   |       | 611          |       | 1.31                  | %          | 47,294 |   | 655 |   | 1.38 | % | 50,756 |   | 438 |   | 0.86 | % |
| Money market  deposits                           |       | 23,920                   |       | 540          |       | 2.26                  | %          | 23,905 |   | 493 |   | 2.06 | % | 29,317 |   | 412 |   | 1.41 | % |
| Time deposits                                    |       | 198,029                  |       | 9,372        |       | 4.73                  | %          | 176,521 |   | 7,251 |   | 4.11 | % | 146,391 |   | 4,424 |   | 3.02 | % |
| Total deposits                                   |       | 327,255                  |       | 10,951       |       | 3.35                  | %          | 309,678 |   | 8,908 |   | 2.88 | % | 291,259 |   | 5,774 |   | 1.98 | % |
|                                             |       |                     |       |         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Short-term  borrowings                           |       | 36,816                   |       | 1,639        |       | 4.45                  | %          | 34,612 |   | 1,503 |   | 4.34 | % | 32,114 |   | 931 |   | 2.90 | % |
| Long-term  borrowings                            |       | 83,490                   |       | 3,857        |       | 4.62                  | %          | 83,237 |   | 3,799 |   | 4.56 | % | 80,820 |   | 3,676 |   | 4.55 | % |
| Total borrowings                                 |       | 120,306                  |       | 5,496        |       | 4.57                  | %          | 117,849 |   | 5,302 |   | 4.50 | % | 112,934 |   | 4,607 |   | 4.08 | % |
|                                             |       |                     |       |         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  interest-bearing liabilities              |       | 447,561                  |       | 16,447       |       | 3.67                  | %          | 427,527 |   | 14,210 |   | 3.32 | % | 404,193 |   | 10,381 |   | 2.57 | % |
|                                             |       |                     |       |         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                  |       | 69,953                   |       |         |       |                  |       | 69,668 |   |   |   |   |   | 69,457 |   |   |   |   |   |
| Other liabilities                                |       | 6,924                    |       |         |       |                  |       | 5,899 |   |   |   |   |   | 4,057 |   |   |   |   |   |
| Shareholders’  equity                       |       | 73,102                   |       |         |       |                  |       | 74,627 |   |   |   |   |   | 74,954 |   |   |   |   |   |
|                                             |       |                     |       |         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| TOTAL LIABILITIES  AND SHAREHOLDERS’ EQUITY |       | $                        | 597,540    |         |       |                  |       |   | $ | 577,721 |   |   |   |   |   | $ | 552,661 |   |   |   |   |   |
| Interest rate  spread                            |       |                     |       |         |       | 3.24                  | %          |   |   |   |   | 3.38 | % |   |   |   |   | 3.72 | % |
| Net interest  income/margin                      |       |                     |       | $            | 21,912     |                  | 3.95       | % |   |   | $ | 21,788 |   | 4.06 | % |   |   | $ | 22,286 |   | 4.29 | % |

 

Fees on loans areincluded with interest on loans.  Loanfees are included in interest income as follows:  2007 $453,000, 2006 $478,000, 2005 $491,000

Information on this table has been calculated using average dailybalances to obtain average balances.

Nonaccrual loans have been included with loans for the purpose ofanalyzing net interest earnings.

Income and rates on afully taxable equivalent basis include an adjustment for the difference betweenannual income from tax-exempt obligations and the taxable equivalent of suchincome at the standard 34% tax rate.

 

18

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**Reconcilement of Taxable Equivalent Net Interest Income**

 
| ** **                                       | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                             |       |     |       |     |       |     |       |
| Total interest  income                           |       | $        | 35,949     |     | $          | 33,753   |       | $ | 30,903 |   |
| Total interest  expense                          |       | 16,447   |       | 14,210   |       | 10,381   |       |
|                                             |       |     |       |     |       |     |       |
| Net interest  income                             |       | 19,502   |       | 19,543   |       | 20,522   |       |
| Tax equivalent  adjustment                       |       | 2,410    |       | 2,245    |       | 1,764    |       |
|                                             |       |     |       |     |       |     |       |
| Net interest  income  (fully taxable equivalent) |       | $        | 21,912     |     | $          | 21,788   |       | $ | 22,286 |   |

 

 

**Rate/Volume Analysis**

 

The table below setsforth certain information regarding changes in our interest income and interestexpense for the periods indicated. For interest-earning assets andinterest-bearing liabilities, information is provided on changes attributableto (i) changes in volume (changes in average volume 

 

19

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

 
| ** **                          | ** ** | **Year Ended December 31,**                        | ** ** |
|-------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                          | ** ** | **2007 vs 2006  Increase (Decrease)  Due to** | ** ** | **2006 vs 2005  Increase (Decrease)  Due to** | ** ** |
| **(In Thousands)**             | ** ** | **Volume**                                                        | ** ** | **Rate** | ** ** | **Net** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Net** | ** ** |
| **Interest  income:**               |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |
| Loans,  tax-exempt                  |       | $                                                                 | (20        | ) | $ | 2 |   | $ | (18 | ) | $ | 174 |   | $ | 22 |   | $ | 196 |   |
| Loans                               |       | 650                                                               |       | 584 |   | 1,234 |   | 1,342 |   | 1,279 |   | 2,621 |   |
| Taxable  investment securities      |       | 88                                                                |       | 549 |   | 637 |   | (1,192 | ) | 500 |   | (692 | ) |
| Tax-exempt  investment securities   |       | 466                                                               |       | 34 |   | 500 |   | 1,304 |   | (84 | ) | 1,220 |   |
| Interest-bearing  deposits          |       | 12                                                                |       | (4 | ) | 8 |   | (32 | ) | 18 |   | (14 | ) |
| Total  interest-earning assets      |       | 1,196                                                             |       | 1,165 |   | 2,361 |   | 1,596 |   | 1,735 |   | 3,331 |   |
|                                |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |
| **Interest  expenses:**             |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |
| Savings deposits                    |       | (30                                                               | )          | (51 | ) | (81 | ) | (23 | ) | 32 |   | 9 |   |
| Super Now  deposits                 |       | (10                                                               | )          | (34 | ) | (44 | ) | (32 | ) | 249 |   | 217 |   |
| Money market  deposits              |       | —                                                            |       | 47 |   | 47 |   | (86 | ) | 167 |   | 81 |   |
| Time deposits                       |       | 344                                                               |       | 1,777 |   | 2,121 |   | 471 |   | 2,356 |   | 2,827 |   |
| Short-term  borrowings              |       | 100                                                               |       | 36 |   | 136 |   | 65 |   | 507 |   | 572 |   |
| Long-term  borrowings               |       | 12                                                                |       | 46 |   | 58 |   | 110 |   | 13 |   | 123 |   |
| Total  interest-bearing liabilities |       | 416                                                               |       | 1,821 |   | 2,237 |   | 505 |   | 3,324 |   | 3,829 |   |
| Change in net  interest income      |       | $                                                                 | 780        |   | $ | (656 | ) | $ | 124 |   | $ | 1,091 |   | $ | (1,589 | ) | $ | (498 | ) |

 

**PROVISION FOR LOAN LOSSES**

 

**2007 vs2006**

 

The provision for loanlosses is based upon management’s quarterly review of the loan portfolio.  The purpose of the review is to assess loanquality, identify impaired loans, analyze delinquencies, ascertain loan growth,evaluate potential charge-offs and recoveries, and assess general economicconditions in the markets served.  Anexternal independent loan review is also performed annually for the Bank.  Management remains committed to an aggressiveprogram of problem loan identification and resolution.

 

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

 

Although managementbelieves that it uses the best information available to make such determinationsand that the allowance for loan losses is adequate at December 31, 2007,future adjustments could be necessary if circumstances or economic conditionsdiffer substantially from the assumptions used in making the initialdeterminations.  A downturn in the localeconomy or employment and delays in receiving financial information fromborrowers could result in increased levels of nonperforming assets andcharge-offs, increased loan loss provisions and reductions in interest income.  Additionally, as an integral part of theexamination process, bank regulatory agencies periodically review the Bank’sloan loss allowance.  The bankingregulators could require the recognition of additions to the loan lossallowance based on their judgment of information available to them at the timeof their examination.

 

20

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The allowance for loanlosses decreased from $4,185,000 at December 31, 2006 to $4,130,000 at December 31,2007.  At December 31, 2007,allowance for loan losses was 1.15% of total loans compared to 1.16% of totalloans at December 31, 2006. Management’s conclusion is that the allowance for loan losses isadequate to provide for probable losses inherent in its loan portfolio as ofthe consolidated balance sheet date.

 

The provision for loanlosses totaled $150,000 for the year ended December 31, 2007.  The provision for the same period in 2006 was$635,000.  Management concluded that thedecrease of the provision was appropriate when considering the gross loangrowth experienced during 2007 of $94,000 coupled with the low levels ofcharge-offs and delinquencies during the year. Utilizing both internal and external resources, as noted, seniormanagement has concluded that the allowance for loan losses remains at a leveladequate to provide for probable losses inherent in the loan portfolio.

 

**2006 vs2005**

 

The allowance for loanlosses increased 13.8% or $506,000 from fiscal 2005 after net charge-offs of$129,000 contributed to a year-end allowance for loan losses of  $4,185,000 or 1.16% of total loans.  Based upon this analysis, as well as theothers noted above, senior management concluded that the allowance for loanlosses was at a level adequate to provide for probable losses inherent in theloan portfolio at December 31, 2006.

 

Following is a tableshowing the changes in the allowance for loan losses for the years ended December 31:

 
| **(In Thousands)**                                                                    | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Balance at  beginning of period                                                            |       | $        | 4,185      |     | $          | 3,679    |       | $        | 3,338      |     | $          | 3,069 |   | $ | 2,953 |   |
| Charge-offs:                                                                               |       |     |       |     |       |     |       |     |       |     |       |
| Real estate                                                                                |       | —   |       | 50       |       | 132      |       | 121      |       | 63       |       |
| Commercial and  industrial                                                                 |       | 103      |       | 28       |       | 206      |       | 50       |       | 37       |       |
| Installment  loans to individuals                                                          |       | 201      |       | 249      |       | 108      |       | 112      |       | 116      |       |
| Total  charge-offs                                                                         |       | 304      |       | 327      |       | 446      |       | 283      |       | 216      |       |
| Recoveries:                                                                                |       |     |       |     |       |     |       |     |       |     |       |
| Real estate                                                                                |       | 13       |       | 68       |       | 45       |       | 50       |       | 42       |       |
| Commercial and  industrial                                                                 |       | 1        |       | 40       |       | 8        |       | 4        |       | 16       |       |
| Installment  loans to individuals                                                          |       | 85       |       | 90       |       | 14       |       | 33       |       | 19       |       |
| Total recoveries                                                                           |       | 99       |       | 198      |       | 67       |       | 87       |       | 77       |       |
| Net charge-offs                                                                            |       | 205      |       | 129      |       | 379      |       | 196      |       | 139      |       |
| Additions  charged to operations                                                           |       | 150      |       | 635      |       | 720      |       | 465      |       | 255      |       |
| Balance at end  of period                                                                  |       | $        | 4,130      |     | $          | 4,185    |       | $        | 3,679      |     | $          | 3,338 |   | $ | 3,069 |   |
| Ratio of net  charge-offs during the period to average loans outstanding during the period |       | 0.06     | %          | 0.04     | %          | 0.11     | %          | 0.06     | %          | 0.05     | %          |

 

**NON-INTEREST INCOME**

 

**2007 vs 2006**

 

Totalnon-interest income decreased $1,551,000 from the year ended December 31,2007 to 2006.  Excluding security (loss)gains and the gain on sale of loans, non-interest income increased$114,000.  Service charges decreased$120,000 as overdraft protection fees declined and customers migrated to newchecking accounts having reduced or no service charges.  Earnings on bank-owned life insuranceincreased $36,000. Insurance commissions decreased $59,000 due to a reductionin the overall commission, from the underwriter, that The M Group receives oneach insurance contract written. Management of The M Group continues to pursue new and build upon currentrelationships.

 

21

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However,the sales cycle for insurance and investment products can take typically fromsix months to one year or more to complete. The sales call program continues toexpand to other financial institutions, which results in additional revenue forThe M Group.  The increase inother income was primarily due to increases in revenues from debit cardtransactions, merchant card commissions, and commissions generated by The M Group for securities transactions.

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

 

**2006 vs 2005**

 

Totalnon-interest income decreased $402,000 from the year ended December 31,2005 to 2006.  Excluding security gainsand the gain on sale of loans, non-interest income increased $120,000.  Service charges increased $138,000 due to thefull year impact of an overdraft protection program that was started in May 2005.  Earnings on bank-owned life insurancedecreased $194,000, however, the year ended December 31, 2005 included thereceipt of $196,000 due to a death benefit claim.  Insurance commissions decreased $46,000 dueto a reduction in the overall commission, from the underwriter, that The MGroup receives on each insurance contract written.  Management of The M Group continues to pursuenew and build upon current relationships. However, the sales cycle for insurance and investment products can taketypically from six months to one year or more to complete. The sales callprogram continues to expand to other financial institutions, which results inadditional revenue for The M Group.  Theincrease in other income was primarily due to increases in revenues from debitcards and fees associated with the origination of mortgage loans on the behalfof PHFA and other secondary market entities.

 
| ** **                 | ** ** | **2006**   | ** ** | **2005**         | ** ** | **Change** | ** ** |
|----------------------------|------------|------------|------------|------------------|------------|------------|------------|
| **(In Thousands)**    | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Deposit service  charges   |       | $          | 2,366      |             | 26.20      | %          | $          | 2,228 |   | 23.62 | % | $ | 138 |   | 6.19 | % |
| Securities  gains, net     |       | 1,679      |       | 18.60            |       | 2,190      |       | 23.22 |   | (511 | ) | (23.33 | ) |
| Bank-owned life  insurance |       | 374        |       | 4.14             |       | 568        |       | 6.02 |   | (194 | ) | (34.15 | ) |
| Gain on sale of  loans     |       | 853        |       | 9.45             |       | 864        |       | 9.16 |   | (11 | ) | (1.27 | ) |
| Insurance  commissions     |       | 2,281      |       | 25.26            |       | 2,327      |       | 24.68 |   | (46 | ) | (1.98 | ) |
| Other income               |       | 1,476      |       | 16.35            |       | 1,254      |       | 13.30 |   | 222 |   | 17.70 |   |
| Total  non-interest income |       | $          | 9,029      |             | 100.00     | %          | $          | 9,431 |   | 100.00 | % | $ | (402 | ) | (4.26 | )% |

 

**NON-INTEREST EXPENSES**

 

**2007 vs 2006**

 

Total non-interestexpenses increased $987,000 from the year ended December 31, 2006 to December 31,2007. Salaries and employee benefits increased by $245,000 and were attributedto several items including standard cost of living wage adjustments foremployees, full year impact of the Montoursville branch, and increased benefitcosts. Occupancy expense increased due to the new branch in Montoursville,which opened in the third quarter of 2006, and increased cost of maintenanceand property taxes.  Amortizationincrease attributed to low income housing partnership that began operationduring the fourth quarter of 2006.

 

22

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

 

**2006 vs 2005**

 

Total non-interestexpenses increased $1,221,000 from the year ended December 31, 2005 to December 31,2006. Salaries and employee benefits increased by $519,000 and was the resultof increased staffing due in part to two new branches since mid 2005, standardwage increases, and increased health insurance costs.  Occupancy expense and furniture and equipmentexpenses increased primarily due to the before mentioned branch additions andincreased maintenance costs related to the software and equipment utilized bythe Bank.  Other expenses andamortization of investment in limited partnership increased $377,000 asamortization of the low income housing partnership investments increased$155,000 and due to general increases in the cost of business specificallyPennsylvania shares tax, donations, and director fees.**  **The increase in low incomehousing partnership investment amortization is the result of the Bank’sinvolvement with two partnerships that became eligible for tax creditrecognition during 2006.

 
| ** **                                         | ** ** | **2006**   | ** ** | **2005**         | ** ** | **Change** | ** ** |
|----------------------------------------------------|------------|------------|------------|------------------|------------|------------|------------|
| **(In Thousands)**                            | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Salaries and  employee benefits                    |       | $          | 8,833      |             | 54.09      | %          | $          | 8,314 |   | 55.03 | % | $ | 519 |   | 6.24 | % |
| Occupancy, net                                     |       | 1,137      |       | 6.96             |       | 1,089      |       | 7.21 |   | 48 |   | 4.41 |   |
| Furniture and  equipment                           |       | 1,201      |       | 7.36             |       | 973        |       | 6.44 |   | 228 |   | 23.43 |   |
| Pennsylvania  shares tax                           |       | 598        |       | 3.66             |       | 549        |       | 3.63 |   | 49 |   | 8.93 |   |
| Amortization of  investment in limited partnership |       | 245        |       | 1.50             |       | 90         |       | 0.60 |   | 155 |   | 172.22 |   |
| Other expenses                                     |       | 4,315      |       | 26.43            |       | 4,093      |       | 27.09 |   | 222 |   | 5.42 |   |
| Total  non-interest expense                        |       | $          | 16,329     |             | 100.00     | %          | $          | 15,108 |   | 100.00 | % | $ | 1,221 |   | 8.08 | % |

 

**INCOME TAXES**

 

**2007 vs 2006**

 

Theprovision for income taxes for the year ended December 31, 2007 resultedin an effective income tax rate of 6.7% compared to 16.9% for 2006.  This decrease is the result of a shift in theinvestment portfolio from taxable mortgage-backed bonds to tax-exempt municipalbonds coupled with the receipt of tax credits related to low income housingpartnerships.

 

**2006 vs 2005**

 

Theprovision for income taxes for the year ended December 31, 2006 resultedin an effective income tax rate of 16.9% compared to 22.8% for 2005.  This decrease is the result of a shift in theinvestment portfolio from taxable mortgage-backed bonds to tax-exempt municipalbonds coupled with the receipt of tax credits related to low income housingpartnerships.

 

23

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**FINANCIAL CONDITION**

** **

**INVESTMENTS**

** **

**2007**

 

The estimated fair valueof the investment portfolio increased $29,429,000 or 15.77% from December 31,2006 to 2007, while the amortized cost increased $35,762,000 over the sameperiod.  The majority of the changes invalue occurred within the state and municipal segment of the portfolio.  The amortized cost position in state andpolitical securities increased $14,993,000 as the Bank continued to build callprotection, maintain taxable equivalent yields, reduce the effective federalincome tax rate, and invest in communities across the Commonwealth ofPennsylvania and the country.  Theamortized cost position of other debt securities increased $13,919,000 as theBank began a new leverage transaction to enhance net interest income, return onaverage assets, and return on average equity. The increased level of unrealized losses, which offset the increase inamortized cost, was the result of changes in the yield curve, not creditquality, as the credit quality of the portfolio remains sound.

