UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





___________________





Form 10-Q


__________________





xQuarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934





for the quarterly period ended June 30, 2004





Or





 ̈   Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934





for the Transition Period From ___________ to __________





Commission file number 0-15237





___________________





HARLEYSVILLE NATIONAL CORPORATION


(Exact name of registrant as specified in its charter)





___________________








Pennsylvania

23-2210237(State or other jurisdiction ofincorporation or organization)

(IRS Employer IdentificationNo.)





483 Main Street


Harleysville, Pennsylvania 19438


(Address of principal executive office and zip code)





(215) 256-8851


(Registrants telephone number, including area code)





___________________





Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.


Yes xNo ̈





Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).


Yesx No ?





Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 24,999,634 shares of Common Stock, $1.00 par value, outstanding on August 5, 2004.








HARLEYSVILLE NATIONAL CORPORATIONINDEX TO FORM 10-Q REPORTPAGEPart I. Financial InformationItem 1. Financial Statements:Consolidated Balance Sheets at June 30, 2004 and December 31, 2003
3Consolidated Statements of Income for the Three Months and Six Months Ended June 30, 2004 and 2003
4Consolidated Statements of Shareholders Equity for the Six Months Ended June 30, 2004 and 2003
5Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2004 and 2003
6Notes to Consolidated Financial Statements
7Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
12Item 3. Quantitative and Qualitative Disclosures about Market Risk
25Item 4. Controls and Procedures
26Part II. Other Information
26Item 1. Legal Proceedings
26Item 2. Change in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
26Item 3. Defaults Upon Senior Securities
26Item 4. Submission of Matters to a Vote of Security Holders
26Item 5. Other Information
27Item 6. Exhibits and Reports on Form 8-K
27Signatures
29Certifications
31-34















PART 1. FINANCIAL INFORMATIONHARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(Unaudited)(Dollars in thousands)


June 30, 2004


December 31, 2003AssetsCash and due from banks

$
55,674

$
56,306Federal funds sold and securities purchased under agreements to resell


36,000


30,000Interest-bearing deposits in banks


1,846


8,551Total cash and cash equivalents


93,520


94,857Residential mortgage loans held for sale


488


164Investment securities available for sale


938,466


904,870Investment securities held to maturity


18,932


20,004(fair value $19,870 and $21,497, respectively)Total loans and leases


1,683,040


1,408,227Less: Allowance for loan losses


(17,940
)

(16,753
)Net loans


1,665,100


1,391,474Premises and equipment, net


27,072


23,329Accrued interest receivable


11,261


10,169Net assets in foreclosure


389


935Goodwill


32,229


-Intangible assets, net


4,338


2,731Bank-owned life insurance


51,825


50,693Other assets


22,329


11,713Total assets

$
2,865,949

$
2,510,939Liabilities and Shareholders' EquityDeposits:Noninterest-bearing

$
345,191

$
294,121Interest-bearing:Checking accounts


258,739


283,607Money market accounts


561,823


506,516Savings


245,768


221,778Time, under $100,000


523,587


491,740Time, $100,000 or greater


157,993


181,319Total deposits


2,093,101


1,979,081Federal funds purchased and securities sold under agreements torepurchase


201,493


75,291Other short-term borrowings


1,760


2,015Long-term borrowings


241,750


172,750Accrued interest payable


24,912


22,920Subordinated debt


25,774


-Guaranteed preferred beneficial interest in Corporation'ssubordinated debentures


-


5,000Other liabilities


25,282


26,829Total liabilities


2,614,072


2,283,886Shareholders' Equity:Series preferred stock, par value $1 per share;authorized 8,000,000 shares, none issued


-


-Common stock, par value $1 per share; authorized 75,000,000shares; issued 25,891,790 shares at June 30, 2004 and24,667,707 shares at December 31, 2003


25,892


24,668Additional paid in capital


129,818


98,646Retained earnings


119,477


109,502Accumulated other comprehensive income (loss)


(9,051
)

8,098Treasury stock, at cost: 849,533 shares at June 30, 2004 and822,633 shares at December 31, 2003


(14,259
)

(13,861
)Total shareholders' equity


251,877


227,053Total liabilities and shareholders' equity

$
2,865,949

$
2,510,939


See accompanying notes to consolidated financial statements.














HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME(Dollars in thousands, except weighted average number of


Three Months Ended


Six Months Endedcommon shares and per share information)

June 30,
June 30,2004


2003


2004


2003(Unaudited)
(Unaudited)Interest Income:Loans, including fees

$
21,076

$
19,726

$
40,572

$
39,448Lease financing


1,193


1,731


2,498


3,580Investment securities:Taxable


5,721


4,462


11,242


9,543Exempt from federal taxes


2,923


3,913


5,686


7,774Federal funds sold and securities purchased underagreements to resell


76


30


150


75Deposits in banks


5


27


19


54Total interest income


30,994


29,889


60,167


60,474Interest Expense:Savings deposits


1,769


1,850


3,496


4,444Time, under $100,000


4,328


4,780


8,652


9,872Time, $100,000 or greater


801


1,063


1,591


2,468Short-term borrowings


444


522


559


522Long-term debt


2,332


1,869


4,319


4,164Total interest expense


9,674


10,084


18,617


21,470Net interest income


21,320


19,805


41,550


39,004Provision for loan losses


497


1,320


986


1,929Net interest income after provision for loan losses


20,823


18,485


40,564


37,075Noninterest Income:Service charges


1,929


1,937


3,854


3,767Gain on sales in investment securities, net


641


4,774


1,541


6,090Trust, investment services and advisory income


1,576


978


2,697


1,866Bank-owned life insurance income


521


631


1,132


1,262Income on life insurance


0


0


0


1,119Other income


1,620


1,639


2,846


3,066Total noninterest income


6,287


9,959


12,070


17,170Net interest income after provision for loan losses andnoninterest income


27,110


28,444


52,634


54,245Noninterest Expense:Salaries, wages and employee benefits


8,834


7,876


17,111


15,717Occupancy


1,120


882


2,204


1,905Furniture and equipment


1,510


1,376


2,768


2,681Prepayment fee


0


2,594


0


2,594Intangible assets amortization


283


369


494


698Other expense


2,846


4,030


5,833


9,045Total noninterest expense


14,593


17,127


28,410


32,640Income before income tax expense


12,517


11,317


24,224


21,605Income tax expense


3,135


2,216


5,935


4,039Net income

$
9,382

$
9,101

$
18,289

$
17,566Net income per share information:Basic

$
0.38

$
0.38

$
0.75

$
0.74Diluted

$
0.37

$
0.37

$
0.73

$
0.71Cash dividends per share

$
0.17

$
0.15

$
0.34

$
0.30Weighted average number of common shares:Basic


24,630,047

23,779,235

24,280,753


23,774,838Diluted


25,450,411

24,540,648

25,167,508


24,531,029See accompanying notes to consolidated financial statements








HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES


CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY


(Unaudited)


(Dollars and share information in thousands)








Six Months Ended June 30, 2004




Common Stock
Treasury StockNumber of shares
Number of shares
Par Value
Additional Paid in Capital
Retained Earnings
Accumulated
Other
Comprehensive
Income
(Loss)
Treasury Stock
Total
Comprehensive Income (Loss)Balance, January 01, 2004

24,668
(823)
$ 24,668
$ 98,646
$ 109,502
$ 8,098
$ (13,861)
$ 227,053Issuance of stock for stock options

278
-
278
3,644
-
-
-
3,922Issuance of stock for stock awards

-
-
-
7
-
-
-
7Net income

-
-
-
-
18,289
-
-
18,289
$ 18,289Other comprehensive loss,net of reclassifications and tax

-
-
-
-
-
(17,149)
-
(17,149)
(17,149)Issuance of common stock foracquisition of Millennium Bank

946
-
946
27,397
-
-
-
28,343Purchases of treasury stock

-
(43)
-
399
-
-
(673)
(274)Sale of treasury stock

-
16
-
(275)
-
-
275
-Cash dividends

-
-
-
-
(8,314)
-
-
(8,314)Comprehensive income









$ 1,140Balance, June 30, 2004

25,892
(850)
$ 25,892
$ 129,818
$ 119,477
$ (9,051)
$ (14,259)
$ 251,877Six Months Ended June 30, 2003Common Stock
Treasury StockNumber of shares
Number of shares
Par Value
Additional Paid in Capital
Retained Earnings
Accumulated
Other
Comprehensive
Income
(Loss)
Treasury
Stock
Total
Comprehensive IncomeBalance, January 01, 2003

19,597
(569)
$ 19,597
$ 96,585
$ 94,677
$ 6,937
$ (11,590)
$ 206,206Issuance of stock for stock options

86
-
86
985
-
-
-
1,071Issuance of stock for stock awards

-
-
-
6
-
-
-
6Net income

-
-
-
-
17,566
-
-
17,566
$ 17,566Other comprehensive income,net of reclassifications and tax

-
-
-
-
-
8,495
-
8,495
8,495Purchases of treasury stock

-
(89)
-
-
-
-
(2,270)
(2,270)Cash dividends

-
-
-
-
(7,225)
-
-
(7,225)Comprehensive income









$ 26,061Balance, June 30, 2003

19,683
(658)
$ 19,683
$ 97,576
$ 105,018
$ 15,432
$ (13,860)
$ 223,849




See accompanying notes to consolidated financial statements.











HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)(Dollars in thousands)

Six months ended June 30,Operating Activities:


2004


2003Net income

$
18,289

$
17,566Adjustments to reconcile net income tonet cash provided by operating activities:Provision for loan losses


986


1,929Depreciation and amortization of intangible assets


1,948


1,401Net amortization of investment securities discounts/premiums


2,903


5,247Deferred income tax benefit


(563
)

(2,106
)Gains on sales of investment securities, net


(1,541
)

(6,090
)Net (increase) decrease in accrued interest receivable


(157
)

2,372Net increase (decrease) in accrued interest payable


1,482


(2,572
)Net increase in other assets


(1,180
)

(80
)Net increase in other liabilities


1,988


3,132Other, net


7


6Net cash provided by operating activities


24,162


20,805Investing Activities:Proceeds from sales of investment securities available for sale


906,891


832,079Proceeds, maturity or calls of investment securities held to maturity


1,097


704Proceeds, maturity or calls of investment securities available for sale


166,288


326,582Purchases of investment securities available for sale


(1,099,869
)

(1,039,633
)Net increase in loans


(119,926
)

(5,192
)Net cash paid due to acquisition, net of cash acquired


(18,697
)

-Net increase in premises and equipment


(3,440
)

(1,737
)Net increase in bank-owned life insurance


(1,132
)

(709
)Proceeds from sales of other real estate


983


645Net cash provided by (used in) investing activities


(167,805
)

112,739Financing Activities:Net decrease in deposits


(37,228
)

(106,604
)Increase in federal funds purchased and securities sold underagreements to repurchase


114,681


10,036Decrease in short-term borrowings


(3,255
)

(379
)Advances (payments) of long-term borrowings


52,000


(9,000
)Advances of long-term debt


20,774


-Cash dividends


(8,314
)

(7,225
)Repurchase of common stock


(274
)

(2,270
)Proceeds from the exercise of stock options


3,922


1,071Net cash provided by (used in) financing activities


142,306


(114,371
)Net increase (decrease) in cash and cash equivalents


(1,337
)

19,173Cash and cash equivalents at beginning of period


94,857


104,087Cash and cash equivalents at end of the period

$
93,520

$
123,260Cash paid during the period for:Interest

$
17,308

$
24,042Income taxes

$
4,300

$
4,600Supplemental disclosure of noncash investing and financing activities:Transfer of assets from loans to other real estate owned

$
437

$
984Acquisition of Millennium Bank, common stock issued

$
28,343

$
-See accompanying notes to consolidated financial statements.




















HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





Note 1  Basis of Presentation





In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the consolidated financial position of Harleysville National Corporation (the "Corporation") and its wholly owned subsidiaries - Harleysville National Bank and Trust Company ("Harleysville"), HNC Financial Company and HNC Reinsurance Company, as of June 30, 2004, the results of its operations for the three and six month periods, ended June 30, 2004 and 2003 and the cash flows for the six month periods, ended June 30, 2004 and 2003. Certain prior period amounts have been reclassified to conform to current year presentation. All significant intercompany accounts and transactions have been eliminated. We recommend that you read these unaudited consolidated financial statements in conjunction with the audited consolidated financial statements of the Corporation and the accompanying notes in the Corporation's 2003 Annual Report on Form 10-K. The results of operations for the three and six month periods, ended June 30, 2004 and 2003 are not necessarily indicative of the results to be expected for the full year.





Note 2  Comprehensive Income





The Corporation follows SFAS No. 130, Reporting Comprehensive Income, which establishes standards to provide prominent disclosure of comprehensive income items. The components of other comprehensive income are as follows:





Comprehensive Income(Dollars in thousands)


Before tax


Tax Benefit


Net of taxSix months ended June 30, 2004


amount


(Expense
)

amountNet unrealized losses on available for sale securities:Net unrealized holding lossesarising during period

$
(25,512
)
$
8,929

$
(16,583
)Less reclassificationadjustment for net gainsrealized in net income


1,541


(539
)

1,002Net unrealized losses


(27,053
)

9,468


(17,585
)Change in minimum pension liability


460


-


460Change in fair value of derivatives








-used for cash flow hedges


(37
)

13


(24
)Other comprehensive loss, net

$
(26,630
)
$
9,481

$
(17,149
)(Dollars in thousands)


Before tax


Tax


Net of taxSix months ended June 30, 2003


amount


(Expense
)

amountNet unrealized gains on available for sale securities:Net unrealized holding gainsarising during period

$
19,160

$
(6,706
)
$
12,454Less reclassificationadjustment for net gainsrealized in net income


6,090


(2,131
)

3,959Net unrealized gains


13,070


(4,575
)

8,495Minimum pension liability


-


-


-Change in fair value of derivativesused for cash flow hedges


-


-


-Other comprehensive income, net

$
13,070

$
(4,575
)
$
8,495








8





Note 3  Stock Based Compensation





The Corporation follows SFAS No. 123, Accounting for Stock-Based Compensation, which contains a fair value-based method for valuing stock-based compensation that entities may use, which measures compensation cost at the grant date based on the fair value of the award. Compensation is then recognized over the service period, which is usually the vesting period. The Corporation has chosen an alternative permitted by the standard to continue accounting for employee stock options and similar instruments under Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees.





Entities that continue to account for stock options using APB Opinion 25 are required to make pro forma disclosures of net income and earnings per share, as if the fair value-based method of accounting defined in SFAS No. 123 has been applied.





The Corporation has four shareholder approved fixed stock option plans that allow the Corporation to grant options up to an aggregate of 3,300,917 shares of common stock to key employees and directors. At June 30, 2004, 2,052,738stock options had been granted under the stock option plans. The options have a term of ten years when issued and vest over a five-year period. The exercise price of each option is the market price of the Corporations stock on the date of grant. Additionally, at June 30, 2004, the Corporation has 283,601 granted stock options, which were converted from the Millennium Bank acquisition. The options have a term of ten years and are exercisable at prices ranging from $10.71 to $15.98, at June 30, 2004, except for 31,280 non-qualified stock options, which are performance based and exercisable at $13.59 per share after December 31, 2006.





The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants at June 30, 2004 and June 30, 2003, respectively: dividend yield of 2.50% and 2.80%; expected volatility of 28.94% and 5.39%; risk-free interest rate of 4.47% and 3.23%; and an expected life of 7.15 years and 7.37 years.





The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation:





Three Months Ended
Six Months Ended(Dollars in thousands, except per share amounts)

June 30,
June 30,2004


2003


2004


2003Net IncomeAs reported

$
9,382

$
9,101

$
18,289

$
17,566Less: Stock-based compensation cost determinedunder fair value method for all awards


515


252


965


505Proforma

$
8,867

$
8,849

$
17,324

$
17,061Earnings per share (Basic)As reported

$
.38

$
.38

$
.75

$
.74Proforma

$
.36

$
.37

$
.71

$
.72Earnings per share (Diluted)As reported

$
.37

$
.37

$
.73

$
.71Proforma

$
.35

$
.36

$
.69

$
.70





On March 31, 2004, the Financial Accounting Standards Board (FASB) issued a proposed Statement, Share-Based Payment an Amendment of FASB Statements No. 123 and APB No. 95, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprises equity instruments or that may be settled by the issuance of such equity instruments. Under the FASBs proposal, all forms of share-based payments to employees, including employee stock options, would be treated the same as other forms of compensation by recognizing the related cost in the income statement. The expense of the award would generally be measured at fair value at the grant date. Current accounting guidance requires that the expense relating to so-called fixed plan employee stock options only be disclosed in the footnotes to the financial statements. The proposed Statement would eliminate the ability to account for share-based compensation transactions using APB Opinion No. 25, Accounting for Stock Issued to Employees. The Corporation is currently evaluating this proposed statement and its effects on its results of operations.








Note 4 -Variable Interest Entities





Management has determined that HNC Statutory Trust I (Trust I) qualifies as a variable interest entity under FASB Interpretation 46 (FIN 46) Consolidation of Variable Interest Entities, as revised. Trust I issued mandatorily redeemable preferred stock to investors and loaned the proceeds to the Corporation. Trust I is included in the Corporations consolidated balance sheet and statements of income as of and for the year ended December 31, 2003. Subsequent to the issuance of FIN 46 in January 2003, the FASB issued a revised interpretation, FIN 46(R)Consolidation of Variable Interest Entities, the provisions of which must be applied to certain variable interest entities by March 31, 2004.





The Corporation adopted the provisions under the revised interpretation in the first quarter of 2004. Accordingly, the Corporation no longer consolidates Trust I as of March 31, 2004. FIN 46(R) precludes consideration of the call option embedded in the preferred stock when determining if the Corporation has the right to a majority of Trust Is expected residual returns. The deconsolidiation resulted in the investment 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. In addition, the income received on the Corporations common stock investment is included in other income. The adoption of FIN 46(R)) did not have a material impact on the financial position or results of operations. The Federal Reserve has issued proposed guidance on the regulatory capital treatment for the trust-preferred securities issued by Trust I as a result of the adoption of FIN 46(R). The proposed rule would retain the current maximum percentage of total capital permitted for Trust Preferred Securities at 25%, but would enact other changes to the rules governing Trust Preferred Securities that affect their use as part of the collection of entities known as restricted core capital elements. The rule would take effect March 31, 2007; however, a three year transition period starting now and leading up to that date would allow bank holding companies to continue to count Trust Preferred Securities as Tier 1 Capital after applying FIN-46(R). Management has evaluated the effects of the proposed rule and does not anticipate a material impact on its capital ratios when the proposed rule is finalized.





Note 5 -Pension Plan





The Corporation has a non-contributory defined benefit pension plan covering substantially all employees. The plans benefits are based on years of service and the employees average compensation during any five consecutive years within the 10-year period preceding retirement.





Net periodic defined benefit pension expense for the six months ended June 30, 2004 and 2003 included the following components:





2004


2003Service cost

$
436,000

$
392,000Interest cost


282,000


244,000Expected return on plan assets


(238,000
)

(180,000
)Amortization of prior service cost


(52,000
)

(56,000
)Amortization of unrecognized net actuarial loss


40,000


96,000Net periodic benefit expense

$
468,000

$
496,000





We have contributed $1,250,000 to our pension plan in 2004. We are currently evaluating the impact of the Pension Funding Equity Act enacted in April 2004 on our projected funding.





Note 6  Acquisition





On April 30, 2004, the Corporation completed its acquisition of Millennium Bank which was merged with and into Harleysville. Millennium Bank was based in Malvern, Pennsylvania with four banking offices, specializing in commercial lending and client relationship banking along with the wealth management unit, Cumberland Advisors, Inc. . Millennium Banks results of operations are included in the Corporations results beginning April 30, 2004 through June 30, 2004.





