**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-K**

 

**ý****ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

**FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004**

 

**COMMISSION FILE NUMBER 333-90273**

 

**FIDELITY D & D BANCORP, INC.**

 

COMMONWEALTH OF PENNSYLVANIA I.R.S. EMPLOYERIDENTIFICATION NO:**23-3017653**

**BLAKELY AND DRINKER STREETS**

**DUNMORE, PENNSYLVANIA  18512**

**TELEPHONE NUMBER (570) 342-8281**

 

SECURITIES REGISTERED UNDER SECTION 12(b) OF THE ACT:

**None**

 

SECURITIES REGISTERED UNDER SECTION 12(g) OF THE ACT:

**Common Stock, without par value**

 

The Registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the Registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.

 

ý  YES    o  NO

 

Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-Kis not contained herein, and will not be contained, to the best of theregistrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment tothis form 10-K. ý

 

The Registrant isan accelerated filer (as defined in Exchange Act Rule 12b-2)

 

o  YES    ý  NO

 

Aggregate marketvalue of the voting common stock held by non-affiliates of the registrantequals $51,734,825, as of June 30, 2004, based on a market price of $35.00.  The number of shares of common stockoutstanding as of March 11, 2005, equals 1,843,997.

 

DOCUMENTSINCORPORATED BY REFERENCE:

 

Excerpts from the Registrant’s 2004 Annual Report to Shareholders areincorporated herein by reference in response to Part I.  Portions of the Registrant’s definitive ProxyStatement to be used in connection with the 2005 Annual Meeting of Shareholdersare incorporated herein by reference in partial response to Part III.

 

 

----

 

**Fidelity D & D Bancorp, Inc.**

**2004 Annual Report on Form 10-K**

**Table of Contents**

 

| **Part I.**    |                                                                                                                 |   |
|----------------|----------------------------------------------------------------------------------------------------------------------|--------|
|           |                                                                                                                 |   |
| Item 1.        | Business                                                                                                             |   |
| Item 2.        | Properties                                                                                                           |   |
| Item 3.        | Legal  Proceedings                                                                                                   |   |
| Item 4.        | Submission of  Matters to a Vote of Security Holders                                                                 |   |
|           |                                                                                                                 |   |
| **Part II.**   |                                                                                                                 |   |
|           |                                                                                                                 |   |
| Item 5.        | Market for the  Company’s Common Equity, Related Stockholder Matters and Issuer Purchases of  Equity Securities |   |
| Item 6.        | Select  Financial Data                                                                                               |   |
| Item 7.        | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                          |   |
| Item 7A.       | Quantitative  and Qualitative Disclosures About Market Risk                                                          |   |
| Item 8.        | Financial  Statements and Supplementary Data                                                                         |   |
| Item 9.        | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure                                |   |
| Item 9A.       | Controls  and Procedures                                                                                             |   |
|           |                                                                                                                 |   |
| **Part  III.** |                                                                                                                 |   |
|           |                                                                                                                 |   |
| Item 10.       | Directors and Executive Officers of the  Company                                                                     |   |
| Item 11.       | Executive Compensation                                                                                               |   |
| Item 12.       | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters                      |   |
| Item 13.       | Certain  Relationships and Related Transactions                                                                      |   |
| Item 14.       | Principal  Accountant Fees and Services                                                                              |   |
|           |                                                                                                                 |   |
| **Part IV.**   |                                                                                                                 |   |
|           |                                                                                                                 |   |
| Item 15.       | Exhibits, Financial Statement Schedules and  Reports on Form 8-K                                                     |   |
|           |                                                                                                                 |   |
| Signatures     |                                                                                                                 |   |
| Exhibit Index  |                                                                                                                 |   |
| Certifications |                                                                                                                 |   |

 

2

----

** **

**FIDELITY D & D BANCORP, INC.**

 

###### ***PART I***

 

# ***ITEM1***:                                              BUSINESS

 

Fidelity D & DBancorp, Inc. (the Company) was incorporated in the Commonwealth ofPennsylvania, on August 10, 1999, and is a bank holding company, whose whollyowned state chartered commercial bank is The Fidelity Deposit and Discount Bank(the Bank) (collectively, the Company). The Company is headquartered at Blakely and Drinker Streets in Dunmore,Pennsylvania.

 

The Bank hasoffered a full range of traditional banking services since it commencedoperations in 1903.  In addition, theBank has a personal and corporate trust department and also providesalternative financial and insurance products with asset management services.  A complete list of services provided by theBank is detailed in the section entitled “Products & Services” containedwithin the 2004 Annual Report to Shareholders, incorporated by reference.  The service area is comprised of the Boroughof Dunmore and the surrounding communities within Lackawanna and Luzernecounties.

 

The Bank is one oftwo financial institutions headquartered in Dunmore, Pennsylvania.  The banking business is highly competitive,and the profitability of the Company depends principally upon the Company’sability to compete in its market area. The Company competes with, among other sources, the following:

 
| • |   | local community banks              |
|--------|--------|------------------------------------|
| • |   | savings banks                      |
| • |   | regional banks                     |
| • |   | credit unions                      |
| • |   | savings & loans                |
| • |   | insurance companies                |
| • |   | money market funds                 |
| • |   | mutual funds                       |
| • |   | small loan companies               |
| • |   | other financial service  companies |

 

The Company has been able to compete effectively with other financialinstitutions by emphasizing technology and customer service, including localbranch decision making on loans, establishing long-term customer relationshipsand building customer loyalty and providing products and services designed toaddress the specific needs of its customers.

 

There are noconcentrations of loans that, if lost, would have a materially adverse effecton the continued business of the Bank. The Bank’s loan portfolio does not havea material concentration within a single industry or group of relatedindustries that are vulnerable to the risk of a near-term severe impact.  However, the Company’s success is dependentto a significant degree on economic conditions in Northeastern Pennsylvania,especially in Lackawanna and Luzerne counties, which the Company defines as itsprimary market area.  The banking industryis affected by general economic conditions including the effects of inflation,recession, unemployment, real estate values, trends in the national and globaleconomics and other factors beyond the Company’s control.  An economic recession or a delayed economic recoveryover a prolonged period of time in the Company’s primary market area couldcause an increase in the level of the Bank’s non-performing assets and loanlosses, and thereby cause operating losses, impairment of liquidity and erosionof capital.  We cannot assure you thatadverse changes in the local economy would not have a material effect on theCompany’s consolidated financial condition, results of operations and cashflows.

 

The Company had 173full-time equivalent employees, on December 31, 2004, which includes exempt officersand part-time employees.

 

Federal and statebanking laws contain numerous provisions that affect various aspects of thebusiness and operations of the Company and the Bank.  The Company is subject to, among others, theregulations of the Securities and Exchange Commission (the “SEC”) and theFederal Reserve Board (the “FRB”) and the Bank is subject to, among others, theregulations of the Pennsylvania Department of Banking and the Federal DepositInsurance Corporation (the “FDIC”). Refer to Part II, Item 7 “Supervision and Regulation” for descriptionsof and references to applicable statutes and regulations which are not intendedto be complete descriptions of these provisions or their effects on the Companyor the Bank.  They are summaries only andare qualified in their entirety by reference to such statutes and regulations.

 

3

----

 

Applicableregulations relate to, among other things:

 
| • |   | operations          |
|--------|--------|---------------------|
| • |   | securities          |
| • |   | risk management     |
| • |   | consumer compliance |
| • |   | mergers             |
| • |   | consolidation       |
| • |   | reserves            |
| • |   | dividends           |
| • |   | branches            |
| • |   | capital adequacy    |

 

The Bank isexamined by the Pennsylvania Department of Banking and the FDIC. The lastexamination was jointly conducted by the Pennsylvania Department of Banking andthe FDIC as of September 30, 2004.

 

The Company’s websiteaddress is www.the-fidelity.com.  TheCompany makes available through this website the Annual Report on Form 10-K,quarterly reports on Form 10-Q and current reports on Form 8-K and amendmentsto those reports as soon as reasonably practical after filing with the SEC.  Further, you may read and copy any materialsfiled with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, NW,Washington, DC 20549.  You may obtaininformation on the operation of the Public Reference Room by calling the SEC at1-800-SEC-0330.  The SEC also maintainsan internet site that contains reports, proxy and information statements andother information about the Company at http://www.sec.gov.

 

The Company’s accountingpolicies and procedures are designed to comply with accounting principles,generally accepted in the United States of America (GAAP).  Refer to “Critical Accounting Policies,” whichare incorporated by reference in Part II, Item 7.

 

***ITEM2******:***  ***PROPERTIES***

 

As of December 31,2004, the Bank operated 12 full-service banking offices, of which three wereowned and nine were leased.  None of thelessors of the properties leased by the Bank are affiliated with the Company orthe Bank and all of these properties are located in the state ofPennsylvania.  The Company is headquarteredat its owner occupied main branch located on the corner of Blakely and DrinkerStreets in Dunmore, PA.  The main office isa full-service banking center including a walk-up teller window, drive-thru tellerwindows and two 24-hour automated teller machines (ATMs).  Executive and administrative, loan, trust, assetmanagement services, operational departments and customer service areas arealso located at this facility.  The mainoffice complex is owned by the Company and free of any encumbrances.

 

The Green RidgeBranch, the first Scranton facility, operates from leased space in the GreenRidge Shopping Center in Scranton, PA. This branch is a full-service officewith a 24-hour ATM.

 

A second ScrantonBranch is in a leased facility located at 139 Wyoming Avenue, Scranton, PA.  This office has a walk-up window and providesfull-service banking to the downtown Scranton area.

 

The AbingtonBranch is located on the Morgan Highway in Clarks Summit, PA. The building fromwhich the branch operates is leased. This office provides full-servicefinancial products, including a 24-hour ATM and drive-thru teller windows. Thisoffice provides convenience to our customers located throughout the greaterAbington area.

 

The Keystone Industrial Park Branch (KIP) is located in Dunmore, PA.  This office provides full-service banking withdrive-thru teller windows and a 24-hour ATM. KIP is owned by the Company and isfree of encumbrances.

 

The Pittston Branch is located in Bruno’s Supermarket, 403 KennedyBoulevard, Pittston, PA.  The space inthe supermarket is leased.  This officeprovides full-service banking including a 24-hour ATM.  This location provides convenient service atextended hours to the Bank’s clientele in Luzerne County, Pennsylvania.

 

The Financial Center Branch is located at 338 North Washington Avenuein Scranton, PA.  This office providesfull-service banking, including a 24-hour ATM. Executive, finance and operational offices are located in thisbuilding.  A portion of the third flooris leased to a non-related entity.  TheCompany owns the property free of encumbrance. The Company also owns, free of encumbrance, an adjacent attachedbuilding, which was available for lease during 2004.

 

The Moosic Branch is located at 4010 Birney Avenue, Moosic, PA.  The branch operates from leased space and providesfull-service banking, including a 24-hour ATM and drive-thru teller windows.  The branch’s location provides the necessarylink between the Lackawanna and Luzerne County branch office networks.

 

4

----

 

The West PittstonBranch is located in the Insalaco Shopping Center at 801 Wyoming Avenue, WestPittston, PA.  The branch operates fromleased space.  This office providesfull-service banking, including a 24-hour ATM, to the Luzerne County area.

 

The PeckvilleBranch is located at 1598 Main Street, Peckville, PA.  The branch operates from leased space and providesfull-service banking, including a 24-hour ATM and drive-thru teller windows.

 

The Bank’s branchcoverage in Luzerne County includes a leased space known as the KingstonBranch, located at 247 Wyoming Avenue, Kingston, PA.  This office provides full-service financialproducts, including a 24-hour ATM and drive-thru teller windows.

 

The Eynon Branchis located on Route 6 Business, Eynon, PA. The branch operates from leasedspace. This office provides full-service financial products, including a 24-hourATM and drive-thru teller windows.

 

In addition to thefull-service branches, there is a banking facility, limited to serve employeesand patients, located in the Clarks Summit State Hospital, Clarks Summit, PA.  The office is leased from the hospital undera lease for service provided agreement.

 

In addition to theproperties above, the Bank maintains several free-standing 24-hour ATMs locatedat the following locations in Pennsylvania:

•                  300 MeadowAvenue, Scranton

•                  511 Main Street,Childs

•                  1650 West MainStreet, Stroudsburg

•                  320 SouthBlakely Street, Dunmore

•                  MarywoodCollege, 2300 Adams Avenue, Nazareth Hall, Scranton

•                  Montage SkiLodge, Moosic

•                  LackawannaCounty Stadium, Moosic

•                  Route 307, RR #7, Box 7159, Daleville

•                  Convenient FoodMart, Highland Avenue, Clarks Summit

 

During 2004, theBank contracted space for a free-standing 24-hour ATM located at the Ice BoxSports Complex, Olive Street, Scranton, PA.

 

The Bank also ownsa commercial facility located at 116 – 118 N. Blakely Street, Dunmore, PA whichis leased by a non-related entity.

 

Other real estate owned includes all foreclosed properties listed forsale. Foreclosed properties are recorded on the Company’s balance sheet, uponpossession, at the lower of cost or fair value.

 

***ITEM3******:    LEGAL PROCEEDINGS***

 

The nature of the Company’sbusiness generates some litigation involving matters arising in the ordinarycourse of business.  However, in theopinion of the Company after consulting with legal counsel, no legalproceedings are pending, which, if determined adversely to the Company or theBank, would have a material effect on the Company’s undivided profits orfinancial condition.  No legalproceedings are pending other than ordinary routine litigation incidental tothe business of the Company and the Bank. In addition, to Management’s knowledge, no governmental authorities haveinitiated or contemplated any material legal actions against the Company or theBank.

 

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

 

No matter wassubmitted during the quarter ended December 31, 2004 to a vote of our securityholders through solicitation of proxies or otherwise.

 

5

----

 

###### ***PART II***

 

***ITEM 5******:***  ***MARKET FOR THE COMPANY’SCOMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITYSECURITIES***

 

The common stockof the Company is traded on the over-the-counter bulletin board under thesymbol “FDBC.”

Shareholdersrequesting information about the Company’s common stock may contact SalvatoreR. DeFrancesco, Jr., Treasurer.  Requestsmay be mailed to:

 

Fidelity D & D Bancorp, Inc.

Blakely and Drinker St.

Dunmore, PA 18512

(570) 342-8281

 

The followingtable lists the quarterly cash dividends paid per share and the range of bidand asked prices for the Company’s common stock.  Such over-the-counter prices do not includeretail mark-ups, markdowns or commissions:

 
| ** **   | ** ** | **2004  Prices** | ** ** | **Dividends  Paid** | ** ** | **2003  Prices** | ** ** | **Dividends  Paid** | ** ** |
|--------------|------------|------------------|------------|---------------------|------------|------------------|------------|---------------------|------------|
| **High**     | ** ** | **Low**          | **High**   | ** **          | **Low**    |
| 1st  Quarter |       | $                | 37.00      |                | $          | 35.25            |       | $                   | 0.22       |   | $ | 39.00 |   | $ | 35.50 |   | $ | 0.22 |   |
| 2nd  Quarter |       | $                | 36.20      |                | $          | 33.60            |       | $                   | 0.22       |   | $ | 37.00 |   | $ | 35.15 |   | $ | 0.22 |   |
| 3rd  Quarter |       | $                | 35.50      |                | $          | 33.55            |       | $                   | 0.22       |   | $ | 37.00 |   | $ | 35.00 |   | $ | 0.22 |   |
| 4th  Quarter |       | $                | 36.00      |                | $          | 33.25            |       | $                   | 0.22       |   | $ | 37.50 |   | $ | 35.00 |   | $ | 0.22 |   |

 

The Companyexpects to continue to pay dividends in the future.  However, future dividends are dependent uponearnings, financial condition, capital needs of the Company and other factors.  The Company’s dividend is dependent on theBank’s ability to pay dividends.  Priorto the formation of the Company, the Bank paid dividends on a quarterly basisfor over thirty years.  Dividends aredetermined and declared by the Board of Directors.  For a further discussion of regulatory capitalrequirements see Note 14 “Regulatory Matters”, contained within the notes to consolidatedfinancial statements.

 

The Company hasestablished a dividend reinvestment plan for its shareholders. The plan isdesigned to make the Company’s stock more available to our shareholders and toraise additional capital for future needs.

 

The Company hadapproximately 1,411 shareholders at March 11, 2005 and approximately 1,422 atDecember 31, 2004. The number of shareholders is the actual number ofindividual shareholders of record.  Securitydepositories are considered as individual shareholders for the purpose ofdetermining the approximate number of shareholders.

 

**ITEM 6:**  ***SELECTED FINANCIAL DATA***

 

Set forth beloware our selected consolidated financial and other data.  This financial data is derived in part from,and should be read in conjunction with, our consolidated financial statementsand related notes:

 

6

----

 
| ** **                                           | ** ** | **2004**    | ** **  | **2003**    | ** ** | **2002**    | ** ** | **2001**    | ** **  | **2000**    | ** ** |
|------------------------------------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|-------------|-------------|-------------|------------|
| **Balance Sheet Data:**                              | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** | ** **  | ** **  | ** **  | ** ** |
| Total assets                                         |       | $           | 536,675,138 |        | $          | 575,215,466 |       | $           | 577,993,316 |        | $          | 569,029,838 |   | $ | 491,077,054 |   |
| Total investment  securities                         |       | 120,237,518 |        | 144,407,374 |       | 149,549,607 |       | 153,973,988 |        | 119,756,391 |       |
| Net loans                                            |       | 381,546,375 |        | 366,981,640 |       | 354,262,050 |       | 353,976,324 |        | 333,600,975 |       |
| Loans available–for-sale                        |       | 576,378     |        | 19,863,577  |       | 28,715,355  |       | 16,150,020  |        | 9,953,958   |       |
| Total deposits                                       |       | 365,615,335 |        | 401,442,546 |       | 413,788,176 |       | 407,778,728 |        | 339,310,328 |       |
| Total borrowings                                     |       | 121,653,234 |        | 126,633,012 |       | 114,213,014 |       | 117,480,988 |        | 111,024,721 |       |
| Total shareholders’  equity                     |       | 46,366,760  |        | 43,931,899  |       | 45,234,433  |       | 40,172,230  |        | 37,215,063  |       |
|                                                 |       |        |        |        |       |        |       |        |        |        |       |
| **Operating  Data for the year ended:**              |       |        |        |        |       |        |       |        |        |        |       |
| Total interest  income                               |       | $           | 27,395,491  |        | $          | 28,462,093  |       | $           | 34,567,393  |        | $          | 36,379,689 |   | $ | 35,085,780 |   |
| Total interest  expense                              |       | 11,180,135  |        | 14,237,129  |       | 17,882,440  |       | 20,853,631  |        | 21,468,230  |       |
| Net interest  income                                 |       | 16,215,356  |        | 14,224,964  |       | 16,684,953  |       | 15,526,058  |        | 13,617,550  |       |
| Provision for  loan losses                           |       | 2,150,000   |        | 3,715,000   |       | 1,664,000   |       | 2,474,637   |        | 1,158,260   |       |
|                                                 |       |        |        |        |       |        |       |        |        |        |       |
| Net interest  income after provision for loan losses |       | 14,065,356  |        | 10,509,964  |       | 15,020,953  |       | 13,051,421  |        | 12,459,290  |       |
| Other income                                         |       | 4,161,402   |        | 4,183,137   |       | 3,302,749   |       | 3,701,578   |        | 2,940,009   |       |
| Other operating  expense                             |       | 13,826,690  |        | 12,903,361  |       | 12,751,174  |       | 11,998,997  |        | 11,634,280  |       |
|                                                 |       |        |        |        |       |        |       |        |        |        |       |
| Income before  provision for income taxes            |       | 4,400,068   |        | 1,789,740   |       | 5,572,528   |       | 4,754,002   |        | 3,765,019   |       |
| Provision for  income taxes                          |       | 1,035,594   |        | 146,492     |       | 1,526,355   |       | 905,866     |        | 582,391     |       |
| Net Income                                           |       | $           | 3,364,474   |        | $          | 1,643,248   |       | $           | 4,046,173   |        | $          | 3,848,136 |   | $ | 3,182,628 |   |
|                                                 |       |        |        |        |       |        |       |        |        |        |       |
| **Per  Share Data:**                                 |       |        |        |        |       |        |       |        |        |        |       |
| Net income per  share – basic*                  |       | $           | 1.84        |        | $          | 0.90        |       | $           | 2.23        |        | $          | 2.12 |   | $ | 1.76 |   |
| Net income per  share – diluted*                |       | $           | 1.84        |        | $          | 0.90        |       | $           | 2.22        |        | $          | 2.12 |   | $ | 1.76 |   |
| Dividends  declared                                  |       | $           | 1,610,423   |        | $          | 1,601,898   |       | $           | 1,526,371   |        | $          | 1,426,097 |   | $ | 1,366,075 |   |
| Dividends per  share                                 |       | $           | 0.88        |        | $          | 0.88        |       | $           | 0.84        |        | $          | 0.79 |   | $ | 0.76 |   |
| Book value per  share                                |       | $           | 25.21       |        | $          | 24.10       |       | $           | 24.86       |        | $          | 22.08 |   | $ | 20.60 |   |
| Weighted average  number of shares outstanding**     |       | 1,830,725   |        | 1,820,403   |       | 1,817,430   |       | 1,811,391   |        | 1,803,674   |       |
| Number of shares  outstanding at year-end            |       | 1,839,572   |        | 1,823,043   |       | 1,819,376   |       | 1,819,168   |        | 1,806,274   |       |
|                                                 |       |        |        |        |       |        |       |        |        |        |       |
| **Ratios:**                                          |       |        |        |        |       |        |       |        |        |        |       |
| Return on  average assets                            |       | 0.61        | %           | 0.29        | %          | 0.70        | %          | 0.72        | %           | 0.67        | %          |
| Return on  average equity                            |       | 7.51        | %           | 3.63        | %          | 9.47        | %          | 9.64        | %           | 9.54        | %          |
| Net interest  margin                                 |       | 3.20        | %           | 2.74        | %          | 3.10        | %          | 3.17        | %           | 3.14        | %          |
| Efficiency ratio                                     |       | 64.37       | %           | 72.32       | %          | 63.42       | %          | 62.42       | %           | 67.66       | %          |
| Expense ratio                                        |       | 1.69        | %           | 1.68        | %          | 1.68        | %          | 1.68        | %           | 1.88        | %          |
| Allowance for  loan losses to total loans            |       | 1.54        | %           | 1.28        | %          | 1.01        | %          | 1.00        | %           | 0.94        | %          |
| Dividend payout  ratio                               |       | 47.87       | %           | 97.48       | %          | 37.72       | %          | 37.06       | %           | 42.92       | %          |
| Equity to assets                                     |       | 8.64        | %           | 7.64        | %          | 7.83        | %          | 7.06        | %           | 7.58        | %          |
| Equity to  deposits                                  |       | 12.68       | %           | 10.94       | %          | 10.93       | %          | 9.85        | %           | 10.97       | %          |

 

----

*Based on weighted average shares and adjusted for the stock exchange in 2000.

**Basedon actual shares outstanding and adjusted for the stock exchange in 2000.

 

***ITEM 7******: MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS***

 

***ForwardLooking Statements***

 

This Annual Report on Form 10-K contains a number of forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933, asamended, or the Securities Act, and Section 21E of the Securities Exchange Actof 1934, as amended, or the Exchange Act. These statements may be identified by the use of the words “anticipate,”“believe,” “could,” “estimate,” “expect,” “intend,” “may,” “outlook,” “plan,” “potential,”“predict,” “project,” “should,” “will,” “would” and similar terms and phrases,including references to assumptions.  Forwardlooking statements include risks and uncertainties.

 

Forward-looking statements are based on various assumptions andanalyses made by us in light of management’s experience and its perception ofhistorical trends, current conditions and expected future developments, as wellas other factors it believes are appropriate under the circumstances.  These statements are not guarantees of futureperformance and are subject to risks, uncertainties and other factors (many ofwhich are beyond our control) that could cause actual results to differmaterially from future results expressed or implied by such forward-lookingstatements.  These factors include, withoutlimitation, the following:

 

•                  the timingand occurrence or non-occurrence of events may be subject to circumstancesbeyond our control;

 

•                  there may beincreases in competitive pressure among financial institutions or fromnon-financial institutions;

 

7

----

 

•                  changes inthe interest rate environment may reduce interest margins;

 

•                  changes indeposit flows, loan demand or real estate values may adversely affect ourbusiness;

 

•                  changes inaccounting principles, policies or guidelines may cause our financial conditionto be perceived differently;

 

•                  general economic conditions, eithernationally or locally in some or all areas in which we do business, orconditions in the securities markets or the banking industry may be lessfavorable than we currently anticipate;

 

•                  legislativeor regulatory changes may adversely affect our business;

 

•                  technologicalchanges may be more rapid, difficult or expensive than we anticipate;

 

•                  success orconsummation of new business initiatives may be more difficult or expensivethan we anticipate; or

 

•                  acts of waror terrorism.

 

Management cautions readers not to place undue reliance onforward-looking statements, which reflect analyses only as of the date of thisreport.  We have no obligation to updateany forward-looking statements to reflect events or circumstances after thedate of this document.

 

Readers should review the risk factors described in other documentsthat we file, from time to time with the SEC, including Quarterly Reports onForm 10-Q and any Current Reports on Form 8-K.

 

# ***Critical AccountingPolicies***

 

The presentation of financial statements in conformity with GAAPrequires management to make estimates and assumptions that affect many of thereported amounts and disclosures.  Actualresults could differ from these estimates.

 

A material estimate that is particularly susceptible to significantchange relates to the determination of the allowance for loan losses.  Management believes that the allowance forloan losses at December 31, 2004 is adequate and reasonable.  Given the very subjective nature ofidentifying and valuing loan losses, it is likely that well-informedindividuals could make different assumptions, and could, therefore calculate amaterially different allowance value. While management uses available information to recognize losses onloans, changes in economic conditions may necessitate revisions in thefuture.  In addition, various regulatoryagencies, as an integral part of their examination process, periodically reviewthe Company’s allowance for loan losses. Such agencies may require the Companyto recognize adjustments to the allowance based on their judgment ofinformation available to them at the time of their examination.

Another material estimate is the calculation of fair values of theCompany’s investment securities. The Company receives estimated fair values ofinvestment securities from an independent valuation service. In developingthese fair values, the valuation service uses estimates of cash flows, based onhistorical performance of similar instruments in similar interest rateenvironments. Based on experience, management is aware that estimated fairvalues of investment securities tend to vary among valuation services.  Accordingly, when selling investmentsecurities, management typically obtains price quotes from more than onesource.  As described in Notes 1 and 3 ofthe consolidated financial statements, the large majority of the Company’sinvestment securities are classified as available-for-sale. Available-for-salesecurities are carried at fair value on the consolidated balance sheet, withunrealized gains and losses, net of income tax, reported separately withinshareholders’ equity through accumulated other comprehensive income.

 

The fair value of residential mortgage loans, classified asavailable-for-sale (AFS), is obtained from the Federal National MortgageAssociation (FNMA).  The fair value of SmallBusiness Administration (SBA) loans, classified as AFS, is obtained from an outsidepricing source.  To determine the fairmarket value of student loans, classified as AFS, the Bank uses the pricingobtained from the most recent student loans sold from its AFS portfolio.  The market to which the Bank sells mortgageand other loans is restricted and price quotes from other sources are nottypically obtained.  Further discussionon the accounting treatment of available-for-sale loans is in the sectionentitled “Loans-available-for sale”, contained within Management’s Discussionand Analysis.

 

All significantaccounting policies are contained in Note 1 “Nature of Operations and Summaryof Significant Accounting Policies”, contained within the notes to consolidatedfinancial statements, and incorporated by reference in Part II, Item 8.

 

8

----

 

The following discussion and analysis presents the significant changesin the financial condition and in the results of operations of the Company asof December 31, 2004 and December 31, 2003 and for each of the years then ended.This discussion should be read in conjunction with the consolidated financialstatements and notes included in Part II, Item 8 of this report.

 

***Comparison of Financial Conditionas of December 31, 2004***

***and******2003 and Results of Operations for each of theYears then Ended***

 

***FinancialCondition***

 

The followingtable is a comparison of condensed balance sheet accounts and percentage tototal assets at December 31, 2004, 2003 and 2002;

 
| ** **                                             | ** ** | **(Thousands of Dollars)** | ** ** |
|--------------------------------------------------------|------------|----------------------------|------------|
| ** **                                             | ** ** | **2004**                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                             | ** ** | **Amount**                 | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| **Assets:**                                            |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Cash and due  from banks                               |       | $                          | 9,013      |   | 1.68 | % | $ | 13,148 |   | 2.29 | % | $ | 18,763 |   | 3.25 | % |
| Interest bearing  deposits with Financial institutions |       | 1,203                      |       | 0.22 |   | 6,083 |   | 1.06 |   | 7,456 |   | 1.29 |   |
| Investment  securities                                 |       | 120,238                    |       | 22.41 |   | 144,407 |   | 25.10 |   | 149,550 |   | 25.87 |   |
| Net loans                                              |       | 381,546                    |       | 71.09 |   | 366,982 |   | 63.80 |   | 354,262 |   | 61.29 |   |
| Loans  available-for-sale                              |       | 576                        |       | 0.11 |   | 19,864 |   | 3.45 |   | 28,715 |   | 4.97 |   |
| Accrued interest  receivable                           |       | 1,723                      |       | 0.32 |   | 1,807 |   | 0.31 |   | 2,347 |   | 0.41 |   |
| Bank premises  and equipment                           |       | 11,163                     |       | 2.08 |   | 12,092 |   | 2.10 |   | 12,735 |   | 2.20 |   |
| Foreclosed  assets held for sale                       |       | 213                        |       | 0.04 |   | 467 |   | 0.08 |   | 437 |   | 0.08 |   |
| Life insurance  cash surrender value                   |       | 7,614                      |       | 1.42 |   | 7,293 |   | 1.27 |   | — |   | — |   |
| Other assets                                           |       | 3,386                      |       | 0.63 |   | 3,072 |   | 0.54 |   | 3,728 |   | 0.64 |   |
| **Total  assets**                                      |       | $                          | 536,675    |   | 100.00 | % | $ | 575,215 |   | 100.00 | % | $ | 577,993 |   | 100.00 | % |
| ** **                                             |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| **Liabilities:**                                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Deposits,  non-interest bearing                        |       | $                          | 65,358     |   | 12.18 | % | $ | 64,399 |   | 11.20 | % | $ | 61,151 |   | 10.58 | % |
| Certificates of  deposit of $100,000 or more.          |       | 93,986                     |       | 17.51 |   | 112,857 |   | 19.62 |   | 129,487 |   | 22.40 |   |
| Other  interest-bearing deposits                       |       | 206,272                    |       | 38.44 |   | 224,186 |   | 38.96 |   | 223,150 |   | 38.61 |   |
| Short-term  borrowings                                 |       | 50,534                     |       | 9.42 |   | 54,757 |   | 9.52 |   | 51,213 |   | 8.86 |   |
| Other borrowed  funds                                  |       | 71,119                     |       | 13.25 |   | 71,876 |   | 12.50 |   | 63,000 |   | 10.90 |   |
| Accrued interest  payable and other liabilities        |       | 3,039                      |       | 0.56 |   | 3,208 |   | 0.56 |   | 4,758 |   | 0.82 |   |
| **Total  liabilities**                                 |       | 490,308                    |       | 91.36 |   | 531,283 |   | 92.36 |   | 532,759 |   | 92.17 |   |
| **Shareholders’  equity**                         |       | 46,367                     |       | 8.64 |   | 43,932 |   | 7.64 |   | 45,234 |   | 7.83 |   |
| **Total  liabilities and shareholders’ equity**   |       | $                          | 536,675    |   | 100.00 | % | $ | 575,215 |   | 100.00 | % | $ | 577,993 |   | 100.00 | % |

 

A comparison ofnet changes in selected balance sheet categories as of December 31, are asfollows:

 
| ** ** | ** ** | **Assets** | ** **  | **%**  | ** ** | **Earning  Assets*** | ** ** | **%**       | ** ** | **Deposits** | ** ** | **%**  | ** **  | **Short-term  Borrowings** | ** ** | **%**  | ** ** | **Other  Borrowings** | ** ** | **%**  | ** ** |
|------------|------------|------------|-------------|--------|------------|----------------------|------------|-------------|------------|--------------|------------|--------|-------------|----------------------------|------------|--------|------------|-----------------------|------------|--------|------------|
|       |       |       |        |   |       |                 |       |        |       |         |       |   |        |                       |       |   |       |                  |       |   |       |
| 2004       |       | $          | (38,540,328 | )      | (7         | )%                   | $          | (35,884,098 | )          | (7           | )%         | $      | (35,827,211 | )                          | (9         | )%     | $          | (4,222,932            | )          | (8     | )%         | $ | (756,846 | ) | (1 | )% |
| 2003       |       | (2,777,850 | )           | (1     | )          | (3,007,038           | )          | (1          | )          | (12,345,630  | )          | (3     | )           | 3,543,964                  |       | 7      |       | 8,876,034             |       | 14     |       |
| 2002       |       | 8,963,478  |        | 2      |       | 7,325,219            |       | 1           |       | 6,009,448    |       | 1      |        | (3,267,974                 | )          | (6     | )          | —                |       | — |       |
| 2001       |       | 77,952,784 |        | 16     |       | 60,585,502           |       | 13          |       | 68,468,400   |       | 20     |        | 6,456,267                  |       | 13     |       | —                |       | — |       |
| 2000       |       | 44,507,549 |        | 10     |       | 44,562,595           |       | 10          |       | 44,943,343   |       | 15     |        | (12,224,325                | )          | (20    | )          | 5,695,000             |       | 10     |       |
|            |            |            |             |        |            |                      |            |             |            |              |            |        |             |                            |            |        |            |                       |            |        |            |  |  |  |  |  |

 

----

* - Earning assets excludeloans placed on non-accrual status.

 

***Deposits***

 

The Bank is a community-based commercial financial institution thatoffers a variety of deposit accounts with a range of interest rates andterms.  Deposit products include passbookand statement savings accounts, NOW, money market, demand deposits andcertificates of deposit accounts.  Theflow of deposits is significantly influenced by general economic conditions,changes in prevailing interest rates, pricing and competition.