 

**2006**

 

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

 

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

 
| ** **                                      | ** ** | **2007**    | ** ** | **2006**             | ** ** | **2005**    | ** ** |
|-------------------------------------------------|------------|-------------|------------|----------------------|------------|-------------|------------|
| **(In Thousands)**                         | ** ** | **Balance** | ** ** | **% Portfolio** | ** ** | **Balance** | ** ** | **% Portfolio** | ** ** | **Balance** | ** ** | **% Portfolio** | ** ** |
| U.S. Treasury  securities:                      |       |        |       |                 |       |        |       |   |   |   |   |   |   |
| Available for  Sale                             |       | $           | —     |                 | —     |        | $          | — |   | — |   | $ | — |   | — |   |
| U.S. Government  agencies:                      |       |        |       |                 |       |        |       |   |   |   |   |   |   |
| Held to Maturity                                |       | 14          |       | 0.01                 | %          | 26          |       | 0.01 | % | 28 |   | 0.01 | % |
| Available for  Sale                             |       | 62,904      |       | 29.29                | %          | 54,152      |       | 29.20 | % | 63,953 |   | 34.15 | % |
| State and  political subdivisions (tax-exempt): |       |        |       |                 |       |        |       |   |   |   |   |   |   |
| Held to Maturity                                |       | —      |       | —               |       | —      |       | — |   | — |   | — |   |
| Available for  Sale                             |       | 107,314     |       | 49.98                | %          | 103,057     |       | 55.56 | % | 89,265 |   | 47.66 | % |
| State and  political subdivisions (taxable):    |       |        |       |                 |       |        |       |   |   |   |   |   |   |
| Held to Maturity                                |       | —      |       | —               |       | —      |       | — |   | — |   | — |   |
| Available for  Sale                             |       | 10,501      |       | 4.89                 | %          | 2,889       |       | 1.56 | % | 4,826 |   | 2.58 | % |
| Other bonds,  notes and debentures:             |       |        |       |                 |       |        |       |   |   |   |   |   |   |
| Held to Maturity                                |       | 263         |       | 0.12                 | %          | 257         |       | 0.14 | % | 237 |   | 0.13 | % |
| Available for  Sale                             |       | 15,767      |       | 7.34                 | %          | 2,024       |       | 1.09 | % | 1,719 |   | 0.92 | % |
| Total bonds,  notes and debentures              |       | 196,763     |       | 91.63                | %          | 162,405     |       | 87.56 | % | 160,028 |   | 85.45 | % |
| Corporate stock  - Available for Sale           |       | 17,969      |       | 8.37                 | %          | 23,078      |       | 12.44 | % | 27,255 |   | 14.55 | % |
| Total                                           |       | $           | 214,732    |                 | 100.00     | %           | $          | 185,483 |   | 100.00 | % | $ | 187,283 |   | 100.00 | % |

 

The following table showsthe maturities and repricing of investment securities, at amortized cost, at December 31,2007 and the weighted average yields (for tax-exempt obligations on a fullytaxable basis assuming a 34% tax rate) of such:

 

24

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| ** **                                     | ** ** | **Within** | ** ** | **After One**  | ** ** | **After Five** | ** ** | **After** | ** ** | **Amortized** | ** ** |
|------------------------------------------------|------------|------------|------------|---------------------|------------|---------------------|------------|-----------|------------|---------------|------------|
| ** **                                     | ** ** | **One**    | ** ** | **But Within** | ** ** | **But Within** | ** ** | **Ten**   | ** ** | **Cost**      | ** ** |
| **(In Thousands)**                        | ** ** | **Year**   | ** ** | **Five Years** | ** ** | **Ten Years**  | ** ** | **Years** | ** ** | **Total**     | ** ** |
| U.S. Treasury  securities:                     |       |       |       |                |       |                |       |      |       |          |       |
| HTM Amount                                     |       | $          | —     |                | $          | —              |       | $         | —     |          | $          | — |   | $ | — |   |
| Yield                                          |       | —     |       | —              |       | —              |       | —    |       | —        |       |
| AFS Amount                                     |       | —     |       | —              |       | —              |       | —    |       |          |       |
| Yield                                          |       | —     |       | —              |       | —              |       | —    |       | —        |       |
| U.S. Government  agencies:                     |       |       |       |                |       |                |       |      |       |          |       |
| HTM Amount                                     |       | —     |       | —              |       | —              |       | 14        |       | 14            |       |
| Yield                                          |       | —     |       | —              |       | —              |       | 9.07      | %          | 9.07          | %          |
| AFS Amount                                     |       | —     |       | 750                 |       | —              |       | 61,632    |       | 62,382        |       |
| Yield                                          |       | —     |       | 5.02                | %          | —              |       | 5.81      | %          | 5.80          | %          |
| State and  political subdivisions(tax-exempt): |       |       |       |                |       |                |       |      |       |          |       |
| HTM Amount                                     |       | —     |       | —              |       | —              |       | —    |       | —        |       |
| Yield                                          |       | —     |       | —              |       | —              |       | —    |       | —        |       |
| AFS Amount                                     |       | —     |       | —              |       | 392                 |       | 108,355   |       | 108,747       |       |
| Yield                                          |       | —     |       | —              |       | 6.24                | %          | 4.31      | %          | 4.32          | %          |
| State and  political subdivisions(taxable):    |       |       |       |                |       |                |       |      |       |          |       |
| HTM Amount                                     |       | —     |       | —              |       | —              |       | —    |       | —        |       |
| Yield                                          |       | —     |       | —              |       | —              |       | —    |       | —        |       |
| AFS Amount                                     |       | —     |       | —              |       | —              |       | 10,904    |       | 10,904        |       |
| Yield                                          |       | —     |       | —              |       | —              |       | 5.41      | %          | 5.41          | %          |
| Other bonds,  notes and debentures:            |       |       |       |                |       |                |       |      |       |          |       |
| HTM Amount                                     |       | 50         |       | 123                 |       | 90                  |       | —    |       | 263           |       |
| Yield                                          |       | 5.83       | %          | 6.37                | %          | 5.77                | %          | —    |       | 6.06          | %          |
| AFS Amount                                     |       | 75         |       | 50                  |       | 3                   |       | 15,789    |       | 15,917        |       |
| Yield                                          |       | 4.96       | %          | 6.45                | %          | 5.54                | %          | 6.18      | %          | 6.18          | %          |
| Total Amount                                   |       | $          | 125        |                | $          | 923                 |       | $         | 485        |          | $          | 196,694 |   | $ | 198,227 |   |
| Total Yield                                    |       | 5.31       | %          | 5.28                | %          | 6.15                | %          | 4.99      | %          | 5.00          | %          |
|                                           |       |       |       |                |       |                |       |      |       |          |       |
| Equity  Securities                             |       |       |       |                |       |                |       |      |       | $             | 19,776     |   |
| Total Investment  Portfolio Value              |       |       |       |                |       |                |       |      |       | $             | 218,003    |   |
| Total Investment  Portfolio Yield              |       |       |       |                |       |                |       |      |       | 4.54          | %          |

 

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

 

**LOAN PORTFOLIO**

 

**2007**

 

Gross loans of $360,478,000at December 31, 2007 represented an increase of $94,000 from December 31,2006.  The continued emphasis on wellcollateralized real estate loans resulted in real estate secured loansincreasing $1,991,000 from December 31, 2006 to 2007.  The success in carrying out this long termstrategy has played a significant role in limiting net charge-offs for 2007 to0.06% of average loans.  Commercial andagricultural loans declined due to the before mentioned emphasis on real estatesecured loans versus equipment, receivables, or inventory secured loans.

 

25

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**2006**

 

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

 

The amounts of loansoutstanding at the indicted dates are shown in the following table according totype of loan:

 
| **(In Thousands)**           | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Commercial and  agricultural      |       | $        | 35,739     |     | $          | 36,995   |       | $        | 37,553     |     | $          | 31,100 |   | $ | 24,520 |   |
| Real estate  mortgage:            |       |     |       |     |       |     |       |     |       |     |       |
| Residential                       |       | 163,268  |       | 158,219  |       | 150,000  |       | 147,461  |       | 147,697  |       |
| Commercial                        |       | 132,943  |       | 135,404  |       | 127,131  |       | 123,757  |       | 82,896   |       |
| Construction                      |       | 16,152   |       | 16,749   |       | 10,681   |       | 8,365    |       | 7,652    |       |
| Installment  loans to individuals |       | 13,317   |       | 14,035   |       | 14,135   |       | 14,918   |       | 14,003   |       |
| Less: Net  deferred loan fees     |       | 941      |       | 1,018    |       | 1,062    |       | 1,096    |       | 940      |       |
| Gross loans                       |       | $        | 360,478    |     | $          | 360,384  |       | $        | 338,438    |     | $          | 324,505 |   | $ | 275,828 |   |

 

The amounts of domesticloans at December 31, 2007 are presented below by category and maturity:

 
| ** **                                | ** ** | ** **           | ** ** | **Commercial** | ** ** | **Installment**   | ** ** | ** ** | ** ** |
|-------------------------------------------|------------|----------------------|------------|----------------|------------|-------------------|------------|------------|------------|
| ** **                                | ** ** | ** **           | ** ** | **and**        | ** ** | **Loans to** | ** ** | ** ** | ** ** |
| **(In Thousands)**                   | ** ** | **Real Estate** | ** ** | **Other**      | ** ** | **Individuals**   | ** ** | **Total**  | ** ** |
| Loans with  floating interest rates:      |       |                 |       |           |       |              |       |       |       |
| 1 year or less                            |       | $                    | 25,014     |           | $          | 9,105             |       | $          | 2,258      |   | $ | 36,377 |   |
| 1 through 5  years                        |       | 9,215                |       | 1,608          |       | 151               |       | 10,974     |       |
| 5 through 10  years                       |       | 28,421               |       | 4,421          |       | 6                 |       | 32,848     |       |
| After 10 years                            |       | 196,938              |       | 1,918          |       | 391               |       | 199,247    |       |
| Total floating  interest rate loans       |       | 259,588              |       | 17,052         |       | 2,806             |       | 279,446    |       |
| Loans with  predetermined interest rates: |       |                 |       |           |       |              |       |       |       |
| 1 year or less                            |       | 5,609                |       | 1,091          |       | 1,355             |       | 8,055      |       |
| 1 through 5  years                        |       | 15,843               |       | 9,992          |       | 8,495             |       | 34,330     |       |
| 5 through 10  years                       |       | 19,578               |       | 7,693          |       | 646               |       | 27,917     |       |
| After 10 years                            |       | 10,480               |       | 189            |       | 61                |       | 10,730     |       |
| Total  predetermined interest rate loans  |       | 51,510               |       | 18,965         |       | 10,557            |       | 81,032     |       |
| Total                                     |       | $                    | 311,098    |           | $          | 36,017            |       | $          | 13,363     |   | $ | 360,478 |   |

 

26

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----

| * |   | The loan  maturity information is based upon original loan terms and is not adjusted  for “rollovers.” In the ordinary course of business, loans maturing within  one year may be renewed, in whole or in part, as to principal amount at  interest rates prevailing at the date of renewal. |
|---|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| * |   | Scheduled  repayments are reported in maturity categories in which the payment is due.                                                                                                                                                                                                                 |

 

The Bank does notmake loans that provide for negative amortization nor do any loans containconversion features. The Bank does not have any foreign loans outstanding at December 31,2007.

 

**ALLOWANCE FOR LOAN LOSSES**

 

**2007**

 

The allowance for loan losses represents the amountwhich management estimates is adequate to provide for probable losses inherentin its loan portfolio, as of the consolidated balance sheet date.  The allowance method is used in providing forloan losses.  Accordingly, all loanlosses are charged to the allowance and all recoveries are credited to it.  The allowance for loan losses is establishedthrough a provision for loan losses charged to operations. ** **The provision for loan losses is based upon management’s quarterlyreview of the loan portfolio.  Thepurpose of the review is to assess loan quality, identify impaired loans,analyze delinquencies, ascertain loan growth, evaluate potential charge-offsand recoveries, and assess general economic conditions in the marketsserved.  An external independent loan reviewis also performed annually for the Bank. Management remains committed to an aggressive program of problem loanidentification and resolution.

 

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

 

Althoughmanagement believes that it uses the best information available to make suchdeterminations and that the allowance for loan losses is adequate at December 31,2007, future adjustments could be necessary if circumstances or economicconditions differ substantially from the assumptions used in making the initialdeterminations.  A downturn in the localeconomy or employment and delays in receiving financial information fromborrowers could result in increased levels of nonperforming assets andcharge-offs, increased loan loss provisions and reductions in interestincome.  Additionally, as an integralpart of the examination process, bank regulatory agencies periodically reviewthe Bank’s loan loss allowance.  Thebanking agencies could require the recognition of additions to the loan lossallowance based on their judgment of information available to them at the timeof their examination.

 

Theallowance for loan losses decreased from $4,185,000 at December 31, 2006to $4,130,000 at December 31, 2007. At December 31, 2007, allowance for loan losses was 1.15% of totalloans compared to 1.16% of total loans at December 31, 2006.  This percentage is consistent with the Bank’shistorical experience and peer banks. Management’s conclusion is that the allowance for loan losses isadequate to provide for probable losses inherent in its loan portfolio as ofthe balance sheet date.

 

27

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**2006**

 

AtDecember 31, 2006, the allowance for loan losses as a percent of totalloans increased to 1.16% from 1.09% at December 31, 2005.  Gross loans increased by $21,946,000 from$338,438,000 at December 31, 2005 to $360,384,000 at December 31,2006.

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

 

**NONPERFORMINGLOANS**

 

Non-accrualloans increased to $955,000 at December 31, 2007 primarily due to theaddition of a commercial real estate relationship which has filed forbankruptcy. Overall nonperforming loans increased $831,000 to $1,320,000 fromfiscal year end 2006.

 

Thefollowing table presents information concerning nonperforming loans.  The accrual of interest will be discontinuedwhen the principal or interest of a loan is in default for 90 days or more, oras soon as payment is questionable, unless the loan is well secured and in theprocess of collection.  Consumer loansand residential real estate loans secured by 1 to 4 family dwellings shallordinarily not be subject to those guidelines. The reversal of previously accrued but uncollected interest applicableto any loan placed in a nonaccrual status and the treatment of subsequentpayments of either principal or interest will be handled in accordance withU.S. generally accepted accounting principles. These principles do not require a write-off of previously accruedinterest if principal and interest are ultimately protected by sound collateralvalues.  A nonperforming loan may berestored to an accruing status when:

 
| 1. | Principal  and interest is no longer due and unpaid.               |
|----|--------------------------------------------------------------------|
| 2. | It  becomes well secured and in the process of collection.         |
| 3. | Prospects  for future contractual payments are no longer in doubt. |

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

 

Thelevel of nonaccruing loans continues to fluctuate annually and is attributed tothe various economic factors experienced both regionally and nationally.  Overall the portfolio is well secured with amajority of the balance making regular payments or scheduled to be satisfied inthe near future.  Presently there are nosignificant amounts of loans where serious doubts exist as to the ability ofthe borrower to comply with the current loan payment terms which are notincluded in the nonperforming categories as indicated above.

 

Management’sjudgment in determining the amount of the additions to the allowance charged tooperating expense considers the following factors:

 
| 1. |   | Economic  conditions and the impact on the loan portfolio.                                       |
|----|--------|--------------------------------------------------------------------------------------------------|
| 2. |   | Analysis  of past loan charge-offs experienced by category and comparison to  outstanding loans. |
| 3. |   | Problem  loans on overall portfolio quality.                                                     |

 

28

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4.               Reports of examination of the loan portfolioby the Pennsylvania State Banking Department and the Federal Deposit InsuranceCorporation.

 

**Allocation In The Allowance For Loan Losses**

 
| ** **                               | ** ** | ** ** | ** ** | **Percent Of**  | ** ** |
|------------------------------------------|------------|------------|------------|----------------------|------------|
| ** **                               | ** ** | ** ** | ** ** | **Loan In**     | ** ** |
| ** **                               | ** ** | ** ** | ** ** | **Each**             | ** ** |
| ** **                               | ** ** | ** ** | ** ** | **Category To** | ** ** |
| **(In Thousands)**                  | ** ** | **Amount** | ** ** | **Total Loans** | ** ** |
| **December 31,  2007:**             |       |       |       |                 |       |
| Balance at end  of period applicable to: |       |       |       |                 |       |
| Commercial and  agricultural             |       | $          | 823        |                 | 9.9        | % |
| Real estate  mortgage:                   |       |       |       |                 |       |
| Residential                              |       | 1,031      |       | 45.2                 | %          |
| Commercial                               |       | 1,634      |       | 36.8                 | %          |
| Construction                             |       | 112        |       | 4.5                  | %          |
| Installment  loans to individuals        |       | 228        |       | 3.6                  | %          |
| Unallocated                              |       | 302        |       | —               |       |
| Total                                    |       | $          | 4,130      |                 | 100.0      | % |
| **December 31,  2006:**             |       |       |       |                 |       |
| Balance at end  of period applicable to: |       |       |       |                 |       |
| Commercial and  agricultural             |       | $          | 679        |                 | 7.9        | % |
| Real estate  mortgage:                   |       |       |       |                 |       |
| Residential                              |       | 951        |       | 43.8                 | %          |
| Commercial                               |       | 1,972      |       | 37.5                 | %          |
| Construction                             |       | 108        |       | 4.6                  | %          |
| Installment  loans to individuals        |       | 295        |       | 6.2                  | %          |
| Unallocated                              |       | 180        |       | —               |       |
| Total                                    |       | $          | 4,185      |                 | 100.0      | % |
| **December 31,  2005:**             |       |       |       |                 |       |
| Balance at end  of period applicable to: |       |       |       |                 |       |
| Commercial and  agricultural             |       | $          | 582        |                 | 10.1       | % |
| Real estate  mortgage:                   |       |       |       |                 |       |
| Residential                              |       | 1,107      |       | 44.2                 | %          |
| Commercial                               |       | 1,482      |       | 37.5                 | %          |
| Construction                             |       | 79         |       | 3.1                  | %          |
| Installment  loans to individuals        |       | 192        |       | 5.1                  | %          |
| Unallocated                              |       | 237        |       | —               |       |
| Total                                    |       | $          | 3,679      |                 | 100.0      | % |
| **December 31,  2004:**             |       |       |       |                 |       |
| Balance at end  of period applicable to: |       |       |       |                 |       |
| Commercial and  agricultural             |       | $          | 361        |                 | 9.1        | % |
| Real estate  mortgage:                   |       |       |       |                 |       |
| Residential                              |       | 1,280      |       | 46.1                 | %          |
| Commercial                               |       | 1,399      |       | 37.5                 | %          |
| Construction                             |       | 75         |       | 2.5                  | %          |
| Installment  loans to individuals        |       | 207        |       | 4.8                  | %          |
| Unallocated                              |       | 16         |       | —               |       |
| Total                                    |       | $          | 3,338      |                 | 100.0      | % |
| **December 31,  2003:**             |       |       |       |                 |       |
| Balance at end of  period applicable to: |       |       |       |                 |       |
| Commercial and  agricultural             |       | $          | 353        |                 | 8.5        | % |
| Real estate  mortgage:                   |       |       |       |                 |       |
| Residential                              |       | 1,483      |       | 53.4                 | %          |
| Commercial                               |       | 916        |       | 29.9                 | %          |
| Construction                             |       | 77         |       | 2.8                  | %          |
| Installment  loans to individuals        |       | 240        |       | 5.4                  | %          |
| Total                                    |       | $          | 3,069      |                 | 100.0      | % |

 

29

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**DEPOSITS**

 

**2007 vs 2006**

 

Total average depositswere $397,208,000 for 2007, an increase of $17,862,000 or 4.71% from 2006.  Noninterest-bearing deposits increasedslightly to $69,953,000.  Time depositsincreased $21,508,000 or 12.19% as deposits shifted from transaction accountsto time deposits due to the continued rate disparity between time deposits andother deposit types.  The rate on timedeposits increased due to the actions taken by the FOMC during 2006, whichincreased the overall rate paid on time deposits.  In addition, the Bank utilized brokered timedeposits to supplement market area deposit funding with the level of brokereddeposits decreasing $16,197,000 to $8,831,000 at December 31, 2007.

 

**2006 vs 2005**

 

Total average depositswere $379,346,000 for 2006, an increase of $18,630,000 or 5.16% from 2005.  Non-interest bearing deposits increasedslightly to $69,668,000.  Time depositsincreased $30,130,000 or 20.58% as deposits shifted from transaction accountsto time deposits due to the continued rate disparity between time deposits andother deposit types.  The rate on timedeposits has been increasing due to the actions taken by the FOMC and market competition.  In addition, the Bank utilized brokered timedeposits to supplement market area deposit funding.

