**UNITED STATES SECURITIES ANDEXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

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**FORM 10-K**

 

 

**x****         ****ANNUALREPORT UNDER SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

** **

**For thefiscal year ended December 31, 2007**

** **

**Or**

 

**o****          ****TRANSITION REPORT UNDER SECTION 13or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thetransition period from                          to                          **

 

**Commission file Number:  2-88927**

 

**FIRSTKEYSTONE CORPORATION**

(Exact name of registrant asspecified in its Charter)

 

| **Pennsylvania**                                               | ** ** | **23-2249083**                          |
|----------------------------------------------------------------|------------|-----------------------------------------|
| (State or other jurisdiction of incorporation or organization) |       | (I.R.S. Employer Identification Number) |

 

| **111 West Front Street, Berwick, Pennsylvania** | ** ** | **18603**  |
|--------------------------------------------------|------------|------------|
| (Address of principal executive offices)         |       | (Zip Code) |

 

Registrant’s telephonenumber, including area code:  **(570) 752-3671**

 

Securities registered pursuant to Section 12(b) of theAct:  **None**

 

Securities registered pursuant to Section 12(g) of theAct:  **CommonStock, par value $2.00 per share**

 

Indicate by check mark if the registrant is a well-known seasonedissuer as defined in Rule 405 of the Securities Act.Yes  o   No  x

 

Indicate by check mark if the registrant is not required to filereports pursuant to Section 13 or Section 15(d) of the ExchangeAct.Yes  o   No  x

 

Indicateby check mark whether the Registrant (1) filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934during the past 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

Yes  x   No  o

 

Indicateby check mark if there is no disclosure of delinquent filers in response toItem 405 of Regulation S-K contained in this form, and no disclosure will be contained,to the best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K orany amendment to this Form 10-K.

Yes  o   No  x

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reporting company. Seedefinitions of “large accelerated filer,” “accelerated filer,” and “smallreporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o  Acceleratedfiler x  Non-accelerated filer o  Smaller reporting company o

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Act).    Yes  o   No  x

 

Theaggregate market value of the registrant’s outstanding voting common stock heldby non-affiliates on June 30, 2007, determined by using a per shareclosing price on that date of $18.85, as quoted on The Over The CounterBulletin Board, was $73,777,637.

 

AtMarch 7, 2008, there were 5,440,076 shares of Common Stock, $2.00 parvalue, outstanding.

 

DOCUMENTS INCORPORATED BYREFERENCE

Portions of the Registrant’s 2008 definitive Proxy Statement areincorporated by reference in Part III of this Report.

 

 

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FIRST KEYSTONE CORPORATION

FORM 10-K

 

Table of Contents

 
| Part I   |                                                                                                                   |     |
|---------------|------------------------------------------------------------------------------------------------------------------------|----------|
| ** **    | ** **                                                                                                             | **Page** |
| Item 1.       | Business                                                                                                               | 1        |
| Item 1A.      | Risk Factors                                                                                                           | 8        |
| Item 1B.      | Unresolved  Staff Comments                                                                                             | 10       |
| Item 2.       | Properties                                                                                                             | 10       |
| Item 3.       | Legal Proceedings                                                                                                      | 11       |
| Item 4.       | Submission  of Matters to a Vote of Security Holders                                                                   | 11       |
|          |                                                                                                                   |     |
| Part II  |                                                                                                                   |     |
|          |                                                                                                                   |     |
| Item 5.       | Market for  Registrant’s Common Equity and Related Shareholder Matters and Issuer  Purchases of Equity Securities | 11       |
| Item 6.       | Selected Financial  Data                                                                                               | 14       |
| Item 7.       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                            | 15       |
| Item 7A.      | Quantitative  and Qualitative Disclosure About Market Risk                                                             | 29       |
| Item 8.       | Financial  Statements and Supplementary Data                                                                           | 30       |
| Item 9.       | Changes in  and Disagreements with Accountants on Accounting and Financial Disclosure                                  | 68       |
| Item 9A.      | Controls and  Procedures                                                                                               | 68       |
| Item 9B.      | Other Information                                                                                                      | 68       |
|          |                                                                                                                   |     |
| Part III |                                                                                                                   |     |
|          |                                                                                                                   |     |
| Item 10.      | Directors,  Executive Officers and Corporate Governance                                                                | 69       |
| Item 11.      | Executive  Compensation                                                                                                | 69       |
| Item 12.      | Security  Ownership of Certain Beneficial Owners and Management and Related Shareholder  Matters                       | 69       |
| Item 13.      | Certain  Relationships and Related Transactions, and Director Independence                                             | 69       |
| Item 14.      | Principal  Accountant Fees and Services                                                                                | 69       |
|          |                                                                                                                   |     |
| Part IV  |                                                                                                                   |     |
|          |                                                                                                                   |     |
| Item 15.      | Exhibits and  Financial Statement Schedules                                                                            | 70       |
|          | Signatures                                                                                                             | 72       |
|          | Exhibit 21                                                                                                        | 1        |
|          | Exhibit 23                                                                                                        | 1        |
|          | Exhibit 31.1                                                                                                      | 1        |
|          | Exhibit 31.2                                                                                                      | 1        |
|          | Exhibit 32.1                                                                                                      | 1        |
|          | Exhibit 32.2                                                                                                      | 1        |

 

iii

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FIRST KEYSTONE CORPORATION

FORM 10-K

 

PART I

 

Forward Looking Statements

 

The management of First Keystone Corporation (Corporation), has madeforward-looking statements in this annual report on Form 10-K.  These forward-looking statements may besubject to risks and uncertainties. Forward-looking statements include the information concerning possibleor assumed future results of operations of the Corporation and its subsidiary,First Keystone National Bank (Bank). When words such as “believes,” “expects,” “anticipates” or similarexpressions occur in this annual report, management is making forward-lookingstatements.

 

Shareholders should note that many factors, some of which are discussedelsewhere in this annual report, could affect the future financial results ofthe Corporation and its subsidiary, both individually and collectively, andcould cause those results to differ materially from those expressed in theforward-looking statements contained in this annual report on Form 10-K.  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. |

 

The Corporation undertakes no obligation to publicly revise or updatethese forward-looking statements to reflect events or circumstances that ariseafter the date of this report.  Readersshould carefully review the risk factors described in other documents that arefiled periodically with the Securities and Exchange Commission (SEC).

 

ITEM 1.       BUSINESS

 

First Keystone Corporation is a Pennsylvania business corporation, anda bank holding company, registered with and supervised by the Board ofGovernors of the Federal Reserve System. The Corporation was incorporated on July 6, 1983, and commencedoperations on July 2, 1984, upon consummation of the acquisition of all ofthe outstanding stock of First Keystone National Bank.  The Corporation has one wholly-ownedsubsidiary, the Bank, which has a commercial banking operation and trustdepartment as its major lines of business. Since commencing operations, the Corporation’s business has consistedprimarily of managing and supervising the Bank, and its principal source ofincome has been dividends paid by the Bank. Greater than 98% of the company’s revenue and profit came from thecommercial banking department for the years ended December 31, 2007, 2006,and 2005, and was the only reportable segment. At December 31, 2007, the Corporation had total consolidatedassets, deposits and stockholders’ equity of approximately $681 million, $493million and $71 million, respectively.

 

The Bank was organized in 1864. The Bank is a national banking association that is a member of theFederal Reserve System.  Its deposits areinsured by the Federal Deposit Insurance Corporation (FDIC) to the maximumextent of the law regulated by The Office of the Comptroller of the Currency(OCC).  The Bank, has fourteen branchlocations (five branches within Columbia County, four branches within LuzerneCounty, one branch in Montour County, and four branches within Monroe County,Pennsylvania), and is a full service commercial bank providing a wide range ofservices to individuals and small to medium sized businesses in itsNortheastern and Central Pennsylvania market area.  The Bank’s commercial banking activitiesinclude accepting time, demand, and savings deposits and making secured andunsecured commercial, real estate and consumer loans.  Additionally, the Bank also provides personaland corporate trust and agency services to individuals, corporations, andothers, including trust investment accounts, investment advisory services,mutual funds, estate planning, and management of pension and profit sharingplans.

 

1

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Acquisition

 

Effective November 1, 2007, the Corporation completed its acquisitionof Pocono Community Bank through the merger of Pocono with and into theBank.  On the acquisition date, PoconoCommunity Bank had approximately $150 million in assets, $105 million in loansand $110 million in deposits. Headquartered in Stroudsburg, Pennsylvania and organized in 1996, Poconohad 4 banking offices located in Montour County, Pennsylvania.  The acquisition expands the branch network ofthe Corporation and provides Pocono customers with a broader array of productsand services.  The Pocono branchescontinue to operate as a division of the Bank under the name “Pocono CommunityBank, a division of First Keystone National Bank.”

 

Supervision and Regulation

 

The Corporation is subject to the jurisdiction of the SEC and of statesecurities laws for matters relating to the offering and sale of itssecurities.  The Corporation is currentlysubject to the SEC’s rules and regulations relating to company’s whoseshares are registered under Section 12 of the Securities Exchange Act of1934, as amended.

 

The Corporation is also subject to the provisions of the Bank HoldingCompany Act of 1956, as amended , and to supervision by the Federal ReserveBoard.  The Bank Holding Company Actrequires the Corporation to secure the prior approval of the Federal ReserveBoard before it owns or controls, directly or indirectly, more than 5% of thevoting shares of substantially all of the assets of any institution, includinganother bank.

 

The Bank Holding Company Act also prohibits acquisition of control of abank holding company, such as the Corporation, without prior notice to theFederal Reserve Board.  Control isdefined for this purpose as the power, directly or indirectly, to direct themanagement or policies of a bank holding company or to vote 25% (or 10%, if noother person or persons acting on concert, holds a greater percentage of theCommon Stock) or more of the Corporation’s Common Stock.

 

The Corporation is required to file an annual report with the FederalReserve Board and any additional information that the Federal Reserve Board mayrequire pursuant to the Bank Holding Company Act.  The Federal Reserve Board may also makeexaminations of the Corporation and any or all of its subsidiaries.

 

The Bank is subject to federal and state statutes applicable to bankschartered under the banking laws of the United States, to members of theFederal Reserve System and to banks whose deposits are insured by theFDIC.  Bank operations are also subjectto regulations of the OCC, the Federal Reserve Board and the FDIC.

 

The primary supervisory authority of the Bank is the OCC, whichregulates and examines the Bank.  The OCChas the authority under the Financial Institutions Supervisory Act to prevent anational bank from engaging in an unsafe or unsound practice in conducting itsbusiness.

 

Federal and state banking laws and regulations govern, among otherthings, the scope of a bank’s business, the investments a bank may make, thereserves against deposits a bank must maintain, loans a bank makes andcollateral it takes, and the activities of a bank with respect to mergers andconsolidations and the establishment of branches.

 

As a subsidiary of a bank holding company, the Bank is subject tocertain restrictions imposed by the Federal Reserve Act on any extensions of creditto the bank holding company or its subsidiaries, on investments in the stock orother securities of the bank holding company or its subsidiaries and on takingsuch stock or securities as collateral for loans.  The Federal Reserve Act and Federal ReserveBoard regulations also place certain limitations and reporting requirements onextensions of credit by a bank to principal shareholders of its parent holdingcompany, among others, and to related interests of such principal shareholders.  In addition, such legislation and regulationsmay affect the terms upon which any person becoming a principal shareholder ofa holding company may obtain credit from banks with which the subsidiary bankmaintains a correspondent relationship.

 

Under the Federal Deposit Insurance Act , the OCC possesses the powerto prohibit institutions regulated by it from engaging in any activity thatwould be an unsafe or unsound banking practice or would otherwise be inviolation of the law.

 

2

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Permitted Non-Banking Activities

 

The Federal Reserve Board permits bank holding companies to engage innon-banking activities so closely related to banking, managing or controllingbanks as to be a proper incident thereto. The Corporation does not at this time engage in any of these non-bankingactivities, nor does the Corporation have any current plans to engage in anyother permissible activities in the foreseeable future.

 

Legislation and Regulatory Changes

 

From time to time, various types of federal and state legislation havebeen proposed that could result in additional regulations of, and restrictionson, the business of the Bank.  It cannotbe predicted whether any such legislation will be adopted or how suchlegislation would affect the business of the Bank.  As a consequence of the extensive regulationof commercial banking activities in the United States, the Bank’s business isparticularly susceptible to being affected by federal legislation andregulations that may increase the costs of doing business.

 

From time to time, legislation is enacted which has the effect ofincreasing the cost of doing business, limiting or expanding permissibleactivities or affecting the competitive balance between banks and otherfinancial institutions.  No predictioncan be made as to the likelihood of any major changes or the impact suchchanges might have on the Corporation and the Bank.  Certain changes of potential significance tothe Corporation which have been enacted recently and others which are currentlyunder consideration by Congress or various regulatory agencies are discussedbelow.

 

Federal Deposit Insurance Corporation Improvement Act of 1991

 

The FDICIA established five different levels of capitalization offinancial institutions, with “prompt corrective actions” and significantoperational restrictions imposed of institutions that are capital deficientunder the categories.  The fivecategories are:

 

·  well capitalized

·  adequately capitalized

·  undercapitalized

·  significantly undercapitalized,and

·  critically undercapitalized.

 

To be considered well capitalized, an institution must have a totalrisk-based capital ratio of at least 10%, a Tier 1 risk-based capital ratio ofat least 6%, a leverage capital ratio of at least 5%, and must not be subjectto any order or directive requiring the institution to improve its capitallevel.  An institution falls within theadequately capitalized category if it has a total risk-based capital ratio ofat least 8%, a Tier 1 risk-based capital ratio of at least 4%, and a leveragecapital ratio of at least 4%. Institutions with lower capital levels are deemed to beundercapitalized, significantly undercapitalized or criticallyundercapitalized, depending on their actual capital levels.  In addition, the appropriate federalregulatory agency may downgrade an institution to the next lower capitalcategory upon a determination that the institution is in an unsafe or unsoundcondition, or is engaged in an unsafe or unsound practice.  Institutions are required under FDICIA toclosely monitor their capital levels and to notify their appropriate regulatoryagency of any basis for a change in capital category.  On December 31, 2007 the Corporation andthe Bank exceeded the minimum capital levels of the well capitalized category.

 

Regulatory oversight of an institution becomes more stringent with eachlower capital category, with certain “prompt corrective actions” imposeddepending on the level of capital deficiency.

 

3

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Other Provisions of FDICIA

 

Each depository institution must submit audited financial statements toits primary regulator and the FDIC, which reports are made publiclyavailable.  In addition, the auditcommittee of each depository institution must consist of outside directors andthe audit committee at “large institutions” (as defined by FDIC regulation)must include members with banking or financial management expertise.  The audit committee at “large institutions”must also have access to independent outside counsel.  In addition, an institution must notify theFDIC and the institution’s primary regulator of any change in the institutionsindependent auditor, and annual management letters must be provided to the FDICand the depository institution’s primary regulator.  The regulations define a “large institution”as one with over $500 million in assets, which does include the Bank.  Also, under the rule, an institution’sindependent auditor must examine the institution’s internal controls over financialreporting and perform agreed-upon procedures to test compliance with laws andregulations concerning safety and soundness.

 

Under FDICIA, each federal banking agency must prescribe certain safetyand soundness standards for depository institutions and their holdingcompanies.  Three types of standards mustbe prescribed:

 

·  asset quality and earnings

·  operational and managerial, and

·  compensation

 

Such standards would include a ratio of classified assets to capital,minimum earnings, and, to the extent feasible, a minimum ratio of market valueto book value for publicly traded securities of such institutions and holdingcompanies.  Operational and managerialstandards must relate to:

 

·  internal controls, informationsystems and internal audit systems

·  loan documentation

·  credit underwriting

·  interest rate exposure

·  asset growth, and

·  compensation, fees and benefits

 

FDICIA also sets forth Truth in Savings disclosure and advertisingrequirements applicable to all depository institutions.

 

*Real Estate Lending Standards*. Pursuant to the FDICIA, the OCC and other federal banking agenciesadopted real estate lending guidelines which would set loan-to-value ratios fordifferent types of real estate loans.  ALTV ratio is generally defined as the total loan amount divided by theappraised value of the property at the time the loan is originated.  If the institution does not hold a first lienposition, the total loan amount would be combined with the amount of all seniorliens when calculating the ratio.  Inaddition to establishing the LTV ratios, the guidelines require all real estateloans to be based upon proper loan documentation and a recent appraisal of theproperty.

 

Regulatory Capital Requirements

 

The federal banking regulators have adopted certain risk-based capitalguidelines to assist in the assessment of the capital adequacy of a bankingorganization’s operations for both transactions reported on the balance sheetas assets and transactions, such as letters of credit, and recourse agreements,which are recorded as off balance sheet items. Under these guidelines, nominal dollar amounts of assets and creditequivalent amounts of off balance sheet items are multiplied by one of severalrisk adjustment percentages, which range from 0% for assets with low creditrisk, such as certain U.S. Treasury securities, to 100% for assets withrelatively high credit risk, such as business loans.

 

4

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The following table presents the Corporation’s capital ratios at December 31,2007.

 
| ** **                               | ** ** | **(In Thousands)** | ** ** |
|------------------------------------------|------------|-------------------------|------------|
| Tier I Capital                           |       | $                       | 49,970     |   |
| Tier II Capital                          |       | 5,047                   |       |
| Total Capital                            |       | $                       | 55,017     |   |
|                                     |       |                    |       |
| Adjusted Total Average Assets            |       | $                       | 649,217    |   |
| Total Adjusted Risk-Weighted Assets(1)   |       | 421,285                 |       |
|                                     |       |                    |       |
| Tier I Risk-Based Capital Ratio(2)       |       | 11.86                   | %          |
| Required Tier I Risk-Based Capital Ratio |       | 4.00                    | %          |
| Excess Tier I Risk-Based Capital Ratio   |       | 7.86                    | %          |
| Total Risk-Based Capital Ratio(3)        |       | 13.06                   | %          |
| Required Total Risk-Based Capital Ratio  |       | 8.00                    | %          |
| Excess Total Risk-Based Capital Ratio    |       | 5.06                    | %          |
| Tier I Leverage Ratio(4)                 |       | 7.96                    | %          |
| Required Tier I Leverage Ratio           |       | 4.00                    | %          |
| Excess Tier I Leverage Ratio             |       | 3.96                    | %          |

 

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(1) Includesoff-balance sheet items at credit-equivalent values less intangible assets.

(2) Tier IRisk-Based Capital Ratio is defined as the ratio of Tier I Capital to TotalAdjusted Risk-Weighted Assets.

(3) TotalRisk-Based Capital Ratio is defined as the ratio of Tier I and Tier II Capitalto Total Adjusted Risk-Weighted Assets.

(4) Tier ILeverage Ratio is defined as the ratio of Tier I Capital to Adjusted TotalAverage Assets.

 

The Corporation’s ability to maintain the required levels of capital issubstantially dependent upon the success of Corporation’s capital and businessplans; the impact of future economic events on the Corporation’s loancustomers; and the Corporation’s ability to manage its interest rate risk andinvestment portfolio and control its growth and other operating expenses.  See also, the information under the caption “CapitalStrength” appearing on page 25 of this 2007 Annual Report on Form 10-K.

 

Effectof Government Monetary Policies

 

The earnings of the Corporation are and will be affected by domesticeconomic conditions and the monetary and fiscal policies of the United Statesgovernment and its agencies.

 

The Federal Reserve Board have had, and will likely continue to have,an important impact on the operating results of commercial banks through itspower to implement national monetary policy in order to, among other things,curb inflation or combat a recession. The Federal Reserve Board has a major effect upon the levels of bankloans, investments and deposits through its open market operations in UnitedStates government securities and through its regulations of, among otherthings, the discount rate on borrowings of member banks and the reserverequirements against member bank deposits. It is not possible to predict the nature and impact of future changes inmonetary and fiscal policies.

 

Effectsof Inflation

 

Inflation has some impact on the Bank’s operating costs.  Unlike industrial companies, however,substantially all of the Bank’s assets and liabilities are monetary innature.  As a result, interest rates havea more significant impact on the Bank’s performance than the general levels ofinflation.  Over short periods of time,interest rates may not necessarily move in the same direction or in the samemagnitude as prices of goods and services.

 

EnvironmentalRegulation

 

There are several federal and state statutes that regulate theobligations and liabilities of financial institutions pertaining toenvironmental issues.  In addition to thepotential for attachment of liability resulting from its own actions, a bankmay be held liable, under certain circumstances, for the actions of itsborrowers, or third parties, when such actions result in environmental problemson properties that collateralize loans held by the bank.  Further, the liability has the potential tofar exceed the original amount of the loan issued by the Bank.  Currently, neither the Corporation nor theBank is a party to any pending legal proceeding pursuant to any environmentalstatute, nor are the Corporation and the Bank aware of any circumstances thatmay give rise to liability under any such statute.

 

5

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InterestRate Risk

 

Federal banking agency regulations specify that the Bank’s capitaladequacy include an assessment of the Bank’s interest rate risk  exposure. The standards for measuring the adequacy and effectiveness of a bankingorganization’s Interest Rate Risk (IRR) management includes a measurement ofBoard of Directors and senior management oversight, and a determination ofwhether a banking organization’s procedures for comprehensive risk managementare appropriate to the circumstances of the specific banking organization.  First Keystone National Bank has internal IRRmodels that are used to measure and monitor IRR.  Additionally, the regulatory agencies havebeen assessing IRR on an informal basis for several years.  For these reasons, the Corporation does notexpect the addition of IRR evaluation to the agencies’ capital guidelines toresult in significant changes in capital requirements for the Bank.

 

TheGramm-Leach-Bliley Act of 2000

 

In 2000, the Gramm-Leach-Bliley Act became law, which is also known asthe Financial Services Modernization Act. The act repealed some Depression-era banking laws and will permit banks,insurance companies and securities firms to engage in each others’ businessesafter complying with certain conditions and regulations.  The act grants to community banks the powerto enter new financial markets as a matter of right that larger institutionshave managed to do on an ad hoc basis. At this time, our company has no plans to pursue these additionalpossibilities.

 

TheSarbanes-Oxley Act

 

In 2002, the Sarbanes-Oxley Act became law.  The Act was in response to public concernsregarding corporate accountability in connection with recent high visibilityaccounting scandals.  The stated goals ofthe Sarbanes-Oxley Act are:

 
| · |   | to increase corporate responsibility;                                                                                     |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------|
| · |   | to provide for enhanced penalties for accounting and auditing  improprieties at publicly traded companies; and            |
| · |   | to protect investors by improving the accuracy and reliability of  corporate disclosures pursuant to the securities laws. |

 

The Sarbanes-Oxley Act generally applies to all companies, both U.S.and non-U.S., that file periodic reports with the SEC under the SecuritiesExchange Act of 1934.  The legislationincludes provisions, among other things:

 
| · |   | governing the services that can be provided by a public company’s  independent auditors and the procedures for approving such services;                                                |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| · |   | requiring the chief executive officer and chief financial officer to  certify certain matters relating to the company’s periodic filings under the  Exchange Act;                      |
| · |   | requiring expedited filings of reports by insiders of their  securities transactions and containing other provisions relating to insider  conflicts of interest;                            |
| · |   | increasing disclosure requirements relating to critical financial  accounting policies and their application;                                                                               |
| · |   | increasing penalties for securities law violations; and                                                                                                                                     |
| · |   | creating a public accounting oversight board, a regulatory body  subject to SEC jurisdiction with broad powers to set auditing, quality  control and ethics standards for accounting firms. |

 

The American Jobs Creation Act of 2004

 

In 2004, the American Jobs Creation Act was enacted as the first majorcorporation tax act in years.  The actaddresses a number of areas of corporate taxation including executive deferredcompensation restrictions.  The impact ofthe act on the Corporation is unknown at this time, but management ismonitoring its developments.

 

History and Business - Bank

 

The Bank’s legal headquarters are located at 111 West Front Street,Berwick, Pennsylvania.

 

As of December 31, 2007, the Bank had total assets of$681,207,000, total shareholders’ equity of $70,924,000 and total deposits andother liabilities of $610,283,000.

 

6

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The Bank engages in a full-service commercial banking business,including accepting time and demand deposits, and making secured and unsecuredcommercial and consumer loans.  The Bank’sbusiness is not seasonal in nature.  Itsdeposits are insured by the FDIC to the extent provided by law.  The Bank has no foreign loans or highlyleveraged transaction loans, as defined by the Federal Reserve Board.  Substantially all of the loans in the Bank’sportfolio have been originated by the Bank. Policies adopted by the Board of Directors are the basis by which theBank conducts its lending activities.

 

At December 31, 2007, the Bank had 151 full-time employees and 27part-time employees.  In the opinion ofmanagement, the Bank enjoys a satisfactory relationship with itsemployees.  The Bank is not a party toany collective bargaining agreement.

 

Competition - Bank

 

The Bank competes actively with other area commercial banks and savingsand loan associations, many of which are larger than the Bank, as well as withmajor regional banking and financial institutions.  The Bank’s major competitors in Columbia,Luzerne, Montour, and Monroe counties are:

 

·   First Columbia Bank &Trust Co. of Bloomsburg

·   PNC Bank, N.A.

·   Columbia County FarmersNational Bank of Bloomsburg

·   M & T Bank

·   FNB Bank, NA

·   Wachovia Bank

·   Sovereign Bank

·   Citizens Bank

·   ESSA Bank & Trust

·   First National CommunityBank

·   North Penn Bank

·   Wayne Bank

 

Credit unions are also competitors, especially in Luzerne and Montourcounties.  The Bank is generallycompetitive with all competing financial institutions in its service area withrespect to interest rates paid on time and savings deposits, service charges ondeposit accounts and interest rates charged on loans.

 

Concentration

 

The Corporation and the Bank are not dependent for deposits nor exposedby loan concentrations to a single customer or to a small group of customersthe loss of any one or more of whom would have a materially adverse effect onthe financial condition of the Corporation or the Bank.

 

Available Information

 

The Corporation’s common stock is registered under Section 12(b) ofthe Securities Exchange Act of 1934.  TheCorporation is subject to the informational requirements of the Exchange Act,and, accordingly, files reports, proxy statements and other information withthe Securities and Exchange Commission. The reports, proxy statements and other information filed with the SECare available for inspection and copying at the SEC’s Public Reference Room atJudiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549.  You may obtain information on the operationof the Public Reference Room by calling the SEC at 1-800-SEC-0330.  The Corporation is an electronic filer withthe SEC.  The SEC maintains an Internetsite that contains reports, proxy and information statements, and otherinformation regarding issuers that file electronically with the SEC.  The SEC’s internet site address iswww.sec.gov.

 

A copy of the Corporation’s Annual Report on Form 10-K may beobtained without charge at www.fkyscorp.com or via email atinfo@fknbank.com.  Information may alsobe obtained via written request to Investor Relations at First KeystoneCorporation, Attention: Cheryl Wynings, 111 West Front Street, P.O. Box289, Berwick, Pennsylvania 18603.

 

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ITEM 1A.     RISK FACTORS

 

Investments in First Keystone Corporation common stock involverisk.  The market price of First Keystonecommon stock may fluctuate significantly in response to a number of factors,including:

 

*The Corporation Is Subject To Interest Rate Risk*

 

The Corporation’s earnings and cash flows are largely dependent uponits net interest income.  Net interestincome is the difference between interest income earned on interest-earningassets such as loans and securities and interest expense paid oninterest-bearing liabilities such as deposits and borrowed funds.  Interest rates are highly sensitive to manyfactors that are beyond the Corporation’s control, including general economicconditions and policies of various governmental and regulatory agencies and, inparticular, the Board of Governors of the Federal Reserve System.  Changes in monetary policy, including changesin interest rates, could influence not only the interest the Corporationreceives on loans and securities and the amount of interest it pays on depositsand borrowings, but such changes could also affect (I) the Corporation’sability to originate loans and obtain deposits, (ii) the fair value of theCorporation’s financial assets and liabilities, and (iii) the averageduration of the Corporation’s mortgage-backed securities portfolio.  If the interest rates paid on deposits andother borrowings increase at a faster rate than the interest rates received onloans and other investments, the Corporation’s net interest income, andtherefore earnings, could be adversely affected.  Earnings could also be adversely affected ifthe interest rates received on loans and other investments fall more quicklythan the interest rates paid on deposits and other borrowings.

 

Although management believes it has implemented effective asset andliability management strategies, to reduce the potential effects of changes ininterest rates on the Corporation’s results of operations, any substantial,unexpected, prolonged change in market interest rates could have a materialadverse effect on the Corporation’s financial condition and results ofoperations.

 

*The Corporation’s Profitability Depends SignificantlyOn Economic Conditions In The Commonwealth of Pennsylvania*

 

The Corporation’s success depends primarily on the general economicconditions of the Commonwealth of Pennsylvania and the specific local marketsin which the Corporation operates. Unlike larger national or other regional banks that are moregeographically diversified, the Corporation provides banking and financialservices to customers primarily in the Columbia, Luzerne, Montour, and MonroeCounties.  The local economic conditionsin these areas have a significant impact on the demand for the Corporation’sproducts and services as well as the ability of the Corporation’s customers torepay loans, the value of the collateral securing loans and the stability ofthe Corporation’s deposit funding sources. Also a significant decline in general economic conditions could impactthe local economic conditions and, in turn, have a material adverse effect onthe Corporation’s financial condition and results of operations.

 

*The Corporation Operates In A Highly CompetitiveIndustry*

 

The Corporation faces substantial competition in all areas of itsoperations from a variety of different competitors, many of which are largerand may have more financial resources. Such competitors primarily include national, regional, and communitybanks within the various markets the Corporation operates.  Additionally, various out-of-state banks havebegun to enter or have announced plans to enter the market areas in which theCorporation currently operates.  TheCorporation also faces competition from many other types of financialinstitutions, including, without limitation, savings and loans, credit unions,finance companies, brokerage firms, insurance companies, factoring companiesand other financial intermediaries. Also, technology has lowered barriers to entry and made it possible fornon-banks to offer products and services traditionally provided by banks, suchas automatic transfer and automatic payment systems.  Many of the Corporation’s competitors havefewer regulatory constraints and may have lower cost structures.

 

The Corporation’s ability to compete successfully depends on a numberof factors, including, among other things:

 

·      The ability to develop, maintain and build upon long-term customerrelationships based on top quality service, high ethical standards and safe,sound assets.

·      The ability to expand the Corporation’smarket position.

·      The scope, relevance and pricing of productsand services offered to meet customer needs and demands.

·      The rate at which the Corporation introducesnew products and services relative to its competitors.

·      Customer satisfaction with the Corporation’slevel of service.

·      Industry and general economic trends.

 

8

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Failure to perform in any of these areas could significantly weaken theCorporation’s competitive position, which could adversely affect theCorporation’s growth and profitability, which, in turn, could have a materialadverse effect on the Corporation’s financial condition and results ofoperations.

 

*The Corporation Is Subject To Extensive GovernmentRegulation and Supervision*

 

The Corporation, primarily through the Bank, is subject to extensivefederal and state regulation and supervision. Banking regulations are primarilyintended to protect depositors’ funds, federal deposit insurance funds and thebanking system as a whole, not shareholders. These regulations affect theCorporation’s lending practices, capital structure, investment practices,dividend policy and growth, among other things. Congress and federal regulatoryagencies continually review banking laws, regulations and policies for possiblechanges. Changes to statutes, regulations or regulatory policies could affectthe Corporation in substantial and unpredictable ways. Such changes couldsubject the Corporation to additional costs, limit the types of financialservices and products the Corporation may offer and/or increase the ability ofnon-banks to offer competing financial services and products, among otherthings. Failure to comply with laws, regulations or policies could result insanctions by regulatory agencies, civil money penalties and/or reputationdamage, which could have a material adverse effect on the Corporation’sbusiness, financial condition and results of operations.

 

*The Corporation Is Subject To Claims and LitigationPertaining To Fiduciary Responsibility*

 

From time to time, customers make claims and take legal actionpertaining to the Corporation’s performance of its fiduciary responsibilities.Whether customer claims and legal action related to the Corporation’sperformance of its fiduciary responsibilities are founded or unfounded, if suchclaims and legal actions are not resolved in a manner favorable to theCorporation they may result in significant financial liability and/or adverselyaffect the market perception of the Corporation and its products and servicesas well as impact customer demand for those products and services. Anyfinancial liability or reputation damage could have a material adverse effecton the Corporation’s financial condition and results of operations.

 

*The Trading Volume In The Corporation’s Common StockIs Less Than That Of Other Larger Financial Services Companies*

 

The Corporation’s common stock is currently not listed but traded onthe Over The Counter Bulletin Board.  Asa result, trading volume is less than that of other larger financial servicescompanies.  A public trading markethaving the desired characteristics of depth, liquidity and orderliness dependson the presence in the marketplace of willing buyers and sellers of theCorporation’s common stock at any given time. This presence depends on the individual decisions of investors andgeneral economic and market conditions over which the Corporation has nocontrol.  Given the lower trading volumeof the Corporation’s common stock, significant sales of the Corporation’scommon stock, or the expectation of these sales, could cause the Corporation’sstock price to fall.

 

*The Corporation Is Subject To Lending Risk*

 

As of December 31, 2007, approximately 58.4% of the Corporation’sloan portfolio consisted of commercial and industrial, construction andcommercial real estate loans.  Thesetypes of loans are generally viewed as having more risk of default thanresidential real estate loans or consumer loans.  These types of loans are also typicallylarger than residential real estate loans and consumer loans.  Because the Corporation’s loan portfoliocontains a significant number of commercial and industrial, construction andcommercial real estate loans with relatively large balances, the deteriorationof one or a few of these loans could cause a significant increase innon-performing loans.  An increase innon-performing loans could result in a net loss of earnings from these loans,an increase in the provision for possible loan losses and an increase in loancharge-offs, all of which could have a material adverse effect on theCorporation’s financial condition and results of operations.

 

*If The Corporation’s Allowance For Loan Losses Is NotSufficient To Cover Actual Loan Losses, Its Earnings Could Decrease*

 

The Corporation’s loan customers may not repay their loans according tothe terms of their loans, and the collateral securing the payment of theirloans may be insufficient to assure repayment. The Corporation may experience significant credit losses, which couldhave a material adverse effect on its operating results.  In determining the amount of the allowancefor loan losses, the Corporation reviews its loans and its loss and delinquencyexperience, and the Corporation evaluates economic conditions.  If its assumptions prove to be incorrect, itsallowance for loan losses may not cover inherent losses in its loan portfolioat the date of its financial statements. Material additions to the Corporation’s allowance would materiallydecrease its net income. At December 31, 2007, its allowance for loanlosses totaled $5.05 million, representing 1.8% of its average total loans.