The aggregate purchase price was $52,819,000 in cash and stock which included $5,496,000 in expenses associated with the acquisition.. The Corporation acquired 100% of the outstanding shares of Millennium Bank. Millennium Bank shares of 1,511,624 were exchanged at a conversion ratio of .6256 for 945,672 common shares of the Corporations common stock and Millennium Bank shares of 1,008,050 were exchanged for cash consideration of $16,129,000. Millennium Bank options of 302,250 were cashed out for consideration of $2,274,000 and options of 453,325 were exchanged at a conversion ratio of .6256 to acquire 283,601 shares of the Corporations common stock (252,321 options at an exercise price of $10.71 to $15.98 and 31,280 performance based options at an exercise price of $13.59.)











The following table summarizes the fair values of the assets acquired and liabilities assumed at the date of acquisition. This transaction was accounted for using the purchase method of accounting in accordance with SFAS No. 141 "Business Combinations.





At April 30, 2004(Dollars in thousands)Assets:Cash and cash equivalents

$
5,460Investment securities available for sale


35,345Loans


157,135Less: Allowance for loan losses


(1,688
)Net loans


155,447Other assets


8,330Total assets

$
204,582Liabilities:Noninterest-bearing deposits

$
17,494Interest-bearing deposits


133,754Short-term borrowings


14,521Long-term borrowings


17,000Other liabilities


1,223Total liabilities

$
183,992Net assets acquired

$
20,590





Goodwill of $32,229,000 was recorded in connection with the acquisition of Millennium Bank. The Corporation is in the process of obtaining third party valuation of certain intangible assets, thus the allocation of the purchase price is subject to refinement. The following table provides the calculation of the goodwill:





(Dollars in thousands)Purchase Price:

$
47,323Expense associated with the acquisition


5,496Total purchase price


52,819Net Assets Acquired:Seller shareholders equity, net of intangible assets


15,768Estimated adjustments to reflect assets acquired at fair value:Loans (seven year weighted average life)


1,432Core deposit intangible (eight year amortization)


1,782Estimated amount allocated to liabilities assumed at fair value:Deposits (four year weighted average life)


(931
)Deferred tax and current taxes payable


2,539Net assets acquired


20,590Goodwill

$
32,229








Note 7  Capital Securities





HNC Statutory Trust II, a Delaware statutory trust subsidiary of Corporation (the "Trust II"), completed an offering of $20,000,000 of floating rate (three- month LIBOR plus a margin of 2.70%) Capital Securities (the "Capital Securities"), which represent undivided beneficial interests in the assets of the Trust II on March 25, 2004. The Trust II qualifies as a variable interest entity under FIN 46. The Trust issued mandatorily redeemable preferred stock to investors and loaned the proceeds to the Corporation. The Trust II holds, as its sole asset, a subordinated debenture in the amount of $20,619,000 issued by the Corporation on March 25, 2004.











Note 8- Earnings Per Share





The Corporation follows the provisions of SFAS No. 128, Earnings per Share (EPS). Basic earnings per share excludes dilution and is computed by dividing income available to common shareholders by the weighted-average common shares outstanding during the period. Diluted earnings per share take into account the potential dilution that could occur if securities or other contracts to issue common stock were exercised and converted into common stock. All weighted average, actual shares and per share information in these financial statements have been adjusted retroactively for the effect of stock dividends and splits. The calculation of basic earnings per share and diluted earnings per share are as follows:





For the three months ended June 30,

2004
2003(Dollars in thousands, except number of shares and per share data)

Income
Shares
Per Share Amount
Income
Shares
Per Share AmountBasic earnings per share:Income available to common shareholders

$9,382
24,630,047
$.38
$9,101
23,779,235
$.38Effect of dilutive securities:Stock options(1)


820,364
(0.01)

761,413
(0.01)Diluted earnings per share:Income available to common shareholders and assumed conversions

$9,382
25,450,411
$.37
$9,101
24,540,648
$.37For the six months ended June 30,

2004
2003(Dollars in thousands, except number of shares and per share data)

Income
Shares
Per Share Amount
Income

Shares
Per Share AmountBasic earnings per share:Income available to common shareholders

$18,289
24,280,753
$.75
$17,566

23,774,838
$.74Effect of dilutive securities:Stock options(1)


886,755
(0.02)


756,191
(0.03)Diluted earnings per share:Income available to common shareholders and assumed conversions

$18,289
25,167,508
$.73
$17,566

24,531,029
$.71





(1)For the three and six months ended June 30, 2004, options to purchase 218,000 shares of common stock at $30.62 per share have been excluded in the computation of diluted EPS because the options exercise price was greater than the average market price of the common stock. For the three and six months ended June 30, 2003, there were no antidilutive options.





Note 9 - Stock Split





On September 15, 2003, the Corporation paid a five-for-four common stock split to shareholders of record as of September 2, 2003. On September 16, 2002, the Corporation paid a 5% stock dividend on its common stock to shareholders of record as of September 3, 2002. All prior period amounts were restated to reflect these stock dividends.





Note 10 - Loan Commitments





The Corporation had commitments with customers to extend mortgage loans at a specified rate in the amount of $4,029,000 at June 30, 2004. The loan commitments are accounted for as a derivative and recorded at fair value. The Corporation estimates the fair value of these commitments by comparing the secondary market price at June 30, 2004 to the price specified in the contract to sell the loan initiated at the time of the loan commitment. At June 30, 2004, the fair value of the loan commitments was $24,000 which was recorded as other income.





Note 11  New Accounting Pronouncement





In November 2003, the Emerging Issues Task Force (EITF) of the FASB issued EITF Abstract 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments(EITF 03-1). The quantitative and qualitative disclosure provisions of EITF 03-1 were effective for years ending after December 15, 2003 and were included in the Corporations 2003 Form 10-K. In March 2004, the EITF issued a Consensus on Issue 03-1 requiring that the provisions of EITF 03-1 be applied for reporting periods beginning after June 15, 2004 to investments accounted for under SFAS No. 115 and 124. EITF 03-1 establishes a three-step approach for determining whether an investment is considered impaired, whether that impairment is other-than-temporary, and the measurement of an impairment loss. The Corporation is in the process of determining the impact that this EITF will have on its financial statements.








Item 2.





MANAGEMENT'S DISCUSSION AND ANALYSIS OF


RESULTS OF OPERATIONS AND FINANCIAL CONDITION





Results of Operations





The following is managements discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in its accompanying consolidated financial statements for the Corporation, Harleysville, HNC Financial Company and HNC Reinsurance Company. The Corporations consolidated financial condition and results of operations consist almost entirely of Harleysvilles financial condition and results of operations. Current performance does not guarantee, and may not be indicative of similar performance in the future. These are unaudited financial statements and, as such, are subject to year-end audit review.





In addition to historical information, this Form 10-Q contains forward-looking statements. We have made forward-looking statements in this document, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include the information concerning possible or assumed future results of operations of the Corporation and its subsidiaries. When we use words such as believes, expects, anticipates, or similar expressions, we are making forward-looking statements.





Shareholders should note that many factors, some of which are discussed elsewhere in this document and in the documents that we incorporate by reference, could affect the future financial results of the Corporation and its subsidiaries and could cause those results to differ materially from those expressed in our forward-looking statements contained or incorporated by reference in this document. These factors include the following:








*Operating, legal and regulatory risks;





*Economic, political and competitive forces affecting our banking, securities, asset management and credit services businesses; and





*The risk that our analyses of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful.





Critical Accounting Policies, Judgements and Estimates





The accounting and reporting policies of the Corporation and its subsidiaries conform to accounting principles generally accepted in the United States of America (US GAAP) and general practices with the financial services industry. All significant inter-company transactions are eliminated in consolidation and certain reclassifications are made when necessary to conform with the previous years financial statements to the current years presentation. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amount of assets and liabilities as of the dates of the balance sheets and revenues and expenditures for the periods presented. Therefore, actual results could differ significantly from those estimates. Accounting policies involving significant judgements and assumptions by management, which have, or could have a material impact on the carrying value of certain assets or comprehensive income, are considered critical accounting policies. The Company recognizes the following as critical accounting policies: Allowance for Loan Loss, Goodwill and Other Intangible Asset Impairment, Stock-Based Compensation, Unrealized Gains and Losses on Debt Securities Available for Sale, and Deferred Taxes.





Allowance for Loan Losses: The Corporation maintains an allowance for loan losses at a level management believes is sufficient to absorb estimated probable credit losses. Managements determination of the adequacy of the allowance is based on periodic evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective as it requires significant estimates by management. Consideration is given to a variety of factors in establishing these estimates including current and anticipated economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, borrowers perceived financial and management strengths, the adequacy of underlying collateral, the dependence on collateral, or the strength of the present value of future cash flows and other relevant factors. These factors may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provisions for loan losses may be required which may adversely affect the Corporations results of operations in the future.








Goodwill and Other Intangible Asset Impairment: The Corporation employs general industry practices in evaluating the fair value of its goodwill and other intangible assets. If the fair value exceeds book value, no write-down of recorded goodwill is necessary. If the fair value is less than book value, a charge may be required on the books to reduce the goodwill to the proper carrying value. Goodwill is subject to impairment testing annually. No assurance can be given that future impairment tests will not result in a charge to earnings.





Stock-based Compensation: Under SFAS No. 123 Accounting for Stock-Based Compensation (FAS 123), companies have a choice whether to adopt the fair value based method of accounting for stock-based compensation or remain with the intrinsic value based method prescribed under APB Opinion No. 25, Account for Stock Issued to Employees (APB 25) but provide pro-forma disclosure as if the fair value based method was applied. The Corporation chose the intrinsic value based method under APB 25 and provides pro-forma disclosure required under FAS 123. In preparing the pro-forma disclosure, the Corporation estimates the fair value of employee stock options using a pricing model which takes into consideration the exercise price and expected life of the options, the current price of the underlying stock and its expected volatility, the expected dividends on the stock and the current risk-free interest rate for the expected life of the option. The Corporations estimate of the fair value of a stock option is based on expectations derived from historical experience and may not necessarily equate to its market value when fully vested.





Unrealized Gains and Losses on Debt Securities Available for Sale: The Corporation receives estimated fair values of debt securities from independent valuation services and brokers. In developing these fair values, the valuation services and brokers use estimates of cash flows based on historical performance of similar instruments in similar rate environments. Debt securities available for sale are mostly comprised of mortgage-backed securities.





