** **

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**2005 ANNUAL REPORT**

**ON FORM 10-K**

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**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**Form 10-K**

**(Mark One)**

**x**                               Annual report pursuant to Section 13or 15(d) of the Securities Exchange Act of 1934 for the fiscal year endedDecember 31, 2005.

**OR**

**o**                                  Transition report pursuant toSection 13 or 15(d) of the Securities Exchange Act of 1934 for thetransition periodfrom                to                .

**Commissionfile number 0-15237**

**Harleysville NationalCorporation**

(Exact name of registrantas specified in its charter)

| **Pennsylvania**                                                               | ** ** | **23-2210237**                        |
|--------------------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization)               |       | (I.R.S. Employer  Identification No.) |
| **483 Main Street,  Harleysville, Pennsylvania**                               | ** ** | **19438**                             |
| (Address of  principal executive offices)                                      | ** ** | (Zip Code)                            |
| **(215) 256-8851**                                                        |
| Registrant’s  telephone number, including area code:                      |
| Securities  registered pursuant to Section 12(b) of the Act:**None** |
| Securities  registered pursuant to Section 12(g) of the Act:         |
| **Common  Stock, $1.00 par value**                                             |
| **Title of  Class**                                                            |

 

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes o No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o No x

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 preceding12 months (or for such shorter period that the Registrant was required tofile such reports) and (2) has been subject to such filing requirementsfor the past 90 days. Yes xNo o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained 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 tothis Form 10-K. o

Indicate by check markwhether the Registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer (as defined in Rule 12b-2 of the ExchangeAct).

| Large accelerated filer o | Accelerated filer x | Non-accelerated filer o |
|---------------------------|---------------------|-------------------------|

 

Indicate by check markwhether the Registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o No x

The aggregate market valueof the Registrant’s Common Stock held by non-affiliates is $546,390,728 basedon the June 30, 2005 closing price of the Registrant’s Common Stock of$22.06 per share (restated for stock dividend paid on September 15, 2005).

As of March 8, 2006,there were 27,515,862 outstanding shares of the Registrant’s Common Stock.

**DOCUMENTS INCORPORATED BYREFERENCE:**

1.                  Portions of the Registrant’s DefinitiveProxy Statement relating to the Annual Meeting of Shareholders to be held April 25,2006 are incorporated by reference into Part II, Item 5 and Part III,Items 10-14 of this report.

 

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**HARLEYSVILLE NATIONAL CORPORATIONFORM 10-KINDEX**

|               | ** **                                                                                                          | **Page** | ** ** |
|---------------|---------------------------------------------------------------------------------------------------------------------|----------|------------|
| Part I   |                                                                                                                | 4        |       |
| Item 1.       | Business                                                                                                            |     | 4          |   |
| Item 1A.      | Risk Factors                                                                                                        |     | 11         |   |
| Item 1B.      | Unresolved  Staff Comments                                                                                          |     | 13         |   |
| Item 2.       | Properties                                                                                                          |     | 14         |   |
| Item 3.       | Legal  Proceedings                                                                                                  |     | 15         |   |
| Item 4.       | Submission  of Matters to a Vote of Security Holders                                                                |     | 15         |   |
| Part II  |                                                                                                                | 16       |       |
| Item 5.       | Market  for Registrant’s Common Equity, Related Stockholder Matters and Issuer  Purchases of Equity Securities |     | 16         |   |
| Item 6.       | Selected  Financial Data                                                                                            |     | 18         |   |
| Item 7.       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         |     | 19         |   |
| Item 7A. | Quantitative  and Qualitative Disclosures About Market Risk                                                         |     | 41         |   |
| Item 8.       | Financial  Statements and Supplementary Data                                                                        |     | 42         |   |
| Item 9.       | Changes  in and Disagreements With Accountants on Accounting and Financial Disclosure                               |     | 83         |   |
| Item 9A. | Controls  and Procedures                                                                                            |     | 83         |   |
| Item 9B. | Other  Information                                                                                                  |     | 85         |   |
| Part III |                                                                                                                | 86       |       |
| Item 10.      | Directors  and Executive Officers of the Registrant                                                                 |     | 86         |   |
| Item 11.      | Executive  Compensation                                                                                             |     | 86         |   |
| Item 12.      | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    |     | 86         |   |
| Item 13.      | Certain  Relationships and Related Transactions                                                                     |     | 86         |   |
| Item 14.      | Principal  Accounting Fees and Services                                                                             |     | 86         |   |
| Part IV  |                                                                                                                | 87       |       |
| Item 15.      | Exhibits,  Financial Statement Schedules                                                                            |     | 87         |   |
| Signatures    |                                                                                                                | 91       |       |

 

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**Forward-Looking Statements**

In addition to historical information, this reportcontains forward-looking statements within the meaning of the PrivateSecurities Litigation Reform Act of 1995. We have made forward-lookingstatements in this report, and in documents that we incorporate by reference,that are subject to risks and uncertainties. Forward-looking statementsinclude the information concerning possible or assumed future results ofoperations of Harleysville National Corporation and its subsidiaries. When weuse words such as “believes,” “expects,” “anticipates,” “may,” “estimates,” or “intends”or similar expressions, we are making forward-looking statements.Forward-looking statements are representative only as of the date they aremade, and the Corporation undertakes no obligation to update anyforward-looking statement.

Shareholders should notethat many factors, some of which are discussed elsewhere in this report and inthe documents that we incorporate by reference, could affect the future financialresults of the Corporation and its subsidiaries and could cause those resultsto differ materially from those expressed or implied in our forward-lookingstatements contained or incorporated by reference in this document. Thesefactors include but are not limited to those described in Item 1A, “RiskFactors.”

**The SEC has not approved or disapproved this Report orpassed upon its accuracy or adequacy.**

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**PART I**

**Item 1.        Business**

Harleysville National Corporation (the Corporation), aPennsylvania corporation, was incorporated in June, 1982. On January 1,1983, the Corporation became the parent bank holding company of HarleysvilleNational Bank and Trust Company (the Bank or Harleysville National Bank),established in 1909, a wholly owned subsidiary of the Corporation. TheCorporation is registered as a bank holding company under the Bank HoldingCompany Act of 1956.

Since commencing operations, the Corporation’sbusiness has consisted primarily of providing financial services through itssubsidiaries and has acquired seven financial institutions since 1991 and alsorecently completed the acquisition of the Cornerstone Companies (registeredinvestment advisors) in January 2006. The Corporation is also the parentholding company of HNC Financial Company and HNC Reinsurance Company. HNCFinancial Company was incorporated on March 17, 1997 as a DelawareCorporation and its principal business function is to expand the investmentopportunities of the Corporation. HNC Reinsurance Company was incorporated on March 30,2001 as an Arizona Corporation and reinsures consumer loan credit life andaccident and health insurance.

The Bank is a national banking association under thesupervision of the Office of the Comptroller of the Currency (the OCC). TheCorporation’s and the Bank’s legal headquarters are located at 483 Main Street,Harleysville, Pennsylvania 19438. HNC Financial Company’s legal headquarters islocated at 2751 Centerville Road, Suite 3164, Wilmington, Delaware 19808.HNC Reinsurance Company’s legal headquarters is located at 101 North FirstAvenue, Suite 2460, Phoenix, AZ 85003.

The Bank provides a full range of banking servicesincluding loans and deposits, investment management and trust and investmentadvisory services to individual and corporate customers located in easternPennsylvania. The Bank engages in the full-service commercial banking and trustbusiness, including accepting time and demand deposits, making secured andunsecured commercial and consumer loans, financing commercial transactions,making construction and mortgage loans and performing corporate pension andpersonal investment and trust services. Deposits are insured by the FederalDeposit Insurance Corporation (FDIC) to the extent provided by law. The Bankhas 45 branch offices located in Montgomery, Bucks, Chester, Berks, Carbon,Wayne, Monroe, Lehigh and Northampton counties, Pennsylvania.

The Bank enjoys a stable base of core deposits and isa leading community bank in its service areas. The Bank believes it has gainedits position as a result of a customer-oriented philosophy and a strongcommitment to service. Senior management has made the development of a salesorientation throughout the Bank one of their highest priorities and emphasizesthis objective with extensive training and sales incentive programs. The Bankmaintains close contact with the local business community to monitor commerciallending needs and believes it responds to customer requests quickly and withflexibility. Management believes these competitive strengths are reflected inthe Corporation’s results of operations.

The Bank opened a new location in Dorneyville, LehighCounty during the fourth quarter of this year. The location houses a retailbranch as well as a Millennium Wealth Management office. The Bank also plans toopen a new retail branch in Warminster, Bucks County during 2006. The Bankcontinues to evaluate potential new branch sites that are contiguous to ourcurrent service area and will expand the Bank’s market area and market share ofloans and deposits.

At the close of business on January 13, 2006, theCorporation completed its acquisition of the Cornerstone Companies, registeredinvestment advisors for high net worth, privately held business owners, wealthyfamilies and institutional clients. Located in the Lehigh Valley, Pennsylvania,the firm specializes in providing sophisticated open architecture assetmanagement platforms, business succession and estate planning services, lifeinsurance sales and compensation and benefits consulting. With assets under 

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management ofapproximately $1.5 billion, the Cornerstone Companies serve clients within theHarleysville footprint, throughout Pennsylvania and other mid-Atlantic states.

The acquisition was consummated pursuant to thePurchase Agreement dated November 15, 2005, by and among the Bank andCornerstone Financial Consultants, Ltd., a Pennsylvania corporation (CFC),Cornerstone Institutional Investors, Inc., a Pennsylvania corporation(CII), Cornerstone Advisors Asset Management, Inc., a Pennsylvaniacorporation ((CAAM), and together with CFC and CII collectively, theCornerstone Companies), Cornerstone Management Resources, Inc., (CMR),John R. Yaissle, Malcolm L. Cowen, II and Thomas J. Scalici. Under thePurchase Agreement, the Bank acquired (i) all of the outstanding capitalstock of CFC and CII, (ii) substantially all of the assets of CAAM, and (iii) certainlimited assets of CMR. The purchase price consisted of $15.0 million in cashpaid at closing and a contingent payment of up to $7.0 million to be paidpost-closing. The contingent payment is based upon the Cornerstone Companiesmeeting certain minimum operating results during a five-year earn-out period,with a maximum payout of $7.0 million over this period. Management expects thetransaction to be immediately accretive to earnings per share.

The acquisition has been accounted for using thepurchase method of accounting, which requires that the financial statementsinclude activity of the Cornerstone Companies effective January 1, 2006.Accordingly, the Corporation’s consolidated financial statements and theinformation herein at and for the year ended December 31, 2005 does notinclude the Cornerstone Companies. The Cornerstone Companies have become partof the Millennium Wealth Management division of the Bank. The acquisition isexpected to provide significant strategic advantages to the Corporation,broadening wealth management products and services, growing our business clientbase and positioning the Millennium Wealth Management division as a leader inour market.

On June 30, 2005, the Bank sold its formersubsidiary, Cumberland Advisors, Inc. Cumberland Advisors, based inVineland, New Jersey, is a SEC registered investment advisor specializing infixed income money management and equities. It was acquired by the Corporationon April 30, 2004 as part of its Millennium Bank acquisition.

On April 30, 2004, the Corporation completed itsacquisition of Millennium Bank, which was merged with and into the Bank.Millennium Bank was based in Malvern, Pennsylvania with four banking offices,specializing in commercial lending and client relationship banking along withCumberland Advisors, Inc.

As of December 31, 2005, the Corporation hadtotal assets of $3.12 billion, total shareholders’ equity of$273.2 million and total deposits of $2.37 billion.

As of December 31,2005, the Corporation and the Bank employed approximately 665 full-timeequivalent employees. The Corporation provides a variety of employment benefitsand considers its relationships with its employees to be satisfactory.

**Competition**

The Bank competes activelywith other eastern Pennsylvania financial institutions, many larger than theBank, as well as with financial and non-financial institutions headquarteredelsewhere. Commercial banks, savings banks, savings and loan associations,credit unions, and money market funds actively compete for deposits and loans.Such institutions, as well as consumer finance and insurance companies, may beconsidered competitors with respect to one or more services they render. TheBank is generally competitive with all competing institutions in its serviceareas with respect to interest rates paid on time and savings deposits, servicecharges on deposit accounts, interest rates charged on loans and fees for trustand investment advisory services. At December 31, 2005, the Bank’s legallending limit to a single customer was $39.0 million. Many of theinstitutions with which the Bank competes are able to lend significantly morethan this amount to a single customer.

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**Supervisionand Regulation—The Registrant**

The Gramm-Leach-Bliley FinancialModernization Act of 1999 (Modernization Act) allows bank holding companiesmeeting management, capital, and Community Reinvestment Act standards to engagein a substantially broader range of non-banking activities than permissiblebefore enactment, including underwriting insurance and making merchant bankinginvestments in commercial and financial companies. It allows insurers and otherfinancial services companies to acquire banks, removes various restrictionsthat currently apply to bank holding company ownership of securities firms andmutual fund advisory companies, and establishes the overall regulatorystructure applicable to bank holding companies that also engage in insuranceand securities operations.

The Modernization Act alsomodified law related to financial privacy and community reinvestment. Theprivacy provisions generally prohibit financial institutions, including theCorporation, from disclosing nonpublic financial information to nonaffiliatedthird parties unless customers have the opportunity to “opt out” of thedisclosure.

**Pending Legislation**

Management is not aware ofany other current specific recommendations by regulatory authorities orproposed legislation which, if they were implemented, would have a materialadverse effect upon the liquidity, capital resources, or results of operations,although the general cost of compliance with numerous federal and state lawsand regulations does have, and in the future may have, a negative impact on theCorporation’s results of operations.

**Effects of Inflation**

Inflation has some impacton the Corporation’s and the Bank’s operating costs. Unlike many industrialcompanies, however, substantially all of the Bank’s assets and liabilities aremonetary in nature. As a result, interest rates have a more significant impacton the Corporation’s and the Bank’s performance than the general level ofinflation. Over short periods of time, interest rates may not necessarily movein the same direction or in the same magnitude as prices of goods and services.

**Effectof Government Monetary Policies**

The earnings of the Corporation are and will be affectedby domestic economic conditions and the monetary and fiscal policies of theUnited States government and its agencies. An important function of the FederalReserve is to regulate the money supply and interest rates. Among theinstruments used to implement those objectives are open market operations inUnited States government securities and changes in reserve requirements tomember bank deposits. These instruments are used in varying combinations toinfluence overall growth and distribution of bank loans, investments anddeposits, and their use may also affect rates charged on loans or paid fordeposits.

The Bank is a member ofthe Federal Reserve and, therefore, the policies and regulations of the FederalReserve have a significant effect on its deposits, loans and investment growth,as well as the rate of interest earned and paid, and are expected to affect theBank’s operations in the future. The effect of such policies and regulationsupon the future business and earnings of the Corporation and the Bank cannot bepredicted.

**Environmental Regulations**

There are several federaland state statutes which regulate the obligations and liabilities of financialinstitutions pertaining to environmental issues. In addition to the potentialfor attachment of liability resulting from its own actions, a bank may be heldliable under certain circumstances for the actions of its 

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borrowers,or third parties, when such actions result in environmental problems onproperties that collateralize loans held by the bank. Further, the liabilityhas the potential to far exceed the original amount of a loan issued by thebank. Currently, neither the Corporation nor the Bank are a party to anypending legal proceeding pursuant to any environmental statute, nor are theCorporation and the Bank aware of any circumstances that may give rise toliability under any such statute.

**Supervision and Regulation—Bank**

The operations of the Bank are subject to federal andstate statutes applicable to banks chartered under the banking laws of theUnited States, to members of the Federal Reserve and to banks whose depositsare insured by the FDIC. The Bank’s operations are also subject to regulationsof the OCC, the Federal Reserve and the FDIC. The primary supervisory authorityof the Bank is the OCC, who regularly examines the Bank. The OCC has authorityto prevent a national bank from engaging in unsafe or unsound practices inconducting its business.

Federal and state banking laws and regulations govern,among other things, the scope of a bank’s business, the investments a bank maymake, the reserves against deposits a bank must maintain, loans a bank makesand collateral it takes, the activities of a bank with respect to mergers andconsolidations and the establishment of branches.

The Corporation and the Bank are subject toregulations of certain state and federal agencies and, accordingly, theseregulatory authorities periodically examine the Corporation and the Bank. As aconsequence of the extensive regulation of commercial banking activities, theCorporation’s and the Bank’s business is susceptible to being affected by stateand federal legislation and regulations.

As a subsidiary bank of a bank holding company, theBank is subject to certain restrictions imposed by the Federal Reserve Act onany extensions of credit to the bank holding company or its subsidiaries, orinvestments in the stock or other securities as collateral for loans. TheFederal Reserve Act and Federal Reserve regulations also place certainlimitations and reporting requirements on extensions of credit by a bank toprincipal shareholders of its parent holding company, among others, and torelated interests of such principal shareholders. In addition, such legislationand regulations may affect the terms upon which any person becoming a principalshareholder of a holding company may obtain credit from banks with which thesubsidiary bank maintains a correspondent relationship.

Under the Federal DepositInsurance Act, the OCC possesses the power to prohibit institutions regulatedby it (such as the Bank) from engaging in any activity that would be an unsafeand unsound banking practice or would otherwise be in violation of the law.

*CommunityReinvestment Act*

Under the CommunityReinvestment Act, the OCC is required to assess the record of all financialinstitutions regulated by it to determine if these institutions are meeting thecredit needs of the community, including low and moderate income neighborhoodswhich they serve and to take this record into account in its evaluation of anyapplication made by any of such institutions for, among other things, approvalof a branch or other deposit facility, office relocation, a merger or anacquisition of bank shares. The Financial Institutions Reform, Recovery andEnforcement Act amended the CRA to require, among other things, that the OCCmake publicly available the evaluation of a bank’s record of meeting the creditneeds of its entire community, including low and moderate income neighborhoods.This evaluation will include a descriptive rating like “outstanding,” “satisfactory,”“needs to improve” or “substantial noncompliance” and a statement describingthe basis for the rating. These ratings are publicly disclosed.

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*Bank Secrecy Act*

Under the Bank SecrecyAct, banks and other financial institutions are required to report to theInternal Revenue Service currency transactions of more than $10,000 or multipletransactions of which a bank is aware in any one day that aggregate in excessof $10,000. Civil and criminal penalties are provided under the Bank SecrecyAct for failure to file a required report, for failure to supplyinformation required by the Bank Secrecy Act or for filing a false orfraudulent report.

*CapitalRequirements / FDICIA*

TheFederal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) requiresthat institutions be classified, based on their risk-based capital ratios intoone of five defined categories, as illustrated below: well capitalized,adequately capitalized, undercapitalized, significantly undercapitalized andcritically undercapitalized. Under these guidelines, the Bank was consideredwell capitalized as of December 31, 2005.

| ** **                      | ** ** | **Total  Risk  Based  Ratio** | ** ** | **Tier 1  Risk  Based  Ratio** | ** ** | **Tier 1  Leverage  Ratio** | ** ** | **Under a  Capital  Order  or  Directive** | ** ** |
|---------------------------------|------------|-------------------------------|------------|-------------------------------------|------------|----------------------------------|------------|-------------------------------------------------|------------|
| **Capital  category**           |       |                          |       |                                |       |                             |       |                                            |       |   |   |   |   |
| Well capitalized                |       | 310.0%                   |       | 36.0%                          |       |                             | 35.0  | %                                               |       |   | NO |   |   |
| Adequately  capitalized         |       | 38.0%                    |       | 34.0%                          |       |                             | 34.0  | %(1)                                            |       |   |   |   |   |
| Undercapitalized                |       | <8.0%                      |       | <4.0%                            |       |                             | <4.0    | %(1)                                            |       |   |   |   |   |
| Significantly  undercapitalized |       | <6.0%                      |       | <3.0%                            |       |                             | <3.0    | %                                               |       |   |   |   |   |
| Critically undercapitalized     |       |                          |       |                                |       |                             | <2.0    | %                                               |       |   |   |   |   |

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(1)          3.0 for those bankshaving the highest available regulatory rating.

In the event an institution’s capital deteriorates tothe undercapitalized category or below, FDICIA prescribes an increasing amountof regulatory intervention, including: the institution of a capital restorationplan and a guarantee of the plan by a parent institution; and the placement ofa hold on increases in assets, number of branches or lines of business. Ifcapital has reached the significantly or critically undercapitalized levels,further material restrictions can be imposed, including restrictions oninterest payable on accounts, dismissal of management and, in criticallyundercapitalized situations, appointment of a receiver. For well capitalized institutions,FDICIA provides authority for regulatory intervention where the institution isdeemed to be engaging in unsafe or unsound practices or receives a less thansatisfactory examination report rating for asset quality, management, earningsor liquidity. All but well capitalized institutions are prohibited fromaccepting brokered deposits without prior regulatory approval.

Under FDICIA, financial institutions are subject toincreased regulatory scrutiny and must comply with certain operational, managerialand compensation standards to be developed by Federal Reserve Boardregulations. FDICIA also requires the regulators to issue new rules establishingcertain minimum standards to which an institution must adhere includingstandards requiring a minimum ratio of classified assets to capital, minimumearnings necessary to absorb losses and minimum ratio of market value to bookvalue for publicly held institutions. In addition, FDICIA requires regulatorsto develop standards relating to internal controls, loan documentation, creditunderwriting, interest rate exposure, asset growth and excessive compensation,fees and benefits.

Annual full-scope, on site regulatory examinations arerequired for all the FDIC-insured institutions except institutions with assetsunder $100 million which are well capitalized, well-managed and notsubject to a recent change in control, in which case, the examination period isevery 18 months. Banks with total 

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assets of$500 million or more are required to submit to their supervising federaland state banking agencies a publicly available annual audit report. Theindependent accountants of banks with total assets of $1 billion or more arerequired to attest to the accuracy of management’s report regarding theinternal controls of the bank. In addition, such banks also are required tohave an independent audit committee composed of outside directors who areindependent of management, to review with management and the independentaccountants, the reports that must be submitted to the bank regulatoryagencies. If the independent accountants resign or are dismissed, writtennotification must be given to the bank’s supervising government bankingagencies.

FDICIA also requires that banking agencies reintroduceloan-to-value ratio regulations which were previously repealed by the 1982 Act.Loan-to-values limit the amount of money a financial institution may lend to aborrower, when the loan is secured by real estate, to no more than apercentage, set by regulation, of the value of the real estate.

A separate subtitle withinFDICIA, called the “Bank Enterprise Act of 1991,” requires “truth-in-savings”on consumer deposit accounts so that consumers can make meaningful comparisonsbetween the competing claims of banks with regard to deposit accounts andproducts. Under this provision, a bank is required to provide information todepositors concerning the terms of their deposit accounts, and in particular,to disclose the annual percentage yield.

*CapitalDistributions*

The Corporation is a legal entity separate anddistinct from its banking and other subsidiaries. The majority of theCorporation’s revenue is from dividends paid to the Corporation by the Bank.The Bank is subject to various regulatory policies and requirements relating tothe amount and frequency of dividend declarations. Future dividend payments tothe Corporation by the Bank will be dependent on a number of factors, includingthe earnings and financial condition of the Bank, and are subject tolimitations and other statutory powers of bank regulatory agencies.

The National Banking Lawsrequire the approval of the OCC if the total of all dividends declared by anational bank in any calendar year exceed the net profits of the bank for thatyear combined with its retained net profits for the preceding two calendaryears. An insured depository institution is prohibited from making any capitaldistributions to its owner, including any dividend, if, after making suchdistribution, the depository institution fails to meet the required minimum levelfor any relevant capital measure, including the risk-based capital adequacy andleverage standards previously discussed in the capital requirements section.

*Deposit Insuranceand Premiums*

The Bank’s deposits are insured by the Bank InsuranceFund (BIF), which is administered by the FDIC. The basic insurance limit is$100,000 per depositor, per insured institution and such insurance is backed bythe full faith and credit of the United States government. As insurer, the FDICimposes deposit insurance premiums and is authorized to conduct examinationsof, and to require reporting by, FDIC-insured institutions. It also mayprohibit any FDIC-insured institution from engaging in any activity the FDICdetermines by regulation or order to pose a serious risk to the insurance fund.The FDIC also has the authority to terminate an institution’s deposit insuranceif it determines that the institution has engaged in unsafe or unsoundpractices or is in an unsafe or unsound condition. The deposit insurancepremiums are assessed based both on the balance of insured deposits held aswell as the degree of risk the institution poses to the insurance fund. Eachinsured institution is placed in one of nine risk categories based upon theinstitution’s capital classifications and supervisory evaluation. Riskclassification of all insured institutions is made by the FDIC for eachsemi-annual assessment period.

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The FDIC is authorized to increase assessment rates,on a semi-annual basis, to maintain the reserve ratio at the designated minimumratio of 1.25% of estimated insured deposits or such higher reserve ratio asestablished by the FDIC. The current premium schedule for BIF insuredinstitutions ranges from 0 to 27 basis points per $100 of deposits depending onthe assessment category into which the insured institution is placed. Banksclassified as strongest by the FDIC were subject in 2005 to a 0.00% assessment.The Bank was placed in this category and, therefore, had a 0.00% assessmentrate in 2005.

In addition, all insured institutions are required topay a Financing Corporation (FICO) assessment. FICO is a governmentagency-sponsored entity that was formed to borrow money necessary to carry outthe closing and disposition of failed thrift institutions in the 1980’s. Theannual FICO rate for all insured institutions as of December 31, 2005 was1.32 basis points. These assessments are revised quarterly and will continueuntil the bonds mature in the year 2019. The Bank paid FICO premiums of$306,000 in 2005.

Any significant increasesin assessment rates or additional special assessments by the FDIC could have anadverse impact on the results of operations and capital of the Bank and theCorporation.

*Sarbanes-Oxley Actof 2002*

The Sarbanes-Oxley Act of2002 implemented a broad range of corporate governance, accounting andreporting measures for companies that have securities registered under theExchange Act, including publicly-held bank holding companies. The moresignificant reforms of the Sarbanes-Oxley Act of 2002 include: (1) newrequirements for audit committees, including independence, expertise, andresponsibilities; (2) certification of financial statements by the ChiefExecutive Officer and Chief Financial Officer of the reporting company; (3) newstandards for auditors and regulation of audits, including independenceprovisions that restrict non-audit services that accountants may provide totheir audit clients; (4) increased disclosure and reporting obligationsfor the reporting company and their directors and executive officers, includingaccelerated reporting of stock transactions and a prohibition on trading duringpension blackout periods; (5) a range of new and increased civil andcriminal penalties for fraud and other violations of the securities laws.

*USA Patriot Act*

The Uniting andStrengthening America by Providing Appropriate Tools Required to Intercept andObstruct Terrorism Act of 2001 (USA Patriot Act) imposes additional obligationson financial institutions, including banks and broker-dealer subsidiaries, toimplement policies, procedures and controls which are reasonably designed todetect and report instances of money laundering and the financing of terrorism.In addition, provisions of the USA Patriot Act require the federal financialinstitution regulatory agencies to consider the effectiveness of a financialinstitution’s anti-money laundering activities when reviewing bank mergers andbank holding company acquisitions.

*Regulatory Impactof the Cornerstone Companies Acquisition*

CII is subject to regulation by a number of federalregulatory agencies that are charged with safeguarding the integrity of thesecurities and other financial markets and with protecting the interests ofcustomers participating in those markets. The SEC is the federal agency that isprimarily responsible for the regulation of broker-dealers and investmentadvisers doing business in the United States. The Federal Reserve Boardpromulgates regulations applicable to securities credit transactions involvingbroker-dealers and certain other institutions. Much of the regulation ofbroker-dealers, however, has been delegated to self-regulatory organizations(SROs), principally the NASD (and its subsidiaries NASD Regulation, Inc.and the Nasdaq Stock Market), and the national securities exchanges. TheseSROs, which are subject to oversight by the SEC, adopt rules (which aresubject to approval by the SEC) that govern the industry, monitor dailyactivity and conduct periodic examinations of member broker-dealers.

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CII, CFC and CAAM are registered as investmentadvisers with the SEC and are subject to the requirements of the InvestmentAdvisers Act of 1940 and the SEC’s regulations, as well as certain statesecurities laws and regulations. These requirements relate to limitations onthe ability of an investment adviser to charge performance-based ornon-refundable fees to clients, record-keeping and reporting requirements,disclosure requirements, limitations on principal transactions between anadviser or its affiliates and advisory clients, as well as general anti-fraudprohibitions. CII, as a broker-dealer registered with the SEC and as a memberfirm of the NASD, is subject to capital requirements of the SEC and the NASD.These capital requirements specify minimum levels of capital that CII isrequired to maintain and also limit the amount of leverage that it is able toobtain in its respective business.

In the event of non-compliance with an applicableregulation, governmental regulators and the NASD may institute administrativeor judicial proceedings that may result in censure, fine, civil penalties, theissuance of cease-and-desist orders or the deregistration or suspension of thenon-compliant broker-dealer or investment adviser or other adverseconsequences. The imposition of any such penalties or orders on CII could havea material adverse effect on CII’S (and therefore the Corporation’s) operatingresults and financial condition.

CII is a member of theSecurities Investor Protection Corporation (SIPC), which is a non-profitcorporation that was created by the United States Congress under the SecuritiesProtection Act of 1970. SIPC protects customers of member broker-dealersagainst losses caused by the financial failure of the broker-dealer but notagainst a change in the market value of securities in customers’ accounts atthe broker-dealer. In the event of the inability of a member broker-dealer tosatisfy the claims of its customers in the event of its failure, the SIPC’sfunds are available to satisfy the remaining claims up to maximum of $500,000per customer, including up to $100,000 on claims for cash. In addition, CII’sclearing firm carries private insurance that provides unlimited accountprotection in excess of SIPC’s protection.

**Changes in Regulations**

From time to time, various types of federal and statelegislation have been proposed that could result in additional regulation of,and restriction on, the business of the Corporation and the Bank. It cannot bepredicted whether any such legislation will be adopted or, if adopted, how suchlegislation would affect the business of the Corporation or the Bank. As aconsequence of the extensive regulation of commercial banking activities in theUnited States, the Corporation and the Bank are particularly susceptible tobeing affected by federal legislation and regulations that may increase thecosts of doing business.

**Additional Information**

The Corporation’s AnnualReport on Form 10-K, Quarterly Reports on Form 10-Q, Current Reportson Form 8-K and amendments to those reports filed or furnished pursuant toSection 13(a) or 15(d) of the Securities Exchange Act of 1934are available free of charge on the Corporation’s website (*www.hncbank.com*under “Investor Information”) as soon as reasonably practicableafter the Corporation electronically files such material with, or furnishes itto the Securities and Exchange Commission. These filings are also accessible onthe Securities and Exchange Commission’s website (*www.sec.gov*).In addition, the Corporation makes available on *www.hncbank.com*under “Investor Information—Corporate Governance” the following:1) Audit Committee Charter, 2) Code of Ethics, which applies to alldirectors and all employees, 3) Whistleblower Policy, 4) Nominatingand Corporate Governance Committee Charter and 5) Compensation CommitteeCharter.

**Item 1A.**                RiskFactors

The business of theCorporation and the Bank involve significant risks as described below.Additional risks may arise in the future or risks that are currently notconsidered significant may also impact the operations of the Corporation andthe Bank. The Corporation may amend or supplement the risk factors 

11

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describedbelow from time to time by reports filed with the SEC in the future. Management’sability to analyze and manage these and other risks could affect the futurefinancial results of the Corporation. If any of the events or circumstancesdescribed in the following risks occur, the financial condition or results ofoperations of the Corporation could suffer and the trading price of theCorporation’s common stock could decline.

*Interest ratemovements impact the earnings of the Corporation.*

The Corporation is exposedto interest rate risk, through the operations of its banking subsidiary, sincesubstantially all of the Bank’s assets and liabilities are monetary in nature.Interest rate risk arises from market driven fluctuations in interest ratesthat affect cash flows, income, expense and value of financial instruments. TheBank’s earnings, like that of most financial institutions, largely depends onnet interest income, which is the difference between the interest income earnedon interest-earning assets, such as loans and investments, and the interestexpense paid on interest-bearing liabilities, such as deposits and borrowings. Inan increasing interest rate environment, the cost of funds is expected toincrease more rapidly than the interest earned on the loans and securitiesbecause the primary source of funds are deposits with generally shortermaturities than the maturities on loans and investment securities. This causesthe net interest rate spread to compress and negatively impacts the Bank’sprofitability. The Corporation actively manages its interest rate sensitivitypositions. The objectives of interest rate risk management are to controlexposure of net interest income to risks associated with interest ratemovements and to achieve consistent growth in net interest income.

*The Corporation is exposed to risks in connection withloans the Bank makes and if the allowance for loan losses is not sufficient tocover actual loan losses, the Corporation’s earnings could decrease.*

A significant source of risk for the Corporationarises from the possibility that losses will be sustained because borrowers,guarantors and related parties may fail to perform in accordance with the termsof their loans. The Corporation has underwriting and credit monitoringprocedures and credit policies, including the establishment and review of theallowance for loan losses, that are believed to be adequate to minimize thisrisk by assessing the likelihood of nonperformance, tracking loan performanceand diversifying loan portfolios. Such policies and procedures, however, maynot prevent unexpected losses that could adversely affect the Corporation’sresults of operations.

The Corporation maintainsan allowance for loan losses at a level management believes is sufficient toabsorb estimated probable credit losses. Management’s determination of theadequacy of the allowance is based on periodic evaluations of the loanportfolio and other relevant factors. However, this evaluation is inherentlysubjective as it requires significant estimates by management. Consideration isgiven to a variety of factors in establishing these estimates including currentand anticipated economic conditions, diversification of the loan portfolio,delinquency statistics, results of internal loan reviews, borrowers’ perceivedfinancial and management strengths, the adequacy of underlying collateral, thedependence on collateral, or the strength of the present value of future cashflows and other relevant factors. These factors may be susceptible tosignificant change. To the extent actual outcomes differ from managementestimates, additional provisions for loan losses may be required which mayadversely affect the Corporation’s results of operations in the future.

*Strong competitionwithin the Corporation’s market area may limit its growth and profitability.*

Competition in the bankingand financial services industry is intense. The Bank competes actively withother eastern Pennsylvania financial institutions, many larger than the Bank,as well as with financial and non-financial institutions headquarteredelsewhere. Commercial banks, savings banks, savings and loan associations, creditunions, and money market funds actively compete for deposits and loans. Suchinstitutions, as well as consumer finance and insurance companies, may beconsidered competitors with 

12

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respectto one or more services they render. The Bank is generally competitive with allcompeting institutions in its service areas with respect to interest rates paidon time and savings deposits, service charges on deposit accounts, interestrates charged on loans and fees for trust and investment advisory services.Many of the institutions with which the Bank competes have substantiallygreater resources and lending limits and may offer certain services that theBank does not or cannot provide. The Corporation’s profitability depends uponthe Bank’s ability to successfully compete in its market area.

*Aneconomic downturn in eastern Pennsylvania or a general decline in economicconditions could adversely affect the Corporation’s financial results.*

The Bank’s operations areconcentrated in eastern Pennsylvania. As a result of this geographicconcentration, the Corporation’s financial results may correlate to theeconomic conditions in this area. Deterioration in economic conditions in thismarket area, particularly in the industries on which this geographic areasdepend, or a general decline in economic conditions may adversely affect thequality of the loan portfolio (including the level of non-performing assets,charge offs and provision expense) and the demand for products and services,and accordingly, the Corporation’s results of operations. Inflation has some impact on the Corporation’s andthe Bank’s operating costs.

*The Corporation operates in a highly regulatedenvironment and may be adversely affected by changes in laws and regulations.*

The Corporation and theBank are subject to extensive regulation, supervision and examination bycertain state and federal agencies including the Pennsylvania State Departmentof Banking, the Federal Deposit Insurance Corporation, as insurer of the Bank’sdeposits, the Board of Governors of the Federal Reserve System, as regulator ofthe holding company and the Office of the Comptroller of Currency. Suchregulation and supervision governs the activities in which an institution andits holding company may engage, and are intended primarily to ensure the safetyand soundness of financial institutions. Regulatory authorities have extensivediscretion in their supervisory and enforcement activities, including theimposition of restrictions on operations, the classification of assets anddetermination of the level of the allowance for loan losses. Any change in suchregulation and oversight, whether in the form of regulatory policy,regulations, legislation or supervisory action, may have a material impact onthe Bank’s and the Corporation’s operations.

**Item 1B.**               UnresolvedStaff Comments

None.

13

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**Item 2.**                        Properties

Theprincipal executive offices of the Corporation and of the Bank are located inHarleysville, Pennsylvania in a two-story office building owned by the Bank,built in 1929. The Bank also owns the buildings in which twenty-two ofits branches are located and leases space for the other twenty-fivebranches from unaffiliated third parties under leases expiring at various timesthrough 2036. The Bank leases office space for commercial business developmentin Lansdale, Pennsylvania. HNC Investment Company leases an office inWilmington, Delaware. HNC Reinsurance Company leases an office in Phoenix,Arizona. HNB Auto Sales re-markets off lease vehicles at a Bank owned propertyin Harleysville, Pennsylvania.

| **Office**            | ** ** | ** **                                        | ** ** | **Office   Location** | ** ** | **Owned/Leased** |
|-----------------------|------------|---------------------------------------------------|------------|-----------------------|------------|------------------|
| Harleysville          |       | 483 Main Street,  Harleysville, PA                |       | Owned                 |
| Harleysville          |       | 278 Main Street,  Harleysville, PA                |       | Leased                |
| Skippack              |       | 3893 Skippack Pike,  Skippack, PA                 |       | Owned                 |
| Limerick              |       | 260 West Ridge Pike,  Limerick, PA                |       | Owned                 |
| North Wales           |       | 1498 North Wales Road,  North Wales, PA           |       | Owned                 |
| Gilbertsville         |       | 1050 East Philadelphia  Avenue, Gilbertsville, PA |       | Leased                |
| Hatfield              |       | 1632 Cowpath Road,  Hatfield, PA                  |       | Leased                |
| North Broad           |       | 1804 North Broad Street,  Lansdale, PA            |       | Owned                 |
| Marketplace           |       | 1551 Valley Forge Road,  Lansdale, PA             |       | Leased                |
| Normandy Farms        |       | Morris Road &  Route 202, Blue Bell, PA  |       | Leased                |
| Horsham               |       | 955 Horsham Road,  Horsham, PA                    |       | Leased                |
| Meadowood             |       | 3205 Skippack Pike,  Worcester, PA                |       | Leased                |
| Collegeville          |       | 364 Main Street,  Collegeville, PA                |       | Owned                 |
| Sellersville          |       | 209 North Main Street,  Sellersville, PA          |       | Owned                 |
| Trainers Corner       |       | 120 North West End  Boulevard, Quakertown, PA     |       | Leased                |
| Quakertown Main       |       | 224 West Broad Street,  Quakertown, PA            |       | Owned                 |
| Spring House          |       | 1017 North Bethlehem  Pike, Spring House, PA      |       | Owned                 |
| Red Hill              |       | 400 Main Street, Red  Hill, PA                    |       | Owned                 |
| Doylestown            |       | 500 East Farm Lane,  Doylestown, PA               |       | Leased                |
| Audubon               |       | 2624 Egypt Road,  Norristown, PA                  |       | Owned(1)              |
| Chalfont              |       | 251 West Butler Avenue,  Chalfont, PA             |       | Leased                |
| Royersford            |       | 440 W. Linfield-Trappe  Road, Royersford, PA      |       | Owned(1)              |
| Souderton             |       | 702 Route 113,  Souderton, PA                     |       | Leased                |
| Foulkeways            |       | 1120 Meetinghouse Road,  Gwynedd, PA              |       | Leased                |
| Malvern(2)            |       | 30 Valley Stream  Parkway, Malvern, PA            |       | Leased                |
| Malvern               |       | 83 Lancaster Avenue,  Malvern, PA                 |       | Leased                |
| Blue Bell(2)          |       | 721 Skippack Pike, Blue  Bell, PA                 |       | Leased                |
| Wyomissing(2)         |       | 2800 State Hill Road,  Wyomissing, PA             |       | Owned                 |
| Lansford              |       | 13-15 West Ridge  Street, Lansford, PA            |       | Owned                 |
| Summit Hill           |       | 2 East Ludlow Street,  Summit Hill, PA            |       | Owned                 |
| Lehighton             |       | 904 Blakeslee Blvd,  Lehighton, PA                |       | Owned                 |
| Honesdale             |       | 1001 Main Street,  Honesdale, PA                  |       | Owned                 |
| Slatington            |       | 502 Main Street,  Slatington, PA                  |       | Owned                 |
| Slatington Handi-Bank |       | 701-705 Main  Street, Slatington, PA              |       | Owned                 |
| Lehigh Township       |       | 4421 Lehigh Drive,  Walnutport, PA                |       | Owned                 |
| Palmerton             |       | 372 Delaware Avenue,  Palmerton, PA               |       | Owned                 |
| Kresgeville           |       | Route 209, Kresgeville,  PA                       |       | Leased                |
| Allentown(2)          |       | 1602 Allen Street,  Allenton, PA                  |       | Leased                |
| Pottstown             |       | One Security Plaza,  Pottstown, PA                |       | Leased                |

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| Pottstown     |   | 1450 East High Street,  Pottstown, PA         |   | Leased   |
|---------------|--------|-----------------------------------------------|--------|----------|
| Pottstown     |   | 930 North Charlotte  Street, Pottstown, PA    |   | Leased   |
| Pottstown     |   | Rt. 100 and Shoemaker  Road, Pottstown, PA    |   | Owned(1) |
| Pottstown     |   | 2 Glocker Way,  Pottstown, PA                 |   | Leased   |
| Boyertown     |   | Rt. 100 and Baus Road,  Boyertown, PA         |   | Leased   |
| Douglassville |   | 1191 Ben Franklin  Parkway, Douglassville, PA |   | Leased   |
| Dorneyville   |   | 3570 Hamilton Boulevard,  Allentown, PA       |   | Leased   |
| Warminster(3) |   | 190 Veterans Way, Warminster, PA              |   | Leased   |

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(1)          Branch buildings areowned by the Bank and the land is leased.