 

9

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Although theCorporation believes it has underwriting standards to manage normal lendingrisks, it is difficult to assess the future performance of its loan portfoliodue to the relatively recent origination of many of these loans.  The Corporation cannot assure that itsnon-performing loans will not increase or that its non-performing or delinquentloans will not adversely affect its future performance.

 

In addition, federal andstate regulators periodically review the Corporation’s allowance for loan lossesand may require it to increase its allowance for loan losses or recognizefurther loan charge-offs.  Any increasein its allowance for loan losses or loan charge-offs as required by theseregulatory agencies could have a material adverse effect on its results ofoperations and financial condition.

 

*The Corporation’s Ability To Pay Dividends Is Subjectto Limitations*

 

The Corporation is a bank holding company and its operations areconducted by First Keystone National Bank, which is a separate and distinctlegal entity.  Substantially all of theCorporation’s assets are held by First Keystone National Bank.

 

The Corporation’s ability to pay dividends depends on its receipt ofdividends from First Keystone National Bank, is its primary source ofdividends.  Dividend payments from FirstKeystone National Bank are subject to legal and regulatory limitations,generally based on net profits and retained earnings, imposed by the variousbanking regulatory agencies.  The abilityof banking subsidiaries to pay dividends is also subject to theirprofitability, financial condition, capital expenditures and other cash flowrequirements.  There is no assurance thatFirst Keystone National Bank will be able to pay dividends in the future orthat the Corporation will generate adequate cash flow to pay dividends in thefuture.  The Corporation’s failure to paydividends on its common stock could have material adverse effect on the marketprice of its common stock.

 

ITEM 1B.    UNRESOLVEDSTAFF COMMENTS

 

Not Applicable.

 

ITEM 2.      DESCRIPTIONOF PROPERTIES

 

The Corporation and its subsidiary occupies sixteen properties inColumbia, Luzerne, Montour, and Monroe counties in Pennsylvania, which are usedprincipally as banking offices. Properties owned are:

 

·    Main Office located at 111 West Front Street, Berwick, Pennsylvania18603;

·    Salem Office located at 400 Fowler Avenue, Berwick, Pennsylvania 18603;

·    Freas Avenue Office located at 701 Freas Avenue, Berwick, Pennsylvania18603;

·    Scott Township Office located at Central Road and Route 11, Bloomsburg,Pennsylvania 17815;

·    Mifflinville Office located at Third and Race Streets, Mifflinville,Pennsylvania 18631;

·    Hanover Township Office located at 1540 Sans Souci Highway,Wilkes-Barre, Pennsylvania 18706;

·    Danville Office located at 1519 Bloom Road, Danville, Pennsylvania17821;

·    Mountainhome Office located at Route 390 & Price’s Drive,Mountainhome, Pennsylvania 18342;

·    Brodheadsville Office located at Route 209, Brodheadsville,Pennsylvania 18322;

·    Swiftwater Office located at Route 611, Swiftwater, Pennsylvania 18370;

·    Vacant lot held for expansion located at 117-119 West Front Street,Berwick, Pennsylvania 18603;

·    Parking lot located at Second and Market Streets, Berwick, Pennsylvania18603; and

·    16 ATM’s located in Columbia, Luzerne, Montour, and Monroe counties.

 

Properties leased are:

 

·    Briar Creek Office located inside the Giant Market at 50 Briar CreekPlaza, Berwick, Pennsylvania 18603;

·    Nescopeck Office located at 437 West Third Street, Nescopeck,Pennsylvania 18635;

·    Kingston Office located at 179 South Wyoming Avenue, Kingston,Pennsylvania 18704;

·    Stroudsburg Office located at 559 Main Street, Stroudsburg,Pennsylvania 18360;

·    Operations Center located at 105 Market Street, Berwick, Pennsylvania18603;

·    Operations Center located at 610 Main Street, Stroudsburg, Pennsylvania18360; and

·    Vacant lot held for expansion located at State Route 309, Mountaintop,Pennsylvania 18707.

 

10

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ITEM 3.      LEGALPROCEEDINGS

 

The Corporation and/or theBank are defendants in various legal proceedings arising in the ordinary courseof their business.  However, in theopinion of management of the Corporation and the Bank, there are no proceedingspending to which the Corporation and the Bank is a party or to which theirproperty is subject, which, if determined adversely to the Corporation and theBank, would be material in relation to the Corporation’s and Bank’s individualprofits or financial condition, nor are there any proceedings pending otherthan ordinary routine litigation incident to the business of the Corporationand the Bank.  In addition, no materialproceedings are pending or are known to be threatened or contemplated against theCorporation and the Bank by government authorities or others.

 

ITEM 4.      SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

 

No matter was submittedduring the fourth quarter of the fiscal year covered by this report to a voteof security holders through the solicitation of proxies or otherwise.

 

PART II

 

ITEM5.                             MARKET FOR REGISTRANT’S COMMON EQUITY,RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

The Corporation’s CommonStock is traded in the over-the-counter market on the OTC Bulletin Board underthe symbol “FKYS.OB”.  The followingtable sets forth:

 

·    Thequarterly high and low prices for a share of the Corporation’s Common Stockduring the periods indicated as reported to the management of the Corporationand

·    Quarterlydividends on a share of the Common Stock with respect to each quarter since January 1,2006.

 

The following table reflectsthe high and low closing sale prices reported for First Keystone Corporation’scommon stock, and the cash dividends declared on First Keystone Corporation’scommon stock, for the periods indicated, after giving retroactive effect to a5% stock dividend paid December 5, 2006.

 

MARKET VALUE OF COMMON STOCK

 
| ** **     |       | **High** | ** ** | **Low**    | ** ** | **Per Share****Dividend** | ** ** |
|----------------|------------|----------|------------|------------|------------|--------------------------------|------------|
| **2007:**      |       |     |       |       |       |                           |       |
| First quarter  | ** ** | **$**    | **19.00**  | ** ** | **$**      | **17.50**                      | ** ** | **$** | **.22** | ** ** |
| Second quarter | ** ** | **$**    | **21.75**  | ** ** | **$**      | **17.90**                      | ** ** | **$** | **.22** | ** ** |
| Third quarter  | ** ** | **$**    | **19.25**  | ** ** | **$**      | **17.00**                      | ** ** | **$** | **.22** | ** ** |
| Fourth quarter | ** ** | **$**    | **18.25**  | ** ** | **$**      | **15.80**                      | ** ** | **$** | **.22** | ** ** |
|           |       |     |       |       |       |                           |       |
| 2006:          |       |     |       |       |       |                           |       |
| First quarter  |       | $        | 19.91      |       | $          | 18.57                          |       | $ | .21 |   |
| Second quarter |       | $        | 19.05      |       | $          | 17.43                          |       | $ | .21 |   |
| Third quarter  |       | $        | 19.33      |       | $          | 16.81                          |       | $ | .21 |   |
| Fourth quarter |       | $        | 19.20      |       | $          | 17.29                          |       | $ | .22 |   |

 

As of December 31, 2007, the Corporationhad approximately 820 shareholders of record.

 

The Corporation has paid dividends sincecommencement of business in 1984.  It isthe present intention of the Corporation’s Board of Directors to continue thedividend payment policy; however, further dividends must necessarily dependupon earnings, financial condition, appropriate legal restrictions and otherfactors relevant at the time the Board of Directors of the

 

11

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Corporation considers dividend policy. Cash available for dividend distributions to shareholders of theCorporation must initially come from dividends paid by the Bank to theCorporation.  Therefore, the restrictionson the Bank’s dividend payments are directly applicable to the Corporation.

 
| Transfer  Agent:                |   |            |
|---------------------------------|--------|-----------------|
|                            |   |            |
| Registrar  and Transfer Company |   | (800)  368-5948 |
| 10  Commerce Drive              |   |            |
| Cranford,  NJ 07016-3752        |   |            |

 

The following brokerage firms make a marketin First Keystone Corporation common stock:

 
| RBC  Dain Rauscher                          |   | (800)  223-4207 |
|---------------------------------------------|--------|-----------------|
| Janney  Montgomery Scott LLC                |   | (800)  526-6397 |
| Stifel,  Nicolas                            |   | (800)  223-6807 |
| Boenning &  Scattergood, Inc. |   | (800)  842-8928 |
| Ferris  Baker Watts, Inc.              |   | (800)  638-7411 |

 

Dividend Restrictions on the Bank

 

The OCC rules govern the payment ofdividends by national banks. Consequently, the Bank, which is subject to these rules, may not paydividends from capital (unimpaired common and preferred stock outstanding) butonly from retained earnings after deducting losses and bad debtstherefrom.  To the extent that (1) theBank has capital surplus in an amount in excess of common capital and (2) theBank can prove that such surplus resulted from prior period earnings, the Bank,upon approval of the OCC, may transfer earned surplus to retained earnings andthereby increase its dividend capacity.

 

The Bank may not pay any dividends on itscapital stock during a period in which it may be in default in the payment ofits assessment for a deposit insurance premium due to the FDIC, nor may it paydividends on Common Stock until any cumulative dividends on the Bank’spreferred stock (if any) have been paid in full.  The Bank has never been in default in thepayments of its assessments to the FDIC; and the Bank has no outstandingpreferred stock.  In addition, under theFederal Deposit Insurance Act (912 U.S.C. Section 1818), dividends cannotbe declared and paid if the OCC obtains a cease and desist order because, inthe opinion of the OCC, such payment would constitute an unsafe and unsoundbanking practice.  As of December 31,2007, there was $439,000 in unrestricted retained earnings and net incomeavailable at the Bank that could be paid as a dividend to the Corporation underthe current OCC regulations.

 

Dividend Restrictions on the Corporation

 

Under the Pennsylvania Business CorporationLaw of 1988, as amended, the Corporation may not pay a dividend if, aftergiving effect thereto, either:

 

·   TheCorporation would be unable to pay its debts as they become due in the usualcourse of business or;

·   TheCorporation’s total assets would be less than its total liabilities.

 

Thedetermination of total assets and liabilities may be based upon:

 

·   Financialstatements prepared on the basis of generally accepted accounting principles,

·   Financialstatements that are prepared on the basis of other accounting practices andprinciples that are reasonable under the circumstances, or;

·   A fairvaluation or other method that is reasonable under the circumstances.

 

Equity Compensation Plan Information

 

Informationregarding the Corporation’s equity compensation plan is incorporated herein byreference from the “Equity Compensation Plan Information” section of theCorporation’s 2008 definitive proxy statement filed on Schedule 14A.

 

12

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**PERFORMANCEGRAPH**

 

Thefollowing graph and table compare the cumulative total shareholder return onthe corporation’s common stock during the period December 31, 2002,through and including December 31, 2007, with

 

·    thecumulative total return on the SNL Securities Corporate Performance Index(1) forbanks with less than $500 million in total assets in the Middle Atlanticarea(2), and

·    thecumulative total return for all United States stocks traded on the NASDAQ StockMarket.

 

The comparison assumes $100was invested on December 31, 2002, in the corporation’s common stock andin each of the indices below and assumes further the reinvestment of dividendsinto the applicable securities.  Theshareholder return shown on the graph and table below is not necessarilyindicative of future performance.

 

***FIRST KEYSTONE CORPORATION***

Total Return Performance

 

 
| ** **                 | ** ** | **Period Ending** | ** ** |
|----------------------------|------------|------------------------|------------|
| ** **                 | ** ** | **12/31/02**           | ** ** | **12/31/03** | ** ** | **12/31/04** | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** | **12/31/07** | ** ** |
| First Keystone Corporation |       | 100.00                 |       | 142.68 |   | 138.77 |   | 128.92 |   | 126.01 |   | 116.06 |   |
| NASDAQ - Total US          |       | 100.00                 |       | 150.01 |   | 162.89 |   | 165.13 |   | 180.85 |   | 198.60 |   |
| SNL <$500M Bank Index   |       | 100.00                 |       | 145.97 |   | 168.49 |   | 178.39 |   | 187.41 |   | 152.17 |   |

 

----

(1) SNL Securities is a research and publishing firm specializingin the collection and dissemination of data on the banking, thrift andfinancial services industries.

(2) TheMiddle Atlantic area comprises the states of Delaware, Pennsylvania, Maryland,New Jersey, New York, the District of Columbia and Puerto Rico.

 

13

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ITEM 6.      SELECTEDFINANCIAL DATA

 
| ** **                                                     | ** ** | **Year Ended December 31,** | ** **  |
|----------------------------------------------------------------|------------|--------------------------------------------|-------------|
| **(Amounts in thousands, except per share)**                   | ** ** | **2007**                                   | ** **  | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                           |       |                                       |        |   |   |   |   |   |   |   |   |
| SELECTED FINANCIAL DATA:                                       |       |                                       |        |   |   |   |   |   |   |   |   |
| Total Assets                                                   | ** ** | **$**                                      | **681,207** |   | $ | 525,920 |   | $ | 512,399 |   | $ | 497,615 |   | $ | 481,840 |   |
| Total Investment securities                                    | ** ** | **246,059**                                |        | 243,938 |   | 251,536 |   | 239,053 |   | 231,272 |   |
| Net loans                                                      | ** ** | **371,557**                                |        | 248,086 |   | 230,917 |   | 229,972 |   | 225,549 |   |
| Total Deposits                                                 | ** ** | **493,041**                                |        | 384,020 |   | 362,796 |   | 357,956 |   | 343,020 |   |
| Stockholders’ equity                                      | ** ** | **70,924**                                 |        | 53,387 |   | 53,443 |   | 53,312 |   | 51,351 |   |
|                                                           |       |                                       |        |   |   |   |   |   |   |   |   |
| SELECTED OPERATING DATA:                                       |       |                                       |        |   |   |   |   |   |   |   |   |
| Interest income                                                | ** ** | **$**                                      | **31,899**  |   | $ | 28,577 |   | $ | 26,382 |   | $ | 25,036 |   | $ | 25,063 |   |
| Interest expense                                               | ** ** | **17,785**                                 |        | 14,972 |   | 11,621 |   | 10,006 |   | 10,200 |   |
| Net interest income                                            | ** ** | **$**                                      | **14,114**  |   | $ | 13,605 |   | $ | 14,761 |   | $ | 15,030 |   | $ | 14,863 |   |
| Provision for loan losses                                      | ** ** | **150**                                    |        | 500 |   | 750 |   | 1,750 |   | 500 |   |
| Net interest income after provision for  loan and lease losses |       | **$**                                      | **13,964**  |   | $ | 13,105 |   | $ | 14,011 |   | $ | 13,280 |   | $ | 14,363 |   |
| Other income                                                   | ** ** | **4,199**                                  |        | 3,788 |   | 3,782 |   | 4,596 |   | 3,275 |   |
| Other expense                                                  | ** ** | **10,645**                                 |        | 9,515 |   | 9,583 |   | 9,426 |   | 8,371 |   |
| Income before income taxes                                     | ** ** | **$**                                      | **7,518**   |   | $ | 7,378 |   | $ | 8,210 |   | $ | 8,450 |   | $ | 9,267 |   |
| Income tax expense                                             | ** ** | **1,391**                                  |        | 1,188 |   | 1,363 |   | 1,663 |   | 1,950 |   |
| Net income                                                     | ** ** | **$**                                      | **6,127**   |   | $ | 6,190 |   | $ | 6,847 |   | $ | 6,787 |   | $ | 7,317 |   |
|                                                           |       |                                       |        |   |   |   |   |   |   |   |   |
| PER COMMON SHARE DATA:                                         |       |                                       |        |   |   |   |   |   |   |   |   |
| Net income                                                     | ** ** | **$**                                      | **1.31**    |   | $ | 1.35 |   | $ | 1.48 |   | $ | 1.47 |   | $ | 1.58 |   |
| Cash dividends                                                 | ** ** | **.88**                                    |        | .85 |   | .78 |   | .70 |   | .62 |   |
|                                                           |       |                                       |        |   |   |   |   |   |   |   |   |
| PERFORMANCE RATIOS:                                            |       |                                       |        |   |   |   |   |   |   |   |   |
| Return on average assets                                       | ** ** | **1.09**                                   | **%**       | 1.20 | % | 1.35 | % | 1.37 | % | 1.57 | % |
| Return on average equity                                       | ** ** | **10.48**                                  | **%**       | 11.76 | % | 12.65 | % | 12.76 | % | 14.27 | % |
| Dividend payout ratio                                          | ** ** | **68.25**                                  | **%**       | 62.63 | % | 52.61 | % | 47.41 | % | 39.41 | % |
| Average equity to average assets ratio                         | ** ** | **10.37**                                  | **%**       | 10.19 | % | 10.69 | % | 10.76 | % | 11.00 | % |

 

14

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ITEM7.                             MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The purpose of Management’s Discussion and Analysisof First Keystone Corporation, a bank holding company (the Corporation), andits wholly owned subsidiary, First Keystone National Bank (the Bank), is toassist the reader in reviewing the financial information presented and shouldbe read in conjunction with the consolidated financial statements and otherfinancial data contained herein. Refer to Forward Looking Statements on page 1for detailed information.

 

This annual report contains certain forward-lookingstatements (as defined in the Private Securities Litigation Reform Act of1995), which reflect management’s beliefs and expectations based on informationcurrently available. These forward-looking statements are inherently subject tosignificant risks and uncertainties, including changes in general economic andfinancial market conditions, the Corporation’s ability to effectively carry outits business plans and changes in regulatory or legislative requirements. Otherfactors that could cause or contribute to such differences are changes incompetitive conditions. Although management believes the expectations reflectedin such forward-looking statements are reasonable, actual results may differmaterially.

 

**ACQUISITION**

 

On November 1, 2007, the Corporation acquiredPocono Community Bank (hereinafter referred to as Pocono) of Stroudsburg,Pennsylvania. Pocono was a $120 million bank which operated four full-servicebanking offices in Monroe County, Pennsylvania. Period-to-period comparisonsand the Management’s Discussion are impacted by this acquisition when 2007results are compared to 2006. The tables in Management’s Discussion includecontributions of this acquisition as well as internal changes. Refer to Note 2on page 43 of the Notes to Consolidated Financial Statements for detailedinformation.

 

**RESULTS OF OPERATIONS**

 

***Year Ended December 31, 2007Versus Year Ended December 31, 2006***

 

Net income decreased to $6,127,000 for the yearended December 31, 2007, as compared to $6,190,000 for the prior year, adecrease of 1.0%. Earnings per share, both basic and diluted, for 2007 were$1.31 as compared to $1.35 in 2006. Cash dividends per share increased to $.88in 2007 from $.85 in 2006, an increase of 3.5%. The Corporation’s return onaverage assets was 1.09% in 2007 as compared to 1.20% in 2006. Return onaverage equity decreased to 10.48% in 2007 from 11.76% in 2006. An increase inearning asset levels resulted in an overall increase of interest income to$31,899,000 up $3,322,000 or 11.6% from 2006. Likewise, there was theaccompanying increase in deposits and borrowings which resulted in interestexpense of $17,785,000 in 2007, an increase of $2,813,000 or 18.8% from 2006.The majority of the increases in earning assets and deposits were a result ofmerging Pocono into the Corporation.

 

Net interest income, as indicated below in Table 1,increased by $509,000 or 3.7% to $14,114,000 for the year ended December 31,2007. The Corporation’s net interest income on a fully taxable equivalent basisincreased by $193,000, or 1.3% to $15,493,000 in 2007 as compared to a decreaseof $1,326,000, or 8.0% to $15,300,000 in 2006.

 

***Year Ended December 31, 2006Versus Year Ended December 31, 2005***

 

Net income decreased to $6,190,000 for the yearended December 31, 2006, as compared to $6,847,000 for the prior year, adecrease of 9.6%. Earnings per share, both basic and diluted, for 2006 were$1.35 as compared to $1.48 in 2005. Cash dividends per share increased to $.85in 2006 from $.78 in 2005, an increase of 9.0%.

 

The Corporation’s return on average assets was 1.20%in 2006 as compared to 1.35% in 2005. Return on average equity decreased to11.76% in 2006 from 12.65% in 2005. The series of increases in interest ratesin 2005 ended in 2006 and resulted in an overall increase of interest income to$28,577,000 up 8.3% from 2005. Likewise, there was the accompanying increase inthe cost of funds which resulted in interest expense of $14,972,000 in 2006, anincrease of 28.8% from 2005. The increases in deposit rates in 2006 and theflattened yield curve resulted in interest expense increasing faster thaninterest income.

 

**Table 1 — Net Interest Income**

 
| ** **                                 | ** ** | ** **              | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------|------------|-------------------------|------------|-------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **(Amounts in thousands)**       | ** ** | **2007/2006**           | ** ** | **2006/2005**           | ** ** |
| ** **                                 | ** ** | **Increase/(Decrease)** | ** ** | **Increase/(Decrease)** | ** ** |
| ** **                                 | ** ** | **2007**                | ** ** | **Amount**              | ** ** | **%**      | ** ** | **2006**   | ** ** | **Amount** | ** ** | **%**      | ** ** | **2005**   | ** ** |
| Interest Income                            | ** ** | **$**                   | **31,899** | ** **              | **$**      | **3,322**  | ** ** | **11.6**   |       | $          | 28,577     |       | $          | 2,195      |       | 8.3 |   | $ | 26,382 |   |
| Interest Expense                           | ** ** | **17,785**              | ** ** | **2,813**               | ** ** | **18.8**   |       | 14,972     |       | 3,351      |       | 28.8       |       | 11,621     |       |
|                                       |       |                    |       |                    |       |       |       |       |       |       |       |       |       |       |       |
| Net Interest Income                        | ** ** | **14,114**              | ** ** | **509**                 | ** ** | **3.7**    |       | 13,605     |       | (1,156     | )          | (7.8       | )          | 14,761     |       |
| Tax Equivalent Adjustment                  | ** ** | **1,379**               | ** ** | **(316**                | **)**      | **(18.6**  | **)**      | 1,695      |       | (170       | )          | (9.1       | )          | 1,865      |       |
|                                       |       |                    |       |                    |       |       |       |       |       |       |       |       |       |       |       |
| Net Interest Income (fully tax equivalent) | ** ** | **$**                   | **15,493** | ** **              | **$**      | **193**    | ** ** | **1.3**    |       | $          | 15,300     |       | $          | (1,326     | )          | (8.0 | ) | $ | 16,626 |   |

 

15

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**Table 2 — Distribution of Assets,Liabilities and Stockholders’ Equity**

 
| ** **                                   | ** ** | **2007**             | ** **  | **2006**              | ** ** | **2005**         | ** ** |
|----------------------------------------------|------------|----------------------|-------------|-----------------------|------------|------------------|------------|
| ** **                                   | ** ** | **Average  Balance** | ** **  | **Revenue/  Expense** | ** ** | **Yield/  Rate** | ** ** | **Average  Balance** | ** ** | **Revenue/  Expense** | ** ** | **Yield/  Rate** | ** ** | **Average  Balance** | ** ** | **Revenue/  Expense** | ** ** | **Yield/  Rate** | ** ** |
| Interest Earning  Assets:                    |       |                 |        |                  |       |             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans:                                       |       |                 |        |                  |       |             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial(1)                                | ** ** | **$**                | **21,054**  | ** **            | **$**      | **1,938**        | ** ** | **9.20** | **%** | $ | 28,120 |   | $ | 2,003 |   | 7.12 | % | $ | 30,933 |   | $ | 1,953 |   | 6.31 | % |
| Real Estate(1)                               | ** ** | **234,465**          | ** **  | **15,993**            | ** ** | **6.82**         | **%**      | 198,854 |   | 13,200 |   | 6.64 | % | 182,019 |   | 11,501 |   | 6.32 | % |
| Installment  Loans, Net(1),(2)               | ** ** | **21,097**           | ** **  | **1,263**             | ** ** | **5.99**         | **%**      | 17,681 |   | 1,402 |   | 7.93 | % | 19,706 |   | 1,492 |   | 7.57 | % |
| Fees on Loans                                | ** ** | **—**           | ** **  | **(31**               | **)**      | **—**       | **%**      | — |   | (39 | ) | — | % | — |   | (26 | ) | — | % |
| Total Loans  (Including Fees)(3)             | ** ** | **$**                | **276,616** | ** **            | **$**      | **19,163**       | ** ** | **6.93** | **%** | $ | 244,655 |   | $ | 16,566 |   | 6.77 | % | $ | 232,658 |   | $ | 14,920 |   | 6.41 | % |
|                                         |       |                 |        |                  |       |             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Investment  Securities:                      |       |                 |        |                  |       |             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Taxable                                      | ** ** | **$**                | **179,431** | ** **            | **$**      | **9,894**        | ** ** | **5.51** | **%** | $ | 156,109 |   | $ | 8,488 |   | 5.44 | % | $ | 158,749 |   | $ | 7,638 |   | 4.81 | % |
| Tax Exempt(1)                                | ** ** | **66,844**           | ** **  | **4,124**             | ** ** | **6.17**         | **%**      | 82,669 |   | 5,188 |   | 6.28 | % | 87,564 |   | 5,635 |   | 6.44 | % |
| Total Investment  Securities                 | ** ** | **$**                | **246,275** | ** **            | **$**      | **14,018**       | ** ** | **5.69** | **%** | $ | 238,778 |   | $ | 13,676 |   | 5.73 | % | $ | 246,313 |   | $ | 13,273 |   | 5.39 | % |
| Interest Bearing  Deposits in Banks          | ** ** | **1,086**            | ** **  | **66**                | ** ** | **6.05**         | **%**      | 606 |   | 31 |   | 5.12 | % | 1,784 |   | 51 |   | 2.85 | % |
| Federal Funds  Sold                          | ** ** | **688**              | ** **  | **31**                | ** ** | **4.56**         | **%**      | — |   | — |   | — | % | 90 |   | 3 |   | 3.04 | % |
| Total Other  Interest-Earning Assets         | ** ** | **1,774**            | ** **  | **97**                | ** ** | **5.47**         | **%**      | 606 |   | 31 |   | 5.12 | % | 1,874 |   | 54 |   | 2.86 | % |
| Total  Interest-Earning Assets               | ** ** | **$**                | **524,665** | ** **            | **$**      | **33,278**       | ** ** | **6.34** | **%** | $ | 484,039 |   | $ | 30,273 |   | 6.25 | % | $ | 480,845 |   | $ | 28,247 |   | 5.87 | % |
|                                         |       |                 |        |                  |       |             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-Interest  Earning Assets:                |       |                 |        |                  |       |             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and Due From  Banks                     | ** ** | **$**                | **8,132**   |                  |       |             |       |   | $ | 7,437 |   |   |   |   |   | $ | 7,006 |   |   |   |   |   |
| Allowance for  Loan Losses                   | ** ** | **(3,960**           | **)**       |                  |       |             |       | (3,662 | ) |   |   |   |   | (3,738 | ) |   |   |   |   |
| Premises and  Equipment                      | ** ** | **5,519**            |        |                  |       |             |       | 4,991 |   |   |   |   |   | 5,230 |   |   |   |   |   |
| Foreclosed Assets  Held for Sale             | ** ** | **—**           |        |                  |       |             |       | 229 |   |   |   |   |   | 150 |   |   |   |   |   |
| Other Assets                                 | ** ** | **29,741**           |        |                  |       |             |       | 23,707 |   |   |   |   |   | 17,028 |   |   |   |   |   |
| Total  Non-Interest Earning Assets           | ** ** | **39,432**           |        |                  |       |             |       | 32,702 |   |   |   |   |   | 25,676 |   |   |   |   |   |
| Total Assets                                 | ** ** | **$**                | **564,097** |                  |       |             |       |   | $ | 516,741 |   |   |   |   |   | $ | 506,521 |   |   |   |   |   |
|                                         |       |                 |        |                  |       |             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-Bearing  Liabilities:               |       |                 |        |                  |       |             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings, NOW  Accounts, and Money Markets    | ** ** | **$**                | **154,200** | ** **            | **$**      | **3,681**        | ** ** | **2.39** | **%** | $ | 136,481 |   | $ | 2,921 |   | 2.14 | % | $ | 137,134 |   | $ | 1,711 |   | 1.25 | % |
| Time Deposits                                | ** ** | **214,232**          | ** **  | **9,876**             | ** ** | **4.61**         | **%**      | 202,780 |   | 8,263 |   | 4.07 | % | 191,455 |   | 6,394 |   | 3.34 | % |
| Short-Term  Borrowings                       | ** ** | **14,551**           | ** **  | **735**               | ** ** | **5.05**         | **%**      | 6,909 |   | 352 |   | 5.09 | % | 5,039 |   | 179 |   | 3.56 | % |
| Long-Term  Borrowings                        | ** ** | **58,345**           | ** **  | **2,901**             | ** ** | **4.97**         | **%**      | 62,376 |   | 2,895 |   | 4.64 | % | 66,305 |   | 3,017 |   | 4.55 | % |
| Fed Funds  Purchased                         | ** ** | **11**               | ** **  | **—**            | ** ** | **4.65**         | **%**      | — |   | — |   | — | % | — |   | — |   | — | % |
| Securities Sold  U/A to Repurchase           | ** ** | **14,553**           | ** **  | **592**               | ** ** | **4.07**         | **%**      | 13,411 |   | 542 |   | 4.04 | % | 10,770 |   | 320 |   | 2.97 | % |
| Total  Interest-Bearing Liabilities          | ** ** | **$**                | **455,892** | ** **            | **$**      | **17,785**       | ** ** | **3.90** | **%** | $ | 421,957 |   | $ | 14,973 |   | 3.55 | % | $ | 410,703 |   | $ | 11,621 |   | 2.83 | % |
|                                         |       |                 |        |                  |       |             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-Interest  Bearing Liabilities:           |       |                 |        |                  |       |             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand Deposits                              | ** ** | **$**                | **43,795**  |                  |       |             |       |   | $ | 39,076 |   |   |   |   |   | $ | 38,177 |   |   |   |   |   |
| Other Liabilities                            | ** ** | **5,940**            |        |                  |       |             |       | 3,074 |   |   |   |   |   | 3,511 |   |   |   |   |   |
| Stockholders’  Equity                   | ** ** | **58,470**           |        |                  |       |             |       | 52,634 |   |   |   |   |   | 54,130 |   |   |   |   |   |
| Total  Liabilities/Stockholders’ Equity | ** ** | **$**                | **564,097** |                  |       |             |       |   | $ | 516,741 |   |   |   |   |   | $ | 506,521 |   |   |   |   |   |
|                                         |       |                 |        |                  |       |             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net Interest  Income Tax Equivalent          | ** ** | ** **           |        | **$**                 | **15,493** |             |       |   |   |   | $ | 15,300 |   |   |   |   |   | $ | 16,626 |   |   |   |
|                                         |       |                 |        |                  |       |             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net Interest  Spread                         | ** ** | ** **           |        |                  |       | **2.44**         | **%**      |   |   |   |   | 2.70 | % |   |   |   |   | 3.04 | % |
|                                         |       |                 |        |                  |       |             | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |
| Net Interest  Margin                         | ** ** | ** **           |        |                  |       | **2.95**         | **%**      |   |   |   |   | 3.16 | % |   |   |   |   | 3.46 | % |

 

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(1)Tax-exempt income has been adjusted to a tax equivalent basis usingan incremental rate of 34%, and statutory interest expense disallowance.

(2)Installment loans are stated net of unearned interest.

(3)Average loan balances include non-accrual loans.  Interest income on non-accrual loans is notincluded.

 

16

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** **

**NET INTEREST INCOME**

 

The major source ofoperating income for the Corporation is net interest income. Net interestincome is the difference between interest income on earning assets, such asloans and securities, and the interest expense on liabilities used to fundthose assets, including deposits and other borrowings. The amount of interestincome is dependent upon both the volume of earning assets and the level ofinterest rates. In addition, the volume of non-performing loans affectsinterest income. The amount of interest expense varies with the amount of fundsneeded to support earning assets, interest rates paid on deposits and borrowedfunds, and finally, the level of interest free deposits.

 

Table 2 on the preceding pages providesa summary of average outstanding balances of earning assets and interestbearing liabilities with the associated interest income and interest expense aswell as average tax equivalent rates earned and paid as of year-end 2007, 2006,and 2005.

 

The yield on earning assetswas 6.34% in 2007, 6.25% in 2006, and 5.87% in 2005. The rate paid on interestbearing liabilities was 3.90% in 2007, 3.55% in 2006, and 2.83% in 2005. Thisresulted in a decrease in our net interest spread to 2.44% in 2007, as comparedto 2.70% in 2006 and 3.04% in 2005.

 

As Table 2 illustrates, thenet interest margin, which is interest income less interest expenses divided byaverage earnings assets, was 2.95% in 2007 as compared to 3.16% in 2006 and3.46% in 2005. The net interest margins are presented on a tax-equivalentbasis. The decreases in net interest margin in 2007 and 2006 were due primarilyto the increased interest paid on interest bearing liabilities. This was a result of more interest bearing liabilities repricing thanearning assets.

 

In an effort to maintain ortry to increase our net interest margin, we look to higher earning asset yieldsand lower funding costs in 2008. We feel it is apparent that interest marginexpansion will be experienced if the yield curve returns to its more normal upwardsloping environment.

 

Table 3 sets forth changesin interest income and interest expense for the periods indicated for eachcategory of interest earning assets and interest bearing liabilities.Information is provided on changes attributable to (I) changes in volume(changes in average volume multiplied by prior rate); (ii) changes in rate(changes in average rate multiplied by prior average volume); and, (iii) changesin rate and volume (changes in average volume multiplied by change in averagerate).

 

Interest income exempt fromfederal tax was $3,118,000 in 2007, $3,755,000 in 2006, and $4,043,000 in2005.  Tax-exempt income has beenadjusted to a tax-equivalent basis using an incremental rate of 34%.

 

In 2007, the increase in netinterest income of $193,000 resulted from an increase in volume of $1,405,000and a decrease of $1,212,000 due to changes in rate. In 2006, the decrease innet interest income of $1,326,000 resulted from a decrease in volume of $45,000and a decrease of $1,281,000 due to changes in rate.