 

9

----

 

Most of the Bank’s deposits are obtained from the communitiessurrounding its 12 branch offices.  Weattempt to attract and retain deposit customers via sales and marketing effortswith new products, quality service, competitive rates and long-standingcustomer relationships.

 

To determine deposit product interest rates, the Bank considers localcompetition, market yields and the rates charged for alternative sources offunding such as borrowings.  Although wehave experienced a continued intense competition for deposits, we have notincreased rates significantly as we only consider cost effective strategies ina relatively low, yet rising, interest rate environment.

 

The followingtable represents the components of total deposits as of December 31, 2004 andcomparative funding changes from December 31, 2003:

 
| ** **                               | ** ** | **December 31, 2004** | ** **  | **December 31, 2003** | ** ** | **Dollar  change** | ** ** | **Percent  change** | ** **  |
|------------------------------------------|------------|-----------------------|-------------|-----------------------|------------|--------------------|------------|---------------------|-------------|
| **Non-interest-bearing deposits**        | ** ** | ** **            | ** **  | ** **            | ** ** | ** **         | ** ** | ** **          | ** **  |
| Personal                                 |       | $                     | 28,927,588  |                  | $          | 26,206,156         |       | $                   | 2,721,432   |   | 10.38 | % |
| Non-personal                             |       | 29,248,882            |        | 29,561,169            |       | (312,287           | )          | -1.06               | %           |
| Public fund                              |       | 2,479,373             |        | 3,635,074             |       | (1,155,701         | )          | -31.79              | %           |
| Bank checks                              |       | 4,701,692             |        | 4,996,259             |       | (294,567           | )          | -5.90               | %           |
| Total                                    |       | $                     | 65,357,535  |                  | $          | 64,398,658         |       | $                   | 958,877     |   | 1.49 | % |
|                                     |       |                  |        |                  |       |               |       |                |        |
| **Time deposits of $100,000 or greater** |       |                  |        |                  |       |               |       |                |        |
| Personal                                 |       | $                     | 61,694,837  |                  | $          | 78,560,841         |       | $                   | (16,866,004 | ) | -21.47 | % |
| Non-personal                             |       | 17,749,896            |        | 16,057,391            |       | 1,692,505          |       | 10.54               | %           |
| Public fund                              |       | 9,023,956             |        | 12,412,714            |       | (3,388,758         | )          | -27.30              | %           |
| IRA’s                               |       | 5,517,344             |        | 5,826,474             |       | (309,130           | )          | -5.31               | %           |
| Total                                    |       | $                     | 93,986,033  |                  | $          | 112,857,420        |       | $                   | (18,871,387 | ) | -16.72 | % |
|                                     |       |                  |        |                  |       |               |       |                |        |
| **Other interest-bearing deposits**      |       |                  |        |                  |       |               |       |                |        |
| Time deposits  less than $100,000:       |       |                  |        |                  |       |               |       |                |        |
| Personal                                 |       | $                     | 66,918,765  |                  | $          | 83,057,733         |       | $                   | (16,138,968 | ) | -19.43 | % |
| Non-personal                             |       | 4,024,801             |        | 5,387,417             |       | (1,362,616         | )          | -25.29              | %           |
| Public fund                              |       | 662,876               |        | 597,772               |       | 65,104             |       | 10.89               | %           |
| IRA’s                               |       | 19,090,551            |        | 19,694,374            |       | (603,823           | )          | -3.07               | %           |
| sub total                                |       | 90,696,993            |        | 108,737,296           |       | (18,040,303        | )          | -16.59              | %           |
| NOW accounts                             |       | 41,421,525            |        | 44,290,199            |       | (2,868,674         | )          | -6.48               | %           |
| Money market  deposits                   |       | 27,606,102            |        | 28,284,225            |       | (678,123           | )          | -2.40               | %           |
| Savings and  clubs                       |       | 46,547,147            |        | 42,874,748            |       | 3,672,399          |       | 8.57                | %           |
| Total                                    |       | $                     | 206,271,767 |                  | $          | 224,186,468        |       | $                   | (17,914,701 | ) | -7.99 | % |
|                                     |       |                  |        |                  |       |               |       |                |        |
| **Total deposits**                       |       |                  |        |                  |       |               |       |                |        |
| Noninterest-bearing  deposits            |       | $                     | 65,357,535  |                  | $          | 64,398,658         |       | $                   | 958,877     |   | 1.49 | % |
| Interest-bearing  deposits               |       | 300,257,800           |        | 337,043,888           |       | (36,786,088        | )          | -10.91              | %           |
| Total                                    |       | $                     | 365,615,335 |                  | $          | 401,442,546        |       | $                   | (35,827,211 | ) | -8.92 | % |
|                                     |       |                  |        |                  |       |               |       |                |        |
| **Public funds**                         |       |                  |        |                  |       |               |       |                |        |
| Noninterest-bearing                      |       | $                     | 2,479,373   |                  | $          | 3,635,074          |       | $                   | (1,155,701  | ) | -31.79 | % |
| Certificates of  deposit                 |       | 9,686,832             |        | 13,010,486            |       | (3,323,654         | )          | -25.55              | %           |
| NOW accounts                             |       | 8,406,827             |        | 9,850,661             |       | (1,443,834         | )          | -14.66              | %           |
| Money market  deposits                   |       | 4,710,720             |        | 8,029,671             |       | (3,318,951         | )          | -41.33              | %           |
| Savings and  clubs                       |       | 1,266,834             |        | 3,278,114             |       | (2,011,280         | )          | -61.35              | %           |
| Total                                    |       | $                     | 26,550,586  |                  | $          | 37,804,006         |       | $                   | (11,253,420 | ) | -29.77 | % |
|                                     |       |                  |        |                  |       |               |       |                |        |
| Total assets                             |       | $                     | 536,675,138 |                  | $          | 575,215,466        |       |                |        |   |   |
| Total deposits  to total assets          |       | 68.13                 | %           | 69.79                 | %          |               |       |                |        |
| Public funds to  total deposits          |       | 7.26                  | %           | 9.42                  | %          |               |       |                |        |
| Public funds to  total assets            |       | 4.95                  | %           | 6.57                  | %          |               |       |                |        |

 

10

----

 

Total deposits decreased $35,827,000 or 9% during 2004 to $365,315,000.  Total average deposits decreased $29,619,000or 7% from $412,068,000 at December 31, 2003 to $382,449,000 at December 31,2004.  The decrease in deposits wasprimarily due to a $36,911,000 decrease in certificate of deposits (CDs) to$184,683,000 at December 31, 2004 from $221,595,000 at December 31, 2003. Core deposits, which excludes time deposits of $100,000 andgreater, decreased $16,956,000 or 6% during 2004 to $271,629,000.  Approximately $18,000,000 of this decline wascaused by time deposit run-off.  NOW andmoney market accounts decreased $2,869,000 and $678,000, respectively whilenon-interest bearing and savings deposits increased $4,631,000, in total.  However, on average, money market accountsincreased $11,800,000.  In 2003, the Bankdeveloped a tiered money market checking account which customers foundattractive through 2004 and helped capture time deposit run-off.

 

Non-interest bearing deposits (DDAs) are an important source of fundsfor the Bank because they lower the overall cost of funds.  The average balance of these accountsincreased $5,056,000 or 8%, during 2004. The Bank is largely dependent upon its base of competitively priced coredeposits to provide a source of low-cost funding.  The Bank attempts to retain and grow itscustomer base through a combination of rate, product diversification, qualityof service, convenience and a stable and experienced staff.

 

During 2004, the Bank’s deposit mix continued to be heavilyconcentrated in time deposits but relative to total deposits, continued itsdownward trend.  As of December 31, 2004,time deposits represented 51% of total deposits, down from 55% at December 31,2003.  Management believes a combinationof the Bank’s strategy to exit high-cost competitive pricing pressure andrecovery in the financial markets has caused a sustained period of time depositoutflow, albeit to a level that is more cost effective as evident byimprovement in the Bank’s interest rate spread and margin.  Approximately 44% of the current time depositportfolio, representing 22% of total deposits, will mature in 2005 and providean opportunity for the Bank to retain these deposits at competitive rates.  The Bank has implemented several newrelationship programs designed to attract both low- and no-interest products tothe Bank while preserving its cultivated reputation of outstanding customer service.

 

The maturity distribution of time deposits at December 31, 2004 is asfollows:

 
| ** **                           | ** ** | **Three months  or less** | ** ** | **Three to six  months** | ** ** | **Six to twelve  months** | ** ** | **Over  twelve months** | ** ** | **Total**  | ** ** |
|--------------------------------------|------------|---------------------------|------------|--------------------------|------------|---------------------------|------------|-------------------------|------------|------------|------------|
| Time deposits of $100,000 or greater |       | $                         | 12,920,031 |                     | $          | 13,653,882                |       | $                       | 16,921,988 |       | $          | 50,490,132 |   | $ | 93,986,033 |   |
| Time deposits of less than $100,000  |       | 9,785,780                 |       | 11,928,364               |       | 16,551,450                |       | 52,431,399              |       | 90,696,993 |       |
| Total time deposits                  |       | $                         | 22,705,811 |                     | $          | 25,582,246                |       | $                       | 33,473,438 |       | $          | 102,921,531 |   | $ | 184,683,026 |   |

 

The over-twelvemonth maturity distribution of time deposits represents 28.2% of total depositsat December 31, 2004.  The Bank believesthis category provides a stable source of funds for future requirements.

 

***Short-termborrowings***

 

In addition todeposits, other funding sources available to the Bank are overnight federalfunds purchased from the Federal Home Loan Bank of Pittsburgh (FHLB) andrepurchase agreements (Repos) with various individuals, businesses and publicentities.  The Bank will use overnightfunding from the FHLB to fund asset growth and deposit run-off.  Repos, offered in both sweep and fixed-term products,are non-insured interest-bearing liabilities that have a security interest inqualified pledged investments of the Bank.  A sweep account is designed to ensure that ona daily basis, an attached DDA is adequately funded and excess DDA funds aretransferred, or swept, into an interest-bearing overnight Repo.  In addition, the sweep will transfer funds tothe DDA as necessary, to cover checks presented for payment.  As of December 31, 2004, sweep accountsrepresented approximately 66% of total Repos. Due to the nature of the sweep product, this account is more volatilethan a fixed-term Repo.  Overnightborrowings and Repos are included with short-term borrowings on the consolidatedbalance sheet.  Refer to Note 7 “Short-termBorrowings”, contained within the notes to consolidated financial statements inPart II, Item 8.

 

Customer liquidity,investment needs and negotiated interest rates caused a net increase in Repos from$39,363,000 at December 31, 2003, to $40,684,000 at December 31, 2004.  However, the balance in Repos will fluctuatedaily due to the nature of the daily-sweep product which is dependent on thelevel of available funds in customer DDAs.

 

Fundingrequirements of the Bank, due largely to the reduction in deposits, necessitated$8,760,000 in overnight borrowings from the FHLB, at December 31, 2004.  FHLB overnight borrowings at December 31, 2003amounted to $14,920,000.

 

11

----

 

***Long-term debt***

 

Long-term debtconsists of borrowings from the FHLB.  Theweighted-average rate on funds borrowed at December 31, 2004, was 5.06%.  The weighted-average rate is 28 basis pointsbelow the tax-equivalent yield of 5.34% on average earning-assets for the yearended December 31, 2004.  Rates on $58,000,000of “convertible select” advances are adjustable quarterly, should market ratesincrease beyond the issue’s original rate.  At December 31, 2004, similar FHLB advances were261 basis points below the average rate paid by the Bank.  The Bank is deterred from paying off thecurrent borrowings by significant prepayment penalties.  Rates currently being quoted by the FHLBcould increase above the rates currently paid on these borrowings.  In the event this was to occur, the Bank hasthe option, at that time, to repay or to renegotiate the converted advance.

 

During the third quarter of 2004, the Bank entered into a leveragedtransaction and borrowed a total of $5,000,000 to purchase preferred termsecurities.  The three-month interestrate reset intervals for both the purchased securities and the borrowing thatfunded them, are evenly matched and therefore will be accretive to earnings.  The new borrowings mature in 2006 and 2007and carry a weighted-average interest rate of 2.61% at December 31, 2004.  In addition, during the fourth quarter of2004, the Bank paid off a matured $5,000,000 borrowing that carried an interestrate of 5.92%.    The effect of thesetransactions helped reduce the overall weighted-average rate of the Bank’s longterm debt.  At December 31, 2004, theBank had the ability to borrow an additional $99,947,000 at the FHLB.  The FHLB has short-, medium- and long-termfunding products available to the Bank.

 

***Accrued expenses and other liabilities***

 

Time depositrun-off and rate reductions on high-cost funds caused accrued interest payableto decrease from $1,270,000 at December 31, 2003, to $985,000 at December 31,2004.

 

At December 31,2004 other liabilities included a balance due on a $453,000 retirement obligationrecorded in the second half of 2004.  Theliability represents the present value of an obligation for certain benefits,to be paid periodically in future years. Based upon the subjective nature of the medical insurance reimbursement portionof the liability, as it relates to future premiums, and the uncertainty of theduration of the future period to be covered, the Company may find it necessaryto increase or decrease the accrual accordingly.

 

***  Assets:***

 

***Investments***

 

The Bank’sinvestment policy is designed to complement its lending activities, generate afavorable return without incurring undue interest rate and credit risk, manageinterest rate sensitivity, provide monthly cash flow and manage liquidity atacceptable levels.  In establishinginvestment strategies, the Bank considers its business and growth orrestructuring plans, the economic environment, the interest rate sensitivityposition, the types of securities held, permissiblepurchases, credit quality, maturity and re-pricing terms, call or average-lifeintervals and investment concentrations. The policy prescribes permissible investment categories that meet thepolicy standards and Management is responsible for structuring and executingthe specific investment purchases within these policy parameters.  Management buys and sells investmentsecurities from time-to-time depending on market conditions, business trends,liquidity needs, capital levels and structuring strategies.  Investment security purchases provide a wayto quickly invest excess liquidity in order to generate additionalearnings.  The Bank generally earns apositive interest spread by assuming interest rate risk and using depositsand/or borrowings to purchase securities with longer maturities.

 

At the time ofpurchase, Management classifies investment securities into one of threecategories: trading, AFS or, held-to-maturity (HTM).  To date, management has not purchased anysecurities for trading purposes.  Most ofthe securities purchased are classified as AFS even though there is noimmediate intent to sell them.  The AFSdesignation affords management the flexibility to sell securities and positionthe balance sheet in response to capital levels, liquidity needs or changes inmarket conditions.  Securities AFS are recordedat market values in the consolidated balance sheet with an adjustment toshareholders’ equity, net of tax and is presented under the caption “Accumulatedother comprehensive income (loss)”. Securities designated as HTM are carried at their amortized cost.

 

Total investmentsdeclined $24,171,000, net of a $170,000 appreciation in the market value of AFSinvestments.  The carrying value ofinvestment securities, at December 31, 2004, was $120,237,000 or 22% of totalassets compared to $144,407,000 or 25% as December 31, 2003.  At December 31, 2004 approximately 54% of theinvestment portfolio was comprised of mortgage-backed securities that amortizeand provide monthly cash flow.  At thatsame time, agency bonds and municipal bonds comprised 25% and

 

12

----

 

9%of the investment portfolio, respectively.  During 2004, the Bank increased its positionin preferred term securities.  See thediscussion under “Long-term debt” above for a further discussion on thistransaction.    Preferred Term Securities, Ltd. pools trustpreferred securities issued by bank and insurance companies.  These issuers utilize trust preferredsecurities because they are afforded favorable capital treatment and provided atax deduction for the interest paid. Preferred Term Securities, Ltd., in turn, issue securities that arebacked by obligations of these issuers, which are asset backed securities that havemultiple classes, each with different credit ratings.  The fact that these securities are backed bymultiple issuers with geographic dispersion, have size limits per issuer whichenhance credit appeal, afforded lower regulatory risk-weighting and float without a cap at three-month LIBOR make these securities attractive within a lowinterest rate environment.

 

With the relativelylow, but increasing, market interest rate environment throughout 2004, higheryielding U.S. Government Agency bonds along with state and municipal securitiesof $14,195,000 were called.  Thiscompares to $24,810,000 in 2003 and $90,600,000 in 2002.  The increase in the U.S. Treasury yieldsduring the second half of 2003 resulted in a decrease in refinance activity andrelated cash flows during the fourth quarter of 2003 and continued during 2004.  As a result, prepayments on the Bank’sportfolio of mortgage-backed securities have subsided significantly.  Prepayments during 2004 amounted to $18,643,000,compared to $60,127,000 in 2003.

 

During the firsthalf of 2004, interest rates throughout the U.S. Treasury yield curve (the “yieldcurve”) increased.  The Federal OpenMarket Committee (the “FOMC”) raised short-term interest rates five times (125basis points) since the end of June 2004. While short-term U.S. Treasury yields have shown somewhat similarincreases during the second half of 2004, medium- and long-term rates havesomewhat decreased resulting in a flattening of the yield curve.  Accordingly, the Bank used a significantamount of the cash flows from its investment portfolio to fund high-cost time depositoutflow and repayment of overnight borrowings rather than redeploy the funds inthe securities markets.  The Bank willcontinue to monitor the investment markets but will remain cautious aboutadding securities until a meaningful accretion to earnings can be achieved.

 

A comparison ofinvestments at December 31, for the three previous periods is as follows:

 
| ** **                         | ** ** | **2004**   | ** **  | **2003**    | ** ** | **2002**   | ** ** |
|------------------------------------|------------|------------|-------------|-------------|------------|------------|------------|
| ** **                         | ** ** | **Amount** | ** **  | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| U.S. government agencies           |       | $          | 30,497,185  |        | 25.36      | %          | $          | 36,323,404 |   | 25.15 | % | $ | 13,275,625 |   | 8.88 | % |
| Mortgage-backed securities         |       | 64,457,326 |        | 53.61       |       | 85,598,752 |       | 59.28 |   | 118,614,057 |   | 79.31 |   |
| State & municipal subdivisions |       | 11,199,084 |        | 9.32        |       | 13,275,289 |       | 9.19 |   | 9,736,815 |   | 6.51 |   |
| Preferred term securities          |       | 9,034,375  |        | 7.51        |       | 4,007,507  |       | 2.78 |   | 3,990,000 |   | 2.67 |   |
| Equity securities: regulatory      |       | 4,568,700  |        | 3.80        |       | 4,753,300  |       | 3.29 |   | 3,604,400 |   | 2.41 |   |
| other                              |       | 480,848    |        | 0.40        |       | 449,122    |       | 0.31 |   | 328,710 |   | 0.22 |   |
| Total                              |       | $          | 120,237,518 |        | 100.00     | %          | $          | 144,407,374 |   | 100.00 | % | $ | 149,549,607 |   | 100.00 | % |

 

The distributionof debt securities by stated maturity date at December 31, 2004 is as follows:

 
| ** **                         | ** ** | **One year  or less** | ** ** | **One through  five years** | ** ** | **Five through  ten years** | ** ** | **More than  ten years** | ** ** | **Total**  | ** ** |
|------------------------------------|------------|-----------------------|------------|-----------------------------|------------|-----------------------------|------------|--------------------------|------------|------------|------------|
| U.S. government agencies           |       | $                     | —     |                        | $          | 4,946,069                   |       | $                        | 17,789,632 |       | $          | 7,761,484 |   | $ | 30,497,185 |   |
| Mortgage-backed securities         |       | —                |       | 391,330                     |       | 19,919,218                  |       | 44,146,778               |       | 64,457,326 |       |
| State & municipal subdivisions |       | —                |       | 446,147                     |       | 1,562,265                   |       | 9,190,672                |       | 11,199,084 |       |
| Preferred term securities          |       | —                |       | —                      |       | —                      |       | 9,034,375                |       | 9,034,375  |       |
| Total debt securities              |       | $                     | —     |                        | $          | 5,783,546                   |       | $                        | 39,271,115 |       | $          | 70,133,309 |   | $ | 115,187,970 |   |

 

AFS securities arestated net of unrealized gains and losses.  As of December 31, 2004, AFS debt securities wererecorded with a net unrealized loss in the amount of $355,000.  At December 31, 2004 AFS equity securitieswere recorded at $481,000 including an unrealized gain of $202,000.  In addition, the Company had $4,568,000 ofrestricted regulatory equity securities, recorded at cost.

 

13

----

 

The tax-equivalentyield on debt securities by stated maturity date at December 31, 2004, is asfollows:

 
| ** **                         | ** ** | **One year  or less** | ** ** | **One through  five years** | ** ** | **Five through  ten years** | ** ** | **More than  ten years** | ** ** | **Total** | ** ** |
|------------------------------------|------------|-----------------------|------------|-----------------------------|------------|-----------------------------|------------|--------------------------|------------|-----------|------------|
| U.S. government agencies           |       | —                | %          | 3.02                        | %          | 3.12                        | %          | 3.98                     | %          | 3.32      | %          |
| Mortgaged-backed securities        |       | —                |       | 5.40                        |       | 3.66                        |       | 4.85                     |       | 4.48      | ** ** |
| State & municipal subdivisions |       | —                |       | 5.66                        |       | 4.93                        |       | 5.84                     |       | 5.71      | ** ** |
| Preferred term securities          |       | —                |       | —                      |       | —                      |       | 4.12                     |       | 4.12      | ** ** |
| Total debt securities              |       | 0.00                  | %          | 3.37                        | %          | 3.46                        | %          | 4.79                     | %          | 4.26      | %          |

----

In the above table, the bookyields on state & municipal subdivisions were adjusted to a tax-equivalentbasis using the corporate federal tax rate of 34%. In addition, average yieldson securities AFS are based on amortized cost and do not reflect unrealizedgains or losses.

 

***Loansand leases***

 

Loans and leases,net of unearned income, increased $15,555,000 or 4.2% from $371,979,000 atDecember 31, 2003, to $387,534,000 at December 31, 2004. Gross loans represented72.2% of total assets at December 31, 2004.

 

In 2004, the Bankoriginated $34,981,000 of commercial loans, $31,368,000 of mortgage loans,including $13,066,000 of unfunded real estate construction lines, and $19,671,000of consumer loans.  This compares to$37,797,000, $40,028,000 and $24,041,000, respectively, in 2003.  In addition for 2004, the Bank committed to additionalfunding in the amounts of $20,799,000 for commercial borrowers, $10,489,000 inhome equity lines and $83,000 for consumer borrowers.  The increase in the portfolio was primarilyin residential real estate due the transfer of mortgage loans fromavailable-for-sale to the loan portfolio which is described in more detail inthe, “Loans available-for-sale,” section, below.

 

Loan refinancingto lower interest rates that began in 2002 and accelerated through 2003 hassubsided in 2004 - in response to anticipated increases in short-term interestrates and volatility in the mid- and long-term rates of U.S. Treasury yieldcurve.  The Bank expects the loan prepaymentand refinance activity to be minimal in the near-term.

 

*Commercial and Commercial Real Estate Loans**:*

Net of scheduledprincipal curtailments (run-off), loan participation sales and pre-payments,commercial loans increased $692,000 during 2004.  This increase was primarily due to increasedlending within the small business community.

 

The Bank continuesto originate loans using the Small Business Administration (SBA) guaranteedloan program.  Under this program, inreturn for the Bank funding a qualified loan, the SBA guarantees a materialportion of the principal balance to the Bank. As of December 31, 2004, the Bank had $2,002,000 in SBA guaranteed loansoutstanding.

 

Tax-freeindustrial development loans, a component of commercial loans, made to orbacked by local municipalities increased from $9,020,000 at December 31, 2003to $9,898,000 at December 31, 2004.  The increasein this sector was due mainly to fund loans to local municipalities for variousinfrastructure and sustaining projects.

 

*Residential Real Estate Loans*:

Residential realestate loans increased $14,217,000 or 18.4% to $91,294,000.  These loans increased due to the transfer,from the available-for-sale to the loan portfolio which is described in moredetail in the, “Loans available-for-sale,” section, below.  In addition, originations of these loansremained strong due to the sustained relative low interest rate environment.

 

*Consumer Loans and Direct Financing Leases**:*

Consumer loans anddirect-financing leases decreased $2,905,000 or 4.4% during 2004.  The home equity installment loan portfolio,included within the consumer loans, experienced declines due to prior year’srefinancing into lower rate mortgages. In addition, the combined effect of run-off and decision to no longeroriginate direct financing leases brought about the overall decline in consumerloans.

 

14

----

 

*Real Estate Construction Loans**:*

Real estateconstruction loans increased $3,353,000 or 46.1% during 2004.  Real estate construction loans consist of $8,095,000for residential construction and $2,526,000 for commercial real estateconstruction.  These loans fundresidential and commercial construction projects and then convert to aresidential mortgage or to a commercial real estate loan after one year fromthe origination date.  Generally, theconverted loans will bear the same terms as the residential or the commercial constructionloan.

 

A comparison of loans atDecember 31, for the five previous periods is as follows (all loans aredomestic):

 
| ** **                            | ** ** | **2004**    | ** **  | **2003**    | ** ** | **2002**    | ** ** | **2001**    | ** **  | **2000**    | ** ** |
|---------------------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|-------------|-------------|-------------|------------|
| Residential real estate               |       | $           | 91,294,401  |        | $          | 77,077,315  |       | $           | 78,132,262  |        | $          | 90,766,420 |   | $ | 104,618,240 |   |
| Consumer                              |       | 61,487,608  |        | 62,919,070  |       | 64,300,368  |       | 73,756,002  |        | 71,765,719  |       |
| Commercial and commercial real estate |       | 221,968,137 |        | 221,275,922 |       | 202,974,155 |       | 179,043,816 |        | 146,610,685 |       |
| Direct financing leases               |       | 2,211,978   |        | 3,685,802   |       | 6,578,720   |       | 9,961,967   |        | 12,733,075  |       |
| Real estate construction              |       | 10,620,472  |        | 7,267,616   |       | 6,797,002   |       | 5,446,870   |        | 2,971,504   |       |
| Gross loans                           |       | 387,582,596 |        | 372,225,725 |       | 358,782,507 |       | 358,975,075 |        | 338,699,223 |       |
| Less:                                 |       |        |        |        |       |        |       |        |        |        |       |
| Unearned discount                     |       | 48,423      |        | 247,119     |       | 620,704     |       | 1,256,818   |        | 1,833,968   |       |
| Allowance for loan losses             |       | 5,987,798   |        | 4,996,966   |       | 3,899,753   |       | 3,741,933   |        | 3,264,280   |       |
| Net loans                             |       | $           | 381,546,375 |        | $          | 366,981,640 |       | $           | 354,262,050 |        | $          | 353,976,324 |   | $ | 333,600,975 |   |
|                                  |       |        |        |        |       |        |       |        |        |        |       |
| Loans available-for-sale              |       | $           | 576,378     |        | $          | 19,863,577  |       | $           | 28,715,355  |        | $          | 16,150,020 |   | $ | 9,953,958 |   |

 

A comparison of grossloans by percent at year-end for the five previous periods is as follows:

 
| ** **                            | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Residential real estate               |       | 23.56    | %          | 20.71    | %          | 21.78    | %          | 25.28    | %          | 30.89    | %          |
| Consumer                              |       | 15.86    |       | 16.90    |       | 17.92    |       | 20.55    |       | 21.19    |       |
| Commercial and commercial real estate |       | 57.27    |       | 59.45    |       | 56.57    |       | 49.88    |       | 43.29    |       |
| Direct financing leases               |       | 0.57     |       | 0.99     |       | 1.83     |       | 2.77     |       | 3.76     |       |
| Real estate construction              |       | 2.74     |       | 1.95     |       | 1.90     |       | 1.52     |       | 0.87     |       |
| Gross loans                           |       | 100.00   | %          | 100.00   | %          | 100.00   | %          | 100.00   | %          | 100.00   | %          |

 

There are noconcentrations of loans to a number of borrowers engaged in similar activitiesexceeding 10.00% of total loans that are not otherwise disclosed as a categoryin tables above.

 

The following table setsforth the maturity distribution of select components of the loan portfolio atDecember 31, 2004.  Excluded from thetable are non-construction real estate loans, consumer loans and directfinancing leases (amounts in thousands):

 
| ** **                                  | ** ** | **One year  or less** | ** ** | **One to five  years** | ** ** | **More than  five years** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|-----------------------|------------|------------------------|------------|---------------------------|------------|-----------|------------|
| Commercial and commercial real estate loans |       | $                     | 37,579     |                   | $          | 39,753                    |       | $         | 144,636    |   | $ | 221,968 |   |
| Real estate construction                    |       | 10,620                |       | —                 |       | —                    |       | 10,620    |       |
| Total                                       |       | $                     | 48,199     |                   | $          | 39,753                    |       | $         | 144,636    |   | $ | 232,588 |   |

 

Real estateconstruction loans are included in the one-year or less category since, bytheir nature, these loans are converted intocommercial and commercial real estate loans within one year from the date thereal estate construction loan was consummated. Upon conversion, the commercial and commercial real estate loans would normallymature after five years.

 

15

----

 

The followingtable sets forth the sensitivity changes in interest rates for commercial and commercialreal estate loans at December 31, 2004 (amounts in thousands):

 
| ** **             | ** ** | **One to five  years** | ** ** | **More than  five years** | ** ** | **Total** | ** ** |
|------------------------|------------|------------------------|------------|---------------------------|------------|-----------|------------|
| Fixed interest rate    |       | $                      | 8,798      |                      | $          | 13,894    |       | $ | 22,692 |   |
| Variable interest rate |       | 30,955                 |       | 130,742                   |       | 161,697   |       |
| Total                  |       | $                      | 39,753     |                      | $          | 144,636   |       | $ | 184,389 |   |

 

Non-refundablefees or costs associated with all loan originations are deferred.   Using the principal reduction method, theBank releases the deferral as a charge or credit to loan interest income overthe life of the loan.

 

There are noconcentrations of loans that, if lost, would have a material adverse effect onthe business of the Bank. The Bank’s loan portfolio does not have a materialconcentration within a single industry or group of related industries that arevulnerable to the risk of a near-term severe negative business impact.

 

***Loans available-for-sale***

 

Generally, uponorigination, certain residential mortgages, the guaranteed portions of SBAloans and student loans are classified as AFS. Should market rates increase, fixed-rate loans and loans not immediatelyscheduled to re-price would no longer produce yields consistent with thecurrent market.  In a declining interestrate environment, the Bank would be exposed to prepayment risk and, as rates onadjustable rate loans decrease interest income would be negativelyaffected.  Consideration is also given tothe current liquidity position and projected future liquidity needs.  To better manage interest rate and prepaymentrisk, loans meeting these conditions may be classified as AFS.  The carrying value of loans AFS are carriedat the lower of cost or estimated fair market value.  If the fair values of these loans fall belowtheir original cost, the difference is written down and charged to currentearnings.  Any subsequent appreciation inthe portfolio is credited to current earnings but only to the extent ofprevious write-downs.

 

Loans AFS, at December31, 2004, were $576,000, with a corresponding fair value of $582,000 comparedto $19,864,000 and $20,501,000, respectively at December 31, 2003.  During the second quarter of 2004, the Banktransferred higher yielding mortgage loans with relatively short lives and aggregateprincipal balances of $11,246,000 and aggregate market values of $11,446,000from AFS to its loan portfolio. Similarly, during the third quarter of 2004, the Bank transferred SBAloans, with aggregate principal and market values of $1,561,000 and $1,634,000,respectively, from AFS to its loan portfolio. In both cases, the loans were transferred at the lower of cost orestimated market value and therefore, no gain or loss was recognized.  The Bank has both the ability and intent tohold these loans until maturity and they will continue to provide the Bank withyields in excess of the rates in effect at the time of transfer.  By transferring the loans from the AFS to theloan portfolio, the Bank will no longer be required to apply lower of cost ormarket treatment to the principal balances. Had the transferred loans remained in the AFS portfolio, in anincreasing interest rate environment, the loans could attain market valuessignificantly below their principal balances and, as a result, could create asignificant drag on current earnings. During 2004, residential mortgages, student loans and SBA loans withprincipal balances of $14,307,000, $1,128,000 and $61,000, respectively were soldinto the secondary market and gains of approximately $195,000 have beenrecognized.

 

The Bank retains the mortgageservicing rights (MSRs) on loans sold into the secondary market.  MSRs are retained so that the Bank cancontinue the personal relationship developed with its customers.  At December 31, 2004, the servicing portfoliobalance of sold residential mortgage loans was $57,939,000.  For a further discussion on MSRs, see Note 4,“Loans and leases” contained within the notes to consolidated financialstatements in Part II, Item 8.

 

***Allowance for loan losses***

 

Management continuallyevaluates the credit quality of the Bank’s loan portfolio and performs a formalreview of the allowance for loan losses (the allowance) adequacy, on aquarterly basis.  The allowance reflectsmanagement’s best estimate of the amount of credit losses in the loanportfolio.  Management’s judgment isbased on the evaluation of individual loans, past experience, the assessment ofcurrent economic conditions and other relevant factors including the amountsand timing of cash flows expected to be received on impaired loans. Thoseestimates may be susceptible to significant change.  The provision for loan losses represents theamount necessary to maintain an appropriate allowance.  Loan losses are charged directly against theallowance when loans are deemed to be uncollectible.  Recoveries on previously charged-off loans areadded to the allowance when received.

 

16

----

 

Management applies twoprimary components during the loan review process to determine proper allowancelevels.  The two levels are specific loanloss allocation for loans that are deemed impaired and a general loan lossallocation for those loans not specifically allocated.  The methodology to analyze the adequacy ofthe allowance for loan losses is as follows:

 

•                  Identification of specific problemloans by loan category by credit administration;

•                  Calculation of specific allowances requiredbased on collateral and other persuasive evidence;

•                  Identification of loanscollateralized by cash and cash equivalents;

•                  Determination of remaining homogenouspools by loan category and eliminating loans collateralized by cash and cashequivalents and eliminating loans with specific allocations;

•                  Application of historical losspercentages (three-year average) to pools to determine the allowance allocation;and

•                  Application of qualitative factoradjustment percentages to historical losses for trends or changes in the loanportfolio.