(2)          Locations includeMillennium Wealth Management and Private Banking offices.

(3)          This branch is expectedto open for business in 2006.

In management’s opinion,all of the above properties are in good condition and are adequate for theCorporation’s and the Bank’s purposes.

**Item 3.**                        LegalProceedings

Management, based onconsultation with the Corporation’s legal counsel, is not aware of anylitigation that would have a material adverse effect on the consolidatedfinancial position of the Corporation. There are no proceedings pending otherthan the ordinary routine litigation incident to the business of theCorporation and its subsidiaries—the Bank, HNC Financial Company and HNCReinsurance Company. In addition, no material proceedings are pending or areknown to be threatened or contemplated against the Corporation and the Bank bygovernment authorities.

**Item 4.**                        Submissionof Matters to a Vote of Security Holders

No matter was submitted during the fourth quarter of2005 to a vote of holders of the Corporation’s Common Stock.

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**PART II**

**Item 5.**                        Marketfor Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities

The following table setsforth high and low closing sales prices for the Corporation’s common stock andquarterly cash dividends paid per share for 2005 and 2004. The Corporation’sstock is traded under the symbol “HNBC” on the NASDAQ National Market Systems.All share information has been restated to reflect stock dividends and splits.For certain limitations on the Bank’s ability to pay dividends to theCorporation, see Item 1, “Supervision and Regulation—Bank” and Item 8,Note 18, “Notes to Consolidated Financial Statements—Regulatory Capital.”

**Price of Common Stock and Cash Dividends**

| **2005**          | ** ** | ** ** | ** ** | **High Price** | ** ** | **Low Price** | ** ** | **Cash dividends  per share** | ** ** |
|-------------------|------------|------------|------------|---------------------|------------|--------------------|------------|-----------------------------------------|------------|
| First Quarter(1)  | ** ** |       | **$**      | **24.96**           | ** ** |               |       | **$**                                   | **19.80**  | ** ** |   |   | **$** | **0.17** | ** ** |   |
| Second Quarter(1) | ** ** |       | **23.48**  | ** **          |       |               | **18.72**  | ** **                              |       |   | **0.17** | ** ** |   |
| Third Quarter     | ** ** |       | **24.26**  | ** **          |       |               | **21.00**  | ** **                              |       |   | **0.18** | ** ** |   |
| Fourth Quarter    | ** ** |       | **22.75**  | ** **          |       |               | **19.02**  | ** **                              |       |   | **0.23** | ** ** |   |

 

| **2004**          | ** ** | ** ** | ** ** | **High Price** | ** ** | **Low Price** | ** ** | **Cash dividends  per share** | ** ** |
|-------------------|------------|------------|------------|---------------------|------------|--------------------|------------|-----------------------------------------|------------|
| First Quarter(2)  |       |       | $          | 28.27               |       |               |       | $                                       | 23.62      |   |   |   | $ | 0.15 |   |   |
| Second Quarter(2) |       |       | 26.54      |                |       |               | 21.42      |                                    |       |   | 0.16 |   |   |
| Third Quarter(1)  |       |       | 24.51      |                |       |               | 20.23      |                                    |       |   | 0.16 |   |   |
| Fourth Quarter(1) |       |       | 27.10      |                |       |               | 22.72      |                                    |       |   | 0.21 |   |   |

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(1)          Adjusted for a fivepercent stock dividend effective 9/15/05.

(2)          Adjusted for a fivepercent stock dividend effective 9/15/05 and 9/15/04.

At December 31, 2005, there were 3,637shareholders of record, not including the number of persons or entities whosestock is held in nominee or “street” name through various brokerage firms andbanks.

Information on the Corporation’s equity compensationplans included under Item 8, Note 1, “Notes to Consolidated FinancialStatements—Stock Based Compensation, Note 13, “Stock Options,” and the2005 Proxy Statement under the caption, “Equity Compensation Plan Information,is incorporated herein by reference.

The Corporation has a stock repurchase program thatpermits the repurchase of up to five percent of its outstanding common stock.The repurchased shares will be used for general corporate purposes.

16

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Thefollowing table provides information about purchases made by the Corporation ofits common stock during the quarter ended December 31, 2005:

**Issuer Purchases of Common Stock**

| ** **                | ** ** | **Total Number of  Common Shares  Purchased** | ** ** | **Weighted  Average  Price Paid  Per Share** | ** ** | **Total Number  of Shares  Purchased as  Part of Publicly  Announced  Plans** | ** ** | **Maximum  Number of  Shares that may  yet be  Purchased  under the  Plans(1)** | ** ** |
|---------------------------|------------|--------------------------------------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|------------|
| October 1-31,  2005  |       |                                                         | 34,500     |                                                   |       |                                                                                                   | $          | 19.58                                                                                                    |       |   |   | 34,500 |   |   |   | 1,161,117 |   |   |
| November 1-30,  2005 |       |                                                         | 55,678     |                                                   |       |                                                                                                   | 21.26      |                                                                                                     |       |   | 55,678 |   |   |   | 1,105,439 |   |   |
| December 1-31,  2005 |       |                                                         | 17,400     |                                                   |       |                                                                                                   | 21.26      |                                                                                                     |       |   | 17,400 |   |   |   | 1,088,039 |   |   |
| Total                     |       |                                                         | 107,578    |                                                   |       |                                                                                                   | $          | 20.72                                                                                                    |       |   |   | 107,578 |   |   |   |   |   |   |

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(1)          OnDecember 14, 2000, the Board of Directors authorized a program to purchaseup to 1,311,450 shares (restated for stock dividends and splits), or 5%,of its outstanding common stock. This repurchase plan was completed during thesecond quarter of 2005. On May 12, 2005, the Board of Directors authorizeda plan to purchase up to 1,349,250 shares (restated for five percent stockdividend paid on September 15, 2005) or 4.9%, of its outstanding commonstock.

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**Item6.**                        SelectedFinancial Data

| ** **                                           | ** ** | **Year Ended December 31,**                                             | ** **    |
|------------------------------------------------------|------------|----------------------------------------------------------------------------------------|---------------|
| ** **                                           | ** ** | **2005**                                                                               | ** **    | **2004(2)** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                           | ** ** | **(Dollars in thousands, except per share information)** | ** **    |
| **Income and expense**                               | ** ** | ** **                                                                             | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest income                                      | ** ** | **$**                                                                                  | **151,739**   |   | $ | 127,729 |   | $ | 119,200 |   | $ | 132,630 |   | $ | 138,679 |   |
| Interest expense                                     | ** ** | **64,618**                                                                             |          | 42,638 |   | 40,079 |   | 52,610 |   | 64,937 |   |
| Net interest income                                  | ** ** | **87,121**                                                                             |          | 85,091 |   | 79,121 |   | 80,020 |   | 73,742 |   |
| Provision for loan losses                            | ** ** | **3,401**                                                                              |          | 2,555 |   | 3,200 |   | 4,370 |   | 3,930 |   |
| Net interest income  after provision for loan losses | ** ** | **83,720**                                                                             |          | 82,536 |   | 75,921 |   | 75,650 |   | 69,812 |   |
| Noninterest income                                   | ** ** | **29,990**                                                                             |          | 28,158 |   | 27,638 |   | 22,523 |   | 22,225 |   |
| Noninterest expense                                  | ** ** | **62,479**                                                                             |          | 59,561 |   | 59,529 |   | 56,297 |   | 55,043 |   |
| Income before income tax  expense                    | ** ** | **51,231**                                                                             |          | 51,133 |   | 44,030 |   | 41,876 |   | 36,994 |   |
| Income tax expense                                   | ** ** | **12,403**                                                                             |          | 12,566 |   | 8,697 |   | 8,949 |   | 8,174 |   |
| Net income                                           | ** ** | **$**                                                                                  | **38,828**    |   | $ | 38,567 |   | $ | 35,333 |   | $ | 32,927 |   | $ | 28,820 |   |
| **Per  share information(1)**                        | ** ** | ** **                                                                             |          |   |   |   |   |   |   |   |   |
| Basic earnings                                       | ** ** | **$**                                                                                  | **1.41**      |   | $ | 1.42 |   | $ | 1.35 |   | $ | 1.25 |   | $ | 1.09 |   |
| Diluted earnings                                     | ** ** | **1.38**                                                                               |          | 1.37 |   | 1.30 |   | 1.21 |   | 1.06 |   |
| Cash dividends paid                                  | ** ** | **0.75**                                                                               |          | 0.68 |   | 0.59 |   | 0.51 |   | 0.45 |   |
| Basic average common  shares outstanding             | ** ** | **27,515,630**                                                                         |          | 27,147,992 |   | 26,244,807 |   | 26,352,201 |   | 26,489,291 |   |
| Diluted average common  shares outstanding           | ** ** | **28,085,920**                                                                         |          | 28,062,489 |   | 27,148,029 |   | 27,149,733 |   | 27,147,635 |   |
| **Average  balance sheet**                           | ** ** | ** **                                                                             |          |   |   |   |   |   |   |   |   |
| Loans                                                | ** ** | **$**                                                                                  | **1,900,023** |   | $ | 1,625,419 |   | $ | 1,354,127 |   | $ | 1,333,300 |   | $ | 1,264,750 |   |
| Investments                                          | ** ** | **903,063**                                                                            |          | 941,910 |   | 950,225 |   | 823,004 |   | 660,983 |   |
| Other interest-earning  assets                       | ** ** | **51,740**                                                                             |          | 41,064 |   | 28,782 |   | 25,411 |   | 19,228 |   |
| Total assets                                         | ** ** | **3,039,186**                                                                          |          | 2,773,405 |   | 2,466,070 |   | 2,309,422 |   | 2,058,738 |   |
| Deposits                                             | ** ** | **2,259,831**                                                                          |          | 2,094,998 |   | 1,927,899 |   | 1,808,390 |   | 1,599,515 |   |
| Borrowed funds                                       | ** ** | **456,599**                                                                            |          | 372,141 |   | 270,325 |   | 247,221 |   | 226,247 |   |
| Shareholders’ equity                            | ** ** | **272,974**                                                                            |          | 251,963 |   | 216,846 |   | 198,373 |   | 182,178 |   |
| **Balance  sheet at year-end**                       | ** ** | ** **                                                                             |          |   |   |   |   |   |   |   |   |
| Loans                                                | ** ** | **$**                                                                                  | **1,985,493** |   | $ | 1,845,802 |   | $ | 1,408,391 |   | $ | 1,333,292 |   | $ | 1,316,609 |   |
| Investments                                          | ** ** | **901,208**                                                                            |          | 943,563 |   | 924,874 |   | 971,467 |   | 732,470 |   |
| Other interest-earning  assets                       | ** ** | **37,455**                                                                             |          | 56,291 |   | 38,551 |   | 41,910 |   | 19,650 |   |
| Total assets                                         | ** ** | **3,117,359**                                                                          |          | 3,024,515 |   | 2,510,939 |   | 2,490,864 |   | 2,208,971 |   |
| Deposits                                             | ** ** | **2,365,457**                                                                          |          | 2,212,563 |   | 1,979,081 |   | 1,979,822 |   | 1,746,862 |   |
| Borrowed funds                                       | ** ** | **439,168**                                                                            |          | 488,182 |   | 255,056 |   | 253,906 |   | 215,820 |   |
| Shareholders’ equity                            | ** ** | **273,232**                                                                            |          | 270,532 |   | 227,053 |   | 206,206 |   | 189,349 |   |
| **Performance  ratios**                              | ** ** | ** **                                                                             |          |   |   |   |   |   |   |   |   |
| Return on average assets                             | ** ** | **1.28**                                                                               | **%**         | 1.39 | % | 1.43 | % | 1.43 | % | 1.40 | % |
| Return on average equity                             | ** ** | **14.22**                                                                              |          | 15.31 |   | 16.29 |   | 16.60 |   | 15.82 |   |
| Average equity to  average  assets                   | ** ** | **8.98**                                                                               |          | 9.08 |   | 8.79 |   | 8.59 |   | 8.85 |   |
| Dividend payout ratio                                | ** ** | **53.41**                                                                              |          | 48.16 |   | 44.06 |   | 40.94 |   | 41.27 |   |

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(1)          Adjusted for a fivepercent stock dividend effective 9/15/05, 9/15/04 and 9/16/02, a five-for-fourstock split effective 9/15/03 and a one hundred percent stock dividendeffective 8/10/01

(2)          The results ofoperations include the acquisition of Millennium Bank effective April 30,2004

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**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

The following ismanagement’s discussion and analysis of the significant changes in the resultsof operations, capital resources and liquidity presented in its accompanyingconsolidated financial statements for Harleysville National Corporation (theCorporation), and its wholly owned subsidiaries—Harleysville National Bank (theBank), HNC Financial Company and HNC Reinsurance Company. The Corporation’sconsolidated financial condition and results of operations consist almostentirely of the Bank’s financial condition and results of operations. Currentperformance does not guarantee, and may not be indicative of, similarperformance in the future. The information in Management’s Discussion andAnalysis of Financial Condition and Results of Operations should be read inconjunction with the Corporation’s consolidated financial statements and theaccompanying footnotes under Item 8 of this report on Form 10-K.

**Critical Accounting Estimates**

The accounting and reporting policies of theCorporation and its subsidiaries conform to accounting principles generallyaccepted in the United States and general practices with the financial servicesindustry. The Corporation’s significant accounting policies are described inNote 1 of the consolidated financial statements and are essential inunderstanding Management’s Discussion and Analysis of Results of Operations andFinancial Condition. In applying accounting policies and preparing theconsolidated financial statements, management is required to make estimates andassumptions that affect the reported amount of assets and liabilities as of thedates of the balance sheets and revenues and expenditures for the periodspresented. Therefore, actual results could differ significantly from thoseestimates. Judgments and assumptions required by management, which have, orcould have a material impact on the Corporation’s financial condition orresults of operations are considered critical accounting estimates. Thefollowing is a summary of the policies the Corporation recognizes as involvingcritical accounting estimates: Allowance for Loan Loss, Goodwill and OtherIntangible Asset Impairment, Stock-Based Compensation, Unrealized Gainsand Losses on Debt Securities Available for Sale, and Deferred Taxes.

Allowance for Loan Losses:   The Corporationmaintains an allowance for loan losses at a level management believes issufficient to absorb estimated probable credit losses. Management’sdetermination of the adequacy of the allowance is based on periodic evaluationsof the loan portfolio and other relevant factors. However, this evaluation isinherently subjective as it requires significant estimates by management.Consideration is given to a variety of factors in establishing these estimatesincluding current and anticipated economic conditions, diversification of theloan portfolio, delinquency statistics, results of internal loan reviews,borrowers’ perceived financial and management strengths, the adequacy ofunderlying collateral, the dependence on collateral, or the strength of thepresent value of future cash flows and other relevant factors. These factorsmay be susceptible to significant change. To the extent actual outcomes differfrom management estimates, additional provisions for loan losses may berequired which may adversely affect the Corporation’s results of operations inthe future.

Goodwill and Other Intangible Asset Impairment:   Goodwilland other intangible assets are reviewed for potential impairment on an annualbasis, or more often if events or circumstances indicate that there may beimpairment, in accordance with SFAS No. 142, “Goodwill and OtherIntangible Assets.” Goodwill is tested for impairment at the reporting unitlevel and an impairment loss is recorded to the extent that the carrying amountof goodwill exceeds its implied fair value. The Corporation employs generalindustry practices in evaluating the fair value of its goodwill and otherintangible assets. The Corporation calculates the fair value using acombination of the following valuations: deposit premiums based on marketdeals, current stock pricing tracking as a multiple of book value, discountedcash flow of earnings with a terminal value and market multiple of earnings.Management performed its annual review of goodwill at June 30, 2005 inaccordance with SFAS No. 142 and determined there was no impairment of 

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goodwill and identifiableintangible assets. No assurance can be given that future impairment tests willnot result in a charge to earnings.

Stock-based Compensation:   Under SFAS No. 123“Accounting for Stock-Based Compensation” (FAS 123), companies havea choice whether to adopt the fair value based method of accounting for stock-basedcompensation or remain with the intrinsic value based method prescribed underAPB Opinion No. 25, “Accounting for Stock Issued to Employees” (APB25) but provide pro-forma disclosure as if the fair value based method wasapplied. The Corporation chose the intrinsic value based method under APB 25and provides pro-forma disclosure required under FAS 123. In preparing thepro-forma disclosure, the Corporation estimates the fair value of employeestock options using a pricing model which takes into consideration the exerciseprice and expected life of the options, the current price of the underlyingstock and its expected volatility, the expected dividends on the stock and thecurrent risk-free interest rate for the expected life of the option. TheCorporation’s estimate of the fair value of a stock option is based onexpectations derived from historical experience and may not necessarily equateto its market value when fully vested. In December 2004, the FASB issuedSFAS No. 123 (revised 2004), “Share-Based Payment”(FAS 123(R)). Under FAS 123(R), all forms of share-basedpayments to employees, including employee stock options, will be treated thesame as other forms of compensation by recognizing the related cost in theincome statement. Registrants are required to implement FAS 123(R) atthe beginning of their next fiscal year that begins after June 15, 2005,per the Securities and Exchange Commission’s rule issued in April 2005amending the FAS 123(R) compliance date.

The Corporation has adopted SFAS 123(R) on January 1,2006. The Corporation will use the modified prospective application method oftransition. Effective January 1, 2006, the Corporation will recognizecompensation expense for the portion of outstanding awards at January 1,2006 for which the requisite service has not yet been rendered, based on thegrant-date fair value of those awards calculated under SFAS 123 for pro formadisclosures. For new grants awarded on or after January 1, 2006, theCorporation has chosen to continue the use of the Black-Scholes option-pricingmodel to estimate the fair value of each option on the date of grant. Inaccordance with SFAS 123(R), the Corporation will estimate the number ofoptions for which the requisite service is expected to be rendered as comparedto accounting for forfeitures as they occur under SFAS 123. The Corporation haschosen to recognize compensation expense for new grants using the straight-linemethod which spreads compensation expense for shares vesting evenly over theperiod of vesting. Proforma disclosures under SFAS 123 have been based upon theaccrual method which treats each vesting tranche as a separate award andamortizes expense evenly (prorated) from grant date to vest date for eachtranche. The Corporation estimates that share-based compensation expense, netof tax, to be recognized during the year of 2006 will be approximately$284,000. The number and timing of options granted during 2006 and vestingcriteria may alter this projected number.

Unrealized Gains and Losses on Debt SecuritiesAvailable for Sale:   The Corporation receives estimated fair values ofdebt securities from independent valuation services and brokers. In developingthese fair values, the valuation services and brokers use estimates of cashflows based on historical performance of similar instruments in similar rateenvironments. Debt securities available for sale are mostly comprised ofmortgage-backed securities.

Deferred Taxes:   The Corporation recognizesdeferred tax assets and liabilities for the future effects of temporarydifferences, net operating loss carryforwards, and tax credits. Deferred taxassets are subject to management’s judgment based upon available evidence thatfuture realizations are likely. If management determines that the Corporationmay not be able to realize some or all of the net deferred tax asset in thefuture, a charge to income tax expense may be required to reduce the value ofthe net deferred tax asset to the expected realizable value.

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The Corporation has notsubstantively changed its application of the foregoing policies, and there havebeen no material changes in assumptions or estimation techniques used ascompared to prior periods.

**Financial Overview**

The Corporation achieved its 30th consecutive year of earnings growth and the 31th consecutive year of dividend increases toshareholders during 2005. Net income in 2005 was $38.8 million compared to$38.6 million in 2004. The earnings for 2005 reflected an increase in loaninterest income partially offset by increases in interest expense on depositsand borrowings. Growth in average earning assets for 2005 was 9.4%.

For the year ended December 31, 2005, dilutedearnings per share were $1.38 compared to $1.37 for 2004 and basic earnings pershare were $1.41 for 2005 compared to $1.42 in 2004. The financial results for2005 include the issuance of 1,310,000 shares of the Corporation’s common stockfor a 5% stock dividend payable September 15, 2005. All share and pershare information has been restated to reflect this stock dividend.

The Corporation’s consolidated total assets were $3.12billion at December 31, 2005, an increase of 3.1% or $92.8 million over$3.02 billion in total assets reported at December 31, 2004. Of thisincrease, 4.6% or $140.0 million was due to loan growth, partially offset by anet decrease in cash and investments of 1.8% or $54.1 million. The return on average shareholders’ equity was14.22% in 2005 compared to 15.31% in 2004. The return on average assets was1.28% in 2005 compared to 1.39% in 2004. The decrease in the annualized returnon average shareholders’ equity during 2005 was primarily due to the retentionof earnings.

Net interest income on atax-equivalent basis increased $962,000, or 1.0%, for the year ending December 31,2005, over the prior year. The increase in net interest income for the year wasmainly attributed to higher loan volume from commercial mortgage and homeequity loans partially offset by higher deposit rates. The net interest marginfor 2005 was 3.27% compared to 3.55% for 2004. The decline in the net interest margin from 2004 was primarily due tohigher funding costs, particularly in money market deposit accounts andshort-term borrowings. As a result of market conditions, deposit rates haveincreased more quickly than the loan rates have increased. During 2005, noninterestincome increased $1.8 million, or 6.5% primarily attributed to an increase ingain on sales of investment securities of $1.1 million and the gain on the saleof the Bank’s McAdoo branch of $690,000. Noninterest expense increased $2.9million mainly due to increased expenses for occupancy and professional fees(Sarbanes-Oxley related) as well as lower loan origination expensedeferrals related to decreased loan origination volume.

The quality of the loan portfolio is a key focus ofthe Corporation. Nonperforming assets (including nonaccrual loans, net assetsin foreclosure and loans 90 days or more past due) were .27% of totalassets at December 31, 2005, compared to .20% at December 31, 2004.The increase in nonperforming assets at December 31, 2005, in relation to December 31,2004 was mainly due to commercial mortgage loans for one borrower totaling $1.5million and commercial business loans for four borrowers totaling $1.1 millionwhich have been placed on nonaccrual of interest. The increase in the provisionfor 2005, compared to 2004, was primarily due to inherent risk related to loangrowth and the increase in nonperforming loans.

Core deposits increased2.1% or $33.6 million, to $1.61 billion at December 31, 2005, up from$1.58 billion at December 31, 2004. Total deposits increased $152.9million, or 6.9% for the same period, which was primarily attributable to thegrowth in core deposit checking products and public funds time deposits of$100,000 or greater.

On June 30, 2005, the Bank sold its formersubsidiary, Cumberland Advisors, Inc., to David R. Kotok and Associates, Inc.in a stock sale. The sale price was $2.0 million cash. Cumberland Advisors,based in Vineland, New Jersey, is a SEC registered investment advisorspecializing in fixed income money management and equities. It was acquired bythe Corporation on April 30, 2004 as part of its 

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Millennium Bankacquisition. Based upon management’s analysis of Cumberland Advisors’ resultsof operations and assets in comparison to the Corporation’s, managementdetermined the impact of the sale of Cumberland Advisors is immaterial, andtherefore the transaction is not presented as discontinued operations.

On April 30, 2004, the Corporation completed theacquisition of Millennium Bank, Malvern, PA. Millennium Bank was merged intothe Bank. This transaction was accounted for in accordance with SFAS No. 141“Business Combinations.” Millennium Bank’s shareholders received 946,000 shares(1,043,000 restated*) of the Corporation’s common stock and $16.1 millionin exchange for all outstanding common shares. Millennium Bank option holdersreceived $2.3 million and options to acquire 284,000 shares (313,000restated*) of the Corporation’s common stock in exchange for all outstandingoptions.

For a five-year summary of financial information, seeItem 6, “Selected Financial Data,” which is incorporated herein by reference.

For quarterly informationfor 2005 and 2004, see Item 7, “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Fourth Quarter 2005 Results,” andTable 17, “Selected Quarterly Financial Data,” which are incorporated herein byreference.

**Investment Securities**

SFAS No. 115, “Accounting for Certain Investmentsin Debt and Equity Securities” requires that debt and equity securitiesclassified as available for sale be reported at fair value, with unrealizedgains and losses excluded from earnings and reported in other comprehensiveincome. The net effect of unrealized gains or losses, caused by marking anavailable for sale portfolio to market, causes fluctuations in the level ofshareholders’ equity and equity-related financial ratios as marketinterest rates cause the fair value of fixed-rate securities to fluctuate.

Investmentsecurities decreased 4.5% to $901.2 million at December 31, 2005 from$943.6 million at December 31, 2004. The investment securitiesavailable for sale decreased $33.1 million and the investment securitiesheld to maturity decreased $9.3 million. During 2005, $273.9 million ofsecurities available for sale were sold which generated a pretax gain of$4.8 million. The securities sold consisted primarily of tax-exempt bonds,trust preferred bonds and equity securities. In comparison, $1.35 billionof securities available for sale were sold in 2004 which generated a pretaxgain of $3.7 million. During the fourth quarter of 2004, the Corporationtransferred $50.0 million of obligations of states and politicalsubdivisions from available for sale to held to maturity. The Bank intends tohold these securities to maturity as these securities are an effective tool tolower the Corporation’s effective tax rate. The Corporation sells investmentsecurities available for sale to fund the purchase of other securities in aneffort to enhance the overall return of the portfolio and to reduce theinterest rate risk within different interest rate environments.

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*—Restated for five percent stock dividends paid onSeptember 15, 2005 and September 15, 2004.

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Thefollowing table shows the carrying value of the Corporation’s investmentsecurities available for sale and held to maturity:

**Table 1—Investment Portfolio**

| ** **                                                      | ** ** | **December 31,**                | ** **  |
|-----------------------------------------------------------------|------------|--------------------------------------|-------------|
| ** **                                                      | ** ** | **2005**                             | ** **  | **2004** | ** ** | **2003** | ** ** |
| ** **                                                      | ** ** | **(Dollars in thousands)** | ** **  |
| Investment securities available for sale:                       |       |                                 |        |   |   |   |   |
| Obligations of other  U.S. government agencies and corporations | ** ** | **$**                                | **157,396** |   | $ | 153,103 |   | $ | 32,495 |   |
| Obligations of states  and political subdivisions               | ** ** | **173,845**                          |        | 198,499 |   | 240,149 |   |
| Mortgage-backed  securities                                     | ** ** | **467,568**                          |        | 454,730 |   | 575,788 |   |
| Other securities                                                | ** ** | **42,844**                           |        | 68,400 |   | 56,438 |   |
| Total investment securities  available for sale                 | ** ** | **$**                                | **841,653** |   | $ | 874,732 |   | $ | 904,870 |   |
| Investment securities held to maturity:                         | ** ** | ** **                           |        |   |   |   |   |
| Obligations of other  U.S. government agencies and corporations | ** ** | **$**                                | **3,843**   |   | $ | 3,830 |   | $ | — |   |
| Obligations of states  and political subdivisions               | ** ** | **55,712**                           |        | 64,662 |   | 19,568 |   |
| Mortgage-backed  securities                                     |       | —                               |        | 339 |   | 436 |   |
| Total investment  securities held to maturity                   | ** ** | **$**                                | **59,555**  |   | $ | 68,831 |   | $ | 20,004 |   |

 

The maturity analysis of investment securitiesincluding the weighted average yield for each category as of December 31,2005 is as follows. Actual maturities may differ from contractual maturitiesbecause issuers and borrowers may have the right to call or prepay obligationswith or without call or prepayment penalties.

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**Table 2—Maturity and Tax-Equivalent Yield Analysis ofInvestment Securities**

| ** **                                                       | ** ** | **December 31, 2005**                | ** ** |
|------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                       | ** ** | **Due in 1 year  or less** | ** ** | **Due after  1 year through  5 years** | ** ** | **Due after  5 years through  10 years** | ** ** | **Due after  10 years** | ** ** | **Total** | ** ** |
| ** **                                                       | ** ** | **(Dollars in thousands)**           | ** ** |
| **Investment securities available  for sale**                    |       |                                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Obligations of other  U.S. government agencies and corporations: |       |                                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Fair value                                                       |       |                                           | $          | 2,959 |   |   |   | $ | 88,663 |   |   |   | $ | 55,149 |   |   | $ | 10,625 |   | $ | 157,396 |   |
| Weighted average yield                                           |       |                                           | 3.31       | % |   |   | 3.93 | % |   |   | 4.81 | % |   | 5.23 | % | 4.31 | % |
| Weighted average  maturity                                       |       |                                           |       |   |   |   |   |   |   |   |   |   |   |   |   | 5.1 years |   |
| Obligations of states  and political subdivisions:               |       |                                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Fair value                                                       |       |                                           | —     |   |   |   | 29,594 |   |   |   | 65,371 |   |   | 78,880 |   | 173,845 |   |
| Weighted average  yield(1)                                       |       |                                           | —     | % |   |   | 6.48 | % |   |   | 6.26 | % |   | 6.26 | % | 6.29 | % |
| Weighted average  maturity                                       |       |                                           |       |   |   |   |   |   |   |   |   |   |   |   |   | 7.9 years |   |
| Mortgage-backed  securities:                                     |       |                                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Fair value                                                       |       |                                           | 47,210     |   |   |   | 393,358 |   |   |   | 13,909 |   |   | 13,091 |   | 467,568 |   |
| Weighted average yield                                           |       |                                           | 3.83       | % |   |   | 3.94 | % |   |   | 3.98 | % |   | 4.35 | % | 3.94 | % |
| Weighted average  maturity                                       |       |                                           |       |   |   |   |   |   |   |   |   |   |   |   |   | 3.2 years |   |
| Other debt securities:                                           |       |                                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Fair value                                                       |       |                                           | —     |   |   |   | 10,942 |   |   |   | — |   |   | — |   | 10,942 |   |
| Weighted average yield                                           |       |                                           | —     | % |   |   | 4.68 | % |   |   | — | % |   | — | % | 4.68 | % |
| Weighted average  maturity                                       |       |                                           |       |   |   |   |   |   |   |   |   |   |   |   |   | 3.6 years |   |
| Equity securities:                                               |       |                                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Fair value                                                       |       |                                           | —     |   |   |   | — |   |   |   | — |   |   | — |   | 31,902 |   |
| Weighted average yield                                           |       |                                           | —     | % |   |   | — | % |   |   | — | % |   | — | % | 3.53 | % |
| **Total investment securities  available for sale**              |       |                                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Fair  value**                                                  | ** ** | ** **                                     | **$**      | **50,169** | ** ** | ** ** | ** ** | **$** | **522,557** | ** ** | ** ** | ** ** | **$** | **134,429** | ** ** | ** ** | **$** | **102,596** | ** ** | **$** | **841,653** | ** ** |
| **Weighted  average yield**                                      | ** ** | ** **                                     | **3.80**   | **%** | ** ** | ** ** | **4.10** | **%** | ** ** | ** ** | **5.43** | **%** | ** ** | **5.91** | **%** | **4.49** | **%** |
| **Weighted  average maturity**                                   | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **4.6 years** | ** ** |
| **Investment  securities held to maturity**                      |       |                                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Obligations of other  U.S. government agencies and corporations: |       |                                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Amortized cost                                                   |       |                                           | $          | — |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 3,843 |   | $ | 3,843 |   |
| Weighted average yield                                           |       |                                           | —     | % |   |   | — | % |   |   | — | % |   | 5.45 | % | 5.45 | % |
| Weighted average  maturity                                       |       |                                           |       |   |   |   |   |   |   |   |   |   |   |   |   | 12.5 years |   |
| Obligations of states  and political subdivisions:               |       |                                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Amortized Cost                                                   |       |                                           | 1,104      |   |   |   | 35,444 |   |   |   | — |   |   | 19,164 |   | 55,712 |   |
| Weighted average  yield(1)                                       |       |                                           | 9.02       | % |   |   | 6.84 | % |   |   | — | % |   | 6.28 | % | 6.69 | % |
| Weighted average  maturity                                       |       |                                           |       |   |   |   |   |   |   |   |   |   |   |   |   | 6.8 years |   |
| **Total investment securities  held to maturity:**               |       |                                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Amortized  Cost**                                              | ** ** | ** **                                     | **$**      | **1,104** | ** ** | ** ** | ** ** | **$** | **35,444** | ** ** | ** ** | ** ** | **$** | **—** | ** ** | ** ** | **$** | **23,007** | ** ** | **$** | **59,555** | ** ** |
| **Weighted  average yield**                                      | ** ** | ** **                                     | **9.02**   | **%** | ** ** | ** ** | **6.84** | **%** | ** ** | ** ** | **—** | **%** | ** ** | **6.15** | **%** | **6.61** | **%** |
| **Weighted average maturity**                                    | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **7.1  years** | ** ** |

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(1)          Weighted average yieldon nontaxable investment securities is shown on a tax equivalent basis (taxrate of 35%).

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**Loans**

Loans increased $140.0 million, or 7.6% in 2005,primarily attributed to growth in commercial real estate loans and home equityloans. The growth in real estate loans was due to the Bank’s strategy ofgrowing real estate loans in its primary market. One of the Bank’s strategicobjectives is to increase its loan to deposit ratio by growing its loanportfolio at a faster pace than its deposits. The planned reduction in leasefinancing was due to run-off and sales. Loans increased $437.4 million, or31.1% in 2004, primarily due to growth in real estate loans and home equityloans and lines of credit along with $157.1 million in loans acquired inthe acquisition of Millennium Bank.

The following table showsthe composition of the Bank’s loans:

**Table3—Composition of Loan Portfolio**

| ** **                | ** ** | **December 31,**                | ** **    |
|---------------------------|------------|--------------------------------------|---------------|
| ** **                | ** ** | **2005**                             | ** **    | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                | ** ** | **Amount**                           | ** **    | **Percent  of Loans** | ** ** | **Amount** | ** ** | **Percent  of Loans** | ** ** | **Amount** | ** ** | **Percent  of Loans** | ** ** | **Amount** | ** ** | **Percent  of Loans** | ** ** | **Amount** | ** ** | **Percent  of Loans** | ** ** |
| ** **                | ** ** | **(Dollars in thousands)** | ** **    |
| Real estate               | ** ** | **$**                                | **791,358**   | ** ** |   | **40** | **%** |   | $ | 693,468 |   |   | 37 | % |   | $ | 498,135 |   |   | 35 | % |   | $ | 422,692 |   |   | 33 | % |   | $ | 418,742 |   |   | 32 | % |   |
| Commercial and industrial | ** ** | **479,238**                          | ** **    |   | **24** | **%** |   | 473,514 |   |   | 26 | % |   | 385,554 |   |   | 27 | % |   | 376,406 |   |   | 27 | % |   | 349,849 |   |   | 26 | % |   |
| Consumer                  | ** ** | **697,373**                          | ** **    |   | **35** | **%** |   | 645,718 |   |   | 35 | % |   | 463,492 |   |   | 34 | % |   | 446,953 |   |   | 33 | % |   | 440,182 |   |   | 34 | % |   |
| Lease financing           | ** ** | **17,524**                           | ** **    |   | **1** | **%** |   | 33,102 |   |   | 2 | % |   | 61,210 |   |   | 4 | % |   | 87,241 |   |   | 7 | % |   | 107,836 |   |   | 8 | % |   |
| Total                     | ** ** | **$**                                | **1,985,493** | ** ** |   | **100** | **%** |   | $ | 1,845,802 |   |   | 100 | % |   | $ | 1,408,391 |   |   | 100 | % |   | $ | 1,333,292 |   |   | 100 | % |   | $ | 1,316,609 |   |   | 100 | % |   |

 

Thefollowing table details outstanding loans by type as of December 31,2005, in terms of contractual maturity date:

**Table4—Selected Loan Maturity Data**

| ** **                                       | ** ** | **December 31, 2005**                | ** ** |
|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                       | ** ** | **Due in  1 year or less** | ** ** | **Due after  1 year  through 5 years** | ** ** | **Due after  5 years** | ** ** | **Total** | ** ** |
| ** **                                       | ** ** | **(Dollars in thousands)**           | ** ** |
| Real estate                                      |       |                                           | $          | 100,625 |   |   |   | $ | 319,756 |   |   | $ | 370,977 |   | $ | 791,358 |   |
| Commercial and  industrial                       |       |                                           | 110,209    |   |   |   | 164,137 |   |   | 204,892 |   | 479,238 |   |
| Consumer                                         |       |                                           | 291,924    |   |   |   | 170,589 |   |   | 234,860 |   | 697,373 |   |
| Lease financing                                  |       |                                           | 17,524     |   |   |   | — |   |   | — |   | 17,524 |   |
| Total                                            |       |                                           | $          | 520,282 |   |   |   | $ | 654,482 |   |   | $ | 810,729 |   | $ | 1,985,493 |   |
| Loans with  variable or floating interest  rates |       |                                           | $          | 361,463 |   |   |   | $ | 135,948 |   |   | $ | 293,791 |   | $ | 791,202 |   |
| Loans with fixed  predetermined interest rates   |       |                                           | 158,819    |   |   |   | 518,534 |   |   | 516,938 |   | 1,194,291 |   |
| Total                                            |       |                                           | $          | 520,282 |   |   |   | $ | 654,482 |   |   | $ | 810,729 |   | $ | 1,985,493 |   |

 

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Thefollowing table details those loans that were placed on nonaccrual status, orwere delinquent by 90 days or more and still accruing interest:

**Table5—Nonaccrual Loans and Loans 90 Days or more Past Due Accruing Interest**

| ** **                                             | ** ** | **December 31,**                | ** ** |
|--------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                             | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                             | ** ** | **(Dollars in thousands)** | ** ** |
| Nonaccrual loans                                       | ** ** | **$**                                | **7,493**  |   | $ | 4,705 |   | $ | 3,343 |   | $ | 5,109 |   | $ | 6,354 |   |
| Loans  90 days or more past due accruing interest | ** ** | **846**                              |       | 981 |   | 1,164 |   | 1,193 |   | 1,926 |   |
| Total                                                  | ** ** | **$**                                | **8,339**  |   | $ | 5,686 |   | $ | 4,507 |   | $ | 6,302 |   | $ | 8,280 |   |

 

The Bank had no concentration of loans to individualborrowers which exceeded 10% of total loans at December 31, 2005 and 2004.The Bank actively monitors the risk of this loan concentration. The Bank had noforeign loans, and the impact of nonaccrual and delinquent loans on totalinterest income was not material.

A loan is generally classified as nonaccrual whenprincipal or interest has consistently been in default for a period of90 days or more, when there has been deterioration in the financialcondition of the borrower, or payment in full of principal or interest is notexpected. Delinquent loans past due 90 days or more and still accruinginterest are loans that are generally well-secured and expected to be restoredto a current status in the near future.

Nonperforming assets (including nonaccrual loans, netassets in foreclosure and loans 90 days or more past due) was .27% oftotal assets at December 31, 2005, compared to 0.20% at December 31,2004 and 0.22% at December 31, 2003. The ratio of nonperforming loans tototal net loans was 0.42% at December 31, 2005, compared to 0.31% at December 31,2004 and 0.32% at December 31, 2003.

Nonaccruing loans increased $2.8 million to $7.5million at December 31, 2005, as compared to December 31, 2004. Theincrease was primarily due to commercial mortgage loans for one borrowertotaling $1.5 million and commercial business loans for four borrowers totaling$1.1 million which were placed on nonaccrual of interest. Nonaccruing loans increased$1.3 million to $4.7 million at December 31, 2004, in comparisonto December 31, 2003. The increase in nonaccruing loans was primarily theresult of increases in nonaccruing commercial real estate loans of$1.4 million and commercial and industrial loans of $514,000 partiallyoffset by decreases in nonaccruing residential real estate loans of $443,000.The increase in nonaccruing commercial real estate consists primarily of twoloans to one borrower in the amount of $1.3 million. The Bank’s policy forinterest income recognition on nonaccrual loans is to recognize income underthe cash basis when the loans are both current and the collateral on the loanis sufficient to cover the outstanding obligation to the Bank. The Bank willnot recognize income if these factors do not exist. During 2005, interestaccrued on nonaccruing loans and not recognized as interest income was $310,000and interest paid on nonaccruing loans of $250,000 was recognized as interestincome. During 2004, interest accrued on nonaccruing loans and not recognizedas interest income was $238,000 and interest paid on nonaccruing loans of$47,000 was recognized as interest income.