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





The Corporation has not substantively changed its application of the foregoing policies, and there have been no material changes in assumptions or estimation techniques used as compared to prior periods.








Overview





The Corporation earned $9,382,000 in the second quarter of 2004, a 3.1% increase over second quarter 2003 earnings of $9,101,000 and a 5.3% increase over $8,907,000 earned in the first quarter of 2004. Earnings for the first six months of 2004 increased 4.1% to $18,289,000 from $17,566,000 during the same period in 2003. Lower operating expenses, a reduction in the provision for loan losses, an increase in trust and investment services income, partially offset by lower security gains and non-recurring income from life insurance proceeds contributed to the first half of 2004 performance. Asset quality at June 30, 2004 also improved through a reduction in non-performing assets, compared to both December 31, 2003 and June 30, 2003.








Second quarter 2004 diluted earnings per share of $.37 were equal to the $.37 earned during the second quarter of 2003, and basic earnings per share at $.38 were equal to $.38 in the second quarter of 2003.





The current quarter results include the impact of operations from the acquisition of Millennium Bank effective April 30, 2004 and the related issuance by the Corporation of 945,672 common shares. The Corporations consolidated total assets were $2,865,949,000 at June 30, 2004, 19.1% above the June 30, 2003 level of $2,406,132,000. Of this increase, 9.6% or $230,738,000 was attributable to the acquisition of Millennium Bank and 8.3% or $200,177,000 was due to loan growth.





For the three months ended June 30, 2004, the annualized return on average shareholders equity and the annualized return on average assets were 15.06% and 1.37%, respectively. For the same period in 2003, the annualized return on average shareholders equity was 16.67% and the annualized return on average assets was 1.49%. Excluding accumulated other comprehensive income, the annualized return on average realized shareholders equity for the second quarters of 2004 and 2003 was 15.17% and 17.53%, respectively. The decrease in the annualized return on average shareholders equity during 2004 was primarily due to the increase in equity in the Millennium Bank acquisition.





Asset quality continued to improve in this economy that is slowly beginning to show signs of strength, as reflected by the improvement in loan quality ratios at June 30, 2004. Nonperforming assets (nonaccruing loans, net assets in foreclosure and loans past due 90 days or more and still accruing interest) were .16% of total assets at June 30, 2004, compared to .22% at December 31, 2003 and .27% at June 30, 2003. The ratio of the allowance for loan losses to nonperforming loans was 430.8% at June 30, 2004, compared to 371.7% at December 31, 2003 and 301.0% at June 30, 2003. The increase in the ratio of loan loss reserve to nonperforming loans was primarily due to improved loan quality. The annualized net loans charged-off to average loans was 0.18% during the second quarter of 2004, compared to 0.20% during the second quarter of 2003.





Net income is affected by five major elements: net interest income, or the difference between interest income earned on loans and investments and interest expense paid on deposits and borrowed funds; the provision for loan losses, or the amount added to the allowance for loan losses to provide reserves for inherent losses on loans; noninterest income, which is made up primarily of certain fees, trust income and gains and losses from sales of securities; noninterest expenses, which consist primarily of salaries, employee benefits and other operating expenses; and income taxes. Each of these major elements will be reviewed in more detail in the following discussion.





On April 30, 2004, the Corporation completed the acquisition of Millennium Bank, Malvern, PA. Millennium Bank was merged into Harleysville. This transaction was accounted for in accordance with SFAS No. 141 Business Combinations. Millennium Banks shareholders received 945,672 of the Corporations common stock and $16,129,000 in exchange for all outstanding common shares. Millennium Bank option holders received $2,274,000 and options to acquire 283,601 shares of the Corporations common stock in exchange for all outstanding options.





Net Interest Income and Related Assets and Liabilities





Net interest income for the second quarter 2004 of $21,320,000 was $1,515,000 or 7.6% higher than the same period 2003 net interest income of $19,805,000. Net interest income of $41,550,000 for the first six months of 2004 was $2,546,000 or 6.5% higher than the same period 2003 net interest income of $39,004,000. This increase in net interest income was primarily the result of higher earning asset volumes partially offset by lower rates. Interest income was higher during the second quarter 2004 compared to 2003 as a result of the impact of the increase in earning assets acquired through growth and the Millennium Bank acquisition. Interest income for the first six months of 2004 of $60,167,000 was $307,000 or .5% lower than interest income of $60,474,000 during the same period in 2003. This is a result of the impact of lower interest rates partially offset by the effect of growth in the loan portfolio.





The rate-volume variance analysis in the table below, which is computed on a tax-equivalent basis (tax rate of 35%), analyzes changes in net interest income for the three and six months ended June 30, 2004 compared to June 30, 2003 by their volume and rate components. The change attributable to both volume and rate has been allocated proportionately.





Three Months Ended
Six Months EndedJune 30, 2004 compared to
June 30, 2004 compared to(Dollars in thousands)

June 30, 2003
June 30, 2003Total
Due to change in:
Total
Due to change in:Change
Volume
Rate
Change

Volume
RateIncrease (decrease) in interest income:Investment securities *

$ 0
$ 344
$ (344)
$ (994)

$ (310)
$ (684)Federal funds sold and deposits
in banks

25
59
(34)
40

103
(63)Loans *

856
3,393
(2,537)
96

4,707
(4,611)Total

881
3,796
(2,915)
(858)

4,500
(5,358)Increase (decrease) in interest expense:Savings deposits

(82)
210
(292)
(948)

424
(1,372)Time deposits

(713)
(144)
(569)
(2,097)

(936)
(1,161)Borrowed funds

385
954
(569)
192

1,014
(822)Total

(410)
1,020
(1,430)
(2,853)

502
(3,355)Net increase (decrease) in interest income

$1,291
$2,776
$(1,485)
$1,995

$3,998
$(2,003)*Tax equivalent basis














BALANCE SHEET ANALYSISThe table below presents the major asset and liability categories on an average basis for the periodspresented, along with interest income and expense, and key rates and yields.AVERAGE BALANCE SHEET AND INTEREST RATES(Dollars in thousands)

Three Months Ended June 30, 2004
Three Months Ended June 30, 2003Average

Average
Average

AverageAssets


Balance
Interest
Rate
Balance
Interest
RateEarning assets:Investment securities:Taxable investments


$ 724,609
$ 5,721
3.18%
$ 608,181
$ 4,463
2.94%Nontaxable investments (1)


258,811
4,608
7.16
340,601
5,866
6.89Total investment securities


983,420
10,329
4.22
948,782
10,329
4.35Federal funds sold and deposits in banks


36,855
81
.88
14,050
56
1.59Loans (1) (2)


1,572,830
22,580
5.77
1,342,758
21,724
6.47Total earning assets


2,593,105
32,990
5.12
2,305,590
32,109
5.57Noninterest-earning assets


166,458


129,990Total assets


$2,759,563


$2,435,580Liabilities and Shareholders' EquityInterest-bearing liabilities:Interest-bearing deposits:Savings


$1,052,563
1,769
.68
$ 933,158
1,851
.79Time


679,001
5,129
3.04
695,817
5,842
3.36Total interest-bearing deposits


1,731,564
6,898
1.60
1,628,975
7,693
1.89Borrowed funds


404,446
2,776
2.76
274,567
2,391
3.48Total interest bearing liabilities


2,136,010
9,674
1.82
1,903,542
10,084
2.12Noninterest-bearing liabilities:Demand deposits


316,715


260,688Other liabilities


56,334


52,987Total noninterest-bearing liabilities


373,049


313,675Total liabilities


2,509,059


2,217,217Shareholders' equity


250,504


218,363Total liabilities and shareholders'
equity


$2,759,563


$2,435,580Net interest spread




3.30


3.45Effect of noninterest-bearing sources




.32


37Net interest income/margin on earning assets



$23,316
3.62%

$22,025
3.82%














(Dollars in thousands)

Six Months Ended June 30, 2004
Six Months Ended June 30, 2003Average


AverageAssets

Balance
Interest
Rate
Balance
Interest
RateEarning assets:Investment securities:Taxable investments

$ 700,990
$ 11,242
3.23%
$ 625,236
$ 9,543
3.05%Nontaxable investments (1)

245,877
8,962
7.33
334,263
11,655
6.97Total investment securities

946,867
20,204
4.29
959,499
21,198
4.42Federal funds sold and deposits in banks

38,618
169
.88
18,094
129
1.43Loans (1) (2)

1,493,816
43,663
5.88
1,335,963
43,567
6.52Total earning assets

2,479,301
64,036
5.19
2,313,556
64,894
5.61Noninterest-earning assets

149,023


129,392Total assets

$2,628,324


$2,442,948Liabilities and Shareholders' EquityInterest-bearing liabilities:Interest-bearing deposits:Savings

$1,036,679
3,496
.68
$ 937,226
4,444
.95Time

669,439
10,243
3.08
725,061
12,340
3.40Total interest-bearing deposits

1,706,118
13,739
1.62
1,662,287
16,784
2.02Borrowed funds

327,862
4,878
2.99
263,550
4,686
3.56Total interest bearing liabilities

2,033,980
18,617
1.84
1,925,837
21,470
2.23Noninterest-bearing liabilities:Demand deposits

298,762


251,791Other liabilities

54,137


51,493Total noninterest-bearing liabilities

352,899


303,284Total liabilities

2,386,879


2,229,121Shareholders' equity

241,445


213,827Total liabilities and shareholders'
equity

$2,628,324


$2,442,948Net interest spread



3.35


3.38Effect of noninterest-bearing sources



.33


.37Net interest income/margin on earning assets


$45,419
3.68%

$43,424
3.75%(1) The interest earned on nontaxable investment securities and loans is shown on a tax equivalent basis (tax rate of 35%)(2) Nonaccrual loans have been included in the appropriate average loan balance category, but interest onnonaccrual loans has not been included for purposes of determining interest income.