 

17

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**Table 3 — Changesin Income and Expense, 2007 and 2006**

 
| ** **                           | ** ** | **2007 COMPARED TO 2006** | ** ** | **2006 COMPARED TO 2005** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| **(Amounts in thousands)** | ** ** | **VOLUME**                               | ** ** | **RATE**                                 | ** ** | **NET** | ** ** | **VOLUME** | ** ** | **RATE** | ** ** | **NET** | ** ** |
|                                 |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Interest Income:                     |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Loans, Net                           | ** ** | **$**                                    | **2,164**  | ** **                               | **$**      | **433** | ** ** | **$** | **2,597** |   | $ | 769 |   | $ | 877 |   | $ | 1,646 |   |
| Taxable Investment Securities        | ** ** | **1,268**                                | ** ** | **138**                                  | ** ** | **1,406** |   | (127 | ) | 977 |   | 850 |   |
| Tax-Exempt Investment Securities     | ** ** | **(993**                                 | **)**      | **(71**                                  | **)**      | **(1,064** | ) | (315 | ) | (132 | ) | (447 | ) |
| Other Short-Term Investments         | ** ** | **60**                                   | ** ** | **6**                                    | ** ** | **66** |   | (37 | ) | 14 |   | (23 | ) |
|                                 |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| **Total Interest Income**            | ** ** | **$**                                    | **2,499**  | ** **                               | **$**      | **506** | ** ** | **$** | **3,005** |   | $ | 290 |   | $ | 1,736 |   | $ | 2,026 |   |
|                                 |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Interest Expense:                    |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Savings, Now, and Money Markets      | ** ** | **$**                                    | **379**    | ** **                               | **$**      | **381** | ** ** | **$** | **760** |   | $ | (8 | ) | $ | 1,218 |   | $ | 1,210 |   |
| Time Deposits                        | ** ** | **467**                                  | ** ** | **1,146**                                | ** ** | **1,613** |   | 378 |   | 1,491 |   | 1,869 |   |
| Short-Term Borrowings                | ** ** | **389**                                  | ** ** | **(6**                                   | **)**      | **383** |   | 66 |   | 107 |   | 173 |   |
| Long-Term Borrowings                 | ** ** | **(187**                                 | **)**      | **193**                                  | ** ** | **6** |   | (179 | ) | 57 |   | (122 | ) |
| Securities Sold U/A to Repurchase    | ** ** | **46**                                   | ** ** | **4**                                    | ** ** | **50** |   | 78 |   | 144 |   | 222 |   |
| **Total Interest Expense**           | ** ** | **$**                                    | **1,094**  | ** **                               | **$**      | **1,718** | ** ** | **$** | **2,812** |   | $ | 335 |   | $ | 3,017 |   | $ | 3,352 |   |
| **Net Interest Income**              | ** ** | **$**                                    | **1,405**  | ** **                               | **$**      | **(1,212** | **)** | **$** | **193** |   | $ | (45 | ) | $ | (1,281 | ) | $ | (1,326 | ) |

 

----

The change in interest due to both volume and yield/rate has beenallocated to change due to volume and change due to yield/rate in proportion tothe absolute value of the change in each.

Balance on non-accrual loans are included for computationalpurposes.  Interest income on non-accrualloans is not included.

 

**PROVISION FOR LOAN LOSSES**

 

For the year ended December 31, 2007, the provision for loanlosses was $150,000 as compared to $500,000 as of December 31, 2006 and$750,000 as of December 31, 2005. The provision in 2007, decreasedprimarily because of the reduced net charge-offs and improved loan quality. Netcharge-offs by the Corporation for the fiscal year end December 31, 2007,2006, and 2005, were $57,000, $505,000, and $902,000, respectively.

 

The allowance for loan losses as a percentage of loans, net of unearnedinterest, was 1.34% as of December 31, 2007, 1.46% as of December 31,2006, 1.57% as of December 31, 2005.

 

On a quarterly basis, the Corporation’s Board of Directors andmanagement performs a detailed analysis of the adequacy of the allowance forloan losses. This analysis includes an evaluation of credit risk concentration,delinquency trends, past loss experience, current economic conditions,composition of the loan portfolio, classified loans and other relevant factors.

 

The Corporation will continue to monitor its allowance for loan lossesand make future adjustments to the allowance through the provision for loanlosses as conditions warrant. Although the Corporation believes that theallowance for loan losses is adequate to provide for losses inherent in theloan portfolio, there can be no assurance that future losses will not exceedthe estimated amounts or that additional provisions will not be required in thefuture.

 

The Bank is subject to periodic regulatory examination by the Office ofthe Comptroller of the Currency (OCC). As part of the examination, the OCC will assess the adequacy of the bank’sallowance for loan losses and may include factors not considered by the Bank.In the event that an OCC examination results in a conclusion that the Bank’sallowance for loan losses is not adequate, the Bank may be required to increaseits provision for loan losses.

 

**NON-INTEREST INCOME**

 

Non-interest income is derived primarily from trust department revenue,service charges and fees, income on bank owned life insurance, othermiscellaneous revenue and the gain on the sale of mortgage loans. In addition,investment securities gains or losses also impact total non-interest income.

 

18

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For the year ended December 31, 2007, non-interest income amountedto $4,199,000, an increase of $411,000, or 10.9% as compared to an increase of$6,000, or 0.2% for the year ended December 31, 2006. Table 4 provides themajor categories of non-interest income and each respective change comparingthe past three years.

 

Excluding investment securities gains, non-interest income in 2007increased $309,000, or 9.1% to $3,716,000. This compares to a increase of$45,000, or 1.3% in 2006 before investment securities gains. Income from thetrust department, which consists of fees generated from individual andcorporate accounts, increased in 2007 by $74,000, or 14.6% after increasing by$30,000, or 6.3% in 2006.  Increased incomefrom the trust department in 2007 and 2006 was due primarily to an increase inaccount volume and increased fees from estate settlements.

 

Service charges and fees, consisting primarily of service charges ondeposit accounts, was the largest source of non-interest income in 2007 and2006. Service charges and fees increased by $34,000, or 1.6% in 2007 comparedto a decrease of $14,000, or 0.6% in 2006.

 

Income on Bank Owned Life Insurance (BOLI) increased $86,000 to$558,000 in 2007 as compared to an increase of $35,000 to $472,000 in 2006. Theincome from BOLI represents the increase in the cash surrender value of BOLIand is intended to partially cover the costs of the Bank’s employee benefitplan, including group life, disability, and health insurance.

 

The gain on sale of mortgages provided $89,000 in 2007 as compared to$39,000 in 2006. The increase in gains on sale of mortgages was largely afunction of the increased originations and subsequent mortgage sales in thesecondary market during the past year. The Corporation continues to service themortgages which are sold, this servicing income provides an additional sourceof non-interest income on an ongoing basis.

 

Other income, consisting primarily of safe deposit box rentals, incomefrom the sale of non-deposit products, and miscellaneous fees amounted to$305,000 for 2007, an increase of $65,000 or 27.1% over the $240,000 otherincome reported in 2006. The increased sale of non-deposit products, especiallyannuities, accounts for the majority of the increase in 2007.

 

**Table 4 — Non-Interest Income**

 
| ** **                           | ** ** | **2007/2006**           | ** ** | **2006/2005**           | ** ** |
|--------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                           | ** ** | **Increase/(Decrease)** | ** ** | **Increase/(Decrease)** | ** ** |
| **(Amounts in thousands)** | ** ** | **2007**                | ** ** | **Amount**              | ** ** | **%** | ** ** | **2006** | ** ** | **Amount** | ** ** | **%** | ** ** | **2005** | ** ** |
| Trust Department                     | ** ** | **$**                   | **581**    | ** **              | **$**      | **74** | ** ** | **14.6** |   | $ | 507 |   | $ | 30 |   | 6.3 |   | $ | 477 |   |
| Service Charges and Fees             | ** ** | **2,183**               | ** ** | **34**                  | ** ** | **1.6** |   | 2,149 |   | (14 | ) | (0.6 | ) | 2,163 |   |
| Income on Bank Owned Life Insurance  | ** ** | **558**                 | ** ** | **86**                  | ** ** | **18.2** |   | 472 |   | 35 |   | 8.0 |   | 437 |   |
| Gain on Sale of Mortgages            | ** ** | **89**                  | ** ** | **50**                  | ** ** | **128.2** |   | 39 |   | (24 | ) | (38.1 | ) | 63 |   |
| Other                                | ** ** | **305**                 | ** ** | **65**                  | ** ** | **27.1** |   | 240 |   | 18 |   | 8.1 |   | 222 |   |
|                                 |       |                    |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Subtotal                             | ** ** | **$**                   | **3,716**  | ** **              | **$**      | **309** | ** ** | **9.1** |   | $ | 3,407 |   | $ | 45 |   | 1.3 |   | $ | 3,362 |   |
| Investment Securities Gains          | ** ** | **483**                 | ** ** | **102**                 | ** ** | **26.8** |   | 381 |   | (39 | ) | (9.3 | ) | 420 |   |
|                                 |       |                    |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Total                                | ** ** | **$**                   | **4,199**  | ** **              | **$**      | **411** | ** ** | **10.9** |   | $ | 3,788 |   | $ | 6 |   | 0.2 |   | $ | 3,782 |   |

 

**NON-INTEREST EXPENSE**

 

Non-interest expenseconsists of salaries and benefits, occupancy, furniture and equipment, andother miscellaneous expenses. Table 5 provides the yearly non-interest expenseby category, along with the amount, dollar changes, and percentage of change.

 

Total non-interest expenseamounted to $10,645,000, an increase of $1,130,000, or 11.9% in 2007 comparedto a decrease of $68,000, or 0.7% in 2006. Expenses associated with employees(salaries and employee benefits) continue to be the largest non-interest expenditure.Salaries and employee benefits amounted to 52.4% of total non-interest expensein 2007 and 54.5% in 2006. Salaries and employee benefits increased $391,000,or 7.5% in 2007 and $111,000, or 2.2% in 2006. The increases in both yearslargely reflect normal salary adjustments and increased benefit costs. Thenumber of full time equivalent employees was 167 as of December 31, 2007,and 128 as of December 31, 2006, relating primarily to the Poconoacquisition.

 

19

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Net occupancy expenseincreased $150,000, or 24.7% in 2007 as compared to an increase of $30,000, or5.2% in 2006. Furniture and equipment expense increased $13,000, or 1.7% in2007 compared to a increase of $67,000, or 9.8% in 2006. The increases inoccupancy and furniture and equipment expense in 2007 relate to the Poconoacquisition and to increases in rent and lease payments and new equipmentpurchases. Other operating expenses increased $576,000, or 19.4% in 2007 ascompared to a decrease of $276,000, or 8.5% in 2006. Increases in professionalfees, marketing, advertising, and miscellaneous expense associated with bothour name change from The First National Bank of Berwick to First KeystoneNational Bank and the Pocono acquisition account for much of the increase inother operating expenses in 2007.

 

The overall level ofnon-interest expense remains low, relative to our peers. In fact, our totalnon-interest expense was less than 2% of average assets in both 2007 and 2006.Non-interest expense as a percentage of average assets under 2% places us amongthe leaders in our peer financial institution categories in controllingnon-interest expense.

 

**Table 5 — Non-InterestExpense**

 
| ** **                                  | ** ** | **2007/2006**           | ** ** | **2006/2005**           | ** ** |
|---------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                  | ** ** | **Increase/(Decrease)** | ** ** | **Increase/(Decrease)** | ** ** |
| **(Amounts in thousands)**        | ** ** | **2007**                | ** ** | **Amount**              | ** ** | **%** | ** ** | **2006** | ** ** | **Amount** | ** ** | **%** | ** ** | **2005** | ** ** |
| Salaries and Employee Benefits              | ** ** | **$**                   | **5,576**  | ** **              | **$**      | **391** | ** ** | **7.5** | ** ** | **$** | **5,185** |   | $ | 111 |   | 2.2 |   | $ | 5,074 |   |
| Occupancy, Net                              | ** ** | **758**                 | ** ** | **150**                 | ** ** | **24.7** | ** ** | **608** |   | 30 |   | 5.2 |   | 578 |   |
| Furniture and Equipment                     | ** ** | **764**                 | ** ** | **13**                  | ** ** | **1.7** | ** ** | **751** |   | 67 |   | 9.8 |   | 684 |   |
| Other, Shares Tax, and Professional Service | ** ** | **3,547**               | ** ** | **576**                 | ** ** | **19.4** | ** ** | **2,971** |   | (276 | ) | (8.5 | ) | 3,247 |   |
|                                        |       |                    |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Total                                       | ** ** | **$**                   | **10,645** | ** **              | **$**      | **1,130** | ** ** | **11.9** | ** ** | **$** | **9,515** |   | $ | (68 | ) | (0.7 | ) | $ | 9,583 |   |

 

**INCOME TAX EXPENSE**

 

Income tax expense for theyear ended December 31, 2007, was $1,391,000 as compared to $1,188,000 and$1,363,000  for the years ended December 31,2006, and December 31, 2005, respectively. In 2007, our income tax expenseincreased because income before taxes increased $140,000 to $7,518,000 from$7,378,000 in 2006. In 2005, our income before taxes amounted to $8,210,000.The corporation looks to maximize its tax-exempt interest derived from bothtax-free loans and tax-free municipal investments without triggering alternativeminimum tax. The effective income tax rate was 18.5% in 2007, 16.1% in 2006,and 16.6% in 2005. The limited availability of tax-free municipal investmentsat attractive interest rates may result in a higher effective tax rate infuture years.

 

**FINANCIAL CONDITION**

 

**GENERAL**

 

Total assets increased to$681,207,000, at year-end 2007, an increase of 29.5% over year-end 2006. As of December 31,2007, total deposits amounted to $493,041,000, an increase of 28.4% over 2006.Assets as of December 31, 2006, were $525,920,000, an increase of 2.6%over 2005, while total deposits as of year-end 2006 amounted to $384,020,000,an increase of 5.9% from 2005.

 

In both 2007 and 2006,deposit growth was used principally to fund loan growth. The Corporationcontinues to maintain and manage its asset growth. Our strong equity capitalposition provides us an opportunity to further leverage our asset growth.Borrowings increased in 2007 by $27,810,000 after decreasing in 2006 by$7,972,000. Increased borrowings in 2007 helped fund loan growth and otherasset growth on the balance sheet. Decreased borrowings in 2006 resulted in areduction in investment securities. Core deposits, which include demanddeposits and interest bearing demand deposits (NOWs), money market accounts, savingsaccounts, and time deposits of individuals continues to be our most significantsource of funds. In 2007 and 2006, several successful sales campaigns attractednew customers and  generated growth inretail certificates of deposit (time deposits of individuals) as well assavings and money market accounts.

 

20

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**EARNING ASSETS**

 

Earning assets are definedas those assets that produce interest income. By maintaining a healthy assetutilization rate, i.e., the volume of earning assets as a percentage of totalassets, the Corporation maximizes income. The earning asset ratio (averageinterest earning assets divided by average total assets) equaled 93.0% for2007, compared to 93.7% for 2006 and 94.9% for 2005. This indicates that themanagement of earning assets is a priority and non-earning assets, primarilycash and due from banks, fixed assets and other assets, are maintained  at minimal levels. The primary earning assetsare loans and investment securities.

 

**LOANS**

 

Total loans, net of unearnedincome, increased to $376,603,000 as of December 31, 2007, as compared toa balance of $251,757,000 as of December 31, 2006. Table 6 provides datarelating to the composition of the Corporation’s loan portfolio on the datesindicated. Total loans, net of unearned income increased $124,846,000, or 49.6%in 2007 compared to an increase of $17,164,000, or 7.3% in 2006.

 

The loan portfolio is welldiversified and increases in the portfolio in 2007 were primarily in commercialloans secured by commercial real estate—other, tax exempt, and real estateloans. In 2006, the increase in loans was also entirely in commercial realestate. Outstanding balances in all categories, except consumer loans,increased in 2007. The Corporation continues to originate and sell certainlong-term fixed rate residential mortgage loans which conform to secondarymarket requirements. The Corporation derives ongoing income from the servicingof mortgages sold in the secondary market.

 

The Corporation continues tointernally underwrite each of its loans to comply with prescribed policies andapproval levels established by its Board of Directors.

 

**Table 6 — LoansOutstanding, Net of Unearned Income**

 
| ** **                                                   | ** ** | **December 31,** | ** **  |
|--------------------------------------------------------------|------------|-----------------------|-------------|
| **(Amounts in thousands)**                         | ** ** | **2007**              | ** **  | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Commercial, financial and agricultural:                      |       |                  |        |   |   |   |   |   |   |   |   |
| Commercial secured by real estate                            | ** ** | **$**                 | **190,803** |   | $ | 123,673 |   | $ | 92,930 |   | $ | 86,735 |   | $ | 73,433 |   |
| Commercial - other                                           | ** ** | **29,129**            |        | 22,169 |   | 29,284 |   | 33,470 |   | 33,890 |   |
| Tax exempt                                                   | ** ** | **10,899**            |        | 3,264 |   | 3,840 |   | 3,629 |   | 3,930 |   |
|                                                         |       |                  |        |   |   |   |   |   |   |   |   |
| Real estate (primarily residential mortgage  loans)          | ** ** | **130,865**           |        | 86,208 |   | 92,840 |   | 92,408 |   | 96,422 |   |
| Consumer loans                                               | ** ** | **16,712**            |        | 18,728 |   | 18,467 |   | 20,823 |   | 25,626 |   |
| Total Gross Loans                                            | ** ** | **$**                 | **378,408** |   | $ | 254,042 |   | $ | 237,361 |   | $ | 237,065 |   | $ | 233,301 |   |
| Less:Unearned income and unamortized loan  fees net of costs | ** ** | **1,805**             |        | 2,285 |   | 2,768 |   | 3,265 |   | 4,228 |   |
| Total Loans, net of unearned income                          | ** ** | **$**                 | **376,603** |   | $ | 251,757 |   | $ | 234,593 |   | $ | 233,800 |   | $ | 229,073 |   |

 

**INVESTMENT SECURITIES**

 

The Corporation usesinvestment securities to not only generate interest and dividend revenue, butalso to help manage interest rate risk and to provide liquidity to meetoperating cash needs.

 

The investment portfolio hasbeen allocated between securities available for sale and securities held tomaturity. No investment securities were established in a trading account.Available for sale securities increased $4,512,000, or 1.9% to $241,521,000after declining to $237,009,000 in 2006, a 4.2% decrease from 2005. At December 31,2007 the net unrealized loss, net of the tax effect, on these securities was$166,000 and is included in stockholders’ equity as accumulated othercomprehensive loss. At December 31, 2006, accumulated other comprehensiveincome, net of tax effect, amounted to a loss of $126,000. In 2007, held tomaturity securities decreased $2,391,000, or 34.5% to $4,538,000 afterincreasing $2,681,000, or 63.1% in 2006. Table 7 provides data on the carryingvalue of our investment portfolio on the dates indicated. The vast majority ofinvestment security purchases are allocated as available for sale. Thisprovides the Corporation with increased flexibility should  there be a need or desire to liquidate aninvestment security.

 

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The investment portfolioincludes U.S. Government Corporations and Agencies, corporate obligations,mortgage backed securities, state and municipal securities, and other debtsecurities. In addition, the investment portfolio includes restricted equitysecurities consisting primarily of common stock investments in the FederalReserve Bank and the Federal Home Loan Bank. Marketable equity securitiesconsists of common stock investments in other commercial banks and bank holdingcompanies.

 

Securities available forsale may be sold as part of the overall asset and liability management process.Realized gains and losses are reflected in the results of operations on ourstatements of income. The investment portfolio does not contain any structurednotes, step-up bonds, or any off-balance sheet derivatives.

 

During 2007, interestbearing deposits in other banks decreased to $89,000 from $4,307,000 in 2006.Interest bearing deposits in other banks are generally kept relatively low asfunds were invested in marketable securities to maximize income while stilladdressing liquidity needs.

 

**Table 7 — CarryingValue of Investment Securities**

 
| ** **                                 | ** ** | **December 31,**        | ** **  |
|--------------------------------------------|------------|------------------------------|-------------|
| ** **                                 | ** ** | **2007**                     | ** **  | **2006** | ** ** | **2005** | ** ** |
| **(Amounts  in thousands)**                | ** ** | **Available  for Sale** | ** **  | **Held to  Maturity** | ** ** | **Available  for Sale** | ** ** | **Held to  Maturity** | ** ** | **Available  for Sale** | ** ** | **Held to  Maturity** | ** ** |
| U. S. Government Corporations and Agencies | ** ** | **$**                        | **149,607** | ** ** | **$** | **2,191** |   | $ | 153,211 |   | $ | 4,205 |   | $ | 142,403 |   | $ | 1,524 |   |
| State and Municipal                        | ** ** | **74,359**                   | ** **  | **2,347** |   | 73,456 |   | 2,724 |   | 84,434 |   | 2,724 |   |
| Corporate                                  | ** ** | **8,530**                    | ** **  | **—** |   | 2,019 |   | — |   | 12,698 |   | — |   |
| Marketable Equity Securities               | ** ** | **2,916**                    | ** **  | **—** |   | 3,711 |   | — |   | 2,966 |   | — |   |
| Restricted Equity Securities               | ** ** | **6,109**                    | ** **  | **—** |   | 4,612 |   | — |   | 4,787 |   | — |   |
| Total Investment Securities                | ** ** | **$**                        | **241,521** | ** ** | **$** | **4,538** |   | $ | 237,009 |   | $ | 6,929 |   | $ | 247,288 |   | $ | 4,248 |   |

 

**ALLOWANCE FOR LOAN LOSSES**

 

The allowance for loanlosses constitutes the amount available to absorb losses within the loanportfolio. As of December 31, 2007, the allowance for loan losses was$5,046,000 as compared to $3,671,000 and $3,676,000 as of December 31,2006 and 2005, respectively. The allowance for loan losses as of December 31,2007 included $1,282,000 acquired through the Pocono Community Bankacquisition. The allowance for loan losses is established through a provision forloan losses charged to expenses. Loans are charged against the allowance forpossible loan losses when management believes that the collectibility of theprincipal is unlikely. The risk characteristics of the loan portfolio aremanaged through the various control processes, including credit evaluations ofindividual borrowers, periodic reviews, and diversification by industry. Riskis further mitigated through the application of lending procedures such as theholding of adequate collateral and the establishment of contractual guarantees.

 

Management performs aquarterly analysis to determine the adequacy of the allowance for loan losses.The methodology in determining adequacy incorporates specific and generalallocations together with a risk/loss analysis on various segments of theportfolio according to an internal loan review process. This assessment resultsin an allocated allowance. Management maintains its loan review and loanclassification standards consistent with those of its regulatory supervisoryauthority.

 

Management feels based uponits methodology, that the allowance for loan losses is adequate to coverforeseeable future losses. Table 8 contains an analysis of our Allowance forLoan Losses indicating charge-offs and recoveries by the year and annualadditional provisions charged to operations. In 2007, net charge-offs as apercentage of average loans were .02% compared to .21% in 2006 and .39% in  2005. Net charge-offs amounted to $57,000 in2007 compared to $505,000 in 2006 and $902,000 in 2005, respectively. Thedecrease in net charge-offs in 2007 follows the decrease in net charge-offs in2006 and 2005.

 

22

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**Table 8 — Analysisof Allowance for Loan Losses**

 
| ** **                                                                                 | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| **(Amounts in thousands)**                                                       | ** ** | **2007**                                    | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Balance at beginning of period                                                             | ** ** | **$**                                       | **3,671**  |   | $ | 3,676 |   | $ | 3,828 |   | $ | 3,524 |   | $ | 3,174 |   |
| Charge-offs:                                                                               | ** ** | ** **                                  | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial, financial, and agricultural                                                    | ** ** | **12**                                      |       | 493 |   | 338 |   | 1,209 |   | 43 |   |
| Real estate                                                                                | ** ** | **138**                                     |       | 183 |   | 497 |   | 132 |   | 22 |   |
| Consumer                                                                                   | ** ** | **86**                                      |       | 110 |   | 98 |   | 143 |   | 133 |   |
| ** **                                                                                 |       | **236**                                     |       | 786 |   | 933 |   | 1,484 |   | 198 |   |
| Recoveries:                                                                                |       |                                        |       |   |   |   |   |   |   |   |   |
| Commercial, financial, and agricultural                                                    | ** ** | **135**                                     |       | 228 |   | — |   | — |   | 1 |   |
| Real estate                                                                                | ** ** | **11**                                      |       | 4 |   | 1 |   | 18 |   | 1 |   |
| Consumer                                                                                   | ** ** | **33**                                      |       | 49 |   | 30 |   | 20 |   | 46 |   |
| ** **                                                                                 |       | **179**                                     |       | 281 |   | 31 |   | 38 |   | 48 |   |
|                                                                                       |       |                                        |       |   |   |   |   |   |   |   |   |
| Net charge-offs                                                                            | ** ** | **57**                                      |       | 505 |   | 902 |   | 1,446 |   | 150 |   |
| Additions charged to operations                                                            | ** ** | **150**                                     |       | 500 |   | 750 |   | 1,750 |   | 500 |   |
| Allowance purchased                                                                        | ** ** | **1,282**                                   |       | — |   | — |   | — |   | — |   |
| Balance at end of period                                                                   | ** ** | **$**                                       | **5,046**  |   | $ | 3,671 |   | $ | 3,676 |   | $ | 3,828 |   | $ | 3,524 |   |
|                                                                                       |       |                                        |       |   |   |   |   |   |   |   |   |
| Ratio of net charge-offs during the period  to average loans outstanding during the period |       | **.02**                                     | **%**      | .21 | % | .39 | % | .62 | % | .07 | % |
| Allowance for loan losses to average loans outstanding  during the period                  |       | **1.82**                                    | **%**      | 1.50 | % | 1.58 | % | 1.64 | % | 1.66 | % |

 

It is the policy ofmanagement and the Corporation’s Board of Directors to provide for losses onboth identified  and unidentified lossesinherent in its loan portfolio. A provision for loan losses is charged tooperations based upon an evaluation of the potential losses in the loanportfolio. This evaluation takes into account such factors  as portfolio concentrations, delinquency,trends, trends of non-accrual and classified loans, economic conditions, andother relevant factors.

 

The loan review processwhich is conducted quarterly, is an integral part of our evaluation of the loanportfolio. A detailed quarterly analysis to determine the adequacy of theCorporation’s allowance for loan losses is reviewed by our Board of Directors.

 

With our manageable level ofnet charge-offs and the additions to the reserve from our provision out ofoperations, the allowance for loan losses as a percentage of average loansamounted to 1.82% in 2007, 1.50% to 2006, and 1.58% in 2005.

 

Table 9 sets forth theallocation of the Bank’s allowance for loan losses by loan category and thepercentage of loans in each category to total loans receivable at the datesindicated. The portion of the allowance for loan losses allocated to each loancategory does not represent the total available for future losses that mayoccur within the loan category, since the total loan loss allowance is avaluation reserve applicable to the entire loan portfolio.

 

**Table 9 — Allocationof Allowance for Loan Losses**

 
| ** **                              | ** ** | **December 31,** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|
| **(Amounts in thousands)**    | ** ** | **2007**              | ** ** | **%*** | ** ** | **2006** | ** ** | **%*** | ** ** | **2005** | ** ** | **%*** | ** ** | **2004** | ** ** | **%*** | ** ** | **2003** | ** ** | **%*** | ** ** |
| Commercial, financial, and agricultural |       | **$**                 | **1,116**  | ** ** | **22.8** |   | $ | 674 |   | 19.7 |   | $ | 906 |   | 25.2 |   | $ | 858 |   | 14.3 |   | $ | 775 |   | 15.4 |   |
| Real estate - mortgage                  | ** ** | **3,680**             | ** ** | **75.1** |   | 2,613 |   | 76.1 |   | 2,521 |   | 70.2 |   | 2,594 |   | 77.1 |   | 2,106 |   | 72.6 |   |
| Consumer and other loans                | ** ** | **103**               | ** ** | **2.1** |   | 145 |   | 4.2 |   | 164 |   | 4.6 |   | 308 |   | 8.6 |   | 378 |   | 12.0 |   |
| Unallocated                             | ** ** | **147**               | ** ** | **N/A** |   | 239 |   | N/A |   | 85 |   | N/A |   | 68 |   | N/A |   | 265 |   | N/A |   |
| ** **                              | ** ** | **$**                 | **5,046**  | ** ** | **100.0** |   | $ | 3,671 |   | 100.0 |   | $ | 3,676 |   | 100.0 |   | $ | 3,828 |   | 100.0 |   | $ | 3,524 |   | 100.0 |   |

 

----

*Percentage of loans in each category to total loans.

 

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**NON-PERFORMING ASSETS**

 

Table 10 details theCorporation’s non-performing assets at the dates indicated.

 

Non-accrual loans aregenerally delinquent on which principal or interest is past-due approximately90 days or more, depending upon the type of credit and the collateral. When aloan is placed on non-accrual status, any unpaid interest is charged againstincome. Restructured loans are loans where the borrower has been granted aconcession in the interest rate or payment amount because of financialproblems. Foreclosed assets held for sale represents property acquired throughforeclosure, or considered to be an in-substance foreclosure.

 

The total of non-performingassets increased to $3,458,000 as of December 31, 2007, as compared to$2,880,000 as of December 31, 2006. Non-accrual and restructured loansincreased to $3,208,000 in 2007 from $1,704,000 in 2006. Foreclosed assetsincreased to $65,000 in 2007 from $41,000 in 2006. Loans past-due 90 days ormore and still accruing decreased to $185,000 in 2007 from $1,135,000 in 2006.During the fourth quarter of 2007, a borrower with two loans amounting to $1,758,000and secured by commercial real estate was placed on non-accrual. The loans arewell collateralized and repayment is expected from the sale of the commercialreal estate. A specific allocation for potential loss on the two loans securedby commercial real estate has been identified in our allowance for loan losses.Our allowance for loan losses to total non-performing assets increased to145.9% in 2007 from 127.5% in 2006. While asset quality is a priority, thecorporation continues to retain an independent outside loan review consultantto closely tract and monitor overall loan quality.

 

Improving loan quality is apriority, and we actively work with borrowers to resolve credit problems.Excluding the assets disclosed in Table 10, management is not aware of anyinformation about borrowers’ possible credit problems, which cause seriousdoubt as to their ability to comply with present loan repayment terms.

 

Should the economic climateno longer continue to be stable or begin to deteriorate, borrowers mayexperience difficulty, and the level of non-performing loans and assets,charge-offs and delinquencies could rise and possibly require additionalincreases in our allowance for loan losses.

 

In addition, regulatoryauthorities, as an integral part of their examinations, periodically review theallowance for possible loan and lease losses. They may require additions toallowances based upon their judgements about information available to them atthe time of examination.

 

Interest income received onnon-performing loans in 2007 and 2006 was $144,000 and $14,000, respectively.Interest income, which would have been recorded on these loans under theoriginal terms in 2007 and 2006 was $175,000 and $133,000, respectively. At December 31,2006, the Corporation had no outstanding commitments to advance additionalfunds with respect to these non-performing loans.

 

A concentration of creditexists when the total amount of loans to borrowers, who are engaged in similaractivities that are similarly impacted by economic or other conditions, exceed10% of total loans. As of December 31, 2007, 2006 and 2005, management isof the opinion that there were no loan concentrations exceeding 10% of totalloans.

 

**Table 10 — Non-PerformingAssets**

 
| ** **                                                       | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------|------------|-----------------------|------------|
| **(Amounts in thousands)**                             | ** ** | **2007**              | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Non-accrual and restructured loans                               | ** ** | **$**                 | **3,208**  |   | $ | 1,704 |   | $ | 2,069 |   | $ | 3,405 |   | $ | 735 |   |
| Foreclosed assets                                                | ** ** | **65**                |       | 41 |   | 397 |   | 6 |   | — |   |
| Loans past-due 90 days or more and still  accruing               | ** ** | **185**               |       | 1,135 |   | 64 |   | 69 |   | 33 |   |
| Total non-performing assets                                      | ** ** | **$**                 | **3,458**  |   | $ | 2,880 |   | $ | 2,530 |   | $ | 3,480 |   | $ | 768 |   |
|                                                             |       |                  |       |   |   |   |   |   |   |   |   |
| Non-performing assets to period-end loans  and foreclosed assets | ** ** | **0.92**              | **%**      | 1.14 | % | 1.08 | % | 1.49 | % | 0.34 | % |
| Total non-performing assets to total assets                      | ** ** | **0.51**              | **%**      | 0.55 | % | 0.49 | % | 0.70 | % | 0.16 | % |
| Total allowance for loan losses to total  non-performing assets  | ** ** | **145.9**             | **%**      | 127.5 | % | 145.3 | % | 110.0 | % | 458.9 | % |

 

24

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Realestate mortgages comprise 85.4% of the loan portfolio as of December 31,2007, up from 83.4% in 2006. Real estate mortgages consist of both residentialand commercial real estate loans. The real estate loan portfolio is welldiversified in terms of borrowers, collateral, interest rates, and maturities.Also, the real estate loan portfolio has a mix of both fixed rate andadjustable rate mortgages. The real estate loans are concentrated primarily inour marketing area and are subject to risks associated with the local economy.

 

**DEPOSITS AND OTHER BORROWED FUNDS**

 

Consumer and commercial retail deposits are attractedprimarily by First Keystone’s subsidiary bank’s fourteen full service officelocations. The Bank offers a broad selection of deposit products andcontinually evaluates its interest rates and fees on deposit products. The Bankregularly reviews competing financial institutions interest rates along withprevailing market rates, especially when establishing interest rates oncertificates of deposit.

 

Deposits increased by $109,021,000, or a 28.4%increase when comparing December 31, 2007 to December 31, 2006. Thisincrease compares to a deposit increase of 5.9% in 2006 and an increase of 1.4%in 2005. Much of the deposit increase in 2007 relates to the Pocono CommunityBank acquisition.

 

During 2007, the Corporation experienced a depositincrease in both non-interest bearing and interest bearing deposits.Non-interest bearing deposits amounted to $58,844,000 as of December 31,2007, an increase of $17,483,000 or 42.3% over 2006. Interest bearing depositsamounted to $434,197,000 as of December 31, 2007, an increase of$91,538,000, or 26.7% over 2006.

 

During 2007, the Corporation increased its reliance onborrowings. Short-term borrowings amounted to $47,349,000 as of year-end 2007,an increase of $19,170,000 from 2006. Long-term borrowings increased $8,640,000in 2007 to $66,175,000 as of December 31, 2007. Total borrowings were$113,524,000 as of December 31, 2007, compared to $85,714,000 on December 31,2006. Short-term borrowings are comprised of federal funds purchased,securities sold under agreements to repurchase, U.S. Treasury demand notes, andshort-term borrowings from the Federal Home Loan Bank (FHLB).

 

Long-term borrowings are typically FHLB termborrowings with a maturity of one year or more. Short-term borrowings from theFederal Home Loan Bank are commonly used to offset seasonal fluctuations indeposits. In connection with FHLB borrowings and securities sold underagreements to repurchase, the Corporation maintains certain eligible assets ascollateral.