Net assets in foreclosure were $29,000 at December 31,2005, a decrease of $341,000 from December 31, 2004. During 2005,transfers from loans to assets in foreclosure were $288,000, disposals onforeclosed properties were $466,000, and charge offs of $123,000 were recorded.The December 31, 2004 net assets in foreclosure balance of $370,000,decreased $565,000 from December 31, 2003. During 2004, transfers fromloans to assets in foreclosure were $586,000, disposals on foreclosedproperties were $1.1 million, and charge offs of $66,000 were recorded.Efforts to liquidate assets acquired in foreclosure proceed as quickly aspotential buyers can be located and legal constraints permit. Foreclosed assetsare 

26

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carried at the lower ofcost (lesser of carrying value of the asset or fair value at date ofacquisition) or estimated fair value.

Loans past due 90 days or more and still accruinginterest are loans that are generally well secured and are in the process ofcollection. As of December 31, 2005, loans past due 90 days or moreand still accruing interest were $846,000, compared to $981,000 at December 31,2004 and $1.2 million at December 31, 2003.

The Bank uses the reservemethod of accounting for loan losses. The balance in the allowance for loanlosses is determined based on management’s review and evaluation of the loanportfolio in relation to past loss experience, the size and composition of theportfolio, current economic events and conditions, and other pertinent factors,including management’s assumptions as to future delinquencies, recoveries andlosses. Increases to the allowance for loan losses are made by charges to theprovision for loan losses. The allowance for loan losses increased$1.4 million, or 7.6%, to $19.9 million at December 31, 2005 ascompared to December 31, 2004. The increase in the allowance was primarilydue to loan growth and the increase in nonperforming loans of $2.7 million. Theallowance for loan losses increased $1.7 million, or 10.2%, to$18.5 million at December 31, 2004 as compared to December 31,2003. The increase in the allowance was primarily due to loan growth and theincrease in nonperforming loans of $1.2 million.

**Table6—Nonperforming Assets**

| ** **                                         | ** ** | **December 31,**                | ** ** |
|----------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                         | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                         | ** ** | **(Dollars in thousands)** | ** ** |
| Nonaccrual loans                                   | ** ** | **$**                                | **7,493**  |   | $ | 4,705 |   | $ | 3,343 |   | $ | 5,109 |   | $ | 6,354 |   |
| Loans  90 days or more past due               | ** ** | **846**                              |       | 981 |   | 1,164 |   | 1,193 |   | 1,926 |   |
| Total nonperforming loans                          | ** ** | **8,339**                            |       | 5,686 |   | 4,507 |   | 6,302 |   | 8,280 |   |
| Net assets in  foreclosure                         | ** ** | **29**                               |       | 370 |   | 935 |   | 390 |   | 609 |   |
| Total nonperforming assets                         | ** ** | **$**                                | **8,368**  |   | $ | 6,056 |   | $ | 5,442 |   | $ | 6,692 |   | $ | 8,889 |   |
| Allowance for  loan losses to nonperforming  loans | ** ** | **238.2**                            | **%**      | 324.6 | % | 371.7 | % | 272.8 | % | 187.9 | % |
| Nonperforming  loans to total loans                | ** ** | **0.42**                             | **%**      | 0.31 | % | 0.32 | % | 0.47 | % | 0.63 | % |
| Allowance for  loan losses to total loans          | ** ** | **1.00**                             | **%**      | 1.00 | % | 1.19 | % | 1.29 | % | 1.18 | % |
| Nonperforming assets to  total assets              | ** ** | **0.27**                             | **%**      | 0.20 | % | 0.22 | % | 0.27 | % | 0.40 | % |

 

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**Allowance for Loan Losses**

A summary of the activityin the allowance for loan losses is as follows:

**Table7—Allowance for Loan Losses**

| ** **                                             | ** ** | **December 31,**                | ** **    |
|--------------------------------------------------------|------------|--------------------------------------|---------------|
| ** **                                             | ** ** | **2005**                             | ** **    | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                             | ** ** | **(Dollars in thousands)** | ** **    |
| Average loans                                          | ** ** | **$**                                | **1,900,023** |   | $ | 1,625,419 |   | $ | 1,354,127 |   | $ | 1,333,300 |   | $ | 1,264,750 |   |
| Allowance,  beginning of  period                       | ** ** | **18,455**                           |          | 16,753 |   | 17,190 |   | 15,558 |   | 15,210 |   |
| Loans charged  off:                                    | ** ** | ** **                           |          |   |   |   |   |   |   |   |   |
| Commercial and industrial                              | ** ** | **353**                              |          | 522 |   | 515 |   | 108 |   | 494 |   |
| Consumer                                               | ** ** | **2,123**                            |          | 1,921 |   | 2,173 |   | 2,589 |   | 2,594 |   |
| Real estate                                            | ** ** | **383**                              |          | 208 |   | 1,311 |   | 352 |   | 498 |   |
| Lease financing                                        | ** ** | **188**                              |          | 883 |   | 556 |   | 828 |   | 1,075 |   |
| Total loans charged off                                | ** ** | **3,047**                            |          | 3,534 |   | 4,555 |   | 3,877 |   | 4,661 |   |
| Recoveries:                                            | ** ** | ** **                           |          |   |   |   |   |   |   |   |   |
| Commercial and industrial                              | ** ** | **66**                               |          | 58 |   | 33 |   | 105 |   | 38 |   |
| Consumer                                               | ** ** | **586**                              |          | 496 |   | 685 |   | 786 |   | 607 |   |
| Real estate                                            | ** ** | **326**                              |          | 307 |   | 80 |   | 163 |   | 328 |   |
| Lease financing                                        | ** ** | **78**                               |          | 143 |   | 120 |   | 85 |   | 106 |   |
| Total recoveries                                       | ** ** | **1,056**                            |          | 1,004 |   | 918 |   | 1,139 |   | 1,079 |   |
| Net loans charged  off                                 | ** ** | **1,991**                            |          | 2,530 |   | 3,637 |   | 2,738 |   | 3,582 |   |
| Reserve from  Millennium Bank acquisition              | ** ** | **—**                           |          | 1,677 |   | — |   | — |   | — |   |
| Provision for  loan losses                             | ** ** | **3,401**                            |          | 2,555 |   | 3,200 |   | 4,370 |   | 3,930 |   |
| Allowance, end of  period                              | ** ** | **$**                                | **19,865**    |   | $ | 18,455 |   | $ | 16,753 |   | $ | 17,190 |   | $ | 15,558 |   |
| Ratio of net charge offs  to average loans outstanding | ** ** | **0.10**                             | **%**         | 0.16 | % | 0.27 | % | 0.21 | % | 0.28 | % |

 

The following table setsforth an allocation of the allowance for loan losses by category. The specificallocations in any particular category may be reallocated in the future toreflect then current conditions. Accordingly, management considers the entireallowance to be available to absorb losses in any category.

**Table8—Allocation of the Allowance for Loan Losses by Loan Type**

| ** ** | ** ** | **December 31,**                | ** ** |
|------------|------------|--------------------------------------|------------|
| ** ** | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** ** | ** ** | **Amount**                           | ** ** | **Percent  of  Reserve** | ** ** | **Amount** | ** ** | **Percent  of  Reserve** | ** ** | **Amount** | ** ** | **Percent  of  Reserve** | ** ** | **Amount** | ** ** | **Percent  of  Reserve** | ** ** | **Amount** | ** ** | **Percent  of  Reserve** | ** ** |
| ** ** | ** ** | **(Dollars in thousands)** | ** ** |
|            |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

| Real estate               | ** ** |   | **$**     | **6,422**  | ** ** |   |   | **32**  | **%**  |   |   | $      | 4,923  |   |   |   | 27     | %      |   |   | $      | 3,919  |   |   |   | 23     | %     |   |   | $      | 2,980  |   |   |   | 17    | %      |   |   | $  | 2,874  |   |   |   | 19  | % |   |
|---------------------------|------------|--------|-----------|------------|------------|--------|--------|---------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|-------|--------|--------|--------|--------|--------|--------|--------|-------|--------|--------|--------|----|--------|--------|--------|--------|-----|---|--------|
| Commercial and industrial | ** ** |   | **8,534** | ** ** |       |   | **43** | **%**   |   |   | 7,456  |   |   |   | 40     | %      |   |   | 6,840  |   |   |   | 41     | %      |   |   | 5,248 |   |   |   | 31     | %      |   |   | 5,482 |   |   |   | 35 | %      |   |
| Consumer                  | ** ** |   | **4,596** | ** ** |       |   | **23** | **%**   |   |   | 5,515  |   |   |   | 30     | %      |   |   | 4,990  |   |   |   | 30     | %      |   |   | 7,392 |   |   |   | 43     | %      |   |   | 5,432 |   |   |   | 35 | %      |   |
| Lease financing           | ** ** |   | **313**   | ** ** |       |   | **2**  | **%**   |   |   | 561    |   |   |   | 3      | %      |   |   | 1,004  |   |   |   | 6      | %      |   |   | 1,570 |   |   |   | 9      | %      |   |   | 1,770 |   |   |   | 11 | %      |   |
| Total                     | ** ** |   | **$**     | **19,865** | ** ** |   |   | **100** | **%**  |   |   | $      | 18,455 |   |   |   | 100    | %      |   |   | $      | 16,753 |   |   |   | 100    | %     |   |   | $      | 17,190 |   |   |   | 100   | %      |   |   | $  | 15,558 |   |   |   | 100 | % |   |

 

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**Allowance for Loan Losses**

The Bank uses the reserve method of accounting forloan losses. The balance in the allowance for loan losses is determined basedon management’s review and evaluation of the loan portfolio in relation to pastloss experience, the size and composition of the portfolio, current economicevents and conditions, and other pertinent factors, including management’sassumptions as to future delinquencies, recoveries and losses. Increases to theallowance for loan losses are made by charges to the provision for loan losses.Credit exposures deemed to be uncollectible are charged against the allowancefor loan losses. Recoveries of previously charged-off amounts are credited tothe allowance for loan losses.

While management considers the allowance for loanlosses to be adequate based on information currently available, futureadditions to the allowance may be necessary due to changes in economicconditions or management’s assumptions as to future delinquencies, recoveriesand losses and management’s intent with regard to the disposition of loans. Inaddition, the Office of the Comptroller of the Currency (the OCC), as anintegral part of their examination process, periodically reviews the Bank’sallowance for loan losses. The OCC may require the Bank to recognize additionsto the allowance for loan losses based on their judgments about informationavailable to them at the time of their examination.

The Bank’s allowance for loan losses is theaccumulation of various components that are calculated based on variousindependent methodologies. The components of the allowance for credit lossesconsists of both historical losses and estimates. Management bases itsrecognition and estimation of each allowance component on certain observabledata that it believes is the most reflective of the underlying loan lossesbeing estimated. The observable data and accompanying analysis is directionallyconsistent, based upon trends, with the resulting component amount for theallowance for loan losses. The Bank’s allowance for loan losses componentsincludes the following: historical loss estimation by loan product type and byrisk rating within each product type, payment (past due) status, industryconcentrations, internal and external variables such as economic conditions,credit policy and underwriting changes and competence of the loan reviewprocess. The Bank’s historical loss component is the most significant componentof the allowance for loan losses, and all other allowance components are basedon the inherent loss attributes that management believes exist within the totalportfolio that are not captured in the historical loss component.

The historical loss components of the allowancerepresent the results of analysis of historical charge-offs andrecoveries within pools of homogeneous loans, within each risk rating andbroken down further by segment, within the portfolio. Criticized assets arefurther assessed based on trends, expressed as percentages, relative todelinquency, risk rating and non-accrual, by credit product.

The historical loss components of the allowance forcommercial loans are based principally on current risk ratings, historical lossrates adjusted, by adjusting the risk window, to reflect current events andconditions, as well as analysis of other factors that may have affected thecollectibility of loans. The Bank analyzes all commercial loans that have beenidentified as having potential credit risk. The review is accomplished viaWatchlist Memorandum, and is designed to determine whether such loans areindividually impaired, with impairment measured by reference to the collateralcoverage and/or debt service coverage. The historical loss component of theallowance for consumer loans is based principally on loan payment status,retail classification and historical loss rates, adjusted by altering the riskwindow, to reflect current events and conditions.

The industry concentration component is recognized asa possible factor in the estimation of loan losses. Two industries representpossible concentrations: commercial real estate and consumer loans relying onresidential home equity. No specific loss-related observable data is recognizedby management currently, therefore no specific factor is calculated in thereserve solely for the impact of these concentrations, although managementcontinues to carefully consider relevant data for possible future sources ofobservable data.

29

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The historic loss modelincludes a judgmental component (environmental factors) that reflectsmanagement’s belief that there are additional inherent credit losses based onloss attributes not adequately captured in the lagging indicators. Furthermore,given that past-performance indicators may not adequately capture current risklevels, allowing for a real-time adjustment enhances the validity of the lossrecognition process. There are many credit risk management reports that aresynthesized by credit management staff to assess the direction of credit riskand its instant effect on losses. It is important to continue to useexperiential data to confirm risk as measurable losses will continue tomanifest themselves at higher than normal levels even after the economic cyclehas begun an upward swing and lagging indicators begin to show improvement. Thejudgmental component is allocated to the specific segments of the portfoliobased on the historic loss component.

**Deposits and Borrowings**

Depositsand borrowings are the primary funding sources of the Corporation. Coredeposits increased 2.1% or $33.6 million, to $1.61 billion at December 31,2005, up from $1.58 billion at December 31, 2004. Total deposits increased$152.9 million, or 6.9% for the same period, which was primarily attributableto the growth in core deposit checking products and time deposits of $100,000or greater. The Corporation has placed more emphasis on government banking toprovide additional funding sources through relationships with municipalitiesand school districts resulting in both interest-bearing checking accounts andlarge time deposits.

*Deposit Structure*

The following table is adistribution of average balances and average rates paid on the depositcategories for the last three years:

**Table 9—Average Deposits**

| ** **                      | ** ** | **December 31,**                | ** **    |
|---------------------------------|------------|--------------------------------------|---------------|
| ** **                      | ** ** | **2005**                             | ** **    | **2004** | ** ** | **2003** | ** ** |
| ** **                      | ** ** | **Amount**                           | ** **    | **Rate** | ** ** | **Amount** | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
| ** **                      | ** ** | **(Dollars in thousands)** | ** **    |
| Demand—noninterest-bearing | ** ** | **$**                                | **335,962**   | ** ** | **—** | **%** | $ | 312,963 |   | — | % | $ | 265,399 |   | — | % |
| Demand—interest-bearing    | ** ** | **351,071**                          | ** **    | **1.64** | **%** | 289,611 |   | 0.66 | % | 245,116 |   | 0.56 | % |
| Money market and  savings       | ** ** | **889,332**                          | ** **    | **1.86** | **%** | 824,123 |   | 0.96 | % | 709,327 |   | 0.90 | % |
| Time—under $100,000        | ** ** | **517,969**                          | ** **    | **3.57** | **%** | 509,695 |   | 3.47 | % | 509,757 |   | 3.73 | % |
| Time—$100,000 or  greater  | ** ** | **165,497**                          | ** **    | **3.51** | **%** | 158,606 |   | 2.04 | % | 198,300 |   | 2.17 | % |
| Total interest-bearing deposits | ** ** | **$**                                | **1,923,869** | ** ** | **2.42** | **%** | 1,782,035 |   | 1.73 | % | 1,662,500 |   | 1.87 | % |
| Total deposits                  | ** ** | **$**                                | **2,259,831** | ** ** | ** ** |   | $ | 2,094,998 |   |   |   | $ | 1,927,899 |   |   |   |

 

The maturity distributionof certificates of deposit of $100,000 and over as of December 31, 2005 isas follows:

**Table 10—Maturity Distribution of Certificates ofDeposit $100,000 and Over**

| ** **                        | ** ** | **(Dollars  in thousands)** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|
| Three months or  less             |       |                             | $          | 78,728 |   |   |
| Over three months  to six months  |       |                             | 40,476     |   |   |
| Over six months  to twelve months |       |                             | 28,768     |   |   |
| Over twelve  months               |       |                             | 70,122     |   |   |
| Total                             |       |                             | $          | 218,094 |   |   |

 

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*Borrowings*

Borrowings decreased $49.0 million to $439.2 millionat December 31, 2005 from $488.2 million at December 31, 2004.The decrease was the result of reductions of $99.8 million in short-termborrowings offset in part by increases of $25.0 million in long-term FederalHome Loan Bank (FHLB) borrowings and $25.8 in subordinated debt. Subordinateddebt increased to $51.5 million at December 31, 2005. The Corporationcompleted a private placement of $25.0 million in aggregate principal amount offixed/floating rate preferred securities (subordinated debt) through a newlyformed Delaware trust affiliate HNC Statutory Trust III (Trust III) on September 28,2005. The trust preferred securities represent undivided beneficial interestsin the assets of Trust III. The trust preferred securities mature on November 23,2035, are redeemable at the Corporation’s option beginning after five years andrequire quarterly distributions by Trust III to the holders of the trustpreferred securities at a fixed rate equal to 5.67% through November 2010and then will be payable at a variable interest rate equal to the three-monthLondon Interbank Offered Rate (LIBOR) plus 1.40% per annum.

Borrowings increased $233.1 million to$488.2 million at December 31, 2004 from $255.1 million at December 31,2003. This increase was primarily to support loan growth and the Millenniumacquisition. FHLB advances increased $145.0 million of which$45.0 million was short-term and $100.0 million was long-term. Fedfunds purchased and securities sold under agreements to repurchase rose$67.2 million.

The Bank, pursuant to adesignated cash management agreement, utilizes securities sold under agreementsto repurchase as vehicles for customers’ sweep and term investment products.Securitization under these cash management agreements are in U.S. TreasurySecurities and obligations of states and political subdivisions securities.Securities sold under agreements to repurchase are generally overnighttransactions. These securities are held in a third-party custodian’saccount, designated by the Bank under a written custodial agreement thatexplicitly recognizes the Bank’s interest in the securities.

**Table 11—Securities Sold under Agreements toRepurchase**

| ** **                                                                  | ** ** | **At or for the year ended December 31,** | ** **  |
|-----------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|-------------|
| **Securities sold under agreement to repurchase:** | ** ** | ** **                                                                   | ** **  | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                  | ** ** | **(Dollars in thousands)**                                         | ** **  |
| Balance at year-end                                                         | ** ** | **$**                                                                        | **88,118**  |   | $ | 84,945 |   | $ | 72,291 |   |
| Weighted average  rate at year-end                                          | ** ** | **3.45**                                                                     | **%**       | 1.51 | % | 0.62 | % |
| Maximum month-end  balance                                                  | ** ** | **$**                                                                        | **155,239** |   | $ | 199,493 |   | $ | 101,991 |   |
| Average balance  during the year                                            | ** ** | **$**                                                                        | **102,722** |   | $ | 106,169 |   | $ | 83,277 |   |
| Weighted average rate  during the year                                      | ** ** | **2.64**                                                                     | **%**       | 0.93 | % | 0.87 | % |
|                                                                             |            |                                                                              |             |  |  |  |  |  |  |  |  |  |

 

**Results of Operations**

Net income is affected byfive major elements: (1) net interest income, or the difference betweeninterest income earned on loans and investments and interest expense paid on depositsand borrowed funds; (2) the provision for loan losses, or the amount addedto the allowance for loan losses to provide reserves for inherent losses onloans; (3) noninterest income, which is made up primarily of certain fees,trust income and gains and losses from sales of securities; (4) noninterestexpense, which consists primarily of salaries, employee benefits and otheroperating expenses; and (5) income taxes. Each of these major elements isreviewed in more detail in the following discussion.

*Net Interest Income*

Net interest income on a tax equivalent basis in 2005increased $962,000, or 1.0% to $93.5 million, compared to 2004. The increase in2005 was mostly due to higher loan volume, partially offset by higher depositrates. As a result of market conditions, deposit rates have increased morequickly than the loan 

31

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rates have increased. Netinterest income on a tax equivalent basis in 2004 increased $3.8 million,or 4.3% to $92.5 million in comparison to 2003. The increase in 2004 wasprimarily the result of loan growth partially offset by lower loan rates and ahigher level of borrowings. The lower loan rates were largely attributable tothe general decline in market interest rates.

The rate volume analysisin the following table, which is computed on a tax-equivalent basis (tax rateof 35%), analyzes changes in net interest income for the last three years bytheir volume and rate components. The change attributable to both volume andrate has been allocated proportionately.

**Table 12—Analysis of Changes in Net Interest Income—FullyTaxable-Equivalent Basis**

| ** **                                  | ** ** | **2005 compared to 2004** | ** ** | **2004 compared to 2003** | ** ** |
|---------------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| ** **                                  | ** ** | **Net**                                  | ** ** | **Due to Change in**      | ** ** | **Net** | ** ** | **Due to Change in** | ** ** |
| ** **                                  | ** ** | **Change**                               | ** ** | **Volume**                               | ** ** | **Rate** | ** ** | **Change** | ** ** | **Volume** | ** ** | **Rate** | ** ** |
| ** **                                  | ** ** | **(Dollars in thousands)**     | ** ** |
| Increase  (decrease) in interest income:    |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Investment securities(1)                    | ** ** | **$**                                    | **(800**   | **)**                                    | **$**      | **(1,705** | **)** | **$** | **905** |   | $ | (658 | ) | $ | (348 | ) | $ | (310 | ) |
| Federal funds sold and deposits in banks    | ** ** | **1,113**                                | ** ** | **166**                                  | ** ** | **947** |   | 176 |   | 155 |   | 21 |   |
| Loans(1)(2)                                 | ** ** | **22,629**                               | ** ** | **16,600**                               | ** ** | **6,029** |   | 6,848 |   | 16,198 |   | (9,350 | ) |
| Total                                       | ** ** | **22,942**                               | ** ** | **15,061**                               | ** ** | **7,881** |   | 6,366 |   | 16,005 |   | (9,639 | ) |
| Increase (decrease) in interest expense:    | ** ** | ** **                               | ** ** | ** **                               | ** ** | ** ** |   |   |   |   |   |   |   |
| Savings and money market deposits           | ** ** | **12,448**                               | ** ** | **1,237**                                | ** ** | **11,211** |   | 2,094 |   | 1,348 |   | 746 |   |
| Time deposits                               | ** ** | **3,428**                                | ** ** | **483**                                  | ** ** | **2,945** |   | (2,401 | ) | (1,282 | ) | (1,119 | ) |
| Borrowed funds                              | ** ** | **6,104**                                | ** ** | **2,994**                                | ** ** | **3,110** |   | 2,866 |   | 3,257 |   | (391 | ) |
| Total                                       | ** ** | **21,980**                               | ** ** | **4,714**                                | ** ** | **17,266** |   | 2,559 |   | 3,323 |   | (764 | ) |
| Net increase  (decrease) in interest income | ** ** | **$**                                    | **962**    | ** **                               | **$**      | **10,347** | ** ** | **$** | **(9,385** | **)** | $ | 3,807 |   | $ | 12,682 |   | $ | (8,875 | ) |

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(1)          The interest earned onnontaxable investment securities and loans is shown on a tax-equivalent basisusing a tax rate of 35%.

(2)          Nonaccrual loans havebeen included in the appropriate average loan balance category, but interest onnonaccrual loans has not been included for purposes of determining interestincome.

Interest income on a tax-equivalent basis in 2005increased $22.9 million, or 17.0% to $158.1 million, compared to2004. This increase was mainly due to higher average loans of$274.6 million, or 16.9% and a 35 basis point rise in the average ratesearned on loans. Interest expense increased $22.0 million, to$64.6 million during 2005 mostly attributed to higher deposit andborrowing rates.

The average rate paid on deposits during 2005 of 2.42%was 69 basis points higher compared to 2004 primarily due to higher rates onmoney market accounts, interest checking accounts and time deposits accounts of$100,000 or more. These higher rates resulted from the increase in short-termrates during 2005. The average rate paid on borrowings for 2005 of 3.94% was 75basis points higher than 2004 mainly due to an increase in short-term borrowingrates.

Interest income on atax-equivalent basis in 2004 increased $6.4 million, or 4.9% to$135.2 million as compared to 2003. This increase was mainly due to anincrease in average loans of $271.3 million, or 20.0% partially offset bya 65 basis point reduction in the average rates earned on loans. Loans totaling$157.1 million were acquired in the acquisition of Millennium Bank whichcontributed to the increase in average loans. Interest expense increased$2.6 million, or 6.4% to $42.6 million during 2004 primarily due to ahigher level of borrowings. Average borrowings increased $101.8 million,or 37.7% during 2004 to support loan growth and the Millennium Bankacquisition.

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*Net Interest Margin*

The 2005 net interest margin of 3.27% was lower thanthe net interest margins for 2004 and 2003 of 3.55% and 3.80%, respectively.The decline in the net interest margin from 2004 is primarily due to higherfunding costs, particularly in money market deposit accounts and short-termborrowings. As a result of market conditions, deposit rates have increased morequickly than the loan rates have increased, although net interest income hasincreased primarily as a result of higher earning assets volume. The decline inthe net interest margin in 2004 from 2003 was primarily due to a decline inloan yields impacted by the lower interest rate environment.

During 2005, the Corporation continued to manage itsbalance sheet in an effort to position it for potentially higher rates in thefuture. The Corporation continued to sell securities with longer average livesin a rising rate environment and purchased securities with more stable cashflows in such a rate environment. As a result, the balance sheet is betterpositioned to minimize market risk from rising rates.

The table below presentsthe major asset and liability categories on an average basis for the periodspresented, along with interest income and expense, and key rates and yields:

**Table 13—Average Balance Sheets and Interest Rates—FullyTaxable-Equivalent Basis**

| ** **                                       | ** ** | **Year Ended December 31,** | ** **    |
|--------------------------------------------------|------------|--------------------------------------------|---------------|
| ** **                                       | ** ** | **2005**                                   | ** **    | **2004** | ** ** | **2003** | ** ** |
| ** **                                       | ** ** | **Average  Balance**                       | ** **    | **Interest** | ** ** | **Rate** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Rate** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Rate** | ** ** |
| ** **                                       | ** ** | **(Dollars in thousands)**       | ** **    |
| **Assets**                                       |       |                                       |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Earning Assets:                                  |       |                                       |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Investment  securities:                          |       |                                       |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Taxable  investments                             | ** ** | **$**                                      | **648,630**   | ** ** | **$** | **23,923** | ** ** | ** ** | **3.69** | **%** |   | $ | 702,183 |   | $ | 23,891 |   |   | 3.40 | % |   | $ | 638,036 |   | $ | 18,697 |   |   | 2.93 | % |   |
| Nontaxable investments(1)                        | ** ** | **254,433**                                | ** **    | **16,183** | ** ** | ** ** | **6.36** |   |   | 239,727 |   | 17,015 |   |   | 7.10 |   |   | 312,189 |   | 22,867 |   |   | 7.32 |   |   |
| Total investment  securities                     | ** ** | **903,063**                                | ** **    | **40,106** | ** ** | ** ** | **4.44** |   |   | 941,910 |   | 40,906 |   |   | 4.34 |   |   | 950,225 |   | 41,564 |   |   | 4.37 |   |   |
| Federal funds sold  and deposits in   banks      | ** ** | **51,740**                                 | ** **    | **1,637** | ** ** | ** ** | **3.16** |   |   | 41,064 |   | 524 |   |   | 1.28 |   |   | 28,782 |   | 348 |   |   | 1.21 |   |   |
| Loans(1)(2)                                      | ** ** | **1,900,023**                              | ** **    | **116,354** | ** ** | ** ** | **6.12** |   |   | 1,625,419 |   | 93,725 |   |   | 5.77 |   |   | 1,354,127 |   | 86,877 |   |   | 6.42 |   |   |
| Total earning  assets                            | ** ** | **2,854,826**                              | ** **    | **158,097** | ** ** | ** ** | **5.54** |   |   | 2,608,393 |   | 135,155 |   |   | 5.18 |   |   | 2,333,134 |   | 128,789 |   |   | 5.52 |   |   |
| Noninterest-earning  assets                      | ** ** | **184,360**                                | ** **    | ** ** | ** ** | ** ** | ** ** |   |   | 165,012 |   |   |   |   |   |   |   | 132,936 |   |   |   |   |   |   |   |
| Total assets                                     | ** ** | **$**                                      | **3,039,186** | ** ** | ** ** | ** ** | ** ** | ** ** |   |   | $ | 2,773,405 |   |   |   |   |   |   |   | $ | 2,466,070 |   |   |   |   |   |   |   |
| **Liabilities and Shareholders’  Equity**   | ** ** | ** **                                 | ** **    | ** ** | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:                   | ** ** | ** **                                 | ** **    | ** ** | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits:                      | ** ** | ** **                                 | ** **    | ** ** | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings and money  market                        | ** ** | **$**                                      | **1,240,403** | ** ** | **22,319** | ** ** | ** ** | **1.80** | **%** |   | $ | 1,113,734 |   | 9,871 |   |   | 0.89 | % |   | $ | 954,443 |   | 7,777 |   |   | 0.81 | % |   |
| Time                                             | ** ** | **683,466**                                | ** **    | **24,330** | ** ** | ** ** | **3.56** |   |   | 668,301 |   | 20,902 |   |   | 3.13 |   |   | 708,057 |   | 23,303 |   |   | 3.29 |   |   |
| Total interest-bearing  deposits                 | ** ** | **1,923,869**                              | ** **    | **46,649** | ** ** | ** ** | **2.42** |   |   | 1,782,035 |   | 30,773 |   |   | 1.73 |   |   | 1,662,500 |   | 31,080 |   |   | 1.87 |   |   |
| Borrowed funds                                   | ** ** | **456,599**                                | ** **    | **17,969** | ** ** | ** ** | **3.94** |   |   | 372,141 |   | 11,865 |   |   | 3.19 |   |   | 270,325 |   | 8,999 |   |   | 3.33 |   |   |
| Total interest-bearing  liabilities              | ** ** | **2,380,468**                              | ** **    | **64,618** | ** ** | ** ** | **2.71** |   |   | 2,154,176 |   | 42,638 |   |   | 1.98 |   |   | 1,932,825 |   | 40,079 |   |   | 2.07 |   |   |
| Noninterest-bearing  liabilities:                | ** ** | ** **                                 | ** **    | ** ** | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                  | ** ** | **335,962**                                | ** **    | ** ** | ** ** | ** ** | ** ** |   |   | 312,963 |   |   |   |   |   |   |   | 265,399 |   |   |   |   |   |   |   |
| Other liabilities                                | ** ** | **49,782**                                 | ** **    | ** ** | ** ** | ** ** | ** ** |   |   | 54,303 |   |   |   |   |   |   |   | 51,000 |   |   |   |   |   |   |   |
| Total noninterest-bearing  liabilities           | ** ** | **385,744**                                | ** **    | ** ** | ** ** | ** ** | ** ** |   |   | 367,266 |   |   |   |   |   |   |   | 316,399 |   |   |   |   |   |   |   |
| Total liabilities                                | ** ** | **2,766,212**                              | ** **    | ** ** | ** ** | ** ** | ** ** |   |   | 2,521,442 |   |   |   |   |   |   |   | 2,249,224 |   |   |   |   |   |   |   |
| Shareholders’  equity                       | ** ** | **272,974**                                | ** **    | ** ** | ** ** | ** ** | ** ** |   |   | 251,963 |   |   |   |   |   |   |   | 216,846 |   |   |   |   |   |   |   |
| Total liabilities  and shareholders’ equity | ** ** | **$**                                      | **3,039,186** | ** ** | ** ** | ** ** | ** ** | ** ** |   |   | $ | 2,773,405 |   |   |   |   |   |   |   | $ | 2,466,070 |   |   |   |   |   |   |   |
| Net interest  spread                             | ** ** | ** **                                 | ** **    | ** ** | ** ** | ** ** | **2.83** |   |   |   |   |   |   |   | 3.20 |   |   |   |   |   |   |   | 3.45 |   |   |
| Effect of  noninterest-bearing sources           | ** ** | ** **                                 | ** **    | ** ** | ** ** | ** ** | **0.44** |   |   |   |   |   |   |   | 0.35 |   |   |   |   |   |   |   | 0.35 |   |   |
| Net interest  income/margin on earning   assets  | ** ** | ** **                                 | ** **    | **$** | **93,479** | ** ** | ** ** | **3.27** | **%** |   |   |   | $ | 92,517 |   |   | 3.55 | % |   |   |   | $ | 88,710 |   |   | 3.80 | % |   |
| Less tax  equivalent adjustment                  | ** ** | ** **                                 | ** **    | **6,358** | ** ** | ** ** | ** ** |   |   |   |   | 7,426 |   |   |   |   |   |   |   | 9,589 |   |   |   |   |   |
| Net interest  income                             | ** ** | ** **                                 | ** **    | **$** | **87,121** | ** ** | ** ** | ** ** |   |   |   |   | $ | 85,091 |   |   |   |   |   |   |   | $ | 79,121 |   |   |   |   |   |

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(1)                The interest earned on nontaxableinvestment securities and loans is shown on a tax-equivalent basis (tax rate of35%).

(2)                Nonaccrual loans have been included in the appropriateaverage loan balance category, but interest on nonaccrual loans has not beenincluded for purposes of determining interest income.

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*Interest RateSensitivity Analysis*

In the normal course of conducting businessactivities, the Corporation is exposed to market risk, principally interestrate risk, through the operations of its banking subsidiary. Interest rate riskarises from market driven fluctuations in interest rates that affect cashflows, income, expense and value of financial instruments.

The Corporation actively manages its interest ratesensitivity positions. The objectives of interest rate risk management are tocontrol exposure of net interest income to risks associated with interest ratemovements and to achieve consistent growth in net interest income. TheAsset/Liability Committee, using policies and procedures approved by theCorporation’s Board of Directors, is responsible for managing the ratesensitivity position. The Corporation manages interest rate sensitivity bychanging the mix and repricing characteristics of its assets and liabilitiesthrough the management of its investment securities portfolio, its offering of loanand deposit terms and through borrowings from the Federal Home Loan Bank. Thenature of the Corporation’s current operations is such that it is not subjectto foreign currency exchange or commodity price risk.

The Corporation only utilizes derivative instrumentsfor asset/liability management. These transactions involve both credit andmarket risk. The notional amounts are amounts on which calculations andpayments are based. The notional amounts do not represent direct creditexposures. Direct credit exposure is limited to the net difference between thecalculated amounts to be received and paid, if any. Interest rate swaps arecontracts in which a series of interest-rate flows (fixed and floating) areexchanged over a prescribed period. The notional amounts on which the interestpayments are based are not exchanged.

At December, 31, 2005, the Corporation had cash flowhedges in the form of interest rate swaps with a notional value totaling $20.0million that have the effect of converting the rates on money market depositaccounts to a fixed-rate cost of funds. This strategy will cause the Bank torecognize, in a rising rate environment, a larger interest rate spread than itotherwise would have without the swaps in effect. For these swaps, theCorporation recognized $69,000 of net interest income for the year ended December 31,2005 and estimates that for 2006, $286,000 will be recognized as an increase innet interest income. These swaps mature in 2008. During the first quarter of2005, the Corporation terminated a cash flow hedge with a notional value of$25.0 million. The gross loss related to the termination of this swap is$310,000 which is being amortized through October 2006 in accordance withSFAS No. 133 “Accounting for Derivative Instruments and HedgingActivities.” For the year ended December 31, 2005, the Corporationamortized into net interest income $159,000 related to this swap. Periodically,the Corporation may enter into fair value hedges to limit the exposure tochanges in the fair value of loan assets. During December 2005, theCorporation entered into a fair value hedge for $2.1 million which had noimpact to earnings for 2005. This swap matures in 2015. At December 31,2005, the interest rate swap agreements have a positive fair market value of$623,000 compared to $53,000 at December 31, 2004.

The Corporation uses threeprincipal reports to measure interest rate risk: (1) asset/liabilitysimulation reports; (2) gap analysis reports; and (3) net interestmargin reports. The Corporation’s interest rate sensitivity, as measured by therepricing of its interest sensitive assets and liabilities at December 31,2005, is presented in Table 14. The data in the table was based in part onassumptions that are regularly reviewed for accuracy. The table presents dataat a single point in time and includes management assumptions estimating theprepayment rate and the interest rate environment prevailing at December 31,2005. The table indicates an asset sensitive one-year cumulative gap positionof 1.81% of total earning assets.

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**Table 14—Contractual Repricing Data of InterestSensitive Assets and Liabilities**

| ** **                                        | ** ** | **December 31, 2005**      | ** ** |
|---------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                        | ** ** | **0 to  90 days**          | ** ** | **91 to  365 days** | ** ** | **After 1 year  through  5 years** | ** ** | **Over  5 years** | ** ** | **Total** | ** ** |
| ** **                                        | ** ** | **(Dollars in thousands)** | ** ** |
| **Earning assets**                                |       |                                 |       |   |   |   |   |   |   |   |   |
| Investment  securities                            |       | $                                    | 112,979    |   | $ | 161,037 |   | $ | 330,258 |   | $ | 296,934 |   | $ | 901,208 |   |
| Federal funds  sold and deposits in banks         |       | 37,455                               |       | — |   | — |   | — |   | 37,455 |   |
| Loans                                             |       | 673,394                              |       | 162,367 |   | 644,230 |   | 505,502 |   | 1,985,493 |   |
| Total earning assets                              |       | $                                    | 823,828    |   | $ | 323,404 |   | $ | 974,488 |   | $ | 802,436 |   | $ | 2,924,156 |   |
| **Interest-bearing  liabilities**                 |       |                                 |       |   |   |   |   |   |   |   |   |
| Interest-bearing  checking accounts               |       | $                                    | 97,799     |   | $ | 119,108 |   | $ | 170,467 |   | $ | — |   | $ | 387,374 |   |
| Money market  funds                               |       | 85,129                               |       | 213,076 |   | 369,747 |   | — |   | 667,952 |   |
| Savings accounts                                  |       | 9,506                                |       | 28,504 |   | 152,023 |   | — |   | 190,033 |   |
| Time deposits                                     |       | 139,763                              |       | 267,901 |   | 348,963 |   | 31 |   | 756,658 |   |
| Borrowed funds                                    |       | 125,489                              |       | 30,000 |   | 193,524 |   | 90,155 |   | 439,168 |   |
| Total interest-bearing liabilities                |       | $                                    | 457,686    |   | $ | 658,589 |   | $ | 1,234,724 |   | $ | 90,186 |   | $ | 2,441,185 |   |
| Interest rate  swaps                              |       | $                                    | 22,100     |   | $ | — |   | $ | (20,000 | ) | $ | (2,100 | ) | $ | — |   |
| Incremental gap                                   |       | $                                    | 388,242    |   | $ | (335,185 | ) | $ | (280,236 | ) | $ | 710,150 |   |   |   |
| Cumulative gap(1)                                 |       | $                                    | 388,242    |   | $ | 53,057 |   | $ | (227,179 | ) | $ | 482,971 |   |   |   |
| Cumulative gap as a  percentage of earning assets |       | 13.28                                | %          | 1.81 | % | -7.77% |   | 16.52 | % |   |   |

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(1)          The information is basedupon significant assumptions, including the following: loans and leases arerepaid by contractual maturity and repricings; securities, except mortgage-backedsecurities, are repaid according to contractual maturity adjusted for callfeatures; mortgage-backed security repricing is adjusted for estimatedearly paydowns; interest-bearing demand, regular savings, and moneymarket savings deposits are estimated to exhibit some rate sensitivity based onmanagement’s analysis of deposit withdrawals; and time deposits are shown inthe table based on contractual maturity.

Management also simulates possible economic conditionsand interest rate scenarios in order to quantify the impact on net interestincome. The effect that changing interest rates have on the Corporation’s netinterest income is simulated by increasing and decreasing interest rates. Thissimulation is known as rate shocking. The results of the December 31, 2005net interest income rate shock simulations show that the Corporation is withinguidelines set by the Corporation’s Asset/Liability Policy.

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The following tableforecasts changes in the Corporation’s market value of equity under alternativeinterest rate environments as of December 31, 2005. The market value ofequity is defined as the net present value of the Corporation’s existing assetsand liabilities. The Corporation is within guidelines set by the Corporation’sAsset/Liability Policy for the percentage change in the market value of equity.