Net interest income on a fully tax-equivalent basis in the second quarter of 2004 increased $1,291,000 or 5.9% over the same period in 2003. This increase was the result of higher earning asset volumes combined with lower rates on average deposits and borrowings. The net interest margin for the second quarter of 2004 of 3.62% decreased 20 basis points from the second quarter of 2003 net interest margin of 3.82%. Average earning assets increased $287,515,000 or 12.5% during the second quarter of 2004 versus the comparable period in 2003. This increase was primarily due to an increase in average loans of $230,072,000 or 17.1% and an increase in average investments of $34,638,000 or 3.7%. Loans totaling $157,135,000 and investments totaling $35,345,000 were acquired in the acquisition of Millennium Bank. The lower net interest margin is primarily due to the continuing decline in loan yields.





The yield earned on average earning assets during the second quarter of 2004 of 5.12% was 45 basis points lower than the 5.57% earned during the second quarter of 2003. The rate paid on average deposits and other borrowings of 1.82% during the second quarter of 2004 was 30 basis points lower than the 2.12% rate paid during the second quarter of 2003. Lower rate average savings deposits grew $119,405,000 and higher rate average time deposits decreased $16,816,000. Savings deposits of $15,798,000 and time deposits of $91,421,000 were acquired from Millennium Bank during the quarter. Borrowed funds increased $129,879,000 during this period. The average rate paid on borrowed funds decreased 72 basis points, from 3.48% to 2.76%.








Net Interest Margin





The net interest margins for the three-month periods ending June 30, 2004 and June 30, 2003 were 3.62% and 3.82%, respectively. The second quarter 2004 net interest margin was lower than both the second and fourth quarter of 2003 net interest margins of 3.82% and 3.68%, respectively.





During the second quarter of 2004, the Corporation continued to manage its balance sheet in an effort to position it for the longer term and potentially higher rates. The Corporation maintained a larger portion of its investment securities in shorter-term securities with less extension risk during the first and second quarters of 2004. As a result the balance sheet is better positioned to benefit from rising interest rates once the economy begins to improve.





Interest Rate Sensitivity Analysis





The Corporation actively manages its interest rate sensitivity positions. The objectives of interest rate risk management are to control exposure of net interest income to risks associated with interest rate movements and to achieve consistent growth in net interest income. The Asset/Liability Committee, using policies and procedures approved by the Corporations Board of Directors, is responsible for managing the rate sensitivity position. The Corporation manages interest rate sensitivity by changing the mix and repricing characteristics of its assets and liabilities through the management of its investment securities portfolios, its offering of loan and deposit terms and through borrowings from the Federal Home Loan Bank. The nature of the Corporations current operations is such that it is not subject to foreign currency exchange or commodity price risk.





The Corporation only utilizes derivative instruments for asset/liability management, specifically, to convert variable rate debt and loans to a fixed rate. These transactions involve both credit and market risk. The notional amounts are amounts on which calculations and payments are based. The notional amounts do not represent direct credit exposures. Direct credit exposure is limited to the net difference between the calculated amounts to be received and paid, if any. Interest rate swaps are contracts in which a series of interest-rate flows (fixed and floating) are exchanged over a prescribed period. The notional amounts on which the interest payments are based are not exchanged.





The Corporation entered into three interest-rate swaps with a notional value totaling $45,000,000 on and a positive fair value of $230,000 at June 30, 2004.





The Corporation uses three principal reports to measure interest rate risk: asset/liability simulation reports; gap analysis reports; and net interest margin reports. Management also simulates possible economic conditions and interest rate scenarios in order to quantify the impact on net interest income. The effect that changing interest rates have on the Corporations net interest income is simulated by increasing and decreasing interest rates. This simulation is known as rate shocks. The results of the June 30, 2004 net interest income rate shock simulations show that the Corporation is within guidelines set by the Corporations Asset/Liability Policy when rates are shocked up 300 basis points, but is outside of guidelines when rates are shocked down over 100 basis points.





The report below forecasts changes in the Corporations market value of equity under alternative interest rate environments. The market value of equity is defined as the net present value of the Corporations existing assets and liabilities.





Change in








Asset/Liability(Dollars in thousands)


Market Value


Market Value


Percentage


Approvedof Equity


of Equity


Change


Percent Change+300 Basis Points

$
326,634

$
(66,819
)

-16.98
%

45
%+200 Basis Points


351,507


(41,946
)

-10.66


30+100 Basis Points


381,470


(11,983
)

-3.05


15Flat Rate


393,453


-


0.00-100 Basis Points


384,413


(9,040
)

-2.30


15-200 Basis Points


348,761


(44,692
)

-11.36


30-300 Basis Points


24,442


(69,011
)

-17.54


45





In the event the Corporation should experience a mismatch in its desired gap ranges or an excessive decline in their market value of equity resulting from changes in interest rates, it has a number of options that it could use to remedy the mismatch. The Corporation could restructure its investment portfolios through sale or purchase of securities with more favorable repricing attributes. It could also emphasize growth in loan products with appropriate maturities or repricing attributes, or attract deposits or obtain borrowings with desired maturities.











Provision for Loan Losses





Harleysville uses the reserve method of accounting for credit losses. The balance in the allowance for loan and lease losses is determined based on managements review and evaluation of the loan portfolio in relation to past loss experience, the size and composition of the portfolio, current economic events and conditions, and other pertinent factors, including managements assumptions as to future delinquencies, recoveries and losses. Increases to the allowance for loan and lease losses are made by charges to the provision for loan losses. Credit exposures deemed to be uncollectible are charged against the allowance for loan losses. Recoveries of previously charged-off amounts are credited to the allowance for loan losses.





While management considers the allowance for loan losses to be adequate based on information currently available, future additions to the allowance may be necessary due to changes in economic conditions or managements assumptions as to future delinquencies, recoveries and losses and managements intent with regard to the disposition of loans. In addition, the Office of the Comptroller of the Currency (the OCC), as an integral part of their examination process, periodically reviews Harleysvilles allowance for loan losses. The OCC may require Harleysville to recognize additions to the allowance for loan losses based on their judgments about information available to them at the time of their examination.





Harleysvilles allowance for loan and lease losses is the accumulation of various components that are calculated based on various independent methodologies. All components of the allowance for loan losses are an estimation. Management bases its recognition and estimation of each allowance component on certain observable data that it believes is the most reflective of the underlying loan losses being estimated. The observable data and accompanying analysis is directionally consistent, based upon trends, with the resulting component amount for the allowance for loan losses. Harleysvilles allowance for loan losses components includes the following: historical loss estimation by loan product type and by risk rating within each product type, payment (past due) status, industry concentrations, internal and external variables such as economic conditions, credit policy and underwriting changes, competence of the loan review process and other historical loss model imprecision. Harleysvilles historical loss component is the most significant component of the allowance for loan losses, and all other allowance components are based on the inherent loss attributes that management believes exist within the total portfolio that are not captured in the historical loss component.





The historical loss components of the allowance represent the results of analyses of historical charge-offs and recoveries within pools of homogeneous loans within each risk rating and broken down further by segment, within the portfolio. Criticized assets are further assessed based on trends, expressed as percentages, relative to delinquency, risk rating and non-accrual, by segment.





The historical loss components of the allowance for commercial loans is based principally on current risk ratings, historical loss rates adjusted, by adjusting the risk window, to reflect current events and conditions, as well as analyses of other factors that may have affected the collectibility of loans. Harleysville analyzes all commercial loans that have been identified as having potential risk. The review is accomplished via Watchlist Memorandum, and designed to determine whether such loans are individually impaired, with impairment measured by reference to the collateral coverage and/or debt service coverage. The historical loss component of the allowance for consumer loans is based principally on loan payment status, retail classification and historical loss rates adjusted, by adjusting the risk window, to reflect current events and conditions.





The industry concentration component is recognized as a possible factor in the estimation of loan losses. Two industries represent possible concentrations: commercial real estate and automobile dealers. No specific loss-related observable data is recognized by management currently, therefore no specific factor is calculated in the reserve solely for the impact of these concentrations, although management continues to carefully consider relevant data for possible future sources of observable data.





The historic loss model includes an imprecision component that reflects managements belief that there were additional inherent credit losses based on loss attributes not adequately captured in the lagging indicators. Furthermore, given that past performance indicators may not adequately capture current risk levels, allowing for a real-time adjustment enhances the validity of the loss recognition process. There are many credit risk management reports that are synthesized by credit management staff to assess the direction of credit risk and its instant affect on losses. These reports include the exception tracking reports, the credit bureau score distribution report, the debt to income summary, etc. These are a few of the many reports that drive the judgmental component. It is important to continue to use experiential data to confirm risk as measurable losses will continue to manifest themselves at higher than normal levels even after the economic cycle has begun an upward swing and lagging indicators begin to show improvement.








For the second quarter of 2004, the provision for loan losses was $497,000, compared to $1,320,000 for the same period in 2003. This reduction in the provision for loan losses is reflective of the improvement in key loan quality related ratios. For the six months ended June 30, 2004, the provision for loan losses was $986,000, compared to $1,929,000 for the same period in 2003, a decrease of $943,000 or 48.9%. This decrease reflects improved loan quality and managements periodic analysis as described above. Non-performing assets decreased in the second quarter of 2004 by $2,003,000 and $889,000 from the second and fourth quarters of 2003, respectively. The ratio of the allowance for loan losses to non-performing loans (non-accruing loans and loans 90 days or more past due) was 430.8% at June 30, 2004, compared to 371.7% at December 31, 2003, and 301.0% at June 30, 2003. Non-performing assets, including non-accrual loans, net assets in foreclosure and loans 90 days or more past due are .16% of total assets at June 30, 2004, an improvement from the .22% at December 31, 2003, and the .27% at June 30, 2003. Net loans charged off were $697,000 for the quarter ended June 30, 2004 compared to $684,000 for the quarter June 30, 2003. Net loans charged off for the six months ended June 30, 2004 were $1,476,000 compared to $1,581,000 for the same period in 2003.