 

Theaverage amount and the average rate paid on deposits are summarized below:

 
| ** **              | ** ** | **2007**    | ** ** | **2006**   | ** ** | **2005**    | ** ** |
|-------------------------|------------|-------------|------------|------------|------------|-------------|------------|
| ** **              | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** |
| **(In Thousands)** | ** ** | **Amount**  | ** ** | **Rate**   | ** ** | **Amount**  | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
| Noninterest-bearing     |       | $           | 69,953     |       | 0.00       | %           | $          | 69,668 |   | 0.00 | % | $ | 69,457 |   | 0.00 | % |
| Savings                 |       | 58,710      |       | 0.73       | %          | 61,958      |       | 0.82 | % | 64,795 |   | 0.77 | % |
| Super Now               |       | 46,596      |       | 1.31       | %          | 47,294      |       | 1.38 | % | 50,756 |   | 0.86 | % |
| Money Market            |       | 23,920      |       | 2.26       | %          | 23,905      |       | 2.06 | % | 29,317 |   | 1.41 | % |
| Time                    |       | 198,029     |       | 4.73       | %          | 176,521     |       | 4.11 | % | 146,391 |   | 3.02 | % |
| Total average  deposits |       | $           | 397,208    |       | 2.76       | %           | $          | 379,346 |   | 2.35 | % | $ | 360,716 |   | 1.60 | % |

##### ** **

##### **SHAREHOLDERS’ EQUITY**

##### ** **

**2007**

 

Shareholders’equity decreased $4,035,000 to $70,559,000 at December 31, 2007 as netincome outpaced dividends paid, accumulated comprehensive income decreased$5,094,000, and $972,000 in treasury stock was strategically purchased as partof the previously announced stock buyback plan. The decrease in accumulated comprehensive income is the result of adecrease in market value, or net unrealized loss, of the investment portfolioat December 31, 2007 as compared to December 31, 2006, and the netexcess of the projected benefit obligation over the market value of the planassets of the defined benefit pension plan. The current level of shareholders’ equity equates to a book value pershare of $18.21 at December 31, 2007 as compared to $19.12 at December 31,2006 and an equity to asset ratio of 11.23% at December 31, 2007.  During the twelve months ended December 31,2007 cash dividends of $1.79 per share were paid to shareholders.  The dividends represented a 3% increase or$0.06 per share over the dividends paid during the comparable period of 2006.

 

**2006**

 

Shareholders’equity increased $675,000 to $74,594,000 at December 31, 2006 as netincome outpaced dividends paid, accumulated comprehensive income increased$710,000, and $2,929,000 in 

 

30

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treasurystock was strategically purchased as part of the previously announced stockbuyback plan.  The increase inaccumulated comprehensive income is the result of an increase in market value,or net unrealized gains, of the investment portfolio at December 31, 2006as compared to December 31, 2005, offset by the net excess of theprojected benefit obligation over the market value of the plan assets of thedefined benefit pension plan.  Thecurrent level of shareholders’ equity equates to a book value per share of$19.12 at December 31, 2006 as compared to $18.59 at December 31,2005 and an equity to asset ratio of 12.59% at December 31, 2006.  During the twelve months ended December 31,2006 cash dividends of $1.73 per share were paid to shareholders.  The dividends represented an 11% increase or$0.17 per share over the dividends paid during the comparable period of 2005.

 

Bank regulators have riskbased capital guidelines.  Under theseguidelines the Company and Bank are required to maintain minimum ratios of corecapital and total qualifying capital as a percentage of risk weighted assetsand certain off-balance sheet items.  At December 31,2007, both the Company’s and Bank’s required ratios were well above the minimumratios as follows:

 
| ** **            | ** ** | ** **  | ** ** | ** ** | ** ** | **Minimum**   | ** ** |
|-----------------------|------------|-------------|------------|------------|------------|---------------|------------|
| ** **            | ** ** | **Company** | ** ** | **Bank**   | ** ** | **Standards** | ** ** |
| Tier 1 capital  ratio |       | 10.8        | %          | 8.8        | %          | 4.0           | %          |
| Total capital  ratio  |       | 18.0        | %          | 15.1       | %          | 8.0           | %          |

 

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

 

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

##### ** **

The ratio of net incometo average total assets and average shareholders’ equity and other certainequity ratios are presented as follows:

 
| ** **                                                               | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Percentage of  net income to:                                            |       |     |       |     |       |     |       |
| Average total  assets                                                    |       | 1.49     | %          | 1.67     | %          | 1.97     | %          |
| Average  shareholders’ equity                                       |       | 12.14    | %          | 12.93    | %          | 14.54    | %          |
| Percentage of  dividends declared to net income                          |       | 78.33    | %          | 70.51    | %          | 57.10    | %          |
| Percentage of  average shareholders’ equity to average total assets |       | 12.23    | %          | 12.92    | %          | 13.56    | %          |

 

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

##### ** **

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

 

TheCompany, like other financial institutions, must have sufficient fundsavailable to meet its liquidity needs for deposit withdrawals, loancommitments, and expenses.   In order tocontrol cash flow, the bank estimates future flows of cash from deposits andloan payments.  The primary sources offunds are deposits, principal and interest payments on loans andmortgage-backed securities, as well as Federal Home Loan Bank borrowings.  Funds generated are used principally to fundloans and purchase investment securities. Management believes the Company has adequate resources to meet itsnormal funding requirements.

 

31

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Managementmonitors the Company’s liquidity on both a long and short-term basis thereby,providing management necessary information to react to current balance sheettrends.  Cash flow needs are assessed andsources of funds are determined.  Fundingstrategies consider both customer needs and economical cost.  Both short and long term funding needs areaddressed by maturities and sales of available for sale investment securities,loan repayments and maturities, and liquidating money market investments suchas federal funds sold.  The use of theseresources, in conjunction with access to credit provides core ingredients tosatisfy depositor, borrower, and creditor needs.

 

Managementmonitors and determines the desirable level of liquidity.  Consideration is given to loan demand,investment opportunities, deposit pricing and growth potential as well as thecurrent cost of borrowing funds.  TheCompany has a current borrowing capacity at the Federal Home Loan Bank of $220,053,000with $144,538,000 utilized, leaving $75,515,000 available.  In addition to this credit arrangement, theCompany has additional lines of credit with correspondent banks of $29,539,000.The Company’s management believes that it has sufficient liquidity to satisfyestimated short-term and long-term funding needs.

 

Interestrate sensitivity, which is closely related to liquidity management, is afunction of the repricing characteristics of the Company’s portfolio of assetsand liabilities.  Asset/liabilitymanagement strives to match maturities and rates between loan and investmentsecurity assets with the deposit liabilities and borrowings that fundthem.  Successful asset/liabilitymanagement results in a balance sheet structure which can cope effectively withmarket rate fluctuations. The matching process is affected by segmenting bothassets and liabilities into future time periods (usually 12 months, or less)based upon when repricing can be effected. Repriceable assets are subtracted from repriceable liabilities, for aspecific time period to determine the “gap”, or difference. Once known, the gapis managed based on predictions about future market interest rates.  Intentional mismatching, or gapping, canenhance net interest income if market rates move as predicted.  However, if market rates behave in a mannercontrary to predictions, net interest income will suffer.  Gaps, therefore, contain an element of riskand must be prudently managed.  Inaddition to gap management, the Company has an asset liability managementpolicy which incorporates a market value at risk calculation which is used todetermine the effects of interest rate movements on shareholders’ equity and asimulation analysis to monitor the effects of interest rate changes on theCompany’s balance sheet.

 

**INTEREST RATE SENSITIVITY**

 

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

 

Thefollowing is a rate shock forecast for the twelve month period ended December 31,2008 assuming a static balance sheet as of December 31, 2007.

 
| ** **                  | ** ** | **Parallel Rate Shock in Basis Points** | ** ** |
|-----------------------------|------------|------------------------------------------------------------------|------------|
| **(In Thousands)**     | ** ** | **-200**                                                         | ** ** | **-100** | ** ** | **Static** | ** ** | **+100** | ** ** | **+200** | ** ** |
| Net interest  income        |       | $                                                                | 21,322     |   | $ | 21,484 |   | $ | 21,134 |   | $ | 20,578 |   | $ | 19,797 |   |
| Change from  static         |       | 188                                                              |       | 350 |   | — |   | (556 | ) | (1,337 | ) |
| Percent change  from static |       | 0.89                                                             | %          | 1.66 | % | — |   | (2.63 | )% | (6.33 | )% |
|                             |            |                                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Themodel utilized to create the report presented above makes various estimates ateach level of interest rate change regarding cash flow from principal repaymenton loans and mortgage-backed securities and or call activity on investmentsecurities.  Actual results could differsignificantly from these estimates which would result in significantdifferences in the calculated projected change. In

 

32

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addition,the limits stated above do not necessarily represent the level of change underwhich management would undertake specific measures to realign its portfolio inorder to reduce the projected level of change. Generally, management believes the Company is well positioned to respondexpeditiously when the market interest rate outlook changes.

 

**INFLATION**

##### ** **

##### **The asset and liability structure of a financialinstitution is primarily monetary in nature, therefore, interest rates ratherthan inflation have a more significant impact on the Company’sperformance.  Interest rates are notalways affected in the same direction or magnitude as prices of other goods andservices, but are reflective of fiscal policy initiatives or economic factorsthat are not measured by a price index.**

##### ** **

**CRITICAL ACCOUNTING POLICIES**

 

TheCompany’s accounting policies are integral to understanding the resultsreported.  The accounting policies aredescribed in detail in Note 1 of the consolidated financial statements.  Our most complex accounting policies requiremanagement’s judgment to ascertain the valuation of assets, liabilities,commitments, and contingencies.  We haveestablished detailed policies and control procedures that are intended toensure valuation methods are well controlled and applied consistently from periodto period.  In addition, the policies andprocedures are intended to ensure that the process for changing methodologiesoccurs in an appropriate manner.  Thefollowing is a brief description of our current accounting policies involvingsignificant management valuation judgments.

 

*Other Than Temporary Impairment of Equity Securities*

 

Equitysecurities are evaluated periodically to determine whether a decline in theirvalue is other than temporary. Management utilizes criteria such as themagnitude and duration of the decline, in addition to the reason underlying thedecline, to determine whether the loss in value is other than temporary. Theterm “other than temporary” is not intended to indicate that the decline ispermanent.  It indicates that the prospectsfor a near term recovery of value are not necessarily favorable, or that thereis a lack of evidence to support fair values equal to, or greater than, thecarrying value of the investment.  Once adecline in value is determined to be other than temporary, the value of thesecurity is reduced and a corresponding charge to earnings is recognized.  For a full discussion of the Company’smethodology of assessing impairment, refer to Note 3 of “Notes and ConsolidatedFinancial Statements” of the Annual Report on Form 10-K.

 

*Allowance for Loan Losses*

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

 

Managementuses historical information to assess the adequacy of the allowance for loanlosses as well as the prevailing business environment; as it is affected bychanging economic conditions and various external factors, which may impact theportfolio in ways currently unforeseen. The allowance is increased by provisions for loan losses and byrecoveries of loans previously charged-off and reduced by loans charged-off.  For a full discussion of the Company’smethodology of assessing the adequacy of the reserve for loan losses, refer toNote 1 of “Notes and Consolidated Financial Statements” of the Annual Report ofForm 10-K.

 

*Goodwill and Other Intangible Assets*

Asdiscussed in Note 6 of the “Notes to Consolidated Financial Statements” of theAnnual Report on Form 10-K, the Company must assess goodwill and otherintangible assets each year for impairment.

 

33

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Thisassessment involves estimating cash flows for future periods.  If the future cash flows were less than therecorded goodwill and other intangible assets balances, we would be required totake a charge against earnings to write down the assets to the lower value.

 

*Deferred Tax Assets*

Weuse an estimate of future earnings to support our position that the benefit ofour deferred tax assets will be realized. If future income should prove non-existent or less than the amount ofthe deferred tax assets within the tax years to which they may be applied, theasset may not be realized and our net income will be reduced.  Our deferred tax assets are described furtherin Note 10 of “Notes to Consolidated Financial Statements” of the Annual Reporton Form 10-K.

 

*PensionBenefits*

Pensioncosts and liabilities are dependent on assumptions used in calculating suchamounts.  These assumptions includediscount rates, benefits earned, interest costs, expected return on planassets, mortality rates, and other factors. In accordance with generally accepted accounting principles, actual resultsthat differ from the assumptions are accumulated and amortized over futureperiods and, therefore, generally affect recognized expense and the recordedobligation of future periods.  Whilemanagement believes that the assumptions used are appropriate, differences inactual experience or changes in assumptions may affect the Company’s pensionobligations and future expense.  Ourpension benefits are described further in Note 11 of “Notes to ConsolidatedFinancial Statements” of the Annual Report on Form 10-K.

 

**CONTRACTUAL OBLIGATIONS**

 

TheCompany has various financial obligations, including contractual obligationswhich may require future cash payments. The following table presents, as of December 31,2007, significant fixed and determinable contractual obligations to thirdparties by payment date.   Furtherdiscussion of the nature of each obligation is included in “Notes to theConsolidated Financial Statements” of the Annual Report on Form 10-K.

 
| ** **                              | ** ** | **Payments  Due in** | ** ** |
|-----------------------------------------|------------|----------------------|------------|
| ** **                              | ** ** | ** **           | ** ** | **One to** | ** ** | **Three to** | ** ** | **Over** | ** ** | ** ** | ** ** |
| ** **                              | ** ** | **One Year**    | ** ** | **Three** | ** ** | **Five** | ** ** | **Five** | ** ** | ** ** | ** ** |
| **(In Thousands)**                      | ** ** | **or Less**          | ** ** | **Years** | ** ** | **Years** | ** ** | **Years** | ** ** | **Total** | ** ** |
| **Deposits  without a stated maturity** |       | $                    | 203,340    |   | $ | — |   | $ | — |   | $ | — |   | $ | 203,340 |   |
| **Time  Deposits**                      |       | 157,621              |       | 24,372 |   | 3,064 |   | 625 |   | 185,682 |   |
| **Repurchase  agreements**              |       | 17,154               |       | — |   | — |   | — |   | 17,154 |   |
| **Short-term  borrowings, FHLB**        |       | 38,160               |       | — |   | — |   | — |   | 38,160 |   |
| **Long-term  borrowings, FHLB**         |       | 29,600               |       | 15,000 |   | 25,500 |   | 36,278 |   | 106,378 |   |
| **Operating  leases**                   |       | 396                  |       | 614 |   | 382 |   | 1,427 |   | 2,819 |   |
|                                         |            |                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The Corporation’s operating lease obligations represent short andlong-term lease and rental payments for branch facilities.  The Bank leases certain facilities underoperating leases which expire on various dates through 2024.  Renewal options are available on theseleases.

 

**CAUTIONARYSTATEMENT FOR PURPOSES OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF1995**

 

This Report containscertain “forward-looking statements” including statements concerning plans,objectives, future events or performance and assumptions and other statementswhich are other than statements of historical fact.

 

34

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The Private SecuritiesLitigation Reform Act of 1995 provides a safe harbor for forward-lookingstatements. In order to comply with the terms of the safe harbor, the Companynotes that a variety of factors could cause the Company’s actual results andexperience to differ materially from the anticipated results or otherexpectations expressed in the Company’s forward-looking statements. The risksand uncertainties that may affect the operations, performance, development andresults of the Company’s business include the following: general economicconditions and changes in interest rates including their impact on capitalexpenditures; business conditions in the banking industry; the regulatoryenvironment; rapidly changing technology and evolving banking industrystandards; the effect of changes in accounting policies and practices,including increased competition with community, regional and national financialinstitutions; new service and product offerings by competitors and pricepressures; changes in the Company’s organization, compensation and benefitplans; and similar items.

 

35

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

Market risk for the Company is comprised primarily from interest raterisk exposure and liquidity risk. Interest rate risk and liquidity risk management is performed at theBank level as well as the Company level. The Company’s interest rate sensitivity is monitored by managementthrough selected interest rate risk measures produced internally.  Additional information and details areprovided in the Interest Sensitivity section of Item 7 Management’s Discussionand Analysis of Financial Condition and Results of Operations.

 

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

 

36

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##### ** **

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

##### ** **

**PENNSWOODS BANCORP, INC.**

**CONSOLIDATEDBALANCE SHEET**

 
| ** **                                                                                           | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| **(In Thousands, Except Share Data)**                                            | ** ** | **2007**              | ** ** | **2006** | ** ** |
| ** **                                                                                           | ** ** | ** **            | ** ** | ** ** | ** ** |
| ASSETS:                                                                                              |       |                  |       |   |   |
| Noninterest-bearing  balances                                                                        |       | $                     | 15,417     |   | $ | 15,348 |   |
| Interest-bearing  deposits in other financial institutions                                           |       | 16                    |       | 25 |   |
| Total cash and  cash equivalents                                                                     |       | 15,433                |       | 15,373 |   |
|                                                                                                 |       |                  |       |   |   |
| Investment  securities, available for sale, at fair value                                            |       | 214,455               |       | 185,200 |   |
| Investment  securities, held to maturity, (fair value of $279 and $286)                              |       | 277                   |       | 283 |   |
| Loans held for  sale                                                                                 |       | 4,214                 |       | 3,716 |   |
|                                                                                                 |       |                  |       |   |   |
| Loans                                                                                                |       | 360,478               |       | 360,384 |   |
| Less: Allowance  for loan losses                                                                     |       | 4,130                 |       | 4,185 |   |
| Loans, net                                                                                           |       | 356,348               |       | 356,199 |   |
|                                                                                                 |       |                  |       |   |   |
| Premises and  equipment, net                                                                         |       | 6,774                 |       | 6,737 |   |
| Accrued interest  receivable                                                                         |       | 3,343                 |       | 2,939 |   |
| Bank-owned life  insurance                                                                           |       | 12,375                |       | 11,346 |   |
| Investment in  limited partnerships                                                                  |       | 5,439                 |       | 4,950 |   |
| Goodwill                                                                                             |       | 3,032                 |       | 3,032 |   |
| Other assets                                                                                         |       | 6,448                 |       | 2,510 |   |
| TOTAL ASSETS                                                                                         |       | $                     | 628,138    |   | $ | 592,285 |   |
|                                                                                                 |       |                  |       |   |   |
| LIABILITIES:                                                                                         |       |                  |       |   |   |
| Interest-bearing  deposits                                                                           |       | $                     | 314,351    |   | $ | 322,031 |   |
| Noninterest-bearing  deposits                                                                        |       | 74,671                |       | 73,160 |   |
| Total deposits                                                                                       |       | 389,022               |       | 395,191 |   |
|                                                                                                 |       |                  |       |   |   |
| Short-term  borrowings                                                                               |       | 55,315                |       | 34,697 |   |
| Long-term  borrowings, Federal Home Loan Bank (FHLB)                                                 |       | 106,378               |       | 82,878 |   |
| Accrued interest  payable                                                                            |       | 1,744                 |       | 1,532 |   |
| Other  liabilities                                                                                   |       | 5,120                 |       | 3,393 |   |
| TOTAL  LIABILITIES                                                                                   |       | 557,579               |       | 517,691 |   |
|                                                                                                 |       |                  |       |   |   |
| SHAREHOLDERS’  EQUITY:                                                                          |       |                  |       |   |   |
| Common stock,  par value $8.33, 10,000,000 shares authorized; 4,006,934 and 4,003,514 shares  issued |       | 33,391                |       | 33,362 |   |
| Additional  paid-in capital                                                                          |       | 17,888                |       | 17,810 |   |
| Retained  earnings                                                                                   |       | 27,707                |       | 25,783 |   |
| Accumulated  other comprehensive (loss) income:                                                      |       |                  |       |   |   |
| Net unrealized  (loss) gain on available-for-sale securities                                         |       | (2,159                | )          | 2,139 |   |
| Defined benefit  plan                                                                                |       | (1,375                | )          | (579 | ) |
| Less: Treasury  stock at cost, 131,302 and 102,772 shares                                            |       | (4,893                | )          | (3,921 | ) |
| TOTAL  SHAREHOLDERS’ EQUITY                                                                     |       | 70,559                |       | 74,594 |   |
| TOTAL  LIABILITIES AND SHAREHOLDERS’ EQUITY                                                     |       | $                     | 628,138    |   | $ | 592,285 |   |