**Table 15—Market Value of Equity**

| ** **         | ** ** | **December 31, 2005**       | ** ** |
|--------------------|------------|---------------------------------------|------------|
| ** **         | ** ** | **Market Value  of Equity** | ** ** | **Change in  Market Value  of Equity** | ** ** | **Percentage  Change** | ** ** | **Asset/Liability  Approved  Percent  Change** | ** ** |
| ** **         | ** ** | **(Dollars in thousands)**  | ** ** |
| +300 Basis Points  |       |                                  | $          | 316,893 |   |   |   | $ | (97,991 | ) |   |   | -23.62 | % |   |   | +/-35 | % |   |
| +200 Basis Points  |       |                                  | 346,852    |   |   |   | (68,032 | ) |   |   | -16.40 |   |   |   | +/-25 |   |   |
| +100 Basis Points  |       |                                  | 378,065    |   |   |   | (36,819 | ) |   |   | -8.87 |   |   |   | +/-15 |   |   |
| Flat Rate          |       |                                  | 414,884    |   |   |   | — |   |   |   | 0.00 |   |   |   | — |   |   |
| -100  Basis Points |       |                                  | 412,977    |   |   |   | (1,907 | ) |   |   | -.46 |   |   |   | +/-15 |   |   |
| -200  Basis Points |       |                                  | 400,302    |   |   |   | (14,582 | ) |   |   | -3.51 |   |   |   | +/-25 |   |   |
| -300  Basis Points |       |                                  | 382,689    |   |   |   | (32,195 | ) |   |   | -7.76 |   |   |   | +/-35 |   |   |

 

In the event theCorporation should experience a mismatch in its desired gap ranges or anexcessive decline in its market value of equity resulting from changes ininterest rates, it has a number of options that it could use to remedy themismatch. The Corporation could restructure its investment portfolio throughthe sale or purchase of securities with more favorable repricing attributes. Itcould also emphasize growth in loan products with appropriate maturities orrepricing attributes, or attract deposits or obtain borrowings with desiredmaturities.

*Provision for LoanLosses*

The provision for loanlosses of $3.4 million for 2005 reflected an increase of $846,000 compared tothe 2004 provision of $2.6 million. The increase in the provision during2005 was primarily due to inherent risk related to loan growth which totaled$140.0 million and the increase in non-performing loans of $2.7 million. Totalnet loans charged off in 2005, 2004 and 2003 were $2.0 million,$2.5 million and $3.6 million, respectively.

*Noninterest Income*

Noninterest income of $30.0 million for the year endedDecember 31, 2005 reflects an increase of $1.8 million, or 6.5% from2004.The increase in noninterest income was attributed to gains of $1.1 millionon sales of investment securities and gains of $690,000 and $287,000 on thesales of Harleysville National Bank’s McAdoo branch and Cumberland Advisors, Inc.,respectively, during the second quarter of 2005. The increase in net securitygains in 2005 was primarily the result of sales of tax-exempt, trust preferred and equity securities to position thebalance sheet in the current interest rate environment. On April 1, 2005, the Bank completed the sale of its McAdoo branchlocated in Schuylkill County, Pennsylvania with deposits of $13.9 million aswell as certain loans and other assets of $5.8 million to The Legacy Bank. Inconnection with the sale, the Bank paid net cash of $7.4 million and recorded apre-tax profit of $690,000 during the second quarter of 2005. On June 30,2005, the Bank sold its former subsidiary, Cumberland Advisors, Inc. in astock sale. The sale price was $2.0 million cash and resulted in a non-taxablegain of $287,000 recorded in the second quarter of 2005. It was acquired by theCorporation on April 30, 2004 as part of its Millennium Bank acquisition.Management does not believe the sale of Cumberland Advisors will have amaterial impact on the Corporation’s future results of operations.

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Noninterest income of$28.2 million during 2004 increased $520,000, or 1.9%, to $28.2 millionduring 2004, compared to 2003. This was mainly due to an increase of$2.7 million in trust and investment advisory fees and an increase of$1.4 million in the gains related to the auto leasing portfolio, partiallyoffset by a decrease of $2.9 million in the gain on sales of investmentsecurities and a decrease of $868,000 in gains related to the sale ofresidential mortgages. The increase in trust and investment advisory fees of$2.7 million, or 71.6% during 2004, was primarily attributable to theCumberland subsidiary acquired with the Millennium Bank acquisition, growth intrust assets and the higher market value of equities in trust assetsexperienced in 2004, compared to 2003. Gains related to the auto leasingportfolio increased $1.4 million during 2004 mostly due to residualinsurance fund valuations. Gains related to the sale of residential mortgagesdecreased $868,000 in 2004 primarily attributable to lower origination volume.

*Noninterest Expense*

Noninterest expense of $62.5million for the year ended December 31, 2005 increased $2.9 million,or 4.9% compared to 2004. Salaries and benefits expense increased$361,000 for the year of 2005 over 2004, primarily due to the acquisition ofMillennium Bank, increased staffing levels resulting from growth and higherpension and healthcare costs partially offset by lower bonus expense. Occupancyexpense increased $619,000 in 2005 over 2004, mostly due to the Millenniumacquisition and a new branch opening. Other expense increased $2.3 millionduring 2005 mainly due to increased expenses for advertising and professionalfees (Sarbanes-Oxley related) as well as lower loan origination expensedeferrals related to decreased loan origination volume.

Noninterest expenseremained level at $59.6 million for 2004, compared to 2003. Salary andemployee benefits expense increased $5.9 million in 2004 primarily due tothe Millennium acquisition and higher pension and medical costs. Occupancyexpense increased $787,000 during 2004 mostly due to the Millennium acquisitionand a new branch opening. Partially offsetting these variances was Federal HomeLoan Bank borrowings prepayment fees which decreased $2.6 million andother expenses which decreased $5.0 million. During 2003, the Corporationpaid off $29 million of FHLB borrowings with rates over 6.0% prior totheir scheduled maturity dates. This provided the opportunity to lock in historicallylow rates on new long-term borrowings. The early retirement of these borrowingsresulted in a $2.6 million prepayment fee. The decrease in other expenseswas primarily due to lower off-lease vehicle residual reserve of$2.6 million, higher loan origination expense deferrals amounting to$3.8 million mainly related to higher loan origination volume, partiallyoffset by an increase in deferred compensation expense for directors andemployees of $717,000.

*Federal IncomeTaxes*

Theeffective federal income tax rate for 2005 was 24.0% versus the statutory rateof 35%. The Corporation’s effective rate was lower than the statutorytax rate primarily as a result of tax-exempt income earned from state andmunicipal securities and loans and bank-owned life insurance as well as the taxloss recorded related to the sale of Cumberland Advisors, Inc. during2005. The effective income tax rate for 2004was 24.3% and for 2003 was 19.6%. The lower effective tax rate during 2003 wasprimarily the result of higher non-taxable income on life insurance proceedsduring 2003 as well as lower non-taxable investment securities income andhigher taxable loan interest during 2004.

*Capital*

Capital formation is important tothe Corporation’s well being and future growth. Capital, at the end of 2005,was $273.2 million, an increase of $2.7 million over the end of 2005. Theincrease was primarily the result of the retention of the Corporation’searnings partially offset by dividends paid to the shareholders, theCorporation’s repurchase of its common stock and the accumulated othercomprehensive loss. The accumulated othercomprehensive loss at December 31, 2005 was $8.6 million, compared toa gain of 

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$1.2 millionat December 31, 2004. This change resulted from an increase in marketrates and the effect on the Corporation’s securities portfolio. At December 31, 2004, capital was$270.5 million, an increase of $43.5 million over December 31,2003. The increase was primarily due to the acquisition of Millennium Bank andthe retention of the Corporation’s earnings partially offset by dividends paidto shareholders and a decrease in accumulated other comprehensive income. Theissuance of common stock for the acquisition of Millennium Bank resulted in anincrease in capital of $28.9 million. Management believes that theCorporation’s current capital position and liquidity position are strong andthat its capital position is adequate to support its operations. Management isnot aware of any recommendation by any regulatory authority, which, if it wereto be implemented, would have a material effect on the Corporation’s capital.

Pursuant to the federal regulators’ risk-based capitaladequacy guidelines, the components of capital are called Tier 1 and Tier 2capital. For the Corporation, Tier 1 capital is shareholders’ equity and Tier 2capital is the allowance for loan losses. The risk-based capital ratios arecomputed by dividing the components of capital by risk-adjusted assets.Risk-adjusted assets are determined by assigning credit risk-weighting factorsfrom 0% to 100% to various categories of assets and off-balance sheet financialinstruments. The minimum for the Tier 1 capital ratio is 4.0%, and the totalcapital ratio (Tier 1 plus Tier 2 capital divided by risk-adjustedassets) minimum is 8.0%. At December 31, 2005, the Corporation’s Tier 1risk-adjusted capital ratio was 12.17%, and the total risk-adjusted capitalratio was 12.98%, both well above regulatory requirements. The risk-basedcapital ratios of the Bank also exceeded regulatory requirements at the end of2005. At December 31, 2004, the Corporation’s Tier 1 risk-adjusted capitalratio was 11.36%, and the total risk-adjusted capital ratio was 12.21%. Thehigher risk-based capital ratios of the Corporation at December 31, 2005compared to December 31, 2004 were primarily attributable to the increasein Tier 1 capital from the issuance of $25.0 million of trust preferredsecurities during the third quarter of 2005.

To supplement the risk-based capital adequacyguidelines, the Federal Reserve Board (FRB) established a leverage ratioguideline. The leverage ratio consists of Tier 1 capital divided by quarterlyaverage total assets, excluding intangible assets. The minimum leverage ratioguideline is 3% for banking organizations that do not anticipate significantgrowth and that have well-diversified risk, excellent asset quality, highliquidity, good earnings and, in general, are considered top-rated, strongbanking organizations. Other banking organizations are expected to have ratiosof at least 4% or 5%, depending upon their particular condition and growthplans. Higher leverage ratios could be required by the particular circumstancesor risk profile of a given banking organization. The Corporation’s leverageratios were 9.69% and 8.91% at December 31, 2005 and 2004, respectively.Thehigher leverage ratio of the Corporation at December 31, 2005 was mainlydue to the increase in Tier 1 capital from the issuance of $25.0 million oftrust preferred securities during the third quarter of 2005.

Under FDIC regulations, a “wellcapitalized” institution must have a leverage ratio of at least 5%, a Tier 1risk-based capital ratio of at least 6% and a total risk-based capital ratio ofat least 10% and not be subject to a capital directive order. To be considered “adequatelycapitalized” an institution must generally have a leverage ratio of at least4%, a Tier 1 risk-based capital ratio of at least 4% and a total risk-basedcapital ratio of at least 8%. An institution is deemed to be “critically undercapitalized” if it has a tangible equity ratio of 2% or less. As of December 31,2005, the Bank is above the regulatory minimum guidelines and meets thecriteria to be categorized as a “well capitalized” institution.

*Liquidity*

Liquidity is a measure of the ability of the Bank tomeet its needs and obligations on a timely basis. For a bank, liquidityrequires the ability to meet the day-to-day demands of deposit customers, andthe ability to fulfill the needs of borrowing customers. Generally, the Bankarranges its mix of cash, money market investments, investment securities andloans in order to match the volatility, seasonality, interest sensitivity andgrowth trends of its deposit funds. The liquidity measurement is based on theasset/liability 

38

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model’s projection of potentialsources and uses of funds for the next 120 days. The resulting projectionsas of December 31, 2005, show the potential sources of funds exceeding thepotential uses of funds. The Corporation has external sources of funds, whichcan be drawn upon when funds are required. The primary source of externalliquidity is an available line of credit with the FHLB of Pittsburgh. As of December 31,2005, the Bank had borrowings outstanding with the FHLB of $297.8 million, allof which were long-term and pledged investment securities available for sale of$514.6 million. At December 31, 2005, the Bank had unused lines ofcredit at the FHLB of $273.1 million and unused federal funds lines ofcredit with commercial banks of $130.0 million.

There are no known trends or any known demands,commitments, events or uncertainties that will result in, or that arereasonably likely to result in liquidity increasing or decreasing in anymaterial way.

The following table setsforth contractual obligations and other commitments representing required andpotential cash outflows as of December 31, 2005:

**Table 16—Contractual Obligations and Other Commitments**

| ** **                                         | ** ** | **December 31, 2005**      | ** ** |
|----------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                         | ** ** | **Total**                            | ** ** | **One year or  less** | ** ** | **After one  year through  three years** | ** ** | **After three  years through  five years** | ** ** | **After five  years** | ** ** |
| ** **                                         | ** ** | **(Dollars in thousands)** | ** ** |
| Minimum annual  operating leases                   |       | $                                    | 18,374     |   |   | $ | 1,993 |   |   |   | $ | 3,546 |   |   |   | $ | 2,966 |   |   | $ | 9,869 |   |
| Remaining  contractual maturities of time deposits |       | 756,658                              |       |   | 406,137 |   |   |   | 272,713 |   |   |   | 77,777 |   |   | 31 |   |
| Long-term  borrowings and subordinated debt        |       | 349,298                              |       |   | 40,000 |   |   |   | 113,000 |   |   |   | 54,750 |   |   | 141,548 |   |
| Unfunded home  equity lines of credit(1)           |       | 271,954                              |       |   | 2,204 |   |   |   | 1,982 |   |   |   | 23,518 |   |   | 244,250 |   |
| Unfunded other  loan lines of credit               |       | 442,494                              |       |   | 382,687 |   |   |   | 52,460 |   |   |   | 7,347 |   |   | — |   |
| Unfunded residential  mortgages                    |       | 7,586                                |       |   | 7,586 |   |   |   | — |   |   |   | — |   |   | — |   |
| Standby letters  of credit                         |       | 21,661                               |       |   | 16,006 |   |   |   | 4,038 |   |   |   | 41 |   |   | 1,576 |   |
| Total                                              |       | $                                    | 1,868,025  |   |   | $ | 856,613 |   |   |   | $ | 447,739 |   |   |   | $ | 166,399 |   |   | $ | 397,274 |   |

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(1)          Home equity lines ofcredit in the after five years category have no stated expiration.

The Bank also had commitments with customers to extendmortgage loans at a specified rate at December 31, 2005 and 2004 of$1.8 million and $5.1 million, respectively and commitments to sellmortgage loans at a specified rate at December 31, 2005 and 2004 of$1.1 million and $2.2 million, respectively. The commitments areaccounted for as a derivative and recorded at fair value. The Bank estimatesthe fair value of these commitments by comparing the secondary market price atthe reporting date to the price specified in the contract to extend or sell theloan initiated at the time of the loan commitment. At December 31, 2005and 2004, the fair values of the loan commitments were $320 and $5,000,respectively, which were recorded as other income.

During December 2004 and January 2005, theBank sold lease financing receivables of $10.5 million. Of these leases,$1.2 million were sold with full recourse and the remaining leases weresold subject to recourse with a maximum exposure of ten percent of theoutstanding receivable. The total recourse exposure at the time of the sale ofthe leases was $2.0 million. During the first quarter of 2005, the Bankrecorded a recourse liability of $216,000 which is the entire recourseliability recorded. This estimate was based on our historic losses asexperienced on similar lease financing receivables. After the first anniversaryof the sale agreement, and on a quarterly basis thereafter, upon writtenrequest by the Bank, the purchaser will review the portfolio performance andmay reduce the total exposure to an amount equal 

39

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to ten percent of theoutstanding net book value. The Corporation will be subject to the full andpartial recourse obligations until all the lease financing receivables havebeen paid or otherwise been terminated and all equipment has been sold ordisposed of. The final lease payment is due in 2010 with approximately 90% ofthe lease financing receivables estimated to be paid down by 2007. Theoutstanding balance of these sold leases at December 31, 2005 was $6.6million with a total recourse exposure of $1.4 million.

For information on knownuncertainties, see Item 1, “Business.”

**FourthQuarter 2005 Results (Unaudited)**

Net income for the fourth quarter of 2005 was $9.8million, as compared to $10.1 million for the fourth quarter of 2004.Diluted earnings per share of $.35 remained level with the earnings during thefourth quarter of 2004 and basic earnings per share were $.36 compared with$.37 for the fourth quarter of 2004.

Net interest income on a tax equivalent basis in thefourth quarter of 2005 remained level with the same period in 2004. During thefourth quarter of 2005, higher loan volume and loan rates were offset by higherdeposit and borrowing rates resulting in level net interest income. The net interest margin for the fourth quarterof 2004 was 3.16%, compared to 3.34% for the fourth quarter of 2004, thedecline being primarily due to higher funding costs, particularly inmoney-market deposit accounts and short-term borrowings. Average earningassets increased $148.6 million or 5.4% during the fourth quarter of 2005versus the comparable period in 2004. Average loans grew by $167.8 million or9.4% during the same period, partially offset by a decrease in investmentsecurities of $44.7 million or 4.7%.

Total noninterest income of $7.6 million for thefourth quarter of 2005 reflects a decrease of $1.8 million or 19.5% from thecomparable period in 2004. The decrease was primarily due to a reduction of $589,000in trust and investment advisory fees related to the sale of CumberlandAdvisors, Inc., which took place in the second quarter of this year, lowergains on sales of investment securities of $289,000 and life insurance incomeof $586,000 recognized in 2004.

Noninterest expense of $14.8 million for the fourthquarter of 2005 decreased $1.9 million or 11.4% from $16.7 million in thefourth quarter of 2004. The decrease in noninterest expense was mainly due to a$382,000 decrease in salaries and benefits expense related to the sale ofCumberland Advisors, Inc. and lower bonus expense of $1.1 million.

40

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The following is thesummarized (unaudited) consolidated quarterly financial data of the Corporationwhich, in the opinion of management, reflects all adjustments, consisting only ofnormal recurring adjustments, necessary for fair presentation of theCorporation’s results of operations:

**Table 17—Selected Quarterly Financial Data (Unaudited)**

| ** **                                               | ** ** | **Three Months Ended 2005**                                             | ** ** | **Three Months Ended 2004** | ** ** |
|----------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                               | ** ** | **Dec. 31**                                                                       | ** ** | **Sept. 30**                          | ** ** | **June 30** | ** ** | **March 31** | ** ** | **Dec. 31** | ** ** | **Sept. 30** | ** ** | **June 30** | ** ** | **March 31** | ** ** |
| ** **                                               | ** ** | **(Dollars in thousands, except per share information)** | ** ** |
| **Interest  income**                                     | ** ** | **$**                                                                                  | **41,008** | ** **                                 | **$**      | **38,570** | ** ** | **$** | **36,889** | ** ** |   | **$** | **35,272** |   |   | $ | 34,196 |   | $ | 33,366 |   | $ | 30,994 |   |   | $ | 29,173 |   |   |
| **Interest  expense**                                    | ** ** | **19,148**                                                                             | ** ** | **16,826**                                 | ** ** | **15,042** | ** ** |   | **13,602** |   |   | 12,735 |   | 11,286 |   | 9,674 |   |   | 8,943 |   |   |
| **Net  interest income**                                 | ** ** | **21,860**                                                                             | ** ** | **21,744**                                 | ** ** | **21,847** | ** ** |   | **21,670** |   |   | 21,461 |   | 22,080 |   | 21,320 |   |   | 20,230 |   |   |
| **Provision  for loan  losses**                          | ** ** | **1,351**                                                                              | ** ** | **650**                                    | ** ** | **650** | ** ** |   | **750** |   |   | 1,070 |   | 499 |   | 497 |   |   | 489 |   |   |
| **Net  interest income after provision for loan losses** | ** ** | **20,509**                                                                             | ** ** | **21,094**                                 | ** ** | **21,197** | ** ** |   | **20,920** |   |   | 20,391 |   | 21,581 |   | 20,823 |   |   | 19,741 |   |   |
| **Noninterest  income**                                  | ** ** | **7,565**                                                                              | ** ** | **7,730**                                  | ** ** | **7,752** | ** ** |   | **6,943** |   |   | 9,395 |   | 6,693 |   | 6,287 |   |   | 5,783 |   |   |
| **Noninterest  expense**                                 | ** ** | **14,770**                                                                             | ** ** | **15,313**                                 | ** ** | **16,893** | ** ** |   | **15,503** |   |   | 16,674 |   | 14,477 |   | 14,593 |   |   | 13,817 |   |   |
| **Income  before income tax expense**                    | ** ** | **13,304**                                                                             | ** ** | **13,511**                                 | ** ** | **12,056** | ** ** |   | **12,360** |   |   | 13,112 |   | 13,797 |   | 12,517 |   |   | 11,707 |   |   |
| **Income  tax expense**                                  | ** ** | **3,493**                                                                              | ** ** | **3,349**                                  | ** ** | **2,366** | ** ** |   | **3,195** |   |   | 2,999 |   | 3,632 |   | 3,135 |   |   | 2,800 |   |   |
| **Net  income**                                          | ** ** | **$**                                                                                  | **9,811**  | ** **                                 | **$**      | **10,162** | ** ** | **$** | **9,690** | ** ** |   | **$** | **9,165** |   |   | $ | 10,113 |   | $ | 10,165 |   | $ | 9,382 |   |   | $ | 8,907 |   |   |
| **Net  income per share(1)**                             | ** ** | ** **                                                                             | ** ** | ** **                                 | ** ** | ** ** | ** ** |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |
| **Basic**                                                | ** ** | **$**                                                                                  | **0.36**   | ** **                                 | **$**      | **0.37** | ** ** | **$** | **0.35** | ** ** |   | **$** | **0.33** |   |   | $ | 0.37 |   | $ | 0.37 |   | $ | 0.34 |   |   | $ | 0.34 |   |   |
| **Diluted**                                              | ** ** | **$**                                                                                  | **0.35**   | ** **                                 | **$**      | **0.36** | ** ** | **$** | **0.35** | ** ** |   | **$** | **0.32** |   |   | $ | 0.35 |   | $ | 0.36 |   | $ | 0.33 |   |   | $ | 0.33 |   |   |

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(1)          Adjustedfor five percent stock dividend effective 9/15/05 and 9/15/04.

**Item 7A.**                Quantitativeand Qualitative Disclosures about Market Risk

In the normal course of conducting businessactivities, the Corporation is exposed to market risk, principally interestrisk, through the operations of its banking subsidiary. Interest rate riskarises from market driven fluctuations in interest rates that affect cashflows, income, expense and values of financial instruments. The Asset/LiabilityCommittee, using policies and procedures approved by the Bank’s Board ofDirectors, is responsible for managing the rate sensitivity position.

No material changes in market risk strategy occurredduring the fourth quarter of 2005. Information on quantitative and qualitativedisclosures about market risk is incorporatedby reference to the discussion contained in Item 7, under the caption “InterestRate Sensitivity,” and Table 14, “Contractual Repricing Data of InterestSensitive Assets and Liabilities,” and Table 15, “Market Value of Equity.”

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**Item 8.**                        FinancialStatements and Supplementary Data

**HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                           | ** ** | **December 31,**                | ** **    |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|---------------|
| ** **                                                                                                                           | ** ** | **2005**                             | ** **    | **2004** | ** ** |
| ** **                                                                                                                           | ** ** | **(Dollars in thousands)** | ** **    |
| **Assets**                                                                                                                           |       |                                 |          |   |   |
| Cash and due from  banks                                                                                                             | ** ** | **$**                                | **57,756**    |   | $ | 50,699 |   |
| Federal funds sold  and securities purchased under agreements to resell                                                              | ** ** | **35,000**                           |          | 52,000 |   |
| Interest-bearing  deposits in banks                                                                                                  | ** ** | **2,455**                            |          | 4,291 |   |
| Total cash and  cash equivalents                                                                                                     | ** ** | **95,211**                           |          | 106,990 |   |
| Residential  mortgage loans held for sale                                                                                            | ** ** | **2,028**                            |          | 1,236 |   |
| Investment  securities available for sale                                                                                            | ** ** | **841,653**                          |          | 874,732 |   |
| Investment  securities held to maturity (market value $59,753 and $69,704, respectively)                                             | ** ** | **59,555**                           |          | 68,831 |   |
| Loans and leases                                                                                                                     | ** ** | **1,983,465**                        |          | 1,844,566 |   |
| Less: Allowance  for loan losses                                                                                                     | ** ** | **(19,865**                          | **)**         | (18,455 | ) |
| Net loans                                                                                                                            | ** ** | **1,963,600**                        |          | 1,826,111 |   |
| Premises and  equipment, net                                                                                                         | ** ** | **27,570**                           |          | 26,963 |   |
| Accrued interest  receivable                                                                                                         | ** ** | **13,282**                           |          | 12,089 |   |
| Net assets in  foreclosure                                                                                                           | ** ** | **29**                               |          | 370 |   |
| Goodwill                                                                                                                             | ** ** | **31,552**                           |          | 32,548 |   |
| Intangible assets,  net                                                                                                              | ** ** | **4,031**                            |          | 4,168 |   |
| Bank-owned  life insurance                                                                                                           | ** ** | **59,334**                           |          | 52,109 |   |
| Other assets                                                                                                                         | ** ** | **19,514**                           |          | 18,368 |   |
| Total assets                                                                                                                         | ** ** | **$**                                | **3,117,359** |   | $ | 3,024,515 |   |
| **Liabilities and Shareholders’ Equity**                                                                                        | ** ** | ** **                           |          |   |   |
| Deposits                                                                                                                             | ** ** | ** **                           |          |   |   |
| Noninterest-bearing                                                                                                                  | ** ** | **$**                                | **363,440**   |   | $ | 333,516 |   |
| Interest-bearing:                                                                                                                    | ** ** | ** **                           |          |   |   |
| Checking accounts                                                                                                                    | ** ** | **387,374**                          |          | 305,584 |   |
| Money market  accounts                                                                                                               | ** ** | **667,952**                          |          | 713,039 |   |
| Savings                                                                                                                              | ** ** | **190,033**                          |          | 223,039 |   |
| Time, under  $100,000                                                                                                                | ** ** | **538,564**                          |          | 508,010 |   |
| Time, $100,000 or  greater                                                                                                           | ** ** | **218,094**                          |          | 129,375 |   |
| Total deposits                                                                                                                       | ** ** | **2,365,457**                        |          | 2,212,563 |   |
| Federal funds  purchased and securities sold under agreements to repurchase                                                          | ** ** | **88,118**                           |          | 142,445 |   |
| Other short-term  borrowings                                                                                                         | ** ** | **1,752**                            |          | 47,213 |   |
| Long-term  borrowings                                                                                                                | ** ** | **297,750**                          |          | 272,750 |   |
| Accrued interest  payable                                                                                                            | ** ** | **28,276**                           |          | 26,613 |   |
| Subordinated debt                                                                                                                    | ** ** | **51,548**                           |          | 25,774 |   |
| Other liabilities                                                                                                                    | ** ** | **11,226**                           |          | 26,625 |   |
| Total liabilities                                                                                                                    | ** ** | **2,844,127**                        |          | 2,753,983 |   |
| Shareholders’ equity:                                                                                                           | ** ** | ** **                           |          |   |   |
| Series preferred  stock, par value $1 per share; authorized 8,000,000 shares, none issued                                       | ** ** | **—**                           |          | — |   |
| Common stock, par  value $1 per share; authorized 75,000,000 shares; issued 27,500,407 shares in  2005 and 27,319,988 shares in 2004 | ** ** | **27,500**                           |          | 27,320 |   |
| Additional paid-in  capital                                                                                                          | ** ** | **167,418**                          |          | 160,039 |   |
| Retained earnings                                                                                                                    | ** ** | **88,285**                           |          | 99,730 |   |
| Accumulated other  comprehensive income (loss)                                                                                       | ** ** | **(8,618**                           | **)**         | 1,243 |   |
| Treasury stock, at  cost: 64,700 shares in 2005 and 1,042,734 shares in 2004                                                         | ** ** | **(1,353**                           | **)**         | (17,800 | ) |
| Total  shareholders’ equity                                                                                                     | ** ** | **273,232**                          |          | 270,532 |   |
| Total liabilities  and shareholders’ equity                                                                                     | ** ** | **$**                                | **3,117,359** |   | $ | 3,024,515 |   |

 

See accompanying notes to consolidated financial statements.

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**HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OFINCOME**

| ** **                                                                         | ** ** | **Year Ended December 31,**                                      | ** **  |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|-------------|
| ** **                                                                         | ** ** | **2005**                                                                        | ** **  | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                         | ** ** | **(Dollars in thousands, except per share data)** | ** **  |
| **Interest income**                                                                |       |                                                                            |        |   |   |   |   |
| Loans, including  fees                                                             | ** ** | **$**                                                                           | **113,240** |   | $ | 88,079 |   | $ | 79,064 |   |
| Lease financing                                                                    | ** ** | **2,093**                                                                       |        | 4,439 |   | 6,582 |   |
| Investment securities:                                                             | ** ** | ** **                                                                      |        |   |   |   |   |
| Taxable                                                                            | ** ** | **23,923**                                                                      |        | 23,891 |   | 18,697 |   |
| Exempt from federal taxes                                                          | ** ** | **10,846**                                                                      |        | 10,796 |   | 14,509 |   |
| Federal funds sold  and securities purchased under agreements to resell  | ** ** | **1,451**                                                                       |        | 489 |   | 244 |   |
| Deposits in banks                                                                  | ** ** | **186**                                                                         |        | 35 |   | 104 |   |
| Total interest income                                                              | ** ** | **151,739**                                                                     |        | 127,729 |   | 119,200 |   |
| **Interest expense**                                                               | ** ** | ** **                                                                      |        |   |   |   |   |
| Savings and money  market deposits                                                 | ** ** | **22,319**                                                                      |        | 9,871 |   | 7,777 |   |
| Time, under  $100,000                                                              | ** ** | **18,516**                                                                      |        | 17,662 |   | 18,999 |   |
| Time, $100,000 or  greater                                                         | ** ** | **5,814**                                                                       |        | 3,240 |   | 4,304 |   |
| Short-term  borrowings                                                             | ** ** | **3,972**                                                                       |        | 1,381 |   | 946 |   |
| Long-term  borrowings                                                              | ** ** | **13,997**                                                                      |        | 10,484 |   | 8,053 |   |
| Total interest expense                                                             | ** ** | **64,618**                                                                      |        | 42,638 |   | 40,079 |   |
| Net interest income                                                                | ** ** | **87,121**                                                                      |        | 85,091 |   | 79,121 |   |
| Provision for loan  losses                                                         | ** ** | **3,401**                                                                       |        | 2,555 |   | 3,200 |   |
| Net interest income after  provision for loan losses                               | ** ** | **83,720**                                                                      |        | 82,536 |   | 75,921 |   |
| **Noninterest income**                                                             | ** ** | ** **                                                                      |        |   |   |   |   |
| Service charges                                                                    | ** ** | **8,202**                                                                       |        | 7,807 |   | 7,855 |   |
| Gains on sales of  investment securities, net                                      | ** ** | **4,794**                                                                       |        | 3,689 |   | 6,613 |   |
| Gain on sale of  branch                                                            | ** ** | **690**                                                                         |        | — |   | — |   |
| Trust, investment  services and advisory income                                    | ** ** | **6,651**                                                                       |        | 6,586 |   | 3,837 |   |
| Bank-owned  life insurance income                                                  | ** ** | **2,234**                                                                       |        | 2,406 |   | 2,615 |   |
| Income on life  insurance                                                          | ** ** | **177**                                                                         |        | 586 |   | 1,119 |   |
| Other income                                                                       | ** ** | **7,242**                                                                       |        | 7,084 |   | 5,599 |   |
| Total noninterest income                                                           | ** ** | **29,990**                                                                      |        | 28,158 |   | 27,638 |   |
| Net interest income after  provision for loan losses and noninterest income   | ** ** | **113,710**                                                                     |        | 110,694 |   | 103,559 |   |
| **Noninterest expense**                                                            | ** ** | ** **                                                                      |        |   |   |   |   |
| Salaries, wages  and employee benefits                                             | ** ** | **37,441**                                                                      |        | 37,080 |   | 31,173 |   |
| Occupancy                                                                          | ** ** | **5,176**                                                                       |        | 4,557 |   | 3,770 |   |
| Furniture and  equipment                                                           | ** ** | **4,231**                                                                       |        | 4,863 |   | 4,995 |   |
| Marketing                                                                          | ** ** | **2,506**                                                                       |        | 2,262 |   | 1,191 |   |
| Prepayment fee                                                                     | ** ** | **—**                                                                      |        | — |   | 2,594 |   |
| Other expense                                                                      | ** ** | **13,125**                                                                      |        | 10,799 |   | 15,806 |   |
| Total noninterest expense                                                          | ** ** | **62,479**                                                                      |        | 59,561 |   | 59,529 |   |
| Income before  income tax expense                                                  | ** ** | **51,231**                                                                      |        | 51,133 |   | 44,030 |   |
| Income tax expense                                                                 | ** ** | **12,403**                                                                      |        | 12,566 |   | 8,697 |   |
| Net income                                                                         | ** ** | **$**                                                                           | **38,828**  |   | $ | 38,567 |   | $ | 35,333 |   |
| Net income per share information:                                                  | ** ** | ** **                                                                      |        |   |   |   |   |
| Basic                                                                              | ** ** | **$**                                                                           | **1.41**    |   | $ | 1.42 |   | $ | 1.35 |   |
| Diluted                                                                            | ** ** | **$**                                                                           | **1.38**    |   | $ | 1.37 |   | $ | 1.30 |   |
| Cash dividends per  share                                                          | ** ** | **$**                                                                           | **0.75**    |   | $ | 0.68 |   | $ | 0.59 |   |
| Weighted average number of common shares:                                          | ** ** | ** **                                                                      |        |   |   |   |   |
| Basic                                                                              | ** ** | **27,515,630**                                                                  |        | 27,147,992 |   | 26,244,807 |   |
| Diluted                                                                            | ** ** | **28,085,920**                                                                  |        | 28,062,489 |   | 27,148,029 |   |

 

See accompanying notes to consolidated financial statements.

43

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**HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTSOF SHAREHOLDERS’ EQUITY**

| ** **                                                             | ** ** | **Common  Stock**                                                         | ** ** | **Treasury  Stock** | ** ** | **Common**     | ** ** | ** **                | ** ** | ** **             | ** ** | **  Accumulated **     | ** ** | ** **          | ** ** | ** ** | ** **  | ** **                            | ** **  |       |
|------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|---------------------|------------|----------------|------------|---------------------------|------------|------------------------|------------|---------------------------------------|------------|---------------------|------------|------------|-------------|---------------------------------------|-------------|------------|
| ** **                                                             | ** ** | **Number**                                                                | ** ** | **Number**          | ** ** | **Stock**      | ** ** | **Additional**            | ** ** | ** **             | ** ** | **Other **                       | ** ** | ** **          | ** ** | ** ** | ** **  | ** **                            | ** **  |       |
| ** **                                                             | ** ** | **of  Shares**                                                            | ** ** | **of  Shares**      | ** ** | **Par  Value** | ** ** | **Paid in  Capital** | ** ** | **Retained  Earnings** | ** ** | **Comprehensive  Income (Loss)** | ** ** | **Treasury  Stock** | ** ** | **Total**  | ** **  | **Comprehensive  Income (Loss)** | ** **  |       |
| ** **                                                             | ** ** | **(Dollars and share information in thousands)** | ** ** |                |
| Balance  January 1, 2003                                          |       |                                                                      | 19,597     | ** **          |       |           | (569       | )                         |       |                   | $          | 19,597                                | ** ** |                |       | $          | 96,585      |                                  |        |       | $ | 94,677 |   |   |   | $ | 6,937 |   |   |   | $ | (11,590 | ) |   | $ | 206,206 |   |   |   |   |   |
| Issuance of stock  for stock options, net of tax  benefits             |       |                                                                      | 142        | ** **          |       |           | —     |                      |       |                   | 142        | ** **                            |       |                | 2,055      |       |        |                                  | —      |       |   |   | — |   |   |   | — |   |   | 2,197 |   |   |   |   |   |
| Issuance of stock  for stock awards                                    |       |                                                                      | —     | ** **          |       |           | —     |                      |       |                   | —     | ** **                            |       |                | 6          |       |        |                                  | —      |       |   |   | — |   |   |   | — |   |   | 6 |   |   |   |   |   |
| Stock dividend                                                         |       |                                                                      | 4,929      | ** **          |       |           | (165       | )                         |       |                   | 4,929      | ** **                            |       |                | —     |       |        |                                  | (4,942      | )          |   |   | — |   |   |   | — |   |   | (13 | ) |   |   |   |   |
| Net income                                                             |       |                                                                      | —     | ** **          |       |           | —     |                      |       |                   | —     | ** **                            |       |                | —     |       |        |                                  | 35,333      |       |   |   | — |   |   |   | — |   |   | 35,333 |   |   | $ | 35,333 |   |   |
| Other  comprehensive income, net of reclassifications and tax     |       |                                                                      | —     | ** **          |       |           | —     |                      |       |                   | —     | ** **                            |       |                | —     |       |        |                                  | —      |       |   |   | 1,161 |   |   |   | — |   |   | 1,161 |   |   | 1,161 |   |   |
| Purchases of  treasury stock                                           |       |                                                                      | —     | ** **          |       |           | (89        | )                         |       |                   | —     | ** **                            |       |                | —     |       |        |                                  | —      |       |   |   | — |   |   |   | (2,271 | ) |   | (2,271 | ) |   |   |   |   |
| Cash dividends                                                         |       |                                                                      | —     | ** **          |       |           | —     |                      |       |                   | —     | ** **                            |       |                | —     |       |        |                                  | (15,566     | )          |   |   | — |   |   |   | — |   |   | (15,566 | ) |   |   |   |   |
| Comprehensive  income                                                  |       |                                                                      |       | ** **          |       |           |       |                      |       |                   |       | ** **                            |       |                |       |       |        |                                  |        |       |   |   |   |   |   |   |   |   |   |   |   |   | $ | 36,494 |   |   |
| Balance  December 31, 2003                                   |       |                                                                      | 24,668     | ** **          |       |           | (823       | )                         |       |                   | 24,668     | ** **                            |       |                | 98,646     |       |        |                                  | 109,502     |       |   |   | 8,098 |   |   |   | (13,861 | ) |   | 227,053 |   |   |   |   |   |
| Issuance of stock  for stock options, net of tax  benefits             |       |                                                                      | 411        | ** **          |       |           | —     |                      |       |                   | 411        | ** **                            |       |                | 4,832      |       |        |                                  | —      |       |   |   | — |   |   |   | — |   |   | 5,243 |   |   |   |   |   |
| Issuance of stock  for stock awards                                    |       |                                                                      | —     | ** **          |       |           | —     |                      |       |                   | —     | ** **                            |       |                | 7          |       |        |                                  | —      |       |   |   | — |   |   |   | — |   |   | 7 |   |   |   |   |   |
| Stock dividend                                                         |       |                                                                      | 1,295      | ** **          |       |           | (46        | )                         |       |                   | 1,295      | ** **                            |       |                | 28,456     |       |        |                                  | (29,764     | )          |   |   | — |   |   |   | — |   |   | (13 | ) |   |   |   |   |
| Net income                                                             |       |                                                                      | —     | ** **          |       |           | —     |                      |       |                   | —     | ** **                            |       |                | —     |       |        |                                  | 38,567      |       |   |   | — |   |   |   | — |   |   | 38,567 |   |   | $ | 38,567 |   |   |
| Other  comprehensive loss, net of reclassifications and tax  |       |                                                                      | —     | ** **          |       |           | —     |                      |       |                   | —     | ** **                            |       |                | —     |       |        |                                  | —      |       |   |   | (6,855 | ) |   |   | — |   |   | (6,855 | ) |   | (6,855 | ) |   |
| Issuance of common  stock for acquisition of Millennium Bank           |       |                                                                      | 946        | ** **          |       |           | —     |                      |       |                   | 946        | ** **                            |       |                | 27,974     |       |        |                                  | —      |       |   |   | — |   |   |   | — |   |   | 28,920 |   |   |   |   |   |
| Purchases of  treasury stock                                           |       |                                                                      | —     | ** **          |       |           | (190       | )                         |       |                   | —     | ** **                            |       |                | 399        |       |        |                                  | —      |       |   |   | — |   |   |   | (4,214 | ) |   | (3,815 | ) |   |   |   |   |
| Sale of treasury  stock                                                |       |                                                                      | —     | ** **          |       |           | 16         |                      |       |                   | —     | ** **                            |       |                | (275       | )          |        |                                  | —      |       |   |   | — |   |   |   | 275 |   |   | — |   |   |   |   |   |
| Cash dividends                                                         |       |                                                                      | —     | ** **          |       |           | —     |                      |       |                   | —     | ** **                            |       |                | —     |       |        |                                  | (18,575     | )          |   |   | — |   |   |   | — |   |   | (18,575 | ) |   |   |   |   |
| Comprehensive  income                                                  |       |                                                                      |       | ** **          |       |           |       |                      |       |                   |       | ** **                            |       |                |       |       |        |                                  |        |       |   |   |   |   |   |   |   |   |   |   |   |   | $ | 31,712 |   |   |
| Balance  December 31, 2004                                   |       |                                                                      | 27,320     | ** **          |       |           | (1,043     | )                         |       |                   | 27,320     | ** **                            |       |                | 160,039    |       |        |                                  | 99,730      |       |   |   | 1,243 |   |   |   | (17,800 | ) |   | 270,532 |   |   |   |   |   |
| **Issuance  of stock for stock options, net of tax benefits**     | ** ** | ** **                                                                | **142**    | ** **          | ** ** | ** **     | **153**    | ** **                | ** ** | ** **             | **142**    | ** **                            | ** ** | ** **          | **1,284**  | ** ** | ** **  | ** **                            | **—**  | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **3,027** | ** ** | ** ** | **4,453** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Issuance  of stock for stock awards**                                | ** ** | ** **                                                                | **—** | ** **          | ** ** | ** **     | **—** | ** **                | ** ** | ** **             | **—** | ** **                            | ** ** | ** **          | **5**      | ** ** | ** **  | ** **                            | **—**  | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | **5** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Stock  dividend**                                                    | ** ** | ** **                                                                | **38**     | ** **          | ** ** | ** **     | **1,272**  | ** **                | ** ** | ** **             | **38**     | ** **                            | ** ** | ** **          | **6,090**  | ** ** | ** **  | ** **                            | **(29,535** | **)**      | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **23,392** | ** ** | ** ** | **(15** | **)** | ** ** | ** ** | ** ** | ** ** |
| **Net  income**                                                        | ** ** | ** **                                                                | **—** | ** **          | ** ** | ** **     | **—** | ** **                | ** ** | ** **             | **—** | ** **                            | ** ** | ** **          | **—** | ** ** | ** **  | ** **                            | **38,828**  | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | **38,828** | ** ** | ** ** | **$** | **38,828** | ** ** | ** ** |
| **Other  comprehensive loss, net of reclassifications and tax**   | ** ** | ** **                                                                | **—** | ** **          | ** ** | ** **     | **—** | ** **                | ** ** | ** **             | **—** | ** **                            | ** ** | ** **          | **—** | ** ** | ** **  | ** **                            | **—**  | ** ** | ** ** | ** ** | **(9,861** | **)** | ** ** | ** ** | **—** | ** ** | ** ** | **(9,861** | **)** | ** ** | **(9,861** | **)** | ** ** |
| **Purchases  of treasury stock**                                       | ** ** | ** **                                                                | **—** | ** **          | ** ** | ** **     | **(446**   | **)**                     | ** ** | ** **             | **—** | ** **                            | ** ** | ** **          | **—** | ** ** | ** **  | ** **                            | **—**  | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **(9,972** | **)** | ** ** | **(9,972** | **)** | ** ** | ** ** | ** ** | ** ** |
| **Cash  dividends**                                                    | ** ** | ** **                                                                | **—** | ** **          | ** ** | ** **     | **—** | ** **                | ** ** | ** **             | **—** | ** **                            | ** ** | ** **          | **—** | ** ** | ** **  | ** **                            | **(20,738** | **)**      | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | **(20,738** | **)** | ** ** | ** ** | ** ** | ** ** |
| **Comprehensive  income**                                              | ** ** | ** **                                                                | ** ** | ** **          | ** ** | ** **     | ** ** | ** **                | ** ** | ** **             | ** ** | ** **                            | ** ** | ** **          | ** ** | ** ** | ** **  | ** **                            | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **$** | **28,967** | ** ** | ** ** |
| **Balance  December 31, 2005**                                    | ** ** | ** **                                                                | **27,500** | ** **          | ** ** | ** **     | **(64**    | **)**                     | ** ** | ** **             | **$**      | **27,500**                            | ** ** | ** **          | ** ** | **$**      | **167,418** | ** **                            | ** **  | ** ** | **$** | **88,285** | ** ** | ** ** | ** ** | **$** | **(8,618** | **)** | ** ** | ** ** | **$** | **(1,353** | **)** | ** ** | **$** | **273,232** | ** ** | ** ** | ** ** | ** ** | ** ** |

 

 

See accompanying notes to consolidated financial statements.