Allowance for Loan LossesA summary of the allowance for loan losses is as follows:Six Months Ended(Dollars in thousands)

June 30,2004


2003Average loans

$
1,493,816

$
1,335,963Allowance, beginning of period


16,753


17,190Loans charged off:Commercial and industrial


188


439Consumer


1,065


1,065Real estate


159


312Lease financing


416


276Total loans charged off


1,828


2,092Recoveries:Commercial and industrial


0


8Consumer


277


434Real estate


30


15Lease financing


45


54Total recoveries


352


511Net loans charged off


1,476


1,581Reserve from Millennium Bank acquisition


1,677


Provision for loan losses


986


1,929Allowance, end of period

$
17,940

$
17,538Ratio of net charge offs to averageloans outstanding (annualized)


0.20
%
0.24%











Analysis of Credit Risk








June 30,
2004


December 31,
2003


June 30,
2003(Dollars in thousands)Non-accrual loans and leases

$
3,245

$
3,343

$
4,146Loans and leases 90 days or more past due


919


1,164


1,681Total nonperforming loans and leases


4,164


4,507


5,827Net assets in foreclosure


389


935


729Total nonperforming assets

$
4,553

$
5,442

$
6,556Allowance for loan and lease losses to non performing loans and leases


430.8
%

371.7
%

301.0
%Nonperforming loans and leases to total net loans and leases


0.25
%

0.32
%

0.44
%Allowance for loan and lease losses to total loans and leases


1.07
%

1.19
%

1.31
%Nonperforming assets to total assets


0.16
%

0.22
%

0.27
%








The following table sets forth an allocation of the allowance for loan losses by loan category:





June 30, 2004
December 31, 2003Percent





Percent(Dollars in thousands)


Amount


Of Loans


Amount


of LoansReal estate

$
4,468


33
%
$
3,919


35
%Commercialand industrial


6,818


29
%

6,840


27
%Consumer


5,446


35
%

4,990


34
%Lease financing


1,208


3
%

1,004


4
%Total

$
17,940


100
%
$
16,753


100
%








Nonperforming assets (nonaccruing loans, loans 90 days past due and net assets in foreclosure) were 0.16% of total assets at June 30, 2004 and 0.22% and 0.27% at December 31, 2003 and June 30, 2003, respectively. The ratio of the allowance for loan losses to loans at June 30, 2004 of 1.07% was lower than the December 31, 2003 ratio of 1.19% and the June 30, 2003 ratio of 1.31%.





Nonaccruing loans at June 30, 2004 of $3,245,000, decreased $98,000 from the December 31, 2003 level of $3,343,000, and decreased $901,000 from the June 30, 2003 level of $4,146,000. The decrease in nonaccruing loans at June 30, 2004, compared to June 30, 2003 was primarily the result of a decrease in nonaccruing commercial and residential real estate loans of $540,000 and a decrease in non-accruing leases of $344,000.





Net assets in foreclosure were $389,000 as of June 30, 2004, a decrease of $546,000 from the December 31, 2003 balance of $935,000. During the second quarter of 2004, transfers from loans to assets in foreclosure were $179,000, disposals on foreclosed properties were $179,000, and a write-down of $64,000 was made. Efforts to liquidate assets acquired in foreclosure are proceeding as quickly as potential buyers can be located and legal constraints permit. Foreclosed assets are carried at the lower of cost (lesser of carrying value of asset or fair value at date of acquisition) or estimated fair value.





Loans past due 90 days or more and still accruing interest are loans that are generally well secured and expected to be restored to a current status in the near future. As of June 30, 2004, loans past due 90 days or more and still accruing interest were $919,000 compared to $1,164,000, as of December 31, 2003, and $1,681,000 as of June 30, 2003. The decrease in loans past due 90 days at June 30, 2004, compared to December 31, 2003, was due to a decrease consumer and real estate loans past due 90 days or more. The reduction from June 30, 2003 is the result of the lower level of real estate loans past due 90 days or more.

















The following information concerns impaired loans:(Dollars in thousands)


June 30, 2004


Dec. 31, 2003


June 30, 2003Impaired Loans

$
1,969

$
1,811

$
2,213Average year-to-date impaired loans

$
1,997

$
2,189

$
2,424Impaired loans with specific loss allowances

$
1,969

$
1,811

$
2,213Loss allowances reserved on impaired loans

$
204

$
185

$
260Year-to-date income recognized on impaired loans

$
0

$
63

$
40





Harleysvilles policy for interest income recognition on nonaccrual loans is to recognize income under the cash basis when the loans are both current and the collateral on the loan is sufficient to cover the outstanding obligation to Harleysville. Harleysville will not recognize income if these factors do not exist.





Non-Interest Income





In the three months ending June 30, 2004, non-interest income of $6,287,000 decreased $3,672,000, or 36.9%, from $9,959,000 for the same period in 2003. This decrease in non-interest income is primarily the result of decreases in gains on sales of investment securities of $4,133,000 partially offset by an increase in trust and advisory services income of $598,000. Non-interest income for the six months ended June 30, 2004 decreased $5,100,000 or 29.7% to $12,070,000 from $17,170,000 during the comparable period of 2003. This was mainly due to a decrease of $4,549,000 in gain on sale of investment securities and a $1,119,000 decrease in life insurance income, partially offset by an increase of $831,000 in trust and investment advisory income.





The Corporation recorded net security gains of $641,000 in the second quarter of 2004 and $4,774,000 in the second quarter of 2003. The Corporation sold investment securities available for sale to fund the purchase of other securities in an effort to reduce the interest rate risk and market risk within different interest rate environments.





Income from the Wealth Management and Private Banking Division increased $598,000 from $978,000 at June 30, 2003 to $1,576,000 at June 30, 2004, a 61.1% increase from the prior year. Of this increase, $442,000, or 45.2% was attributable to the Cumberland Advisors subsidiary acquired with the Millennium Bank acquisition. Additionally, the increase was due to growth in trust assets and the higher market value of equities in trust assets experienced in 2004, compared to 2003.





The Corporations bank owned life insurance (BOLI) income decreased $110,000 or 17.4% during the second quarter of 2004, compared to the same period in 2003, and decreased $130,000 or 10.3% during the first six months of 2004 compared to the same period in 2003. The reduction is due to lower yields on the insurance contracts partially offset by higher amounts of BOLI insurance. BOLI involves the purchase of life insurance by the Corporation on a chosen group of employees. The corporation is the owner and beneficiary of the policies. This pool of insurance, due to tax advantages to Harleysville, is profitable to the Corporation. This profitability is used to offset a portion of future employee benefit cost increases.





Other income for the first six months of 2004 decreased $220,000 or 7.2%, compared to the same period in 2003. This decrease was primarily associated with lower gains on the sale of residential mortgages due to lower sales volume partially offset by an increase in miscellaneous fees. The year-to-date gain on the sale of residential mortgages was $343,000 in 2004, compared to $1,025,000 in the same period in 2003, and 2004 year-to-date miscellaneous fees were $2,436,000 compared to 1,941,000 in the same period of 2003.





Total non-interest income for the first six months of 2004 was $12,070,000, a decrease of $5,100,000 or 29.7% when compared to $17,170,000 for the same period in 2003. This decrease was mainly due to a decrease of $4,549,000 on gain on sale of investment securities and a $1,119,000 decrease in income on life insurance.








Non-Interest Expenses





During the second quarter 2004, non-interest expenses of $14,593,000 decreased $2,534,000 or 14.8% from $17,127,000 in the second quarter of 2003. The reduction in non-interest expenses was primarily due to a $2,594,000 decrease in prepayment fees related to the early retirement of Federal Home Loan Bank borrowings during the second quarter of 2003 along with reduced off-lease vehicle residual reserve expense amounting to $800,000 in the second quarter of 2003 compared to no reserve in the second quarter of 2004. Net of these reductions, non-interest expenses increased $900,000 or 6.3% in the second quarter of 2004 compared to the second quarter of 2003. Contributing to this growth were increases in salaries and employee benefits of $958,000, occupancy expense of $238,000 and equipment expense $134,000. For the first six months of 2004, non-interest expense decreased $4,230,000 or 13.0% to $28,410,000 from $32,640,000 during the first six months of 2003. This decrease was mainly due to reduced off-lease residual reserve of $2,600,000 and a decrease of $2,594,000 in Federal Home Loan bank borrowing prepayment fees, partially offset by an increase in salaries and employees benefits of $1,394,000 and $299,000 in occupancy expense. Increases of $711,000 in salaries and employee benefits and $114,000 in occupancy expense are attributable to the Millennium Bank acquisition.





Employee salaries increased $721,000 or 5.6% from $12,899,000 for the first six months of 2003 to $13,620,000 for the same period in 2004. This increase reflects cost of living increases, merit increases, and additional staff necessitated by the growth of Harleysville and the acquisition of Millennium Bank. Employee benefits of $3,490,000 expensed in the first six months of 2004, were $674,000 or 23.9% higher than the $2,816,000 of employee benefits expensed during the same period in 2003. The increase in employee benefits is primarily the result of $346,000 higher pension expense experienced during the first six months of 2004 and an increase in health care coverage of $218,000 compared to the first six months of 2003.





Net occupancy expense increased $238,000 or 27.0%, from $882,000 in the second quarter of 2003 to $1,120,000 in the second quarter of 2004. For the first six months of 2004, occupancy expense increased $299,000 or 15.7% over the first six months of 2003. This increase was primarily the result of higher rent expenses and the Millennium Bank acquisition, partially offset by a decrease in snow removal expenses associated with a milder winter in 2004. Furniture and equipment expense increased $134,000 or 9.7% in the second quarter of 2004 as compared to the second quarter of 2003. This is mainly due to an increase in maintenance expense.





Amortization of intangible assets, which includes mortgage servicing rights and core deposit intangibles, decreased $86,000 or 23.3% for the second quarter of 2004 as compared with the second quarter of 2003. Year-to-date amortization decreased $204,000 or 29.2% when compared with 2003. This decrease was mainly due to a decrease in provision for valuation allowance of $145,000 during the second quarter of 2004 as compared to the second quarter of 2003 and a $225,000 decrease in the provision year-to-date.





Other expenses decreased $1,184,000, or 29.4%, from $4,030,000 in the second quarter of 2003, compared to $2,846,000 in other expenses recorded during the same period in 2004. This decrease was largely due to $800,000 reduction in expenses related to the off-lease vehicle residual reserve expense and higher deferred loan origination costs of $925,000 partially offset by increases in other expense related to mergers, charter collapse, and legal expenses. During the first six months of 2004, other expenses decreased $3,212,000 or 35.5% to $5,833,000 when compared to other expenses of $9,045,000 recorded during the first six months of 2003. This decrease is due to reduced off-lease vehicle residual reserve of $2,600,000 and higher deferred loan origination costs of $1,083,000 partially offset by increases in expenses of $393,000 related to the charter collapse and the acquisition of Millennium Bank. The Corporation reviews and adjusts, if necessary, the off-lease vehicle residual reserve on a quarterly basis.