 

**CAPITAL STRENGTH**

 

Normal increases in capital are generated by netincome, less cash dividends paid out. Also, the net unrealized gains or losseson investment securities available-for-sale, net of taxes, referred to asaccumulated other comprehensive income may increase or decrease total equitycapital. The total net increase in capital was $17,537,000 in 2007 after anincrease of $56,000 in 2006. Much of the increase in equity capital in 2007relates to the Pocono Community Bank acquisition. The accumulated othercomprehensive income amounted to $(166,000) in 2007 and $(126,000) in 2006. Onefactor which also decreased total equity capital in 2007 and 2006 relates tostock repurchase. The Corporation had 247,691 shares of common stock as of December 31,2007, and 228,900 shares in 2006, at a cost of $6,242,000 and $5,910,000,respectively as treasury stock.

 

Return on equity (ROE) is computed by dividing netincome by average stockholders’ equity. This ratio was 10.48% for 2007, 11.76% for 2006, and 12.65% for 2005.Refer to Performance Ratios on page 14 — Selected Financial Data for amore expanded listing of the ROE.

 

Adequate capitalization of banks and bank holdingcompanies is required and monitored by regulatory authorities. Table 11reflects risk-based capital ratios and the leverage ratio for our Corporationand Bank. The Corporation’s leverage ratio was 7.96% at December 31, 2007,and 9.94% at December 31, 2006.

 

The Corporation has consistently maintained regulatorycapital ratios at or above the “well capitalized” standards. For additionalinformation on capital ratios, see page 26 - Corporations Capital Ratiosor Table 11 — Capital Ratios. The risk-based capital ratios for both theCorporation and the Bank, remained very strong. The risk-based capitalcalculation assigns various levels of risk to different categories of bankassets, requiring higher levels of capital for assets with more risk. Alsomeasured in the risk-based capital ratio is credit risk exposure associatedwith off-balance sheet contracts and commitments.

 

25

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**Table 11  —  Capital Ratios**

 
| ** **                                         | ** ** | **December 31, 2007** | ** ** | **December 31, 2006** | ** ** |
|----------------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                         | ** ** | **Corporation**                 | ** ** | **Bank**                        | ** ** | **Corporation** | ** ** | **Bank** | ** ** |
|                                               |       |                            |       |                            |       |   |   |   |   |
| Risk-Based Capital:                                |       |                            |       |                            |       |   |   |   |   |
| Tier I risk-based capital ratio                    | ** ** | **11.86**                       | **%**      | **13.10**                       | **%**      | 17.45 | % | 16.17 | % |
| Total risk-based capital ratio (Tier 1 and Tier 2) | ** ** | **13.06**                       | **%**      | **14.28**                       | **%**      | 18.82 | % | 17.41 | % |
| Leverage Ratio:                                    |       |                            |       |                            | ** ** |   |   |   |   |
| Tier I capital to average assets                   | ** ** | **7.96**                        | **%**      | **9.00**                        | **%**      | 9.94 | % | 9.19 | % |

 

**LIQUIDITY MANAGEMENT**

 

Effective liquidity management ensures that the cashflow requirements of depositors and borrowers, as well as the operating cashneeds of the Corporation, are met.

 

Liquidity is needed to provide the fundingrequirements of depositors withdrawals, loan growth, and other operationalneeds. Asset liquidity is provided by investment securities maturing in oneyear or less, other short-term investments, federal funds sold, and cash anddue from banks. At year-end 2007, cash and due from banks and interest-bearingdeposits in other banks totaled $9,975,000 as compared to $10,188,000 atyear-end 2006. Additionally, maturing loans and repayment of loans are anothersource of asset liquidity.

 

Liability liquidity is accomplished by maintaining acore deposit base, acquired by attracting new deposits and retaining maturingdeposits.  Also, short-term borrowingsprovide funds to meet liquidity.

 

Management feels its current liquidity position issatisfactory given the fact that the Corporation has a very stable core depositbase which has increased annually. Secondly, our loan payments and principalpaydowns on our mortgage backed securities provide a steady source of funds.Also, short-term investments and maturing investments represent additionalsources of liquidity.

 

Finally, the Corporation’s subsidiary bank does haveaccess to funds on a short-term basis from the Federal Reserve Bank discountwindow. Also, Fed funds can be purchased by means of a borrowing line at theAtlantic Central Bankers Bank. The Corporation has indirect access to thecapital markets through its membership in the Federal Home Loan Bank. Advanceson borrowings, both short-term and long-term, are available to help address anyliquidity needs.

 

**FORWARD LOOKING STATEMENTS**

 

The sections that follow, Market Risk andAsset/Liability Management contain certain forward looking statements. Theseforward looking statements involve significant risks and uncertainties,including changes in economic and financial market conditions.  Although First Keystone Corporation believesthat the expectations reflected in such forward looking statements arereasonable, actual results may differ materially.

 

**MARKET RISK**

 

Market risk is the risk of loss arising from adversechanges in the fair value of financial instruments due to changes in interestrates, exchange rates and equity prices. First Keystone Corporation’s market risk is composed primarily ofinterest rate risk. The Corporation’s interest rate risk results from timingdifferences in the repricing of assets, liabilities, off-balance sheetinstruments, and changes in relationships between ratio indices and thepotential exercise of explicit or embedded options.

 

Increases in the level of interest rates also mayadversely affect the fair value of the Corporation’s securities and otherearning assets. Generally, the fair value of fixed-rate instruments fluctuatesinversely with changes in interest rates. As a result, increases in interestrates could result in decreases in the fair value of the Corporation’sinterest-earning assets, which could adversely affect the Corporation’s resultsof operations if sold, or, in the case of interest earning assets classified asavailable for sale, the Corporation’s stockholders’ equity, if retained. UnderThe Financial Accounting Standards Board (FASB) Statement 115, changes in theunrealized gains and losses, net of taxes, on securities classified asavailable for sale will be reflected in the Corporation’s stockholders’ equity.The Corporation does not own any trading assets.

 

26

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***Asset/LiabilityManagement***

 

The principal objective of asset liability managementis to manage the sensitivity of the net interest margin to potential movementsin interest rates and to enhance profitability through returns from managedlevels of interest rate risk. The Corporation actively manages the interestrate sensitivity of its assets and liabilities. Table 12 presents an interest sensitivityanalysis of assets and liabilities as of December 31, 2007. Severaltechniques are used for measuring interest rate sensitivity. Interest rate riskarises from the mismatches in the repricing of assets and liabilities within agiven time period, referred to as a rate sensitivity gap. If more assets thanliabilities mature or reprice within the time frame, the Corporation is assetsensitive. This position would contribute positively to net interest income ina rising rate environment. Conversely, if more liabilities mature or reprice,the Corporation is liability sensitive. This position would contributepositively to net interest income in a falling rate environment.

 

Limitations of interest rate sensitivity gap analysisas illustrated in Table 12 include:  a)assets and liabilities which contractually reprice within the same period maynot, in fact, reprice at the same time or to the same extent; b) changes inmarket interest rates do not affect all assets and liabilities to the sameextent or at the same time, and c) interest rate sensitivity gaps reflect theCorporation’s position on a single day (December 31, 2007 in the case ofthe following schedule) while the Corporation continually adjusts its interestsensitivity throughout the year. The Corporation’s cumulative gap at one yearindicates the Corporation is liability sensitive.

 

**Table 12  —  Interest Rate Sensitivity Analysis**

 
| ** **                      | ** ** | **December 31, 2007** | ** **  |
|---------------------------------|------------|---------------------------------|-------------|
| ** **                      | ** ** | **One**                         | ** **  | **1 - 5** | ** ** | **Beyond** | ** ** | **Not Rate** | ** ** | ** ** | ** ** |
| **(Amounts in thousands)**      | ** ** | **Year**                        | ** **  | **Years** | ** ** | **5 Years** | ** ** | **Sensitive** | ** ** | **Total** | ** ** |
|                            | ** ** | ** **                      | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Assets                          | ** ** | **$**                           | **238,206** | ** ** | **$** | **211,253** | ** ** | **$** | **180,738** | ** ** | **$** | **51,010** | ** ** | **$** | **681,207** | ** ** |
|                            |       |                            |        |   |   |   |   |   |   |   |   |
| Liabilities/Stockholders Equity | ** ** | **266,204**                     | ** **  | **248,617** | ** ** | **92,304** | ** ** | **74,082** | ** ** | **681,207** | ** ** |
|                            |       |                            |        |   |   |   |   |   |   |   |   |
| Interest Rate Sensitivity Gap   | ** ** | **(27,998**                     | **)**       | **(37,364** | **)** | **88,434** | ** ** | **(23,072** | ) |   |   |
|                            |       |                            |        |   |   |   |   |   |   |   |   |
| Cumulative Gap                  | ** ** | **(27,998**                     | **)**       | **(65,362** | **)** | **23,072** |   |   |   |   |   |
|                                 |            |                                 |             |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Earnings at Risk***

 

The Bank’s Asset/Liability Committee (ALCO) isresponsible for reviewing the interest rate sensitivity position andestablishing policies to monitor and limit exposure to interest rate risk. Theguidelines established by ALCO are reviewed by the Corporation’s Board ofDirectors. The Corporation recognizes that more sophisticated tools exist formeasuring the interest rate risk in the balance sheet beyond interest ratesensitivity gap. Although the Corporation continues to measure its interestrate sensitivity gap, the Corporation utilizes additional modeling for interestrate risk in the overall balance sheet. Earnings at risk and economic values atrisk are analyzed.

 

Earnings simulation modeling addresses earnings atrisk and net present value estimation addresses economic value at risk. Whileeach of these interest rate risk measurements has limitations, taken togetherthey represent a reasonably comprehensive view of the magnitude of interestrate risk in the Corporation.

 

***Earnings SimulationModeling***

 

The Corporation’s net income is affected by changes inthe level of interest rates.  Net incomeis also subject to changes in the shape of the yield curve.  For example, a flattening of the yield curvewould result in a decline in earnings due to the compression of earning assetyields and increased liability rates, while a steepening would result inincreased earnings as earning asset yields widen.

 

27

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Earnings simulation modeling is the primary mechanismused in assessing the impact of changes in interest rates on net interestincome. The model reflects management’s assumptions related to asset yields andrates paid on liabilities, deposit sensitivity, size and composition of thebalance sheet. The assumptions are based on what management believes at thattime to be the most likely interest rate environment. Earnings at risk is thechange in net interest income from a base case scenario under an increase anddecrease of 200 basis points in the interest rate earnings simulation model.

 

Table 13 presents an analysis of the changes innet-interest income and net present value of the balance sheet resulting froman increase or decrease of two percentage points (200 basis points) in thelevel of interest rates. The calculated estimates of change in net interestincome and net present value of the balance sheet are compared to currentlimits approved by ALCO and the Board of Directors. The earnings simulationmodel projects net-interest income would decrease by approximately 6.5% ifrates fell by two percentage points over one year. The model projects adecrease of approximately 15.0% in net-interest income if rates rise by twopercentage points over one year. Both of these forecasts are within the oneyear policy guidelines.

 

***Net Present ValueEstimation***

 

The net present value measures economic value at riskand is used for helping to determine levels of risk at a point in time presentin the balance sheet that might not be taken into account in the earningssimulation model. The net present value of the balance sheet is defined as thediscounted present value of asset cash flows minus the discounted present valueof liability cash flows. At year-end 2007, a 200 basis point immediate decreasein rates is estimated to increase net present value by 6.0%. Additionally, netpresent value is projected to decrease by 46.0% if rates increase immediatelyby 200 basis points. The +2% scenario slightly exceeds policy limits of 40%.

 

The computation of the effects of hypotheticalinterest rate changes are based on many assumptions. They should not be reliedupon solely as being indicative of actual results, since the computations donot contemplate actions management could undertake in response to changes ininterest rates.

 

**Table 13  —  Effect of Change in Interest Rates**

 
| ** **                                       | ** ** | **Projected Change** | ** ** |
|--------------------------------------------------|------------|---------------------------|------------|
| **Effect on Net Interest Income**                |       |                      |       |
| 1-year Net Income simulation Projection          |       |                      |       |
| –200 bp Shock vs Stable Rate                |       | (6.5                      | )%         |
| +200 bp Shock vs Stable Rate                     |       | (15.0                     | )%         |
|                                             |       |                      |       |
| **Effect on Net Present Value of Balance Sheet** |       |                      |       |
| Static Net Present Value Change                  |       |                      |       |
| –200 bp Shock vs Stable Rate                |       | 6.0                       | %          |
| +200 bp Shock vs Stable Rate                     |       | (46.0                     | )%         |

 

**MARKETPRICE/DIVIDEND HISTORY**

 

As of December 31, 2007, the corporation had5,440,076 shares of $2.00 par value common stock outstanding held byshareholders of record. First Keystone Corporation’s common stock is quoted onthe Over The Counter (OTC) Bulletin Board under the symbol “FKYS.OB”.

 

Table 14 reports the highest and lowest per shareprices known to the Corporation and the dividends paid during the periodsindicated. The market prices and dividend paid have been adjusted to reflect a5% stock dividend paid December 5, 2006. These prices do not necessarilyreflect any dealer or retail markup, markdown or commission.

 

28

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**Table 14  — Market Price/Dividend History**

 
| ** **     | ** ** | **2007**              | ** ** | **2006**      | ** ** | **2005**              | ** **    |
|----------------|------------|-----------------------|------------|---------------|------------|-----------------------|---------------|
| ** **     | ** ** | **Common Stock** | ** ** | **Dividends** | ** ** | **Common Stock** | ** **    | **Dividends** | ** ** | **Common Stock** | ** ** | **Dividends** | ** ** |
| ** **     | ** ** | **High/Low**          | ** ** | **Paid**      | ** ** | **High/Low**          | ** **    | **Paid** | ** ** | **High/Low** | ** ** | **Paid** | ** ** |
| First Quarter  | ** ** | **$19.00/$17.50**     | ** ** | **$**         | **.22**    |                  | $19.91/$18.57 |   | $ | .21 |   | $22.76/$20.48 |   | $ | .19 |   |
| Second Quarter | ** ** | **$21.75/$17.90**     | ** ** | **.22**       |       | $19.05/$17.43         |          | .21 |   | $20.95/$18.81 |   | .19 |   |
| Third Quarter  | ** ** | **$19.25/$17.00**     | ** ** | **.22**       |       | $19.33/$16.81         |          | .21 |   | $21.67/$19.14 |   | .19 |   |
| Fourth Quarter | ** ** | **$18.25/$15.80**     | ** ** | **.22**       |       | $19.20/$17.29         |          | .22 |   | $20.81/$19.05 |   | .21 |   |
|                |            |                       |            |               |            |                       |               |  |  |  |  |  |  |  |  |  |

 

**Table 15  — Quarterly Results of Operations (Unaudited)**

 

*(Amounts inthousands, except per share)*

 
| ** **                 | ** ** | **Three Months Ended** | ** ** |
|----------------------------|------------|----------------------------------|------------|
| **2007**                   | ** ** | **March 31**                | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
|                       |       |                             |       |   |   |   |   |   |   |
| Interest income            | ** ** | **$**                            | **7,407**  | ** ** | **$** | **7,550** | ** ** | **$** | **7,830** | ** ** | **$** | **9,113** | ** ** |
| Interest expense           | ** ** | **4,086**                        | ** ** | **4,175** | ** ** | **4,469** | ** ** | **5,056** | ** ** |
| Net interest income        | ** ** | **$**                            | **3,321**  | ** ** | **$** | **3,375** | ** ** | **$** | **3,361** | ** ** | **$** | **4,057** | ** ** |
| Provision for loan losses  | ** ** | **50**                           | ** ** | **75** | ** ** | **25** | ** ** | **0** | ** ** |
| Other non-interest income  | ** ** | **953**                          | ** ** | **1,042** | ** ** | **973** | ** ** | **1,201** | ** ** |
| Non-interest expense       | ** ** | **2,491**                        | ** ** | **2,669** | ** ** | **2,430** | ** ** | **3,025** | ** ** |
| Income before income taxes | ** ** | **$**                            | **1,733**  | ** ** | **$** | **1,673** | ** ** | **$** | **1,879** | ** ** | **$** | **2,233** | ** ** |
| Income taxes               | ** ** | **299**                          | ** ** | **289** | ** ** | **338** | ** ** | **465** | ** ** |
| Net income                 | ** ** | **$**                            | **1,434**  | ** ** | **$** | **1,384** | ** ** | **$** | **1,541** | ** ** | **$** | **1,768** | ** ** |
|                       |       |                             |       |   |   |   |   |   |   |
| Per share                  | ** ** | **$**                            | **.32**    | ** ** | **$** | **.30** | ** ** | **$** | **.34** | ** ** | **$** | **.35** | ** ** |

 
| **2006**                   | ** ** | **March 31** | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
|----------------------------|------------|-------------------|------------|------------------|------------|-----------------------|------------|----------------------|------------|
|                       |       |              |       |             |       |                  |       |                 |       |
| Interest income            |       | $                 | 6,858      |             | $          | 7,051                 |       | $                    | 7,236      |   | $ | 7,432 |   |
| Interest expense           |       | 3,343             |       | 3,626            |       | 3,910                 |       | 4,093                |       |
| Net interest income        |       | $                 | 3,515      |             | $          | 3,425                 |       | $                    | 3,326      |   | $ | 3,339 |   |
| Provision for loan losses  |       | 100               |       | 200              |       | 100                   |       | 100                  |       |
| Other non-interest income  |       | 867               |       | 901              |       | 952                   |       | 1,068                |       |
| Non-interest expense       |       | 2,432             |       | 2,423            |       | 2,380                 |       | 2,280                |       |
| Income before income taxes |       | $                 | 1,850      |             | $          | 1,703                 |       | $                    | 1,798      |   | $ | 2,027 |   |
| Income taxes               |       | 284               |       | 244              |       | 295                   |       | 365                  |       |
| Net income                 |       | $                 | 1,566      |             | $          | 1,459                 |       | $                    | 1,503      |   | $ | 1,662 |   |
|                       |       |              |       |             |       |                  |       |                 |       |
| Per share                  |       | $                 | .34        |             | $          | .31                   |       | $                    | .33        |   | $ | .36 |   |

 

ITEM 7A.     QUANTITATIVE AND QUALITATIVE DISCLOSUREABOUT MARKET RISK

 

Information with respect to quantitative andqualitative disclosures about market risk is included in the information underManagement’s Discussion and Analysis in Item 7 hereof.

 

29

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ITEM 8.       FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

BOARD OF DIRECTORS AND STOCKHOLDERS OF FIRST KEYSTONECORPORATION:

 

We have audited the accompanying consolidated balancesheets of First Keystone Corporation and Subsidiary as of December 31,2007 and 2006, and the related consolidated statements of income, changes instockholders’ equity, and cash flows for each of the years in the three-yearperiod ended December 31, 2007. These consolidated financial statements are the responsibility of theCorporation’s management.  Ourresponsibility is to express an opinion on these consolidated financialstatements based on our audits.

 

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the consolidated financial statements are free ofmaterial misstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe consolidated financial statements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallconsolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the consolidatedfinancial position of First Keystone Corporation and Subsidiary as of December 31,2007 and 2006, and the consolidated results of their operations and their cashflows for each of the years in the three-year period ended December 31,2007, in conformity with accounting principles generally accepted in the UnitedStates of America.

 

As discussed in Note 1 to the consolidated financialstatements, the Corporation changed its method of accounting for endorsementsplit-dollar life insurance arrangements in accordance with the Emerging IssuesTask Force (EITF) Issue No. 06-4 “Accounting for Deferred Compensation andPostretirement Benefits Aspects of Endorsement Split-Dollar Life InsuranceArrangements” as of January 1, 2007.

 

We have also audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States) theeffectiveness of First Keystone Corporation and Subsidiary’s internal controlover financial reporting as of December 31, 2007, based on criteriaestablished in *Internal Control-IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (the COSO criteria) and our report dated March 11,2008, expressed an unqualified opinion thereon.

 

 
|                    | /s/ J. H.  Williams & Co., LLP |
|-------------------------|-----------------------------------------|
|                    | J. H.  Williams & Co., LLP     |
|                    |                                    |
|                    |                                    |
| Kingston,  Pennsylvania |                                    |
| March 11,  2008    |                                    |

 

30

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**FIRST KEYSTONE CORPORATION ANDSUBSIDIARY**

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                                             | ** ** | **December 31,** | ** **  |
|------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|-------------|
| **(Amounts in thousands)**                                                                                   | ** ** | **2007**              | ** **  | **2006** | ** ** |
|                                                                                                                   |       |                  |        |   |   |
| **ASSETS**                                                                                                             |       |                  |        |   |   |
|                                                                                                                   |       |                  |        |   |   |
| Cash and due from banks                                                                                                | ** ** | **$**                 | **9,886**   |   | $ | 5,881 |   |
| Interest-bearing deposits in other banks                                                                               | ** ** | **89**                |        | 4,307 |   |
| Investment securities available-for-sale                                                                               | ** ** | **241,521**           |        | 237,009 |   |
| Investment securities held-to-maturity (estimated fair value 2007 -  $4,553; 2006 - $6,908)                            |       | **4,538**             |        | 6,929 |   |
| Loans, net of unearned income                                                                                          | ** ** | **376,603**           |        | 251,757 |   |
| Allowance for loan losses                                                                                              | ** ** | **(5,046**            | **)**       | (3,671 | ) |
| Net loans                                                                                                              | ** ** | **$**                 | **371,557** |   | $ | 248,086 |   |
| Premises and equipment, net                                                                                            | ** ** | **8,486**             |        | 5,016 |   |
| Accrued interest receivable                                                                                            | ** ** | **3,241**             |        | 2,686 |   |
| Cash surrender value of bank owned life insurance                                                                      | ** ** | **16,450**            |        | 11,942 |   |
| Goodwill                                                                                                               | ** ** | **18,981**            |        | 1,224 |   |
| Other assets                                                                                                           | ** ** | **6,458**             |        | 2,840 |   |
| **TOTAL ASSETS**                                                                                                       | ** ** | **$**                 | **681,207** |   | $ | 525,920 |   |
|                                                                                                                   |       |                  |        |   |   |
| **LIABILITIES**                                                                                                        |       |                  |        |   |   |
|                                                                                                                   |       |                  |        |   |   |
| Deposits:                                                                                                              |       |                  |        |   |   |
| Non-interest bearing                                                                                                   | ** ** | **$**                 | **58,844**  |   | $ | 41,361 |   |
| Interest bearing                                                                                                       | ** ** | **434,197**           |        | 342,659 |   |
| Total Deposits                                                                                                         | ** ** | **493,041**           |        | 384,020 |   |
| Short-term borrowings                                                                                                  | ** ** | **47,349**            |        | 28,179 |   |
| Long-term borrowings                                                                                                   | ** ** | **66,175**            |        | 57,535 |   |
| Accrued interest and other expenses                                                                                    | ** ** | **3,454**             |        | 2,581 |   |
| Other liabilities                                                                                                      | ** ** | **264**               |        | 218 |   |
| **TOTAL LIABILITIES**                                                                                                  | ** ** | **$**                 | **610,283** |   | $ | 472,533 |   |
|                                                                                                                   |       |                  |        |   |   |
| **STOCKHOLDERS’ EQUITY**                                                                                          |       |                  |        |   |   |
|                                                                                                                   |       |                  |        |   |   |
| Preferred stock, par value $10.00 per share; authorized and unissued  500,000 shares                                   |       | **$**                 | —      |   | $ | — |   |
| Common stock, par value $2.00 per share; authorized 10,000,000 shares;  issued 5,687,767 in 2007 and 4,755,564 in 2006 |       | **11,375**            |        | 9,511 |   |
| Surplus                                                                                                                | ** ** | **30,252**            |        | 16,119 |   |
| Retained earnings                                                                                                      | ** ** | **35,705**            |        | 33,793 |   |
| Accumulated other comprehensive (loss)                                                                                 | ** ** | **(166**              | **)**       | (126 | ) |
| Treasury stock, at cost, 247,691 shares in 2007 and 228,900 shares in  2006                                            | ** ** | **(6,242**            | **)**       | (5,910 | ) |
|                                                                                                                   |       |                  |        |   |   |
| **TOTAL STOCKHOLDERS’ EQUITY**                                                                                    | ** ** | **$**                 | **70,924**  |   | $ | 53,387 |   |
|                                                                                                                   |       |                  |        |   |   |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                    | ** ** | **$**                 | **681,207** |   | $ | 525,920 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**CONSOLIDATEDSTATEMENTS OF INCOME**

 
| ** **                                                                      | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| **(Amounts in thousands, except per share data)** | ** ** | **2007**                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                            |       |                                       |       |   |   |   |   |
| **INTEREST INCOME**                                                             |       |                                       |       |   |   |   |   |
| Interest and fees on loans                                                      | ** ** | **$**                                      | **19,049** |   | $ | 16,484 |   | $ | 14,834 |   |
| Interest and dividends on investment securities:                                |       |                                       |       |   |   |   |   |
| Taxable                                                                         | ** ** | **9,484**                                  |       | 8,104 |   | 7,424 |   |
| Tax-exempt                                                                      | ** ** | **2,860**                                  |       | 3,574 |   | 3,857 |   |
| Dividends                                                                       | ** ** | **409**                                    |       | 384 |   | 213 |   |
| Deposits in banks                                                               | ** ** | **66**                                     |       | 31 |   | 51 |   |
| Federal funds sold                                                              | ** ** | **31**                                     |       | — |   | 3 |   |
| **Total interest income**                                                       | ** ** | **$**                                      | **31,899** |   | $ | 28,577 |   | $ | 26,382 |   |
|                                                                            |       |                                       |       |   |   |   |   |
| **INTEREST EXPENSE**                                                            |       |                                       |       |   |   |   |   |
| Deposits                                                                        | ** ** | **$**                                      | **13,557** |   | $ | 11,184 |   | $ | 8,105 |   |
| Short-term borrowings                                                           | ** ** | **1,327**                                  |       | 893 |   | 499 |   |
| Long-term borrowings                                                            | ** ** | **2,901**                                  |       | 2,895 |   | 3,017 |   |
| **Total interest expense**                                                      | ** ** | **$**                                      | **17,785** |   | $ | 14,972 |   | $ | 11,621 |   |
| Net interest income                                                             | ** ** | **$**                                      | **14,114** |   | $ | 13,605 |   | $ | 14,761 |   |
| Provision for loan losses                                                       | ** ** | **150**                                    |       | 500 |   | 750 |   |
| **Net interest income after provision for loan  losses**                        | ** ** | **$**                                      | **13,964** |   | $ | 13,105 |   | $ | 14,011 |   |
|                                                                            |       |                                       |       |   |   |   |   |
| **NON-INTEREST INCOME**                                                         |       |                                       |       |   |   |   |   |
| Trust department                                                                | ** ** | **$**                                      | **581**    |   | $ | 507 |   | $ | 477 |   |
| Service charges and fees                                                        | ** ** | **2,183**                                  |       | 2,149 |   | 2,163 |   |
| Bank owned life insurance income                                                | ** ** | **558**                                    |       | 472 |   | 437 |   |
| Gain on sale of loans                                                           | ** ** | **89**                                     |       | 39 |   | 63 |   |
| Investment securities gains (losses) - net                                      | ** ** | **483**                                    |       | 381 |   | 420 |   |
| Other                                                                           | ** ** | **305**                                    |       | 240 |   | 222 |   |
| **Total non-interest income**                                                   | ** ** | **$**                                      | **4,199**  |   | $ | 3,788 |   | $ | 3,782 |   |
|                                                                            |       |                                       |       |   |   |   |   |
| **NON-INTEREST EXPENSE**                                                        |       |                                       |       |   |   |   |   |
| Salaries and employee benefits                                                  | ** ** | **$**                                      | **5,576**  |   | $ | 5,185 |   | $ | 5,074 |   |
| Occupancy, net                                                                  | ** ** | **758**                                    |       | 608 |   | 578 |   |
| Furniture and equipment                                                         | ** ** | **764**                                    |       | 751 |   | 684 |   |
| Professional services                                                           | ** ** | **443**                                    |       | 402 |   | 407 |   |
| State shares tax                                                                | ** ** | **572**                                    |       | 520 |   | 482 |   |
| Other                                                                           | ** ** | **2,532**                                  |       | 2,049 |   | 2,358 |   |
| **Total non-interest expense**                                                  | ** ** | **$**                                      | **10,645** |   | $ | 9,515 |   | $ | 9,583 |   |
|                                                                            |       |                                       |       |   |   |   |   |
| **Income before income taxes**                                                  | ** ** | **$**                                      | **7,518**  |   | $ | 7,378 |   | $ | 8,210 |   |
| **Income tax expense**                                                          | ** ** | **1,391**                                  |       | 1,188 |   | 1,363 |   |
| **NET INCOME**                                                                  | ** ** | **$**                                      | **6,127**  |   | $ | 6,190 |   | $ | 6,847 |   |
|                                                                            |       |                                       |       |   |   |   |   |
| **PER SHARE DATA**                                                              |       |                                       |       |   |   |   |   |
| Net income per share:*                                                          |       |                                       |       |   |   |   |   |
| Basic                                                                           | ** ** | **$**                                      | **1.31**   |   | $ | 1.35 |   | $ | 1.48 |   |
| Diluted                                                                         | ** ** | **$**                                      | **1.31**   |   | $ | 1.35 |   | $ | 1.48 |   |
| Cash dividends per share*                                                       | ** ** | **$**                                      | **.88**    |   | $ | .85 |   | $ | .78 |   |

 

----

*Adjusted for a5% stock dividend declared October 24, 2006, to shareholders of record November 14,2006, distributed December 5, 2006.

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

32

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**CONSOLIDATEDSTATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY**