44

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**HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS**

| ** **                                                                                               | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                               | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                               | ** ** | **(Dollars in thousands)**       | ** ** |
| **Operating activities**                                                                                 |       |                                       |       |   |   |   |   |
| Net income                                                                                               | ** ** | **$**                                      | **38,828** |   | $ | 38,567 |   | $ | 35,333 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities:                       | ** ** | ** **                                 |       |   |   |   |   |
| Provision for loan losses                                                                                | ** ** | **3,401**                                  |       | 2,555 |   | 3,200 |   |
| Depreciation and  amortization                                                                           | ** ** | **3,909**                                  |       | 4,178 |   | 3,124 |   |
| Net amortization of  investment securities discounts/premiums                                            | ** ** | **5,890**                                  |       | 6,011 |   | 9,609 |   |
| Deferred income expense  (benefit)                                                                       | ** ** | **(5,530**                                 | **)**      | (3,582 | ) | (2,930 | ) |
| Gains on sales of  investment securities, net                                                            | ** ** | **(4,794**                                 | **)**      | (3,689 | ) | (6,613 | ) |
| Gain on sale of branch                                                                                   | ** ** | **(690**                                   | **)**      | — |   | — |   |
| Gain on sale of bank  subsidiary                                                                         | ** ** | **(287**                                   | **)**      | — |   | — |   |
| Net (increase) decrease in  accrued interest receivable                                                  | ** ** | **(1,205**                                 | **)**      | (985 | ) | 2,971 |   |
| Net increase in accrued  interest payable                                                                | ** ** | **2,039**                                  |       | 3,183 |   | 929 |   |
| Net (increase) decrease  in other assets                                                                 | ** ** | **3,205**                                  |       | (2,997 | ) | 958 |   |
| Net increase (decrease)  in other liabilities                                                            | ** ** | **(8,850**                                 | **)**      | 6,416 |   | (246 | ) |
| Other, net                                                                                               | ** ** | **45**                                     |       | 7 |   | 6 |   |
| Net cash provided by  operating activities                                                               | ** ** | **35,961**                                 |       | 49,664 |   | 46,341 |   |
| **Investing activities**                                                                                 | ** ** | ** **                                 |       |   |   |   |   |
| Proceeds from  sales of investment securities available for sale                                         | ** ** | **273,919**                                |       | 1,348,441 |   | 1,233,050 |   |
| Proceeds, maturity  or calls of investment securities held to maturity                                   | ** ** | **9,243**                                  |       | 5,040 |   | 2,811 |   |
| Proceeds, maturity  or calls of investment securities available for sale                                 | ** ** | **196,161**                                |       | 260,892 |   | 594,762 |   |
| Purchases of  investment securities held to maturity                                                     | ** ** | **—**                                 |       | (3,826 | ) | — |   |
| Purchases of  investment securities available for sale                                                   | ** ** | **(454,254**                               | **)**      | (1,607,251 | ) | (1,784,799 | ) |
| Net increase in  loans                                                                                   | ** ** | **(147,029**                               | **)**      | (283,337 | ) | (80,513 | ) |
| Net cash paid in  sale of branch                                                                         | ** ** | **(7,431**                                 | **)**      | — |   | — |   |
| Net cash received  from sale of bank subsidiary                                                          | ** ** | **1,931**                                  |       | — |   | — |   |
| Net cash paid due  to acquisition, net of cash acquired                                                  | ** ** | **—**                                 |       | (18,439 | ) | — |   |
| Net increase in  premises and equipment                                                                  | ** ** | **(4,707**                                 | **)**      | (5,244 | ) | (4,808 | ) |
| Purchase of  bank-owned life insurance                                                                   | ** ** | **(5,000**                                 | **)**      | — |   | — |   |
| Net increase in  bank-owned life insurance                                                               | ** ** | **(2,225**                                 | **)**      | (1,416 | ) | (2,062 | ) |
| Proceeds from  sales of other real estate                                                                | ** ** | **466**                                    |       | 1,085 |   | 1,232 |   |
| Net cash used in  investing activities                                                                   | ** ** | **(138,926**                               | **)**      | (304,055 | ) | (40,327 | ) |
| **Financing activities**                                                                                 | ** ** | ** **                                 |       |   |   |   |   |
| Net increase  (decrease) in deposits                                                                     | ** ** | **166,472**                                |       | 82,234 |   | (741 | ) |
| Increase  (decrease) in federal funds purchased and securities sold under agreements  to repurchase | ** ** | **(54,327**                                | **)**      | 55,633 |   | (8,850 | ) |
| Increase  (decrease) in short-term borrowings                                                            | ** ** | **(45,461**                                | **)**      | 42,198 |   | — |   |
| Advances of long-term  borrowings                                                                        | ** ** | **25,000**                                 |       | 83,000 |   | 10,000 |   |
| Advances of  subordinated debt                                                                           | ** ** | **25,774**                                 |       | 20,619 |   | — |   |
| Cash dividends                                                                                           | ** ** | **(20,738**                                | **)**      | (18,575 | ) | (15,566 | ) |
| Repurchase of  common stock                                                                              | ** ** | **(9,972**                                 | **)**      | (3,815 | ) | (2,271 | ) |
| Proceeds from the  exercise of stock options                                                             | ** ** | **4,453**                                  |       | 5,243 |   | 2,197 |   |
| Other, net                                                                                               | ** ** | **(15**                                    | **)**      | (13 | ) | (13 | ) |
| Net cash provided by  (used in) financing activities                                                     | ** ** | **91,186**                                 |       | 266,524 |   | (15,244 | ) |
| Net increase  (decrease) in cash and cash equivalents                                                    | ** ** | **(11,779**                                | **)**      | 12,133 |   | (9,230 | ) |
| Cash and cash  equivalents at beginning of year                                                          | ** ** | **106,990**                                |       | 94,857 |   | 104,087 |   |
| Cash and cash  equivalents at end of year                                                                | ** ** | **$**                                      | **95,211** |   | $ | 106,990 |   | $ | 94,857 |   |
| Cash paid during the year for:                                                                           | ** ** | ** **                                 |       |   |   |   |   |
| Interest                                                                                                 | ** ** | **$**                                      | **62,860** |   | $ | 39,994 |   | $ | 39,150 |   |
| Income taxes                                                                                             | ** ** | **$**                                      | **18,950** |   | $ | 10,600 |   | $ | 10,700 |   |
| Supplemental disclosure of noncash investing and  financing activities:                                  | ** ** | ** **                                 |       |   |   |   |   |
| Transfer of assets from  loans to other real estate owned                                                | ** ** | **$**                                      | **288**    |   | $ | 586 |   | $ | 1,777 |   |
| Transfer of investments  available for sale to investments held to maturity                              | ** ** | **—**                                 |       | 50,009 |   | — |   |
| Acquisition of Millennium Bank, common stock issued                                                      | ** ** | **—**                                 |       | 28,920 |   | — |   |

 

See accompanying notes to consolidated financial statements.

45

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 1—Summary of Significant Accounting Policies**

Harleysville National Corporation (the Corporation)through its subsidiary bank, Harleysville National Bank (the Bank), provides afull range of banking services including loans and deposits and investment management,and trust and investment advisory services to individual and corporatecustomers located in eastern Pennsylvania. HNC Financial Company and HNCReinsurance Company are wholly owned subsidiaries of the Corporation. HNCFinancial Company’s principal business function is to expand the investmentopportunities of the Corporation. HNC Reinsurance Company functions as areinsurer of consumer loan credit life and accident and health insurance. At March 26,2004, the charters of the Corporation’s subsidiary banks, Security NationalBank and Citizens National Bank, were combined into the largest subsidiary,Harleysville National Bank.

The Corporation and the Bank are subject toregulations of certain state and federal agencies and, accordingly, these regulatoryauthorities periodically examine the Corporation and the Bank. As a consequenceof the extensive regulation of commercial banking activities, the Corporation’sand the Bank’s businesses are susceptible to being affected by state andfederal legislation and regulations.

A summary of thesignificant accounting policies consistently applied in the preparation of theaccompanying consolidated financial statements follows.

*Principles ofConsolidation and Basis of Presentation*

The consolidated financial statements include theCorporation and its wholly owned subsidiaries, the Bank, HNC Financial Company,and HNC Reinsurance Company. All significant intercompany accounts andtransactions have been eliminated in consolidation and certain prior periodamounts have been reclassified to conform to current year presentation. Theaccounting and reporting policies of the Corporation and its subsidiariesconform with accounting principles generally accepted in the United States andgeneral practices within the financial services industry.

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amount of assets and liabilities as ofthe dates of the balance sheets and revenues and expenditures for the periodspresented. Actual results could differ from those estimates.

*Cash and CashEquivalents*

Cash and cash equivalentsinclude cash and due from banks, federal funds sold, securities purchased underagreements to resell and interest-bearing deposits in banks with anoriginal maturity of generally three months or less.

*InvestmentSecurities*

The Corporation accounts for securities underStatement of Financial Accounting Standards (SFAS) No. 115, “Accountingfor Certain Investments in Debt and Equity Securities.” Debt securities, whichmanagement has the intent and ability to hold until maturity, are classified asheld to maturity and reported at amortized cost, adjusted for amortization ofpremiums and accretion of discounts using the interest method over the life ofthe securities. Debt and equity securities expected to be held for anindefinite period of time are classified as available for sale and are statedat fair value with unrealized gains and losses excluded from earnings andreported in other comprehensive income, net of income taxes. The 

46

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note1—Summary of Significant Accounting Policies (Continued)**

Corporation receivesestimated fair values of debt securities from independent valuation servicesand brokers. In developing these fair values, the valuation services andbrokers use estimates of cash flows based on historical performance of similar instrumentsin similar rate environments.

Amortization of premiums and accretion of discountsfor investment securities available for sale and held to maturity are includedin interest income. Realized gains and losses on the sale of investmentsecurities are recognized using the specific identification method and areincluded in the consolidated statements of income.

In November 2005, theFASB issued FSP FAS Nos. 115-1 and FAS 124-1 “The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments,” togive guidance on determining when investments in certain debt and equitysecurities are considered impaired, whether that impairment is other thantemporary, and on measuring such impairment loss. This FSP nullifies certainrequirements of EITF Issue 03-1, “The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments” and supersedes EITFTopic No. D-44, “Recognition of Other-Than-Temporary Impairment uponthe Planned Sale of a Security Whose Cost Exceeds Fair Value.” This FSP nullifiesthe requirements of paragraphs 10-18 of Issue 03-1, carries forwardthe requirements of paragraphs 8 and 9 of Issue 03-1 with respect tocost-method investments, carries forward the disclosure requirements includedin paragraphs 21 and 22 of Issue 03-1 and related examples, andreferences existing other-than-temporary guidance. The guidance in this FSPwill apply to reporting periods beginning after December 15, 2005. Theadoption of this FSP is not expected to have a material impact on theCorporation’s results of operations or financial condition.

***Loans***

Loans that management intends to hold to maturity arestated at the principal amount outstanding. Net loans represent the principalloan amount outstanding net of deferred fees and costs, unearned income and theallowance for loan losses. Interest on loans is credited to income based on theprincipal amount outstanding.

Lease financing represents automobile and equipmentleasing. The lease financing receivable included in loans is stated at thegross amount of lease payments receivable, plus the residual value, less incometo be earned over the life of the leases. Income is recognized over the term ofthe leases using the level yield method.

Loan origination fees and direct loan originationcosts of completed loans are deferred and recognized over the life of the loanas an adjustment to the yield. The net loan origination fees recognized asyield adjustments are reflected in loan interest income in the consolidatedstatements of income and the unamortized balance of the net loan originationfees is reported in loans outstanding in the consolidated balance sheets.

Income recognition of interest on loans isdiscontinued when, in the opinion of management, the collectibility ofprincipal or interest becomes doubtful. A loan is generally classified asnonaccrual when principal or interest has consistently been in default for aperiod of 90 days or more or because of deterioration in the financialcondition of the borrower, and payment in full of principal or interest is notexpected. When a loan is placed on nonaccrual status, all accrued butuncollected interest is reversed from income. The Corporation recognizes incomeon nonaccrual loans under the cash basis when the loans are 

47

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note1—Summary of Significant Accounting Policies (Continued)**

both current and thecollateral on the loan is sufficient to cover the outstanding obligation to theCorporation. The Corporation will not recognize income if these factors do notexist. Loans past due 90 days or more and still accruing interest areloans that are generally well-secured and expected to be restored to a currentstatus in the near future.

A loan is considered impaired when, based on currentinformation and events, it is probable that the Corporation will be unable tocollect all amounts due, including principal and interest, according to thecontractual terms of the loan agreement. The Corporation accounts for impairedloans under SFAS No. 114, “Accounting by Creditors for Impairment ofa Loan”, as amended by SFAS No. 118, “Accounting by Creditors forImpairment of a Loan—Income Recognition and Disclosures.” Individually impairedloans are measured based on the present value of expected future cash flowsdiscounted at the loan’s effective interest rate, a loan’s observable marketprice, or the fair value of the collateral if the loan is collateral dependent.Regardless of the measurement method, impairment is based on the fair value ofthe collateral when foreclosure is probable. If the recorded investment inimpaired loans exceeds the measure of estimated fair value, a specificallowance is established as a component of the allowance for loan losses. TheCorporation’s policy for interest income recognition on impaired loans is torecognize income on restructured loans under the accrual method.

The Corporation follows FASB Interpretation No. 45,“Guarantor’s Accounting and Disclosure Requirements for Guarantees, includingIndirect Guarantees of Indebtedness of Others” (FIN 45). FIN 45 requires aguarantor entity, at the inception of a guarantee covered by the measurementprovisions of the interpretation, to record a liability for the fair value ofthe obligation undertaken in issuing the guarantee.

In October 2003, the AmericanInstitute of Certified Public Accountants issued Statement of Position No. 03-3,“Accounting for Loans or Certain Debt Securities Acquired in a Transfer” (SOP 03-3).SOP 03-3 requires impaired loans for which it is probable that theinvestor will be unable to collect all contractually required paymentsreceivable to be recorded at the present value of amounts expected to bereceived and prohibits carrying over or creation of valuation allowances in theinitial accounting for these loans. SOP 03-3 is effective for loansacquired in fiscal years beginning after December 15, 2004. Early adoptionis permitted. The adoption of SOP 03-3 did not have a material affect onthe Corporation’s financial position or results of operations.

*Allowance for LoanLosses*

The allowance for loanlosses is maintained at a level that management believes is sufficient toabsorb estimated probable credit losses. The allowance for loan losses is basedon estimated net realizable value unless it is probable that loans will be foreclosed,in which case the allowance for loan losses is based on the fair value of thecollateral less selling costs. Management’s determination of the adequacy ofthe allowance is based on periodic evaluations of the loan portfolio and otherrelevant factors. However, this evaluation is inherently subjective as itrequires significant estimates by management. Consideration is given to avariety of factors in establishing these estimates including current andanticipated economic conditions, diversification of the loan portfolio,delinquency statistics, results of internal loan review, borrowers’ perceivedfinancial and management strengths, the adequacy of underlying collateral, thedependence on collateral, or the strength of the present value of future cashflows and other relevant factors. These factors may be susceptible tosignificant change. To the extent actual outcomes differ from managementestimates, additional provisions for loan losses may be required which mayadversely affect 

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note1—Summary of Significant Accounting Policies (Continued)**

theCorporation’s results of operations in the future. In addition, variousregulatory agencies, as an integral part of their examination process,periodically review the allowance for loan losses. Such agencies may requirethe Corporation to recognize additions to the allowance based on their judgmentof information available to them at the time of their examination.

*Mortgage Servicing*

The Corporation performs various servicing functionson mortgage loans owned by others. A fee, usually based on a percentage of theoutstanding principal balance of the loan, is received for these services.

The Corporation accounts for its transfers andservicing financial assets in accordance with SFAS No. 140, “Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities.” The Corporation originates mortgages under a definitive plan tosell or securitize those loans and service the loans owned by the investor. TheCorporation initially measures servicing assets retained in a sale orsecuritization of the assets being serviced at their allocated previouscarrying amount based on relative fair values at the date of the sale orsecuritization. Servicing assets purchased or assumed rather than undertaken ina sale or securitization of the financial assets being serviced, are measuredinitially at fair value. Servicing assets are amortized in proportion to andover the period of net servicing income.

The Corporation estimates the fair value of servicingrights based upon the present value of expected future cash flows associatedwith the servicing rights discounted at a current market rate using the sameassumptions used by bidders of servicing portfolios. The loans are grouped intohomogenous pools for analysis based upon the predominant risk characteristicsincluding origination date, loan type, interest rate and term. Assumptions aredeveloped that include estimates of servicing costs, loan defaults, prepaymentspeeds, discount rates, market conditions and other factors that impact thevalue of retained interests. If the carrying value of mortgage servicing rightsfor a pool exceeds the estimated fair value, an impairment loss is recognizedthrough a charge to the valuation allowance with a corresponding adjustment toearnings.

Mortgage loans originated and intended for sale in thesecondary market are carried at the lower of aggregate cost or estimated fairvalue. Gains and losses on sales of loans are also accounted for in accordancewith SFAS No. 134, “Accounting for Mortgage Securities Retained afterthe Securitization of Mortgage Loans Held for Sale by a Mortgage BankingEnterprise.” This statement requires that an entity engaged in mortgage bankingactivities classify the retained mortgage-backed security or otherinterest, which resulted from the securitizations of a mortgage loan held forsale, based upon its ability and intent to sell or hold these investments.

The Corporation followsSFAS No. 149, “Amendment of Statement 133 on Derivative Instrumentsand Hedging Activities.” Implementation issue C13, “When a Loan Commitment IsIncluded in the Scope of Statement 133,” is included in SFAS No. 149.SFAS No. 149 amends SFAS No. 133 to add a scope exceptionfor borrowers (all commitments) and lenders (all commitments except thoserelating to mortgage loans that will be held for sale). Statement 149 alsoamends SFAS No. 133 to require a lender to account for loancommitments related to mortgage loans that will be held for sale asderivatives. The Corporation periodically enters into commitments with itscustomers, which it intends to sell in the future.**Consistentwith SAB 105, “Application of Accounting Principles to Loan Commitments,”effective April 1, 2004, the Corporation does not consider the expectedfuture cash flows related to the servicing of loans in 

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note1—Summary of Significant Accounting Policies (Continued)**

thecalculation of the fair value of derivative loan commitments. Theimplementation of SAB No. 105 had no impact on the Corporation’s financialposition or results of operations.

*Premises andEquipment*

Premises and equipment arestated at cost less accumulated depreciation. Depreciation is recorded usingthe straight-line and accelerated depreciation methods over the estimateduseful lives of the assets. Leaseholdimprovements are amortized over the term of the lease or estimated usefullives, whichever is shorter.

*Net Assets inForeclosure*

Net assets in foreclosureinclude foreclosed real estate which is carried at the lower of cost (lesser ofcarrying value of loan or fair value at date of acquisition) or estimated fairvalue of the collateral less selling costs. Any write-down, at or prior to thedates the real estate is considered foreclosed, is charged to the allowance forloan losses. Subsequent write-downs and expenses incurred in connectionwith holding such assets are recorded in other expenses. Any gain or loss uponthe sale of real estate owned is charged to operations as incurred. Net assetsin foreclosure also includes foreclosed leases which are carried at lower ofcost (lesser of carrying value of loan or fair value at date of acquisition) orestimated fair value less selling costs.

*Goodwill and OtherIntangible Assets*

Goodwill represents the excess of the cost of anacquired entity over the fair value of the identifiable net assets acquired inaccordance with the purchase method of accounting. Goodwill is not amortizedbut is reviewed for potential impairment on an annual basis, or more often ifevents or circumstances indicate that there may be impairment, in accordancewith SFAS No. 142, “Goodwill and Other Intangible Assets.” Goodwillis tested for impairment at the reporting unit level and an impairment loss isrecorded to the extent that the carrying amount of goodwill exceeds its impliedfair value. Core deposit intangibles are a measure of the value of checking andsavings deposits acquired in business combinations accounted for under thepurchase method. Core deposit intangibles and other identified intangibleassets with finite useful lives are amortized over their estimated lives andare evaluated for impairment if events and circumstances indicate a possibleimpairment. The Corporation employs general industry practices in evaluatingthe fair value of its goodwill and other intangible assets. The Corporationcalculates the fair value using a combination of the following valuations:deposit premiums based on market deals, current stock pricing tracking as amultiple of book value, discounted cash flow of earnings with a terminal valueand market multiple of earnings. Any impairment loss related to goodwill andother intangible assets is reflected as other noninterest expense in thestatement of operations in the period in which the impairment was determined.No assurance can be given that future impairment tests will not result in acharge to earnings.

Goodwill was $31.6 millionat December 31, 2005 and $32.5 million at December 31, 2004. On June 30,2005, the Corporation completed the sale of Cumberland Advisors, Inc.including $996,000 of goodwill. Amortization of intangible assets, primarilycore deposit intangible, were $246,000 and $171,000 for the years ended December 31,2005 and December 31, 2004, respectively. Management performed its 

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note1—Summary of Significant Accounting Policies (Continued)**

annualreview of goodwill at June 30, 2005 in accordance with SFAS No. 142and determined there was no impairment of goodwill and identifiable intangibleassets.

*Derivatives*

The Corporation accounts for derivatives in accordancewith SFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities” as amended. The statement requires the Corporation to recognize allderivative instruments at fair value as either assets or liabilities. Financialderivatives are reported at fair value in other assets or other liabilities.The accounting for changes in the fair value of a derivative instrument dependson whether it has been designated and qualifies as part of a hedgingrelationship. For derivatives not designated as hedges, the gain or loss isrecognized in current earnings.

The Corporation entersinto interest rate swap contracts to modify the interest rate characteristicsfrom variable to fixed in order to reduce the impact of interest rate changeson future net interest income. Net amounts payable or receivable from thesecontracts are accrued as an adjustment to net interest. The fair value of thesederivatives is reported in other assets or other liabilities and offset in accumulated other comprehensive income for theeffective portion of the derivatives. Amounts reclassed into earnings, when thehedged transaction culminates, are included in net interest. Ineffectiveness ofthe strategy, as defined under SFAS No. 133, if any, is reported innet interest. The Corporation performs an assessment, both at the inception ofthe hedge and quarterly thereafter, to determine whether these derivatives arehighly effective in offsetting changes in the value of the hedged items.

*Stock BasedCompensation*

The Corporation follows SFAS No. 123, “Accountingfor Stock-Based Compensation,” which contains a fair value based methodfor valuing stock-based compensation that entities may use, whichmeasures compensation cost at the grant date based on the fair value of theaward. Compensation is then recognized over the service period, which isusually the vesting period. The Corporation has chosen an alternative permittedby the standard to account for employee stock options and similar instrumentsunder Accounting Principles Board (APB) Opinion No. 25, “Accounting forStock Issued to Employees.”

Entities that account for stock options using APBOpinion No. 25 are required to make *pro forma*disclosures of net income and earnings per share as if the fair value-basedmethod of accounting defined in SFAS No. 123 has been applied. Inpreparing the pro-forma disclosure, the Corporation estimates the fair value ofemployee stock options using a pricing model which takes into consideration theexercise price and expected life of the options, the current price of theunderlying stock and its expected volatility, the expected dividends on thestock and the current risk-free interest rate for the expected life of theoption. The Corporation’s estimate of the fair value of a stock option is basedon expectations derived from historical experience and may not necessarilyequate to its market value when fully vested.

The Corporation has four shareholder approved fixedstock option plans that allow the Corporation to grant options up to anaggregate of 3,617,011 shares of common stock to key employees and directors.At December 31, 2005, 2,459,734 stock options had been granted under thestock option plans. The options have a term of ten years when issued andtypically vest over a five-year period. The exercise price of each option isthe market price of the Corporation’s stock on the date of grant. Additionally,at December 31, 2005, the Corporation has an additional 312,681 grantedstock options, which were converted into the Corporation’s options as a resultof the Millennium Bank acquisition. The options have 

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note1—Summary of Significant Accounting Policies (Continued)**

a term of ten years andare exercisable at prices ranging from $9.71 to $14.50, at December 31,2005, except for 34,485 non-qualified performance based stock options whichwere cancelled in conjunction with the sale of Cumberland Advisors, Inc.

The fair value of each option grant is estimated onthe date of grant using the Black-Scholes option-pricing model withthe following weighted-average assumptions used for grants in 2005, 2004and 2003, respectively: dividend yield of 3.27%, 2.83% and 2.17%; expectedvolatility of 31.15%, 29.38% and 28.91%; risk-free interest rate of 4.41%,4.06% and 4.08%; and an expected life of 7.15 years, 7.06 years and7.41 years. The options converted as a result of the Millennium Bankacquisition have been excluded from the valuation since they were fully vested.

Thefollowing table illustrates the effect on net income and earnings per share ifthe Corporation had applied the fair value recognition provisions of SFAS No. 123,to stock-based employee compensation. See Note 14, “Earnings PerShare,” for calculation of earnings per share.

| ** **                                                                                   | ** ** | **Year ended December 31,**                                         | ** **           |
|----------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|----------------------|
| ** **                                                                                   | ** ** | **2005**                                                                           | ** **           | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                   | ** ** | **(Dollars in thousands,  except per share information)** | ** **           |
| Net income                                                                                   |       |                                                                               |                 |   |   |   |   |
| As reported                                                                                  | ** ** | **$**                                                                              | **38,828**** ** |   | $ | 38,567  |   | $ | 35,333  |   |
| Less: Stock-based compensation costs  determined under fair value method for all awards, net | ** ** | **602**                                                                            |                 | 1,148 |   | 2,046 |   |
| *Pro forma*                                                                                  | ** ** | **$**                                                                              | **38,226**** ** |   | $ | 37,419  |   | $ | 33,287  |   |
| Earnings per  share (Basic)                                                                  | ** ** | ** **                                                                         |                 |   |   |   |   |
| As reported                                                                                  | ** ** | **$**                                                                              | **1.41**** **   |   | $ | 1.42  |   | $ | 1.35  |   |
| *Pro forma*                                                                                  | ** ** | **$**                                                                              | **1.39**** **   |   | $ | 1.38  |   | $ | 1.27  |   |
| Earnings per  share (Diluted)                                                                | ** ** | ** **                                                                         |                 |   |   |   |   |
| As reported                                                                                  | ** ** | **$**                                                                              | **1.38**** **   |   | $ | 1.37  |   | $ | 1.30  |   |
| *Pro  forma*                                                                                 | ** ** | **$**                                                                              | **1.36**** **   |   | $ | 1.33  |   | $ | 1.23  |   |

 

In December 2004, the FASB issued SFAS No. 123(revised 2004), “Share-Based Payment” (SFAS 123(R)). SFAS 123(R) replacesSFAS No. 123, “Accounting for Stock-Based Compensation” andsupersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.”SFAS 123(R) establishes standards for the accounting for transactionsin which an entity exchanges its equity instruments for goods or services andaddresses transactions in which an entity incurs liabilities in exchange forgoods or services that are based on the fair value of the entity’s equityinstruments or that may be settled by the issuance of those equity instruments.SFAS 123(R) focuses primarily on accounting for transactions in whichan entity obtains employee services in share-based payment transactions.Under SFAS 123(R), all forms of share-based payments to employees,including employee stock options, will be treated the same as other forms ofcompensation by recognizing the related cost in the income statement. Theexpense of the award will generally be measured at fair value at the grantdate. SFAS No. 123 requires that the expense relating to so-called fixedplan employee stock options only be disclosed in the footnotes to the financialstatements. SFAS 123(R) eliminates the ability to account for share-basedcompensation transactions using APB Opinion No. 25. In April 2005,the Securities and Exchange Commission adopted a new rule amendingRegulation S-X to amend the date for compliance with SFAS 123(R). Under SFAS123(R), 

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note1—Summary of Significant Accounting Policies (Continued)**

the Corporation would havebeen required to apply the provisions of SFAS 123(R) as of the firstinterim or annual reporting period that begins after June 15, 2005. TheCommission’s new rule allows registrants to implement SFAS 123(R) atthe beginning of their next fiscal year that begins after June 15, 2005.

In October 2005, the FASB issued Staff Position(FSP) No. 123(R)-2, “Practical Accommodation to the Application ofGrant Date as Defined in SFAS No. 123(R).” The FSP stipulates thatassuming all other criteria in the grant date definition are met, a mutualundertanding of the key terms and conditions of an award to an individualemployee is presumed to exist upon the award’s approval in accordance with therelevant corporate governance requirements, provided that the terms andconditions of an award (a) cannot be negotiated by the recipient with theemployer and (b) are expected to be communicated to an individualrecipient within a relatively short time period from the date of approval. FSP123(R)-2 applies upon initial adoption of SFAS 123(R).

In November 2005, the FASB issued FSP No. 123(R)-3,“Transition Election Related to Accounting for the Tax Effects of Share-BasedPayments Awards.” The FSP provides an alternative transition method foraccounting for the tax effects of share-based payment awards to employees forentities that do not have the necessary information to comply with thetransition requirements of SFAS 123(R). An entity may take up to one year fromthe later of its initial adoption of SFAS 123(R) or the effective date ofthis FSP (November 10, 2005) to evaluate its available transitionalternatives and make its one-time election.

In February 2006, the FASB issued FSP No. 123(R)-4,“Classification of Options and Similar Instruments Issued as Employee CompensationThat Allow for Cash Settlement upon the Occurrence of a Contingent Event” toamend guidance in SFAS 123(R) on classifying options and similarinstruments issued as part of employee compensation arrangements. Prior toamendment, SFAS 123(R) required the classification of such instruments asliabilities if the entity could be required under any circumstances to settlethe option or similar instrument by transferring cash or other assets. FSP123(R)-4 amends paragraphs 32 and A229 of SFAS 123(R) to incorporatea practical accommodation similar to the probability approach provided infootnote 16 of the statement for shares subject to contingent cash settlementfeatures. As a result, SFAS 123(R) requires options issued as compensationto employees to be classified as liabilities if the cash settlement feature canbe exercised only upon the occurrence of a contingent event that is outside theemployee’s control, and such event is deemed probable to occur. Accounting forthe modification of the option or similar instrument from equity to liabilityis similar to accounting for a modification from an equity to liability award.This FSP is applicable upon initial adoption of SFAS 123(R). FSP 123(R)-4is not expected to have any impact on the Corporation’s financial position orresults of operations.

The Corporation hasadopted SFAS 123(R) on January 1, 2006. The Corporation will use themodified prospective application method of transition. Effective January 1,2006, the Corporation will recognize compensation expense for the portion ofoutstanding awards at January 1, 2006 for which the requisite service hasnot yet been rendered, based on the grant-date fair value of those awardscalculated under SFAS 123 for pro forma disclosures. For new grants awarded onor after January 1, 2006, the Corporation has chosen to continue the useof the Black-Scholes option-pricing model to estimate the fair value of eachoption on the date of grant. In accordance with SFAS 123(R), the Corporationwill estimate the number of options for which the requisite service is expectedto be rendered as compared to accounting for forfeitures as they occur underSFAS 123. The Corporation has chosen to recognize compensation expense for newgrants using the straight-line method which spreads compensation expense 

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note1—Summary of Significant Accounting Policies (Continued)**

forshares vesting evenly over the period of vesting. Pro forma disclosures underSFAS 123 have been based upon the accrual method which treats each vestingtranche as a separate award and amortizes expense evenly (prorated) from grantdate to vest date for each tranche. The Corporation estimates that share-basedcompensation expense, net of tax, to be recognized during the year of 2006 willbe approximately $284,000. The number and timing of options granted during 2006and vesting criteria may alter this projected number.

*Income Taxes*

There are two componentsof income tax expense: current and deferred. Current income tax expenseapproximates cash to be paid or refunded for taxes for the applicable period.Deferred tax assets and liabilities are recognized due to differences betweenthe basis of assets and liabilities as measured by tax laws and their basis asreported in the financial statements. Deferred tax assets are subject tomanagement’s judgment based upon available evidence that future realizationsare likely. If management determines that the Corporation may not be able torealize some or all of the net deferred tax asset in the future, a charge toincome tax expense may be required to reduce the value of the net deferred taxasset to the expected realizable value. Deferred tax assets and liabilities aremeasured using enacted tax rates expected to apply to taxable income in theyears in which those temporary differences are expected to be recovered orsettled. The effect on deferred taxes of a change in tax rates is recognized inincome in the period that includes the enactment date. Deferred tax expense orbenefit is recognized for the change in deferred tax liabilities or assetsbetween periods.

*Pension Plans*

The Corporation hascertain employee benefit plans covering substantially all employees. TheCorporation accrues service cost as incurred.

*Bank-Owned LifeInsurance*

The Corporation invests inbank-owned life insurance (BOLI). BOLI involves the purchasing of lifeinsurance by the Corporation on a chosen group of employees. The Corporation isthe owner and beneficiary of the policies. This pool of insurance, due to tax advantagesto the Bank, is profitable to the Corporation. This profitability is used tooffset a portion of future benefit cost increases. The Bank’s deposits fundBOLI and the earnings from BOLI are recognized as noninterest income.

*Earnings Per Share*

The Corporation followsthe provisions of SFAS No. 128, “Earnings per Share.” Basic earningsper share exclude dilution and are computed by dividing income available tocommon shareholders by the weighted-average common shares outstandingduring the period. Diluted earnings per share take into account the potentialdilution that could occur if securities or other contracts to issue commonstock were exercised and converted into common stock. Proceeds assumed to havebeen received on such exercise or conversion are assumed to be used to purchaseshares of the Corporation’s common stock at the average market price during theperiod, as required by the “treasury stock method” of accounting. The effectsof securities or other contracts to issue common stock are excluded from thecomputation of diluted earnings per share in periods in which the effect wouldbe antidilutive. All weighted average shares, actual shares 

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note1—Summary of Significant Accounting Policies (Continued)**

and pershare information in the financial statements have been adjusted retroactivelyfor the effect of stock dividends and splits.

*ComprehensiveIncome*

The Corporation recordsunrealized gains and losses on available for sale investment securities andgains and losses on cash flow hedges in other comprehensive income inshareholders’ equity. Gains and losses on available for sale investmentssecurities are reclassified to net income as the gains or losses are realizedupon sale of the securities. Other-than-temporary impairment charges arereclassified to net income at the time of the charge. Gains or losses onderivatives are reclassified to net income as the hedged item affects earnings.The Corporation follows SFAS No. 130, “Reporting ComprehensiveIncome,” which establishes standards to provide prominent disclosure ofcomprehensive income items.

*Segment Information*

SFAS No. 131, “Disclosures about Segments ofan Enterprise and Related Information” establishes standards for the way publicbusiness enterprises report information about operating segments in annualfinancial statements and requires that those enterprises report selectedinformation about operating segments in interim financial reports issued toshareholders. It also establishes standards for related disclosure aboutproducts and services, geographic areas, and major customers. Operatingsegments are components of an enterprise about which separate financialinformation is available that is evaluated regularly by the chief operating decisionmaker in deciding how to allocate resources and assess performance. Thestatement also requires that public enterprises report a measure of segmentprofit or loss, certain specific revenue and expense items and segment assets.It also requires that information be reported about revenues derived from theenterprises’ products or services, or about the countries in which theenterprises earn revenues and hold assets, and about major customers,regardless of whether the information is used in making operating decisions.

The Corporation has one reportable segment, “CommunityBanking.” All of the Corporation’s activities are interrelated, and eachactivity is dependent and assessed based on how each of the activities of theCorporation supports the others. For example, commercial lending is dependentupon the ability of the Bank to fund itself with retail deposits and otherborrowings and to manage interest rate and credit risk. This situation is alsosimilar for consumer and residential mortgage lending. Accordingly, allsignificant operating decisions are based upon analysis of the Corporation asone operating segment or unit.

The Corporation has alsoidentified several operating segments. These operating segments within theCorporation’s operations do not have similar characteristics to the communitybanking operations and do not meet the quantitative thresholds requiringseparate disclosure. These nonreportable segments include HNC FinancialCompany, HNC Reinsurance Company and the Parent.

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 1—Summary ofSignificant Accounting Policies (Continued)**

*Variable InterestEntities*

Harleysville StatutoryTrust I (Trust I), HNC Statutory Trust II (Trust II) and HNC Statutory Trust III(Trust III) are considered variable interest entities under FASB Interpretation46, “Consolidation of Variable Interest Entities,” as revised (FIN 46R).Accordingly, Trust II and Trust III are not consolidated in the Corporation’sfinancial statements and the Corporation no longer consolidates Trust I as of March 31,2004. FIN 46(R) precludes consideration of the call option embedded in thepreferred stock when determining if the Corporation has the right to a majorityof Trust I’s expected residual returns. The deconsolidation resulted in theinvestment in the common stock of Trust I to be included in other assets as of March 31,2004 and the corresponding increase in outstanding debt of $155,000. Inaddition, the income received on the Corporation’s common stock investment isincluded in other income. The adoption of FIN 46(R) did not have amaterial impact on the financial position or results of operations.