Income Taxes





The effective income tax rate for the quarter ended June 30, 2004 was 25.0% and for the six months ended June 30, 2004 was 24.5% versus the statutory rate of 35%. The Corporations lower effective rate is lower than the statutory tax rate primarily as a result of tax-exempt income earned from state and municipal securities and loans and bank-owned life insurance. The lower effective rate of 19.6% for the second quarter of 2003 and 18.7% for the six months ended June 30, 2003 was primarily the result of non-taxable income on life insurance proceeds amounting to $1,119,000 received during 2003.





Balance Sheet Analysis





Total assets increased $355,010,000, or 14.1%, from $2,510,939,000 at December 31, 2003 to $2,865,949,000 at June 30, 2004. This increase in assets was primarily the result of a $230,738,000 from the acquisition of Millennium Bank and $118,000,000 growth in loans.








The balance of securities available for sale at June 30, 2004 of $938,466,000 increased $33,596,000 compared to the December 31, 2003 balance of $904,870,000. The increase was primarily as a result of security acquisitions from Millennium Bank of $35,345,000 and additional purchase of agencies partially offset by a decrease in market value of $25,688,000 during the first half of 2004. Total loans and leases grew by $274,813,000 from $1,408,227,000 at December 31, 2003 to $1,683,040,000 at June 30, 2004. This growth was primarily due to the increase of $157,135,000 with the Millennium acquisition along with increases in home equity loans, partially offset by lower indirect vehicle financing and vehicle leases.





Total deposits increased $114,020,000, or 5.8% from $1,979,081,000 at December 31, 2003 to $2,093,101,000 at June 30, 2004. During this period, deposits of $151,248,000 were acquired in the acquisition of Millennium Bank. Net of the acquisition, core deposits grew $12,096,000 or 1.2% and certificates of deposits decreased $82,900,000 or 12.3%. The change in deposit mix was due to the Harleysvilles strategy to de-emphasize higher costing certificates of deposit and increase core deposits (noninterest-bearing checking, interest-bearing checking, money market accounts and savings accounts) to lower overall funding costs.





Borrowings increased $194,947,000 or 78.1% during the first six months of 2004. This increase was the result of a $126,200,000 rise in securities sold under agreement to repurchase and a $69,000,000 increase in long-term Federal Home Loan Bank borrowings. Subordinated debt increased $20,774,000 from $5,000,000 (previously classified as guaranteed preferred beneficial interest in Corporations subordinated debentures) at December 31, 2003 to $25,774,000 at June 30, 2004. The increase is a result of HNC Statutory Trust II, a Delaware statutory trust subsidiary of the Corporation (the "Trust"), completing an offering of $20,000,000 of floating rate (three- month LIBOR plus a margin of 2.70%) Capital Securities (the "Capital Securities"), which represent undivided beneficial interests in the assets of the Trust on March 25, 2004.





Capital





Capital formation is important to the Corporation's well being and future growth. Capital for the period ending June 30, 2004 was $251,877,000 an increase of $24,824,000 over the end of 2003. The increase is primarily the result of the acquisition of Millennium Bank, the retention of the Corporation's earnings and the exercise of stock options, partially offset by a decrease in accumulated other comprehensive income and dividends paid to the shareholders. The accumulated other comprehensive income at June 30, 2004 was a loss of $9,051,000, compared to a gain of $8,098,000 at December 31, 2003. Management believes that the Corporation's current capital and liquidity positions are adequate to support its operations. Management is not aware of any recommendations by any regulatory authority, which, if it were to be implemented, would have a material effect on the Corporation's capital.





(Dollars in thousands)





For Capital
Adequacy Purposes
To Be Well Capitalized
Under Prompt Corrective
Action ProgramAs of June 30, 2004


Actual
Amount


Ratio


Amount


Ratio


Amount


RatioTotal Capital (to risk weighted assets):Corporation

$
272,188


12.92
%

168,533


8.00
%
$
210,666


-Harleysville National Bank


231,475


11.11
%

166,631


8.00
%

208,289


10
%Tier 1 Capital (to risk weighted assets):Corporation


252,514


11.99
%

84,266


4.00
%

126,400


-Harleysville National Bank


213,435


10.25
%

83,315


4.00
%

124,973


6
%Tier 1 Capital (to average assets):Corporation


252,514


9.28
%

108,823


4.00
%

136,028


-Harleysville National Bank


213,435


7.96
%

107,296


4.00
%

134,121


5
%











(Dollars in thousands)





For Capital
Adequacy Purposes
To Be Well Capitalized
Under Prompt Corrective
Action ProgramAs of December 31, 2003


Actual
Amount


Ratio


Amount


Ratio


Amount


RatioTotal Capital (to risk weighted assets):Corporation

$
242,363


13.73
%
$
141,260


8.00
%
$
-


-Harleysville National Bank


148,666


11.44
%

104,001


8.00
%

130,002


10.00
%Citizens National Bank


39,397


13.07
%

24,108


8.00
%

30,135


10.00
%Security National Bank


18,511


12.56
%

11,789


8.00
%

14,736


10.00
%Tier 1 Capital (to risk weighted assets):Corporation

$
223,613


12.66
%
$
70,630


4.00
%
$
-


-Harleysville National Bank


137,756


10.60
%

52,001


4.00
%

78,001


6.00
%Citizens National Bank


35,630


11.82
%

12,054


4.00
%

18,081


6.00
%Security National Bank


16,666


11.31
%

5,895


4.00
%

8,842


6.00
%Tier 1 Capital (to average assets):Corporation

$
223,613


8.79
%
$
101,731


4.00
%
$
-


-Harleysville National Bank


137,756


7.45
%

73,989


4.00
%

92,486


5.00
%Citizens National Bank


35,630


7.49
%

19,033


4.00
%

23,791


5.00
%Security National Bank


16,666


7.90
%

8,435


4.00
%

10,544


5.00
%








Pursuant to the federal regulators risk-based capital adequacy guidelines, the components of capital are called Tier 1 and Tier 2 capital. For the Corporation, Tier 1 capital is the shareholders equity and Tier 2 capital is the allowance for loan losses. The minimum for the Tier 1 ratio is 4.0% and the total capital ratio (Tier 1 plus Tier 2 capital divided by risk-adjusted assets) minimum is 8.0%. At June 30, 2004, the Corporations Tier 1 risk-adjusted capital ratio was 11.99%, and the total risk-adjusted capital ratio was 12.92%, both well above the regulatory requirements. The risk-based capital ratios of Harleysville also exceeded regulatory requirements at June 30, 2004.





The leverage ratio consists of Tier 1 capital divided by quarterly average total assets, excluding intangible assets. Banking organizations are expected to have ratios of at least 4% and 5%, depending upon their particular condition and growth plans. Higher leverage ratios could be required by the particular circumstances or risk profile of a given banking organization. The Corporations leverage ratios were 9.28% at June 30, 2004 and 8.77% at December 31, 2003.





The year-to-date June 30, 2004 cash dividend per share of $.34 was 13.3% higher than the cash dividend for the same period in 2003 of $.30. The dividend payout ratio for the first six months of 2004 was 46.6%, compared to 42.3% for the same period in 2003. Activity in both the Corporations dividend reinvestment and stock purchase plan did not have a material impact on capital during the first half of 2004.





Liquidity





Liquidity is a measure of the ability of Harleysville to meet its needs and obligations on a timely basis. For a bank, liquidity provides the means to meet the day-to-day demands of deposit customers and the needs of borrowing customers. Generally, Harleysville arranges its mix of cash, money market investments, investment securities and loans in order to match the volatility, seasonality, interest sensitivity and growth trends of its deposit funds. The liquidity measurement is based on the asset/liability models projection of potential sources and uses of funds for the next 120 days. The resulting projections as of June 30, 2004 show the potential sources of funds exceeding the potential uses of funds. The Corporation has external sources of funds which can be drawn upon when funds are required. The primary source of external liquidity is an available line of credit with the Federal Home Loan Bank of Pittsburgh (the FHLB). Unused lines of credit at the FHLB were $750,504,000 as of June 30, 2004. Harleysville also has unused federal funds lines of credit of $58,000,000 and non-pledged investment securities available for sale of $453,605,000 as of June 30, 2004.








Other Information





Pending Legislation





Management is not aware of any other current specific recommendations by regulatory authorities or proposed legislation which, if they were implemented, would have a material adverse effect upon the liquidity, capital resources, or results of operations, although the general cost of compliance with numerous and multiple federal and state laws and regulations does have, and in the future may have, a negative impact on the Corporations results of operations.





Effects of Inflation





Inflation has some impact on the Corporation and Harleysvilles operating costs. Unlike many industrial companies, however, substantially all of Harleysvilles assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on the Corporations and Harleysvilles performance than the general level of inflation. Over short periods of time, interest rates may not necessarily move in the same direction or in the same magnitude as prices of goods and services.








Effect of Government Monetary Policies





The earnings of the Corporation are and will be affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. An important function of the Federal Reserve is to regulate the money supply and interest rates. Among the instruments used to implement those objectives are open market operations in United States government securities and changes in reserve requirements against member bank deposits. These instruments are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may also affect rates charged on loans or paid for deposits.





Harleysville is a member of the Federal Reserve and, therefore, the policies and regulations of the Federal Reserve 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 Harleysvilles operations in the future. The effect of such policies and regulations upon the future business and earnings of the Corporation and Harleysville cannot be predicted.








Environmental Regulations





There are several federal and state statutes, which regulate the obligations and liabilities of financial institutions pertaining to environmental issues. In addition to the potential for attachment of liability resulting from its own actions, a bank may be held liable under certain circumstances for the actions of its borrowers, or third parties, when such actions result in environmental problems on properties that collateralize loans held by the bank. Further, the liability has the potential to far exceed the original amount of a loan issued by the bank. Currently, neither the Corporation nor Harleysville are a party to any pending legal proceeding pursuant to any environmental statute, nor are the Corporation and Harleysville aware of any circumstances that may give rise to liability under any such statute.