 
| ** **                                                                                                                                               | ** ** | ** ** | ** ** | ** **  | ** ** | ** **        | ** ** | ** **   | ** ** | **Accumulated**        | ** ** | ** **   | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|-------------|------------|-------------------|------------|--------------|------------|------------------------|------------|--------------|------------|------------|------------|
| ** **                                                                                                                                               | ** ** | ** ** | ** ** | ** **  | ** ** | ** **        | ** ** | ** **   | ** ** | **Other**              | ** ** | ** **   | ** ** | ** ** | ** ** |
| ** **                                                                                                                                               | ** ** | **Common** | ** ** | ** **  | ** ** | **Comprehensive** | ** ** | **Retained** | ** ** | **Comprehensive**      | ** ** | **Treasury** | ** ** | ** ** | ** ** |
| **(Amounts in thousands)**                                                                                                                     | ** ** | **Stock**  | ** ** | **Surplus** | ** ** | **Income**        | ** ** | **Earnings** | ** ** | **Income (Loss)** | ** ** | **Stock**    | ** ** | **Total**  | ** ** |
| *Balance At December 31, 2004*                                                                                                                      |       | $          | 9,079      |        | $          | 12,505            |       |         |       | $                      | 32,469     |         | $          | 3,767      |       | $ | (4,508 | ) | $ | 53,312 |   |
| Comprehensive Income:                                                                                                                                    |       |       |       |        |       |              |       |         |       |                   |       |         |       |       |       |
| Net income                                                                                                                                               |       |       |       |        |       | $                 | 6,847      |         | 6,847      |                   |       |         |       |       | 6,847      |   |
| Change in net unrealized (loss) on investment  securities available-for-  sale, net of reclassification  adjustment and tax effects       |       |       |       |        |       | (2,960            | )          |         |       | (2,960                 | )          |         |       | (2,960     | )          |
| Total comprehensive income                                                                                                                               |       |       |       |        |       | $                 | 3,887      |         |       |                   |       |         |       |       |       |   |
| Purchase of 11,571 shares of treasury stock                                                                                                              |       |       |       |        |       |              |       |         |       |                   |       | (247         | )          | (247       | )          |
| Issuance of 6,211 shares of treasury stock upon exercise  of employee stock options                                                                 |       |       |       | (116        | )          |              |       |         |       |                   |       | 211          |       | 95         |       |
| Stock option forfeitures in excess of stock option expense                                                                                               |       |       |       | (2          | )          |              |       |         |       |                   |       |         |       | (2         | )          |
| Cash dividends - $.78 per share                                                                                                                          |       |       |       |        |       |              |       | (3,602       | )          |                   |       |         |       | (3,602     | )          |
| *Balance At December 31, 2005*                                                                                                                      |       | $          | 9,079      |        | $          | 12,387            |       |         |       | $                      | 35,714     |         | $          | 807        |       | $ | (4,544 | ) | $ | 53,443 |   |
| Comprehensive Income:                                                                                                                                    |       |       |       |        |       |              |       |         |       |                   |       |         |       |       |       |
| Net income                                                                                                                                               |       |       |       |        |       | $                 | 6,190      |         | 6,190      |                   |       |         |       |       | 6,190      |   |
| Change in net unrealized (loss) on investment   securities available-for-  sale, net of reclassification  adjustment and tax effects |       |       |       |        |       | (933              | )          |         |       | (933                   | )          |         |       | (933       | )          |
| Total comprehensive income                                                                                                                               |       |       |       |        |       | $                 | 5,257      |         |       |                   |       |         |       |       |       |   |
| Purchase of 79,691 shares of treasury stock                                                                                                              |       |       |       |        |       |              |       |         |       |                   |       | (1,514       | )          | (1,514     | )          |
| Issuance of 4,415 shares of treasury stock upon exercise  of employee stock options                                                                 |       |       |       | (77         | )          |              |       |         |       |                   |       | 148          |       | 71         |       |
| 5% stock dividend                                                                                                                                        |       | 432        |       | 3,801       |       |              |       | (4,233       | )          |                   |       |         |       | 0          |       |
| Cash paid in lieu of fractional shares                                                                                                                   |       |       |       |        |       |              |       | (4           | )          |                   |       |         |       | (4         | )          |
| Recognition of stock option expense                                                                                                                      |       |       |       | 8           |       |              |       |         |       |                   |       |         |       | 8          |       |
| Cash dividends - $.85 per share                                                                                                                          |       |       |       |        |       |              |       | (3,874       | )          |                   |       |         |       | (3,874     | )          |
| *Balance At December 31, 2006*                                                                                                                      |       | $          | 9,511      |        | $          | 16,119            |       |         |       | $                      | 33,793     |         | $          | (126       | )          | $ | (5,910 | ) | $ | 53,387 |   |
| Comprehensive Income:                                                                                                                                    |       |       |       |        |       |              |       |         |       |                   |       |         |       |       |       |
| Net Income                                                                                                                                               | ** ** | ** ** | ** ** | ** **  | ** ** | **$**             | **6,127**  | ** **   | **6,127**  |                   |       |         |       |       | **6,127**  |   |
| Change in net unrealized (loss) on investment  securities available-for-  sale, net of reclassification  adjustment and tax effects       |       |       |       |        |       | **(40**           | **)**      |         |       | **(40**                | **)**      |         |       | **(40**    | )          |
| Total comprehensive income                                                                                                                               | ** ** | ** ** |       |        |       | **$**             | **6,087**  |         |       |                   |       |         |       |       |       |   |
| Purchase of 18,791 shares of treasury stock                                                                                                              |       |       |       |        |       |              |       |         |       |                   |       | **(332**     | **)**      | **(332**   | )          |
| Issuance of 932,203 shares pursuant to acquisition                                                                                                       |       | **1,864**  | ** ** | **14,132**  | ** ** | ** **        |       |         |       |                   |       |         |       | **15,996** |       |
| Cumulative effect of change in accounting for deferred  compensation endorsement  split-dollar life insurance  arrangements               |       |       |       |        |       |              |       | **(36**      | **)**      |                   |       |         |       | **(36**    | **)**      |
| Recognition of stock option expense                                                                                                                      | ** ** | ** ** | ** ** | **1**       |       |              |       |         |       |                   |       |         |       | **1**      |       |
| Cash dividends - $.88 per share                                                                                                                          | ** ** | ** ** | ** ** | ** **  |       |              |       | **(4,179**   | **)**      |                   |       |         |       | **(4,179** | **)**      |
|                                                                                                                                                     |       |       |       |        |       |              |       |         |       |                   |       |         |       |       |       |
| ***Balance at December 31, 2007***                                                                                                                  | ** ** | **$**      | **11,375** | ** **  | **$**      | **30,252**        | ** ** | ** **   | ** ** | **$**                  | **35,705** | ** **   | **$**      | **(166**   | **)**      | **$** | **(6,242** | **)** | **$** | **70,924** |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
| ** **                                                                            | ** ** | **Year Ended December 31,** | ** **  |
|---------------------------------------------------------------------------------------|------------|--------------------------------------------|-------------|
| **(Amounts in thousands)**                                                  | ** ** | **2007**                                   | ** **  | **2006** | ** ** | **2005** | ** ** |
|                                                                                  |       |                                       |        |   |   |   |   |
| **OPERATING ACTIVITIES**                                                              |       |                                       |        |   |   |   |   |
| Net income                                                                            | ** ** | **$**                                      | **6,127**   |   | $ | 6,190 |   | $ | 6,847 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities:    |       |                                       |        |   |   |   |   |
| Provision for loan losses                                                             | ** ** | **150**                                    |        | 500 |   | 750 |   |
| Depreciation and amortization                                                         | ** ** | **663**                                    |        | 542 |   | 551 |   |
| Stock option expense (Forfeitures in excess of expense)                               | ** ** | **1**                                      |        | 8 |   | (2 | ) |
| Premium amortization on investment securities                                         | ** ** | **120**                                    |        | 187 |   | 411 |   |
| Discount accretion on investment securities                                           | ** ** | **(549**                                   | **)**       | (537 | ) | (681 | ) |
| Core deposit discount accretion net of amortization                                   | ** ** | **(35**                                    | **)**       | 1 |   | (73 | ) |
| Deferred income tax benefit                                                           | ** ** | **(104**                                   | **)**       | (263 | ) | (49 | ) |
| Gain on sale of mortgage loans originated for resale                                  | ** ** | **(89**                                    | **)**       | (39 | ) | (63 | ) |
| Proceeds from sale of mortgage loans originated for resale                            | ** ** | **7,467**                                  |        | 7,470 |   | 4,759 |   |
| Originations of mortgage loans originated for resale                                  | ** ** | **(4,035**                                 | **)**       | (9,013 | ) | (6,271 | ) |
| Gain on sales of investment securities                                                | ** ** | **(483**                                   | **)**       | (381 | ) | (420 | ) |
| Loss on sale of foreclosed real estate                                                | ** ** | **—**                                 |        | 13 |   | — |   |
| (Increase) decrease in accrued interest receivable                                    | ** ** | **41**                                     |        | (38 | ) | 108 |   |
| Increase in cash surrender value of bank owned life insurance                         | ** ** | **(558**                                   | **)**       | (472 | ) | (437 | ) |
| (Increase) decrease in other assets - net                                             | ** ** | **(143**                                   | **)**       | (82 | ) | 410 |   |
| Increase in accrued interest and other expenses                                       | ** ** | **734**                                    |        | 208 |   | 494 |   |
| Decrease in other liabilities - net                                                   | ** ** | **5**                                      |        | (108 | ) | (136 | ) |
| Loss from sale of premises and equipment                                              | ** ** | **3**                                      |        | — |   | — |   |
| NET CASH PROVIDED BY OPERATING ACTIVITIES                                             | ** ** | **$**                                      | **9,315**   |   | $ | 4,186 |   | $ | 6,198 |   |
|                                                                                  |       |                                       |        |   |   |   |   |
| **INVESTING ACTIVITIES**                                                              |       |                                       |        |   |   |   |   |
| Proceeds from sales of investment securities available-for-sale                       | ** ** | **$**                                      | **83,255**  |   | $ | 103,736 |   | $ | 119,669 |   |
| Proceeds from maturities and redemptions of investment securities  available-for-sale |       | **22,874**                                 |        | 28,583 |   | 34,112 |   |
| Purchases of investment securities available-for-sale                                 | ** ** | **(96,788**                                | **)**       | (122,716 | ) | (169,780 | ) |
| Proceeds from maturities and redemption of investment securities  held-to-maturity    |       | **2,012**                                  |        | 110 |   | 113 |   |
| Proceeds from sales of investment securities held-to-maturity                         | ** ** | **375**                                    |        | 201 |   | — |   |
| Purchases of investment securities held-to-maturity                                   | ** ** | **—**                                 |        | (3,015 | ) | (1,000 | ) |
| Net increase in loans                                                                 | ** ** | **(22,277**                                | **)**       | (16,087 | ) | (575 | ) |
| Purchases of premises and equipment                                                   | ** ** | **(692**                                   | **)**       | (218 | ) | (177 | ) |
| Purchase of investment in real estate venture                                         | ** ** | **(485**                                   | **)**       | — |   | — |   |
| Purchase of bank net of cash acquired                                                 | ** ** | **(13,626**                                | **)**       | — |   | — |   |
| Proceeds from sales of premises and equipment                                         | ** ** | **2**                                      |        | — |   | — |   |
| Purchase of bank owned life insurance                                                 | ** ** | **(1,000**                                 | **)**       | — |   | — |   |
| Proceeds from sale of foreclosed real estate                                          | ** ** | **41**                                     |        | 320 |   | 60 |   |
| NET CASH (USED IN) INVESTING ACTIVITIES                                               | ** ** | **$**                                      | **(26,309** | **)** | $ | (9,086 | ) | $ | (17,578 | ) |
|                                                                                  |       |                                       |        |   |   |   |   |
| **FINANCING ACTIVITIES**                                                              |       |                                       |        |   |   |   |   |
| Net increase (decrease) in deposits                                                   | ** ** | **$**                                      | **(616**    | **)** | $ | 21,225 |   | $ | 4,840 |   |
| Net increase in short-term borrowings                                                 | ** ** | **17,170**                                 |        | 28 |   | 12,639 |   |
| Proceeds from long-term borrowings                                                    | ** ** | **15,000**                                 |        | 5,000 |   | 8,000 |   |
| Repayment of long-term borrowings                                                     | ** ** | **(10,262**                                | **)**       | (13,000 | ) | (9,375 | ) |
| Cash paid in lieu of fractional shares                                                | ** ** | **—**                                 |        | (4 | ) | — |   |
| Proceeds from sale of treasury stock                                                  | ** ** | **—**                                 |        | 71 |   | 95 |   |
| Acquisition of treasury stock                                                         | ** ** | **(332**                                   | **)**       | (1,514 | ) | (247 | ) |
| Cash dividends paid                                                                   | ** ** | **(4,179**                                 | **)**       | (3,874 | ) | (3,602 | ) |
| NET CASH PROVIDED BY FINANCING ACTIVITIES                                             | ** ** | **$**                                      | **16,781**  |   | $ | 7,932 |   | $ | 12,350 |   |
|                                                                                  |       |                                       |        |   |   |   |   |
| INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                      | ** ** | **$**                                      | **(213**    | **)** | $ | 3,032 |   | $ | 970 |   |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR                                        | ** ** | **10,188**                                 |        | 7,156 |   | 6,186 |   |
| CASH AND CASH EQUIVALENTS AT END OF YEAR                                              | ** ** | **$**                                      | **9,975**   |   | $ | 10,188 |   | $ | 7,156 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notesto Consolidated Financial Statements for the Years Ended December 31,2007, 2006 and 2005**

 

**NOTE1  — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

The accounting policies of First Keystone Corporationand Subsidiary (the “Corporation”) are in accordance with accounting principlesgenerally accepted in the United States of America and conform to commonpractices within the banking industry. The more significant policies follow:

 

**Principles of Consolidation**

 

The consolidated financial statements include theaccounts of First Keystone Corporation and its wholly-owned Subsidiary, FirstKeystone National Bank (the “Bank”). All significant inter-company balances andtransactions have been eliminated in consolidation.

 

**Nature of Operations**

 

The Corporation, headquartered in Berwick,Pennsylvania, provides a full range of banking, trust and related servicesthrough its wholly-owned Bank subsidiary and is subject to competition fromother financial institutions in connection with these services. The Bank servesa customer base which includes individuals, businesses, public andinstitutional customers primarily located in the Northeast Region ofPennsylvania. The Bank has 14 full service offices and 16 ATMs located in Columbia,Luzerne, Montour and Monroe Counties. The Corporation and its subsidiary mustalso adhere to certain federal banking laws and regulations and are subject toperiodic examinations made by various federal agencies.

 

**Segment Reporting**

 

The Corporation’s banking subsidiary acts as anindependent community financial services provider, and offers traditionalbanking and related financial services to individual, business and governmentcustomers. Through its branch and automated teller machine network, the Bankoffers a full array of commercial and retail financial services, including thetaking of time, savings and demand deposits; the making of commercial, consumerand mortgage loans; and the providing of other financial services. The Bankalso performs personal, corporate, pension and fiduciary services through itsTrust Department.

 

Management does not separately allocate expenses,including the cost of funding loan demand, between the commercial, retail,trust and mortgage banking operations of the Corporation. Currently, managementmeasures the performance and allocates the resources of First KeystoneCorporation as a single segment.

 

**Use of Estimates**

 

The preparation of these consolidated financialstatements in conformity with accounting principles generally accepted in theUnited States of America, requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of these consolidated financialstatements and the reported amounts of income and expenses during the reportingperiods. Actual results could differ from those estimates.

 

**Investment Securities**

 

The Corporation classifies its investment securitiesas either “Held-to-Maturity” or “Available-for-Sale” at the time of purchase.Debt securities are classified as Held-to-Maturity when the Corporation has theability and positive intent to hold the securities to maturity. Investmentsecurities Held-to-Maturity are carried at cost adjusted for amortization ofpremium and accretion of discount to maturity.

 

Debt securitiesnot classified as Held-to-Maturity and equity securities are included in theAvailable-for-Sale category and are carried at fair value. The amount of anyunrealized gain or loss, net of the effect of deferred income taxes, isreported as other comprehensive income (loss) in the Consolidated Statement ofChanges in Stockholders’ Equity. Management’s decision to sellAvailable-for-Sale securities is based on changes in economic conditions controllingthe sources and applications of funds, terms, availability of and yield ofalternative investments, interest rate risk and the need for liquidity.

 

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** **

**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005**

 

The cost of debt securities classified asHeld-to-Maturity or Available-for-Sale is adjusted for amortization of premiumsand accretion of discounts to expected maturity. Such amortization andaccretion, as well as interest and dividends is included in interest incomefrom investments. Realized gains and losses are included in net investmentsecurities gains and losses.

 

The cost of investment securities sold, redeemed ormatured is based on the specific identification method.

 

**Loans**

 

Loans are stated at their outstanding unpaid principalbalances, net of deferred fees or costs, unearned income and the allowance forloan losses. Interest on installment loans is recognized as income over theterm of each loan, generally, by the actuarial method. Interest on all otherloans is primarily recognized based upon the principal amount outstanding on anactual day basis. Loan origination fees and certain direct loan originationcosts have been deferred with the net amount amortized using the interestmethod over the contractual life of the related loans as an interest yieldadjustment.

 

Mortgage loans held for resale are carried at thelower of cost or market on an aggregate basis. These loans are sold withoutrecourse to the Corporation.

 

*Past-Due Loans —*Generally, a loan is considered to be past-due whenscheduled loan payments are in arrears 15 days or more. Delinquent notices aregenerated automatically when a loan is 15 days past-due, depending on the typeof loan. Collection efforts continue on loans past-due beyond 60 days that havenot been satisfied, when it is believed that some chance exists for improvementin the status of the loan. Past-due loans are continually evaluated with thedetermination for charge-off being made when no reasonable chance remains thatthe status of the loan can be improved.

 

*Non-Accrual Loans —*Generally, a loan is classified as non-accrual and theaccrual of interest on such a loan is discontinued when the contractual paymentof principal or interest has become 90 days past due or management has seriousdoubts about further collectibility of principal or interest, even though theloan currently is performing. A loan may remain on accrual status if it is inthe process of collection and is either guaranteed or well secured. When a loanis placed on non-accrual status, unpaid interest credited to income in thecurrent year is reversed and unpaid interest accrued in prior years is chargedagainst the allowance for loan losses. Certain non-accrual loans may continueto perform, that is, payments are still being received. Generally, the paymentsare applied to principal. These loans remain under constant scrutiny and ifperformance continues, interest income may be recorded on a cash basis based onmanagement’s judgement as to collectibility of principal.

 

*Allowance for Loan Losses —* The allowance for loan losses isestablished through provisions for loan losses charged against income. Loansdeemed to be uncollectible are charged against the allowance for loan lossesand subsequent recoveries, if any, are credited to the allowance.

 

A principal factor in estimating the allowance forloan losses is the measurement of impaired loans. A loan is considered impairedwhen, based on current information and events, it is probable that theCorporation will be unable to collect all amounts due according to thecontractual terms of the loan agreement. Under current accounting standards,the allowance for loan losses related to impaired loans is based on discountedcash flows using the effective interest rate of the loan or the fair value ofthe collateral for certain collateral dependent loans.

 

The allowance forloan losses is maintained at a level estimated by management to be adequate toabsorb potential loan losses. Management’s periodic evaluation of the adequacyof the allowance for loan losses is based on the Corporation’s past loan lossexperience, known and inherent risks in the portfolio, adverse situations thatmay affect the borrower’s ability to repay (including the timing of futurepayments), the estimated value of any underlying collateral, composition of theloan portfolio, current economic conditions, and other relevant factors. Thisevaluation is inherently subjective as it requires material estimates includingthe amounts and timing of future cash flows expected to be received on impairedloans that may be susceptible to significant change.

 

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

**Derivatives**

 

The Bank has outstanding loan commitments that relateto the origination of mortgage loans that will be held for resale.  Pursuant to Statement of Financial AccountingStandards (SFAS) No. 133, “Accounting for Derivative Instruments andHedging Activities” as amended by SFAS No. 138, “Accounting for CertainDerivative Instruments and Certain Hedging Activities” and the guidancecontained within the Derivatives Implementation Group Statement 133Implementation Issue No. C 13, the Bank has accounted for such loancommitments as derivative instruments. The outstanding loan commitments in this category did not give rise toany losses for the years ended December 31, 2007 and 2006, as the fairmarket value of each outstanding loan commitment exceeded the Bank’s cost basisin each outstanding loan commitment.

 

**Premises and Equipment**

 

Premises, improvements and equipment are stated atcost less accumulated depreciation computed principally on the straight-linemethod over the estimated useful lives of the assets. Long-lived assets arereviewed for impairment whenever events or changes in business circumstancesindicate that the carrying value may not be recovered.  Maintenance and minor repairs are charged tooperations as incurred. The cost and accumulated depreciation of the premisesand equipment retired or sold are eliminated from the property accounts at thetime of retirement or sale, and the resulting gain or loss is reflected incurrent operations.

 

**Mortgage Servicing Rights**

 

The Corporation originates and sells real estate loansto investors in the secondary mortgage market. After the sale, the Corporationmay retain the right to service these loans. When originated mortgage loans aresold and servicing is retained, a servicing asset is capitalized based onrelative fair value at the date of sale. Servicing assets are amortized as anoffset to other fees in proportion to, and over the period of, estimated netservicing income. The unamortized cost is included in other assets in theaccompanying consolidated balance sheet. The servicing rights are periodicallyevaluated for impairment based on their relative fair value.

 

**Foreclosed Real Estate**

 

Real estate properties acquired through, or in lieuof, loan foreclosure are held for sale and are initially recorded at fair valueon the date of foreclosure establishing a new cost basis. After foreclosure,valuations are periodically performed by management and the real estate iscarried at the lower of carrying amount or fair value less cost to sell and isincluded in other assets. Revenues derived from and costs to maintain theassets and subsequent gains and losses on sales are included in othernon-interest income and expense.  Thetotal of foreclosed real estate properties included in other assets amounted to$65,000 and $41,000 at December 31, 2007 and 2006, respectively.

 

**Bank Owned Life Insurance**

 

The Corporation invests in Bank Owned Life Insurance(BOLI) with split dollar life provisions. Purchase of BOLI provides life insurance coverage on certain employeeswith the Corporation being owner and beneficiary of the policies.

 

**Investments in Real Estate Ventures**

 

The Bank is a limited partner in  real estate ventures that own and operateaffordable residential low-income housing apartment buildings for elderlyresidents. The investments are accounted for under the effective yield methodunder the Emerging Issues Task Force (EITF) 94-1, “Accounting for Tax BenefitsResulting from Investments in Affordable Housing Projects”. Under the effectiveyield method, the Bank recognizes tax credits as they are allocated andamortizes the initial cost of the investment to provide a constant effectiveyield over the period that the tax credits are allocated to the Bank.  Under this method, the tax credits allocated,net of any amortization of the investment in the limited partnerships, arerecognized in the consolidated statements of

 

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

incomeas a component of income tax expense. The amount of tax credits allocated to the Bank were $151,000 in 2007and $128,000 in 2006 and 2005, and the amortization of the investments in thelimited partnerships were $108,000, $100,000 and $96,000 in 2007, 2006 and2005, respectively.  The carrying valueof the investments as of December 31, 2007, 2006 and 2005, was $975,000,$595,000 and $695,000, respectively, and is included in other assets in theaccompanying consolidated balance sheets.

 

**Income Taxes**

 

The provision for income taxes is based on the resultsof operations, adjusted primarily for tax-exempt income. Certain items ofincome and expense are reported in different periods for financial reportingand tax return purposes. Deferred tax assets and liabilities are determined basedon the differences between the consolidated financial statement and income taxbases of assets and liabilities measured by using the enacted tax rates andlaws expected to be in effect when the timing differences are expected toreverse. Deferred tax expense or benefit is based on the difference betweendeferred tax asset or liability from period to period.

 

**Goodwill, Other Intangible Assets, and PremiumDiscount**

 

Goodwill resulted from the acquisition of the PoconoCommunity Bank in November 2007 (See Note 2) and of certain fixed andoperating assets acquired and deposit liabilities assumed of the branch ofanother financial institution in Danville, Pennsylvania, in January 2004.  Such goodwill represents the excess cost ofthe acquired assets relative to the assets fair value at the dates ofacquisition.  The Corporation accountsfor goodwill pursuant to the Statement of Financial Accounting Standards (SFAS)No. 142, “Goodwill and Intangible Assets”. SFAS No. 142 includes requirements to test goodwill for impairmentsrather than to amortize goodwill.  TheCorporation has tested the goodwill included in its consolidated balance sheetat December 31, 2006, and has determined there was no impairment as ofthat date.

 

Intangible assets are comprised of core depositintangibles and premium discount (negative premium) on certificates of depositacquired.  The core deposit intangible isbeing amortized over the average life of the deposits acquired as determined byan independent third party.  Premiumdiscount (negative premium) on acquired certificates of deposit resulted fromthe valuation of certificate of deposit accounts by an independent thirdparty.  The book value of certificates ofdeposit acquired was greater than their fair value at the date of acquisitionwhich resulted in a negative premium due to higher cost of the certificates ofdeposit compared to the cost of similar term financing.

 

**Stock Based Compensation**

 

The Corporation sponsors a stock option plan (see Note20).  Prior to January 1, 2006 theCorporation had accounted for this Plan under the fair value recognition andmeasurement provisions of Statement of Financial Accounting Standards (SFAS)123, “Accounting for Stock Based Compensation”. Effective January 1, 2006 the Corporation adopted SFAS 123 (revised2004), “Share-Based Payment”, using the modified prospective applicationmethod.  Based on the terms of the Plan,the Corporation did not have a cumulative effect related to the Plan.  Since the fair value recognition provisionsof SFAS 123 and SFAS 123R are essentially the same as they relate to theCorporation’s Plan, the adoption of SFAS 123R did not and will not have amaterial impact on the Corporation’s consolidated financial condition, resultsof operations or liquidity.  The fair valuesof the stock awards are determined using the estimated expected life.  The Corporation recognized stock basedcompensation expense on the straight line basis over the period the stock awardis earned by the employee.

 

**Per Share Data**

 

Statement of Financial Accounting Standards (SFAS) No. 128,“Earnings Per Share”, requires dual presentation of basic and fully dilutedearnings per share. Basic earnings per share is calculated by dividing netincome by the weighted average number of shares of common stock outstanding atthe end of each period. Diluted earnings per share is calculated by increasingthe denominator for the assumed conversion of all potentially dilutivesecurities. The Corporation’s dilutive securities are limited to stock options.

 

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

Per share data has been adjusted retroactively forstock splits and stock dividends.  Thereconciliation of the numerators and denominators of the basis and dilutedearnings per share follows:

 
| ** **                              | ** ** | **Year Ended December 31, 2007** | ** ** |
|-----------------------------------------|------------|------------------------------------------------------|------------|
| ** **                              | ** ** | **Net Income  Numerators**                      | ** ** | **Weighted Average  Number of Shares  Denominators** | ** ** | **Per Share  Amount** | ** ** |
|                                    | ** ** | ** **                                           |       |   |   |   |   |
| Net income                              | ** ** | **$**                                                | **6,127**  |   |   |   |   |   |
| Basic earnings per share:               |       |                                                 |       |   |   |   |   |
| Income available to common stockholders | ** ** | **$**                                                | **6,127**  | ** ** | **4,674** | ** ** | **$** | **1.31** | ** ** |
| Effect of dilutive securities:          |       |                                                 |       |   |   |   |   |
| Stock options                           | ** ** | ** **                                           |       | **6** |   |   |   |
| Diluted earnings per share:             |       |                                                 |       |   |   |   |   |
| Income available to common stockholders | ** ** | **$**                                                | **6,127**  | ** ** | **4,680** | ** ** | **$** | **1.31** | ** ** |

 
| ** **                              | ** ** | **Year Ended December 31, 2006** | ** ** |
|-----------------------------------------|------------|------------------------------------------------------|------------|
| ** **                              | ** ** | **Net Income  Numerators**                      | ** ** | **Weighted Average  Number of Shares  Denominators** | ** ** | **Per Share  Amount** | ** ** |
|                                    | ** ** | ** **                                           | ** ** |
| Net income                              | ** ** | $                                                    | 6,190      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic earnings per share:               | ** ** | ** **                                           |       |   |   |   |   |
| Income available to common stockholders | ** ** | $                                                    | 6,190      |   | 4,571 |   | $ | 1.35 |   |
| Effect of dilutive securities:          | ** ** | ** **                                           |       |   |   |   |   |
| Stock options                           | ** ** | ** **                                           |       | 7 |   |   |   |
| Diluted earnings per share:             | ** ** | ** **                                           |       |   |   |   |   |
| Income available to common stockholders | ** ** | $                                                    | 6,190      |   | 4,578 |   | $ | 1.35 |   |

 
| ** **                              | ** ** | **Year Ended December 31, 2005** | ** ** |
|-----------------------------------------|------------|------------------------------------------------------|------------|
| ** **                              | ** ** | **Net Income  Numerators**                      | ** ** | **Weighted Average  Number of Shares  Denominators** | ** ** | **Per Share  Amount** | ** ** |
|                                    | ** ** | ** **                                           | ** ** |
| Net income                              | ** ** | $                                                    | 6,847      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic earnings per share:               | ** ** | ** **                                           |       |   |   |   |   |
| Income available to common stockholders | ** ** | $                                                    | 6,847      |   | 4,613 |   | $ | 1.48 |   |
| Effect of dilutive securities:          | ** ** | ** **                                           |       |   |   |   |   |
| Stock options                           | ** ** | ** **                                           |       | 9 |   |   |   |
| Diluted earnings per share:             | ** ** | ** **                                           |       |   |   |   |   |
| Income available to common stockholders | ** ** | $                                                    | 6,847      |   | 4,622 |   | $ | 1.48 |   |

 

**CashFlow Information**

 

For purposes of reporting consolidated cash flows,cash and cash equivalents include cash on hand and due from other banks andinterest bearing deposits in other banks. The Corporation considers cashclassified as interest bearing deposits with other banks as a cash equivalentsince they are represented by cash accounts essentially on a demand basis.

 

39

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

**Trust Assets and Income**

 

Property held by the Corporation in a fiduciary oragency capacity for its customers is not included in the accompanyingconsolidated financial statements since such items are not assets of theCorporation. Trust Department income is generally  recognized on a cash basis and is notmaterially different than if it were reported on an accrual basis.

 

**Recent Accounting Pronouncements**

 

In December 2007, the Financial AccountingStandards Board (FASB) issued State of Financial Accounting Standards SFAS141®, *“Business Combinations”*.SFAS 141® will significantly change how entities apply the acquisition methodto business combinations. The most significant changes affecting how theCorporation will account for business combinations under this Statementinclude: the acquisition date will be the date the acquirer obtains control;all (and only) identifiable assets acquired, liabilities assumed, andnoncontrolling interests in the acquiree will be stated at fair value on theacquisition date; assets or liabilities arising from noncontractualcontingencies will be measured at their acquisition date fair value only if itis more likely than not that they meet the definition of an asset or liabilityon the acquisition date; adjustments subsequently made to the provisionalamounts recorded on the acquisition date will be made retroactively during ameasurement period not to exceed one year; acquisition-related restructuringcosts that do not meet the criteria in SFAS 146, *“Accounting for Costs Associated with Exit or Disposal Activities”*,will be expensed as incurred; transaction costs will be expensed as incurred;reversals of deferred income tax valuation allowances and income taxcontingencies will be recognized in earnings subsequent to the measurementperiod; and the allowance for loan losses of an acquiree will not be permittedto be recognized by the acquirer. Additionally, SFAS 141® will require new andmodified disclosures surrounding subsequent changes to acquisition-relatedcontingencies, contingent consideration, noncontrolling interests,acquisition-related transaction costs, fair values and cash flows not expectedto be collected for acquired loans, and an enhanced goodwill rollforward.

 

The Corporation will be required to prospectivelyapply SFAS 141® to all business combinations completed on or after January 1,2009. Early adoption is not permitted. For business combinations in which theacquisition date was before the effective date, the provisions of SFAS 141®will apply to the subsequent accounting for deferred income tax valuationallowances and income tax contingencies and will require any changes in thoseamounts to be recorded in earnings. Management is currently evaluating theeffects that SFAS 141® will have on the financial condition, results ofoperations, liquidity, and the disclosures that will be presented in theconsolidated financial statements.

 

In December 2007, the FASB issued Statement ofFinancial Accounting Standards SFAS 160, *“NoncontrollingInterests in Consolidated Financial Statements, an Amendment of ARB 51”*.SFAS 160 establishes new accounting and reporting standards for noncontrollinginterests in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160will require entities to classify noncontrolling interests as a component ofstockholders’ equity and will require subsequent changes in ownership interestin a subsidiary to be accounted for as an equity transaction. Additionally,SFAS 160 will require entities to recognize a gain or loss upon the loss ofcontrol of a subsidiary and to remeasure any ownership interest retained atfair value on that date. This statement also requires expanded disclosures thatclearly identify and distinguish between the interests of the parent and theinterests of the noncontrolling owners. SFAS 160 is effective on a prospectivebasis for fiscal years, and interim periods within those fiscal years,beginning on or after December 15, 2008, except for the presentation anddisclosure requirements, which are required to be applied retrospectively.Early adoption is not permitted. The adoption of this standard is not expectedto have a material impact on the Corporation’s consolidated financialcondition, results of operations or liquidity.

 

EITF 06-4, *“Accountingfor Deferred Compensation and Postretirement Benefit Aspects of EndorsementSplit-Dollar Life Insurance Arrangements”*, was issued in September 2006and is effective for fiscal years beginning after December 15, 2007 withearlier application permitted. EITF 06-4 requires that, for split-dollar lifeinsurance arrangements that provide a benefit to an employee that extends topostretirement periods, an employer should recognize a liability for futurebenefits in accordance with SFAS No. 106. EITF 06-4 requires thatrecognition of the effects of adoption should be either by (a) a change inaccounting principle through a cumulative-effect adjustment to retainedearnings as of the beginning of the year of adoption or (b) a change inaccounting principle through retrospective application to all prior periods.The Corporation adopted this standard as of January 1, 2007 through acumulative-effect adjustment to beginning retained earnings. This adjustmentrepresented a decrease of $36,000 to retained earnings.

 

40

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

In November 2007, the Securities and ExchangeCommission issued Staff Accounting Bulletin (SAB) No. 109, which addressesthe valuation of written loan commitments accounted for a fair value throughearnings. The guidance in SAB 109 expresses the staff’s view that themeasurement of fair value for a written loan commitment accounted for at fairvalue through earnings should incorporate the expected net future cash flowsrelated to the associated servicing of the loan. Previously under SAB 105,Application of Accounting Principles to Loan Commitments, this component ofvalue was not incorporated into the fair value of the loan commitment. TheCorporation does not account for any written loan commitments at fair valuethrough earnings.

 

In June 2007, the FASB ratified the consensusreached in EITF 06-11, *“Accounting forIncome Tax Benefits of Dividends on Share-Based Payment Awards”*.EITF 06-11 applies to entities that have share-based payment arrangements thatentitle employees to receive dividends or dividend equivalents onequity-classified nonvested shares when those dividends or dividend equivalentsare charged to retained earnings and result in an income tax deduction.Entities that have share-based payment arrangements that fall within the scopeof EITF 06-11 will be required to increase capital surplus for any realizedincome tax benefit associated with dividends or dividend equivalents paid toemployees for equity classified nonvested equity awards. Any increase recordedto capital surplus is required to be included in any entity’s pool of excesstax benefits that are available to absorb potential future tax deficiencies onshare-based payment awards. The Corporation will adopt EITF 06-11 on January 1,2008 for dividends declared on share-based payment awards subsequent to thisdate. The impact of adoption is not expected to have a material impact onfinancial condition, results of operations, or liquidity.

 

In April 2007, the FASB issued FSP 39-1, *“Amendments of FASB Interpretation No. 39.Offsetting of Amounts Related to Certain Contracts”*. FSP 39-1permits entities to offset fair value amounts recognized for multiple derivativeinstruments executed with the same counterparty under a master nettingagreement. FSP 39-1 clarifies that the fair value amounts recognized for theright to reclaim cash collateral, or the obligation to return cash collateral,arising from the same master netting arrangement, should also be offset againstthe fair value of the related derivative instruments.

 

Effective January 1, 2008, the Corporationadopted a net presentation for derivative positions and related collateralentered into under master netting agreements pursuant to the guidance in FIN 39and FSP 39-1. The adoption of this guidance would result in balance sheetreclassifications of certain cash collateral-based short-term investmentsagainst the related derivative liabilities and certain deposit liabilitybalances against the related fair values of derivative assets. The effects ofthese reclassifications will fluctuate based on the fair values of derivativecontracts but overall would not have a material impact on either total assets ortotal liabilities. The adoption of these standards will not have an impact onthe Corporations consolidated financial condition, results of operations orliquidity.

 

In February 2007, the FASB issued SFAS No. 159,*“The Fair Value Option for Financial Assetsand Liabilities”*. The statement allows an entity to elect to measurecertain financial assets and liabilities at fair value with changes in fairvalue recognized in the income statement each period. The statement alsorequires additional disclosures to identify the effects of an entity’s fairvalue election on its earnings. The election is irrevocable. The Corporation iscurrently assessing whether it will elect to adopt SFAS 159.

 

In September 2006, the Financial AccountingStandards Board (FASB) issued Statement of Financial Accounting Standards SFAS158 *“Employers’ Accounting for DefinedBenefit Pension and Other Post Retirement Plans”*, which requires theCorporation to recognize the funded status of a benefit plan as either assetsor liabilities in the consolidated balance sheet and to recognize as acomponent of other comprehensive income, net of tax, unrecognized actuarialgains or losses, prior service costs and transition obligations that ariseduring the period. The adoption of SFAS 158 for year ended December 31,2007 did not have a material impact on the Corporation’s consolidated financialposition, results of operations, or liquidity.

 

In September 2006, the FASB issued Statement ofFinancial Accounting Standards (SFAS) 157, *“FairValue Measurements”*, which upon adoption will replace variousdefinitions of fair value in existing accounting literature with a singledefinition, will establish a framework for measuring fair value, and willrequire additional disclosures about fair value measurements. The statementclarifies that fair value is the price that would be received to sell an assetor the price paid to transfer a liability in the most advantageous marketavailable to the entity and emphasizes that fair value is a market-basedmeasurement and should be based on the assumptions market participants woulduse. The statement also creates a three-level hierarchy under which individualfair value estimates are to be ranked based on the relative reliability of theinputs used in the valuation. This hierarchy is the basis for the disclosurerequirements, with fair value estimates based on the least reliable inputsrequiring more

 

41

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

extensivedisclosures about the valuation method used and the gains and losses associatedwith those estimates. SFAS 157 is required to be applied whenever anotherfinancial accounting standard requires or permits an asset or liability to bemeasured at fair value. The statement does not expand the use of fair value toany new circumstances. The Corporation will be required to apply the newguidance beginning January 1, 2008, and does not expect it to have amaterial impact on the Corporation’s consolidated financial condition, resultsof operations, or liquidity.

 

In July 2006, the FASB issued FASB Staff PositionFSP 13-2, *“Accounting for a Change orProjected Change in the Timing of Cash Flows Related to Income Taxes Generatedby a Leveraged Lease Transaction”*. This FSP amends SFAS 13, *“Accounting for Leases”*, to require alessor in a leveraged lease transaction to recalculate the leveraged lease forthe effects of a change or projected change in the timing of cash flowsrelating to income taxes that are generated by the leveraged lease. Theguidance in FSP 13-2 was adopted by the Corporation on January 1, 2007.The application of this FSP is not expected to have a material impact on theCorporation’s consolidated financial condition, results of operations, orliquidity.