 

Allocation of theallowance for different categories of loans is based on the methodology used bythe Bank, as explained above.  A keyelement of the methodology to determine the allowance is the Company’s creditrisk evaluation process, which includes credit risk-grading of individual commercialloans.  Commercial loans are assignedcredit risk grades based on the Company’s assessment of conditions that affectthe borrower’s ability to meet its contractual obligations under the loanagreement.  That process includesreviewing borrowers’ current financial information, historical paymentexperience, credit documentation, public information and other informationspecific to each individual borrower.  Thechanges in the allocations from period to period are based upon reviews of theloan and lease portfolios.

 

Charge-offs, net ofrecoveries, for the year ended December 31, 2004, were $1,159,000, compared to$2,618,000 in 2003.  Combined consumerloan and lease financing net charge-offs decreased from $1,019,000, throughDecember 31, 2003, to $364,000, through December 31, 2004.  Commercial loan net charge-offs were $549,000for the full year 2004 compared to $1,130,000 for 2003.  Mortgage loan net-charge-offs were $246,000 in2004 compared to $469,000 in 2003.  Theaddition of a seasoned loan workout specialist and efforts of collections andcredit administration improved the level of net charge-offs in 2004.  For further discussion on the provision forloan losses, see the “Provision for loan losses” located in the Results ofOperations section of Management’s Discussion and Analysis contained herein.

 

For a furtherdiscussion of delinquencies and net charge-offs, see the section entitled “Non-performingassets.” Additional discussion is in Note 1 “Nature of Operations and Summaryof Significant Accounting Policies – Allowance for Loan Losses” and Note 4 “Loansand Leases” contained within the notes to consolidated financial statements,and incorporated herein by reference.

 

Management believes thatthe current balance in the allowance for loan losses of $5,988,000 issufficient to withstand the identified potential credit quality issues that mayarise and are inherent to the portfolio.  Currently, management is unaware of anypotential problem loans that have not been reviewed.  Potential problem loans are those where thereis known information that leads Management to believe repayment of principaland/or interest is in jeopardy and the loans are currently neither onnon-accrual status nor past due 90 days or more.  However, there could be certain instanceswhich become identified over the upcoming year that may require additionalcharge-offs and/or increases to the allowance. The ratio of allowance for loan losses to total loans was 1.54% atDecember 31, 2004 compared to 1.28% at December 31, 2003.

 

17

----

 

The followingtable sets forth the activity in the allowance for loan losses and certain keyratios for the periods indicated (dollars in thousands):

 
| ** **                                                              | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** | **2001**   | ** ** | **2000**   | ** ** |
|-------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance at  beginning of period                                         |       | $          | 4,997      |       | $          | 3,900      |       | $          | 3,742      |       | $          | 3,264 |   | $ | 3,172 |   |
|                                                                    |       |       |       |       |       |       |       |       |       |       |       |
| **Charge-offs:**                                                        |       |       |       |       |       |       |       |       |       |       |       |
| Commercial and  all other                                               |       | 775        |       | 1,334      |       | 928        |       | 1,003      |       | 602        |       |
| Real estate                                                             |       | 266        |       | 503        |       | 40         |       | 119        |       | 75         |       |
| Consumer                                                                |       | 480        |       | 1,167      |       | 850        |       | 909        |       | 456        |       |
| Lease financing                                                         |       | 85         |       | 92         |       | 131        |       | 180        |       | 18         |       |
| Total                                                                   |       | 1,606      |       | 3,096      |       | 1,949      |       | 2,211      |       | 1,151      |       |
|                                                                    |       |       |       |       |       |       |       |       |       |       |       |
| **Recoveries:**                                                         |       |       |       |       |       |       |       |       |       |       |       |
| Commercial and  all other                                               |       | 226        |       | 204        |       | 359        |       | 86         |       | 14         |       |
| Real estate                                                             |       | 20         |       | 34         |       | —     |       | 3          |       | 17         |       |
| Consumer                                                                |       | 178        |       | 230        |       | 69         |       | 108        |       | 53         |       |
| Lease financing                                                         |       | 23         |       | 10         |       | 15         |       | 17         |       | 1          |       |
| Total                                                                   |       | 447        |       | 478        |       | 443        |       | 214        |       | 85         |       |
| Net charge-offs                                                         |       | 1,159      |       | 2,618      |       | 1,506      |       | 1,997      |       | 1,066      |       |
| Provision  charged to operations                                        |       | 2,150      |       | 3,715      |       | 1,664      |       | 2,475      |       | 1,158      |       |
| Balance at end  of period                                               |       | $          | 5,988      |       | $          | 4,997      |       | $          | 3,900      |       | $          | 3,742 |   | $ | 3,264 |   |
| Net charge-offs  to average loans outstanding                           |       | 0.30       | %          | 0.68       | %          | 0.40       | %          | 0.56       | %          | 0.33       | %          |
| Allowance for  loan loss to net charge-offs                             |       | 5.17       | x          | 1.91       | x          | 2.59       | x          | 1.87       | x          | 3.06       | x          |
| Allowance for  loan loss to total gross                                 |       | 1.54       | %          | 1.28       | %          | 1.01       | %          | 1.00       | %          | 0.94       | %          |
| Loans 30 - 89  days past due and accruing                               |       | $          | 4,317      |       | $          | 3,975      |       | $          | 6,047      |       | $          | 7,156 |   | $ | 11,049 |   |
| Loans 90 days or  more past due and accruing                            |       | $          | 557        |       | $          | 958        |       | $          | 2,599      |       | $          | 5,398 |   | $ | 1,493 |   |
| Allowance for  loan loss to loans 90 days or more past due and accruing |       | 10.75      | x          | 5.22       | x          | 1.50       | x          | 0.69       | x          | 2.19       | x          |
| Non-accruing  loans                                                     |       | $          | 9,904      |       | $          | 7,323      |       | $          | 4,000      |       | $          | 4,914 |   | $ | 2,287 |   |
| Allowance for  loan loss to non-accruing loans                          |       | 0.60       | x          | 0.68       | x          | 0.98       | x          | 0.76       | x          | 1.43       | x          |
| Allowance for  loan loss to non-performing loans                        |       | 57.24      | %          | 60.34      | %          | 59.09      | %          | 36.29      | %          | 86.37      | %          |
| Average net  loans                                                      |       | $          | 381,366    |       | $          | 383,226    |       | $          | 380,892    |       | $          | 352,230 |   | $ | 325,163 |   |

 

The allowance forloan losses can generally absorb losses throughout the loan and leaseportfolios.  However, in some instancesan allocation is made for specific loans or groups of loans.  Allocation of the allowance for loan lossesfor different categories of loans is based on the methodology used by the Bank,as previously explained.  The changes inthe allocations from year to year are based upon year-end reviews of the loanand lease portfolios.

 

18

----

 

Allocation of theallowance among major categories of loans for the past five years is summarizedbelow.  This table should not beinterpreted as an indication that charge-offs in future periods will occur inthese amounts or proportions, or that the allocation indicates futurecharge-off trends.  The portion of theallowance designated as unallocated is within the Company’s policyguidelines.  Prior to 2003, consumerloans included credit card receivables:

 
| **Category**                           | ** ** | **2004**  | ** ** | **%**  | ** ** | **2003**  | ** ** | **%**     | ** ** | **2002**  | ** ** | **%**  | ** ** | **2001**  | ** ** | **%**  | ** ** | **2000**  | ** ** | **%**  | ** ** |
|----------------------------------------|------------|-----------|------------|--------|------------|-----------|------------|-----------|------------|-----------|------------|--------|------------|-----------|------------|--------|------------|-----------|------------|--------|------------|
| Residential real estate                |       | $         | 451,349    |   | 7.54       |      | $          | 354,207   |       | 7.09      |       | $      | 383,858    |      | 9.84       |   | $          | 269,490   |       | 7.20   |       | $ | 117,534 |   | 3.60 |   |
| Consumer                               |       | 966,081   |       | 16.13  |       | 884,689   |       | 17.70     |       | 1,092,140 |       | 28.01  |       | 959,408   |       | 25.64  |       | 736,613   |       | 22.57  |       |
| Commercial and  commercial real estate |       | 4,349,227 |       | 72.63  |       | 3,699,488 |       | 74.04     |       | 2,198,783 |       | 56.38  |       | 2,197,365 |       | 58.72  |       | 2,270,663 |       | 69.56  |       |
| Direct financing leases                |       | 40,891    |       | 0.69   |       | 42,706    |       | 0.85      |       | 81,664    |       | 2.09   |       | 136,091   |       | 3.64   |       | 131,150   |       | 4.02   |       |
| Real estate construction               |       | 27,523    |       | 0.46   |       | 15,876    |       | 0.32      |       | —    |       | — |       | —    |       | — |       | —    |       | — |       |
| Unallocated                            |       | 152,727   |       | 2.55   |       | —    |       | —    |       | 143,307   |       | 3.68   |       | 179,579   |       | 4.80   |       | 8,320     |       | 0.25   |       |
| Total                                  |       | $         | 5,987,798  |   | 100.00     | %         | $          | 4,996,966 |       | 100.00    | %          | $      | 3,899,752  |      | 100.00     | %      | $          | 3,741,933 |       | 100.00 | %          | $ | 3,264,280 |   | 100.00 | % |

 

Allowance for loanlosses based upon the commercial loan portfolio comprised 73%, or $4,349,000,of the total allowance for loan losses at December 31, 2004.  Although the Bank identified 34 commercialloan relationships which comprises most of this allowance, the bulk of theallowance fell among only several large non-performing relationships.  Collateral values were prudently valued toprovide a conservative and realistic value of the collateral supporting theseloans.  The allocations to the othercategories of loans are adequate compared to the actual three-year historicalnet charge-offs.

 

***Non-performing assets***

 

The Bank definesnon-performing assets as accruing loans past due 90 days or more, non-accrualloans, restructured loans, other real estate owned and repossessed assets.  As of December 31, 2004, non-performing assetsrepresented 1.99% of total assets compared to 1.52% at December 31, 2003.

 

The followingtable sets forth non-performing assets at December 31 (dollars in thousands):

 

| ** **                                                                         | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Net loans, including loans available-for-sale                                      |       | $        | 382,123    |     | $          | 386,846  |       | $        | 382,977    |     | $          | 370,126 |   | $ | 343,555 |   |
|                                                                               |       |     |       |     |       |     |       |     |       |     |       |
| Loans past due 90 days or more and accruing                                        |       | $        | 557        |     | $          | 958      |       | $        | 2,599      |     | $          | 5,398 |   | $ | 1,493 |   |
| Non-accrual loans                                                                  |       | 9,904    |       | 7,323    |       | 4,000    |       | 4,914    |       | 2,287    |       |
| Total non-performing loans                                                         |       | 10,461   |       | 8,281    |       | 6,599    |       | 10,312   |       | 3,780    |       |
| Restructured loans                                                                 |       | —   |       | —   |       | 1,474    |       | —   |       | —   |       |
| Other real estate owned                                                            |       | 163      |       | 394      |       | 262      |       | 465      |       | 353      |       |
| Repossessed assets                                                                 |       | 50       |       | 73       |       | 175      |       | 158      |       | —   |       |
| Total non-performing assets                                                        |       | $        | 10,674     |     | $          | 8,748    |       | $        | 8,510      |     | $          | 10,935 |   | $ | 4,133 |   |
|                                                                               |       |     |       |     |       |     |       |     |       |     |       |
| Non-accrual loans to net loans                                                     |       | 2.59     | %          | 1.89     | %          | 1.04     | %          | 1.33     | %          | 0.67     | %          |
| Non-performing assets to net loans, foreclosed real estate and  repossessed assets |       | 2.79     | %          | 2.26     | %          | 2.22     | %          | 2.95     | %          | 1.20     | %          |
| Non-performing assets to total assets                                              |       | 1.99     | %          | 1.52     | %          | 1.47     | %          | 1.92     | %          | 0.84     | %          |
| Non-performing loans to net loans                                                  |       | 2.74     | %          | 2.14     | %          | 1.72     | %          | 2.79     | %          | 1.10     | %          |

 

In the internalreview of loans for both delinquency and collateral sufficiency, managementconcluded that there were an above average number of loans that lacked theability to repay in accordance with contractual terms.  The decision to place loans or leases on anon-accrual status is made on an individual basis after considering factorspertaining to each specific loan.

 

The majority ofnon-performing loans for the period is attributed to commercial business loans,indirect auto lending and real estate loans in the process of foreclosure.  Most of these loans are collateralized andsome of the commercial loans are guaranteed by governmental agencies and theBank’s loss exposure is reduced accordingly. In 2004, non-performing loans increased $2,180,000, or 26%, to$10,461,000.  Approximately $7,997,000 ofnon-accrual loans were added during 2004 of which $687,000 was subsequentlycollected.  The increase was primarily incommercial loans caused mostly by a single relationship with two loansamounting to $4,825,000.  The loans inthis relationship were subsequently refinanced and are expected to return toperforming status once a

 

19

----

 

satisfactoryrepayment history is evidenced.  Theincrease in non-accrual loans was partially offset by total payoffs or paydowns of $2,101,000, charge offs of $961,000, $204,000 in transfers to foreclosedassets and $1,463,000 of loans that have migrated to performing status.  As a result, the percentage of non-performingloans to net loans has increased from 2.14% at December 31, 2003, to 2.74% atDecember 31, 2004.

 

Repossessed assets consist of previously financed vehicles held forsale.  Subsequent to the loan or lease,the borrower or lessee defaulted on their contract and the Company repossessedthe unit.  Repossessed assets are soldthrough either a private or public sale and any deficiency balance from thesale of the asset is charged to the allowance for loan losses.

 

Payments receivedon non-accrual loans are recognized on a cash basis.  Payments are first applied against theoutstanding principal balance until the balance is satisfied.  Subsequent payments are then recorded asinterest income and finally late charges. During 2004, the Bank collected $419,000 of interest income recognizedon the cash basis.  Interest income thatwould have been recorded in 2004, if non-accrual loans were current, was $942,000.

 

***Bankpremises and equipment, net***

 

The Bank’spremises and equipment decreased $929,000 due primarily to depreciation.  During 2004, the Bank purchased approximately$278,000 in equipment compared to $621,000 in 2003.

 

***Foreclosed******assets held for sale***

 

Real estateacquired through foreclosure decreased by $231,000, due to the sale offoreclosed properties during the year.  Anincrease in the turn-around time on sales of vehicles has resulted in a netdecrease of $23,000 in other repossessed assets.

 

***Terminatedlease assets held for sale***

 

Terminated lease assets are vehicles that were lease-financed by theCompany with contractual terms fulfilled. Pursuant the lease agreement, the vehicles are returned to the Companyand recorded on the books in other assets at the residual value.  These vehicles are subsequently sold as soonas practicable.  The difference betweensales price and residual value, if any, is charged against current earnings.  Simultaneously, a claim is submitted to the Company’sresidual insurance carrier for payment.  Receiptof any residual insurance proceeds is then credited to current earnings.

 

***Cashsurrender value of bank owned life insurance***

 

***During February 2003, the Bank purchased $7,000,000 of bankowned life insurance (BOLI) for a chosen group of employees, namely itsofficers, where the Bank is the owner and beneficiary of the policies.  BOLI is classified as a non-interest earningasset.  Increases in the cash surrendervalue are recorded as non-interest income. The BOLI is profitable from the appreciation of the cash surrendervalues of the pool of insurance, and its tax-free advantage to the Bank.  This profitability is used to offset aportion of current and future employee benefit costs.  The BOLI can be liquidated, if necessary,with tax costs associated.  However, theBank intends to hold this pool of insurance, because it provides income thatenhances the Bank’s capital position. Therefore, the Bank has not provided for deferred income taxes on theearnings from the increase in cash surrender value.***

 

***Resultsof Operations***

 

***EarningsSummary:***

 

**General**

 

The Company’s results of operations depend primarily on its netinterest income.  Net interest income isthe difference between interest income and interest expense.  Interest income is generated from yields oninterest-earning assets which consist principally of loans and investmentsecurities.  Interest expense is incurredfrom rates paid on interest-bearing liabilities which consist of deposits andborrowings.  Net interest income isdetermined by the Company’s interest rate spread (i.e., the difference betweenthe yields earned on its interest-earning assets and the rates paid on itsinterest-bearing liabilities) and the relative amounts of interest-earning

 

20

----

 

assets and interest-bearingliabilities.  The interest rate spread isinfluenced by the overall interest rate environment, the composition andcharacteristics of interest-earning assets and interest-bearing liabilities andby the competition in our marketplace. The interest rate spread and the changes in the interest rate spread,from period-to-period, is also influenced by differences in the maturity andre-pricing characteristics of assets compared to the maturity and re-pricingcharacteristics of the liabilities that fund them.

 

The Company’s profitability is also affected by the level of itsnon-interest income and expenses, provision for loan losses and provision forincome taxes.  Non-interest incomeconsists mostly of service charges on the Bank’s loan and deposit products,trust and asset management service fees and increases in the cash surrendervalue of the bank owned life insurance. Non-interest expense consists of compensation and related employeebenefit expenses, occupancy, equipment, data processing, advertising,marketing, professional fees, insurance and other operating overhead.

 

The Company’s profitability is significantly affected by generaleconomic and competitive conditions, changes in market interest rates,government policies and actions of regulatory authorities.  The Company’s loan portfolio is comprised principallyof commercial and commercial real estate loans. The properties underlying the Company’s mortgages are concentrated innortheastern Pennsylvania.  Credit risk,which represents the possibility of the Company not recovering amounts due fromits borrowers, is significantly related to local economic conditions in theareas the properties are located as well as the Company’s underwritingstandards.  Economic conditions affectthe market value of the underlying collateral as well as the levels ofoccupancy of multi-family dwellings and levels of other income-producingproperties and establishments.

 

**Overview**

 

Net income for the yearended December 31, 2004 nearly doubled to $3,364,000 from $1,643,000 for theyear ended December 31, 2003.  Similarly,diluted earnings per share increased to $1.84 for the twelve months endedDecember 31, 2004 from $0.90 during the year ended December 31, 2003.  The increase in net earnings was primarily theresult of decreases in both interest expense and the provision for loan losses.

 

Return on average assetsand return on average equity improved to 0.61% and 7.51%, respectively, for theyear ended December 31, 2004 from 0.29% and 3.63%, respectively, in 2003.  The improvement in these ratios is dueprincipally to increased net income.

 

21

----

 

***Net interestincome***

 

The followingtable sets forth a comparison of average balances of assets and liabilities andtheir related net tax equivalent yields and rates for 2004, 2003 and 2002 is asfollows (dollars in thousands):

 
| ** **                            | ** ** | **2004**             | ** ** | **2003**     | ** ** | **2002**         | ** ** |                 |
|---------------------------------------|------------|----------------------|------------|--------------|------------|------------------|------------|----------------------|
| ** **                            | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Yield/  rate** | ** ** | **Average  balance** | ** ** | **Interest** | ** ** | **Yield/  rate** | ** ** | **Average  balance** | ** ** | **Interest** | ** ** | **Yield/  rate** | ** ** |   |
| Interest-earning assets               |       |                 |       |         |       |             |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |
|                                  |       |                 |       |         |       |             |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits             |       | $                    | 637        |         | $          | 6                |       | 0.93                 | % | $ | 761 |   | $ | 6 |   | 0.79 | % | $ | 919 |   | $ | 17 |   | 1.81 | % |   |
|                                  |       |                 |       |         |       |             |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |
| Investments:                          |       |                 |       |         |       |             |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. government agencies              |       | 36,360               |       | 1,333        |       | 3.67             |       | 26,550               |   | 1,035 |   | 3.90 |   | 76,396 |   | 4,374 |   | 5.73 |   |   |
| Mortgage-backed securities            |       | 73,939               |       | 3,029        |       | 4.10             |       | 99,050               |   | 3,451 |   | 3.48 |   | 61,082 |   | 3,106 |   | 5.08 |   |   |
| State and municipal                   |       | 11,618               |       | 739          |       | 6.36             |       | 10,953               |   | 716 |   | 6.53 |   | 10,185 |   | 662 |   | 6.50 |   |   |
| Other                                 |       | 10,213               |       | 291          |       | 2.85             |       | 8,206                |   | 241 |   | 2.94 |   | 6,337 |   | 240 |   | 3.78 |   |   |
| Total investments                     |       | 132,130              |       | 5,392        |       | 4.08             |       | 144,759              |   | 5,443 |   | 3.76 |   | 154,000 |   | 8,382 |   | 5.44 |   |   |
|                                  |       |                 |       |         |       |             |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans:                                |       |                 |       |         |       |             |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial                            |       | 223,660              |       | 12,172       |       | 5.44             |       | 212,351              |   | 11,813 |   | 5.56 |   | 202,500 |   | 12,547 |   | 6.20 |   |   |
| Consumer                              |       | 47,030               |       | 3,321        |       | 7.06             |       | 51,836               |   | 3,879 |   | 7.48 |   | 58,157 |   | 4,925 |   | 8.47 |   |   |
| Real estate                           |       | 113,589              |       | 6,737        |       | 5.93             |       | 117,939              |   | 7,386 |   | 6.26 |   | 113,679 |   | 8,095 |   | 7.12 |   |   |
| Direct financing leases               |       | 3,013                |       | 201          |       | 6.66             |       | 4,546                |   | 319 |   | 7.02 |   | 7,558 |   | 552 |   | 7.30 |   |   |
| Credit cards                          |       | —               |       | —       |       | —           |       | 427                  |   | 43 |   | 10.13 |   | 2,897 |   | 283 |   | 9.77 |   |   |
| Total loans                           |       | 387,292              |       | 22,431       |       | 5.79             |       | 387,099              |   | 23,440 |   | 6.06 |   | 384,791 |   | 26,402 |   | 6.86 |   |   |
|                                  |       |                 |       |         |       |             |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold                    |       | 1,530                |       | 17           |       | 1.13             |       | 3,919                |   | 46 |   | 1.17 |   | 11,584 |   | 190 |   | 1.64 |   |   |
|                                  |       |                 |       |         |       |             |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |
| Total earning assets                  |       | $                    | 521,589    |         | $          | 27,846           |       | 5.34                 | % | $ | 536,538 |   | $ | 28,935 |   | 5.39 | % | $ | 551,294 |   | $ | 34,991 |   | 6.35 | % |
|                                  |       |                 |       |         |       |             |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities          |       |                 |       |         |       |             |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits:                             |       |                 |       |         |       |             |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings                               |       | $                    | 41,860     |         | $          | 219              |       | 0.52                 | % | $ | 40,439 |   | $ | 255 |   | 0.63 | % | $ | 36,031 |   | $ | 363 |   | 1.01 | % |
| NOW                                   |       | 37,312               |       | 121          |       | 0.32             |       | 39,949               |   | 173 |   | 0.43 |   | 37,068 |   | 400 |   | 1.08 |   |   |
| MMDA                                  |       | 30,394               |       | 383          |       | 1.26             |       | 18,584               |   | 243 |   | 1.31 |   | 9,895 |   | 142 |   | 1.44 |   |   |
| Time deposits < $100,000           |       | 99,390               |       | 3,020        |       | 3.04             |       | 117,852              |   | 4,602 |   | 3.90 |   | 141,964 |   | 6,422 |   | 4.53 |   |   |
| Time deposits > $100,000           |       | 105,813              |       | 2,974        |       | 2.81             |       | 132,630              |   | 4,732 |   | 3.57 |   | 144,802 |   | 5,929 |   | 4.11 |   |   |
| Clubs                                 |       | 1,759                |       | 19           |       | 1.08             |       | 1,727                |   | 26 |   | 1.50 |   | 1,518 |   | 29 |   | 1.94 |   |   |
| Total deposits                        |       | 316,528              |       | 6,736        |       | 2.13             |       | 351,181              |   | 10,031 |   | 2.86 |   | 371,278 |   | 13,285 |   | 3.58 |   |   |
|                                  |       |                 |       |         |       |             |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |
| Repurchase agreements                 |       | 41,695               |       | 464          |       | 1.11             |       | 41,355               |   | 503 |   | 1.22 |   | 45,872 |   | 996 |   | 2.17 |   |   |
|                                  |       |                 |       |         |       |             |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |
| Borrowed funds                        |       | 78,318               |       | 3,980        |       | 5.08             |       | 69,471               |   | 3,703 |   | 5.33 |   | 64,045 |   | 3,601 |   | 5.62 |   |   |
|                                  |       |                 |       |         |       |             |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |
| Total interest-bearing liabilities    |       | $                    | 436,541    |         | $          | 11,180           |       | 2.56                 | % | $ | 462,007 |   | $ | 14,237 |   | 3.08 | % | $ | 481,195 |   | $ | 17,882 |   | 3.72 | % |   |
|                                  |       |                 |       |         |       |             |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income                   |       |                 |       | $            | 16,666     |             |       |                 |   |   | $ | 14,698 |   |   |   |   |   | $ | 17,109 |   |   |   |   |
|                                  |       |                 |       |         |       |             |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest spread                   |       |                 |       |         |       | 2.78             | %          |                 |   |   |   | 2.31 | % |   |   |   |   | 2.63 | % |   |
|                                  |       |                 |       |         |       |             |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest margin                   |       |                 |       |         |       | 3.20             | %          |                 |   |   |   | 2.74 | % |   |   |   |   | 3.10 | % |   |
|                                  |       |                 |       |         |       |             |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |
| Total average assets                  |       | $                    | 550,223    |         |       |             |       |                 | $ | 571,429 |   |   |   |   |   | $ | 580,769 |   |   |   |   |   |   |
|                                  |       |                 |       |         |       |             |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |
| Average non-interest bearing deposits |       | $                    | 66,006     |         |       |             |       |                 | $ | 60,985 |   |   |   |   |   | $ | 53,504 |   |   |   |   |   |   |
|                                       |            |                      |            |              |            |                  |            |                      |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

In the above table:

Interest income was adjusted to a tax-equivalent basis to recognize theincome from tax-exempt interest-earning assets as if the interest was taxable.  This treatment allows a uniform comparisonbetween yields on interest-earning assets.  The calculations were computed on a fullytax-equivalent basis using the corporate federal tax rate of 34%.

 

22

----

 

Loans include loans available-for-sale and non-accrual loans but excludethe allowance for loan losses.  Within consumerloans, direct financing leases are presented net of unearned interest.  Average balances are based on amortized costand do not reflect unrealized gains or losses.

 

Net interest rate spread represents the difference between the averageyield on average interest-earning assets and the average cost of averageinterest-bearing liabilities.  Net interestmargin represents net interest income divided by total average interest-earningassets.

 

Changes in netinterest income are a function of both changes in rates and changes in volumeof interest-earning assets and interest-bearing liabilities.  The following table presents the extent towhich changes in interest rates and changes in volume of interest-earningassets and interest-bearing liabilities have affected the Bank’s interestincome and interest expense during the periods indicated. Information isprovided in each category with respect to (1) the changes attributable tochanges in volume (changes in volume multiplied by prior rate), (2) the changesattributable to changes in interest rates (changes in rates multiplied by priorvolume) and (3) the net change.  Thecombined effect of changes in both volume and rate has been allocatedproportionately to the change due to volume and the change due to rate.  Tax-exempt income was not converted to atax-equivalent basis on the rate/volume analysis:

 

 
| ** **                                                                | ** ** | **Years ended December 31,  (dollars in thousands)**  | ** ** |
|---------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                | ** ** | **2004 Compared to 2003  Increase (decrease) due to** | ** ** | **2003 Compared to 2002  Increase (decrease) due to** | ** ** |
| ** **                                                                | ** ** | **Volume**                                            | ** ** | **Rate** | ** ** | **Total** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Total** | ** ** |
| Interest income:                                                          |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Loans and  leases:                                                        |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Mortgage                                                                  |       | $                                                     | (268       | ) | $ | (381 | ) | $ | (649 | ) | $ | 319 |   | $ | (1,028 | ) | $ | (709 | ) |
| Commercial                                                                |       | 605                                                   |       | (195 | ) | 410 |   | 656 |   | (1,353 | ) | (697 | ) |
| Consumer                                                                  |       | (484                                                  | )          | (245 | ) | (729 | ) | (923 | ) | (602 | ) | (1,525 | ) |
| Total loans and  leases                                                   |       | (147                                                  | )          | (821 | ) | (968 | ) | 52 |   | (2,983 | ) | (2,931 | ) |
| Investment  securities, interest- bearing deposits and federal funds sold |       | (1,042                                                | )          | 943 |   | (99 | ) | (795 | ) | (2,379 | ) | (3,174 | ) |
| Total interest  income                                                    |       | $                                                     | (1,189     | ) | $ | 122 |   | $ | (1,067 | ) | $ | (743 | ) | $ | (5,362 | ) | $ | (6,105 | ) |
|                                                                      |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Interest expense:                                                         |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                                                 |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Certificates of  deposit greater than $100,000                            |       | $                                                     | (858       | ) | $ | (900 | ) | $ | (1,758 | ) | $ | (466 | ) | $ | (731 | ) | $ | (1,197 | ) |
| Other                                                                     |       | (184                                                  | )          | (1,353 | ) | (1,537 | ) | (249 | ) | (1,808 | ) | (2,057 | ) |
| Total deposits                                                            |       | (1,042                                                | )          | (2,253 | ) | (3,295 | ) | (715 | ) | (2,539 | ) | (3,254 | ) |
| Other  interest-bearing liabilities                                       |       | 337                                                   |       | (99 | ) | 238 |   | 39 |   | (430 | ) | (391 | ) |
| Total interest  expense                                                   |       | $                                                     | (705       | ) | $ | (2,352 | ) | $ | (3,057 | ) | $ | (676 | ) | $ | (2,969 | ) | $ | (3,645 | ) |
| Net interest  income                                                      |       | $                                                     | (484       | ) | $ | 2,474 |   | $ | 1,990 |   | $ | (67 | ) | $ | (2,393 | ) | $ | (2,460 | ) |

 

The FederalReserve Bank increased the discount rate five times in 2004. The discount rateis the rate at which the Federal Reserve Bank lends overnight funds to banks.  In response to these actions, national prime increasedduring the second half of 2004.  Nationalprime is the benchmark rate banks use to set rates on various lending and otherinterest sensitive products.  Nationalprime increased five times at 25 basis point increments each, for a totalincrease of 1.25% from 4.00% at December 31, 2003 to 5.25% at December 31, 2004.

 

There was a 22basis point differential between the weighted-average rate of national prime in2004 compared to 2003.  Theweighted-average rate of national prime in 2004 and 2003 was 4.34% and 4.12%,respectively.  This difference has begunto increase the yield on the Bank’s interest-earning assets and should continueto do so as new product is originated and variable rate loans re-price to thesehigher rates.

 

The increase inthe U.S. Treasury yields during the second half of 2003 resulted in a decreasein refinance activity and related cash flows during the latter part of 2003which continued during 2004.  As marketrates rise along with the increase in national prime, loan originations, renewingcommercial and residential loans and lines of credit should price above the average2003 portfolio yields.  In addition, Treasuryyields and slowing mortgage refinance activity will also positively impact theinvestment portfolio, increasing yields which had begun during the thirdquarter of 2004 and should continue to do so in a rising rate environment.  The predominant low interest rate environment during2004, resulting from current economic conditions, had a negative affect onearning assets, causing total interest income to decrease 3.8%, from $28,462,000in 2003 to $27,395,000 in 2004 and further caused the tax-equivalent yield onearning assets to decrease 5 basis points. However, as previously mentioned, the Bank has begun to see an increasein the tax-equivalent yield on its earning assets during the second half of2004.

 

23

----

 

Interest expensedecreased 21.5%, from $14,237,000 in 2003 to $11,180,000 in 2004.  The cost of interest paying liabilitiesdecreased 52 basis points in 2004.  Ratespaid on maturing time and retained transactional deposit products were reducedto market deposit rates throughout 2004.  However, certain contractual based, long-term timedeposit products and borrowings, which must reach maturity before they can re-price,continue to pay at above market rates.  Thelow-cost overnight funding needs and the addition of the low-costing $5,000,000FHLB borrowings during the third quarter and the payoff of the higher costing$5,000,000 FHLB borrowing in the fourth quarter helped reduce the average costof these funding sources 25 basis points.

 

As a result, netinterest income increased $1,990,000, or 14%, from $14,225,000 in 2003 to $16,215,000in 2004.  On a tax-equivalent basis, thenet interest rate spread improved 47 basis points from 2.31% to 2.78% and thetax-equivalent margin improved 36 basis points, from 2.74% in 2003 to 3.20% in2004.

 

***Provisionfor loan losses***

 

The provision for loanlosses represents the necessary amount to charge against current earnings, thepurpose of which is to increase the allowance for loan losses to a level thatrepresents management’s best estimate of known and inherent losses in the Bank’sloan portfolio.  Loans and leasesdetermined to be uncollectible are charged-off against the allowance for loanlosses.

 

The required amount ofthe provision for loan losses, based upon the adequate level of the allowancefor loan losses, is subject to ongoing analysis of the loan portfolio.  The Bank maintains a Special Asset Committeewhich meets periodically to review problem loans and leases.  The committee is comprised of Bank management,including the credit administration officer, loan workout officers andcollection personnel.  The committeereports quarterly to the Credit Administration Committee of the Board ofDirectors.

 

Management continuouslyreviews the risks inherent in the loan and lease portfolio. Specific factorsused to evaluate the adequacy of the loan loss provision during the formalprocess include:

 

•                  Specific loans that could have losspotential

•                  Levels of and trends in delinquenciesand non-accrual loans

•                  Levels of and trends in charge-offsand recoveries

•                  Trends in volume and terms of loans

•                  Changes in risk selection andunderwriting standards

•                  Changes in lending policies,procedures and practices

•                  Experience, ability and depth oflending management

•                  National and local economic trendsand conditions

•                  Changes in credit concentrations

 

The provision for loanlosses was $2,150,000, for the year ended December 31, 2004, compared to $3,715,000in 2003.  As a result, the allowance forloan losses was $5,988,000 at December 31, 2004, compared to $4,997,000 atDecember 31, 2003.  Non-performing loans,which consist of loans past due 90 days or more and non-accrual loans increased$2,180,000, or 26%, to $10,461,000 at December 31, 2004, from $8,281,000, atDecember 31, 2003.  Of this increase,non-accrual loans increased $2,581,000 in 2004. The amount provided for loan losses, for the year ended December 31, 2004,was driven by increasing the allowance for loan losses to match the riskprofile inherent to the loan portfolio.