 

See Accompanying Notes to the Consolidated Financial Statements

 

37

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**PENNS WOODS BANCORP, INC.**

**CONSOLIDATED STATEMENT OF INCOME**

 
| ** **                                                         | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------------|------------|
| **(In Thousands, Except Per Share Data)** | ** ** | **2007**                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                               |       |                                       |       |   |   |   |   |
| INTEREST AND  DIVIDEND INCOME:                                     |       |                                       |       |   |   |   |   |
| Loans including  fees                                              |       | $                                          | 26,099     |   | $ | 24,878 |   | $ | 22,126 |   |
| Investment  Securities:                                            |       |                                       |       |   |   |   |   |
| Taxable                                                            |       | 4,098                                      |       | 3,577 |   | 4,351 |   |
| Tax-exempt                                                         |       | 4,357                                      |       | 4,027 |   | 3,223 |   |
| Dividend and  other interest income                                |       | 1,395                                      |       | 1,271 |   | 1,203 |   |
|                                                               |       |                                       |       |   |   |   |   |
| TOTAL INTEREST  AND DIVIDEND INCOME                                |       | 35,949                                     |       | 33,753 |   | 30,903 |   |
|                                                               |       |                                       |       |   |   |   |   |
| INTEREST  EXPENSE:                                                 |       |                                       |       |   |   |   |   |
| Deposits                                                           |       | 10,951                                     |       | 8,908 |   | 5,774 |   |
| Short-term  borrowings                                             |       | 1,639                                      |       | 1,503 |   | 931 |   |
| Long-term  borrowings                                              |       | 3,857                                      |       | 3,799 |   | 3,676 |   |
|                                                               |       |                                       |       |   |   |   |   |
| TOTAL INTEREST  EXPENSE                                            |       | 16,447                                     |       | 14,210 |   | 10,381 |   |
|                                                               |       |                                       |       |   |   |   |   |
| NET INTEREST  INCOME                                               |       | 19,502                                     |       | 19,543 |   | 20,522 |   |
|                                                               |       |                                       |       |   |   |   |   |
| PROVISION FOR  LOAN LOSSES                                         |       | 150                                        |       | 635 |   | 720 |   |
|                                                               |       |                                       |       |   |   |   |   |
| NET INTEREST  INCOME AFTER PROVISION FOR LOAN LOSSES               |       | 19,352                                     |       | 18,908 |   | 19,802 |   |
|                                                               |       |                                       |       |   |   |   |   |
| NON-INTEREST  INCOME:                                              |       |                                       |       |   |   |   |   |
| Service charges                                                    |       | 2,246                                      |       | 2,366 |   | 2,228 |   |
| Securities  (losses) gains, net                                    |       | (54                                        | )          | 1,679 |   | 2,190 |   |
| Bank-owned life  insurance                                         |       | 410                                        |       | 374 |   | 568 |   |
| Gain on sale of  loans                                             |       | 921                                        |       | 853 |   | 864 |   |
| Insurance  commissions                                             |       | 2,222                                      |       | 2,281 |   | 2,327 |   |
| Other income                                                       |       | 1,733                                      |       | 1,476 |   | 1,254 |   |
|                                                               |       |                                       |       |   |   |   |   |
| TOTAL  NON-INTEREST INCOME                                         |       | 7,478                                      |       | 9,029 |   | 9,431 |   |
|                                                               |       |                                       |       |   |   |   |   |
| NON-INTEREST  EXPENSES:                                            |       |                                       |       |   |   |   |   |
| Salaries and  employee benefits                                    |       | 9,078                                      |       | 8,833 |   | 8,314 |   |
| Occupancy  expense, net                                            |       | 1,306                                      |       | 1,137 |   | 1,089 |   |
| Furniture and  equipment expense                                   |       | 1,126                                      |       | 1,201 |   | 973 |   |
| Pennsylvania  shares tax expense                                   |       | 643                                        |       | 598 |   | 549 |   |
| Amortization of  investment in limited partnerships                |       | 761                                        |       | 245 |   | 90 |   |
| Other expenses                                                     |       | 4,402                                      |       | 4,315 |   | 4,093 |   |
|                                                               |       |                                       |       |   |   |   |   |
| TOTAL  NON-INTEREST EXPENSES                                       |       | 17,316                                     |       | 16,329 |   | 15,108 |   |
|                                                               |       |                                       |       |   |   |   |   |
| INCOME BEFORE  INCOME TAX PROVISION                                |       | 9,514                                      |       | 11,608 |   | 14,125 |   |
|                                                               |       |                                       |       |   |   |   |   |
| INCOME TAX  PROVISION                                              |       | 637                                        |       | 1,961 |   | 3,224 |   |
|                                                               |       |                                       |       |   |   |   |   |
| NET INCOME                                                         |       | $                                          | 8,877      |   | $ | 9,647 |   | $ | 10,901 |   |
|                                                               |       |                                       |       |   |   |   |   |
| NET INCOME PER  SHARE - BASIC                                      |       | $                                          | 2.28       |   | $ | 2.45 |   | $ | 2.75 |   |
|                                                               |       |                                       |       |   |   |   |   |
| NET INCOME PER  SHARE - DILUTED                                    |       | $                                          | 2.28       |   | $ | 2.45 |   | $ | 2.74 |   |
|                                                               |       |                                       |       |   |   |   |   |
| WEIGHTED AVERAGE  SHARES OUTSTANDING - BASIC                       |       | 3,886,277                                  |       | 3,934,138 |   | 3,971,926 |   |
|                                                               |       |                                       |       |   |   |   |   |
| WEIGHTED AVERAGE  SHARES OUTSTANDING - DILUTED                     |       | 3,886,514                                  |       | 3,934,617 |   | 3,974,055 |   |

 

See Accompanying Notes to the Consolidated Financial Statements.

 

38

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**PENNS WOODS BANCORP, INC.**

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

 
| ** **                                                                                     | ** ** | ** **            | ** ** | ** **  | ** ** | ** **     | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** **        | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|----------------|------------|-------------------|------------|------------------------|------------|-------------------|------------|------------|------------|
| ** **                                                                                     | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional** | ** ** | ** **        | ** ** | **Other**              | ** ** | ** **        | ** ** | **Total**  | ** ** |
| ** **                                                                                     | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Retained**   | ** ** | **Comprehensive** | ** ** | **Treasury**           | ** ** | **Shareholders'** | ** ** |
| **(In Thousands, Except Per Share Data)**                             | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**    | ** ** | **Earnings**      | ** ** | **Income (Loss)** | ** ** | **Stock**         | ** ** | **Equity** | ** ** |
|                                                                                           |       |                  |       |        |       |           |       |              |       |                   |       |              |       |       |       |
| Balance, December  31, 2004                                                                    |       | 3,998,204             |       | $           | 33,318     |           | $          | 17,700            |       | $                      | 18,262     |              | $          | 4,331      |       | $ | (446 | ) | $ | 73,165 |   |
|                                                                                           |       |                  |       |        |       |           |       |              |       |                   |       |              |       |       |       |
| Stock split  fractional shares                                                                 |       | (293                  | )          | (2          | )          | 2              |       |              |       |                   |       |              |       | —     |       |
| Comprehensive  income:                                                                         |       |                  |       |        |       |           |       |              |       |                   |       |              |       |       |       |
| Net income                                                                                     |       |                  |       |        |       |           |       | 10,901            |       |                   |       |              |       | 10,901     |       |
| Other  comprehensive loss                                                                      |       |                  |       |        |       |           |       |              |       | (3,481                 | )          |              |       | (3,481     | )          |
| Total  comprehensive income                                                                    |       |                  |       |        |       |           |       |              |       |                   |       |              |       | 7,420      |       |
| Dividends  declared ($1.56 per share)                                                          |       |                  |       |        |       |           |       | (6,225            | )          |                   |       |              |       | (6,225     | )          |
| Stock options  exercised                                                                       |       | 4,248                 |       | 35          |       | 70             |       |              |       |                   |       |              |       | 105        |       |
| Purchase of  treasury stock (14,000 shares)                                                    |       |                  |       |        |       |           |       |              |       |                   |       | (546              | )          | (546       | )          |
|                                                                                           |       |                  |       |        |       |           |       |              |       |                   |       |              |       |       |       |
| Balance, December  31, 2005                                                                    |       | 4,002,159             |       | 33,351      |       | 17,772         |       | 22,938            |       | 850                    |       | (992              | )          | 73,919     |       |
|                                                                                           |       |                  |       |        |       |           |       |              |       |                   |       |              |       |       |       |
| Comprehensive  income:                                                                         |       |                  |       |        |       |           |       |              |       |                   |       |              |       |       |       |
| Net income                                                                                     |       |                  |       |        |       |           |       | 9,647             |       |                   |       |              |       | 9,647      |       |
| Other  comprehensive income                                                                    |       |                  |       |        |       |           |       |              |       | 1,289                  |       |              |       | 1,289      |       |
| Total  comprehensive income                                                                    |       |                  |       |        |       |           |       |              |       |                   |       |              |       | 10,936     |       |
| Cumulative effect  of change in accounting for pension obligations, net of tax bemefit of $298 |       |                  |       |        |       |           |       |              |       | (579                   | )          |              |       | (579       | )          |
| Dividends  declared ($1.73 per share)                                                          |       |                  |       |        |       |           |       | (6,802            | )          |                   |       |              |       | (6,802     | )          |
| Common shares  issued for employee stock purchase plan                                         |       | 1,355                 |       | 11          |       | 38             |       |              |       |                   |       |              |       | 49         |       |
| Purchase of  treasury stock (76,400 shares)                                                    |       |                  |       |        |       |           |       |              |       |                   |       | (2,929            | )          | (2,929     | )          |
|                                                                                           |       |                  |       |        |       |           |       |              |       |                   |       |              |       |       |       |
| Balance, December  31, 2006                                                                    |       | 4,003,514             |       | 33,362      |       | 17,810         |       | 25,783            |       | 1,560                  |       | (3,921            | )          | 74,594     |       |
|                                                                                           |       |                  |       |        |       |           |       |              |       |                   |       |              |       |       |       |
| Comprehensive  income:                                                                         |       |                  |       |        |       |           |       |              |       |                   |       |              |       |       |       |
| Net income                                                                                     |       |                  |       |        |       |           |       | 8,877             |       |                   |       |              |       | 8,877      |       |
| Other  comprehensive loss                                                                      |       |                  |       |        |       |           |       |              |       | (5,094                 | )          |              |       | (5,094     | )          |
| Total  comprehensive income                                                                    |       |                  |       |        |       |           |       |              |       |                   |       |              |       | 3,783      |       |
| Dividends  declared ($1.79 per share)                                                          |       |                  |       |        |       |           |       | (6,953            | )          |                   |       |              |       | (6,953     | )          |
| Purchase of  treasury stock (28,530 shares)                                                    |       |                  |       |        |       |           |       |              |       |                   |       | (972              | )          | (972       | )          |
| Stock options  exercised                                                                       |       | 330                   |       | 3           |       | 5              |       |              |       |                   |       |              |       | 8          |       |
| Common shares  issued for employee stock purchase plan                                         |       | 3,090                 |       | 26          |       | 73             |       |              |       |                   |       |              |       | 99         |       |
|                                                                                           |       |                  |       |        |       |           |       |              |       |                   |       |              |       |       |       |
| Balance, December  31, 2007                                                                    |       | 4,006,934             |       | $           | 33,391     |           | $          | 17,888            |       | $                      | 27,707     |              | $          | (3,534     | )          | $ | (4,893 | ) | $ | 70,559 |   |

 

**PENNSWOODS BANCORP, INC.**

**CONSOLIDATEDSTATEMENT OF COMPREHENSIVE INCOME**

 
| ** **                                                                                       | ** ** | **For the years ended** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                       | ** ** | **2007**                               | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                                             |       |                                   |       |   |   |   |   |
| Net Income                                                                                       |       | $                                      | 8,877      |   | $ | 9,647 |   | $ | 10,901 |   |
| Other  Comprehensive (loss) income, net of tax:                                                  |       |                                   |       |   |   |   |   |
| Change in  unrealized gain (loss) on available for sale securities                               |       | (4,334                                 | )          | 2,397 |   | (2,036 | ) |
| Net realized  (gain) loss included in net income, net of (benefit)taxes of $(18), $571, and $745 |       | 36                                     |       | (1,108 | ) | (1,445 | ) |
|                                                                                             |       | (4,298                                 | )          | 1,289 |   | (3,481 | ) |
| Defined benefit  pension plans:                                                                  |       |                                   |       |   |   |   |   |
| Net transition  asset                                                                            |       | (2                                     | )          | — |   | — |   |
| Prior service  cost                                                                              |       | 17                                     |       | — |   | — |   |
| Net loss                                                                                         |       | (811                                   | )          | — |   | — |   |
| Other  comprehensive (loss) income, net of tax                                                   |       | (5,094                                 | )          | 1,289 |   | (3,481 | ) |
| Comprehensive  income                                                                            |       | $                                      | 3,783      |   | $ | 10,936 |   | $ | 7,420 |   |

 

See accompanyingnotes to the unaudited consolidated financial statements.

 

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**PENNS WOODS BANCORP, INC.**

**CONSOLIDATED STATEMENT OF CASH FLOWS**

 
| ** **                                                                         | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| **(In Thousands)**                                                            | ** ** | **2007**                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                               |       |                                       |       |   |   |   |   |
| OPERATING  ACTIVITIES                                                              |       |                                       |       |   |   |   |   |
| Net income                                                                         |       | $                                          | 8,877      |   | $ | 9,647 |   | $ | 10,901 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                       |       |   |   |   |   |
| Depreciation and  amortization                                                     |       | 680                                        |       | 744 |   | 549 |   |
| Provision for  loan losses                                                         |       | 150                                        |       | 635 |   | 720 |   |
| Accretion and  amortization of investment security discounts and premiums          |       | (1,011                                     | )          | (784 | ) | (453 | ) |
| Securities  losses (gains), net                                                    |       | 54                                         |       | (1,679 | ) | (2,190 | ) |
| Originations of  loans held for sale                                               |       | (43,783                                    | )          | (37,192 | ) | (30,353 | ) |
| Proceeds of  loans held for sale                                                   |       | 44,206                                     |       | 37,874 |   | 32,296 |   |
| Gain on sale of  loans                                                             |       | (921                                       | )          | (853 | ) | (864 | ) |
| Increases in  bank-owned life insurance                                            |       | (410                                       | )          | (374 | ) | (568 | ) |
| Other, net                                                                         |       | (214                                       | )          | (29 | ) | 254 |   |
|                                                                               |       |                                       |       |   |   |   |   |
| Net cash  provided by operating activities                                         |       | 7,628                                      |       | 7,989 |   | 10,292 |   |
|                                                                               |       |                                       |       |   |   |   |   |
| INVESTING  ACTIVITIES                                                              |       |                                       |       |   |   |   |   |
| Investment  securities available for sale:                                         |       |                                       |       |   |   |   |   |
| Proceeds from  sales                                                               |       | 60,485                                     |       | 76,249 |   | 123,546 |   |
| Proceeds from  calls and maturities                                                |       | 5,233                                      |       | 7,477 |   | 12,664 |   |
| Purchases                                                                          |       | (98,799                                    | )          | (78,241 | ) | (141,798 | ) |
| Investment  securities held to maturity:                                           |       |                                       |       |   |   |   |   |
| Proceeds from  calls and maturities                                                |       | 12                                         |       | 25 |   | 328 |   |
| Purchases                                                                          |       | —                                     |       | (25 | ) | (35 | ) |
| Net increase in  loans                                                             |       | (374                                       | )          | (22,353 | ) | (14,745 | ) |
| Acquisition of  bank premises and equipment                                        |       | (717                                       | )          | (1,072 | ) | (2,076 | ) |
| Proceeds from  the sale of foreclosed assets                                       |       | 65                                         |       | 329 |   | 329 |   |
| Proceeds from  bank-owned life insurance death benefit                             |       | —                                     |       | — |   | 826 |   |
| Purchase of  bank-owned life insurance                                             |       | (619                                       | )          | (254 | ) | — |   |
| Investment in  limited partnership                                                 |       | (1,250                                     | )          | (1,646 | ) | (3,124 | ) |
| Proceeds from  redemption of regulatory stock                                      |       | 5,081                                      |       | 3,630 |   | 4,862 |   |
| Purchases of  regulatory stock                                                     |       | (6,816                                     | )          | (2,899 | ) | (4,760 | ) |
|                                                                               |       |                                       |       |   |   |   |   |
| Net cash used  for investing activities                                            |       | (37,699                                    | )          | (18,780 | ) | (23,983 | ) |
|                                                                               |       |                                       |       |   |   |   |   |
| FINANCING  ACTIVITIES                                                              |       |                                       |       |   |   |   |   |
| Net (decrease)  increase in interest-bearing deposits                              |       | (7,680                                     | )          | 40,881 |   | (1,636 | ) |
| Net increase  (decrease) in noninterest-bearing deposits                           |       | 1,511                                      |       | 1,781 |   | (2,671 | ) |
| Net increase  (decrease) in short-term borrowings                                  |       | 20,618                                     |       | (19,306 | ) | 17,528 |   |
| Proceeds from  long-term borrowings, FHLB                                          |       | 40,000                                     |       | — |   | 10,000 |   |
| Repayment of  long-term borrowings, FHLB                                           |       | (16,500                                    | )          | (1,600 | ) | (1,400 | ) |
| Dividends paid                                                                     |       | (6,953                                     | )          | (6,802 | ) | (6,225 | ) |
| Issuance of  common stock                                                          |       | 99                                         |       | 49 |   | — |   |
| Stock options  exercised                                                           |       | 8                                          |       | — |   | 105 |   |
| Purchase of  treasury stock                                                        |       | (972                                       | )          | (2,929 | ) | (546 | ) |
|                                                                               |       |                                       |       |   |   |   |   |
| Net cash  provided by financing activities                                         |       | 30,131                                     |       | 12,074 |   | 15,155 |   |
|                                                                               |       |                                       |       |   |   |   |   |
| NET INCREASE IN  CASH AND CASH EQUIVALENTS                                         |       | 60                                         |       | 1,283 |   | 1,464 |   |
|                                                                               |       |                                       |       |   |   |   |   |
| CASH AND CASH  EQUIVALENTS, BEGINNING                                              |       | 15,373                                     |       | 14,090 |   | 12,626 |   |
|                                                                               |       |                                       |       |   |   |   |   |
| CASH AND CASH  EQUIVALENTS, ENDING                                                 |       | $                                          | 15,433     |   | $ | 15,373 |   | $ | 14,090 |   |
|                                                                               |       |                                       |       |   |   |   |   |
| SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION:                                |       |                                       |       |   |   |   |   |
|                                                                               |       |                                       |       |   |   |   |   |
| Interest paid                                                                      |       | $                                          | 16,235     |   | $ | 13,786 |   | $ | 10,123 |   |
| Income taxes  paid                                                                 |       | 1,610                                      |       | 2,645 |   | 2,625 |   |
| Transfer of  loans to foreclosed real estate                                       |       | 75                                         |       | 278 |   | 433 |   |

 

See Accompanying Notes to the Consolidated Financial Statements.

 

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**PENNS WOODS BANCORP, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1 - OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

**Principles of Consolidation**

The accompanying consolidated financial statements include the accountsof Penns Woods Bancorp, Inc. and its wholly owned subsidiaries, JerseyShore State Bank (the “Bank”), Woods Real Estate Development Co., Inc.,Woods Investment Company, Inc., and The M Group Inc. D/B/A TheComprehensive Financial Group (“The M Group”), a wholly owned subsidiary of theBank (collectively, the “Company”).  Allsignificant intercompany balances and transactions have been eliminated.