 

In June 2006, the FASB issued Interpretation No. 48FIN 48, *“Accounting for Uncertainty inIncome Taxes”*, an interpretation of SFAS 109, *“Accounting for Income Taxes”*. FIN 48prescribes a comprehensive model for how companies should recognize, measure,present, and disclose in their financial statements uncertain tax positionstaken or expected to be taken on a tax return. Under FIN 48, tax positionsshall initially be recognized in the financial statements when it is morelikely than not the position will be sustained upon examination by the taxauthorities. Such tax positions shall initially and subsequently be measured asthe largest amount of tax benefit that is greater than 50% likely of beingrealized upon ultimate settlement with the tax authority assuming fullknowledge of the position and all relevant facts. FIN 48 also revisesdisclosure requirements to include an annual tabular roll-forward of unrecognizedtax benefits. The provisions of this interpretation were adopted by theCorporation on January 1, 2007. The adoption of FIN 48 is not expected tohave a material impact on the Corporation’s consolidated financial condition,result of operations, or liquidity.

 

In March 2006, the FASB issued Statement ofFinancial Accounting Standards SFAS 156, *“Accountingfor Servicing of Financial Assets”*, an amendment of SFAS 140. Thisstandard requires entities to separately recognize a servicing asset orliability whenever it undertakes an obligation to service financial assets andalso requires all separately recognized servicing assets or liabilities to beinitially measured at fair value. Additionally, this standard permits entitiesto choose among two alternatives, the amortization method or fair valuemeasurement method, for the subsequent measurement of each class of separatelyrecognized servicing assets and liabilities. Under the amortization method, anentity shall amortize the value of servicing assets or liabilities inproportion to and over the period of estimated net servicing income or netservicing loss and assess servicing assets or liabilities for impairment orincreased obligation based on fair value at each reporting date. Under the fairvalue measurement method, an entity shall measure servicing assets orliabilities at fair value at each reporting date and report changes in fairvalue in earnings in the period in which the changes occur.

 

Effective January 1, 2006, the Corporationadopted this statement by electing amortization method as the measurementmethod for residential real estate mortgage servicing rights (MSRs).

 

In February 2006, the FASB issued Statement ofFinancial Accounting Standards SFAS 155, *“Accountingfor Certain Hybrid Financial Instruments”*, which amends SFAS 133, *“Accounting for Derivative Instruments and HedgingActivities”*, and SFAS 140, *“Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities”*. SFAS 155 requires entities to evaluate and identifywhether interests in securitized financial assets are freestanding derivatives,hybrid financial instruments that contain an embedded derivative requiringbifurcation, or hybrid financial instruments that contain embedded derivativesthat do not require bifurcation. SFAS 155 also permits fair value measurementfor any hybrid financial instrument that contains an embedded derivative thatotherwise would require bifurcation. This statement was effective for allfinancial instruments acquired or issued by the Corporation on or after January 1,2007 and the adoption of SFAS 155 did not have a material impact on theCorporation’s consolidated financial condition, results of operations orliquidity.

 

**Advertising Costs**

 

It is the Corporation’s policy to expense advertisingcosts in the period in which they are incurred. Advertising expense for theyears ended December 31, 2007, 2006 and 2005, was approximately $349,000,$246,000 and $219,000, respectively.

 

42

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

**Reclassifications**

 

Certain amounts in the consolidated financialstatements of prior periods have been reclassified to conform with presentationused in the 2007 consolidated financial statements. Such reclassifications haveno effect on the Corporation’s consolidated financial condition or net income.

 

**NOTE 2**  —   **ACQUISITIONS**

 

Effective November 1, 2007, the Corporationcompleted its acquisition of Pocono Community Bank. Under the terms of theAgreement and Plan of Merger dated as of May 10, 2007, Pocono was acquiredby First Keystone Corporation and merged with and into First Keystone NationalBank, its wholly owned subsidiary. Headquartered and founded in Stroudsburg,Pennsylvania in 1996, Pocono had 4 banking offices located in Monroe County,Pennsylvania.  The acquisition expandsthe branch network that the Corporation has and its opportunity to provide Poconocustomers with a broader mix of products and services. As part of the mergeragreement, Pocono continues to operate under the Pocono name and logo, and hasbecome a division of the Bank. The Corporation acquired 100% of the outstandingshares of Pocono for a total purchase price of $33.565 million. The transactionwas accounted for in accordance with SFAS No. 141, “Business Combinations.”In connection therewith, 1,042,266 Pocono shares were exchanged for 932,203shares of the Corporation’s common stock and 703,684 Pocono shares wereexchanged for cash consideration totaling $11.329 million. Pocono options of63,785 and warrants of 396,134 were exchanged for cash consideration of $5.034million. The allocation of the Corporation’s common stock and cash was suchthat the Pocono shareholders did not recognize gain or loss for federal incometax purposes on those Pocono shares that were exchanged for the Corporation’scommon stock in the merger. Pocono’s results of operations are included in theCorporation’s results from the date of acquisition, November 1, 2007 to December 31,2007.

 

Assets and liabilities of Pocono are recorded atestimated fair values as of the acquisition date and the results of Pocono’soperations included in income from November 1, 2007 to December 31,2007. The fair values of acquired assets and liabilities, includingidentifiable intangible assets, are finalized as quickly as possible followingan acquisition. The purchase price allocations are complete.

 

The following table shows the excess purchase priceover carrying value of net assets acquired, purchase price allocation andresulting goodwill recorded for this acquisition:

 
| **(Amounts in thousands)**                                | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------|------------|------------|------------|
|                                                                |       |       |       |
| Purchase price                                                      |       | $          | 33,565     |   |
| Carrying value of net assets acquired                               |       | (14,329    | )          |
| Excess of purchase price over carrying value of net assets acquired |       | 19,236     |       |
| Purchase accounting adjustments:                                    |       |       |       |
| Investment securities                                               |       | 182        |       |
| Loans                                                               |       | 1,101      |       |
| Premises and equipment                                              |       | (148       | )          |
| Deposits                                                            |       | 167        |       |
| Borrowings                                                          |       | 97         |       |
| Severance and related costs                                         |       | (1,029     | )          |
| Deferred taxes                                                      |       | 232        |       |
| Subtotal                                                            |       | 19,838     |       |
| Core deposit intangibles                                            |       | (2,081     | )          |
| Goodwill                                                            |       | $          | 17,757     |   |

 

43

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

The following table summarized the estimated fairvalue of net assets acquired:

* *
| **(****Amounts in thousands)**          | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|------------|------------|
|                                              |       |       |       |
| Assets                                            |       |       |       |
| Cash and cash equivalents                         |       | $          | 1,387      |   |
| Interest-bearing deposits in other banks          |       | 68         |       |
| Federal funds sold                                |       | 2,488      |       |
| Investment securities                             |       | 13,122     |       |
| Loans, net of allowances for loan losses          |       | 104,752    |       |
| Premises and equipment-net                        |       | 3,292      |       |
| Accrued interest receivable                       |       | 596        |       |
| Cash surrender value of bank-owned life insurance |       | 2,950      |       |
| Goodwill and other intangibles                    |       | 19,838     |       |
| Other assets                                      |       | 1,065      |       |
| Total Assets                                      |       | $          | 149,558    |   |
|                                              |       |       |       |
| Liabilities                                       |       |       |       |
| Deposits                                          |       | $          | 109,672    |   |
| Borrowings                                        |       | 5,908      |       |
| Other liabilities                                 |       | 413        |       |
| Total Liabilities                                 |       | $          | 115,993    |   |
|                                              |       |       |       |
| Fair Value of Net Assets Acquired                 |       | $          | 33,565     |   |

 

Assets and liabilities of Pocono are recorded atestimated fair values as of the acquisition date under the required purchaseaccounting method and the results of Pocono’s operations are included in incomefrom November 1, 2007 to December 31, 2007. The fair values ofacquired assets and liabilities, including identifiable intangible assets, arefinalized as quickly as possible following an acquisition. The purchase priceallocations are complete.

 

The following unaudited pro forma consolidatedfinancial information presents the combined results of operations of theCorporation as if the Pocono acquisition had occurred as of the beginning of2007 and 2006, respectively:

 
| **(Dollars in thousands, except per share amounts)** | ** ** | **For the Year Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                         | ** ** | **2007**                              | ** ** | **2006** | ** ** |
| Net interest income                                                                | ** ** | **$**                                 | **17,100** |   | $ | 17,182 |   |
| Provision for loan losses                                                          | ** ** | **206**                               |       | 580 |   |
| Net interest income after provision for loan losses                                | ** ** | **16,894**                            |       | 16,602 |   |
| Noninterest income                                                                 | ** ** | **4,658**                             |       | 4,245 |   |
| Noninterest expense                                                                | ** ** | **13,575**                            |       | 12,897 |   |
| Income before income tax expense                                                   | ** ** | **7,977**                             |       | 7,950 |   |
| Income tax expense                                                                 | ** ** | **1,206**                             |       | 1,415 |   |
| Net Income                                                                         | ** ** | **$**                                 | **6,771**  |   | $ | 6,535 |   |
|                                                                               | ** ** | ** **                            |       |   |   |
| Net Income Per Common Share                                                        |       |                                  |       |   |   |
| Basic                                                                              | ** ** | **$**                                 | **1.21**   |   | $ | 1.19 |   |
| Diluted                                                                            | ** ** | **$**                                 | **1.21**   |   | $ | 1.19 |   |
|                                                                               | ** ** | ** **                            |       |   |   |
| Average Common Shares Outstanding                                                  |       |                                  |       |   |   |
| Basic                                                                              | ** ** | **5,606,316**                         |       | 5,503,359 |   |
| Diluted                                                                            | ** ** | **5,611,990**                         |       | 5,509,996 |   |

 

44

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

The pro forma results include amortization of fairvalue adjustments on loans, deposits, and debt, and amortization of newlyacquired intangibles. The pro forma number of average common shares outstandingincludes adjustments for shares issued for the acquisitions and the impact ofadditional dilutive securities but does not assume any incremental sharerepurchases. The pro forma results presented do not reflect cost savings orrevenue enhancements anticipated from the acquisition and are not necessarilyindicative of what actually would have occurred if the acquisition had beencompleted as of the beginning of the periods presented, nor are theynecessarily indicative of future consolidated results.

 

**NOTE 3**  —   **RESTRICTEDCASH BALANCES**

 

The Bank is required to maintain certain averagereserve balances as established by the Federal Reserve Bank. The amount ofthose reserve balances for the reserve computation period which included December 31,2007, was $1,842,000, which was satisfied through the restriction of vaultcash. In addition, the Bank maintains a clearing balance at the Federal ReserveBank to offset specific charges for services. At December 31, 2007, theamount of this balance was $700,000.

 

**NOTE 4**  —   **INVESTMENTSECURITIES**

 

The amortized cost, related estimated fair value, andunrealized gains and losses for investment securities classified as “Available-For-Sale”or “Held-to-Maturity” were as follows at December 31, 2007 and 2006:

 
| **(Amounts  in thousands)**                               | ** ** | **Available-for-Sale Securities** | ** **  |
|-----------------------------------------------------------|------------|----------------------------------------|-------------|
| **Amortized  Cost**                                       | ** ** | **Gross  Unrealized  Gains**           | ** **  | **Gross  Unrealized  Losses** |   | **Estimated  Fair  Value** |   |
| ***December 31, 2007:***                             |       |                                   |        |   |   |   |   |   |   |
| Obligations of U.S. Government Corporations and Agencies: |       |                                   |        |   |   |   |   |   |   |
| Mortgage-backed                                           | ** ** | **$**                                  | **116,693** | ** ** | **$** | **793** | ** ** | **$** | **(467** | **)** | **$** | **117,019** | ** ** |
| Other                                                     | ** ** | **32,348**                             | ** **  | **248** | ** ** | **(8** | **)** | **32,588** | ** ** |
| Obligations of state and political subdivisions           | ** ** | **75,347**                             | ** **  | **442** | ** ** | **(1,430** | **)** | **74,359** | ** ** |
| Corporate securities                                      | ** ** | **8,367**                              | ** **  | **163** | ** ** | **—** | ** ** | **8,530** | ** ** |
| Marketable equity securities                              | ** ** | **2,914**                              | ** **  | **508** | ** ** | **(506** | **)** | **2,916** | ** ** |
| Restricted equity securities                              | ** ** | **6,109**                              | ** **  | **—** | ** ** | **—** | ** ** | **6,109** | ** ** |
| Total                                                     | ** ** | **$**                                  | **241,778** | ** ** | **$** | **2,154** | ** ** | **$** | **(2,411** | **)** | **$** | **241,521** | ** ** |

 
| ** **                                                | ** ** | **Held-to-Maturity Securities** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------|------------|
| **(Amounts in thousands)**                      | ** ** | **Amortized  Cost**                  | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
| ***December 31, 2007:***                             |       |                                 |       |   |   |   |   |   |   |
| Obligations of U.S. Government Corporations and Agencies: |       |                                 |       |   |   |   |   |   |   |
| Mortgage-backed                                           | ** ** | **$**                                | **191**    | ** ** | **$** | **—** | ** ** | **$** | **(1** | **)** | **$** | **190** | ** ** |
| Other                                                     | ** ** | **2,000**                            | ** ** | **7** | ** ** | **—** | ** ** | **2,007** | ** ** |
| Obligations of state and political subdivisions           | ** ** | **2,347**                            | ** ** | **9** | ** ** | **—** | ** ** | **2,356** | ** ** |
| Total                                                     | ** ** | **$**                                | **4,538**  | ** ** | **$** | **16** | ** ** | **$** | **(1** | **)** | **$** | **4,553** | ** ** |

 

45

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 
| ** **                                                | ** ** | **Available-for-Sale Securities** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------------|------------|
| **(Amounts in thousands)**                      | ** ** | **Amortized  Cost**                    | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
| *December 31, 2006:*                                 |       |                                   |       |   |   |   |   |   |   |
| Obligations of U.S. Government Corporations and Agencies: |       |                                   |       |   |   |   |   |   |   |
| Mortgage-backed                                           |       | $                                      | 133,786    |   | $ | 209 |   | $ | 1,514 |   | $ | 132,481 |   |
| Other                                                     |       | 20,933                                 |       | 51 |   | 254 |   | 20,730 |   |
| Obligations of state and political subdivisions           |       | 73,058                                 |       | 770 |   | 372 |   | 73,456 |   |
| Corporate securities                                      |       | 1,936                                  |       | 83 |   | — |   | 2,019 |   |
| Marketable equity securities                              |       | 2,782                                  |       | 955 |   | 26 |   | 3,711 |   |
| Restricted equity securities                              |       | 4,612                                  |       | — |   | — |   | 4,612 |   |
| Total                                                     |       | $                                      | 237,107    |   | $ | 2,068 |   | $ | 2,166 |   | $ | 237,009 |   |

 
| ** **                                                | ** ** | **Held-to-Maturity Securities** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------|------------|
| **(Amounts in thousands)**                      | ** ** | **Amortized  Cost**                  | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
| *December 31, 2006:*                            | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Obligations of U.S. Government Corporations and Agencies: |       |                                 |       |   |   |   |   |   |   |
| Mortgage-backed                                           |       | $                                    | 204        |   | $ | — |   | $ | 2 |   | $ | 202 |   |
| Other                                                     |       | 4,000                                |       | 14 |   | 3 |   | 4,011 |   |
| Obligations of state and political subdivisions           |       | 2,725                                |       | — |   | 30 |   | 2,695 |   |
| Total                                                     |       | $                                    | 6,929      |   | $ | 14 |   | $ | 35 |   | $ | 6,908 |   |

 

SecuritiesAvailable-for-Sale with an aggregate fair value of $99,997,000 in 2007 and$64,191,000 in 2006; and securities Held-to-Maturity with an aggregate bookvalue of $2,539,000 in 2007 and $1,813,000 in 2006, were pledged to securepublic funds, trust funds, securities sold under agreements to repurchase, FHLBadvances and other balances of $57,991,000 in 2007 and $54,569,000 in 2006 asrequired by law.

 

Theamortized cost, estimated fair value and weighted average yield of debtsecurities, by contractual maturity, are shown below at December 31, 2007.Expected maturities will differ from contractual maturities because borrowersmay have the right to call or prepay obligations with or without call or prepaymentpenalties.

 

46

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 
| **(Amounts in thousands)**                                     | ** ** | **December 31, 2007**                                       | ** **  |
|--------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|-------------|
| **U.S. Government  Agency &  Corporation  Obligations(1)** | ** ** | **Obligations  of State  & Political  Subdivisions(2)** | ** **  | **Marketable  Equity  Securities(3)** | ** ** | **Restricted  Equity  Securities(3)** | ** ** | **Corporate  Securities** | ** ** |
| **Available-For-Sale:**                                                  |       |                                                                  |        |   |   |   |   |   |   |   |   |
| Within 1 Year:                                                           |       |                                                                  |        |   |   |   |   |   |   |   |   |
| Amortized cost                                                           | ** ** | **$**                                                                 | **2,095**   | ** ** | **$** | **—** | ** ** | **$** | **—** | ** ** | **$** | **—** | ** ** | **$** | **986** | ** ** |
| Estimated fair value                                                     | ** ** | **2,098**                                                             | ** **  | **—** | ** ** | **—** | ** ** | **—** | ** ** | **996** | ** ** |
| Weighted average yield                                                   | ** ** | **5.47**                                                              | **%**       | **—** | ** ** | **—** | ** ** | **—** | ** ** | **7.71** | **%** |
| 1 - 5 Years:                                                             |       |                                                                  |        |   |   |   |   |   |   |   |   |
| Amortized cost                                                           | ** ** | **14,788**                                                            | ** **  | **510** | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** |
| Estimated fair value                                                     | ** ** | **14,785**                                                            | ** **  | **531** | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** |
| Weighted average yield                                                   | ** ** | **4.93**                                                              | **%**       | **6.18** | **%** | **—** | ** ** | **—** | ** ** | **—** | ** ** |
| 5 - 10 Years:                                                            |       |                                                                  |        |   |   |   |   |   |   |   |   |
| Amortized cost                                                           | ** ** | **10,563**                                                            | ** **  | **4,499** | ** ** | **—** | ** ** | **—** | ** ** | **7,381** | ** ** |
| Estimated fair value                                                     | ** ** | **10,734**                                                            | ** **  | **4,548** | ** ** | **—** | ** ** | **—** | ** ** | **7,534** | ** ** |
| Weighted average yield                                                   | ** ** | **5.61**                                                              | **%**       | **5.65** | **%** | **—** | ** ** | **—** | ** ** | **5.99** | **%** |
| After 10                                                                 |       |                                                                  |        |   |   |   |   |   |   |   |   |
| Amortized cost                                                           | ** ** | **121,595**                                                           | ** **  | **70,338** | ** ** | **2,914** | ** ** | **6,109** | ** ** | **—** | ** ** |
| Estimated fair value                                                     | ** ** | **121,990**                                                           | ** **  | **69,280** | ** ** | **2,916** | ** ** | **6,109** | ** ** | **—** | ** ** |
| Weighted average yield                                                   | ** ** | **5.53**                                                              | **%**       | **6.19** | **%** | **3.94** | **%** | **5.13** | **%** | **—** | ** ** |
| Total:                                                                   |       |                                                                  |        |   |   |   |   |   |   |   |   |
| Amortized cost                                                           | ** ** | **$**                                                                 | **149,041** | ** ** | **$** | **75,347** | ** ** | **$** | **2,914** | ** ** | **$** | **6,109** | ** ** | **$** | **8,367** | ** ** |
| Estimated fair value                                                     | ** ** | **149,607**                                                           | ** **  | **74,359** | ** ** | **2,916** | ** ** | **6,109** | ** ** | **8,530** | ** ** |
| Weighted average yield                                                   | ** ** | **5.46**                                                              | **%**       | **6.15** | **%** | **3.94** | **%** | **5.13** | **%** | **6.19** | **%** |

 

----

(1)Mortgage-backedsecurities are allocated for maturity reporting at their original maturitydate.

(2)Average yieldson tax-exempt obligations of state and political subdivisions have beencomputed on a tax-equivalent basis using a 34% tax rate.

(3)Marketableequity securities and restricted equity securities are not considered to havedefined maturities and are included in the after ten year category.

 

47

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 
| **(Amounts in  thousands)**                                              | ** ** | **December 31, 2007**                                            | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| **U.S. Government  Agency &  Corporation  Obligations(1)** | ** ** | **Obligations  of State  & Political  Subdivisions(2)** | ** ** | **Marketable  Equity  Securities(3)** | ** ** | **Restricted  Equity  Securities(3)** | ** ** | **Corporate  Securities** | ** ** |
| **Held-To-Maturity:**                                                    |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Within 1 Year:                                                           |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Amortized cost                                                           | ** ** | **$**                                                                 | **—** | ** ** | **$** | **—** | ** ** | **$** | **—** | ** ** | **$** | **—** | ** ** | **$** | **—** | ** ** |
| Estimated fair value                                                     | ** ** | **—**                                                            | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** |
| Weighted average yield                                                   | ** ** | **—**                                                            | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** |
| 1 - 5 Years:                                                             |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Amortized cost                                                           | ** ** | **—**                                                            | ** ** | **983** | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** |
| Estimated fair value                                                     | ** ** | **—**                                                            | ** ** | **986** | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** |
| Weighted average yield                                                   | ** ** | **—**                                                            | ** ** | **4.65** | **%** | **—** | ** ** | **—** | ** ** | **—** | ** ** |
| 5 - 10 Years:                                                            |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Amortized cost                                                           | ** ** | **2,000**                                                             | ** ** | **364** | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** |
| Estimated fair value                                                     | ** ** | **2,007**                                                             | ** ** | **366** | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** |
| Weighted average yield                                                   | ** ** | **6.00**                                                              | **%**      | **5.10** | **%** | **—** | ** ** | **—** | ** ** | **—** | ** ** |
| After 10 Years:                                                          |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Amortized cost                                                           | ** ** | **191**                                                               | ** ** | **1,000** | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** |
| Estimated fair value                                                     | ** ** | **190**                                                               | ** ** | **1,004** | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** |
| Weighted average yield                                                   | ** ** | **5.41**                                                              | **%**      | **5.83** | **%** | **—** | ** ** | **—** | ** ** | **—** | ** ** |
| Total:                                                                   |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Amortized cost                                                           | ** ** | **$**                                                                 | **2,191**  | ** ** | **$** | **2,347** | ** ** | **$** | **—** | ** ** | **$** | **—** | ** ** | **$** | **—** | ** ** |
| Estimated fair value                                                     | ** ** | **2,197**                                                             | ** ** | **2,356** | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** |
| Weighted average yield                                                   | ** ** | **5.94**                                                              | **%**      | **5.22** | **%** | **—** | ** ** | **—** | ** ** | **—** | ** ** |

 

----

(1)Mortgage-backedsecurities are allocated for maturity reporting at their original maturitydate.

(2)Average yieldson tax-exempt obligations of state and political subdivisions have beencomputed on a tax-equivalent basis using a 34% tax rate.

(3)Marketableequity securities and restricted equity securities are not considered to havedefined maturities and are included in the after ten year category.

 

Restrictedequity securities consist of stock in the Federal Home Loan Bank of Pittsburgh(FHLB), Federal Reserve Bank (FRB) and Atlantic Central Bankers Bank (ACBB) anddo not have a readily determinable fair value for purposes of SFAS 115, becausetheir ownership is restricted and they can be sold back only to the FHLB, FRB,ACBB or to another member institution. Therefore, these securities areclassified as restricted equity investment securities, carried at cost, andevaluated for impairment.

 

Therewere no aggregate investments with a single issuer (excluding the U.S.Government and its agencies) which exceeded ten percent of consolidatedshareholders’ equity at December 31, 2007. The quality rating of all obligationsof state and political subdivisions are “A” or higher, as rated by Moody’s orStandard and Poors. The only exceptions are local issues which are not rated,but are secured by the full faith and credit obligations of the communitiesthat issued these securities. All of the state and political subdivisioninvestments are actively traded in a liquid market.

 

Proceedsfrom sale of investments in Available-for-Sale debt and equity securitiesduring 2007, 2006 and 2005 were $83,255,000, $103,736,000 and $119,669,000,respectively. Gross gains realized on these sales were $1,117,000, $1,441,000and $2,242,000, respectively. Gross losses on these sales were $631,000,$1,054,000 and $1,822,000, respectively.

 

48

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

Proceedsfrom sale of investments in Held-To-Maturity debt and equity securities during2007, 2006, and 2005 were $375,000, $201,000 and $0, respectively.  Gross losses on these sales were $3,000,$6,000 and $0, respectively and there were no gains realized during theseperiods.

 

Inaccordance with disclosures required by EITF No. 03-1, the summary belowshows the gross unrealized losses and fair value of the Bank’s investments,aggregated by investment category, that individual securities have been in acontinuous unrealized loss position for less than 12 months or more than 12months as of December 31, 2007 and 2006:

 

**December 31,2007**

 
| ** **                           | ** ** | **Less Than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total**       | ** ** |
|--------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-----------------|------------|
| **(Amounts in thousands)** | ** ** | **Fair  Value**                        | ** ** | **Unrealized  Loss**                 | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** |
|                                 |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| Direct obligations of the            |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| U.S. Government                      | ** ** | **$**                                  | **13,993** | ** **                           | **$**      | **8**           | ** ** | **$** | **—** | ** ** | **$** | **—** | ** ** | **$** | **13,993** | ** ** | **$** | **8** | ** ** |
| Federal Agency                       |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| Backed Securities                    | ** ** | **—**                             | ** ** | **—**                           | ** ** | **32,949**      | ** ** | **468** | ** ** | **32,949** | ** ** | **468** | ** ** |
| Municipal Bonds                      | ** ** | **38,818**                             | ** ** | **1,149**                            | ** ** | **2,880**       | ** ** | **281** | ** ** | **41,698** | ** ** | **1,430** | ** ** |
| Equities                             | ** ** | **1,498**                              | ** ** | **453**                              | ** ** | **174**         | ** ** | **53** | ** ** | **1,672** | ** ** | **506** | ** ** |
| ** **                           | ** ** | **$**                                  | **54,309** | ** **                           | **$**      | **1,610**       | ** ** | **$** | **36,003** | ** ** | **$** | **802** | ** ** | **$** | **90,312** | ** ** | **$** | **2,412** |   |

 

December 31, 2006

 
| ** **                           | ** ** | **Less Than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total**       | ** ** |
|--------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-----------------|------------|
| **(Amounts in thousands)** | ** ** | **Fair  Value**                        | ** ** | **Unrealized  Loss**                 | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** |
|                                 |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| Direct obligations of the            |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| U.S. Government                      |       | $                                      | 1,000      |                                 | $          | —          |       | $ | 15,743 |   | $ | 257 |   | $ | 16,743 |   | $ | 257 |   |
| Federal Agency Mortgage              |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| Backed Securities                    |       | 27,426                                 |       | 145                                  |       | 53,837          |       | 1,371 |   | 81,263 |   | 1,516 |   |
| Municipal Bonds                      |       | 31,258                                 |       | 313                                  |       | 5,113           |       | 89 |   | 36,371 |   | 402 |   |
| Equities                             |       | 381                                    |       | 26                                   |       | —          |       | — |   | 381 |   | 26 |   |
|                                 |       | $                                      | 60,065     |                                 | $          | 484             |       | $ | 74,693 |   | $ | 1,717 |   | $ | 134,758 |   | $ | 2,201 |   |

 

The Corporation investsin various forms of agency debt including mortgage backed securities andcallable debt. The mortgage backed securities are issued by FHLMC (Federal HomeLoan Mortgage Corporation) of FNMA (Federal National Mortgage Association). Themunicipal securities consist of general obligations and revenue bonds. The equitysecurities consist of FHLMC preferred stocks. The fair market value of the above securities is influenced by marketinterest rates, prepayment speeds on mortgage securities, bid to offer spreadsin the market place and credit premiums for various types of agency debt. Thesefactors change continuously and therefore the market value of these securitiesmay be higher or lower that the Corporation’s carrying value at any measurementdate. Management does not believe any of their 132 securities in an unrealizedposition as of December 31, 2007 represents an other-than-temporaryimpairment. The Corporation has the ability to hold the securities contained inthe above table for a time necessary to recover the cost.

 

49

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

**NOTE5**  —   **LOANS**

 

Major classifications ofloans at December 31, 2007 and 2006 consisted of:

 
| **(Amounts in thousands)**         | ** ** | **2007**    | ** **  | **2006** | ** ** |
|----------------------------------------------|------------|-------------|-------------|----------|------------|
| Commercial, Financial, and Agricultural      | ** ** | **$**       | **29,129**  |     | $          | 22,169 |   |
| Tax-exempt                                   | ** ** | **10,899**  |        | 3,264    |       |
| Real estate mortgages - Held-for-sale        | ** ** | **334**     |        | 3,829    |       |
| Real estate mortgages - Consumer             | ** ** | **130,531** |        | 82,378   |       |
| Real estate mortgages - Commercial           | ** ** | **190,803** |        | 123,674  |       |
| Consumer                                     | ** ** | **16,712**  |        | 18,728   |       |
| Gross loans                                  | ** ** | **$**       | **378,408** |     | $          | 254,042 |   |
| Add (deduct):   Unearned  discount |       | **(2,074**  | **) ** | (2,543   | )          |
| Net deferred loan fees and costs             | ** ** | **269**     |        | 258      |       |
| Loans, net of unearned income                | ** ** | **$**       | **376,603** |     | $          | 251,757 |   |

 

Changesin the allowance for loan losses for the years ended December 31, 2007,2006 and 2005, were as follows:

 
| **(Amounts in thousands)** | ** ** | **2007**  | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------|------------|-----------|------------|----------|------------|----------|------------|
| Balance, January 1              | ** ** | **$**     | **3,671**  |     | $          | 3,676    |       | $ | 3,828 |   |
| Provision charged to operations      | ** ** | **150**   |       | 500      |       | 750      |       |
| Loans charged off                    | ** ** | **(236**  | **)**      | (786     | )          | (933     | )          |
| Recoveries                           | ** ** | **179**   |       | 281      |       | 31       |       |
| Allowance purchased                  | ** ** | **1,282** |       | —   |       | —   |       |
| Balance, December 31            | ** ** | **$**     | **5,046**  |     | $          | 3,671    |       | $ | 3,676 |   |

 

Non-accrual loans at December 31, 2007, 2006 and2005 were $3,208,000, $1,704,000 and $2,069,000, respectively. The grossinterest that would have been recorded if these loans had been current inaccordance with their original terms and the amounts actually recorded inincome were as follows:

 
| **(Amounts in thousands)** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Gross interest due under terms       | ** ** | **$**    | **258**    |     | $          | 133      |       | $ | 149 |   |
| Amount included in income            | ** ** | **(144** | **)**      | (14      | )          | (57      | )          |
| Interest income not recognized       | ** ** | **$**    | **114**    |     | $          | 119      |       | $ | 92 |   |

 

AtDecember 31, 2007, 2006 and 2005 the recorded investment in loans that areconsidered to be impaired as defined by SFAS 114 was $3,208,000, $1,704,000 and$2,069,000, respectively. No additional charge to operations was required toprovide for the impaired loans allowance of $492,000, $131,000 and $327,000,respectively at December 31, 2007, 2006 and 2005, since the totalallowance for loan losses is estimated by management to be adequate to providefor the loan loss allowance required by SFAS 114 along with any other potentiallosses. The average recorded investment in impaired loans during the year endedDecember 31, 2007, 2006 and 2005 was approximately $1,837,000, $1,937,000and $2,187,000, respectively.

 

Loanspast-due 90 days or more and still accruing interest were $185,000 at December 31,2007 and $1,135,000 at December 31, 2006.

 

AtDecember 31, 2007, there were no significant commitments to lendadditional funds with respect to non-accrual and restructured loans.

 

50

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

**NOTE6**  —   **MORTGAGE SERVICING RIGHTS**

 

The mortgage loans soldserviced for others are not included in the accompanying consolidated balancesheets. The unpaid principal balances of mortgage loans serviced for otherswere $44,769,000 and $35,966,000 at December 31, 2007 and 2006,respectively. The balances of amortized capitalized mortgage servicing rights, netof valuation allowances, included in other assets at December 31, 2007 and2006, were $297,000 and $254,000, respectively. A valuation allowance isprovided when the carrying amount exceeds fair value determined by using adiscount rate of 7.6% and average lives of generally 3 to 13 years depending onloan rates.

 

The following summarizesmortgage servicing rights capitalized and amortized along with the aggregateactivity in the related valuation allowances:

 
| **(Amounts in thousands)** | ** ** | **2007**   | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------|------------|------------|------------|----------|------------|----------|------------|
| Balance, January 1              | ** ** | **$**      | **254**    |     | $          | 268      |       | $ | 297 |   |
| Servicing asset additions            | ** ** | **103**    |       | 43       |       | 28       |       |
| Amortization                         | ** ** | **(60**    | **)**      | (57      | )          | (57      | )          |
| Balance, December 31            | ** ** | **$**      | **297**    |     | $          | 254      |       | $ | 268 |   |
|                                 |       |       |       |     |       |     |       |
| Valuation Allowances:                |       |       |       |     |       |     |       |
| Balance, January 1              |       | **—** |       | $        | 13         |     | $          | 47 |   |
| Additions                            | ** ** | **—** |       | —   |       | —   |       |
| Reductions                           | ** ** | **—** |       | (13      | )          | (34      | )          |
| Writedowns                           | ** ** | **—** |       | —   |       | —   |       |
| Balance, December 31            | ** ** | **$**      | **—** |     | $          | —   |       | $ | 13 |   |
| Net Mortgage Servicing Rights        | ** ** | **$**      | **297**    |     | $          | 254      |       | $ | 255 |   |

 

Custodial escrow balances maintained in connectionwith the foregoing loan servicing, and included in demand deposits, wereapproximately $33,000 and $26,000 at December 31, 2007 and 2006,respectively.

 

**NOTE7**  —   **PREMISES AND EQUIPMENT**

 

A summary of premises andequipment at December 31, 2007 and 2006 follows:

 
| **(Amounts in thousands)** | ** ** | **2007**   | ** ** | **2006** | ** ** |
|--------------------------------------|------------|------------|------------|----------|------------|
| Land                                 | ** ** | **$**      | **1,746**  |     | $          | 1,055 |   |
| Buildings                            | ** ** | **7,832**  |       | 4,494    |       |
| Leasehold improvements               | ** ** | **391**    |       | 214      |       |
| Equipment                            | ** ** | **6,401**  |       | 5,332    |       |
| ** **                           |       | **16,370** |       | 11,095   |       |
| Less: Accumulated depreciation       | ** ** | **7,884**  |       | 6,079    |       |
| Total                                | ** ** | **$**      | **8,486**  |     | $          | 5,016 |   |

 

Depreciation amounted to $472,000 for 2007, $442,000for 2006 and $455,000 for 2005.