*Recent AccountingPronouncements*

In December, 2005, the FASB issued FSP SOP 94-6-1,“Terms of Loan Products That May Give Rise to a Concentration of CreditRisk.” The guidance in this FSP emphasizes the requirement to assess theadequacy of disclosures for all lending products and the effect of changes inmarket or economic conditions on the adequacy of those disclosures. Thisguidance is effective for interim and annual periods ending after the date theFSP is posted to the website (December 19, 2005). The adoption of FSP SOP 94-6-1did not require additional disclosures as the Corporation did not haveadditional material concentrations of credit risk.

In November, 2005, the FASB issued FSP FIN 45-3,“Application of FASB Interpretation No. 45 to Minimum Revenue GuaranteesGranted to a Business or Its Owners.” The guidance in this FSP amends FIN No. 45,“Guarantor’s Accounting and Disclosure Requirements for Guarantees, IncludingIndirect Guarantees of Indebtedness of Others” to explicitly state that therecognition, measurement and disclosure provisions of FIN No. 45 apply toa minimum revenue guarantee. A minimum revenue guarantee is a guarantee grantedto a business or its owners that the revenue of the business will be at least aspecified minimum amount for a specified period of time. FSP FIN 45-3 iseffective for new minimum revenue guarantees issued or modified on or after thebeginning of the first fiscal quarter following November 10, 2005 (thedate posted to the FASB website). The disclosure requirements are to be appliedto all minimum revenue guarantees in financial statements of interim or annualperiods ending after the beginning of the first fiscal quarter following November 10,2005, although earlier application is permitted. FSP FIN 45-3 is notexpected to have a material impact on the Corporation’s financial position orresults of operations.

In May 2005, the FASB issued SFAS No. 154, “AccountingChanges and Error Corrections” (SFAS 154). SFAS 154 replaces APB Opinion No. 20,“Accounting Changes” and SFAS No. 3, “Reporting Accounting Changes inInterim Financial Statements.” SFAS 154 requires retrospective application toprior periods’ financial statements of every voluntary change in accountingprinciple unless it is impracticable. APB Opinion No. 20 previouslyrequired that most voluntary changes in accounting principle be recognized byincluding in net income of the period of the change the cumulative effect ofchanging to the new accounting principle. SFAS 154 also requires that a changein depreciation, amortization, or depletion method for long-lived nonfinancialassets be accounted for as a change in accounting estimate effected by a changein accounting principle. SFAS 154 carries forward without change the guidancein APB Opinion No. 20 for reporting the correction of an error inpreviously issued 

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note1—Summary of Significant Accounting Policies (Continued)**

financial statements and achange in accounting estimate. SFAS 154 carries forward the provisions of SFAS No. 3that govern reporting accounting changes in interim financial statements. SFAS154 is effective for accounting changes and corrections of errors made infiscal years beginning after December 15, 2005, although earlierapplication is permitted for changes and corrections of errors made in fiscalyears beginning after June 1, 2005. SFAS 154 is not expected to have amaterial impact on the Corporation’s financial position or results ofoperations.

In March 2005, theFASB issued Interpretation No. 47, “Accounting for Conditional AssetRetirement Obligations” (FIN 47). FIN 47 clarifies that an entity mustrecognize a liability for the fair value of a conditional asset retirementobligation when incurred if the liability’s fair value can be reasonablyestimated. This Interpretation also defines when an entity would havesufficient information to reasonably estimate the fair value of an asset retirementobligation. FIN 47 is effective no later than the end of fiscal years endingafter December 15, 2005, although early adoption is encouraged. Theimplementation of FIN 47 did not have any impact on the Corporation’s financialposition or results of operations.

**Note 2—Acquisitions /Dispositions**

At the close of business on January 13, 2006, theCorporation completed its acquisition of the Cornerstone Companies, registeredinvestment advisors for high net worth, privately held business owners, wealthyfamilies and institutional clients. Located in the Lehigh Valley, Pennsylvania,the firm specializes in providing sophisticated open architecture assetmanagement platforms, business succession and estate planning services, lifeinsurance sales and compensation and benefits consulting. With assets undermanagement of approximately $1.5 billion, the Cornerstone Companies serveclients within the Harleysville footprint, throughout Pennsylvania and othermid-Atlantic states.

The acquisition was consummated pursuant to thePurchase Agreement dated November 15, 2005, by and among the Bank andCornerstone Financial Consultants, Ltd., a Pennsylvania corporation (CFC),Cornerstone Institutional Investors, Inc., a Pennsylvania corporation(CII), Cornerstone Advisors Asset Management, Inc., a Pennsylvaniacorporation ((CAAM), and together with CFC and CII collectively, theCornerstone Companies), Cornerstone Management Resources, Inc., (CMR),John R. Yaissle, Malcolm L. Cowen, II and Thomas J. Scalici. Underthe Purchase Agreement, the Bank acquired (i) all of the outstandingcapital stock of CFC and CII, (ii) substantially all of the assets ofCAAM, and (iii) certain limited assets of CMR. The purchase priceconsisted of $15.0 million in cash paid at closing and a contingent payment ofup to $7.0 million to be paid post-closing. The contingent payment is basedupon the Cornerstone Companies meeting certain minimum operating results duringa five-year earn-out period, with a maximum payout of $7.0 million over thisperiod.

The acquisition has been accounted for using thepurchase method of accounting, which requires that the financial statementsinclude activity of the Cornerstone Companies effective January 1, 2006.Accordingly, the Corporation’s consolidated financial statements and theinformation herein at and for the year ended December 31, 2005 do notinclude the Cornerstone Companies.

On June 30, 2005, the Bank sold its formersubsidiary, Cumberland Advisors, Inc., to David R. Kotok and Associates, Inc.in a stock sale. The sale price was $2.0 million cash and resulted in anon-taxable gain of $287,000 recorded in the second quarter of 2005. CumberlandAdvisors had assets of $1.8 million. Cumberland Advisors, based in Vineland,New Jersey, is a SEC registered investment advisor specializing 

57

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note2—Acquisitions / Dispositions (Continued)**

in fixed income moneymanagement and equities with approximately $700 million in assets undermanagement at June 30, 2005. It was acquired by the Corporation on April 30,2004 as part of its Millennium Bank acquisition. Based upon management’sanalysis of Cumberland Advisors’ results of operations and assets in comparisonto the Corporation’s, management determined the impact of the sale of CumberlandAdvisors is immaterial, and therefore the transaction is not presented asdiscontinued operations.

On April 1, 2005, the Bank completed the sale ofits McAdoo branch located in Schuylkill County, Pennsylvania with deposits of$13.9 million as well as certain loans and other assets of $5.8 million to TheLegacy Bank. In connection with the sale, the Bank paid net cash of $7.4million and recorded a pre-tax profit of $690,000 during the second quarter of2005.

On April 30, 2004, the Corporation completed itsacquisition of Millennium Bank which was merged with and into the Bank.Millennium Bank was based in Malvern, Pennsylvania with four banking offices,specializing in commercial lending and client relationship banking along withthe wealth management unit, Cumberland Advisors, Inc. Millennium Bank’sresults of operations are included in the Corporation’s results beginning April 30,2004 through December 31, 2005.

The aggregate purchaseprice was $52.8 million in cash and stock which included $5.5 million inexpenses associated with the acquisition. The Corporation acquired 100% of theoutstanding shares of Millennium Bank. Millennium Bank shares of 1,511,624 wereexchanged at a conversion ratio of .6256 (.68972 restated*) for 945,672(1,042,603 restated*) shares of the Corporation’s common stock and MillenniumBank shares of 1,008,050 were exchanged for cash consideration of $16.1million. Millennium Bank options of 302,250 were cashed out for considerationof $2.3 million and options of 453,325 were exchanged at a conversion ratio of..6256 (.68972 restated*) to acquire 283,601 shares (312,681 restated*) of theCorporation’s common stock (252,321 (278,196 restated*) options at an exerciseprice of $10.71 to $15.98 ($9.71 to $14.50 restated*) and 31,280 (34,485restated*) performance based options at an exercise price of $13.59 ($12.33restated*)). This transaction was accounted for using the purchase method ofaccounting in accordance with SFAS No. 141, “Business Combinations.”Goodwill of $32.5 million was recorded in connection with the acquisitionof Millennium Bank.

**Note 3—Restrictionson Cash and Due From Banks**

As of December 31,2005 and 2004, the Bank did not need to maintain reserves (in the form ofdeposits with the Federal Reserve Bank) to satisfy federal regulatoryrequirements.

----

*—Restated for fivepercent stock dividends paid on September 15, 2005 and September 15,2004.

58

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 4—InvestmentSecurities**

The amortized cost,unrealized gains and losses, and the estimated market value of the Corporation’sinvestment securities available for sale and held to maturity are as follows:

| ** **                                                           | ** ** | **December 31, 2005**      | ** **            |
|----------------------------------------------------------------------|------------|--------------------------------------|-----------------------|
| ** **                                                           | ** ** | **Amortized  Cost**                  | ** **            | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| ** **                                                           | ** ** | **(Dollars in thousands)** | ** **            |
| **Available  for sale**                                              |       |                                 |                  |   |   |   |   |   |   |   |   |   |   |
| Obligations of  other U.S. government agencies and corporations | ** ** | **$**                                | **161,371**** ** | ** ** | ** ** | **$** | **2**** ** |   | ** ** | ** ** | **$** | **(3,977**** ** | **)** | ** ** | **$** | **157,396**** ** | ** ** |
| Obligations of  states and political subdivisions                    | ** ** | **175,246**                          | ** **            | ** ** | **278** |   | ** ** | ** ** | **(1,679** | **)** | ** ** | **173,845** | ** ** |
| Mortgage-backed  securities                                          | ** ** | **475,261**                          | ** **            | ** ** | **245** |   | ** ** | ** ** | **(7,938** | **)** | ** ** | **467,568** | ** ** |
| Other securities                                                     | ** ** | **43,491**                           | ** **            | ** ** | **56** |   | ** ** | ** ** | **(703** | **)** | ** ** | **42,844** | ** ** |
| Total investment securities available for sale                       | ** ** | **$**                                | **855,369**** ** | ** ** | ** ** | **$** | **581**** ** |   | ** ** | ** ** | **$** | **(14,297**** ** | **)** | ** ** | **$** | **841,653**** ** | ** ** |
| **Held to  maturity**                                                | ** ** | ** **                           | ** **            | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Obligations of  other U.S. government agencies and corporations | ** ** | **$**                                | **3,843**** **   | ** ** | ** ** | **$** | **—**** ** |   | ** ** | ** ** | **$** | **(45**** ** | **)** | ** ** | **$** | **3,798**** ** | ** ** |
| Obligations of  states and political subdivisions                    | ** ** | **55,712**                           | ** **            | ** ** | **615** |   | ** ** | ** ** | **(372** | **)** | ** ** | **55,955** | ** ** |
| Total investment  securities held to maturity                        | ** ** | **$**                                | **59,555**** **  | ** ** | ** ** | **$** | **615**** ** |   | ** ** | ** ** | **$** | **(417**** ** | **)** | ** ** | **$** | **59,753**** ** | ** ** |

 

| ** **                                                           | ** ** | **December 31, 2004**      | ** **    |
|----------------------------------------------------------------------|------------|--------------------------------------|---------------|
| ** **                                                           | ** ** | **Amortized  Cost**                  | ** **    | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| ** **                                                           | ** ** | **(Dollars in thousands)** | ** **    |
| **Available for sale**                                               |       |                                 |          |   |   |   |   |   |   |   |   |   |   |
| Obligations of  other U.S. government agencies and corporations |       | $                                    | 154,482  |   |   | $ | 57  |   |   |   | $ | (1,436  | ) |   | $ | 153,103  |   |
| Obligations of  states and political subdivisions                    |       | 195,614                              |          |   | 3,556 |   |   |   | (671 | ) |   | 198,499 |   |
| Mortgage-backed  securities                                          |       | 457,171                              |          |   | 600 |   |   |   | (3,041 | ) |   | 454,730 |   |
| Other securities                                                     |       | 65,606                               |          |   | 3,168 |   |   |   | (374 | ) |   | 68,400 |   |
| Total investment securities available for sale                       |       | $                                    | 872,873  |   |   | $ | 7,381  |   |   |   | $ | (5,522  | ) |   | $ | 874,732  |   |
| **Held to maturity**                                                 |       |                                 |          |   |   |   |   |   |   |   |   |   |   |
| Obligations of  other U.S. government agencies and corporations |       | $                                    | 3,830    |   |   | $ | 14  |   |   |   | $ | —  |   |   | $ | 3,844  |   |
| Obligations of  states and political subdivisions                    |       | 64,662                               |          |   | 1,106 |   |   |   | (275 | ) |   | 65,493 |   |
| Mortgage-backed  securities                                          |       | 339                                  |          |   | 28 |   |   |   | — |   |   | 367 |   |
| Total investment  securities held to maturity                        |       | $                                    | 68,831   |   |   | $ | 1,148  |   |   |   | $ | (275  | ) |   | $ | 69,704  |   |

 

59

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 4—Investment Securities (Continued)**

Thetables below indicate the length of time individual securities have been in acontinuous unrealized loss position at December 31, 2005 and 2004:

| ** **                                                      | ** ** | **December 31, 2005**        | ** ** |                                   |
|-----------------------------------------------------------------|------------|----------------------------------------|------------|----------------------------------------|
| ** **                                                      | ** ** | **Less than 12 months** | ** ** | **12 months or longer** | ** ** | **Total** | ** ** |   |
| **Description of  Securities**                             | ** ** | ** **                             | ** ** | **# of  Securities**              | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **# of  Securities** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **# of  Securities** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** |   |
| ** **                                                      | ** ** | **(Dollars in thousands)**   | ** ** |                                   |
| Obligations of other U.S. government agencies and  corporations | ** ** |                                   | **19**     | ** **                             |   | **$** | **52,713** | ** ** |   | **$** | **(1,232** | **)** |   |   | **37** | ** ** |   | **$** | **104,405** | ** ** |   | **$** | **(2,790** | **)** |   |   | **56** | ** ** |   | **$** | **157,118** | ** ** |   | **$** | **(4,022** | **)** |   |
| Obligations of states and political subdivisions                | ** ** |                                   | **252**    | ** **                             |   | **120,860** | ** ** |   | **(1,407** | **)** |   |   | **48** | ** ** |   | **22,460** | ** ** |   | **(644** | **)** |   |   | **300** | ** ** |   | **143,320** | ** ** |   | **(2,051** | **)** |   |
| Mortgage-backed securities                                      | ** ** |                                   | **78**     | ** **                             |   | **259,830** | ** ** |   | **(4,332** | **)** |   |   | **55** | ** ** |   | **137,899** | ** ** |   | **(3,606** | **)** |   |   | **133** | ** ** |   | **397,729** | ** ** |   | **(7,938** | **)** |   |
| Other securities                                                | ** ** |                                   | **6**      | ** **                             |   | **5,271** | ** ** |   | **(148** | **)** |   |   | **3** | ** ** |   | **12,417** | ** ** |   | **(555** | **)** |   |   | **9** | ** ** |   | **17,688** | ** ** |   | **(703** | **)** |   |
| Totals                                                          | ** ** |                                   | **355**    | ** **                             |   | **$** | **438,674** | ** ** |   | **$** | **(7,119** | **)** |   |   | **143** | ** ** |   | **$** | **277,181** | ** ** |   | **$** | **(7,595** | **)** |   |   | **498** | ** ** |   | **$** | **715,855** | ** ** |   | **$** | **(14,714** | **)** |   |
|                                                                 |            |                                        |            |                                        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                                      | ** ** | **December 31, 2004**        | ** ** |                                   |
|-----------------------------------------------------------------|------------|----------------------------------------|------------|----------------------------------------|
| ** **                                                      | ** ** | **Less than 12 months** | ** ** | **12 months or longer** | ** ** | **Total** | ** ** |   |
| **Description of  Securities**                             | ** ** | ** **                             | ** ** | **# of  Securities**              | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **# of  Securities** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **# of  Securities** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** |   |
| ** **                                                      | ** ** | **(Dollars in thousands)**   | ** ** |                                   |
| Obligations of other U.S. government agencies and  corporations |       |                                   | 45         |                                   |   | $ | 136,246 |   |   | $ | (1,429 | ) |   |   | 1 |   |   | $ | 4,993 |   |   | $ | (7 | ) |   |   | 46 |   |   | $ | 141,239 |   |   | $ | (1,436 | ) |   |
| Obligations of states and political subdivisions                |       |                                   | 167        |                                   |   | 85,736 |   |   | (878 | ) |   |   | 9 |   |   | 3,162 |   |   | (68 | ) |   |   | 176 |   |   | 88,898 |   |   | (946 | ) |   |
| Mortgage-backed securities                                      |       |                                   | 75         |                                   |   | 277,251 |   |   | (2,766 | ) |   |   | 11 |   |   | 23,302 |   |   | (275 | ) |   |   | 86 |   |   | 300,553 |   |   | (3,041 | ) |   |
| Other securities                                                |       |                                   | 8          |                                   |   | 19,611 |   |   | (346 | ) |   |   | 1 |   |   | 589 |   |   | (28 | ) |   |   | 9 |   |   | 20,200 |   |   | (374 | ) |   |
| Totals                                                          |       |                                   | 295        |                                   |   | $ | 518,844 |   |   | $ | (5,419 | ) |   |   | 22 |   |   | $ | 32,046 |   |   | $ | (378 | ) |   |   | 317 |   |   | $ | 550,890 |   |   | $ | (5,797 | ) |   |
|                                                                 |            |                                        |            |                                        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The unrealized losses associated with these securitiesthat management has the ability and intent to hold, are not considered to beother-than-temporary because the unrealized losses are related to changes ininterest rates and do not affect the expected cash flows of the underlyingcollateral or issuer. There were 143 individual securities in a continuousunrealized loss position for twelve months or longer as of December 31,2005.

Securities with a carrying value of$568.2 million and $475.2 million at December 31, 2005 and 2004,respectively, were pledged to secure public funds, government deposits andrepurchase agreements.

60

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 4—InvestmentSecurities (Continued)**

The amortized cost andestimated market value of investment securities, at December 31, 2005, bycontractual maturities are shown in the following table. Actual maturities willdiffer from contractual maturities because issuers and borrowers may have theright to call or prepay obligations with or without call or prepaymentpenalties.

| ** **                              | ** ** | **December 31, 2005**      | ** ** |
|-----------------------------------------|------------|--------------------------------------|------------|
| ** **                              | ** ** | **Held to Maturity**       | ** ** | **Available for Sale** | ** ** |
| ** **                              | ** ** | **Amortized  Cost**                  | ** ** | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
| ** **                              | ** ** | **(Dollars in thousands)** | ** ** |
| Due in one year  or less                |       |                                 | $          | 1,104 |   |   | $ | 1,129 |   | $ | 2,998 |   | $ | 2,959 |   |
| Due after one  year through five years  |       |                                 | 35,444     |   |   | 35,912 |   | 131,375 |   | 129,199 |   |
| Due after five  years through ten years |       |                                 | —     |   |   | — |   | 122,738 |   | 120,520 |   |
| Due after ten  years                    |       |                                 | 23,007     |   |   | 22,712 |   | 90,458 |   | 89,505 |   |
|                                    |       |                                 | 59,555     |   |   | 59,753 |   | 347,569 |   | 342,183 |   |
| Mortgage-backed  securities             |       |                                 | —     |   |   | — |   | 475,261 |   | 467,568 |   |
| Equity securities                       |       |                                 | —     |   |   | — |   | 32,539 |   | 31,902 |   |
| Totals                                  |       |                                 | $          | 59,555 |   |   | $ | 59,753 |   | $ | 855,369 |   | $ | 841,653 |   |

 

Thecomponents of net realized gains on sales of investment securities were asfollows:

| ** **                                            | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                            | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                            | ** ** | **(Dollars in thousands)**       | ** ** |
| Gross realized  gains                                 | ** ** | **$**                                      | **5,812**  |   | $ | 7,642 |   | $ | 11,420 |   |
| Gross realized  losses                                | ** ** | **(1,018**                                 | **)**      | (3,953 | ) | (4,807 | ) |
| Net realized gains on  sales of investment securities | ** ** | **$**                                      | **4,794**  |   | $ | 3,689 |   | $ | 6,613 |   |

 

**Note 5—Loans**

Majorclassification of loans are as follows:

| ** **                                                        | ** ** | **December 31,**                | ** **    |
|-------------------------------------------------------------------|------------|--------------------------------------|---------------|
| ** **                                                        | ** ** | **2005**                             | ** **    | **2004** | ** ** |
| ** **                                                        | ** ** | **(Dollars in thousands)** | ** **    |
| Real estate  (including loans held for sale of $2,028 and $1,236) | ** ** | **$**                                | **792,345**   |   | $ | 694,536 |   |
| Commercial and  industrial                                        | ** ** | **477,664**                          |          | 471,415 |   |
| Consumer loans                                                    | ** ** | **694,251**                          |          | 643,340 |   |
| Lease financing                                                   | ** ** | **17,524**                           |          | 33,219 |   |
| Total loans                                                       | ** ** | **1,981,784**                        |          | 1,842,510 |   |
| Deferred costs,  net                                              | ** ** | **3,709**                            |          | 3,292 |   |
| Allowance for  loan losses                                        | ** ** | **(19,865**                          | **)**         | (18,455 | ) |
| Net loans and  loans held for sale                                | ** ** | **$**                                | **1,965,628** |   | $ | 1,827,347 |   |

 

On December 31, 2005, nonaccrual loans were$7.5 million and loans 90 days or more past due and still accruinginterest were $846,000. On December 31, 2004, nonaccrual loans were$4.7 million and loans 90 days or more past due and still accruinginterest were $981,000. The Bank’s policy for interest income 

61

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 5—Loans(Continued)**

recognition on nonaccrualloans is to recognize income under the cash basis when the loans are bothcurrent and the collateral on the loan is sufficient to cover the outstandingobligation to the Bank. The Bank will not recognize income if these factors donot exist. During 2005, interest accrued on nonaccruing loans and notrecognized as interest income was $310,000 and interest paid on nonaccruingloans of $250,000 was recognized as interest income. During 2004, interestaccrued on nonaccruing loans and not recognized as interest income was$238,000, and interest paid on nonaccruing loans of $47,000 was recognized asinterest income. During 2003, interest accrued on nonaccruing loans and notrecognized as interest income was $227,000, and interest paid on nonaccruingloans of $29,000 was recognized as interest income

The balance of impaired loans was $3.3 million at December 31,2005 compared to $2.1 million at December 31, 2004. At December 31,2005 and 2004, impaired loans with specific loss allowances were $3.3 millionand $2.1 million and the related allowance for loan losses were $675,000and $243,000, respectively. The average impaired loan balance was$1.5 million in 2005, compared to $1.8 million and $2.2 millionin 2004 and 2003, respectively. The income recognized on impaired loans during2005, 2004 and 2003 was $33,000, $2,000 and $63,000, respectively.

The Bank has no concentration of loans to individualborrowers which exceeded 10% of total loans at December 31, 2005 and 2004.The Bank actively monitors the risk of this loan concentration.

The Bank continued to pursue new lending opportunitieswhile seeking to maintain a portfolio that is diverse as to industryconcentration, type and geographic distribution. The Bank’s geographic lendingarea is primarily concentrated in Montgomery, Carbon, Bucks, Chester, Berks andWayne counties, but also includes Lehigh, Monroe and Northhampton counties.

At December 31, 2005 and 2004, loans serviced forothers totaled approximately $328.3 million and $329.0 million,respectively.

Loansto directors, executive officers and their associates are made in the ordinarycourse of business and on substantially the same terms, including interestrates and collateral, as those prevailing at the time for comparabletransactions with others. Activity of these loans is as follows:

| ** **                 | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------|------------|--------------------------------------------|------------|
| ** **                 | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                 | ** ** | **(Dollars in thousands)**       | ** ** |
| Balance,  January 1   | ** ** | **$**                                      | **22,863** |   | $ | 21,038 |   | $ | 15,280 |   |
| New loans                  | ** ** | **75,230**                                 |       | 70,711 |   | 65,528 |   |
| Repayments                 | ** ** | **(75,994**                                | **)**      | (68,886 | ) | (59,770 | ) |
| Balance,  December 31 | ** ** | **$**                                      | **22,099** |   | $ | 22,863 |   | $ | 21,038 |   |

 

62

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 6—Allowance for Loan Losses**

Thetable below summarizes the changes in the allowance for loan losses:

| ** **                               | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------|------------|--------------------------------------------|------------|
| ** **                               | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                               | ** ** | **(Dollars in thousands)**       | ** ** |
| Balance,  beginning of year              | ** ** | **$**                                      | **18,455** |   | $ | 16,753 |   | $ | 17,190 |   |
| Provision for loan losses                | ** ** | **3,401**                                  |       | 2,555 |   | 3,200 |   |
| Reserve from Millennium Bank acquisition |       | —                                     |       | 1,677 |   | — |   |
| Loans charged off                        | ** ** | **(3,047**                                 | **)**      | (3,534 | ) | (4,555 | ) |
| Recoveries                               | ** ** | **1,056**                                  |       | 1,004 |   | 918 |   |
| Balance, end of year                     | ** ** | **$**                                      | **19,865** |   | $ | 18,455 |   | $ | 16,753 |   |

 

**Note 7—Premises and Equipment**

Premisesand equipment consist of the following:

| ** **                                      | ** ** | **Estimated**         | ** ** | **December 31,**      | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|----------------------------|------------|
| ** **                                      | ** ** | **Useful Lives** | ** ** | **2005**                   | ** ** | **2004** | ** ** |
| ** **                                      | ** ** | ** **            | ** ** | **(Dollars in thousands)** | ** ** |
| Land                                            |       | Indefinite            | ** ** | **$**                      | **4,797**  |   | $ | 5,008 |   |
| Buildings                                       |       | 15-39 years      | ** ** | **26,503**                 |       | 24,815 |   |
| Furniture,  fixtures and equipment              |       | 3-7 years        | ** ** | **32,853**                 |       | 31,027 |   |
| Total cost                                      | ** ** | ** **            |       | **64,153**                 |       | 60,850 |   |
| Less accumulated  depreciation and amortization | ** ** | ** **            |       | **(36,583**                | **)**      | (33,887 | ) |
| Premises and  equipment, net                    | ** ** | ** **            |       | **$**                      | **27,570** |   | $ | 26,963 |   |

 

Depreciation expense forthe years ended December 31, 2005, 2004, and 2003 was $3.4 million,$3.4 million and $3.1 million, respectively.

**Note 8—Deposits**

At December 31,2005, scheduled maturities of certificates of deposit are as follows:

| ** ** | ** ** | **Amount**                           | ** ** |
|------------|------------|--------------------------------------|------------|
| ** ** | ** ** | **(Dollars in thousands)** | ** ** |
| 2006       |       |                                 | $          | 406,137 |   |   |
| 2007       |       |                                 | 234,415    |   |   |
| 2008       |       |                                 | 38,298     |   |   |
| 2009       |       |                                 | 22,465     |   |   |
| 2010       |       |                                 | 55,312     |   |   |
| Thereafter |       |                                 | 31         |   |   |
| Total      |       |                                 | $          | 756,658 |   |   |

 

63

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 9—Borrowings**

*Federal Funds Linesof Credit with Correspondent Banks*

Total federal funds linesof credit with correspondent banks at December 31, 2005 were$130.0 million all of which is unused. These lines of credit are availablefor overnight funds and the rate is based on the correspondent bank’s quotedrate at the time of the transaction.

*Federal Home LoanBank Advances*

Federal Home Loan Bank (FHLB) advances at December 31,2005 totaled $297.8 million, all of which were long-term with a weightedaverage interest rate of 4.25%. FHLB advances at December 31, 2004 totaled$317.8 million, of which $272.8 million was long-term with a weighted averageinterest rate of 4.10% and $45.0 million was short-term. The advances arecollateralized by FHLB stock and certain first mortgage loans and mortgage-backedsecurities. Advances are made pursuant to several different credit programsoffered from time to time by the FHLB. Unused lines of credit with the FHLBwere $273.1 million at December 31, 2005 and $578.8 million at December 31,2004. During 2003, the Corporation paid off approximately $29 million ofFHLB borrowings with rates over 6.0% prior to their scheduled maturity dates.This provided the opportunity to lock in historically low rates on newlong-term borrowings. The early retirement of these borrowings resulted in a$2.6 million prepayment fee.

At December 31,2005, scheduled maturities of long-term borrowings with the FHLB are asfollows:

| ** ** | ** ** | **Balance**                          | ** ** | **Weighted  Average Rate** | ** ** |
|------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** ** | ** ** | **(Dollars in thousands)** | ** ** |
| 2006       |       | 40,000                               |       |                            | 4.01       | % |   |
| 2007       |       | 55,000                               |       |                            | 4.08       | % |   |
| 2008       |       | 58,000                               |       |                            | 4.67       | % |   |
| 2009       |       | 40,750                               |       |                            | 4.13       | % |   |
| 2010       |       | 14,000                               |       |                            | 4.34       | % |   |
| Thereafter |       | 90,000                               |       |                            | 4.24       | % |   |
| Total      |       | $                                    | 297,750    |                            |       | 4.25 | % |   |
|            |            |                                      |            |                                 |            |  |  |  |

 

*Trust PreferredSecurities*

On September 28, 2005, HNC Statutory Trust III(Trust III), a newly formed Delaware statutory trust subsidiary of theCorporation, issued $25.0 million of fixed/floating rate trust preferredsecurities which represent undivided beneficial interests in the assets ofTrust III. Trust III issued mandatory redeemable preferred stock to investorsand loaned the proceeds to the Corporation for general corporate purposes.Trust III holds, as its sole asset, a subordinated debenture in the amount of$25.8 million issued by the Corporation on September 28, 2005. TrustIII qualifies as a variable interest entity under FASB Interpretation 46, “Consolidationof Variable Interest Entities,” as revised (FIN 46R). The trust preferredsecurities require quarterly distributions by Trust III to the holders of thetrust preferred securities at a fixed rate equal to 5.67% through November 2010and then will be payable at a variable interest rate equal to the three-monthLondon Interbank Offered Rate (LIBOR) plus 1.40% per annum. The trust preferredsecurities must be redeemed upon maturity of the subordinate debentures on November 23,2035. The Corporation may redeem the debentures prior to their stated maturityupon the occurrence of specified special events or at the specified optionalredemption dates. The Corporation may redeem the debentures, 

64

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 9—Borrowings(Continued)**

in whole but not in part,at any time, within 90 days following the occurrence and continuation of atax event, an investment company event or a capital treatment event as setforth in the indentures relating to the trust preferred securities and in eachcase subject to regulatory approval if required. The Corporation also mayredeem the debentures, in whole or in part, at the stated optional redemption dateof November 23, 2010, and quarterly thereafter, subject to regulatoryapproval if required. The special and optional redemption price is equal to100% of the principal amount of the debentures being redeemed plus accrued andunpaid interest on the debentures to the redemption date.

On March 25, 2004, HNC Statutory Trust II (TrustII), a Delaware statutory trust subsidiary of the Corporation, issued$20.0 million of floating rate (three-month LIBOR plus a margin of2.70%) trust preferred securities, which represent undivided beneficialinterests in the assets of Trust II. Trust II issued mandatory redeemablepreferred stock to investors and loaned the proceeds to the Corporation. TrustII holds, as its sole asset, a subordinated debenture in the amount of $20.6 millionissued by the Corporation on March 25, 2004. Trust II qualifies as avariable interest entity under FIN 46R. The trust preferred securities must beredeemed upon maturity of the subordinate debentures on April 6, 2034. TheCorporation may redeem the debentures prior to their stated maturity upon theoccurrence of specified special events or at the specified optional redemptiondates. The Corporation may redeem the debentures, in whole or in part, at anytime, within 90 days following the occurrence and continuation of a taxevent, an investment company event or a capital treatment event as set forth inthe indentures relating to the trust preferred securities and in each casesubject to regulatory approval if required. The Corporation also may redeem thedebentures, in whole or in part, at the stated optional redemption date of April 7,2009 and quarterly thereafter, subject to regulatory approval if required. Thespecial and optional redemption price is equal to 100% of the principal amountof the debentures being redeemed plus accrued and unpaid interest on thedebentures to the redemption date.

On February 22, 2001, the Corporation issued$5.0 million of 10.2% junior subordinate deferrable interest debentures(the debentures) to Harleysville Statutory Trust I (Trust I), a Connecticutbusiness trust, in which the Corporation owns all of the common equity. Trust Iissued mandatorily redeemable preferred stock to investors and loaned theproceeds to the Corporation. Trust I qualifies as a variable interest entityunder FIN 46R. The trust preferred securities must be redeemed upon maturity ofthe subordinate debentures on February 22, 2031. The Corporation mayredeem the debentures prior to their stated maturity upon the occurrence ofspecified special events or at the specified optional redemption dates. TheCorporation may redeem the debentures, in whole but not in part, at any time,within 90 days following the occurrence and continuation of a tax event,an investment company event or a capital treatment event as set forth in theindentures relating to the trust preferred securities and in each case subjectto regulatory approval if required. If the special redemption date is before February 22,2011, the special redemption price is the greater of (i) 100% of theprincipal amount of the debentures, plus accrued and unpaid interest on thedebentures to the special redemption date, or (ii) as determined by aquotation agent, the sum of (a) the present value of the principal amountof the debentures at 105.10% of the principal amount and the present value ofinterest payable from the special redemption date to February 22, 2011,each discounted to the special redemption date on a semi-annual basis, plus (b) accruedand unpaid interest on the debentures to the special redemption date. If thespecial redemption date is on February 22, 2011, the redemption price is105.10% of the principal amount, and declines annually to 100.00% on February 22,2021 and thereafter, plus accrued and unpaid interest on the debentures to theredemption date. The Corporation also may redeem the debt securities, in wholeor in part, at the stated 

65

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 9—Borrowings(Continued)**

optional redemption dateof February 22, 2011 and semi-annually thereafter, subject to regulatoryapproval if required. The redemption price on February 22, 2011 is equalto 105.10% of the principal amount, and declines annually to 100.00% on February 22,2021 and thereafter, plus accrued and unpaid interest on the debentures to theredemption date.

The Corporation’s obligations under the debentures andrelated documents, taken together, constitute a full and unconditionalguarantee by the Corporation of Trust I’s, Trust II’s and Trust III’sobligations under the trust preferred securities.

In March 2005, theFederal Reserve Board adopted a final rule that allows the continuedlimited inclusion of outstanding and prospective issuances of trust preferredsecurities in Tier 1 capital of bank holding companies. Under the final rule,trust preferred securities and other restricted core capital elements will besubject to stricter quantitative limits. The Board’s final rule limitsrestricted core capital elements to 25% of all core capital elements, net ofgoodwill, less any associated deferred tax liability. Amounts of restrictedcore capital elements in excess of these limits generally may be included inTier 2 capital. The final rule provides a five-year transition periodending March 31, 2009, for application of the quantitative limits. Inaddition, the requirement for trust preferred securities to include a calloption has been eliminated, and standards for the junior subordinated debtunderlying trust preferred securities eligible for Tier 1 capital treatmenthave been clarified. Management has evaluated the effects of the rule anddoes not anticipate a material impact on its capital ratios uponimplementation.

**Note 10—Income Taxes**

Thecomponents of income tax expense were as follows:

| ** **                       | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------|------------|--------------------------------------------|------------|
| ** **                       | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                       | ** ** | **(Dollars in thousands)**       | ** ** |
| Current income tax  expense:     | ** ** | ** **                                 |       |   |   |   |   |
| Federal                          | ** ** | **$**                                      | **17,814** |   | $ | 16,029 |   | $ | 11,512 |   |
| State                            | ** ** | **119**                                    |       | 117 |   | 100 |   |
| Total current income tax expense | ** ** | **17,933**                                 |       | 16,146 |   | 11,612 |   |
| Deferred federal  income tax     | ** ** | **(5,530**                                 | **)**      | (3,580 | ) | (2,915 | ) |
| Total income tax expense         | ** ** | **$**                                      | **12,403** |   | $ | 12,566 |   | $ | 8,697 |   |

 

Theeffective income tax rates of 24.2% for 2005, 24.6% for 2004 and 19.8% for 2003were less than the applicable federal income tax rate of 35% for each year. Thereason for these differences follows:

| ** **                                               | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                               | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                               | ** ** | **(Dollars in thousands)**       | ** ** |
| Expected income  tax expense                             | ** ** | **$**                                      | **18,008** |   | $ | 17,972 |   | $ | 15,474 |   |
| Tax-exempt  income net of interest disallowance          | ** ** | **(5,078**                                 | **)**      | (5,365 | ) | (6,769 | ) |
| Other                                                    | ** ** | **(201**                                   | **)**      | (41 | ) | (8 | ) |
| Tax benefit from  sale of Cumberland Advisors, Inc. | ** ** | **(326**                                   | **)**      | — |   | — |   |
| Actual income tax  expense                               | ** ** | **$**                                      | **12,403** |   | $ | 12,566 |   | $ | 8,697 |   |

 

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 10—IncomeTaxes (Continued)**

The tax effect oftemporary differences that give rise to significant portions of deferred taxassets and liabilities are as follows:

| ** **                                                  | ** ** | **2005**                             | ** ** | **2004**      | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------|------------|---------------|------------|
| ** **                                                  | ** ** | **Asset**                            | ** ** | **Liability** | ** ** | **Asset** | ** ** | **Liability** | ** ** |
| ** **                                                  | ** ** | **(Dollars in thousands)** | ** ** |
| Allowance for  loan losses                                  | ** ** | **$**                                | **6,768**  | ** **    |       | **$** | **—** |   |   | $ | 6,274 |   | $ | — |   |
| Lease assets                                                | ** ** | **—**                           | ** ** |          | **3,895**  |   |   | — |   | 9,683 |   |
| Deferred loan  fees                                         | ** ** | **—**                           | ** ** |          | **2,214**  |   |   | — |   | 1,810 |   |
| Deferred  compensation                                      | ** ** | **2,798**                            | ** ** |          | **—** |   |   | 2,489 |   | — |   |
| Pension                                                     | ** ** | **—**                           | ** ** |          | **106**    |   |   | — |   | 23 |   |
| Depreciation                                                | ** ** | **—**                           | ** ** |          | **690**    |   |   | — |   | 1,409 |   |
| Net operating  loss carryforward                            | ** ** | **701**                              | ** ** |          | **—** |   |   | 1,414 |   | — |   |
| Unrealized gain  on investment securities                   | ** ** | **4,801**                            | ** ** |          | **—** |   |   | — |   | 651 |   |
| Net unrealized  gain on derivative used for cash flow hedge | ** ** | **—**                           | ** ** |          | **160**    |   |   | — |   | 18 |   |
| Purchase  accounting adjustments                            | ** ** | **—**                           | ** ** |          | **692**    |   |   | — |   | — |   |
| Other                                                       | ** ** | **—**                           | ** ** |          | **721**    |   |   | — |   | 835 |   |
| Total deferred taxes                                        | ** ** | **$**                                | **15,068** | ** **    |       | **$** | **8,478** |   |   | $ | 10,177 |   | $ | 14,429 |   |

 

The exercise of stock options which have been grantedunder the Corporation’s various stock option plans gives rise to compensation,which is includible in the taxable income of the applicable employees anddeductible by the Corporation for income tax purposes. Compensation resultingfrom increases in the fair market value of the Corporation’s common stocksubsequent to the date of grant of the applicable exercised stock options isnot recognized, in accordance with APB Opinion No. 25, as an expense forfinancial accounting purposes and the related tax benefits are taken directlyto additional paid in capital. The amounts recorded in paid in capital for 2005and 2004 were $1.4 million and $695,000, respectively.

As a result of the acquisition of Millennium Bankduring 2004, the Corporation had net operating loss carry forwards ofapproximately $4.5 million. As of 12/31/05, $2.6 million of these net operatinglosses remain and are scheduled to expire 2020 through 2024. The recognition ofthe net operating loss carry forward is subject to an annual limitation;however the Corporation expects to fully utilize the remaining carry forward.

The Corporation acquired Cumberland Advisors as partof the Millennium Bank acquisition. Cumberland Advisors was subsequently soldin 2005. This sale generated a tax loss as a result of the tax basis exceedingthe book basis of the net assets acquired. A tax benefit of approximately$326,000 was recorded in 2005 associated with this sale. Additional taxbenefits of $245,000 remain from this sale and are subject to certainlimitations and will be utilized through 2016.