 

**Nature of Business**

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

 

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

 

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

 

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

 

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

 

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

 

# **Use ofEstimates**

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

 

Material estimates that are particularly susceptible to significantchange relate to the determination of the allowance for loan losses, deferredtax assets and liabilities, and the valuation of real estate acquired through,or in lieu of, foreclosure on settlement of debt.

 

**Stock Split**

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

 

41

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**Cash and Cash Equivalents**

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

 

**Restrictionson Cash and Cash Equivalents**

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

 

**Investment Securities**

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

 

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

 

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

 

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

 

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

 

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

 

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

 

**Loans**

Loans are stated at the principal amountoutstanding, net of deferred fees, unamortized loan fees and costs, and theallowance for loan losses.  Interest onloans is recognized as income when earned on the accrual method.  The Company’s general policy has been to stopaccruing interest on loans when it is determined a reasonable doubt exists asto the collectibility of additional interest. Income is subsequently recognized only to the extent that cash paymentsare received provided the loan is not delinquent in payment and, in management’sjudgment, the borrower has the ability and intent to make future principalpayments.

 

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

 

**Allowance for Loan Losses**

The allowance for loan losses represents the amountwhich management estimates is adequate to provide for probable losses inherentin its loan portfolio, as of the balance sheet date.  The allowance method is used in providing forloan losses.  Accordingly, all loanlosses are charged to the allowance and all recoveries are credited to it.  The allowance for loan losses is establishedthrough a provision

 

42

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for loan losses charged to operations.  The provision for loan losses is based upon management’s quarterlyreview of the loan portfolio.  Thepurpose of the review is to assess loan quality, identify impaired loans,analyze delinquencies, ascertain loan growth, evaluate potential charge-offsand recoveries, and assess general economic conditions in the marketsserved.  An external independent loanreview is also performed annually for the Bank. Management remains committed to an aggressive program of problem loanidentification and resolution.

 

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

 

Althoughmanagement believes that it uses the best information available to make suchdeterminations and that the allowance for loan losses is adequate at December 31,2007, future adjustments could be necessary if circumstances or economicconditions differ substantially from the assumptions used in making the initialdeterminations.  A downturn in the localeconomy, rising unemployment, or negative performance trends in financialinformation from borrowers could be indicators of subsequent increased levelsof nonperforming assets and possible charge-offs, which would normally requireincreased loan loss provisions.   Anintegral part of the periodic regulatory examination process is the review ofthe adequacy of the Bank’s loan loss allowance. The regulatory agencies could require the Bank, based on theirevaluation of information available at the time of their examination, toprovide additional loan loss provisions to further supplement the allowance.

 

Impaired loans are commercial and commercial real estateloans for which it is probable the Bank will not be able to collect all amountsdue according to the contractual terms of the loan agreement.  The Bank individually evaluates such loansfor impairment and does not aggregate loans by major risk classifications.  The definition of “impaired loans” is not thesame as the definition of  “nonaccrualloans,” although the two categories overlap. The Bank may choose to place a loan on nonaccrual status due to paymentdelinquency or uncertain collectibility, while not classifying the loan asimpaired if the loan is not a commercial or commercial real estate loan.  Factors considered by management indetermining impairment include payment status and collateral value.  The amount of impairment for these types ofloans is determined by the difference between the present value of the expectedcash flows related to the loan, using the original interest rate, and itsrecorded value, or as a practical expedient in the case of collateralizedloans, the difference between the fair value of the collateral and the recordedamount of the loans.  When foreclosure isprobable, impairment is measured based on the fair value of the collateral.

 

Mortgageloans on one-to-four family properties and all consumer loans are large groupsof smaller-balance homogeneous loans and are measured for impairmentcollectively. Loans that experience insignificant payment delays, which aredefined as 90 days or less, generally are not classified as impaired.  Management determines the significance ofpayment delays on a case-by-case basis taking into consideration allcircumstances surrounding the loan and the borrower including the length of thedelay, the borrower’s prior payment record, and the amount of shortfall inrelation to the principal and interest owed.

 

# **Loans Heldfor Sale**

In general, fixed rate residentialmortgage loans originated by the Bank are held for sale and are carried at costdue to their short holding period, which can range from less than two weeks toa maximum of thirty days.  Sold loans arenot serviced by the Bank.  Proceeds fromthe sale of loans in excess of the carrying value are accounted for as again.  Total gains on the sale of loansare shown as a component of non-interest income within the consolidatedstatement of income.

 

43

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# **Foreclosed Assets Held for Sale**

Foreclosed assets held for sale are carried atthe lower of cost or fair value minus estimated selling costs.  Prior to foreclosure, the value of theunderlying loan is written down to the fair value of the real estate to beacquired by a charge to the allowance for loan losses, if necessary.  Any subsequent write-downs are chargedagainst operating expenses.  Netoperating expenses and gains and losses realized from disposition are includedin non-interest expense and income, respectively.

 

# **Premisesand Equipment**

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

 

# **Bank-Owned Life Insurance**

The Company has purchasedlife insurance policies on certain officers and directors.  Bank-owned life insurance is recorded at itscash surrender value, or the amount that can be realized.  Increases in the cash surrender value arerecognized as a component of non-interest income within the ConsolidatedStatement of Income.

 

# **Goodwill**

The Company accounts forgoodwill in accordance with Statement of Financial Accounting Standards (“FAS”)No. 142, *Goodwill and Other IntangibleAssets.*  This statement, amongother things, requires a two-step process for testing the impairment ofgoodwill on at least an annual basis. This approach could cause more volatility in the Company’s reported netincome because impairment losses, if any, could occur irregularly and invarying amounts.  The Company performs anannual impairment analysis of goodwill for its purchased subsidiary, The MGroup.  Based on the fair value of thisreporting unit, estimated using the expected present value of future cashflows, no impairment of goodwill was recognized in 2007 and 2006.

 

**Investments in Limited Partnerships**

The Company is a limited partner in four partnerships at December 31,2007 that provide low income elderly housing in the Company’s geographic marketarea. The carrying value of the Company’s investments in limited partnershipswas $5,439,000 at December 31, 2007 and $4,950,000 at December 31,2006. The Company is fully amortizing the investment in the partnership enteredinto prior to 2005 over the fifteen-year holding period.  The partnerships entered into after 2004 arebeing fully amortized over the ten-year tax credit receipt period utilizing thestraight-line method.  The partnershipsbegan being amortized once the projects reached the level of occupancy neededto begin the ten year tax credit recognition period.  Amortization of limited partnershipinvestments amounted to $761,000 in 2007, $245,000 in 2006, and $90,000 in2005.

 

**Off-Balance Sheet Financial Instruments**

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

 

**AdvertisingCost**

Advertisingcosts are generally expensed as incurred.

 

# **IncomeTaxes**

The Company  adopted the provisions of FIN No. 48, *Accounting for Uncertainty in Income**Taxes, aninterpretation of FASB Statement 109*, effective January 1,2007. FIN No. 48 prescribes a recognition

 

44

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threshold and ameasurement attribute for the financial statement recognition and measurementof a tax position taken or expected to be taken in a tax return. Benefits fromtax positions should be recognized in the financial statements only when it ismore likely than not that the tax position will be sustained upon examinationby the appropriate taxing authority that would have full knowledge of allrelevant information. A tax position that meets the more-likely-than-notrecognition threshold is measured at the largest amount of benefit that isgreater than fifty percent likely of being realized upon ultimate settlement.Tax positions that previously failed to meet the more-likely-than-notrecognition threshold should be recognized in the first subsequent financialreporting period in which that threshold is met. Previously recognized taxpositions that no longer meet the more-likely-than-not recognition thresholdshould be derecognized in the first subsequent financial reporting period inwhich that threshold is no longer met. FIN No. 48 also provides guidanceon the accounting for and disclosure of unrecognized tax benefits, interest andpenalties. Adoption of FIN No. 48 did not have a significant impact on theCompany’s financial statements.

 

Deferred tax assets and liabilities result from temporarydifferences in financial and income tax methods of accounting, and arereflected at currently enacted income tax rates applicable to the period inwhich the deferred tax assets or liabilities are expected to be realized orsettled.  As changes in tax laws or ratesare enacted, deferred tax assets and liabilities are adjusted through theprovision for income taxes.

 

# **EarningsPer Share**

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

 

# **EmployeeBenefits**

Pensionand employee benefits include contributions, determined actuarially, to adefined benefit retirement plan covering the eligible employees of theBank.  The plan is funded on a currentbasis to the extent that it is deductible under existing federal taxregulations.  Pension and other employeebenefits also include contributions to a defined contribution Section 401(k) plancovering eligible employees. Contributions matching those made by eligible employees are fundedthroughout the year. In addition, an elective contribution is made annually atthe discretion of the Board of Directors.

 

**The MGroup Products and Income Recognition**

TheM Group product line is comprised primarily of annuities, life insurance, andmutual funds.  The revenues generatedfrom life insurance sales are commission only, as The M Group does notunderwrite the policies.  Life insurancesales include permanent and term policies with the majority of the policieswritten being permanent.  Term lifeinsurance policies are written for 10, 15, 20, and 30 year terms with themajority of the policies being written for 20 years.  None of these products are offered as anintegral part of lending activities.

 

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

 

Lifeinsurance commissions are recognized at varying points based on the paymentoption chosen by the customer. Commissions from monthly and annual payment plans are recognized at thestart of each annual period for the life insurance, while quarterly andsemi-annual premium payments are recognized quarterly and semi-annually whenthe earnings process is complete.  Forexample, semi-annual payments on the first of January and July wouldresult in commission income recognition on the first of January and July,while payments on the first of January, April, July, and October wouldresult in commission income recognition on those dates.  The potential for chargebacks only exists for

 

45

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thosepolicies on a monthly payment plan since income is recognized at the beginningof the annual coverage period versus at the time of each monthly payment.  No liability is maintained for chargebacks asthese are removed from income at the time of the occurrence.

 

# **StockOptions**

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

 

# **AccumulatedOther Comprehensive Income**

The Company is required to present accumulated othercomprehensive income in a full set of general-purpose financial statements forall periods presented.  Accumulated othercomprehensive income is comprised of unrealized holding gains (losses) on theavailable for sale securities portfolio and the unrecognized components of  net periodic benefit costs of the definedbenefit pension plan.

 

**Segment Reporting**

FASNo. 131, *Disclosure about Segments of an Enterpriseand Related Information*, requires that public business enterprisesreport financial and descriptive information about their reportable operatingsegments. Based on the guidance provided by the Statement, the Company hasdetermined that its only reportable segment is Community Banking.

 

**Reclassificationof Comparative Amounts**

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

 

**RecentAccounting Pronouncements**

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

 

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

 

In February 2007, theFASB issued FAS No. 159*, The Fair Value Optionfor Financial Assets and**Financial Liabilities –Including an amendment of FASB Statement No. 115*, whichprovides all entities with an option to report selected financial assets andliabilities at fair value. The objective of the FAS No. 159 is to improvefinancial reporting by providing entities with the opportunity to mitigatevolatility in earnings caused by measuring related assets and liabilitiesdifferently without having to apply the complex provisions of hedge accounting.  FAS No. 159 is effective as of thebeginning of an entity’s first fiscal year beginning after November 15,2007.  Early adoption is permitted as ofthe beginning of a fiscal year that begins on or before November 15, 2007provided the entity also elects to apply the provisions of FAS No. 157, *Fair Value Measurements*. The adoption of

 

46

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this standard is notexpected to have a material effect on the Company’s results of operations orfinancial position.

 

In December 2007, the FASB issued FAS No. 160,*Noncontrolling Interests in Consolidated FinancialStatements — an amendment of ARB No. 51*.  FAS No. 160 amends ARB No. 51 toestablish accounting and reporting standards for the noncontrolling interest ina subsidiary and for the deconsolidation of a subsidiary.  It clarifiesthat a noncontrolling interest in a subsidiary, which is sometimes referred toas minority interest, is an ownership interest in the consolidated entity thatshould be reported as equity in the consolidated financial statements. Among other requirements, this statement requires consolidated net income to bereported at amounts that include the amounts attributable to both the parentand the noncontrolling interest.  It also requires disclosure, on the faceof the consolidated income statement, of the amounts of consolidated net incomeattributable to the parent and to the noncontrolling interest.   FAS No. 160is effective for fiscal years beginning on or after December 15,2008.  Earlier adoption isprohibited.  The adoption of this standard is not expected to have amaterial effect on the Company’s results of operations or financial position.

 

In September 2006, theFASB reached consensus on the guidance provided by Emerging Issues Task ForceIssue 06-4 (“EITF 06-4”), *Accounting for DeferredCompensation and Postretirement Benefit**Aspects ofEndorsement Split-Dollar Life Insurance Arrangements*.  The guidance is applicable to endorsementsplit-dollar life insurance arrangements, whereby the employer owns andcontrols the insurance policy, that are associated with a postretirementbenefit.  EITF 06-4 requires that for asplit-dollar life insurance arrangement within the scope of the Issue, an employershould recognize a liability for future benefits in accordance with FAS No. 106(if, in substance, a postretirement benefit plan exists) or AccountingPrinciples Board Opinion No. 12 (if the arrangement is, in substance, anindividual deferred compensation contract) based on the substantive agreementwith the employee.  EITF 06-4 iseffective for fiscal years beginning after December 15, 2007.    The adoption of the EITF on January 1,2008 will result in an adjustment to retained earnings and an associatedliability in the amount of $437,000.

 

In March 2007, the FASBratified Emerging Issues Task Force Issue No. 06-10 (“EITF 06-10”), *Accounting for Collateral Assignment Split-Dollar Life InsuranceAgreements*. EITF 06-10 provides guidance for determining a liabilityfor the postretirement benefit obligation as well as recognition andmeasurement of the associated asset on the basis of the terms of the collateralassignment agreement. EITF 06-10 is effective for fiscal years beginning after December 15,2007.  The adoption of this EITF will nothave a material effect on the Company’s results of operations or financialposition.

 

In June 2007, the FASBratified Emerging Issues Task Force Issue No. 06-11 (“EITF 06-11”), *Accounting for Income Tax Benefits of Dividends on Share-Based PaymentAwards*.  EITF 06-11 applies toshare-based payment arrangements with dividend protection features that entitleemployees to receive (a) dividends on equity-classified nonvested shares, (b) dividendequivalents on equity-classified nonvested share units, or (c) paymentsequal to the dividends paid on the underlying shares while an equity-classifiedshare option is outstanding, when those dividends or dividend equivalents arecharged to retained earnings under FAS No. 123R, Share-Based Payment, andresult in an income tax deduction for the employer. A consensus was reachedthat a realized income tax benefit from dividends or dividend equivalents thatare charged to retained earnings and are paid to employees forequity-classified nonvested equity shares, nonvested equity share units, andoutstanding equity share options should be recognized as an increase inadditional paid-in capital.  EITF 06-11is effective for fiscal years beginning after December 15, 2007, andinterim periods within those fiscal years. The adoption of this EITF is not expected to have a material effect onthe Company’s results of operations or financial position.

 

**NOTE 2 - PER SHARE DATA**

 

There are no convertible securities, which would affect the numerator incalculating basic and dilutive earnings per share, therefore, net income aspresented on the consolidated statement of income will be

 

47

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used as the numerator.  Thefollowing table sets forth the composition of the weighted average common shares(denominator) used in the basic and dilutive per share computation.

 
| ** **                                                                                                 | ** ** | **2007**  | ** ** | **2006**  | ** ** | **2005**  | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
|                                                                                                       |       |      |       |      |       |      |       |
| Weighted average  common shares outstanding                                                                |       | 4,005,181 |       | 4,002,416 |       | 3,986,569 |       |
|                                                                                                       |       |      |       |      |       |      |       |
| Average treasury  stock shares                                                                             |       | (118,904  | )          | (68,278   | )          | (14,643   | )          |
|                                                                                                       |       |      |       |      |       |      |       |
| Weighted average  common shares and common stock equivalents used to calculate basic earnings  per share   |       | 3,886,277 |       | 3,934,138 |       | 3,971,926 |       |
|                                                                                                       |       |      |       |      |       |      |       |
| Additional  common stock equivalents (stock options) used to calculate diluted earnings  per share         |       | 237       |       | 479       |       | 2,129     |       |
|                                                                                                       |       |      |       |      |       |      |       |
| Weighted average  common shares and common stock equivalents used to calculate diluted earnings  per share |       | 3,886,514 |       | 3,934,617 |       | 3,974,055 |       |

 

Options to purchase 8,273 shares of common stock at a price of $40.29were outstanding during 2007  and 9,002shares of common stock at a price of $40.29 were outstanding during 2006 and2005.  The options were not included inthe computation of diluted earnings per share as they were anti-dilutive due tothe strike price at December 31, of each period presented being greaterthan the market value at that time.

 

**NOTE 3 - INVESTMENT SECURITIES**

 

The amortized cost and estimated fair values of investment securities at December 31,2007 and 2006 are as follows:

 

48

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

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

 

**The following tables show theCompany’s gross unrealized losses and estimated fair value, aggregated byinvestment category and length of time, that the individual securities havebeen in a continuous unrealized loss position, at December 31, 2007 and2006.**

** **

**49**

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

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

** **

**At December 31, 2007 therewere a total of 173 and 50 individual securities that were in a continuousunrealized loss position for less than twelve months and greater than twelvemonths, respectively.**

** **

The policy of the Company is torecognize other than temporary impairment of equity securities where the fairvalue has been significantly below cost for four consecutive quarters or if themarket value is 50% or less for two consecutive quarters.   Certain equity investments were determinedto be impaired at December 31, 2007 resulting in a reduction of carryingvalue and a charge to earnings in the amount of $834,000. For fixed maturityinvestments with unrealized losses due to interest rates where the Company hasthe positive intent and ability to hold the investment for a period of timesufficient to allow a market recovery, declines in value below cost are notassumed to be other than temporary.  TheCompany reviews its position quarterly and has asserted that at December 31,2007, the declines outlined in the above table for debt securities representtemporary declines due to interest rate changes that are not expected to resultin the non-collection of principal and interest during the period.  In addition, the Company does have the intentand ability to hold those securities either to maturity or to allow a marketrecovery.

 

The Company has concluded that anyimpairment of its investment securities portfolio is not other than temporary.

 

The amortized cost and estimated fair value of debt securities at December 31,2007, by contractual maturity, are shown below. Expected maturities may differfrom contractual maturities since borrowers may have the right to call orprepay obligations with or without call or prepayment penalties.

 
| ** **                         | ** ** | **Available for Sale** | ** ** | **Held to Maturity** | ** ** |
|------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                         | ** ** | **Amortized**                    | ** ** | **Estimated**                  | ** ** | **Amortized** | ** ** | **Estimated** | ** ** |
| **(In Thousands)**            | ** ** | **Cost**                         | ** ** | **Fair Value**            | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
| Due in one year  or less           |       | $                                | 75         |                           | $          | 75 |   | $ | 50 |   | $ | 50 |   |
| Due after one  year to five years  |       | 800                              |       | 790                            |       | 123 |   | 124 |   |
| Due after five  years to ten years |       | 395                              |       | 421                            |       | 90 |   | 90 |   |
| Due after ten  years               |       | 196,680                          |       | 195,200                        |       | 14 |   | 15 |   |
| Total                              |       | $                                | 197,950    |                           | $          | 196,486 |   | $ | 277 |   | $ | 279 |   |

 

50

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Total gross proceeds from sales of securities available for sale were$60,485,000, $76,249,000, and $123,546,000 for 2007, 2006, and 2005,respectively.  The following tablerepresents gross realized gains and losses on those transactions:

 
| **(In Thousands)**                | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Gross realized  gains:                 |       |     |       |     |       |     |       |
| U.S. Government  and agency securities |       | $        | 68         |     | $          | —   |       | $ | 128 |   |
| State and  political securities        |       | 840      |       | 1,248    |       | 819      |       |
| Other debt  securities                 |       | 2        |       | —   |       | —   |       |
| Equity  securities                     |       | 772      |       | 1,655    |       | 2,209    |       |
| Total gross  realized gains            |       | $        | 1,682      |     | $          | 2,903    |       | $ | 3,156 |   |
|                                   |       |     |       |     |       |     |       |
| Gross realized  losses:                |       |     |       |     |       |     |       |
| U.S. Government  and agency securities |       | $        | 902        |     | $          | 913      |       | $ | 791 |   |
| State and  political securities        |       | —   |       | 302      |       | 116      |       |
| Other debt  securities                 |       | —   |       | —   |       | 59       |       |
| Equity  securities                     |       | 834      |       | 9        |       | —   |       |
| Total gross  realized losses           |       | $        | 1,736      |     | $          | 1,224    |       | $ | 966 |   |

 

Investment securities with a carrying value of approximately $97,647,000and $64,821,000 at December 31, 2007 and 2006, respectively, were pledgedto secure certain deposits, repurchase agreements, and for other purposes asrequired by law.