 

***Otherincome***

 

Other (non-interest) income consists of service charges or feescollected on the Bank’s various deposit and loan products, net mortgageservicing revenue, fees from trust, asset management and other financialservices, the increase in the cash surrender value of bank owned lifeinsurance, the realized gains and losses from the sales of investmentsecurities, loans, leased assets and foreclosed assets held-for-sale and othervarious classifications of non-interest related income.

 

For the year ended December 31, 2004, other income was $4,161,000 or $22,000less than the $4,183,000 recorded in 2003. Of this decrease approximately $404,000 was related to a decline in netgains recognized from the sales of loans available-for-sale into the secondarymarket.  The decline in loan sales wasthe result of the slowing of the mortgage refinance activity that was propelled,during 2003, by relatively low interest rates and the anticipated rise ininterest rates on mortgage and other loan products.  In addition, recognized net gains from salesof securities AFS declined from $329,000 in 2003 to $9,000 in 2004.  Partially offsetting these decreases wasgrowth in service charges on deposit related accounts by approximately $309,000in 2004 compared to 2003.

The Bank continues to focus and monitor various fee generatingactivities related to deposit accounts and considers this revenue

 

24

----

 

source a viable complement to netinterest income.  The Bank’s trust and assetmanagement services continue to increase its efforts to provide full-service alternativefinancial products to the Bank’s customer base. During 2004, these two areas combined for an increase in fees of $59,000compared to 2003.

 

Items further impacting other income included the reduction in recordedlosses on sales of full-term leased assets in the amounts of $291,000 for thetwelve months ended December 31, 2004. This compares to losses in 2003 of $409,000.  In addition, amortization of mortgageservicing rights (an offset service fee income) declined $206,000 for the yearended 2004 compared to 2003.  The decreasewas due to the lower volume of mortgage prepayments and mortgage re-financingin 2004.

 

***Otherexpense***

 

For the twelve monthsended December 31, 2004, other operating expenses were $13,827,000 or $924,000more than the $12,903,000 recorded in the same period of 2003.  Salary and employee benefit costs increased$366,000 for the twelve months ended December 31, 2004 compared to the sameperiod in 2003.  The increase wasprimarily due to the staffing of new key management positions as well as annualmerit increases on compensation costs and the related incremental payroll taxesthereon.  In addition, the Bank continuesto experience escalating costs of various employee benefit programs.  In 2004, the cost to provide health insurancepremiums to the Bank’s employees increased 21% from 2003.  Advertising expenses increased $95,000, or28% during the year ended 2004 compared to the year ended 2003.  The increase in advertising was due toimplementation of direct marketing programs with focus on brand awareness andthe acquisition of core deposits.  A morescientific approach to buying media was instituted, using various marketingmodels to reach a more targeted audience. This led to the purchase of alternative media resources, such astelevision spots and “screen vision” at a local unaffiliated movie theater complexthat it did not use during 2003.  Inaddition, the Bank used more radio advertising in 2004 compared to 2003.  The increase in the other operating expenseswas primarily the result of recording an incremental obligation related to theretirement benefit for the Company’s former chairman and president in theamount of $476,000.  The retirementbenefit represents a present value obligation for certain benefits, to be paidperiodically in the future, that include payments, reduced by appropriatetaxes, and estimated medical insurance reimbursements.  Based upon the subjective nature of themedical insurance premium portion of the accrual, as it relates to futurepremium costs, and the uncertainty of the future benefit period to be covered,the Company may find it necessary to increase or decrease the accrual.

 

Components of other operating expense also include professional fees,office supplies, printing, communications and data processing which did notvary significantly for the twelve months ended December 31, 2004 compared tothe same period in 2003.

 

The ratio ofnon-interest expense less non-interest income to average assets at December 31,2004 and 2003 was 1.69% and 1.68%, respectively.  This ratio continues to perform favorablyagainst the Uniform Bank Performance Report peer comparison groups, whichsupports Management’s commitment to maintain and reasonably control overheadexpenses.

 

***Provision for income taxes***

 

Income beforeprovision for income taxes in 2004 increased $2,610,000 from 2003.  The effective federal income tax rate was 23.5%and 8.2% for the years ending December 31, 2004 and 2003, respectively.  The effective tax rate increase is contributedto a decreased portion of combined tax-free interest income from municipalsecurities, tax-free loans and tax-free earnings from the Bank Owned LifeInsurance representing a smaller percentage of pre-tax earnings.

 

 

***Comparison of Financial Conditionas of December 31, 2003 and 2002***

 

***Deposits***

 

Total deposits decreased $12,346,000 or 3% during 2003 to$401,443,000.  Total average depositsdecreased $12,616,000 or 3% from $424,782,000 at December 31, 2002 to$412,166,000 at December 31, 2003.  Theinterest rates offered on most deposit products were lowered in 2002 andcontinued through 2003 in response to overall market conditions.

 

Core deposits, which excludes time deposits of$100,000 and greater, increased $4,283,000 or 2% during 2003, to $288,585,000.  Checking accounts increased $11,099,000 or12%, and savings and club accounts grew $4,355,000 or 11%.  Money market accounts grew $11,723,000 or71%.

 

25

----

 

Time deposits of $100,000 or greater decreased $16,629,000 or 13% from$129,486,000 at December 31, 2002 to $112,857,000 at December 31, 2003.The time deposit reduction occurred from the run-off of high cost non-personaland public fund accounts.  The personaltime deposit reduction was fully offset by the shift into savings and moneymarket accounts.  Total time deposits, atDecember 31, 2003 were $221,595,000 or 55% of total deposits compared to$256,836,000 or 62% at December 31, 2002.

 

***Short-term borrowings***

 

Interest ratereductions and customer liquidity and investment needs caused repurchaseagreements (Repos) to decrease from $47,232,000 at December 31, 2002, to$39,363,000 at December 31, 2003. Sweep accounts comprised approximately 70% ofRepos.

 

Fundingrequirements of the Bank, due largely to the reduction in deposits,necessitated $14,920,000 overnight borrowings from the FHLB, at December 31,2003.  FHLB borrowings at December 31,2002 amounted to $2,850,000.

 

***Long-term debt***

 

Long-term debtconsisted of borrowings from the FHLB. The weighted-average rate on fundsborrowed at December 31, 2003, was 5.31%. The weighted-average rate was 6 basispoints below the tax-equivalent yield of 5.39% on average earning assets forthe year ended December 31, 2003.  Rateson $63,000,000 of convertible select advances are adjustable quarterly, shouldmarket rates significantly increase beyond the issue’s three- month strikeprice.  However, year-end rates onsimilar FHLB advances were 401 basis points below the average rate paid by theBank. The Bank is deterred from paying off the current borrowings bysignificant prepayment penalties.

 

In October2003, the Bank borrowed $9,000,000 from the FHLB to replenish funds utilizedfrom the investment securities portfolio, to fund deposit run-off.  The new borrowings were a $5,000,000 ten yearconvertible select with a 7.5% strike price costing 3.61% and a five yearamortizing $4,000,000 advance fixed at 2.98%. The addition of this debt helped to reduce the overall weighted-averagerate of long-term debt outstanding.

 

***Accrued expenses and other liabilities***

 

Ratereductions in interest-bearing deposits and short-term borrowings causedaccrued interest payable to decrease from $1,707,000 at December 31, 2002, to $1,270,080 at December 31, 2003.

 

A $746,000pending settlement of investment securities purchased was recorded in otherliabilities at December 31, 2002. The Bank did not have any pending investmentpurchases at December 31, 2003.

 

***  Assets:***

 

***Investments***

 

Total investments declined $5,143,000, ofwhich $2,240,000 was due to depreciation in the market value ofavailable-for-sale (AFS) investments.

 

The carrying value of investmentsecurities, at December 31, 2003, was $144,730,000 or 25% of total assets.  At December 31, 2003 approximately 59% of theinvestment portfolio was comprised of mortgage-backed securities that amortizeand provide monthly cash flow. Agency bonds and municipal bonds comprised 26%and 9% of the investment portfolio, respectively.

 

With the relative low market interestrate environment, which continued through 2003, higher yielding United StatesGovernment Agency bonds along with state and municipal securities of$24,810,000 were called. In 2002, when the composition of the investmentportfolio was more susceptible to being called, securities approximating$90,600,000 were called.  No losses wereincurred, in 2002 or 2003, on any of the called bonds.

 

The low interest rate environment alsocaused many borrowers to prepay and/or refinance home mortgages. In terms ofinvestments, this contributed to a major prepayment in the Bank’s portfolio ofmortgage-backed securities (MBS), which represents investments in pools ofresidential mortgages.

 

26

----

 

Of the total MBS prepayments received in2002, $11,682,000 or 64% was received during the fourth quarter, $4,436,000 inDecember alone. At the prepayment speed experienced during this period, theentire MBS portfolio could have been paid off in just over two years.  In addition, amortization of bond premium inthe amount of $2,449,000 would have been accelerated into this shorter timeperiod, opposed to over the estimated average life of seven years at the timesof purchase. Amortization of bond premium is the periodic charge to earningsfor the amount by which the purchase price of a bond exceeds its par value.

 

A restructuring of the investmentportfolio was undertaken in 2003, to protect earnings which were beingadversely impacted by bond calls and MBS prepayments. The objective of therestructuring was to effectively manage and predict cash flows from securitieswithin a four year average life range where redeployment of the proceeds couldgo into higher yielding investments. This control would help reduce interest rate risk and coordinate theBank’s desired earnings and liquidity needs. To accomplish the restructuring of the MBS portfolio, the Bankparticipated in a series of strategically planned sales with subsequent buys ofsimilar type securities (swaps). The swaps were designed to maintain cash flowthrough the sale of the faster prepaying available-for-sale MBS and reinvestingthe proceeds into MBS issues with weighted-average coupons that provided thedesired structured cash flows. This strategy would help to reduce prepaymentrisk and take advantage of the steep yield curve.  The swaps produced modest gains on the salesand securities were purchased at effective yields above the bonds sold.  At December 31, 2003, the estimatedweighted-average life of the MBS portfolio extended to approximately four yearsand the net premiums were reduced to $1,153,000. At December 31, 2003, the MBSportfolio was producing yields that were approximately 56 basis points morethan the portfolio was producing at December 31, 2002.

 

The other aspect of the restructuringstrategy was to reinvest the proceeds from called bonds and MBS paymentsdefensively into U.S. Agency and municipal obligations that provided greaterprotection from future calls. Approximately $27,990,000 of the acquired Agencybonds contained rate steps, whereby the rate automatically increased, if thebond continued past the call date.  Thesedefensive structures mitigate extension risks inherent within this low interestrate environment.

 

Debt securities are stated net ofunrealized gain or loss on AFS securities. Net unrealized loss on AFS debtsecurities at December 31, 2003 was $493,000. Debt securities do not includethe $279,000 of AFS equity securities or the $4,753,000 of restrictedregulatory equity securities owned at December 31, 2003. Net unrealized gain onAFS equity securities was $170,000 at December 31, 2003.

 

The tax equivalent yield on debt securities by stated maturity date atDecember 31, 2003, is as follows:

 
| ** **                          | ** ** | **One year** | ** ** | **One through** | ** ** | **Five through** | ** ** | **More than** | ** ** | ** ** | ** ** |
|-------------------------------------|------------|--------------|------------|-----------------|------------|------------------|------------|---------------|------------|------------|------------|
| ** **                          | ** ** | **or less**  | ** ** | **five years**  | ** ** | **ten years**    | ** ** | **ten years** | ** ** | **Total**  | ** ** |
| U.S. Government Agencies            |       | —       | %          | 2.60            | %          | 3.51             | %          | 4.72          | %          | 3.86       | %          |
| Mortgaged Backed Securities         |       | —       |       | 5.52            |       | 3.60             |       | 4.78          |       | 4.45       |       |
| State & Municipal  Subdivisions |       | —       |       | 6.09            |       | 5.09             |       | 5.82          |       | 5.70       |       |
| Preferred Term Securities           |       | —       |       | —          |       | —           |       | 3.81          |       | 3.81       |       |
| Total debt securities               |       | 0.00         | %          | 3.37            | %          | 3.64             | %          | 4.84          | %          | 4.40       | %          |

 

***Loans***

 

Loans, net of unearned income, increased $13,817,000 or 3.86% from$358,162,000 at December 31, 2002, to $371,979,000 at December 31, 2003. Grossloans represented 64.67% of total assets at December 31, 2003.

 

In 2003, the Bank originated $37,797,000 of commercial loans,$40,028,000 of mortgage loans and $24,041,000 of consumer loans.  In addition for 2003, the Bank committed tomaximum lines of credit of $33,158,000 for commercial borrowers, $14,523,000for real estate construction loans, $15,528,000 in home equity lines and$213,000 for consumer borrowers.  Growthin the portfolio was primarily in commercial and commercial real estate.

 

Loan refinancing to lower interest rates continued in 2003 at a muchgreater volume than in 2002.  Suchrefinancing occurred in all loan portfolios and followed a corresponding dropin interest rates which correlated with a national trend.  It is anticipated that the volume ofprepayments and refinance requests could begin to ease, as rates become stableor increase. Furthermore, new loans are being structured, when possible, tobetter withstand market fluctuations.

 

27

----

 

*Commercial Loans:*

Net of scheduled principal curtailments, loan participation sales, andpre-payment, commercial loans increased $18,302,000 or 9.02% during 2003. Thisincrease in commercial loans was primarily due to increased lending within thesmall business community.

 

Tax-free industrial development loans made to or backed by localmunicipalities increased to $9,020,000 at December 31, 2003. The surge in thissector was due mainly to several large term loans to local municipalities forvarious infrastructure projects.

 

*Residential Real Estate Loans*:

Residential real estate loans increased $5,332,000 or 6.24% to$90,779,000.  These loans increased dueto strong demand for such loans due to the historic low interest rateenvironment.

 

Real estate and construction loan totals of $98,047,000 were 25.02% ofgross loans at December 31, 2003. Included with real estate loans are homeequity lines of credit. The outstanding balance on the credit lines increased$6,387,000 or 87.31% from $7,315,000 at December 31, 2002, to $13,702,000 atDecember 31, 2003.

 

*Consumer Loans and Direct Financing Leases:*

Consumer loans and direct-financing leases decreased $10,661,000 or16.77% during 2003. The home equity installment loan portfolio, included withinthe consumer loans, experienced significant payoffs caused by refinancing intolower rate mortgages.  In addition,prepayments could not be successfully replaced due to the tightened creditunderwriting standards on indirect auto loans and the decision to no longeroriginate direct financing leases. A combination of these events brought aboutthis overall decline in consumer loans.

 

The following table sets forth thematurity distribution of the loan portfolio at December 31, 2003. Excluded fromthe table are non-construction real estate loans, consumer loans and directfinancing leases (amounts in thousands):

 
| ** **                                   | ** ** | **One year** | ** ** | **One to**     | ** ** | **More than**  | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|--------------|------------|----------------|------------|----------------|------------|------------|------------|
| ** **                                   | ** ** | **or less**  | ** ** | **five years** | ** ** | **five years** | ** ** | **Total**  | ** ** |
| Commercial and commercial  real estate loans |       | $            | 42,652     |           | $          | 42,297         |       | $          | 136,327    |   | $ | 221,276 |   |
| Real estate construction                     |       | 7,268        |       | —         |       | —         |       | 7,268      |       |
| Total                                        |       | $            | 49,920     |           | $          | 42,297         |       | $          | 136,327    |   | $ | 228,544 |   |
|                                              |            |              |            |                |            |                |            |            |            |  |  |  |  |  |  |

 

The following table sets forth thesensitivity changes in interest rates for commercial and commercial real estateloans at December 31, 2003 (amounts in thousands):

 
| ** **             | ** ** | **One to five** | ** ** | **More than**  | ** ** | ** ** | ** ** |
|------------------------|------------|-----------------|------------|----------------|------------|------------|------------|
| ** **             | ** ** | **years**       | ** ** | **five years** | ** ** | **Total**  | ** ** |
| Fixed interest rate    |       | $               | 8,286      |           | $          | 14,511     |       | $ | 22,797 |   |
| Variable interest rate |       | 34,011          |       | 121,816        |       | 155,827    |       |
| Total                  |       | $               | 42,297     |           | $          | 136,327    |       | $ | 178,624 |   |
|                        |            |                 |            |                |            |            |            |  |  |  |  |  |

 

***Loans available-for-sale***

 

Loans available-for-sale at December 31, 2003 was $19,864,000, with acorresponding fair value of $20,500,000. The year-end balance was comprised of $17,783,000 of residentialmortgages, $1,338,000 of SBA loans, and $743,000 in student loans.  The Bank decreased loans available-for-saleby $8,852,000 or 30.83% from the December 31, 2002 balance.  Available-for-sale loans decreased in partfrom the overall sale of these types of loans and, in part, from a managementdecision to temporarily classify fewer residential loans as available-for-sale,in order to take advantage of higher rates offered in this loan categorycompared to market rates.  Also, atDecember 31, 2002, the AFS portfolio included $2,872,000 of credit cardreceivables which the Bank sold during the first quarter of 2003. The decisionto sell these receivables was based upon lack of an adequate credit cardservicing system, lack of consistent growth, high overhead associated withcredit card activities and a high loss experience on non-performing creditcards.  

 

Servicing rights on sold loans wereretained by the Bank and at December 31, 2003, the servicing portfolio balanceof sold residential mortgage loans was $56,021,000.

 

28

----

 

***Bank premises and equipment, net***

 

Due to the fact that expansion plans were deferred and a major computersystem conversion was completed in 2002, additions to premises and equipmentwere minimal and amounted to $621,000 for 2003 compared to $2,542,000 in 2002.

 

***Foreclosed******assets held for sale***

 

Real estate acquired through foreclosure increased $132,000 in 2003compared to 2002 due to the receipt of five properties foreclosed during thefourth quarter and held for sale at year end. Repossessed vehicles had a net decrease of $102,000, mostly from theincreased turn around time on the sale of these vehicles.

 

***Comparison of the Results of Operations forthe Years December 31, 2003 and 2002***

 

***Results of Operations***

 

***Net interest income***

 

The Federal Reserve Bank lowered thediscount rate once in 2003. The discount rate is the rate at which the FederalReserve Bank lends overnight funds to banks. In response to these actions,national prime dropped 25 basis points from 4.25% to 4.00%.

 

There is a 55 basis point differentialbetween the weighted-average of national prime in 2003 compared to 2002. Theweighted-average of national prime in 2003 and 2002 was 4.12% and 4.67%,respectively. This difference reflects the reduction of total interest incomeand corresponding yield on earning assets, when comparing both years.

 

As market rates remained at low levels throughout 2003, along with thereduction of national prime, loan originations and renewing commercial loansand lines of credit priced substantially below the portfolio yields of 2002.Treasury yields and the waves of mortgage refinancing also adversely impactedthe investment portfolio, driving yields downward throughout 2003.  The MBS, mortgage and consumer home equity installmentloan portfolios each experienced significant payoffs caused from the number ofmortgage refinance waves experienced throughout 2003.  Besides the natural reduction of interestincome from repricing, the significant prepayments of MBS led to the recognitionof a $1,167,000 net increase in amortization of premium held on these bondsover 2002.  The low interest rateenvironment resulting from current economic conditions had a negative affect onearning assets, causing total interest income to decrease 17.66%, from$34,567,000 in 2002 to $28,462,000 in 2003 and further caused thetax-equivalent yield on earning assets to decrease 96 basis points.

 

Interest expense decreased 20.38%, from $17,882,000 in 2002 to$14,237,000 in 2003. The cost of interest paying liabilities decreased 64 basispoints in 2003.  Rates paid on depositproducts were reduced to market deposit rates throughout 2003. However, certaincontractual based deposit products and borrowings, which must reach maturity tore-price, continued to pay at above market rates.  The inability to reduce interest expense onthese products prevented the Bank from fully mitigating the reduced interestincome for the year to maintain our margin. The low cost overnight funding needs and the addition of the $9,000,000FHLB borrowings during the fourth quarter helped to reduce the average cost ofthese long-term funds 29 basis points, which somewhat eased the negative impacton net interest income.

 

As an overall result, net interest income decreased $2,460,000, or14.75%, from $16,685,000 in 2002 to $14,225,000 in 2003. The net interestmargin, on a tax-equivalent basis, declined 36 basis points, from 3.10% in 2002to 2.74% in 2003.

 

***Provision for loan losses***

 

The provision for loan losses was $3,715,000, for the year endedDecember 31, 2003, compared to $1,664,000 in 2002.  Non-performing loans, which consisted ofloans past due 90 days or more and non-accrual loans, were $8,281,000 atDecember 31, 2003, compared to $6,599,000, at December 31, 2002.  Of this amount, non-accrual loans increased$3,323,000 in 2003.  The increase innon-accrual loans was primarily due to the addition of three large commercialrelationships. The amount provided for loan losses, for

 

29

----

 

the year ended December 31, 2003, wasdriven by increasing the allowance for loan losses to match the risk profileinherent to the loan portfolio and, to a lesser extent, an increase in loanvolume.

 

***Other income***

 

For the year ended December 31, 2003, other income was $4,183,000 or$880,000 more than the $3,303,000 recorded in 2002.  Of this increase, $360,000 pertained toservice charge activities related to deposit accounts, which grew considerablyduring 2003 from the focused management of these services and addition of ourCourtesy Coverage service.  The Bankrecorded income of $294,000 on the increase in the cash surrender value of bankowned life insurance policy, which was a new addition of tax-free earnings for2003.  In addition, the Bank recognizedgains, during 2003, on the sales of AFS investments and loans held-for-sale inthe amounts of $329,000 and $548,000, respectively.  This compares favorably to $59,000 and$378,000, respectively, recognized in 2002. Trust and financial services income was approximately $86,000 higher in2003 due to stepped-up efforts to service all of the financial needs of ourcustomers.

 

Items further impacting other income included the recorded losses onsales of full-term leased assets and foreclosed assets held-for-sale in theamounts of $409,000 and $12,000, respectively for the twelve months endedDecember 31, 2003.  This compares tolosses in 2002 of $48,000 and $3,000, respectively.  Also negatively impacting other income wasthe high amount of amortization of mortgage servicing rights, which for thetwelve months ended December 31, 2003, was $174,000 more than 2002amortization.  This increase was due tothe near record low-interest rate environment, which, in turn, resulted in ahigh volume of mortgage prepayments and re-financing in 2003 and a decrease inthe Bank’s loan servicing portfolio.

 

***Other expense***

 

For the twelve months ended December 31, 2003, other operating expenseswere $12,903,000 or $152,000 more than the $12,751,000 recorded in the sameperiod of 2002.  Premises and equipmentrelated expenses increased approximately $372,000 in 2003 compared to2002.  Of this increase, deprecationexpense increased $195,000.  The increasein depreciation expense can be primarily attributed to the Eynon branch, whichopened during the third quarter of 2002 and the Bank’s new core processingsystem which was installed during the fourth quarter of 2002. Advertisingexpenses were approximately $61,000 or 15% lower for the twelve months endedDecember 31, 2003 compared to the same 2002 period.  The decrease is due to a strategic approachto reduce expenses by targeting lower cost advertising methods for the Bank’sbranch system.

 

Salaries and Employee Benefits were $30,000 lower for the twelve monthsended December 31, 2003 compared to the same period in 2002.  Inflationary increases on salaries andtherefore, the increased payroll related taxes were more than offset byreductions in employee benefit costs resulting from health care andprofit-sharing cuts.  Due to thecontinued escalating cost of health insurance, during 2003, the Bank increasedthe employees’ co-pay portion of that cost. In addition, the Bank’s financial performance in 2003 caused thecontribution to the profit-sharing plan to decrease 32%, from $130,000 in 2002to $89,000 in 2003.  The Bank’scontribution to the profit-sharing plan continued, in order to reward employeesfor work accomplished.

 

For the twelve months ended December 31, 2003, the Bank recorded legaland audit fees in the amount of $617,000 or 174% more than the $225,000 recordedfor the twelve months ended December 31, 2002. The Company incurred significant legal expenses to aggressively defend alaw suit filed against the Bank, which was settled in October 2003.  In the fourth quarter of 2003, the Bankutilized a national independent accounting firm to consult with Management onthe review, documentation and reporting on the Company’s system of internalcontrols, to achieve full compliance with current FDICIA and SECregulations.  In addition, the AuditCommittee decided to outsource the internal auditing function to a localcertified public accounting firm.   Theoutsourcing was required to complete the thirty-six internal audit reportsnecessary to meet the FDICIA regulations. The outsourcing arrangement willcontinue to maximize the effectiveness of the internal auditing process, bothon a quarterly interim and annual basis.

 

The ratio of non-interest expense less non-interest income to averageassets at December 31, 2003 and 2002 was 1.68% for both years.

 

***Provision for income taxes***

 

Income before provision for income taxes in 2003 decreased $3,783,000from 2002. The effective federal income tax rate was 8.19% and 27.39% for theyears ending December 31, 2003 and 2002, respectively. The decrease in theeffective tax rate was due to the increased portion of combined tax-freeinterest income from municipal securities, tax-free loans and tax-free earningsfrom the Bank Owned Life Insurance that was included in pre-tax earnings.  Non-taxable income as a percentage of incomebefore taxes increased from 18.90% in 2002, to 67.72% in 2003.

 

30

----

 

***Capital Resources***

 

The Company is subject to variousregulatory capital requirements administered by the federal banking agencies.Failure to meet minimum capital requirements can initiate certain mandatory andpossible additional discretionary actions by regulators that, if undertaken,could have a direct material effect on the Company’s financial statements.Under capital adequacy guidelines and the regulatory framework for promptcorrective action, the Company must meet specific capital guidelines thatinvolve quantitative measures of the Company’s assets, liabilities and certainoff-balance-sheet items as calculated under regulatory accounting practices.The Company’s capital amounts and classification are also subject toqualitative judgments by the regulators about components, risk weightings andother factors.

 

Capital is fundamental to support ourcontinued growth. In addition, the Company and Bank are subject to variousregulatory capital requirements. Regulatory capital is defined in terms of TierI capital (shareholders’ equity plus the allowable portion of the minorityinterest in equity of subsidiaries, minus unrealized gains or plus unrealizedlosses on available for sale securities, and minus certain intangible assets),Tier II capital (which includes a portion of the allowance for loan losses,minority interest in equity of subsidiaries and subordinated debt), and totalcapital (Tier I plus Tier II). Risk-based capital ratios are expressed as apercentage of risk-weighted assets. Risk-weighted assets are determined byassigning various weights to all assets and off-balance sheet financialinstruments, such as letters of credit and loan commitments, based onassociated risk. Regulators have also adopted minimum Tier I leverage ratiostandards, which measure the ratio of Tier I capital to total average quarterlyassets.

 

Quantitative measures established byregulation to ensure capital adequacy require the Company to maintain minimumamounts and ratios of total and Tier I capital to risk-weighted assets, and ofTier I capital to average assets. Capital is evaluated in relation to totalassets and the risk associated with those assets. With greater capitalresources, a bank is more likely to be able to meet its cash obligations andabsorb unforeseen losses. The Company exceeds all minimum regulatory capitalrequirements (see Note 14 “Regulatory Matters”, contained within the notes toconsolidated financial statements, and incorporated herein by reference).

 

The Company’s major source of capital hasbeen from the retention of equity in undistributed earnings of the Bank, asreflected below:

 
| ** ** | ** ** | **Net**    | ** ** | **Dividends** | ** ** | **Earnings** | ** ** |
|------------|------------|------------|------------|---------------|------------|--------------|------------|
|       |       | **income** | ** ** | **declared**  | ** ** | **retained** | ** ** |
|       |       | ** ** | ** ** | ** **    | ** ** | ** **   | ** ** |
| 2004       |       | $          | 3,364,474  |          | $          | 1,610,423    |       | $ | 1,754,051 |   |
| 2003       |       | 1,643,248  |       | 1,601,898     |       | 41,350       |       |
| 2002       |       | 4,046,173  |       | 1,526,371     |       | 2,519,802    |       |
| 2001       |       | 3,848,136  |       | 1,426,097     |       | 2,422,039    |       |
| 2000       |       | 3,182,628  |       | 1,366,075     |       | 1,816,553    |       |
|            |            |            |            |               |            |              |            |  |  |  |

 

Capital was further increased in 2004 through the Company’s DividendReinvestment Plan (DRIP). Shareholders reinvested $501,000 in dividends topurchase additional shares of stock.  Inaddition, through the Employee Stock Purchase Plan and via the exercise ofstock options through the Stock Incentive Plan, capital increased by $53,000and $16,000, respectively.

 

Capital was further enhanced by changes in market rates.  The Bank’s investment strategy reacting tomarket changes resulted in a $112,000 improvement, netof deferred taxes, in the fair value of AFS investments.  At December 31, 2003, the Bank reported a netunrealized loss on AFS securities of $213,000. At December 31, 2004, a netunrealized loss of $101,000 was reported. Fluctuations in the capital markets cause frequent changes in the fairvalue of AFS securities.  A futuredecline in value should not indicate a material weakness in the capitalposition of the Company. The Company monitors market conditions closely and isprepared to take remedial action when appropriate.

 

During the second quarter of 2003, 12,720 shares of common stock becameavailable on the open market.  TheCompany purchased the stock for $458,000 with the intention to reissue thestock under the DRIP and Employee Stock Purchase Plan.  During the first two quarters of 2004, theremaining 5,227 shares of treasury stock were reissued under the DRIP andEmployee Stock Purchase Plan.

 

***Liquidity***

 

Liquidity management ensures that adequate funds will be available tomeet customers’ needs for borrowings, deposit withdrawals and maturities andnormal operating expenses of the Bank. Current sources of liquidity are cash and cash equivalents, assetmaturities and pay downs within one year, loans and investments available-for-sale,growth of core deposits, growth of repurchase agreements,

 

31

----

 

increase of other borrowed funds fromcorrespondent banks and issuance of capital stock. Although regularly scheduledinvestment and loan payments are a dependable source of daily funds, the saleof loans and AFS investments, deposit activity, and investment and loanprepayments are significantly influenced by general economic conditions and thelevel of interest rates.

 

At December 31, 2004, the Company maintained $10,216,000 in cash andcash equivalents.  In addition, theCompany had $576,000 of loans available-for-sale and $117,181,000 ininvestments available-for-sale.  Thiscombined total of $127,973,000 represented 24% of total assets at December 31,2004.  Management believes that thepresent level of liquidity is strong and adequate for current operations.

 

The Company considers its primary source of liquidity to be its coredeposit base consisting of deposits from customers throughout the branchnetwork.  The Company will continue topromote the acquisition of deposits through its branch offices.  At December 31, 2004, approximately 68% ofthe Company’s assets were funded by deposits and an additional 9% of the assetswere funded by the Company’s equity.  Thecompany expects to grow these two components, which provides a substantial andsteady source of funds.

 

As detailed in the statement of cash flows incorporated by reference,total cash and cash equivalents had a net $9,015,000 decrease stemming from netcash used by financing activities due to decline in deposits and net reductionsin borrowings, financed by net increases in funds provided from investingactivities and funds provided from operations. Sources of funds from investment activities include proceeds from thesale of loans and securities AFS and net proceeds from pay-downs and maturitiesof securities.

 

At December 31, 2004, the Bank had approximately $125 million in unusedsources of borrowed funds available to meet liquidity requirements.  The sources were the approximated borrowingcapacity at the Federal Reserve Bank of Philadelphia of $25 million along withavailable funding at the FHLB of $100 million. The borrowing capacity at the Federal Reserve Bank of Philadelphia isthe discounted market value of investment securities pledged as collateral atthe date of borrowing.

 

***Management of interest rate risk and marketrisk analysis***

 

The Company is subject to the interest rate risks inherent in ourlending, investing and financing activities. Fluctuations of interest rates will impact interest income and interestexpense along with affecting market values of all interest-earning assets andinterest-bearing liabilities, except for those assets or liabilities with ashort-term remaining to maturity.  Interestrate risk management is an integral part of the asset/liability managementprocess.  The Company has institutedcertain procedures and policy guidelines to manage the interest rate riskposition.  Those internal policies enablethe Company to react to changes in market rates to protect net interest incomefrom significant fluctuations.  Theprimary objective in managing interest rate risk is to minimize the adverseimpact of changes in interest rates on net interest income along with creatingan asset/liability structure that maximizes earnings.

 

*Asset/Liability Management*.  One major objective of the Company whenmanaging the rate sensitivity of its assets and liabilities is to stabilize netinterest income.  The management of andauthority to assume interest rate risk is the responsibility of the Company’sAsset/Liability Committee (ALCO), which is comprised of senior management andBoard members.  ALCO meets quarterly tomonitor the ratio of interest sensitive assets to interest sensitiveliabilities.  The process to reviewinterest rate risk is a regular part of managing the Company.  Consistent policies and practices ofmeasuring and reporting interest rate risk exposure, particularly regarding thetreatment of non-contractual assets and liabilities, are in effect.  In addition, there is an annual process toreview the interest rate risk policy with the Board of Directors which includeslimits on the impact to earnings from shifts in interest rates.

 

*Interest Rate Risk Measurement.*** Interest rate risk ismonitored through the use of three complementary measures:  static gap analysis, earnings at risksimulation and economic value at risk simulation.  While each of the interest rate riskmeasurements has limitations, taken together they represent a reasonablycomprehensive view of the magnitude of interest rate risk in the Company andthe distribution of risk along the yield curve, the level of risk through timeand the amount of exposure to changes in certain interest rate relationships.

 

*Static Gap*.The ratio between assets and liabilities re-pricing in specific time intervalsis referred to as an interest rate sensitivity gap.  Interest rate sensitivity gaps can be managedto take advantage of the slope of the yield curve as well as forecasted changesin the level of interest rate changes.