Branching





During the second quarter of 2004, Harleysville opened a new location in Lower Salford Township, Montgomery County, Pennsylvania. The Company discontinued plans to open a location in Plymouth Township, Montgomery County, Pennsylvania, but continues to evaluate potential new branch sites that are contiguous to our current service area and will expand Harleysvilles market area and market share of loans and deposits.





Item 3  Qualitative and Quantitative Disclosures About Market Risk





In the normal course of conducting business activities, the Corporation is exposed to market risk, principally interest risk, through the operations of its banking subsidiaries. Interest rate risk arises from market driven fluctuations in interest rates that affect cash flows, income, expense and values of financial instruments. The Asset/Liability Committee, using policies and procedures approved by Harleysvilles Boards of Directors, is responsible for managing the rate sensitivity position.





No material changes in market risk strategy occurred during the current period. A detailed discussion of market risk is provided on page 17 of this Form 10-Q.








Item 4  Controls and Procedures





(a) We maintain a system of controls and procedures designed to provide reasonable assurance as to the reliability of the financial statements and other disclosures included in this report, as well as to safeguard assets from unauthorized use or disposition. During the second quarter of 2004, management uncovered a defalcation in the pre-tax amount of $699,000. The Company determined the defalcation was the result of unauthorized activities by an officer of the bank who was immediately terminated. Restitution has been made in full. The appropriate regulatory and governmental authorities were notified in a timely manner.





(b)The Company has conducted a review of its controls and procedures, which has resulted in certain changes related to processing of employee personal accounts, account reconciliation procedures, and approvals related thereto. The Office of the Comptroller of the Currency (OCC) has also conducted a preliminary review in connection with the defalcation noted above and identified certain weaknesses in Harleysvilles internal controls and procedures. They suggested certain corrective actions which Harleysville has responded to in order to reduce the potential for internal fraud.





(c)  We evaluated the effectiveness of the design and operation of our disclosure controls and procedures under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, as of the end of the second quarter of 2004. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in alerting them in a timely manner to material information required to be included in our periodic Securities and Exchange Commission filings.








PART II. OTHER INFORMATION





Item 1.Legal Proceedings





Management, based upon discussions with the Corporation's legal counsel, is not aware of any litigation that would have a material adverse effect on the consolidated financial position of the Corporation. There are no proceedings pending other than the ordinary routine litigation incident to the business of the Corporation and its subsidiaries - Harleysville, HNC Financial Company and HNC Reinsurance Company. In addition, no material proceedings are pending or are known to be threatened or contemplated against the Corporation and its subsidiaries by government authorities.








Item 2.Change in Securities, Use of Proceeds and Issuer Purchases of Equity Securities





The following table presents the repurchase activity of the stock repurchase program during the second quarter of 2004:





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)April 1-30, 2004

16,457
$ -
16,457
350,035May 1-31, 2004

3,000
24.25
3,000
347,035June 1-30, 2004

23,900
25.13
23,900
323,135Total

43,357
$15.53
43,357





(1) On December 14, 2000, the Board of Directors authorized a program to purchase up to 1,189,000 shares of its common stock.








Item 3.Defaults Upon Senior Securities





Not applicable








Item 4.Submission of Matters to a Vote of Security Holders


Not applicable














Item 5.Other Information





1. None
2. There has been no change to manner shareholders may recommend nominees to Registrants Board of Directors.







Item 6.Exhibits and Reports on Form 8-K








(a) Exhibits:


The following exhibits are being filed as part of this Report:








Exhibit No .Description of Exhibits




|(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 3.2 to the Corporations Registration Statement No. 333-111709 on Amendment No. 1 to Form S-4, as filed on February 6, 2004.)                                                                                                                                                                   
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.1)  | Employment Agreement by and among Harleysville National Corporation, Harleysville National Bank and Trust Company and David E. Sparks, dated as of 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)  | Complete Settlement Agreement and General Release by and between David E. Sparks, Harleysville National Corporation and Harleysville National Bank (incorporated by reference to Exhibit 99.2 to the Corporations Current Report on Form 8-K, as filed on June 22, 2004).                                                                                                                            
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.3)  | 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 referenced 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.)
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.4)  | Harleysville National Corporation 1993 Stock Incentive Plan. (Incorporated by Reference to Exhibit 4.3 of Registrants Registration Statement No. 33-57790 on Form S-8, filed with the Commission on October 1, 1993.)                                                                                                                                                                                
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.5)  | Harleysville National Corporation Stock Bonus Plan. (Incorporated by Reference to Exhibit 99A of Registrants Registration Statement No. 33-17813 on Form S-8, filed with the Commission on December 13, 1996.)                                                                                                                                                                                       
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.6)  | 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.)                                                                                                                                                                                     
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.7)  | Walter E. Daller, Jr., Chairman, President and Chief Executive Officers employment agreement. (Incorporated by Reference to Registrants Registration Statement on Form 8-K, filed with the Commission on March 25, 1999.)                                                                                                                                                                           
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.8)  | Demetra M. Takes, President and Chief Executive Officer of Harleysville employment agreement. (Incorporated by Reference to Registrants Registration Statement on Form 8-K, filed with the Commission on March 25, 1999.)                                                                                                                                                                            
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.9)  | 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.)                                                                                                                                                                                                  
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.10) | 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.)                                                                                                                                                                               
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.11) | Employment agreement dated February 23, 2004 between Michael B. High, Executive Vice President & Chief Financial Officer and Harleysville Management Services, LLC.                                                                                                                                                                                                                                   
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.12) | Supplemental executive retirement benefit agreement dated February 23, 2004 between Michael B. High, Executive Vice President & Chief Financial Officer and Harleysville Management Services, LLC.                                                                                                                                                                                                    
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.13) | Employment agreement dated March 9, 2004 between Mikkalya Murray, Executive Vice President and Harleysville Management Services, LLC.                                                                                                                                                                                                                                                                 
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(11)    | Computation of Earnings per Common Share. The information for this Exhibit is incorporated by reference to page 4 and 11 of this Form 10-Q.                                                                                                                                                                                                                                                           
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(31)    | Section 302 Certification. Walter E. Daller, Jr. Chairman, President and Chief Executive Officer and Michael B. High, Executive Vice President and Chief Financial Officer.                                                                                                                                                                                                                           
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(32)    | Section 906 Certification. Walter E. Daller, Jr. Chairman, President and Chief Executive Officer and Michael B. High, Executive Vice President and Chief Financial Officer.                                                                                                                                                                                                                           
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(b)     | Reports on Form 8-K                                                                                                                                                                                                                                                                                                                                                                                   
|        |                                                                                                                                                                                                                                                                                                                                                                                                       


































SIGNATURES





Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.











HARLEYSVILLE NATIONAL CORPORATION

















/s/ Walter E. Daller, Jr.


Walter E. Daller, Jr., Chairman, President and Chief Executive Officer


(Principal executive officer)











/s/ Michael B. High


Michael B. High, Executive Vice President and Chief Financial Officer


(Principal financial and accounting officer)














EXHIBIT INDEX





Exhibit No Description of Exhibits






|(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 3.2 to the Corporations Registration Statement No. 333-111709 on Amendment No. 1 to Form S-4, as filed on February 2, 2004.)                                                                                                                                                                   
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.1)  | Employment Agreement by and among Harleysville National Corporation, Harleysville National Bank and Trust Company and David E. Sparks, dated as of 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)  | Complete Settlement Agreement and General Release by and between David E. Sparks, Harleysville National Corporation and Harleysville National Bank (incorporated by reference to Exhibit 99.2 to the Corporations current report on Form 8-K, as filed on Jun 22, 2004).                                                                                                                             
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.3)  | 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 referenced 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.)
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.4)  | Harleysville National Corporation 1993 Stock Incentive Plan. (Incorporated by Reference to Exhibit 4.3 of Registrants Registration Statement No. 33-57790 on Form S-8, filed with the Commission on October 1, 1993.)                                                                                                                                                                                
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.5)  | Harleysville National Corporation Stock Bonus Plan. (Incorporated by Reference to Exhibit 99A of Registrants Registration Statement No. 33-17813 on Form S-8, filed with the Commission on December 13, 1996.)                                                                                                                                                                                       
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.6)  | 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.)                                                                                                                                                                                     
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.7)  | Walter E. Daller, Jr., Chairman, President and Chief Executive Officers employment agreement. (Incorporated by Reference to Registrants Registration Statement on Form 8-K, filed with the Commission on March 25, 1999.)                                                                                                                                                                           
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.8)  | Demetra M. Takes, President and Chief Executive Officer of Harleysville employment agreement. (Incorporated by Reference to Registrants Registration Statement on Form 8-K, filed with the Commission on March 25, 1999.)                                                                                                                                                                            
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.9)  | 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 June4, 1999.)                                                                                                                                                                                                   
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.10) | 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.)                                                                                                                                                                               
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.11) | Employment agreement dated February 23, 2004 between Michael B. High, Executive Vice President & Chief Financial Officer and Harleysville Management Services, LLC.                                                                                                                                                                                                                                   
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.12) | Supplemental executive retirement benefit agreement dated February 23, 2004 between Michael B. High, Executive Vice President & Chief Financial Officer and Harleysville Management Services, LLC.                                                                                                                                                                                                    
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(10.13) | Employment agreement dated March 9, 2004 between Mikkalya Murray, Executive Vice President and Harleysville Management Services, LLC.                                                                                                                                                                                                                                                                 
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(11)    | Computation of Earnings per Common Share. The information for this Exhibit is incorporated by reference to pages 4 and 11 of this Form 10-Q.                                                                                                                                                                                                                                                          
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(31)    | Section 302 Certification. Walter E. Daller, Jr. Chairman, President and Chief Executive Officer and Michael B. High, Executive Vice President and Chief Financial Officer.                                                                                                                                                                                                                           
|        |                                                                                                                                                                                                                                                                                                                                                                                                       
|(32)    | Section 906 Certification. Walter E. Daller, Jr. Chairman, President and Chief Executive Officer and Michael B. High, Executive Vice President and Chief Financial Officer.