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

 

**NOTE 4 – LOANS**

 

Major loan classifications as of December 31, 2007 and 2006 are summarizedas follows:

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

 
| ** **                        | ** ** | **2006**    | ** ** |
|-----------------------------------|------------|-------------|------------|
| ** **                        | ** ** | ** **  | ** ** | ** ** | ** ** | **Past Due** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **  | ** ** | ** ** | ** ** | **90 Days** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **  | ** ** | **Past Due** | ** ** | **Or More** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **  | ** ** | **30 To 90** | ** ** | **& Still** | ** ** | **Non-** | ** ** | ** ** | ** ** |
| **(In Thousands)**           | ** ** | **Current** | ** ** | **Days** | ** ** | **Accruing** | ** ** | **Accrual** | ** ** | **Total** | ** ** |
| Commercial and  agricultural      |       | $           | 36,122     |   | $ | 764 |   | $ | 109 |   | $ | — |   | $ | 36,995 |   |
| Real estate  mortgage:            |       |        |       |   |   |   |   |   |   |   |   |
| Residential                       |       | 156,976     |       | 1,050 |   | 8 |   | 185 |   | 158,219 |   |
| Commercial                        |       | 133,813     |       | 1,406 |   | — |   | 185 |   | 135,404 |   |
| Construction                      |       | 16,695      |       | 54 |   | — |   | — |   | 16,749 |   |
| Installment  loans to individuals |       | 13,687      |       | 346 |   | 2 |   | — |   | 14,035 |   |
|                              |       | 357,293     |       | $ | 3,620 |   | $ | 119 |   | $ | 370 |   | 361,402 |   |
| Less: Net  deferred loan fees     |       | 1,018       |       |   |   |   |   |   |   | 1,018 |   |
| Allowance for  loan losses        |       | 4,185       |       |   |   |   |   |   |   | 4,185 |   |
| Loans, net                        |       | $           | 352,090    |   |   |   |   |   |   |   | $ | 356,199 |   |

 

Impaired loans totaled $1,477,000 and $574,000 at December 31,2007 and 2006, respectively.  The portionof the allowance for loan losses allocated for impaired loans was $102,000 and$42,000 at

 

51

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December 31, 2007 and 2006. The average recordedinvestment in impaired loans during the years ended December 31, 2007 and2006 was approximately $1,130,000 and $504,000, respectively.  There were no impaired loans for the yearended December 31, 2005.

 

The Company recognized interest income on impaired loans inthe amount of $42,000 and $72,000 for the years ended December 31, 2007and 2006, respectively. On a cash basis, interest income on impaired loansamounted to $29,000 and $58,000 for the years ended December 31, 2007 and2006, respectively.

 

No additional funds are committed to be advanced inconnection with impaired loans.

 

Loans on which the accrual of interest has been discontinuedor reduced, exclusive of impaired loans, amounted to approximately $955,000 and $370,000 at December 31,2007 and 2006, respectively.  If interesthad been recorded based on the original loan agreement terms and rate ofinterest for those loans, income would have approximated $87,000, $23,000, and$39,000 for the years ended December 31, 2007, 2006, and 2005,respectively.  Interest income on suchloans, is recorded as received and amounted to approximately $17,000, $15,000,and $18,000, for the years ended December 31, 2007, 2006, and 2005,respectively.

 

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

 
| **(In Thousands)**          | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                             |       |     |       |     |       |     |       |
| Balance,  beginning of year      |       | $        | 4,185      |     | $          | 3,679    |       | $ | 3,338 |   |
| Provision  charged to operations |       | 150      |       | 635      |       | 720      |       |
| Loans charged  off               |       | (304     | )          | (327     | )          | (446     | )          |
| Recoveries                       |       | 99       |       | 198      |       | 67       |       |
| Balance, end of  year            |       | $        | 4,130      |     | $          | 4,185    |       | $ | 3,679 |   |

 

The Company has a concentration of loans to both owners of commercial andresidential rental properties at December 31, 2007 and 2006 of 14.43% and15.38% and 14.56% and 15.82% of total loans , respectively.

 

The Company grants commercial, industrial, residential, and installmentloans to customers throughout north-central Pennsylvania.  Although the Company has a diversified loanportfolio at December 31, 2007 and 2006, a substantial portion of itsdebtors’ ability to honor their contracts is dependent on the economicconditions within this region.

 

**NOTE 5 - PREMISES AND EQUIPMENT**

 

Major classifications of premises and equipment are summarized as followsat December 31:

 

52

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| **(In Thousands)**                         | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
|                                            |       |     |       |     |       |
| Land                                            |       | $        | 1,391      |     | $          | 1,370 |   |
| Premises                                        |       | 6,218    |       | 6,038    |       |
| Furniture and  equipment                        |       | 5,356    |       | 4,844    |       |
| Leasehold  improvements                         |       | 815      |       | 811      |       |
| Total                                           |       | 13,780   |       | 13,063   |       |
| Less accumulated  depreciation and amortization |       | 7,006    |       | 6,326    |       |
| Net premises and  equipment                     |       | $        | 6,774      |     | $          | 6,737 |   |

 

Depreciation and amortization charged to operations for the years ended2007, 2006, and 2005 was $680,000, $744,000, and $549,000, respectively.

 

**NOTE 6 – GOODWILL**

 

As of December 31, 2007, 2006, and 2005 goodwill had a grosscarrying value of $3,308,000 and accumulated amortization of $276,000 resultingin a net carrying amount of $3,032,000.

 

The gross carrying amount of goodwill is tested for impairment in thethird quarter of each fiscal year.  Basedon fair value of the reporting unit, estimated using the expected present valueof future cash flows, there was no evidence of impairment of the carryingamount at December 31, 2007 and 2006, repectively.

 

**NOTE 7 – TIME DEPOSITS**

 

Time deposits of $100,000 or more totaled approximately$59,424,000 on December 31, 2007 and $49,793,000 on December 31,2006.  Interest expense related to suchdeposits was approximately $3,216,000, $1,873,000, and $1,417,000, for theyears ended December 31, 2007, 2006, and 2005, respectively.  There were no individual retirement accountsin excess of $250,000 as of December 31, 2007 and 2006.  Time certificates of deposits in excess of$100,000 and individual retirement accounts in excess of $250,000 are notfederally insured.

 

At December 31, 2007, the scheduled maturities on timedeposits of $100,000 or more are as follows:

 
| **(In Thousands)**      | ** ** | **2007** | ** ** |
|------------------------------|------------|----------|------------|
|                         |       |     |       |
| Three months or  less        |       | $        | 22,258     |   |
| Three months to  six months  |       | 13,724   |       |
| Six months to  twelve months |       | 17,554   |       |
| Over twelve  months          |       | 5,888    |       |
| Total                        |       | $        | 59,424     |   |

 

Total time deposit maturities are as follows:

 

53

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| **(In Thousands)** | ** ** | **2007** | ** ** |
|-------------------------|------------|----------|------------|
|                    |       |     |       |
| 2008                    |       | $        | 157,621    |   |
| 2009                    |       | 18,702   |       |
| 2010                    |       | 5,670    |       |
| 2011                    |       | 2,409    |       |
| 2012                    |       | 655      |       |
| Thereafter              |       | 625      |       |
| Total                   |       | $        | 185,682    |   |

 

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

 

Short-term borrowings consist of securities sold underagreements to repurchase and FHLB advances which generally represent overnightor less than six month borrowings.  Inaddition to the outstanding balances noted below, the Bank also had additionallines of credit totaling $29,539,000 available from correspondent banks otherthan the FHLB.  The outstanding balancesand related information for short-term borrowings are summarized as follows:

 
| **(In Thousands)**                      | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Repurchase  Agreements:**                  |       |     |       |     |       |     |       |
| Balance at year  end                         |       | $        | 17,155     |     | $          | 15,991   |       | $ | 15,263 |   |
| Maximum amount  outstanding at any month end |       | 19,058   |       | 19,916   |       | 16,754   |       |
| Average balance  outstanding during the year |       | 16,746   |       | 16,028   |       | 14,268   |       |
| Weighted-average  interest rate:             |       |     |       |     |       |     |       |
| At year end                                  |       | 3.37     | %          | 3.96     | %          | 2.74     | %          |
| Paid during the  year                        |       | 3.69     | %          | 3.55     | %          | 2.19     | %          |
|                                         |       |     |       |     |       |     |       |
| **Open  Repo Plus:**                         |       |     |       |     |       |     |       |
| Balance at year  end                         |       | $        | 38,160     |     | $          | 18,706   |       | $ | 1,740 |   |
| Maximum amount  outstanding at any month end |       | 38,895   |       | 43,040   |       | 24,990   |       |
| Average balance  outstanding during the year |       | 19,299   |       | 15,301   |       | 10,765   |       |
| Weighted-average  interest rate:             |       |     |       |     |       |     |       |
| At year end                                  |       | 4.32     | %          | 5.40     | %          | 4.25     | %          |
| Paid during the  year                        |       | 5.09     | %          | 5.07     | %          | 3.33     | %          |
|                                         |       |     |       |     |       |     |       |
| **Short-Term  FHLB:**                        |       |     |       |     |       |     |       |
| Balance at year  end                         |       | $        | —     |     | $          | —   |       | $ | 37,000 |   |
| Maximum amount  outstanding at any month end |       | 15,000   |       | —   |       | 37,000   |       |
| Average balance  outstanding during the year |       | 771      |       | 3,283    |       | 7,081    |       |
| Weighted-average  interest rate:             |       |     |       |     |       |     |       |
| At year end                                  |       | —   |       | —   |       | 4.24     | %          |
| Paid during the  year                        |       | 5.06     | %          | 4.82     | %          | 3.66     | %          |

 

**NOTE 9 – LONG TERM BORROWINGS**

 

The following represents outstanding long-term borrowings with the FHLBby contractual maturities at December 31, 2007 and 2006:

 

54

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| **(In Thousands)**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
|-----------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                      |       |     |       |     |       |
| Variable rate of  4.49%, maturing in 2007                 |       | $        | —     |     | $          | 5,000 |   |
| Variable rates  between 3.14% and 5.56%, maturing in 2008 |       | 29,600   |       | 29,600   |       |
| Variable rate of  5.06%, maturing in 2009                 |       | —   |       | 5,000    |       |
| Variable rates  between 3.98% and 6.65%, maturing in 2010 |       | 15,000   |       | 5,000    |       |
| Variable rates  between 4.25% and 4.72%, maturing in 2011 |       | 10,000   |       | 10,000   |       |
| Variable rates  between 3.68% and 4.43%, maturing in 2012 |       | 15,000   |       | 5,000    |       |
| Variable rate of  3.74%, maturing in 2013                 |       | 5,000    |       | 5,000    |       |
| Variable rate of  3.97%, maturing in 2015                 |       | 10,000   |       | 10,000   |       |
| Variable rates  between 4.15% and 4.28%, maturing in 2017 |       | 20,000   |       | —   |       |
| Fixed rates  between 2.67% and 3.13%, maturing in 2007    |       | —   |       | 6,500    |       |
| Fixed rate of  6.92%, maturing in 2011                    |       | 500      |       | 500      |       |
| Fixed rate of  5.87%, maturing in 2013                    |       | 528      |       | 528      |       |
| Fixed rate of  6.92%, maturing in 2015                    |       | 750      |       | 750      |       |
| Total                                                     |       | $        | 106,378    |     | $          | 82,878 |   |

 

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

 

The Bank maintains a credit arrangement, which includes a revolving lineof credit with the FHLB.  Under thiscredit arrangement, the Bank has a remaining borrowing capacity of $75,515,000at December 31, 2007, which is subject to annual renewal, and typicallyincurs no service charges.  Under termsof a blanket agreement, collateral for the FHLB borrowings must be secured bycertain qualifying assets of the Bank which consist principally of firstmortgage loans and mortgage-backed securities.

 

**NOTE 10 - INCOME TAXES**

 

The following temporary differences gave rise to the net deferred taxposition at December 31, 2007 and 2006:

 

55

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| **(In Thousands)**                            | ** ** | **2007**   | ** ** | **2006** | ** ** |
|----------------------------------------------------|------------|------------|------------|----------|------------|
| Deferred tax  assets:                              |       | ** ** |       |     |       |
| Allowance for  loan losses                         |       | $          | 1,404      |     | $          | 1,292 |   |
| Deferred compensation                              |       | 408        |       | 386      |       |
| Pension                                            |       | 870        |       | 517      |       |
| Loan fees and  costs                               |       | 320        |       | 346      |       |
| Investment  securities allowance                   |       | 278        |       | 2        |       |
| Unrealized loss  on available for sale securities  |       | 1,112      |       | —   |       |
| Low income  housing credit carryforwrds            |       | 827        |       | —   |       |
| Other                                              |       | 212        |       | 134      |       |
| Total                                              |       | 5,431      |       | 2,677    |       |
|                                               |       |       |       |     |       |
| Deferred tax  liabilities:                         |       |       |       |     |       |
| Bond accretion                                     |       | 44         |       | 49       |       |
| Depreciation                                       |       | 117        |       | 85       |       |
| Amortization                                       |       | 451        |       | 376      |       |
| Unrealized gains  on available for sale securities |       | —     |       | 1,102    |       |
| Total                                              |       | 612        |       | 1,612    |       |
|                                               |       |       |       |     |       |
| Deferred tax  asset, net                           |       | $          | 4,819      |     | $          | 1,065 |   |

 

No valuation allowance was established at December 31, 2007 and2006, in the view of the Company’s ability to carry back taxes paid in previousyears and certain tax strategies, coupled with the anticipated future taxableincome as evidenced by the Company’s earning potential.

 

The provision for income taxes is comprised of the following:

 
| **(In Thousands)**     | ** ** | **2007** | ** ** | **2006**   | ** ** | **2005** | ** ** |
|-----------------------------|------------|----------|------------|------------|------------|----------|------------|
|                        |       |     |       | ** ** |       |     |       |
| Currently  payable          |       | $        | 1,758      |       | $          | 2,112    |       | $ | 3,188 |   |
| Deferred  (benefit) expense |       | (1,121   | )          | (151       | )          | 36       |       |
|                        |       |     |       |       |       |     |       |
| Total provision             |       | $        | 637        |       | $          | 1,961    |       | $ | 3,224 |   |

 

A reconciliation between the expected income tax and the effective incometax rate on income before income tax provision follows:

 
| ** **                       | ** ** | **2007**   | ** ** | **2006** | ** ** | **2005**   | ** ** |
|----------------------------------|------------|------------|------------|----------|------------|------------|------------|
| **(In Thousands)**          | ** ** | **Amount** | ** ** | **%**    | ** ** | **Amount** | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** |
|                             |       |       |       |     |       |       |       |   |   |   |   |   |   |
| Provision at  expected rate      |       | $          | 3,235      |     | 34.0       | %          | $          | 3,947 |   | 34.0 | % | $ | 4,803 |   | 34.0 | % |
| Decrease in tax resulting  from: |       |       |       |     |       |       |       |   |   |   |   |   |   |
| Tax-exempt  income               |       | (1,512     | )          | (15.9    | )          | (1,425     | )          | (12.3 | ) | (1,275 | ) | (9.0 | ) |
| Tax credits                      |       | (1,048     | )          | (11.0    | )          | (363       | )          | (3.1 | ) | (177 | ) | (1.3 | ) |
| Other, net                       |       | (38        | )          | (0.4     | )          | (198       | )          | (1.7 | ) | (127 | ) | (0.9 | ) |
|                             |       |       |       |     |       |       |       |   |   |   |   |   |   |
| Effective income  tax and rate   |       | $          | 637        |     | 6.7        | %          | $          | 1,961 |   | 16.9 | % | $ | 3,224 |   | 22.8 | % |

 

56

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**NOTE 11 - EMPLOYEE BENEFIT PLANS**

 

### DefinedBenefit Pension Plan

 

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

 

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

 

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

 
| **(In Thousands)**                                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **Change  in benefit obligation**                                                 |       |     |       |     |       |
| Benefit  obligation at beginning of year                                          |       | $        | 8,510      |     | $          | 8,780 |   |
| Service cost                                                                      |       | 466      |       | 467      |       |
| Interest cost                                                                     |       | 486      |       | 434      |       |
| Actuarial loss  (gain)                                                            |       | 80       |       | (785     | )          |
| Benefits paid                                                                     |       | (210     | )          | (186     | )          |
| Other, change in  actuarial assumptions                                           |       | 1,118    |       | (200     | )          |
| Benefit  obligation at end of year                                                |       | 10,450   |       | 8,510    |       |
|                                                                              |       |     |       |     |       |
| **Change  in plan assets**                                                        |       |     |       |     |       |
| Fair value of  plan assets at beginning of year                                   |       | 6,990    |       | 6,011    |       |
| Actual return on  plan assets                                                     |       | 531      |       | 629      |       |
| Employer  contribution                                                            |       | 580      |       | 550      |       |
| Benefits paid                                                                     |       | (210     | )          | (186     | )          |
| Expenses paid                                                                     |       | —   |       | (14      | )          |
| Fair value of  plan assets at end of year                                         |       | 7,891    |       | 6,990    |       |
| Funded status                                                                     |       | $        | (2,559     | )        | $          | (1,520 | ) |
|                                                                              |       |     |       |     |       |
| **Accounts  recognized on balance sheet as:**                                     |       |     |       |     |       |
| Total  liabilities                                                                |       | $        | (2,559     | )        | $          | (1,520 | ) |
|                                                                              |       |     |       |     |       |
| **Amounts  not yet recognized as a component of net periodic pension cost:**      |       |     |       |     |       |
| Amounts  recognized in accumulated other comprehensive income (loss) consists of: |       |     |       |     |       |
| Net transition  asset                                                             |       | $        | (12        | )        | $          | (15 | ) |
| Prior service  cost                                                               |       | 153      |       | 179      |       |
| Net loss                                                                          |       | 1,942    |       | 713      |       |
| Total                                                                             |       | $        | 2,083      |     | $          | 877 |   |

 

The accumulated benefit obligation for the Plan was $7,835,000 and$6,451,000 at December 31, 2007 and 2006, respectively.