 

To manage this interest rate sensitivity gap position, anasset/liability model called cumulative gap analysis is used to monitor thedifference in the volume of the Company’s interest sensitive assets andliabilities that mature or re-price within given periods.  A positive gap (asset sensitive) indicatesthat more assets reprice during a given period compared to liabilities, while anegative gap (liability sensitive) has the opposite effect.  The Company employs computerized net interestincome simulation modeling to assist in quantifying interest rate riskexposure.  This process measures andquantifies the impact on net interest income through varying interest ratechanges and balance sheet compositions. The use of this model assists the ALCO to gauge the effects of theinterest rate

 

32

----

 

changes on interest sensitive assets andliabilities in order to determine what impact these rate changes will have uponthe net interest spread.  At December 31,2004, the Bank maintained a one-year cumulative positive gap of $63.4 millionor 11.8% of total assets.  The effect ofthis positive gap position provided a mismatch of assets and liabilities whichmay expose the Bank to interest rate risk during periods of declining interestrates.  Conversely, in an increasinginterest rate environment, net interest income could be positively impactedbecause more assets than liabilities will re-price during a given period.

 
| ** **                                     | ** ** | **Interest sensitivity gap at December 31, 2004** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                     | ** ** | **Three months**                                  | ** ** | **Three to** | ** ** | **One to** | ** ** | **Over** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **or less**                                       | ** ** | **twelve months** | ** ** | **three years** | ** ** | **three years** | ** ** | **Total** | ** ** |
| Cash and cash equivalents                      |       | $                                                 | 1,315      |   | $ | — |   | $ | — |   | $ | 8,901 |   | $ | 10,216 |   |
| Investment securities  (1)(2)             |       | 13,537                                            |       | 13,836 |   | 38,711 |   | 54,154 |   | 120,238 |   |
| Loans (2)                                      |       | 150,981                                           |       | 74,291 |   | 80,381 |   | 76,470 |   | 382,123 |   |
| Fixed and other assets                         |       | —                                            |       | 7,613 |   | — |   | 16,485 |   | 24,098 |   |
| Total assets                                   |       | $                                                 | 165,833    |   | $ | 95,740 |   | $ | 119,092 |   | $ | 156,010 |   | $ | 536,675 |   |
| Total cumulative assets                        |       | $                                                 | 165,833    |   | $ | 261,573 |   | $ | 380,665 |   | $ | 536,675 |   |   |   |
|                                           |       |                                              |       |   |   |   |   |   |   |   |   |
| Non-interest bearing transaction deposits  (3) |       | $                                                 | —     |   | $ | 6,536 |   | $ | 17,974 |   | $ | 40,848 |   | $ | 65,358 |   |
| Interest-bearing transaction deposits (3)      |       | 5,521                                             |       | 55,027 |   | 44,031 |   | 10,995 |   | 115,574 |   |
| Time deposits                                  |       | 22,721                                            |       | 59,066 |   | 89,433 |   | 13,463 |   | 184,683 |   |
| Repurchase agreements                          |       | 33,056                                            |       | 598 |   | 7,029 |   | — |   | 40,683 |   |
| Short-term borrowings                          |       | 9,850                                             |       | — |   | — |   | — |   | 9,850 |   |
| Long-term debt                                 |       | 5,204                                             |       | 610 |   | 1,628 |   | 63,677 |   | 71,119 |   |
| Other liabilities                              |       | —                                            |       | — |   | — |   | 3,041 |   | 3,041 |   |
| Total liabilities                              |       | $                                                 | 76,352     |   | $ | 121,837 |   | $ | 160,095 |   | $ | 132,024 |   | $ | 490,308 |   |
| Total cumulative liabilities                   |       | $                                                 | 76,352     |   | $ | 198,189 |   | $ | 358,284 |   | $ | 490,308 |   |   |   |
|                                           |       |                                              |       |   |   |   |   |   |   |   |   |
| Interest sensitivity gap                       |       | $                                                 | 89,481     |   | $ | (26,097 | ) | $ | (41,003 | ) | $ | 23,986 |   |   |   |
|                                           |       |                                              |       |   |   |   |   |   |   |   |   |
| Cumulative gap                                 |       | $                                                 | 89,481     |   | $ | 63,384 |   | $ | 22,381 |   | $ | 46,367 |   |   |   |
|                                           |       |                                              |       |   |   |   |   |   |   |   |   |
| Cumulative gap to total assets                 |       | 16.67                                             | %          | 11.81 | % | 4.17 | % | 8.64 | % |   |   |
|                                                |            |                                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)                                  Includes netunrealized gains/losses on available-for-sale securities.

(2)                                  Investments and loansare included in the earlier of the period in which interest rates were nextscheduled to adjust or the period in which they are due.  In addition, loans were included in theperiods in which they are scheduled to be repaid based on scheduledamortization.  For amortizing loans andmortgage-backed securities, annual prepayment rates are assumed reflectinghistorical experience as well as management’s knowledge and experience of itsloan products.

(3)                                  The Bank’s demand andsavings accounts were generally subject to immediate withdrawal.  However, management considers a certainamount of such accounts to be core accounts having significantly longereffective maturities based on the retention experiences of such deposits inchanging interest rate environments.  Theeffective maturities presented are the recommended maturity distribution limitsfor non-maturing deposits based on historical deposit studies.

 

Certain shortcomings are inherent in the method of analysis presentedin the above table.  Although certainassets and liabilities may have similar maturities or periods of repricing,they may react in different degrees to changes in market interest rates.  The interest rates on certain types of assetsand liabilities may fluctuate in advance of changes in market interest rates,while interest rates on other types of assets and liabilities may lag behindchanges in market interest rates. Certain assets, such as adjustable-rate mortgages, have features whichrestrict changes in interest rates on a short-term basis and over the life ofthe asset.  In the event of a change ininterest rates, prepayment and early withdrawal levels may deviatesignificantly from those assumed in calculating the table.  The ability of many borrowers to service theiradjustable-rate debt may decrease in the event of an interest rate increase.

 

*Earnings at Risk and Economic Value at RiskSimulations*. The Company recognizes that more sophisticated tools exist for measuringthe interest rate risk in the balance sheet beyond static re-pricing gapanalysis.  Although it will continue tomeasure its repricing gap position, the Company utilizes additional modelingfor identifying and measuring the interest rate risk in the overall balancesheet.

 

33

----

 

The ALCO is responsible for focusing on “earnings at risk” and “economicvalue at risk”, and how both relate to the risk-based capital position whenanalyzing the interest rate risk.

 

*Earnings at Risk*.  Earnings at risk simulationmeasures the change in net interest income and net income shouldinterest rates rise and fall.  Thesimulation recognizes that not all assets and liabilities re-price one-for-onewith market rates (e.g., savings rate). The ALCO looks at “earnings at risk” to determine income changes from abase case scenario under an increase and decrease of 200 basis points ininterest rate simulation models.

 

*Economic Value at Risk.*Earnings at risk simulation measures the short-termrisk in the balance sheet.  Economicvalue (or portfolio equity) at risk measures the long-term risk by finding thenet present value of the future cash flows from the Company’s existing assetsand liabilities.  The ALCO examines thisratio quarterly utilizing an increase and decrease of 200 basis points ininterest rates simulation model.  TheALCO recognizes that, in some instances, this ratio may contradict the “earningsat risk” ratio.

 

The following table illustrates the simulated impact of an immediate200 basis points upward or downward movement in interest rates on net interestincome, net income and the change in the economic value (portfolioequity).  This analysis assumed thatinterest-earning asset and interest-bearing liability levels at December 31,2004 remained constant.  The impact ofthe rate movements was developed by simulating the effect of the rate changeover a twelve-month period from the December 31, 2004 levels:

 
| ** **                                             | ** ** | **Rates +200** | ** ** | **Rates -200** | ** ** |
|--------------------------------------------------------|------------|----------------|------------|----------------|------------|
|                                                   |       |           |       |           |       |
| Earnings at risk:                                      |       |           |       |           |       |
| Percent change in:                                     |       |           |       |           |       |
| Net interest income                                    |       | 9.3            | %          | (20.9          | )%         |
| Net income                                             |       | 26.8           |       | (58.8          | )          |
|                                                   |       |           |       |           |       |
| Economic value at risk:                                |       |           |       |           |       |
| Percent change in:                                     |       |           |       |           |       |
| Economic value of equity                               |       | (11.3          | )          | (17.5          | )          |
|                                                   |       |           |       |           |       |
| Economic value of equity as a percent of  total assets |       | (1.10          | )          | (1.71          | )          |

 

Economic value has the most meaning when viewed within the context ofrisk-based capital.  Therefore, theeconomic value may normally change beyond the Company’s policy guideline for ashort period of time as long as the risk-based capital ratio (after adjustingfor the excess equity exposure) is greater than 10%.  At December 31, 2004, the Company’srisk-based capital ratio was 13.3%.

 

The table below summarizes estimated changes in net interest incomeover a twelve-month period beginning January 1, 2005, under alternate interestrate scenarios using the income simulation model described above:

 
| ** **                   | ** ** | **Net interest**           | ** ** | **Dollar**   | ** ** | **%**        | ** ** |
|------------------------------|------------|----------------------------|------------|--------------|------------|--------------|------------|
| **Change in interest rates** | ** ** | **income**                 | ** ** | **variance** | ** ** | **variance** | ** ** |
| ** **                   | ** ** | **(dollars in thousands)** | ** ** | ** **   | ** ** |
| +200 basis points            |       | $                          | 19,689     |         | $          | 1,676        |       | 9.3 | % |
| +100 basis points            |       | 18,956                     |       | 943          |       | 5.2          |       |
| Flat rate                    |       | 18,013                     |       | —       |       | —       |       |
| -100 basis points            |       | 16,287                     |       | (1,726       | )          | (9.6         | )          |
| -200 basis points            |       | 14,248                     |       | (3,765       | )          | 20.9         |       |
|                              |            |                            |            |              |            |              |            |  |  |

 

Simulation models require assumptions about certain categories ofassets and liabilities.  The modelsschedule existing assets and liabilities by their contractual maturity,estimated likely call date or earliest re-pricing opportunity.  Mortgage-backed securities and amortizingloans are scheduled based on their anticipated cash flow including estimatedprepayments.  For investment securities,we use a third-party service to provide cash flow estimates in the various rateenvironments.  Savings accounts,including passbook, statement savings, money market and interest checkingaccounts, do not have a stated maturity or re-pricing term and can be withdrawnor re-price at any time.  This may impactthe margin if more expensive alternative sources of deposits are required tofund

 

34

----

 

loans or deposit runoff.  Management projects the re-pricingcharacteristics of these accounts based on historical performance andassumptions that it believes reflect their rate sensitivity.  The consulting model reinvests allmaturities, repayments and prepayments for each type of asset or liability intothe same product for a new like term then applies growth or run-off estimatesprovided by management. As a result, the mix of interest-earning assets andinterest bearing-liabilities is not held constant.

 

***SUPERVISION AND REGULATION***

 

The following is a brief summary of the regulatory environment in whichthe Company and the Bank operate and is not designed to be a completediscussion of all statures and regulations affecting such operations, includingthose statutes and regulations specifically mentioned herein.  Changes in the laws and regulationsapplicable to the Company and the Bank can affect the operating environment insubstantial and unpredictable ways.  Wecannot accurately predict whether legislation will ultimately be enacted, andif enacted, the ultimate effect that it or implementing regulations would haveon our financial condition or results of operations.  While banking regulations are material to theoperations of the Company and the Bank, it should be noted that supervision, regulation,and examination of the Company and the Bank are intended primarily for theprotection of depositors, not shareholders.

 

***Recent Legislation:***

 

***USA Patriot Act of 2001.***  On October 26, 2001, theUniting and Strengthening America by Providing Appropriate Tools Required toIntercept and Obstruct Terrorism Act of 2001 (USA Patriot Act) was signed intolaw. The USA Patriot Act broadened the application of anti-money launderingregulations to apply to additional types of financial institutions, such as broker-dealers,and strengthened the ability of the U.S. government to detect and prosecuteinternational money laundering and the financing of terrorism. The principalprovisions of Title III of the USA Patriot Act require that regulated financialinstitutions, including national banks: (1) establish an anti-money launderingprogram that includes training and audit components; (2) comply withregulations regarding the verification of the identity of any person seeking toopen an account; (3) take additional required precautions with regard tonon-U.S. owned accounts; and (4) perform certain verification and certificationof money laundering risk for their foreign correspondent banking relationships.The USA Patriot Act also expanded the conditions under which funds in a U.S.inter-bank account may be subject to forfeiture and increased the penalties forviolation of anti-money laundering regulations. Failure of a financialinstitution to comply with the USA Patriot Acts requirements could have seriouslegal and reputational consequences for the institution. The Bank has adoptedpolicies, procedures and controls to address compliance with the requirementsof the USA Patriot Act under the existing regulations and will continue torevise and update its policies, procedures and controls to reflect changesrequired by the USA Patriot Act and implementing regulations.

 

***IMLAFATA.***  As part of the USA Patriot Act, Congressadopted the International Money Laundering Abatement and FinancialAnti-Terrorism Act of 2001 (IMLAFATA). IMLAFATA amended the Bank Secrecy Actand adopted certain additional measures that increase the obligation offinancial institutions, including the Bank, to identify their customers, watchfor and report upon suspicious transactions, respond to requests forinformation by federal banking regulatory authorities and law enforcementagencies, and share information with other financial institutions. TheSecretary of the Treasury has adopted several regulations to implement theseprovisions. The bank is also barred from dealing with foreign “shell” banks. Inaddition, IMLAFATA expands the circumstances under which funds in a bankaccount may be forfeited. IMLAFATA also amended the Bank Holding Company Actand the Bank Merger Act to require the federal banking regulatory authoritiesto consider the effectiveness of a financial institution’s anti-moneylaundering activities when reviewing an application to expand operations. TheFidelity Deposit and Discount Bank has in place a BankSecrecy Act compliance program.

 

***Sarbanes-Oxley Act of 2002.******   ***On July 30,2002, President Bush signed into law the Sarbanes-Oxley Act of 2002. The statedgoals of the Act are to increase corporate responsibility, to provide forenhanced penalties for accounting and auditing improprieties at publicly tradedcompanies and to protect investors by improving the accuracy and reliability ofcorporate disclosures pursuant to the securities laws.

 

The Act is the most far-reaching U.S. securities legislation enacted indecades. The Act generally applies to all companies, both U.S. and non-U.S.,that file or are required to file periodic reports with the Securities andExchange Commission under the Securities Exchange Act of 1934. Due to the SEC’sextensive role in implementing rules relating to manyof the Act’s new requirements, the final scope of these requirements remains tobe determined.

 

35

----

 

The Act includes very specific additional disclosure requirements andnew corporate governance rules, requires the SEC and securities exchanges toadopt extensive additional disclosure, corporate governance and other relatedrules and mandates further studies of certain issues by the SEC. The Actrepresents significant federal involvement in matters traditionally left tostate regulatory systems, such as the regulation of the accounting profession,and to state corporate law, such as the relationship between a board ofdirectors and management and between a board of directors and its committees.

 

The Actaddresses, among other matters:

 

•      audit committees for allreporting companies;

 

•      certificationof financial statements by the chief executive officer and the chief financialofficer;

 

•      the forfeiture of bonuses orother incentive-based compensation and profits from the sale of an issuer’ssecurities by directors and senior officers in the twelve month periodfollowing initial publication of any financial statements that later requirerestatement;

 

•      aprohibition on insider trading during pension plan black out periods;

 

•      disclosureof off-balance sheet transactions;

 

•      aprohibition on personal loans to directors and officers;

 

•      expedited filingrequirements for Forms 4’s;

 

•      disclosureof a code of ethics and filing a Form 8-K for a change or waiver of suchcode;

 

•      “real time” filing ofperiodic reports;

 

•      theformation of a public accounting oversight board;

 

•      auditorindependence; and

 

•      variousincreased criminal penalties for violations of securities laws.

 

***Regulation W.******   ***Transactionsbetween a bank and its “affiliates” are quantitatively and qualitativelyrestricted under the Federal Reserve Act. The Federal Deposit Insurance Actapplies Sections 23A and 23B to insured nonmember banks in the same mannerand to the same extent as if they were members of the Federal Reserve System.The Federal Reserve Board has also recently issued Regulation W, whichcodifies prior regulations under Sections 23A and 23B of the FederalReserve Act and interpretative guidance with respect to affiliate transactions.

 

Regulation W incorporates the exemption from the affiliatetransaction rules but expands the exemption to cover the purchase of any typeof loan or extension of credit from an affiliate. Affiliates of a bank include,among other entities, the bank’s holding company and companies that are undercommon control with the bank. The company is considered to be an affiliate ofthe Bank.

 

***Federal and State Legislation:***

 

From time to time, various types of federal and state legislation havebeen proposed that could result in additional regulations and restrictions onthe business of the Company and the Bank. We cannot predict whether legislationwill be adopted, or if adopted, how the new laws would affect our business. Asa consequence, we are susceptible to legislation that may increase the cost ofdoing business. Management believes that the effect of any current legislativeproposals on the liquidity, capital resources and the results of operations ofthe Company and the Bank will be minimal.

 

Other specific regulatory recommendations which, if implemented, couldhave a material effect upon our liquidity, capital resources or results ofoperations. In addition, the general cost of compliance with numerous federaland state laws does have, and in the future may have, a negative impact on ourresults of operations.

 

36

----

 

Further, our business is also affected by the state of the financialservices industry, in general. As a result of legal and industry changes,management predicts that the industry will continue to experience an increasein consolidations as the financial industry strives for greater costefficiencies and market share. Management is optimistic that theseconsolidations may enhance the Bank’s competitive position as a community bank.

 

***Future Outlook:***

 

Based upon the current uncertain economicoutlook and inability to predict when interest rate changes will occur, theCompany recognizes that there are challenges ahead.  The Company is prepared to meet thechallenges and effects of a changing interest rate environment.  The addition of key management personnel isan important step in addressing future challenges.  Management believes that a significant impacton earnings depends on its ability to react to changes in interest rates.

 

The Company will continue to monitorinterest rate sensitivity of its interest-earning assets and interest-bearingliabilities to minimize any adverse effects on future earnings.  The Company’s commitment to remaining acommunity based organization is very strong. Our intention is to recognize a steady disciplined growth in the loanportfolios, while increasing our base of core deposits.  Review and implementation of policies andprocedures along with adding innovative products and services will continue.These steps are designed to provide the Company with stability and thewherewithal to provide customer service and increase shareholder value.

 

***Item 7A******:QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK***

 

# ***The information required by 7A is setforth at Item 7, under “Liquidity” and “Management of Interest Rate Risk andMarket Risk Analysis,” contained within Management’s Discussion and Analysis ofFinancial Condition and Results of Operations and incorporated herein by reference.***

# *** ***

37

----

 

## ***Item 8:***  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

 

Boardof Directors and Shareholders Fidelity D & D Bancorp, Inc. Dunmore, Pennsylvania:

 

 

Wehave audited the accompanying consolidated balance sheets of Fidelity D & DBancorp, Inc. and Subsidiary as of December 31, 2004 and 2003 and the relatedconsolidated statements of income, changes in shareholders’ equity and cashflows for each of the three years in the period ended December 31, 2004. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

 

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well as evaluatingthe overall financial statement presentation. We believe that our auditsprovide a reasonable basis for our opinion.

 

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of Fidelity D & DBancorp, Inc. and Subsidiary as of December 31, 2004 and 2003, and the resultsof their operations and their cash flows for each of the three years in theperiod ended December 31, 2004 in conformity with accounting principles generallyaccepted in the United States of America.

 
| /s/ Parente Randolph, LLC |   |
|---------------------------|--------|

Wilkes-Barre,Pennsylvania January 28, 2005

 

38

----

 

**FIDELITY D & D BANCORP, INC. ANDSUBSIDIARY**

 

Consolidated Balance Sheets

As of December 31, 2004 and 2003

 
| ** **                                                                                                                                   | ** ** | **2004**    | ** **  | **2003**    | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|-------------|-------------|------------|
| ** **                                                                                                                                   | ** ** | ** **  | ** **  | ** **  | ** ** |
| Assets:                                                                                                                                      |       |        |        |        |       |
| Cash and due from banks                                                                                                                      |       | $           | 9,013,060   |        | $          | 13,148,199 |   |
| Interest-bearing deposits with financial  institutions                                                                                       |       | 1,203,334   |        | 6,083,402   |       |
|                                                                                                                                         |       |        |        |        |       |
| Total cash and cash equivalents                                                                                                              |       | 10,216,394  |        | 19,231,601  |       |
|                                                                                                                                         |       |        |        |        |       |
| Held-to-maturity securities                                                                                                                  |       | 3,056,305   |        | 4,712,142   |       |
| Available-for-sale securities                                                                                                                |       | 117,181,213 |        | 139,695,232 |       |
| Loans and leases, net (allowance for loan  losses of $5,987,798 in 2004 and $4,996,966 in 2003)                                              |       | 381,546,375 |        | 366,981,640 |       |
| Loans available-for-sale (fair value  $582,141 in 2004; $20,500,507 in 2003)                                                                 |       | 576,378     |        | 19,863,577  |       |
| Accrued interest receivable                                                                                                                  |       | 1,722,850   |        | 1,807,081   |       |
| Bank premises and equipment, net                                                                                                             |       | 11,163,292  |        | 12,091,937  |       |
| Foreclosed assets held for sale                                                                                                              |       | 213,104     |        | 467,166     |       |
| Cash surrender value of bank owned life  insurance                                                                                           |       | 7,613,437   |        | 7,293,538   |       |
| Other assets                                                                                                                                 |       | 3,385,790   |        | 3,071,552   |       |
|                                                                                                                                         |       |        |        |        |       |
| Total assets                                                                                                                                 |       | $           | 536,675,138 |        | $          | 575,215,466 |   |
|                                                                                                                                         |       |        |        |        |       |
| Liabilities:                                                                                                                                 |       |        |        |        |       |
| Deposits:                                                                                                                                    |       |        |        |        |       |
| Non-interest-bearing                                                                                                                         |       | $           | 65,357,535  |        | $          | 64,398,658 |   |
| Certificates of deposit of $100,000 or more                                                                                                  |       | 93,986,033  |        | 112,857,420 |       |
| Other interest-bearing deposits                                                                                                              |       | 206,271,767 |        | 224,186,468 |       |
|                                                                                                                                         |       |        |        |        |       |
| Total deposits                                                                                                                               |       | 365,615,335 |        | 401,442,546 |       |
|                                                                                                                                         |       |        |        |        |       |
| Accrued interest payable and other  liabilities                                                                                              |       | 3,039,809   |        | 3,208,009   |       |
| Short-term borrowings                                                                                                                        |       | 50,534,046  |        | 54,756,978  |       |
| Long-term debt                                                                                                                               |       | 71,119,188  |        | 71,876,034  |       |
|                                                                                                                                         |       |        |        |        |       |
| Total liabilities                                                                                                                            |       | 490,308,378 |        | 531,283,567 |       |
|                                                                                                                                         |       |        |        |        |       |
| Shareolders’ equity:                                                                                                                    |       |        |        |        |       |
| Preferred stock authorized 5,000,000 shares  with no par value; none issued                                                                  |       | —      |        | —      |       |
| Capital stock authorized 10,000,000 shares  with no par value; issued and outstanding 1,839,572 shares in 2004 and  1,828,270 shares in 2003 |       | 10,072,134  |        | 9,698,879   |       |
| Treasury stock, at cost                                                                                                                      |       | —      |        | (196,048    | )          |
| Retained earnings                                                                                                                            |       | 36,396,027  |        | 34,641,976  |       |
| Accumulated other comprehensive loss                                                                                                         |       | (101,401    | )           | (212,908    | )          |
|                                                                                                                                         |       |        |        |        |       |
| Total shareholders’ equity                                                                                                              |       | 46,366,760  |        | 43,931,899  |       |
|                                                                                                                                         |       |        |        |        |       |
| Total liabilities and shareholders’ equity                                                                                              |       | $           | 536,675,138 |        | $          | 575,215,466 |   |

 

Seenotes to consolidated financial statements

 

39

----

 

**FIDELITY D & D BANCORP, INC. ANDSUBSIDIARY**

 

Consolidated Statements of Income

For the years ended December 31, 2004, 2003 and 2002

 
| ** **                                             | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|--------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                                                   |       |       |       |       |       |       |       |
| Interest income:                                       |       |       |       |       |       |       |       |
| Loans:                                                 |       |       |       |       |       |       |       |
| Taxable                                                |       | $          | 21,793,474 |       | $          | 22,534,871 |       | $ | 25,062,274 |   |
| Nontaxable                                             |       | 319,188    |       | 400,674    |       | 576,516    |       |
| Leases                                                 |       | 153,446    |       | 298,318    |       | 526,194    |       |
| Interest-bearing deposits with financial  institutions |       | 5,919      |       | 6,051      |       | 16,623     |       |
| Investment securities:                                 |       |       |       |       |       |       |       |
| U.S. Government agency and corporations                |       | 4,362,455  |       | 4,486,310  |       | 7,479,520  |       |
| States and political subdivisions  (nontaxable)        |       | 481,481    |       | 477,327    |       | 476,601    |       |
| Other securities                                       |       | 262,277    |       | 212,791    |       | 239,827    |       |
| Federal funds sold                                     |       | 17,251     |       | 45,751     |       | 189,838    |       |
|                                                   |       |       |       |       |       |       |       |
| Total interest income                                  |       | 27,395,491 |       | 28,462,093 |       | 34,567,393 |       |
|                                                   |       |       |       |       |       |       |       |
| Interest expense:                                      |       |       |       |       |       |       |       |
| Certificates of deposit of $100,000 or more            |       | 2,974,337  |       | 4,731,839  |       | 5,928,991  |       |
| Other deposits                                         |       | 3,762,459  |       | 5,299,440  |       | 7,356,522  |       |
| Securities sold under repurchase agreements            |       | 463,663    |       | 503,131    |       | 996,133    |       |
| Other short-term borrowings and long-term  debt        |       | 3,963,945  |       | 3,686,166  |       | 3,583,127  |       |
| Other                                                  |       | 15,731     |       | 16,553     |       | 17,667     |       |
|                                                   |       |       |       |       |       |       |       |
| Total interest expense                                 |       | 11,180,135 |       | 14,237,129 |       | 17,882,440 |       |
|                                                   |       |       |       |       |       |       |       |
| Net interest income                                    |       | 16,215,356 |       | 14,224,964 |       | 16,684,953 |       |
|                                                   |       |       |       |       |       |       |       |
| Provision for loan losses                              |       | 2,150,000  |       | 3,715,000  |       | 1,664,000  |       |
|                                                   |       |       |       |       |       |       |       |
| Net interest income after provision for  loan losses   |       | 14,065,356 |       | 10,509,964 |       | 15,020,953 |       |
|                                                   |       |       |       |       |       |       |       |
| Other income                                           |       |       |       |       |       |       |       |
| Service charges on deposit accounts                    |       | 2,233,682  |       | 1,925,061  |       | 1,565,532  |       |
| Gain on sale of:                                       |       |       |       |       |       |       |       |
| Investment securities                                  |       | 9,497      |       | 329,419    |       | 58,828     |       |
| Loans                                                  |       | 144,834    |       | 548,409    |       | 377,572    |       |
| Loss on leased assets                                  |       | (290,679   | )          | (408,921   | )          | (48,349    | )          |
| Loss on sale of foreclosed assets held for  sale       |       | (15,256    | )          | (11,880    | )          | (3,222     | )          |
| Fees and other service charges                         |       | 2,079,324  |       | 1,801,049  |       | 1,352,388  |       |
|                                                   |       |       |       |       |       |       |       |
| Total other income                                     |       | 4,161,402  |       | 4,183,137  |       | 3,302,749  |       |
|                                                   |       |       |       |       |       |       |       |
| Other expenses:                                        |       |       |       |       |       |       |       |
| Salaries and employee benefits                         |       | 6,765,551  |       | 6,399,792  |       | 6,429,057  |       |
| Premises and equipment                                 |       | 2,831,418  |       | 2,889,536  |       | 2,517,441  |       |
| Advertising                                            |       | 430,667    |       | 336,046    |       | 396,865    |       |
| Other                                                  |       | 3,799,054  |       | 3,277,987  |       | 3,407,811  |       |
|                                                   |       |       |       |       |       |       |       |
| Total other expenses                                   |       | 13,826,690 |       | 12,903,361 |       | 12,751,174 |       |
|                                                   |       |       |       |       |       |       |       |
| Income before provision for income taxes               |       | 4,400,068  |       | 1,789,740  |       | 5,572,528  |       |
|                                                   |       |       |       |       |       |       |       |
| Provision for income taxes                             |       | 1,035,594  |       | 146,492    |       | 1,526,355  |       |
|                                                   |       |       |       |       |       |       |       |
| Net income                                             |       | $          | 3,364,474  |       | $          | 1,643,248  |       | $ | 4,046,173 |   |
|                                                   |       |       |       |       |       |       |       |
| Per share data:                                        |       |       |       |       |       |       |       |
| Net income - basic                                     |       | $          | 1.84       |       | $          | 0.90       |       | $ | 2.23 |   |
| Net income - diluted                                   |       | $          | 1.84       |       | $          | 0.90       |       | $ | 2.22 |   |
| Dividends                                              |       | $          | 0.88       |       | $          | 0.88       |       | $ | 0.84 |   |

 

Seenotes to consolidated financial statements

 

40

----

 

**FIDELITY D & D BANCORP, INC. ANDSUBSIDIARY**

 

Consolidated Statements of Changes in Shareholders’ Equity

For the years ended December 31, 2004, 2003 and 2002

 
| ** **                                                                                                                            | ** ** | ** **        | ** ** | ** **         | ** ** | ** **   | ** ** | ** **        | ** ** | ** **   | ** ** | **Accumulated**   | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|--------------------|------------|--------------|------------|-------------------|------------|--------------|------------|-------------------|------------|------------|------------|
| ** **                                                                                                                            | ** ** | ** **        | ** ** | ** **         | ** ** | ** **   | ** ** | ** **        | ** ** | ** **   | ** ** | **other**         | ** ** | ** ** | ** ** |
| ** **                                                                                                                            | ** ** | **Capital stock** | ** ** | **Treasury stock** | ** ** | **Retained** | ** ** | **comprehensive** | ** ** | ** **   | ** ** |
| ** **                                                                                                                            | ** ** | **Shares**        | ** ** | **Amount**         | ** ** | **Shares**   | ** ** | **Amount**        | ** ** | **earnings** | ** ** | **income (loss)** | ** ** | **Total**  | ** ** |
|                                                                                                                                  |       |              |       | .                  |       |         |       |              |       |         |       |              |       |       |       |
| Balance, December 31, 2001                                                                                                            |       | 1,819,168         |       | $                  | 9,353,452  |         |       |              |       |         | $          | 32,080,824        |       | $          | (1,262,046 | ) | $ | 40,172,230 |   |
| Comprehensive income:                                                                                                                 |       |              |       |               |       |         |       |              |       |         |       |              |       |       |       |
| Net income                                                                                                                            |       |              |       |               |       |         |       |              |       | 4,046,173    |       |              |       | 4,046,173  |       |
| Change in net unrealized holding gains (losses) on available-for-sale  securities, net of reclassification adjustment and tax effects |       |              |       |               |       |         |       |              |       |         |       | 2,527,270         |       | 2,527,270  |       |
| Comprehensive income                                                                                                                  |       |              |       |               |       |         |       |              |       |         |       |              |       | 6,573,443  |       |
| Re-issuance of treasury stock through Dividend                                                                                        |       |              |       |               |       |         |       |              |       |         |       |              |       |       |       |
| Reinvestment Plan                                                                                                                     |       | (6,973            | )          | (258,081           | )          | 6,973        |       | $                 | 258,081    |         |       |              |       |       | —     |   |
| Dividends reinvested through Dividend                                                                                                 |       |              |       |               |       |         |       |              |       |         |       |              |       |       |       |
| Reinvestment Plan                                                                                                                     |       | 12,768            |       | 479,411            |       |         |       |              |       |         |       |              |       | 479,411    |       |
| Stock options exercised                                                                                                               |       | 400               |       | 15,360             |       |         |       |              |       |         |       |              |       | 15,360     |       |
| Purchase of treasury stock                                                                                                            |       |              |       |               |       | (12,960      | )          | (479,640          | )          |         |       |              |       | (479,640   | )          |
| Dividends declared                                                                                                                    |       |              |       |               |       |         |       |              |       | (1,526,371   | )          |              |       | (1,526,371 | )          |
|                                                                                                                                  |       |              |       |               |       |         |       |              |       |         |       |              |       |       |       |
| Balance, December 31, 2002                                                                                                            |       | 1,825,363         |       | 9,590,142          |       | (5,987       | )          | (221,559          | )          | 34,600,626   |       | 1,265,224         |       | 45,234,433 |       |
| Comprehensive income:                                                                                                                 |       |              |       |               |       |         |       |              |       |         |       |              |       |       |       |
| Net income                                                                                                                            |       |              |       |               |       |         |       |              |       | 1,643,248    |       |              |       | 1,643,248  |       |
| Change in net unrealized holding losses on available-for-sale  securities, net of reclassification adjustment and tax effects         |       |              |       |               |       |         |       |              |       |         |       | (1,478,132        | )          | (1,478,132 | )          |
| Comprehensive income                                                                                                                  |       |              |       |               |       |         |       |              |       |         |       |              |       | 165,116    |       |
| Issuance of common stock through Employee Stock                                                                                       |       |              |       |               |       |         |       |              |       |         |       |              |       |       |       |
| Purchase Plan                                                                                                                         |       |              |       |               |       | 1,264        |       | 42,654            |       |         |       |              |       | 42,654     |       |
| Dividends reinvested through Dividend                                                                                                 |       |              |       |               |       |         |       |              |       |         |       |              |       |       |       |
| Reinvestment Plan                                                                                                                     |       | 2,907             |       | 108,737            |       | 11,416       |       | 410,978           |       |         |       |              |       | 519,715    |       |
| Stock options exercised                                                                                                               |       |              |       |               |       | 800          |       | 29,800            |       |         |       |              |       | 29,800     |       |
| Purchase of treasury stock                                                                                                            |       |              |       |               |       | (12,720      | )          | (457,921          | )          |         |       |              |       | (457,921   | )          |
| Dividends declared                                                                                                                    |       |              |       |               |       |         |       |              |       | (1,601,898   | )          |              |       | (1,601,898 | )          |
|                                                                                                                                  |       |              |       |               |       |         |       |              |       |         |       |              |       |       |       |
| Balance, December 31, 2003                                                                                                            |       | 1,828,270         |       | 9,698,879          |       | (5,227       | )          | (196,048          | )          | 34,641,976   |       | (212,908          | )          | 43,931,899 |       |
| Comprehensive income:                                                                                                                 |       |              |       |               |       |         |       |              |       |         |       |              |       |       |       |
| Net income                                                                                                                            |       |              |       |               |       |         |       |              |       | 3,364,474    |       |              |       | 3,364,474  |       |
| Change in net unrealized holding losses on available-for-sale  securities, net of reclassification adjustment and tax effects         |       |              |       |               |       |         |       |              |       |         |       | 111,507           |       | 111,507    |       |
| Comprehensive income                                                                                                                  |       |              |       |               |       |         |       |              |       |         |       |              |       | 3,475,981  |       |
| Reissued treasury stock through Employee Stock                                                                                        |       |              |       |               |       |         |       |              |       |         |       |              |       |       |       |
| Purchase Plan                                                                                                                         |       |              |       | (8,329             | )          | 1,635        |       | 61,370            |       |         |       |              |       | 53,041     |       |
| Dividends reinvested through Dividend                                                                                                 |       |              |       |               |       |         |       |              |       |         |       |              |       |       |       |
| Reinvestment Plan                                                                                                                     |       | 10,802            |       | 366,084            |       | 3,592        |       | 134,678           |       |         |       |              |       | 500,762    |       |
| Stock options exercised                                                                                                               |       | 500               |       | 15,500             |       |         |       |              |       |         |       |              |       | 15,500     |       |
| Dividends declared                                                                                                                    |       |              |       |               |       |         |       |              |       | (1,610,423   | )          |              |       | (1,610,423 | )          |
|                                                                                                                                  |       |              |       |               |       |         |       |              |       |         |       |              |       |       |       |
| Balance, December 31, 2004                                                                                                            |       | 1,839,572         |       | $                  | 10,072,134 |         | —     |              | $          | —       |       | $                 | 36,396,027 |       | $          | (101,401 | ) | $ | 46,366,760 |   |