 

The banking subsidiary leases land and a bank buildingunder a lease expiring in 2017 (See Note 15). Included in buildings above isthe bank building held under a capital lease with a cost of $953,000 andaccumulated amortization of $481,000 at December 31, 2007. Amortization onthe bank building held under the capital lease was $8,000 for the year ended December 31,2007.

 

51

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

**NOTE 8**  —   **GOODWILL,OTHER INTANGIBLE ASSETS, AND PREMIUM DISCOUNTS**

 

Goodwill, other intangible assets, and premium discountswere comprised of the following at December 31, 2007 and 2006:

 
| ** **                                                               | ** ** | **Gross**                | ** ** | **Accumulated**              | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------|------------|------------------------------|------------|
| **(Amounts in thousands)**                                     | ** ** | **Carrying Amount** | ** ** | **Amortization/(Accretion)** | ** ** |
| ** **                                                               | ** ** | **2007**                 | ** ** | **2006**                     | ** ** | **2007** | ** ** | **2006** | ** ** |
| Unamortized intangible asset:                                            |       |                     |       |                         |       |   |   |   |   |
| Goodwill                                                                 | ** ** | **$**                    | **18,981** |                         | $          | 1,224 | ** ** | **$** | **—** |   | $ | — |   |
|                                                                     |       |                     |       |                         |       |   |   |   |   |
| Core deposit intangibles                                                 | ** ** | **$**                    | **2,109**  |                         | $          | 137 | ** ** | **$** | **109** |   | $ | 48 |   |
| Premium discount (negative premium) on acquired certificates of  deposit | ** ** | **$**                    | **(385**   | **)**                        | $          | (217 | ) | **$** | **(253** | **)** | $ | (216 | ) |

 

Amortization expense of the core deposit intangibleswas $61,000 for the year ended December 31, 2007 and $16,000 for each ofthe years ended December 31, 2006 and 2005. Accretion of the premiumdiscount (negative premium) of the acquired certificates of deposit was$36,000, $15,000 and $89,000 for the years ended December 31, 2007, 2006and 2005, respectively.

 

Estimated amortization/accretion is as follows for theyears ending December 31:

 
| **(Amounts in thousands)** | ** ** | **Amortization  of Core  Deposit Intangible** | ** ** | **Accretion of Premium Discount  (Negative Premium)  on Certificates of Deposit** | ** ** |
|--------------------------------------|------------|---------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------|------------|
| 2008                                 |       | $                                                       | 289        |                                                                                                                 | $          | (109 | ) |
| 2009                                 |       | 289                                                     |       | (21                                                                                                                  | )          |
| 2010                                 |       | 289                                                     |       | (2                                                                                                                   | )          |
| 2011                                 |       | 289                                                     |       | —                                                                                                               |       |
| 2012                                 |       | 283                                                     |       | —                                                                                                               |       |
|                                      |            |                                                         |            |                                                                                                                      |            |  |  |

 

**NOTE9**  —   **DEPOSITS**

 

Major classifications ofdeposits at December 31, 2007 and 2006 consisted of:

 
| **(Amounts in thousands)** | ** ** | **2007**    | ** **  | **2006** | ** ** |
|--------------------------------------|------------|-------------|-------------|----------|------------|
| Demand - non-interest bearing        | ** ** | **$**       | **58,844**  |     | $          | 41,361 |   |
| Demand - interest bearing            | ** ** | **88,628**  |        | 68,593   |       |
| Savings                              | ** ** | **93,168**  |        | 69,950   |       |
| Time, $100,000 and over              | ** ** | **72,212**  |        | 47,703   |       |
| Other time                           | ** ** | **180,189** |        | 156,413  |       |
| Total deposits                       | ** ** | **$**       | **493,041** |     | $          | 384,020 |   |

 

52

----

 

**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

Thefollowing is a schedule reflecting classification and remaining maturities oftime deposits of $100,000 and over at December 31, 2007:

 
| **(Amounts in thousands)** | ** ** | ** ** | ** ** |
|--------------------------------------|------------|------------|------------|
| 2008                                 |       | $          | 50,025     |   |
| 2009                                 |       | 11,553     |       |
| 2010                                 |       | 1,112      |       |
| 2011                                 |       | 2,108      |       |
| 2012                                 |       | 7,414      |       |
|                                 |       | $          | 72,212     |   |

 

Interest expenserelated to time deposits of $100,000 or more was $2,693,000 in 2007, $1,907,000in 2006, and $1,330,000 in 2005.

 

In November 2007,approximately $109,672,000 of deposit accounts were assumed through theacquisition of Pocono Community Bank (See Notes 2 and 13).

 

**NOTE10**  —   **SHORT-TERM BORROWINGS**

 

Federal funds purchased,securities sold under agreements to repurchase and Federal Home Loan Bankadvances generally represent overnight or less than 30-day borrowings. U.S.Treasury tax and loan notes for collections made by the Bank are payable ondemand. Short-term borrowings consisted of the following at December 31,2007 and 2006:

 
| ** **                                                                  | ** ** | ** **  | ** ** | **2007**    | ** ** |
|-----------------------------------------------------------------------------|------------|-------------|------------|-------------|------------|
| ** **                                                                  | ** ** | ** **  | ** ** | ** **  | ** ** | **Maximum** | ** ** | ** ** | ** ** |
| ** **                                                                  | ** ** | **Ending**  | ** ** | **Average** | ** ** | **Month End** | ** ** | **Average** | ** ** |
| **(Amounts in thousands)**                                        | ** ** | **Balance** | ** ** | **Balance** | ** ** | **Balance** | ** ** | **Rate** | ** ** |
| Federal funds purchased and securities sold under agreements to  repurchase | ** ** | **$**       | **16,386** | ** **  | **$**      | **14,563** | ** ** | **$** | **23,842** | ** ** | **4.07** | **%** |
| Federal Home Loan Bank                                                      | ** ** | **29,500**  | ** ** | **14,136**  | ** ** | **29,500** | ** ** | **4.99** | **%** |
| U.S. Treasury tax and loan notes                                            | ** ** | **1,463**   | ** ** | **537**     | ** ** | **1,686** | ** ** | **5.47** | **%** |
| Total                                                                       | ** ** | **$**       | **47,349** | ** **  | **$**      | **29,236** | ** ** | **$** | **55,028** | ** ** | **5.54** | **%** |

 
| ** **                                                                  | ** ** | ** **  | ** ** | **2006**    | ** ** |
|-----------------------------------------------------------------------------|------------|-------------|------------|-------------|------------|
| ** **                                                                  | ** ** | ** **  | ** ** | ** **  | ** ** | **Maximum** | ** ** | ** ** | ** ** |
| ** **                                                                  | ** ** | **Ending**  | ** ** | **Average** | ** ** | **Month End** | ** ** | **Average** | ** ** |
| **(Amounts in thousands)**                                        | ** ** | **Balance** | ** ** | **Balance** | ** ** | **Balance** | ** ** | **Rate** | ** ** |
| Federal funds purchased and securities sold under agreements to  repurchase |       | $           | 15,688     |        | $          | 13,411 |   | $ | 16,138 |   | 4.04 | % |
| Federal Reserve - Discount Window                                           |       | —      |       | 4           |       | — |   | 6.25 | % |
| Federal Home Loan Bank                                                      |       | 11,000      |       | 6,525       |       | 13,325 |   | 5.06 | % |
| U.S. Treasury tax and loan notes                                            |       | 1,491       |       | 367         |       | 1,491 |   | 5.83 | % |
| Total                                                                       |       | $           | 28,179     |        | $          | 20,307 |   | $ | 30,954 |   | 5.10 | % |

 

**NOTE10**  —   **LONG-TERM BORROWINGS**

 

Long-termborrowings are comprised of advances from the Federal Home Loan Bank (FHLB) anda capital lease assumed as a result of the acquisition of Pocono Community Bankin the amount of $811,000. Long term capital lease scheduled maturities as of December 31,2007 are: $47,000 in 2008, $51,000 in 2009, $55,000 in 2010, $60,000 in 2011,$67,000 in 2012, and $524,000 thereafter for a total balance of $804,000 as of December 31,2007.

 

53

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

Under terms of ablanket agreement, collateral for the loans is secured by certain qualifyingassets of the Corporation’s banking subsidiary with FHLB.  The principal assets are real estatemortgages with a carrying value of $347,965,000 and certain investmentsecurities with a carrying value of $151,803,000 at December 31, 2007.

 

A schedule oflong-term borrowings by maturity as of December 31, 2007 and 2006 follows:

 
| **(Amounts in thousands)** | ** ** | **2007**   | ** ** | **2006** | ** ** |
|--------------------------------------|------------|------------|------------|----------|------------|
| Due 2007, 3.09% to 3.91%             | ** ** | **$**      | **—** |     | $          | 10,255 |   |
| Due 2008, 3.54% to 5.48%             | ** ** | **9,030**  |       | 9,030    |       |
| Due 2009, 3.87% to 5.01%             | ** ** | **12,000** |       | 7,000    |       |
| Due 2010, 4.95% to 6.76%             | ** ** | **23,591** |       | 15,500   |       |
| Due 2011, 4.23% to 5.03%             | ** ** | **7,000**  |       | 7,000    |       |
| Due 2012, 4.77%                      | ** ** | **10,000** |       | 5,000    |       |
| Due 2014, 5.41%                      | ** ** | **3,750**  |       | 3,750    |       |
| ** **                           |       | **$**      | **65,371** |     | $          | 57,535 |   |

 

**NOTE12**  —   **INCOME TAXES**

 

The current and deferred components of the income taxprovision (benefit) consisted of the following:

 
| **(Amounts in thousands)** | ** ** | **2007**   | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------|------------|------------|------------|----------|------------|----------|------------|
| Federal                              |       |       |       |     |       |     |       |
| Current                              | ** ** | **$**      | **1,456**  |     | $          | 1,417    |       | $ | 1,389 |   |
| Deferred (benefit)                   | ** ** | **(104**   | )          | (263     | )          | (49      | )          |
| ** **                           |       | **$**      | **1,352**  |     | $          | 1,154    |       | $ | 1,340 |   |
| State                                |       |       |       |     |       |     |       |
| Current                              | ** ** | **39**     |       | $        | 34         |     | $          | 23 |   |
| Deferred                             | ** ** | **—** |       | —   |       | —   |       |
| ** **                           |       | **$**      | **39**     |     | $          | 34       |       | $ | 23 |   |
| ** **                           |       | ** ** |       |     |       |     |       |
| Total provision for income taxes     | ** ** | **$**      | **1,391**  |     | $          | 1,188    |       | $ | 1,363 |   |

 

The following is areconciliation between the actual provision for federal income taxes and theamount of federal income taxes which would have been provided at the statutoryrate of 34%:

 
| ** **                                                    | ** ** | **2007**   | ** **      | **2006**   | ** ** | **2005**   | ** ** |
|---------------------------------------------------------------|------------|------------|-----------------|------------|------------|------------|------------|
| **(Amounts in thousands)**                          | ** ** | **Amount** | ** **      | **Rate**   | ** ** | **Amount** | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
| Provision at statutory rate                    |       | **$**      | ** 2,556** |       | **34.0**   | **%**      | $          |  2,508 |   | 34.0 | % | $ |  2,792 |   | 34.0 | % |
| Tax-exempt income                                             | ** ** | **(1,060** | **)**           | **(14.1**  | **)**      | (1,276     | )          | (17.3 | ) | (1,374 | ) | (16.7 | ) |
| Non-deductible expenses                                       | ** ** | **165**    | ** **      | **2.2**    |       | 176        |       | 2.4 |   | 161 |   | 2.0 |   |
| Tax credit from limited partnership   Less amortization - net | ** ** | **(79**    | **)**           | **(1.1**   | **)**      | (62        | )          | (.8 | ) | (64 | ) | (.8 | ) |
| Bank owned life insurance income - net                        | ** ** | **(190**   | **)**           | **(2.5**   | **)**      | (160       | )          | (2.2 | ) | (149 | ) | (1.8 | ) |
| Other-net                                                     | ** ** | **(40**    | **)**           | **(.5**    | **)**      | (32        | )          | (.5 | ) | (26 | ) | (.4 | ) |
| Applicable federal income tax and rate                        | ** ** | **$**      | **1,352**       | ** ** | **18.0**   | **%**      | $          | 1,154 |   | 15.6 | % | $ | 1,340 |   | 16.3 | % |

 

54

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

Total federal income taxattributable to realized security gains and losses was $164,000 in 2007,$130,000 in 2006 and $143,000 in 2005.

 

The deferred tax assetsand liabilities resulting from temporary timing differences have been netted toreflect a net deferred tax asset (liability) included in other assets or otherliabilities in these consolidated financial statements. The components of thenet deferred tax asset (liability) at December 31, 2007 and 2006, are asfollows:

 
| **(A****mounts in thousands)**    | ** ** | **2007**   | ** ** | **2006** | ** ** |
|---------------------------------------------|------------|------------|------------|----------|------------|
| Deferred Tax Assets:                        |       |       |       |     |       |
| Allowance for loan losses                   | ** ** | **$**      | **1,631**  |     | $          | 1,145 |   |
| Deferred compensation                       | ** ** | **364**    |       | 339      |       |
| Deferred health benefits                    | ** ** | **2**      |       | 4        |       |
| Contributions                               | ** ** | **13**     |       | 9        |       |
| Non-accrual interest                        | ** ** | **41**     |       | 3        |       |
| Leases                                      | ** ** | **114**    |       | —   |       |
| Limited partnership                         | ** ** | **69**     |       | 58       |       |
| Alternative minimum tax credits             | ** ** | **85**     |       | 85       |       |
| Tax credits from limited partnerships       | ** ** | **184**    |       | 147      |       |
| Unrealized investment securities losses-net | ** ** | **85**     |       | —   |       |
| Total                                       | ** ** | **$**      | **2,588**  |     | $          | 1,790 |   |
| Deferred Tax Liabilities:                   |       |       |       |     |       |
| Loan fees and costs                         | ** ** | **$**      | **219**    |     | $          | (195 | ) |
| Depreciation                                | ** ** | **223**    |       | (229     | )          |
| Accretion                                   | ** ** | **72**     |       | (80      | )          |
| Mortgage servicing rights                   | ** ** | **28**     |       | (11      | )          |
| Intangibles                                 | ** ** | **441**    |       | (135     | )          |
| Unrealized investment securities gains      | ** ** | **—** |       | (28      | )          |
| Total                                       | ** ** | **$**      | **983**    |     | $          | (678 | ) |
| Net Deferred Tax Asset (Liability)          | ** ** | **$**      | **1,605**  |     | $          | 1,112 |   |

 

It is anticipated that all deferred tax assets are tobe realized and accordingly, no valuation allowance has been provided.

 

The Corporation and its subsidiary file a consolidatedfederal income tax return.

 

**NOTE 13** —   **SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION**

 

During the years ended December 31, 2007, 2006and 2005, cash payments for interest expense and income taxes were as follows:

 
| **(Amounts in thousands)**           | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest paid on deposits and other borrowings | ** ** | **$**      | **17,448** |       | $          | 14,784     |       | $ | 11,401 |   |
|                                           | ** ** | ** ** |       |       |       |       |       |
| Income taxes paid                              | ** ** | **$**      | **1,752**  |       | $          | 1,380      |       | $ | 921 |   |

 

The Corporation transferred loans to foreclosed assetsheld-for-sale in amounts of $624,000, $28,000 and $457,000 in 2007, 2006 and2005, respectively.

 

55

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

**Non-Cash Investing and Financing Activities**

 

On November 1, 2007 First Keystone Corporationcompleted its acquisition of Pocono Community Bank (See Note 2). A summary ofthe estimated fair value of the non-cash assets acquired and the liabilitiesassumed at the date of acquisition were as follows:

 
| **(Amounts in thousands)**              | ** ** | ** **  | ** **  |
|---------------------------------------------------|------------|-------------|-------------|
| Assets Acquired:                                  |       |        |        |
| Investment securities                             | ** ** | **$**       | **13,122**  | ** ** |
| Loan, net of allowances for loan losses           | ** ** | **104,752** | ** **  |
| Premises and equipment-net                        | ** ** | **3,292**   | ** **  |
| Accrued interest receivable                       | ** ** | **596**     | ** **  |
| Cash surrender value of bank-owned life insurance | ** ** | **2,950**   | ** **  |
| Goodwill and other intangibles                    | ** ** | **19,838**  | ** **  |
| Other assets                                      | ** ** | **1,065**   | ** **  |
| Total Assets Acquired                             | ** ** | **$**       | **145,615** | ** ** |
|                                              | ** ** | ** **  | ** **  |
| Liabilities Assumed:                              |       |        |        |
| Deposits                                          | ** ** | **$**       | **109,672** | ** ** |
| Borrowings                                        | ** ** | **5,908**   | ** **  |
| Other liabilities                                 | ** ** | **413**     | ** **  |
| Total Liabilities Assumed                         | ** ** | **$**       | **115,993** | ** ** |
|                                              | ** ** | ** **  | ** **  |
| Net Non-Cash Assets Acquired                      | ** ** | **$**       | **29,622**  | ** ** |

 

The Corporation issued932,203 shares of common stock to the shareholders of Pocono Community for atotal of $15,996,000. The company paid $17,569,000 for the acquisition lesscash acquired from Pocono Community Bank in the amount of $3,943,000 or a netcash expenditure of $13,626,000.

 

**NOTE14**  —   **EMPLOYEE BENEFIT PLANS AND DEFERRED COMPENSATIONAGREEMENTS**

 

TheCorporation maintains a 401K Plan which has a combined tax qualified savingsfeature and profit sharing feature for the benefit of its employees. Under thesavings feature, the Corporation matches 100% of the employee contribution upto 3% of compensation which amounted to $111,000, $102,000 and $99,000, in 2007,2006 and 2005, respectively. Under the profit sharing feature, contributions,at the discretion of the Board of Directors, are funded currently and amountedto $273,000, $263,000 and $301,000 in 2007, 2006 and 2005, respectively.

 

TheBank also has non-qualified deferred compensation agreements with two of itsofficers and three retired officers. These agreements are essentially unsecuredpromises by the Bank to make monthly payments to the officers over a twentyyear period. Payments begin based upon specific criteria — generally, when theofficer retires. To account for the cost of payments yet to be made in thefuture, the Bank recognizes an accrued liability in years prior to whenpayments begin based on the present value of those future payments. The Bank’saccrued liability for these deferred compensation agreements as of December 31,2007 and 2006, was $1,071,000 and $998,000, respectively.  The related expense for these plans amountedto $125,000, $108,000 and $179,000 in 2007, 2006 and 2005, respectively.

 

TheBank entered into agreements to provide post-retirement benefits to a retiredemployee in the form of life insurance payable to the employee’s estate upontheir death through endorsement split dollar life insurance arrangements. TheCorporation adopted the guidance in EITF 06-4 (See recent accountingpronouncements in Note 1) effective January 1, 2007 to recognize theliabilities for future benefits in the amount of $36,000.

 

56

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

**NOTE 15** —  **COMMITMENTS AND CONTINGENCIES**

 

TheCorporation’s banking subsidiary currently leases four branch banking facilitiesand one parcel of land, as well as two operation centers, under operatingleases. Rent expense for the years ended December 31, 2007, 2006 and 2005was $216,000, $162,000 and $152,000, respectively.  Minimum rental payments required under theseoperating leases are:  2008 - $256,000,2009 - $207,000, 2010 - $182,000, 2011 - $151,000, 2012 - $76,000 andthereafter $2,460,000.

 

Thebanking subsidiary leases land and a bank building under a lease expiring in2017. This lease has an operating lease commitment and a capital leasecomponent.

 

Minimumfuture rental payments as of December 31, 2007 under this noncancelableoperating lease component for land are due as follows and are included in theamounts of operating lease payments above. 2008 - $36,000, 2009 - $36,000, 2010- $36,000, 2011 - $36,000, 2012 - $36,000 and thereafter $182,000.

 

Minimumfuture lease payments under the capital lease component for the bank buildingas of December 31, 2007 for each of the next five years and in theaggregate are:

 
| **Year Ending December 31** | ** ** | ** ** | ** ** |
|--------------------------------------------|------------|------------|------------|
| 2008                                       |       | $          | 113,000    |   |
| 2009                                       |       | 113,000    |       |
| 2010                                       |       | 113,000    |       |
| 2011                                       |       | 113,000    |       |
| 2012                                       |       | 115,000    |       |
| Thereafter                                 |       | 647,000    |       |
|                                       |       |       |       |
| Total minimum lease payments               |       | 1,214,000  |       |
| Less amounts representing interest         |       | 410,000    |       |
| Present value of net minus lease payments  |       | $          | 804,000    |   |

 

In the normal course ofbusiness, there are various pending legal actions and proceedings that are notreflected in the consolidated financial statements. Management does not believethe outcome of these actions and proceedings will have a material effect on theconsolidated financial position of the Corporation.

 

**NOTE 16**  —  **RELATED PARTY TRANSACTIONS**

 

Certain directors andexecutive officers of First Keystone Corporation and its Subsidiary andcompanies in which they are principal owners (i.e., at least 10%) were indebtedto the Corporation at December 31, 2007, 2006 and 2005. These loans weremade on substantially the same terms and conditions, including interest ratesand collateral, as those prevailing at the time for comparable transactionswith unrelated parties. The loans do not involve more than the normal risk ofcollectibility nor present other unfavorable features.

 

A summary of the activityon the related party loans, comprised of 8 directors and 3 executive officersand their related companies consists of the following:

* *
| **(Amounts in thousands)** | ** ** | **2007**   | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------|------------|------------|------------|----------|------------|----------|------------|
| Balance at January 1            | ** ** | **$**      | **939**    |     | $          | 1,221    |       | $ | 744 |   |
| Additions                            | ** ** | **4,074**  |       | 1,359    |       | 1,289    |       |
| Deductions                           | ** ** | **(1,363** | )          | (1,641   | )          | (812     | )          |
| Balance at December 31          | ** ** | **$**      | **3,650**  |     | $          | 939      |       | $ | 1,221 |   |

 

57

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

The above loans representfunds drawn and outstanding at the date of the accompanying consolidatedfinancial statement. Commitments by the Bank to related parties on lines ofcredit and letters of credit for 2007, 2006 and 2005,  presented an additional off-balance sheetrisk to the extent of undisbursed funds in the amounts of $2,574,000,$1,908,000 and $2,785,000, respectively, on the above loans.

 

Deposits from certainofficers and directors and/or their affiliated companies held by the Bankamounted to $7,950,000 and $4,996,000 at December 31, 2007 and 2006,respectively.

 

**NOTE 17**  —  **REGULATORY MATTERS**

 

Dividends are paid by theCorporation to shareholders which are mainly provided by dividends from theBank. However, national banking laws place certain restrictions on the amountof cash dividends allowed to be paid by the Bank to the Corporation. Generally,the limitation provides that dividend payments may not exceed the Bank’scurrent year’s retained income plus retained net income for the preceding twoyears. During 2007, the Bank paid dividends to the Corporation in the amount of$10,459,000. The Bank’s undistributed net income for 2005 and 2006 at thebeginning of 2007 was $5,081,000 and the Bank’s net income for the year ended December 31,2007 was $5,817,000. Accordingly, in 2008, without prior regulatory approval,the Bank may declare dividends to the Corporation in the amount of $439,000plus additional amounts equal to the net income earned in 2008 for the period January 1,2008, through the date of declaration, less any dividends which may havealready been paid in 2008. Regulations also limit the amount of loans andadvances from the Bank to the Corporation to 10% of consolidated net assets.

 

The Corporation issubject to various regulatory capital requirements administered by the federalbanking agencies. Failure to meet minimum capital requirements can initiatecertain mandatory — and possibly additional discretionary — actions byregulators that, if undertaken, could have a direct material effect on theCorporation’s financial statements. Under capital adequacy guidelines and theregulatory framework for prompt corrective action, the Corporation must meetspecific capital guidelines that involve quantitative measures of theCorporation’s assets, liabilities, and certain off-balance sheet items ascalculated under regulatory accounting practices. The Corporation’s capitalamounts and classification are also subject to qualitative judgements by theregulators about components, risk weightings and other factors. Managementbelieves, as of December 31, 2007 and 2006, that the Corporation and theBank met all capital adequacy requirements to which they are subject.

 

Quantitative measuresestablished by regulation to ensure capital adequacy require the Bank tomaintain minimum amounts and ratios (set fourth in the table below) of Totaland Tier I Capital (as defined in the regulations) to Risk-Weighted Assets (asdefined), and of Tier I Capital (as defined) to Average Assets (as defined).

 

As of December 31,2007, the most recent notification from the Office of the Comptroller of theCurrency categorized the Bank as Well Capitalized under the regulatoryframework for prompt corrective action. To be categorized as Well Capitalized,the Bank must maintain minimum Total Risk-Based, Tier I Risked-Based and Tier ILeverage Ratios as set forth in the table. There are no conditions or eventssince the notification that management believes have changed the Bank’scategory.

 
| ** **                           | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
|--------------------------------------|------------|------------|------------|----------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| **(Amounts in thousands)** | ** ** | **Amount** | ** ** | **Ratio**                                    | ** ** | **Amount**                                                                                       | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| **As of December 31, 2007:**    |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
| Total Capital                        |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
| (to Risk Weighted Assets)            | ** ** | **$**      | **61,056** | ** **                                   | **14.28**  | **%**                                                                                            | **$**      | **34,203** | ** ** | **8.00** | **%** | **$** | **42,754** | ** ** | **10.00** | **%** |
| Tier I Capital                       |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
| (to Risk Weighted Assets)            | ** ** | **56,010** | ** ** | **13.10**                                    | **%**      | **17,102**                                                                                       | ** ** | **4.00** | **%** | **25,652** | ** ** | **6.00** | **%** |
| Tier I Capital                       |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
| (to Average Assets)                  | ** ** | **56,010** | ** ** | **9.00**                                     | **%**      | **24,891**                                                                                       | ** ** | **4.00** | **%** | **31,113** | ** ** | **5.00** | **%** |
|                                      |            |            |            |                                              |            |                                                                                                  |            |  |  |  |  |  |  |  |  |  |

 

58

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 
| ** **                           | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
|--------------------------------------|------------|------------|------------|----------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| **(Amounts in thousands)** | ** ** | **Amount** | ** ** | **Ratio**                                    | ** ** | **Amount**                                                                                       | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| As of December 31, 2006:        |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
| Total Capital                        |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
| (to Risk Weighted Assets)            |       | $          | 51,320     |                                         | 17.41      | %                                                                                                | $          | 23,578 |   | 8.00 | % | $ | 29,472 |   | 10.00 | % |
| Tier I Capital                       |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
| (to Risk Weighted Assets)            |       | 47,649     |       | 16.17                                        | %          | 11,789                                                                                           |       | 4.00 | % | 17,683 |   | 6.00 | % |
| Tier I Capital                       |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
| (to Average Assets)                  |       | 47,649     |       | 9.19                                         | %          | 20,731                                                                                           |       | 4.00 | % | 25,914 |   | 5.00 | % |
|                                      |            |            |            |                                              |            |                                                                                                  |            |  |  |  |  |  |  |  |  |  |

 

The Corporation’s capitalratios are not materially different from those of the Bank.

 
| **NOTE 18** | —                | **FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK  AND CONCENTRATIONS OF** |
|-------------|-----------------------|------------------------------------------------------------------------------|
|        | ** CREDIT RISK** |

 

The Corporation is aparty to financial instruments with off-balance sheet risk in the normal courseof business to meet the financing needs of its customers. These financialinstruments include commitments to extend credit and standby letters of credit.Those instruments involve, to varying degrees, elements of credit and interestrate risk in excess of the amount recognized in the consolidated balancesheets. The contract or notional amounts of those instruments reflect theextent of involvement the Corporation has in particular classes of financialinstruments. The Corporation does not engage in trading activities with respectto any of its financial instruments with off-balance sheet risk.

 

The Corporation’sexposure to credit loss in the event of nonperformance by the other party tothe financial instrument for commitments to extend credit and standby lettersof credit is represented by the contractual notional amount of thoseinstruments.

 

The Corporation uses thesame credit policies in making commitments and conditional obligations as itdoes for on-balance sheet instruments.

 

The Corporation mayrequire collateral or other security to support financial instruments withoff-balance sheet credit risk.

 

The contract or notionalamounts at December 31, 2007 and 2006 were as follows:

 
| **(Amounts in thousands)**                                | ** ** | **2007** | ** ** | **2006** | ** ** |
|---------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Financial instruments whose contract amounts represent credit risk: |       |     |       |     |       |
| Commitments  to extend credit                                       | ** ** | **$**    | **42,776** |     | $          | 33,811 |   |
| Financial  standby letters of credit                                | ** ** | **$**    | **1,744**  |     | $          | 1,160 |   |
| Performance  standby letters of credit                              | ** ** | **$**    | **2,471**  |     | $          | 2,155 |   |

 

Commitmentsto extend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the contract. Commitments generallyhave fixed expiration dates or other termination clauses that may requirepayment of a fee. Since many of the commitments are expected to expire withoutbeing drawn upon, the total commitment amounts do not necessarily representfuture cash requirements. The Corporation evaluates each customer’screditworthiness on a case-by-case basis. The amount of collateral obtained, ifdeemed necessary by the Corporation upon extension of credit, is based onmanagement’s credit evaluation of the counter-party. Collateral held varies butmay include accounts receivable, inventory, property, plant and equipment, andincome-producing commercial properties.

 

59

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

Standbyletters of credit are conditional commitments issued by the Corporation toguarantee payment to a third party when a customer either fails to repay anobligation or fails to perform some non-financial obligation. The credit riskinvolved in issuing letters of credit is essentially the same as that involvedin extending loan facilities to customers. The Corporation may hold collateralto support standby letters of credit for which collateral is deemed necessary.

 

TheCorporation grants commercial, agricultural, real estate mortgage and consumerloans to customers primarily in the counties of Columbia, Luzerne, Montour andMonroe, Pennsylvania. The concentrations of credit by type of loan are setforth in Note 4, “Loans”. It is management’s opinion that the loan portfoliowas well balanced and diversified at December 31, 2007, to the extentnecessary to avoid any significant concentration of credit risk. However, itsdebtors ability to honor their contracts may be influenced by the region’seconomy.

 

**NOTE19**  —  **COMPREHENSIVE INCOME**

 

Thecomponents of other comprehensive income and related tax effects are asfollows:

 
| ** **                                                                                         | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| **(Amounts in thousands)**                                                               | ** ** | **2007**                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
| Unrealized holding (losses) on available-for-sale investment  securities arising during the period |       | **$**                                       | **273**    |   | $ | (1,220 | ) | $ | (3,300 | ) |
| Less reclassification adjustment for net gains and losses realized in  income                      | ** ** | **426**                                     |       | 210 |   | 1,203 |   |
| Change in unrealized (losses) before tax effect                                                    | ** ** | **$**                                       | **(153**   | **)** | $ | (1,430 | ) | $ | (4,503 | ) |
| Tax effects                                                                                        | ** ** | **(113**                                    | **)**      | (497 | ) | (1,543 | ) |
| Net change in unrealized (losses)                                                                  | ** ** | **$**                                       | **(40**    | **)** | $ | (933 | ) | $ | (2,960 | ) |

 

**NOTE20**  —  **STOCKHOLDERS’ EQUITY**

 

On November 1, 2007 First Keystone Corporationcompleted its acquisition of Pocono Community Bank (See Note 2) and inconnection therewith, issued 932,203 shares of First Keystone common stock fora total of $15,996,000.

 

On October 24, 2006 the Board of Directorsdeclared a 5% stock dividend payable to shareholders of record November 14,2006 and distributed December 5, 2006. A total of 215,991 shares wereissued as a result of this stock dividend, with a total value transferred fromretained earnings of $4,237,480, including cash in lieu of fractional shares.

 

The Corporation also offers to its shareholders aDividend Reinvestment and Stock Purchase Plan. First Keystone Corporation isauthorized to issue up to 100,000 shares of its common stock under the plan.The plan provides First Keystone shareholders a convenient and economical wayto purchase additional shares of common stock by reinvesting dividends. A planparticipant can elect full dividend reinvestment or partial dividendreinvestment provided at least 25 shares are enrolled in the plan. In addition,plan participants may make additional voluntary cash purchases of common stockunder the plan of not less than $100 per calendar quarter or more than $2,500in any calendar quarter.

 

Shares of First Keystone common stock are purchasedfor the plan either in the open market by an independent broker on behalf ofthe plan, directly from First Keystone as original issue shares, or throughnegotiated transactions. A combination of the previous methods could alsooccur.

 

60

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

Participation in this plan by shareholders began in2001. Shares transferred under this dividend reinvestment and stock purchaseplan were as follows:

 
| **Year** | ** ** | **Number of Shares** | ** ** |
|----------|------------|--------------------------------|------------|
| 2001     |       | 3,260                          |       |
| 2002     |       | 7,747                          |       |
| 2003     |       | 8,000                          |       |
| 2004     |       | 13,932                         |       |
| 2005     |       | 21,491                         |       |
| 2006     |       | 22,964                         |       |
| 2007     |       | 25,900                         |       |

 

**NOTE21**  —  **STOCK COMPENSATION PLAN**

 

On February 10, 1998, the Board of Directorsadopted a stock option incentive plan and initially reserved 100,000 shares ofcommon stock for issuance under the plan for certain employees of the Bank.After adjustments for the effects of stock dividends, options exercised andoptions forfeited there remains 68,104 options for possible issuance.  Under the Plan, options are granted at fairmarket value and the time period during which any option granted may beexercised may not commence before six months or continue beyond the expirationof ten years after the option is awarded. Upon exercise of the stock options, shares of the Corporation’s stockare issued from Treasury Stock.

 

On December 27, 2007, the Board of Directorsissued 6,250 stock options.

 

The fair value of stock options issued to employees ismeasured on the date of the grant and is recognized as compensation expenseover the requisite service period. Expected volatility and dividend yield are based on historical stockprices and dividend amounts over past time periods equal in length to the lifeof the options.  The risk-free interestrate is determined using the U.S. Treasury yield curve in effect at the date ofthe grant.  The expected life of theoptions is calculated using the average term of the vesting period and themaximum term.

 

Stock based compensation expense was $1,000 for theyear ended December 31, 2007 attributable to stock options granted in2007.  Stock based compensation expensewas $8,000 for the year ended  December 31,2006 attributable to stock options granted in 2005.  Forfeitures in excess of stock optionsexpense was ($2,000) for the year ended December 31, 2005 for stockoptions issued in 2003.