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 11—Pension Plans**

*Defined BenefitPension Plan*

The Corporation has anon-contributory defined benefit pension plan covering substantially allemployees. The plan’s benefits are based on years of service and the employee’saverage compensation during any five consecutive years within the ten-yearperiod preceding retirement. The plan’s funded status and amounts recognized inthe financial statements follow:

| ** **                                      | ** ** | **2005**                             | ** ** | **2004** | ** ** |
|-------------------------------------------------|------------|--------------------------------------|------------|----------|------------|
| ** **                                      | ** ** | **(Dollars in thousands)** | ** ** |
| **Change  in benefit obligation:**              |       |                                 |       |     |       |
| Benefit  obligation at beginning of year        | ** ** | **$**                                | **10,921** |     | $          | 9,439 |   |
| Service cost                                    | ** ** | **1,052**                            |       | 873      |       |
| Interest cost                                   | ** ** | **642**                              |       | 564      |       |
| Actual loss                                     | ** ** | **308**                              |       | 218      |       |
| Benefits paid                                   | ** ** | **(1,871**                           | **)**      | (465     | )          |
| Change in  assumptions                          | ** ** | **—**                           |       | 292      |       |
| Benefits  obligation at end of year             | ** ** | **$**                                | **11,052** |     | $          | 10,921 |   |
| **Change  in plan assets:**                     | ** ** | ** **                           |       |     |       |
| Fair value of  plan assets at beginning of year | ** ** | **$**                                | **8,469**  |     | $          | 6,870 |   |
| Actual return on  plan assets                   | ** ** | **486**                              |       | 564      |       |
| Employer  contribution                          | ** ** | **1,500**                            |       | 1,500    |       |
| Benefits paid                                   | ** ** | **(1,871**                           | **)**      | (465     | )          |
| Fair value of  plan assets at end of year       | ** ** | **$**                                | **8,584**  |     | $          | 8,469 |   |
| Funded status                                   | ** ** | **$**                                | **(2,468** | **)**    | $          | (2,452 | ) |
| Unrecognized  transition (asset)                | ** ** | **(85**                              | **)**      | (103     | )          |
| Unrecognized  prior service cost                | ** ** | **—**                           |       | —   |       |
| Unrecognized net  loss                          | ** ** | **2,860**                            |       | 2,624    |       |
| Minimum liability  recognized                   | ** ** | **—**                           |       | —   |       |
| Accrued benefit cost                            | ** ** | **$**                                | **307**    |     | $          | 69 |   |

 

| ** **                                                                 | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **(Dollars in thousands)**                     | ** ** |
| **Amounts  recognized in the statement of financial position consist of:** |       |                                                     |       |                                                     |       |   |   |   |   |
| Prepaid benefit  cost                                                      | ** ** | ** **                                               | **$**      | **307**                                                  |       |   |   | $ | (390 | ) |   |
| Accumulated other  comprehensive income                                    |       |                                                     | **—** |                                                     |       |   | 459 |   |   |
| Net amount recognized                                                      | ** ** | ** **                                               | **$**      | **307**                                                  |       |   |   | $ | 69 |   |   |

 

| **Weighted-average assumptions used to determine**        | ** ** | **Year Ended  December 31,** | ** ** |
|-------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| **pension plan obligations as of December 31,** | ** ** | ** **                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Discount rate                                                                 | ** ** | **6.00**                               | **%**      | 6.00 | % | 6.00 | % |
| Rate of compensation  increase                                                | ** ** | **4.00**                               | **%**      | 4.00 | % | 4.00 | % |
|                                                                               |            |                                        |            |  |  |  |  |  |  |

                                                                                                                                                                                                                                                

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 11—PensionPlans (Continued)**

| **Weighted-average assumptions used to determine**                                     | ** ** | **Year Ended  December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| **pension plan net periodic benefit cost as of December 31,** | ** ** | ** **                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Discount rate                                                                                              | ** ** | **6.00**                               | **%**      | 6.00 | % | 6.00 | % |
| Expected return  on plan assets                                                                            | ** ** | **6.00**                               | **%**      | 6.50 | % | 6.50 | % |
| Rate of compensation  increase                                                                             | ** ** | **4.00**                               | **%**      | 4.00 | % | 4.00 | % |
|                                                                                                            |            |                                        |            |  |  |  |  |  |  |

 

| ** **                                                                           | ** ** | **Year Ended  December 31,** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| **Components of net periodic defined benefit expense** | ** ** | ** **                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                           | ** ** | **(Dollars in thousands)**   | ** ** |
| Service cost                                                                         | ** ** | **$**                                  | **1,052**  |   | $ | 873 |   | $ | 785 |   |
| Interest cost                                                                        | ** ** | **642**                                |       | 564 |   | 488 |   |
| Expected return  on plan assets                                                      | ** ** | **(524**                               | **)**      | (477 | ) | (359 | ) |
| Amortization of  prior service cost                                                  | ** ** | **—**                             |       | (105 | ) | (111 | ) |
| Amortization of  unrecognized net actuarial losses                                   | ** ** | **92**                                 |       | 79 |   | 195 |   |
| Net periodic  benefit expense                                                        | ** ** | **$**                                  | **1,262**  |   | $ | 934 |   | $ | 998 |   |
|                                                                                      |            |                                        |            |  |  |  |  |  |  |  |  |  |

 

The pension plan assets are invested in a growth andincome strategy with a target asset allocation of 60% equity and 40% fixedincome securities. The allocation range for equities is between 55 to 65% andbetween 35 to 45% for fixed income. Long-term rate of return assumptions of thevarious asset classes are based primarily on empirical long-term historicalreturn data, adjusted for near-term expectations. To make the returnexpectations more conservative, our near-term expectations are for 8.0% equityand 4.5% fixed income returns for the next 10 years. The expected 2006employer contribution to the pension plan is $1.3 million.

As of December 31, 2005, Harleysville NationalCorporation’s Pension Plans had an investment in the Corporation’s stock with amarket value of $165,000.

TheCorporation’s pension plan weighted-average asset allocations by assetcategory is as follows:

| ** **        | ** ** | **Percentage of**                          | ** ** |
|-------------------|------------|-------------------------------------------------|------------|
| ** **        | ** ** | **Plan Assets at  December 31,** | ** ** |
| ** **        | ** ** | **2005**                                        | ** ** | **2004** | ** ** |
| Asset Category    |       |                                            |       |   |   |
| Equity securities | ** ** | **65.6**                                        | **%**      | 64.4 | % |
| Debt securities   | ** ** | **32.5**                                        | **%**      | 31.8 | % |
| Other             | ** ** | **1.9**                                         | **%**      | 3.8 | % |
| Total             | ** ** | **100.00**                                      | **%**      | 100.0 | % |

 

*SupplementalBenefit Plans*

The Corporation maintains a Supplemental ExecutiveRetirement Plan for certain officers and key employees. The plan provides forpayment to the covered employee of an annual supplemental retirement benefit upto 50% of their average annual compensation upon retirement, thereafter offsetby the employer’s share of social security, defined benefit pension andavailable employer’s 401(k) matching contribution. There is a lifetimepayout in retirement benefits with a minimum payout of 10 years. There is 

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 11—PensionPlans (Continued)**

apre-retirement death benefit, payable for 10 years, of 100% of the averageannual compensation for the first year, and up to 50% of the average annualcompensation for the next 9 years. The Corporation’s liability under theseagreements is being accrued over the participants’ remaining service period.The accrued benefit obligation as of December 31, 2005 and 2004 was$5.5 million and $4.7 million, respectively.

*DefinedContribution Plan*

The Corporation maintainsa 401(k) defined contribution retirement savings plan which allowsemployees to contribute a portion of their compensation on a pre-tax and/orafter-tax basis in accordance with specified guidelines. The Corporationmatches 50% of pre-tax employee contributions up to a maximum of 3%.Contributions charged to earnings were $569,000, $514,000 and $471,000 for2005, 2004 and 2003, respectively.

**Note 12—StockRepurchase Program and Stock Dividend/Split**

The Corporation has a stock repurchase program thatpermits the repurchase of up to five percent of its outstanding common stock.The repurchased shares will be used for general corporate purposes. On December 14,2000, the Board of Directors authorized a program to purchase up to 1,311,450shares (restated for stock dividends and splits), or 5%, of its outstandingcommon stock. This repurchase plan was completed during the second quarter of2005. On May 12, 2005, the Board of Directors authorized a plan topurchase up to 1,349,250 shares (restated for five percent stock dividend paidon September 15, 2005) or 4.9%, of its outstanding common stock. As of December 31,2005, the maximum number of shares that may yet be purchased under the plan is1,088,039.

On September 15, 2005, the Corporation paid afive percent stock dividend on its common stock to shareholders of record as ofSeptember 1, 2005.

On September 15, 2004, the Corporation paid afive percent stock dividend on its common stock to shareholders of record as ofAugust 30, 2004.

On September 15, 2003, the Corporation paid afive-for-four common stock split to shareholders of record as of September 2,2003.

All prior period amountsin the consolidated financial statements and footnotes have been restated toreflect these stock dividends/splits.

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 13—Stock Options**

The Corporation has five shareholder approved fixedstock option plans that are maintained to advance the development, growth andfinancial condition of the Corporation as described below. In connection withthe acquisition of Millennium Bank in 2004, the Corporation assumed allobligations under the Millennium Bank Stock Compensation Program. All shareinformation has been adjusted to reflect stock dividends and splits. Foradditional information on the accounting for stock based compensation plans andpro-forma disclosures, see Note 1, “Significant Accounting Policies—StockBased Compensation.”

*1998Independent Directors Stock Option Plan:*   Thisplan provides that shares of the Corporation’s stock be issued to non-employeedirectors. During 2005, there were 45,696 shares granted under the plan. As of December 31,2005, a total of 50,559 shares remained available for grant under the plan. At December 31,2005, there were 272,352 options outstanding under the plan.

*1993Stock Incentive Plan:*   This plan provides thatshares of the Corporation’s common stock be issued to certain employees of theCorporation and the Bank. Awards can be made in the form of incentive stockoptions, non-qualified stock options, stock appreciation rights or restrictedstock. No stock options remain available for grant under the 1993 StockIncentive Plan. At December 31, 2005, there were 60,644 optionsoutstanding under the plan.

*1998Stock Incentive Plan:*   This plan provides thatshares of the Corporation’s common stock be issued to certain employees of theCorporation and the Bank. Awards can be made in the form of incentive stockoptions, non-qualified stock options, stock appreciation rights or restrictedstock. No stock options remain available for grant under the 1998 StockIncentive Plan. During 2005, 110,336 stock options were granted. At December 31,2005, there were 1,196,782 options outstanding under the plan.

*2004Omnibus Stock Incentive:*   This plan provides thatshares of the Corporation’s common stock be issued to certain employees and/ordirectors of the Corporation and the Bank. Awards can be made in the form ofincentive stock options, non-qualified stock options, stock appreciation rightsor restricted stock. During 2005, there were 3,764 shares granted under theplan. As of December, 31, 2005, stock options of 1,098,736 remain available forgrant. At December 31, 2005, there were 3,764 options outstanding underthe plan.

*MillenniumStock Compensation Program Converted to Harleysville Stock Options:*   Inconnection with the acquisition of Millennium Bank in 2004, the Corporationassumed all obligations under the Millennium Bank Stock Compensation Program.The change in control accelerated the vesting of all outstanding stock optionsto 100%. Upon consummation of the merger, outstanding stock options wereconverted according to pro-ration parameters outlined in the merger agreement.Stock options totaling 312,681 were assumed on the effective date of themerger. During 2005, 115,436 stock options were exercised. In conjunction withthe sale of Cumberland Advisors, Inc. which took place in the secondquarter of this year, 34,485 non-qualified performance based stock options werecancelled. A total of 38,257 stock options remain outstanding under the programat December 31, 2005. No further stock options may be granted under theprogram.

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 13—StockOptions (Continued)**

The following tablepresents a summary of the status of all stock option plans at December 31,2005, 2004 and 2003, and the changes during the years then ended. The number ofoptions and option prices have been adjusted to reflect stock dividends andsplits.

| ** **                                                       | ** ** | **Shares Under  Option** | ** **    | **Weighted-Average  Exercise Price** | ** ** |
|------------------------------------------------------------------|------------|-------------------------------|---------------|-------------------------------------------|------------|
| **Balance  1/1/03**                                              |       |                          | 1,828,549     |                                      |       |   | $ | 10.03 |   |   |
| Granted                                                          |       |                          | 180,810       |                                      |       |   | 26.21 |   |   |
| Exercised                                                        |       |                          | (201,492      | )                                         |       |   | 9.60 |   |   |
| Cancelled                                                        |       |                          | (861          | )                                         |       |   | 9.59 |   |   |
| **Balance  12/31/03**                                            |       |                          | 1,807,006     |                                      |       |   | $ | 11.70 |   |   |
| Options  exercisable at 12/31/03                                 |       |                          | 1,154,585     |                                      |       |   | $ | 10.65 |   |   |
| **Balance 1/1/04**                                               |       |                          | 1,807,006     |                                      |       |   | $ | 11.70 |   |   |
| Granted                                                          |       |                          | 191,682       |                                      |       |   | 26.10 |   |   |
| Options from Millennium Bank acquisition  (see note 2) |       |                          | 312,681       |                                      |       |   | 11.30 |   |   |
| Exercised                                                        |       |                          | (453,897      | )                                         |       |   | 10.39 |   |   |
| Cancelled                                                        |       |                          | (77,662       | )                                         |       |   | 11.36 |   |   |
| **Balance  12/31/04**                                            |       |                          | 1,779,810     |                                      |       |   | $ | 13.52 |   |   |
| Options  exercisable at 12/31/04                                 |       |                          | 1,365,632     |                                      |       |   | $ | 12.76 |   |   |
| **Balance 1/1/05**                                               | ** ** | ** **                    | **1,779,810** | ** **                                | ** ** | ** ** | **$** | **13.52** |   |   |
| Granted                                                          | ** ** | ** **                    | **159,796**   | ** **                                | ** ** | ** ** | **22.31** |   |   |
| Exercised                                                        | ** ** | ** **                    | **(311,996**  | **)**                                     | ** ** | ** ** | **10.40** |   |   |
| Cancelled                                                        | ** ** | ** **                    | **(55,811**   | **)**                                     | ** ** | ** ** | **15.01** |   |   |
| **Balance  12/31/05**                                            | ** ** | ** **                    | **1,571,799** | ** **                                | ** ** | ** ** | **$** | **14.99** |   |   |
| Options exercisable at  12/31/05                                 | ** ** | ** **                    | **1,353,082** | ** **                                | ** ** | ** ** | **$** | **13.57** |   |   |

 

The weighted average fair value of options grantedduring 2005, 2004 and 2003 were $6.12, $7.12 and $7.87, respectively.

Thefollowing table summarizes information about stock options outstanding as of December 31, 2005:

| ** **                                 | ** ** | **Options as of December 31, 2005** | ** ** |
|--------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                 | ** ** | **Options Outstanding**                                 | ** ** | **Options Exercisable** | ** ** |
| **Range of Exercise price** | ** ** | ** **                                                   | ** ** | **Number  Outstanding** | ** ** | **Weighted-  Average  Remaining  Contractual Life** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted-  Average  Exercise Price** | ** ** |
| $8.62—$11.50                          |       |                                                         | 973,189    |   |   |   | 4.7 Years |   |   |   | $ | 9.77 |   |   | 973,189 |   |   | $ | 9.77 |   |   |
| 11.50—14.37                           |       |                                                         | 36,999     |   |   |   | 3.0 Years |   |   |   | $ | 12.82 |   |   | 36,999 |   |   | $ | 12.82 |   |   |
| 14.37—17.24                           |       |                                                         | 40,572     |   |   |   | 6.0 Years |   |   |   | $ | 16.02 |   |   | 40,572 |   |   | $ | 16.02 |   |   |
| 17.24—20.12                           |       |                                                         | 54,305     |   |   |   | 7.0 Years |   |   |   | $ | 18.57 |   |   | 54,305 |   |   | $ | 18.57 |   |   |
| 20.12—22.99                           |       |                                                         | 119,613    |   |   |   | 9.9 Years |   |   |   | $ | 21.18 |   |   | 1,102 |   |   | $ | 22.71 |   |   |
| 22.99—25.87                           |       |                                                         | 126,609    |   |   |   | 8.9 Years |   |   |   | $ | 25.60 |   |   | 61,962 |   |   | $ | 25.47 |   |   |
| 25.87—28.74                           |       |                                                         | 220,512    |   |   |   | 8.0 Years |   |   |   | $ | 27.85 |   |   | 184,953 |   |   | $ | 27.68 |   |   |
|                                       |       |                                                         | 1,571,799  |   |   |   | 5.9 Years |   |   |   | $ | 14.99 |   |   | 1,353,082 |   |   | $ | 13.57 |   |   |
|                                            |            |                                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

72

----

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 14—Earnings PerShare**

Thecalculations of basic earnings per share and diluted earnings per share arepresented below. All weighted average shares, actual shares and per shareinformation in the financial statements have been adjusted retroactively forthe effect of stock dividends and splits. See Note 1 of the consolidatedfinancial statements for a discussion on the calculation of earnings per share.

| ** **                                                                | ** ** | **Year Ended December 31,**                                         | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                                                                | ** ** | **2005**                                                                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands, except  per share information)** | ** ** |
| **Basic  earnings per share**                                             |       |                                                                               |       |   |   |   |   |
| Net income  available to common shareholders                              | ** ** | **$**                                                                              | **38,828** |   | $ | 38,567 |   | $ | 35,333 |   |
| Weighted average  common shares outstanding                               | ** ** | **27,515,630**                                                                     |       | 27,147,992 |   | 26,244,807 |   |
| Basic earnings  per share                                                 | ** ** | **$**                                                                              | **1.41**   |   | $ | 1.42 |   | $ | 1.35 |   |
| **Diluted earnings per share**                                            | ** ** | ** **                                                                         |       |   |   |   |   |
| Net income  available to common shareholders and assumed conversions | ** ** | **$**                                                                              | **38,828** |   | $ | 38,567 |   | $ | 35,333 |   |
| Weighted average  common shares outstanding                               | ** ** | **27,515,630**                                                                     |       | 27,147,992 |   | 26,244,807 |   |
| Dilutive  potential common shares(1),(2)                                  | ** ** | **570,290**                                                                        |       | 914,497 |   | 903,222 |   |
| Total diluted  weighted average common shares outstanding                 | ** ** | **28,085,920**                                                                     |       | 28,062,489 |   | 27,148,029 |   |
| Diluted earnings per  share                                               | ** ** | **$**                                                                              | **1.38**   |   | $ | 1.37 |   | $ | 1.30 |   |

----

(1)          Includes incrementalshares from assumed conversions of stock options.

(2)          Antidilutiveoptions have been excluded in the computation of diluted earnings per sharebecause the options’ exercise prices were greater than the average market priceof the common stock. For 2005, 2004, and 2003, there were 354,734, 314,061 and134,505 antidilutive options at an average price of $26.93, $27.24, and $28.74per share, respectively.

**Note 15—ComprehensiveIncome**

Thecomponents of other comprehensive income (loss) are as follows:

| **For the year ended December 31, 2005**      | ** ** | ** **                           | ** **  | **Before  tax amount** | ** ** | **Tax Benefit  (Expense)** | ** ** | **Net of  tax amount** | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------------|-------------|-----------------------------|------------|---------------------------------|------------|----------------------------------|------------|
| ** **                                                                  | ** ** | **(Dollars in thousands)** | ** **  |
| Net unrealized  losses on available for sale securities:                    |       |                                 |        |                        |       |                            |       |                             |       |   |   |   |   |
| Net unrealized holding losses arising during period                         | ** ** | ** **                           | **$**       | **(10,783**                 | **)**      | ** **                      | ** ** | **$**                            | **3,774**  | ** ** | ** ** | ** ** | **$** | **(7,009** | **)** | ** ** |
| Less reclassification adjustment for net gains  realized in net income | ** ** | ** **                           | **4,794**   | ** **                  | ** ** | ** **                      | **(1,678** | **)**                            | ** ** | ** ** | **3,116** | ** ** | ** ** |
| Net unrealized losses                                                       | ** ** | ** **                           | **(15,577** | **)**                       | ** ** | ** **                      | **5,452**  | ** **                       | ** ** | ** ** | **(10,125** | **)** | ** ** |
| Change in fair value of derivatives used for cash  flow hedges              | ** ** | ** **                           | **557**     | ** **                  | ** ** | ** **                      | **(195**   | **)**                            | ** ** | ** ** | **362** | ** ** | ** ** |
| Unrealized loss on termination of cash flow hedge                           | ** ** | ** **                           | **(151**    | **)**                       | ** ** | ** **                      | **53**     | ** **                       | ** ** | ** ** | **(98** | **)** | ** ** |
| Other  comprehensive loss, net                                              | ** ** | ** **                           | **$**       | **(15,171**                 | **)**      | ** **                      | ** ** | **$**                            | **5,310**  | ** ** | ** ** | ** ** | **$** | **(9,861** | **)** | ** ** |

 

73

----

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 15—ComprehensiveIncome (Continued)**

| **For the year ended December 31, 2004** | ** ** | ** **                           | ** ** | **Before  tax amount** | ** ** | **Tax Benefit  (Expense)** | ** ** | **Net of  tax amount** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|----------------------------------|------------|
| ** **                                                             | ** ** | **(Dollars in thousands)** | ** ** |
| Net unrealized  losses on available for sale securities:               |       |                                 |       |                        |       |                            |       |                             |       |   |   |   |   |
| Net unrealized holding losses arising during period                    |       |                                 | $          | (7,350                      | )          |                            |       | $                                | 2,573      |   |   |   | $ | (4,777 | ) |   |
| Less reclassification adjustment for net gains  realized in net income |       |                                 | 3,689      |                        |       |                            | (1,291     | )                                |       |   | 2,398 |   |   |
| Net unrealized losses                                                  |       |                                 | (11,039    | )                           |       |                            | 3,864      |                             |       |   | (7,175 | ) |   |
| Change in minimum pension liability                                    |       |                                 | 459        |                        |       |                            | —     |                             |       |   | 459 |   |   |
| Change in fair value of derivatives used for cash  flow hedges         |       |                                 | (214       | )                           |       |                            | 75         |                             |       |   | (139 | ) |   |
| Other  comprehensive loss, net                                         |       |                                 | $          | (10,794                     | )          |                            |       | $                                | 3,939      |   |   |   | $ | (6,855 | ) |   |

 

| **For the year ended December 31, 2003** | ** ** | ** **                           | ** ** | **Before  tax amount** | ** ** | **Tax  Expense** | ** ** | **Net of  tax amount** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|------------------|------------|----------------------------------|------------|
| ** **                                                             | ** ** | **(Dollars in thousands)** | ** ** |
| Net unrealized gains  on available for sale securities:                |       |                                 |       |                        |       |             |       |                             |       |   |   |
| Net unrealized holding gains arising during period                     |       |                                 | $          | 8,839                       |       |             | $          | (3,094                           | )          |   | $ | 5,745 |   |   |
| Less reclassification adjustment for net gains  realized in net income |       |                                 | 6,613      |                        |       | (2,315           | )          |                             | 4,298      |   |   |
| Net unrealized gains                                                   |       |                                 | 2,226      |                        |       | (779             | )          |                             | 1,447      |   |   |
| Change in minimum pension liability                                    |       |                                 | (459       | )                           |       | —           |       |                             | (459       | ) |   |
| Change in fair value of derivatives used for cash  flow hedges    |       |                                 | 266        |                        |       | (93              | )          |                             | 173        |   |   |
| Other  comprehensive income, net                                       |       |                                 | $          | 2,033                       |       |             | $          | (872                             | )          |   | $ | 1,161 |   |   |

 

**Note 16—Lease Commitments and ContingentLiabilities**

*Lease Commitments*

Lease commitments for equipment and banking locationsexpire intermittently over the years through 2036. Most banking location leasesrequire the lessor to pay insurance, maintenance costs, and property taxes.Approximate minimum rental commitments for non-cancelable operating leases atDecember 31, 2005, are as follows:

| ** **               | ** ** | **Minimum  Lease  Payments**     | ** ** |
|--------------------------|------------|----------------------------------|------------|
| ** **               | ** ** | **(Dollars  in thousands)** | ** ** |
| **For the year ending:** |       |                             |       |   |   |
| 2006                     |       |                             | $          | 1,993 |   |   |
| 2007                     |       |                             | 1,891      |   |   |
| 2008                     |       |                             | 1,655      |   |   |
| 2009                     |       |                             | 1,494      |   |   |
| 2010                     |       |                             | 1,472      |   |   |
| Thereafter               |       |                             | 9,869      |   |   |
| Total                    |       |                             | $          | 18,374 |   |   |

 

74

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 16—LeaseCommitments and Contingent Liabilities (Continued)**

Total rent expenseamounted to $2.4 million, $2.4 million and $2.1 million for theyears ended December 31, 2005, 2004 and 2003, respectively.

*Other*

Based on consultation withthe Corporation’s legal counsel, management is not aware of any litigation thatwould have a material adverse effect on the consolidated financial position ofthe Corporation. There are no proceedings pending other than the ordinaryroutine litigation incident to the business of the Corporation. In addition, nomaterial proceedings are pending or are known to be threatened or contemplatedagainst the Corporation by government authorities.

**Note 17—Financial Instruments with Off-BalanceSheet Risk**

The Bank is a party to financial instruments withoff-balance-sheet risk in the normal course of business to meet thefinancing needs of its customers. These financial instruments includecommitments to extend credit and standby letters of credit. Such financialinstruments are recorded in the financial statements when they become payable.Those instruments involve, to varying degrees, elements of credit and interestrate risk in excess of the amount recognized in the consolidated balancesheets. The contract or notional amounts of those instruments reflect theextent of involvement the Bank has in particular classes of financialinstruments.

The Bank’s exposure to credit loss in the event ofnonperformance by the other party to the financial instrument for commitmentsto extend credit and standby letters of credit is represented by thecontractual or notional amounts of those instruments. The Bank uses the samestringent credit policies in extending these commitments as they do forrecorded financial instruments and controls exposure to loss through creditapproval and monitoring procedures. These commitments are generally issued forone year or less, often expire without being drawn upon, and often are securedwith appropriate collateral.

The Bank offerscommercial, mortgage and consumer credit products to their customers in thenormal course of business. These products represent a diversified creditportfolio and are generally issued to borrowers within the Bank’s branch officesystems in eastern Pennsylvania. The ability of the customers to repay theircredits is, to some extent, dependent upon the economy in the Bank’s marketareas.

Unlessnoted otherwise, the Bank does not require collateral or other security tosupport financial instruments with credit risk. The approximate contractamounts are as follows:

| ** **                                                                                   | ** ** | **Total Amount  Committed at  December 31,** | ** **  |
|----------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------|-------------|
| **Commitments**                                                                              | ** ** | ** **                                                  | ** **  | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                   | ** ** | **(Dollars in thousands)**                        | ** **  |
| Financial  instruments whose contract amounts represent credit risk:                         |       |                                                        |        |   |   |
| Commitments to extend credit                                                                 | ** ** | **$**                                                       | **722,034** |   | $ | 660,238 |   |
| Standby letters of credit and financial guarantees  written                                  | ** ** | **21,661**                                                  |        | 17,217 |   |
| Financial  instruments whose notional or contract amounts exceed the amount of credit  risk: |       |                                                        |        |   |   |
| Interest rate  swap agreements                                                               | ** ** | **22,100**                                                  |        | 45,000 |   |
|                                                                                              |            |                                                             |             |  |  |  |  |  |  |

 

75

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 17—FinancialInstruments with Off-Balance Sheet Risk (Continued)**

Standby letters of credit expire as follows:$16.0 million in one year or less, $4.0 million after one yearthrough three years, $41,000 after three years through five years and $1.6million after five years.

At December, 31, 2005, the Corporation had cash flowhedges in the form of interest rate swaps totaling $20.0 million that have theeffect of converting the rates on money market deposit accounts to a fixed-ratecost of funds. This strategy will cause the Bank to recognize, in a rising rateenvironment, a larger interest rate spread than it otherwise would have withoutthe swaps in effect. For these swaps, the Corporation recognized $69,000 of netinterest income for the year ended December 31, 2005 and estimates thatfor 2006, $286,000 will be recognized as an increase in net interest income.These swaps mature in 2008. During the first quarter of 2005, the Corporationterminated a cash flow hedge with a notional value of $25.0 million. Thegross loss related to the termination of this swap is $310,000 which is beingamortized through October 2006 in accordance with SFAS No. 133 “Accountingfor Derivative Instruments and Hedging Activities.” For the year ended December 31,2005, the Corporation amortized into net interest income $159,000 related tothis swap. Periodically, the Corporation may enter into fair value hedges tolimit the exposure to changes in the fair value of loan assets. During December 2005,the Corporation entered into a fair value hedge for $2.1 million which had noimpact to earnings for 2005. This swap matures in 2015.

The Bank also had commitments with customers to extendmortgage loans at a specified rate at December 31, 2005 and 2004 of$1.8 million and $5.1 million, respectively and commitments to sellmortgage loans at a specified rate at December 31, 2005 and 2004 of$1.1 million and $2.2 million, respectively. The commitments areaccounted for as a derivative and recorded at fair value. The Bank estimatesthe fair value of these commitments by comparing the secondary market price atthe reporting date to the price specified in the contract to extend or sell theloan initiated at the time of the loan commitment. At December 31, 2005and 2004, the fair values of the loan commitments were $320 and $5,000,respectively, which were recorded as other income.

During December 2004and January 2005, the Bank sold lease financing receivables of $10.5million. Of these leases, $1.2 million were sold with full recourse andthe remaining leases were sold subject to recourse with a maximum exposure often percent of the outstanding receivable. The total recourse exposure at thetime of the sale of the leases was $2.0 million. During the first quarter of2005, the Bank recorded a recourse liability of $216,000 which is the entirerecourse liability recorded. This estimate was based on our historic losses asexperienced on similar lease financing receivables. After the first anniversaryof the sale agreement, and on a quarterly basis thereafter, upon writtenrequest by the Bank, the purchaser will review the portfolio performance andmay reduce the total exposure to an amount equal to ten percent of theoutstanding net book value. The Corporation will be subject to the full andpartial recourse obligations until all the lease financing receivables havebeen paid or otherwise been terminated and all equipment has been sold ordisposed of. The final lease payment is due in 2010 with approximately 90% ofthe lease financing receivables estimated to be paid down by 2007. Theoutstanding balance of these sold leases at December 31, 2005 was $6.6million with a total recourse exposure of $1.4 million.

76

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 18—RegulatoryCapital**

| ** **                                        | ** **   | **Actual**                           | ** **   | **For Capital  Adequacy Purposes** | ** **   | **To Be Well  Capitalized  Under Prompt  Corrective  Action Provision** | ** **   |
|---------------------------------------------------|--------------|--------------------------------------|--------------|----------------------------------------------|--------------|---------------------------------------------------------------------------------------------|--------------|
| **As of December 31, 2005**   | ** **   | ** **                           | ** **   | **Amount**                                   | ** **   | **Ratio**                                                                                   | ** **   | **Amount** | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| ** **                                        | ** **   | **(Dollars in thousands)** | ** **   |
| *Total Capital (to risk weighted  assets):*       | *** *** | *** ***                         | *** *** | *** ***                                 | *** *** | *** ***                                                                                | *** *** |   | *** *** | *** *** |   | *** *** | *** *** |   | *** *** | *** *** |   |
| Corporation                                       | ** **   | **$**                                | **318,911**  | ** **                                   | **12.98**    | **%**                                                                                       | **$**        | **196,563** | ** ** |   | **8.00** | **%** |   | **$** | **245,703** | ** ** |   | **—** | *** *** |   |
| Harleysville  National Bank                       | ** **   | **259,883**                          | ** **   | **10.64**                                    | **%**        | **195,390**                                                                                 | ** **   |   | **8.00** | **%** |   | **244,238** | ** ** |   | **10** | **%** |   |
| *Tier 1 Capital (to risk  weighted assets):* | *** *** | *** ***                         | *** *** | *** ***                                 | *** *** | *** ***                                                                                | *** *** |   | *** *** | ** ** |   | *** *** | *** *** |   | *** *** | ** ** |   |
| Corporation                                       | ** **   | **298,946**                          | ** **   | **12.17**                                    | **%**        | **98,281**                                                                                  | ** **   |   | **4.00** | **%** |   | **147,422** | ** ** |   | **—** | ** ** |   |
| Harleysville  National Bank                       | ** **   | **239,918**                          | ** **   | **9.82**                                     | **%**        | **97,695**                                                                                  | ** **   |   | **4.00** | **%** |   | **146,543** | ** ** |   | **6** | **%** |   |
| *Tier 1 Capital (to average  assets):*       | ** **   | ** **                           | ** **   | ** **                                   | ** **   | ** **                                                                                  | ** **   |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |
| Corporation                                       | ** **   | **298,946**                          | ** **   | **9.69**                                     | **%**        | **123,408**                                                                                 | ** **   |   | **4.00** | **%** |   | **154,260** | ** ** |   | **—** | ** ** |   |
| Harleysville National  Bank                       | ** **   | **239,918**                          | ** **   | **7.86**                                     | **%**        | **122,154**                                                                                 | ** **   |   | **4.00** | **%** |   | **152,693** | ** ** |   | **5** | **%** |   |
|                                                   |              |                                      |              |                                              |              |                                                                                             |              |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                        | ** ** | **Actual**                           | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized  Under Prompt  Corrective  Action Provision** | ** ** |
|---------------------------------------------------|------------|--------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|
| **As of December 31, 2004**   | ** ** | ** **                           | ** ** | **Amount**                                   | ** ** | **Ratio**                                                                                   | ** ** | **Amount** | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| ** **                                        | ** ** | **(Dollars in thousands)** | ** ** |
| *Total Capital (to risk weighted  assets):*       | * *   | * *                             | * *   | * *                                     | * *   | * *                                                                                    | * *   |   | * * | * * |   | * * | * * |   | * * | * * |   |
| Corporation                                       |       | $                                    | 280,055    |                                         | 12.21      | %                                                                                           | $          | 183,436 |   |   | 8.00 | % |   | $ | 229,295 |   |   | — |   |   |
| Harleysville  National Bank                       |       | 240,695                              |       | 10.60                                        | %          | 181,647                                                                                     |       |   | 8.00 | % |   | 227,059 |   |   | 10 | % |   |
| *Tier 1 Capital (to risk  weighted assets):* | * *   | * *                             | * *   | * *                                     | * *   | * *                                                                                    | * *   |   | * * | * * |   | * * | * * |   | * * | * * |   |
| Corporation                                       |       | 260,480                              |       | 11.36                                        | %          | 91,718                                                                                      |       |   | 4.00 | % |   | 137,577 |   |   | — |   |   |
| Harleysville  National Bank                       |       | 222,140                              |       | 9.78                                         | %          | 90,823                                                                                      |       |   | 4.00 | % |   | 136,235 |   |   | 6 | % |   |
| *Tier 1 Capital (to average  assets):*       |       |                                 |       |                                         |       |                                                                                        |       |   |   |   |   |   |   |   |   |   |   |
| Corporation                                       |       | 260,480                              |       | 8.91                                         | %          | 116,950                                                                                     |       |   | 4.00 | % |   | 146,187 |   |   | — |   |   |
| Harleysville National  Bank                       |       | 222,140                              |       | 7.70                                         | %          | 115,439                                                                                     |       |   | 4.00 | % |   | 144,299 |   |   | 5 | % |   |
|                                                   |            |                                      |            |                                              |            |                                                                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The Bank is subject tovarious regulatory capital requirements administered by the federal bankingagencies. Failure to meet minimum capital requirements can initiate certainmandatory and possibly additional discretionary actions by regulators that, ifundertaken, could have a direct material affect on the Corporation’s financialstatements. Under capital adequacy guidelines and the regulatory framework forprompt corrective action, the Bank must meet specific capital guidelines thatinvolve quantitative measures of the Bank’s assets, liabilities, and certainoff-balance-sheet items as calculated under regulatory accountingpractices. The Bank’s capital amounts and classification are also subject toqualitative judgments by the regulators about components, risk weightings, andother factors.

Quantitative measuresestablished by regulation to ensure capital adequacy require the Bank tomaintain minimum amounts and ratios (set forth in the table) of total and Tier1 capital to risk-weighted assets. Management believes, as of December 31,2005, that the Bank meets all capital adequacy requirements to which it issubject. To be categorized as well capitalized, the Bank must maintain minimumtotal risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth inthe table. There are no conditions or events that have occurred that managementbelieves have changed the Bank’s category.

77

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 18—RegulatoryCapital (Continued)**

The National Banking Laws require the approval of theOffice of the Comptroller of the Currency if the total of all dividendsdeclared by a national bank in any calendar year exceed the net profits of thebank (as defined) for that year combined with its retained net profits for thepreceding two calendar years. Under this formula, the Bank may declaredividends in 2006 of approximately $34.5 million plus an amount equal tothe net profits of the Bank in 2006 up to the date of any such dividend declaration.

Additionally, bankingregulations limit the amount of investments, loans, extensions of credit andadvances that a subsidiary bank can make to an affiliate at any time to 10% andin the aggregate, 20% of the Bank’s capital stock and surplus. These regulationsalso require that any such investment, loan, extension of credit or advance besecured by securities having a market value in excess of the amount thereof. AtDecember 31, 2005, the Bank did not engage in any material transactionswith affiliates.

**Note 19—Fair Value ofFinancial Instruments**

SFAS No. 107, “Disclosures about Fair Values ofFinancial Instruments,” requires disclosure of the estimated fair value of anentity’s assets and liabilities considered to be financial instruments. For theCorporation, as for most financial institutions, the majority of its assets andliabilities are considered financial instruments as defined in SFAS No. 107.However, many such instruments lack an available trading market, ascharacterized by a willing buyer and seller engaging in an exchangetransaction. Also, it is the Corporation’s general practice and intent to holdits financial instruments to maturity and not to engage in trading or salesactivities, except for certain loans and investments. Therefore, theCorporation had to use significant estimates and present value calculations toprepare this disclosure.

Changes in the assumptions or methodologies used toestimate fair values may materially affect the estimated amounts. Also,management is concerned that there may not be reasonable comparability betweeninstitutions due to the wide range of permitted assumptions and methodologiesin the absence of active markets. This lack of uniformity gives rise to a highdegree of subjectivity in estimating financial instrument fair values.

Estimated fair values havebeen determined by the Corporation using the best available data and anestimation methodology suitable for each category of financial instruments. Theestimation methodologies used at December 31, 2005 and 2004 are outlinedas follows:

*Short-termfinancial instruments*

The carrying value ofshort-term financial instruments including cash and due from banks, federalfunds sold and securities purchased under agreements to resell, interest-bearingdeposits in banks and other short-term investments and borrowings, approximatesthe fair value of these instruments. These financial instruments generallyexpose the Corporation to limited credit risk and have no stated maturities orhave short-term maturities with interest rates that approximate market rates.

*Investmentsecurities*

The estimated fair valuesof investment securities are based on quoted market prices, if available.Estimated fair values are based on quoted market prices of comparableinstruments if quoted market prices are not available.

78

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 19—FairValue of Financial Instruments (Continued)**

*Loans*

The loan portfolio, net ofunearned income, has been valued using a present value discounted cash flowanalysis where market prices were not available. The discount rate used inthese calculations is the estimated current market rate adjusted for creditrisk.

*Deposits*

The estimated fair valuesof demand deposits (i.e., interest and noninterest-bearing checking accounts,savings and certain types of money market accounts) are, by definition, equalto the amount payable on demand at the reporting date (i.e., their carryingamounts). The carrying amounts of variable rate, fixed-term money marketaccounts and certificates of deposit approximate their fair values at thereporting date. The fair value for deposits with stated maturities wascalculated by discounting contractual cash flows using current market rates forinstruments with similar maturities. The carrying amount of accrued interestreceivable and payable approximates fair value.

*Long-termborrowings and subordinated debt*

The amounts assigned tolong-term borrowings and subordinated debt was based on quoted market prices,when available, or were based on discounted cash flow calculations usingprevailing market interest rates for debt of similar terms.

*Off-balance sheetinstruments*

The fair value ofcommitments to extend credit is estimated based on the amount of unamortizeddeferred loan commitment fees. The fair value of letters of credit is based onthe amount of unearned fees plus the estimated cost to terminate the letters ofcredit. Fair values of unrecognized financial instruments including commitmentsto extend credit and the fair value of letters of credit are consideredimmaterial.

The fair value of interestrate swaps are based upon the estimated amount the Corporation would receive orpay to terminate the contracts or agreements, taking into account currentinterest rates and, when appropriate, the current creditworthiness of thecounterparties. The fair value of the interest rate swap agreements are$623,000 at December 31, 2005 and $53,000 at December 31, 2004.