 

Seenotes to consolidated financial statements

 

41

----

 

**FIDELITY DEPOSIT & DISCOUNT BANCORP, INC.AND SUBSIDIARY**

 

Consolidated Statements of Cash Flows

For the years ended December 31, 2004, 2003 and 2002

 
| ** **                                                                         | ** ** | **2004**    | ** ** | **2003**     | ** ** | **2002**     | ** ** |
|------------------------------------------------------------------------------------|------------|-------------|------------|--------------|------------|--------------|------------|
|                                                                               |       |        |       |         |       |         |       |
| Cash flows from operating activities:                                              |       |        |       |         |       |         |       |
| Net income                                                                         |       | $           | 3,364,474  |         | $          | 1,643,248    |       | $ | 4,046,173 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |        |       |         |       |         |       |
| Depreciation                                                                       |       | 1,198,863   |       | 1,263,376    |       | 1,068,037    |       |
| Amortization of securities (net of  accretion)                                     |       | 555,443     |       | 1,577,783    |       | 325,544      |       |
| Provision for loan losses                                                          |       | 2,150,000   |       | 3,715,000    |       | 1,664,000    |       |
| Deferred income taxes                                                              |       | (625,994    | )          | (564,570     | )          | 231,931      |       |
| Write-down of foreclosed assets held for  sale                                     |       | 155,448     |       | 746,244      |       | —       |       |
| Increase in cash surrender value of life  insurance                                |       | (319,899    | )          | (293,538     | )          | —       |       |
| Gain on sale of investment securities                                              |       | (9,497      | )          | (329,419     | )          | (58,828      | )          |
| Gain on sale of loans                                                              |       | (144,834    | )          | (548,409     | )          | (377,572     | )          |
| Loss on sale of foreclosed assets held for  sale                                   |       | 15,256      |       | 11,880       |       | 3,222        |       |
| Loss on sale of leased assets                                                      |       | 290,679     |       | 408,921      |       | —       |       |
| Loss on sale of equipment                                                          |       | 8,125       |       | 398          |       | 43,612       |       |
| Amortization of loan servicing rights                                              |       | 101,389     |       | 307,085      |       | 133,060      |       |
| Change in:                                                                         |       |        |       |         |       |         |       |
| Accrued interest receivable                                                        |       | 84,231      |       | 540,251      |       | 921,124      |       |
| Other assets                                                                       |       | 166,448     |       | 706,845      |       | (273,620     | )          |
| Accrued interest payable and other  liabilities                                    |       | (168,200    | )          | (788,222     | )          | (146,205     | )          |
|                                                                               |       |        |       |         |       |         |       |
| Net cash provided by operating activities                                          |       | 6,821,932   |       | 8,396,873    |       | 7,580,478    |       |
|                                                                               |       |        |       |         |       |         |       |
| Cash flows from investing activities:                                              |       |        |       |         |       |         |       |
| Held-to-maturity securities:                                                       |       |        |       |         |       |         |       |
| Proceeds from maturities, calls and pay  downs                                     |       | 1,643,513   |       | 6,992,617    |       | 18,894,931   |       |
| Purchases                                                                          |       | —      |       | —       |       | (9,057,722   | )          |
| Available-for-sale securities:                                                     |       |        |       |         |       |         |       |
| Proceeds from sales                                                                |       | 6,479,362   |       | 38,101,057   |       | 37,251,760   |       |
| Proceeds from maturities, calls and pay  downs                                     |       | 31,194,737  |       | 77,944,142   |       | 90,284,145   |       |
| Purchases                                                                          |       | (15,524,752 | )          | (121,383,541 | )          | (129,386,253 | )          |
| Proceeds from sale of loans  available-for-sale                                    |       | 15,640,705  |       | 28,618,110   |       | 26,413,229   |       |
| Net increase in loans and leases                                                   |       | (14,768,944 | )          | (38,795,877  | )          | (40,812,718  | )          |
| Proceeds from sale of premises and  equipment                                      |       | —      |       | —       |       | 208,694      |       |
| Proceeds from sale of leased assets                                                |       | 971,841     |       | 1,297,402    |       | —       |       |
| Purchase of life insurance policies                                                |       | —      |       | (7,000,000   | )          | —       |       |
| Acquisition of bank premises and equipment                                         |       | (278,343    | )          | (620,510     | )          | (2,542,390   | )          |
| Proceeds from sale of foreclosed assets  held for sale                             |       | 652,851     |       | 855,363      |       | 509,887      |       |
|                                                                               |       |        |       |         |       |         |       |
| Net cash provided by (used in) investing  activities                               |       | 26,010,970  |       | (13,991,237  | )          | (8,236,437   | )          |
|                                                                               |       |        |       |         |       |         |       |
| Cash flows from financing activities:                                              |       |        |       |         |       |         |       |
| Net increase in non-interest-bearing  deposits                                     |       | 958,877     |       | 3,247,193    |       | 7,849,860    |       |
| Net decrease in certificates of deposit of  $100,000 or more                       |       | (18,871,387 | )          | (16,629,078  | )          | (3,193,497   | )          |
| Net (decrease) increase in other  interest-bearing deposits                        |       | (17,914,701 | )          | 1,036,255    |       | 1,353,085    |       |
| Net (decrease) increase in short-term  borrowings                                  |       | (4,222,932  | )          | 3,543,964    |       | (3,267,974   | )          |
| Net (decrease) increase in long-term debt                                          |       | (756,846    | )          | 8,876,034    |       | —       |       |
| Purchase of treasury stock                                                         |       | —      |       | (457,921     | )          | (479,640     | )          |
| Proceeds from employee stock purchase plan                                         |       | 53,041      |       | 42,654       |       | —       |       |
| Exercise of stock options                                                          |       | 15,500      |       | 29,800       |       | 15,360       |       |
| Dividends paid, net of dividends reinvested                                        |       | (1,109,661  | )          | (1,082,183   | )          | (1,046,960   | )          |
|                                                                               |       |        |       |         |       |         |       |
| Net cash (used in) provided by financing  activities                               |       | (41,848,109 | )          | (1,393,282   | )          | 1,230,234    |       |
|                                                                               |       |        |       |         |       |         |       |
| Net (decrease) increase in cash and cash  equivalents                              |       | (9,015,207  | )          | (6,987,646   | )          | 574,275      |       |
|                                                                               |       |        |       |         |       |         |       |
| Cash and cash equivalents, beginning                                               |       | 19,231,601  |       | 26,219,247   |       | 25,644,972   |       |
|                                                                               |       |        |       |         |       |         |       |
| Cash and cash equivalents, ending                                                  |       | $           | 10,216,394 |         | $          | 19,231,601   |       | $ | 26,219,247 |   |

 

See notes to consolidatedfinancial statements

 

42

----

 

**FIDELITY D & D BANCORP, INC.**

**AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

 

**1.****                   NATURE OFOPERATIONS AND SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

 

**PRINCIPLES OF CONSOLIDATION**

 

The accompanying consolidated financial statements include the accountsof Fidelity D & D Bancorp, Inc. and its wholly-owned subsidiary, TheFidelity Deposit and Discount Bank (the “Bank”) (collectively, the“Company”).  All significantinter-company balances and transactions have been eliminated in consolidation.

 

**NATURE OF OPERATIONS**

 

The Company provides a variety of financial services to individuals andcorporate customers in Lackawanna and Luzerne Counties, Pennsylvania.  This region has a diversified and fairlystable economy.  The Company’s primarydeposit products are checking accounts, savings accounts, NOW accounts, moneymarket deposit accounts and certificates of deposit accounts.  Its primary lending products aresingle-family residential loans, secured consumer loans and secured loans tobusinesses.  In addition to thesetraditional banking services, the Company also provides annuities, mutual fundsand trust services.

 

Although the Company has a diversified loan portfolio, a substantialportion of its debtor’s ability to honor their contracts is dependent on theeconomic sector in which the Company operates. While management uses available information torecognize losses on loans and foreclosed assets, future additions to theallowances for loan losses and foreclosed assets may be necessary based onchanges in local economic conditions. In addition, regulatory agencies, as an integral part of theirexamination process, periodically review the Company’s allowances.  Such agencies may require the Company to recognizeadditions to the allowances based on their judgments about informationavailable to them at the time of their examination.  Because of these factors, it is reasonablypossible that the allowances for loan losses and foreclosed assets may changematerially in the near future.

 

**USE OF ESTIMATES**

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the reporting period. Actual results could differ from those estimates.

 

Material estimates that are particularly susceptible to significantchange relate to the determination of the allowance for loan losses and thevaluation of real estate acquired in connection with foreclosures or insatisfaction of loans.  In connectionwith the determination of allowances for losses on loans and foreclosed realestate, management obtains independent appraisals for significant properties.

 

43

----

 

**HELD-TO-MATURITY SECURITIES**

 

Debt securities for which the Company has the positive intent andability to hold to maturity are reported at cost, adjusted for premiums anddiscounts that are recognized in interest income over the period to maturity.

 

**TRADING SECURITIES**

 

Debt and equity securities held principally for resale in the near termare recorded at their fair values. Unrealized gains and losses are included in other income.  The Company did not have any investmentsecurities held for trading purposes during 2004, 2003 or 2002.

 

**AVAILABLE-FOR-SALE SECURITIES**

 

Available-for-sale securities consist of debt and equity securities notclassified as either held-to-maturity securities or trading securities and arereported at fair value. Unrealized holding gains and losses, net of deferredincome taxes, on available-for-sale securities are reported as a net amount asa separate component of shareholders’ equity, until realized.  These net unrealized holding gains and lossesare the sole component of accumulated other comprehensive (loss) income.

 

**LOANS**

# *** ***

Loans that management has the intent and ability to hold for theforeseeable future or until maturity or payoff are stated at face value, net ofunearned income, unamortized loan fees and costs and the allowance for loanlosses.  Interest on residential realestate loans is recorded on an amortized schedule.  Commercial loan interest is accrued on theprincipal balance on an actual day basis. Interest on consumer loans is determined using the actuarial method orthe simple interest method.

 

The accrual of interest on impaired loans is discontinued when, in the opinionof management, there is an indication that the borrower may be unable to meetpayments as they become due.  Anypayments received on impaired loans are applied, first to the outstanding loanamounts, then to the recovery of any charged-off loan amounts.  Any excess is treated as a recovery of lostinterest.

 

**LOANS HELD FOR SALE**

 

Loans originated and intended for sale in the secondary market arecarried at the lower of cost or estimated fair value in the aggregate.  Net unrealized losses are recognized througha valuation allowance by charges to income. Unrealized gains are recognized to the extent of previous write-downs.

 

**ALLOWANCE FOR LOAN LOSSES**

 

The allowance for loan losses is established through a provision forloan losses.  The allowance represents anamount which, in management’s judgment, will be adequate to absorb losses onexisting loans and leases that may become uncollectible.  Management’s judgment in determining theadequacy of the allowance is based on evaluations of the collectibility of theloans.  These evaluations take intoconsideration such factors as changes in the nature and volume of the loanportfolio, current economic conditions that may affect the borrower’s abilityto pay, overall portfolio quality and review of specific impaired loans.  Loans considered uncollectible are charged tothe allowance.  Recoveries on loanspreviously charged off are added to the allowance.

 

44

----

 

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable tocollect the scheduled payments in accordance to the contractual terms of theloan.  Factors considered in determiningimpairment include payment status, collateral value and the probability ofcollecting payments when due.  Thesignificance of payment delays and/or shortfalls is determined on a case bycase basis.  All circumstancessurrounding the loan are taken into account. Such factors include the length of the delinquency, the underlyingreasons and the borrower’s prior payment record.  Impairment is measured on these loans on aloan by loan basis.

 

Large groups of smaller balance homogeneous loans are collectivelyevaluated for impairment.  Accordingly,the Company does not separately identify individual consumer and residentialloans for impairment disclosures.

 

**LEASES**

 

Financing of equipment and automobiles is provided to customers underlease arrangements accounted for as direct financing leases.  Income earned is based on a constant periodicreturn on the net investment in the lease.

 

**LOAN FEES**

# *** ***

Nonrefundable loan origination fees and certain direct loan originationcosts are recognized over the life of the related loans as an adjustment ofyield.  The unamortized balance of thesefees and costs are included as part of the loan balance to which it relates.

 

**BANK PREMISES AND EQUIPMENT**

 

Land is carried at cost.  Bankpremises and equipment are stated at cost less accumulated depreciation.  Depreciation is computed on the straight-lineand accelerated methods over the estimated useful lives of the assets.  Leasehold improvements are amortized over theshorter of the term of the lease or the estimated useful lives of the improvedproperty.

 

**LOAN SERVICING AND LOAN SERVICING RIGHTS**

 

The Company services real estate loans for investors in the secondarymortgage market, which are not included in the balance sheet.  Thecost of mortgage servicing rights is amortized in proportion to, and over theperiod of, estimated net servicing revenues. For purposes of measuring impairment, the rights are stratified based onthe present dominant risk characteristics of the underlying loans, stated termof the loan and interest rate.  Theamount of impairment recognized is the amount by which the capitalized mortgageservicing rights for a stratum exceeds its fair value.  Fair values are estimated using discountedcash flows based on a current market interest rate.

*** ***

**BANK OWNED LIFE INSURANCE**

# *** ***

The Company is the owner and beneficiary ofbank owned life insurance (“BOLI”) policies on certain employees.  The earnings from the BOLI are recognized asa component of other income.  The BOLI isan asset that can be liquidated, if necessary, with tax costs associated.  However, the Company intends to hold these policiesand, accordingly, the Bank has not provided for deferred income taxes on theearnings from the increase in cash surrender value.

 

45

----

 

**FORECLOSED ASSETS HELD FOR SALE**

 

Foreclosed assets held for sale are carried at the lower of cost orfair value less cost to sell.  Lossesfrom the acquisition of property in full and partial satisfaction of debt aretreated as credit losses.  Routineholding costs and write downs for subsequent declines in value are included inother operating expenses.

 

#### **STOCK OPTIONS**

#### ** **

At December 31, 2004, the Company has two stock-based compensationplans, which are described more fully in Note 9.  The Company accounts for these plans underthe recognition and measurement principles of APB Opinion No. 25, *Accounting for Stock Issued to Employees*, and relatedInterpretations.  No stock-based employeecompensation cost is reflected in net income, as all options granted underthese plans had an exercise price equal to the fair value of the underlyingcommon stock on the date of grant.  Thefollowing table illustrates the effect on net income and earnings per share ifthe Company had applied the fair value recognition provisions of Statement ofFinancial Accounting Standards (“SFAS”) No. 123, *Accounting for Stock-Based Compensation*, to stock-basedemployee compensation for each of the years ended December 31, (dollars inthousand except for per share data):

 
| ** **                                                                                                                  | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                                                                        |       |     |       |     |       |     |       |
| Net income, as reported                                                                                                     |       | $        | 3,364      |     | $          | 1,643    |       | $ | 4,046 |   |
| Less: total stock-based employee  compensation expense determined under fair value based method for all awards,  net of tax |       | —   |       | —   |       | (7       | )          |
|                                                                                                                        |       |     |       |     |       |     |       |
| Pro forma net income                                                                                                        |       | $        | 3,364      |     | $          | 1,643    |       | $ | 4,039 |   |
| Earnings per share:                                                                                                         |       |     |       |     |       |     |       |
| Basic – as reported                                                                                                    |       | $        | 1.84       |     | $          | 0.90     |       | $ | 2.23 |   |
| Basic – pro forma                                                                                                      |       | $        | 1.84       |     | $          | 0.90     |       | $ | 2.22 |   |
|                                                                                                                        |       |     |       |     |       |     |       |   |   |   |
| Diluted – as reported                                                                                                  |       | $        | 1.84       |     | $          | 0.90     |       | $ | 2.21 |   |
| Diluted – pro forma                                                                                                    |       | $        | 1.84       |     | $          | 0.90     |       | $ | 2.18 |   |

 

The Company did not grant stock options in 2004 or 2003.

 

Forpurposes of the pro forma calculations, the fair value of each option isestimated using the Black-Scholes option pricing model with the followingweighted-average assumptions for grants issued in 2002:

 
| Dividend yield          |   | 3.79    | %      |
|-------------------------|--------|---------|--------|
| Expected volatility     |   | 5.91    | %      |
| Risk-free interest rate |   | 3.62    | %      |
| Expected lives          |   | 5 years |   |

 

46

----

 

**TRUST AND FINANCIAL SERVICE FEES**

 

Trust and financial service fees are recorded on the cash basis, whichis not materially different from the accrual basis.

 

**ADVERTISING COSTS**

 

Advertising costs are charged to expense as incurred.  For the years December 31, 2004, 2003 and2002, advertising costs amounted to approximately $431,000, $336,000 and$397,000, respectively.

 

**FAIR VALUE OF FINANCIAL INSTRUMENTS**

# *** ***

**Cash and short-term instruments:**  The carrying amounts of cash and short-terminstruments approximate their fair value.

 

**Available-for-sale and held-to-maturitysecurities:** Fair values for securities are based on bid prices received fromsecurities dealers.  Restricted equitysecurities are carried at cost.

 

**Loans receivable:**  The fair value of all loans is estimated bythe net present value of the future expected cash flows.

 

**Loans available for sale:**  For loans available for sale, the fair valueis estimated using rates currently offered for similar borrowings and arestated at the lower of cost or market.

 

**Deposit liabilities:**  The fair value of demand deposits, NOWaccounts, savings accounts and money market deposits is estimated by the netpresent value of the future expected cash flows.  For certificates of deposit, the discountrates used reflect the Company’s current market pricing.  The discount rates used for non-maturitydeposits are the current book rate of the deposits.

 

**Short-term borrowings:**  For short-term borrowings, the fair value isestimated using the rates currently offered for similar borrowings.

 

**Long-term debt:**  For other borrowed funds, the fair value isestimated using the rates currently offered for similar borrowings.

 

**Accrued interest:**  The carrying amounts of accrued interestapproximate their fair values.

 

**Off-balance-sheet instruments:**  Commitments to extend credit are generallyshort-term and are priced to market.  Therates on standby letters of credit are priced on prime.  Therefore, the estimated fair value of thesefinancial instruments is face value.

 

**INCOME TAXES**

 

Deferred tax assets and liabilities are reflected at currently enactedincome tax rates applicable to the period in which the deferred tax assets orliabilities are expected to be realized or settled.  As changes in tax laws or rates are enacted,deferred tax assets and liabilities are adjusted through the provision forincome taxes.

 

47

----

 

**CASH FLOWS**

 

For purposes of reporting cash flows, cash and cash equivalentsincludes cash on hand, amounts due from banks and interest-bearing depositswith financial institutions.

 

For the years ended December 31, 2004, 2003, and 2002, the Company paidinterest of $16,500,384, $14,674,100 and $18,934,972, respectively.  For the years ended December 31, 2004,2003, and 2002, the Company paid cash for income taxes of $1,200,000, $869,561and $1,040,000, respectively.

 

Transfers from loans to foreclosed assets held for sale amounted to$504,415, $1,560,832 and $835,741 in 2004, 2003, and 2002, respectively.  Non-cash investing activities also includedtransferring $12,807,221 from loans available-for-sale to loans in 2004 and$2,871,752 from loans to loans available-for-sale in 2002.

 

**RECLASSIFICATIONS**

 

Certain reclassifications have been made to the 2002 financialstatements to conform to the current presentation.

 

**OTHER COMPREHENSIVE INCOME (LOSS)**

 

The components of other comprehensive income (loss) and related taxeffects are as follows:

 
| ** **                                                          | ** ** | **2004** | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|---------------------------------------------------------------------|------------|----------|------------|------------|------------|------------|------------|
|                                                                |       |     |       |       |       |       |       |
| Unrealized holding gains (losses) on  available-for-sale securities |       | $        | 178,447    |       | $          | (1,910,175 | )          | $ | 3,888,024 |   |
|                                                                |       |     |       |       |       |       |       |
| Less reclassification adjustment for gains  realized in income      |       | (9,497   | )          | (329,419   | )          | (58,828    | )          |
|                                                                |       |     |       |       |       |       |       |
| Net unrealized gains (losses)                                       |       | 168,950  |       | (2,239,594 | )          | 3,829,196  |       |
|                                                                |       |     |       |       |       |       |       |
| Tax effect                                                          |       | (57,443  | )          | 761,462    |       | (1,301,926 | )          |
|                                                                |       |     |       |       |       |       |       |
| Net of tax amount                                                   |       | $        | 111,507    |       | $          | (1,478,132 | )          | $ | 2,527,270 |   |
|                                                                     |            |          |            |            |            |            |            |  |  |  |  |  |

 

**2.****              CASH**

 

The Company is required by the Federal Reserve Bank to maintain averagereserve balances based on a percentage of deposits.  The amounts of those reserve requirements onDecember 31, 2004 and 2003 were $616,000 and $569,000, respectively.

 

Deposits with any one financial institution are insured up to$100,000.  From time-to-time, the Companymaintains cash and cash equivalents with certain other financial institutionsin excess of the insured amount.

 

48

----

 

**3.     INVESTMENTSECURITIES**

 

Amortized cost and fair value of investment securities at December 31,2004 and 2003 are as follows (in thousands):

 

| ** **                                        | ** ** | **2004**            | ** ** |
|---------------------------------------------------|------------|---------------------|------------|
| ** **                                        | ** ** | **Amortized  cost** | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  losses** | ** ** | **Fair  value** | ** ** |
|                                              |       |                |       |   |   |   |   |   |   |
| Held to maturity securities:                      |       |                |       |   |   |   |   |   |   |
| Mortgage-backed securities                        |       | $                   | 3,056      |   | $ | 137 |   | $ | — |   | $ | 3,194 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Available-for-sale securities:                    |       |                |       |   |   |   |   |   |   |
| U.S. government agencies and Corporations         |       | $                   | 31,006     |   | $ | 1 |   | $ | 511 |   | $ | 30,496 |   |
| Obligations of states and political  Subdivisions |       | 11,043              |       | 160 |   | 4 |   | 11,199 |   |
| Corporate bonds                                   |       | 9,034               |       | 26 |   | 25 |   | 9,035 |   |
| Mortgage-backed securities                        |       | 61,404              |       | 322 |   | 324 |   | 61,402 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Total debt                                        |       | 112,487             |       | 509 |   | 864 |   | 112,132 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Equity securities:                                |       |                |       |   |   |   |   |   |   |
| Restricted                                        |       | 4,568               |       | — |   | — |   | 4,568 |   |
| Other                                             |       | 279                 |       | 202 |   | — |   | 481 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Total                                             |       | $                   | 117,334    |   | $ | 711 |   | $ | 864 |   | $ | 117,181 |   |

 

| ** **                                        | ** ** | **2003**            | ** ** |
|---------------------------------------------------|------------|---------------------|------------|
| ** **                                        | ** ** | **Amortized  cost** | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  losses** | ** ** | **Fair  value** | ** ** |
|                                              |       |                |       |   |   |   |   |   |   |
| Held to maturity securities:                      |       |                |       |   |   |   |   |   |   |
| Mortgage-backed securities                        |       | $                   | 4,712      |   | $ | 196 |   | $ | — |   | $ | 4,908 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Available-for-sale securities:                    |       |                |       |   |   |   |   |   |   |
| U.S. government agencies and Corporations         |       | $                   | 37,040     |   | $ | 61 |   | $ | 778 |   | $ | 36,323 |   |
| Obligations of states and political  Subdivisions |       | 13,190              |       | 123 |   | 37 |   | 13,276 |   |
| Corporate bonds                                   |       | 3,991               |       | 16 |   | — |   | 4,007 |   |
| Mortgage-backed securities                        |       | 80,765              |       | 467 |   | 345 |   | 80,887 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Total debt                                        |       | 134,986             |       | 667 |   | 1,160 |   | 134,493 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Equity securities:                                |       |                |       |   |   |   |   |   |   |
| Restricted                                        |       | 4,753               |       | — |   | — |   | 4,753 |   |
| Other                                             |       | 279                 |       | 170 |   | — |   | 449 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Total                                             |       | $                   | 140,018    |   | $ | 837 |   | $ | 1,160 |   | $ | 139,695 |   |

 

49

----

 

There are no significant concentrations of investments (greater than 10percent of shareholders’ equity) in any individual security issuer other thansecurities of the United States government and agencies.

 

Most of the Company’s debt and equity securities are pledged to securetrust funds, public deposits, repurchase agreements, other short-termborrowings, Federal Home Loan Bank of Pittsburgh (“FHLB”) borrowings, FederalReserve Bank of Philadelphia Discount Window borrowings and certain otherdeposits as required by law.  U.S.government securities pledged on repurchase agreements are under the Company’scontrol.

 

The amortized cost and fair value of debt securities at December 31,2004 by contractual maturity are shown below. Expected maturities will differ from contractual maturities becauseborrowers may have the right to call or repay obligations with or without callor repayment penalties.

 
| ** **                             | ** ** | **Amortized  cost** | ** ** | **Fair  value** | ** ** |
|----------------------------------------|------------|---------------------|------------|-----------------|------------|
|                                   |       | **(in thousands)**  |       |
|                                   |       |                |       |            |       |
| Held-to-maturity securities            |       |                |       |            |       |
| Mortgage-backed securities             |       | $                   | 3,056      |            | $          | 3,194 |   |
|                                   |       |                |       |            |       |
| Available-for-sale securities          |       |                |       |            |       |
| Debt securities:                       |       |                |       |            |       |
| Due in one year or less                |       | $                   | —     |            | $          | — |   |
| Due after one year through five years  |       | 5,430               |       | 5,392           |       |
| Due after five years through ten years |       | 19,530              |       | 19,352          |       |
| Due after ten years                    |       | 26,123              |       | 25,986          |       |
|                                   |       |                |       |            |       |
| Total debt securities                  |       | 51,083              |       | 50,730          |       |
|                                   |       |                |       |            |       |
| Mortgage-backed securities             |       | 61,404              |       | 61,402          |       |
|                                   |       |                |       |            |       |
| Equity securities                      |       | 4,847               |       | 5,049           |       |
|                                   |       |                |       |            |       |
| Total available-for-sale securities    |       | $                   | 117,334    |            | $          | 117,181 |   |

 

50

----

 

The following table presents gross unrealized lossesand fair value of investments aggregated by investment category and length oftime that individual securities have been in a continuous unrealized lossposition at December 31, 2004 and 2003(in thousands):

 
| ** **                                        | ** ** | **Less than 12 months** | ** ** | **12 months or more**  | ** ** | **Total**       | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|------------------------|------------|-----------------|------------|
| ** **                                        | ** ** | **Fair  value**         | ** ** | **Unrealized  Losses** | ** ** | **Fair  value** | ** ** | **Unrealized  losses** | ** ** | **Fair  value** | ** ** | **Unrealized  losses** | ** ** |
|                                              |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| December 31, 2004                                 |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| U.S. government  agencies and corporations        |       | $                       | 15,778     |                   | $          | 222             |       | $ | 9,711 |   | $ | 289 |   | $ | 25,489 |   | $ | 511 |   |
| Obligations of states  and political subdivisions |       | 1,673                   |       | 4                      |       | —          |       | — |   | 1,673 |   | 4 |   |
| Mortgage-backed  securities                       |       | 26,859                  |       | 197                    |       | 8,716           |       | 127 |   | 35,575 |   | 324 |   |
| Corporate bonds                                   |       | 5,014                   |       | 25                     |       | —          |       | — |   | 5,014 |   | 25 |   |
|                                              |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| Subtotal, debt  securities                        |       | 49,324                  |       | 448                    |       | 18,427          |       | 416 |   | 67,751 |   | 864 |   |
|                                              |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| Equity securities                                 |       | —                  |       | —                 |       | —          |       | — |   | — |   | — |   |
|                                              |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| Total temporarily  impaired securities            |       | $                       | 49,324     |                   | $          | 448             |       | $ | 18,427 |   | $ | 416 |   | $ | 67,751 |   | $ | 864 |   |
|                                              |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| December 31, 2003                                 | ** ** | ** **              | ** ** | ** **             | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                              |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| U.S. government  agencies and corporations        |       | $                       | 26,232     |                   | $          | (778            | )          | $ | — |   | $ | — |   | $ | 26,232 |   | $ | (778 | ) |
| Obligations of states  and political subdivisions |       | 4,327                   |       | (345                   | )          | —          |       | — |   | 4,327 |   | (345 | ) |
| Mortgage-backed  securities                       |       | 39,997                  |       | (37                    | )          | —          |       | — |   | 39,997 |   | (37 | ) |
|                                              |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| Subtotal, debt  securities                        |       | 70,556                  |       | (1,160                 | )          |            |       |   |   | 70,556 |   | (1,160 | ) |
|                                              |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| Equity securities                                 |       | —                  |       | —                 |       | —          |       | — |   | — |   | — |   |
|                                              |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| Total temporarily  impaired securities            |       | $                       | 70,556     |                   | $          | (1,160          | )          | $ | — |   | $ | — |   | $ | 70,556 |   | $ | (1,160 | ) |

 

The investments in debt securities have not beensignificantly impaired.  The unrealizedlosses are primarily the result of volatility in interest rates.  The debt securities considered temporarilyimpaired are approximately 1.3% below cost at December 31, 2004.  Based on the credit worthiness of theissuers, in conjunction with interest rate volatility, management determinedthat the debt securities were not other-than-temporarily impaired.

 

51

----

 

Gross realizedgains and losses on sales of available-for-sale securities, determined usingspecific identification of the securities were as follows:

 
| ** **            | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------|------------|----------|------------|----------|------------|----------|------------|
|                  |       |     |       |     |       |     |       |
| Gross realized gains  |       | $        | 19,978     |     | $          | 329,419  |       | $ | 58,828 |   |
| Gross realized losses |       | 10,481   |       | —   |       | —   |       |
|                       |            |          |            |          |            |          |            |  |  |  |

 

**4.****              LOANS AND LEASES**

 

The majorclassifications of loans and leases at December 31, 2004 and 2003 aresummarized as follows:

 
| ** **                             | ** ** | **2004**    | ** **  | **2003**    | ** ** |
|----------------------------------------|------------|-------------|-------------|-------------|------------|
|                                   |       |        |        |        |       |
| Commercial and  commercial real estate |       | $           | 221,968,137 |        | $          | 221,275,922 |   |
| Residential real estate                |       | 91,294,401  |        | 77,077,315  |       |
| Consumer                               |       | 61,487,608  |        | 62,919,070  |       |
| Real estate  construction              |       | 10,620,472  |        | 7,267,616   |       |
| Direct financing leases                |       | 2,211,978   |        | 3,685,802   |       |
|                                   |       |        |        |        |       |
| Total                                  |       | 387,582,596 |        | 372,225,725 |       |
|                                   |       |        |        |        |       |
| Less:                                  |       |        |        |        |       |
| Unearned income                        |       | 48,423      |        | 247,119     |       |
| Allowance for loan  losses             |       | 5,987,798   |        | 4,996,966   |       |
|                                   |       |        |        |        |       |
| Loans and leases, net                  |       | $           | 381,546,375 |        | $          | 366,981,640 |   |

 

Net deferred loan costsof $372,778 and $305,155 have been added to the carrying value of loans atDecember 31, 2004 and 2003, respectively.

 

The Company has noconcentration of loans to borrowers engaged in similar businesses or activitieswhich exceed five percent of total assets at December 31, 2004 or 2003.