 

57

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Components of Net Periodic Cost and Other Amounts Recognized in otherComprehensive Income as of December 31, 2007, 2006, and 2005,respectively, are as follows:

 
| **(In Thousands)**                | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Net periodic  pension cost:            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service cost                           |       | $          | 467        |       | $          | 467        |       | $ | 505 |   |
| Interest cost                          |       | 486        |       | 434        |       | 446        |       |
| Expected return  on plan assets        |       | (562       | )          | (485       | )          | (402       | )          |
| Amortization of  transition asset      |       | (3         | )          | (3         | )          | (2         | )          |
| Amortization of  prior service cost    |       | 26         |       | 26         |       | 25         |       |
| Amortization of  unrecognized net loss |       | —     |       | 22         |       | 65         |       |
| Net periodic  benefit cost             |       | $          | 414        |       | $          | 461        |       | $ | 637 |   |

 

The estimated net transition asset and priorservice cost for the defined benefit pension plan that will be amortized fromaccumulated other comprehensive income (loss) into net periodic benefit costover the next fiscal year are $3,000 and $25,000, respectively.

 

**Assumptions**

 

Weighted-average assumptions used to determine benefit obligations at December 31:

 
| ** **                     | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Discount rate                  |       | 6.00     | %          | 5.75     | %          | 5.50     | %          |
| Rate of  compensation increase |       | 5.00     | %          | 4.75     | %          | 4.50     | %          |

 

Weighted-average assumptions used to determine net periodic cost foryears ended December 31:

 
| ** **                                | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Discount rate                             |       | 5.75     | %          | 5.50     | %          | 5.75     | %          |
| Expected  long-term return on plan assets |       | 8.00     | %          | 8.00     | %          | 8.00     | %          |
| Rate of  compensation increase            |       | 4.75     | %          | 4.50     | %          | 4.75     | %          |

 

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

 

**Plan Assets**

 

The Plan’s weighted-average asset allocations at December 31 byasset category are as follows:

 
| **Asset Category**  | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Cash                     |       | 0.2      | %          | 0.4      | %          |
| Fixed income  securities |       | 39.6     | %          | 39.2     | %          |
| Equity                   |       | 60.2     | %          | 60.4     | %          |
| Total                    |       | 100.0    | %          | 100.0    | %          |

 

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

 

Asset allocation favors equities, with target allocation of approximately60% equity securities, 37.5% fixed income securities and 2.5% cash.  Due to volatility in the market, the targetallocation is not

 

58

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always desirable and asset allocations will fluctuate between theacceptable ranges.  The equity portfolio’sexposure is primarily in mid and large capitalization domestic equities withlimited exposure to small capitalization and international stocks.

 

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

 

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

 

(In Thousands)

 

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

 
| 2008      |   |   | $      | 256    |   |
|-----------|--------|--------|--------|--------|--------|
| 2009      |   |   | 299    |   |
| 2010      |   |   | 320    |   |
| 2011      |   |   | 346    |   |
| 2012      |   |   | 519    |   |
| 2013-2017 |   |   | 3,043  |   |
|      |   |   |   |
|      |   | $      | 4,783  |   |

 

The company expects to contribute $450,000 to its Pension Plan in 2008.

 

### 401(k) SavingsPlan

###  

The Company also offers a 401(k) savings plan in which eligibleparticipating employees may elect to contribute up to a maximum percentageallowable not to exceed the limits of Code Sections 401(k), 404, and 415.  The Company may make matching contributionsequal to a discretionary percentage that is determined by the Board ofDirectors.  Participants are at all timesfully vested in their contributions and vest over a period of five yearsregarding the employer contribution. Contribution expense was approximately $97,000, $96,000, and $80,000 forthe years ended December 31, 2007, 2006, and 2005, respectively.

 

### DeferredCompensation Plan

###  

The Company has a deferred compensation plan whereby participating directorselect to forego directors’ fees paid in cash. Under this plan, the Company will make payments for a ten-year periodbeginning at age 65 in most cases or at death, if earlier, at which timepayments would be made to their designated beneficiaries.

 

To fund benefits under the deferred compensation plan, theCompany has acquired bank-owned life insurance policies on the lives of theparticipating directors for which insurance benefits are payable to theCompany.  The Company incurred expensesrelated to the plan of $84,750, $69,000, and $69,000 for the years ended December 31,2007, 2006, and 2005, respectively. Benefits paid under the plan were approximately $125,000, $122,000, and$112,000 in 2007, 2006, and 2005 respectively.

 

59

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**NOTE 12 – EMPLOYEE STOCK PURCHASE PLAN**

 

Effective April 26, 2006 the Company implemented the Penns WoodsBancorp, Inc. 2006 Employee Stock Purchase Plan (“Plan”).  The Plan is intended to encourage employeeparticipation in the ownership and economic progress of the Company.  The Plan allows for up to 1,000,000 shares tobe purchased by employees.  The purchaseprice of the shares is 95% of market value with an employee eligible topurchase up to the lesser of 15% of base compensation or $12,000 in marketvalue annually.  There were 3,090 and1,355 shares issued under the plan for the years ended December 31, 2007and 2006, respectively.

 

**NOTE 13 - STOCK OPTIONS**

 

Prior to 1998, the Company granted a select group of its officers optionsto purchase shares of its common stock. These options, which are immediately exercisable, expire within three toten years after having been granted. Also, in 1998, the Company adopted the “1998 Stock Option Plan” for keyemployees and directors.  Incentive stockoptions and nonqualified stock options may be granted to eligible employees ofthe Bank and nonqualified options may be granted to directors of theCompany.  

 

Incentive nonqualified stock options granted under the 1998 Plan may beexercised not later than ten years after the date of grant.  Each option granted under the 1998 Plan shallbe exercisable only after the expiration of six months following the date ofgrant of such options.

 

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

 
| ** **                        | ** ** | **2007**   | ** ** | **2006**     | ** ** |
|-----------------------------------|------------|------------|------------|--------------|------------|
| ** **                        | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                        | ** ** | ** ** | ** ** | **Average**  | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                        | ** ** | ** ** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                        | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Shares** | ** ** | **Price** | ** ** |
|                              |       |       |       |         |       |   |   |   |   |
| Outstanding,  beginning of year   |       | 11,972     |       | $            | 37.41      |   | 11,972 |   | $ | 37.41 |   |
| Granted                           |       | —     |       | —       |       | — |   | — |   |
| Exercised                         |       | (330       | )          | 24.72        |       | — |   | — |   |
| Forfeited                         |       | (729       | )          | 40.29        |       | — |   | — |   |
|                              |       |       |       |         |       |   |   |   |   |
| Outstanding, end  of year         |       | 10,913     |       | 37.60        |       | 11,972 |   | 37.41 |   |
|                              |       |       |       |         |       |   |   |   |   |
| Options  exercisable at  year-end |       | 10,913     |       | $            | 37.60      |   | 11,972 |   | $ | 37.41 |   |

 

The following table summarizes information about nonqualified andincentive stock options outstanding at December 31, 2007:

 
| ** **              | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
|-------------------------|------------|-----------------|------------|-----------------|------------|
| ** **              | ** ** | ** **      | ** ** | ** **      | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **              | ** ** | ** **      | ** ** | **Average**     | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| **Exercise Price** | ** ** | **Shares**      | ** ** | **Life**        | ** ** | **Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
| $                       | 40.29      |            | 8,273      |            | 1          |   | $ | 40.29 |   | 8,273 |   | $ | 40.29 |   |
| 31.82                   |       | 1,650           |       | 2               |       | 31.82 |   | 1,650 |   | 31.82 |   |
| 24.72                   |       | 990             |       | 3               |       | 24.72 |   | 990 |   | 24.72 |   |
|                         |            |                 |            |                 |            |  |  |  |  |  |  |  |  |  |

 

60

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**NOTE 14- RELATED PARTY TRANSACTIONS**

** **

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

 

A summary of loan activity with executive officers, directors, principalshareholders, and associates of such persons is listed below for the yearsended December 31:

 
| ** **              | ** ** | **Beginning** | ** ** | ** **    | ** ** | ** **   | ** ** | **Ending**  | ** ** |
|-------------------------|------------|---------------|------------|---------------|------------|--------------|------------|-------------|------------|
| **(In Thousands)** | ** ** | **Balance**   | ** ** | **Additions** | ** ** | **Payments** | ** ** | **Balance** | ** ** |
|                    |       |          |       |          |       |         |       |        |       |
| 2007                    |       | $             | 9,742      |          | $          | 1,711        |       | $           | 2,118      |   | $ | 9,335 |   |
| 2006                    |       | 9,635         |       | 2,001         |       | 1,894        |       | 9,742       |       |
|                         |            |               |            |               |            |              |            |             |            |  |  |  |  |

 

Deposits from related parties held by the Company amounted to $7,796,000at December 31, 2007 and $4,653,000 at December 31, 2006.

 

**NOTE 15 - COMMITMENTS AND CONTINGENT LIABILITIES**

 

The following schedule of future minimum rental paymentsunder operating leases with noncancellable terms in excess of one year as of December 31,2007:

 
| **(In Thousands)** | ** ** | ** ** | ** ** |
|-------------------------|------------|------------|------------|
|                    |       |       |       |
| 2008                    |       | $          | 396        |   |
| 2009                    |       | 326        |       |
| 2010                    |       | 288        |       |
| 2011                    |       | 202        |       |
| 2012                    |       | 180        |       |
| Thereafter              |       | 1,427      |       |
| Total                   |       | $          | 2,819      |   |

 

TheCompany’s operating lease obligations represent short and long-term lease andrental payments for facilities.  Totalrental expense for all operating leases for the years ended December 31,2007, 2006, and 2005 were $423,000, $380,000, and $361,000 respectively.

 

The Company is subject to lawsuits and claims arisingout of its business.  There are no suchlegal proceedings or claims currently pending or threatened other than thoseencountered during the normal course of business.

 

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

 

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

 

The Company’s exposure to credit loss from nonperformance by the otherparty to the financial instruments for commitments to extend credit and standbyletters of credit is represented by the

 

61

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contractual amount of these instruments. The Company uses the same credit policies in making commitments andconditional obligations as it does for on-balance sheet instruments.  The Company may require collateral or othersecurity to support financial instruments with off-balance sheet credit risk.

 

Financial instruments whose contract amounts represent credit risk are asfollows at December 31:

 
| **(In Thousands)**       | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
|                          |       |     |       |     |       |
| Commitments to  extend credit |       | $        | 74,349     |     | $          | 61,736 |   |
| Standby letters  of credit    |       | 974      |       | 1,033    |       |
|                               |            |          |            |          |            |  |  |

 

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

 

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

 

**NOTE 17 - CAPITAL REQUIREMENTS**

 

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

 

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

 

As of December 31, 2007 and 2006, the Federal Deposit InsuranceCorporation (“FDIC”) categorized the Bank as well capitalized under theregulatory framework for prompt corrective action.  To be classified as a well capitalizedfinancial institution, Total risk-based, Tier 1 risk-based, and Tier 1 leveragecapital ratios must be at least 10%, 6%, and 5%, respectively.

 

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

 

62

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Consolidated Company

 
| ** **                     | ** ** | **2007**   | ** ** | **2006**  | ** ** |
|--------------------------------|------------|------------|------------|-----------|------------|
| **(In Thousands)**        | ** ** | **Amount** | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| Total Capital                  |       |       |       |      |       |   |   |   |   |
| (to  Risk-weighted Assets)     |       |       |       |      |       |   |   |   |   |
|                           |       |       |       |      |       |   |   |   |   |
| Actual                         |       | $          | 70,381     |      | 18.0       | % | $ | 74,342 |   | 20.2 | % |
| For Capital  Adequacy Purposes |       | 31,280     |       | 8.0       |       | 29,299 |   | 8.0 |   |
| To Be Well  Capitalized        |       | 39,100     |       | 10.0      |       | 36,623 |   | 10.0 |   |
|                           |       |       |       |      |       |   |   |   |   |
| Tier I Capital                 |       |       |       |      |       |   |   |   |   |
| (to  Risk-weighted Assets)     |       |       |       |      |       |   |   |   |   |
|                           |       |       |       |      |       |   |   |   |   |
| Actual                         |       | $          | 66,251     |      | 16.9       | % | $ | 68,931 |   | 18.8 | % |
| For Capital  Adequacy Purposes |       | 15,640     |       | 4.0       |       | 14,649 |   | 4.0 |   |
| To Be Well  Capitalized        |       | 23,460     |       | 6.0       |       | 21,974 |   | 6.0 |   |
|                           |       |       |       |      |       |   |   |   |   |
| Tier I Capital                 |       |       |       |      |       |   |   |   |   |
| (to Average  Assets)           |       |       |       |      |       |   |   |   |   |
|                           |       |       |       |      |       |   |   |   |   |
| Actual                         |       | $          | 66,251     |      | 10.8       | % | $ | 68,931 |   | 11.8 | % |
| For Capital  Adequacy Purposes |       | 24,664     |       | 4.0       |       | 23,332 |   | 4.0 |   |
| To Be Well  Capitalized        |       | 30,830     |       | 5.0       |       | 29,165 |   | 5.0 |   |

 

Bank

 
| ** **                     | ** ** | **2007**   | ** ** | **2006**  | ** ** |
|--------------------------------|------------|------------|------------|-----------|------------|
| **(In Thousands)**        | ** ** | **Amount** | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| Total Capital                  |       |       |       |      |       |   |   |   |   |
| (to  Risk-weighted Assets)     |       |       |       |      |       |   |   |   |   |
|                           |       |       |       |      |       |   |   |   |   |
| Actual                         |       | $          | 57,295     |      | 15.1       | % | $ | 57,260 |   | 16.2 | % |
| For Capital  Adequacy Purposes |       | 30,350     |       | 8.0       |       | 28,243 |   | 8.0 |   |
| To Be Well  Capitalized        |       | 37,938     |       | 10.0      |       | 35,304 |   | 10.0 |   |
|                           |       |       |       |      |       |   |   |   |   |
| Tier I Capital                 |       |       |       |      |       |   |   |   |   |
| (to  Risk-weighted Assets)     |       |       |       |      |       |   |   |   |   |
|                           |       |       |       |      |       |   |   |   |   |
| Actual                         |       | $          | 53,165     |      | 14.0       | % | $ | 52,860 |   | 15.0 | % |
| For Capital  Adequacy Purposes |       | 15,175     |       | 4.0       |       | 14,121 |   | 4.0 |   |
| To Be Well  Capitalized        |       | 22,763     |       | 6.0       |       | 21,182 |   | 6.0 |   |
|                           |       |       |       |      |       |   |   |   |   |
| Tier I Capital                 |       |       |       |      |       |   |   |   |   |
| (to Average  Assets)           |       |       |       |      |       |   |   |   |   |
|                           |       |       |       |      |       |   |   |   |   |
| Actual                         |       | $          | 53,165     |      | 8.8        | % | $ | 52,860 |   | 9.3 | % |
| For Capital  Adequacy Purposes |       | 24,124     |       | 4.0       |       | 22,671 |   | 4.0 |   |
| To Be Well  Capitalized        |       | 30,155     |       | 5.0       |       | 28,339 |   | 5.0 |   |

 

##### **NOTE 18 – REGULATORY RESTRICTIONS**

 

The Pennsylvania Banking Code restricts the availability of capital fundsfor payment of dividends by all state-chartered banks to the additional paid incapital of the Bank.  Accordingly, at December 31,2007, the balance in the additional paid in capital account totaling$11,657,000 is unavailable for dividends.

 

The Bank is subject to regulatory restrictions, which limit its abilityto loan funds to Penns Woods Bancorp, Inc. At December 31, 2007, the regulatory lending limit amounted toapproximately $5,780,000.

 

63

----

 

**Cash and Due from Banks**

 

Included in cash and due from banks are reserves required by the districtFederal Reserve Bank of $1,009,000 and $990,000 at December 31, 2007 and2006.  The required reserves are computedby applying prescribed ratios to the classes of average deposit balances.  These are held in the form of cash on handand a balance maintained directly with the Federal Reserve Bank.

 

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

 

The Company is required to disclose estimated fair values forits financial instruments.  Fair valueestimates are made at a specific point in time, based on relevant marketinformation and information about the financial instrument.  These estimates do not reflect any premium ordiscount that could result from offering for sale at one time the Company’sentire holdings of a particular financial instrument.  Also, it is the Company’s general practiceand intention to hold most of its financial instruments to maturity and not toengage in trading or sales activities. Because no market exists for a significant portion of the Company’sfinancial instruments, fair value estimates are based on judgments regardingfuture expected loss experience, current economic conditions, riskcharacteristics of various financial instruments, and other factors.  These estimates are subjective in nature andinvolve uncertainties and matters of significant judgment and therefore cannotbe determined with precision.  Changes inassumptions can significantly affect the estimates.

 

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

 

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

 

The estimated fair values of the Company’s financial instruments are asfollows at December 31:

 
| ** **                    | ** ** | **2007**     | ** ** | **2006**  | ** ** |
|-------------------------------|------------|--------------|------------|-----------|------------|
| ** **                    | ** ** | **Carrying** | ** ** | **Fair**  | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| **(In Thousands)**       | ** ** | **Value**    | ** ** | **Value** | ** ** | **Value** | ** ** | **Value** | ** ** |
| Financial  assets:            |       |         |       |      |       |   |   |   |   |
| Cash and cash  equivalents    |       | $            | 15,433     |      | $          | 15,433 |   | $ | 15,373 |   | $ | 15,373 |   |
| Investment  securitites:      |       |         |       |      |       |   |   |   |   |
| Available for  sale           |       | 214,455      |       | 214,455   |       | 185,200 |   | 185,200 |   |
| Held to maturity              |       | 277          |       | 279       |       | 283 |   | 286 |   |
| Loans held for  sale          |       | 4,214        |       | 4,214     |       | 3,716 |   | 3,716 |   |
| Loans, net                    |       | 356,348      |       | 357,628   |       | 356,199 |   | 356,788 |   |
| Bank-owned life  insurance    |       | 12,375       |       | 12,375    |       | 11,346 |   | 11,346 |   |
| Accrued interest  receivable  |       | 3,343        |       | 3,343     |       | 2,939 |   | 2,939 |   |
|                          |       |         |       |      |       |   |   |   |   |
| Financial  liabilities:       |       |         |       |      |       |   |   |   |   |
| Interest-bearing  deposits    |       | $            | 314,351    |      | $          | 314,501 |   | $ | 322,031 |   | $ | 320,906 |   |
| Noninterest-bearing  deposits |       | 74,671       |       | 74,671    |       | 73,160 |   | 73,160 |   |
| Short-term  borrowings        |       | 55,315       |       | 55,315    |       | 34,697 |   | 34,697 |   |
| Long-term  borrowings, FHLB   |       | 106,378      |       | 106,154   |       | 82,878 |   | 82,050 |   |
| Accrued interest  payable     |       | 1,744        |       | 1,744     |       | 1,532 |   | 1,532 |   |

 

64

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

 

The fair value is equal to the carrying value.

 

# **Investment Securities:**

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

 

# **Loans:**

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

 

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

 

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

 

**Bank-OwnedLife Insurance:**

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

 

# **Deposits:**

The fair value of deposits with no statedmaturity, such as noninterest-bearing demand deposits, savings, NOW, and moneymarket accounts, is equal to the amount payable on demand as of December 31,2007 and 2006.  The fair value ofcertificates of deposit is based on the discounted value of contractual cashflows.

 

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

 

**LongTerm Borrowings:**

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

 

#### **Commitments to ExtendCredit, Standby Letters of Credit, and Financial Guarantees Written:**

There is no material difference between thenotional amount and the estimated fair value of off-balance sheet items at December 31,2007 and 2006, respectively.  Thecontractual amounts of unfunded commitments and letters of credit are presentedin Note 16.