*The carrying and fair values of certain financialinstruments were as follows:*

| ** **                                  | ** ** | **December 31,**                | ** **  |
|---------------------------------------------|------------|--------------------------------------|-------------|
| ** **                                  | ** ** | **2005**                             | ** **  | **2004** | ** ** |
| ** **                                  | ** ** | **Carrying  Amount**                 | ** **  | **Fair  Value** | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** |
| ** **                                  | ** ** | **(Dollars in thousands)** | ** **  |
| Investment  securities                      | ** ** | **$**                                | **901,208** | ** ** | **$** | **901,406** |   | $ | 943,563 |   | $ | 944,436 |   |
| Loans, net                                  | ** ** | **1,985,493**                        | ** **  | **1,946,051** |   | 1,845,802 |   | 1,824,984 |   |
| Time deposits                               | ** ** | **756,658**                          | ** **  | **753,008** |   | 637,385 |   | 639,822 |   |
| Long-term  borrowings and subordinated debt | ** ** | **349,298**                          | ** **  | **343,882** |   | 298,524 |   | 300,858 |   |
| Bank-owned life  insurance                  | ** ** | **59,334**                           | ** **  | **59,334** |   | 52,109 |   | 52,109 |   |
|                                             |            |                                      |             |  |  |  |  |  |  |  |  |  |  |

 

79

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 20—Parent-CompanyOnly Financial Information**

Condensedfinancial statements of Harleysville National Corporation follow:

**CONDENSED BALANCE SHEETS**

| ** **                                       | ** ** | **December 31,**                | ** **            |
|--------------------------------------------------|------------|--------------------------------------|-----------------------|
| ** **                                       | ** ** | **2005**                             | ** **            | **2004** | ** ** |
| ** **                                       | ** ** | **(Dollars in thousands)** | ** **            |
| **Assets**                                       |       |                                 |                  |   |   |
| Cash                                             | ** ** | **$**                                | **26,152**** **  |   | $ | 3,456  |   |
| Investments in subsidiaries                      | ** ** | **294,726**                          |                  | 291,126 |   |
| Other investments                                | ** ** | **1,548**                            |                  | 774 |   |
| Other assets                                     | ** ** | **3,025**                            |                  | 1,578 |   |
| Total assets                                     | ** ** | **$**                                | **325,451**** ** |   | $ | 296,934  |   |
| **Liabilities  and shareholders’ equity**   | ** ** | ** **                           |                  |   |   |
| Subordinated debt                                | ** ** | **$**                                | **51,548**** **  |   | $ | 25,774  |   |
| Other liabilities                                | ** ** | **671**                              |                  | 628 |   |
| Total liabilities                                | ** ** | **52,219**                           |                  | 26,402 |   |
| Shareholders’ equity                        | ** ** | **273,232**                          |                  | 270,532 |   |
| Total liabilities  and shareholders’ equity | ** ** | **$**                                | **325,451**** ** |   | $ | 296,934  |   |

 

**CONDENSEDSTATEMENTS OF INCOME**

| ** **                                                                                | ** ** | **Year Ended December 31,** | ** **           |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------------|----------------------|
| ** **                                                                                | ** ** | **2005**                                   | ** **           | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                | ** ** | **(Dollars in thousands)**       | ** **           |
| Dividends from  subsidiaries                                                              | ** ** | **$**                                      | **26,638**** ** |   | $ | 18,575  |   | $ | 16,566  |   |
| Interest from  subsidiaries                                                               | ** ** | **191**                                    |                 | — |   | — |   |
| Investment income                                                                         | ** ** | **57**                                     |                 | 29 |   | 16 |   |
| Total income                                                                              | ** ** | **26,886**                                 |                 | 18,604 |   | 16,582 |   |
| Interest on  subordinated debt                                                            | ** ** | **2,180**                                  |                 | 1,249 |   | 517 |   |
| Noninterest  expense                                                                      | ** ** | **3**                                      |                 | 23 |   | 9 |   |
| Total expense                                                                             | ** ** | **2,183**                                  |                 | 1,272 |   | 526 |   |
| Income before  income tax benefit and equity in undistributed net  income of subsidiaries | ** ** | **24,703**                                 |                 | 17,332 |   | 16,056 |   |
| Income tax  benefit                                                                       | ** ** | **(677**                                   | **)**                | (426 | ) | (179 | ) |
| Income before  equity in undistributed net income of subsidiaries                         | ** ** | **25,380**                                 |                 | 17,758 |   | 16,235 |   |
| Equity in  undistributed net income of subsidiaries                                       | ** ** | **13,448**                                 |                 | 20,809 |   | 19,098 |   |
| Net income                                                                                | ** ** | **$**                                      | **38,828**** ** |   | $ | 38,567  |   | $ | 35,333  |   |

 

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES**

**Note 20—Parent-CompanyOnly Financial Information (Continued)**

**CONDENSEDSTATEMENTS OF CASH FLOWS**

| ** **                                                                         | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                         | ** ** | **(Dollars in thousands)**       | ** ** |
| **Operating activities:**                                                          |       |                                       |       |   |   |   |   |
| Net income                                                                         | ** ** | **$**                                      | **38,828** |   | $ | 38,567 |   | $ | 35,333 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities: | ** ** | ** **                                 |       |   |   |   |   |
| Equity in undistributed net income of subsidiaries                                 | ** ** | **(13,448**                                | **)**      | (20,809 | ) | (19,098 | ) |
| Net increase in other assets                                                       | ** ** | **(1,447**                                 | **)**      | (1,115 | ) | (172 | ) |
| Net increase (decrease) in other liabilities                                       | ** ** | **43**                                     |       | 540 |   | (537 | ) |
| Other, net                                                                         | ** ** | **(782**                                   | **)**      | (693 | ) | 6 |   |
| Net cash provided  by operating activities                                         | ** ** | **23,194**                                 |       | 16,490 |   | 15,532 |   |
| **Investing  activities:**                                                         | ** ** | ** **                                 |       |   |   |   |   |
| Net cash paid due to acquisition                                                   | ** ** | **—**                                 |       | (18,403 | ) | — |   |
| Capital contributions made to the subsidiaries                                     | ** ** | **—**                                 |       | — |   | — |   |
| Net cash used in  investing activities                                             | ** ** | **—**                                 |       | (18,403 | ) | — |   |
| **Financing  activities:**                                                         | ** ** | ** **                                 |       |   |   |   |   |
| Advances of long-term subordinated debt                                            | ** ** | **25,774**                                 |       | 20,619 |   | — |   |
| Cash dividends                                                                     | ** ** | **(20,738**                                | **)**      | (18,575 | ) | (15,566 | ) |
| Repurchase of common stock                                                         | ** ** | **(9,972**                                 | **)**      | (3,815 | ) | (2,271 | ) |
| Proceeds from the exercise of stock options                                        | ** ** | **4,453**                                  |       | 5,243 |   | 2,197 |   |
| Other, net                                                                         | ** ** | **(15**                                    | **)**      | (13 | ) | (13 | ) |
| Net cash provided  by (used in) financing activities                               | ** ** | **(498**                                   | **)**      | 3,459 |   | (15,653 | ) |
| Net increase  (decrease) in cash                                                   | ** ** | **22,696**                                 |       | 1,546 |   | (121 | ) |
| Cash and cash  equivalents at beginning of year                                    | ** ** | **3,456**                                  |       | 1,910 |   | 2,031 |   |
| Cash and cash  equivalents at end of year                                          | ** ** | **$**                                      | **26,152** |   | $ | 3,456 |   | $ | 1,910 |   |

 

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

Board of DirectorsHarleysville National Corporation

We have audited the accompanying consolidated balancesheets of Harleysville National Corporation (a Pennsylvania corporation) andits subsidiaries as of December 31, 2005 and 2004, and the relatedconsolidated statements of income, shareholders’ equity, and cash flows foreach of the three years in the period ended December 31, 2005. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of Harleysville National Corporation as of December 31, 2005 and2004, and the consolidated results of its operations and its cash flows foreach of the three years in the period ended December 31, 2005 inconformity with accounting principles generally accepted in the United Statesof America.

Wealso have audited, in accordance with the standards of the Public Company AccountingOversight Board (United States), the effectiveness of Harleysville NationalCorporation’s internal control over financial reporting as of December 31,2005, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO) and our report dated March 3, 2006 expressed an unqualified opinionon management’s assessment and an unqualified opinion on internal controleffectiveness.
| /s/ Grant Thornton LLP     |
|----------------------------|
| Philadelphia, Pennsylvania |
| March 3, 2006         |

 

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**Item9.**                        Changes inand Disagreements with Accountants on Accounting and Financial Disclosure

None

**Item9A.**                Controls andProcedures

Therehave been no changes in the Corporation’s internal control over financialreporting during the fourth quarter of 2005 that have materially affected, orreasonably likely to materially affect, the Corporation’s internal control overfinancial reporting.

**(i)****            ConclusionRegarding the Effectiveness of Disclosure Controls and Procedures**

Ourmanagement evaluated, with the participation of our Chief Executive Officer andChief Financial Officer, the effectiveness of our disclosure controls andprocedures (as defined in Rules 13a-15(e) or 15(d)-15(e) underthe Securities Exchange Act of 1934) as of the end of the period covered by thisreport. Based upon that evaluation, our Chief Executive Officer and ChiefFinancial Officer have concluded that our disclosure controls and proceduresare designed to ensure that information required to be disclosed by us in thereports that we file or submit under the Securities Exchange Act of 1934 isrecorded, processed, summarized, and reported within the time periods specifiedin the SEC’s rules and regulations and are operating in an effectivemanner.

**(ii)****        Management’sReport on Internal Control Over Financial Reporting**

Management of theCorporation is responsible for establishing and maintaining adequate internalcontrol over financial reporting. Internal control over financial reporting isdefined in Rule 13a-15(f) and 15d-15(f) under theSecurities Exchange Act of 1934, as amended, as a process designed by, or underthe supervision of, the Corporation’s principal executive and principalfinancial officers and effected by the Corporation’s board of directors,management and other personnel to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with accounting principles generallyaccepted in the United States of America and includes those policies andprocedures that:

·       Pertainto the maintenance of records that in reasonable detail accurately and fairlyreflect the transactions and dispositions of the assets of the Corporation;

·       Providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the Corporationare being made only in accordance with authorizations of management anddirectors of the Corporation; and

·       Providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use or disposition of the Corporation’s assets that could have amaterial effect of the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Projectionsof any evaluation of effectiveness to future periods are subject to the risksthat controls may become inadequate because of changes in conditions, or thatthe degree of compliance with the policies or procedures may deteriorate.

Management assessed the effectiveness of theCorporation’s internal control over financial reporting as of December 31,2005. In making this assessment, management used the criteria set forth by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO) in *Internal Control-Integrated Framework.* Managementbelieves that, as of December 31, 2005, the Corporation’s internal controlover financial reporting was effective.

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**Item 9A.     Controls and Procedures (Continued)**

The Corporation’sindependent registered Public Accounting Firm has issued an audit report onmanagement’s assessment of the Corporation’s internal control over financialreporting. This report appears herein in Item 9A, section iii.

(**iii)****    Reportof Independent Registered Public Accounting Firm on Internal Control OverFinancial Reporting**

Board of DirectorsHarleysville National Corporation

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Control Over FinancialReporting, that Harleysville National Corporation (a Pennsylvania corporation)maintained effective internal control over financial reporting as of December 31,2005, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO). Harleysville National Corporation’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting. Ourresponsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of the company’s internal control over financialreporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinions.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal 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 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.

In our opinion, management’s assessment thatHarleysville National Corporation maintained effective internal control over financial reporting as of December 31,2005, is fairly stated, in all material respects, based on criteria establishedin Internal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO). Also in our opinion,Harleysville National Corporation, Inc. maintained, in all materialrespects, effective internal control over 

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**Item 9A.     Controls and Procedures (Continued)**

financial reporting as of December 31,2005, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO).

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the consolidated balance sheets ofHarleysville National Corporation and its subsidiaries as of December 31,2005 and 2004, and the related consolidated statements of income, shareholders’equity, and cash flows for each of the three years in the period ended December 31,2005 and our report dated March 3, 2006 expressed an unqualified opinionon those financial statements.

| /s/ Grant Thornton LLP     |
|----------------------------|
| Philadelphia, Pennsylvania |
| March 3,  2006        |

 

**Item 9B.**               OtherInformation

None

85

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**PART III**

**Item 10.**                 Directorsand Executive Officers of Registrant

The Corporation has a Code of Ethics for directors,officers and employees of the corporation. It is intended to promote honest andethical conduct, full and accurate reporting, and compliance with laws as wellas other matters.

The SEC requires disclosure concerning whether or notthe Corporation has at least one “audit committee financial expert” on theAudit Committee. During 2005, Walter R. Bateman, II was the committee’sindependent financial expert, as defined by SEC regulations, and chaired thecommittee.

Additional information regarding directors andexecutives is included under the following captions in the Corporation’s proxystatement relating to its 2006 annual meeting of shareholders (the “2006 ProxyStatement”) and is incorporated herein by reference:

“Directors”“Executive Officers”“Executive Compensation and Plan Information—Executive Employment Agreements”“Corporate Governance”“Meetings and Committees of the Board of Directors”“Section 16(a) Beneficial Ownership Reporting Compliance”

In addition, theCorporation makes available on *www.hncbank.com*(under “Investor Information—Corporate Governance”) the following:1) Audit Committee Charter, 2) Code of Ethics, 3) Whistleblower Policy,4) Nominating Committee Charter and 5) Compensation Committee Charter.

**Item 11.**                 ExecutiveCompensation

Information regarding executive compensation includedunder the following captions in the 2006 Proxy Statement is incorporated hereinby reference:

“Directors”“Meetings and Committees of the Board of Directors”“Compensation of Directors”“Executive Compensation and Plan Information”

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters

Information included underthe captions, “Equity Compensation Plan Information” and “Beneficial Ownership,”in the 2006 Proxy Statement is incorporated herein by reference.

**Item 13.**                 CertainRelationships and Related Transactions

Information included in Part II, Item 8,Footnote 5 “Loans” of this Report on Form 10-K is incorporatedherein by reference.

Information included underthe caption, “Executive Compensation and Plan Information—Certain Transactions,”in the 2006 Proxy Statement is incorporated herein by reference.

**Item 14.**                 PrincipalAccounting Fees and Services

Information included underthe caption, “Independent Registered Public Accounting Firm,” in the 2006 ProxyStatement is incorporated herein by reference.

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**PART IV**

**Item 15.**                 Exhibits,Financial Statement Schedules

(a)           The following documentsare filed as part of this report (see Part II, Item 8, “FinancialStatements and Supplementary Data”):

(1)         Financial Statements:

(a)           Consolidated BalanceSheets at December 31, 2005 and 2004

(b)          Consolidated Statementsof Income for the years ended December 31, 2005, 2004 and 2003

(c)           Consolidated Statementsof Shareholders’ Equity for the years ended December 31, 2005, 2004 and2003

(d)          Consolidated Statementsof Cash Flows for the years ended December 31, 2005, 2004 and 2003

(e)           Notes to ConsolidatedFinancial Statements

(f)             Report of IndependentRegistered Public Accounting firm

(2)         Financial StatementSchedules are not applicable

(3)         Theexhibits filed as part of this Report on Form 10-K and exhibitsincorporated herein by reference to other documents are listed as follows:

**Exhibits**

| Exhibit   No. | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | ** ** | **Description   of Exhibits** |
|---------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|
| (2.1)         |       | Purchase Agreement,  dated as of November 15, 2005, by and among Harleysville National Bank  and Trust Company, Cornerstone Financial Consultants, Ltd., Cornerstone  Advisors Asset Management, Inc., Cornerstone Institutional  Investors, Inc., Cornerstone Management Resources, Inc., John R.  Yaissle, Malcolm L. Cowen, II, and Thomas J. Scalici. The schedules and  exhibits to the Purchase Agreement are listed at the end of the Purchase  Agreement but have been omitted from this exhibit to Form 10-K.  The Registrant agrees to supplementally furnish a copy of any omitted  schedule or exhibit to the Securities and Exchange Commission upon request. |
| (3.1)         |       | Harleysville National  Corporation Amended and Restated Articles of Incorporation. (Incorporated by  reference to Exhibit 3.1 to the Corporation’s Registration Statement  No. 333-111709 on Form S-4, as filed on January 5,  2004.)                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| (3.2)         |       | Harleysville National  Corporation Amended and Restated By-laws. (Incorporated by reference to  Exhibit 3.1 to the Corporation’s Current Report on Form 8-K,  filed with the Commission on February 14, 2005.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| (10.1)        |       | Amendment to Employment  Agreement by and among David R. Kotok, Millennium Bank, Cumberland  Advisors, Inc., Harleysville National Corporation and Harleysville  National Bank and Trust Company dated October 15, 2003 (incorporated by  reference to Appendix ”A” to the proxy statement/prospectus on the Corporation’s  Registration Statement No. 333-111709 on Form S-4, as  filed on January 5, 2004.)                                                                                                                                                                                                                                          |
| (10.2)        |       | Harleysville National  Corporation 1993 Stock Incentive Plan. (Incorporated by reference to  Exhibit 4.3 of Registrant’s Registration Statement No. 33-69784  on Form S-8, filed with the Commission on October 1, 1993.)                                                                                                                                                                                                                                                                                                                                                                                                                                                       |

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| (10.3)  |   | Harleysville National  Corporation Stock Bonus Plan. (Incorporated by reference to Exhibit 99A  of Registrant’s Registration Statement No. 333-17813 on  Form S-8, filed with the Commission on December 13, 1996.)                                                                                                                                                             |
|---------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (10.4)  |   | Supplemental Executive  Retirement Plan. (Incorporated by reference to Exhibit 10.3 of  Registrant’s Annual Report in Form 10-K for the year ended  December 31, 1997, filed with the Commission on March 27, 1998.)                                                                                                                                                            |
| (10.5)  |   | Walter E.  Daller, Jr., Chairman and former President and Chief Executive Officer’s  Employment Agreement. (Incorporated by reference to Registrant’s Current  Report on Form 8-K, filed with the Commission on March 25,  1999.)                                                                                                                                          |
| (10.6)  |   | Consulting Agreement and  General Release dated November 12, 2004 between Walter E.  Daller, Jr., Harleysville National Corporation and Harleysville National  Bank and Trust Company. (Incorporated by reference to Registrant’s Current  Report on Form 8-K, filed with the Commission on November 16,  2004.)                                                           |
| (10.7)  |   | Amendment to  Supplemental Executive Retirement Benefit Agreement dated March 14, 2005  by and among Harleysville Management Services, LLC and Walter E.  Daller, Jr. (Incorporated by reference to Registrant’s Current Report on  Form 8-K, filed with the Commission on March 14, 2005.)                                                                                     |
| (10.8)  |   | Employment Agreement  dated October 26, 1998 by and among Harleysville National Corporation,  Harleysville National Bank and Trust Company and Demetra M. Takes,  President and Chief Executive Officer of Harleysville National Bank and Trust  Company. (Incorporated by reference to Registrant’s Current Report on  Form 8-K, filed with the Commission on March 25, 1999.) |
| (10.9)  |   | Amendment to  Supplemental Executive Retirement Benefit Agreement dated March 14, 2005  by and among Harleysville Management Services, LLC and Demetra M. Takes,  President and Chief Executive Officer of Harleysville National Bank and Trust  Company. (Incorporated by reference to Registrant’s Current Report on  Form 8-K, filed with the Commission on March 14, 2005.)      |
| (10.10) |   | Harleysville National  Corporation 1998 Stock Incentive Plan. (Incorporated by reference to  Registrant’s Registration Statement No. 333-79971 on Form S-8,  filed with the Commission on June 4, 1999.)                                                                                                                                                                             |
| (10.11) |   | Harleysville National  Corporation 1998 Independent Directors Stock Option Plan. (Incorporated by  reference to Registrant’s Registration Statement No. 333-79973 on  Form S-8, filed with the Commission on June 4, 1999.)                                                                                                                                                          |
| (10.12) |   | Supplemental Executive  Retirement Benefit Agreement dated February 23, 2004 between  Michael B. High, Executive Vice President and former Chief Financial  Officer, and Harleysville Management Services, LLC. (Incorporated by  reference to Registrant’s Quarterly Report on Form 10-Q, filed  with the Commission on May 10, 2004.)                                    |
| (10.13) |   | Employment Agreement  effective April 1, 2005 between Michael B. High, Executive Vice  President and Chief Operating Officer of the Corporation, and Harleysville  Management Services, LLC. (Incorporated by reference to Registrant’s  Current Report on Form 8-K, filed with the Commission on  November 16, 2004.)                                                     |

88

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| (10.14) |   | Amendment to  Supplemental Executive Retirement Benefit Agreement dated March 14, 2005  by and among Harleysville Management Services, LLC and Michael B. High,  Executive Vice President and Chief Operating Officer of the Corporation.  (Incorporated by reference to Registrant’s Current Report on Form 8-K,  filed with the Commission on March 14, 2005.)                       |
|---------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (10.15) |   | Employment Agreement  dated March 9, 2004 between Mikkalya Murray, Executive Vice President  and Harleysville Management Services, LLC. (Incorporated by reference to  Registrant’s Quarterly Report on Form 10-Q, filed with the  Commission on May 10, 2004.)                                                                                                                   |
| (10.16) |   | Amendment to  Supplemental Executive Retirement Benefit Agreement dated March 14, 2005  by and among Harleysville Management Services, LLC and Mikkalya Murray,  Executive Vice President. (Incorporated by reference to Registrant’s Current  Report on Form 8-K, filed with the Commission on March 14,  2005.)                                                                      |
| (10.17) |   | Harleysville National  Corporation 2004 Omnibus Stock Incentive Plan. (Incorporated by reference to  Exhibit 4 of Registrant’s Registration Statement No. 333-116183  on Form S-8, filed with the Commission on June 4, 2004).                                                                                                                                                    |
| (10.18) |   | Employment Agreement  dated August 23, 2004 between James F. McGowan, Jr., Executive  Vice President & Chief Credit Officer and Harleysville Management  Services, LLC. (Incorporated by reference to Registrant’s Current Report  on Form 8-K, filed with the Commission on August 25, 2004.)                                                                 |
| (10.19) |   | Supplemental Executive  Retirement Benefit Agreement dated August 23, 2004 between James F.  McGowan, Jr., Executive Vice President & Chief Credit Officer,  and Harleysville Management Services, LLC. (Incorporated by reference to  Registrant’s Current Report on Form 8-K, filed with the Commission  on August 25, 2004.)                                |
| (10.20) |   | Amendment to  Supplemental Executive Retirement Benefit Agreement dated March 14, 2005  by and among Harleysville Management Services, LLC and James F.  McGowan, Jr., Executive Vice President & Chief Credit Officer.  (Incorporated by reference to Registrant’s Current Report on Form 8-K,  filed with the Commission on March 14, 2005.)                           |
| (10.21) |   | Employment Agreement  dated September 27, 2004 between John Eisele, Executive Vice  President & President of Millennium Wealth Management and Private  Banking, and Harleysville Management Services, LLC. (Incorporated by  reference to Registrant’s Current Report on Form 8-K, filed with  the Commission on September 29, 2004.)                                    |
| (10.22) |   | Supplemental Executive  Retirement Benefit Agreement dated September 27, 2004 between John  Eisele, Executive Vice President & President of Millennium Wealth  Management and Private Banking, and Harleysville Management  Services, LLC. (Incorporated by reference to Registrant’s Current Report  on Form 8-K, filed with the Commission on September 29,  2004.)    |
| (10.23) |   | Amendment to  Supplemental Executive Retirement Benefit Agreement dated March 14, 2005  by and among Harleysville Management Services, LLC and John Eisele, Executive  Vice President & President of Millennium Wealth Management and  Private Banking. (Incorporated by reference to Registrant’s Current Report on  Form 8-K, filed with the Commission on March 14, 2005.) |
| (10.24) |   | Employment Agreement  effective January 1, 2005 between Gregg J. Wagner, President and  Chief Executive Officer of the Corporation, and Harleysville Management  Services, LLC. (Incorporated by reference to Registrant’s Current Report  on Form 8-K, filed with the Commission on November 16, 2004.)                                                                     |

89

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| (10.25) |   | Amendment to  Supplemental Executive Retirement Benefit Agreement dated March 14, 2005  by and among Harleysville Management Services, LLC and Gregg J. Wagner, the  current President and Chief Executive Officer of the Corporation.  (Incorporated by reference to Registrant’s Current Report on Form 8-K,  filed with the Commission on March 14, 2005.)                                                      |
|---------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (10.26) |   | Employment  Agreement dated May 18, 2005, between George S. Rapp, Senior Vice  President and Chief Financial Officer, and Harleysville Management Services,  LLC. (Incorporated by reference to Registrant’s Current Report on Form 8-K,  filed with the Commission on May 20, 2005.)                                                                                                                              |
| (10.27) |   | Stock Purchase Agreement  dated June 30, 2005, between David R. Kotok &  Associates, Inc., Harleysville National Corporation and Harleysville  National Bank and Trust Company. (Incorporated by reference to Registrant’s  Current Report on Form 8-K, filed with the Commission on  July 1, 2005.)                                                                                                 |
| (10.28) |   | Amended and  Restated Declaration of Trust for HNC Statutory Trust III by and among  Wilmington Trust Company, as Institutional Trustee and Delaware Trustee,  Harleysville National Corporation, as Sponsor, and the Administrators named  therein, dated as of September 28, 2005. (Incorporated by reference to  Registrant’s Quarterly Report on Form 10-Q/A, filed with the  Commission on November 9, 2005.) |
| (10.29) |   | Indenture between  Harleysville National Corporation, as Issuer, and Wilmington Trust Company,  as Trustee, for Fixed/Floating Rate Junior Subordinated Debt Securities,  dated as of September 28, 2005. (Incorporated by reference to  Registrant’s Quarterly Report on Form 10-Q/A, filed with the  Commission on November 9, 2005.)                                                                            |
| (10.30) |   | Guarantee Agreement  between Harleysville National Corporation and Wilmington Trust Company, dated  as of September 28, 2005. (Incorporated by reference to Registrant’s  Quarterly Report on Form 10-Q/A, filed with the Commission on  November 9, 2005.)                                                                                                                                                        |
| (11)    |   | Computation of Earnings  per Common Share, incorporated by reference to Part II, Item 8,  Footnote 14, “Earnings Per Share,” of this Report on Form 10-K                                                                                                                                                                                                                                                 |
| (21)    |   | Subsidiaries of  Registrant                                                                                                                                                                                                                                                                                                                                                                                                            |
| (23)    |   | Consent of Grant  Thornton LLP, Independent Registered Public Accounting firm                                                                                                                                                                                                                                                                                                                                                     |
| (31.1)  |   | Certification of the  Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                                                                                                                                                                     |
| (31.2)  |   | Certification of the  Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                                                                                                                                                                     |
| (32.1)  |   | Certification of the  Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act  of 2002                                                                                                                                                                                                                                                           |
| (32.2)  |   | Certification of the  Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act  of 2002                                                                                                                                                                                                                                                           |

 

90

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**SIGNATURES**

**Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.**
|        | HARLEYSVILLE NATIONAL  CORPORATION |
|--------|------------------------------------|
|   | By:                                | /s/  GREGG J. WAGNER |
|   |                               | Gregg J. Wagner |
|   |                               | *President,  Chief Executive Officer and Director* |

 

Date: March 2, 2006

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

|                                 | **Signature** | ** **                                         | ** ** | ** **         | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|---------------------------------|---------------|----------------------------------------------------|------------|--------------------|-----------|------------|------------|------------|----------|------------|
| /s/ WALTER R.  BATEMAN, II |          | Director                                           |       | March 2, 2006 |
| Walter  R. Bateman, II     |          |                                               |       |               |
| /s/ LEEANN  BERGEY              |          | Director                                           |       | March 2, 2006 |
| LeeAnn  Bergey                  |          |                                               |       |               |
| /s/ WALTER E.  DALLER, JR. |          | Director                                           |       | March 2, 2006 |
| Walter  E. Daller, Jr.     |          |                                               |       |               |
| /s/ HAROLD A.  HERR             |          | Director                                           |       | March 2, 2006 |
| Harold  A. Herr                 |          |                                               |       |               |
| /s/ THOMAS C.  LEAMER           |          | Director                                           |       | March 2, 2006 |
| Thomas  C. Leamer               |          |                                               |       |               |
| /s/ STEPHANIE  S. MITCHELL      |          | Director                                           |       | March 2, 2006 |
| Stephanie  S. Mitchell          |          |                                               |       |               |
| /s/ GEORGE S.  RAPP             |          | Senior Vice  President and Chief Financial Officer |       | March 2, 2006 |
| George  S. Rapp                 |          | (Principal Financial and  Accounting Officer)      |       |               |
| /s/ DEMETRA M.  TAKES           |          | Director and  Executive Vice President             |       | March 2, 2006 |
| Demetra  M. Takes               |          |                                               |       |               |
| /s/ GREGG J.  WAGNER            |          | President, Chief  Executive Officer and Director   |       | March 2, 2006 |
| Gregg  J. Wagner                |          | (Principal Executive  Officer)                     |       |               |
| /s/ JAMES A.  WIMMER            |          | Director                                           |       | March 2, 2006 |
| James A. Wimmer                 |          |                                               |       |               |

 

 

91

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**EXHIBIT INDEX**
| Exhibit   No. | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | ** ** | **Description   of Exhibits** |
|---------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|
| (2.1)         |       | Purchase Agreement,  dated as of November 15, 2005, by and among Harleysville National Bank  and Trust Company, Cornerstone Financial Consultants, Ltd., Cornerstone  Advisors Asset Management, Inc., Cornerstone Institutional  Investors, Inc., Cornerstone Management Resources, Inc., John R.  Yaissle, Malcolm L. Cowen, II, and Thomas J. Scalici. The schedules and  exhibits to the Purchase Agreement are listed at the end of the Purchase  Agreement but have been omitted from this exhibit to Form 10-K.  The Registrant agrees to supplementally furnish a copy of any omitted  schedule or exhibit to the Securities and Exchange Commission upon request. |
| (3.1)         |       | Harleysville  National Corporation Amended and Restated Articles of Incorporation.  (Incorporated by reference to Exhibit 3.1 to the Corporation’s  Registration Statement No. 333-111709 on Form S-4, as  filed on January 5, 2004.)                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| (3.2)         |       | Harleysville  National Corporation Amended and Restated By-laws. (Incorporated by reference  to Exhibit 3.1 to the Corporation’s Current Report on Form 8-K,  filed with the Commission on February 14, 2005.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| (10.1)        |       | Amendment to  Employment Agreement by and among David R. Kotok, Millennium Bank,  Cumberland Advisors, Inc., Harleysville National Corporation and  Harleysville National Bank and Trust Company dated October 15, 2003  (incorporated by reference to Appendix ”A” to the proxy  statement/prospectus on the Corporation’s Registration Statement No. 333-111709  on Form S-4, as filed on January 5, 2004.)                                                                                                                                                                                                                                          |
| (10.2)        |       | Harleysville  National Corporation 1993 Stock Incentive Plan. (Incorporated by reference to  Exhibit 4.3 of Registrant’s Registration Statement No. 33-69784  on Form S-8, filed with the Commission on October 1, 1993.)                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| (10.3)        |       | Harleysville  National Corporation Stock Bonus Plan. (Incorporated by reference to  Exhibit 99A of Registrant’s Registration Statement No. 333-17813  on Form S-8, filed with the Commission on December 13, 1996.)                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| (10.4)        |       | Supplemental  Executive Retirement Plan. (Incorporated by reference to Exhibit 10.3 of  Registrant’s Annual Report in Form 10-K for the year ended  December 31, 1997, filed with the Commission on March 27, 1998.)                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| (10.5)        |       | Walter E.  Daller, Jr., Chairman and former President and Chief Executive Officer’s  Employment Agreement. (Incorporated by reference to Registrant’s Current  Report on Form 8-K, filed with the Commission on March 25,  1999.)                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| (10.6)        |       | Consulting  Agreement and General Release dated November 12, 2004 between  Walter E. Daller, Jr., Harleysville National Corporation and  Harleysville National Bank and Trust Company. (Incorporated by reference to  Registrant’s Current Report on Form 8-K, filed with the Commission  on November 16, 2004.)                                                                                                                                                                                                                                                                                                                                                           |
| (10.7)        |       | Amendment to  Supplemental Executive Retirement Benefit Agreement dated March 14, 2005  by and among Harleysville Management Services, LLC and Walter E.  Daller, Jr. (Incorporated by reference to Registrant’s Current Report on  Form 8-K, filed with the Commission on March 14, 2005.)                                                                                                                                                                                                                                                                                                                                                                                     |

----

 
| (10.8)  |   | Employment Agreement  dated October 26, 1998 by and among Harleysville National Corporation,  Harleysville National Bank and Trust Company and Demetra M. Takes,  President and Chief Executive Officer of Harleysville National Bank and Trust  Company. (Incorporated by reference to Registrant’s Current Report on  Form 8-K, filed with the Commission on March 25, 1999.) |
|---------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (10.9)  |   | Amendment to  Supplemental Executive Retirement Benefit Agreement dated March 14, 2005  by and among Harleysville Management Services, LLC and Demetra M. Takes,  President and Chief Executive Officer of Harleysville National Bank and Trust  Company. (Incorporated by reference to Registrant’s Current Report on  Form 8-K, filed with the Commission on March 14, 2005.)      |
| (10.10) |   | Harleysville  National Corporation 1998 Stock Incentive Plan. (Incorporated by reference to  Registrant’s Registration Statement No. 333-79971 on Form S-8,  filed with the Commission on June 4, 1999.)                                                                                                                                                                             |
| (10.11) |   | Harleysville  National Corporation 1998 Independent Directors Stock Option Plan.  (Incorporated by reference to Registrant’s Registration Statement  No. 333-79973 on Form S-8, filed with the Commission on  June 4, 1999.)                                                                                                                                                         |
| (10.12) |   | Supplemental  Executive Retirement Benefit Agreement dated February 23, 2004 between  Michael B. High, Executive Vice President and former Chief Financial  Officer, and Harleysville Management Services, LLC. (Incorporated by  reference to Registrant’s Quarterly Report on Form 10-Q, filed  with the Commission on May 10, 2004.)                                    |
| (10.13) |   | Employment  Agreement effective April 1, 2005 between Michael B. High,  Executive Vice President and Chief Operating Officer of the Corporation, and  Harleysville Management Services, LLC. (Incorporated by reference to  Registrant’s Current Report on Form 8-K, filed with the Commission  on November 16, 2004.)                                                     |
| (10.14) |   | Amendment to  Supplemental Executive Retirement Benefit Agreement dated March 14, 2005  by and among Harleysville Management Services, LLC and Michael B. High,  Executive Vice President and Chief Operating Officer of the Corporation.  (Incorporated by reference to Registrant’s Current Report on Form 8-K,  filed with the Commission on March 14, 2005.)                     |
| (10.15) |   | Employment  Agreement dated March 9, 2004 between Mikkalya Murray, Executive Vice  President and Harleysville Management Services, LLC. (Incorporated by  reference to Registrant’s Quarterly Report on Form 10-Q, filed  with the Commission on May 10, 2004.)                                                                                                                 |
| (10.16) |   | Amendment to  Supplemental Executive Retirement Benefit Agreement dated March 14, 2005  by and among Harleysville Management Services, LLC and Mikkalya Murray,  Executive Vice President. (Incorporated by reference to Registrant’s Current  Report on Form 8-K, filed with the Commission on March 14,  2005.)                                                                    |
| (10.17) |   | Harleysville  National Corporation 2004 Omnibus Stock Incentive Plan. (Incorporated by  reference to Exhibit 4 of Registrant’s Registration Statement  No. 333-116183 on Form S-8, filed with the Commission  on June 4, 2004).                                                                                                                                                 |
| (10.18) |   | Employment  Agreement dated August 23, 2004 between James F. McGowan, Jr.,  Executive Vice President & Chief Credit Officer and Harleysville  Management Services, LLC. (Incorporated by reference to Registrant’s  Current Report on Form 8-K, filed with the Commission on  August 25, 2004.)                                                              |

----

 
| (10.19) |   | Supplemental Executive  Retirement Benefit Agreement dated August 23, 2004 between James F.  McGowan, Jr., Executive Vice President & Chief Credit Officer,  and Harleysville Management Services, LLC. (Incorporated by reference to  Registrant’s Current Report on Form 8-K, filed with the Commission  on August 25, 2004.)                                                            |
|---------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (10.20) |   | Amendment to  Supplemental Executive Retirement Benefit Agreement dated March 14, 2005  by and among Harleysville Management Services, LLC and James F.  McGowan, Jr., Executive Vice President & Chief Credit Officer.  (Incorporated by reference to Registrant’s Current Report on Form 8-K,  filed with the Commission on March 14, 2005.)                                                       |
| (10.21) |   | Employment  Agreement dated September 27, 2004 between John Eisele, Executive Vice  President & President of Millennium Wealth Management and Private  Banking, and Harleysville Management Services, LLC. (Incorporated by  reference to Registrant’s Current Report on Form 8-K, filed with  the Commission on September 29, 2004.)                                                                |
| (10.22) |   | Supplemental  Executive Retirement Benefit Agreement dated September 27, 2004 between  John Eisele, Executive Vice President & President of Millennium  Wealth Management and Private Banking, and Harleysville Management  Services, LLC. (Incorporated by reference to Registrant’s Current Report  on Form 8-K, filed with the Commission on September 29,  2004.)                                |
| (10.23) |   | Amendment to  Supplemental Executive Retirement Benefit Agreement dated March 14, 2005  by and among Harleysville Management Services, LLC and John Eisele, Executive  Vice President & President of Millennium Wealth Management and  Private Banking. (Incorporated by reference to Registrant’s Current Report on  Form 8-K, filed with the Commission on March 14, 2005.)                             |
| (10.24) |   | Employment  Agreement effective January 1, 2005 between Gregg J. Wagner,  President and Chief Executive Officer of the Corporation, and Harleysville  Management Services, LLC. (Incorporated by reference to Registrant’s  Current Report on Form 8-K, filed with the Commission on  November 16, 2004.)                                                                                                |
| (10.25) |   | Amendment to  Supplemental Executive Retirement Benefit Agreement dated March 14, 2005  by and among Harleysville Management Services, LLC and Gregg J. Wagner, the  current President and Chief Executive Officer of the Corporation.  (Incorporated by reference to Registrant’s Current Report on Form 8-K,  filed with the Commission on March 14, 2005.)                                                      |
| (10.26) |   | Employment  Agreement dated May 18, 2005, between George S. Rapp, Senior Vice  President and Chief Financial Officer, and Harleysville Management Services,  LLC. (Incorporated by reference to Registrant’s Current Report on Form 8-K,  filed with the Commission on May 20, 2005.)                                                                                                                              |
| (10.27) |   | Stock Purchase  Agreement dated June 30, 2005, between David R. Kotok &  Associates, Inc., Harleysville National Corporation and Harleysville  National Bank and Trust Company. (Incorporated by reference to Registrant’s  Current Report on Form 8-K, filed with the Commission on  July 1, 2005.)                                                                                                 |
| (10.28) |   | Amended and  Restated Declaration of Trust for HNC Statutory Trust III by and among  Wilmington Trust Company, as Institutional Trustee and Delaware Trustee,  Harleysville National Corporation, as Sponsor, and the Administrators named  therein, dated as of September 28, 2005. (Incorporated by reference to  Registrant’s Quarterly Report on Form 10-Q/A, filed with the  Commission on November 9, 2005.) |

----

 
| (10.29) |   | Indenture between  Harleysville National Corporation, as Issuer, and Wilmington Trust Company,  as Trustee, for Fixed/Floating Rate Junior Subordinated Debt Securities,  dated as of September 28, 2005. (Incorporated by reference to  Registrant’s Quarterly Report on Form 10-Q/A, filed with the  Commission on November 9, 2005.) |
|---------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (10.30) |   | Guarantee  Agreement between Harleysville National Corporation and Wilmington Trust  Company, dated as of September 28, 2005. (Incorporated by reference to  Registrant’s Quarterly Report on Form 10-Q/A, filed with the  Commission on November 9, 2005.)                                                                             |
| (11)    |   | Computation of  Earnings per Common Share, incorporated by reference to Part II,  Item 8, Footnote 14, “Earnings Per Share,” of this Report on  Form 10-K                                                                                                                                                                     |
| (21)    |   | Subsidiaries of  Registrant                                                                                                                                                                                                                                                                                                                                 |
| (23)    |   | Consent of Grant  Thornton LLP, Independent Registered Public Accounting firm                                                                                                                                                                                                                                                                          |
| (31.1)  |   | Certification of  the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                                                                                          |
| (31.2)  |   | Certification of the  Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                                                                                          |
| (32.1)  |   | Certification of  the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act  of 2002                                                                                                                                                                                |
| (32.2)  |   | Certification of the  Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act  of 2002                                                                                                                                                                                |

 

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