 

Impaired loans information is as follows:

 
| ** **                                                                                  | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|---------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| At December 31:                                                                             |       |       |       |       |       |
| Accruing loans that are  contractually past due 90 days or more as to principal or interest |       | $          | 557,492    |       | $          | 957,971 |   |
| Amount of impaired  loans that have a specific allowance                                    |       | 15,552,895 |       | 14,898,872 |       |
| Amount of impaired  loans with no specific allowance                                        |       | 3,190,794  |       | 2,964,967  |       |
| Allowance for impaired  loans                                                               |       | 2,123,315  |       | 2,533,842  |       |
|                                                                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| During the year ended December 31:                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Average investment in  impaired loans                                                       |       | 10,817,639 |       | 8,428,334  |       |
| Interest income  recognized on impaired loans (cash basis)                                  |       | 1,044,673  |       | 574,355    |       |
| Principal collected on  impaired loans                                                      |       | 2,788,053  |       | 2,205,023  |       |
|                                                                                             |            |            |            |            |            |  |  |

 

52

----

 

Changes in theallowance for loan losses are as follows:

 
| ** **                   | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                         |       |       |       |       |       |       |       |
| Balance, beginning           |       | $          | 4,996,966  |       | $          | 3,899,753  |       | $ | 3,741,933 |   |
| Recoveries                   |       | 447,772    |       | 478,297    |       | 443,189    |       |
| Provision for loan  losses   |       | 2,150,000  |       | 3,715,000  |       | 1,664,000  |       |
| Losses charged to  allowance |       | (1,606,940 | )          | (3,096,084 | )          | (1,949,369 | )          |
|                         |       |       |       |       |       |       |       |
| Balance, ending              |       | $          | 5,987,798  |       | $          | 4,996,966  |       | $ | 3,899,753 |   |

 

For federal incometax purposes, the allowance for loan losses was $5,987,798, $4,976,228 and $3,879,015at December 31, 2004, 2003, and 2002, respectively.  The amounts deducted for loan losses in thefederal income tax returns were $1,159,168 in 2004, $2,617,787 in 2003 and $1,352,428in 2002.  These amounts were the maximumallowable deduction.

 

The Company servicesreal estate loans for investors in the secondary mortgage market which are notincluded in the accompanying consolidated balance sheet.  The approximate amount of mortgages servicedamounted to $57,939,000 at December 31, 2004 and $56,021,000 at December 31,2003.

 

The followingtable sets forth the activity in mortgage service rights (MSR) for the yearsended December 31:

 
| ** **         | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------|------------|----------|------------|----------|------------|----------|------------|
|               |       |     |       |     |       |     |       |
| Balance, beginning |       | $        | 347,212    |     | $          | 422,634  |       | $ | 327,690 |   |
| Additions          |       | 144,246  |       | 231,663  |       | 228,004  |       |
| Amortization       |       | (101,389 | )          | (307,085 | )          | (133,060 | )          |
| Balance, ending    |       | $        | 390,069    |     | $          | 347,212  |       | $ | 422,634 |   |

 

The fair value ofmortgage servicing rights are estimated using a discounted cash flow techniquewhich combines a discount rate and prepayment speeds that range from 5.2% to8.0%.  The Company recognized gains onthe sale of loans of $144,000 in 2004, $232,000 in 2003, and $228,000 in 2002.

 

53

----

 

**5.****             ****BANKPREMISES AND EQUIPMENT**

 

Components of bankpremises and equipment at December 31, 2004 and 2003 are summarized as follows:

 
| ** **                                      | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
|                                            |       |       |       |       |       |
| Land                                            |       | $          | 1,054,330  |       | $          | 1,054,330 |   |
| Bank premises                                   |       | 7,469,594  |       | 7,469,594  |       |
| Furniture, fixtures and  equipment              |       | 7,331,548  |       | 7,397,551  |       |
| Leasehold improvements                          |       | 3,021,256  |       | 3,019,928  |       |
|                                            |       |       |       |       |       |
| Total                                           |       | 18,876,728 |       | 18,941,403 |       |
|                                            |       |       |       |       |       |
| Less accumulated  depreciation and amortization |       | 7,713,436  |       | 6,849,466  |       |
|                                            |       |       |       |       |       |
| Bank premises and  equipment, net               |       | $          | 11,163,292 |       | $          | 12,091,937 |   |

 

The Company leases its Green Ridge, Scranton, Pittston, West Pittston,Moosic, Kingston, Peckville, Clarks Summit and Eynon branches under the termsof operating leases.  Rental expense was$386,980 for 2004, $382,001 for 2003 and $353,589 for 2002.  The future minimum rental payments at December31, 2004 under these leases are as follows:

 
| **Year ending December 31,** | ** ** | **Amount** | ** ** |
|------------------------------|------------|------------|------------|
|                         |       |       |       |
| 2005                         |       | $          | 354,723    |   |
| 2006                         |       | 341,600    |       |
| 2007                         |       | 343,018    |       |
| 2008                         |       | 344,478    |       |
| 2009                         |       | 345,981    |       |
| 2010 and thereafter          |       | 4,240,349  |       |
|                         |       |       |       |
| Total                        |       | $          | 5,970,149  |   |

 

Amortization ofleasehold improvements is included in depreciation expense.

 

**6.      DEPOSITS**

 

At December 31,2004, the scheduled maturities of certificates of deposit are as follows:

 
| 2005       |   | $          | 81,761,495  |   | 44.27  | % |
|------------|--------|------------|-------------|--------|--------|---|
| 2006       |   | 66,784,043 |        | 36.16  |   |
| 2007       |   | 22,658,900 |        | 12.27  |   |
| 2008       |   | 4,110,209  |        | 2.23   |   |
| 2009       |   | 9,346,769  |        | 5.06   |   |
| Thereafter |   | 21,610     |        | 0.01   |   |
|       |   |       |        |   |   |
|       |   | $          | 184,683,026 |   | 100.00 | % |
|            |        |            |             |        |        |   |  |

 

54

----

 

**7.      SHORT-TERM BORROWINGS**

 

Short-termborrowings are as follows at December 31:

 
| ** **                                   | ** ** | **2004**  | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|----------------------------------------------|------------|-----------|------------|------------|------------|------------|------------|
|                                         |       |      |       |       |       |       |       |
| Securities sold under  repurchase agreements |       | $         | 40,684,343 |       | $          | 39,363,052 |       | $ | 47,231,946 |   |
| Demand note, U.S.  Treasury                  |       | 1,089,703 |       | 473,926    |       | 1,131,068  |       |
| Federal funds purchased                      |       | 8,760,000 |       | 14,920,000 |       | 2,850,000  |       |
|                                         |       |      |       |       |       |       |       |
| Total                                        |       | $         | 50,534,046 |       | $          | 54,756,978 |       | $ | 51,213,014 |   |

 

The maximum and average amounts of short-term borrowings outstandingand related interest rates for the years ended December 31, 2004, 2003 and 2002are as follows:

 
| ** **                                   | ** ** | **Maximum  outstanding   at any   month end** | ** ** | **Average   outstanding** | ** ** | **Weighted  average   rate during  the year** | ** ** | **Rate at   year end** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------|------------|---------------------------|------------|-----------------------------------------------|------------|------------------------|------------|
| ** **                                   | ** ** | ** **                                    | ** ** | ** **                | ** ** | ** **                                    | ** ** | ** **             | ** ** |
| 2004                                         |       |                                          |       |                      |       |                                          |       |                   |       |
| Federal funds purchased                      |       | $                                             | 17,997,400 |                      | $          | 4,931,714                                     |       | 1.50                   | %          | 2.21 | % |
| Securities sold under  repurchase agreements |       | 44,194,836                                    |       | 41,695,108                |       | 1.11                                          | %          | 1.23                   | %          |
| Demand note, U. S.  Treasury                 |       | 1,089,703                                     |       | 750,719                   |       | 1.14                                          | %          | 1.88                   | %          |
|                                         |       |                                          |       |                      |       |                                          |       |                   |       |
| Total                                        |       | $                                             | 63,281,939 |                      | $          | 47,377,541                                    |       |                   |       |   |   |
|                                         |       |                                          |       |                      |       |                                          |       |                   |       |
| 2003                                         |       |                                          |       |                      |       |                                          |       |                   |       |
| Federal funds purchased                      |       | $                                             | 17,900,000 |                      | $          | 3,716,192                                     |       | 1.26                   | %          | 1.03 | % |
| Securities sold under  repurchase agreements |       | 46,285,260                                    |       | 41,326,103                |       | 1.22                                          | %          | 0.80                   | %          |
| Demand note, U. S.  Treasury                 |       | 1,119,775                                     |       | 716,817                   |       | 0.93                                          | %          | 0.73                   | %          |
|                                         |       |                                          |       |                      |       |                                          |       |                   |       |
| Total                                        |       | $                                             | 65,305,035 |                      | $          | 45,759,112                                    |       |                   |       |   |   |
|                                         |       |                                          |       |                      |       |                                          |       |                   |       |
| 2002                                         |       |                                          |       |                      |       |                                          |       |                   |       |
| Federal funds purchased                      |       | $                                             | 3,000,000  |                      | $          | 108,767                                       |       | 1.68                   | %          | 1.48 | % |
| Securities sold under  repurchase agreements |       | 52,280,479                                    |       | 45,871,723                |       | 2.17                                          | %          | 1.35                   | %          |
| Demand note, U. S.  Treasury                 |       | 1,145,783                                     |       | 654,747                   |       | 1.58                                          | %          | 1.10                   | %          |
|                                         |       |                                          |       |                      |       |                                          |       |                   |       |
| Total                                        |       | $                                             | 56,426,262 |                      | $          | 46,635,237                                    |       |                   |       |   |   |

 

Securities soldunder agreements to repurchase (repurchase agreements) are secured short-termborrowings, and generally mature within 1 to 89 days from the transactiondate.  Repurchase agreements arereflected at the amount of cash received in connection with thetransaction.  The carrying value of theunderlying securities is approximately $40,700,000, $39,500,000 and $47,300,000at December 31, 2004, 2003 and 2002, respectively.  The Bank may be required to provideadditional collateral based on the fair value of the underlyingsecurities.  The demand note, U. S.Treasury is generally repaid within 1 to 90 days.

 

At December 31,2004, the Company had approximately $99,947,000 available to borrow from theFederal Home Loan Bank of Pittsburgh and approximately $25,061,000 that it canborrow at the Discount Window from the Federal Reserve Bank ofPhiladelphia.  There were no borrowingsfrom the Federal Reserve Bank Discount Window at December 31, 2004, 2003 or2002.

 

55

----

 

**8.****             ****LONG-TERMDEBT**

 

Long-term debt consists of advances from the FHLB withinterest rates ranging from 2.60% to 6.22% at December 31, 2004.  These advances are secured by unencumberedU.S. government agency securities, mortgage-backed securities, U.S. Treasurynotes and certain residential mortgages.

 

At December 31,2004, the maturities and weighted-average interest rates of long-term debt areas follows:

 
| **Year ending December 31,** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
|------------------------------|------------|------------|------------|----------|------------|
|                         |       |       |       |     |       |
| 2006                         |       | $          | 2,000,000  |     | 2.60       | % |
| 2007                         |       | 3,000,000  |       | 2.62     |       |
| 2008                         |       | 13,119,188 |       | 4.28     |       |
| 2010                         |       | 48,000,000 |       | 5.74     |       |
| 2013                         |       | 5,000,000  |       | 3.61     |       |
|                         |       |       |       |     |       |
| Total                        |       | $          | 71,119,188 |     | 5.10       | % |

 

**9.****             ****STOCKPLANS**

 

At December 31,2004, the Company has reserved 100,000 shares of its unissued capital stock forissuance under a dividend reinvestment plan. Shares issued under this plan are valued at fair value as of thedividend payment date.  At December 31,2004, 66,838 shares are available for future issuance.

 

The Company hasestablished the 2002 Employee Stock Purchase Plan and has reserved 100,000shares of its unissued capital stock for issuance under the plan.  Under the 2002 Employee Purchase Plan,employees may have automatic payroll deductions to purchase the Company’scapital stock at a discounted price based on the fair market value of theCompany’s capital stock on either the commencement date or terminationdate.  At December 31, 2004, 2,899 shareswere issued under the plan.

 

The Company hasestablished the 2000 Independent Directors Stock Option Plan and has reserved 50,000shares of its unissued capital stock for issuance under the plan.  Under the 2000 Independent Directors StockOption Plan, each outside director is awarded stock options to purchase 500shares of the Company’s common stock on the first business day of January, eachyear, at the fair market value on date of grant.  In 2002, 4,500 stock options with a ten-yearlife were awarded.  No stock options wereawarded in 2004 or 2003 due to the directors’ voluntary election to forego theaward.  At December 31, 2004, there were13,500 unexercised stock options outstanding under this plan.

 

The Company hasestablished the 2000 Stock Incentive Plan and has reserved 50,000 shares of itsunissued capital stock for issuance under the plan.  Under the 2000 Stock Incentive Plan, keyofficers and certain other employees are eligible to be awarded qualified stockoptions to purchase the Company’s common stock at the fair market value on thedate of grant.  In 2002, 4,000 qualifiedstock options with a ten-year life were awarded.  No stock options were awarded in 2004 and2003.  As of December 31, 2004, therewere 5,200 unexercised stock options outstanding under this plan.

 

56

----

 

A summary of thestatus of the Company’s stock option plans as of December 31, 2004, 2003, and2002, and changes during the year ended is presented below:

 
| ** **                                      | ** ** | **Shares** | ** ** | **Weighted-average exercise price** | ** ** |
|-------------------------------------------------|------------|------------|------------|------------------------------------------|------------|
|                                            |       |       |       |                                     |       |
| Outstanding and  exercisable, December 31, 2001 |       | 19,300     |       | $                                        | 34.33      |   |
| Granted                                         |       | 8,500      |       | 37.50                                    |       |
| Exercised                                       |       | (400       | )          | 31.00                                    |       |
| Forfeited                                       |       | (1,500     | )          | 34.21                                    |       |
|                                            |       |       |       |                                     |       |
| Outstanding and  exercisable, December 31, 2002 |       | 25,900     |       | 35.43                                    |       |
| Granted                                         |       | —     |       | —                                   |       |
| Exercised                                       |       | (800       | )          | 35.81                                    |       |
| Forfeited                                       |       | (400       | )          | 37.50                                    |       |
|                                            |       |       |       |                                     |       |
| Outstanding and  exercisable, December 31, 2003 |       | 24,700     |       | 35.39                                    |       |
| Granted                                         |       | —     |       | —                                   |       |
| Exercised                                       |       | (500       | )          | 31.00                                    |       |
| Forfeited                                       |       | (5,500     | )          | 35.34                                    |       |
|                                            |       |       |       |                                     |       |
| Outstanding, December  31, 2004                 |       | 18,700     |       | $                                        | 35.52      |   |

 

The followingtable summarizes all stock options outstanding and exercisable for the plans asof December 31, 2004, segmented by exercise prices:

 
| **Exercise prices** | ** ** | **Number** | ** ** | **Remaining  contractual   life** | ** ** |
|---------------------|------------|------------|------------|-----------------------------------|------------|
|                |       |       |       |                              |       |
| $                   | 31.00      |       | 3,400      |                              | 4 years    |   |
|                | 35.13      |       | 4,300      |                              | 5 years    |   |
|                | 36.50      |       | 4,800      |                              | 6 years    |   |
|                | 37.50      |       | 6,200      |                              | 7 years    |   |
|                |       |       |       |                              |       |
| Total               |       | 18,700     |       |                              |       |

 

The stock optionshave a weighted-average life of 5.7 years.

 

57

----

 

**10.****      ****INCOMETAXES**

 

The followingtemporary differences gave rise to the deferred tax asset (liability) atDecember 31:

 
| ** **                                          | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-----------------------------------------------------|------------|------------|------------|------------|------------|
| Deferred tax assets:                                |       |       |       |       |       |
| Allowance for loan  losses                          |       | $          | 2,035,851  |       | $          | 1,691,918 |   |
| Retirement settlement  reserve                      |       | 153,914    |       | —     |       |
| Deferred compensation                               |       | 90,868     |       | 101,904    |       |
| Unrealized losses on  available-for-sale securities |       | 52,237     |       | 109,680    |       |
| Other                                               |       | 21,404     |       | 37,886     |       |
|                                                |       |       |       |       |       |
| Total                                               |       | 2,354,274  |       | 1,941,388  |       |
|                                                |       |       |       |       |       |
| Deferred tax  liabilities:                          |       |       |       |       |       |
| Leasing                                             |       | (431,900   | )          | (702,933   | )          |
| Depreciation                                        |       | (536,393   | )          | (567,983   | )          |
| Loan fees and costs                                 |       | (291,658   | )          | (188,033   | )          |
| Other                                               |       | (250,602   | )          | (207,269   | )          |
|                                                |       |       |       |       |       |
| Total                                               |       | (1,510,553 | )          | (1,666,218 | )          |
|                                                |       |       |       |       |       |
| Deferred tax asset, net                             |       | $          | 843,721    |       | $          | 275,170 |   |

 

The provision for income taxes for the years endedDecember 31, are as follows:

 
| ** **      | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------|------------|----------|------------|----------|------------|----------|------------|
|            |       |     |       |     |       |     |       |
| Current         |       | $        | 1,661,588  |     | $          | 711,062  |       | $ | 1,294,424 |   |
| Deferred        |       | (625,994 | )          | (564,570 | )          | 231,931  |       |
|            |       |     |       |     |       |     |       |
| Total provision |       | $        | 1,035,594  |     | $          | 146,492  |       | $ | 1,526,355 |   |

 

The reconciliation between the expected statutoryincome tax and the actual provision for income taxes is as follows:

 
| ** **                                | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                      |       |     |       |     |       |     |       |
| Expected provision at  the statutory rate |       | $        | 1,496,023  |     | $          | 608,510  |       | $ | 1,894,659 |   |
| Tax-exempt income                         |       | (297,236 | )          | (312,287 | )          | (379,139 | )          |
| Nondeductible interest  expense           |       | 29,748   |       | 36,934   |       | 52,129   |       |
| Bank owned life  insurance                |       | (108,766 | )          | (99,803  | )          | —   |       |
| Other nondeductible  expenses             |       | 33,977   |       | 31,290   |       | 41,574   |       |
| Low income housing tax  credits           |       | (118,152 | )          | (118,152 | )          | (118,152 | )          |
| Other, net                                |       | —   |       | —   |       | 35,284   |       |
|                                      |       |     |       |     |       |     |       |
| Actual provision for  income taxes        |       | $        | 1,035,594  |     | $          | 146,492  |       | $ | 1,526,355 |   |

 

58

----

 

**11.    RETIREMENT PLAN**

 

The Company has adefined profit sharing 401(k) plan covering substantially all of its employees.  The plan is subject to the provisions of theEmployee Retirement Income Security Act of 1974 (ERISA).  Contributions to the plan were $196,749 in2004, $214,756 in 2003 and $246,201 in 2002.

 

 

**12.    FINANCIAL INSTRUMENTS**

 

The Company is aparty to financial instruments with off-balance-sheet risk in the normal courseof business to meet the financing needs of its customers.  These financial instruments includecommitments to extend credit and standby letters of credit.  Those instruments involve, to varyingdegrees, elements of credit and interest rate risk in excess of the amountrecognized in the balance sheet.  Thecontract or notional amounts of those instruments reflect the extent of theCompany’s involvement in particular classes of financial instruments.

 

The Company’s exposure to credit loss fromnonperformance by the other party to the financial instruments for commitmentsto extend credit and standby letters of credit is represented by thecontractual amount of those instruments. The Company uses the same credit policies in making commitments andconditional obligations as it does for on-balance-sheet instruments.

 

A summary of thenotional amounts of the Bank’s financial instruments with off-balance-sheetrisk at December 31, 2004 follows:

 
| ** **                    | ** ** | **Notional  amount** | ** ** |
|-------------------------------|------------|----------------------|------------|
|                          |       |                 |       |
| Commitments to extend  credit |       | $                    | 69,086,000 |   |
| Standby letters of  credit    |       | 5,811,000            |       |
|                               |            |                      |            |  |

 

Commitments toextend credit are legally binding agreements to lend to customers. Commitmentsgenerally have fixed expiration dates or other termination clauses and mayrequire payment of fees.  Sincecommitments may expire without being drawn upon, the total commitment amountsdo not necessarily represent future liquidity requirements.  The Company evaluates each customer’scredit-worthiness on a case-by-case basis. The amount of collateral obtained, if considered necessary by theCompany on extension of credit, is based on management’s credit assessment ofthe customer.

 

Financial standbyletters of credit are conditional commitments issued by the Company toguarantee performance of a customer to a third party.  Those guarantees are issued primarily tosupport public and private borrowing arrangements, including commercial paper,bond financing, and similar transactions. The Company’s performance under the guarantee is required uponpresentation by the beneficiary of the financial standby letter of credit.  The credit risk involved in issuing lettersof credit is essentially the same as that involved in extending loan facilitiesto customers.  The Company does not haveany recourse provisions or hold any assets that would enable it to recover fromthird parties any of the amounts paid under the guarantee. The Company was notrequired to recognize any liability in connection with the issuance of thesefinancial standby letters of credit.

 

59

----

 

The followingtable summarizes outstanding financial letters of credit as ofDecember 31, 2004 (in thousands):

 
| ** **           | ** ** | **Less than  one year** | ** ** | **One to five  years** | ** ** | **Over five  years** | ** ** | **Total** | ** ** |
|----------------------|------------|-------------------------|------------|------------------------|------------|----------------------|------------|-----------|------------|
|                 |       |                    |       |                   |       |                 |       |      |       |
| Secured by:          |       |                    |       |                   |       |                 |       |      |       |
| Collateral           |       | $                       | 2,582      |                   | $          | 67                   |       | $         | 2,923      |   | $ | 5,572 |   |
| Guarantees           |       | 130                     |       | 24                     |       | —               |       | 154       |       |
| Bank lines of credit |       | 44                      |       | —                 |       | —               |       | 44        |       |
|                 |       |                    |       |                   |       |                 |       |      |       |
|                 |       | 2,756                   |       | 91                     |       | 2,923                |       | 5,770     |       |
|                 |       |                    |       |                   |       |                 |       |      |       |
| Unsecured            |       | 41                      |       | —                 |       | —               |       | 41        |       |
|                 |       |                    |       |                   |       |                 |       |      |       |
| Total                |       | $                       | 2,797      |                   | $          | 91                   |       | $         | 2,923      |   | $ | 5,811 |   |
|                      |            |                         |            |                        |            |                      |            |           |            |  |  |  |  |  |

 

The Company hasnot incurred any losses on its commitments in 2004, 2003 or 2002.

 

The carrying ornotional amount and estimated fair values of the Company’s financialinstruments were as follows at December 31, 2004 and 2003 (in thousands):

 
| ** **                      | ** ** | **2004**                             | ** ** | **2003**                   | ** ** |
|---------------------------------|------------|--------------------------------------|------------|----------------------------|------------|
| ** **                      | ** ** | **Carrying  or   notional   amount** | ** ** | **Estimated   fair value** | ** ** | **Carrying   or   notional   amount** | ** ** | **Estimated fair value** | ** ** |
|                            |       |                                 |       |                       |       |   |   |   |   |
| Financial assets:               |       |                                 |       |                       |       |   |   |   |   |
| Cash and cash  equivalents      |       | $                                    | 10,216     |                       | $          | 10,216 |   | $ | 19,232 |   | $ | 19,232 |   |
| Held-to-maturity  securities    |       | 3,056                                |       | 3,194                      |       | 4,712 |   | 4,908 |   |
| Available-for-sale  securities  |       | 117,181                              |       | 117,181                    |       | 139,695 |   | 139,695 |   |
| Loans and leases                |       | 381,546                              |       | 382,824                    |       | 366,982 |   | 369,914 |   |
| Loans available for  sale       |       | 576                                  |       | 582                        |       | 19,864 |   | 20,501 |   |
| Accrued interest                |       | 1,723                                |       | 1,723                      |       | 1,807 |   | 1,807 |   |
|                            |       |                                 |       |                       |       |   |   |   |   |
| Financial liabilities:          |       |                                 |       |                       |       |   |   |   |   |
| Deposit liabilities             |       | $                                    | 365,615    |                       | $          | 365,920 |   | $ | 401,443 |   | $ | 404,484 |   |
| Short-term borrowings           |       | 50,534                               |       | 50,518                     |       | 54,757 |   | 54,757 |   |
| Long-term debt                  |       | 71,119                               |       | 75,969                     |       | 71,876 |   | 79,146 |   |
| Accrued interest                |       | 985                                  |       | 985                        |       | 1,270 |   | 1,270 |   |
|                            |       |                                 |       |                       |       |   |   |   |   |
| Off-balance sheet  liabilities: |       |                                 |       |                       |       |   |   |   |   |
| Commitments to extend  credit   |       | 69,086                               |       | 69,086                     |       | 84,050 |   | 84,050 |   |
| Standby letters of  credit      |       | 5,811                                |       | 5,811                      |       | 6,599 |   | 6,599 |   |

 

60

----

 

 

**13.    EARNINGS PER SHARE**

 

Basic earnings pershare (“EPS”) is computed using the weighted-average number of shares of commonstock outstanding.  Diluted EPS iscomputed the same as basic EPS but reflects the potential dilution of commonstock equivalents.  Dilution would occurif “in-the-money” stock options were exercised and converted into commonstock.  The Company uses the treasurystock method to determine the dilutive effect of its unexercised stock options. Under this method, the proceeds receivedfrom shares issued in a hypothetical exercise of stock options is assumed to beused to purchase treasury stock.

 

The following data illustrates the data used incomputing earnings per share and the effects on income and the weighted-averagenumber of shares of potentially dilutive common stock for the years endedDecember 31, 2004, 2003 and 2002.

 
| ** **                                 | ** ** | **Income   numerator** | ** ** | **Common shares   denominator** | ** ** | **EPS** | ** ** |
|--------------------------------------------|------------|------------------------|------------|---------------------------------|------------|---------|------------|
|                                       |       |                   |       |                            |       |    |       |
| 2004                                       |       | $                      | 3,364,474  |                            | 1,830,725  |    | $          | 1.84 |   |
| Basic EPS                                  |       |                   |       |                            |       |    |       |
|                                       |       |                   |       |                            |       |    |       |
| Dilutive effect of  potential common stock |       |                   |       |                            |       |    |       |
| Stock options:                             |       |                   |       |                            |       |    |       |
| Exercise of options  outstanding           |       |                   |       | 3,400                           |       |    |       |
| Hypothetical share  repurchase at $33.90   |       |                   |       | (3,109                          | )          |    |       |
|                                       |       |                   |       |                            |       |    |       |
| Diluted EPS                                |       | $                      | 3,364,474  |                            | 1,831,016  |    | $          | 1.84 |   |
|                                       |       |                   |       |                            |       |    |       |
| 2003                                       |       | $                      | 1,643,248  |                            | 1,820,403  |    | $          | 0.90 |   |
| Basic EPS                                  |       |                   |       |                            |       |    |       |
|                                       |       |                   |       |                            |       |    |       |
| Dilutive effect of  potential common stock |       |                   |       |                            |       |    |       |
| Stock options:                             |       |                   |       |                            |       |    |       |
| Exercise of options  outstanding           |       |                   |       | 16,600                          |       |    |       |
| Hypothetical share  repurchase at $37.00   |       |                   |       | (15,413                         | )          |    |       |
|                                       |       |                   |       |                            |       |    |       |
| Diluted EPS                                |       | $                      | 1,643,248  |                            | 1,821,590  |    | $          | 0.90 |   |
|                                       |       |                   |       |                            |       |    |       |
| 2002                                       |       |                   |       |                            |       |    |       |
| Basic EPS                                  |       | $                      | 4,046,173  |                            | 1,817,430  |    | $          | 2.23 |   |
|                                       |       |                   |       |                            |       |    |       |
| Dilutive effect of  potential common stock |       |                   |       |                            |       |    |       |
| Stock options:                             |       |                   |       |                            |       |    |       |
| Exercise of options  outstanding           |       |                   |       | 25,900                          |       |    |       |
| Hypothetical share  repurchase at $38.25   |       |                   |       | (23,991                         | )          |    |       |
|                                       |       |                   |       |                            |       |    |       |
| Diluted EPS                                |       | $                      | 4,046,173  |                            | 1,819,339  |    | $          | 2.22 |   |

 

61

----

 

**14.****      ****REGULATORYMATTERS**

 

The Company (on aconsolidated basis) and the Bank are subject to various regulatory capitalrequirements administered by the federal banking agencies.  Failure to meet minimum capital requirementscan initiate certain mandatory and possible additional discretionary actions byregulators that, if undertaken, could have a direct material effect on theCompany’s and the Bank’s financial statements.  Under capital adequacy guidelines and theregulatory framework for prompt corrective action, the Company and the Bankmust meet specific capital guidelines that involve quantitative measures oftheir assets, liabilities and certain off-balance-sheet items as calculatedunder regulatory accounting practices. The capital amounts and classification are also subject to qualitativejudgments by the regulators about components, risk-weightings and otherfactors.  Prompt corrective actionprovisions are not applicable to bank holding companies.

 

Quantitativemeasures, established by regulation to ensure capital adequacy, require theCompany and the Bank to maintain minimum amounts and ratios (set forth in thetable below) of total and Tier I capital (as defined in the regulations) torisk-weighted assets (as defined), and of Tier I capital (as defined) toaverage assets (as defined).  As ofDecember 31, 2004, the Company and the Bank met all capital adequacyrequirements to which they are subject.

 

62

----

 

To be categorizedas well capitalized the Company must maintain minimum total risk-based, Tier Irisk-based and Tier I leverage ratios as set forth in the table.  The Company’s and the Bank’s actual capitalamounts and ratios are also presented in the table.  No amounts were deducted from capital forinterest-rate risk in either 2004 or 2003.

 
| ** **                                | ** ** | **Actual** | ** ** | **For capital   adequacy purposes** | ** ** | **To be well capitalized   under prompt corrective   action provisions** | ** ** |
|-------------------------------------------|------------|------------|------------|-------------------------------------|------------|--------------------------------------------------------------------------|------------|
| ** **                                | ** ** | **Amount** | ** ** | **Ratio**                           | ** ** | **Amount**                                                               | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
|                                      |       |       |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| As of December 31,  2004:                 |       |       |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| Total capital (to  risk-weighted assets)  |       |       |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| Consolidated                              |       | $          | 51,359,380 |                                | 13.3       | %                                                                        | $          | 330,879,151 |   | 38.0 | % | N/A |   | N/A |   |
| Bank                                      |       | $          | 51,032,749 |                                | 13.2       | %                                                                        | $          | 330,879,966 |   | 38.0 | % | $ | 38,599,957 |   | 310.0 | % |
|                                      |       |       |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| Tier I capital (to  risk-weighted assets) |       |       |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| Consolidated                              |       | $          | 46,429,154 |                                | 12.0       | %                                                                        | $          | 315,439,576 |   | 34.0 | % | N/A |   | N/A |   |
| Bank                                      |       | $          | 46,183,330 |                                | 12.0       | %                                                                        | $          | 315,439,983 |   | 34.0 | % | $ | 23,159,974 |   | 36.0 | % |
|                                      |       |       |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| Tier I capital (to  average assets)       |       |       |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| Consolidated                              |       | $          | 46,429,154 |                                | 8.6        | %                                                                        | $          | 321,665,350 |   | 34.0 | % | N/A |   | N/A |   |
| Bank                                      |       | $          | 46,183,330 |                                | 8.5        | %                                                                        | $          | 321,651,008 |   | 34.0 | % | $ | 27,063,760 |   | 35.0 | % |
|                                      |       |       |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| As of December 31,  2003:                 |       |       |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| Total capital (to  risk-weighted assets)  |       |       |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| Consolidated                              |       | $          | 49,938,524 |                                | 12.9       | %                                                                        | $          | 330,391,532 |   | 38.0 | % | N/A |   | N/A |   |
| Bank                                      |       | $          | 48,977,279 |                                | 12.9       | %                                                                        | $          | 330,390,364 |   | 38.0 | % | $ | 37,987,955 |   | 310.0 | % |
|                                      |       |       |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| Tier I capital (to  risk-weighted assets) |       |       |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| Consolidated                              |       | $          | 44,110,086 |                                | 11.6       | %                                                                        | $          | 315,195,676 |   | 34.0 | % | N/A |   | N/A |   |
| Bank                                      |       | $          | 44,148,993 |                                | 11.6       | %                                                                        | $          | 315,195,182 |   | 34.0 | % | $ | 22,792,773 |   | 36.0 | % |
|                                      |       |       |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| Tier I capital (to  average assets)       |       |       |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| Consolidated                              |       | $          | 44,110,086 |                                | 7.7        | %                                                                        | $          | 322,857,147 |   | 34.0 | % | N/A |   | N/A |   |
| Bank                                      |       | $          | 44,148,993 |                                | 7.7        | %                                                                        | $          | 322,857,147 |   | 34.0 | % | $ | 28,571,434 |   | 35.0 | % |

 

The Bank can pay dividends to the Company equal to the Bank’s retainedearnings which approximated $37,400,000 at December 31, 2004.  However, such dividends are limited due tothe capital requirements discussed above.