 

The fair value of each option grant is estimated onthe date of grant using the Binomial Option Pricing Model derived from theBlack-Scholes Option Pricing Model with the following weighted-averageassumptions used for options granted in 2007 and 2005, respectively: dividendyield of 5.25% and 4.05%; expected volatility of 26.17% and 23.04%; risk-freeinterest rate of 3.64% and 4.39%; and an expected life of 5.25 years and 10years.

 

61

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

Information about stock options outstanding at December 31,2007, is summarized as follows:

 
| ** **                      | ** ** | **2007**    | ** ** | **2006**     | ** ** | **2005**    | ** ** |
|---------------------------------|------------|-------------|------------|--------------|------------|-------------|------------|
| ** **                      | ** ** | ** **  | ** ** | **Weighted** | ** ** | ** **  | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                      | ** ** | ** **  | ** ** | **Average**  | ** ** | ** **  | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                      | ** ** | **Stock**   | ** ** | **Exercise** | ** ** | **Stock**   | ** ** | **Exercise** | ** ** | **Stock** | ** ** | **Exercise** | ** ** |
| ** **                      | ** ** | **Options** | ** ** | **Price**    | ** ** | **Options** | ** ** | **Price** | ** ** | **Options** | ** ** | **Price** | ** ** |
| Balance at January 1       | ** ** | **51,383**  | ** ** | **$**        | **17.55**  |        | 60,619     |   | $ | 18.61 |   | 66,653 |   | $ | 18.29 |   |
| Granted                         | ** ** | **6,250**   | ** ** | **16.75**    |       | —      |       | — |   | 4,000 |   | 22.00 |   |
| Granted due to stock dividend   | ** ** | **—**  | ** ** | **—**   |       | 2,404       |       | 17.56 |   | — |   | — |   |
| Exercised                       | ** ** | **—**  | ** ** | **—**   |       | (4,415      | )          | 16.23 |   | (6,211 | ) | 15.40 |   |
| Forfeited                       | ** ** | **(3,071**  | **)**      | **15.95**    |       | (7,225      | )          | 21.33 |   | (3,823 | ) | 21.80 |   |
| Balance at December 31     | ** ** | **54,562**  | ** ** | **17.55**    |       | 51,383      |       | 17.55 |   | 60,619 |   | 18.61 |   |
|                            | ** ** | ** **  | ** ** | ** **   |       |        |       |   |   |   |   |   |   |
| Exercisable at December 31 | ** ** | **48,312**  | ** ** | **$**        | **17.65**  |        | 51,383     |   | $ | 17.55 |   | 56,619 |   | $ | 18.37 |   |
| Weighted average fair value of  |       |        |       |         |       |        |       |   |   |   |   |   |   |
| options granted during the year | ** ** | ** **  |       | **$**        | **2.98**   |        |       |   |   |   |   |   | $ | 5.02 |   |

 

Underthe terms of the stock option incentive plan, the stock options includingamendments as to price and terms were adjusted for the stock dividend in 2006.

 

Exerciseprices of options outstanding as of December 31, 2007, ranged from $10.28to $21.11 per share. The weighted average remaining contracted life isapproximately 4.22 years.

 

The54,562 options outstanding as December 31, 2007 have an intrinsic value,which is the amount that the value of the underlying stock exceeds the exerciseprice of the options of $33,000.  Thetotal intrinsic value of the options exercised during the years ended December 31,2007, 2006 and 2005 was $0, $10,000 and $31,000, respectively.  Cash received from stock options exercisedfor the years ended December 31, 2007, 2006 and 2005 was $0, $72,000 and$96,000, respectively.

 

Thefollowing table summarizes information concerning the 1998 Employee StockOption Plan at December 31, 2007.

 
| ** ** | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|------------|------------|------------------------------|------------|------------------------------|------------|
| ** ** | ** ** | ** **                   | ** ** | **Weighted**                 | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** ** | ** ** | ** **                   | ** ** | **Average**                  | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** ** | ** ** | **Number**                   | ** ** | **Remaining**                | ** ** | **Exercise** | ** ** | **Number** | ** ** | **Exercise** | ** ** |
| **Year**   | ** ** | **Outstanding***             | ** ** | **Contractual Life**    | ** ** | **Price** | ** ** | **Exercisable** | ** ** | **Price** | ** ** |
| 1998       |       | 10,319                       |       | .75                          |       | $ | 20.26 |   | 10,319 |   | $ | 20.26 |   |
| 1999       |       | 10,041                       |       | 1.75                         |       | 15.88 |   | 10,041 |   | 15.88 |   |
| 2000       |       | 4,950                        |       | 2.75                         |       | 10.28 |   | 4,950 |   | 10.28 |   |
| 2002       |       | 8,574                        |       | 4.75                         |       | 15.08 |   | 8,574 |   | 15.08 |   |
| 2003       |       | 11,018                       |       | 5.75                         |       | 21.11 |   | 11,018 |   | 21.11 |   |
| 2005       |       | 3,410                        |       | 7.75                         |       | 20.95 |   | 3,410 |   | 20.95 |   |
| 2007       |       | 6,250                        |       | 9.75                         |       | 16.75 |   | 0 |   | — |   |
|       |       |                         |       |                         |       |   |   |   |   |   |   |
|       |       | 54,562                       |       | 4.22                         |       | $ | 17.55 |   | 48,312 |   | $ | 17.65 |   |
|            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |

 

----

*Asadjusted for stock dividend noted above.

 

62

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

**NOTE 22** —   **FAIR VALUES OF FINANCIAL INSTRUMENTS**

 

Statement of Financial Accounting Standards (SFAS)107, “Disclosures about Fair Value of Financial Instruments”, requiresdisclosure of fair value information about financial instruments, whether ornot required to be recognized in the consolidated balance sheets, for which itis practicable to estimate such fair value. In cases where quoted market pricesare not available, fair values are based on estimates using present value orother valuation techniques. These techniques are significantly affected by theassumptions used, including the discount rate and estimates of future cashflows. Fair value estimates derived through these techniques cannot besubstantiated by comparison to independent markets and, in many cases, couldnot be realized in immediate settlement of the instrument. SFAS 107 excludescertain financial instruments and all nonfinancial instruments from itsdisclosure requirements. Accordingly, the aggregate fair value amountspresented do not represent the underlying value of the Corporation.

 

The following methods and assumptions were used by theCorporation in estimating its fair value disclosures for financial instruments:

 

**Cash and Due From Banks, Short-TermInvestments, Accrued Interest Receivable and Accrued Interest Payable**

 

The fair values are equalto the current carrying values.

 

**Investment Securities**

 

Fair values have beenindividually determined based on currently quoted market prices. If a quotedmarket price is not available, fair value is estimated using quoted marketprices for similar securities.

 

**Loans**

 

Fair values are estimatedfor categories of loans with similar financial characteristics. Loans weresegregated by type such as commercial, tax-exempt, real estate mortgages andconsumer. For estimation purposes each loan category was further segmented intofixed and adjustable rate interest terms and also into performing andnon-performing classifications.

 

The fair value of eachcategory of performing loans is calculated by discounting future cash flowsusing the current rates at which similar loans would be made to borrowers withsimilar credit ratings and for the same remaining maturities.

 

Fair value fornon-performing loans is based on management’s estimate of future cash flowsdiscounted using a rate commensurate with the risk associated with theestimated future cash flows. The assumptions used by management arejudgmentally determined using specific borrower information.

 

**Cash Surrender Value of Bank OwnedLife Insurance**

 

Fair value is equal tothe cash surrender value of life insurance policies.

 

**Deposits**

 

Under SFAS 107, the fairvalue of deposits with no stated maturity, such as Demand Deposits, SavingsAccounts and Money Market Accounts is equal to the amount payable on demand at December 31,2007 and 2006.

 

Fair values forfixed-rate certificates of deposit are estimated using a discounted cash flowcalculation that applies interest rates currently being offered on similar termborrowings, to a schedule of aggregated expected monthly maturities on timedeposits.

 

63

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

**Short-Term and Long-Term Borrowings**

 

The fair values ofshort-term and long-term borrowings are estimated using discounted cash flowanalyses based on the Corporation’s incremental borrowing rate for similarinstruments.

 

**Commitments to Extend Credit andStandby Letters of Credit**

 

Management estimates thatthere are no material differences between the notional amount and the estimatedfair value of those off-balance sheet items since they are primarily composedof unfunded loan commitments which are generally priced at market at the timeof funding.

 

At December 31, 2007and 2006, the carrying values and estimated fair values of financialinstruments of the Corporation are presented in the table below:

 
| ** **                                 | ** ** | **2007**     | ** ** | **2006**            | ** ** |
|--------------------------------------------|------------|--------------|------------|---------------------|------------|
| ** **                                 | ** ** | **Carrying** | ** ** | **Estimated**       | ** ** | **Carrying** | ** ** | **Estimated** | ** ** |
| **(Amounts in thousands)**       | ** ** | **Amount**   | ** ** | **Fair Value** | ** ** | **Amount** | ** ** | **Fair Value** | ** ** |
| FINANCIAL ASSETS:                          |       |         |       |                |       |   |   |   |   |
| Cash and due from banks                    | ** ** | **$**        | **9,886**  | ** **          | **$**      | **9,886** |   | $ | 5,881 |   | $ | 5,881 |   |
| Short-term investments                     | ** ** | **89**       | ** ** | **89**              |       | 4,307 |   | 4,307 |   |
| Investment securities - available for sale | ** ** | **241,521**  | ** ** | **241,521**         |       | 237,009 |   | 237,009 |   |
| Investment securities - held to maturity   | ** ** | **4,539**    | ** ** | **4,553**           |       | 6,929 |   | 6,908 |   |
| Net loans                                  | ** ** | **371,556**  | ** ** | **364,380**         |       | 248,086 |   | 250,989 |   |
| Accrued interest receivable                | ** ** | **3,241**    | ** ** | **3,241**           |       | 2,686 |   | 2,686 |   |
| Cash surrender value of life insurance     | ** ** | **16,450**   | ** ** | **16,450**          |       | 11,942 |   | 11,942 |   |
|                                       |       |         |       |                |       |   |   |   |   |
| FINANCIAL LIABILITIES:                     |       |         |       |                |       |   |   |   |   |
| Deposits                                   | ** ** | **493,041**  | ** ** | **478,109**         |       | 384,020 |   | 367,952 |   |
| Short-term borrowings                      | ** ** | **47,349**   | ** ** | **47,349**          |       | 28,179 |   | 28,179 |   |
| Long-term borrowings                       | ** ** | **66,175**   | ** ** | **68,736**          |       | 57,535 |   | 57,902 |   |
| Accrued interest and other expenses        | ** ** | **3,454**    | ** ** | **3,454**           |       | 2,581 |   | 2,581 |   |
|                                       |       |         |       |                |       |   |   |   |   |
| OFF-BALANCE SHEET FINANCIAL INSTRUMENTS:   |       |         |       |                |       |   |   |   |   |
| Commitments to extend credit               | ** ** | ** **   |       | **42,776**          |       |   |   | 33,811 |   |
| Financial standby letters of credit        | ** ** | ** **   |       | **1,744**           |       |   |   | 1,160 |   |
| Performance standby letters of credit      | ** ** | ** **   |       | **2,471**           |       |   |   | 2,155 |   |
|                                            |            |              |            |                     |            |  |  |  |  |  |  |  |  |

 

64

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

**NOTE 23** —  **PARENT COMPANY FINANCIAL INFORMATION**

 

Condensedfinancial information for First Keystone Corporation (parent company only) wasas follows:

 

**BALANCESHEETS**
| ** **                                      | ** ** | **December 31** | ** ** |
|-------------------------------------------------|------------|----------------------|------------|
| **(Amounts in thousands)**            | ** ** | **2007**             | ** ** | **2006** | ** ** |
| ASSETS                                          |       |                 |       |   |   |
| Cash in subsidiary bank                         | ** ** | **$**                | **316**    |   | $ | 1,648 |   |
| Investment in subsidiary bank                   | ** ** | **76,962**           |       | 48,594 |   |
| Investment in other equity securities           | ** ** | **2,917**            |       | 3,711 |   |
| Prepayments and other assets                    | ** ** | **330**              |       | 274 |   |
| TOTAL ASSETS                                    | ** ** | **$**                | **80,525** |   | $ | 54,227 |   |
|                                            |       |                 |       |   |   |
| LIABILITIES                                     |       |                 |       |   |   |
| Accrued expenses and other liabilities          | ** ** | **$**                | **102**    |   | $ | 440 |   |
| Advance from subsidiary bank                    | ** ** | **9,499**            |       | 400 |   |
| TOTAL LIABILITIES                               | ** ** | **$**                | **9,601**  |   | $ | 840 |   |
|                                            |       |                 |       |   |   |
| STOCKHOLDERS’ EQUITY                       |       |                 |       |   |   |
| Preferred stock                                 | ** ** | **$**                | **—** |   | $ | — |   |
| Common stock                                    | ** ** | **11,375**           |       | 9,511 |   |
| Surplus                                         | ** ** | **30,252**           |       | 16,119 |   |
| Retained earnings                               | ** ** | **35,705**           |       | 33,793 |   |
| Accumulated other comprehensive income (loss)   | ** ** | **(166**             | **)**      | (126 | ) |
| Treasury stock, at cost                         | ** ** | **(6,242**           | **)**      | (5,910 | ) |
| TOTAL STOCKHOLDERS’ EQUITY                 | ** ** | **$**                | **70,924** |   | $ | 53,387 |   |
|                                            |       |                 |       |   |   |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY | ** ** | **$**                | **80,525** |   | $ | 54,227 |   |

 

**STATEMENTSOF INCOME**
| ** ** | ** ** | **Year Ended December 31** | ** ** |
|------------|------------|-------------------------------------------|------------|

 
| **(Amounts in thousands)**                         | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|--------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| INCOME                                                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Dividends from Subsidiary Bank                               | ** ** | **$**      | **10,459** |       | $          | 3,902      |       | $ | 3,607 |   |
| Dividends - other                                            | ** ** | **107**    |       | 89         |       | 69         |       |
| Securities gains                                             | ** ** | **420**    |       | 362        |       | 252        |       |
| Interest                                                     | ** ** | **32**     |       | 33         |       | 38         |       |
| TOTAL INCOME                                                 | ** ** | **$**      | **11,018** |       | $          | 4,386      |       | $ | 3,966 |   |
|                                                         | ** ** | ** ** |       |       |       |       |       |
| Operating Expenses                                           | ** ** | **89**     |       | 84         |       | 82         |       |
| Income Before Taxes and Equity in                            |       |       |       |       |       |       |       |
| Undistributed Net Income of Subsidiary                       | ** ** | **$**      | **10,929** |       | $          | 4,302      |       | $ | 3,884 |   |
| Income tax expense                                           | ** ** | **160**    |       | 137        |       | 93         |       |
| Income Before Equity in Undistributed Net                    |       |       |       |       |       |       |       |
| Income of Subsidiary                                         | ** ** | **$**      | **10,769** |       | $          | 4,165      |       | $ | 3,791 |   |
| Equity in (excess of) Undistributed Net Income of Subsidiary | ** ** | **(4,642** | **)**      | 2,025      |       | 3,056      |       |
|                                                         | ** ** | ** ** |       |       |       |       |       |
| NET INCOME                                                   | ** ** | **$**      | **6,127**  |       | $          | 6,190      |       | $ | 6,847 |   |

 

65

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**FIRSTKEYSTONE CORPORATION AND SUBSIDIARY**

**Notes toConsolidated Financial Statements for the Years Ended December 31, 2007,2006 and 2005 - Continued**

 

**STATEMENTS OF CASH FLOWS**

 
| ** **                                                                         | ** ** | **Year Ended December 31** | ** **  |
|------------------------------------------------------------------------------------|------------|-------------------------------------------|-------------|
| **(Amounts in thousands)**                                               | ** ** | **2007**                                  | ** **  | **2006** | ** ** | **2005** | ** ** |
| OPERATING ACTIVITIES                                                               |       |                                      |        |   |   |   |   |
| Net income                                                                         | ** ** | **$**                                     | **6,127**   |   | $ | 6,190 |   | $ | 6,847 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |                                      |        |   |   |   |   |
| Securities gains                                                                   | ** ** | **(420**                                  | )           | (362 | ) | (252 | ) |
| Equity in (excess of) undistributed net income of subsidiary                       | ** ** | **4,642**                                 |        | (2,025 | ) | (3,056 | ) |
| (Increase) decrease in prepaid expenses and other assets                           | ** ** | **(56**                                   | **)**       | (150 | ) | 336 |   |
| Increase (decrease) in advances payable to subsidiary bank - net  operating        | ** ** | **71**                                    |        | 102 |   | (342 | ) |
| Increase (decrease) in accrued expenses and other liabilities                      | ** ** | **38**                                    |        | (30 | ) | 42 |   |
| NET CASH PROVIDED BY OPERATING ACTIVITIES                                          | ** ** | **$**                                     | **10,402**  |   | $ | 3,725 |   | $ | 3,575 |   |
|                                                                               |       |                                      |        |   |   |   |   |
| INVESTING ACTIVITIES                                                               |       |                                      |        |   |   |   |   |
| Purchase of equity securities                                                      | ** ** | **$**                                     | **(765**    | **)** | $ | (1,403 | ) | $ | (685 | ) |
| Proceeds from sale of equity securities                                            | ** ** | **1,052**                                 |        | 859 |   | 479 |   |
| Purchase of bank                                                                   | ** ** | **(16,539**                               | **)**       | — |   | — |   |
| NET CASH (USED IN) INVESTING ACTIVITIES                                            | ** ** | **$**                                     | **(16,252** | **)** | $ | (544 | ) | $ | (206 | ) |
|                                                                               |       |                                      |        |   |   |   |   |
| FINANCING ACTIVITIES                                                               |       |                                      |        |   |   |   |   |
| Proceeds from sale of treasury stock                                               |       | $                                         |        |   | $ | 71 |   | $ | 95 |   |
| Acquisition of treasury stock                                                      | ** ** | **(332**                                  | **)**       | (1,514 | ) | (247 | ) |
| Cash dividends paid                                                                | ** ** | **(4,179**                                | **)**       | (3,874 | ) | (3,602 | ) |
| Dividends paid in lieu of fractional shares                                        | ** ** | **—**                                |        | (4 | ) | — |   |
| Advances from subsidiary bank                                                      | ** ** | **9,029**                                 |        | — |   | — |   |
| NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES                                | ** ** | **$**                                     | **4,518**   |   | $ | (5,321 | ) | $ | (3,754 | ) |
|                                                                               |       |                                      |        |   |   |   |   |
| (DECREASE) IN CASH AND CASH EQUIVALENTS                                            | ** ** | **$**                                     | **(1,332**  | **)** | $ | (2,140 | ) | $ | (385 | ) |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR                                     | ** ** | **1,648**                                 |        | 3,788 |   | 4,173 |   |
| CASH AND CASH EQUIVALENTS AT END OF YEAR                                           | ** ** | **$**                                     | **316**     |   | $ | 1,648 |   | $ | 3,788 |   |
|                                                                                    |            |                                           |             |  |  |  |  |  |  |  |  |

 

66

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**REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM**

 

BOARD OF DIRECTORS AND STOCKHOLDERS OF FIRST KEYSTONECORPORATION

 

We have audited FirstKeystone Corporation’s internal control over financial reporting as of December 31,2007, based on criteria established in *InternalControl — Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (the COSO criteria).  The Corporation’s management is responsiblefor maintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reportingincluded in the accompanying Report on Management’s Assessment of InternalControl over Financial Reporting.  Ourresponsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of the Corporation’s internal control overfinancial reporting based on our audit.

 

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States).  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether effective internal control over financial reporting was maintained inall material respects.  Our audit ofinternal control over financial reporting included obtaining an understandingof internal control over financial reporting, assessing a risk that a materialweakness exists and testing and evaluating the design and operatingeffectiveness of internal control based on the assessed risk. Our audit alsoincluded performing such other procedures as we considered necessary in the circumstances.  We believe that our audit provides areasonable basis for our opinion.

 

A company’s internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with accountingprinciples generally accepted in the United States of America.  A company’s internal control over financialreporting includes those policies and procedures that (1) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with accounting principlesgenerally accepted in the United States of America and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and (3) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the company’s assets that could have amaterial effect on the financial statements.

 

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

 

In our opinion, FirstKeystone Corporation maintained, in all material respects, effective internalcontrol over financial reporting as of December 31, 2007, based oncriteria established in *Internal Control —Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (the COSO criteria).

 

We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board (UnitedStates), the consolidated balance sheets of First Keystone Corporation andSubsidiary as of December 31, 2007 and 2006 and the related consolidatedstatements of income, changes in stockholders’ equity and cash flows for eachof the years in the three-year period ended December 31, 2007 and ourreport dated March 11, 2008 expressed an unqualified opinion on thosethereon.

 

 
|                   | J. H. Williams & Co., LLP |
|------------------------|------------------------------------|
|                   | J. H. Williams & Co., LLP |
|                   |
| Kingston, Pennsylvania |
| March 11, 2008    |

 

67

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ITEM 9.           CHANGES IN ANDDISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

 

Not Applicable.

 

ITEM 9A.        CONTROLS ANDPROCEDURES

 

**Evaluationof Disclosure Controls and Procedures**

 

The Management of FirstKeystone Corporation (the “Corporation”), with the participation of the ChiefExecutive Officer and Chief Financial Officer, conducted an evaluation of theeffectiveness of our disclosure controls and procedures, pursuant to SecuritiesExchange Act Rules 13a-15, as amended, as of December 31, 2007. Basedupon such evaluation, the Corporation’s Chief Executive Officer and ChiefFinancial Officer have concluded that, as of the end of such period, theCorporation’s disclosure controls and procedures are effective in timelyalerting them to material information relating to the Corporation required tobe included in our periodic SEC filings.

 

**Management’sReport on Internal Control Over Financial Reporting**

 

The management of FirstKeystone Corporation is responsible for establishing and maintaining adequateinternal control over financial reporting. The Corporation’s internal control system was designed to providereasonable assurance to the Corporation’s management and Board of Directorsregarding the preparation and fair presentation of published financialstatements.

 

The Corporation’sinternal control over financial reporting are supported by written policiesthat pertain to the maintenance of records that, in reasonable detail,accurately and fairly reflect transactions and dispositions of assets; providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with accounting principlesgenerally accepted in the United States of America, and that receipt andexpenditures of the Corporation are being made only in accordance withauthorization of the Corporation’s management and Board of Directors; andprovide reasonable assurance regarding prevention or timely detection ofunauthorized acquisition, use or disposition of the Corporation’s assets thatcould have a material effect on the consolidated financial statements.

 

All internal controlsystems, no matter how well designed, have inherent limitations.  Therefore, even those systems determined tobe effective can provide only reasonable assurance with respect to financialstatement preparation and presentation. Also, projections of any evaluation of effectiveness to future periodsare subject to the risk that controls may become inadequate because of changesin conditions, or that the degree of compliance with the policies or proceduresmay deteriorate.

 

The management of FirstKeystone Corporation assessed the effectiveness of the Corporation’s internalcontrol over financial reporting as of December 31, 2007.  In making this assessment, we used thecriteria set forth by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO) in  *Internal Control — Integrated Framework*.  Based on our assessment we believe that, asof December 31, 2007, the Corporation’s internal control over financialreporting is effective based on those criteria.

 

First KeystoneCorporation’s independent registered public accounting firm that audited theconsolidated financial statements has issued an audit report on our assessmentof, and the effective operation of, the Corporation’s internal control overfinancial reporting as of December 31, 2007.  This report appears on page 67.

 

**Changesin Internal Controls**

 

The Corporation made nochanges in its internal controls or in other factors that has materiallyaffected, or is reasonably likely to materially affect these controlssubsequent to the date of the evaluation of the controls by the Chief Executiveand Chief Financial Officers.

 

ITEM 9B.         OTHER INFORMATION

 

Not Applicable.

 

68

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PART III

 

ITEM 10.         DIRECTORS, EXECUTIVEOFFICERS AND CORPORATE GOVERNANCE

 

The information under thecaptions “Information As To Directors and Nominees,” “Principal Officers of theBank and the Corporation” and “Committees of the Board of Directors” areincorporated here by reference from First Keystone Corporation’s proxystatement for its 2008 annual meeting of shareholders scheduled for May 6,2008.  The information under the caption “Section 16(A) BeneficialOwnership Reporting Compliance” and “Code of Ethics” are as follows:

 

SECTION 16(A) BENEFICIALOWNERSHIP

REPORTING COMPLIANCE

 

Section 16(a) ofthe Securities Exchange Act of 1934 requires the Corporation’s directors,executive officers and shareholders who own more than 10% of the Corporation’soutstanding equity stock to file initial reports of ownership and reports ofchanges in ownership of common stock and other equity securities of theCorporation with the Securities and Exchange Commission.  Based solely on its review of copies of Section 16(a) formsreceived by it, or written representations from reporting persons that no Form 5’swere required for those persons, the corporation believes that during theperiod January 1, 2007 through December 31, 2007, its officers,directors and reporting shareholders were in compliance with all filingrequirements applicable to them.

 

CODE OF ETHICS

 

The Corporation hasadopted a Directors and Senior Management Code of Ethical Conduct, whichapplies to all members of the Board of Directors and to senior officers of theCorporation.  It can be found on theInvestor Relations section of our website at www.firstkeystonecorporation.com.

 

ITEM 11.         EXECUTIVECOMPENSATION

 

The information under thecaptions “Executive Compensation” (pages 20 through 29), “CompensationDiscussion and Analysis (CD&A),” Compensation Committee Interlocks andInsider Participation,” and Compensation Committee Report” are incorporatedhere by reference from First Keystone Corporation’s proxy statement for its2008 annual meeting of shareholders scheduled for May 6, 2008.

 

ITEM 12.         SECURITY OWNERSHIPOF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED   SHAREHOLDERMATTERS

 

The information under thecaption “Share Ownership” and “Equity Compensation Plan Information” areincorporated here by reference from First Keystone Corporation’s proxystatement for its 2008 annual meeting of shareholders scheduled for May 6,2008.

 

ITEM 13.         CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

 

The information under thecaptions “Related Person Transactions” and “Governance Of The Company” areincorporated here by reference from First Keystone Corporation’s proxystatement for its 2008 annual meeting of shareholders scheduled for

May 6, 2008.

 

ITEM 14.         PRINCIPAL ACCOUNTANTFEES AND SERVICES

 

The information under thecaption “Report of the Audit Committee” is incorporated here by reference fromFirst Keystone Corporation’s proxy statement for its 2008 annual meeting ofshareholders scheduled for May 6, 2008.

 

69

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PART IV

 

ITEM 15.         EXHIBITS ANDFINANCIAL STATEMENT SCHEDULES

 

(a)                 1.        FinancialStatements

 

Thefollowing consolidated financial statements are included in Part II, Item8, of this Report:

 

FirstKeystone Corporation and Subsidiary.

 
| Report of Independent Registered Public Accounting  Firm |   | 30 |
|----------------------------------------------------------|--------|----|
| Consolidated Balance Sheets                              |   | 31 |
| Consolidated Statements of Income                        |   | 32 |
| Consolidated Statements of Stockholders’ Equity     |   | 33 |
| Consolidated Statements of Cash Flows                    |   | 34 |
| Notes to Consolidated Financial Statements               |   | 35 |
| Report of Independent Registered Public Accounting  Firm |   | 67 |

 

2.       FinancialStatement Schedules

 

Financialstatements schedules are omitted because the required information is either notapplicable, not required,  or is shown inthe financial statements or in their notes.

 

3.       Exhibits

 

Exhibitsrequired by Item 601 of Regulation S:

 
| **Exhibit Number Referred to** | ** ** | ** **                                                                                                                                                                                         |
|-------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Item 601 of Regulation S-K**      | ** ** | **Description of Exhibit**                                                                                                                                                                         |
|                                |       |                                                                                                                                                                                               |
| 3i                                  |       | Articles of Incorporation, as amended (Incorporated by reference to  Exhibit 3(I) to the Registrant’s Report on Form 10-Q for the  quarter ended March 31, 2006).         |
|                                |       |                                                                                                                                                                                               |
| 3ii                                 |       | By-Laws, as amended (Incorporated by reference to  Exhibit 3(ii) to the Registrant’s Report on Form 10-Q for the  quarter ended March 31, 2006).                          |
|                                |       |                                                                                                                                                                                               |
| 10.1                                |       | Supplemental Employee Retirement Plan (Incorporated by reference to  Exhibit 10 to Registrant’s Annual Report on Form 10-Q for the  quarter ended September 31, 2005).         |
|                                |       |                                                                                                                                                                                               |
| 10.2                                |       | Management Incentive Compensation Plan (Incorporated by reference to  Exhibit 10 to Registrant’s Report on Form 10-Q for the quarter  ended September 30, 2006).               |
|                                |       |                                                                                                                                                                                               |
| 10.3                                |       | Profit Sharing Plan (Incorporated by reference to Exhibit 10 to  Registrant’s Report on Form 10-Q for the quarter ended  September 30, 2006).                                  |
|                                |       |                                                                                                                                                                                               |
| 10.4                                |       | First Keystone Corporation 1998 Stock Incentive Plan (Incorporated by  reference to Exhibit 10 to Registrant’s Report on Form 10-Q for the  quarter ended September 30, 2006). |

 

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| **Exhibit Number Referred to** | ** ** | ** **                                                                                                                                                                                                                                                                                                                     |
|-------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Item 601 of Regulation S-K**      | ** ** | **Description of Exhibit (Continued)**                                                                                                                                                                                                                                                                                    |
|                                |       |                                                                                                                                                                                                                                                                                                                           |
| 10.5                                |       | Employment Agreement between First Keystone Corporation, First  Keystone National Bank and John G. Gerlach dated May 10, 2007  (Incorporated by reference to Annex B to the Proxy Statement/Prospectus on  the Registrant’s Registration Statement on Form S-4, as amended  (No. 333-145658)).             |
|                                |       |                                                                                                                                                                                                                                                                                                                           |
| 10.6                                |       | Consulting Agreement between Keystone Corporation, First Keystone  National Bank and John G. Gerlach dated May 10, 2007 (Incorporated by  reference to Annex C to the Proxy Statement/Prospectus on the Registrant’s  Registration Statement on Form S-4, as amended (No. 333-145658)).                    |
|                                |       |                                                                                                                                                                                                                                                                                                                           |
| 10.7                                |       | Form of Non-Competition and Non-Solicitation Agreement by and  between First Keystone Corporation and the Pocono Community Bank directors  (Incorporated by reference to Annex F to the Proxy Statement/Prospectus on  the Registrant’s Registration Statement on Form S-4, as amended  (No. 333-145658)). |
|                                |       |                                                                                                                                                                                                                                                                                                                           |
| 14                                  |       | Code of Ethics (Incorporated by reference to Exhibit 14 to  Registrant’s Report on   Form 8-K dated January 9, 2007).                                                                                                                                                                                      |
|                                |       |                                                                                                                                                                                                                                                                                                                           |
| 21                                  |       | List of Subsidiaries of the Corporation.                                                                                                                                                                                                                                                                                       |
|                                |       |                                                                                                                                                                                                                                                                                                                           |
| 23                                  |       | Consent of Independent Auditors.                                                                                                                                                                                                                                                                                               |
|                                |       |                                                                                                                                                                                                                                                                                                                           |
| 31.1                                |       | Rule 13a-14(a)/15d-14(a) Certification of Chief Executive  Officer.                                                                                                                                                                                                                                                  |
|                                |       |                                                                                                                                                                                                                                                                                                                           |
| 31.2                                |       | Rule 13a-14(a)/15d-14(a) Certification of Chief Financial  Officer.                                                                                                                                                                                                                                                  |
|                                |       |                                                                                                                                                                                                                                                                                                                           |
| 32.1                                |       | Section 1350 Certification of Chief Executive Officer.                                                                                                                                                                                                                                                                    |
|                                |       |                                                                                                                                                                                                                                                                                                                           |
| 32.2                                |       | Section 1350 Certification of Chief Financial Officer.                                                                                                                                                                                                                                                                    |

 

71

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**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 

 

**FIRST KEYSTONE CORPORATION**

 
| /s/ J. Gerald Bazewicz            |                |
|-----------------------------------|---------------------|
| J. Gerald Bazewicz                |                |
| President/Chief Executive Officer |                |
|                              |
| Date:                             | March 11, 2008 |   |
|                                   |                     |  |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Registrant and inthe capacities and on the dates indicated.

 

 
| /s/ John Arndt                             |   |   | March 11, 2008 |   |
|--------------------------------------------|--------|--------|---------------------|--------|
| John Arndt, Secretary/Director             |   |   | Date                |   |
|                                       |   |   |                |   |
| /s/ J. Gerald Bazewicz                     |   |   | March 11, 2008 |   |
| J. Gerald Bazewicz, President/             |   |   | Date                |   |
| Chief Executive Officer/Director           |   |   |                |   |
|                                       |   |   |                |   |
| /s/ Don E. Bower                           |   |   | March 11, 2008 |   |
| Don E. Bower, Director                     |   |   | Date                |   |
|                                       |   |   |                |   |
| /s/ Robert A. Bull                         |   |   | March 11, 2008 |   |
| Robert A. Bull, Director                   |   |   | Date                |   |
|                                       |   |   |                |   |
| /s/ Robert E. Bull                         |   |   | March 11, 2008 |   |
| Robert E. Bull, Chairman/Director          |   |   | Date                |   |
|                                       |   |   |                |   |
| /s/ Joseph B. Conahan, Jr.            |   |   | March 11, 2008 |   |
| Joseph B. Conahan, Jr., Director      |   |   | Date                |   |
|                                       |   |   |                |   |
| /s/ Dudley P. Cooley                       |   |   | March 11, 2008 |   |
| Dudley P. Cooley, Director                 |   |   | Date                |   |
|                                       |   |   |                |   |
| /s/ Jerome F. Fabian                       |   |   | March 11, 2008 |   |
| Jerome F. Fabian, Director                 |   |   | Date                |   |
|                                       |   |   |                |   |
| /s/ John G. Gerlach                        |   |   | March 11, 2008 |   |
| John G. Gerlach, Director                  |   |   | Date                |   |
|                                       |   |   |                |   |
| /s/ Diane C. A. Rosler                     |   |   | March 11, 2008 |   |
| Diane C.A. Rosler, Chief Financial Officer |   |   | Date                |   |
|                                       |   |   |                |   |
| /s/ David R. Saracino                      |   |   | March 11, 2008 |   |
| David R. Saracino, Director                |   |   | Date                |   |
|                                       |   |   |                |   |
| /s/ Robert J. Wise                         |   |   | March 11, 2008 |   |
| Robert J. Wise, Vice Chairman/Director     |   |   | Date                |   |

 

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