 

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

 

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

 

65

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| **CONDENSED BALANCE SHEET, DECEMBER 31,****(In Thousands)** | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                 |       |     |       |     |       |
| ASSETS                                                                               |       |     |       |     |       |
| Cash                                                                                 |       | $        | 15         |     | $          | 41 |   |
| Investment in  subsidiaries:                                                         |       |     |       |     |       |
| Bank                                                                                 |       | 56,971   |       | 57,790   |       |
| Nonbank                                                                              |       | 13,473   |       | 16,595   |       |
| Other assets                                                                         |       | 234      |       | 234      |       |
|                                                                                 |       |     |       |     |       |
| Total Assets                                                                         |       | $        | 70,693     |     | $          | 74,660 |   |
|                                                                                 |       |     |       |     |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                           |       |     |       |     |       |
| Other  liabilities                                                                   |       | $        | 134        |     | $          | 66 |   |
| Shareholders’  equity                                                           |       | 70,559   |       | 74,594   |       |
|                                                                                 |       |     |       |     |       |
| Total liability  and shareholders’ equity                                       |       | $        | 70,693     |     | $          | 74,660 |   |

 
| **CONDENSED  STATEMENT OF INCOME**

**FOR THE YEARS ENDED DECEMBER 31,****(In Thousands)** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                                            |       |     |       |     |       |     |       |
| Operating  income:                                                                              |       |     |       |     |       |     |       |
| Dividends from  subsidiaries                                                                    |       | $        | 8,039      |     | $          | 9,890    |       | $ | 7,311 |   |
| Equity in  undistributed net income of subsidiaries                                             |       | 1,152    |       | 53       |       | 3,822    |       |
|                                                                                            |       |     |       |     |       |     |       |
| Operating  expenses:                                                                            |       | (314     | )          | (296     | )          | (232     | )          |
|                                                                                            |       |     |       |     |       |     |       |
| Net income                                                                                      |       | $        | 8,877      |     | $          | 9,647    |       | $ | 10,901 |   |

 
| **CONDENSED  STATEMENT OF CASH FLOWS**

**FOR THE YEARS ENDED DECEMBER 31,****(In Thousands)** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                                                |       |     |       |     |       |     |       |
| OPERATING  ACTIVITIES                                                                               |       |     |       |     |       |     |       |
| Net income                                                                                          |       | $        | 8,877      |     | $          | 9,647    |       | $ | 10,901 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:                  |       |     |       |     |       |     |       |
| Equity in  undistributed net income of subsidiaries                                                 |       | (1,152   | )          | (53      | )          | (3,822   | )          |
| Other, net                                                                                          |       | 67       |       | (30      | )          | (70      | )          |
| Net cash  provided by operating activities                                                          |       | 7,792    |       | 9,564    |       | 7,009    |       |
|                                                                                                |       |     |       |     |       |     |       |
| INVESTING  ACTIVITIES                                                                               |       |     |       |     |       |     |       |
| Additional  investment in subsidiaries                                                              |       | —   |       | —   |       | (637     | )          |
|                                                                                                |       |     |       |     |       |     |       |
| FINANCING  ACTIVITIES                                                                               |       |     |       |     |       |     |       |
| Dividends paid                                                                                      |       | (6,953   | )          | (6,802   | )          | (6,225   | )          |
| Issuance of  common stock                                                                           |       | 99       |       | 49       |       | —   |       |
| Proceeds from  exercise of stock options                                                            |       | 8        |       | —   |       | 105      |       |
| Purchase of  treasury stock                                                                         |       | (972     | )          | (2,929   | )          | (546     | )          |
| Net cash used  for financing activities                                                             |       | (7,818   | )          | (9,682   | )          | (6,666   | )          |
|                                                                                                |       |     |       |     |       |     |       |
| NET DECREASE IN  CASH                                                                               |       | (26      | )          | (118     | )          | (294     | )          |
| CASH, BEGINNING  OF YEAR                                                                            |       | 41       |       | 159      |       | 453      |       |
| CASH, END OF  YEAR                                                                                  |       | $        | 15         |     | $          | 41       |       | $ | 159 |   |

 

66

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**NOTE 21 –CONSOLIDATED QUARTERLY FINANCIAL DATA (UNAUDITED)**

** **
| **(In Thousands, Except Per Share Data)** | ** ** | **For The Three Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| **2007**                                                           | ** ** | **March 31,**                                 | ** ** | **June 30,** | ** ** | **Sept. 30,** | ** ** | **Dec. 31,** | ** ** |
| Interest income                                                    |       | $                                                  | 8,679      |   | $ | 8,793 |   | $ | 8,977 |   | $ | 9,500 |   |
| Interest expense                                                   |       | 3,939                                              |       | 3,999 |   | 4,112 |   | 4,397 |   |
|                                                               |       |                                               |       |   |   |   |   |   |   |
| Net interest  income                                               |       | 4,740                                              |       | 4,794 |   | 4,865 |   | 5,103 |   |
|                                                               |       |                                               |       |   |   |   |   |   |   |
| Provision for  loan losses                                         |       | 40                                                 |       | 10 |   | 10 |   | 90 |   |
| Non-interest  income                                               |       | 1,648                                              |       | 1,893 |   | 2,006 |   | 1,985 |   |
| Securities gains  (losses), net                                    |       | 326                                                |       | 293 |   | — |   | (673 | ) |
| Non-interest  expenses                                             |       | 4,128                                              |       | 4,340 |   | 4,430 |   | 4,418 |   |
|                                                               |       |                                               |       |   |   |   |   |   |   |
| Income before  income tax provision                                |       | 2,546                                              |       | 2,630 |   | 2,431 |   | 1,907 |   |
| Income tax  provision (benefit)                                    |       | 265                                                |       | 295 |   | 109 |   | (32 | ) |
|                                                               |       |                                               |       |   |   |   |   |   |   |
| Net income                                                         |       | $                                                  | 2,281      |   | $ | 2,335 |   | $ | 2,322 |   | $ | 1,939 |   |
|                                                               |       |                                               |       |   |   |   |   |   |   |
| Earnings per  share - basic                                        |       | $                                                  | 0.59       |   | $ | 0.60 |   | $ | 0.59 |   | $ | 0.50 |   |
|                                                               |       |                                               |       |   |   |   |   |   |   |
| Earnings per  share - diluted                                      |       | $                                                  | 0.59       |   | $ | 0.60 |   | $ | 0.59 |   | $ | 0.50 |   |

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

 

**ITEM 9           CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None

 

**ITEM 9A        CONTROLS AND PROCEDURES**

 

The Company, under thesupervision and with the participation of the Company’s management, includingthe Company’s President and Chief Executive Officer along with the Company’sPrincipal Accounting Officer (the Principal Financial Officer), has evaluatedthe effectiveness as of December 31, 2007 of the design and operation ofthe Company’s disclosure controls and procedures, as such 

 

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termis defined under Rule 13a-15(e) promulgated under the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”).  Based upon that evaluation, theCompany’s President and Chief Executive Officer along with the Company’s Principal Accounting Officer concludedthat the Company’s disclosure controls and procedures were effective as of December 31,2007.

 

There have been no materialchanges in the Company’s internal control over financial reporting during thefourth quarter of 2007 that have materially affected, or are reasonably likelyto materially affect, the Company’s internal control over financial reporting.

 

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

 

Management of the Company is responsible forestablishing and maintaining adequate internal control over financial reportingas defined in Rules 13a-15(f) and 15d-15(f) under the ExchangeAct. The Company’s internal control over financial reporting is designed toprovide reasonable assurance regarding the reliability of financial reportingand the preparation of financial statements for external purposes in accordancewith generally accepted accounting principles.

 

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

 

A material weakness is a significant deficiency (asdefined in Public Company Accounting Oversight Board Auditing Standard No. 2),or a combination of significant deficiencies, that results in there being morethan a remote likelihood that a material misstatement of the annual or interimfinancial statements will not be prevented or detected on a timely basis by  management or employees in the normal courseof performing their assigned functions.

 

Management assessed the effectiveness of the Company’sinternal control over financial reporting as of December 31, 2007.Management’s assessment did not identify any material weaknesses in the Company’sinternal control over financial reporting.

 

In making this assessment, management used thecriteria set forth by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO) in Internal Control-Integrated Framework. Because therewere no material weaknesses discovered, management believes that, as of December 31,2007, the Company’s internal control over financial reporting was effective.

 

S.R. Snodgrass, A.C. anindependent registered public accounting firm, has audited the consolidatedfinancial statements included in this Annual Report on Form 10-K, as part ofthe audit, has issued a report, included herein, on the effectiveness of theCompany’s internal control over financial reporting as of December 31, 2007.

 
| Date:  March 11, 2008 | /s/  Ronald A. Walko     |                           | /s/  Brian L. Knepp |
|----------------------------|--------------------------|--------------------------------|---------------------|
|                       | Chief  Executive Officer | Principal  Accounting Officer  |
|                       |                     | (Principal  Financial Officer) |

 

 

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# **[**LETTERHEAD OF S.R. SNODGRASS, A.C.]

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

Boardof Directors and Shareholders

PennsWoods Bancorp, Inc.

 

Wehave audited the consolidated balance sheets of Penns Woods Bancorp, Inc.and subsidiaries (the “Company”) as of December 31, 2007 and 2006,and the related consolidated statements of income, changes in shareholders’equity, and cash flows for each of the three years in the period ended December 31,2007.  We also have audited Penns WoodsBancorp, Inc.’s internal control over financial reporting as of December 31,2007, based on criteria established in *Internal Control*—*Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO)*.  Management is responsible for theseconsolidated financial statements, for maintaining effective internal controlover financial reporting, and for its assessment of the effectiveness ofinternal control over financial reporting included in the accompanying *Report on Management’s Assessment of Internal Control Over FinancialReporting*.  Our responsibilityis to express an opinion on these consolidated financial statements and anopinion on the company’s internal control over financial reporting based on ouraudits.

 

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States).  Those standards requirethat we plan and perform the audits to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement and whethereffective internal control over financial reporting was maintained in allmaterial respects.  Our audits of theconsolidated financial statements include examining, on a text basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management,and evaluating the overall financial statement presentation.  Our audit of internal control over financialreporting included obtaining an understanding of internal control overfinancial reporting, assessing the risk that a material weakness exists, andtesting and evaluating the design and operating effectiveness of internalcontrol based on the assessed risk.  Ouraudits also included performing such other procedures as we considered necessaryin the circumstances.  We believe thatour audits provide a reasonable basis for our opinion.

 

A company’s internal control overfinancial reporting is a process designed to provide reasonable assuranceregarding the reliability of financial reporting and the preparation offinancial statements for external purposes in accordance with generallyaccepted accounting principles.  Acompany’s internal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements.  Also, projectionsof any evaluation of effectiveness to future periods are subject to the riskthat controls may become inadequate because of changes in conditions, or thatthe degree of compliance with the policies or procedures may deteriorate.

 

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the consolidated financial position of PennsWoods Bancorp, Inc. and subsidiaries as of December 31, 2007 and 2006,and the consolidated results of their operations and their cash flows for eachof the three years in the period ended December 31, 2007, in conformitywith U.S. generally accepted accounting principles.  Also in our opinion, Penns Woods Bancorp, Inc.maintained, in all material respects, effective internal control over financialreporting as of December 31, 2007, based on the criteria established in *Internal Control*—*Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO)*.

 
| /s/  S. R. Snodgrass, A.C. |   |
|----------------------------|--------|

Wexford,Pennsylvania

March 10, 2008

 

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**ITEM 9B – OTHER INFORMATION**

 

None.

 

**PART III**

 

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

 

The information appearingunder the captions “The Board of Directors and Committees,” “Election ofDirectors,” “Section 16(a) Beneficial Ownership Reporting Compliance,” “PrincipalOfficers of the Corporation,” “Certain Transactions,” and “Audit Committee FinancialExpert” in the Company’s Proxy Statement dated March 25, 2008 (the “ProxyStatement”) is incorporated herein by reference.

 

##### **ITEM 11    EXECUTIVE COMPENSATION**

##### ** **

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

 

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

 

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

 

**ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, ANDDIRECTOR INDEPENDENCE**

 

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

 

Total loans outstandingfrom the Bank at December 31, 2007 to the Company’s and the Bank’sOfficers and Directors as a group and members of their immediate families andcompanies in which they had an ownership interest of 10% or more was $9,335,000or approximately 13.23% of the total equity capital of the Company.  Loans to such persons were made in theordinary course of business, were made on substantially the same terms,including interest rates and collateral, as those prevailing at the time forcomparable transactions with other persons, and did not involve more than thenormal risk of collectability or present other unfavorable features.  See also the information appearing in Note 14to the Consolidated Financial Statements included elsewhere in the AnnualReport.

 

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

 

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**ITEM 14     PRINCIPALACCOUNTING FEES AND SERVICES**

 

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

 

**PART IV**

 

**ITEM 15     EXHIBITS ANDFINANCIAL STATEMENT SCHEDULES**

 
| (a)1.  | Financial Statements                                                                                                                                                                            |   |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   | The following  consolidated financial statements and reports are set forth in Item 8:                                                                                                           |   |
|   | Report of Independent  Auditors                                                                                                                                                                 |   |
|   | Consolidated  Balance Sheet                                                                                                                                                                     |   |
|   | Consolidated  Statement of Income                                                                                                                                                               |   |
|   | Consolidated  Statement of Changes in Shareholders’ Equity                                                                                                                                 |   |
|   |                                                                                                                                                                                            |   |
|   | Consolidated  Statement of Cash Flows                                                                                                                                                           |   |
|   | Notes  to the Consolidated Financial Statements                                                                                                                                                 |   |
| 2.     | Financial Statement  Schedules                                                                                                                                                                  |   |
|   | Financial statement schedules are omitted because  the required information is either not applicable, not required or is shown  in the respective financial statements or in the notes thereto. |   |
|        |                                                                                                                                                                                                 |        |  |

 
| (b) Exhibits |
|-------------------|
| (3)   (i)    |   | Articles of  Incorporation of the Registrant, as presently in effect (incorporated by  reference to Exhibit 3(i) of the Registrant’s Annual Report on  Form 10-K for the year ended December 31, 2005). |
| (3)   (ii)   |   | Bylaws of the  Registrant as presently in effect (incorporated by reference to  Exhibit 3(ii) of the Registrant’s Current Report on Form 8-K  filed on June 17, 2005). |
| (10) (i)     |   | Employment Agreement,  dated August, 1991, between Jersey Shore State Bank and Ronald A. Walko  (incorporated by reference to Exhibit 10.3 of the Registrant’s  Registration Statement on form S-4, No. 333-65821).* |
| (10) (ii)    |   | Employment Agreement,  dated May 31, 2005, between Jersey Shore State Bank and Thomas A.  Donofrio (incorporated by reference to Exhibit 10.1 of the Registrant’s  Form 8-K filed on June 3, 2005).* |
| (10) (iii)   |   | Employee Severance  Benefit Plan, dated May 30, 1996, for Ronald A. Walko (incorporated by  reference to Exhibit 10.4 of the Registrant’s Registration Statement on form  S-4, No. 333-65821).* |
| (10) (iv)    |   | Penns Woods  Bancorp, Inc. 1998 Stock Option Plan (incorporated by reference to  Exhibit 10.1 of the Registrant’s Registration Statement on form S-4,  No. 333-65821).* |
| (10) (v)     |   | Form of First  Amendment to the Jersey Shore State Bank Amendment and Restatement of the  Director Fee Agreement, dated as of October 1, 2004 (incorporated by  reference to Exhibit 10.7 of the Registrant’s Current Report on  Form 8-K filed on June 29, 2006). |
| (10) (vi)    |   | Consulting Agreement,  dated July 18, 2005 between Hubert A. Valencik and Penns Woods  Bancorp, Inc. (incorporated by reference to Exhibit 10.1 of the  Registrant’s Current Report on Form 8-K filed on July 18, 2005). |
| (10) (vii)   |   | Employment Agreement,  dated January 11, 1999, among Penns Woods Bancorp, Inc. , Jersey  Shore State Bank and William H. Rockey.* |
| (21)              |   | Subsidiaries of the  Registrant. |
| (23)              |   | Consent of Independent  Certified Public Accountants. |
| (31) (i)          |   | Rule 13a-14(a)/Rule 15d-14(a) Certification  of Chief Executive Officer. |
| (31) (ii)         |   | Rule 13a-14(a)/Rule 15d-14(a) Certification  of Principle Accounting Officer. |
| (32) (i)          |   | Section 1350  Certification of Chief Executive Officer. |

 

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| (32) (ii) |   | Section 1350  Certification of Principle Accounting Officer. |
|-----------|--------|-------------------------------------------------------------------|

 

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*Denotes compensatory plan or arrangement.

 

**EXHIBITINDEX**

 
| (10) (vii) |   | Employment Agreement,  dated January 11, 1999, among Penns Woods Bancorp, Inc. , Jersey  Shore State Bank and William H. Rockey. |
|-----------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------|
| (21)            |   | Subsidiaries of the  Registrant.                                                                                                           |
| (23)            |   | Consent of Independent  Certified Public Accountants.                                                                                      |
| (31) (i)        |   | Rule 13a-14(a)/Rule 15d-14(a) Certification  of Chief Executive Officer.                                                    |
| (31) (ii)       |   | Rule 13a-14(a)/Rule 15d-14(a) Certification  of Principle Accounting Officer.                                               |
| (32) (i)        |   | Section 1350  Certification of Chief Executive Officer.                                                                               |
| (32) (ii)       |   | Section 1350  Certification of Principle Accounting Officer.                                                                          |

 

72

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 
| March 11, 2008 | PENNS WOODS BANCORP,  INC. |
|---------------------|----------------------------|
|                |                       |
|                | BY:                        | /s/ Ronald A. Walko |
|                |                       | President and Chief  Executive Officer |

 

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

 
| /s/ Ronald A. Walko                                 |   |                 |
|-----------------------------------------------------|--------|----------------------|
| Ronald A. Walko,  President, Chief Executive        |   | March 11,  2008 |
| Officer and Director  (Principal Executive Officer) |   |                 |
|                                                |   |                 |
|                                                |   |                 |
| /s/ Brian L. Knepp                                  |   |                 |
| Brian L. Knepp,  Principal Accounting Officer       |   | March 11,  2008 |
|                                                |   |                 |
|                                                |   |                 |
| /s/ Lynn S. Bowes                                   |   |                 |
| Lynn S. Bowes, Director                             |   | March 11,  2008 |
|                                                |   |                 |
|                                                |   |                 |
| /s/ Michael J.  Casale, Jr.                    |   |                 |
| Michael J.  Casale, Jr., Director              |   | March 11,  2008 |
|                                                |   |                 |
|                                                |   |                 |
| /s/ H. Thomas  Davis, Jr.                      |   |                 |
| H. Thomas  Davis, Jr., Director                |   | March 11,  2008 |
|                                                |   |                 |
|                                                |   |                 |
| /s/ James M.  Furey, II                        |   |                 |
| James M. Furey II,  Director                        |   | March 11,  2008 |
|                                                |   |                 |
|                                                |   |                 |
| /s/ D. Michael  Hawbaker                       |   |                 |
| D. Michael Hawbaker,  Director                      |   | March 11,  2008 |
|                                                |   |                 |
|                                                |   |                 |
| /s/ Leroy H. Keiler III                             |   |                 |
| Leroy H. Keiler III,  Director                      |   | March 11,  2008 |

 

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| /s/ Jay H. McCormick                                             |   |                 |
|------------------------------------------------------------------|--------|----------------------|
| Jay H. McCormick,  Director                                      |   | March 11,  2008 |
|                                                             |   |                 |
|                                                             |   |                 |
| /s/ R. Edward  Nestlerode, Jr.                              |   |                 |
| R. Edward  Nestlerode, Jr., Director                        |   | March 11,  2008 |
|                                                             |   |                 |
|                                                             |   |                 |
| /s/ James E. Plummer                                             |   |                 |
| James E. Plummer,  Director                                      |   | March 11,  2008 |
|                                                             |   |                 |
|                                                             |   |                 |
| /s/ William H. Rockey                                            |   |                 |
| William H.  Rockey, Sr. Vice President  & Director |   | March 11,  2008 |
|                                                             |   |                 |
|                                                             |   |                 |
| /s/ Hubert A. Valencik                                           |   |                 |
| Hubert A. Valencik,  Director                                    |   | March 11,  2008 |

 

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