 

63

----

 

**15.    RELATED PARTY TRANSACTIONS**

 

During theordinary course of business, loans are made to executive officers, directors,shareholders and associates of such persons. These transactions are executed on substantially the same terms and atthe rates prevailing at the time for comparable transactions with others.  These loans do not involve more than thenormal risk of collectibility or present other unfavorable features.  A summary of loan activity with officers,directors, associates of such persons and shareholders who own more than 5% ofthe Company’s outstanding shares is as follows:

 
| ** **                                                                                                       | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                                                                                                             |       |       |       |       |       |       |       |
| Balance, beginning                                                                                               |       | $          | 10,125,429 |       | $          | 11,692,596 |       | $ | 6,225,458 |   |
| Adjustments for loans  to individuals no longer officers, directors, associates or greater than 5%  shareholders |       | (473,612   | )          | (221,750   | )          | —     |       |
| Loans sold/participated                                                                                          |       | (260,000   | )          | (758,680   | )          | —     |       |
| Additions                                                                                                        |       | 1,183,788  |       | 1,367,263  |       | 10,146,773 |       |
| Collections                                                                                                      |       | (1,332,319 | )          | (1,954,000 | )          | (4,679,635 | )          |
|                                                                                                             |       |       |       |       |       |       |       |
| Balance, ending                                                                                                  |       | $          | 9,243,286  |       | $          | 10,125,429 |       | $ | 11,692,596 |   |

 

Aggregate loans todirectors and associates exceeding 2.5% of shareholders’ equity included in thetable above are as follows:

 
| ** **                                         | ** ** | **2004**   | ** ** | **2003** | ** ** | **2002**   | ** ** |
|----------------------------------------------------|------------|------------|------------|----------|------------|------------|------------|
|                                               |       |       |       |     |       |       |       |
| Number of persons                                  |       | 2          |       | 3        |       | 3          |       |
|                                               |       |       |       |     |       |       |       |
| Balance, beginning                                 |       | $          | 9,386,280  |     | $          | 10,691,179 |       | $ | 5,597,515 |   |
| Loans sold/participated                            |       | —     |       | (753,296 | )          | —     |       |
| Additions                                          |       | 480,580    |       | 444,184  |       | 9,609,764  |       |
| Collections                                        |       | (748,322   | )          | (995,787 | )          | (4,516,100 | )          |
| Prior loan balances no  longer exceeding threshold |       | (1,228,463 | )          | —   |       | —     |       |
|                                               |       |       |       |     |       |       |       |
| Balance, ending                                    |       | $          | 7,890,075  |     | $          | 9,386,280  |       | $ | 10,691,179 |   |

 

64

----

 

**16.    QUARTERLY FINANCIAL INFORMATION (UNAUDITED)**

 

The following is asummary of quarterly results of operations for the years ended December 31, 2004,2003 and 2002:

 
| **2004**                               | ** ** | **First   quarter**                           | ** ** | **Second   quarter** | ** ** | **Third   quarter** | ** ** | **Fourth  quarter** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|-----------------------------------------------|------------|----------------------|------------|---------------------|------------|---------------------|------------|-----------|------------|
| ** **                             | ** ** | **(in thousands, except per share  amounts)** | ** ** |
|                                   |       |                                          |       |                 |       |                |       |                |       |      |       |
| Interest income                        |       | $                                             | 6,963      |                 | $          | 6,813               |       | $                   | 6,738      |      | $          | 6,881 |   | $ | 27,395 |   |
| Interest expense                       |       | (3,030                                        | )          | (2,722               | )          | (2,720              | )          | (2,708              | )          | (11,180   | )          |
|                                   |       |                                          |       |                 |       |                |       |                |       |      |       |
| Net interest income                    |       | 3,933                                         |       | 4,091                |       | 4,018               |       | 4,173               |       | 16,215    |       |
| Provision for loan  losses             |       | (850                                          | )          | (400                 | )          | (450                | )          | (450                | )          | (2,150    | )          |
| Gain on sale of investment  securities |       | 9                                             |       | —               |       | —              |       | —              |       | 9         |       |
| Other income                           |       | 937                                           |       | 1,071                |       | 1,149               |       | 995                 |       | 4,152     |       |
| Other expenses                         |       | (3,275                                        | )          | (3,539               | )          | (3,658              | )          | (3,354              | )          | (13,826   | )          |
|                                   |       |                                          |       |                 |       |                |       |                |       |      |       |
| Income before income  taxes            |       | 754                                           |       | 1,223                |       | 1,059               |       | 1,364               |       | 4,400     |       |
| Provision for income  taxes            |       | (129                                          | )          | (302                 | )          | (245                | )          | (360                | )          | (1,036    | )          |
|                                   |       |                                          |       |                 |       |                |       |                |       |      |       |
| Net income                             |       | $                                             | 625        |                 | $          | 921                 |       | $                   | 814        |      | $          | 1,004 |   | $ | 3,364 |   |
|                                   |       |                                          |       |                 |       |                |       |                |       |      |       |
| Net income per share                   |       | $                                             | 0.34       |                 | $          | 0.50                |       | $                   | 0.45       |      | $          | 0.55 |   | $ | 1.84 |   |

 
| **2003**                                         | ** ** | **First   quarter**                           | ** ** | **Second   quarter** | ** ** | **Third   quarter** | ** ** | **Fourth  quarter** | ** ** | **Total** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------------|------------|----------------------|------------|---------------------|------------|---------------------|------------|-----------|------------|
| ** **                                       | ** ** | **(in thousands, except per share  amounts)** | ** ** |
|                                             |       |                                          |       |                 |       |                |       |                |       |      |       |
| Interest income                                  |       | $                                             | 7,638      |                 | $          | 7,147               |       | $                   | 6,783      |      | $          | 6,894 |   | $ | 28,462 |   |
| Interest expense                                 |       | (3,806                                        | )          | (3,718               | )          | (3,443              | )          | (3,270              | )          | (14,237   | )          |
|                                             |       |                                          |       |                 |       |                |       |                |       |      |       |
| Net interest income                              |       | 3,832                                         |       | 3,429                |       | 3,340               |       | 3,624               |       | 14,225    |       |
| Provision for loan  losses                       |       | (300                                          | )          | (460                 | )          | (300                | )          | (2,655              | )          | (3,715    | )          |
| Gain on sale of  investment securities           |       | 82                                            |       | 132                  |       | —              |       | 115                 |       | 329       |       |
| Other income                                     |       | 875                                           |       | 1,129                |       | 1,021               |       | 829                 |       | 3,854     |       |
| Other expenses                                   |       | (3,295                                        | )          | (3,014               | )          | (3,193              | )          | (3,401              | )          | (12,903   | )          |
|                                             |       |                                          |       |                 |       |                |       |                |       |      |       |
| Income (loss) before  provision for income taxes |       | 1,194                                         |       | 1,216                |       | 868                 |       | (1,488              | )          | 1,790     |       |
| (Provision) benefit for  income taxes            |       | (307                                          | )          | (293                 | )          | (183                | )          | 636                 |       | (147      | )          |
|                                             |       |                                          |       |                 |       |                |       |                |       |      |       |
| Net income (loss)                                |       | $                                             | 887        |                 | $          | 923                 |       | $                   | 685        |      | $          | (852 | ) | $ | 1,643 |   |
|                                             |       |                                          |       |                 |       |                |       |                |       |      |       |
| Net income (loss) per  share                     |       | $                                             | 0.49       |                 | $          | 0.49                |       | $                   | 0.38       |      | $          | (0.46 | ) | $ | 0.90 |   |

 

65

----

 
| ** **                                    | ** ** | **First   quarter**                           | ** ** | **Second   quarter** | ** ** | **Third   quarter** | ** ** | **Fourth  quarter** | ** ** | **Total** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------|------------|----------------------|------------|---------------------|------------|---------------------|------------|-----------|------------|
| ** **                                    | ** ** | **(in thousands, except per share  amounts)** | ** ** |
| ** **                                    | ** ** | ** **                                    | ** ** |
| Interest income                               |       | $                                             | 8,730      |                 | $          | 8,759               |       | $                   | 8,556      |      | $          | 8,522 |   | $ | 34,567 |   |
| Interest expense                              |       | (4,648                                        | )          | (4,566               | )          | (4,481              | )          | (4,187              | )          | (17,882   | )          |
|                                          |       |                                          |       |                 |       |                |       |                |       |      |       |
| Net interest income                           |       | 4,082                                         |       | 4,193                |       | 4,075               |       | 4,335               |       | 16,685    |       |
| Provision for loan  losses                    |       | (460                                          | )          | (496                 | )          | (220                | )          | (488                | )          | (1,664    | )          |
| Gain (loss) on sale of  investment securities |       | 20                                            |       | 40                   |       | (1                  | )          | —              |       | 59        |       |
| Other income                                  |       | 952                                           |       | 939                  |       | 738                 |       | 614                 |       | 3,243     |       |
| Other expenses                                |       | (3,144                                        | )          | (3,158               | )          | (3,302              | )          | (3,147              | )          | (12,751   | )          |
|                                          |       |                                          |       |                 |       |                |       |                |       |      |       |
| Income before provision  for income taxes     |       | 1,450                                         |       | 1,518                |       | 1,290               |       | 1,314               |       | 5,572     |       |
| Provision for income  taxes                   |       | (372                                          | )          | (409                 | )          | (357                | )          | (388                | )          | (1,526    | )          |
|                                          |       |                                          |       |                 |       |                |       |                |       |      |       |
| Net income                                    |       | $                                             | 1,078      |                 | $          | 1,109               |       | $                   | 933        |      | $          | 926 |   | $ | 4,046 |   |
|                                          |       |                                          |       |                 |       |                |       |                |       |      |       |
| Net income per share                          |       | $                                             | 0.59       |                 | $          | 0.61                |       | $                   | 0.51       |      | $          | 0.52 |   | $ | 2.23 |   |

 

**17.****      ****CONTINGENCIES**

 

The nature of the Company’s business generates somelitigation involving matters arising in the ordinary course of business.  However, in the opinion of management of theCompany after consulting with the Company’s legal counsel, no legal proceedingsare pending, which, if determined adversely to the Company or the Bank, wouldhave a material effect on the Company’s shareholders’ equity or results of operations.  No legal proceedings are pending other thanordinary routine litigation incident to the business of the Company and theBank.  In addition, to management’sknowledge, no government authorities have initiated or contemplated anymaterial legal actions against the Company or the Bank.

 

**18.****      ****RECENTACCOUNTING PRONOUNCEMENTS**

 

In May 2003, the FASB Issued SFAS No. 150, *Accounting for Certain Financial Instruments withCharacteristics of Both Liabilities and Equity*.  This statement establishes how an issuerclassifies financial instruments with characteristics of both liabilities andequity.  It requires that an issuerclassify these financial instruments as a liability (or, in certaincircumstances, an asset).  Previously,these financial instruments would have been classified entirely as equity, orbetween the liabilities and equity section of the balance sheet.  This statement also addresses questions aboutthe classification of certain financial instruments that embody obligations toissue equity shares.  The provisions ofthis statement are effective for interim periods beginning after June 15,2003.  The adoption of this statement didnot have an effect on the Company’s earnings, financial condition or equity.

 

In January 2003,the FASB issued Interpretation No. 46, *Consolidationof Variable Interest Entities*, in an effort to expand upon andstrengthen existing accounting guidance that addresses when a company shouldinclude in its financial statements the assets, liabilities and activities ofanother entity.  The objective of thisinterpretation is not to restrict the use of variable interest entities but toimprove financial reporting by companies involved with variable interestentities.  Prior to this interpretation,one company generally has included another entity in its consolidated financialstatements only if it controlled the entity through voting interests.  This interpretation changes that by requiringa variable interest entity to be consolidated by a company if that company issubject to a majority of the

 

66

----

 

risk of loss fromthe variable interest entity’s activities or entitled to receive a majority ofthe entity’s residual returns or both. The consolidation requirements of this interpretation apply immediatelyto variable interest entities created after January 31, 2003.  The consolidation requirements apply to olderentities in the first fiscal year or interim period beginning after June 15,2003.  Certain of the disclosurerequirements apply in all financial statements issued after January 31, 2003,regardless of when the variable interest entity was established.  The adoption of the interpretation did nothave an effect on the Company’s earnings, financial condition or equity.

 

In March 2004, the FASBissued Emerging Issues Task Force (EITF) Issue No. 03-1, *The Meaning of Other-Than-Temporary Impairment andIts Application to Certain Investments*.  This statement provides guidance forevaluating whether an investment is other-than-temporarily impaired and waseffective for the other-than-temporary impairment evaluations made in thereporting periods beginning after June 15, 2004.  The FASB staff has issued a proposedBoard-directed FASB Staff Position, FSP EITF Issue 03-1-a, Implementation Guidancefor the Application of Paragraph 16 of EITF Issue No. 03-1.  The proposed FSP would provide implementationguidance with respect to debt securities that are impaired solely due tointerest rates and/or sector spreads and analyzed for other-than-temporaryimpairment under paragraph 16 of Issue 03-1. In September 2004, based on comment letters received by constituents,the Board decided to further consider whether application guidance is necessaryfor all securities analyzed for impairment under paragraph 10-20 of Issue 03-1.The delay did not include the disclosure provisions which will remain in effectuntil the full reconsideration of Issue 03-01 guidance is completed.  The Company will delay the effectiveapplication until the implementation guidance is finalized.

 

In December 2004, theFASB issued SFAS 123(R) which replaces SFAS 123, *Accounting for Stock-Based Compensation*, and supersedes APBOpinion 25, *Accounting for Stock Issued toEmployees*.  SFAS 123(R)requires that the cost of share-based payment transactions (including thosewith employees and non-employees) be recognized in the financialstatements.  SFAS 123(R) applies to allshare-based payment transactions in which an entity acquires goods or servicesby issuing (or offering to issue) its shares, share options, or other equityinstruments (except for those held by an ESOP) or by incurring liabilities (1)in amounts based (even in part) on the price of the entity’s shares or otherequity instruments, or (2) that require (or may require) settlement by theissuance of an entity’s shares or other equity instruments.  Public entities such as the Company are notrequired to apply SFAS 123(R) until the beginning of the first interim reportingperiod or fiscal year beginning after June 15, 2005.  The Company does not plan early implementationof the provisions of SFAS 123(R).

 

67

----

 

 

**19.    PARENT COMPANY ONLY**

 

The following iscondensed financial information for Fidelity D & D Bancorp, Inc. on aparent company only basis (in thousands):

 

**CondensedBalance Sheets**

 
| ** **                                  | ** ** | **December 31,** | ** ** |
|---------------------------------------------|------------|------------------|------------|
| ** **                                  | ** ** | **2004**         | ** ** | **2003** | ** ** |
|                                        |       |             |       |   |   |
| Assets:                                     |       |             |       |   |   |
| Cash                                        |       | $                | 5          |   | $ | 2 |   |
| Investment in  subsidiary                   |       | 46,002           |       | 43,971 |   |
| Securities  available-for-sale              |       | 452              |       | — |   |
| Other                                       |       | —           |       | 12 |   |
|                                        |       |             |       |   |   |
| Total                                       |       | $                | 46,459     |   | $ | 43,985 |   |
|                                        |       |             |       |   |   |
| Liabilities and  shareholders’ equity: |       |             |       |   |   |
| Liabilities                                 |       | $                | 92         |   | $ | 53 |   |
| Shareholders’ equity                   |       | 46,367           |       | 43,932 |   |
|                                        |       |             |       |   |   |
| Total                                       |       | $                | 46,459     |   | $ | 43,985 |   |

 

**Condensed Income Statements**

 
| ** **                                      | ** ** | **Years ended December 31,** | ** ** |
|-------------------------------------------------|------------|------------------------------|------------|
| ** **                                      | ** ** | **2004**                     | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                            |       |                         |       |   |   |   |   |
| Income:                                         |       |                         |       |   |   |   |   |
| Equity in undistributed  earnings of subsidiary |       | $                            | 2,311      |   | $ | 182 |   | $ | 2,598 |   |
| Dividends from  subsidiary                      |       | 1,156                        |       | 1,590 |   | 1,542 |   |
| Other income                                    |       | 13                           |       | — |   | — |   |
|                                            |       |                         |       |   |   |   |   |
| Total income                                    |       | 3,480                        |       | 1,772 |   | 4,140 |   |
|                                            |       |                         |       |   |   |   |   |
| Operating expenses                              |       | 168                          |       | 195 |   | 142 |   |
|                                            |       |                         |       |   |   |   |   |
| Income before income  taxes                     |       | 3,312                        |       | 1,577 |   | 3,998 |   |
|                                            |       |                         |       |   |   |   |   |
| Credit for income taxes                         |       | 52                           |       | 66 |   | 48 |   |
|                                            |       |                         |       |   |   |   |   |
| Net income                                      |       | $                            | 3,364      |   | $ | 1,643 |   | $ | 4,046 |   |

 

68

----

 

**CondensedStatements of Cash Flows**

 
| ** **                                                           | ** ** | **Years ended  December 31,** | ** ** |
|----------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                           | ** ** | **2004**                      | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                                 |       |                          |       |   |   |   |   |
| Cash flows from  operating activities:                               |       |                          |       |   |   |   |   |
| Net income                                                           |       | $                             | 3,364      |   | $ | 1,643 |   | $ | 4,046 |   |
| Adjustments to  reconcile net income to net cash used in operations: |       |                          |       |   |   |   |   |
| Equity in earnings of  subsidiary                                    |       | (3,467                        | )          | (1,772 | ) | (4,140 | ) |
| Deferred income taxes                                                |       | 2                             |       | (66 | ) | 2 |   |
| Changes in other assets  and liabilities, net                        |       | (11                           | )          | 54 |   | 24 |   |
|                                                                 |       |                          |       |   |   |   |   |
| Net cash used in  operating activities                               |       | (112                          | )          | (141 | ) | (68 | ) |
|                                                                 |       |                          |       |   |   |   |   |
| Cash flows from  investing activities:                               |       |                          |       |   |   |   |   |
| Dividends received from  subsidiary                                  |       | 1,156                         |       | 1,590 |   | 1,542 |   |
|                                                                 |       |                          |       |   |   |   |   |
| Cash flows from  financing activities:                               |       |                          |       |   |   |   |   |
| Dividends paid, net of  dividend reinvestment                        |       | (1,110                        | )          | (1,081 | ) | (1,047 | ) |
| Exercise of stock  options                                           |       | 16                            |       | 30 |   | 15 |   |
| Withholdings to  purchase capital stock                              |       | 53                            |       | 60 |   | 39 |   |
| Purchase of treasury  stock                                          |       | —                        |       | (458 | ) | (480 | ) |
|                                                                 |       |                          |       |   |   |   |   |
| Net cash used in  financing activities                               |       | (1,041                        | )          | (1,449 | ) | (1,473 | ) |
|                                                                 |       |                          |       |   |   |   |   |
| Net increase in cash                                                 |       | 3                             |       | — |   | 1 |   |
|                                                                 |       |                          |       |   |   |   |   |
| Cash, beginning                                                      |       | 2                             |       | 2 |   | 1 |   |
|                                                                 |       |                          |       |   |   |   |   |
| Cash, ending                                                         |       | $                             | 5          |   | $ | 2 |   | $ | 2 |   |

 

69

----

 

I***tem9:******  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTSON ACCOUNTING AND INANCIAL DISCLOSURE***

 

None.

 

***Item 9A******:*****               *CONTROLS AND PROCEDURES***

 

The Company maintains controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. Based upon their evaluation of those controls and procedures performed within 90 days of the filing date of this report, the Chief Executive and Chief Financial Officers of the Company concluded that the Company’s disclosure controls and procedures were adequate.

 

### **PARTIII**

 

***Item 10:******DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY***

 

The information requiredunder Items 401 and 406 of Regulation S-K is incorporated by reference herein,to the information presented in the Company’s definitive Proxy Statement forits 2005 Annual Meeting of Shareholders to be filed with the SEC.

 

***Section16(a) Beneficial Ownership Reporting Compliance***

 

The information requiredunder this section is incorporated by reference herein, to the informationpresented in the Company’s definitive Proxy Statement for its 2005 AnnualMeeting of Shareholders to be filed with the SEC.

 

***Item11:******EXECUTIVE COMPENSATION***

 

Theinformation required by this Item is incorporated by reference herein, to theinformation presented in the Company’s 2005 definitive Proxy Statement.

 

***Item 12:******SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERSAND MANAGEMENT AND RELATED STOCKHOLDER MATTERS***

 

The information requiredby this Item is incorporated by reference herein, to the information presentedin the Company’s 2005 definitive Proxy Statement.

 

##### ***Item 13****: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS*

 

The information requiredby this Item, relating to transactions with management and others, certainbusiness relationships and indebtedness of management, is set forth above inItem 8 “Financial Statements and Supplementary Data” and is incorporated byreference herein to the information presented in the Company’s 2005 definitiveProxy Statement.

 

***Item 14******:******PRINCIPAL ACCOUNTANT FEES AND SERVICES***

 

The information required by this Item is incorporatedby reference herein, to the information presented in the Company’s 2005definitive Proxy Statement.

 

70

----

 

***PARTIV***

 

***Item15:******EXHIBITS, FINANCIALSTATEMENT SCHEDULES AND REPORTS ON FORM 8-K***

 

***(a)(1) Financial Statements*** - The following financialstatements are included by reference in Part II, Item 8 hereof:

 

Report of Independent Registered Public AccountingFirm.

Consolidated Balance Sheets.

Consolidated Statements of Income.

Consolidated Statements of Changes in Shareholders’Equity.

Consolidated Statements of Cash Flows.

Notes to Consolidated Financial Statements.

 

***(2)Financial Statement Schedules***

 

Financial Statement Schedules are omitted because therequired information is either not applicable, the data is not significant orthe required information is shown in the respective financial statements or inthe notes thereto or elsewhere herein.

 

***(3)Exhibits***

 

The following exhibits are filed herewith orincorporated by reference as a part of this Form 10-K:

 

***3(i) Amended and RestatedArticles of Incorporation of Registrant.*** Incorporated byreference to Exhibit 3(i) to Registrant’s Registration Statement No. 333-90273on Form S-4, filed with the SEC on November 3, 1999 and as amended on April 6,2000.

 

***3(ii) Bylaws of Registrant***.Incorporated by reference to Exhibit 3(ii) to Registrant’s Registration StatementNo. 333-90273 on Form S-4, filed with the SEC on November 3, 1999 and asamended on April 6, 2000.

 

***10.1 1998 Independent DirectorsStock Option Plan of The Fidelity Deposit and Discount Bank, as assumed byRegistrant.*** Incorporated by reference to Exhibit 10.1 toRegistrant’s Registration Statement No. 333-90273 on Form S-4, filed with theSEC on November 3, 1999 and as amended on April 6, 2000.

 

***10.2 1998 Stock Incentive Plan ofThe Fidelity Deposit and Discount Bank, as assumed by Registrant.***Incorporated by reference to Exhibit 10.2 of Registrant’s RegistrationStatement No. 333-90273 on Form S-4, filed with the SEC on November 3, 1999 andas amended on April 6, 2000.

 

***10.3 Form of DeferredCompensation Plan of The Fidelity Deposit and Discount Bank.***Incorporated by reference to Exhibit 10.3 to Registrant’s RegistrationStatement No.333-45668 on Form S-1, filed with the SEC on September 12, 2000and as amended on October 11, 2000.

 

***10.4 Registrant’s 2000 DividendReinvestment Plan.***Incorporated by reference to Exhibit 4to Registrant’s Registration Statement No. 333-45668 on Form S-1, filed withthe SEC on September 12, 2000 and as amended by Pre-Effective Amendment No. 1on October 11, 2000 and by Post-Effective Amendment No. 1 on May 30, 2001.

 

***10.5 Registrant’s 2000Independent Directors Stock Option Plan.***Incorporated byreference to Exhibit 4.3 to Registrant’s Registration Statement No. 333-64356on Form S-8 filed with the SEC on July 2, 2001.

 

***10.6 Registrant’s 2000 StockIncentive Plan.***Incorporated by reference to Exhibit 4.4to Registrant’s Registration Statement No. 333-64356 on Form S-8 filed with theSEC on July 2, 2001.

 

71

----

 

***10.7 Registrant’s 2002 EmployeeStock Purchase Plan.***Incorporated by reference to Exhibit4.5 to Registrant’s Registration Statement No. 333-113339 on Form S-8 filedwith the SEC on March 5, 2004.

 

*** 10.8 Employment Agreement between Fidelity D& D Bancorp, Inc., The Fidelity Deposit and Discount Bank and      Steven C. Ackmann, dated June 21,2004.  ***Incorporatedby reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filedwith the SEC on June 24, 2004.

 

***11 Statement regardingcomputation of earnings per share.***Included herein inNote 13 “Earnings per Share”, contained within the notes to consolidatedfinancial statements, and incorporated herein by reference.

 

***12 Statement regardingcomputation of ratios.***Included herein in Item 6,“Selected Financial Data”.

 

***13 Annual Report toShareholders. ***Incorporatedby reference to the 2004 Annual Report to Shareholders filed with the SEC onForm ARS.

 

***14 Code of Ethics.***Incorporated by reference to the 2003 Annual Report to Shareholders on Form10-K filed with the SEC on March 29, 2004.

 

***21 Subsidiaries of the Registrant.***

 

***23        Consent of Independent Registered Public Accounting Firm.***

 

***31.1 Rule 13a-14(a) Certificationof Principal Executive Officer, filed herewith.***

*** ***

***31.2 Rule 13a-14(a) Certificationof Principal Financial Officer, filed herewith.***

*** ***

***32.1 Certification of PrincipalExecutive Officer pursuant to 18 U.S.C. Section 1350,***

*** ***

***as adopted pursuant to Section906 of the Sarbanes-Oxley Act of 2002, filed herewith.***

*** ***

***32.2 Certification of PrincipalAccounting Officer pursuant to 18 U.S.C. Section 1350,***

*** ***

***as adopted pursuant to Section906 of the Sarbanes-Oxley Act of 2002, filed herewith.***

 

***(b)       The exhibits required to be filed by thisItem are listed under Item 15(a) 3, above.***

 

***(c)       Not applicable.***

 

72

----

 

**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 

**FIDELITY D & D BANCORP, INC.**

(Registrant)

 

 
| Date: March 29, 2005 | By:    | /s/    | Steven C. Ackmann                      |   |   |
|----------------------|--------|--------|----------------------------------------|--------|--------|
|                 |   |   | Steven S. Ackmann,                     |   |   |
|                 |   |   | President and  Chief Executive Officer |   |   |
|                 |   |   |
|                 |   |   |
|                 |   |   |
| Date: March 29, 2005 | By:    | /s/    | Salvatore R. DeFrancesco, Jr.          |   |   |
|                 |   |   | Salvatore R. DeFrancesco, Jr.,         |   |   |
|                 |   |   | Treasurer and Chief Financial Officer  |   |   |

 

73

----

 

Pursuant to the requirements of theSecurities and Exchange Act of 1934, this report has been signed below by thefollowing person on behalf of the registrant and in the capacities and on thedates indicated.

 
|   | **DATE**                                                                    |
|--------|-----------------------------------------------------------------------------|
|   |                                                                        |
| By:    | /s/ Steven C. Ackmann                                                       |   | March 29, 2005 |
|   | Steven C. Ackmann,  President and  Chief Executive Officer                  |   |   |
|   |                                                                        |   |   |
| By:    | /s/ Salvatore R. DeFrancesco, Jr.                                           |   | March 29, 2005 |
|   | Salvatore R.  DeFrancesco, Jr., Treasurer  and Chief Financial Officer      |   |   |
|   |                                                                        |   |   |
| By:    | /s/ Samuel C. Cali                                                          |   | March 29, 2005 |
|   | Samuel C. Cali,  Chairman Emeritus  and Director                            |   |   |
|   |                                                                        |   |   |
| By:    | /s/ Patrick J. Dempsey                                                      |   | March 29, 2005 |
|   | Patrick J. Dempsey,  Chairman  of the Board of Directors and Director       |   |   |
|   |                                                                        |   |   |
| By:    | /s/ Paul A. Barrett                                                         |   | March 29, 2005 |
|   | Paul A. Barrett,  Secretary and Director                                    |   |   |
|   |                                                                        |   |   |
| By:    | /s/ John T. Cognetti                                                        |   | March 29, 2005 |
|   | John T. Cognetti,  Assistant Secretary  and Director                        |   |   |
|   |                                                                        |   |   |
| By:    | /s/ Michael J. McDonald                                                     |   | March 29, 2005 |
|   | Michael J. McDonald,  Vice Chairman  of the Board of Directors and Director |   |   |
|   |                                                                        |   |   |
| By:    | /s/ David L. Tressler                                                       |   | March 29, 2005 |
|   | David L. Tressler,  Director                                                |   |   |
|   |                                                                        |   |   |
| By:    | /s/ Mary E. McDonald                                                        |   | March 29, 2005 |
|   | Mary E. McDonald,  Director                                                 |   |   |
|   |                                                                        |   |   |
| By:    | /s/ Brian J. Cali                                                           |   | March 29, 2005 |
|   | Brian J. Cali, Director                                                     |   |

 

74

----

 

**EXHIBITINDEX**

 
|                                                                                                                                                                                                                                                                                 |   | **Page** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|
| ***3(i) Amended and Restated  Articles of Incorporation of Registrant.***                                                                                                                                                                                                            |   | *****    |
| Incorporated by reference to Exhibit 3(i) to  Registrant’s Registration Statement No. 333-90273 on Form S-4, filed with the  SEC on November 3, 1999 and as amended on April 6, 2000.                                                                                           |   |     |
|                                                                                                                                                                                                                                                                                 |   |     |
| ***3(ii) Bylaws of Registrant***.                                                                                                                                                                                                                                                    |   | *****    |
| Incorporated by reference to Exhibit 3 (ii) to  Registrant’s Registration Statement No. 333-90273 on Form S-4, filed with the  SEC on November 3, 1999 and as amended on April 6, 2000.                                                                                         |   |     |
|                                                                                                                                                                                                                                                                                 |   |     |
| ***10.1 1998 Independent Directors  Stock Option Plan of The Fidelity***                                                                                                                                                                                                             |   | *******  |
| ***Deposit and Discount Bank, as  assumed by Registrant.*** Incorporated by reference to  Exhibit 10.1 to Registrant’s Registration Statement No. 333-90273 on Form  S-4, filed with the SEC on November 3, 1999 and as amended on April 6, 2000.                               |   |     |
|                                                                                                                                                                                                                                                                                 |   |     |
| ***10.2 1998 Stock Incentive Plan  of The Fidelity Deposit and Discount***                                                                                                                                                                                                           |   | *******  |
| ***Bank, as assumed by Registrant.***Incorporated by reference to Exhibit 10.2 of Registrant’s  Registration Statement No. 333-90273 on Form S-4, filed with the SEC on Nov.  3, 1999 and as amended on April 6, 2000.                                                          |   |     |
|                                                                                                                                                                                                                                                                                 |   |     |
| ***10.3 Form of Deferred  Compensation Plan of The Fidelity Deposit and***                                                                                                                                                                                                           |   | *******  |
| ***Discount Bank.***  Incorporated by reference to Exhibit 10.3 to Registrant’s Registration  Statement No. 333-45668 on Form S-1, filed with the SEC on September 12, 2000  and as amended on October 11, 2000.                                                                |   |     |
|                                                                                                                                                                                                                                                                                 |   |     |
| ***10.4 Registrant’s 2000 Dividend  Reinvestment Plan.***                                                                                                                                                                                                                       |   | *******  |
| Incorporated by reference to Exhibit 4 to  Registrant’s Registration Statement No. 333-45668 on Form S-1, filed with the  SEC on September 12, 2000 and as amended by Pre-Effective Amendment No. 1 on  October 11, 2000 and by Post-Effective Amendment No. 1 on May 30, 2001. |   |     |
|                                                                                                                                                                                                                                                                                 |   |     |
| ***10.5 Registrant’s 2000  Independent Directors Stock Option Plan.***                                                                                                                                                                                                          |   | *******  |
| Incorporated by reference to Exhibit 4.3 to  Registrant’s Registration Statement No. 333-64356 on Form S-8 filed with the  SEC on July 2, 2001.                                                                                                                                 |   |     |
|                                                                                                                                                                                                                                                                                 |   |     |
| ***10.6 Registrant’s 2000 Stock  Incentive Plan.***                                                                                                                                                                                                                             |   | *******  |
| Incorporated by reference to Exhibit 4.4 to  Registrant’s Registration Statement No. 333-64356 on Form S-8 filed with the  SEC on July 2, 2001.                                                                                                                                 |   |     |
|                                                                                                                                                                                                                                                                                 |   |     |
| ***10.7 Registrant’s 2002 Employee  Stock Purchase Plan.***                                                                                                                                                                                                                     |   | *******  |
| Incorporated by reference to Exhibit 4.5 to  Registrant’s Registration Statement No. 333-113339 on Form S-8 filed with the  SEC on March 5, 2004.                                                                                                                               |   |     |
|                                                                                                                                                                                                                                                                                 |   |     |
| ***10.8 Employment Agreement  between Fidelity D & D Bancorp, Inc.,***                                                                                                                                                                                                           |   | *******  |
| ***The Fidelity Deposit and  Discount Bank and Steven C. Ackmann, dated***                                                                                                                                                                                                           |   |     |
| ***June 21, 2004. ***Incorporated by  reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed  with the SEC on June 24, 2004.                                                                                                                           |   |     |
|                                                                                                                                                                                                                                                                                 |   |     |
| ***11 Statement regarding  computation of earnings per share.***                                                                                                                                                                                                                     |   | 61       |
| Included herein Note 13 “Earnings per Share”,  contained within the Notes  to Consolidated Financial Statements, and incorporated herein by reference.                                                                                                                     |   |     |

 

75

----

 
| ***12 Statement regarding  computation of ratios.***                                                                                                                 |   | 6      |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
| Included herein in Item 6, “Selected Financial  Data”.                                                                                                     |   |   |
|                                                                                                                                                                 |   |   |
| ***13 Annual Report to  Shareholders.***Incorporated by reference  to the 2004 Annual Report to Shareholders  filed with the SEC on Form ARS.                   |   | *      |
|                                                                                                                                                                 |   |   |
| ***14 Code of Ethics.***Incorporated  by reference to the 2003 Annual Report to Shareholders on Form 10-K filed  with the SEC on March 29, 2004***.***               |   | *      |
|                                                                                                                                                                 |   |   |
| ***21 Subsidiaries of the  Registrant.***                                                                                                                            |   | 77     |
|                                                                                                                                                                 |   |   |
| ***23 Consent of Independent  Registered Public Accounting Firm.***                                                                                                  |   | 78     |
|                                                                                                                                                                 |   |   |
| ***31.1 Rule 13a-14(a)  Certification of Principal Executive Officer.***                                                                                             |   | *79*   |
|                                                                                                                                                                 |   |   |
| ***31.2 Rule 13a-14(a)  Certification of Principal Financial Officer.***                                                                                             |   | 80     |
|                                                                                                                                                                 |   |   |
| ***32.1 Certification of Principal  Executive Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.*** |   | 81     |
|                                                                                                                                                                 |   |   |
| ***32.2 Certification of Principal  Financial Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.*** |   | 82     |

 

76

----